UNIVERSITY OF SAINT LOUIS

Tuguegarao City

SCHOOL OF ACCOUNTANCY, BUSINESS and HOSPITALITY

Short Term
A.Y. 2020-2021

ONLINE LEARNING MODULE

FMGT 1013- Financial Management

Lesson 1: Scope and Role of Financial Management

REMINDERS:

Get Involved. USL expects you to do the following:

• Lessons will be uploaded every Monday, and submission will be every Friday of the week.
• Comply with all requirements (written outputs, projects/performance tasks examinations and the
like.)
• Turn in learning tasks on time to avoid backlogs.
• For any query that you want to make about your lessons or procedures in school, contact us through
our messenger group chat, LMS chat boxes or feel free to contact us through the following

Mentor Class code Facebook name e-mail Cell number

Ma’am Belle 055, 056, Belle Siazon siazonbelle56@gmail.com 0917 4229641
057
Ma’am Emy 052, 053, Emelyn Lozada lozadaet@yahoo.com 0917 7995682
054

This Week’s Time Table: (April 21- 26, 2021)

The following shall be your guide for the different lessons and tasks that you need to accomplish. Be
patient, read them carefully before proceeding to the tasks expected of you. HAVE A FRUITFUL
LEARNING EXPERIENCE

Date Topics Activities or Tasks

April 21
April 22
April 23
April 24
April 25
April 26

LEARNING CONTENT

Topic: SCOPE AND ROLE OF FINANCIAL MANAGEMENT

Learning Outcomes: Relate the various concepts and terminologies of financial management to
the present day business operations and its importance to society.

Guys, this video presentation would present to you a macro perspective of finance. Please watch it. This
is a good introductory presentation to our course.

How the Economic Machine Works by Ray Dalio

FMGT 1013 – Financial Management | 1

FINANCIAL MANAGEMENT

Nature : A decision making process concerned with planning, acquiring and utilizing FUNDS in a
manner that achieves the firm's desired goals.

In a layman's term, Financial Management is "HOW YOU MANAGE YOUR MONEY".

Hence, in this course, you will learn how to analyze available information quantitatively and interpret
them to arrive at the BEST DECISION!

Yes, in a corporate setting, financial management a.k.a. Corporate Finance, is more complex and
technical which employs various concepts, procedures, and techniques to meet its ULTIMATE GOAL -
THE MAXIMIZATION OF THE OWNERS' EQUITY OR SHARE.

Purpose : To maximize the current value per share of the existing stock or ownership in a business firm.
How is wealth maximize? It is maximized by way of dividend growth (payment of dividends) and share
price appreciation.

Scope : Business analysis and determination of the firm's total fund requirements, assets and
resources to be acquired and the best pattern of financing the assets.

Goals : (a) shareholders wealth maximization; (b) profit maximization; (c) managerial reward
maximization; (d) behavioral goals; (e) social responsibility.

Relationship between Financial Management and other fields

• Financial Management - the process of planning decisions in order to maximize shareholders
wealth.
• Accounting - The finance manager will make use of the accounting information in the analysis
and review of the firm's business position and decision making. He uses capital budgeting
techniques, statistical and mathematical models and computer applications in decision making to
maximize the value of the firm's wealth and value of the owner's wealth.
• Microeconomics deal with the economic decisions of individuals and firms. It focuses on the
optimal operating strategies based on economic data of individuals and firms
• Macroeconomics looks on the economy as a whole in which a particular business concern is
operating. The success of the business firm is influenced by the overall performance of the
economy and is dependent upon the money and capital markets.

Significance of Financial Management

1. Broad Applicability - equally applicable to all forms of business whether motivated with earning
profit or not having cash flow.
2. Reduction of chances of failure - it enables the other functions (purchasing, production,
marketing, personnel) to be effective in the achievement of organizational goal and objectives
3. Measurement of Return of Investment - It studies the risk-return perception of the owners and the
time value of money. The greater the time and risk associated with the expected cashflow, the
greater is the rate of return required by the owners.

Relationship of Financial Objectives to Organizational Strategy and to Other Organizational Objectives

General objectives (statements in general terms stating what the company expects to achieve) are
developed by to management for long range planning and management control. In order to measure
performance and degree of control, setting of physical targets to be accomplished within a set time frame
would provide the basis of conversion of targets into financial objectives.

FMGT 1013 – Financial Management | 2

 Strategic financial planning provides a basis and information for strategic positioning of the firm in the
industry. It should be able to meet challenges and competition, leading to the firm's failure or success. It
also counter the uncertain and imperfect market conditions and highly competitive business environment.

Nature, Scope and Form of Financial Objectives of Business Organizations

Short and Medium-Term Financial Objectives of a Business Organization

• maximization of return on capital employed or return on investment
• minimization of finance charges
• efficient procurement and utilization of funds
• growth in earning per share and price/earning ratio through maximization of net income or profit
and adoption of optimum level of leverage

Long-term financial Objectives of Business Organization

• growth in the market value of the equity share thru maximization of the form's market share and
sustained growth in dividends to shareholders
• survival and sustained growth of the firm

Foundations of Wealth Maximization

• it considers the risk and time value of money
• it considers all future cash flow, dividends and earnings per share
• it suggests the regular and consistent dividend payments to the shareholders
• the financial decisions are taken with a view to improve the capital appreciation of the share price
• maximization of firm's value is reflected in the market price of share

Decisions in Finance
• Investment - determine how scarce or limited resources in terms of funds for the business firm
are committed to projects.
• Financing - the mix of debt to equity chosen to finance investments should maximize the value of
investments made.
• Operating - managing the firm's working capital to ensure that the firm has sufficient resources to
continue operations and avoid costly interruptions.
• Dividend - determination of quantum of profits to be distributed to the owners, the frequency of
such payments and the amounts to be retained by the firm.

Functions of Finance in Organizations - it is an integral part of total management and cuts across
functional boudaries.

Functions of Chief Financial Officer - decision making involving

1. analysis and planning
2. acquisition of funds
a. impact on risk and return
b. affect the market price of common stock
c. lead to shareholder's wealth maximization
3. utilization of funds

Roles, Responsibilities of Key Personnel involved in organizations

FMGT 1013 – Financial Management | 3

• Chief Finance Officer
a. responsible for financial analysis and planning
b. making investment decisions
c. making financing and capital structure decisions
d. managing financial resources
e. managing risks.

• Controller
a. handles cost and financial accounting. tax payments and management information systems
b. primarily assures that funds are used efficiently (profitability).
c. concerned with collecting and presenting financial information

• Treasurer
a. responsible for managing the firm's cash and credit, its financial planning and its capital
expenditures.
b. strives to prevent bankruptcy and achieve corporate goals. (cashflow)

FMGT 1013 – Financial Management | 4

FMGT 1013 – Financial Management | 5
Agency Theory
Agency theory is a principle that is used to explain and resolve issues in the relationship between
business principals and their agents. Most commonly, that relationship is the one between shareholders,
as principals, and company executives, as agents.

An agency, in broad terms, is any relationship between two parties in which one, the agent, represents
the other, the principal, in day-to-day transactions. The principal or principals have hired the agent to
perform a service on their behalf.

Principals delegate decision-making authority to agents. Because many decisions that affect the principal
financially are made by the agent, differences of opinion and even differences in priorities and interests
can arise. This is sometimes referred to as the principal-agent problem.

By definition, an agent is using the resources of a principal. The principal has entrusted money but has
little or no day-to-day input. The agent is the decision-maker but is incurring little or no risk because any
losses will be borne by the principal.

Agency Conflict
1. If a manager is a partial owner of the firm, he may make decisions that are not aligned with goal
of maximizing shareholder wealth.
2. Managers, acting in the interest of shareholders, may take on projects with greater risk than
creditors anticipated and raise the debt level higher than expected.
Agency Cost
1. Managers may work less eagerly and benefit themselves in terms of salary and perks.
2. Managers may reduce share capital price.
3. Control measures employed to regulate undesirable management actions calls for higher agency
cost
Control Mechanism
1. Severance of contract
2. Provide performance-based incentive plans or stock option plans are given to managers.
3. Involvement by shareholders (institutional) - if he owns a reasonable share in the firm, he can
sponsor a proposal which must be voted at the annual stockholders meeting, regardless of
management's approval.
4. Shareholders in some cases do hostile takeovers.

END of LESSON 1***

REFERENCES

Textbooks

1. Agamata, F. (2011), Management Advisory Services, GIC Enterprises Inc.

2. Brigham, E., Houston, J. (2013), Fundamentals of financial management. Cengage Learning Asia
Pte. Ltd
3. Cabrera, E.(2015) Financial Management: Principles and Applications, GIC Enterprises & Co., Inc.,
Manila
4. Salvador, S., Baysa, G, Gamboa, D., Geronimo, E. (2012) Fundamentals and applications of
financial management, Allan Adrian Books Inc.
5. William, J. (2015), Financial Management

Online Reference

FMGT 1013 – Financial Management | 6

1. https://www.managementstudyguide.com/financial-management.htm
2. https://www.managementstudyhq.com/financial-management-meaning-objectives-functions.html
3. https://opentextbc.ca/businessopenstax/chapter/the-role-of-finance-and-the-financial-manager/
4. https://masterstart.com/blog/financial-management/financial-management-overview/

FMGT 1013 – Financial Management | 1

 UNIVERSITY OF SAINT LOUIS
Tuguegarao City

SCHOOL OF ACCOUNTANCY, BUSINESS and HOSPITALITY

Short Term
A.Y. 2020-2021

ONLINE LEARNING MODULE

FMGT 1013- Financial Management

Lesson 2: Financial Statement Analysis Part 1

REMINDERS:

USL expects you to do the following:

• Lessons will be uploaded every Monday, and submission will be every Friday of the week.
• Comply with all requirements (written outputs, projects/performance tasks examinations and the
like.)
• Turn in learning tasks on time to avoid backlogs.
• For any query that you want to make about your lessons or procedures in school, contact us through
our messenger group chat, LMS chat boxes or feel free to contact us through the following

Mentor Class code Facebook name e-mail Cell number

Ma’am Belle 055, 056, Belle Siazon bellesiazon56@gmail.com 0917 4229641
057, 053
Sir Jilly 052 Jilly Bruno
Sir Jerome 054 Jerome Banera

This Week’s Time Table: (June 28 – July 3, 2021)

The following shall be your guide for the different lessons and tasks that you need to accomplish. Be
patient, read them carefully before proceeding to the tasks expected of you. HAVE A FRUITFUL
LEARNING EXPERIENCE

Date Topics Activities or Tasks

June 28 Financial Statement Analysis Read your books and learning modules
June 29 A. The Financial Statements Discussion of lesson
June 30 B. Analyzing Financial Statements Submission of Drill
July 1 1. Vertical Analysis Discussion of drill
July 2 2. Horizontal Analysis Submission of Quiz
July 3 3. Trend Analysis Discussion of Quiz
4. Financial Ratio Analysis
C. Cash Flow Analysis
D. Valuation Methods
E. Analyzing Management
Performance
1. Return on Investment
2. Du Pont Formula
3. Return on Equity
4. Economic Value Added

Topic: Financial Statement Analysis

Learning 1. Compute the efficiency of business, appraise and communicate financial
Outcomes: position based on available information as applied to various situations.
2. Apply the following techniques in financial statement analysis:
▪ Horizontal analysis of Comparative Statements (Increase-Decrease
Method)
▪ Trend Analysis
▪ Vertical Analysis or Common Size Financial Statements
▪ Financial Ratios Analysis
3. Explain the limitations of financial statement analysis

FMGT 1013 – Financial Management | 2

LEARNING CONTENT

We have learned during week 1 that Financial Management or Corporate Finance aims ultimately to
maximize the wealth of the owners or shareholders. Equally important concept was also introduced in
the name of Corporate Social Responsibility (CSR). It has been a long-time debate among
academicians and scholars on what should be the primary objective of financial management. One
viewpoint (stockholders) emphasizes that FinMan should aim for wealth maximization. The other viewpoint
(other stakeholders) emphasizes that FinMan should aim for CSR. All your arguments have strong basis.

I appreciate all your arguments, however financial practitioners and academics now tend to believe that
the manager’s responsibility should be to maximize shareholders’ wealth and give only secondary
consideration to other stakeholders’ welfare.

The strongest argument was that of Adam Smith, first and well-known proponent of this viewpoint. He
argued that, in capitalism, an individual pursuing his interest tends also to promote the good of his
community. He also pointed out that acting through competition and the free price system, only those
activities most efficient and beneficial to society as a whole would survive in the long run. Thus, those
same activities would also profit the individual most. Owners of the firm hire managers to work on their
behalf, so the manager is morally, ethically, and legally required to act in the owners’ best interest. Any
relationships between the manager and other firm stakeholders are necessarily secondary to the objective
that shareholders give to their hired managers.

Therefore, the overriding premise of financial management is that the firm should be managed to enhance
owner(s) well-being.

Remember the following grounds of wealth maximization:

1. it considers the risk and time value of money – we will elaborate the concept of risk in your
Financial Market course and the time value of money at the later part of this course.
2. it considers all future cash flow, dividends and earnings per share - Cash flows analysis is
part of this chapter. Dividends and earnings per share will be covered at the later part of this course.
3. it suggests the regular and consistent dividend payments to the shareholders - While
dividend payment has disadvantages like giving less priority for future expansion and scalability, it
is also viewed by the existing stockholders as a means of showing financial strength to potential
shareholders’ hence inviting them to invest in the company.
4. the financial decisions are taken with a view to improve the capital appreciation of the share
price - When a company has shown consistent growth of profitability (normally EPS), the
company’s intrinsic value (the true value of the company) would definitely increase. An increase in
intrinsic value would ultimately be reflected on the market price of the share. Since a share price is
market-driven (remember the law of supply and demand), as the company looks promising
(consistent growth of profitability), investors would come in. The demand from investors to have a
share or part of the pie (company) would increase thereby pushing the price of the company’s
shares to rise.
5. maximization of firm's value is reflected in the market price of share - This is widely accepted
quantitative measure of wealth maximization. This is supported by the Efficiency Market Hypothesis
(EMH) Theory where when market or public becomes efficient (lahat nalang about sa company
alam ng public) in obtaining information about the financial condition of the entity including all future
plans of the company, the public will make decisions whether to invest or add more investments or
to sell their current holdings in the company. Hence, all actions and decisions will ultimately be
reflected in price of the share.

With an end of maximizing the wealth of the shareholders, a financial manager has many tools of assessing
the financial health of a company. One of them is Financial Statement Analysis:

Financial Statement Analysis

-involves careful selection of data from financial statements for the primary purpose of forecasting the
financial health of the company.

FMGT 1013 – Financial Management | 3

Sample specific questions to be resolved in arriving at the BEST DECISION after careful analysis of the
financial statements may include the following:

1. Will the e-commerce industry like Amazon, Lazada or Shoppee continue to make good results
after this COVID 19 pandemic? How about the oil industry, can they still recover from massive
losses after this COVID 19 pandemic? What could be the effects of the unending US-China trade
war to emerging economies like the Philippines. (This is a macro environment scanning where a
company may be greatly impacted by the current economic developments in the world or in the
Philippines)
2. Can BPI extend more credit to potential short-term creditors despite the increase in credit defaults
due to government-imposed regulation during this pandemic?
3. Do online sellers have sufficient stock of goods to meet promptly orders despite problems in
logistics brought about by this pandemic?
4. Can ABS-CBN pay its huge long-term obligation amid suspension of franchise renewal?
5. Can GMA7 maintain its position as one of the publicly listed companies in the Philippines which
gives high and consistent dividend payments to the shareholders amid this pandemic?
6. Despite Ramon Ang’s philanthropic activities (CSR) which entails substantial cost, could this greatly
affect San Miguel Corporation’s profitability? How about its effect on the company’s stock price?

In summary of the foregoing questions, we can have the following as general approach when analyzing
financial statements:

1. Background study and evaluation of firm industry, economy and outlook.

2. Analysis of the short-term solvency (working capital analysis)
3. Analysis of the capital structure and long-term solvency (Equity and long term assets and
liabilities analysis)
4. Analysis of operating efficiency and profitability (revenues and expenses analysis)
5. Other considerations:
▪ Quality of earnings – Baka naman one-time gain lang kaya mataas ang profit nila ngayong
taon. A good quality of earnings are those that are result of recurring revenues (operating
income).
▪ Quality of assets and relative amount of debt – Baka naman profitable yung business pero
hindi naman makabayad ng utang on time ang company, or deteriorating na rin pala mga PPE
nila.
▪ Transparent financial reporting – The more reliable the economic information provided by a
company through the financial statements, the more confidence potential investors can place
in that information.

