UNIT 3.

Basic Financial Concepts

If you owe your bank a hundred pounds, you have a problem.
If you owe it a million pounds, it has a problem!
John Maynard Keynes

Individuals, as well as organizations, need some techniques in order

to manage and improve their financial affairs. When we talk about finance,
what we immediately have in mind is the difference between income and
expenditure; if the difference is not satisfactory, we regularly think at some
investments or extra working hours, which is also a kind of investment, but
a human capital consuming one.
If income > expenditure → we can invest the excess income at the
Stock Exchange OR buy different kinds of assets by means of a mutual fund
etc.
If income < expenditure → we can raise capital by borrowing it from
friends (in case you have good ones), from commercial banks, by selling
equity claims OR working extra hours!
In the first case we are the LENDER, while in the second, we are the
BORROWER. In both, we need a FINANCIAL INTERMEDIARY.

LENDER BORROWER

FINANCIAL
INTERMEDIARY
(such as bank)

The lender receives interest, the borrower pays a higher interest than
the lender receives, and the financial intermediary gets the difference. That
is the way, commercial banks, for example, mainly survive, by the
difference = spread = margin between the interest received on deposits and
the interest given for credits. Banks are thus intermediating money flows
from different unknown lenders and borrowers.
But finance is not only used by individuals, also by governments and
businesses (corporate finance); we may also add non-profit organizations,
schools etc. Using the appropriate financial instruments, all of them may
achieve their goal.
An example of corporate finance is: a company may decide to sell
stocks to institutional investors, who in turn sell them to the public.

INSTITUTIONAL
INVESTORS

Investment Pension funds Life insurance

banks companies
Mutual funds
Credit unions
Banks
Banks
Building
societies

If we buy one stock of X company AND → the company is selling

100 stocks → we become 1/100 owner of that company AND we own 1/100
of anything on the asset side of the balance sheet.
In return for the stock, the company receives cash, used to expand
the business. The process is called equity financing.

Some basic financial concepts:

1. Here you are asked to establish whether the following
statements are true or false. Motivate then your choice:
 Adjusted Present Value (APV) is the Net present value (NPV) of
a project if financed only by debt plus the present value (PV) of
any financing benefits.
 Financial instruments exist only within the context of financial
markets and varies according to the risk taken.

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 Cash instruments include only credits and deposits.
 Derivative instruments can be divided into exchange traded
derivatives and over-the-counter derivatives.
 Default means failure to make required debt payments on a timely
basis
 Ratio means one value divided by another.
 Liquidity ratio provides information about a company’s ability to
meet its short-term financial obligations; this information is needed
especially by those who are interested in getting extended credit
from the firm.
 Asset turnover ratio indicates how efficiently the firm is using its
resources
 Financial leverage ratio indicates the long term solvency of the
firm; it measures the extent to which the firm is using long-term
debt.
 Lender of last resort is a term usually used when the Central
Bank extends credit to those commercial banks on the verge of
illiquidity. The Central Bank acts, in this case, as lender of last
resort to commercial banks.
 Offshore banks are banks located in areas with low taxation and
regulation. Many offshore banks are public banks.
 A building society is a financial institution, owned by its
members, that offers different services, especially mortgage
lending.
 Maturity is the date on which an asset becomes due for payment.

2. Chose the correct definition for each of the items in italics:

 money supply
 The total supply of money put in circulation in a given
country’s economy by its Central Bank
 The total supply of money put in circulation in a given
country’s economy at a given time

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 velocity
 The number of times a given currency changes hands in a
specific time period, usually measured by GDP divided by
money supply
 The number of times a given currency changes hands in a
specific time period, usually measured by GNP divided by
money supply
 currency board
 A monetary authority which is required to maintain an
exchange rate with a foreign exchange. The conventional
aims of a central bank must be subordinated to the exchange
rate target
 A monetary authority which is required to maintain an
exchange rate with a foreign currency. The conventional
aims of a central bank must be subordinated to the exchange
rate target
 reserve requirements
 Amount of liquid assets that commercial and investment
banks hold in cash or deposit with Central Banks, usually at a
very low interest
 Amount of liquid assets that commercial banks hold in cash
or deposit with Central Banks, usually at a very low interest
 mutual fund
 A mutual fund is a form of investing money together with
other people to participate in a wider range of investments,
but the costs of doing so are supported by the national
government
 A mutual fund is a form of investing money together with
other people to participate in a wider range of investments
and to share the costs of doing so
 stock life insurance company
 A life insurance company owned by shareholders who share
in its earnings

