MODULE 12: FINANCIAL STATEMENT B.

Vertical Analysis – (common-sized

ANALYSIS analysis) financial statement items are
converted into percentages to determine the
- process of examining a company’s
significance of each component to a
financial statements for decision-making
financial aggregate. (e.g., total assets or
purposes.
total sales)
- (external stakeholders) overall health of an
- a technique where a line item is
organization, financial performance,
expressed as a percentage of another item
business value.
(base) within the same financial
- rely more often on the information statement.
resulting from these analyses than
- effective in comparing two or more firms
managers do. (managers have more
in the same industry despite differences in
information about the financial
the firms’ sizes.
statements)
C. Ratio Analysis – a technique where
- (internal users) monitoring tool for
various items in the financial statements are
finances, other management purposes:
compared, including across financial
using it as basis of results of actions taken
statements.
to improve the efficiency and effectiveness
of operations. - identifies significant relationships
between key financial statement items.
A. Horizontal Analysis – (trend analysis)
technique of examining financial - promotes intra-comparability; comparing
statements from one accounting period to two accounting periods within the same
another. entity.

- effective in identifying significant - also promotes inter-comparability;

changes during the year as result of comparing two or more entities within the
material transactions. same industry regardless of their size.

- identifies unusual relationships between

data; e.g., material error in the financial
a. Liquidity Ratios – measure the ability of
statements.
the company to pay its short-term
- identifies trends, helping the obligations when they come due.
management to project/forecast its future
- (liquidity) ability of the company to
operations.
convert its assets into cash.
- shows the change in the financial
- higher liquidity ratio, better for the
statements from year to year, whether
company; it implies that the company has
there is a increase or decrease in particular
the ability to pay its short-term obligations
items.
when due.
 - although, if liquidity ratios are too high:
(1) even though the company is liquid, the
company is not efficient in managing its
resources.
1. Working Capital (current assets –
current liabilities)
- it is not effective alone in
determining the liquidity of the
company. (absolute amount)
2. Current Ratio (current assets ÷
current liabilities)
3. Acid-Test (Quick) Ratio (quick
assets ÷ current liabilities)
4. Cash Ratio (cash + marketable
instruments ÷ current liabilities)
b. Solvency Ratios – measure the ability of
the company to survive in the long-run.
- survivability (financial viability); ability to
meet all liabilities (esp. long-term
obligations) when they come due.
- presence of debt adds risk to the
company; it puts the company to
insolvency risk.
- (use of debt despite of risk) concept of
leverage; debt magnifies the upside; debt
increases the returns.
1. Debt Ratio (total liabilities ÷ total
assets)
- the lower the ratio, the better. (how
total assets are financed)
2. Debt to Equity Ratio (total debt ÷
total equity)
- the lower the ratio, the better. (how
total assets are financed)
3. Times Interest Earned (EBIT ÷
interest expense)
- measures the ability of the
company to pay the interest expense
from the debt.
- the higher the ratio, the better.
c. Activity Ratios – measure the ability of
the company to efficiently use its resources.
- activity = efficiency/utilization.
- (use of average amounts for SFP items)
to make the figures representative of a
period, aligned with the nature of SCI
items.
1. Total Assets Turnover (sales revenue
÷ average total assets)
2. Fixed Assets Turnover (sales revenue
÷ average fixed assets)
3. Inventory Turnover (cost of goods
sold ÷ average inventory)
4. AR Turnover (credit sales revenue ÷
average AR)
5. AP Turnover (credit purchases ÷
average AP)
6. Days – Inventory - DSI (average
inventory ÷ daily COGS)
7. Days – AR - DSO (average AR ÷ daily
credit sales)
8. Days – AP - DSP (average AP ÷ daily
credit purchases)
9. Operating Cycle (DSI + DSO)
10. Cash Conversion Cycle (DSI + DSO
– DSP)
d. Profitability Ratios – measure the earning
ability of the company. (higher the
margin/return, the better)
- margins: measure how profitable
operations are as represented by net sales.
 1. Gross Margin (gross profit ÷ net - (prospective investor) determines the
sales) attractives of the firm’s share as an
2. Operating Margin (operating income investment.
÷ net sales)
- (current investor) undervalued or
3. Profit Margin (net income ÷ net
overvalued, affecting their investing
sales)
strategies.
- returns: measure investment profitability.
1. Earnings per Share (net income:
1. Return on Assets (net income ÷ ordinary shareholders ÷ ordinary
average total assets) shares)
2. Return on Equity (net income ÷ 2. Price to Earnings Ratio (market stock
average SHE) price ÷ earnings per share)
3. Price to Book Ratio (market stock
Dupont Equation – explains that
price ÷ book value per share*)
entities can maximize the return it
provides to its shareholders through *BVPS = SHE ÷ ordinary shares
three factors:
4. Dividends per Share (dividends:
▪ maximizing profitability, by ordinary shareholders ÷ ordinary
maximizing sales and shares)
minimizing costs; 5. Payout Ratio (dividends per share ÷
▪ maximizing efficiency, by earnings per share)
maximizing the utilization of 6. Plowback Ratio (1 – payback ratio)
the entity’s assets to generate
revenues from its operations;
▪ take advantage of the benefits
of financial leverage, where the
effective use of debt financing
can magnify shareholder value.
𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒 𝑆𝑎𝑙𝑒𝑠 𝐴𝑣𝑒. 𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠
𝑥 𝑥
𝑆𝑎𝑙𝑒𝑠 𝐴𝑣𝑒. 𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠 𝐴𝑣𝑒. 𝑆𝐻𝐸
3. Return on Common Equity (net
income – preference dividends ÷
average common equity)