After knowing the general considerations as mentioned above, we should also look into the procedures or
steps in conducting FS analysis (Pagdadaanan mo ito later sa napakaganda at makatotohanang learning
task na gagawin mo matapos maunawaan itong discussion natin)

Steps in Financial Statement Analysis

1. Establish objectives of the analysis

▪ May balak ka bang pautangan ulit si ABS CBN?
▪ Magiinvest kaba sa GMA7 o Meralco kasi mataas at consistent silang magbayad ng
dividends?
▪ Gusto mo bang mag-invest kay Jollibee despite huge downside ng stock price niya?

2. Study the industry in which firm operates and relate industry climate to current and projected
economic development
▪ Siguro magandang mag-invest kay PUREGOLD or FRUITAS ngayong panahon ng
pandemya. Kasi tumataas ang consumption ng basic goods ngayon.
▪ Siguro maganda rin mag-invest kay Netflix ngayon. Lahat ng tao nasa loob ng bahay at
nanonood ng movies and series.
▪ Iiwas ba muna ako kila PETRON ay PHOENIX kasi bagsak presyo ang langis?

3. Develop knowledge of the firm and the quality of management

4. Evaluate financial statements using any of the techniques below: (This is the gist of the topic)

FMGT 1013 – Financial Management | 4

 A. Horizontal analysis of Comparative Statements (Increase-Decrease Method)
▪ presents a comparative financial statements for the current and previous years. For
every line item, the difference between the two years are computed and divided by the
amount of the base year or previous year to determine the percentage of change.
(Refer to Illustrative Case No. 1 below).

B. Trend Analysis
▪ a modification of the vertical and horizontal analysis. The percentage changes are
determined for several successive periods instead of the typical two-year period
horizontal analysis. In here, items not seen in two-period analysis may surface in a
longer-based study such as trend analysis.
▪ in computing the trend, the oldest year becomes the base year. The percentage
relationship of each account in the statements is then computed by dividing each amount
by the base year figure. A trend is then determined by comparing percentage
relationships. Based on the trends, interpretations, conclusions and implications are
derived. (Refer to Illustrative Case No. 2)

C. Vertical Analysis or Common Size Financial Statements

▪ uses percentages/ratios that present the relationship of the different accounts/items in
the financial statement relative to a base figure or amount. It presents the relative size
of an account/item in proportion to the whole or the base amount. For the Statement of
Financial Condition, the total asset is the base amount while the Statement of Income
uses the net sales/revenue as the base amount.
▪ The outcome of the percentages is presented in the common-sized statement which
management looks into to have a better understanding if the changes to total assets
(SFP) or net sales/revenue (SI) that have transpired from one period to another. This
also aids management to assess their financial position and performance by comparing
their statements with other companies belonging to the same industry. (Refer to
Illustrative Case No. 3)

D. Financial Ratios Analysis

▪ A comparison in fraction, proportion, decimal or percentage form of two significant
figures taken from financial statements.
▪ It expresses the direct relationship between two or more quantities in the statement of
financial position and income statement of a business firm.
▪ Through ratio analysis, the financial statement user comes into possession of measures
which provide insight into the profitability of operations, the soundness of the firm’s
short-term and long-term financial condition and the efficiency with which
management has utilized the resources entrusted to it. (This time consuming because
there a lot of available ways or ratios to measure profitability and efficiency, liquidity, or
solvency. In practice, not all these available ratios are used. There are certain common
ratios that are being used. But for board exam sake, we have to cover the rest. This
topic will be elaborated in a separate module)

5. Summarize findings based on analysis and reach conclusions about firm relevant to the
established objectives.
▪ At the end of the day, you will go back to your objectives. Based on the figures which you
obtained after applying the various techniques, we must make a decision.

Before we proceed to our illustrative cases, let’s have first a quick review of financial statements which you
have learned in your FAR, CFAS and IA series especially in IA 3.

The Financial Statements

1. Statement of Financial Position – it shows the financial condition or financial position of a

company on a particular date. It is a summary of what the firm owns (assets) and what the firm
owes to outsiders (liabilities) and to internal owners (stockholders equity)

a. Assets
CURRENT ASSETS:
▪ Cash and cash equivalents
▪ Marketable securities
▪ Accounts receivable
▪ Inventories

FMGT 1013 – Financial Management | 5

 ▪ Prepaid expenses
NON-CURRENT ASSETS:
▪ Property, plant and equipment (Land, Buildings and Leasehold Improvements, and
Equipment)
▪ Other non-current assets (Long-term investments, Intangible assets, Goodwill,
Deferred tax assets)

b. Liabilities
CURRENT LIABILITIES
▪ Accounts payable
▪ Short-term Notes payable
▪ Current Maturities of Long-term debt
▪ Accrued liabilities
NON-CURRENT LIABILITIES
▪ Long-term debt
▪ Deferred tax liabilities

c. Equity
▪ Share capital
▪ Additional paid-in capital/Share Premium
▪ Retained earnings
▪ Other Equity accounts

2. Statement of Income – the performance of the firm for a period of time.

a. Net sales
b. Cost of goods sold
c. Gross profit or gross margin
d. Operating expenses
▪ Selling and administrative
▪ Marketing/Advertising Costs
▪ Lease payments
▪ Depreciation and amortization
▪ Repairs and Maintenance

e. Operating income
f. Other income/expense (dividend income, interest income, interest expense, gains (losses)
from investments, and gains (losses) from sale of fixed assets)
g. Income from continuing operations before income tax
h. Provision for income taxes on continuing operations
i. Income from continuing operations
j. Gains (losses) on discontinued operations
k. Net income

Sales or service revenues

− Cost of goods sold (COGS)
= Gross profit
− Selling, general, and administrative expenses
= Operating income
+ Interest and dividend income
− Interest expense
+/− Non-operating gains/(losses)
= Income from continuing operations before income tax
− Provision for income taxes on continuing operations
= Income from continuing operations
+/− Gains/(losses) on discontinued operations (net of applicable taxes)
= Net Income

WARNING: There are income statement terms that are used in Financial Statement Analysis which
cannot be seen from a pro-forma or standard income statement (for external use).

FMGT 1013 – Financial Management | 6

Earnings Before Interest and Taxes (EBIT) is a term you will see frequently in financial statement
analysis. EBIT is not the same as operating income, though in some cases they may be the same.

A line titled “EBIT” does not appear on a standard income statement because EBIT is a calculated amount
used in financial statement analysis and other types of analysis. Earnings Before Interest and Taxes is
equivalent to net income adjusted to add back any deduction for interest expense and any deductions for
taxes. EBIT can be calculated in more than one way. Beginning with operating income, it would be
calculated as follows:

Operating income

+ Interest and dividend income

+/− Non-operating gains/(losses)

+/− Gains/(losses) from discontinued operations (gross, not net of applicable taxes)

= Earnings Before Interest and Taxes (EBIT)

In other words, in contrast to operating income, EBIT includes non-operating gains and losses such
as gains and/or losses on acquisitions or investments, interest and dividend income, pretax
additions or deductions for discontinued operations.

EBIT does not include any deductions for interest expense or for taxes.

Therefore, if the company has gains and/or losses on acquisitions or investments, interest or dividend
income, and income/losses from discontinued operations, its Earnings Before Interest and Taxes will
not be the same as its operating income. All of those items constitute the difference between operating
income and EBIT. If the company has none of those items, its operating income will be the same as
its EBIT, but that will be true only because the items that would create the difference are zero.

Earnings Before Taxes (EBT) is another term used in financial statement analysis that you will not see
on a standard income statement. Earnings Before Taxes is Earnings Before Interest and Taxes
minus Interest Expense.

3. Statement of Cash Flow – the sources and uses of funds during an accounting period
• Operating – generation of the principal revenue of the firm or ability to generate sufficient cash
to meet maturing obligations, sustain the firms operating capability and pay dividends without
recourse to external source of financing
• Financing – borrowings to support firm’s operation
• Investing – cash flow from sale or purchase transaction wherein non-operating assets are
involved.

After reviewing the basic financial statements, I will now present to you the illustrative cases for
the first three techniques of financial statement analysis:

FMGT 1013 – Financial Management | 7

Illustrative Case No. 1 - Horizontal analysis of Comparative Statements (Increase-Decrease
Method)

REQUIRED:

Evaluate the company's financial position and results of operations using the Comparative
Statements Analysis.

FMGT 1013 – Financial Management | 8

SOLUTION:

Financial Statements Analysis of Golden Garments, Inc.

a. Short-term Solvency Analysis

( Habang tumataas ang current liabilities, sumasabay rin ba ang mga current assets sa pagtaas?
Kung "Oo" ang sagot, maari ngang may pambayad sila ng current liabilities when they fall due at
hindi mailalagay sa alanganing posisyon ang company. Minsan tinitignan din dito kung mabilis
ba ang conversion ng A/R at Inventories into Cash because ultimately cash parin naman
pambabayad mo ng utang )

• As shown on the statement of financial position, the percentage of increase in total current assets
(10.1%) was lower than the percentage of increase in total current liabilities (15%). It can be
observed that accounts payable and bank loans increased significantly. Accounts receivable and
inventory increased at a much higher percentage than the percentage of increase in Sales
revenue (11%). (Segue ako dito, guys. If AR increased at a higher rate than sales revenue
during the period, ibig sabihin nun, mabagal collection or nahihirapan silang makacollect
ng cash from customers. If Inventory increased at a higher rate than Sales revenue, ibig
sabihin nun marami silang production na hindi nabebenta.) This indicates slower conversion
of inventory and receivables to cash. The changes mentioned resulted to the deterioration in the
short-term solvency position of the company as of the end of year 2014 compared with year
2013.

b. Long-term Financial Position Analysis

(Tumataas ba ang non-current assets ng entity? Alam naman natin na malaki ang pakinabang ng
long-term assets sa kakayahan ng company to generate revenues in the long-run. Mga
"investments" ito like PPE, Intangibles or long-term investments na naglalayung palakasin ang
posisyon ng company sa malayong hinaharap. Aside from long term asset, tinitignan din dito kung
ano ang mas daks, este mas malaki - TOTAL LIABILITIES o EQUITY? Alam naman natin na ang
equity represents the invested capital of the owners including accumulated earnings. Kung mas
mabilis ang pagtaas ng porsyento sa liabilities kesa sa equity, medyo red flag yun. Parang sinasabi
kasi nun na hindi kayang pondohan ng equity ang pangangailan ng company kaya nag-reresort
sila sa utang. Otherwise, kung mas malaki ang porsyento ng pagtaas ng equity kesa sa liabilities,
magandang senyales yun, may pondo ang company, kumikita sila.)

• The book value of property, plant and equipment declined because of the depreciation provision
for the year. Total liabilities increased by only 1%, whereas shareholders' equity increased by
11.8%. Thus, the company's capital structure shifted slightly away from borrowing and toward
capital provided by profitable operations. These changes can be viewed favorably because they
indicate strengthening of the long-term financial position by end of year 2014.

c. Operating Efficiency and Profitability Analysis

(Ang mga tanong dito ganito: Nakatipid ba ang company (efficiency) o kumita ba sila (profitability)?
Hindi lang bottom figure (net income) ang tinitignan dito. Binubusising mabuti talaga dito ang
composition ng income items at expense items. Pinakacomplikadong part ng FS analysis ang
aspetong ito, pero pinaka-exciting aralin. Minsan magtataka ka, mas malaki naman ang airtime
revenues ni ABS kesa ni GMA, pero bakit mas malaki ang net income ni GMA kesa ABS nung 2018?
Ibig ba sabihin nun mas efficient si GMA? Bakit si ABS nagreport ng operating loss, pero net
income parin? Bakit si Shopify or si UBER net loss parin pero tumataas ang kanilang revenues
yearly? Si Jollibbee, akala ko bida ang saya, pero bakit ang laki ng net loss niya sa 1st quarter ng
2020?)

• Sales revenues increased by 11% while cost of goods sold increased by 12.4%. This is
unfavorable because this could indicate that the company was unable to adjust the selling price
of the goods commensurate to the increase in cost of goods purchased or manufactured or it was
unable to control the price factor of its cost of sales. These changes resulted to the reduction in the
gross profit rate which is unfavorable. The 11% increase in sales was accompanied by a 7.8% and
2.8% increase in selling and administrative expenses, respectively. This is favorable because this
could indicate management's efficiency in keeping expenses within control.
• On an overall basis, operating performance could be considered satisfactory or favorable because
of the lower increase in operating costs of 10.5% as compared with the increase in revenue of
which resulted to an 18.4% increase in operating income. Repayment of notes payable reduced

FMGT 1013 – Financial Management | 9

 interest expense by 4.7%. Reduced interest expense together with higher operating income
increased income before taxes by 25.9%.
Illustrative Case No. 2 - Trend Analysis

FMGT 1013 – Financial Management |

10
 REQUIRED:

1. Compute the trend percentages for the Statement of Financial Position and Income
Statements from 2010 to 2014.
2. Evaluate the company’s short-term solvency, long-term financial position and profitability
using the trend percentages obtained in No. 1.

SOLUTION:

Requirement 1 – Computation of trend percentages

Requirement 2 – Analysis and Evaluation

1. Short-term Solvency
• Current assets increased by 9% while current liabilities decreased by 27% by 2014. The
current financial position of the Gilbert Company improved as reflected by the upward trend
in total current assets accompanied by the downward trend in current liabilities. The
improvement in the current financial position is also indicated by the fact that the current
assets were 2.05 times the current liabilities as of December 31, 2010 and 3.05 times at the
most recent date.
• The trend data reveal that cash, receivables and inventory showed upward tendencies
over the years. The increase in receivables and inventory is favorable because net sales
increased at a faster rate. The favorable tendency indicates that more effective credit,
collection and merchandising policies, could have been established and made effective.
The relatively smaller amount of trade receivable reflects more rapid turnover of customer
accounts and possibly a large increase in cash sales.

FMGT 1013 – Financial Management |

11
 • The decline in marketable securities and other current assets over the years also indicates
lesser investment in not-so-productive assets. All these trends in different directions reflect
an increasing efficiency of working capital management.

2. Long-term financial position

•
• A comparison of the trends in total liabilities and equity reveals that the former declined and
the latter increased. As a result of these variations, the creditors' margin of safety increased
significantly.
• The expansion in property, plant and equipment which substantially increased was financed
by shareholders' capital through the issuance of share capital at a premium, long-term
liabilities and working capital derived from operations.
• A greater reliance on equity funds rather than on creditor funds increased the margin of
safety of the creditors and therefore strengthened the financial position of the company.

3. Profitability

•
• It will be observed that both sales and cost of sales showed upward trends with sales
increasing at a faster rate. These data reflect a favorable situation from the point of view of
managerial ability to control costs relative to change on sales volume. This more desirable
percentage may have been the result of one or more factors such as favorable price-level
changes, more effective markup policies or greater efficiency in purchasing.
• An unfavorable tendency is reflected by the fact that trend percentages for selling, general
and administrative expenses increased at a faster rate than the net sales. The company
could have earned more profit if better and more effective control over operating expenses
were instituted.

Illustrative Case No. 3 - Vertical Analysis or Common Size Financial Statements

The percentages here are computed based on the Illustrative Case No.2

FMGT 1013 – Financial Management |

12
Evaluation of the Financial Position

1. The Gilbert Company's statements of financial position showed that there had been substantial
changes in the proportions of current and fixed assets and current and long-term liabilities during
the period from December 31, 2010 to December 31, 2014. The percentages showed a declining
liquidity in the company's assets accompanied by a consistent reduction in liabilities over the five-
year period.
2. It can be observed that Cash balance and accounts receivable as a percentage of total assets had
been increasing while investment in inventory in relation to total assets had been decreasing.
Considering that the volume of sales was increasing, these changes can be viewed as beneficial
to the company.
3. The increase in investment in fixed assets had been financed largely from owners' investment as
indicated in the increasing percentage of equity to total assets.
4. The decreasing percentage of total liabilities to total assets further indicates lesser reliance of the
company from creditors in raising additional capital. This, of course, is favorable as far as the long-
term financial position of the company is concerned because a wider margin of safety is provided
among the creditors.

