INSTRUCTIONAL MATERIAL

BUSINESS FINANCE

Compiled by:
BERNADETTE M. PANIBIO
MICHAEL BRYAN G. DE CASTRO
College of Accountancy and Finance
Department of Financial Management
 BUSINESS FINANCE
By: Bernadette M. Panibio and Michael Bryan G. de
Castro

TABLE OF CONTENTS

Course Content 3
Overview of Business 7
Key Ideas in Finance 15
The Influence of Philippine Business Environment on
Financial Goals, Policy and Management 19
Financial Policy, Planning and Control Functions 22
Promotion 26
Feasibility Studies 27
Time Value of Money 35
Financial Statement Analysis 43
Cost-Volume-Profit Analysis 49
Operating Leverage and Financial Leverage 53
Limitations of Financial Statements 57
Working Capital Management 62
Sources of Funding 72
Capital Budgeting 99
Mergers and Acquisitions 115
Business Failures and Remedies 118
Midterm Examination 128
Final Examination 134

1
 INTRODUCTION

This instructional material is intended for exclusive use of students

enrolled in the course Business Finance.

The course deals with finance applications in a business firm. It

introduces distinctive ways a business can be organized and the
financial implications of each organizational form. It starts with the
promotion of a new enterprise and the preparation of a feasibility
study. It also covers analytical tools in financial evaluation,
management of working and long-term capital, and the causes and
remedies of business failure.

Upon completion of this instructional material, the student is expected

to be able to evaluate the local business environment, develop a
feasibility study of a new enterprise, explain the finance functions,
recognize the importance of an effective and efficient utilization of the
financial resources, apply the concept of time value of money,
analyze financial statements and make recommendations based on
the analysis results and Identify the causes and remedies of business
failures

Assessment questions and activities are also provided at the end of

each topic to gauge how well the student understood the discussions.
Midterm Examination and Final Examination can be found at the end
of the material.
Course Content

WEEK TOPIC LEARNING RESOURCES

OUTCOMES
Week 1 Introduction to the course contents, Demonstrate interest Course Syllabus
activities, and requirements. and appreciation of
the importance of
knowing the course.

Week 2 Overview of Business Discuss the BusinessFinance

business concepts Mejorada, Nenita
 Concept of Business D. JMC Press,
 Kinds of Business Differentiate forms 2006
 Forms of Business
Organization of business Basic Finance
organizations Mayo, Herbert,
Basic Foundation of Business Finance Forms of organization C & E Publishing, Inc. 2011
 Meaning of
Business Finance Explain the finance
 Finance Functions functions

Discuss the role of

Role of Finance Manager the finance manager
Promotion
Week 3 – Discuss the concept Business Finance
 Concept and stages of
5 Promotion and stages of Mejorada, Nenita D.
promotion JMC Press, 2006
Role of Promoters
Describe the role of Basic Finance
The Feasibility Study promoters Mayo, Herbert,
C & E Publishing, Inc. 2011

Week 6 Time Value of Money Recognize the Business Finance

importance of time Mejorada, Nenita D. JMC
 Discounting to value of money Press, 2006
determine the
present value Compute for Basic Finance
 Compounding to present and future Mayo, Herbert,
determine the values C & E Publishing,
future value Inc. 2011
 Present Value of an Apply time value of
Annuity money in decision Introduction to Financial
 Future Value of an Annuity making activities Management,
Scott, Besley; Eugene
Brigham,
CENGAGE Learning, 2013

Week 7 – Financial Analysis and Demonstrate Business Finance

8 Financial Planning awareness in analyzing Mejorada, Nenita D.
the financial statement JMC Press, 2006
as applied in business
  Financial Statement Basic Finance,
Analysis Perform ratio Mayo, Herbert,
 Ratio Analysis analysis andthe C & E Publishing, Inc. 2011
 Percentage of sales different percentage
technique of sales techniques Introduction to Financial
 Cost-volume-profit Management
analysis Perform cost Scott, Besley;
 Operating leverage volume profit Eugene Brigham,
and financial leverage analysis as applied CENGAGE Learning, 2013
 Cash Budget in t business
 Limitations of Financial Business Finance
Compute for the Mejorada, Nenita D.
Statement for financial JMC Press, 2006
operating and
Analysis
financial leverage
Basic Finance,
Apply cash budgeting Mayo, Herbert,
C & E Publishing, Inc. 2011
Identify the
limitations of Introduction to Financial
financial statement Management,
for financial analysis Scott, Besley;
Eugene Brigham,
CENGAGE Learning, 2013
MIDTERM EXAMINATION

Working Capital Management Business Finance

Week 10 Recognize the Mejorada, Nenita D.
-11  Cash Management importance of an JMC Press, 2006
efficient and
 Receivables Management
effective asset Basic Finance,
 Inventory Management management Mayo, Herbert,
C & E Publishing, Inc.
Discuss current 2011
assets and current
liabilities
management Introduction to Financial
Management,
Scott, Besley;
Eugene Brigham,
CENGAGE Learning, 2013

Week 12 Sources of Short-Term Capital Identify the different Business Finance

sources of short- Mejorada, Nenita D.
 Internal Sources term capital thru JMC Press, 2006
 External Sources internal and
external financing Basic Finance,
Mayo,Herbert,
Identify the pros and C & E Publishing, Inc.
cons Assess the 2011
costs involved
Introduction to Financial
Management,
Scott, Besley;
 Eugene Brigham,
CENGAGE Learning,
2013

Week 13 Sources of Long – Term Capital Identify the different Business Finance
sources of long-term Mejorada, Nenita D.
 Internal Sources capital thru internal JMC Press, 2006
 External Sources and external
financing Basic Finance,
Mayo, Herbert
Identify the pros and C & E Publishing, Inc.
cons Assess the 2011
costs involved
Introduction to
Financial
Management,
Scott, Besley;
Eugene Brigham,
CENGAGE Learning,
2013

Week 14 Apply appropriate Business Finance

– 15 Capital Budgeting capital budgeting Mejorada, Nenita D.
technique in decision JMC Press, 2006
 Capital Budgeting making
Process Basic Finance,
 Capital Budgeting Mayo, Herbert
Techniques C & E Publishing, Inc.
2011

Introduction to Financial
Management,
Scott, Besley;
Eugene Brigham,
CENGAGE Learning,
2013

Week 16 Mergers and Acquisitions Discuss mergers and Business Finance

acquisitions Mejorada, Nenita D.
JMC Press, 2006

Basic Finance,
Mayo, Herbert
C & E Publishing, Inc.
2011
Business Finance
Week 17 Business Failure and Demonstrate
Mejorada, Nenita D.
Remedies awareness on
JMC Press, 2006
business failures
Basic Finance,
Identify the causes Mayo, Herbert
and remedies of
C & E Publishing, Inc. 2011
business failure
 Introduction to Financial
Management,
Scott, Besley;
Eugene Brigham,
CENGAGE Learning,
2013
FINAL EXAMINATION
 OVERVIEW OF BUSINESS

Business in the Philippines and in other countries of the free world is basically
capitalistic in nature. This means that society entrusts the workings of business process
to the guidance of the private businessman. In every economy, certain basic functions
have to be accomplished—the determination of what, how, how much and for whom to
produce, the allocation of the goods and services produced, further growth of the
economy, the distribution of economic benefits and maintenance of relations with other
countries.

BUSINESS
 An organization of people with varied skills, which uses property or talents to
produce goods or services, which can be sold to others for more than their costs
 Any lawful economic activity concerned with making goods available as well as
rendering of useful services to those who want and need them

CLASSIFICATIONS OF BUSINESS

Industry
The business is primarily concerned with the creation of form utility or the
production of goods that are used either by the consumer and are therefore called
consumer’s goods or by other industries in the further production of other goods and
therefore called producer’s goods

Commerce
The business is engaged in the transfer or exchange of goods and services with
the movement of goods from the point of production to point of consumption. It covers
buying, selling, marketing and merchandising which are directly involved in the transfer
of goods

Service
The business caters to the personal needs of people or with rendering of a
personal service
 Classification By Asset Size By Employment
Micro-enterprise Up to P3,000,000 1 to 9 employees
Small-scale enterprise P3,000,001 to P15,000,000 10 to 99 employees
Medium-scale enterprise P15,000,001 to P100,000,000 100 to 199 employees
Large-scale enterprise Above P100,000,000 More than 200 employees

FORMS OF BUSINESS ORGANIZATION

Sole or Single Proprietorship

A form of organization where there is only one owner, the proprietor. It is best
suited for those going solo, who best work alone and prefer to make decisions on their
own. It is the simplest form.

Advantages
It is easy to organize. The governmental
requirements are minimal
Decisions can easily be made inasmuch as
they are made by the owner himself
Financial operations are not complicated
inasmuch as this type of organization is
generally for small-scale business
The owner is entitled to all the profits his
business realizes
Disadvantages
Limited ability to raise capital. The
business depends only on the financial
resources that can be procured by the sole
owner
The sole proprietor has unlimited liability.
Business creditors can go after his
personal assets to satisfy their claims
Limited ability to expand. This is due to its
limited capital and operations are limited
only to areas in which the sole proprietor
has expertise
The owner has nobody to share with the
burden of decision making and losses he
might incur

Partnership
An association of two or more persons who bind themselves to contribute money,
property or industry to a common fund, with the intention of dividing profits among
themselves
 Has a juridical personality separate and distinct from that of each of the partners. As
such, the partnership can acquire and possess property of all kinds as well as incur
obligations and bring civil or criminal actions in conformity with laws
 Every partner is an agent of the partnership so that every act of his, including the
execution of any instrument in the partnership name, for apparently carrying
partnership business in the usual way, binds the partnership. An exception to this is
when the partner so acting has in fact no authority to act for the partnership in the
particular matter and the person with whom he is dealing knows that he has no such
authority
 Partnership profits and losses are divided based on the agreement between
themselves. In the absence of stipulation in the partnership contract, the same shall
be divided based on their capital contribution. An industrial partner shares in profits
based on what may be just and equitable under the circumstances. If besides his
services, he contributes capital so that he in effect is an industrial-capitalist partner, he
shall also receive a share in the profits in proportion to his capital

Advantages
It is easy to form. This is because the
partnership is subject to less legal
requirements
Flexibility of operations. Its choice of
activities is not subject to as many
restrictions. Inasmuch as there generally
are few owners in a partnership, an
agreement among partners can be easily
arrived at without unnecessary delay
It is expected to be operated more
efficiently when compared with a sole
proprietorship because of the presence of
more owners. In other words, “two heads
are better than one”
Partners are expected to have great
interest in the operations of the partnership
because of their unlimited liability for
partnership debts aside from their shares
in profits
Disadvantages
Partners have unlimited liability for
partnership
debts
It has limited life because it can easily be
dissolved. A partnership, being a contract
between the partners, is dissolved based
on their agreement and upon the
withdrawal, incapacity or death of a
partner, etc.
Limited ability to raise capital. The amount
of capital depends on how much can be
contributed and/or procured by the
partners

Corporation
An artificial being created by operation of law having the right of succession and
the powers, attributes and properties expressly authorized by law or incident to its
existence
 As an artificial being, a corporation is a legal or juridical person with a personality
separate from its individual stockholders or members. Because of this legal concept
of a corporation, it may acquire and possess property of all kinds, incur obligations,
and bring civil or criminal actions in the same manner as a natural person does
 A corporation has the right to continuous existence irrespective of the death,
withdrawal, insolvency, or incapacity of the individual member or stockholders and
regardless of the transfer of their interest or shares of stock
 Best suited for those businesses having a number of investors
 The components of a corporation are the following:
Corporators – Refers to all persons composing a corporation whether they are
stockholders (in the case of a stock corporation) or members (in the case of a non-
stock corporation)
Incorporators – Refers to corporators mentioned in the articles of incorporation as
originally forming and composing the corporation and who executed and signed the
articles of incorporation as such (Any number of natural persons not less than five but
not more than fifteen, all of legal age and a majority of whom are residents of the
Philippines, may form a private corporation for any lawful purpose. Each of the
incorporators of a stock corporation must own or be a subscriber to at least one share
of capital stock of a corporation
Stockholders – Any natural or juridical person owning at least one share of capital
stock of a corporation
Member – The corporators in a non-stock corporation
Board of Directors/Trustees – This is the governing body in a corporation. The Board
of Directors has the sole authority to determine policy and conduct the ordinary
business of the corporation within the scope of its charter. For non-stock
corporations, the body is called the Board of Trustees

Advantages Disadvantages
Its cost of formation and operation is
It has a legal capacity to act as a legal unit relatively high
Its formation and management are
It has continuity of existence relatively complicated
Management is centralized in the board of It is subject to greater degree of
directors or trustees governmental control and supervision
The creation, organization, management It has limited powers. A corporation can
and dissolution processes are do only what is expressly or impliedly
standardized because they are governed allowed by law or its articles of
by one general incorporation law incorporation
 It is possible for the board of directors to
Shareholders have limited liability abuse powers inasmuch as directors are
usually the majority stockholders
It has the ability to raise more capital. Its There is downside in terms of taxation: the
credit is strengthened by its continuous income of the corporation is taxed, yet any
existence and it can issue additional profit distributed as dividends to investors
shares of stock to a greater number of or shareholders is again subjected to
people and to other corporations further income tax
Shareholders can transfer their
shareholdings without the consent of other
shareholders
Its ability to raise more capital makes
feasible gigantic financial ventures
There is more check structure required in a
corporation which serves as the check and
balance mechanism to ensure that the
investors’ interests are protected
It is governed by a set of defined rules and
laws such as the Corporation Code and is
monitored and regulated by the SEC

GOALS OF A BUSINESS

To Earn Profit
Funds are invested in a business to earn sufficient return on investment. Goods
and services are made available to the public and are billed to customer with
sufficient markup to cover operating expenses, financing charges, income taxes and
desired net income. Net income realized results in an increase in assets and owners’
equity. Part of it may be distributed to the owners of the business (or declared as
dividends in the case of a corporation) with the remainder left in the business (or
plowed back into the business). Among investors, a summary figure is used
regarding the profitability of an enterprise. This is the earnings per share (EPS)
figure. It is used in evaluating past operating performance of a business, in forming
an opinion as to its potential, and in making investment decisions. The simplest
formula in computing for EPS is:
Net Income Related to Common Stock
Weighted Ave. No. of Shares Outstanding of Common Stock
To Increase the Value of the Business as an Economic Entity
A business strives for growth and stability.
Growth may be measured in terms of increase in assets that appreciate in value,
greater production capacity accompanied by increase in sales volume, and increase
in owners’ equity. Profitability contributes to growth and stability specially when part
of realized profit is retained or plowed back into the business.
Stability of a company refers to its ability to weather the ups and downs in the
economy or its ability to continue operations despite anticipated risks in a business. It
is measured primarily based on the relative amount of owners’ equity. Owners’ equity
is the difference between total assets and total liabilities of an entity so that it is also
called net assets or net asset value (NAV). Its primary source is the owners’
investment or capital placed in the business to which realized profit or net income is
added. It is reduced by losses and distribution of earnings (called dividends in the
case of corporation). Owners’ equity reflects a company’s ability to absorb losses. It
is considered the margin of safety to creditors because it is the amount by which
assets may decline in value and still the entity will be able to pay the claims of its
creditors. The greater is the owners’ equity, the more stable a company is and the
higher is the price that its owners can demand for their share in equity should they
decide to dispose or sell said share.

To Improve the Quality of Life in the Community

A business entity provides employment opportunities not only in its own
organization but also in other entities that are directly or indirectly affected by its
business transactions. Business entities also get involved in civic activities such as
providing medical and health services, recreational facilities, livelihood training
facilities and financial assistance for community projects.
NAME: SCORE:
COURSE/YR. & SEC.

OVERVIEW OF BUSINESS

IDENTIFICATION
1 Asset size of a medium-scale enterprise 1
2 Part owners of a corporation 2
3 A form of organization where there is only one owner 3
4 Any lawful economic activity concerned with making 4
goods available as well as rendering of useful services
to those who want and need them
5 The corporators mentioned in the articles of 5
incorporation
6 An association of two or more persons who bind 6
themselves to contribute money, property or industry to
a common fund, with the intention of dividing profits
among themselves
7 It is used in evaluating past operating performance of a 7
business, in forming an opinion as to its potential and in
making investment decisions
8 It covers buying, selling, marketing and merchandising 8
which are directly involved in the transfer of goods
9 It is measured in terms of increase in assets that 9
appreciate in value, greater production capacity and
increase in owners’ equity
10 An artificial being created by operation of law having the 10
right of succession and the powers, attributes and
properties expressly authorized by law or incident to its
existence
11 The ability to weather the ups and downs in the 11
economy
12 The governing body in a stock corporation 12
13 The business is primarily concerned with the creation of 13
form utility or the production of goods
14 It reflects a company’s ability to absorb losses 14
15 Asset size of a large-scale enterprise 15
16 Its primary source is the owners’ investment or capital 16
placed in the business
17 Asset size of a micro-enterprise 17
18 It is considered the margin of safety to creditors 18
because it is the amount by which assets may decline
in
value and still the entity will be able to pay the claims of
 its creditors
19 The governing body in a non-stock corporation 19
20 The business caters to the personal needs of people or 20
with rendering of a personal service

TRUE OR FALSE
1 A sole proprietorship has limited ability to raise capital 1
2 Every partner is an agent of the partnership 2
3 The corporation has a legal capacity to act as a legal unit 3
4 The shareholders can transfer their shareholdings without the 4
consent of other shareholders
5 A corporation has limited powers 5
6 Owners’ equity is the difference between total assets and total 6
liabilities of an entity
7 A sole proprietorship is easy to organize 7
8 Net asset value is reduced by losses and distribution of earnings 8
9 The greater is the owners’ equity, the more stable a company is 9
10 The sole proprietor has unlimited liability 10
11 Shareholders have limited liability 11
12 Partnership profits and losses are divided based on the agreement 12
between themselves
13 The proprietor is entitled to all the profits his business realizes 13
14 Partnership has limited life because it can easily be dissolved 14
15 A corporation has the right to continuous existence irrespective of 15
the death, withdrawal, insolvency, or incapacity of the individual
member or stockholders

ESSAY

1. What are the goals of a firm? Choose one and explain.

2. Which form of business organization will you prefer? Why?

 KEY IDEAS IN FINANCE

THE GOAL OF THE FIRM IS TO MAXIMIZE ITS MARKET VALUE

To understand this objective, think of a firm as a pie. The ingredients that go into
the pie include: the acquisition of resources for the firm and the financing and
management of these resources. How effectively these resources are used is
determined by how much someone else is willing to pay for a claim on them. That is,
if firm B believes it can use firm A’s resources more efficiently, it will offer to buy those
resources. Market forces will operate in the negotiations between the two firms so
that the firm that places the higher value on the resources will obtain them. For
publicly owned firms, the value of the firm itself is determined by the trading of stocks
and bonds in the financial markets.

Thus the financial markets come into play. The financial markets will recognize
the results of the value-maximizing decisions and the market value of the firm will
increase. Conversely, the financial markets will also respond when the firm makes
poor decisions, the market value of the firm will decrease.

Acquisition of Resources
Assessment of
Financing the Resources
how effective
Management of Resources
the ingredients Value of the Firm
are as reflected
by the
financial
markets

INDIVIDUALS ACT IN THEIR OWN SELF-INTEREST

Agency Relationship - a contract in which one party (principal) engages another

(agent) to perform a service and delegate some decision-making authority to the
agent.
 In the context of firm, the owners (the principals) engage the managers as their
agent to operate the firm on their behalf.

As long as the firm is owned and operated by a single owner-manager, no

complications arise with the objective of maximizing stockholders’ wealth. Because
you are both management and stockholder, actions taken in the stockholders’ best
interest also serve the self-interests of the manager.

In larger firms, however, management often owns only a small percentage of the
firm’s outstanding common stock. In this case, managers may be “satisfiers” rather
than maximizers. That is, their goal may be performance that ensures their own
career security and advancement, rather than the goal of maximizing the value of the
firm. Why? It is because only a small percentage of manager’s wealth comes from
changes in the value of the firm’s common stock. This conflict in goals might cause
managers to bypass a risky but potentially beneficial new investment. They may
prefer a safe project to a risky one that, if it fails, might cause the loss of their jobs.

