Contents

Finance:.......................................................................................................................................................7
Time value of Money...................................................................................................................................7
Financial markets.........................................................................................................................................7
Capital Market.........................................................................................................................................7
Money market.........................................................................................................................................8
Primary Market........................................................................................................................................8
Secondary Market...................................................................................................................................8
Public Issue..................................................................................................................................................8
Private placement.......................................................................................................................................8
Initial Public Offering (IPO)..........................................................................................................................8
Types of Long-Term Debt Instruments........................................................................................................9
Debenture...............................................................................................................................................9
Subordinated Debenture.........................................................................................................................9
Income Bond...........................................................................................................................................9
Junk Bond................................................................................................................................................9
Mortgage Bond........................................................................................................................................9
Equipment Trust Certificate...................................................................................................................10
Sinking Fund..............................................................................................................................................10
Balloon Payment.......................................................................................................................................10
Serial Bonds...............................................................................................................................................10
Call Provision.............................................................................................................................................10
Call Price....................................................................................................................................................10
Cash conversion cycle................................................................................................................................10
Hedging (or Maturity Matching) Approach...............................................................................................11
Investment Banker....................................................................................................................................11
Traditional (firm commitment) underwriting............................................................................................11
Underwriting Syndicate.........................................................................................................................12
Competitive-bid.................................................................................................................................12
Negotiated Offering...........................................................................................................................12
Best efforts offering...................................................................................................................................12
Shelf Registration......................................................................................................................................12
Privileged Subscription..............................................................................................................................12
Preemptive Right.......................................................................................................................................12
Subscription right......................................................................................................................................13
Present Value............................................................................................................................................13
Future value=............................................................................................................................................13
Annuity......................................................................................................................................................13
Ordinary Annuity...................................................................................................................................13
Annuity Due...........................................................................................................................................13
Future value of Annuity formulas..............................................................................................................13
Ordinary Annuity=.................................................................................................................................13
Annuity Due =........................................................................................................................................13
Present value of Annuity formulas............................................................................................................14
Ordinary Annuity=.................................................................................................................................14
Annuity Due =........................................................................................................................................14
Perpetuity:.................................................................................................................................................14
Effective Annual Interest Rate...................................................................................................................14
Loan Amortization.....................................................................................................................................14
Bonds.........................................................................................................................................................15
Types of Bonds..........................................................................................................................................15
Secured bonds.......................................................................................................................................15
Unsecured bonds...................................................................................................................................15
Term Bond.............................................................................................................................................15
Serial bond.............................................................................................................................................15
Registered bonds...................................................................................................................................15
Bearer or coupon bonds........................................................................................................................16
Convertible............................................................................................................................................16
Callable..................................................................................................................................................16
Treasury Bonds :....................................................................................................................................16
Corporate Bonds:...................................................................................................................................16
Municipal Bonds:...................................................................................................................................16
 Foreign Bonds:.......................................................................................................................................16
Debentures............................................................................................................................................16
Mortgage Bond:.....................................................................................................................................16
Characteristics of Bonds............................................................................................................................16
Bond indenture..........................................................................................................................................17
Bond Valuation formula............................................................................................................................17
Value of Zero Coupon Bond=.....................................................................................................................18
Interpolation simple formula.....................................................................................................................18
Current Yield..............................................................................................................................................18
Stock..........................................................................................................................................................18
Key Differences b/w Bonds and Stocks......................................................................................................19
Where do bonds & stocks appear on the Balance Sheet?.........................................................................19

Types of Stock............................................................................................................................................19
Preferred Stock......................................................................................................................................19
Common Stock......................................................................................................................................19
Stock Valuation..........................................................................................................................................20
Preferred Stock Valuation..........................................................................................................................20
Common Stock Valuation..........................................................................................................................20
Dividend Valuation Model.........................................................................................................................20
Constant Growth...................................................................................................................................20
 No Growth.............................................................................................................................................20
Varaible growth.....................................................................................................................................20
Risk of Return............................................................................................................................................21
Defining Return.........................................................................................................................................21
Standalone Return.....................................................................................................................................22
Standalone Risk.........................................................................................................................................22
Risk Attitudes.............................................................................................................................................23
Risk Preference......................................................................................................................................23
Risk Indifference....................................................................................................................................23
Risk Aversion.........................................................................................................................................23
Portfolio Investment..................................................................................................................................23
Return of portfolio.....................................................................................................................................23
Risk of portfolio.........................................................................................................................................24
Correlation Coefficient..............................................................................................................................24
Total Risk...................................................................................................................................................24
Systematic Risk......................................................................................................................................24
Unsystematic Risk..................................................................................................................................25
What is Beta?............................................................................................................................................25
Beta of a Portfolio......................................................................................................................................25
Capital Asset Pricing Model (CAPM)..........................................................................................................25
Underpriced...........................................................................................................................................25
Overpriced.............................................................................................................................................25
Cost of Capital...........................................................................................................................................26
Cost of Debt...........................................................................................................................................26
Cost of Preferred Stock..........................................................................................................................26
WACC.........................................................................................................................................................27
What is Capital Budgeting?........................................................................................................................27
Project Evaluation: Alternative Methods..................................................................................................27
Payback Period (PBP).............................................................................................................................27
Discounted Payback Period (DPP)..........................................................................................................27
Net Present Value (NPV)........................................................................................................................28
Internal Rate of Return (IRR).................................................................................................................28
 Modified Internal Rate of Return (MIRR)...............................................................................................28
Profitability Index (PI)............................................................................................................................28
Types of Projects.......................................................................................................................................28
Independent Project..............................................................................................................................28
Dependent.............................................................................................................................................28
Mutually Exclusive.................................................................................................................................28
Cash Management.....................................................................................................................................29
Collection Float:.....................................................................................................................................29
Mail Float..............................................................................................................................................29
Processing Float:....................................................................................................................................29
Availability Float:...................................................................................................................................29
Deposit Float.........................................................................................................................................29
Lockbox System.........................................................................................................................................29
Cash Budget...............................................................................................................................................30
Ratio Analysis............................................................................................................................................30
Financial ratios..........................................................................................................................................30
External Comparisons and Sources of Industry Ratios...............................................................................30
1. Liquidity Ratios..................................................................................................................................30
Current Ratio.........................................................................................................................................30
Quick/ Acid-test ratio............................................................................................................................31
Cash and cash equivalent ratio..............................................................................................................31
Net Working Capital..............................................................................................................................31
Operating cash flow ratio......................................................................................................................31
2. Financial Leverage Ratios...................................................................................................................31
Debt-to-Equity.......................................................................................................................................31
Debt-to-Total-Assets..............................................................................................................................31
Total Capitalization................................................................................................................................31
Debt-to-EBITDA ratio.............................................................................................................................32
Asset to equity ratio..............................................................................................................................32
3. Coverage Ratios.................................................................................................................................32
Interest Coverage..................................................................................................................................32
4. Asset Management ratios/ Activity ratios..........................................................................................32
 Receivable Turnover..............................................................................................................................32
Avg Collection Period.............................................................................................................................32
Payable Turnover (PT)............................................................................................................................32
Payable turnover in days.......................................................................................................................32
Total Asset Turnover..............................................................................................................................32
Inventory Turnover................................................................................................................................33
days sales in inventory ratio..................................................................................................................33
Days Sales Outstanding.........................................................................................................................33
Cash conversion cycle............................................................................................................................33
5. Profitability Ratios.............................................................................................................................33
Gross Profit Margin................................................................................................................................33
Net Profit Margin...................................................................................................................................33
Return on Assets....................................................................................................................................34
Operating margin ratio..........................................................................................................................34
Return on Equity....................................................................................................................................34
6. Market Value Ratios..........................................................................................................................34
EPS.........................................................................................................................................................34
DPS........................................................................................................................................................34
Dividend Payout....................................................................................................................................35
Dividend Yield........................................................................................................................................35
Common-size Analysis/ vertical Analysis...................................................................................................35
Index Analysis/ trend analysis...................................................................................................................35
Horizontal analysis.....................................................................................................................................35
M.V.A (Market Value Added):...................................................................................................................36
Economic Value Added..............................................................................................................................36
Capital Structure........................................................................................................................................36
ri = the yield on the company’s debt......................................................................................................36
re = the expected return on the company’s equity................................................................................36
ro = an overall capitalization rate for the firm........................................................................................36
Arbitrage and Total Market Value of the Firm...........................................................................................37
Arbitrage....................................................................................................................................................37
Agency Costs.............................................................................................................................................37
Tax Shield..................................................................................................................................................37
What is Financial Management (FM)?.......................................................................................................37
Internal Business Environment:.................................................................................................................37
External Business Environment.............................................................................................................38
SWOT ANALYSIS.........................................................................................................................................38
Treasury Stock...........................................................................................................................................39
Bank Statements.......................................................................................................................................39
Petty Cash Fund.........................................................................................................................................39
Long-Term Liabilities..................................................................................................................................39
Why Issue Bonds?......................................................................................................................................39
Yield to Maturity formula..........................................................................................................................40