Evaluation of Profitability

1. Favorable changes could be observed in the gross margin percentage in relation to net sales. The
increase in percentage over the years could be due to improvement in the company's mark-up
policy or better procurement policy.
2. Selling expenses in relation to sales however, show increasing percentages from 2010 to 2014,
while administrative expenses had more or less remained constant. Better control over the selling
expenses should be instituted to further improve the profitability of the company.
3. Decrease in percentage of other expenses to net sales is traceable to the decreasing amount of
notes payable and long-term debts.

It can be concluded that the figures presented will have no meaning without interpreting it.
Financial statement analysis does not end on computation. A good financial manager must be
able to articulate in his financial statement analysis report the relevance and meaning of the
figures computed. Hence, in order to maximize the objectives of this topic, we will not focus only
on computations. The essay part could be challenging for you, but that is the essence of the
topic - to summarize findings based on your analysis and reach conclusions about firm relevant
to your established objectives.

In summary, this module contains:

1. Definition of Financial Statement Analysis

2. General Approach in the conducting FS analysis
3. Steps in FS Analysis
FMGT 1013 – Financial Management |
13
 4. Review of Basic Financial Statements
5. Discussion of the four techniques of FS analysis:

• Horizontal analysis of Comparative Statements (Increase-Decrease Method)

• Trend Analysis
• Vertical Analysis or Common Size Financial Statements
• Financial Ratios Analysis

6. Illustrative Cases for:

• Horizontal analysis of Comparative Statements (Increase-Decrease Method)

• Trend Analysis
• Vertical Analysis or Common Size Financial Statements

If you have realized, the computation part is essentially procedural. Tiyagaan lang talaga kasi buong
financial statements ang subject ng FS analysis. The challenging part is really on the interpretation of
the figures. But having a good grasp on the nature of the accounts or line item is a big help for you to
have good and sound interpretation of the figures. What is good with the interpretation part you have
the freedom to draw conclusions out of the computed figures, so long as the interpretation can capture
the important aspects - Short term solvency, long-term financial position, and profitability. O diba,
napakadaming nakatagong kwento at hiwaga ang financial statements.

This ends the 1st part of Financial Statements Analysis. The 2nd part is exclusively reserved for Financial Ratios
Analysis.

But before you proceed to Financial Ratios Analysis, try to test your knowledge of the 1st part by answering the
Exercises.

Supplemental Readings:

✓ https://courses.lumenlearning.com/boundless-finance/chapter/asset-management-ratios/
✓ https://www.accountingverse.com/managerial-accounting/fs-analysis/financial-ratios.html
✓ https://www.thebalancesmb.com/how-do-you-do-financial-statement-analysis-393235
✓ https://www.principlesofaccounting.com/chapter-16/statement-analysis/
✓ https://www.bdc.ca/en/articles-tools/money-finance/manage-finances/pages/financial-ratios-4- ways-
assess-business.aspx
✓ https://www.elearnmarkets.com/blog/dupont-analysis/
✓ https://www.youtube.com/watch?v=GGsmfRiqcAQ
✓ https://www.youtube.com/watch?v=6Ab95GZVbqI

*** END of LESSON ***

REFERENCES

Textbooks

1. Agamata, F. (2011), Management Advisory Services, GIC Enterprises Inc.

2. Brigham, E., Houston, J. (2013), Fundamentals of financial management. Cengage Learning Asia Pte.
Ltd
3. Cabrera, E.(2015) Financial Management: Principles and Applications, GIC Enterprises & Co., Inc.,
Manila
4. Salvador, S., Baysa, G, Gamboa, D., Geronimo, E. (2012) Fundamentals and applications of financial
management, Allan Adrian Books Inc.
5. William, J. (2015), Financial Management

Online Reference

1. https://www.elearnmarkets.com/blog/dupont-analysis/
2. https://www.wallstreetmojo.com/economic-value-added-eva/
3. https://investinganswers.com/dictionary/e/economic-value-added-eva

FMGT 1013 – Financial Management |

1
 UNIVERSITY OF SAINT LOUIS
Tuguegarao City

SCHOOL OF ACCOUNTANCY, BUSINESS and HOSPITALITY

Short Term
A.Y. 2020-2021

ONLINE LEARNING MODULE

FMGT 1013- Financial Management

Lesson 2: Financial Statement Analysis Part 2

REMINDERS:

USL expects you to do the following:

• Lessons will be uploaded every Monday, and submission will be every Friday of the week.
• Comply with all requirements (written outputs, projects/performance tasks examinations and the
like.)
• Turn in learning tasks on time to avoid backlogs.
• For any query that you want to make about your lessons or procedures in school, contact us through
our messenger group chat, LMS chat boxes or feel free to contact us through the following

Mentor Class code Facebook name e-mail Cell number

Ma’am Belle 055, 056, Belle Siazon bellesiazon56@gmail.com 0917 4229641
057, 053
Sir Jilly 052 Jilly Bruno
Sir Jerome 054 Jerome Banera

This Week’s Time Table: (June 28 – July 3, 2021)

The following shall be your guide for the different lessons and tasks that you need to accomplish. Be
patient, read them carefully before proceeding to the tasks expected of you. HAVE A FRUITFUL
LEARNING EXPERIENCE

Date Topics Activities or Tasks

June 28 Financial Statement Analysis Read your books and learning modules
June 29 A. The Financial Statements Discussion of lesson
June 30 B. Analyzing Financial Statements Submission of Drill
July 1 1. Vertical Analysis Discussion of drill
July 2 2. Horizontal Analysis Submission of Quiz
July 3 3. Trend Analysis Discussion of Quiz
4. Financial Ratio Analysis
C. Cash Flow Analysis
D. Valuation Methods
E. Analyzing Management
Performance
1. Return on Investment
2. Du Pont Formula
3. Return on Equity
4. Economic Value Added

Topic: Financial Statement Analysis

Learning 1. Compute the efficiency of business, appraise and communicate financial
Outcomes: position based on available information as applied to various situations.
2. Apply the financial ratios analysis technique in financial statement analysis

FMGT 1013 – Financial Management |

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LEARNING CONTENT

Let us have a quick recap of the first three techniques of financial statements analysis:

It is illogical to compare the financial statements of a single company from one period to another period or
to compare one company to another company within the same industry by looking on the peso value as
reflected in the financial statements.

When comparing two companies, one may have a higher net income simply because it is bigger and not
because it is more efficient, effective or sells a better product. Or, in comparing financial statements over
several accounting periods for a single company, we may find that its sales may grow significantly during
one of the periods, making comparison difficult. One of the ways to deal with these size differences is
through comparative financial statement analysis.

Comparative financial statement analysis states each item of the financial statement not as a numerical
amount (i.e., peso value), but rather as a percentage of a relevant base amount.

Comparative financial statements can be either vertical or horizontal.

• Vertical analysis (also called common-size financial statements) makes it possible to compare
the performance of companies of different sizes during the same period of time.

• Horizontal and trend analysis enables comparison of data for a single company or single industry
over a period of time.

Your analysis does not end on computation of percentages. It should be interpreted in such a way that
would give enlightenment on the following major concerns:
a. Short-term solvency;
b. Long-term financial position; and
c. Profitability.

New Topic:

FINANCIAL RATIO ANALYSIS

It is the process of looking at the relationships between different numbers in the financial statements to
see if they indicate positive or negative trends developing within a company.

❖ A firm’s equity investors, potential equity investors and stock analysts as well as its creditors use
ratios calculated from the firm’s financial statements to make investment and credit decisions.

❖ While the ultimate purpose of ratio analysis is to enable evaluation of risk and return, different
users need different information.

Examples:
1. Short-term creditors, such as banks and trade creditors, use ratios to determine the firm’s
immediate liquidity.
2. Longer-term creditors such as bondholders use ratios to determine a firm’s long-term
solvency.
3. Both short-term and long-term creditors use financial statement analysis to gain assurance
that the firm has the necessary resources to be able to pay its interest and principal
obligations.
4. Equity investors use ratios to determine the firm’s long-term earning power. The equity
investors’ analysis needs to be more in-depth than the creditors’ analysis, because equity
investors bear the residual risk of the company. The equity investors’ claims on the
company’s funds are settled only after the claims of suppliers and lenders are settled.

❖ Ratios are based on accounting data. Because of the fact that the accounting system uses
historical costs rather than current fair market values, ratios often do not reflect the current values
of the items they are measuring.

❖ When we calculate a ratio, all we get is a number. In order for this number to be meaningful, we
need to put it into some kind of context by comparing it with another number. We can make these
comparisons through:

1. Trend analysis of a single company by comparing current ratios to previous years’

ratios. Trends can be particularly useful in analyzing a firm’s financial condition. For
example, ratios that are becoming less favorable over time may be an indication of financial
FMGT 1013 – Financial Management |
3
 difficulty. The financial difficulty may not yet be apparent, but if the ratios do not improve, it
will manifest itself in the future. Ratio analysis can thus provide an early warning of trouble
ahead.
2. Comparison with other companies in the same industry or with industry averages after
any necessary adjustments have been made to assure that the financial statements are
comparable. If a company’s ratios are less favorable than those of other companies in its
industry, the company will not be able to compete successfully in its market.
3. Comparison with management’s expectations. If the entity set a target current ratio of 2:1
this current year, but it turned out to be 1.5:1, this could be considered an area of concern
by the management since actual result is below than the targeted one. It could be attributed
to inefficiency of managing current resources.

The classification of financial ratios here is based on CMA curriculum. You may encounter other
resources with different classifications, but I find this categorization more accurate. You may also
encounter from your textbooks or review materials different term or label of a certain financial ratio. If this
is the case, try to reconcile them. If you are still confused, PM is the key.

First, I would like you to have a bird’s eye view of the various financial ratios including a brief but concise
concepts and their respective formula so that you will have a guide later in applying these ratios in the
comprehensive illustrative case.

These are concepts that you need to understand and master. It may be true that some of these concepts
are difficult to comprehend especially that you do not have industry practice, along the way while you are
finishing college, you will soon have a better appreciation of them. Personally, I had a deeper
understanding of these ratios when I was immersed in the industry practice evaluating publicly listed
companies.

Halimbawa, guys, si AMAZON. Kilala niyo naman siguro si AMAZON diba. Hindi na lang siya isang e-
commerce company ngayun. Nagmamanufacture narin sila ng electronic devices. May video streaming
service (Amazon Prime) narin sila katulad ni NETFLIX. May cloud-based products narin sila at marami
pang iba.
Pansinin niyo ang mga sumusunod na key financial ratios niya sa kasalukuyan. Kayu nga humusga kung
kumusta ang financial health niya:
ROE = 18.58%
ROA= 5.97%
BVPS= $130.81/share
Profit Margin = 4.13%
Debt to Asset = 72.45%
EPS = $20.93/Share
Current market price, June 15, 2020 = $2,572.68/share
PE Ratio = 122.92
Asset Turnover = 1.48
Inventory Turnover = 9.97
Receivable Turnover = 17.86
Quick Ratio = 0.84
Current Ratio = 1.08

Diba wala kayung ma-draw na conclusion kung healthy ngaba siya. So paano mo malalaman kung
maganda ang financial health niya? KAILANGAN MO NG “BENCHMARKS” O “STANDARDS”. Paano
makukuha mga yun, tatlong paraan:
1. Industry averages – ito yung average ratios ng lahat ng companies that belong in the SAME
INDUSTRY, say Retail industry, banking industry, or real estate industry. So, if the industry ROE is
10% versus Amazon’s 18.58%, then we can conclude that Amazon’s equity investors is earning more
than that of its peers in the industry.
2. Trend comparison – a year to year or trend (say 5 years) analysis. If ROE in 2018 is 15% versus
18.58% in 2019, or for 5 years (10%, 12%, 14%, 16%, and 18%), we can conclude that equity
investors’ earnings growth is increasing, hence a good sign of Amazon’s future profitability.
3. Management expectations – A target ROE of 15% set my management in 2019 versus an actual ROE
of 18.57% is a sign that Amazon is profitable and that management has been very efficient in
managing the resources of the entity

FMGT 1013 – Financial Management |

4
Yes, anu yang graph na ‘yan? This is a trail of AMAZON’s market price per share since May 1, 1997 to
June 16, 2020 or 23 years after. From $1.50 per share on May 1, 1997 to $2,572.68 per share on June
15, 2020. So, that’s a whopping 171,412% increase for 23 years. So if you invested to AMAZON $1,000
on May 1, 1997 and hold it until now, you have already accumulated $1,715,120, excluding dividends. No
wonder, Jeff Bezos, 56 years old, the Founder and CEO of Amazon, still holds the title as the Richest
Man of the World. Currently, AMAZON has a market capitalization (total outstanding shares x current
market price) of 1.30 TRILLION DOLLARS or PhP65,000,000,000,000 (65 trillion pesos).

FYI…
APPLE has a market cap of $1.52 TRILLION (Currently, the most valuable US publicly listed Company),
MICROSOFT is $1.47 TRILLION,
GOOGLE is $486 BILLION,
TESLA is $184 BILLION,
FACEBOOK is $673 BILLION,
SM Investments Corporation is $22.6 BILLION (Phils’ most valuable Company),
AYALA CORPORATION is $9.72 BILLION,
ABS CBN is $266 MILLION, and
GMA is $346 MILLION
.

What I want you to realize is, a company’s financial ratios will ultimately be reflected in the
company’s stock price. If Amazon’s financial ratios have been favorable for the last 23 years, it
could have been the very reason why investors are piling up their money to Amazon, hence
causing the stock price to surge, hence creating more value or wealth for shareholders/investors.

As business students, you should realize that this is an opportunity (huge return) coupled with
risks (losing money). Necessarily, if you realized that there is indeed opportunity, manage the risk.
How will you manage risk? There are many ways – one of them is FINANCIAL RATIO ANALYSIS.

So, after this course, I expect that you will develop an inclination of investing in the stock market
because there is really huge opportunity. While you are still young, the time to accumulate your
wealth is huge. So study unlimitedly and diligently. Set priorities. Monitor your expenses. Save
regularly and invest wisely.

FMGT 1013 – Financial Management |

5
A. Liquidity ratios - they measure the sufficiency of the firm’s cash resources to meet its short-term cash
obligations.
Formula Concept and Significance

• The most commonly used measure of short-

term liquidity
• Measures a company's ability to pay short-
term obligations or those due within one year.
Current Assets
It tells investors and analysts how a company
1. Current Ratio can maximize the current assets on its
Current Liabilities
balance sheet to satisfy its current debt and
other payables.
• The standard for the current ratio is 2:1. A
lower ratio indicates a possible liquidity
problem.
• A more conservative version of the current
Cash + Marketable Securities + ratio
• Compares a company's most short-term
2. Quick Ratio or Net Accounts Receivable
assets to its most short-term liabilities to see
Acid Test Ratio if a company has enough cash to pay its
Current Liabilities
immediate liabilities, such as short-term debt.
Inventories and prepaid expenses are
excluded from the numerator.
Cash & Cash Equivalents + • Is even more conservative than the quick
ratio.
Marketable Securities
• A measure that shows a company's ability to
3. Cash Ratio
cover its short-term obligations using only
Current Liabilities cash and cash equivalents including
marketable securities.
• Compares the cash flow generated by
operations with current liabilities and
measures how many times greater the cash
flow generated by operations is than current
liabilities.
Operating Cash Flow • If a company has positive working capital but
it is not generating enough cash from
4. Cash Flow Ratio
Period-End Current Liabilities operations to settle its obligations as they
become due, the company is probably
borrowing to settle current liabilities.
• Using cash flow as opposed to net income is
considered a cleaner or more accurate
measure since earnings are more easily
manipulated.
Cash & Cash Equivalents +
Marketable Securities + Measures short-term liquidity by considering
5. Cash Flow Operating Cash Flow cash resources plus cash flow from operating
Liquidity Ratio activities.
Current Liabilities

• Compares net liquid assets (net working

capital) to total capitalization (total assets)
and measures the firm’s ability to meet its
obligations and expand by maintaining
sufficient working capital.
Net Working Capital (Current • The net working capital ratio is particularly
6. Net Working Assets – Current Liabilities) meaningful when compared with the same
ratio in previous years, especially if it is
Capital Ratio
Total Assets decreasing. Consistent operating losses will
cause net working capital to shrink relative to
total assets.
• If working capital is negative (current liabilities
are greater than current assets), the net
working capital ratio will also be negative.
Negative working capital and a negative net

FMGT 1013 – Financial Management |

6
 working capital ratio are indicators of very
serious problems.
• A financial metric that indicates the number
of days that a company can operate without
needing to access noncurrent assets, long-
term assets whose full value cannot be
obtained within the current accounting year,
Cash + Marketable Securities + or additional outside financial resources.
Net Accounts Receivable • Alternatively, this can be viewed as how long
7. Defensive
a company can operate while relying only on
Interval Ratio liquid assets.
(DIR) or Basic Projected Daily Operating
Expenses • There is no specific number that is
Defense Interval
considered the best or right number for a
(BDI)
DIR. It is often worth comparing the DIR of
different companies in the same industry to
get an idea of what is appropriate, which
would also help determine which companies
could be better investments.