FINANCIAL MARKETS ARE EFFICIENT

Efficient Market - one in which market prices quickly reflect all available information
about the firm

 In an efficient market, the best indication of what a firm is worth is to look at what
someone is willing to pay for a claim on the firm
 When there is plenty of information and many informed and active investors,
markets tend to be efficient
 If the market is efficient, trust market prices
 If the market is not efficient, market values do not necessarily reflect the economic
value of the assets

FIRMS FOCUS ON CASH FLOWS AND THEIR INCREMENTAL EFFECTS

Cash Flows - the actual movement of cash into or out of a firm, not earnings

This amount is not the same as earnings or net income in an accrual based
accounting sense. There is a fundamental difference between accounting and financial
management. The accountant looks at earnings; financial managers use cash flows.
Earnings are only a clue to the ability of the firm to generate cash flows. Earnings are
often misleading because they are calculated by matching revenues and expenses in
the proper time period based on historical costs.

Incremental Cash Flows - New minus existing cash flows

 Finance is always concerned with after-tax cash flows

Importance of Cash Flows

 Cash flow is unambiguous
The firm can spend cash; it cannot spend net income. The value of the firm at any
point in time is equal to the present value of the expected cash flows. Two firms
can report the same net income but have vast differences in actual cash flows for
the period.
 Cash flow is essential to the well-being of the firm
Firms may have high profits but inadequate cash flow, or low profits but high cash
flow.

Projected Income Statement for the

Balance Sheet Next 3 Months
Assets Sales (50% cash) 2000
Cash 200 Cash expenses except interest 1480
Other assets 800 Depreciation 100
Total 1000 Earnings before interest and taxes 420
Liabilities and Equity Interest 20
Short-term debt 200 Earnings before tax 400
Long-term debt 300 Taxes (30%) 120
Equity 500 Earnings after tax (net income) 280
Total 1000
Cash dividend to be paid in 2 months – 60
For the next 3-month period, the projected cash inflows and outflows are as follows:

Cash Inflows Cash Outflows

Sales for cash 1000 Cash expenses 1480
Cash on hand 200 Interest 20
Total 1200 Taxes 120
Cash dividend 60
Repay short-term debt 200
Total 1880
Net cash flow = Cash inflows - cash outflows
= 1200 – 1880
= - 680 (cash shortage)

Over time, as the sales are corrected, the firm’s cash flow problem will probably
be corrected. But the firm will suffer from a shortage of cash during the next quarter. If
we had looked at the 280 net income figure as reported in the income statement, we
would not know of the firm’s financial problems until the crunch was on.

If cash flows are maximized, the accounting numbers (over time) will reflect this
success and the value of the firm will be maximized. Inadequate cash flows also will be
reflected eventually in the firm’s accounting statements and its market price.

A PESO TODAY IS WORTH MORE THAN A PESO TOMORROW

When dealing with timing problems, finance uses a standardized methodology to

determine whether the cash flows associated with making an investment are worthwhile.
We formalize this idea by using present value and future value techniques.

RISK AND RETURN GO HAND IN HAND

Risk – The uncertainty of something happening or the possibility of a less-than-desirable

outcome
Return – The return necessary in order for a firm or investor to accept a certain level of
risk

Where other things being equal, the required return demanded by investors
increases as they take on more risk. If firms or individuals desire higher returns, then
they must bear more risk.
THE INFLUENCE OF PHILIPPINE BUSINESS ENVIRONMENT ON
FINANCIAL GOALS, POLICY AND MANAGEMENT

The unique Philippine business environment influences the financial policy and
management practices of Philippine business firms. These conditions are:

 High inflation
 Chronic shortage of long-term capital
 Underdeveloped equity and bond markets
 Relatively concentrated industries
 Active participation by the government in industry
 High risk economic and political environment

HIGH INFLATION

Philippine business firms have to face the fact that inflation will remain a primary
unresolved problem in our economy. Some effects of inflation on corporate financial
policy and practices are the following:

Increase in the firm’s capital requirements

Rising prices imply that the company requires an increasing amount of funds to do
the same volume of business as in past periods. Inventories must be replaced at higher
prices and capital investment projects require much more funds. Wages and other
operating expenses increase without an expansion in production. Capital investment
products are deferred, not because of returns considerations, but due to inadequate
capital.

Difficulty in financial planning

The unpredictability in future prices makes financial planning difficult. This creates
a bias for more current financial involvement while emphasizing the inherent risk of long-
term projects. The techniques of financial forecasting would be influenced in two ways.
First, there is a need for improved techniques in forecasting future financial flows.
Second, detailed financial forecasts and analysis make sense only for short-time
periods.

Higher interest rates

The incremental demand for capital will be reflected in the competition for
investment funds and the increase in interest rates, all other factors held constant. The
market rate of interest can also be viewed as consisting of charge for the diminished
purchasing power of the funds upon repayment. If savers will not be compensated for
the diminished value of their capital upon maturity, they would tend to favor investment
of their funds in goods rather than in loans.

CHRONIC SHORTAGE OF LONG-TERM CAPITAL

For various reasons, particularly the undeveloped capital market and inflation, the
availability of long-term capital remains a recurring problem for Philippine business firms.
The frequency and amount of public offerings of stocks in the primary market (fresh
equity shares offered to the public for the first time) is quite limited. The financial sector
with the largest resources, the commercial banking system, concentrated their portfolios
in short-term lending rather than in medium and long-term loans. The banking reforms
of 1980 which set up the unibank system in the country was a response to the need to
expand the long-term capital base.

UNDEVELOPED EQUITY AND BOND MARKETS

Both the primary and secondary markets for corporate long-term equity and debt
instruments have remained undeveloped in this country. The relatively small primary
equity market implies that it would be difficult for Philippine corporations to raise equity
capital from a wide base of stockholders. This partly explains why most Philippine
corporations, large or small, are “closely-held”, i.e., controlled by a few individuals or
families. The trading in the Stock Exchange constitutes a negligible proportion of total
assets and capital of the Philippine corporate sector. The secondary market for bonds
and long-term debt is dormant, with a few listed bonds, which are mostly government
issues. The few primary issues by some large corporations were mostly private issues
to a few institutions primarily insurance companies and trust departments of banks. A
major consequence of the limited capital market is the fact that the majority of Philippine
companies are forced to raise capital by relying on internally generated savings, private
equity issues to existing stockholders and trade from established suppliers.

ACTIVE PARTICIPATION BY THE GOVERNMENT IN INDUSTRY

The government could take either a posture of pure policy-making or indirect role
in industries/markets or conversely, a participating or direct role.

The first role is characterized by the setting up of policies and regulations to

influence the direction of development in industries. This role is representative of the
dual “carrot” (incentive) and “stick” (regulation) role of the government. Examples are
taxes and import restrictions as well as incentives to priority industries.

The second posture is one of direct involvement in industries through government

owned corporations. Such intervention by the government in markets is often justified by
(a) the extremely large capital requirements (b) the unwillingness of the private sector to
take up high risk development and pioneering role (c) the need to protect its investments
and save distressed companies in the economy.

There are some obvious finance policy implications on the government’s multiple
roles in industry. First, the financial goals and policies of the firm should take into
consideration the prevailing government policies for the industry. Second, the financial
policies of the firm may have to be adapted to a rather unique competitor—the
government. In some instances, a government corporation has more access to
resources—statutory provisions for fresh equity contributions and subsidies to
government corporations and the requirement that national treasury funds be deposited
in government banks are examples. In other instances, there may be some perceptions
and fear within private corporations that their government counterparts can also change
the rules of the game while the market competition is in progress.

HIGH RISK ECONOMIC AND POLITICAL ENVIRONMENT

The firm should be prepared to set its financial goals and policies within the
context of the likely future environment.
 FINANCIAL POLICY, PLANNING AND CONTROL FUNCTIONS

FINANCIAL POLICY AND STRATEGY

Investment Policy
 Choice of product lines and capital projects
Capital Structure Policy
 Working Capital Policy: balancing short-term versus long-term assets and
liabilities
 Leverage Policy: balancing long-term financing, i.e., debt versus equity
Growth Strategy
 Whether growth should be pursued using internally generated funds or through
mergers and consolidations
 Whether to integrate toward raw material production and marketing (vertical
integration) or toward diverse products/services (conglomerate or horizontal
integration)
Dividend Policy
 Whether to follow a systematic pattern of earning retention or dividend distribution

FINANCIAL MANAGEMENT AND CONTROL

Project Management
 Assure that long-term projects are implemented according to planned investment
outlays and to yield forecasted cash returns
Working Capital Management
 Cash Management
- Provide for adequate cash balance for day-to-day operating needs
- Maximize returns on idle cash through investment in marketable
securities
- Institute proper control of cash
 Accounts Receivable Management
- Optimize the accounts receivable investment through an evaluation of
the trade-off between lost sales opportunities and bad debts
- Institute sound credit evaluation and collection procedure
 Inventory Management
- Determine inventory levels by optimizing the trade-off between inventory
carrying cost, ordering cost and lost sales opportunities
- Institute sound inventory control procedures
Management of Fund Sources
 Identify possible sources of short-term and long-term funds
 Negotiate and monitor credit facilities with financial institutions
Dividend Policy Implementation
 Determine dividend amounts and form
 Schedule dividend payments
FINANCIAL PLANNING

Financial Forecasting
 Cash Budgeting: forecast of cash needs and sources
 Profit Planning: forecast of revenues and expenditures
 Balance Sheet Forecasting: anticipating future assets, liabilities and net worth
position of the firm
Financial Analysis
 Capital Budgeting Techniques: evaluation of long-term investments
 Operating Leverage Analysis: cost-volume profit relationships
 Financial Leverage Analysis: the effect of debt on earnings to common
stockholders
 Analysis of pricing and costs
Financial Performance and Evaluation
 Financial ratios as overall indicators of performance
NAME: SCORE:
COURSE/YR. & SEC.

KEY IDEAS IN FINANCE/THE INFLUENCE OF PHIIPPINE BUSINESS

ENVIRONMENT ON FINANCIAL GOALS, POLICY AND
MANAGEMENT/FINANCIAL POLICY, PLANNING AND CONTROL FUNCTIONS

IDENTIFICATION
1 A contract in which one party engages another to 1
perform a service and delegate some decision-making
authority to the agent
2 Corporations controlled by a few individuals or families 2
3 Choice of product lines and capital projects 3
4 One in which market prices quickly reflect all available 4
information about the firm
5 Balancing short-term versus long-term assets and 5
liabilities
6 Forecast of cash needs and sources 6
7 Evaluation of long-term investments 7
8 The actual movement of cash into or out of a firm, not 8
earnings
9 Cost-volume profit relationships 9
10 The effect of debt on earnings to common stockholders 10
11 Anticipating future assets, liabilities and net worth 11
position of the firm
12 New minus existing cash flows 12
13 The uncertainty of something happening of a less-than- 13
desirable outcome
14 The return necessary in order for a firm or investor to 14
accept a certain level of risk
15 Determine inventory levels 15

TRUE OR FALSE
1 For publicly owned firms, the value of the firm itself is determined 1
by the trading of stocks and bonds in the financial markets
2 Earnings are only a clue to the ability of the firm to generate cash 2
flows
3 When there is plenty of information and many informed and active 3
investors, markets tend to be efficient
4 The expected value of the firm at any point in time is equal to the 4
present value of the expected cash flows
5 The financial markets will recognize the results of the value- 5
maximizing decisions and the market value of te firm will increase
6 A peso today is worth more than a peso tomorrow 6
7 As long as the firm is owned and operated by a single owner- 7
manager, no complications arise with the objective of maximizing
stockholders; wealth
8 The required return demanded by investors increases as they take 8
on more risk
9 When the firm makes poor decisions, the market value of the firm 9
will decrease
10 Rising prices imply that the company requires a decreasing 10
amount of funds to do the same volume of business as in past
periods
11 The relatively small primary equity market implies that it would be 11
difficult for corporations to raise equity capital from a wide base of
stockholders
12 If the market is inefficient, trust market prices 12
13 Vertical integration is geared towards raw material production and 13
marketing
14 The unpredictability in future prices makes financial planning easier 14
15 If the market is efficient, market values do not necessarily reflect 15
the economic value of the assets

ESSAY

1. How will high inflation affect the firm?

2. Explain agency relationship.

3. Explain why a peso today is worth more than a peso tomorrow

 PROMOTION

It is the first stage in the formation of a company. It begins with a person or a

group of persons having thought of or conceived a possible future business opportunity
and then taking an initiative to give it a practical shape by way of forming a company.
Such a person or a group of persons who proceed to form a company are known as
promoters of the company.

PROMOTER
 Any person who complies with the necessary formalities of company registration,
finds directors and shareholders for the new company, acquires business assets
for use by the company, and negotiates business contracts on behalf of the
company and the like. In order to be regarded as promoter, it is not necessary
that the person should be involved in every stage of company’s formation
 One who undertakes to form a company with reference to a given project and to
set it going and who takes the necessary steps to accomplish that purpose

FUNCTIONS OF A PROMOTER

Identification of Business Opportunity

The promoter first identifies a potential business opportunity. This opportunity may
be regarding the production of a new product or service or making a product available
through a different channel than before or production of an old product with new updated
features or any other such opportunity having an investment potential.

Feasibility Studies
The promoter after having conceived a business opportunity analyzes the
opportunity to see whether it is feasible, technically as well as economically. Therefore,
the promoters undertake detailed feasibility studies so as to investigate all aspects of the
business that they intend to begin with the help of various tools like a study of the market
trend, industry trend, market survey, etc. and with the help of specialists like engineers,
chartered accountants etc. A venture is only feasible when it passes all the three below
mentioned tests.
 Technical feasibility: Sometimes an idea may be good and unique but technically
not possible to execute because the required raw material or technology may not
be easily available. Every business requires funds.
 Financial feasibility: Sometimes it may not be feasible to arrange a large amount
 of funds needed for the business in the limited available means. Also, financial
institutions may hesitate to grant huge amounts of loan for the new businesses.
 Economical feasibility: A business opportunity may be technically and financially
feasible but not economically feasible. It may not be a profitable venture or may
not yield enough profits. In such a case, the promoters refrain from starting the
business

Name Approval
Once the promoters have decided to launch a company next step is to select a
name for the company and get it registered.

Appointment of Professionals
Promoters are also required to appoint certain professionals. These professionals
such as mercantile bankers, auditors, lawyers, etc. help them in the preparation of
necessary documents that are required to be filed

Preparation of Necessary Documents

The promoters are required to prepare necessary legal documents that have to be
submitted for getting the company registered.

FEASIBILITY STUDIES

Uncertainty is a constant that businesses of every size face daily. Getting

customers in the door, encouraging them to spend, and ultimately generating a profit are
basic objectives that can at times seem difficult to achieve. Changing, adapting and
incorporating new products and ideas into your business mix are ways to remove some
of the uncertainties you face, but without proper forethought and planning, those steps
themselves can be highly uncertain. Enter the feasibility study: a chance to ask and get
answers to questions that help you to assess potential, and to predict the likelihood of
success or failure.

A feasibility study examines the practicability of a proposal, business venture or

idea. The principal function of this is to determine if the project will continue or not. In
business, feasibility studies work in a number of reasons.
 The feasibility report will look at how a certain proposal can work in a long-term
basis or endure financial risks that may come.
 It is also helpful in recognizing potential cash flow.
  It helps planners focus on the project and narrow down the possibilities.
Accordingly, a feasibility study can provide reasons not to pursue the said project
or proposal.
 When it comes to the operational aspect, the analysis determines whether the
plan has the necessary resources for it to be practicable. It will also help you
figure out whether or not the people will support the subsequent product or
service.
 You can have knowledge on the trends because a feasibility study looks at the
present-day market and studies the anticipated growth of your target business
sector.

OUTLINE OF A FEASIBILITY STUDY

I. Executive Summary
II. Business Concept
III. Description of the Business
IV. Vision of the Business
V. The Market
A. Customers
B. Competitors
C. Market Research
D. Marketing Plan
1. Product
2. Price
3. Place
4. Promotion
E. Sales Plan

VI. Business Process Workflow (diagram)

VII. Business Requirements
A. Business Organization (Organizational Chart)
B. Staffing and Costing
C. Space requirement
D. Equipment requirement
E. Depreciation cost
F. Business inputs
G. Material costs
H. Interest cost
I. Other costs
VIII. Sales and Cost Plan
IX. Statement of Financial Position
X. Cash Flow Plan
XI. Financial Analysis
XII. Conclusion and Recommendation

DESCRIPTION OF THE BUSINESS

 Brief History:
- Name of business
- How was it conceive
- How did the business developed
 Business Form
 Principal Activity
 Owner(s) – Skills & Experience
 Products or Services
 Sales/Marketing Geographical Area
 Customers
 Selling methods or techniques
 Workforce complement
 Customers’ needs being satisfied

THE MARKET

Assessing the Market

 All businesses need customers.
 Market
- Current customers
- Potential customers
 You are not the only seller.

 To succeed in business, you need to understand the characteristics of:

- Your customers
- Your competitors
- Size of the market

Know Your Customers

 Customers buy to satisfy different kinds of needs and wants.
  If you understand & can supply the products and services that satisfy the needs
and wants of your customers, then your business will probably be successful.

Market Research
 Getting information about your customers is called market research.
 Very important for any business.
 Many questions to be asked about your customers.
- Who are the different types of customers for your business?
- What products or services do they want?
- How much are they willing to pay?
- Where are they and where do they buy?
- How often and how much do they buy?
- Has the number been growing in the past?
- Will it still grow in the future?
- Why do customers buy particular products and services?
- Are people looking for something different?
- Are there similar products and services which are not available nearby?
 Market research can be done in many practical ways:
- Conduct a survey.
- Talk to people that you think will buy from your business.
- Listen to what customers say of your competitors’ businesses.
- Ask people why they buy from some businesses and not from others.
- Ask your suppliers which goods sell well.
- Read business manuals, newspapers, trade journals and magazines.

Know Your Competitors

 There are other businesses which offer the same or similar products or services.
These are your competitors.
 When you know about your competitors, you will be able to think about how you
can make your business successful.
 You should find the answers to the following questions:
- What prices do competitors charge?
- What quality of goods or services do they offer?
- How do they promote their goods or services?
- What extra service do they offer?
- Is their location expensive or cheap?
- Is their equipment modern?
- Are their employees well-trained and well-paid?
- Do they advertise?
 - How do they distribute their products or services?
- What is their market strategy?
- What are your competitors’ strengths and weaknesses?

Know Your Market Size

 Find out the following information:
- How many people live in your business area?
- Estimate their income.
- How many have stable employment?
- How many are self-employed?
- How many are unemployed?
 Estimate the average income of the different groups of potential customers in your
area.
 With this information and the findings of market research, estimate the size of
your market.
 But you are not the only one selling in your business area.
 It is important to estimate how big your market share will be.
 You must work out how many products or services you can realistically expect to
sell.
 A Marketing Plan will help you determine your market share and sales volume.
 One way of preparing a marketing plan is to follow the 4P’s of marketing.

4P’s of Marketing
 Product – the products or services you sell to your customers.
 Price – what you charge for the products or services you sell to your customers.
 Place – where your business is located.
 Promotion – how you tell your market about your business and how you attract
customers to buy your products or services.

BUSINESS ORGANIZATION
 For the business to run smoothly, efficiently and successfully, it has to be
organized.
 This means knowing:
- What needs to be done
- How and where it is to be done
- The people to do the work
 Calculate:
- What staff your business will need?
 - How much space your business needs for shop, workshop, storeroom,
office & public facilities?
- What machines and equipment are necessary?

 The most important people involved in a small business are:

- The owner
- The business partners
- The business staff
- The owner’s family
- Business advisers
 You should identify professionals who can assist you in the future:
- Accountants
- Bankers
- Lawyers
- Consultants
- Government specialists
 You may also consider getting assistance from:
- Business and trade organizations
- Educational institutions
- Government agencies
 If you do not have the time and skills to do all the work, you will need to employ
staff.
 Four steps to find what staff you need in your business:
- Look at the business and make a list of all tasks that have to be done.
- Decide which tasks you will not have time or skill to do yourself.
- Describe what skills and other requirements employees will need to do
these tasks.
- Decide how many employees you will need to perform each of these tasks
 After identifying all the people who will be involved, you can plan the structure of
your business.