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  A life insurance company owned by policyholders who share
in its earnings
 tax
 A fee charged by a government on a product, income, or
activity
 A quota levied by a government on a product, income or
activity
 tariff
 A tax imposed on a product when it is imported into a
country
 A tax imposed on a product when it is exported from a
country
 duty
 A tax on both imports and exports
 A tax on imports
 A tax on exports
 crowding out
 It theoretically occurs when governments expand their
borrowing, by issuing bonds, more to finance increased
expenditure or tax cuts in excess of revenue
 It theoretically occurs when investment banks expand their
borrowing, by issuing bonds, more to finance increased
expenditure or tax cuts in excess of revenue
 foreign exchange (currency or FOREX)
 It includes trading between large banks, central banks,
currency speculators, multinational corporations,
governments and other financial markets and institutions.
 It includes trading just between central banks, multinational
corporations and governments
 the nominal exchange rate
 It is the rate at which only a government can trade the
currency of one country for the currency of another

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  It is the rate at which an organization can trade the currency
of one country for the currency of another
 balance sheet
 It shows a company’s financial condition at a specific point
in time, including assets, liabilities and net worth
 It shows a company’s financial condition at a specific point
in time, including assets and liabilities
 profit and loss account
 It is a record of a company’s trading activities over a period
of time
 It is a record of a company’s financial position at a moment
in time

3. Complete the words below to match the given meanings:

 A market for the trading of companies’ stocks
s_ _ _ _ m_ _ _ _ _
 Financing a company through the sale of stocks in a
company
e_ _ _ _ _ f _ _ _ _ _ _ _
 They are generally viewed as safer investments than stocks
b_ _ _ _
 They are bonds that are rated below investment grade by the
credit rating agencies
j_ _ _ b_ _ _ _
 Dollar deposits in a U.S. bank branch or a non-U.S. bank
located outside the United States
e_ _ _ _ _ _ _ _ _ d_ _ _ _ _ _
 Short-term debt obligations of a national government that are
issued to mature in 3 to 12 months.
t_ _ _ _ _ _ _ b_ _ _ _
 It is a standardized contract to buy or sell a certain
underlying instrument at a certain date in the future, at a pre-
set price
f_ _ _ _ _ _ c_ _ _ _ _ _ _

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  It is an agreement between two parties to buy or sell an asset
at a pre-agreed future point in time. Therefore, the trade date
and delivery date are separated
f_ _ _ _ _ _ c_ _ _ _ _ _ _
 It is the difference between the buying and selling price of
the same stock or currency transaction
b_ _ /o_ _ _ _ s_ _ _ _ _
 It is a person or a firm, which quotes a buy and sell price in a
financial instrument or commodity hoping to make a profit
on the difference
m_ _ _ _ _ m_ _ _ _

4. There are different investment choices below. Mark them as

H (high), M (medium) or L (low) risk
 Common stocks, types of securities that represents ownership
in a corporation
 Corporate bonds, characterized by high yields
 Securities traded on Wall Street
 Long-term buy-and-hold securities, where individuals do no
try to time the markets
 Securities that are traded below their true value
 Switching among mutual fund asset classes in an attempt to
profit from the changes in their market outlook
 Fixed-income securities
 Securities that pay a high level of dividends or coupon
payments
 Treasury bills
 Medium-term treasury notes
 Index funds

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 UNIT 4. Reading a Balance Sheet
Reading furnishes the mind only with
materials of knowledge. It is thinking that
makes what we read ours
John Locke

1. Read the following text and answer the questions:

 Who and what is the balance sheet relevant for?
 What would be the main difference between accounts payable and
accounts receivable?
 What financial ratios can be calculated by reading a balance sheet?

2. Match the following terms with their correspondent explanations:

inventory, fixed assets, current liabilities, retained earnings, current
assets, accounts receivable, owner’s equity, intangible assets,
accounts payable
 They have a life span of one year or less, meaning they can easily be
converted into cash.
 They are typically paid within one year or less and are therefore paid
with current assets. Because current assets pay for them, the ratio
between the two is important: a company should have enough of the
former to cover the latter.
 They have a life span of over one year. Depreciation is calculated
and deducted from these types of assets.
 The initial amount of money invested into a business.
 They are the short-term obligations owed to the company from
clients. It represents the amount of materials currently available for
production.
 What the company owes to suppliers for buying raw materials or
retail products on credit.
 While these assets are not physical in nature, they are often the
resources that can make or break a company.