Finance:
It is the art and science of managing money.

It means attaining amount of money investing it and earning returns on it

Finance is the science of managing financial resources in an optimal pattern i.e. the best use of
available financial sources

Time value of Money

= Value of money is different at different points of time

The first concept, time value of money, says that a rupee in your hand today is worth more than the
rupee that you are going to get tomorrow or the day after.

This is because if you have a rupee in hand, you can put it into a bank (invest it) and can earn interest
(return) on it, and tomorrow you are going to have more than rupee one, which of course, is more
desirable than having just one rupee.

Financial markets
Markets where financial instruments are bought and sold

Capital Market
The market for relatively long-term (greater than one year original maturity) financial instruments.
These are the markets for the long term debt & corporate stocks.
It includes:

Stock Exchange:

A stock exchange is a place where the listed shares, Term finance certificates (TFC) and national
investment trust units (NIT) are exchanged and traded between buyers and sellers.

Long term bonds:

Long term government & corporate bonds are also traded in capital markets.

Money market
The market for relatively short-term (less than one year original maturity) financial instruments

Primary Market
A market where new securities are bought and sold for the first time (a “new issues” market).

Secondary Market
A market for existing (used) securities rather than new issues

Public Issue
Sale of bonds or stock to the general public

Private placement

Sale of stocks, bonds, or securities directly to a private investor. The sale of an entire issue of
unregistered securities (usually bonds) directly to one purchaser or a group of purchasers (usually
financial intermediaries).

Initial Public Offering (IPO)

A company’s first offering of common stock to the general public.
Types of Long-Term Debt Instruments

Debenture
A debenture is a type of long-term bond or other debt instrument that is unsecured by
collateral.

Subordinated Debenture
A long-term, unsecured debt instrument with a lower claim on assets and income than other classes of
debt; known as junior debt.

Income Bond
A bond where the payment of interest is contingent upon sufficient earnings of the firm

Junk Bond
A high-risk, high-yield (often unsecured) bond rated below investment grade

Mortgage Bond
A bond issue secured by a mortgage on the issuer’s property, Secured by real property i.e. Land, house
Equipment Trust Certificate
An intermediate- to long-term security, usually issued by a transportation company such as a railroad or
airline, that is used to finance new equipment.

Sinking Fund
Fund established to periodically retire a portion of a security issue before maturity

Balloon Payment
A payment on debt that is much larger than other payments

Serial Bonds
Bonds that mature in installments

An issue of bonds with different maturities, as distinguished from an issue where all bonds have
identical maturities.

Call Provision
A feature in an indenture that permits the issuer to repurchase securities at a fixed price (or series of
fixed prices) before maturity; also called call feature

Call Price
The price at which a security with a call provision can be purchased by the issuer prior to the security’s
maturity

Cash conversion cycle

The cash conversion cycle (CCC) is a metric that expresses the time (measured in days) it takes for a
company to convert its investments in inventory and other resources into cash flows from sales
Hedging (or Maturity Matching) Approach
A method of financing where each asset would be offset with a financing instrument of the same
approximate maturity

i.e. Insurance

Investment Banker
An investment banker is an individual who often works as part of a financial institution and is primarily
concerned with raising capital for corporations, governments, or other entities.

Investment bankers use three primary means companies use to offer securities to the general public:

– Traditional (firm commitment) underwriting

– Best efforts offering

– Shelf registration

Traditional (firm commitment) underwriting

Bearing the risk of not being able to sell a security at the established price by virtue of purchasing the
security for resale to the public; also known as firm commitment underwriting.
If the security issue does not sell well, either because of an adverse turn in the market or because it is
overpriced, the underwriter, not the company, takes the loss

Underwriting Syndicate
A temporary combination of investment banking firms formed to sell a new security issue.

Three ways an underwriting syndicate is formed are:

Competitive-bid
– The issuing company specifies the date that sealed bids will be received.

– Competing syndicates submit bids.

– The syndicate with the highest bid wins the security issue.

Negotiated Offering
• The issuing company selects an investment banking firm and works directly with the firm to
determine the essential features of the issue.

• Together they discuss and negotiate a price for the security and the timing of the issue.

• Depending on the size of the issue, the investment banker may invite other firms to join in
sharing the risk and selling the issue.

• Generally used in corporate stock and most corporate bond issues.

Best efforts offering

A security offering in which the investment bankers agree to use only their best efforts to sell the
issuer’s securities. The investment bankers do not commit to purchase any unsold securities.

Shelf Registration
A procedure whereby a company is allowed to register securities it plans to sell over the next two years;
also called SEC Rule 415. These securities can then be sold fragmentary whenever the company
chooses.