EQUIPMENT & BUSINESS SPACE

 In the Marketing Plan one of the 4P’s stands for Place.
 In a retail business, you will need a shop in a good location.
 The space you will need depends on the types and ranges of goods you want to
sell.
 Based on your sales plan and your buying possibilities, you need to estimate how
much space you will need:
- To present your goods in your shop
 - To serve your clients in your shop
- To store your stock of goods
- For your office and other facilities.
 In a wholesale business, you need less space for your showroom but much more
space to store your stock.
 For a service business, you will need open air spaces, workshop space and office
space. The amount of space you need will depend on your estimation of your
sales.
 For manufacturing, the business space requirement will depend on the technology
to use and the equipment required

BUSINESS INPUTS
 Every business has many other inputs aside from business personnel, space and
equipment.
 For retailers & wholesalers – lighting, water, forms, etc.
 For repair shops and manufacturers – materials, parts, accessories, supplies,
lighting, water, etc.
 You pay for all of these items, thus it is important that you know exactly how much
you will need for your business.

COSTING
 Costs are the money your business spends to make and sell products or services.
 Costing helps your business to:
- Set prices
- Reduce and control costs
- Make better decisions about what to do in your business
- Plan for the future
 A business owner needs to know in detail the costs of running the business
because if you do not know your costs you cannot set prices.
 Many small and even large businesses get into financial difficulties because they
do not do their costing.
 You have to know whether the total costs of your business will be covered by the
money coming from your expected sales or whether losses will be incurred
 Costs can be separated in different ways. The most common way is to group
costs into categories according to the different production inputs:
- Staff costs
- Material costs
- Other costs
- Capital costs
  Different businesses have different costs. But in every business, there are only
two types of costs:
- Direct costs
- Indirect costs
 Direct costs are all costs that are directly related to the products or services your
business makes or sells. Direct costs are divided into: direct material cost (the
money your business spends on the parts and materials that become part of, or
are directly related to, the products or services you make or sell) and direct labor
cost (all the money your business spends on wages, salaries and benefits for the
people who are directly involved in the production of your product or services)
 Indirect costs are all other costs, except direct costs, that you have for running
your business, for example, rent, interest and electricity. They are not related to
one particular product or service. They are general costs for running your
business. Indirect costs are often called overhead
 The total cost of making or selling a product or providing a service is the sum of
all the direct costs and indirect costs.

FUNDING THE BUSINESS

 There are a number of ways you can finance your resources for your business:
- You can use your own money. This is called equity funds.
- You can borrow money. This is called debt funds.
- You can rent or lease the resources.

FINANCIAL PLANNING
 For your business to run efficiently and profitable, you must understand how to
organize and control your business finances.
 Basic tools in managing finances are financial planning and records-keeping.
 If you can work out what is likely to happen in the future, you will have better
control of your money.
 Business planning helps you find out what is likely to happen to your business in
the future.
 Financial planning will help you:
- Estimate what your costs and sales are likely to be during the year;
- Identify financial problems your business may have during the year and
work out what to do to solve them before they happen; and
- Present a clear picture of the financial workings of your business to a bank
if you apply for a loan.
 To help you estimate and control your profit and cash flow, you should make two
financial documents: Sales and Costs Plan and Cash Flow Plan
 Sales and Costs Plan
- Also called the Projected Income Statement
- You can use your Sales and Costs Plan to measure the financial
performance of your business.
- Your completed Sales and Costs Plan shows sales, costs and profits your
business is likely to have
- The forecast profit must be high enough to allow for something to go wrong
or for problems to happen
- If your plan does not show a reasonable profit, you will have to think hard
and analyze the problem
- The Sales and Costs Plan is what potential investors and lending
institutions will look at carefully. It must be realistic and positive.

Cash Flow Plan

- Shows how much cash you expect to come into your business and how
much cash you expect to pay out of your business every month.
- The Cash Flow Plan helps you to make sure that your business does not
run out of cash.

TIME VALUE OF MONEY

Time value of money (TVM) is the idea that money that is available at the present
time is worth more than the same amount in the future, due to its potential earning
capacity. This core principle of finance holds that provided money can earn interest, any
amount of money is worth more the sooner it is received.. In simpler terms, it would be
safe to say that a peso was worth more yesterday than today and a peso today is worth
more than a peso tomorrow.

The time value of money is also related to the concepts of inflation and
purchasing power. Both factors need to be taken into consideration along with whatever
rate of return may be realized by investing the money. Inflation and purchasing power
must be factored in when you invest money because to calculate your real return on an
investment, you must subtract the rate of inflation from whatever percentage return you
earn on your money. If the rate of inflation is actually higher than the rate of your
investment return, then even though your investment shows a nominal positive return,
you are actually losing money in terms of purchasing power. For example, if you earn a
10% on investments, but the rate of inflation is 15%, you’re actually losing 5% in
purchasing power each year (10% – 15% = -5%).
Present value (PV)
 This is your current starting amount. It is the money you have in your hand at the
present time, your initial investment for your future.
 Present value, also called "discounted value," is the current worth of a future sum
of money or stream of cash flow given a specified rate of return. Future cash
flows are discounted at the discount rate; the higher the discount rate, the lower
the present value of the future cash flows. Determining the appropriate discount
rate is the key to properly valuing future cash flows, whether they are earnings or
obligations.

Future value (FV)

 This is your ending amount at a point in time in the future. It should be worth
more than the present value, provided it is earning interest and growing over
time.

The number of periods (N)

 This is the timeline for your investment (or debts). It is usually measured in years,
but it could be any scale of time such as quarterly, monthly, or even daily.

Interest rate (I)

 This is the growth rate of your money over the lifetime of the investment. It is
stated in a percentage value, such as 8% or .08.
 Simple Simple interest is computed on the original amount as the return on that
Interest principal for one time period.
Compound interest is computed on the original amount as the return on
that principal plus all unpaid interest accumulated to date. Compound
interest is always assumed in TVM problems. This is a powerful
Compound concept that means money can grow at an exponential rate depending
Interest on how often interest is credited to the account. Once interest is
credited, it becomes in effect principal. Hence, it is very critical you
understand the compounding frequency of your investment prior to
committing your money to it
Fixed Fixed interest rate is a straight forward rate that remains constant
Interest Rate during the life of the loan or investment.
Variable Variable interest rate changes during the life of the loan and is usually
Interest Rate tied to the prime rate. It can go up or down depending on the prime rate
Mixed Mixed interest rate changes from fixed to variable or from variable to
Interest Rate fixed. It has some merits depending on your situation, but it is not a
rate you would want to choose for a long-term investment or debt.

Payment amount (PMT)

 These are a series of equal, evenly-spaced cash flows.

TIME VALUE OF MONEY FORMULA

Present Value of a Lump Sum

PV = FV / (1+i)n
PV = Present Value
FV = Future Value
PMT= Payment
i = Interest rate
n = Number of years

Future Value of a Lump Sum

FV = PMT (1+i)n
FV = Future Value
PMT = Payment
i = Rate of return you expect to earn
n = Number of years
Present Value of an Ordinary Annuity
An ordinary annuity is a series of equal payments, with all payments being made at the
end of each successive period)

PV = PMT [(1 – (1 / (1 +i)n)) / i]

PV = The present value of the annuity stream to be paid in the future

PMT= The amount of each annuity payment
i = The interest rate
n = The number of periods over which payments are to be made

Future Value of an Ordinary Annuity

FV = FV = (PMT [((1 + i)n - 1) / r])(1 + i)

FV = The future value of the annuity stream to be paid in the future

PMT = The amount of each annuity payment
i= The interest rate
n = The number of periods over which payments are to be made

Examples:

Present Value of a Lump Sum

Problem
Suppose you are depositing an amount today in an account that earns 5% interest,
compounded annually. If your goal is to have P5,000 in the account at the end of six
years, how much must you deposit in the account today?

Solution
The following information is given:
 Future value = P5,000
 interest rate = 5%
 number of periods = 6

We want to solve for the present value.

Present value = future value / (1 + interest rate)number of periods or, using notation
PV = FV/ (1 + i)n
Inserting the known information,
PV = P5,000 / (1 + 0.05)6
PV = P5,000 / (1.3401)
PV = P3,731

We can use the present value table (or table of discount factors) to solve for the present
value.
PV = FV (discount factor for i and n)
The discount factor, from the table, is 0.7462. Therefore,
PV = P5,000 (0.7462)
PV = P3,731

Present Value of an Ordinary Annuity

Problem
A company has made an investment in government bonds. The bonds will generate an
interest income of P25,000 each year for 5 years. The interest rate is 10% compounded
annually.

Solution
The following information is given:
 the amount of each annuity payment = P25,000
 interest rate = 10% compounded annually
 number of periods = 5

PV = 25,000 [(1 – (1 / (1 +0.1)5)) / i]

= P25,000 [1 – (1 / 1.61051) / 0.10]
= P25,000 [1 – 0.62092 / 0.10]
= P25,000 × [3.791]
PV = P94,775

We can compute present value of an annuity using present value of an annuity of 1

table: 10% interest rate; 5 periods

PV = P25,000 x 3.791
= P94,775
Future Value of a Lump-Sum

Problem
Suppose you are depositing P5,000 today in an account that earns 5% interest,
compounded annually. What will be the balance in the account at the end of six years if
you make no withdrawals?

Solution
The following information is given:
 present value = P5,000
 interest rate = 5%
 number of periods = 6
We want to solve for the future value.
FV = PV (1 + i)n

Inserting the known information,

FV = P5,000 (1 + 0.05)6
FV = P5,000 (1.3401)
FV = P6,701

We can use the future value table (also known as the table of compound factors) to
solve for the future value.

FV = PV (compound factor for 5% and 6)

The compound factor, from the table, is 1.3401
FV = P5,000 (1.3401)
FV = P6,701

Future Value of an Ordinary Annuity

Problem
The treasurer of ABC International expects to invest P100,000 of the firm's funds in
a long-term investment vehicle at the end of each year for the next five years. He
expects that the company will earn 7% interest that will compound annually

Solution
The following information is given:
 present value = P100,000
 interest rate = 7%
 number of periods = 5
We want to solve for the future value of an ordinary annuity
FV = (PMT [((1 + i)n - 1) / r])(1 + i)

Inserting the known information

FV = P100,000 [((1 + .07)5 - 1) / .07](1 + .07)
FV = P575,074

We can compute future value of an annuity using future value of an annuity of 1 table:
7% interest rate; 5 periods
NAME: SCORE:
COURSE/YR. & SEC.

TIME VALUE OF MONEY

1. Mr. A owes a total of P153,000 which includes 12% interest for the three years
he borrowed the money. How much did he originally borrow?

2. If we want P100,000 three years from now and the compounded interest rate is
8%, how much should we invest today?

3. A company has made an investment in government bonds. The bonds will

generate an interest income of P1,250,000 each year for 5 years. The interest
rate is 10% compounded annually.

4. A company expects a series of 24 monthly receipts of P3,600 each. The first

payment will be received 1 month from today. Determine the present value of this
series assuming an interest rate of 12% per year compounded semiannually.

5. You have P90,000 to deposit. ABC Bank offers 12 percent per year compounded
semiannually, while XYZ Bank offers 12 percent but will only compound
annually. How much will your investment be worth in 10 years at each bank?

6. What is the future value of P25,000 invested for 30 years at an average rate of
return of 7%?

7. Suppose that you start a savings plan by depositing P10,000 at the beginning of
every year into an account that offers 8% per year. If you make the first deposit
today, and then three additional ones, how much will have accumulated after four
years?

8. Your client is 40 years old and wants to begin saving for retirement. You advise
the client to put P50,000 a year into the stock market. You estimate that the
market’s return will be on average of 12% a year. Assume the investment will be
made at the end of the year. How much money will she have by age
 FINANCIAL STATEMENT ANALYSIS

Financial statement analysis is the process of analyzing a company's financial

statements for decision-making purposes and to understand the overall health of an
organization. Financial statements record financial data, which must be evaluated
through financial statement analysis to become more useful to investors, shareholders,
managers, and other interested parties.

IMPORTANCE OF FINANCIAL STATEMENT ANALYSIS

The financial statement analysis is important for different reasons:

Holding of Share
Shareholders are the owners of the company. Time and again, they may have to
take decisions whether they have to continue with the holdings of the company's share
or sell them out. The financial statement analysis is important as it provides meaningful
information to the shareholders in taking such decisions.

Decisions and Plans

The management of the company is responsible for taking decisions and
formulating plans and policies for the future. They, therefore, always need to evaluate its
performance and effectiveness of their action to realize the company's goal in the past.
For that purpose, financial statement analysis is important to the company's
management.

Extension of Credit
The creditors are the providers of loan capital to the company. Therefore they may
have to take decisions as to whether they have to extend their loans to the company and
demand for higher interest rates. The financial statement analysis provides important
information to them for their purpose.

Investment Decision
The prospective investors are those who have surplus capital to invest in some
profitable opportunities. Therefore, they often have to decide whether to invest their
capital in the company's share. The financial statement analysis is important to them
because they can obtain useful information for their investment decision making
purpose.
MODELS OF FINANCIAL STATEMENT ANALYSIS

There are at least four traditional techniques of interpreting financial statements, namely:
 Horizontal or Comparative Analysis
 Trend Analysis
 Vertical or Common-size Analysis
 Financial Ratio Analysis

Horizontal (Comparative) Analysis

Horizontal analysis presents the difference in absolute amount and in percentage
between two compared variables such as years, two companies, actual and budgeted
data and other bases of analyses. The difference could either be an increase or a
decrease both in amount and in percentage. A percentage change is computed as
follows:
Percentage of Change = Amount of Change/Base

 The base may be the last year’s data, budgeted data, average industry data or
chief competitor’s data
 The percentage of change is not computed if the denominator or the base is zero
or negative
 Getting the changes in amount and percentage is not the end-in-view of financial
statement analysis. The interpretation about those changes is more relevant

Trend Analysis
 Trend analysis extends beyond two years.
 It uses indexes and ratios to simplify the visible complications of numbers
contained in the financial reports.
 Financial data expressed in indexes and ratios are easily readable than those
presented in terms of millions of pesos
 Indexes are expressed in hundreds while ratios are expressed in normal decimal
places. In computing the trend index or ratio, the base year (100%) is normally
the earliest year. The choice of the base year is, however, purely judgmental.

Vertical (Common-Size) Analysis

The vertical (common-size) analysis gets the proportional component of each of
the variables in the financial statements in relation to a chosen base (i.e., 100%). As in
horizontal analysis, the financial statements are treated individually and each is analyzed
independent of the others.
 The base in the income statement is the net sales; the base in the balance sheet
is the total assets. In the statement of cash flows, the base may be the total cash
 available for use. By expressing the financial data in percentage using a
particular base, the size of different companies is brought to a common
expression.
 Size alone does not reflect the true merits of managerial performance. To
compare the financial data, they should be put in equal standing by expressing
financial figures into percentage and defining a common base (100%)

Financial Ratios

 Since the financial statements are fundamentally-related, we also have to relate

an information contained in one statement with the related information found in
another. This is called inter-financial statements analysis or simply financial mix
ratio analysis.
 In the financial ratio analysis, the income statement data is totaled while the
balance sheet data is averaged.
 There are at least four (4) basic classification of financial mix ratio analysis, as
follows:
- Profitability ratios
- Growth ratios
- Liquidity ratios
- Leverage ratios
 A little bit of caution…
- Ratios have greater disparities from one industry to another
- The economic and business environment keep on changing
- Prices and inflation rates sometimes significantly change from one period to
another
- The availability of many generally accepted accounting principles contribute
to inconsistencies in methods used from one company to another, an industry
to another
- Conservatism has a bias towards diminishing the value of the firm
- Historical cost principle may significantly contribute to a distorted financial
statement analysis
 SUMMARY OF FINANCIAL RATIOS

Ratios Formulas Use

Profitability Ratios

Return on Sales Measures profit percentage per peso

(Net Profit Rate) Net income / Net sales sales
Measures gross profit percentage on
Gross Profit Rate Gross profit / net sales sales to recover operating expenses
Measures divisional performance,
Return on Operating income / determines the accounting rate of
Investment Average total assets return on every peso of investment in a
project or business
Net income + Interest Measures overall asset profitability;
Return on Total expense, net of tax / indicates how effective assets have
Assets average total assets been employed by management
Measures percentage of income
Return on Net income / Average derived for every peso of owners’
Stockholders’ Equity stockholders’ equity equity
Earnings available to Measures the percentage of profit
Return on Common common stockholders / derived for every peso of common
Stockholders’ Equity Average common equity money used, when compared to
stockholders’ equity the return on total assets, it measures
the effective extent in using financial
leverage for or against the common
stockholders’ equity
Measures the number of times profit
Operating Leverage Contribution margin / will increase or decrease in relation to
Net income change in net sales
Measures the adequacy of current
Times Preferred Net income / Preferred earnings to meet preferred dividend
Dividend Earned dividend requirements payments
(Net income – Measures the rate of earnings per
Earnings Per Share Preferred dividends) / share of common stock
Average common
shares outstanding
 Ratios Formulas Use
Liquidity Ratios
Measures the speed of the business
Operating Turnover Collection period + cycle; the number of days from which
Inventory days cash was invested in the normal
business operations until the days of its
recovery
Indicates the number of times
Inventory Turnover Cost of goods sold / inventories were acquired and sold
Average inventory during the period
Indicates the length of time spent
Inventory Days or 360 days / before the average inventory is sold to
Days to Sell Inventory turnover customers; there are 365 days in a
Inventory year, however, 360 days are used for
ease in computation
Net credit sales / Indicates the efficiency in credit and
Receivable Turnover Average trade collection policies; trade receivables
receivables include open account and on notes
360 days / Receivable Measures quickness in collecting trade
Collection Period turnover receivables
Net credit purchases /
Payable Turnover Average trade Measures effectiveness in using trade
payables credit facility from suppliers
Payable Payment 360 days / Indicates the number of days spent
Days Payable turnover before paying liabilities to merchandise
suppliers
Cash operating Measures ability to meet operating
Cash Turnover expenses / expenses payments given a particular
average cash balance cash balance
Indicates the number of days spent
Days to Pay 360 days / before meeting operating expense
Operating Expenses Cash turnover payments
Measures the adequacy and
Working capital Net sales / Average effectiveness in using working capital;
turnover Working Capital
Net sales / Measures effectiveness of asset
Assets Turnover Average total assets utilization
 Ratios Formulas Use

Liquidity Ratios
Current Assets Net sales / Indicates the reasonableness of the
Turnover Average current assets amount of current assets
Indicates the amount invested by the
Net Working Capital Current assets less business to operate its normal
current liabilities business activities
Measures a rough estimate on the
ability of the business to meet its
Current Assets Ratio Current assets / currently maturing obligations; this ratio
Current liabilities varies in great disparity from one
industry to another
A more severe test of immediate
liquidity to meet currently maturing
Quick Assets Ratio Quick assets / obligations; quick assets include cash,
Current liabilities marketable securities and receivables;
this ratio is also referred to as acid-test
ratio

Growth Ratios
EACS / Average Measures the value of common stock
Earnings Per Share common shares by attributing to it a portion of the
outstanding company’s earnings
Price-Earnings Ratio Market price per share/ Measures the profitability of the firm in
(Earnings Multiple) Earnings per share relation to the market value of the stock
Dividend per share / Measures the rate of cash return to
Dividend Yield Ratio Market price per share investment in stock
Represents the percentage of net
Dividend Payout Dividend per share / income distributed as dividends; a low
Ratio Earnings per share payout ratio may indicate a high
investment of profits by a growth-
oriented firm
Indicates the value of the stock on cost
Book Value Per Stockholders’ equity / perspective; the relevance of this ratio
Share Average shares diminishes when the balance sheet
outstanding valuation does not approach fair
market values
 Ratios Formulas Use

Leverage Ratios

Measures the use of debt to finance

Debt-to-Equity Ratio Total debt / Net operations; provides a measure of the
stockholders’ equity relative amount of resources
contributed by the creditors and
owners
Measures the relative share of
Debt-to-Assets Ratio Total debt / total assets creditors over the total resources of the
firm
Equity-to Assets Net stockholders’ Measures the amount of resources
Ratio equity / total assets provided by the owners in the firm
Measures the long-term debt paying
Earnings before ability of the firm; a high number of
Times Interest interest and taxes / times interest is earned ratio indicates
Earned Interest expense that the business is under-leveraged
and its return on common equity could
still be improved
EBIT / Measures the risk associated in using
Financial Leverage EBIT– interest expense debt to finance investments
– preferred dividend
before tax

COST-VOLUME-PROFIT ANALYSIS

Cost Volume Profit (CVP analysis), also commonly referred to as Break Even
Analysis, is a way for companies to determine how changes in costs (both variable and
fixed) and sales volume affect a company’s profit. With this information, companies can
better understand overall performance by looking at how many units must be sold to
break even or to reach a certain profit threshold or the margin of safety.

