FIN207U-BUSINESS FINANCE I
Unit 1: Introduction To Business Financial Management
Introduction
In a modern economy, everyone probably experiences
financial decision-making on a daily basis. The frequency
and number of financial transactions and complexity of
decisions of course may change from person to person.
Throughout the first chapter of this book, you will be
introduced to basic terms and key elements of business
financial management. You will also understand the types
of decisions that financial managers face everyday. You
will realize main themes to be considered in all aspects of
financial management. The purpose of this chapter is to
give core information to ground in a more complex world
of comprehensive financial decision-making.
Financial Environment Of A Company
The environment of a company contains a number of
different elements, such as institutional elements,
economic system, business system, financial system, etc.,
interacting with, and being nested in each other.
Members of these elements are called as interest groups,
or stakeholders. Main stakeholders are owners, employees,
suppliers, lenders, customers, and the community.
Five core components of a financial system are ultimate
borrowers, ultimate lenders, financial intermediaries,
financial instruments, and legal and administrative rules.
A financial company can be described as a company with
a main business activity in financial areas.
Financial intermediary is an institution in a financial
system that acts as a middleman between borrowers and
lenders.
A non-financial company can be described as a company
with a main business activity of producing goods
and/services in areas other than finance.
The Cycle of Money
Money in a financial system simultaneously flows in
many various directions. The movement of money from
lenders to borrowers, and back from borrowers (users of
funds) to lenders (savers of funds) in a financial system is
called the cycle of money. The economic idea of cycling
money is making both lenders and borrowers better off, by
creating a win-win situation.
Security is a kind of negotiable paper, showing claims on
future cash flows of the issuer of the security.
Supply and demand for loanable funds theory of interest
argues that interest rate presents the equilibrium in the
market, where demand for and supply of loanable funds
meet. Liquidity preference theory of interest argues that
interest rate presents the equilibrium in the market, where
demand for and supply of money meet.
Liquidity refers to convenience of Money.
The Cyle of Money Within a Company
Production value tells how much effort is required in order
to produce goods and services.
Customer value tells how much a customer thinks a
product is worth.
Companies, as legal entities, are assumed to survive
perpetually.
Profit is, in simple terms, the difference between revenues
and expenses. We can find profit information at the
bottom line of income statement of a company, as “net
income”. In accounting terms, net income is the net
increase in the owners’ equity that results from a
company’s operations.
This relationship between value creation and profit
generation fits well with one of the basic assumptions in
business theories, which is the infinite lifetime of a
company.
A Financial Manager
Financial performance is a subjective measure of how well
a firm can use assets from its primary mode of business
and generate revenues. This term is also used as a general
measure of a firm’s overall financial health over a given
period of time, and can be used to compare similar firms
across the same industry or to compare industries or
sectors in aggregation.
The financial manager is responsible for the financial
operations of the company. At the same time, we can
expect that it is usually not a one man’s job to make all
financial decisions. Financial manager’s all management
tasks about treasury and control need planning,
organizing, leading, implementing, and control.
Cost-benefit analysis is a technique used in decision-
making that takes into account the estimated costs to be
incurred by a proposed decision and the estimated benefits
likely to arise from it.
Financial managers are assumed to serve best interests of
shareholders of companies that they are working for.
Investing Decisions
Investing decisions are concerned with allocating
company’s limited resources to the best short-term and
long-term investment alternative. Investing decisions also
include strategic decisions such as mergers and
acquisitions and foreign direct investments.
Assets are items of value owned by a company. A real
asset is a physical asset whose value is coming from its
substance and properties, while financial assets are non-
physical assets whose value comes contractual claim.
Tangible asset is an asset with a physical substance.
Intangible asset is an identifiable non-monetary asset
without physical substance.
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 FIN207U-BUSINESS FINANCE I
Unit 1: Introduction To Business Financial Management
Current assets are assets that a company expects to convert
to cash or use within one year. Non-current (fixed) assets
are assets that a company expects to convert to cash or use
later or longer than one year. Capital expenditures (Capex)
are expenditures made to buy new fixed assets or to
increase the value of company’s existing fixed assets.
Capital budgeting is a process of making long-term
decisions on investment projects.
Financing Decisions
It is important to know that companies cannot make all of
their investments with existing funds. They are always in
search of funds at a minimum cost in order to partly or
fully finance their investments in short, medium, and long
term. They have two alternatives for financing:
1. debt financing
2. equity financing.
Maturity of short-term financing is less than one year,
whereas maturity of medium-term financing may be 1
monts to 3 years, and maturity of long-term financing is
longer. If a company issues a debt-based security, then it
will be debt financing. If it issues an equity-based security,
then it will be equity financing. Capital structure (financial
structure) refers to a company’s mixture of debt financing
and equity financing maintained by the firm.
Dividend Decisions
Financial managers should decide on how much of their
profits to pay out to shareholders in the form of dividends,
and how much to retain to finance company’s future
investments and growth. Dividend is the distribution of
part of the profits of a company to its shareholders.
Legal Forms Of Business Organization
Business organizations can be in any of these two forms in
general, a proprietorship (a sole proprietorship and a
partnership), and a corporation. If one person owns a
business, it is a sole proprietorship. This one person
carries all risks and gains all returns. If two or more
people own a business, it is a partnership.
Unlimited liability refers to a situation where shareholders
are liable for all of company debts with all of the company
assets and their personal assets.
Limited liability refers to a situation where shareholders
are liable for all of company debts with only all of the
company assets but not with their personal assets.
Overview Of Key Financial Concepts
In daily life, terms such as “money”, “fund” and “cash”
are usually used synanimously.
Finance means money in very broad terms. Cash refers to
immediate spendable funds such as currencies and coins.
Cash equivalent is a short-term (less than three months)
investment such as treasury bills. Fund refers to money,
which is preserved for a specific objective whether in the
form of cash, credit, cheque, or other resources. The main
difference between cash and fund is that cash is a short-
term asset, whereas fund is a short-term or long-term
liability for a company.
Three broad subdivisions of finance as an academic field
of study are:
1. business financial management,
2. financial markets and intermediaries,
3. investments.
Business financial management covers subjects related to
decisionmakings of company managers, trying to
maximize shareholder wealth at given external
circumstances at local, regional, international, and global
levels of geographical dispersion.
Basic Financial Statements
Financial statements are outputs of accounting system,
which tell about key financial information of a company
for a period of time, or at a certain point of time. Exhibit
1.1(page:13) provides a quick overview of basic financial
statements;
1. balance sheet,
2. income statement,
3. cash flows statement.
Differentiation of Profit, Cash Flow, and Free Cash
Flow
Profit is an accounting term, which shows the difference
between sales revenues, and costs and expenses. It can be
seen on the income statement as net income.
Cash flow refers to an inflow or outflow of cash related to
operating activities, investing activities, or financing
activities.
Free cash flow is the total of cash flow to creditors and
cash flow to stockholders, consisting of the following:
operating cash flow, capital spending, and changes in net
working capital.
Risk and Return Trade off
Risk refers in general to the magnitude and likelihood of
unanticipated changes that have an impact on a firm’s cash
flows, value or profitability. Uncertainty refers to a
prerequisite condition for risk to exist, but uncertainty can
also refer to the possibility that something completely
unforeseen can happen. When we measure risk in finance,
we consider both downside risk and upside risk.
Individuals who like carrying risk have a risk-seeking
attitude, those who dislike carrying risk have a risk-averse
attitude, and those who neither like nor dislike carrying
risk have a risk-neutral attitude.
Time Value of Money
The concept of time value of money suggests that people
prefer cash sooner than later. There are three explanations
behind this way of thinking:
1. reinvestment opportunities,
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Unit 1: Introduction To Business Financial Management

2. uncertainty of future, Business Ethics

3. effects of inflation. Another very relevant subject in financial decision-making
Time value of money concept calls for a need for using is ethical behavior in companies, which has always been
interest rate as a tool to allow lending and borrowing of one of the main concerns of societies. It is also a concern
cash in the economy. of companies because it affects their most important prize,
reputation. Social, environmental and health effects of
Shareholder Wealth Maximization As The Main products and services are the most common issues.
Objective
Business ethics refers to a company’s attitude and conduct
Maximizing wealth can be so broad in a sense that toward its employees, customers, community, and
shareholders can increase their wealth in many ways, such stockholders.
as increasing sales revenue, decreasing costs, increasing
profits, improving cash flows, increasing efficiency, Corporate transparency refers to equity market’s ability to
growing business, entering into new markets, increasing observe a corporation’s operations.
competitive strength, etc. Shareholder value can be Corporate accountability refers to stakeholders’ ability to
expressed using three concepts:
hold corporations to account for their operations.
1. book value,
Together with transparency and accountability at a
2. market value, and
company level, companies are expected to foster a
3. intrinsic value. corporate climate where unethical behavior is not
Book value tells the worth of a company based on its permitted at an individual level. There are certain things
financial statements. companies do to improve moral behavior in their
organizations.
Market value is the price that buyers and sellers trade
company shares in an open market place.
Intrinsic value is the estimated value, which is calculated
by present value of future cash flows that company
expects to generate. If we base our understanding of
shareholder value on intrinsic value, then the shareholder
value would be value of expected future cash flows
adjusted for time and risk. (Trotta, R. J., 2003, p.18-27).
Main objective of a company is assumed to be maximizing
shareholder wealth.
Agency Problems And Corporate Governance
Agency problems refer to potential conflicting interests
between shareholders and managers resulted from
separation of ownership and control. “Agency theory”
which is widely known in the business literature suggests
that there would be a possible conflict, between owners
and managers, which in turn cost company as a result of
poor decisions in general terms. Risk-averse behaviors,
preference of low-return investments, inefficient use of
company assets, and unnecessary spending appear to be
the examples of poor decisions. Agency cost is a
qualitative type of cost, not a quantitative type of cost, and
it is not reflected in financial statements as a cost item.
Corporate governance is the system of rules, practices and
processes by which a company is managed.
Corporate governance is the dominant concept in the
Turkish Commercial Code. The corporate governance
approach of the Turkish Commercial Code is based on
four pillars that have universal characteristics within the
context of corporate governance. (1) full transparency, (2)
fairness, (3) accountability, (4) responsibility.” (PwC
Turkey, 2011, p.9).