Privileged Subscription
The sale of new securities in which existing shareholders are given a preference in purchasing these
securities up to the proportion of common shares that they already own; also known as a rights
offering.

Preemptive Right
The opportunity of shareholders to maintain their proportional company ownership by purchasing a
proportionate share of any new issue of common stock, or securities convertible into common stock.

Subscription right
A short-term option to buy a certain number (or fraction) of securities from the issuing corporation

What gives a right its value?

A right allows you to buy new stock at a discount that typically ranges between 10 to 20 percent from
the current market price.

Present Value= Future value/ (1+i)^n

Also called discounting

Future value= Present Value (1+i)^n

Also called compounding

Annuity
Payments or receipt of equal amount of money occurring over the specified and equal time periods

Ordinary Annuity = Payments or receipt at the end of time period

Annuity Due = Payments or receipt at the beginning of time period

Future value of Annuity formulas

Ordinary Annuity=

Annuity Due =
( 1+i)
Present value of Annuity formulas
Ordinary Annuity=

Annuity Due =

Perpetuity:
It is a never ending annuity

Future Value of Prepetuity= PMT/ interest rate

Effective Annual Interest Rate

The actual rate of interest earned (paid) after adjusting the nominal rate for factors such as the number
of compounding periods per year.

Formula:

Loan Amortization
If a loan is to be repaid in equal periodic payments, it is said to be amortized loan.
 It is an application of compounding interest and annuity.

1. Calculate the payment per period.

2. Determine the interest in Period t. (interest x Beg. Amt)

3. Compute principal payment in Period t. (Payment - interest from Step 2)

4. Determine ending balance in Period t. (Balance - principal payment from Step 3)

5. Start again at Step 2 and repeat.

First we calculate PMT value using PV of annuity formula then perform these steps

When a company or investor rising funds he have two possible options available to him.

1) Equity

2) Debt

Bonds
A bond is a long-term debt instrument issued by a corporation or government.

A bond is a Long term contract under which borrowers agrees to make payments of interest and
principal on specific dates to the bond holder.

To issue bonds approval of board of directors and stakeholders is must

Types of Bonds
Secured bonds
Specific assets of the issuer pledged as collateral for the bonds

Unsecured bonds
No Specific assets of the issuer pledged as collateral for the bonds. Also called debentures

Term Bond
Bonds that mature at a single specified future date

Serial bond
Bonds that mature in installments

Registered bonds
• issued in the name of the owner and have interest payments made by check to bondholders
of record
Bearer or coupon bonds
not registered; thus bondholders must send in coupons to receive interest payments

Convertible
Convert the bonds into common stock at holder’s option

Callable
Subject to call and retirement at a stated dollar amount prior to maturity at the option of the issuer

Treasury Bonds :
o Bonds issued by the government

o No default risk

Corporate Bonds:
o Bonds issued by the corporations

o Exposed to default risk

Municipal Bonds:
o Issued by state or local government

o It has default risk and low interest rate

Foreign Bonds:
o Default risk is involved

o Currency risk

Debentures:
u Unsecured – no asset backing

Mortgage Bond:
u Secured by real property i.e. Land, house

u Others: Eurobond, Zeros, Junk, etc.

Characteristics of Bonds
u The bond’s coupon rate is the stated rate of interest.
 u The maturity value (MV) [Par value or face value] of a bond is the stated value. It represents the
amount of money the firm borrows or promises to repay on maturity date

u The discount rate (required rate of return) is dependent on the risk of the bond and is composed
of the risk-free rate plus a premium for risk.

u Maturity date - Bonds have specified maturity date on which the par value be repaid

A non-zero coupon-paying bond is a coupon-paying bond with a finite life.

A zero-coupon bond is a bond that pays no interest but sells at a deep discount from its face value.

Bonds are given ratings to reflect their probability of going into default

Ratings effects the stability and cost

• CRA in Pakistan:

• PACRA

• JCR-VIS

Bond indenture
Terms of the bond issue as defined in a formal legal document

Bond Valuation formula

VB =INT [1- (1+rd)⁻ⁿ]+MV(1+rd)⁻n

rd

INT = Interest Payment (Interest rate x par value)

rd = Market value of interest

MV = Maturity Value

N = No of Years

Bond at Par Value:

If coupon rate = rd

VB = Fv

• Premium Bond:
 If coupon rate > rd

VB > Fv

• Discount Bond:

If coupon rate <rd

VB < Fv

Zero Coupon Bond

Value of Zero Coupon Bond= VB = MV(1+rd)⁻ⁿ

For bond with semi annual compounding INT AND Rd divided by 2 and N multiplied by 2

• Yield to Maturity

The return earned on bonds held till maturity is defined as YTM

• Yield to Call

The return earned on bonds held till called is defined as YTC

Interpolation simple formula

INT + (MV-VB)/N

0.4(MV)+0.6(VB)

Current Yield
The annual interest payment divided by the bonds current price is the current yield

Stock
A stock (also known as equity) is a security that represents the ownership of a portion of a
corporation. 
Key Differences b/w Bonds and Stocks
• The main difference between shares and bonds is that shares are representation of ownership in
a company while bonds are not representative of ownership.

• The second difference is that shares last as long as the company lasts where as bonds have
limited life.

• Another difference is that the return on a bond is predetermined, i.e., the investor knows in
advance how much return he would get from a bond. However, a stockholder cannot be certain
about the return on a stock investment, since the dividends may or may not be paid in a certain
year or the percentage of dividends announced may vary.

Where do bonds & stocks appear on the Balance Sheet?

In the marketable securities section under cash

Types of Stock
Preferred Stock
Stock with fixed dividend but no voting right

Common Stock
Residual income with voting rights & is a risky Investment
Stock Valuation
It is the calculation of the present value of cash flows expected from stocks.

• Capital Gain- from selling or buying of share

• Dividend Gain- paid by company

Preferred Stock Valuation

Vp = Dp / rp

P for preferred stock

Vp= Value / Price of P. Stock

Dp = Dividend on P. Stock

rp = Required rate of return on P. Stock

Common Stock Valuation

What cash flows will a shareholder receive when owning shares of common stock?

(1) Future dividends

2) Future sale of the common stock shares

Dividend Valuation Model

Constant Growth
P= D1/ rs-g

D1= Do(1+g)

No Growth
P= D0/ rs

Varaible growth
 Risk of Return
Return = Amt Received – Amt Invested

Rate of return = Amt Received – Amt Invested

Amt Invested

Defining Return
Income received on an investment plus any change in market price, usually expressed as a percent of
the beginning market price of the investment.