B. Leverage, capital structure, solvency and earnings coverage ratios – they evaluate the firm’s ability
to satisfy its debt and obligations for other fixed financing charges such as operating leases by looking at
the mix of its financing sources and its historical earnings.
1. Leverage in general refers to the potential to earn a high level of return relative to the amount of cost
expended.
• Financial leverage is the use of debt to
increase earnings. The cost of using debt is
called interest.
• Financial leverage magnifies the effect of
both managerial success (profits) and
managerial failure (losses). When financial
leverage is being used, an increase in
a. Financial earnings before interest and taxes (EBIT) will
Total Assets
Leverage cause an even greater proportionate increase
Ratio, or in net income, and vice versa.
Total Equity
Equity • Financial leverage ratios measure a
Multiplier company’s use of debt to finance its assets
and operations.
• Financial leverage is successful if the firm
earns more by investing the borrowed funds
than it pays in interest to use them. It is not
successful if the firm is not able to earn more
by investing the borrowed funds than it pays
in interest for them.
• Is the factor by which net income can be
expected to change in the future in relation
to a future change in earnings before interest
% [of future] Change in Net and taxes (EBIT), since interest on debt is a
income fixed expense.
b. Degree of • The degree of financial leverage is the ratio
Financial % [of future] Change in EBIT by which earnings before taxes (EBT) will
Leverage (Earnings Before Interest and change in response to a change in
(DFL) earnings before interest and taxes (EBIT),
Taxes)
(2 periods assuming that interest expense does not
and 1 OR change.
period, • When financial leverage is used, a given
respectivel Earnings Before Interest and percentage increase in EBIT will result in an
y) Taxes (EBIT) even greater percentage increase in EBT,
because interest expense (the difference
Earnings Before Taxes (EBT) between EBIT and EBT) is a fixed expense.
Once interest expense has been covered by
EBIT, further increases in EBIT flow straight
to EBT. However, the opposite is also true: a
given percentage decrease in EBIT will result

FMGT 1013 – Financial Management |

7
 in an even greater percentage decrease in
EBT.

• Just as financial leverage measures the use

of fixed interest expense charged on debt
financing to generate greater returns for
% [of future] Change in EBIT
equity investors, operating leverage
measures the use of fixed operating costs
% [of future] Change in Sales to generate greater operating profit.
c. Degree of • Is the ratio by which earnings before interest
OR
Operating and taxes (EBIT) will change in response to a
Leverage change in sales, assuming the contribution
Contribution Margin
margin ratio and fixed operating costs do not
change.
EBIT
• Operating leverage refers to the fact that, for
a given level of fixed expenses, a given
percentage change in sales will result in a
higher percentage of change in profits.

% [of future] Change in Net

Income

% [of future] Change in Sales Expresses the degree to which a company uses
d. Degree of fixed costs in its operations as well as the
Total OR degree to which the company uses fixed rate
Leverage financing in its capital structure.
Contribution Margin

Earnings Before Taxes (EBT)

2. Capital structure refers to the way a firm chooses to finance its business.
Solvency is the ability of the company to pay its long-term obligations as they come due.

• Is a comparison of how much of the financing

of assets comes from creditors with the
amount of financing that comes from owners
in the form of equity.
• A debt to equity ratio of 2.00, or 2:1, for
example, means that the company’s total
debt is twice its total equity, or its debt
financing consists of $2.00 of debt for every
$1.00 of equity.
• The debt to equity ratio can serve as a
Total Liabilities screening device for the analyst when
a. Debt to
Equity looking at capital structure ratios. If this ratio
Ratio Total Equity is extremely low (for instance, 0.1:1), then
there is no need to calculate other capital
structure ratios because there is no real
concern with this part of the company’s
financial situation. The analyst’s time could
be better spent looking at other aspects of
the company’s operations. However, if the
debt to equity ratio is in the neighborhood of
2:1 or higher, it would be important to do
some extended analysis that focuses on
other ratios such as profitability, as well as
the company’s future prospects.
b. Long-Term
Measures how much long-term debt a company
Debt to
Equity Total Debt − Current Liabilities has compared to its total equity.
Ratio
FMGT 1013 – Financial Management |
8
 Total Equity

Measures the proportion of the company’s total

assets that are financed by creditors, an
c. Debt to Total Liabilities
Total indication of the firm’s long-term debt repayment
Assets Total Assets ability
Ratio

3. Earnings coverage ratios focus on the company’s earning power, because the company’s earnings
are the source of its ability to make interest payments and principal repayments on debt.
• Compares the funds available to pay interest
(earnings before interest and taxes) with the
amount of interest expense on the income
statement and gives an indication of how
a. Interest
Earnings Before Interest and much the company has available for the
Coverage
Taxes (EBIT) payment of its fixed interest expense.
(Times
Interest • A high interest coverage ratio is desirable. An
Earned) Interest Expense interest coverage ratio of greater than 3.0 is
Ratio excellent. When the interest coverage ratio
gets down to 1.5, the company has a
heightened risk of default. The further the
ratio declines below 1.5, the higher the risk of
default becomes.
Earnings Before Fixed Charges
and Taxes*

Fixed Charges**

• Measures a firm's ability to cover its fixed

* EBIT (Earnings Before charges, such as debt payments, interest
Interest and Taxes) expense and equipment lease expense and
b. Fixed
shows how well a company's earnings can
Charge + Add back operating lease cover its fixed expenses.
Coverage
payments expensed • A fixed charge coverage ratio of 4.0 is
(Earnings
excellent. It means the company has four
to Fixed
**Interest expense on loans times as much in earnings as it needs in
Charges)
Ratio and capital leases order to fulfill its contractual obligations to
make interest and principal payments on its
+ Required principal payments loans and capital leases and to make its
on loans and capital leases operating lease payments.

+ Total payments on operating

leases

Adjusted Operating Cash Flow*

Fixed Charges Tells us a little more about availability of cash

to fulfill contractual financing obligations than the
c. Cash Flow fixed charge coverage ratio does, because it
to Fixed *Cash flow from operations uses operating cash flow. The cash flow to fixed
Charges (from the Statement of Cash charges ratio tells us how much in operating cash
Ratio Flows) flow the company has available to pay its
contractual obligations.
+ Cash Fixed Charges (to add
back cash interest paid on
loans and capital leases and

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 operating lease payments,
since those items are deducted
in calculating cash flow from
operations)

+ Cash Tax Payments (cash

amount paid in taxes, a
disclosure on the SCF)

A. Activity ratios - they provide information on a firm's ability to manage efficiently its current assets (accounts
receivable and inventory) and current liabilities (accounts payable).
1. Accounts Receivable Activity Ratios
•Measures the number of times receivables
“turn over” during a year’s time, or are
collected and are replaced with new
receivables. It tracks the efficiency of a firm’s
accounts receivable collections and indicates
Net Annual Credit Sales the amount of investment in receivables that
a. Accounts
is needed to maintain the firm’s level of sales.
Receivable
Turnover
Average Gross Accounts • By comparing the accounts receivable
Ratio Receivable turnover ratio from year to year for one
company, we can see how the company’s
collection rate changes over time. An
increase in the accounts receivable turnover
ratio indicates that receivables are being
collected more rapidly. A decrease indicates
slower collections.
• Measures the average number of days that
it takes a company to collect payment after a
sale has been made.
365 • The accounts receivable turnover ratio and
days sales in receivables, or average
Receivables Turnover Ratio collection period, should be compared with
b. Days Sales industry averages, with previous periods’
in OR amounts for the same company, and with the
Receivable company’s credit terms. The number of days
s (Average Average Gross Accounts of sales in receivables should not be higher
Collection Receivable than the standard credit terms offered by
Period) the company. An average collection period
Average Daily Net Credit Sales that is higher than the standard credit terms
(Net Annual Credit Sales ÷ 365) offered may indicate poor collections
efforts, customer dissatisfaction leading to
refusal to pay, customers in financial distress
or an extreme delay of payment by one or
two large customers.
2. Inventory Activity Ratios - The inventory activity ratios will be affected by the company’s choice of
inventory valuation methods (FIFO, WAM, etc.), too. Thus, they may not be useful for comparing
companies when the companies use different inventory valuation methods.
• Indicates how many times during the year
the company sells its average level of
inventory.
• Measures both the quality of the inventory
and the liquidity of the inventory. Both
Annual Cost of Goods Sold
a. Inventory quality and liquidity of inventory give an
Turnover indication of the salability of the inventory.
Average Inventory
Ratio • If a company has a high inventory turnover
ratio, it may mean the company is using
good inventory management and is not
holding excessive amounts of inventories that
may be obsolete, unmarketable goods.
However, it can also mean that the company

FMGT 1013 – Financial Management |

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 is not holding enough inventory and may be
losing sales, if prospective customers are
unable to make purchases because items are
out of stock.

365
Represents the average number of days that
Inventory Turnover inventory items remain in stock before being
sold, or the average number of days required to
b. Days Sales OR sell an item of inventory.
in
Inventory Average Inventory

Average Daily Cost of Sales

(Annual Cost of Sales ÷ 365)

3. Accounts Payable Activity Ratios - indicate the speed with which the company pays its suppliers.
• Represents the number of times payables
“turn over,” or are paid and new ones are
a. Accounts Annual Credit Purchases generated by new purchases, during a year’s
Payable time.
Turnover Average Accounts Payable • A decrease in the accounts payable turnover
Ratio ratio over time means the company is paying
its payables more slowly, an indication of
possible liquidity problems.

Average Accounts Payable

Average Daily Credit

• Represents the average number of days the
b. Days Purchases (Annual Credit company takes to pay its payables.
Purchases Purchases ÷ 365) • An increase in the number of days
in purchases in payables indicates that the
Accounts OR company is paying its payables more slowly,
Payable which could mean the company is having
365 liquidity problems
Accounts Payable Turnover

4. Operating Cycle and the Cash Cycle

Is the length of time it takes to convert an

Days Sales in Receivables + investment of cash in inventory back into cash
a. Operating
Cycle Days Sales in Inventory through collections of the receivables resulting
from sales made

• Is the length of time it takes to convert an

Operating Cycle – Days investment of cash in inventory back into
cash, recognizing that some purchases are
b. Cash cycle Purchases in Accounts Payable made on credit.
or Cash
• In a large company, a small reduction in the
Conversio OR
cash cycle can increase pretax profits
n Cycle or
Days Sales in Receivables + significantly because of the lowered costs of
Net
financing.
Operating Days Sales in Inventory – Days
• Some companies may actually have
Cycle Purchases in Accounts Payable negative cash cycles. A company that
manufactures its product on demand and
requires its customers to pay by credit card
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 before it ships can have a negative cash
cycle if it is granted terms from its own
suppliers. The company’s days sales in
receivables are basically zero, its days sales
in inventory are very low since it
manufactures product only on demand, and
its days purchases in payables are probably
the highest number of all three. That situation
creates a negative cash cycle.
• If a company has a negative 50 day cash
cycle, for instance, it means the company
converts each sale to cash 50 days before it
needs to pay the invoices from its suppliers
for the cost of the sale. Having a negative
cash cycle is a very favorable position for
a company to be in.
• Measures the amount of sales revenue the
company is generating from the use of each
currency unit it has in total assets.
Sales • The total asset turnover ratio provides a
5. Total Asset means of measuring the overall efficiency of
Turnover Ratio Average Total Assets the company’s use of all its investments,
including both current assets and non-current
assets.

Measures the amount of sales revenue the

Sales
company is generating from each currency unit of
6. Fixed Asset only its fixed assets.
Average Net Property, Plant
Turnover Ratio
and Equipment

B. Profitability analysis - measures the firm’s profit in relation to its total revenue or the amount of net
income from each dollar of sales and its return on invested assets.
• Measures the percentage of the sales price
available to cover fixed and
nonmanufacturing costs.
• The company’s gross profit margin is the key
to its overall profitability.
• Changes in the gross profit margin are
usually due to one or more of the following:
o sales volume increases or decreases,
Gross Profit
1. Gross Profit o unit selling price increases or
Margin decreases, and
Percentage Net Sales o increases or decreases in cost per
unit.
• A low gross profit margin can be an indication
that employee theft is taking place. For
example, if the gross profit margin for a
restaurant is lower than the industry norm
but the restaurant’s prices are in line with
other restaurants’ prices, it could mean that
steaks are “going out the back door.”
Operating Income
2. Operating Measures how much of its sales revenue the
Profit Margin firm keeps as operating income.
Percentage Net Sales

Net Income
3. Net Profit • Illustrates how much of each dollar in
Margin revenue collected by a company translates
Percentage Net Sales
into profit.

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 • Vertical analysis (common size financial
statements) and horizontal analysis (common
base year statements) can be helpful in
detecting causes of variations in the net
profit margin from year to year.
4. EBITDA
Margin
Percentage
(Earnings
Before Interest, EBITDA Measures a company's operating profit
Taxes, (EBITDA) as a percentage of its revenue.
Depreciation Net Sales
and
Amortization or
EBITDA)

• Measures how much return the company

receives on the capital it has invested in
assets and thus it measures the company’s
success in using financing to generate profits.
• Probably the most widely recognized
measure of company performance.
Net Income • An analyst can compare the return on assets
5. Return on of a company with the returns of alternative
Assets (ROA) investments, such as government bonds.
Average Total Assets
Since the return on government bonds is
considered to be risk-free, comparison of the
company’s ROA with the government bond’s
rate of return can provide an indication of
whether an adequate risk premium is being
earned by investors to compensate them for
the risk they are assuming in that particular
investment.
Net Income
Measures the return the business receives on the
6. Return on
Equity (ROE) stockholders’ equity invested in the business.
Average Total Equity

Measures the return after deducting preferred

Net Income – Preferred dividends the business receives on the
7. Return on
Common
Dividends common stockholders’ equity invested in the
Equity business.
Average Common Equity

C. Market ratios and earnings per share analysis, or shareholder ratios - they describe the firm’s financial
condition in terms of amounts per share of stock.
Total Stockholders’ Equity – Represents the per share amount for the
Preferred Equity common stockholders that would result if the
1. Book Value company were to be liquidated at the amounts
Per share Number of Common Shares that are reported on the company’s balance
Outstanding sheet.

Market Price per Share

The ratio between the company’s market price
2. Market/Book
ratio per share and its book value per share.
Book Value per Share

• The earnings per share for all common

shares that were actually outstanding
3. Basic Income Available to Common during the period.
Earnings Per Stockholders (IAC)* • Earnings per share (EPS) is the amount of
Share income that the holder of one share of
common stock would have received if 100%
of the company’s profit had been “paid”
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 Weighted-Average Number of (distributed as dividends) to the holders of all
Common Shares Outstanding the common shares outstanding. Earnings
(WANCSO) belong to the common shareholders
whether distributed as dividends or retained
in the company to support future growth, so
earnings per share is an important measure
* Net Income
(We will not elaborate the computation of
− Noncumulative preferred BEPS and DEPS anymore because this is
dividends DECLARED (whether part of IA 3)
or not paid) and/or

− Cumulative preferred
dividends EARNED (whether or
not declared)

A variation of BEPS where IAC and WANCSO are adjusted to reflect the effect of
4. Diluted
Earnings Per potential common shares namely Options & Warrants, Convertible Preferred
Share Shares and Convertible Debt Instruments

• Gives an indication of what shareholders are

paying for continuing earnings per share.
• Investors view it as an indication of what the
market (public) considers to be the firm’s
future earning power.
Market Price per Common • It also sometimes known as the price
Share multiple or the earnings multiple.
5. Price/Earnings • The P/E ratio is greatly influenced by where a
(P/E) ratio Basic Earnings per Share company is in its cycle. A company in a
(annual) growth stage will usually have a high P/E
ratio because of the market’s expectations
of future profits (which makes the market
price higher) despite the fact that at the
current time, profits may be low. Companies
with low growth generally have lower P/E
ratios.
Market Price per Common
Share The ratio between the company’s market price
6. Price/EBITDA
ratio per common share and its EBITDA per share.
EBITDA per Share

Basic Earnings Per Share

(annual) • Measures the income-producing power of
one share of common stock at the current
7. Earnings Yield
Current Market Price Per market price.
Common Share • It is the inverse of the P/E ratio.