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 FIN207U-BUSINESS FINANCE I
Unit 2: Financial Statements and Analysis
Introduction
Businesses acquire resources from their environment and
use them to produce goods and services. Within the
business cycle, they perform three types of activities.
These are financing, investing and operating activities.
Financial statements represent the results of business
activities performed by managers.
The goal of financial statement analysis is to explore the
results of these activities and help internal and external
users of financial information.
The remainder of the chapter contains three sections after
the introduction. First section provides an overview of the
basic financial statements. Second section follows with the
analytical analysis of the major financial statements. Last
section introduces financial ratios and discusses their
interpretations and limitations.
Financial Statements
The general purpose of financial statements is to provide
information about the financial position, financial
performance, and cash flows of an entity that is useful to a
wide range of users in making economic decisions (IAS
1). (International Accounting Standards Board
(…)International Accounting Standards...) A complete set
of financial statements includes; a statement of financial
position (balance sheet), a statement of profit or loss and
other comprehensive income, a statement of changes in
equity, a statement of cash flows, and notes to financial
statements.
Except the statement of cash flows; financial statements
are prepared using accrual accounting. Accrual accounting
records economic transactions on the basis of their
existence instead of the timing of their cash consequences.
Accrual accounting is needed to measure business
performance on a periodic basis. Financial statements are
prepared periodically by closing the books at the end of an
arbitrary accounting period which usually corresponds to a
calendar year in practice. Cash accounting may not report
the full economic outcome of a transaction within an
accounting period since cash outcome of a transaction
may happen outside of the given accounting period.
Accrual accounting is used to measure the full effects of
an economic transaction which takes place within an
accounting period regardless of the timing of cash
outcomes.
Earnings Management: Managers choose accounting
policies, reporting methods and estimates that do not
accurately reflect their firms’ underlying economics.
Statement of Financial Position (Balance Sheet)
The main objective of a statement of financial position is
to disclose fairly what a company owns and means used to
get them at a certain date. It can be thought as a selfie of
the company at a point in time. Statement of financial
position is made up of assets (what a company has),
liabilities (what accompany owes) and owners’ equity
(capital) sections reflecting the “accounting
equation”.(page:40/Picture 2.2)
Accounting equation reflects the resources available for
use of business and how these resources are financed by
the business. Similar assets and similar liabilities are
grouped together to ease financial analysis. All economic
transactions related to business are recorded in the
accounting system by keeping the accounting equation in
balance. Hence, the same equality is reflected in the
statement of financial position.
IAS No.1 requires that the statement of financial position
should give the name of the company, the date it is
prepared for, the monetary unit, and the level of precision.
Assets
Asset is a resource controlled by the entity as a result of
past events and from which future economic benefits are
expected to flow to the entity (IASB Framework). In a
statement of financial position, assets are classified as
current and longterm. This classification helps to analyze
if the company has enough assets to pay for long term and
short term obligations. The grouping of assets can be seen
clearly at Vestel Company’s statement of financial
position (Table 2.1)
Current Assets
Current assets are the assets that are expected to be
converted into cash within the next year or within the next
operating cycle, whichever is longer. Common types of
current assets are; cash and cash equivalents, trade
receivables, inventories, and prepaid expenses. These
items are listed in the order in which they are expected to
be converted into cash faster. As seen in Table 2.1 most of
Vestel’s current assets consist of inventories and
receivables.
Long Term Assets
Long-term assets are the assets that an entity expects to
use for longer than one year or the operating cycle. These
assets are mainly acquired for the purpose of providing
resources for the future operations of the entity. Common
types of long term assets are; property, plant and
equipment, intangible assets, long term investments, and
prepaid expenses.
Liabilities
A liability is a present obligation of the enterprise arising
from past events, the settlement of which is expected to
result in an outflow from the enterprise of resources
embodying economic benefits (IFRS Framework). Similar
to asset classification, liabilities are also classified as
current and longterm.
Current Liabilities
Current liabilities include obligations which are settled
within the next year or operating cycle, resulting in an
outflow from the entity either in cash or in kind. Debt to
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Unit 2: Financial Statements and Analysis
various interest groups such as employees, suppliers,
financial institutions should be clearly identified.
Long Term Liabilities
Long-term liabilities are usually debts incurred by the
entity for the purpose of financing operations and
investments. Unlike current liabilities, longterm liabilities
are due after the next accounting period.
Equity
The Shareholders’ Equity section of the statement of
financial position includes the amounts invested in the
business by the owners or investors, the earnings (losses)
that are retained in the business from previous years’
income (losses), and current year income or loss.
Income Statement/Comprehensive Income Statement
Income statement is a performance statement for a given
period with a bottom line figure of profit or loss. Net
Income/Loss of the company indicates the success of a
company in utilizing its resources in the previous period.
Investors are interested in a company’s past net income
because it provides information for predicting future net
income. Investors invest in the company stock based on
their predictions about a company’s future performance.
Earnings Quality: The extent which the reported income
reflects the true financial condition and performance of the
company.
Statement Of Cash-Flows
The statement of cash flows reports the cash inflows and
outflows from operating, investing, and financing
activities during a period, and reconciles the beginning
and ending cash balances reported in consecutive
statement of financial positions.
A statement of cash flows has three sections; cash-flows
from operating, investing, and financing activities.
1. Operating activities include the cash effects of
transactions that are related to a firm’s
operations.
2. Investing activities include the cash effects of
transactions that involve the purchase or disposal
of investments and property, plant, and
equipment,
3. Financing activities include cash effects of
transactions that involve obtaining cash from
creditors and stockholders and payment of
existing debt dividends.
The operating activities category is considered the most
important by analysts. It shows the cash provided by
company operations.
Free Cash Flow
In the statement of cash flows, cash provided by operating
activities is intended to indicate the cashgenerating
capability of the company. Analysts have noted, however,
that cash provided by operating activities fails to take into
account that a company must invest in new fixed assets
just to maintain its current level of operations.
Analytical Analysis
The most important aspect of financial statement
information is its reliability. Reliability is secured by the
auditing process.
There are two types of analytical analysis employed for
inter-company and intra-company comparisons. One of
them main analyses used for comparison purposes is the
vertical analysis where each item is expressed as
percentage of revenues in income statement and as
percentage of total assets in the statement of financial
position. The other available method is horizontal
analysis, in which a base year is selected and the changes
over time are expressed as a percentage of the base year
figures.
Vertical Analysis (Common Size Anaysis)
In vertical (or common size analysis), the items in the
financial statements are expressed as a percentage of total
assets or sales. The main advantage of vertical analysis is
that such an analysis is not much affected by price
fluctuations and that it lets industry-wide comparisons.
Common-size Income Statement
From this analysis we can conclude that there has been an
increase in cost of production for the company which was
compensated by controlling other operating
expenses.(page 49/table 2.4)
Common-size Statement of Financial Position
When the common-size Statement of Financial Position,
on the asset side, it can be seen that receivables and
inventory constitute most of the assets. in this situation,
notes to the financial statements should be reviewed to
understand who the related parties are. In Vestel’s case,
since the parent company has a strong financial position,
the collection risk for the company could be viewed as
low.(page:50/table 2.5)
Materiality issue: When financial statements are analyzed,
items that have low monetary values can be regarded as
immaterial. Especially in horizontal analysis big changes
in low value items can be ignored in analysis.
Horizontal Analysis
Horizontal analysis is also known as trend analysis. This
analysis performs better for longterm analysis within the
same company. However, selection of the base year is
crucial. Depending on the base year, some items might be
given more weight than the others. Care must also be
taken to incorporate any accounting policy changes during
the analysis period, because horizontal analysis is affected
by changes in accounting methods.
Horizontal Analysis of Income Statement
It can be seen in the horizontal analysis of Vestel that sales
increased each year but the increase in the cost of sales has
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Unit 2: Financial Statements and Analysis
been higher than the increase in revenue. Additionally, the
increase in both items is higher from 2016 to 2017
compared to 2015 to 2016 increase leading to an increase
in income from operating activities.(page:52/table:2.6)
Finally profit has decreased compared to 2016. In the
trend analysis, 2016 seems to be a good year for Vestel
compared to both 2015 and 2017.
Horizontal Analysis of Statement of Financial Position
In the horizontal analysis of Vestel Statement of Financial
Position, the increase in receivables and inventories in
2017 is apparent. As mentioned earlier, since these
receivables are from related parties, collection risk is
minimized.(page:53/table:2.7) An increase in current
liabilities and a decrease in long term liabilities suggest
that the company prefers short term financing to long term
financing during 2017.
Ratio Analysis
Interpretation of the results of the trend and static
(vertical) analyses might be difficult in some cases. For
example, a user might want to know whether the assets are
used efficiently – in other words, might want to assess the
profitability of the firm as measured by the relationship
between profits and assets, and profit and sales. Such a
relationship can be expressed as a ratio.
Although there are several available ratios in the literature,
we will illustrate the most commonly used ratios within
the following classifications.
• liquidity ratios
• solvency/capital structure ratios
• working capital management ratios
• profitability ratios
• market ratios
Liquidity Ratios
These ratios show how well a company manages its cash
inflows and outflows to pay its obligations.
Solvency
These ratios show how the assets of a company are
financed (i.e., through debt or equity) and provide
information about the long-term liquidity of a
company.The most common ratios in this category are:
• debt ratios
• equity measures
• number of times interest charges are covered
Working Capital Management
To analyze the working capital management efficiency of
a company, analysts are interested in trade receivables,
inventories, and trade payables.
Net Working Capital
Net Working Capital is defined as the difference between
the current assets and current liabilities of the same period.
Accounts receivable turnover
Since receivables affect the operating cycle, knowing the
collection cycle will help users to determine the efficiency
of collecting accounts receivable. The shorter the period to
collect credit sales and without losses, the more liquid a
firm will be. The accounts receivable turnover gives an
indication of the collection efficiency.
Operating Cycle
Operating cycle computes the time it takes for a company
to turn finished goods/merchandise inventory into cash
received from sales. (Computed using finished goods
inventory.)
Cash conversion cycle shows effectiveness of
management in managing current assets and liabilities.
Shorter cash conversion cycle shows more efficient
management.
Profitability
Profitability ratios measure for operating success of a
company in regards to its resources.