Simply

Mathematically

Dt + (Pt - Pt-1
R= )
Pt-
1
Investment

Standalone Investment Portfolio Investment

-Standalone Return -Portfolio Return

-Standalone Risk -Portfolio Risk
Standalone Return
r = r1P1 + r2P2+…..+rnPn

Standalone Risk

Coefficient of variation:

CV = risk / return

CV= sigma/r

Risk Attitudes
Risk Preference
Certainty equivalent > Expected value

Tendency to choose a risky investement

Risk Indifference
Certainty equivalent = Expected value

The attitude toward risk in which no change in return would be required for an increase in risk.
Risk Aversion
Risk aversion is the tendency of people to prefer outcomes with low uncertainty to those
outcomes with high uncertainty,

Certainty equivalent < Expected value

Most individuals are Risk Averse

Portfolio Investment
Investment in one or more stocks

Return of portfolio

Risk of portfolio

Correlation Coefficient
A standardized statistical measure of the linear relationship between two variables.
The range is from -1.0 to + 1.0

-1.0 (perfect negative correlation)

0 (no correlation)

+1.0 (perfect positive correlation)

Total Risk = Systematic Risk + Unsystematic Risk

Systematic Risk is the variability of return on stocks or portfolios associated with changes in return
on the market as a whole. Also called market risk

Systematic risk is due to factors such as changes in nation’s economy, tax reform by the Congress,

or a change in the world situation.

Unsystematic Risk is the variability of return on stocks or portfolios not explained by general
market movements. It is avoidable through diversification. Also called diversifiable risk

Factors unique to a particular company or industry. For example, the death of a key executive or loss of
a governmental defense contract.

What is Beta?
It measures the sensitivity of a stock’s returns to changes in returns on the market portfolio.

β measures the tendency of the stock to move up and down with the changes in market

If β= 1.0 it shows the security is as risky as the entire market, it is the beta of an average security

If β= 0.5 it shows the security is half as risky as an average security

If β= 2.0 it shows the security is twice as risky as an average security

Beta of a Portfolio
The beta of a portfolio is the weighted average of beta of its individual securities

βp = w1b1+w2b2+…..+wnbn

Capital Asset Pricing Model (CAPM)

CAPM (Capital Asset Pricing Model) takes into account the systematic risk as the unsystematic risk can
be diversified. It creates a theoretical relationship between risk and rate of return from a portfolio.
CAPM is a model that describes the relationship between risk and expected (required) return; in this
model, a security’s expected (required) return is the risk-free rate plus a premium based on the
systematic risk of the security.

Rj = Rf + bj(RM - Rf)

To calculate if the stock is overvalued or undervalued first use R j = Rf + bj(RM - Rf) formula then use
formula D/ Rj-g.

Underpriced
When the offer price is lower than the price of the first trade, the stock is considered to be
underpriced.

Overpriced
• when the offer price is greater than the price of the first trade, the stock is considered to be
overpriced.

Cost of Capital
It is the required rate of return on the various types of financing. The overall cost of capital is a
weighted average of the individual required rates of return (costs).

It includes

Cost of Debt is the required rate of return on investment of the lenders of a company kite.
r i = rd ( 1 - T )

Cost of Preferred Stock is the required rate of return on investment of the preferred
shareholders of the company.

rP = DP / Vp

The cost of equity capital, re, is the discount rate that equates the present value of all expected
future dividends.

• Dividend Discount Model

Constant dividend growth

Rd = ( D 1 / P 0 ) + g

• Capital-Asset Pricing Model

re = Rj = Rf + (Rm - Rf)bj

• Before-Tax Cost of Debt plus Risk Premium

Rp = Rd + Risk Premium

WACC
What is Capital Budgeting?
The process of identifying, analyzing, and selecting investment projects whose returns (cash flows) are
expected to extend beyond one year.

Project Evaluation: Alternative Methods

Payback Period (PBP)
– PBP is the period of time required for the cumulative expected cash flows from an investment
project to equal the initial cash outflow.

– The period in which the project initial investment will be back

Discounted Payback Period (DPP)

DPP is the period of time required for the cumulative expected cash flows from an investment project to
equal the initial cash outflow at a discount rate.

The period in which the project initial investment will be back

Net Present Value (NPV)

NPV is the present value of an investment project’s net cash flows minus the project’s initial cash
outflow.

The NPV is negative. This means that the project is reducing shareholder wealth

Internal Rate of Return (IRR)

IRR is the discount rate that equates the present value of the future net cash flows from an investment
project with the project’s initial cash outflow.

Modified Internal Rate of Return (MIRR)

When IRR fails and there are non-normal cash flows then we use a modified technique Called as MIRR

Profitability Index (PI)

PI is the ratio of the present value of a project’s future net cash flows to the project’s initial cash
outflow.
The PI is less than 1.00. This means that the project is not profitable

Types of Projects
Independent Project
A project whose acceptance (or rejection) does not prevent the acceptance of other projects under
consideration.

Dependent
A project whose acceptance depends on the acceptance of one or more other projects.

Mutually Exclusive
A project whose acceptance prevents the acceptance of one or more alternative projects.

Cash Management
The basic aim of cash management is to have minimum amount of cash on hand but at the same time
have enough cash to maintain the credit ratings, take advantage of trade discounts and to fulfill the
sudden cash outflow.

Collection Float:
Total time between the mailing of the check by the customer and the availability of cash to the receiving
firm.

Mail Float
Time the check is in the mail.

Processing Float:
Time it takes a company to process the check internally.

Availability Float:
Time consumed in clearing the check through the banking system.

Deposit Float
Time during which the check received by the firm remains uncollected funds

Lockbox System
A post office box maintained by a firm’s bank that is used as a receiving point for customer remittances.

Lockbox is a bank-operated mailing address to which a company directs its customers to send their
payments.

Cash Budget
Cash budget is a schedule showing projected cash inflows and cash outflows over a time

It is a primary cash planning tool and it shows surplus and deficits over a period of time

Ratio Analysis
It means calculating ratios from financial statements to analyze the financial performance of the
company.

Financial ratios
A Financial Ratio is an index that relates two accounting numbers and is obtained by dividing one
number by the other.

Financial Ratios are used to gain meaningful information about a company.

External Comparisons and Sources of Industry Ratios

This involves comparing the ratios of one firm with those of similar firms or with industry averages.

Similarity is important as one should compare “apples to apples.”

  Ratios are compared with the ratios of previous year ratios of the same firm
 Ratios are compared with the ratios of other similar firm
 Ratios are compared with the industry average

1. Liquidity Ratios
Liquidity ratios are financial ratios that measure a company’s ability to repay short-term obligations.
Common liquidity ratios include the following:

Current Ratio
Shows a firm’s ability to cover its current liabilities with its current assets

Current ratio = Current assets / Current liabilities

Generally, the higher the ratio, the better it is considered, but too high a ratio may imply less productive
use of current assets. A ratio of two to one (2:1) is considered ideal.