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  The percentage of net earnings not paid out as dividends, but kept by
the company to be reinvested in its core business or to pay debt. It is
recorded under shareholders’ equity on the balance sheet.

A balance sheet reveals a company’s assets, liabilities and owner’s

equity, also called net worth. The balance sheet provides all the necessary
information to shareholders, those people who contribute with their money
to the internal financing of a company, in exchange for dividends.
The balance sheet is divided into two parts:
assets = liabilities + owners’ equity
Assets are what a company uses for its production process, while
liabilities are obligations to be paid to outside parties. Owners’ equity,
referred to as shareholders’ equity in a PLC, is the amount of money
initially invested into the company plus any retained earnings.
Retained earnings are calculated as following:
Retained earnings (RE) = Beginning retained earnings + Net income –
- Dividends
In most cases, companies retain earnings in order to invest them in,
for example, buying new machinery or spend the money on research and
development.
If beginning RE + Net income – Dividends > RE, then the company
is registering a deficit.

A balance sheet represents a specific period (usually one day) and is

most usually calculated on the last day of a company’s fiscal year, Dec 31.
ASSETS LIABILITIES

Current assets Current liabilities

cash and cash equivalent Dividends payable
accounts receivable Accounts payable
inventory Interest payment on long-term debt
Raw materials   Taxes payable
Work-in-progress (WIP) Owner’s equity
  Finished goods
Bank accounts
Checks  

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 ASSETS LIABILITIES

Stocks
T-bills
Fixed assets or tangible assets
Machinery
Computers
Building
Land
Intangible assets
Patent
Copyright
Goodwill
Franchises and licenses
Leasing

If, at the end of the fiscal year, a company decides to reinvest its net
earnings into the company, the retained earnings will be restated from the
income statement into the balance sheet.
net earnings + retained earnings = total net worth
For a balance sheet to be functional, total assets on the left side have,
at least, to equal total liabilities plus owner’s equity on the right side.

A balance sheet:
 It is also a support for the financial ratios to be calculated
 It helps an investor to realize how liquid a company is and to analyze
its growth potential
 It shows how profits are used to finance the company’s operations
and whether the company has enough cash for growth
 It points to the inventory levels, whether they are stagnant or in
progress, if debt is paid or to be paid
 It shows what cash value would shareholders receive in case of
bankruptcy
 It shows what is the value of current assets, those assets which can
be easily converted into cash.
3. Look at this example of a balance sheet. Fill in the missing words.
Choose from the following: patents, owner’s equity, accounts
receivable, land, capital, accounts payable, WIP, current assets

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 BALANCE SHEET
   
(All figures in RON)
Assets 2005 Liabilities and owners equity 2005
5.000 Current Liabilities  
Cash 500 4.000
T-bills 1.000 Dividend payable 2.000
7.000 Taxes payable 3.000
Total Current Assets 13.500 Total Current Liabilities 9.000
Inventory   Long-term Liabilities  
Raw materials 825 Long-term Bank Loan 5.000
750 Total Liabilities 14.000
Finished Goods 1.200  
Total Inventory 2.775 20.000
Long-term assets   Retained Earnings 28.275
30.000 Total Net Worth 48.275
Machinery 20.000    
Depreciation (machinery) -5.000    
Intangible assets      
1.000    
Total Long-term assets 46.000    
Total Assets 62.275   Total Liabilities + Net Worth 62.275

4. Read now the complete balance sheet above and provide answers to
the requirements below:
 Is the company liquid enough to pay off its debts, or it needs to take
a loan?
 Is the company financing itself through reinvested earnings or debt?
 What does a low cash ratio indicate?
 Calculate the debt ratio by using the balance sheet above.
 Calculate the current ratio by using the balance sheet above
 What would a high amount of leverage indicate?

UNIT 5. Reading a Profit and Loss Account

'Blessed is the man who
expects nothing, for he shall never

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 be disappointed' was the ninth
beatitude
Alexander Pope

1. Read the following text and answer the questions:

 What is a P & L needed for?
 What financial ratios can be calculated by using a P & L account?
 Who is mostly interested in reading a P & L?