Financial Leverage: The extent which the company uses
debt in financing its assets. As long as the cost of debt
financing is lower than equity financing financial leverage
is beneficial for the company.
Sustainable Growth Rate
Sustainable growth rate refers to the rate at which a firm
can grow if its profitability and financial policies do not
change.
Market Ratios
Our last category of ratios ties in closely with the
profitability ratios and earnings per share. We will
demonstrate the following ratios:
• price earnings ratio
• price to book ratio
• dividend payout
• dividend yield
Interpretation And Limitations Of Ratio Analysis
Ratios are used as the major tools of financial analyses.
Studies employing various ratios have been able to predict
business failures. The main problem is determining which
ratios are informative for a particular business depending
on the industry, lifecycle of the company and economic
environment in which the company operates.
Interpretation Issues
When using financial ratios, factors that needs to be
considered are;
• Comparing ratios for the company’s current year
with those of preceding years, e.g., 5 to 10 years;
• Comparing ratios of the company with those of
its competitors (These can be obtained from the
published financial statements of competitors)
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Unit 2: Financial Statements and Analysis

• Comparing the company’s ratios with ratios for

the industry in which the company operates.
(Industry statistics can be obtained from annual
publications of trade associations; for example,
TUSIAD publishes such ratios for various
industries. For some of the ratios, data can be
obtained from weekly stock exchange magazines
or internet databases.)
Limitations
• Ratios are representations of average conditions
that existed in the past, and are influenced by the
selection of accounting methods (e.g., weighted
average vs. FIFO cost flow; accelerated vs.
straight line depreciation);
• Since financial statements are based on historical
data, they do not reflect price level effects and
real economic values;
• Computation of ratios are not standardized, and
thus are influenced by data selection choices;
• Changes in many ratios are strongly associated
with each other; e.g., changes in the current ratio
and quick ratio between two different times are
often in the same direction, and usually
proportional. Therefore, it is not necessary to
calculate all ratios, and interrelationships
between/ among the ratios should be
investigated;
• When ratios for the same company are compared
over a period of time, care must betaken to
analyzethe changes in operating conditions (e.g.,
changes in economic conditions, changes in
product lines or geographic markets, changes in
prices, levels of inflation, etc.); and
• When a specific firm is compared with similar
firms, differences between/among the firms
should be recognized (e.g., accounting policies,
type of financing available, operating
characteristics such as product lines, size and
geographical location).
• The last, but the most important, consideration
for the analysis is to obtain audited financial
statements. Although unaudited statements might
provide valuable information about a company,
conclusions reached with this information are
questionable, because its use brings up fair
representation issues.

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 FIN207U-BUSINESS FINANCE I
Unit 3: Cost-Volume-Profit (CVP) Analysis
Introduction
In the business world, managers evaluate firm
performance by conducting detailed financial analyses and
cost-volume-profit analysis is one of the major tools of
financial performance measurement.
Cost-volume-profit (CVP) analysis is a simple technique
used in managerial accounting for investigating the
relation between the level of business activity and
financial performance.
The unit variable costs are constant at different levels of
activity. On the other hand, the unit fixed cost decreases as
the level of activity increases and is minimized at full
capacity production. All the costs of the business, mainly,
manufacturing, marketing and administrative are
categorized as either fixed or variable. However, in real
life most of the costs are mixed or semi-variable, meaning
that the costs are made both of a fixed and variable
portion. Mixed costs vary in relation to the activity level,
however this variation is not directly proportionate to the
change in the activity. CVP analysis requires all costs to
be split into their fixed and variable components.
Therefore, the breakdown of mixed costs into fixed and
variable components are accomplished by High-Low
method, Scatter Plot method or Regression method.
The CVP analysis is based upon the following
assumptions:
1. The sales price per unit is constant,
2. Variable costs per unit and fixed costs are
constant,
3. The firm sells all units produced,
4. The cost structure is constant meaning that costs
change only by the level of activity,
5. If there is more than one product produced and
sold, the sales mix of these products is constant.
6. Costs and revenues remain constant within a
specified production level, which is usually called
as the relevant range.
Contribution Margin
The difference between the sales revenue and the total
variable costs is named as the contribution margin. The
difference between the sales price per unit and the variable
costs per unit gives the unit contribution margin.
The contribution margin shows the amount of income
generated to cover up the total fixed costs and earn the
targeted profit.
At the break-even point the contribution margin equals the
total fixed costs. The unit contribution margin calculation
enhances the management to decide for efficient capacity
allocations.
Contribution Margin Ratio
The contribution margin ratio is the division of the unit
contribution margin by the sales price per unit.
Break-even sales revenue can be directly estimated when
the total fixed costs are divided by the contribution margin
ratio. The addition of the targeted profit over the total
fixed costs summons the level of sales to be reached for
the desired level of return.
A higher contribution margin ratio for a specific product
suggests that the product contributes more to cover up the
fixed costs, hence managers can allocate production
capacity accordingly to boost the income from operations.
Moreover, the contribution margin ratio supplements the
management with estimating the immediate change in the
profit earned in relation to changes in the sales revenue.
The contribution margin ratio which is stated in
percentages shows the immediate change in the operating
income of the business when multiplied by the change in
the sales revenue.(Page:83/84,Figure 3.3/3.4/3.5)
Margin Of Safety
The margin of safety is the cushion amount that the actual
or budgeted sales can drop by, still enabling the business
to break even. It is the difference between actual/budgeted
sales and the break-even sales. The margin of safety can
be stated in units, dollars or in a ratio form.
The margin of safety indicates the maximum possible
decrease in sales before recording a loss and the margin of
safety ratio can help the management in estimating the risk
of a loss if the budgeted sales are not actualized.
The Effect Of The Changes In The Business
Environment On Firm Performance
The rapid advancements in technology, the global access
to the internet, growing trade between diverse geographies
altogether create a business environment in continuous
change. The intensifying mobility of capital and labour as
the main components of production shifts the demand and
supply equilibrium which in the end may lead to
significant fluctuations in prices. Firms have to be
adaptive to these rapid changes in the business
environment, otherwise they cannot compete. The CVP
analysis provides help to managers who have to take
immediate action against these changes.
Cash Break-Even Point
The CVP analysis is founded on variable costing, where
the costs are classified as variable or fixed according to
their cost behaviour. Businesses record depreciation and
amortization as fixed costs, however they are non-cash.
The cash break-even calculation accounts only for cash
fixed costs and the depreciation(and/or amortization)
expense is deducted from the total fixed costs. The cash
fixed costs are then divided by the contribution margin to
determine the cash break-even quantity.
The cash break-even quantity will be less than the break-
even quantity unless the business records no depreciation
expense. A business can sell less than the break-even point
at which an accounting loss may be incurred but still the
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 FIN207U-BUSINESS FINANCE I
Unit 3: Cost-Volume-Profit (CVP) Analysis
business can continue its operations without failure of
payments if the sales are above the cash break-even point.
Therefore, the cash breakeven quantity shows the level of
sales required to cover up the cash fixed costs, so that the
business can operate without failure of payments though
an accounting loss is recorded.
Break-even Analysis for a Multi-Product Company
Companies produce and sell more than one product to
increase their profits. In a multi-product company break-
even analysis is more complex compared to a single
product business. The reason lies in the fact that each
product has a different price, a different cost structure and
a different contribution margin. Therefore, the break-even
point of a multi-product company is determined according
to the sales mix of these multi products. If the sales mix of
the company changes than the break-even point will also
change. In a multi-product environment a company will
sell first its most profitable product. Here, the product
profitability is measured by the contribution margin ratio.
It is quite rational for a company to produce and sell more
of the product which contributes to its fixed costs most.
Hence, in a multi-product environment a company will
determine the sales mix by ranking the contribution
margin ratios of the products.
Limitations of the CVP Analysis
The CVP analysis is a helpful tool for in evaluating the
effects of activity on the profitability; however, the
method has some limitations. The CVP analysis assumes
constant costs and prices but in real life neither prices nor
costs remain constant. Cost behaviour may change for
higher volumes because of economies of scale and price
reductions may have to be accepted for higher level of
sales. Therefore, the suggested linear total cost and
revenue functions can only be achieved within a very
restricted activity range. The CVP analysis requires all
costs to be split into their fixed and variable components
however in reality most costs are mixed and the separation
is not always easy and accurate. The CVP analysis is
based on variable costing, however in financial reporting
absorption costing is used. Absorption costing categorizes
costs as inventoriable and period costs. Therefore, the
CVP analysis also necessitates the asumption that all
production is sold which does not hold in real life
conditions. Finally, in a multi-product environment the
CVP analysis assumes a constant sales mix, but again in
real life situations companies may experience varying
proportions in their product mix sales.
Leverages
There are two major types of leverage - financial and
operating. Financial leverage refers to the use of debt to
acquire additional assets. Operating leverage measures a
company’s fixed costs as a percentage of its total costs. In
the cases of both financial and operating leverage, the
crucial question is how much leverage is appropriate.
Degree of Operating Leverage (DOL)
The degree of operating leverage is a concept widely used
to assess the operating risk of a business stemming from
its cost structure. Basically, the degree of operating
leverage shows how much the operating income of the
business changes with a relative change in its sales. In fact
it is a multiple depicting how many times the operating
income of a business changes in relation to a percentage
change in the sales.
Degree of Financial Leverage (DFL)
Financial risk stems from the capital structure of a business.
The use of debt, or in other words the extent of financial
leverage determines the level of financial risk. Creditors lend
at fixed interest payments and bear no business risk. Thus, the
use financial leverage increase the business risk on the
stockholders. The degree of financial leverage estimates the
effect of debt financing on the net income. It is a measure of
sensitivity in EPS(earnings per share) to operating income
fluctuations as the result of the variations in financial
leverage. The DFL is a multiple determining the change in
the EPS by a percentage change in the operating income.
Since interest is a fixed cost, a high interest will lead to a
high DFL, which implies a company can make a
significant amount of profit from the investments
undertaken by debt financing when economic conditions
are good and the sales are growing. However, in
worsening economic conditions and sales declines, a high
DFL means incurring more losses. On that account, the
management can evaluate the effects of capital structure
on the profits and decide for the amount of debt in the
capital structure.