Quick/ Acid-test ratio

The acid-test ratio measures a company’s ability to pay off short-term liabilities with the most liquid
assets.

Acid-test ratio = Current assets – Inventories / Current liabilities

A desirable quick ratio can range from (0.8:1) to (1.5:1) depending on the nature of the business.

Cash and cash equivalent ratio

The cash ratio measures a company’s ability to pay off short-term liabilities with cash and cash
equivalents.

Cash ratio = Cash and Cash equivalents / Current Liabilities

Net Working Capital

Current Assets - Current Liabilities

+ive NWC is a good sign that firm can sell assets to pay debts

Operating cash flow ratio

The operating cash flow ratio is a measure of the number of times a company can pay off current
liabilities with the cash generated in a given period:

Operating cash flow ratio = Operating cash flow / Current liabilities

 2. Financial Leverage Ratios
A leverage ratio is any one of several financial measurements that look at how much capital comes in
the form of debt

Debt-to-Equity
It calculates the weight of total debt and financial liabilities against shareholders’ equity.

Debt to equity ratio = Total liabilities / Shareholder’s equity

Debt-to-Total-Assets
It measures the relative amount of a company’s assets that are financed from debt:

Debt to asset ratio = Total liabilities / Total assets

Total Capitalization
Total Debt/ Total Capitalization

Shows the relative importance of long-term debt to the long-term financing of the firm

Debt-to-EBITDA ratio
Measures the amount available before paying interest, taxes, depreciation, and amortizations.

Debt-to-EBITDA ratio= Total debts/ EBITDA

Asset to equity ratio

It measures the proportion of an entity’s assets that has been funded by shareholders.

Asset to equity ratio = Total assets/ total shareholder’s equity

3. Coverage Ratios
Interest Coverage
EBIT/Interest Charges

Indicates a firm’s ability to cover interest charges.

4. Asset Management ratios/ Activity ratios

Efficiency ratios, also known as activity financial ratios, are used to measure how well a company is
utilizing its assets and resources. Common efficiency ratios include:

Receivable Turnover
How quick a company is in receiving its receivables/ The accounts receivable turnover ratio measures
how efficiently a company can turn receivables into cash over a given period:
Receivables turnover ratio = Net credit sales / Average accounts receivable

Avg Collection Period

Average number of days that receivables are outstanding.

365/ receivable turnover ratio

Payable Turnover (PT)

Indicates the promptness of payment to suppliers by the firm.

Net credit purchases/ Average Account payables

Payable turnover in days

Average number of days that payables are outstanding.

365/payable turnover ratio

Total Asset Turnover

Indicates the overall effectiveness of the firm in utilizing its assets to generate sales.

Asset turnover ratio = Net sales / Average total assets

Inventory Turnover
How many times company has sold and replaced inventory over a specified period of time

Inventory turnover ratio = Cost of goods sold / Average inventory

days sales in inventory ratio 

The days sales in inventory ratio measures the average number of days that a company holds on to
inventory before selling it to customers:

Days sales in inventory ratio = 365 days / Inventory turnover ratio

Days Sales Outstanding

Days sales outstanding (DSO) is a measure of the average number of days that it takes a company to
collect payment for a sale.

Days Sales Outstanding = accounts receivable / total credit sales * 365

Cash conversion cycle 

The cash conversion cycle (CCC) is a metric that expresses the time (measured in days) it takes for a
company to convert its investments in inventory and other resources into cash flows from sales.

CCC = Days sales in inventory ratio +DSO−DPO

DPO = Account payables/ CGS on accounting period * 365

 5. Profitability Ratios
Profitability ratios assess a company's ability to earn profits from its sales or operations, Profitability
ratios indicate how efficiently a company generates profit and value for shareholders.

Gross Profit Margin

Indicates the efficiency of operations and firm pricing policies

The gross margin ratio compares the gross profit of a company to its net sales to show how much profit
a company makes after paying its cost of goods sold:

Gross margin ratio = Gross profit / Net sales

Net Profit Margin

Indicates the firm’s profitability after taking account of all expenses and income taxes

Net profit/ net sales

Return on Assets
The overall profitability is called ROA

Indicates the profitability on the assets of the firm (after all expenses and taxes)

Net income/ Total Assets

Net profit margin X Total asset turnover

Operating margin ratio

The operating margin ratio compares the operating income of a company to its net sales to determine
operating efficiency

Operating margin ratio = Operating income / Net sales

Return on Equity
Indicates the profitability to the shareholders of the firm

Return on equity ratio = Net income / Shareholder’s equity

Or

Return On Equity = Net profit margin X Total asset turnover X Equity Multiplier
Equity Multiplier = Total Assets/ Shareholders’ Equity

6. Market Value Ratios

These ratios compare the price of the company's stock with different variables including the Earning per
share (EPS), Dividend per share (DPS) etc

Market value ratios are used to evaluate the current share price of a publicly-held company's stock

EPS
Net earnings / common stock outstanding

This indicates what is the earning on each share investment and what company is paying to its
shareholders.

DPS
Total Dividends/ common stock outstanding

Indicates the amount of dividend being paid out on each share

Price to earning ratio

Market Price per share/EPS

Indicates how the investment community sees our company. A high P/E is considered a Good Sign.

The price-earnings (PE) ratio measures the ratio of the market price of each share of common stock to
the earnings per share.

MARKET PRICE PER SHARE OF COMMON STOCK

PRICE-EARNINGS RATIO = —————————————————————————

EARNINGS PER SHARE

Dividend Payout
DPS/EPS

This ratio indicates how much of the earnings of the company are paid out in the form of dividends.

Dividend Yield
DPS/ Market price per share;

This ratio indicates dividend return to the shareholders of the company

Common-size Analysis/ vertical Analysis
An analysis of percentage financial statements where all balance sheet items are divided by total assets
and all income statement items are divided by net sales or revenues.

Index Analysis/ trend analysis

An analysis of percentage financial statements where all balance sheet or income statement figures for a
base year equal 100.0 (percent) and subsequent financial statement items are expressed as percentages
of their values in the base year.

Horizontal analysis
The purpose of horizontal analysis is to determine the increase or decrease that has taken place. This
change may be expressed as either an amount or a percentage.

It shows the trend in accounts over the years

Formula= new year figure-old year figure/ old year figure

M.V.A (Market Value Added):

Market Value Added is a measure of wealth added to the amount of equity capital provided by the
shareholders. It can be determined by the following equation

• Market Value of Equity – Book Value of Equity Capital

Economic Value Added

Economic Value Added, on the other hand, focuses on the managerial effectiveness in a given year. It
can be obtained by subtracting the cost of total capital from the operating profits of a company

EVA (Rupees) = EBIT (or Operating Profit) – Cost of Total Capital

Capital Structure
The mix (or proportion) of a firm’s permanent long-term financing represented by debt, preferred stock,
and common stock equity.

ri = the yield on the company’s debt

ri= Annual interest on debt / Market value of debt

ri=I/B

re = the expected return on the company’s equity

re= Earnings available to common shareholders/Market value of common stock outstanding

re= E/S

ro = an overall capitalization rate for the firm

ro= Net operating income / Total market value of the firm

ro= O/V

O= I+E

V=B+S

Ro= capitalization rate= The discount rate used to determine the present value of a stream of expected
cash flows.