• Measures the relationship between the

current annual dividend and the current
market price.
• If the company keeps its dividend payout
Annual Dividends Per Common (pagbabayad ng dividendo) low in order to
Share retain profits in the company for future
8. Dividend Yield growth, the dividend yield will be low. If the
Current Market Price Per Share company is able to invest the retained
earnings profitability, the price of the
company’s stock should rise, providing return
to investors in the form of capital gain
(Tumaas ang value ng shares na hawak mo)
rather than in the form of dividends.
Annual Dividend Per Common
9. Dividend • Measures the proportion of earnings paid out
Payout ratio Share
as dividends to common stockholders.

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 Basic Earnings Per Share • Generally, a new company or a company
that is growing will have a low or no
OR dividend payout, because it is retaining
earnings in the company to finance its
Total Common Dividends growth.
(Annual)

Income Available to Common

Shareholders

Ending Stock Price

Measures the total return to individual
– Beginning Stock Price shareholders on their investments in the
10. Shareholder company’s common stock. (Dalawa ang kitaan
Return + Annual Dividends Per Share sa stocks – dividends and capital gains/share
appreciation)
Beginning Stock Price

Ok, let’s go back to our main course. In order for you to appreciate more the concepts, I will now
present to you the illustrative case for Financial Ratio Analysis. This illustration is taken from a
CMA reviewer. This is a comprehensive illustration, so be patient. Let’s go!

FMGT 1013 – Financial Management |

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Below are Balance Sheet, Income Statement, Statement of Cash Flows, and selected Notes to the
Financial Statements.

Required: Compute the financial ratios and evaluate the company.

FMGT 1013 – Financial Management |

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FMGT 1013 – Financial Management |
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FMGT 1013 – Financial Management |
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SOLUTION:

FMGT 1013 – Financial Management |

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FMGT 1013 – Financial Management |
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FMGT 1013 – Financial Management |
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The most important part – ANALYSIS AND INTERPRETATION

Liquidity
This company appears to have a very strong liquidity position. The current ratio has consistently been
over 6:1. This is three times the norm of 2:1. On the other hand, the current ratio needs to be evaluated in
light of the length of the company’s operating cycle. So let’s look at the company’s operating cycle. That
information is in the Activity Ratios. The operating cycle is

Operating Cycle = Days Sales in Receivables + Days Sales in Inventory

For the most current year, the company had 77.6 days of sales in receivables and 51.34 days of sales in
inventory, for an operating cycle of 129 days according to the formula. This appears to be a long operating
cycle, and the previous year’s operating cycle was similarly long. The high level of accounts receivable
that results from having over 77 days of sales in receivables could be the reason for the high current ratio.

But is accounts receivable really that high? Let’s look at that more closely. On the balance sheet, we see
that gross accounts receivable equaled $724,000 at the end of Year 1. Gross receivables increased to
$3,700,000 at the end of Year 2, and then they dropped back to $722,000 at the end of Year 3. An increase
followed by a decrease like this could be caused by a number of things, but one thing we know for sure:
since the number of days in receivables is calculated using average accounts receivable, and since we
calculate the average accounts receivable by averaging the beginning and ending balances, the average
accounts receivable balances we were using for both Year 2 and Year 3 were distorted by the large
increase in Year 2. The averages used may not be representative of the company’s average accounts
receivable. The company may have made a big sale just before the end of Year 2 that caused its accounts
receivable as of December 31, Year 2 to increase temporarily but was collected in a timely manner (a good
thing). Or, the company may have made a big sale earlier in the year that ultimately turned out to be
uncollectible (a bad thing) and was subsequently written off. The situation warrants further inquiry and
investigation.

This question about the treatment of Year 2’s high receivable balance illustrates a rule in financial
statement analysis: we do not just calculate ratios blindly and draw conclusions from them without looking
deeper. Sometimes further investigation is needed to find the story behind the numbers.
FMGT 1013 – Financial Management |
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 In this case, our investigation has revealed that the increase in receivables at the end of Year 2 was due
to a large sale that was made just prior to yearend for which payment was received during the first month
of the following year. The collection period for other trade accounts receivable was 30 days at the end of
Year 2. That is important information, because it means that overall, the company is collecting its
receivables in about 30 days time, not 77 days time, which is favorable.

Furthermore, since the current ratio is calculated using year-end balances only, the Year 3 current ratio
was not distorted by the large increase in accounts receivable at the end of Year 2. This company’s
liquidity position is truly as strong as it appears to be.

Financial Leverage
This company has a little less than twice as much in total assets as it has in common equity, which means
that a little less than half of the company’s financing comes from debt. This is an acceptable level of debt:
not too high and not too low.
Interest expense has remained the same during the three years because the only long-term debt incurring
interest is a bond issue that has been unchanged. The bond was originally sold at par, so there was no
discount or premium to be amortized. Because the level of interest expense has remained unchanged,
any increases or decreases in EBIT flow straight to EBT. However, the effect of increases and decreases
in EBIT is magnified because of the existence of the interest expense. For this company, EBIT decreased
in Year 3 because revenue decreased.

The magnification of increases/decreases in EBIT is measured by the Degree of Financial Leverage (DFL).
Because the DFL is greater than 1, EBT will increase (decrease) more, proportionally, than EBIT increases
(decreases) To illustrate: In Year 3, EBIT fell from $5,319,000 to $3,233,000, a 39% drop. EBT, however,
fell by a greater percentage − 42% − from $4,919,000 to $2,833,000.

Capital Structure and Solvency

This company’s capital structure and solvency ratios generally confirm its financial leverage ratios. The
company’s capital structure is a little less than half debt and a little more than half equity, an acceptable
balance.

Earnings Coverage
The Interest Coverage (or Times Interest Earned) ratio decreased significantly in Year 3, to 8.08 from
13.30 in Year 2. This decrease is due to the fact that EBIT decreased significantly in Year 3. In a weaker
company, this might be a cause for concern. However, this company still has more than enough earnings
to cover its interest expense (8 times as much). If this trend continues, however, this ratio could deteriorate
and interest coverage could become a problem.

The Fixed Charge Coverage (Earnings to Fixed Charges) ratio also decreased sharply in Year 3 for the
same reason.

Activity
We have already reviewed the situation with accounts receivable, so that will not be repeated. The number
of days of sales in inventory is fairly stable, at slightly more than 50 days. The number of days of purchases
in accounts payable has increased from 26.07 days in Year 2 to 33.46 days in Year 3. The company is
generally current with its suppliers, though if the upward trend in the number of days of purchases in
payables continues, it could become a cause for concern.
The fixed Asset Turnover ratio went down in Year 3, a reflection of the decreased revenue the company
experienced in Year 3.

Profitability
Revenue decreased significantly in Year 3 compared to revenue in Year 2. The economy went into a
recession in Year 3, and that probably accounts for the decreased sales. At 69%, the Gross Profit Margin
Percentage has been very stable throughout the three years analyzed, though gross profit in dollars
dropped in Year 3 as compared to Year 2 because of the decreased revenues. Since the Gross Profit
Margin Percentage has held up well, a good working theory is that the decrease in revenues was almost
entirely due to decreased volume of sales and at most only minimally due to any price concessions the
company may have made because of the recession. Any price concessions made would have impacted
revenue and the gross profit margin negatively. However, profitability of the sales that were made was
maintained.

The Operating Profit Margin and the Net Profit Margin have been steadily decreasing, however. The
primary reason for this has been management’s decision to increase its spending on research and
development activities. R&D in Year 1 was $1,200,000, increasing to $1,800,000 in Year 2 and $3,000,000
FMGT 1013 – Financial Management |
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 in Year 3. R&D increases generally predict future increased profits, and so this is probably a good sign. It
is interesting that the company increased its R&D spending even when revenues dropped in Year 3. That
could be an indication of management’s commitment to the future. However, the increased R&D expense
could also result from failed R&D efforts. How successful the company’s R&D efforts have been is a
question that needs to be answered. In this case, there is no indication that the company’s R&D efforts
have been anything but successful.

Return on Invested Capital

ROA, ROE and ROCE all decreased significantly from Year 2 to Year 3, again because of the Year 3
decrease in earnings caused by decreased revenues coupled with increased R&D expense.

Market Ratios
The market punished this stock severely in Year 3 because of its sales and net income decreases, with
the stock price falling from $31 per share at the end of Year 2 to $13 per share at the end of Year 3. That
fact has affected the company’s Year 3 market ratios significantly.

The Market/Book ratio should be at least 1.0. The Market/Book ratio decreased in Year 3 to 1.43 from 3.85
the previous year. It is getting close to the 1.0 mark because of the large decrease in the market price of
the company’s stock.

The Price/Earnings Ratio is used rather extensively by investors to determine whether a publicly-traded
stock is a good investment. Comparing a company’s P/E ratio with that of a benchmark such as the S & P
500 index can give an investor an idea of whether the stock is underpriced, overpriced, or fairly priced. As
this is being written, the average P/E ratio of S & P 500 stocks is 19.30. This company’s P/E ratios for
Years 1, 2 and 3, respectively, have been 15.17, 14.03, and 10.32. Thus, this company’s stock has been
somewhat underpriced compared with stocks in the S & P 500. Furthermore, the company’s P/E ratio has
been declining, indicating its stock price has fallen relatively more than the decrease in its earnings per
share. The low P/E ratio could indicate that the stock is a good value, a positive indicator. Value investors
look for underpriced stocks in the belief that other investors will eventually realize that the stock is
underpriced and the price will increase.

However, a low P/E ratio could also indicate that investors do not consider the company’s future earnings
prospects to be very favorable, which is a negative indicator.

The Dividend Yield has increased each year, from 1.63% in Year 1 to 2.31% in Year 3. However, common
Dividends per Share were cut in half in Year 3 (from $0.60 per share to $0.30 per share) due to the
company’s decreased earnings. The increased Dividend Yield Ratio in Year 3 despite the dividend cut is
due to the large drop in the market price of the stock.

The Dividend Payout Ratio has been between 23% and 27% for the past three years, a healthy level. If a
company pays out too much of its earnings in dividends, the company is weakened financially because it
does not have adequate retained earnings. The dividend payout ratio should be generous, but if it is too
generous, that indicates that dividends will probably be cut in the future, which in turn will probably cause
a drop in the stock’s market price.

Other
The Sustainable Growth Rate has decreased from 22.40% in Year 2 to 11.26% in Year 3. The decrease
was due to the decreased earnings in Year 3. The company has chosen to maintain its dividend payout
ratio (though not the dividend level) in the face of depressed earnings. Considerably fewer earnings were
retained by the company in Year 3 compared to Year 2. Furthermore, the return earned on those retained
earnings was lower in Year 3.

Cash Flow
The statements of cash flows reveal that this company generates quite a bit of cash from its operating
activities. In Year 3, net cash provided by operating activities was $4,609,000, and that amount would have
been even higher if net purchases of trading securities had not been $2,500,000, an activity the company
classifies as an operating activity.

A great deal of Year 3’s operating cash inflow was generated by the collection of accounts receivable.
Accounts receivable decreased from the end of Year 2 to the end of Year 3 by $2,975,000. The unusually
large collection was caused by the large receivable that was generated at the end of Year 2 and was
collected early in Year 3. However, operating cash flows are typically high, even without the large
receivable, as Year 2’s net operating cash flow was over $3,000,000.

FMGT 1013 – Financial Management |

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 In Year 3, the company used $2,709,000 of the operating cash flow it generated for investing activities,
primarily for the purchase of available-for-sale securities. In addition, the company used $505,000 in
financing activities for paying dividends. Proceeds from the issuance of stock in Year 3 were $225,000, for
a net cash used by financing activities of $280,000.

Summary
This is a strong company that is well positioned to not only survive but also to thrive during a temporary
downturn in its revenues and earnings caused by a recession in the economy. As long as the economic
downturn does not continue too long, the company should come out of the recession stronger than ever
and with an improved product offering due to its recent increased R & D activities. However, if the economic
downturn continues for an extended period of time, the company’s financial situation will certainly
deteriorate.

Limitations of Ratio Analysis

Although ratio analysis provides useful information pertaining to the efficiency of operations and the
stability of financial condition, it has inherent limitations.

• A ratio by itself is not significant. It must be interpreted in comparison with prior periods’ ratios,
predetermined benchmarks, or ratios of competitors.

• The ability to make use of ratios is dependent upon the analyst’s ability to adjust the reported
numbers before calculating the ratios and then to interpret the results.

• Financial statement analysis cannot give definite answers. It can point out where further
investigation is warranted; but it is a mistake to place too much importance on a simple analysis of
financial statement numbers.

• Accounting and the preparation of financial statements require judgment in making assumptions
and estimates. The more frequent the publication of financial statements, the more frequent will
be the need to make these estimates, and the greater will be the uncertainty inherent in the financial
statements and thus the ratios calculated from them, because many transactions require several
quarters or several years for completion. The longer the time it takes to complete a transaction, the
more tentative will be the estimates relating to it that affect the financial statements. The short-term
incentives, agendas, and personal interests of those who prepare them may affect these estimates
relating to long-term events.

• Ratios’ usefulness depends on the quality of the numbers used in their calculation. If a
company’s financial statements are not credible because of poor internal controls or fraudulent
finan-cial reporting, then the resulting ratios will be just as unreliable and misleading as the financial
statements. However, a critical analysis of ratios can alert an analyst to the possibility of problems
in the financial reporting, because he or she may see that the ratios do not make sense.

• The numbers constitute only one part of the information that should be considered when evaluating
a company. Qualitative aspects such as employee morale, new products under development, the
company’s reputation, customer loyalty, or the company’s approach to its social responsibilities are
also important.
• When we compare a company with other companies, the various companies’ financial statements
will probably classify items differently. To the extent possible, we should make adjustments in
order to make the statements as comparable as possible. However, making these adjustments
may not always be possible, and that can make it difficult to draw conclusions from the
comparisons.

• Many companies are conglomerates and are made up of many different divisions operating in
different, unrelated industries. This diversification20 can make it difficult to compare any two
companies, because while they may share some markets, they seldom share all of the same
markets.

• Companies can choose different methods of computing things such as depreciation expense,
cost of goods sold, and bad debt expense. Leases can be reported as operating leases, appearing
only in the income statement, or they can be capitalized and reported on the balance sheet. These
variations in reporting also affect the comparability of companies.

• A company may have poor operating results that are caused by several different, small factors.
If an analyst focuses on trying to find one major problem, he or she may miss the confluence of
many factors.
FMGT 1013 – Financial Management |
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 • Traditional ratio analysis focuses on the balance sheet and income statement, and
therefore cash flow ratios may be overlooked.

• The goal of financial analysis is to make predictions about how a company will do in the
future. In contrast, ratio analysis is performed on historical data and may have little to do
with what is going on currently at the company. Current data such as news releases from
the company must be included in the analysis, as well as historical information.

• Many financial statement items are based on historical cost values. Ratios based on
those historical cost values may be less relevant to a decision than current market values.

• To be meaningful, a ratio must measure a relationship that is meaningful. For example,

the relationship between sales and accounts receivable is meaningful, so the ratios that
relate those items are significant. However, there is no meaningful relationship between the
average balance of total long-term debt and freight costs, so a ratio relating those items to
one another would be useless.

• Financial statements consist of summaries and simplifications for the purpose of

classifying the economic events and presenting the information in a form that can be
utilized. In some cases, the details behind the summarized transactions are recoverable,
but in other cases they are not.

• Financial statements deal only with monetary amounts and do not reflect the decrease
in the purchasing power of money that occurs with inflation. Therefore, comparing values
over a long period-od of time may be misleading.

Congratulations for reaching this part! ☺

That ends Financial Statements Analysis.