A high DFL, depicting a higher volatility in EPS to
stockholders also indicates elevated volatility in the stock
prices. At times of economic booms, investors would
prefer to invest in the equities of the companies with high
DFL, conversely, at times of economic recessions the
preference would shift to the stocks of the firms with low
DFL.
Degree of Total Leverage (DTL)
The degree of total leverage shows the combined effects
of operating leverage and financial leverage on a
company’s earnings. Hence, DTL measures the sensitivity
in the EPS relative to a percentage variation in the sales
revenue. Operating leverage is an indicator of business
risk and financial leverage is a measure of financial risk.
Therefore, total leverage indicates the combined effects of
the cost structure and capital structure of a firm on its net
profit. Degree of total leverage is the product of DOL and
DFL.
A business with high fixed costs and a capital structure
relying more on debt financing will both exhibit a high
operating leverage and financial leverage at the same time.
DTL which is the product of DOL and DFL displays the
concurrent impact of the business risk and financial risk
on stockholders wealth.
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 FIN207U-BUSINESS FINANCE I
Unit 4: Time Value Of Money
Introduction
Almost every day, we face decisions that have financial
aspects. Here are some examples:
• You are planning to buy an apartment in your
hometown for investment purposes. Other than
selling price and location you should also
consider potential rental income and expected
changes in value. How are you going to evaluate
multiple apartments in one-go?
• You have ¨100.000 that you are not going to
need for 3 months and plan to hold at the bank.
What should you do with the money until that
time? Should you hold the money in a demand
deposit account that can be withdrawn at any
time with no penalty or put it in a 3-month time
deposit, where it can earn interest? Furthermore,
if you decide on the time deposit, would it make
a difference if the funds were put into a series of
1-month time deposits?
The answers of all these questions are related to the Time
Value of Money concept, which posits that ¨1 received
today is more valuable than ¨1 received tomorrow; since
you can get an additional interest gain between today and
tomorrow.
Future Value
The Future Value (FV) is the amount of money an
investment will grow to over a period of time, at a given
interest (r).
Future Value - Single Period Case
Assume that you have ¨1.000 to invest and that the bank
is currently offering 10% interest per year. How much
money would you have in one year if you invested the
entire ¨1.000? The answer to this simple question is
¨1.100.
¨1.100 is the Future Value of ¨1.000 invested at 10% for
one year. It is made up of the original ¨1.000 (the
principal) plus ¨100 of interest.
1.000 + (1,000 × 0,10) = 1.100
Principal Interest Ending amount.
The FV formula for the single period case may be stated in
the following ways: FV = PV + PV × r FV = PV(1 + r)
Suppose that Ayşe has some land in Denizli and Ayşe’s
auntie offered her ¨100.000 to buy the land. She was
about to accept the offer, but then her uncle Turhan
offered her ¨120.000; though Turhan is going to pay her
next-year. She is sure that both her uncle and auntie are
trustworthy and she has no urgency to sell the land.
However, she cannot decide which offer to pick and hence
Ayşe asks for your advice. You tell her that because the
payments are at different points in time, they are not
directly comparable. In order to make the alternatives
comparable the cash flows must be brought to the same
point in time by using time value of money formulas (As it
is seen on page 106/Figures 4.1/2).
As a result, you should tell Ayşe that, using time value of
money calculations, you have determined that she would
be better off choosing to sell the land to her Uncle Turhan,
as that would yield the most favorable outcome.
Future Value - Multiple Period Case
In order to tackle more complicated time value of money
examples, we would like to introduce the time line as a
useful graphic tool to help identify the amount and timing
of cash flows. Time lines allow us to more easily visualize
and understand complex financial problems. (As it is
shown on page 67/ Figure 4.3)
Example: Kutay is the owner of an apartment and has
rented it to a student. The rental agreement is for 1 year
and monthly rental payments are ¨1.000 to be paid at the
end of each month. The timeline of cash payments to
Kutay may be represented with the following timeline
(Figure 4/4).
Simple interest is the interest that one earns only from the
initial capital (principal). This is the interest that you
would earn in a bank account that takes out the interest
earned and only renews the time deposit for the capital.
Present Value
Present Value - Single Period Case
You have to make a payment of ¨1.000 in one year to a
relative. The bank is currently offering 10% interest per
year. How much money would you have to put in the bank
today, in order to have enough to pay the ¨1.000 next
year. The answer to this question can be calculated by
using the Present Value formula, which is simply an
algebraic restatement of the Future Value formula from
earlier in the chapter (As it is shown on page 109).
Present Value-Multiple Period Case
How much money would you have to put into an
investment expected to return 10% per year for the next 5
years if you want to have ¨10.000 at the end? Using a
timeline and doing some calculations you could calculate
(As it is shown on page 110 / Figure 4/9).
To help us better visualize the effect of time and interest
rates on present values please examine the figure given
below. It shows the present value of ¨1 over time under 4
different interest rate scenarios. As one can notice, the
present value significantly declines as the number of
periods (n) and/or interest rate (r) increases. (As it is
shown on page 111 / Figure 4/11).
Valuing Multiple Cash Flows
Time value of Money problems in real life are seldom
made up of single cash flows. Usually problems will
involve numerous cash flows at different points in time. In
order to deal with these types of problems we must learn
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 FIN207U-BUSINESS FINANCE I
Unit 4: Time Value Of Money
how to deal with cases made up of a number of separate
cash flows.
Let’s suppose, ABC Makine A.Ş. purchased a machine
which is going to generate cash flows of ¨1.000 for the
first two years and ¨5.000 for the next three years. If the
current interest rate in the market is 6%, what is the
present value of the cash generated by the machine? We
first draw the timeline of payments: (As it is shown on
page112 / Figures 4.12/13/14).
Valuing Multiple Cash Flows of Equal Amounts
(Annuities and Perpetuities)
When it comes to valuing multiple cash flows, one of the
groups that gets the most attention are those that involve
equal cash flows at regular intervals. Some examples of
these type of cash flows include installment payments for
the purchase of long-lived assets (refrigerators, cellular
phones, TVs or even automobiles), mortgage payments for
houses and bond payments. The reason that these types of
cash flows get special attention is that in addition to being
relatively common, they also have relatively simple
formulas that can be used to value them.
Annuities
An annuity is a series of equal cash flows that occur for a
given period at regular intervals.
When we go from an ordinary annuity to an annuity due,
the PV of the investment goes up, due to the fact that the
cash flows are brought forward in time, becoming more
valuable as a result.
Perpetuities
A perpetuity is an annuity with an infinite life. Perpetuities
are also commonly referred to as “consols” due to the fact
that they were used by the British Government to
consolidate debts (DMO 2014) from the previous years
issued to finance military campaigns. Over time, all
perpetuity bonds started to be called consols.
The valuation of perpetuities are highly dependent upon
the interest rate. Since interest rate is located in the
denominator of the present value formula, an increase in
interest rates would lead to lower present value of the
given consol, keeping everything else constant.
Non-Annual Compounding Periods
Have you ever noticed that sometimes
investment/borrowing instruments are made very difficult
to compare? Sometimes this is due to quoting some rates
of return in annual terms while others in quarterly or
monthly terms (12% annual vs. 1% monthly). Other times
compounding periods may be different. Up to this point,
we generally assumed that payments are done yearly and
hence compounding or discounting is also annual. On the
other hand, in reality, payments could occur semi-
annually, quarterly, monthly and even daily and hence the
formulas we provided previously would need to be
adjusted to conform to other compounding periods.
Let’s start with a semi-annual compounding example and
then move to others. Let’s suppose you deposit ¨100 in a
bank for one year period with 10% interest rate.
1. If the bank deposits compound annually the ending
amount by the first year would be: (As it is shown on page
116 / Figure 4/18).
2. If the bank compounds semi-annually, the number
of periods will be 2 and the interest rate for each semi-
annual period would be 5%=10%/2. Therefore the ending
amount would be: (As it is shown on page 116 / Figure
4/19).
3. If the bank compounds quarterly, the number of
periods will be 4 and the interest rate for each quarter
would be 2,5%=10%/4. Therefore the ending amount
would be (As it is shown on page 117 / Figure 4/20).
4. If the bank compounds monthly, the number of
periods will be 12 and the interest rate for each quarter
would be 0,83%=10%/12. Therefore the ending amount
would be: (As it is shown on page 117 / Figure 4/21).
Periodic rate is 3%, since the annual interest rate is 12%
and it pays 4 times per year (12% divided by 4).
Number of periods is 8, since the issuer pays 4 times a
year for the next 2 years (4 multiplied by 2).
Annual Percentage Rate and Effective Annual Rate
Annual percentage rate (APR) is the stated rate of which
banks, credit card companies, mortgage loan officers tell
you they charge.
Effective Annual Rate (EAR) is the rate which is actually
earned on an investment and is the rate that should be used
to compare alternatives. . It will exceed the stated rate if
the compounding period is smaller than one year. For
instance, we showed in the previous section, how each
compounding frequency produced different future values.
Loan Calculations
Loan calculations use a lot of time value of money
calculations and loan characteristics are also very
important parts of the agreements.
Pure Discount Loans
Pure discount loans are the most basic type of loans. The
borrower pays a lump sum at maturity which includes the
interest and principal.
Amortizing Loans
Amortizing loans is another common type of loan where
the initial amount borrowed and interest is repaid in equal
periodic installments. These periodic installments can be
monthly, quarterly or annual. Purchases of long lived
consumer goods on installment, leasing agreements and
mortgages are typically in this group.
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 FIN207U-BUSINESS FINANCE I
Unit 5: Valuation of Bonds and Stocks
Bonds
A bond is a debt security that contractually obligates the
issuer to make fixed coupon payments at fixed intervals
for a fixed amount of time plus it also pays out the face
value of the bond at maturity together with the last coupon
payment. The total annual coupon payments are equal to
the coupon rate multiplied by the face value of the bond. e
coupon payments may be split into more than one
payment per year. ese specified payments are in the form
of coupon payments and par value. Par value (also called
face value or nominal value) indicates how much the
issuer will repay to the bondholder at maturity. Par value
of Turkish bonds in general is T100 whereas US bonds
typically have a par value of $1.000. e coupon rate of a
bond determines the coupon (interest) payments. Bonds
can usually only be issued by governments or large, well
known firms. As time passes, the cash flows from the
bond stays the same but market interest rates may change.