Ro= Ri(B/B+S) + Re( S/ B+S)

Arbitrage and Total Market Value of the Firm

Two firms that are alike in every respect EXCEPT capital structure MUST have the same Market value.

Otherwise, arbitrage is possible.

Arbitrage
Arbitrage is the practice of taking advantage of a price difference between two or more market

-- Finding two assets that are essentially the same and buying the cheaper and selling the more
expensive.
Agency Costs
Costs associated with monitoring management to ensure that it behaves in ways consistent with the
firm’s contractual agreements with creditors and shareholders.

Tax Shield
A tax-deductible expense. The expense protects (shields) an equivalent dollar amount of revenue from
being taxed by reducing taxable income.

What is Financial Management (FM)?

FM is the management of financial resources – it means how to best find and use investments and
financing opportunities in an ever-changing and increasingly complex environment.

FM is used to study the design, analysis, and construction of financial plans to help meet the needs of
enterprise.

Internal Business Environment:

• Internal environment of business normally consists of the following.

• Finance

• Marketing

• Human Resources

• Operations (Production, Manufacturing)

• Technology

• Other Functions (Logistics, Communications)

External Business Environment

The following business environment factors outside an organization have a profound effect on the
functions and operations of an organization.

• Customers

• Suppliers

• Competitors

• Government/Legal Agencies & Regulations

 • Macro Economy/Markets:

• Technological Revolution

SWOT ANALYSIS
An analysis which is used in a business is called SWOT Analysis. SWOT is an acronym where

• S stands for Strengths

• W stands for Weaknesses

• O stands for Opportunities

• T stands for Threats

• Strengths and weaknesses are within an organization, i.e., they pertain to the internal
environment of the organization.

• Opportunities and threats, on the other hand, pertain to the external environment, i.e., outside
the organization.

Treasury Stock
Treasury shares are issued shares that have been reacquired by the corporation.

Bank Statements
Shows the beginning bank balance, deposits made, checks paid, other debits and credits in the month,
and the ending bank balance.

Reconciling the Bank Statement

Explains the difference between cash reported on bank statement and cash balance in depositor’s
accounting records.

Petty Cash Fund

Cash for making minor expenses, It is used to meet expenses for which the amount is too small to sign a
checque

Trading securities sell within days or hours, and reported in the other revenue section of income
statement

Other securities are reported in the equity section of the balance sheet
Long-Term Liabilities
• Obligations that are expected to be paid after one year

Why Issue Bonds?

Long-term financing, bonds, offer the following advantages over common stock:

1) Stockholder control not affected

2) Tax savings

3) Earnings per share may be higher

Disadvantages of Bonds

1) Interest must be paid on a periodic basis

2) Principal (face value) must be repaid at maturity

Yield to Maturity formula

Financial Reporting and Analysis

Financial reporting is presenting financial data of a company's position, operating performance, and
funds flow for an accounting period.

Financial statements together with related information may be contained in various forms for external
party use such as in the annual reports.

It is basically financial information that companies give about their activities, including how they prepare
and show it.
Objectives of FRA
• -Usefulness

• -Understandability

• -Target audience: investors and creditors

• -Assessing future cash flows

• -Evaluating economic resources

• -Primary focus on earnings

Meaning of the following accounting concepts;

1. Going concern

The assumption that the business will continue in operation for the foreseeable future without
significantly curtailing its activity.

2. Prudence

Prudence is the inclusion of a degree of caution when making estimates under conditions of uncertainty.

It ensures that assets and income are not overstated and liabilities are not understated

3. Materiality

Materiality is a threshold quality that is demanded of all information given in the financial statements,
i.e. information that is material should be given in the FS but information that is not material need not
be given.

Information is material if its omission or misstatement might reasonably be expected to influence the
economic decisions of users.

Whether or not information is material will depend on the size and nature of the item and the size of
the business

4. Consistency

Items should be treated in the same way year on year. This will enable valid comparisons to be made.
However, if circumstances change then a business is allowed to change policies to give a fairer
representation of the financial statements.

5. Accruals

To calculate the profit for the period, one must include all the revenue and expenditure relating to
the period, whether or not the cash has been received or paid.
This concept also states that income and expenses should be matched against each other within an
accounting period as far as possible

Why a regulatory framework is necessary?

Regulation of accounting information is aimed at ensuring that users of financial statements receive a
minimum amount of information that will enable them to make meaningful decisions regarding their
interest in a reporting entity.

A regulatory framework is required to ensure that relevant and reliable financial reporting is achieved
to meet the needs of shareholders and other users.

Accounting standards on their own would not be a complete regulatory framework. In order to fully
regulate the preparation of financial statements and the obligations of companies and directors, legal
and market regulations are also required.

Principles-based and Rules-based framework

Principles-based framework
• Based upon a conceptual framework such as the IASB’s framework

• Accounting standards are set on the basis of the conceptual framework

Rules-based framework
• Accounting standards are a set of rules which companies must follow

The Standard Setting Process of accounting/financial reporting standard

• IFRS Foundation

Supervise the IASB and ensure each segment is properly funded

• IASB/ IFRS

Is solely responsible for issuing International Accounting Standards

• IFRS Interpretations Committee

Issues rapid guidance on accounting matters where different interpretations of IFRSs have arisen

• IFRS Advisory Council

Advising the board on agenda decisions and priorities in the board’s work

The IASB identifies a subject and appoints an advisory committee to advise on the issues. The IASB
publishes an exposure draft for public comment. Following the consideration of comments received on
the draft, the IASB publishes the final text of the IFRS.
The publication of an IFRS, exposure draft requires the votes of at least eight of the 15 IASB members

What is a conceptual framework?

• A conceptual framework is a framework which prescribes the nature, function, and limits of
financial accounting and financial statements

• A clear system of interrelated objectives and fundamental principles

Why have a conceptual framework?

There are a variety of arguments for having a conceptual framework

• It enables accounting standards and GAPP to be developed in accordance with agreed

principles

• Lack of a conceptual framework may mean that certain critical issues are not addressed.

• Accounting standards based on principles are thought to be harder to avoid

• A conceptual framework strengthens the credibility of financial reporting and the accounting
profession

Objective of financial reporting

The objective of financial reporting is to provide financial information about the entity that is useful to
existing and potential investors.