2. Match the following terms with their correspondent explanations:

return on capital employed (ROCE), gross profit, interest cover,
amortization, earnings per share, matching principle, cost of sales,
operating profit, cost principle, goodwill
 It requires that costs should be matched to the revenues they
generate. This means, for example, that the cost of an asset should be
depreciated over its useful life rather than the entire cost being
charged against profits when it is purchased.
 It arises when a company buys another business at a price greater
than the value of its assets; the excess of the amount paid over the
new asset value of the acquired business, is shown in the balance
sheet of the acquiring company.
 Given that it excludes many costs, including all overheads and all
financing costs, it is not a good measure of how profitable a
company is as a whole.
 It is profit given to shareholders (after tax) divided by the number of
shares in issue.
 It is the amount of a company’s profits that belong to a single
ordinary share.
 It is the rate of return a business is making on the total capital
employed in the business. Capital will include all sources of funding
(shareholders funds + borrowings), which means that the return will
be prior to interest and tax.
 It is the equivalent of depreciation for intangible assets.

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  It is the profit generated by a company’s operations before interest
payments and tax.
 It measures the cost of the goods (or services) supplied in a period.
The cost of what a company sells is accumulated with the cost of
producing or supplying it.
 It is a measure of the adequacy of a company’s profits relative to
interest payments on its debt.
The profit and loss account (P & L), called the income statement in
the US, shows the profit or loss a company has made over a period of time.
It is the most looked accounting statement and it provides the numbers
needed to calculate the ratios investors look at most often: for example PE
and dividend yield are calculated using the P & L.

N. B. The price/earnings ratio, usually abbreviated to PE, compares the

price of a share to the company’s earnings (net profit) per share.
Mature companies tend to have higher dividend yields, while young
companies tend to have lower ones; Ltd-s don’t have a dividend yield at all
because they do not pay out dividends.
The P & L account, in its shortest form, looks like:
Total sales - Total costs = Total profit OR
Revenues – Expenses = Net Income
According to the matching principle, costs and revenues are
matched, so that, sales and purchases made on credit during a year, but not
yet paid for, will be included in the P & L for the year. P & L provides
details of costs and revenues.

The general form of a P & L looks like:

Sales Also called revenues or turnover
Cost of sales Sales-gross profit

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 Gross profit Sales - cost of sales
Other operating expenses Administration, depreciation, marketing
Operating profit Gross profit - other operating expenses
Interest costs Interest payable - interest receivable
Pre-tax profit Operating profit - Interest costs
Tax  
Profit after tax Pre tax profit - tax
Dividends  
Retained profit Profit after tax - dividends
Earnings per share Profit after tax divided by number of shares

The P & L is essential for measuring the performance and efficiency

of the business, such as return on capital employed and some measures of
financial stability e.g. interest cover.
The P & L is in someway quite backward looking and investors will
need to consider correcting some items such as amortization of goodwill.
From an investor’s point of view, the P & L is essential, but it can be
misleading and should never be looked at in isolation.

3. a. Fill in the missing words. Choose from the following: net income,
earnings per share, interest expense, net sales, cost of goods sold

 Revenues
……………… _________________ ………………
Rent revenue _________________ ………………
Interest revenue _________________ ………………
Total revenue _________________ ………………

 Expenses
……………… _________________ ………………
Selling expenses _________________ ………………
Administrative expenses _________________ ………………
……………… _________________ ………………
Total expense
Income before taxes _________________ ………………
Income taxes _________________ ………………
……………… _________________ ………………

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 ……………… _________________ ………………

b. After filling in, match the items in the second example of P &
L (the one above) with the items in the first example of P & L;
some items in the first one may be inclusive for the second
ones.

c. Include the necessary figures in the P & L above so as to

provide an adequate example of a real financial situation.
Take into account that the company is profitable enough and
correlate the figures with the ones placed in the balance sheet
mentioned before.

4. Choose the right items from those given in bold:

 P & L indicates how net revenue is/is not transformed into net
income.
 The purpose of the P & L is to show managers and investors whether
the company made/made not or lost/not lost money during the
period being reported.
 P & L should help investors and creditors assess/ not assess the risk
of achieving future cash flows.
 Income statement is / is not the same as P&L.
 P & L is/is not used for external reporting.
 P & L offers/ does not offer relevant information to shareholders.
 Decision makers fully rely / do not rely on the information provided
by P & L.

Task 1
Use the second example of the P & L that you have completed to
calculate the gross profit margin and the net profit margin.

Task 2
Use the balance sheet and the profit and loss account. Can you calculate
ROCE for the same product?

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Task 3
Assume two companies. Company A has capital assets = $10 million
and makes a profit in 2006 of around $ 2.5 million. Company B has
capital assets of $ 1.2 million. It makes a profit in 2006 of only $
400.000.
Which is the most successful firm? Apply ROCE to find out the answer.

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