As a result, the value of the bond changes with the
changes in interest rates. If market interest rates increase,
the price of bonds decrease.
Valuing Bonds
The value of the bond is the present value of these cash
flows. To find its value, you need to calculate present
value of each future payment discounted at the current
market interest rate (r). The formula used for the
calculation can be seen on page 132.
Interest Rates and Bond Values
There is an inverse relationship between value of bonds
and market interest rates. As market interest rates increase,
the present value of future cash flows declines and the
value of bond decreases. Conversely, if market interest
rates decrease, the present value of future cash flows
increases and the value of bond increases. It is important
to note that market interest rates might change but there is
no change in coupon interest rate. Bonds exhibit interest
rate risk, which is the risk that the return from the bond
will change according to changes in the interest rates. An
increase in interest rates reduces bond values. Bonds carry
reinvestment rate risk, which is the risk that cash flows
received may not be able to be reinvested at the expected
rates if market rates have changed.
Yield-To-Maturity
Yield-to-maturity is the average rate of return that will be
earned on a bond if it is bought at the market price and
held until it matures. It is the discount rate that makes the
present value of its future cash flows equal to its market
price. It is like an internal rate of return of a bond.
Calculating yield-to-maturity of a bond selling at par is
easy. It is equal to its coupon interest rate. For discount
bonds, yield-to-maturity is greater than their coupon rate
whereas yield-to-maturity of premium bonds is less than
their coupon rate.
Yield-to-maturity has two components. The first one is the
return you get from coupon payments, called current yield
(annual coupon/current bond price). The second one is the
return you get from the change in the value of bond, called
capital gains yield. Capital gains yield is negative when
there is a decline in value of a bond.
If an investor does not want to hold the bond until its
maturity, she may sell it after holding it for some time,
like a year. Holding period rate of return can be calculated
with the formula given on page 136.
If the market rate of interest and the bond’s yield-to-
maturity does not change over this period, then the bond’s
rate of return will be equal to its yield-to-maturity. If there
is a decline in interest rates, the rate of return will be
higher than the bond’s yield-to-maturity as in the case of
the example. If there is an increase in interest rates, the
rate of return will be less than the bond’s yield to maturity
because of the decline in the value of the bond with the
increase in interest rates.
Nominal and Real Interest Rates
The interest rates you observe in the world around you are
typically nominal rates. However, they are usually
assumed to have a real interest rate component and
another component to compensate for expected inflation.
Investors in bonds expect to receive fixed payments in the
future (fixed coupon payments and par value at maturity),
however, they are not certain about what they can buy
with these cash flows in the future (purchasing power of
these cash flows). Real interest rate can be calculated with
the formula given on page 137.
The Yield Curve
Yield curve plots the relationship between bond yields and
maturity. In general, yield curves are upward sloping
because investors may require more yield to invest in
long- term bonds. First, as maturity increases, uncertainty
in investing long-term bonds is higher. Second, prices of
long-term bonds fluctuate more with the changes in
interest rates. Long-term bonds have higher interest rate
risk. Upward sloping yield curve implies that short-term
interest rates will increase in the future.
Bond Ratings and Risk of Default
Government bonds are usually considered to be default free,
especially if they are denominated in the local currency.
Governments are expected to pay their obligations, i.e.,
coupon payments and par value, on time. If they do not
have enough cash, they can print their own money. In
general, this is true but there are some exceptions.
Corporations cannot print money and it is possible to
default if they do not make their payments on time. They
hold default risk, i.e., the risk that a bond issuer may
default on its obligations. In order to invest in the bonds of
corporations with higher default risk, investors require
higher returns than the yields on government bonds. The
higher the default risk, the higher is the yield on the bonds.
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 FIN207U-BUSINESS FINANCE I
Unit 5: Valuation of Bonds and Stocks
Stocks
If you purchase stocks of a company, you become an
owner of that company. As an owner, you have several
rights. One of them is voting right. You have a right to
vote in the shareholders’ meeting. Second, you have a
right to receive dividends, if the corporation decides to
distribute any. They will be cash flows you expect to get
in investing in stocks. Third, you have pre-emptive right.
If the company issues additional shares, you have a right
to purchase your share of these shares (sometimes at a
discount) before the new stocks are offered to the public in
order to protect your initial share in the company. Fourth,
the right to receive your share of the residual (Assets-
Liabilities) in case of dissolution of the company. The first
time the company offers its shares to the public is called
initial public offering (IPO).
Market Values Versus Book Values
The book value of a company’s stocks is an accounting
figure calculated from the balance sheet of a company.
Every quarter all listed companies report their financial
statements. The difference between total assets and total
liabilities is the book value of the company’s equity. Since
book value indicates what was collected and retained in
the company, it is like historical value whereas market
value is based on the expectations about the future cash
flows from investing in the company’s stocks.
Stock Valuation
Stock valuation is similar to bond valuation. e value of
stock is equal to the present value of its future cash flows.
However, it is more difficult than calculating the value of a
bond for a few reasons. First, the timing and amount of
future cash flows are not known with certainty as in case of
coupons and par value. It is not possible to know how much
dividend the company will distribute in the future. Second,
unlike bonds, stocks do not have any maturity. It is
generally assumed that the corporations will live forever.
Third, the discount rate used in calculating present values is
difficult to estimate. It is not easy to estimate the rate of
return the market requires for investing in a specific stock. e
cash flows that are associated with stocks are the dividends
that the firm may pay and price that the investor receives
when she sells the shares. Dividends are paid only after
interest and other required payments are made to creditors
and they are not fixed amounts; Dividends depend on the
profitability, growth prospects, investment requirements
and payout decisions of the company. As a result, their
timing and quantities are uncertain and they are more risky
than debt securities. In order to compensate for this greater
risk, they need to offer greater expected returns in order to
make them attractive to investors.
Valuing by Comparables
Compared to bonds, there are uncertainties about cash
flows of stocks and several assumptions have to be made.
It can be assumed that the stocks of similar companies
should be priced in a similar way because investors are
prepared to pay similar price for each lira of assets or
earnings. It is called valuation by comparables. e common
ratios used as comparables are price-earnings (P/E) ratio,
market value-to- book value (MV/BV) ratio, price-to-sales
ratio, price-to-cash flows ratio and PEG, defined as the
P/E ratio divided by the growth rate of earnings.
Dividend Discount Model
According to this model, the value of stock is equal to the
present value of all future dividends that investors expect
to get from that stock. The formula given on page 143 can
be used for the calculation. It is not possible to estimate all
future dividends, we make some simplifying assumptions
about future dividends.
Zero Growth
The simplest assumption is that the company will
distribute same dividend forever. There is no change in
dividend payments. It is same as assuming that there is
zero growth in dividends. Formula given on page 143 can
be used to calculate its value.
Constant Growth
It can be assumed that dividends will grow at a constant
rate (g) every year. It is possible to identify all future
dividends. e intrinsic value of a stock is calculated with
the equation given on page 144.
Supernormal Growth
The amount of dividend the company pays may change
every year. However, it is assumed that after certain time
period, say in year T, it may reach to its steady state level
and have a constant growth rate after year T. e intrinsic
value is still the present value of its future dividends. e
present value of dividends are calculated one by one until
time T and the present value of the value of stock at time
T is added.
Valuation with Free Cash Flows
Another approach to calculate stock price is to discount
free cash flows of a firm. It is similar to dividend discount
model. Free cash flows are defined as cash flows available
to the firm or to the shareholders after the company makes
its capital expenditures. is approach can be used for the
valuation of companies that do not distribute dividends. A
stock price is found by dividing the present value of free
cash flows to equity holders by the number of shares
outstanding.
Expected Rate of Return
Expected rate of return of stocks has two components. e
first component is the return from dividends, called
dividend yield (Div1/P0). e second component is the
return from price appreciation, called capital gains yield
((P1-P0)/P0). At equilibrium, the expected rate of return
needs to be equal to the required rate of return. is is the
case because the intrinsic value of this stock is equal to its
market price. Also, for a company that is growing at a
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 FIN207U-BUSINESS FINANCE I
Unit 5: Valuation of Bonds and Stocks

constant rate, the rate of increase in stock price will be

equal to the rate of increase in dividends.
Stocks that provide all or almost all of their returns from
dividend yield are referred to as income stocks. Whereas,
stocks that pay no or very low dividends and still have
prices that increase are called growth stocks. Rapidly
growing companies require a lot of investments, growth
stock companies usually are using their profits and cash
flows to support these investments and as a result do not
have resources to pay dividends. Different types of
investors may prefer one type of stock over another for
reasons like differences in taxation, consumption time
preference, risk tolerance, etc.

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 FIN207U-BUSINESS FINANCE I
Unit 6: Risk and Return
Returns
Typically, the return on stocks has two components:
dividends and capital gains. As a holder of some stocks,
you own a part of the company and you have the right to
benefit from the profitability of the company. The cash
that you receive arising from the ownership is called a
dividend. Even during periods where the company loses
money, the companies may strategically decide to
distribute dividends (as long as they have cash and
sufficient retained earnings from the past) in order to
satisfy the expectations of their shareholders and manage
their position in the market. In addition to dividends, you
will also have capital gains (losses) if the market price of
your stocks has increased (decreased) since you purchased
them.
Calculative Returns
The dividends represent the income component of your
returns whereas capital gain/loss comes from changes in
the market price of the shares. Note that the capital
gain/loss is used for return calculations regardless of
whether the shares are actually sold at that price (in which
case the gain/loss is said to be realized) or not (unrealized
gain/loss).
Percentage return is nothing but dividend yield plus
capital gain yield, where dividend yield represents the
percentage of income return.
In historical returns, in order to evaluate the performance
of different investment alternatives over time we need to
use some statistics that will summarize the data. We will
use the arithmetic average (mean) to measure the expected
value and the standard deviation to represent the volatility
or dispersion around that expected value (footnote: some
sources prefer to use the geometric average; however, we
will use the more common arithmetic average in this
book). e average return is calculated by summing the
return over the years and then dividing by the number of
years, T. Another important statistic is the standard
deviation of returns that we will use to measure the
volatility. e standard deviation of a series represents the
dispersion or spread of the observations around the mean.