If you are ready, you may now take the Exercises for Financial Ratio Analysis!

Supplemental Readings:
• https://courses.lumenlearning.com/boundless-finance/chapter/asset-management-ratios/
• https://www.accountingverse.com/managerial-accounting/fs-analysis/financial-ratios.html
• https://www.thebalancesmb.com/how-do-you-do-financial-statement-analysis-393235
• https://www.principlesofaccounting.com/chapter-16/statement-analysis/
• https://www.bdc.ca/en/articles-tools/money-finance/manage-
finances/pages/financial- ratios-4-ways-assess-business.aspx

*** END of LESSON ***

REFERENCES

Textbooks

1. Agamata, F. (2011), Management Advisory Services, GIC Enterprises Inc.

2. Brigham, E., Houston, J. (2013), Fundamentals of financial management. Cengage
Learning Asia Pte. Ltd
3. Cabrera, E.(2015) Financial Management: Principles and Applications, GIC Enterprises &
Co., Inc., Manila
4. Salvador, S., Baysa, G, Gamboa, D., Geronimo, E. (2012) Fundamentals and applications
of financial management, Allan Adrian Books Inc.
5. William, J. (2015), Financial Management

Online Reference

1. https://www.elearnmarkets.com/blog/dupont-analysis/
2. https://www.wallstreetmojo.com/economic-value-added-eva/
3. https://investinganswers.com/dictionary/e/economic-value-added-eva

FMGT 1013 – Financial Management |

26
 UNIVERSITY OF SAINT LOUIS
Tuguegarao City

SCHOOL OF ACCOUNTANCY, BUSINESS and HOSPITALITY

Short Term
A.Y. 2020-2021

ONLINE LEARNING MODULE

FMGT 1013- Financial Management

Lesson 3: Cash Flow Analysis

Topic: Cash Flow Analysis

Learning 1. Explain the usefulness of cash flow analysis is in decision making.
Outcomes: 2. Discuss the different cash flow ratios.
3. Calculate the free cash flow of the firm.

LEARNING CONTENT

A very popular phrase in Finance, “CASH IS KING”. Other variations of the phrase include, “Revenue or
Turnover is Vanity, Profit is Sanity but Cash is Reality”, “Cash is King, Profit is Queen”, “Profit is not Cash”,
etc…

Let’s start with the phrase Revenue or Turnover is Vanity. Bannering a huge amount of revenue alone
could create a room of pride or boastfulness. A CFO may boast, “We’re turning over P2 Billion annually”
without stating a more significant metrics – the profit and cash flow of the company. It could be that the
company is generating huge revenues but after considering expenses, it turned out to be a loss. A good
performance during the period should include creating profits out of the generated revenues. If revenue
figures alone are the sole metric of performance, the entity may have been generating huge revenues but
also incurring a huge amount of expenses.

Profit is sanity. A good indicator of performance during the period could be uncovered from the bottom
figure – the net income or profit. It shows the ability of the company to generate huge revenues while
managing their expenses efficiently. It gives us a picture of whether or not resources or assets have been
maximized during the period. It gives us also insights whether or not the management did their work
efficiently and effectively.

But why CASH is considered the King?

Profit is an accounting term which incorporates the principles of accrual accounting. When we say accrual
accounting, we recognize the transaction when they occur regardless of the timing of cash flows. As a
consequence, we recognize in our accounting books Accounts Receivable, Accounts, Payable, Accrued

FMGT 1013 – Financial Management | 1

Income, Deferred Income, etc… Ok. So it is without doubt that profit or net income is not the increase or
decrease in the cash balance during the year. Or in other words, profit is not cash.

Can you use profit to expand your business? Can you use profit to generate more revenues? Of course,
NO! Because profit is not a real money. The real money is CASH.

Another argument. There may be companies even the larger ones who are creating profits before the
COVID 19 pandemic but ultimately lost tract or worst became bankrupt during the pandemic. Why is this
possible? A logical reason for that is they may have no sufficient cash during the pandemic. So what? A
company may have booked large amount of sales, hence a net income. However, this sales could have
been in the form of credit sales. In times of deep crisis, this credit sales could be difficult to collect, but
they have to continue incurring expenses or continue repaying their long term obligations. An unfavorable
scenario during a crisis. So what will the entity’s best alternative when there is no sufficient cash when
there are obligations required to be paid (salary, accounts payable, taxes, interest, long term debt, etc…)?
The worst but the most feasible alternative that an entity may choose – seek for a declaration of
bankruptcy.

Cash is reality. Revenue must be turned into profits. And profits must be turned into cash. No matter how
profitable the company is, if its working capital does not create cash, there may be serious problems in the
management of the entity’s operations or of the entity’s working capital. Remember in our recent previous
topic, working capital plays a vital role in the success of a company. Hence, its management requires a lot
of attention. Why is this so? Because working capital (current assets minus current liabilities) is the source
of cash from operations. Above all other sources of cash (investing and financing), cash flows from
operations remains to be the best and real determinant of future growth. An entity must be able to translate
earnings into cash.

From the article “The Power of Cash Flow Ratios” (1998), it stated that
1. CASH FLOW RATIOS ARE MORE RELIABLE indicators of liquidity than balance sheet or income
statement ratios such as the quick ratio or the current ratio.
2. LENDERS, RATING AGENCIES AND WALL STREET analysts have long used cash flow ratios to
evaluate risk.

Moreover, the article indicated “Balance sheet data are static—measuring a single point in time—while the
income statement contains many arbitrary noncash allocations—for example, pension contributions and
depreciation and amortization. In contrast, the cash flow statement records the changes in the other
statements and nets out the bookkeeping artifice, focusing on what shareholders really care about: cash
available for operations and investments.”

“For years, credit analysts and Wall Street barracudas have been using ratios to mine cash flow statements
for practical revelations. The major credit-rating agencies use cash flow ratios prominently in their rating
decisions. Bondholders—especially junk bond investors—and leveraged buyout specialists use free cash
flow ratios to clarify the risk associated with their investments.”

That's because, over time, free cash flow ratios help people gauge a company's ability to withstand cyclical
downturns or price wars.’

The foregoing arguments clearly support the famous phrase Cash is King. I opened up to you these valid
arguments just to make you realize that CFS has equal importance, if not the most important statement in
the eyes of the investors or shareholders. I am not implying also that Balance Sheet and Income Statement
ratios are inutile. Those ratios remain to be as relevant as CF ratios depending on the user of the
information or ratio and their respective objectives.

So what is the objective of Cash Flow Analysis (CFA)? To analyze the details of cash inflows and
outflows.

STATEMENT OF CASH FLOW

 A financial statement summarizing the operating, investing and financing activities of an enterprise.
 It provides information about the cash receipts (inflow) and cash disbursements (outflow) of the
entity during a particular period.
 Other purposes of the cash flow statement includes:
Provides information that enables users to evaluate the changes in net assets of an entity, its
financial structure, liquidity and solvency
Useful in assessing the ability of the entity to generate cash and cash equivalents.

CASH – cash on hand and demand deposits

FMGT 1013 – Financial Management | 2
 CASH EQUIVALENTS – short-term highly liquid investments that readily convertible to cash
(investments whose maturity is three months or less from date of acquisition)
 It enhances the comparability of operating performance by different entities

Contents of the Cash Flow Statement

1. Operating Activities – cash flow from the entity’s principal revenue producing activities. In other
words, this is the routine or day-to-day activities of the entity. The affected accounts are the working
capital (current assets and current liabilities). By the term itself, “WORKING” capital, these are the
primary source of ORGANIC CASH of an entity.

2. Investing activities – cash flow from acquisition and disposal of long-term assets and other
investments not classified as cash equivalent. Another activity affecting cash is investments.
Normally, it as a negative cash flow, meaning cash outflow is greater than inflow. Why? The entity
would necessarily build PPE for its day-to-day operations, shelling out some amount. They may
also invest in long-term form of investments such as stocks or bonds. What then is the inflow in
here? These are activities such as sale of PPE item that are no longer needed or obsolete. They
may also sell their long term investments when their value has greatly increased.

3. Financing Activities – cash flow from equity and borrowings of the entity. These are cash coming
from shareholders (issuance of shares) or borrowing (long-term debt). Included in here is the
distribution of dividend to shareholders or repurchase of share capital and settlement of obligations
to creditors.

FMGT 1013 – Financial Management | 3

Sample Cash Flow Statement taken from the illustrative case of our previous topic:

Pay attention how the net cash provided by operating activities (ncpoa) is computed. We call this in your
IA 3 as the Indirect Method. We start with the Net Income and adjust it to effect the non-cash transactions
(e.g., depreciation, unrealized gains/losses on trading securities), changes in the working capital (e.g.,
Increase/decrease in accounts receivable, inventories, prepayments, accounts payable, etc…), changes
in long term assets/liabilities that affected the net income (e.g., Increase/decrease in deferred tax assets,
long-term unearned revenues, etc…). This part is actually your struggle in IA 3, but let’s leave it there. Our
goal is to interpret the figures.

FMGT 1013 – Financial Management | 4

The following is a simple interpretation of the CFS above:

Have you noticed the difference between the changes in net income versus the change in ncpoa? The net
income had decreased in year 3 (from $3,689 to $2,125). Our initial analysis could be unfavorable. But if
we look closely on the ncpoa, it actually increased from $3,444 to $4,609. What does this present to us?
Can you identify from the composition of operating activities that created the increase in ncpoa? Game,
locate it! What’s your answer? Do not cheat!

Yes, you are correct! It is the COLLECTION OF PRIOR YEAR’S ACCOUNTS RECEIVABLE! In year 2,
AR had increased to 2,975 (meaning, they have uncollected sales in Year 2 amounting to 2,975) but were
collected in Year 3 that is why there is a decrease in AR amounting to 2,975. This significant amount
created the unprecedented increase in ncpoa. Consequently, this collection of AR helped the entity to
improve its cash position from a net decrease of $111 in Year 2 to $1,620 increase in Year 3.

Another notable observation is the decrease in cash of $111 in Year 2. Although the operations (ncpoa)
had contributed an increase of 3,444, it still resulted into a decrease of $111. Who is at fault?

Yes, you are correct! Two observable events created the decrease. First, the entity purchased significant
amount of intangibles amounting to $2,400 and the entity paid a large amount of dividend amounting to
$1,005. Is this bad? I don’t think so. The outflow of $2,400 is an investment for the long term and this could
create cash in the long run. The payment of dividends is a sign that the entity has the capacity to meet the
expectations of their shareholders. In fairness in Year 2, they still generated an increase in ncpoa
amounting to 3,444. And this matters a lot because it means they can create cash out of their operations.

In summary, the entity has strong cash position evidenced by its positive ncpoa over the two-year period
and on their way to future growth evidenced by their investment in intangibles while maintaining their
commitment to shareholders through distribution of dividends.

To elaborate CFA, we have the following discussion:

Cash flow Analysis

 Financial managers are responsible for planning how and when cash will be obtained and uses. It
is his goal to balance the cash available and the needs for cash over both short and long term.
 It is useful in appraising past performance, projecting the entity’s future direction, forecasting liquidity
trends and evaluating the firm’s ability to satisfy its debts at maturity.
 Questions that cash flow analysis can answer include:
1. Is the company generating sufficient positive cash flows from its ongoing operations to remain
viable?
2. Will the company able to meet its financial obligations to creditors?
3. What expansion activities took place and how were those financed?
4. Will the company be able to pay its customary dividends?
5. Why did cash decrease even though a net income was reported?
6. To what extent will the company have to borrow money in order to make needed investments?
7. What happened to the proceeds received from the issuance of capital stock?

What therefore is the implication of cash flow analysis?

1. Operating Activities – determines the adequacy of cash flow from regular or normal business
activities
2. Investing activities – identifies investments in other companies, either on assumption of control or
diversification. It can also indicate a change in future direction or in business philosophy.
3. Financing Activities – reveals the firm’s ability to obtain funds in money and capital markets as well
as ability to meet obligations.
o Debt financing carries greater risk because the firm must generate adequate funds to pay interest
cost and to retire the obligation at maturity.
o Reducing long term debt is desirable because it points to lowered risk.
o Financing through the issuance of share capital at attractive terms indicates that the investing
public is optimistic about the financial well-being of the business

The following table presents the various cash flow ratio that you may use in your analysis of a company:

FMGT 1013 – Financial Management | 5

One should recognize that companies can fail even though they report income. The difference between
net income and net cash provided by operating activities can be substantial.

Analysts increasingly use cash-flow-based measures of income, such as cash flow provided by operations
instead of or in addition to net income. The reason for the change is that they question the accrual-
accounting based net income.

Reference: Basics of Cash flows: https://www.youtube.com/watch?v=GkGdlgX3xYI

Cash flow ratios: https://www.youtube.com/watch?v=vzdNgaPhBMQ
https://www.journalofaccountancy.com/issues/1998/oct/mills.html

With this you are now ready to tackle working capital management.

*** END of LESSON ***

REFERENCES

Textbooks

1. Agamata, F. (2011), Management Advisory Services, GIC Enterprises Inc.

2. Brigham, E., Houston, J. (2013), Fundamentals of financial management. Cengage Learning Asia
Pte. Ltd
3. Cabrera, E.(2015) Financial Management: Principles and Applications, GIC Enterprises & Co., Inc.,
Manila
4. Salvador, S., Baysa, G, Gamboa, D., Geronimo, E. (2012) Fundamentals and applications of
financial management, Allan Adrian Books Inc.
5. William, J. (2015), Financial Management

FMGT 1013 – Financial Management | 6

Online Reference

1. https://www.extension.iastate.edu/agdm/wholefarm/html/c3-14.html
2. https://www.wallstreetmojo.com/cash-flow-analysis/
3. https://www.thebalancesmb.com/cash-flow-analysis-393050
4. https://www.arborinvestmentplanner.com/cash-flow-statement-analysis-purpose-components-
and-format/
5. https://corporatefinanceinstitute.com/resources/knowledge/accounting/statement-of-cash-flows/
6. https://www.youtube.com/watch?v=VKLEBDLeLLQ
7. https://www.vertex42.com/ExcelTemplates/cash-flow-statement.htm

FMGT 1013 – Financial Management | 7

 UNIVERSITY OF SAINT LOUIS
Tuguegarao City

SCHOOL OF ACCOUNTANCY, BUSINESS and HOSPITALITY

Short Term
A.Y. 2020-2021

ONLINE LEARNING MODULE

FMGT 1013- Financial Management

Lesson 4: Working Capital Management

REMINDERS:

This Week’s Time Table: (July 12 – 17, 2021)

The following shall be your guide for the different lessons and tasks that you need to accomplish. Be patient, read
them carefully before proceeding to the tasks expected of you. HAVE A FRUITFUL LEARNING EXPERIENCE 😊

Date Topics Activities or Tasks

July 12 Working Capital Management Read your learning module on cash flow
A. Nature and Scope of Working Capital analysis
July 13 Management Drill on Cash flow analysis
July 14 B. Importance of effective working Read your module on Working Capital
capital management to corporate Management
July 15 C. Cash and short-term Investments Drill on Working Capital Management
July 16 D. Receivables Management Submission of Quiz
July 17 E. Inventory Management Discussion of Quiz
F. Other items of Working Capital

Learning Prepare a scheme on how to improve working capital management

Outcomes:

LEARNING CONTENT

Last week we summed up our discussion about Financial Statement Analysis. This very helpful tool in Financial
Management helps us to dig into the status of businesses based on the reports that they’ve prepared. Also, we also
discussed Cash Flow Analysis to look into the different activities of the company and how important cash is in a
specific business.

For the past weeks, we looked into the financials of the businesses in a total point of view. This week, we are going
to scrutinize deeper the accounts that a company is dealing with in a daily basis. We are going to look into the different
items of a particular business that moves on a day-to-day basis. So if we try to look into these transactions and the
accounts that are affected when they are being done, we could summarize them in the table below.

Transactions done by a Business on a Daily Basis Accounts Affected

Buying of merchandise on account Inventory, Accounts Payable
Selling of merchandise on account Inventory Inventory, Accounts
Receivable
Payment of merchandise on account Accounts Payable, Cash
Collection of receivables Cash, Accounts Receivable

Thus, we can now say that working capital management deals with the current assets and current liabilities of a
business. These accounts normally fluctuate to a business to a daily basis.