Objectives of financial statements

The objective of FS is to provide information about:

1. The financial position of an entity (provided mainly in the SFP)

2. The financial performance (provided mainly in the IS)

3. Changes in the financial position of an entity (provided in the statement of changes in equity)

Historical cost
Under historical cost accounting, assets are recorded at the amount of cash or cash equivalents paid, or
the fair value of the consideration given for them

Liabilities are recorded at the amount of proceeds received in exchange for the obligation. This method
of accounting has advantages, but it also has serious disadvantages.

Whilst being both easy to ascertain and objective, the historical cost basis of measurement fails to relate
directly to any of the three decisions that might reasonably be made about an asset:
Another, similar asset might be purchased. Management need to know the current replacement cost
which might have changed substantially since the present asset was purchased at its historical cost.

The asset might be sold. Management need to know the amount which would be realized from sale,
less any costs involved in disposal, i.e. the NRV. Again this may bear no relationship to historical cost.

The asset might be used in the business. Management need to estimate the future cash flows arising
from the asset and discount these to their present value, i.e. their economic value. Clearly there is no
direct link with historical cost in this case.

Alternative to historical cost accounting

• Constant purchasing power (CPP) or

• Current cost accounting (CCA)

Constant purchasing power (CPP)

• Accounts figures are adjusted to show all figures in terms of money with the same purchasing
power

• A general price index is used for this

• Figures in the IS and SFP are adjusted by the CPP factor

• CPP factor = Index at the reporting date / Index at the date of entry in accounts

Current cost accounting (CCA)

1. It is based on deprival values or value to the business

Only non-monetary assets are adjusted and monetary assets are not

Assets are stated at their value to the business. Holding gains are eliminated from profit

Auditor’s opinion
An auditor conducts an independent examination of the accounting information presented by the
business and issues a report.

• An auditors report is the formal statement of the auditor’s opinion of the financial statement
after conducting an audit

• Audit opinions are classified as follows;

• Unqualified opinion

• Qualified opinion

• Adverse opinion
 • Disclaimer of opinion

Unqualified opinion
This opinion states that the financial statement present fairly, in all material respects, the financial
position, results from operations and cash flows of the entity, in conformity with generally accepted
accounting principles

Qualified opinion
A qualified opinion states that, except for the effects of the matters to which the qualification relates,
the FS present fairly, in all material respects, the financial position, results from operations and cash
flows of the entity, in conformity with generally accepted accounting principles.

Adverse opinion
This opinion states that the FS do not present fairly the financial position, results from operations and
cash flows of the entity, in conformity with generally accepted accounting principles.

Disclaimer of opinion
A disclaimer of opinion states that the auditor does not express an opinion on the financial statements.
A disclaimer of opinion is rendered when the auditor has not performed an audit sufficient in scope to
form an opinion.

Selection of accounting policies

Accounting policies are the principles bases, conventions, rules and practices applied by an entity which
specify how the effects of transactions and other events are reflected in the financial statements.

Accounting policies selected should be

 Relevant to the decision-making needs of users

 Reliable in that way:
o Represent the faithful position of the financial effects of the company
o Are neutral
o Are free from material misstatements
o Are complete in all material respects

A change in accounting policy occurs if there has been a change in:

1. Recognition, e.g. an expense is now recognized rather than an asset

2. Presentation, e.g. depreciation is now included in cost of sales rather than administrative
expenses, or

3. Measurement basis, e.g. stating assets at replacement cost rather than historical cost
The effects of a change in accounting estimate should be included in the income statement in the period
of the change and, if subsequent periods are affected, in those subsequent periods

If the effect of the change is material, its nature and amount must be disclosed.

Prior period errors

Prior period errors are omissions from, and misstatements in, the financial statements for one or more
prior periods arising from failure to use information that

• Was available when the FS for those periods were authorized for issue and

• Could reasonably be expected to have been taken into account in preparing those FS

• Such errors include mathematical mistakes, mistakes in applying accounting policies, oversights
and fraud

• Current period errors that are discovered in that period should be corrected before the financial
statements are authorized for issue

Correction of prior period errors

• Prior period errors are dealt with by:

• Restating the opening balance of assets, liabilities and equity as if the error had never occurred
and presenting the necessary adjustment to the opening balance of retained earnings in the
statement of changes in equity

• Disclosing within the accounts a statement of financial position at the beginning of the earliest
comparative period.

Intangible assets
Non-monetary assets without physical existence.

It must also meet the normal definition of an asset, like it:

Controlled by the entity as a result of past events

A resource from which future economic benefits are expected to flow

Recognition
To be recognized in the financial statements an intangible asset must

• Meet the definition of an intangible asset, and

• Meet the recognition criteria of the framework:

 – It is probable that future economic benefits attributable to the asset will flow to the
entity.

– The cost of the asset can be measured reliably.

The following internally-generated items may never be recognized:

1. Goodwill

2. Brands

3. Mastheads

4. Publishing titles

5. Customer lists

Purchased and internally-generated intangibles

Purchased intangibles
• If an intangible asset is acquired in a business combination, the fair value of that asset at the
date of acquisition is taken.

• The determination of that fair value is easy if an active market exists, otherwise it may be
necessary to take the price the entity would have paid in an arm’s length transaction.

• Any intangible which cannot be measured reliably in an acquisition has to be included in

goodwill.

Internally-generated intangibles
• It is impossible to separate the costs of internally-generated intangibles from the normal costs
of running and developing a business, so these intangibles cannot be measured reliably.

Measurement after initial recognition of intangible assets

There is a choice between

1. The cost model

The intangible asset should be carried at cost less amortization less impairment loss.

2. The revaluation model

The intangible asset should be carried at carrying value or fair value less amortization less
impairment loss. Fair value should be determined by reference to an active market.
Features of an active market are that

1. The items traded within the market are homogeneous

2. Willing buyers and sellers can normally be found at any time

3. Prices are available to the public

Amortization
• An intangible asset with a finite useful life must be amortized over that life, normally using the
straight-line method with a zero residual value

An intangible asset with an indefinite useful life:

• Should not be amortized.

• Should be tested for impairment annually, and more often if there is an actual indication of
possible impairment.

Goodwill
Goodwill is the difference between the value of a business as a whole and the aggregate of the fair
values of its separable net assets.

Goodwill is defined in IFRS 3 as an asset representing the future economic benefits arising from assets
acquired in a business combination that are not individually identifiable and separately recognized.

Goodwill may exist because of any combination of a number of possible factors:

1. Reputation for quality or service

2. Technical expertise

3. Possession of favorable contracts

4. Good management and staff

Separable net assets are those assets (and liabilities) which can be identifiable and sold off separately
without necessarily disposing of the business as a whole. They include identifiable intangibles such as
patents, licenses and trademarks.