A large standard deviation means that the observations
tend to be widely dispersed around the mean and can
easily change drastically from one period to the next. As a
result, standard deviation is often used as a measure of risk
for a given distribution. It is important to note that there
can be other ways to calculate the dispersion or risk in
returns as well, however, standard deviation (σ) or
variance (σ2), of returns serves as a simple and basic risk
measure. The equations for these calculations can be seen
on page 159.
Risk-free return is the rate of return that investors require
to invest in risk free investments in that environment. e
short term T-Bill rate is usually used to measure it. e Risk
premium is the return in excess of the risk-free rate that
investors require to compensate for the risk of an
investment.
The Efficiency of Financial Markets
After people have observed that prices in financial
markets are almost constantly changing, many of them had
questions about whether these markets were efficient. Our
general statement of the Efficient Markets Hypothesis
(EMH) is given below. In an (informationally) efficient
market, prices fully reflect all available information. In
such a market, it should not be possible for market
participants to consistently earn excess returns, beyond the
return appropriate to investments of that level of risk. Two
important parts of the EMH definition that we should pay
more attention to are “fully reflect” and “all available
information”. The level of efficiency across different
markets varies greatly, however, for developed markets
the findings tend to indicate that markets tend to be
generally weak form and even roughly semistrong form
efficient. However, findings have shown that it is possible
to find private information that would provide excess
returns, yet not as frequently as imagined.
Risk and Return
When deciding on an investment, we should take into
account not only their expected returns and risk levels, but
also possible interactions/ co-movements with other
securities. One way of estimating the expected return of a
security that we have seen is by calculating the average
return over some past period. However, other approaches
that are more forward looking may also be used.
Furthermore, we may also be interested in the co-
movement of certain securities that can be measured with
covariance and correlation. Especially during certain
periods such as announcements affecting a specific
industry, the returns of stocks in the corresponding
industry may show similar trends.
Return and Risk of Individual Securities
Suppose that there are three states of economy:
depression, normal, boom with equally likely probability
to happen. Considering two companies from the market,
Compatible is the one growing with the general economic
conditions whereas Divergent’s business is independent
from macroeconomic conditions. Expected return of each
company would be the average of different possibilities. e
variance would be the weighted average of squared
distances, and standard deviation would be the square root
of the variance. The standard deviation is more useful for
interpretation purposes as it is in the same units as the
original and average values. Equations for these
calculations can be seen on page 163 and 164.
Covariances and Correlations
e covariance between Compatible and Divergent is a
measure of whether the returns tend to move in the same
direction, in other words, do they tend to be above and
below average at the same time or at different times? The
first step in the calculation is to calculate their differences
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 FIN207U-BUSINESS FINANCE I
Unit 6: Risk and Return
from their relative means, and multiply them with each
other for each state of the economy. Second, taking a
weighted average of these terms gives us the covariance.
When both returns tend to be above or below their relative
averages at the same time, then the covariance becomes
positive, and negative when they tend to diverge. Equation
for this calculation can be seen on page 164.
The product term will be:
(i) Positive, whenever both Compatible and Divergent
returns are above or below the average at the same time
(i.e., + times +, or – times -),
(ii) Negative, whenever Compatible and Divergent returns
di er in being above or below their relative averages in the
same period (i.e., + and -, or - and +).
Correlation is simply the covariance that has been
standardized to be between -1 to +1, as a result, the sign of
correlation is also determined by whether the covariance is
positive or negative. A positive correlation means that the
investments will tend to have high or low returns at the
same time.
Since covariance is standardized by dividing by the
standard deviations, the correlation always lies between
+1 (perfect positive correlation) and -1 (perfect negative
correlation). Zero correlation would mean there is no
relation at all. Another important feature of this
standardization is that the magnitude can be comparable:
the values of correlation between X and Y, and correlation
between Y and Z, can be compared to determine which
one is more related.
Return and Risk of Portfolios
The aim of investors is to increase returns and decrease
the risk. However, as we have seen, this is not easy as risk
and return are not independent of each other. In order to
reach this aim, the investor should consider:
(i) Expected return of individual securities, and how each
would contribute to the portfolio return,
(ii) Standard deviation of individual securities, correlation
between securities, and how these would impact the
standard deviation of the portfolio.
Expected return of a portfolio is simply the weighted
average of the returns of securities. The variance of a
portfolio is a function of the individual security return
variances and of the covariance between them. As can be
observed from the formula between. There is a positive
relationship with both the variances and covariance.
Equations for these calculations can be seen on page 166.
Effect of Diversification on a Portfolio
In case returns are perfectly positively correlated the
standard deviation of portfolio is just the weighted average
of risk levels of single securities, and hence there is no
benefit from diversification. As long as is ρ less than 1,
there will always be a diversification benefit to investing
in a portfolio. Remembering that the correlation lies
between -1 and +1, the benefit would be eliminated at +1,
whereas the maximum diversification benefit would be
reached at -1. The results are the same for portfolios with
more than two securities; as long as correlations between
pairs of securities are less than 1, the investor would
always have a portfolio with a lower standard deviation
compared to the weighted average of the securities.
Efficient Set for Two Securities
For a risk-averse investor as higher expected return is
desirable (a good) while higher standard deviation is
undesirable (a bad) the indifference curves in this case
would be as shown in the figure and the investment
decision would be made at the point that the highest
indifference curve is tangent to the feasible set.
Efficient Set for Multiple Securities
In real life investors are faced with many securities,
however, the fundamentals of what we have learned from
two securities are roughly generalizable to this
environment as well.
The expected return for a portfolio composed of N assets
would be calculated as a weighted average of each asset’s
return. Expected return and Variance of an N asset
portfolio can be calculated with the equations given on
page 171.
Expected and Unexpected Returns, Systematic
and Unsystematic Risk
Unexpected returns are the result of new unexpected
information arriving to the market during the period which
changes some of the factors we believe are pertinent to the
valuation of a firm. In any given period, unexpected
returns may be negative or positive, however, on average
they should be zero. is implies that actual returns should
be equal to expected returns on average, otherwise there
would be a bias in expectations that should not be able to
persist in a market with rational participants. The risky
part of returns (unexpected returns) can be broken down
into a systematic risk and unsystematic risk components.
Both of these risks are the result of new unexpected
information arriving to the market and being incorporated
into prices. The difference is that, some of these risks are
relevant to all (or almost all) securities while others are
relevant only to one security (or a limited, small group of
securities). The importance of the separation of risks into
systematic and unsystematic is that unsystematic risks
may be eliminated at little or no cost with proper
diversification. As unsystematic risk can be eliminated as
shown below, then there should be no compensation for
taking on this type of risk. Market, portfolio or systematic
risk is the uncertainty inherent to the market that cannot be
controllable. On the other hand, the diversifiable, unique
or unsystematic risk is the uncertainty that is related to
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Unit 6: Risk and Return

the invested asset. Therefore, unsystematic risk can be risk premium is positive, higher beta value bring higher
reduced through diversification whereas systematic risk returns.
cannot.
The difference between Security Market Line and Capital
Combining Risky Securities with Risk-Free Assets Market Line is that: on CML we are considering a
Investors may want to combine a risky security with some portfolio that is composed of a risky assets plus a risk-free
lower risk or even risk-free securities to change the asset, and all the efficient points on this line denotes the
characteristics of the portfolio. Recall that the risk-free expected return and standard deviation of this
return is the return on securities that always yield their combination.
expected returns, regardless of the economic environment.
The risk-free return is usually approximated with the
returns from very short-term government securities.
Efficient Set with Multiple Securities and Risk-Free
Asset
The Capital Market Line (CML) is the line that connects
the risk-free asset with the market portfolio, where the line
is just tangent to the efficient frontier on an expected
return/ standard deviation graph. e CML depicts the trade-
off between risk and return for diversified (efficient)
portfolios. relationship between the expected returns of
efficient portfolios subject to standard deviation of a
market portfolio and risk-free rate. The CML equation is
given on page 176.
Measuring Risk of a Security: Beta
In order to describe the risk-return relationship for
individual securities, we need a risk measure, which
measures the relevant (systematic) risk as opposed to the
total risk measured by the standard deviation. The
relevant risk measure that is used is called the beta
coefficient (or just beta for short) and measures the co-
movement of a securities returns with the market return,
which is assumed to have average risk. Beta is estimated
by standardizing the covariance between the security “i”
and market portfolio with the variance of the market with
the equation given on page 176. In addition to being able
to measure only the relevant (systematic) risk of securities,
beta has another very nice property. The beta of a portfolio
of securities is simply a weighted average of their
individual betas. So, for a portfolio of N securities, the
portfolio beta would be calculated in a similar way to
calculating the portfolio expected returns.
The Security Market Line (SML) and Capital
Asset Pricing Model (CAPM)
The SML relationship, also referred to as the CAPM,
should hold for both individual securities (including risk-
free) and portfolios of securities. On SML, we can denote
not only portfolios, but also single securities as well.
Besides, SML is the relationship between expected returns
and beta, not standard deviation. In this regard, CML deals
with portfolio risk whereas SML deals with systematic
risk.
Capital-Asset-Pricing Model is a model describing the
relationship between the systematic risk of a security,
namely beta, and expected returns. As long as the market

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 FIN207U-BUSINESS FINANCE I
Unit 7: Financial Planning and Control
Conceptual Framework
The economic entities, which are public, corporate and
individuals, have specific financial and operational goals
and they should act rationally and work systematically to
attain those goals. e financial plans provide direction to
the e orts of the departments within an organization and
also give the details of the division of work, labor and
responsibilities.
Financial planning is the process of creating a picture of
future given the assumptions of today as determined by
the prevailing market and corporate circumstances as well
as strategies. It is process of framing objectives, policies,
procedures, programmes and budgets regarding the
financial activities of a concern. e results of financial
planning activities give direction to the company and they
can be considered as financial targets for which the
organizational e orts are focused to achieve.
Financial Planning has got many objectives to look
forward to, but mainly it serves for determining capital
requirements in short and long term and proper capital
structure for the relevant time frame. It constitutes a
framing tool for the financial policies with regards to cash
control, lending, borrowings, etc. In this framework,
financial planning
• helps in ensuring a reasonable balance between
out ow and in ow of funds so that stability is
maintained.