Components of CVP analysis

The main components of CVP analysis are:

 1. CM ratio and variable expense ratio
2. Break-even point (in units or pesos)
3. Margin of safety
4. Changes in net income
5. Degree of operating leverage

CVP Analysis Setup

The regular income statement follows the order of revenues minus cost of goods
sold gives gross margin, while revenues minus expenses lead to net income. A
contribution margin income statement follows a similar concept but uses a different
format by separating fixed and variable costs.

The contribution margin is the product’s selling price less the variable costs
associated with producing that product. This value can be given in total or per unit.

CM Income Statement Example: Consider the following example in order to calculate the
five important numbers listed above.

XYZ Company has the following contribution margin income statement:

Total Per Unit

Sales (20,000 units) P1,200,000 P60
Less: Variable costs -P900,000 -P45
Contribution Margin P 300,000 P15
Less: Fixed costs -P240,000
Net income P60,000

1. CM Ratio and Variable Expense Ratio

CM ratios and variable expense ratios are numbers that companies generally
want to see to get an idea of how significant variable costs are.

CM Ratio = Contribution Margin / Sales

Variable Expense Ratio = Total variable costs / Sales

 A high CM ratio and a low variable expense ratio indicate low levels of
variable costs incurred.

2. Break-Even Point

The break-even point (BEP), in units, is the number of products the company
must sell to cover all production costs. Similarly, the break-even point in pesos is the
amount of sales the company must generate to cover all production costs. The
formula is shown below:

BEP =Total Fixed Costs / CM Per Unit

The BEP in units, would be equal to 240,000/15 = 16,000 units. Therefore, if

the company sells 16,000 units, the profit will be zero and the company will “break-
even” and only cover its production costs.

3. Changes in Net Income (what-if analysis)

It is quite common for companies to want to estimate how their net income
will change with changes in sales behavior. For example, companies can use sales
performance targets or net income targets to determine their effect on each other.

In this example, if management wants to earn a profit of at least P100,000,

how many units must the company sell?

We can apply the appropriate what-if formula below:

# of units = (fixed costs + target profit) / CM ratio

Therefore, to earn at least P100,000 in net income, the company must sell at
least 22,666 units.

4. Margin of Safety

In addition, companies may also want to calculate the margin of safety. This
is commonly referred to as the company’s “wiggle room” and shows by how much
sales can drop and yet still break even.

The formula for the margin of safety is:

 Margin of safety = Actual sales – break-even sales

The margin of safety in this example is:

Actual Sales – Break even sales = P1,200,000 – 16,000*P60 = P240,000

This margin can also be calculated as a percentage in relation to actual

sales: 240,000/1,200,000 = 20%

Therefore, sales can drop by P240,000 or 20% and the company is still not
losing any money.

5. Degree of Operating Leverage (DOL)

Finally, the degree of operating leverage (DOL) can be calculated using the
following formula:

DOL = CM / Net Income

So the DOL in this example is P300,000 / 60,000 = 5

The DOL number is an important number because it tells companies how net
income changes in relation to changes in sales numbers. More specifically, the
number 5 means that a 1% change in sales will cause a magnified 5% change in net
income.

Many might think that the higher the DOL, the better for companies.
However, the higher the number, the higher the risk, because a higher DOL also
means that a 1% decrease in sales will cause a magnified, larger decrease in net
income, ultimately decreasing its profitability.

CVP Analysis and Decision Making

Putting all the pieces together and conducting the CVP analysis, companies can
then make decisions on whether to invest in certain technologies that will alter their cost
structures, and determine the effects on sales and profitability much quicker.
 The hardest part in these situations involves determining how these changes will
affect sales patterns: will sales remain relatively similar, will they go up or will they go
down? Once sales estimates become somewhat reasonable, it then becomes just a
matter of number crunching and optimizing the company’s profitability.

OPERATING LEVERAGE AND FINANCIAL LEVERAGE

Leverage is a firm’s ability to employ new asset or funds to create better returns
or to reduce costs. That’s why leverage for any company is very significant.

There are two kinds of leverage – operating leverage and financial leverage.
When we combine the two, we get a third type of leverage – combined leverage.

Operating leverage can be defined as firm’s ability to use fixed costs (or
expenses) to generate better returns for the firm.

Financial leverage can be defined as firm’s ability to increase better returns and
to reduce the cost of the firm by paying lesser taxes.
Operating Leverage vs Financial leverage (Comparison Table)

Basis for
Comparison
between
Operating Leverage Financial Leverage
Financial Leverage
& Operating
Leverage
Operating leverage can be Financial leverage can be
defined as firm’s ability to use defined as firm’s ability use
Meaning
fixed costs to generate more capital structure to earn better
returns. returns and to reduce taxes.
It’s about the fixed costs of It’s about the capital structure
What it’s all about?
the firm. of the firm.
Operating leverage measures Financial leverage measures
Measurement the operating risk of a the financial risk of a
business. business.
Calculation Operating leverage can be Financial leverage can be
 calculated when we divide calculated when we divide
contribution by EBIT of the EBIT by EBT of the firm.
firm.
When degree of operating When degree of financial
leverage is higher, it depicts leverage is higher, it depicts
Impact
more operating risk for the more financial risk for the firm
firm and vice versa. and vice versa.
Financial leverage has a direct
The degree of operating
relationship with the liability
In relation with leverage is usually higher than
side of the balance sheet.
Break Even Point.

Operating Leverage

Operating leverage is a cost-accounting formula that measures the degree to

which a firm or project can increase operating income by increasing revenue. A business
that generates sales with a high gross margin and low variable costs has high
operating leverage.

The higher the degree of operating leverage, the greater the potential danger
from forecasting risk, where a relatively small error in forecasting sales can be magnified
into large errors in cash flow projections.
The Operating Leverage and Degree of Operating Leverage

The operating leverage formula is used to calculate a company’s break-even

point and help set appropriate selling prices to cover all costs and generate a profit. The
formula can reveal how well a company is using its fixed-cost items, such as its
warehouse and machinery and equipment, to generate profits. The more profit a
company can squeeze out of the same amount of fixed assets, the higher its operating
leverage.

One conclusion companies can learn from examining operating leverage is that
firms that minimize fixed costs can increase their profits without making any changes to
the selling price, contribution margin or the number of units they sell.
High and Low Operating Leverage

It is important to compare operating leverage between companies in the same

industry, as some industries have higher fixed costs than others. The concept of a high
or low ratio is then more clearly defined.

Most of a company’s costs are fixed costs that recur each month, such as rent,
regardless of sales volume. As long as a business earns a substantial profit on each
sale and sustains adequate sales volume, fixed costs are covered and profits are
earned.

Other company costs are variable costs that are only incurred when sales occur.
This includes labor to assemble products and the cost of raw materials used to make
products. Some companies earn less profit on each sale but can have a lower sales
volume and still generate enough to cover fixed costs.

For example, a software business has greater fixed costs in developers’ salaries
and lower variable costs in software sales. As such, the business has high operating
leverage. In contrast, a computer consulting firm charges its clients hourly and doesn't
need expensive office space because its consultants work in clients' offices. This results
in variable consultant wages and low fixed operating costs. The business thus has low
operating leverage.

Key Takeaways

 Companies with high operating leverage must cover a larger amount of fixed
costs each month regardless of whether they sell any units of product.
 Low-operating-leverage companies may have high costs that vary directly with
their sales but have lower fixed costs to cover each month.
 The operating leverage formula can show how a company's costs and profit
relate to each other, and show that reducing fixed costs can increase profits
without changing sales quantity, contribution margin or selling price.

Financial Leverage

Financial leverage is the main source of financial risk. By issuing more debt, the
company incurs the fixed costs associated with the debt (interest payments). The
company’s inability to meet the obligations may result in financial distress or even
bankruptcy.
 Highly leveraged companies may face significant financial problems during a
recession because their operating income will rapidly decline and, thus, so will their
overall profitability.

Degree of Financial Leverage

The degree of financial leverage is a financial ratio that measures the sensitivity
in fluctuations of the company’s overall profitability to the volatility of its operating income
caused by changes in its capital structure. The degree of financial leverage is one of the
methods used to quantify a company’s financial risk (the risk associated with how the
company finances its operations).

There are several ways to calculate the degree of financial leverage. The choice
of the calculation method depends on the goals and context of the analysis. For
example, a company’s management often wants to decide whether it should or should
not issue more debt. In such a case, net income would be an appropriate measure of the
company’s profitability:

However, if an investor wants to determine the effects of the company’s decision

to incur additional leverage, the earnings per share (EPS) is a more appropriate figure
because of the metric’s strong relationship with the company’s share price.

Finally, there is a formula that allows calculating the degree of financial leverage
in a particular time period:
 Example of Degree of Financial Leverage

ABC Corp. is preparing to launch a new project that will require substantial
external financing. The company’s management wants to determine whether it can
safely issue a significant amount of debt to finance the new project. Currently, the
company’s EBIT is P500,000, and interest payments are P100,000.

In order to make the decision, the company’s management wants to examine the
degree of financial leverage ratio:

Degree of Financial Leverage = P500,000 = 1.25

P500,000 – P100,000

It shows that a 1% change in the company’s leverage will change the company’s
operating income by 1.25%.

A high degree of financial leverage indicates that even a small change in the
company’s leverage may result in a significant fluctuation in the company’s profitability.
Also, a high degree of leverage may translate to a more volatile stock price because of
the higher volatility of the company’s earnings. Increased stock price volatility means the
company is forced to record a higher expense for outstanding stock options, which
represents a higher cost of debt. Therefore, companies with extremely volatile operating
incomes should not take on substantial leverage because there is a high probability of
financial distress for the business.

LIMITATIONS OF FINANCIAL STATEMENTS

The limitations of financial statements are those factors that a user should be
aware of before relying on them to an excessive extent. Knowledge of these factors
could result in a reduction of invested funds in a business, or actions taken to investigate
further. The following are all limitations of financial statements:

Dependence on historical costs

Transactions are initially recorded at their cost. This is a concern when reviewing
the balance sheet, where the values of assets and liabilities may change over time.
Some items, such as marketable securities, are altered to match changes in their market
values, but other items, such as fixed assets, do not change. Thus, the balance sheet
could be misleading if a large part of the amount presented is based on historical costs.
Inflationary effects
If the inflation rate is relatively high, the amounts associated with assets and
liabilities in the balance sheet will appear inordinately low, since they are not being
adjusted for inflation. This mostly applies to long-term assets.

Intangible assets not recorded

Many intangible assets are not recorded as assets. Instead, any expenditures
made to create an intangible asset are immediately charged to expense. This policy can
drastically underestimate the value of a business, especially one that has spent a large
amount to build up a brand image or to develop new products. It is a particular problem
for startup companies that have created intellectual property, but which have so far
generated minimal sales.

Based on specific time period

A user of financial statements can gain an incorrect view of the financial results
or cash flows of a business by only looking at one reporting period. Any one period may
vary from the normal operating results of a business, perhaps due to a sudden spike in
sales or seasonality effects. It is better to view a large number of consecutive financial
statements to gain a better view of ongoing results.

Not always comparable across companies

If a user wants to compare the results of different companies, their financial
statements are not always comparable, because the entities use different accounting
practices. These issues can be located by examining the disclosures that accompany
the financial statements.

Subject to fraud
The management team of a company may deliberately skew the results
presented. This situation can arise when there is undue pressure to report excellent
results, such as when a bonus plan calls for payouts only if the reported sales level
increases. One might suspect the presence of this issue when the reported results spike
to a level exceeding the industry norm.

No discussion of non-financial issues

The financial statements do not address non-financial issues, such as the
environmental attentiveness of a company's operations, or how well it works with the
local community. A business reporting excellent financial results might be a failure in
these other areas
Not verified
If the financial statements have not been audited, this means that no one has
examined the accounting policies, practices, and controls of the issuer to ensure that it
has created accurate financial statements. An audit opinion that accompanies the
financial statements is evidence of such a review.

No predictive value
The information in a set of financial statements provides information about either
historical results or the financial status of a business as of a specific date. The
statements do not necessarily provide any value in predicting what will happen in the
future. For example, a business could report excellent results in one month, and no
sales at all in the next month, because a contract on which it was relying has ended.

Financial statements are normally quite useful documents, but it can pay to be
aware of the preceding issues before relying on them too much.
NAME: SCORE:
COURSE/YR. & SEC.

FINANCIAL STATEMENT ANALYSIS

IDENTIFICATION
1 Measures the number of times profit will increase or 1
decrease in relation to change in sales
2 Indicates the efficiency in credit and collection policies 2
3 The process of analyzing a company’s financial 3
statements for decision-making purposes
4 Measures a rough estimate on the ability of the business 4
to meet its currently maturing obligations
5 Measures profit percentage per peso of sales 5
6 A more severe test of immediate liquidity 6
7 Measures the profitability of the firm in relation to the 7
market value of the stock
8 They are responsible for taking decisions and 8
formulating plans and policies for the future
9 Measures the rate of cash return to investment in stock 9
10 Measures the use of debt to finance operations 10
11 Indicates the number of times inventories were acquired 11
and sold during the period
12 Measures the relative share of creditors over the total 12
resources of the firm
13 Measures the risk associated in using debt to finance 13
investments
14 The providers of loan capital to the business 14
15 Measures the amount of resources provided by the 15
owners of the firm
16 Also known as break-even analysis 16
17 Determines the accounting rate of return on every peso 17
of investment in a project or business
18 The product’s selling price less the variable costs 18
associated with producing the product
19 Measures the rate of earnings per share of common 19
stock
20 The number of products the company must sell to cover 20
all production costs
21 Presents the difference in absolute amount and in 21
percentage between two compared variables
22 This is commonly referred to as the company’s wiggle 22
 room
23 It tells how net income changes in relation to changes in 23
sales numbers
24 The firm’s ability to employ new asset or funds to create 24
better returns or to reduce costs
25 It gets the proportional component of each of the 25
variables in the financial statements in relation to a
chosen base
26 Costs that are only incurred when sales occur 26
27 The main source of financial risk 27
28 The amount of sales the company must generate to 28
cover all production costs
29 Measures the long-term debt paying ability of the firm 29
30 It uses indexes and ratios to simplify the visible 30
complications of numbers contained in the financial
reports

TRUE OR FALSE
1 In vertical analysis, the base in the net income is the total assets 1
2 A high contribution market and a low variable expense ratio indicate 2
low levels of variable costs incurred
3 Operating leverage is about the capitals structure of the firm 3
4 Financial leverage is about the fixed costs of the firm 4
5 Trend analysis extends beyond two years 5
6 Ratios have greater disparities from one industry to another 6
7 The higher the DOL, the higher the risk 7
8 Variable costs only occur when sales occur 8
9 The higher the degree of operating leverage, the greater the potential 9
danger from forecasting risk
10 The degree of operating leverage is usually lower than the break-even 10
point
11 Firms that minimize fixed costs can increase their profits without 11
making any change in the selling price
12 Companies with high operating leverage must cover a larger amount 12
of fixed costs regardless of whether they sell any units of products
13 Highly leveraged companies may face significant financial problems 13
during recession
14 The company’s inability to meet the obligations may result in financial 14
distress
15 The management team of a company may deliberately skew the 15
results presented in the financial statement

Computation: Get a copy of a company’s financial statement for the past 2 years and
analyze it using the different financial statement analysis techniques
 WORKING CAPITAL MANAGEMENT

Working capital management involves the relationship between a firm's short-

term assets and its short-term liabilities. The goal of working capital management is to
ensure that a firm is able to continue its operations and that it has sufficient ability to
satisfy both maturing short-term debt and upcoming operational expenses. The
management of working capital involves managing inventories, accounts receivable and
payable, and cash.

CASH MANAGEMENT

Reasons for Holding Cash

 Meet operational requirements

 Provide reserves of liquidity against
- Routine net outflows of cash
- Scheduled major outlays
- Exploitation of possible opportunities (speculative motive)
- Unexpected drains of cash (precautionary motive)
 Meet bank relationship requirements
 Earn directly

Basic Guidelines in Cash Management

 Maximize available cash by the acceleration of cash collection and deferment of

cash disbursement without sacrificing credit standing
 Invest excess cash over the required minimum
 Promote healthy relationship with financial institutions

Float - the length of time between writing of a check and receipt of funds so that the
recipient can draw upon them (that is, when it has good funds)
Cash budget - forecast of how much collections and inflows are expected at what
time and the corresponding amount and timing of cash payments
Minimum cash balance - the level of average cash a firm maintains on hand
calculated to be able to meet all cash demands and maturing obligations
within a specified period
Precautionary Measures to Prevent Cash Losses

 Periodic audit of accounting records

 Unannounced cash counts of money
 Investigation of cashiers
 Cash receipts are deposited
 Provision of counterchecks

ACCOUNTS RECEIVABLES MANAGEMENT

Since most business sales are made on credit terms, the investment in
receivables represents a major and continuing commitment of funds for most business
enterprises. The investment is increased as new credit sales are recorded and is
reduced as payments in settlement of purchase obligations are received from customers
or bad debts are written off.

Factors that Determine the Level of Investment in Accounts Receivable

Credit Standard – set of screening or pre-qualification standards set by the company

relative to its customers

The trade-offs involved in credit standard choice is quite clear. A “loose credit
standard will increase sales but will also increase the amount of funds tied up in
receivables and could increase bad debts because of credit extended to marginal
customers. A “tight” standard reduce these two problems but may prevent the company
from optimizing on its sales potential.

The trade-offs suggest that the finance manager should evaluate alternative
credit and collection policies. The policy which yields the highest expected net benefit
should be adopted by the company. In principle, the optimal credit standard is that level
where the margin on incremental sales equals the required return on additional
investment in receivables.

The finance manager must respond to such problems as: a) How to determine an
appropriate credit standard based only on observable attributes of the customer b) How
to estimate the effect on sales and any increase in bad debts. The traditional
specification of the customer’s attributes is the so-called “five Cs of credit – character,
capacity, capital, collateral and condition.
Character – the customer’s payment habits and attitudes, i.e., his willingness to pay
Capacity – the customer’s ability to pay as reflected in his cash flows
Capital – the net worth position of the customer relative to outstanding debts
Collateral – any asset which can be pledged against the debt
Condition – the economic factors which affect the customer’s capacity to pay

We can further simplify the above classification by referring to only the first two
elements: character and capacity. The capacity to pay can be expanded to include not
only the primary source of repayment (cash flows) but also the secondary sources
(capital and collateral). Similarly, the economic conditions influence both the customer’s
willingness and ability to pay. Between the two factors, the capacity to pay is the more
observable attribute of the customer.

Credit Terms – the conditions of sales on account which include the credit period and
any cash discounts given to encourage prompt payment

In either case, the incremental approach to the choice problem can be applied.
An extension of the credit period will probably increase sales and profits and should be
done for as long as it compensates for the opportunity cost on the higher investment in
accounts receivable. On the other hand, a decision to grant cash discounts will reduce
margins as well as the investment in accounts receivable for any given level.

Collection Program – strategies, organization and procedures for recovery of receivables

The company may consider various collection strategies: should it subcontract

collections through a collection agency or should collections be done in-house? As a
policy, should it employ “high pressure” collection tactics or the more indirect
approaches? The choice for collections may range from the use of salesmen to double-
up as collectors to a separate decentralized collection unit responsible only for that
function. Finally, procedures involve the keeping of records, billing, conducting follow-up
phone calls or personal client visits and undertaking legal actions.