e. Other Ratios (Ratios on Shareholder

Value) – these ratios assess how all factors
(profitability, efficiency, and leverage) affect
the stock price; giving an idea of what
investors think about the firm’s future
prospects.
 FINANCIAL MANAGEMENT TOPICS:
- (finance) it is the system that includes the
circulation of money, the granting of credit,
the making of investments, and the
provision of banking facilities.
a. capital markets – goods being traded
are stocks and bonds; place where savings
and investments are channeled between
the suppliers who have the capital and
those who are in need of those capital.
(e.g., stock market)
b. investments – determines how stocks
and bonds are valued.
- (security analysis) finding the true
values of a single security.
- (portfolio analysis) deals with valuation
of a group or portfolio of securities.
- (market analysis) how securities are
valued on average in the market,
normally based on the perception of the
marginal investor.
c. financial management (corporate
finance) – financial activities related to
running a corporation.
- (investing) what assets to acquire;
assets pertaining to long-term assets.
- (financing) where to get funds for the
acquisition; debt or equity.
- (operating) how to run the business;
affect the current items of the balance
sheet.
- main financial goal: maximizing
shareholders’ wealth (a measure
requiring a long-term perspective; does
not necessarily equate to maximizing
profits)
- avoid actions that decrease
shareholders’ wealth although increase
profits in the short run.
- means maximizing the stock price and
overall cash flows in the long run.
value = present value of all cash flows it is
expected to generate in the future.
- (intrinsic value) true value of the stock;
based on true cashflows and true risks;
very improbable, if not impossible to
determine.
- (stock/market price) perceived value of
the stock by marginal investors; based on
possibly inaccurate information of the
marginal investors; actual price in the
stock market.
- (equillibrium) point where the investor is
indifferent in buying or selling the stock;
intrinsic = market.
- when the two values differ, overvaluation
(investors would want to sell) or
undervaluation (investors would want to
buy) may occur.
Shareholders-Manager Conflict (Agency
Theory) – managers are naturally inclined to
act in their best interests, which are not
aligned with the interests of the
shareholders.
▪ increased job security
▪ increased compensation and bonuses
▪ increased power and authority
 - solutions:

▪ managerial compensation packages

(based on long-term performances
and average stock prices)
▪ direct intervention by shareholders
(done by insurance companies,
pension funds, and mutual funds)
▪ threat of firing (removal of the
management)
▪ threat of hostile takeover (acquisition
of a company by another company)

Bondholders-Shareholders Conflict (Agency

Theory) – shareholders are more likely to act
in their own best interests.