Fair value is the amount at which an asset or liability could be exchanged in an arm’s length transaction
between informed and willing parties, other than in a forced or liquidation sale.
Purchased and non-purchased goodwill
Purchased goodwill:
1. Arises when one business acquires another as a going concern

2. Includes goodwill arising on the consolidation of a subsidiary or associated company

3. Will be recognized in the financial statements as its value at a particular point in time is certain

Purchased goodwill is recognized within the FS because at a specific point in time there was a market
transaction by which it can be measured. The purchase has established the fair value for the business as
a whole which can be compared with the fair value of the separable net assets of the acquire. The
difference is purchased goodwill.

Purchases goodwill is dealt with in two accounting standards, according to how it arose.

Goodwill arising on the purchase of a subsidiary is covered by IFRS 3 revised, while all other goodwill is
covered by IAS 38.

When the purchased consideration is less than the value of the acquired identifiable net assets this is
known as a bargain purchase (negative goodwill) and should be recognized as a credit in the IS and not
taken to the SFP.

Non-purchased goodwill:
1. Is also known as inherent goodwill

2. Has no identifiable value

3. Is not recognized in the financial statement

Impairment of assets
It occurs when the carrying value of a long-term asset exceeds its fair value—i.e., when an asset loses
some or all of its potential to generate revenue before the end of its useful life. Or

An asset is impaired if its recoverable amount is below the value currently shown on the statement of
financial position, the asset’s current carrying value

Accumulated Impairment loss debit

Asset credit
Objective of IAS 36 impairment of assets
• The objective is to set rules to ensure that the assets of an entity are carried at no more than
their recoverable amount i.e. value to the business

Recoverable amount is taken as the higher of:

• Fair value less costs to sell (net realizable value)

The current market price less costs of disposal

• Value in use

Value in use is determined by estimating future cash inflows and outflows to be derived from the use of
the asset

Indicators of impairment
At the reporting date entity must test its assets for impairment, if there is indication of impairment.

Indications may be derived from within the entity itself (internal sources) or the external market
(external sources)

External sources of information

1. The asset’s market value has declined more than expected.

2. Changes in the technological, market, economic or legal environment have had an adverse
effect on the entity.

3. Interest rates have changed, thus increasing the discount rate used in calculating the asset’s
value in use.

Internal sources of information

1. There is evidence of obsolescence of or damage to the asset

2. Changes in the way the asset is used have occurred or are imminent

3. Evidence is available from internal reporting indicating that the economic performance of an
asset is or will be, worse than expected.

Recognition and measurement of an impairment

Where there is an indication of impairment, an impairment review should be carried out:

1. The recoverable amount should be calculated

2. The asset should be written down to recoverable amount

3. The impairment loss should be immediately recognized in the income statement

Definition of a CGU
A CGU is defined as the smallest identifiable group of assets which generates cash inflows independent
of those of other assets

Compare the CV of CGU with recoverable amount for impairment

Provisions
It is a liability of uncertain amount or timing.

Liability is a present obligation arising from past event. The payment of which will result in the outflow
of resources owned by the entity.

A provision should be recognized when:

1. An entity has a present obligation (legal or constructive) as a result of a past event

2. It is probable that an outflow of resources embodying economic benefits will be required to

settle the obligation

3. A reliable estimate can be made of the amount of the obligation

• If any of these conditions is not met, no provision may be recognized

Warranty provisions

A provision is required at the time of the sale rather than the time of the repair/replacement as the
making of the sale is the past event which gives rise to an obligation.

Guarantees

In some instances (particularly in groups) one company will make a guarantee to another to pay off a
loan, etc. if the other company is unable to do so.

This guarantee should be provided for if it is probable that the payment will have to be made.

It may otherwise require disclosure as a contingent liability.

Future operating losses

• No provision may be made for future operating losses because they arise in the future and
therefore do not meet the criterion of a liability.

Onerous contracts
An onerous contracts is a contract in which the unavoidable costs of meeting the obligations under the
contract exceed the economic benefits expected to be received under it.
For example a lease contract

The expense of onerous contract should be recorded as an expense in income statement for the period
of contract.

Environmental provisions
• A provision will be made for future environmental costs if there is either a legal or co
constructive obligation to carry out the work.

• This will be discounted to present value at a pre-tax market rate.

Restructuring provisions
A restructuring is a program that is planned and controlled by management and materially changes
either:

• The scope of a business undertaken by an entity, or

• The manner in which that business is conducted.

A provision may only be made if:

• A detailed, formal and approved plan exists

• The plan has been announced to those affected

A contingent liability is
A possible obligation that arises from past events and whose existence will be confirmed only by the
occurrence or non-occurrence of one or more uncertain future events not wholly within the control of
the enterprise

Or

A present obligation that arises from past events but is not recognised because:

• It is not probable that an outflow of resources embodying economic benefits will be required to
settle the obligation; or

The amount of the obligation cannot be measured with sufficient reliability

Should not be recognized in the statement of financial position itself, Should be disclosed in a note
unless the possibility of a transfer of economic benefits is remote
 A contingent assets is:
• A contingent assets is a possible asset that arises from past events and whose existence will be
confirmed only by the occurrence or non-occurrence of one or more uncertain future events not
wholly within the control of the enterprise.

• Should not generally be recognized, but if the possibility of inflows of economic benefits is
probable, they should be disclosed.

• If a gain is virtually certain, it falls within the definition of an asset and should be recognized as
such, not as a contingent assets.

The requirements of IAS 37 as regards contingent liabilities and assets are summarized in the
following table:

Degree of possibility of flow Contingent Liability Contingent Asset

of resources

Virtually certain ( > 95%) provide in FS recognize

Probable( 51-95%) provide in FS disclosed by notes

Possible ( 5-50%) disclose by notes ignore

Remote( >5%) ignore ignore

Events after the reporting period date IAS 10

Events after the reporting period are those events, both favourable and unfavourable, which occur
between the reporting date and the date on which the financial statements are approved for issue by
the board of directors

What are adjusting events and non-adjusting events?

Adjusting events
• Adjusting events are events after the reporting date which provides additional evidence of
conditions existing at the reporting date. Such events will, therefore, have an effect on items in
the reporting or income statement.

Non-adjusting events
• These are events arising after the reporting date but which do not concern conditions existing at
the reporting date. Such events will not, therefore, have any effect on items in the reporting or
income statement.
 • However, in order to prevent the financial statements from presenting a misleading position,
some form of additional disclosure is required if the events are material, by way of a note to the
financial statements giving details of the event.

What is a leasing agreement?

A leasing agreement is an agreement whereby one party, the lessee, pays lease rentals to another party,
the lessor in order to gain the use of assets over a period of time.

There are two types of lease:

1. A finance lease

A finance lease is a lease that transfers substantially all the risks and rewards incidental to ownership of
an asset to the lessee.

2. An operating lease

An operating lease is any lease other than a finance lease