The objectives of a collection program are:

a) To reduce the amount of bad debt losses while controlling collection costs
b) To reduce the company’s investment in accounts receivable
 Summary of Trade-offs in Credit and Collection Policies
Contemplated change Benefits Costs
 Opportunity cost of higher
Relax credit standard?  Higher sales and investment in receivables
contribution margin  Higher bad debts
 More clerical and credit
processing costs
 Higher sales and  Opportunity cost of higher
Extend credit period? contribution margin investment in receivables
 Opportunity income on  Lower profit margin
Give cash discounts? lower investment in
receivables
 Possibly higher sales and
total contribution margin
Intensify collection efforts?  Lower bad debts  Higher collection-related
 Opportunity income on expenditures
lower investment in  Possibly lower sales and
receivables contribution margin

Sources of Credit Information

1. Accounting statements
2. Credit ratings and reports
3. Banks
4. Trade associations
5. Company’s own experience

Collection Policy

Collection Department – responsible for monitoring and following up on receivables

The credit manager should determine the reasons why accounts become
overdue and delinquent and then the customers so that proper measures can be
initiated. Customers may be classified into the following:
- Customers who honestly misunderstood the terms of sale
- Customers who overlook their accounts
- Customers who disregard due dates
- Customers who tend to stretch their payables
- Customers who usually pay but are temporarily illiquid
 - Customers who are deliberately delinquent
- Customers who are insolvent

Stages of Collection
1. Preliminary stage- usually involves the sending of monthly statements
2. Reminder stage – reminder is sent to customer several days after due date
3. Follow-up stage – where successive action are undertaken at regularly spaced
interval
4. Drastic stage – this stage is only resorted to if the company is ready to lose the
customer (collection is through an attorney or collection agency)

INVENTORY MANAGEMENT

An inventory is a stock or store of goods. A major distinction in the way inventory

planning and control is managed is whether demand for items in inventory is
independent or dependent. Dependent demand items are typically subassemblies or
component parts that will be used in the production of a final or finished product. In such
cases, demand or subassemblies and component parts essentially depends on the
number of finished units that will be produced. Independent demand items on the other
hand, are the finished goods or other end items. In such cases, there is usually no way
to precisely determine how many of these items will be demanded during any given time
period because demand typically include elements of randomness. Therefore,
forecasting plays an important role in stoking decisions, whereas for dependent demand
items stock requirements are determined by reference to the production plan.
Types of Inventories

1. Raw materials and purchase parts

2. Partially completed goods (work in process) or goods in transit
3. Finished goods inventories (manufacturing firms) or merchandise (retail stores)

Functions of Inventory

1. To meet anticipated customer demand

These inventories are referred to an anticipation stocks because they are
held to satisfy planned or expected
2. To smooth production requirements
Firms that experience seasonal patterns in demand often build up
inventories during off-season periods in order to meet overly high requirements
 that exist during certain seasonal periods. These inventories are aptly named
seasonal inventories.
3. To decouple operations
Unless successive steps in production or distribution systems have a
buffer of inventories between them, they will be so interdependent than an
interruption at one point will quickly cause the entire system to halt, as individual
steps in the operations have to cease and operations shut down after the other in
domino fashion.
4. To protect against stock outs
Delayed deliveries and unexpected increases in demand increase the risk
of shortages. Delays can be due to weather conditions, supplier stock-outs,
deliveries of wrong materials, quality problems and so on. The risk of shortages
can be reduced, by holding safety stocks, which are stocks in excess of
anticipated demand.
5. To take advantage of order cycles
To minimize purchasing and inventory costs, it is often necessary to buy
quantities that exceed immediate usage requirements. Similarly, it is usually
economical to produce in larger rather than in small quantities, again, in excess
output which will be stored for later use.
6. To hedge against price increases
Occasionally, a firm will suspect that a substantial price increase is about
to be made and purchase larger-than-normal amounts to achieve some savings
7. To permit operations
The fact that production operations take a certain amount of time means
that there will be generally be some work-in-process inventory. In addition,
intermediate stocking of goods – including raw materials, semi-finished and
finished goods at production

Risks in Inventory Investment

1. Price decline
2. Obsolescence
3. Risk to liquidity

Inventory Costs

Holding or carrying costs – relate to physically holding items in storage. They include
interest, insurance, taxes, depreciation, obsolescence, deterioration, spoilage, pilferage,
breakage and warehousing costs (heat, light, rent, security). It also includes opportunity
costs associated with having funds tied up in inventory that could be used elsewhere

Ordering costs – are the costs associated with ordering and receiving inventory. These
costs include determining how much is needed, typing up invoices, inspecting goods
upon arrival for quality and quantity and moving the goods to temporary storage. When
a firm produces its own inventory instead of ordering it from a supplier, the costs of
machine setup (preparing equipment for the job by adjusting the machine, changing
cutting tools and so on) are analogous to ordering costs

Shortage costs – results when demand exceeds the supply of inventory on hand. The
costs can include the opportunity cost of not making a sale, loss of customer goodwill,
lateness charges, and similar costs. Furthermore, if the shortage occurs in an item
carried for internal use, the cost of lost production or downtime is considered a shortage
cost. Shortage costs are usually difficult to measure, and they are often subjectively
estimated.

Economic Order Quantity (EOQ)

EOQ is the optimum quantity of goods to be purchased at one time in order to

minimize the annual total costs of ordering and carrying or holding items in inventory.

2SO C
EOQ =

Where: S = total inventory requirement per period

O = ordering cost per order
C = carrying cost per unit

Example: Assume that the total requirement is 5,000 units per year, ordering cost is
P200 per order and carrying cost is P50 per unit per year.
2(5,000)(P200) P50
EOQ = = 200 units

Quantity Discount

The issue in quantity discount is whether the company should deviate from its
EOQ formula in order to take advantage of the discount.
Example: Suppose the supplier is willing to offer a P1 discount/unit if the order is at
least 400 units.

Annual savings due to discount = discount per unit x annual requirement

= P1 x 5,000
= P5,000

The incremental cost is the additional carrying cost less the reduction in ordering costs
due to fewer orders. Let Q’ be the minimum order size to avail the discount.

Incremental cost = [(Q’ – Q) / 2 x C] – [(S/Q – S/Q’) O]

= [(400 – 200) / 2 x P50] – [(5,000/200 – 5,000/400)(200)]
= P5,000 – P2,500
IC = P2,500

Net incremental benefit = P2,500

NAME: SCORE:
COURSE/YR. & SEC.

WORKING CAPITAL MANAGEMENT

IDENTIFICATION
1 Set of screening or pre-qualification standards set by the 1
company relative to its customers
2 Responsible for monitoring and following up on 2
receivables
3 Stock or store of goods 3
4 Its goal is to ensure that a firm is able to continue its 4
operations and that it has sufficient ability to satisfy both
maturing short-term debt and upcoming operational
expenses
5 That level where the margin on incremental sales equals 5
the required return on additional investment in
receivables
6 The customer’s ability to pay as reflected in his cash 6
flows
7 The length of time between writing of a check and 7
receipt of funds so that the recipient can draw upon
them
8 Collection stage resorted to if the company is ready to 8
lose the customer
9 These could include the opportunity cost of not making a 9
sale, loss of customer goodwill, lateness charges
10 Forecast of how much collections and inflows are 10
expected at what time and the corresponding amount
and timing of cash payments
11 The optimum quantity of goods to be purchased at one 11
time in order to minimize the inventory costs
12 The customer’s payment habits and attitudes 12
13 The costs associated with ordering and receiving 13
inventory
14 The level of average cash a firm maintains on hand 14
calculated to be able to meet all cash demands and
maturing obligations within a specified period
15 These are typically subassemblies or component parts 15
that will be used in the production of a final or finished
product
16 The net worth position of the customer relative to 16
 outstanding debts
17 These are finished goods or other end items 17
18 Stocks in excess of anticipated demand 18
19 Any asset which can be pledged against the debt 19
20 Strategies, organization and procedures for recovery of 20
receivables
21 Costs related to physically holding items in storage 21
22 The conditions of sales on account which include the 22
credit period and any cash discounts given to encourage
prompt payment
23 The economic factors which affect the customer’s 23
capacity to pay
24 Collection stage which usually involves the sending of 24
monthly statements
25 The additional carrying cost less the reduction in 25
ordering costs due to fewer orders

TRUE OR FALSE
1 A loose credit standard will lower sales 1
2 A loose credit standard will lower the amount of funds tied up in 2
receivables
3 An intensive collection effort will possibly lower sales and 3
contribution margin
4 Shortage costs are usually easy to measure 4
5 A tight credit standard may prevent the company from optimizing 5
its sales potential
6 A decision to grant cash discounts will increase profit margins 6
7 An intensive collection effort will lower bad debts 7
8 The policy which yields the highest expected net benefit should be 8
adopted by the company
9 Giving cash discounts will probably lead to higher sales and 9
contribution margin
10 An extension of the credit period will lead to a higher opportunity 10
cost due to higher investment in accounts receivables

ESSAY

1. What are the risks incurred when you keep/stock goods? Explain

2. Discuss the factors that determine the level of investment in accounts

receivables

3. Discuss the basic guidelines in cash management

 SOURCES OF FINANCING

Sources of capital are the most explorable area especially for the entrepreneurs
who are about to start a new business. It is perhaps the toughest part of all the efforts.
There are various capital sources, we can classify on the basis of different parameters.

Choosing the right source and the right mix of finance is a key challenge for
every finance manager. The process of selecting the right source of finance involves in-
depth analysis of each and every source of fund. For analyzing and comparing the
sources, it needs the understanding of all the characteristics of the financing sources.
There are many characteristics on the basis of which sources of finance are classified.

On the basis of a time period, sources are classified as long-term, medium term,
and short term. Ownership and control classify sources of finance into owned capital and
borrowed capital. Internal sources and external sources are the two sources of
generation of capital. All the sources of capital have different characteristics to suit
different types of requirements.
ACCORDING TO TIME PERIOD

Sources of financing a business are classified based on the time period for which
the money is required. The time period is commonly classified into following three:

Long Term Sources of Medium Term Sources of Short Term Sources Of

Finance/Funds Finance/Funds Finance/Funds

Share Capital or Equity Preference Capital or Trade Credit

Shares Preference Shares Factoring Services
Preference Capital or Debenture / Bonds Bill Discounting etc.
Preference Shares Lease Finance Advances received from
Retained Earnings or Hire Purchase Finance customers
Internal Accruals Medium Term Loans from Short Term Loans like
Debenture / Bonds Financial Institutions, Working Capital Loans
Term Loans from Financial Government, and from Commercial
Institutes, Government, Commercial Banks Banks
and Commercial Banks Fixed Deposits (<1 Year)
Venture Funding Receivables and Payables
Asset Securitization
International Financing by
way of Euro Issue,
Foreign Currency
Loans, ADR, GDR etc.

Long-Term Sources of Finance

Long-term financing means capital requirements for a period of more than 5

years to 10, 15, 20 years or maybe more depending on other factors. Capital
expenditures in fixed assets like plant and machinery, land and building etc of a
business are funded using long-term sources of finance. Part of working capital which
permanently stays with the business is also financed with long-term sources of funds.
Long-term financing sources can be in form of any of them
Share Capital or Equity Shares

They fall under long-term sources of finance- category because legally they are
irredeemable in nature. For an investor, these shares are a certificate of ownership in
the company by virtue of which investors are entitled to share the net profits and have a
residual claim over the assets of the company in the event of liquidation. Investors have
voting rights in the company and their liability to the company limits to the amount of
issue price of the equity stock.

Normally, a company is started with equity finance as its first source of capital
from the owners or promoters of that company. After a certain level of growth, there is a
requirement for more capital for further growth. The company then finds an investor in
the form of friends, relatives, venture capitalists, mutual funds, or any such small group
of investors and issue fresh equity shares to these investors.

A point comes where the company reaches a very big level and requires huge
capital investment for business growth. Initial Public Offer (IPO) is the offer of shares
which the company makes to the general public for the first time,

Equity financing is one of the main funding options for any corporation. To
understand the pros and cons of equity finance from a company point of view, let’s
discuss the benefits and disadvantages of equity as a source of financing.

Advantages

1. Permanent Source of Finance

Equity financing is the permanent solution to financial needs of a
company. No company’s main focus or objective can be financial management
only. A product manufacturing company will have an objective of producing high-
quality goods and reach to its right consumer. A service provider company will
ensure providing high-quality services. Equity finance provides that leverage to
the management to continuously focus on fulfilling their core objectives. It keeps
management away from the hassles of raising funds again and again like other
sources of financing viz. debt. Debt is raised and paid back over a period of time.

2. No Obligatory Dividend Payments

Equity finance for a new company is like blessings of an angel. The main
limitation of a new company is the uncertainty of cash flows. Equity mode of
finance gives management a breathing space by having no fixed obligation to
pay dividends. A company can choose to pay no dividend or smaller dividends as
per the cash flow position.
3. Open Chances of Borrowing
A company, majorly financed by equity, always has a controlled financial
leverage ratio. Financial leverage ratio measures the ratio of financing to equity
and debt. Lower levered firms have higher chances of smooth borrowing of debt
in times of need.

4. Retained Earnings
A company develops an internal source of finance by having equity
finance on board. The earnings which a company generates using the capital can
be retained by the company to finance the increased working capital and other
fund requirements. It obviates the other hassles of raising funds via other
sources. Also, if the funds are utilized in projects with higher returns compared to
what is available to the equity shareholders, the company effectively achieves its
objective of shareholder’s wealth maximization.

5. Rights Shares
A company can get required capital via an issue of rights shares from its
existing capital providers which have almost nil floatation cost. Floatation cost is
the cost incurred in raising funds.

Disadvantages

1. Floatation Cost
Financing through equity is the most difficult way of getting funds to the
company. Not only does it require a lot of statutory compliances but also have
other costs like fee of a merchant banker, other expenses such as brokerage,
underwriting fee, and lots of other issue expenses.

2. High Cost of Funds

Equity finance is considered to be the costly source of finance especially
in comparison to debt. The obvious reason is the higher required rate of return
from equity share investors. Since equity share investment is a high-risk
investment, an investor will always expect a higher rate of returns.

3. No Tax Shield
The dividends distributed to the shareholders are not a tax-deductible
expense. On the contrary, the interest expense is an eligible expense for tax
 benefits. This benefit is not available to the equity source of financing and
therefore, it is considered as a costly source of financing.

4. Underwriting of Shares
At the time of offering equity shares to the public, the company normally
requires the appointment of underwriters. The job of an underwriter is to assume
the risk of subscription. Underwriters would agree to subscribe the shares to the
extent not subscribed by the general public and will charge a fee for that service.
The fee may be in the form of upfront payment or maybe a discounted equity
share price.

5. Dilution of Control
When a company raises funds via equity, it dilutes the existing
shareholder’s control. Percentage shareholding is reduced when new
shareholders are introduced. In the case of debt financing, the control does not
dilute.

6. No Benefit of Leverage
Debt funding has an indirect benefit available to the existing owners.
Since a project with the higher rate of return (12%) than the cost of debt funds
(8%) would enhance the welfare of the shareholders. It is because the margin of
4% will be distributed to the existing shareholders. If the project was financed by
equity, this additional benefit would not have occurred to the existing
shareholders but would equally distribute between old and new shareholders.

Preference Shares

Preference shares are one of the special types of share capital having fixed rate
of dividend and they carry preferential rights over ordinary equity shares in sharing of
profits and also claims over assets of the firm. It is ranked between equity and debt as
far as priority of repayment of capital is concerned.

Preference shares are a long-term source of finance for a company. They are
neither completely similar to equity nor equivalent to debt. The law treats them as shares
but they have elements of both equity shares and debt. For this reason, they are also
called ‘hybrid financing instruments’. These are also known as preferred stock or
preferred shares.
Features of Preference Shares Similar to Debt

1. Fixed Dividends
Like debt carries a fixed interest rate, preference shares have fixed
dividends attached to them. But the obligation of paying a dividend is not as rigid
as debt. Non-payment of a dividend would not amount to bankruptcy in case of
preference share.

2. Preference over Equity

As the word preference suggests, these type of shares get preference
over equity shares in sharing the income as well as claims on assets.
Alternatively, preference share dividend has to be paid before any dividend
payment to ordinary equity shares. Similarly, at the time of liquidation also, these
shares would be paid before equity shares.

3. No Voting Rights
Preference share capital is not allotted any voting rights normally. They
are similar to debenture holders and do not have any say in the management of
the company

4. No Share in Earnings
Preference shareholders can only claim two things. One agreed on
percentage of dividend and second the amount of capital invested. Equity shares
are entitled to share the residual earnings and residual assets in case of
liquidation which preference shares are not entitled to.

5. Fixed Maturity
Just like debt, preference shares also have fixed maturity date. On the
date of maturity, the preference capital will have to be repaid to the preference
shareholders. A special type of shares i.e. irredeemable preference shares is an
exception to this. They do not have any fixed maturity.

Features of Preference Shares Similar to Equity Shares

1. Dividend from PAT

Equity share dividend is paid out of the profits left after all expenses and
even taxes and same is the case with preference shares. The preference
dividend is paid out of the divisible profits of the company. Out of the divisible
 profits, the preference dividend would be paid first and the remaining profits can
be utilized for paying any dividend to equity shareholders.

2. Management Discretion Over Dividend Payment

The payment of preference dividend is not compulsory and is a decision
of the management. Equity shareholders also do not have any right to ask for
dividends, the dividends are paid at the discretion of the management of the
company. Unlike debt, the nonpayment of a dividend of preference shares does
not amount to bankruptcy.

3. No Fixed Maturity
The maturity of a special variant of preference share is not fixed just like
equity shares. This variant is popularly known as irredeemable preference
shares.

Advantages

1. No Legal Obligation for Dividend Payment

There is no compulsion of payment of preference dividend because
nonpayment of dividend does not amount to bankruptcy. This dividend is not a
fixed liability like the interest on the debt which has to be paid in all
circumstances.

2. Improves Borrowing Capacity

Preference shares become a part of net worth and therefore reduce debt
to equity ratio. This is how the overall borrowing capacity of the company
increases.

3. No dilution in control
Issue of preference share does not lead to dilution in control of existing
equity shareholders because the voting rights are not attached to the issue of
preference share capital. The preference shareholders invest their capital with
fixed dividend percentage but they do not get control rights with them.

4. No Charge on Assets
While taking a term loan security needs to be given to the financial
institution in the form of primary security and collateral security. There are no
such requirements and therefore, the company gets the required money and the
assets also remain free of any kind of charge on them.
Disadvantages

1. Costly Source of Finance

Preference shares are considered a very costly source of finance which is
apparently seen when they are compared with debt as a source of finance. The
interest on the debt is a tax-deductible expense whereas the dividend of
preference shares is paid out of the divisible profits of the company i.e. profit
after taxes and all other expenses. For example, the dividend on preference
share is 9% and an interest rate on debt is 10% with a prevailing tax rate of 50%.
The effective cost of preference is same i.e. 9% but that of the debt is 5% {10% *
(1-50%)}. The tax shield is the main element which makes all the difference. In
no tax regime, the preference share would be comparable to debt but such a
scenario is just an imagination.

2. Skipping Dividend Disregard Market Image

Skipping of dividend payment may not harm the company legally but it
would always create a dent on the image of the company. While applying for
some kind of debt or any other kind of finance, the lender would have this as a
major concern. Under such a situation, counting skipping of dividend as an
advantage is just a fancy. Practically, a company cannot afford to take such a
risk.

3. Preference in Claims
Preference shareholders enjoy a similar situation like that of an equity
shareholder but still get a preference in both payment of their fixed dividend and
claim on assets at the time of liquidation.

Term Loan

The term loan is a long term secured debt extended by banks or financial
institutions to the corporate sector for carrying out their long-term projects maturing
between 5 to 10 Years which is normally repaid in monthly or quarterly equal installment.
They are an external source of finance paid in installments governed by loan agreement
and covenants.

All the capital requirements cannot be fulfilled by the promoters or equity share
issues and that is where the term loans come into the picture. Term loan or project
finance is a long-term source of finance and a credit appraisal for a company normally
extended by financial institutions or banks for a period of more than 5 years to a
maximum of around 10 years. One common feature which helps management in
relatively substituting equity by term loans is the long term of the loan.

The term loan is a type of funding which is most suitable for projects involving
very heavy investment which is not possible by an individual or promoters. Big projects
cannot be concluded in a year or two.

To yield return from them, the long-term perspective is required. Such big
ventures are normally financed by big banks and financial institutions. If the investment
is too large, several banks come together and finance it. Such type of term loan funding
is also called as consortium loan.

The term loan is acquired for new projects, diversification of business, expansion
projects, or for modernization or technology upgrade. Here also, the underlying fact is
that the investment in these projects is normally very huge. Lack of option of funding
from other sources such as equity etc for any reason also directs a company to go for
the term loan.

Features of a Term Loan

1. Loan in any Currency

These loans are provided both in the home or foreign currency. Home
currency loans are offered normally for a purchase of fixed assets such as land,
building, plant and machinery, preliminary and preoperative expenses, technical
know-how, working capital etc. On the other hand, foreign currency loans are
offered for import of certain plant or machinery, payment of foreign consulting fee
etc.

2. Secured Loan
Term loans come under the secured category of loans. Two kinds of
securities are there – primary and collateral. Primary security is the asset which
is purchased using the loan amount and collateral security is the charge on other
assets of the borrower.