▪ riskier projects (higher returns)

- bondholders receive fixed payment

while shareholders receive the
remainder.

▪ additional debt

- during losses, both parties share in

the loss; shareholders would want
higher debt to acquire lower share in
the loss.

- solutions:

▪ more restrictive covenants

 MODULE 13: RISKS AND RETURNS value fluctuates relative to the market vary
across stocks, which is reflected in the
- (risk) deviation from expectations.
stock’s beta.
(undesirable thing)
rs = rrf + RPm x β
- (downward risk) chance that the actual
returns will yield lower than the expected - where:
returns.
RPm = risk premium of the market.
- (upward risk) chance that the actual
β = beta of the stock. (measures its relative
returns will yield higher than the expected
volatility when compared to the market’s)
returns.
- (beta = 1) the stock moves alongside the
A. Risk in a Stand-Alone Basis – analyzing
market rate.
or measuring the risk of one
investment/stock, not within a particular - (beta < 1) less volatile.
group or portfolio.
- (beta > 1) more volatile.
- the tighter the dispersion, the lower the
risk; vice versa.

- uses standard deviation. (statistical

measure of risk)

- (coefficient of variation) statistical

measure of risk per rate of return.

B. Risk in a Portfolio Basis – analyzing or

measuring the risk of a group or portfolio of
investments.

- (diversifiable/nonsystematic risk) the

portion of an investment’s risk that can be
eliminated through diversification. (e.g.,
company-specific risks)

- (market/systematic risk) the portion of an

investment risk that cannot be eradicated
no matter how much the portfolio, in which
it is included, is diversified.

Capital Asset Pricing Model (CAPM) -

remember that a rational investor would
diversify, and hence would be concerned
only of market risks, yet the extent a stock’s
 ADDITIONAL LESSON: CAPITAL (1) CAPM approach:
STRUCTURE AND LONG-TERM FINANCING
𝑟𝑠 = 𝑟𝑟𝑓 + 𝛽 (𝑀𝑅𝑃)
A. COST OF CAPITAL (WACC)
(2) Bond Yield + Risk Premium approach:
- rate of return that a firm must earn on its
𝑟𝑠 = 𝑏𝑜𝑛𝑑 𝑦𝑖𝑒𝑙𝑑 + 𝑟𝑖𝑠𝑘 𝑝𝑟𝑒𝑚𝑖𝑢𝑚
project investments to maintain its market
value and attract funds. (3) Discounted Cash Flow (DCF) model:

- (sources of capital) debt: provided by 𝐷1

𝑟𝑠 = +𝑔
creditors; equity: provided by 𝑃0
investors/shareholders.
- what method to use: (1) most
- (cost) debt: interest; equity: dividends. confident; (2) averaging. (if all methods
are available for use)
- importance:
▪ Cost of New Common Stocks – used
▪ capital budgeting decision
once accumulated earnings have been
▪ capital structure decision
exhausted; with floatation costs.
▪ evaluation of financial performance
▪ other financial decisions 𝐷1
𝑟𝑒 = +𝑔
▪ other areas: market value of the share, 𝑃0 (1 − 𝑓)
earning capacity of shares, etc.
WACC Formula
- components:
𝑊𝐴𝐶𝐶 = 𝑤𝑑 𝑟𝑑 (1 − 𝑇) + 𝑤𝑝 𝑟𝑝 + 𝑤𝑐 𝑟𝑠
▪ cost of debt (after tax)
(non-controllable factors)
▪ cost of preferred equity
▪ cost of common equity (retained - market interest rate (if interest rates
earnings and new stocks) increase, cost of debt increases)

- stock price in general (pulling the firm’s

stock price down will increase its cost of
a. Cost of Debt [rd x (1 – T)] – component
equity)
used as cost of debt should be after tax
because interest paid to creditors is tax - tax rates
deductible.
(controllable factors)
𝑫𝒑
b. Cost of Preferred Stock - component - capital structure (combination of
𝑷𝒑
used as cost of preferred stock is non tax- different sources of capital; weights)
deductible.
- dividend payout ratio (higher payout
c. Cost of Common Equity means company needs to issue new
stocks, which will make them incur
▪ Cost of Retained Earnings – no need to
additional costs)
issue new stocks; cost is based on
accumulated earnings of the company. - capital budgeting decision rules
B. EXTERNAL FINANCING NEEDED (EFN)

- (sales forecast) first item in a financial

plan; determination of growth rate (based on
trends from horizontal analysis)

- most important input.