• ensures that the supply of funds is easily and
effectively invested
• helps in making growth and expansion
programmes which helps in long-run survival of
the company
• reduces uncertainties with regards to changing
market trends which can be faced easily through
enough funds, and
• helps in reducing the uncertainties which can be a
hindrance to growth of the company. is helps in
ensuring stability and profitability in concern.
Main Constituents of Financial Planning
The process of financial planning includes the following
financial analysis and aspects:
• Cash Flows: The cash flows convey the liquidity
performance, flexibility and risk concepts to the
financial planning as supported by the accounting
data and financial reports,
• Departmental analysis: For large companies and
conglomerates, the targets produced by financial
planning for each individual department
generated by taking into account its own
investment finance and cash flow requirements
serves as benchmarks of success,
• Scenario Analysis: The flexibility of financial
planning by the use of the capabilities of
information technology enables to realize
scenario analysis to evaluate the effects of the
possible financial and environmental changes on
corporate activities in the future.
• Short and Long-term Time Frame: The financial
plans can be prepared for short (less than 1 year)
and long term (more than 1 year). They can also
be prepared as monthly, quarterly and
semiannually, each of which are used for control
purposes. In the short-term, the basic motivation
is to determine the funding needs or surplus and
the method to secure or invest the relevant
amounts. In the long run, financial planning is
used as a strategic tool in order to maximize the
return under different risk estimations.
Assumptions of Financial Planning
In order to prepare financial plans, some assumptions
should be made in relation with the variables including,
but not limited to inflation, economic growth, sales
growth, foreign exchange rates etc. It is a fact that during
the planning horizon those assumptions may fail. The
planning process should be designed to be revised
periodically to reflect the effects of those changes to the
financial plans.
The Data Set Used for Financial Planning
The required data mainly includes Break- even Analysis,
Ratio Analysis and the Investment Projects Evaluations.
Additionally, the following operational and financial data
is required for the financial planning process:
• Short and long term pro t targets,
• Divisional financial reports,
• Transactions creating cash flow for the divisions
and the company,
• Divisional proforma and realized budgets,
• Cost accounting data on product basis,
• Special financial analysis in relation with
profitability by product, logistics costs and other
expenditure,
• Analysis of security portfolio and subsidiaries,
• Labor productivity reports,
• Internal control reports.
The Outputs of Financial Planning
The material goal of the financial planning is to generate a
set of reports, budgets and strategy documents to be used
in the managerial decision making. The outputs of
financial planning process are:
• Cash Flow Estimations
• Working Capital Strategy
• Short and Long Term Capital Budgets
• Funding Requirements
The Dimensions of Financial Planning
The first dimension of financial planning is the time
horizon. There exist two time horizons as short and long
term. In the course of financial planning, one of the first
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Unit 7: Financial Planning and Control
tasks is to determine total investment amount by bringing
together all the approved projects of the individual
divisions. This is the second dimension of planning and
specified as collection. After the specification of the
dimensions of time horizon and collection, the data input
grouped under alternative assumption sets. The alternative
plans reflect three degree of expectations specified as
worst case scenario, normal case scenario and best case
scenario.
Process of Financial Planning
The basic two components of the financial planning are
cash and pro t planning. e cash planning is realized by the
formulating the cash budget of the company, whereas pro t
planning requires the proforma financial statements. The
financial planning commences with the development of
strategic long term financial plans and these plans give
direction to the development of short-term operational
plans and budgets. Generally, many operational plans are
figured out for different divisions within an organization
in order to accomplish the strategic plan. The process of
financial planning is summarized in the figure on page
194.
Budgeting
The budget is defined as the numerical report or set of
reports addressing the future policy and activities in order
to achieve predetermined set of targets. e company budget
eases the operational decision making and provides a
framework for control as it contains all the operational
details such as cost figures and production plans. The
budget control is specified as the process of periodic
monitoring and evaluations of the results of the activities
carried out and taking corrective actions when required. e
system of budgeting specifies the principals and
techniques to prepare the budgets as well as the
application and control mechanisms.
Types of Business Budgets
These are sales budget, production plan, cost of goods sold
budget which incorporates direct materials budget, direct
labor budget, manufacturing overhead budget and cash
budget.
The sales budget is the core of the overall budgeting e orts
within an organization. In order to determine the future
activity level and the attached revenue and costs, the sales
budget should be prepared with great care by taking into
account market research and relevant market estimations.
The responsibility to prepare the sales budget is generally
belongs to sales division managers however depending on
the size of the company and organizational structure it
may change. The most proper sales forecast method for a
company depends on the peculiarities of the company, as
well as on the appropriateness of the expected sales
growth and on the education provided to the relevant
personnel. Regression method, managerial assessment
method, special purpose methods, and combined methods
are used for sales forecast.
The production budget should include the planning of the
main production input of direct materials, direct labor and
manufacturing overhead. e major target of the production
budget to secure the optimum balance between sales
budgets, inventory level and production process
requirements without stagnant inventory level. The
productivity of the production inputs and the effective use
of them depend on effective production budgeting. The
responsibility of preparing the production plan belongs to
production managers with the support of sales managers.
The direct materials budgets have three interrelated
sections, which are the volume, the procurement and
inventory of direct materials. The time frame of direct
materials budget should be the same with that of sales and
production budgets. e budget for the procurement of direct
materials is prepared by the procurement managers after
finalizing the volume of direct materials budget. This
budget should contain the existing amount of direct
materials inventory and also pricing level including
storage and loading/uploading costs.
The direct labor budget is used to determine the required
labor hours in order to produce the volume of products as
stipulated in the production budget. The responsibility to
prepare the direct labor budget belongs to production
managers together with cost accounting, human resources
and budget control divisions. In order to achieve the
production targets, the required number of labor can easily
be determined. The direct labor budget also provides input
to the preparation of cash budget of the company.
Manufacturing overhead budget consist of any expenses
directly related with the production except direct materials
and direct labor. Structurally manufacturing overhead may
be in the form of fixed or variable costs. The fixed
manufacturing overhead costs include, but not limited to
amortization, taxes, insurance. The variable costs are the
ones that directly change as parallel to change in the
production volume. e responsibility of the manufacturing
overhead costs is not under a specific division as it is the
case for many types of direct production costs. Instead
responsibility for those kinds of costs belongs to many
different managers of different divisions where those costs
are incurred. For this reason, for each division, a separate
manufacturing overhead budget is prepared.
After the preparation of the budgets for the production
costs of direct materials, direct labor and manufacturing
overhead, the costs of goods sold budget should be figured
out.
Cash Budgets
Cash budget is a management plan for the most important
factor of a company’s viability — its cash position. A
company’s cash position determines how suppliers will be
paid, how a banker will respond to a loan request, how fast
a company can grow, as well as directly influencing
dividends, increases to owner’s equity and profitability. e
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Unit 7: Financial Planning and Control
cash budget involves the cash inflows and outflows
forecasts and the planning to manage the shortfalls.
Term of Cash Budgets
The cash budgets can be prepared for short and long term
depending on the cash conversion terms of the company.
The long-term cash budgets help to define the cash
requirements in order to realize the long-term strategies
and to clarify the relevant funding activities. The short-
term cash budgets is an important management tool in
order to address the future cash inflows and out flows and
to sustain the payment capability of the company.
Structure of Cash Budgets
The cash budgets are prepared in cash terms and this is the
main differential attribute of the cash budgets as compared
to other budgets. e cash budgets mainly consist of three
parts; the cash in ow, cash out ow and budget.
Cash Budget Preparation
The cash budgets are generally prepared by the
methodology of daily and detailed cash flow statement. By
that way, the availability term of the excess cash or the
durability of cash shortfall can be determined. This
information provides main inputs for cash management in
the case of excess cash. The excess cash can be deposited
in a bank or a repo transaction can be realized depending
on the term of availability. There exist two main methods
for preparing the cash budgets: direct estimation of cash
inflows and outflows, adjusted net profit method.
Proforma Financial Reports
The proforma financial reports, balance sheet and income
statement, contain all the information generated by the
budgets on operational level and exhibit the financial
situation of the company under the assumptions. Proforma
financial statements are the complete set of financial
reports issued by an entity incorporating assumptions or
hypothetical conditions about events that may have
occurred in the past or which may occur in the future
which is usually used to present a view of corporate
results to insiders to run the operation smoothly as per
plan and to outsiders as part of an investment or lending
proposal. In order to prepare the proforma financial
reports, the existing financial reports are used as starting
point. The preparation of proforma balance sheet requires
detailed historical data about the company and it is not
easy to visualize the formation process.
Preparation of a proforma balance sheet involves four
basic steps:
• The forecast of sales and distribution of the sales
proceeds to financial accounts,
• Determining the amount of funds intrinsically
generated,
• Determining the equity of the company,
• Balancing the total of projected asset and
liabilities
The methods of preparation of the proforma balance sheet
are Percentage of Sales Method, Ratio Method and
Regression Method.
Financial Control
Financial controls are the means by which an
organization’s resources are directed, monitored, and
measured. It is fact that budgets and proforma financial
statements are the major tools of financial control. e
financial control can be defined as the analysis of a
company’s realized financial results compared to its short,
medium and long-term objectives and business plans, as
well as budgets. These analyses require control and
adjustment processes to ensure that the business plans
which are the core ideas under budgets are being followed.
Financial Control Implementation Strategies
Although there are many different types and
methodologies, an accepted router to establish a financial
control infrastructure within a company involves the
following steps:
1. Analysis of the Initial Situation
2. Preparation of Forecasts and Simulations
3. Detection of Deviations in the Basic Financial
Statements
4. Correction of Deviations
The Benefits of Financial Control
Financial control generates information flow to the
decision makers and managers with regards to the
operational results of the company. e budgets are
generally prepared quarterly and each quarter the decision
makers evaluate the realizations and they compare the
actual results with the figures proposed by the budgets
such as sales, direct materials flow, direct labor and
expenses. In this framework, with the contributions of the
financial planning and budgets, the control activities
became formal, operating targets are revised and decision-
making processes prospers.
Financial control may also serve to implement preventive
measures. Occasionally, early diagnosis of specific
problems detected by financial control makes corrective
actions unnecessary, as they are replaced by solely
preventive actions. It also serves to communicate with and
motivate employees. Last but not the least, financial
planning and control create an environment of
responsiveness. Financial control must be designed on the
basis of very well defined strategies to enable the decision
makers to determine the deviations from the budgeted
financial and operational figures.