3. Loan Instalments
Repayment of the loan is done in installments. These installments cover
both principal and interest. Normally, loan installments are decided by banks
based the borrower’s cash flow capacity. There may be installments paid
 monthly, quarterly, biannually, or even annually. Installments are normally equal
but they may be structured based on the borrower’s business. Moratorium or
grace period is also given by banks in which no installment or very low
installment is asked from the borrower. Sometimes, small installments are kept in
the initial year or two and then the remaining loan is split into the remaining
maturity period making the later installments higher than the initial ones.

4. Maturity
Normally a term loan is ranging between 5 to 10 years. Forecasting for
more than 10 years in the current changing business environment is very difficult.

5. Loan Agreement
An agreement is drafted between the borrower and the bank regarding
the terms and conditions of the loans which are signed by the borrower and is
preserved with a bank.

6. Loan Covenant
Debt covenants are a part of a loan agreement. They are certain
statements in the agreement which states certainly do’s and dont’s for the
company. They are normally related to use of assets, creation of liabilities, cash
flow, and control of the management. They are positive/ affirmative or negative in
nature.

Debentures/Bonds

Debentures are one of the common long-term sources of finance. They normally
carry a fixed interest rate and a certain date of maturity. Debentures are issued to the
general public and therefore the financier is the general public.

Since both debentures and term loans are types of debt financing, they share
basic characteristics of debt and hence their advantages and disadvantages are also
similar. Following are some benefits and disadvantages of debt financing (debentures or
term loans) from the point of view of a company.

Advantages of Debt Financing – Debentures and Term Loans

1. Benefit of Tax
 ‘Debt Financing’ or ‘Issuing of Debenture’ results in interest expense for
the borrower which is a tax-deductible expense. A company can claim an interest
as an expense against its profits. Whereas dividends paid to equity or preference
shareholders are paid out of net profits after taxes. In short, debt financing such
as debentures, term loans etc avails tax benefit to the borrower which is not there
in case of equity.

2. Cheaper Source of Finance

The interest cost incurred on debt financings such as debentures or term
loans enjoys a tax shield which indirectly lowers the cost. Effective interest cost
of a 12% debenture with current tax rate of 30% is 8.4% {12% * (1-30%)}. The
underlying assumption behind the calculation is that the entity is making the profit
at least to the tune of total interest payment. Even the rate of interest is lower
than the cost of equity. It is because of the reason that debt financiers have
comparatively lower risk, so they are offered less return. Following are the
reasons due to which investors of debenture have a comparatively lower risk.

3. No Dilution of Control
Issuing of debentures or accepting bank loan does not dilute the control
of the existing shareholders or the owners of the company over their business. If
there is a rise in the same fund using equity finance, there are chances of losing
the control of existing shareholders.

4. No Dilution in Share of Profits

Opting for debentures over the equity as a source of finance keeps intact
the profit-sharing percentage of existing shareholders. Debenture holders or
financial institutions do not share profits with the company. They are liable to
receive the agreed amount of interest only. Therefore, the same number of
hands share the profits before and after the new project. However, in the case of
convertible debentures (debentures who convert into equity shares after a certain
point of time), this may no more remain an advantage. As the debenture holders
would then become equity shareholders receiving all the rights as of the equity
shareholder’s.

5. The benefit of Financial Leverage

By involving debt in a profit-making company, the management can
always maximize the wealth of the shareholders. For example, the internal rate of
return of a company is 15% against a 12% rate of interest on debt funds. The
shareholders share the extra 3% of earning out of the money of say debenture
 holders. Since there is a definite interest cost on the debt. Therefore the returns
over and above the cost of interest spill over into the hands of shareholders only.
This is how financial leverage converts into wealth maximization. All this is true
under the condition that the rate of return on investment on debt funds is at least
greater than the percentage of interest.

6. Disciplinary Effect
There is a burden of interest despite business profit or loss, operational
situations etc. This makes the entrepreneur all the more cautious and committed
to managing the business and maintaining the cash flows effectively. It is
because a severe punishment i.e. ‘bankruptcy’ is enclosed for nonpayment of
debenture interest on time. It is similar to the situation of a car seat belt. One
uses it more because of the penalties, the government authority imposes rather
than for the safety reason. Similarly, a fixed installment of debt repayment brings
in a discipline in the management for better management of cash flows and other
operations.

7. Low Issue Cost

In the case of a term loan, there is a comparatively lower cost of the
issuance whereas in the case of equity financing, there is a huge cost of
issuance.

8. Fixed Installments
Debt financing by term loan or debentures has fixed installments/coupon
payments till the maturity of the loan. In a rising economy with increasing
inflation, the effective cost of future installments decreases due to a decline in the
value of the currency.

9. No Harm in Communicating Critical Business Secrets

In the case of a term loan, the company may have to reveal a lot of
information about the company to the financial institutions. By entering into NDA
(non-disclosure agreement), the company can ensure its secrets remaining
hidden from its competitors.

10. Callable Debentures / Bonds

There can a debenture or Bond issuance with a callable feature. If in case
there is a decrease in the rate of interest in the market, the company can redeem
 existing debenture. It can do so by offering premium and can issue new debt
financing at a lower interest rate.

Disadvantages of Debt Financing – Debentures And Term Loans

1. Rigid Obligation
‘Interest paid to the debenture holders’ or ‘installment and interest of term
loan’ is a legal obligation and the business has to honor the same come what
may. This feature of debt financing, in general, creates a problem for the
business in the bad times. Economic and other environmental ups and down are
certain to come. Under those situations, a new business which is just about to
take off cannot have such disciplined cash flows to pay the interest or installment
timely.
Therefore, debenture and term loans are not a right kind of financing
option for them, especially in their nascent stage. This fixed expense may create
a big mismatch with their cash flows and the company may have to go into
bankruptcy. A term loan can still be viable because banks provide moratorium or
gestation period or at times adjust the obligation with the pattern of cash inflows
of the company. Such modifications are not possible in debentures.

2. Enlarge Leverage Ratios

Debt financing raises the leverage of the business. High leverage means
the high risk of bankruptcy. Bankruptcy is not the only risk but if the rate of return
of the company declines below the debenture interest rate at a later stage after
issuing the debentures, it can bring the whole project on a toss. The costs of
projects may increase due to market conditions but interest payment would not
change to compensate such increase in costs.

3. Restrictive Covenants
In the trust deed formed between the company and the trustee bank or
financial institution, there are certain restrictive covenants which restrict the
hands of the management from doing business with liberty. There are various
restrictions with respect to usage of assets, the creation of liabilities, cash flows,
control etc. They may stumble upon every business decision and affect the
effectiveness of the overall decision-making process.

4. Bad for Low Inflationary Conditions

Although fixed interest has certain benefits like it is beneficial to high
inflation environment, it also accompanies disadvantages. Under low inflationary
 conditions, the cash outflow remains constant but the value of the money
increases. To compare it with business situations, the market price of the
products of the company will decline in low inflationary conditions but the interest
payment will remain the same and hence that will create a loss-making
mismatch.

Venture Funding

Venture funding is a funding process in which the venture funding companies

manage the funds of the investors who want to invest in new businesses which have the
potential for high growth in future. The venture capital funding firms provide the funds to
start ups in exchange for the equity stake. Such a startup is generally one that
possesses the ability to generate high returns. However, the risk for venture capitalists is
high.

Asset Securitization

Securitization is the financial practice of pooling various types of contractual debt

such as residential mortgages, commercial mortgages, auto loans or credit card debt
obligations (or other non-debt assets which generate receivables) and selling their
related cash flows to third party investors as securities, which may be described as
bonds, pass-through securities, or collateralized debt obligations (CDOs). Investors are
repaid from the principal and interest cash flows collected from the underlying debt and
redistributed through the capital structure of the new financing. Securities backed by
mortgage receivables are called mortgage-backed securities (MBS), while those backed
by other types of receivables are asset-backed securities (ABS).

Internal Accruals and Retained Earnings

The internal accruals of a business are the accumulation of retained earnings

and depreciation charges.

Internal accruals are used by corporate management for a number of reasons.

The term depreciation refers to the capital expenditure allocation to various time periods
for which the expenditure is expected to improve the financial condition of the firm. The
depreciation charge is considered an internal source of funds and is a non-cash charge.
The retained earnings make a portion of the equity earnings that are reinvested in the
business.
 Retained earnings may also be described as sacrifices made by the
shareholders. Companies generally retain 30% to 80% of their after-tax profit for the
financial growth of the firm. The reserves and surplus representing the accumulated
retained earnings constitute an important source of long term financing.

Advantages

1. The retained earnings are easily available to the business, requiring no need to
consult its lenders or shareholders.

2. Control of the business is not weakened when it uses the retained earnings.

3. The extra equity infusion is effectively represented by the retained earnings.

Unlike external equity, retained earnings eliminate the losses and issue costs on
account of under-pricing.

4. Stock markets view retained earnings in a more positive light than equities.

Disadvantages

1. There is a limit to how much a firm can earn from the retained earnings. As the
companies are engaged in a stable dividend policy, the amount of the retained
earnings by the firms is highly variable.

2. There are many firms that do not fully support the opportunity cost of retained
earnings. This makes the retained earnings easily available, and they may invest
in the projects that are sub-marginal.

3. The opportunity costs of retained earnings are quite high.

Medium Term Sources of Finance

Medium term financing means financing for a period of 3 to 5 years and is used
generally for two reasons. One, when long-term capital is not available for the time being
and second, when deferred revenue expenditures like advertisements are made which
are to be written off over a period of 3 to 5 years.

Preference Capital or Preference

Shares Debenture / Bonds

Medium Term Loans from Financial Institutions and

Government Leasing

A famous quote by Donald B. Grant says, “Why own a cow when the milk is so
cheap? All you really need is milk and not the cow.” The concept of Lease is influenced
by this quote. We can compare ‘milk’ with the ‘rights to use an asset’ and ‘cow’ with the
‘asset’ itself. Ultimately, a person who wants to manufacture a product using machinery
can get to use that machinery under a leasing arrangement without owning it.

A lease can be defined as an arrangement between the lessor (owner of the

asset) and the lessee (user of the asset) whereby the lessor purchases an asset for the
lessee and allows him to use it in exchange for periodical payments called lease rentals
or minimum lease payments

At the conclusion of the lease period, the asset goes back to the lessor (the
owner) in an absence of any other provision in the contract regarding compulsory buying
of the asset by the lessee (the user). There are four different things possible post-
termination of the lease agreement.

1. The lease is renewed by the lessee perpetually or for a definite period of

time.
2. The asset goes back to the lessor.
3. The asset comes back to the lessor and he sells it off to a third party.
4. Lessor sells to the lessee.

Advantages of Leasing

1. Balanced Cash Outflow

The biggest advantage of leasing is that cash outflow or payments related
to leasing are spread out over several years, hence saving the burden of one-
time significant cash payment. This helps a business to maintain a steady cash-
flow profile.

2. Quality Assets
While leasing an asset, the ownership of the asset still lies with the lessor
whereas the lessee just pays the rental expense. Given this agreement, it
becomes plausible for a business to invest in good quality assets which might
look unaffordable or expensive otherwise.

3. Better Usage of Capital

Given that a company chooses to lease over investing in an asset by
purchasing, it releases capital for the business to fund its other capital needs or
to save money for a better capital investment decision.
4. Tax Benefit
Leasing expense or lease payments are considered as operating
expenses, and hence, of interest, are tax deductible.

5. Off-Balance Sheet Debt

Although lease expenses get the same treatment as that of interest
expense, the lease itself is treated differently from debt. Leasing is classified as
an off-balance sheet debt and doesn’t appear on the company’s balance sheet.

6. Better Planning
Lease expenses usually remain constant for over the asset’s life or lease
tenor or grow in line with inflation. This helps in planning expense or cash outflow
when undertaking a budgeting exercise.

7. Low Capital Expenditure

Leasing is an ideal option for a newly set-up business given that it means
lower initial cost and lower CapEx requirements.

8. No Risk of Obsolescence
For businesses operating in the sector, where there is a high risk of
technology becoming obsolete, leasing yields great returns and saves the
business from the risk of investing in a technology that might soon become out-
dated. For example, it is ideal for the technology business.

9. Termination Rights
At the end of the leasing period, the lessee holds the right to buy the
property and terminate the leasing contract, thus providing flexibility to business.

Disadvantages of Leasing

1. Lease Expenses

Lease payments are treated as expenses rather than as equity payments

towards an asset.

2. Limited Financial Benefits

If paying lease payments towards a land, the business cannot benefit
from any appreciation in the value of the land. The long-term lease agreement
also remains a burden on the business as the agreement is locked and the
expenses for several years are fixed. In a case when the use of asset does not
serve the requirement after some years, lease payments become a burden.

3. Reduced Return for Equity Holders

 Given that lease expenses reduce the net income without any
appreciation in value, it means limited returns or reduced returns for an equity
shareholder. In such a case, the objective of wealth maximization for
shareholders is not achieved.

4. Debt
Although lease doesn’t appear on the balance sheet of a company,
investors still consider long-term lease as debt and adjust their valuation of a
business to include leases.

5. Limited Access to Other Loans

Given that investors treat long-term leases as debt, it might become
difficult for a business to tap capital markets and raise further loans or other
forms of debt from the market.

6. Processing and Documentation

Overall, to enter into a lease agreement is a complex process and
requires thorough documentation and proper examination of an asset being
leased.

7. No Ownership
At the end of the leasing period, the lessee doesn’t end up becoming the
owner of the asset though quite a good sum of payment is being done over the
years towards the asset.

8. Maintenance of the Asset

The lessee remains responsible for the maintenance and proper
operation of the asset being leased.

9. Limited Tax Benefit

For a new start-up, the tax expense is likely to be minimal. In these
circumstances, there is no added tax advantage that can be derived from leasing
expenses.

Hire Purchase

An agreement in which the owner of the assets lets them on hire for regular
installments paid by the hirer. The hirer has the option to purchase and own the asset
once all the agreed payments have been made. These periodic payments also include
an interest component paid towards the use of the asset apart from the price of the
asset.

The term ‘Hire-Purchase’ is a UK term and is synonymous to ‘rent-to-own’ or

‘installment plan’ in various other countries. Owning goods through hire and purchase
lets companies improve their earnings performance. Not just beneficial to the hirer, this
system is also the most effective and secure form of credit sales for the current owner of
the asset.

Hire purchase is a method of purchasing or financing capital goods whereby the

goods are accessible for use almost instantaneously but the payment is made in smaller
parts over an agreed period. The ownership is transferred only after the paying all
installments. Technically speaking, it is an agreement between the buyer (or user) of the
asset and the financing company whereby the financing company purchases the asset
on behalf of the buyer and the buyer utilized it for business purpose and pays back to
the financing company in small installments called hire charges.

In other words, hire purchase can be defined as an option of financing or

acquiring an asset for use whereby the financing company let the goods on hire to the
buyer against small installments called hire charges and the buyer gets the right to use
the asset with an option to purchase the asset by paying all such installments spread
over a period of time. Hire purchase was very prominent for vehicle financing whether
that is a personal car, commercial vehicle etc but now equipment, machinery etc are
also financed with hire purchase method.

Advantages

1. Immediate use of assets without paying the entire amount.

2. Expensive assets can be utilized as the payment is spread over a period of time.
3. Fixed rental payments make budgeting easier as all the expenditures are known
in advance.
4. Easy accessibility as it is a secured financing.
5. No need to worry about the asset depreciating quickly in value as there is no
obligation to buy the asset.

Disadvantages

1. Total amount paid towards the asset could be much higher than the cost of the
asset due to substantially high-interest rates.
2. The long duration of the rental payments.
3. Ownership only at the end of the agreement. The hirer cannot modify the asset
till then.
4. The addition of any covenants increases the cost.
 5. If the hired asset is no longer needed because of any change in the business
strategy, there may be a resulting penalty.

Short Term Sources of Finance

Short term financing means financing for a period of less than 1 year. The need
for short-term finance arises to finance the current assets of a business like an inventory
of raw material and finished goods, debtors, minimum cash and bank balance etc. Short-
term financing is also named as working capital financing.

Trade Credit

Trade credit is an important source of working capital extended or generated by

the business itself. It can be defined as ‘delay of payment’ permitted by the creditor or
supplier of raw materials, consumables etc against the goods purchased from him. Any
finance has three important parameters – amount of loan, rate of interest and time
period of a loan. In this case, the amount of credit is the bill amount, the rate of interest
is practically nil, and the period of credit is the credit period given in the terms of
payment.

Trade credit is also known as a spontaneous source of finance. It is a major

source of working capital finance for most business whether small or big. Amount and
period of trade credit are dependent on two things. One, the customs and competition in
the particular industry and second, the credibility of the buyer in terms of the liquidity
position, profit making ability, past payment records etc.

There are three main terms of trade credit viz

1. Maximum Credit Limit

It is the maximum amount of credit which a customer is allowed. The
limit is determined by the creditor based on the credibility of the customer,
volume of its transactions, past payment track records, nature of business
etc.

2. Credit Period
The credit cannot be allowed for an infinite time period. It is the
maximum period of time before which a buyer is expected to make payment.
Beyond this period, the creditor may ask for interest on the amount at the rate
 mentioned in the terms of payment. The no. of days of credit is also
determined in the similar fashion like the limit of credit amount.

3. Cash Discount
It is the percentage of discount allowed by the creditor to the buyer to
encourage him to pay as early as possible.

Disadvantages of Trade Credit

1. Opportunity Loss of Discount

All suppliers provide a discount on bills amount if early payment is
made or is made in cash. If the buyer enjoys trade credit, he has to forego the
discount otherwise available.

2. Increase in Input Prices

As very clearly explained above in the advantages of suppliers, the
buyers with liberal credit terms are charged with premium prices. This
increases the cost of raw materials for the buyer making it a direct increase in
the costing of finished goods of the buyer. Finished goods with higher prices
are difficult to sustain in the competitive market. We know that price is an
important factor for a demand of products. Higher prices may badly impact
the demand for the buyer’s products.

3. Loss of Goodwill
Some managers have a tendency to delay payments till the last point
possible. But, they are unaware of the problems posed by their suppliers in
the absence of timely payment. Over a period of time, this idea impacts the
goodwill of the firm in the market. All the suppliers will come to know about
payment delays of the buying firm and will definitely entertain other buyers
first. The firm may face problems like late supplies, no supplies in
emergencies etc.

4. The cost of Administration and Accounting

If goods are purchased on credit and the supplier’s list is too long, the
cost of maintaining and keeping track on defaults of payment will be high.
Business would need a special department just to take care of related issues.
5. Loss of Suppliers
 At times, failure to abide by the terms of credit can cause loss of
supplier as well. The supplier may find it difficult to work with the buyers not
paying on time as suppliers also have their supplier’s obligation to pay on
time.

Factoring

Factoring is a financial service in which the business entity sells its bill
receivables to a third party at a discount in order to raise funds. Factoring involves the
selling of all the accounts receivable to an outside agency. Such an agency is called a
factor. The seller makes the sale of goods or services and generates invoices for the
same. The business then sells all its invoices to a third party called the factor. The factor
pays the seller, after deducting some discount on the invoice value.

Advantages

1. It reduces the credit risk of the seller.

2. The working capital cycle runs smoothly as the factor immediately provides
funds on the invoice.
3. Sales ledger maintenance by the factor leads to a reduction of cost.
4. Improves liquidity and cash flow in the organization.
5. It leads to improvement of cash in hand. This helps the business to pay its
creditors in a timely manner which helps in negotiating better discount terms.
6. It reduces the need for the introduction of new capital in the business.
7. There is a saving of administration or collection cost.

Disadvantages

1. Factor collecting the money on behalf of the company can lead to stress in
the company and the client relationships.
2. The cost of factoring is very high.
3. Bad behavior of factor with the debtors can hamper the goodwill of the
company.
4. Factors often avoid taking responsibility for risky debtors. So the burden of
managing such debtor is always in the company.
5. The company needs to show all details about company customers and sales
to factor.
Advances Received from Customers

A liability account used to record an amount received from a customer before a

service has been provided or before goods have been shipped.

Working Capital Loan

Working capital loans are financial products structured by financial institutions to

help businesses fund their working capital needs and operating cycles. The need for
working capital arises due to the business cycle, commonly known as a working capital
cycle. A working capital cycle of a company is defined as the number of days it takes for
a company to turn its inventory into cash. It is calculated as the number of days required
to turn the inventory items into finished products and to collect the cash from the sale of
these products. They provide additional liquidity to a company by either monetizing
short-term assets such as account receivables and inventory or postponing cash
outflows related to account payables. They are usually arranged by a third-party financial
institution which will act as an intermediary between a company and its suppliers or
clients. The most common loan structures are described in the table below.