In dealing with working capital management, there are different kinds of WORKING CAPITAL POLICIES. These
policies are guidelines of a business to the amount of working capital it should maintain given its operations. Also,
this is concerned with the level and source of financing of each level of current assets. The different working capital
policies are the aggressive, conservative and matching/hedging policy.

Aggressive approach on working capital suggests that temporary/seasonal working capital of the company as well
as half of the permanent working capital of the company is financed with short term funds. This is done because the
cost of short term funds is generally cheaper. However, because the company has few short term funds, it may have
an issue on liquidity. On the other hand, conservative working capital policy suggest that only half of the seasonal
working capital of the company should be financed with short term funds and half of it, plus permanent and fixed
assets be financed with long term funds. In this case, the company might be very liquid but because long term funds
are more expensive form of financing, the profitability of the company may be at stake.

The suggested working capital policy that businesses should use is the matching/ moderate/ hedging working capital
policy. This policy suggests that seasonal as well as permanent current assets must be financed by short term funds

FMGT 1013 – Financial Management | 1

and all your long-term or fixed assets must be financed by long-term funds. In this scenario, company may find a
proper balance of current assets and current liabilities as they become available or when debts become due.

Another thing that we should know before we dwell into the different accounts concerning working capital
management; we should know a firm’s OPERATING CYCLE and CASH CONVERSION CYCLE.

To illustrate the difference between the two, you may refer to the image below:

Based on the figure above, we can now define the two terms:

 Operating Cycle (OC) – the period between the purchases of inventory (raw materials) up to the collection of
cash from the sale of the finished goods made from it.
 Cash Conversion Cycle (CCC) – the period between the payments of inventory purchase up to the collection
of cash from the sale of finished goods.

The OC offers an insight into a company’s operating efficiency. A shorter cycle is preferred and indicates a more
efficient and successful business. A shorter cycle indicates that a company is able to recover its inventory investment
quickly and possesses enough cash to meet obligations. If a company’s OC is long, it can create cash flow problems.
CCC attempts to measure how long each amount of peso is tied up in the production and sales process before it gets
converted into cash received.

Consider this problem:

Emolga Corporation purchases merchandise on 20-day term. Goods are sold, on the average, 15 days after
they are received. The average age of accounts receivable is 45 days. Emolga pays its payable on due date.
How long is Emolga Corporation’s OC and CCC?

Based on the diagram, a company’ OC starts from the time raw materials are purchased. This is basically the age of
inventory or the number of days a finished good is converted into a receivable. This is also called Inventory
Conversion Period. In the problem, this is 15 days. Then we are going to add the number of days that it would take
the said receivable to be converted into cash. This is also called the age of receivables or day sales outstanding
(DSO). DSO is also called Receivables Conversion Period. In case of this problem, it is 45 days. So we are going to
add the age of inventory and the age of receivables to get the company’s OC. Therefore our answer for Emolga
Corporation’s OC would be 60 days (15 days + 45 days).

To compute the CCC, we should deduct from the company’s OC the time that it purchased the inventory up to the
time that the company has paid its payable. This is called the company’s Payables Deferral Period or the age of
payables. In this case, the problem stated that the company is purchasing inventory on 20-day term and also pays
on due date. Therefore, the company’s age of payables is 20 days. Subtract 20 days from the company’s 60 day OC;
we are now going to get the company’s CCC is which 40 days

CASH MANAGEMENT

After knowing the reasons to study working capital management, the different working capital policies and how to
compute for the firm’s operating cycle and cash conversion cycle, we are now going to learn how to manage the
different components of our working capital. We are going to start on cash management. There is a famous maxim
in financial management that states “Cash is the King, not profits.” In order to discover what underlies that maxim,
we should learn how to manage our cash.

According to John Maynard Keynes, there are three reasons why a company should hold cash, the following are the
reasons:

FMGT 1013 – Financial Management | 2

Optimal Transaction Size

In a typical business, it should be noted that all funds must be managed properly. For example, if a company has
excess cash, it should invest this amount to marketable securities so that the interest income it will earn will not be
foregone. If the company failed to invest their excess cash to marketable securities, they will be incurring the so-
called CARRYING COST of CASH. This means that because you just ‘carry’ your excess funds and not invest it, the
income will be converted to opportunity cost. To take advantage of this interest income, a business must all its cash
to marketable securities. However, if a company will be needing cash for its daily transactions, it must convert its
marketable securities back to cash in order to support its transactions motive of holding cash. However, banks
normally charge businesses with a fee when they are converting marketable securities into cash. This is called the
CONVERSION COST of CASH.

The question now is … how much cash must I carry so that I can balance the carrying cost and conversion
cost of cash?

William Baumol, an economist who introduced the concept of economic order quantity, observed that this could be
applied to cash management. He said that companies must determine a specific ‘size’ of marketable securities that
should be converted to cash to finance the needs of a company in order to maintain a balance between the carrying
cost and conversion cost of cash. This is now called as the OPTIMAL TRANSACTION SIZE (OTS). The formula for
OTS is as follows:

Float Management

When a company is using the imprest system for its transactions to suppliers and customers, it may encounter delays
in the collection and disbursement of cash. These delays are called FLOATS. The 2 main types of float are collection
float and disbursement float.
1. Collection float refers to the time delay when customer pays a receivable until it credited to the company’s
bank account. Sound financial management policy states that collection float should be reduced so that we
can accelerate collections. One good strategy that a company may implement is the LOCKBOX system
wherein the customers directly send their payments to a post-office or a bank facility. In this case, the
depository bank of the company will be the one to process the payment thus reducing the time the company
must undertake to process the payments of the customers.
2. Disbursement float refers to the time delay when the company sends a payment to its supplier until the
payment is credited to the bank account of the supplier. A company would like to have a longer disbursement
float considering that if its cash payment is not yet credited to the bank of the supplier, it still earns interest
income in its favor. If a company wants to make longer disbursement float, it could implement a REMOTE
DISBURSEMENT FACILITY. In this method, the company makes a check payment from a bank that is far
away from the supplier. Because of this, the supplier will be forced to pass through the check clearing process
and not encashing it thereby slows down disbursement.
3. Other types of float:
a. MAIL FLOAT – time between the when a payment is made until it is mailed to the payee.
b. PROCESSING FLOAT – time between when a payment is received until it is ready for deposit to the
bank.
c. CLEARING FLOAT – time between when a check is deposited to the bank until it is cleared and credited
to the depositor’s bank account.

FMGT 1013 – Financial Management | 3

ACCOUNTS RECEIVABLE MANAGEMENT

After dealing with Cash Management, we are now ready to learn how to manage our accounts receivables. As we
all know, accounts receivables are open debts to us by our customers and thus has a greater risk of non-collection
because no collateral is made by the customers to back-up these debts. It is therefore needed that we should know
how to properly manage these accounts receivable to the company’s advantage and how changes to its balance may
affect the over-all profitability of the firm.

The first thing that we should take into consideration in A/R management is how to monitor its balance. By doing so,
we can see our exposure to our customers and how much is our investment in A/R. There are two things that we
could use to monitor our A/R balance. First is by using an AGING SCHEDULE to determine if these accounts are still
current as to their status on a receivable balance basis. Another thing that we can consider is to determine the age
of our receivables also known as Day Sales Outstanding (DSO). By computing the DSO, when can compute our A/R
balance. We can use the formula below to compute our A/R balance:

Accounts Receivable Balance = Daily Credit Sales x DSO

The second thing that we should do in doing A/R management is to look into the CREDIT POLICY of the company.
This is composed of the company’s credit standards, credit terms and collection policy.

Credit standards are guidelines followed by a firm in giving credit sales to its customers. This determines the
‘worthiness’ of a customer to be receiving a credit line from the company. Naturally, there is what we call the Five C’s
of Credit. Please take a look on it and how it is used to determine the credit standards of a custom

When we talk about credit terms, we are looking on how long are willing to hold to our A/R. This also determines
when a receivable becomes past due or are there discounts we are willing to extend to motivate payment. Collection
policy on the other hand will state how we are going to collect our A/R so that we can use the cash from it to other
opportunities.

In managing our A/R, we should also be aware of the difference between the A/R balance of the company and the
Investment in A/R of the company. A/R balance refers to the amount presented in the financial statement of the firm
with regard to its receivables. On the other hand, Investment in A/R refers to the relevant cost that the company has
invested to generate its A/R balance. Normally, this is the variable cost portion of the A/R balance.

Lastly, in order for us to know the over-all impact of changing the components of A/R on the profits of the firm, the
following items are also considered in doing our analysis:
a. Change in the amount of discounts taken
b. Change in the amount of bad debts
c. Change in the costs that will be incurred relating to collection
d. Changes in the carrying cost relating to A/R (this is the opportunity cost of not investing in other instruments
because the company chose to invest in A/R)
e. Effect of taxes

INVENTORY MANAGEMENT

Inventories are the prime source of income of merchandising and manufacturing entities. These assets are very
important to the said businesses because if they are not able to manage properly these resources, it may lead to
some serious problems.

Inventory management has been discussed in your course Cost Accounting and Control thus, we are to dwell only
on some salient concepts of inventory management in the perspective of financial management. This will just serve
as some sort or review for you so that there would be continuity of learning. The following are the concepts.
FMGT 1013 – Financial Management | 4
 1. Balance between carrying cost and ordering cost

CARRYING COST – all costs associated when a company decides to carrying investments in inventories.
This includes storage costs, loss due to theft or obsolescence, opportunity cost forgone (interest) because
the company decides to carry inventories and insurance costs.

ORDERING COST – all cost associated when a company orders inventories. This includes mainly
transportation and freight costs.

We know that these two costs are like 2 kids playing seesaw. Kapag tumataas ang isa, bumababa ang isa.
And because, these are cost, we would like to keep them at a low level. So, kung na-try ninyo maglaro ng
seesaw nung bata kayo, alam naman natin na di ka makakapaglaro ng seesaw na parehas kayong nasa
baba o di naman kaya kayong dalawa ay nasa taas.

The question now is, how I can minimize these costs. The answer would be, to get the order quantity that will
give you the same amount of carrying cost and ordering cost. And we know that this is the ECONOMIC
ORDER QUANTITY or the EOQ. The formula of this is just like the computation of OTS in cash management.
If a company will purchase every time at the ‘optimum order size’ or the EOQ, its carrying and ordering cost
will be at equilibrium which is also the lowest possible cost for the company.

2. Balance between carrying cost and stock-out cost

Just like what we discussed in the first concept, carrying cost is incurred when a company decides to invest
in inventories. However, if the company decides to just keep the funds in its bank account to minimize its
carrying cost, it may incur stock-out cost or simply the lost margin it can earn because the inventory it sells
is not available. Sa madaling salita, ang carrying cost at stock-out cost ay para ring mga bata na naglalaro
ng seesaw.

To address the issue on how can a company avoid stock-out costs, it should compute its SAFETY STOCK
or BUFFER STOCK. This can be computed by multiplying the daily usage of a company to the number of
days its supplier can go on delay (MAXIMUM LEAD TIME less NORMAL LEAD TIME). By keeping a desired
level of safety stock, the company will be able to balance the opportunity costs on carrying inventory and on
running out of stock.

3. The level wherein the company needs to restock or REORDER its inventory. This is what we call as the
reorder point. This level of inventory signals the company when to reorder its stocks. This can be computed
by multiplying its daily usage by the maximum lead time.

SHORT EXAMPLE:
A company has an EOQ of 500 units, daily usage of 5 units, normal lead time of 10 days and maximum lead time
of 14 days. To compute its safety stock we are going to multiply its daily usage of 5 units by the number of days
the supplier can go on delay which is 4 days (14 days minus 10 days) which is equal to 20 units. To compute for
its reorder point, we are going to multiply 5 units by 14 days (maximum lead time) to arrive at 70 units reorder
point. Given this scenario, the company will have for example no beginning inventory so it needs to purchase.
How many? The answer is 500 units because it is the EOQ. Next, the company will operate and sell until it will
reach the level of 70 units at which the company needs to order. Because it will NORMALLY take the supplier 10
days to deliver the stocks, the company will still have enough inventories to operate (5 units x 10 days = 50 units).
However, if unforeseeable circumstances will happen and the supplier will be late up to 14 days, the company
still has SAFETY STOCK to operate (20 units safety stock). So when the supplier will now deliver the stocks on
the 14th day, the company will now have again ample inventory to operate.

The question is, on the 14th day, how many units will the company have in its inventory assuming it is already at
the end of the company’s daily business schedule and the inventory has just arrived?

The answer is 500 units. Why? Because the company will order at the EOQ level as wise and sound management
practice suggest. It is not 70 units (REORDER POINT) because this level only signals when to order.

SHORT TERM FINANCING DECISIONS

This topic deals mainly on current liabilities, i.e., accounts payable, short term debt, as one of the components of our
net working capital or simply working capital. Our primary objective here is to determine the costs of borrowing money
in the short-term in order to finance the needed amount for the operating or short-term needs of the company. When
we speak of “costs of borrowing money”, it does not pertain to the principal amount borrowed. It is the cost of using
others’ money. In a layman’s term, we refer to INTEREST. Sir, even open account (i.e., accounts payable) may costs
of borrowing? This is a LOGICAL QUESTION. In IA, we do not journalize any “Interest Expense” pertaining to
Accounts Payable. Right? But in this topic, you will discover that there is an implicit interest associated to accounts
payable or in Finance we call it Trade Credit (a short-term debt as a result of the entity’s ordinary course of business
activity). This implicit costs are relevant in financial decision making.

Later, when we finish this topic, we will discuss the costs of borrowing money or raising funds in the long-term. So,
basically, we will devote our time for the rest of the final term in understanding the concepts behind financing in the

FMGT 1013 – Financial Management | 5

short-run and financing in the long-run and applying them through various problem solving scenarios. Hence, for the
remaining days for this course, please remind yourself to keep the momentum and maintain a healthy pacing.

Short-term financing focuses on the current liabilities portion of the company’s balance sheet and on the way
changes in current liabilities affect a company’s net working capital.

The formula for net working capital is Net Working Capital = Current Assets – Current Liabilities.

Note: Current liabilities are those that need to be paid or settled within 12 months or during the operating
cycle, whichever is longer

The financial structure of a company is the composition of its sources of financing.

Financial structure consists of:

1. current liabilities;
2. long-term debt;
3. Retained earnings and common and preferred equity (in other words, everything on the balance sheet except
for assets).

“Debt” includes many variations of debt: long-term, short-term, convertible, secured, unsecured, callable, non-
callable, and so forth.

“Equity” consists of common stock, preferred stock, retained earnings, and other balance sheet lines in the equity
section. All the balance sheet lines in the equity section with the exception of the preferred stock lines are common
equity.

We will discuss some of the debt and equity items later in the topic on Cost of Capital.

Here we will discuss short-term credit. As with all working capital finance decisions, the type of short-term credit a
firm will choose depends on a cost-benefit analysis of the different options. Here, the “costs” of the different sources
of financing are the differences in the rates of interest that the company must pay on each financial as well as other
costs associated with that particular type of credit (for example, dealer fees or warehousing fees).

TIP: The most desirable financing will be the option that results in the lowest cost of borrowing, given the
associated risks and benefits of that type of financing.

First we will look at the main sources of short-term financing – trade credit, short-term commercial bank loans and
the factoring of receivables. After that we will look at some other sources of short-term financing

Trade Credit

We talked about trade credit in the topic of Cash Management, but we will mention it again here since accounts
payable are a current liability. If vendors give a cash discount for paying within a discount period, payments should
be made within the cash discount period, if taking the discount results in a lower cost of funds than not taking the
discount. To review, the cost of not taking the cash discount offered for early payment is calculated as follows:

If the cost of not taking the discount is HIGHER than the cost of short-term borrowing, the company should take the
cash discount and pay within the discount period, even if it needs to borrow from a bank to do so (as long as the
company is creditworthy, that is). The cost of not taking the discount is generally greater than the company’s cost of
short-term borrowing, so making the payments within the cash discount period is advantageous.

Short-Term Commercial Bank Loans

Commercial banks offer many different types of loans to business borrowers and you need to be familiar with what
the different terms are and also how the interest is calculated under the different arrangements.