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 FIN207U-BUSINESS FINANCE I
Unit 8: Working Capital Management
The Concept of Working Capital
Working Capital basically refers to the money utilized by
companies in their daily activities or operations. It is also
defined as the available capital for day-to-day production
of goods to be sold by a company represented by its net
current assets. The management of working capital is
critical for the financial health of businesses of all sizes.
The working capital is explained from two different
perspectives. e first one focuses on value, and
conceptualizes working capital in two different forms;
Gross Working Capital and Net Working Capital. The
gross working capital refers to the total current asset
holdings of a company which can be converted into cash
in less than a year time. Net Working Capital refers to the
difference between the current assets and the current
liabilities. The current liabilities are those claims to be
paid in less than 1 year time. Net working capital is a
measure of company’s liquidity and ability to survive in
case the only funding source is current assets. In this
regard, a positive net working capital means that the
company is able to meet its short- term liabilities, whereas
a negative working capital means that the company
currently is unable to meet its short-term liabilities.
From the “time” perspective, the working capital is
conceptualized in two different forms: Permanent and
Temporary. The permanent working capital represents the
minimum level of investment in the current assets that is
carried by the business at all times to carry out its
activities. Temporary working capital, on the other hand,
refers to that part of total working capital over its
permanent working capital. It is also named as variable
working capital as it fluctuates depending on the level of
business activities. As a general rule, the temporary
working capital is financed by short-term sources.
The Level of Adequate Working Capital
Maintaining adequate working capital is important in the
short-term, but also liquidity must be maintained in order
to ensure the survival of the business in the long-term as
well. In case the opportunity cost of keeping working
capital increases, then the companies pretend not to see
the promising investment decisions which have the
potential to motivate the business activity. In this
framework, each company should determine the optimal
working capital level. Optimal level of working capital
maximizes the firm’s value, hence a trade-off between
liquidity and profitability.
Some of the factors affecting the level of working capital
are:
• Nature of business
• Length of period of manufacture
• Volume of business
• The proportion of the cost of raw materials to
total cost
• Use of manual labor or mechanization
• Inventory level for raw materials of finished
goods
• Turnover of working capital
• Terms of credit
• Short term financing options
• Seasonality of product demand
• Price level changes
Working Capital Management
Working Capital Management means managing the
balance between a firm’s short- term assets and its short-
term liabilities. It ensures that the company is able to
continue its operations by meeting the payment
requirements sourced by the short-term debt and
operational expenses. It is observed that many
manufacturing companies have large amount of
investments in working capital, as well as substantial
amounts of short-term payables especially to the suppliers
as a course of financing. In this framework, working
capital management has the following four dimensions:
Time, investment, credibility, growth.
Working Capital Management Policies
The working capital policy of a company should focus on
maintaining sufficient liquidity. The decision on how
much working capital to be maintained and especially the
funding of it is a very important strategic decision.
Generally, three types of working capital policies are
accepted, Hedging Policy, Conservative policy and
Aggressive policy each of which describes different
financing strategies to meet the working capital
requirements.
Hedging policy, which is also named as matching policy,
proposes a strategy by which the fluctuating part of the
current assets are financed by the current liabilities.
Consequently, the fixed and permanent current assets are
financed through long-term sources. Such a policy creates
a medium level of risk and should be managed
accordingly.
Conservative policy aims to minimize the risks associated
with the financing of the current assets. It proposes to
finance a higher proportion of current assets by the long-
term sources. e company not only matches the current
assets with current liabilities but also keeps some excess
amount to meet any uncertainty in the working capital
requirements. While the conservative policy of working
capital management creates the lowest level of risk, it fails
to ensure optimum utilization of funds.
Aggressive policy is specified as the most risky working
capital financing policy as a higher proportion of current
assets including permanent ones is financed by the short-
term debt. To apply such a policy, the company should
ensure that the receivables are supposed to be collected on
time and payments to the creditors are easily made as late
as possible.
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Unit 8: Working Capital Management
Cash Management
Cash management is the process to reduce the cash
conversion cycle as short as possible. This achievement
reduces financing cost such as lost opportunities due to
lack of fund, as well as the interest costs incurred for the
borrowings to meet the cash requirements. Under the
framework of cash management, the operating cycle is
defined as the length of time it takes the inventories are
sold and the proceedings are collected in cash from
customers. e net operating cycle (or the cash conversion
cycle) is the length of time it takes the inventories are sold
to generate cash, considering that some or whole of the
inventory is purchased using credit. The length of the
company’s operating and cash conversion cycles
determines the level of liquidity. e cash cycle calculation
is as given on page 227.
Cash Management Models
There exist two basic methods for the determination of the
optimal cash level for a company. These are Boumal and
Miller-Orr Models.
The Baumol model finds a balance by combining holding
cost and transaction costs, so as to minimize the total cost
of holding cash by the using the formula given on page
228. According to Baumol’s Model, at the optimum cash
level, holding costs of cash and the transaction cost are
equal. Cash holding cost is defined by referring to the
opportunity cost concept as the interest foregone on
marketable securities. Transaction costs are the costs
incurred in getting the marketable securities converted into
cash or vice versa.
Unlike Baumol, Miller and Orr model (1966) assumes that
the cash ow of a company has a stochastic structure, as
different amounts of cash payments are made on different
points of time. It is assumed that the movements in cash
balance occur randomly. Miller and Orr also suggest that
there exist control limits, which sets control points for
time and size of transfers between Investment Account
and Cash Accounts. It is proposed that when cash balance
touched the upper control limit, securities are brought up
to an amount the return point of cash is reached. When
cash balance touches lower control limit, marketable
securities are sold in amount to reach the return point.
Equations for this model are given on page 229.
Cash planning is a strategic part of strategic planning and
involves cash flows forecasts as the base of cash
management. Information sources for cash forecast
preparation are historical records, corporate aim and
objectives, inputs from business units/departments,
previous period forecast and errors therein and experts
judgmental inputs. Cash flows forecast is an vital early
warning tool for financial management and serves for
proactive financial management to make sure that a
company does not run out of cash.
In order to build the most realistic cash flow statement,
Cash Position Report has great importance. It is a good
memorandum record and explains daily cash movements.
Cash/Bank Reconciliation is a methodological procedure
of comparing two sets of related cash/ bank accounts or
records gathered from either internal systems or from the
banks. It includes the all the activities for categorizing and
analyzing any differences, and making needed
amendments.
Inventory Management
The basic objective of managing inventory is to determine
and maintain the level of inventory that is sufficient to
meet demand, but not more than necessary. The inventory
includes a vast spectrum of materials that is being
transferred, stored, consumed, produced, packaged and
sold. The inventory management processes should balance
two different tasks, one of which is having enough
inventories to fulfill orders and the other is minimizing the
inventory carrying costs for maximizing the company`s
profitability. Effective inventory management is realized
by fixing up a sound inventory control and management
system. Inventory control means having accurate,
complete and timely inventory transactions records to
avoid any difference between accounting entries and real
inventory levels.
Kinds of Inventories
Inventories can be classified into five major categories:
Raw Material, Work in Progress, Consumables, Finished
Goods, Spares.
Holding inventory requires financing, mainly for the costs
of production costs, but also for the inventory-related
costs. These are:
1. Holding (or Carrying) Costs
2. Setup (or production change) costs
3. Ordering costs
4. Shortage costs
Inventory management techniques may be classified into
various types such as the ones based on the order quantity
of inventories, based on the classification of inventories
and techniques on the basis of records. Techniques based
on the order quantity of inventories are Stock Level,
Minimum Level, Re-order Level, Maximum Level,
Danger Level, Average Stock Level.
Techniques based on the classification of the inventories
are ABC analysis and Aging Schedule of Inventories.
Techniques on the basis of records are Inventory Budget,
Inventory Reports, and Just-in-Time or Zero-Inventory.
Receivable Management
Management of Receivables is mainly the process of
managing the trade credit. It is a fact that apart from cash
and inventory, receivable management constitutes the
third component of working capital management.
Receivables are generally represented by acceptance; bills
or notes and the like due from others at an assignable date
in the due course of the business. In many markets,
2
 FIN207U-BUSINESS FINANCE I
Unit 8: Working Capital Management

receivables act as tools to attract potential customers and

retaining the older ones at the same time by keeping them
away from the competitors. Receivables also contribute to
accelerate the velocity of distributions.
Costs of Maintaining Receivables
Receivables can be regarded as a type of investment made
by a company. However, despite all the contributing
benefits of granting credit to the buyers, there exist many
types of costs incurred in the course of receivables
management: Administrative cost, capital cost,
delinquency cost, default cost.
Factors Affecting Size of Receivables
The size of receivables of a company is determined by a
number of factors including but not limited to the
following: Stability of Sales, Terms of Sales, The Volume
of Credit Sales, Credit Policy and Bills Discounting and
Endorsement.
Receivables Management
e primary objective of management of receivables should
not be limited to expansion of sales but should involve
maximization of overall returns on investment. So,
receivables management should not be the only focus on
the collection within the shortest possible period but also
other possible related benefit and costs should be
considered.
Credit Policy
A credit policy establishes guidelines to follow in the
decision to grant or reject credit to a customer as well as
the terms and conditions of the grant. By that definition, it
directly affects the volume of investment a company
makes in receivables. It should be prepared by the
involvement of sales and finance managers of the
company by taking into account the requirements of
competition, industry and general economic conditions.
The cost of trade credit (C) is calculated by the formula
given on page 238.
Working Capital Finance
After the determination of the level of the working capital
for a firm, the next step is to determine a policy to finance
the working capital requirement. There exist two main
sources of financing which are short–term and long–term.
Short-term financing refers to borrowing funds or raising
credit for a maximum of 1 year period. On the other hand,
long term financing refers to the borrowing of funds or
raising credit for one year or more. The finance manager
has to mix funds from these two sources optimally to
ensure profitability and liquidity.
Financing Sources of Working Capital
The firms may create financing alternatives from internal
(mainly in the form of accruals) and external sources:
accruals, trade credit, working capital advance by
commercial banks, letter of credit, factoring.