Factoring –
recourse or Factoring is the sale of account receivables to a third-party,
non- often a financial institution, at a discount.
Receivables recourse
Financing Invoice discounting is a loan provided by a financial
Invoice institution with the account receivables used as collateral.
discounting The quality and liquidity of the receivables will determine the
exact amount and pricing of the facility.
This is an asset-based loan secured by the inventory or a
Inventory
part of the inventory such as work-in-progress or finished
finance
products. The amount will be determined by the realizable
(asset-
value of the inventory and pricing will be determined by the
Inventory based
creditworthiness of the borrower and the quality of the
Financing loan)
inventory.
A lender will purchase the inventory and, as the inventory is
Floor
sold, the company will repay the debt. This method of
planning
financing is often used by a company with strong balance
 sheet such as car dealers.
The bank will pay the supplier promptly in cash when the
invoice is issued and the company will repay the bank at a
later date. The company will effectively stretch its payables
Payables Payable
and benefit from better payment terms. Payables facilities
Financin s
are usually provided on an unsecured basis but a bank
g Funding
could require a guarantee depending on the
creditworthiness of the counterparty.
NAME: SCORE:
COURSE/YR. & SEC.

SOURCES OF FINANCING

IDENTIFICATION
1 Capital requirements for a period of more than 5 years 1
2 These are represent ownership in a company 2
3 The offer of shares which the company makes to the 3
general public for the first time
4 Measures the ratio of financing to equity and debt 4
5 It assumes the risk of subscription 5
6 One of the special types of share capital having fixed rate 6
of dividend and they carry preferential rights over
ordinary equity shares in sharing of profits
7 The asset which is purchased using the loan amount 7
8 Certain statements in the loan agreement which states 8
certainly do’s and don’ts for the company
9 They provide the funds to start ups in exchange for the 9
equity stake
10 The financial practice of pooling various types of 10
contractual debt
11 These are the accumulation of retained earnings and 11
depreciation charges
12 An arrangement between the lessor and the lessee 12
13 Asset-based loan secured by the inventory or a part of 13
the inventory
14 Also known as a spontaneous source of finance 14
15 The business entity sells its bills receivables to a third 15
party at a discount in order to raise funds

TRUE OR FALSE
1 Capital expenditures in fixed assets are funded using long-term 1
sources of finance
2 Part of working capital which permanently stays with the business is 2
also financed with long-term sources of funds
3 Normally, a company is started with equity finance as its first source of 3
capital from the owners or promoters of that company
4 Debt financing is the permanent solution to financial needs of a 4
company
5 Equity mode of finance gives management a breathing space by 5
having no fixed obligation to pay dividends
6 Lower levered firms have higher chances of smooth borrowing of debt 6
 in times of need
7 Since equity share investment is a high-risk investment, an investor 7
will always expect a higher rate of return
8 The dividends distributed to the shareholders are tax deductible 8
expense
9 Interest expense is an eligible expense for tax benefits 9
10 Low leverage means high risk of bankruptcy 10
 CAPITAL BUDGETING

Capital budgeting is the process in which a business determines and evaluates

potential large expenses or investments.

These expenditures and investments include projects such as building a new

plant or investing in a long-term venture. Often, a company assesses a prospective
project's lifetime cash inflows and outflows to determine whether the potential returns
generated meet a sufficient target benchmark, also known as "investment appraisal."

Ideally, businesses should pursue all projects and opportunities that enhance
shareholder value. However, because the amount of capital available for new projects is
limited, management needs to use capital budgeting techniques to determine which
projects will yield the most return over an applicable period.

IMPORTANCE OF CAPITAL BUDGETING

1. Long term investments involve risks

Capital expenditures are long term investments which involve more
financial risks. That is why proper planning through capital budgeting is needed.

2. Huge investments and irreversible ones

As the investments are huge but the funds are limited, proper planning
through capital expenditure is a pre-requisite. Also, the capital investment
decisions are irreversible in nature, i.e. once a permanent asset is purchased its
disposal shall incur losses.

3. Long run in the business

Capital budgeting reduces the costs as well as brings changes in the
profitability of the company. It helps avoid over or under investments. Proper
planning and analysis of the projects helps in the long run.

CAPITAL BUDGETING TECHNIQUES

There are different methods adopted for capital budgeting. The traditional
methods or non-discount methods include: Payback period and Accounting Rate of
return method. The discounted cash flow method includes the Net Present Value (NPV)
method, profitability index method and Internal Rate of Return (IR
Payback Period

This method refers to the period in which the proposal will generate cash to
recover the initial investment made. Simply put, it is the length of time an investment
reaches a break-even point.

It purely emphasizes on the cash inflows, economic life of the project and the
investment made in the project, with no consideration to time value of money. Through
this method selection of a proposal is based on the earning capacity of the project. With
simple calculations, selection or rejection of the project can be done, with results that will
help gauge the risks involved.

An investment with a shorter payback period is considered to be better, since the

investor's initial outlay is at risk for a shorter period of time. The payback period is
expressed in years and fractions of years.

Payback Method Advantages

1. The payback period is useful from a risk analysis perspective, since it gives a
quick picture of the amount of time that the initial investment will be at risk. If
you were to analyze a prospective investment using the payback method, you
would tend to accept those investments having rapid payback periods and
reject those having longer ones.
2. It tends to be more useful in industries where investments become obsolete
very quickly, and where a full return of the initial investment is therefore a
serious concern. Though the payback method is widely used due to its
simplicity, it suffers from the following problems:

Payback Method Disadvantages

1. Asset life span
If an asset’s useful life expires immediately after it pays back the initial
investment, then there is no opportunity to generate additional cash flows.
The payback method does not incorporate any assumption regarding asset
life span.
2. Additional cash flows
The concept does not consider the presence of any additional cash flow
that may arise from an investment in the periods after full payback has been
achieved.
 3. Cash flow complexity
The formula is too simplistic to account for the multitude of cash flows that
actually arise with a capital investment. For example, cash investments may
be required at several stages, such as cash outlays for periodic upgrades.
Also, cash outflows may change significantly over time, varying with customer
demand and the amount of competition.
4. Profitability
The payback method focuses solely upon the time required to pay back
the initial investment; it does not track the ultimate profitability of a project at
all. Thus, the method may indicate that a project having a short payback but
with no overall profitability is a better investment than a project requiring a
long-term payback but having substantial long-term profitability.
5. Time value of money
The method does not take into account the time value of money, where
cash generated in later periods is worth less than cash earned in the current
period. A variation on the payback period formula, known as the discounted
payback formula, eliminates this concern by incorporating the time value of
money into the calculation. Other capital budgeting analysis methods that
include the time value of money are the net present value method and the
internal rate of return.
6. Individual asset orientation
Many fixed asset purchases are designed to improve the efficiency of a
single operation, which is completely useless if there is a process bottleneck
located downstream from that operation that restricts the ability of the
business to generate more output. The payback period formula does not
account for the output of the entire system, only a specific operation. Thus, its
use is more at the tactical level than at the strategic level.
7. Incorrect averaging
The denominator of the calculation is based on the average cash flows
from the project over several years - but if the forecasted cash flows are
mostly in the part of the forecast furthest in the future, the calculation will
incorrectly yield a payback period that is too soon. The following example
illustrates the problem.

The formula for the payback method is simplistic: Divide the cash outlay (which is
assumed to occur entirely at the beginning of the project) by the amount of net cash
inflow generated by the project per year (which is assumed to be the same in every
year)
 Payback period = Cash Outlay or Initial Investment
Annual cash inflow

Example 1: If a company invests P3,000,000 in a new production line, and the

production line then produces positive cash flow of P1,000,000 per year, then the
payback period is 3.0 years (P3,000,000 initial investment ÷ P1,000,000 annual
payback).

Example 2: Alas Lumber is considering the purchase of a band saw that costs
P2,500,000 and which will generate P500,000 per year of net cash flow. The
payback period for this capital investment is 5.0 years. Alas is also considering
the purchase of a conveyor system for P1,800,000 which will reduce sawmill
transport costs by P600,000 per year. The payback period for this capital
investment is 3.0 years. If Alas only has sufficient funds to invest in one of these
projects, and if it were only using the payback method as the basis for its
investment decision, it would buy the conveyor system, since it has a shorter
payback period.

Example 3: ABC International has received a proposal from a manager, asking to

spend P1,500,000 on equipment that will result in cash inflows in accordance
with the following table:

Year Cash Flow

1 + 150,000
2 + 150,000
3 + 200,000
4 + 600,000
5 + 900,000

The total cash flows over the five-year period are projected to be P2,000,000,
which is an average of P400,000 per year. When divided into the P1,500,000
original investment, this results in a payback period of 3.75 years. However, the
briefest perusal of the projected cash flows reveals that the flows are heavily
weighted toward the far end of the time period, so the results of this calculation
cannot be correct. Instead, the company's financial analyst runs the calculation
 year by year, accumulating the cash flows in each successive year. The results
of this calculation are:

Accumulated
Year Cash Flow Cash Flows
1 +150,000 150,000
2 +150,000 300,000
3 +200,000 500,000
4 +600,000 1,100,000
5 +900,000 2,000,000

The table indicates that the real payback period is located somewhere between
Year 4 and Year 5. There is P400,000 of investment yet to be paid back at the
end of Year 4, and there is P900,000 of cash flow projected for Year 5.

The Payback is between years 4 and 5, since the cumulative net income reaches
P1,500,000 in that period..

By Interpolation: Payback Period = 4 + 1,500,000 – 1,100,000 = 4.44 years

2,000,000 – 1,100,000

Accounting Rate of Return

The accounting rate of return is used in capital budgeting to estimate whether to

proceed with an investment. These typically include situations where companies are
deciding on whether or not to proceed with a specific investment (a project, an
acquisition, etc.) based on the future net earnings expected compared to the capital
cost.

This method takes into account the entire economic life of a project providing a
better means of comparison. It also ensures compensation of expected profitability of
projects through the concept of net earnings. However, this method also ignores time
value of money and doesn’t consider the length of life of the projects. Also it is not
consistent with the firm’s objective of maximizing the market value of shares.

In terms of decision making, if the ARR is equal to or greater than the required
rate of return, the project is acceptable because the company will earn at least the
required rate of return. If the ARR is less than the required rate of return, the project
should be rejected. Therefore, the higher the ARR, the more profitable the investment is.

There are several serious problems with the accounting rate of return concept,
which are:

Time value of money

The measure does not factor in the time value of money. Thus, if there is
currently a high market interest rate, the time value of money could completely
offset any profit reported by a project - but the accounting rate of return does
incorporate this factor, so it clearly overstates the profitability of proposed
projects.

Constraint analysis
The measure does not factor in whether or not the capital project under
consideration has any impact on the throughput of a company's operations.

System view
The measure does not account for the fact that a company tends to
operate as an interrelated system, and so capital expenditures should really be
examined in terms of their impact on the entire system, not on a stand-alone
basis.

Comparison
The measure is not adequate for comparing one project to another, since
there are many other factors than the rate of return that should be considered,
not all of which can be expressed quantitatively.

Cash flow
The measure includes all non-cash expenses, such as depreciation and
amortization, and so does not reveal the return on actual cash flows experienced
by a business.
 Time-based risk
There is no consideration of the increased risk in the variability of
forecasts that arises over a long period of time.

In short, the accounting rate of return is not by any means a perfect method for
evaluating a capital project, and so should be used only in concert with a number of
other evaluation tools. In particular, you should find another tool to address the time
value of money and the risk associated with a long-term investment, since this tool does
not provide for it.

The formula for the accounting rate of return is:

ARR = Average Annual Accounting Profit

Average Investment

Where,
Average investment = (book value at year 1+ book value at end of useful life) / 2
Average annual profit = total profit over investment period/number of years
The result of the calculation is expressed as a percentage.

Example 1: XYZ Company is looking to invest in some new machinery to replace

its current malfunctioning one. The new machine, which costs P4,200,000, would
increase annual revenue by P2,000,000 and annual expenses by P500,000. The
machine is estimated to have a useful life of 12 years and zero salvage value.

Step 1: Calculate the depreciation expense per year: P4,200,000 / 12 =

P350,000
Step 2: Calculate the average annual profit: P2,000,000 – (P500,000 +
P350,000) = P1,150,000
Step 3: Use the formula: ARR = P1,150,000 / P4,200,000 = 27.4%

Therefore, this means that for every peso invested, the investment will
return a profit of about 27 cents.

Example 2: XYZ Company is considering investing in a project that requires an

initial investment of P1,000,000 for some machinery. There will be net inflows of
P200,000 for the first two years, P100,000 in years three and four, and P300,000
in year five. Finally, the machine has a salvage value of P250,000.
 Step 1: Calculate average annual profit
Php
Inflows, Years 1 & 2
400,000
(200,000*2)
Inflow, Year 3 & 4
200,000
(100,000*2)
Inflow, Year 5 300,000
Less: Deprecation
(750,000)
(1,000,000 – 250,000)
Total Profit of Project 150,000
Average Annual Profit
30,000
(150,000/5)

Step 2: Calculate average investment

Average investment = (P1,000,000 + P250,000) / 2 = P620,500

Step 3: Divide profit into cost

ARR = 30,000/620,500 = 4.8%

Net Present Value (NPV) Method:

Net present value (NPV) is a calculation that compares the amount invested
today to the present value of the future cash receipts from the investment. In other
words, the amount invested is compared to the future cash amounts after they are
discounted by a specified rate of return. his method considers the time value of money
and is consistent with the objective of maximizing profits for the owners.

The first step involved in the calculation of NPV is the estimation of net cash
flows from the project over its life. The second step is to discount those cash flows at the
hurdle rate.
 The net cash flows may be even (i.e. equal cash flows in different periods) or
uneven (i.e. different cash flows in different periods). When they are even, present value
can be easily calculated by using the formula for present value of annuity. However, if
they are uneven, we need to calculate the present value of each individual net cash
inflow separately.

Once we have the total present value of all project cash flows, we subtract the
initial investment on the project from the total present value of inflows to arrive at net
present value.

When cash inflows are even:

1 − (1 + i)-n
NPV = R × − Initial Investment
i
Where,
R is the net cash inflow expected to be received in each period;
i is the required rate of return per period;
n are the number of periods during which the project is expected to
operate and generate cash inflows

When cash inflows are uneven:

R2 R3
NPV = R1 + + + ... − Initial Investment
(1+i)1 (1+i)2 (1+i)3

Where,
i is the target rate of return per period;
R1 is the net cash inflow during the first period;
R2 is the net cash inflow during the second period; R3 is the net cash
inflow during the third period, and so on ...

Decision Rule
In case of stand-alone projects,
accept a project only if its NPV is positive
reject it if its NPV is negative
stay indifferent between accepting or rejecting if NPV is zero.
 In case of mutually exclusive projects (i.e. competing projects), accept the
project with higher NPV.

Example 1: Even Cash Inflows

Calculate the net present value of a project which requires an initial investment of
P243,000 and it is expected to generate a cash inflow of P50,000 each month for
12 months. Assume that the salvage value of the project is zero. The target rate
of return is 12% per annum.

Solution

We have,
Initial Investment = P243,000
Net Cash Inflow per Period = P50,000
Number of Periods = 12
Discount Rate per Period = 12% ÷ 12 = 1%

Net Present Value

= P50,000 × (1 − (1 + 1%)-12) ÷ 1% − P243,000
= P50,000 × (1 − 1.01-12) ÷ 0.01 − P243,000
≈ P50,000 × (1 − 0.887449) ÷ 0.01 − P243,000
≈ P50,000 × 0.112551 ÷ 0.01 − P243,000
≈ P50,000 × 11.2551 − P243,000
≈ P562,754 − P243,000
≈ P319,754

Example 2: Uneven Cash Inflows

An initial investment of P8,320 thousand on plant and machinery is expected to

generate cash inflows of P3,411 thousand, P4,070 thousand, P5,824 thousand
and P2,065 thousand at the end of first, second, third and fourth year
respectively. At the end of the fourth year, the machinery will be sold for P900
thousand. Calculate the net present value of the investment if the discount rate is
18%. Round your answer to nearest thousand pesos.

Solution

PV Factors:
Year 1 = 1 ÷ (1 + 18%)1 ≈ 0.8475
Year 2 = 1 ÷ (1 + 18%)2 ≈ 0.7182
Year 3 = 1 ÷ (1 + 18%)3 ≈ 0.6086
Year 4 = 1 ÷ (1 + 18%)4 ≈ 0.5158
The rest of the calculation is summarized below:

Year 1 2 3 4
Net Cash Inflow P3,411 P4,070 P5,824 P2,065
Salvage Value 900
Total Cash Inflow P3,411 P4,070 P5,824 P2,965
× Present Value Factor 0.8475 0.7182 0.6086 0.5158
Present Value of Cash Flows P2,890.68 P2,923.01 P3,544.67 P1,529.31
Total PV of Cash Inflows P10,888
− Initial Investment − 8,320
Net Present Value P2,568 thousand

Strengths and Weaknesses of

NPV Strengths
Net present value accounts for time value of money which makes it a
better approach than those investment appraisal techniques which do not
discount future cash flows such as payback period and accounting rate of return.

Net present value is even better than some other discounted cash flows
techniques such as IRR. In situations where IRR and NPV give conflicting
decisions, NPV decision should be preferred.

Weaknesses
NPV is after all an estimation. It is sensitive to changes in estimates for
future cash flows, salvage value and the cost of capital. NPV analysis is
commonly coupled with sensitivity analysis and scenario analysis to see how the
conclusion changes when there is a change in inputs.

Net present value does not take into account the size of the project. For
example, say Project A requires initial investment of P4 million to generate NPV
of P1 million while a competing Project B requires P2 million investment to
generate an NPV of P0.8 million. If we base our decision on NPV alone, we will
prefer Project A because it has higher NPV, but Project B has generated more
shareholders’ wealth per peso of initial investment (P0.8 million/P2 million vs P1
million/P4 million).
Internal Rate of Return (IRR)

This is defined as the rate at which the net present value of the investment is
zero. The discounted cash inflow is equal to the discounted cash outflow. This method
also considers time value of money. It tries to arrive to a rate of interest at which funds
invested in the project could be repaid out of the cash inflows. It is called internal rate
because it depends solely on the outlay and proceeds associated with the project and
not any rate determined outside the investment. However, computation of IRR is a
tedious task.

Decision Rule
A project should only be accepted if its IRR is NOT less than the hurdle
rate, the minimum required rate of return. The minimum required rate of return is
based on the company's cost of capital (i.e. WACC) and is adjusted to properly
reflect the risk of the project.
When comparing two or more mutually exclusive projects, the project
having highest value of IRR should be accepted.

If IRR > WACC then the project is profitable.

If IRR > k = accept
If IRR < k = reject

Calculation
Since IRR is defined as the discount rate at which NPV = 0, we can write that:
NPV = 0; or
PV of future cash flows − Initial Investment = 0; or
CF1 CF CF
2 3
+ + + ... − Initial Investment = 0
( 1 + r )1 ( 1 + r )2 ( 1 + r )3

Where,

r is the internal rate of return;

CF1 is the period one net cash inflow;
CF2 is the period two net cash inflow,
CF3 is the period three net cash inflow, and so on ...
 The simplest method is to use hit and trial as described below:
Step 1: Guess the value of r and calculate the NPV of the project at that value.
Step 2: If NPV is close to zero then IRR is equal to r.
Step 3: If NPV is greater than 0 then increase r and jump to step 5.
Step 4: If NPV is smaller than 0 then decrease r and jump to step 5.
Step 5: Recalculate NPV using the new value of r and go back to step 2.

Example
Find the IRR of an investment having initial cash outflow of P213,000. The cash
inflows during the first, second, third and fourth years are expected to be
P65,200, P96,000, P73,100 and P55,400 respectively.

Solution
Assume that r is 10%.
NPV at 10% discount rate = P18,372
Since NPV is greater than zero we have to increase discount rate,
thus NPV at 13% discount rate = P4,521
But it is still greater than zero we have to further increase the discount rate,
thus NPV at 14% discount rate = P204
NPV at 15% discount rate = (P3,975)
Since NPV is fairly close to zero at 14% value of r, therefore IRR ≈ 14%

Profitability Index

Profitability index is an investment appraisal technique calculated by dividing the

present value of future cash flows of a project by the initial investment required for the
project.

Profitability index is actually a modification of the net present value method.

While present value is an absolute measure (i.e. it gives as the total peso figure for a
project), the profitability index is a relative measure (i.e. it gives as the figure as a ratio).