Additional/External Financing Needed

(AFN/EFN) – increase in sales → increase in
assets needs.

- increase in assets → increase in funding

needed:

- spontaneously-generated liabilities
(arising from normal operations; e.g., AP →
from suppliers, accruals → employee
salaries)

- increase in retained earnings

(undistributed earnings reinvested to the
companies)

- if not enough: additional financing.

(formula)

Projected Increase in Total Assets

(-) Spontaneous Increase in Liabilities

(-) Increase in Retained Earnings h

Additional Financing Needed (AFN)

 MODULE 11: WORKING CAPITAL
MANAGEMENT
A. INVENTORY MANAGEMENT:
- carrying vs. stock out costs:
- (carrying costs) if the company maintains
too much inventory, carrying costs (e.g.,
storage, insurance, taxes, opportunity cost
for idle investments) will also increase.
- company finances its assets according to
their maturities; it matches the maturity of
the assets (short-term or long-term) its
finances.
- conservative working capital policy:
prioritizes the liquidity of the company,
instead of its profitability; high maintenance
of level of current assets. (more idle assets
= profit at minimum level)

- (stock out costs) if the company - low levels of current liabilities; long-term
maintains too little inventory, the company liabilities are higher (safer, but generally
may not be able to meet customer more expensive = profit at minimum level)
demands, including unexpected demand.
- aggressive working capital policy: priority
(increased stock out costs)
is on the company’s profitability, which
- carrying vs. ordering costs: (EOQ model) entails more risk; low levels of current
assets. (less idle assets = liquidity issues)
- (carrying costs) if the company maintains
too much inventory, carrying costs (e.g., - rely more on current liabilities than long-
storage, insurance, taxes, opportunity cost term liabilities.
for idle investments) will also increase.
M C A
- (ordering costs) if the company maintains short- (1/2) s-t; short-
Seasonal CA
too little inventory, the company may incur term (1/2) l-t term
Permanent long- long- (1/2) s-t;
increased ordering costs.
CA term term (1/2) l-t
- reorder point: based on the optimal safety Fixed long- long- long-
Assets term term term
stock determined by the EOQ model,
considering delay to be incurred by the
supplier. - (fixed assets) generally do not change,
except when there is a major corporate
- do not wait for inventory levels to be zero
restructuring or major expansion.
to reorder new units of inventory. (safety
stock) - (permanent CA) minimum levels of
inventory maintained all throughout the
-----------------------------------------------------------------------
period/year regardless of the season.
B. FINANCIAL WORKING CAPITAL:
- (seasonal/temporary CA) increases during
a. Working Capital Policy peak season, declines during non-peak
season. (fluctuates)
- (working capital policy) moderate or
maturity-matching or self-liquidating or
hedging working capital policy:
b. Sources of Financing
1. Trade Credits/Accounts Payable

- generally free, but for faster payment,

the supplier grants trade discounts.

- implicit cost: trade discount.

2. Bank Loans

- explicit cost: interest cost.

- (simple rate) rate x principal.

- (deductions from proceeds)

▪ discounted loan – interest on loan will

be deducted in advance

▪ compensating balance – when

borrowing, there is a maintaining
balance not to be withdrawn.

▪ outstanding only for a given period

3. Commercial Paper – highly liquid, short-

term debt instruments issued by large and
stable private corporations. (similar to
treasury bills issued by the government)

- open to public; has a maximum maturity

date of 270 days.

4. Installment Loans

5. Line of Credit

6. Revolving Credit