Profitability index is sometimes called benefit-cost ratio too and is useful in

capital rationing since it helps in ranking projects based on their per peso return.

Decision Rule
Accept a project if the profitability index is greater than 1
 Stay indifferent if the profitability index is 1
Reject a project if the profitability index is below 1.

Formula:
Profitability Index
Present Value of Future Cash Flows
=
Initial Investment Required
Net Present Value
=1+
Initial Investment Required

Example
Company C is undertaking a project at a cost of P50 million which is expected to
generate future net cash flows with a present value of P65 million. Calculate the
profitability index.

Solution
Profitability Index = PV of Future Net Cash Flows / Initial Investment Required
Profitability Index = P65M / P50M = 1.3
Net Present Value = PV of Net Future Cash Flows − Initial Investment Required
Net Present Value = P65M – P50M = P15M.

The information about NPV and initial investment can be used to calculate
profitability index as follows:

Profitability Index = 1 + (Net Present Value / Initial Investment Required)

Profitability Index = 1 + $15M/$50M = 1.3
NAME: SCORE:
COURSE/YR. & SEC.

CAPITAL BUDGETING

IDENTIFICATION
1 The length of time an investment reaches a break-even 1
point
2 The process in which a business determines and evaluates 2
potential large expenses or investments
3 A calculation that compares the amount invested today to 3
the present value of the future cash receipts from the
investment
4 These are long-term investments which involve more 4
financial risks
5 The rate at which the net present value of the investment is 5
zero
6 It is sometimes called benefit-cost ratio and is useful in 6
capital rationing since it helps in ranking projects based on
their peso return

TRUE OR FALSE
1 Business should pursue all projects and opportunities that enhance 1
shareholder value
2 Capital investment decisions are reversible in nature 2
3 An investment with a shorter payback period is considered to be better 3
4 Accounting rate of return takes into account the entire economic life of 4
a project providing a better means of comparison
5 When cash flows are even, present value can be easily calculated by 5
using the formula for present value of annuity
6 Payback method tends to be more useful in industries where 6
investments become obsolete very quickly
7 In case of stand-alone projects, accept a project if its NPV is positive 7
8 Payback method and accounting rate of return consider time value of 8
money
9 If ARR is equal to or greater than the required rate of return, the 9
project is acceptable
10 If ARR is less than the required rate of return, the project should be 10
rejected
11 In case of mutually exclusive projects, accept the project with lower 11
NPV
12 NPV method accounts for time value of money 12
13 NPV does not take into account the size of the project 13
14 If IRR > WACC then the project is profitable 14
15 If IRR < k, reject the project 15
16 Accept a project if the profitability index is below 1 16

ESSAY
1. Explain the advantages and disadvantages of the different capital budgeting
techniques
 MERGERS AND ACQUISITIONS

DEFINITION OF MERGER AND ACQUISITION

An acquisition involves one firm buying only a portion of another firm. The
acquisition may happen to acquire assets or an altogether different segment of the other
firm.
A merger involves the total absorption of a target firm by the acquirer. As a
result, one firm ceases to exist and only the new firm (acquirer) remains.

DIFFERENCE OF MERGER AND ACQUISITION

Mergers and acquisitions are generally used synonymously; however, as defined

above the two combinations are different in subtle ways.

In a merger transaction, a new company is formed by two companies. Post-

merger, these separately owned firms become a single entity and are jointly owned.
During the process of merger, the stocks of these companies are surrendered and the
new company’s stocks are issued. Generally, companies of similar sizes undergo the
process of merger.

In Merger, A + B = C

Whereas in the case of an acquisition, one company is taken over by another

company and in the process, a single owner is established. Generally, a stronger and a
bigger company takes over a smaller and a less powerful one. The bigger company runs
the whole establishment with its identity and the smaller company has to lose its
existence. In contrast to the merger, shares of the acquired company are not
surrendered at all. These shares continue to be traded by the general public in the stock
market.

In Acquisition, A + B = A

A merger typically refers to a friendly deal between two firms, even if it is a

complete buyout. However, an acquisition refers to an unfriendly takeover of the smaller
firm, at times even unwillingly, by the stronger firm commonly heard as “Hostile
Takeover“. Several times a less powerful company is compelled by the bigger company
to announce the transaction as a merger, even if it is an acquisition. Companies do this
to avoid any negative marketin
PROCESS OF MERGER AND ACQUISITION

The process involving merger and acquisition is important as it can dictate the
benefits derived from the deal. The process involves the following steps:

1. Preliminary Valuation
This step primarily focuses on the business assessment of the target
company. Not only the latest financials of the target company are scrutinized, its
expected market value in future is also calculated. This close analysis includes
the company’s products, capital requirements, brand value, organizational
structure, etc.

2. Proposal Phase
Once the target company’s business performance is analyzed and
reviewed, the proposal for the business transaction is given. It could be either a
merger or an acquisition. Generally, the mode of giving a proposal is an issuance
of a non-binding offer document.

3. Planning for Exit

After the proposal is given to the target company and it takes the offer,
the target company then engages in planning for the exit. This includes planning
the right time to exit and considering all the options such as a full sale or partial
sale. This is also a time for tax planning and evaluating the reinvestment options.

4. Marketing
Once the exit plan is finalized, the target company engages in a
marketing plan and aims to achieve the highest selling price.

5. Agreement
In the case of an acquisition deal, the purchase agreement is finalized. In
the case of a merger, the final agreement is signed.

6. Integration
This is the final step that involves the complete integration of the two
companies. It is important to ensure that the same rules are followed throughout
in the new company.
ADVANTAGES OF MERGERS AND ACQUISITIONS

Advantages of Mergers and Acquisitions

1. Synergy
The synergy created by the merger of two companies is powerful enough
to enhance business performance, financial gains, and overall shareholders
value in long-term.

2. Cost Efficiency
The merger results in improving the purchasing power of the company
which helps in negotiating the bulk orders and leads to cost efficiency. The
reduction in staff reduces the salary costs and increases the margins of the
company. The increase in production volume causes the per unit production cost
resulting in benefits from economies of scale.

3. Competitive Edge
The combined talent and resources of the new company help it gain and
maintain a competitive edge.

4. New Markets
The market reach is improved by the merger due to the diversification or
the combination of two businesses. This results in better sales opportunities.

Disadvantages of Mergers and Acquisitions

1. Bad for Consumers

With the merger, competition can reduce the industry and the new
company may have higher pricing power.

2. Decrease in Jobs
A merger can result in job losses. An acquiring company may shut down
the under-performing segments of the company.

3. Sometimes Dis-economies of Scale

The increased size may lead to dis-economies of scale for the new
company. It may not have the control required for running a bigger company.
 BUSINESS FAILURE AND REMEDIES

A fundamental part of overcoming business failure is rooted in the

mindset you have. It begins with a flexible and positive attitude and a willingness to
change. Winston Churchill stressed this vital factor by saying, “To improve is to change;
to be perfect is to change often.” Failure, including when running a business, is part of
life. How we deal with it determines whether or not it ultimately leads to success.

Reasons Why Business Fails and How to Prevent

It Poor Management Skills

Your business can fail if you don’t possess quality management skills. Whether
it’s about financial aspects or man management, poor administration impairs the entire
process. Eventually, the overall aesthetics of the business gets affected due to bad
management.
Here’s how you can make the best use of management skills:
 Make good management decisions
 Have the vision to lead your organization
 Hire right people to delegate responsibility
 Supervise staffs regularly
 Resolve critical issues quickly

Management of a business encompasses several activities: planning, organizing,

operating, directing and communicating. Do these things methodically to prevent
business failure.

Misplaced Focus
The focus is the art of converging your efforts into functional activities.
Entrepreneurs often think about making their services too much multidimensional. When
that goes across the board, your resources get overstretched unnecessarily. As a result,
your brand would be less effective to attract customers. This is considered as one of the
major reasons why businesses fail.
So, how to prevent a business failure that has been caused by your misplaced
focus?
Here are some effective ways to do it:
 Establish a niche for your business
 Set achievable goals
 Prioritise your activities
 Focus on being great at what you can offer best
  Put importance on customer satisfaction

Don’t think about becoming the jack of all trades. Just concentrate on the right
segments, and you would surely make the best out of your services.

Incompetency in Planning
Strategic planning is crucial for your business success. As your business starts to
grow, you will need increased revenues to pay more employees. With bigger facilities,
there will be a hike in the production costs too. In such circumstances, not having a right
plan can affect your business growth significantly. Have you ever thought why plans fail?
It is because of:
 Not understanding the business environment
 Partial commitment
 Not having a clear roadmap
 Narrow focus
Here’s how to plan tactically:
 Simplify your thoughts and stick to the basics
 Get inside the minds of your competitors
 Make accurate projections
 Have enough capital
 Know your strengths and weaknesses and plan accordingly

With these actionable steps, now you know what to do when your business is in
trouble as a result of wrong planning.

No Performance Monitoring
As you successfully devise a plan, you feel quite confident about the
proceedings. But that’s not the end of it! Failure to adapt to market changes and
technological aspects can affect a business greatly. So, what to do when there is a lack
of performance monitoring?
Try these to resolve the issue:
 Review your services regularly
 Be reactive to competition
 Clearly, define your value proposition
 Gather relevant data
Ask yourself:
 What’s the value I am providing to my customers?
 Do my services connect with what has been promised earlier?
 You should constantly evaluate the process to ensure you’re meeting the
business goals.

Premature Scaling
Scaling is essential for the positive growth of a business. But when a business
starts to spend money beyond the essentials, they unknowingly risk everything to
unknown possibilities. For example, if you hire more people than the requirement, or
spend too much on marketing, it gets wasted. Premature scaling never helps to grow
your business rapidly. So, what should be the strategy to avoid business failure due to
premature scaling?
Here are some effective ways to do it:
 Avoid hastiness in achieving business growth
 Take your time with funding
 Validate your market thoroughly
 Don’t drain your resources unnecessarily

Remember: It’s good to grow strong rather than accelerating too soon.

Funding Shortfall
Managing finance is one of the crucial aspects of any business. Besides securing
your business, it also helps in business growth. As you proceed along with your
business venture, you will require more funding to pay for:
 new employees
 developing new products and features
 raw materials
 supplies
 facilities

A company that has inadequate cash, may not execute the chosen strategies at
the right time. Thus, it upsets the strategic plan which could have been essential to
business growth.
How to fund your business properly?
 Get a bank loan
 Look for multiple sources of finance
 Try crowd funding
 Seek help from angel investors
 Pay heed to strategic partnership
Inadequate Profit
Profits are the life-blood of business that paves the way for growth. If you can’t
achieve enough profit, it can result in:
 laying off employees
 selling equipment or assets
 closing of underperforming business facilities
Here are some useful tips to increase profit:
 Increase output
 Make better use of production capacity
 Reduce variable cost
 Raise product prices
 Ask for referrals
 Use digital platforms to decrease marketing costs

An excess amount of loss can eventually lead to business bankruptcy. On the

other hand, generating profits continually prove your worth as an entrepreneur.

Negative Cash Flow

Maintaining cash flow properly is the crux of your business. Without this, your
business cannot survive for long. Even the most profitable firms find themselves in deep
water when the outflow is more than the earnings. If the cash flow becomes consistently
negative and the cash is used up, then the problem becomes even more serious.
The main causes of cash flow problems are:
 Low profits or massive losses
 Excess spending on production capacity
 Holding too much stock
 Allowing customers too much credit
 Overtrading
 Seasonal demand
How to avoid business failure due to negative cash flow?
 Increase your sales.
 Ask for deposits or full payment in advance.
 Negotiate better payment terms with suppliers.
 Sell non-core business assets
 Be very selective in offering credit to customers.
 Acquire loans for emergencies.

If implemented properly, these can help you manage the crisis quite effectively.
Insufficient Coverage
Life is full of surprises and you can’t predict everything in advance. This is also
true in case of any business. If you don’t have enough coverage for your business, the
results could be catastrophic when there is a disaster. Eventually, you would end up
asking yourself: why my business failed?

A good insurance coverage is pivotal for the survival of a business. It helps

mitigate the risk of unforeseen damage. All you need to do is just pay a premium and
can rest assured of avoiding most of the economic turmoil caused by unfortunate events.
Take a note of these things when you plan for insuring your business:
 While starting a business, perform a risk-management audit.
 Assess the potential risks of your business
 Do risk management analysis every year.
 Consult licensed agents about the right coverage.

Limited Knowledge of The Market

The entrepreneur on the path to failure thinks business is all about how much
one can make. He gets blinded by the thirst for money. Moreover, he doesn’t realize the
need to refine his business IQ.

Here’s how you can develop a good knowledge of the market:

 Carry out researches to know customer needs
 Know what your competitors are doing
 Focus on self-improvement

To be successful in business, you need to have adequate knowledge of the

market. Put your finger on the pulse and be adaptive to the changing market needs.
Staying innovative will keep your business alive in the competitive market.

Small Customer Base

When you don’t have a large network of customers, it’s almost impossible to
grow your business to further heights. Without a strong network in place, you’ll miss out
on these benefits. Thus, you would lag behind competitors who have stronger
connections.

Your contacts will provide you with potential clients, partnerships, suppliers and
even employees. And if lucky enough, you may even come across investors or mentors
who can provide you brilliant advice.
 Follow these steps to grow your customer base:
 Support existing clients and bring new ones
 Offer great customer service
 Look for partnerships with other businesses
 Offer discounts and free trials
.
Ignoring Customer Needs
Sometimes, marketers get so engrossed in numerous facets, that they forget
about focusing on customer needs. If you neglect customer needs or don’t get a right
idea about what exactly they want from you, it can be a critical issue.
Here’s what you can do to focus on customer needs:
 Know what they like or dislike about your services
 Reply to their feedbacks with a positive tone
 Be innovative with your products
 Implement features that they look for
 Use web analysis
 Try surveys

Even if they like your services, maybe they would love it more if you improve or
alter a particular feature. So, connect with them and find out their interests to provide
services accordingly.

Lack of Promotional Strategies

As a marketer, if you can’t improve your outreach, it’ll be hard to survive amidst
tremendous competition. In the age of digitization, those who are not utilizing online
marketing, often miss a lot of golden opportunities. People won’t even know about your
services unless you make them aware of your presence in the best possible ways. With
digital marketing, you can be more interactive with prospective customers. It would help
you in several ways:
 Higher visibility
 Real-time results
 Cost-effective marketing
 Useful information through analytics
 Higher ROI
 And many more!
Promote your services through various forms of digital platforms such as:
 Content marketing
 Social media marketing
  Newsletters
 Google AdWords
 Search Engine Optimization (SEO)

No Data Security
The information that you gather about your employees, customers and business
activities is highly sensitive. Any security breaches or physical damage can be
devastating for a business. Moreover, organizations with poor data security practices
can be sued legally.
Here are some ways through which you can secure necessary data:
 Encrypt your data
 Add anti-malware protection
 Install software updates periodically
 Secure your network connections
 Change important passwords frequently
 Update your OS
 Limit access of sensitive information

No Contingency Plan
Having an effective backup plan is crucial for the safety of businesses in
hazardous situations. If you can’t face the negative situation efficiently, it might have a
dramatic impact on your business.
Here are the main instances where contingency plan helps a lot:
 Mismanagement of assets
 Sudden opening created by retirements
 Unexpected departures of employees
 Death of an important personnel
 Natural disasters
 Inflation
 Recessions

To maintain your business operations smoothly, try the following things:

 Learn how to identify critical issues in advance
 Run thorough analysis to identify potential risk factors
 Identify operational inefficiencies
 Develop recovery strategies
Inability to Become Unique
You may have great products to offer but your business is still falling. Have you
ever thought why so? Maybe your products lack strong value proposition and the quality
isn’t good enough to attract potential customers. Would you be able to stand out in the
competition? The answer is – a big “No”.
Here’s what sets your identity apart from competitors:
 Conduct business in a way that is totally unique
 Develop a customized approach different from other marketers
 Bring distinctiveness by including exceptional aesthetics to the brand

image Thus, you can separate your services from the herd and make more

profits.

Unsatisfactory Partnerships
Bringing diverse contributors together can be a challenging thing in case of
partnerships. When the objective doesn’t get unified and self-interests are valued more,
businesses can fail catastrophically.
Having right kind of partnership can help you in several ways, such as:
 Access to marketing knowledge
 Wider pool of expertise
 Enhancement of competency in workforce
 Reputation and credibility
 Long-term stability

With right kind of business partners, it’ll be easier to succeed significantly.

Therefore, find suitable partners to avail the benefits of collaboration. Build trust and
integrity with a common motto:

Choice of Location
At times, your organization might decide to relocate or open new branches in
new places. Expansion can be a terrible thing if you don’t have a proper idea of the new
location.

A place that can’t offer you good employees, customer base and adds excess
expenditures on labour costs and transport, eventually would hinder your business
extremely.
Before settling on business premises, focus on the following aspects:
 Whether your services can attract customers
 Where the suppliers are located and their accessibility
 Whether your business would get competitive advantage
  Local pay rates
 Utilities and other costs

Conclusion:
Failure can be a depressing thing. But knowing to learn from failure can help you
strengthen your marketing strategies significantly. With the above-mentioned points, now
you know what can be the main reasons of business failure and what to do when
business is failing
NAME: SCORE:
COURSE/YR. & SEC.

MERGERS AND ACQUISITIONS

BUSINESS FAILURE AND REMEDIES

ESSAY

1. Differentiate merger and acquisition

2. Discuss the advantages and disadvantages of merger and acquisition

3. Cite some of the reasons why business fail and how they can be prevented
 MIDTERM EXAMINATION

1. Explain the importance of the following financial statements. Provide at least 5

key accounts per financial statement and explain its use to financial analysis.
 Income Statement
 Balance Sheet
 Cash Flow Statement
 Statement of Shareholders Equity

2. Differentiate horizontal analysis, vertical analysis and trend analysis and provide
scenarios to explain when these financial analysis tools should be used.

3. Using Jollibee Foods, prepare the following:

Horizontal analysis for 2019

Graph/ Trend analysis of:
Revenue or Sales from 2017 to 2019
Interest Expense from 2017 to 2019
Net income from 2017 to 2019
Vertical analysis for 2019 and 2019

4. Conduct liquidity ratio analysis for Jollibee Foods using the available formula in
this module. Provide a narrative of your findings after every ratio computation.

5. Conduct capital structure ratio analysis for Jollibee Foods using the available
formula in this module. Provide a narrative of your findings after every ratio
computation.

6. Conduct asset management efficiency analysis for Jollibee Foods using the
available formula in this module. Provide a narrative of your findings after every
ratio computation.

7. Conduct profitability ratio analysis for Jollibee Foods using the available formula
in this module. Provide a narrative of your findings after every ratio computation
8. Conduct market value ratio analysis for Jollibee Foods using the available
formula in this module. Provide a narrative of your findings after every
ratio computation.

9. Provide a summary of all your findings and discuss the highlights and
lowlights of Jollibee Foods financial performance.
 BUSINESS FINANCE
By: Bernadette M. Panibio and Michael Bryan G. de
Castro

129
 BUSINESS FINANCE
By: Bernadette M. Panibio and Michael Bryan G. de
Castro

130
 BUSINESS FINANCE
By: Bernadette M. Panibio and Michael Bryan G. de
Castro

REFERENCES

Alvaralo, Eveline, A Simple Guide to Preparing a Project Feasibility

Study

Brigham, Eugene, Fundamentals of Financial Management, 2015,

Cengage Learning

Hernandez, Victor M., Business Plan Writing

Mayo, Herber, Basic Finance, 2011 C & E Publishing, Inc.

Mejorada, Nenita D., Business Finance, 2006 JMC Press

https://www.accountingtools.com

https://www.lawteacher.net

https://psu.instructive.com

https://smallbusiness.chron.com

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 BUSINESS FINANCE
By: Bernadette M. Panibio and Michael Bryan G. de
Castro

132
 FINAL EXAMINATION

1. As the CEO of the company, what is the importance of

understanding business failures and remedies. Explain your
answer by providing 3 scenarios wherein CEO is very much
involved in the process.

2. Provide 2 scenarios wherein merger is required for a company

and explain your answer in the point of view of a CEO/CFO.

3. Explain the advantages and disadvantages of the different

capital budgeting techniques in the eyes of a financial manager.

4. Differentiate the sources or short term, medium term and long term
financing. Provide 3 scenarios each per term and explain your
answer.

5. What do you think is the most important and most crucial step in
cash management – explain your answer by citing 2 scenarios.