Short-term bank loans are perhaps the most common source of short-term financing used by companies, after trade
credit. A short-term loan is a loan that matures in less than one year. A short-term working capital loan is usually self-
liquidating. A self-liquidating loan is a loan that is repaid from the liquidation of inventory and accounts receivable.
FMGT 1013 – Financial Management | 6
It is used to finance seasonal needs for cash to build up inventory ahead of a busy season. When the inventory is
sold and the accounts receivable from its sale have been collected, the cash flow received used to pay off the short-
term loan.

Commercial loans may be secured or unsecured.

• A secured loan is one for which the borrower has pledged an asset as collateral. If the borrower defaults
(does not repay the loan), the lender can take the collateral and sell it and use the proceeds to repay the
loan. Collateral for a loan is considered a secondary repayment source.

Short-term debt is often secured by a floating lien on the borrower’s accounts receivable and inventory. A
floating lien is a security interest in property that is constantly changing its structural makeup, such as
accounts receivable and inventory. Accounts receivable are constantly being paid off and re-placed with new
ones, and inventory is constantly being sold and replaced with new inventory. Whatever specific accounts
receivable or inventory items are included on any day in the classification “accounts receivable” or “inventory”
that is pledged as collateral serve as the security for the loan, and those specific items will be different from
day to day.

Receivables that are pledged as collateral are “given” to the bank as a guarantee for the repayment of the
loan. If the borrower defaults, the bank will instruct the borrower’s customers to send their payments on their
accounts directly to the bank instead of to the borrower. The bank will apply the payments to the borrower’s
loan balance until the principal and all accrued interest on the loan have been repaid.

The amount a bank will lend against any collateral depends upon its lending policies and the amount of risk
it perceives. If the collateral is receivables and there is little risk that the receivables will prove to be
uncollectible or that the borrower will default, a bank may lend up to 80% of the receivables taken as
collateral. The greater the risk the bank perceives, the less the bank will loan against the collateral.

• An unsecured loan has no collateral backing it and thus if the borrower defaults, the lender has no secondary
repayment source. Everything else being equal, the interest rate on an unsecured loan will be HIGHER than
the interest rate on a secured debt, to compensate the lender for the greater risk of loss

Interest on a Short-Term Bank Loan

Two issues here are the calculation of the interest that needs to be paid on a bank loan and calculation of the effective
interest rate of the loan

The effective interest rate is the percentage that is really paid on the loan based upon the amount of interest paid
and the actual amount of funds received. The effective interest rate is what is most important to the company in
making a decision regarding what financing source to use because it eliminates any distortions caused by
compensating balances, withheld interest or other items discussed below.

Banks calculate interest using various methods. Simple versus Compound Interest

In regular simple interest, the interest is calculated only on the original principal amount. Interest on short-term
notes— 90-day notes, for example—is usually simple interest. If the note is for $10,000 and the simple interest rate
is 5%, at the end of 90 days the borrower will repay the $10,000 principal plus $125 interest, calculated as $10,000
× .05 ÷ 360 × 90. In other words, the accrued interest each day is not added to the principal and thus the borrower
does not pay interest on accrued interest during the term of the note.

The following formula can be used to find the simple interest rate for loans with terms of up to and including one year
when the amount of interest charged and the term are known:

The 360 or 365 days divided by # of days outstanding in the above formula is necessary when the loan term is less
than one year. Multiplying by 360 or 365 and dividing by the number of days the loan is outstanding annualizes the
interest rate.

Sometimes a bank will use a 360-day year and sometimes it will use a 365-day year, though 360 days is used more
commonly for commercial loans. Hence, we will use 360 days when a certain problem is silent as to the computation
of interest

When we know the interest rate, the term and the amount borrowed, we can use the following formula to find the
amount of interest that will be due:

Interest Charged = Principal × Annual Interest Rate ÷ 360 or 365 × # of Days Outstanding

FMGT 1013 – Financial Management | 7

Example of simple interest:
Using 360 days to annualize the interest, a $10,000 loan at 6% per annum interest for 90 days would require an
interest payment of $150 ($10,000 × .06 ÷ 360 days in a year × 90 days the loan is outstanding). At the end of 90
days, the borrower repays the $10,000 principal plus $150 interest, for a total of $10,150.

The amount that would be charged if the loan were outstanding for a full year would be 6% of $10,000, or $600. But
since the loan is outstanding for only 90 days out of 360 days, the amount of interest due would be 90/360, or one-
fourth (25%) of the amount that would be charged for a loan outstanding for a full year.

To calculate the interest rate if we have the amount of interest charged, we use the first formula:
Interest Rate = ($150.00 ÷ $10,000) × (360 ÷ 90) = .06 or 6%

Simple interest contrasts with compound interest, in which interest is charged on the principal plus any accumulated,
unpaid interest

Loans with Compensating Balances

If a loan has a compensating balance requirement, the borrower is required to keep some minimum balance in an
account with the bank. The account is usually a non-interest bearing account, although in some cases the account
may pay some interest.

The compensating balance gives the bank some assurance that if the borrower does not fulfill the terms of the loan,
some cash will be available to the bank that it can take to partially offset the amount due on the loan (partially pay
down the interest and/or principal).

TIP: The amount of the cash required may be a percentage of the amount of the loan or it may be a fixed amount. In
any case, the requirement to keep a minimum amount on deposit with the bank is called a compensating balance
requirement, and it raises the effective rate of interest paid by the borrower, since not all of the borrowed funds
are available.

This amount that is held as a compensating balance reduces the amount of the loan that is available for use but not
the amount of interest paid, as interest is calculated on the full amount of the loan. This greater interest rate
compensates the bank for services provided and results in greater profitability for the financial institution.

Sometimes, funds kept as a compensating balance can be withdrawn for short periods of time as long as a certain
average balance is maintained. When a company is negotiating a compensating balance with a bank, it is better to
use an average compensating balance because for some periods during the month the amount in the account may
be below the required amount as long as the average is above the limit. This flexible average compensating balance
can then be used as a cushion for the days when cash demands are greatest and expected deposits are not received.
With an absolute compensating balance, the company’s use of the compensating cash for short periods is not allowed
because the minimum must be maintained at all times.

The effective interest rate on loans requiring compensating balances equals net interest cost divided by the effective
amount of cash received (the amount of new funds the company has available as a result of the loan). It is calculated
as follows:

FMGT 1013 – Financial Management | 8

When there is a compensating balance, it is very possible that the company already has some cash in the bank and
therefore already has some of the compensating balance. Therefore, in the calculation of total cash received in the
denominator, we will subtract only the balance that the company needs to add to its account at the bank in order to
meet the compensating balance requirement.

Loans with Discounted Interest (INTEREST IS DEDUCTED IN ADVANCED)

When a loan’s interest is discounted, the bank deducts the full amount of the interest that will be due on the loan or
note in advance, and the interest is withheld and not disbursed to the borrower.

Having the interest discounted and withheld results in a higher effective rate than simple interest because the
borrower receives less than the face value of the loan but has to repay the full amount of the loan, effectively paying
interest on the entire amount.

In effect, discounted interest is similar to a compensating balance in that it reduces the amount of funds that are
received by and available to the borrower; therefore, raising the effective rate of interest on the loan because the
interest is paid on the full amount. The following formula can be used only for loans with terms of exactly one year.

However, because the bank is guaranteed receipt of the interest portion of the repayment, the overall risk to the
lender is reduced. Therefore, the lender should offer the funds at a lower stated rate of interest

Loans with a Compensating Balance and Discounted Interest

If a compensating balance is also required on a loan that has discounted interest, then the amount of available funds
is further reduced, causing the effective interest rate to be even higher.

Installment Loans

An Installment loan requires periodic payments, and each payment includes both the repayment of some of the
principal and the interest owed on the outstanding balance.

Installment loans are often used to purchase vehicles.

The periodic payments constitute an annuity in which the amount borrowed is equal to the present value of all of the
payments on the loan

FMGT 1013 – Financial Management | 9

Other Sources of Financing

The other sources of short-term financing that you need to be familiar follow.

Secured Sources of Financing

 A revolving line of credit is one that is contractually available to the borrower. It is usually secured by a first
lien on the borrower’s receivables and possibly the borrower’s inventory as well. The borrower’s customers
send their payments directly to the bank, and the bank applies them to the outstanding line of credit balance.
Whenever the borrower needs funds, it borrows against the line.

Interest on a revolving line of credit is usually charged on the outstanding balance against it.

For example, a line commitment might permit borrowings up to $500,000, but the actual interest charged will
be on the amount drawn against the line. If $250,000 is outstanding on the line, interest will be charged on
only the $250,000 outstanding. The bank usually charges a commitment fee on the un-used portion of the
commitment.

The effective annual interest rate on a revolving line of credit is calculated as follows:
Average balance outstanding against the line of credit
× Annual Interest rate
= Total interest cost for one year
+ Commitment fee on unused balance, if any
= Total cost
÷ Average balance outstanding against the line of credit less any compensating balance
= Effective Annual Interest Rate

• Warehouse financing is a source of financing in which something that is held at a third party warehouse is
used as the collateral for a loan. In many cases inventory is used as the collateral, and it is held by the
warehouse, which is acting as the agent of the creditor (the bank). The bank will usually hold the warehouse
receipts as evidence of its claim to the items in the warehouse. This is called a terminal warehouse receipt.

In a field warehouse receipt, the inventory is kept at the premises of the borrower and the inventory is then
released as needed for sale.

• In inventory financing the creditor buys and retains title to the inventory. The debtor then acts as his trustee
in the selling of the inventory and also assumes the risk of loss of the inventory. Inventory financing enables
a company to buy inventory when it does not have the cash to pay for it. However, because the money is
FMGT 1013 – Financial Management | 10
 essentially being loaned to the company, the interest that needs to be paid to the bank reduces the profit
from the sale of the inventory.

• A transaction loan is a loan made for a specific purpose such as a mortgage loan made for the purchase of
real estate or a term loan made for the purchase of equipment. Usually the loan is se-cured by the purchased
item and is disbursed directly to the seller of the item so the lender can be certain that the loan is being used
for its designated purpose.

• A chattel mortgage is a loan that are secured by movable, identifiable personal property (such as a car).

Unsecured Sources of Financing

• Trade credit (accounts payable), mentioned earlier, is a source of credit that arises from the process of
purchasing an item on credit, and it is a major source of financing for many small and medium sized
businesses. Because trade credit is created automatically at the time of the purchase, it is called a
spontaneous source of financing. Unfortunately, the interest that is paid on trade credit is often very high and
because the creditor (seller) sets the terms, the terms may not be very advantageous to the buyer. (See
previous computations of the cost of foregoing a cash discount.)

• Repurchase Agreements are sales of governmental securities by a dealer who also has agreed to repurchase
them at a specific time at a specific price. Because of the way repurchase agreements are structured, it is
essentially a guaranteed, short-term loan for the dealer who sells and then re-purchases the securities. To
the purchaser, it is a short-term investment.

• Accrued expenses (including wages and taxes) may also be used as a source of financing. Expenses such
as salaries and interest are accrued before they are paid and the company has use of these funds until the
end of the month, quarter or whenever the payment is required to be made. Accrued expenses are another
source of spontaneous financing since they occur automatically for the company.

• A line of credit is an amount of money that is available to a company at a bank. It is essentially a preapproved
loan that the company may access as it needs the money. The line of credit is usually approved for one year
at a time. Under this arrangement, interest is not paid until the money is actually borrowed. An unsecured
line of credit is generally to be used only for short-term, seasonal needs; thus there is usually a requirement
that the line be “cleared,” or paid down to zero, for at least 30 days each year, in order to show the bank that
the company is not using the line for long-term financing needs. A line of credit such as this might be
unsecured, or it might be secured with a lien on the borrower’s accounts receivable and inventory. It is
different from a revolving line of cred-it, however, because it does not involve any requirement that the
borrower’s customers send their payments directly to the bank for credit on the line. The borrower collects
its own receivables and is responsible for paying down or paying off the line balance when it has the cash to
do so.

• Commercial paper is another source of unsecured financing. Commercial paper is a short-term, unsecured
promissory note issued by a large firm. Commercial paper is usually a cheaper form of financing for large
firms than a commercial loan. Commercial paper is a marketable security, though it does not have an active
secondary market. Its secondary market is very small because the term of commercial paper is very short
and buyers of commercial paper usually purchase it with a maturity that coincides with when they expect to
need their money back from their investment. Therefore, most buyers of commercial paper hold it until it
matures. However, if an investor in commercial paper needs the money from the investment back before the
maturity date, the investor can usually liquidate the commercial paper. The commercial paper can be sold
back to either the issuer it was purchased from, if it was purchased directly from the company that issued it,
or to the dealer it was bought from if bought from a dealer.

• Bankers’ acceptances (BAs) are another source of financing, as discussed in the section on marketable
securities management. A bankers’ acceptance is not a secured debt even though the bank guarantees it,
because there is no specific asset supporting the note.

*** END of LESSON ***

REFERENCES

Textbooks

1. Agamata, F. (2011), Management Advisory Services, GIC Enterprises Inc.

2. Brigham, E., Houston, J. (2013), Fundamentals of financial management. Cengage Learning Asia Pte. Ltd
3. Cabrera, E.(2015) Financial Management: Principles and Applications, GIC Enterprises & Co., Inc., Manila
4. Salvador, S., Baysa, G, Gamboa, D., Geronimo, E. (2012) Fundamentals and applications of financial
management, Allan Adrian Books Inc.
5. William, J. (2015), Financial Management

Online Reference

FMGT 1013 – Financial Management | 11

1.

FMGT 1013 – Financial Management | 12

 UNIVERSITY OF SAINT LOUIS
Tuguegarao City

SCHOOL OF ACCOUNTANCY, BUSINESS and HOSPITALITY

Short Term
A.Y. 2020-2021

ONLINE LEARNING MODULE

FMGT 1013- Financial Management

Lesson 5: Leverage and Capital Structure

This Week’s Time Table: (July 19 - 24, 2021)

The following shall be your guide for the different lessons and tasks that you need to accomplish. Be patient, read
them carefully before proceeding to the tasks expected of you. HAVE A FRUITFUL LEARNING EXPERIENCE 😊

Date Topics Activities or Tasks

July 19 Leverage and Capital Structure Read your books and learning modules
July 20 A. Break-even analysis, Operating Discussion of lesson
July 21 Leverage and Financial Leverage Submission of Drill
July 22 B. Tools of Capital Structure Discussion of drill
July 23 Management Submission of Quiz
July 24 C. Making Capital Structure Decisions Discussion of Quiz
in Practice
Learning Measure the operating leverage and financial leverage of a firm and evaluate the best capital
Outcomes: structure

LEARNING CONTENT

Our discussion on Financial Statements Analysis gave us a bird’s eye view of a company’s journey. Financial
statements serve as a historical documentation about the entity’s financial health or condition, how the entity scored
during a certain period, and how sound their cash flow position was. In this topic, we made used various metrics to
assess the overall position, performance, and cash flows of the company. However, we realized that financial
management does not end on assessment. Above all others, a company must seek for continuous improvement
particularly in their operation. Hence, we discussed the importance of managing our current assets through various
concepts and applications.

Working capital management is guided by the principle of balancing profitability and liquidity. It is a trade-off decision
whether a company should forego liquidity and aim for profitability or vice versa. That is why Accounts Receivable
Management and Inventory Management came into limelight to explore their complexity in order to achieve the
balance. Having an optimal balance of these two important areas (liquidity and profitability) should be of utmost
consideration. The importance of cash flow is also emphasized here where a company would implement policies to
accelerate the inflow of cash and to delay outflow of cash.

The entity inevitably requires financing parts of their operations in order to maximize their profitability. That is why our
discussion on short-term financing decisions. This topic essentially discusses on how to manage our current liabilities
to attain an optimal balance of profitability and liquidity. Also, it paved the way on familiarizing ourselves on various
sources of short-term financing and computing their relevant costs vis-à-vis the benefits that may be derived from
these sources.

After our discussion on the current items of the balance sheet, we look also on the non-current items. The
discussion on non-current items include the following:
a. Cost of Capital (pertaining to the capital structure – Noncurrent Liabilities and Equity); and
b. Capital Budgeting (pertaining to Noncurrent Assets)

We start our discussion by understanding the concept of CAPITAL STRUCTURE.

What is CAPITAL STRUCTURE?

- This is the mix of the long-term sources of funds used by the firm.

What are these sources?

These could be in the form of
a. Long-term debt, i.e., Bonds
b. Equity, i.e., Common Shares and Retained Earnings
c. Hybrid, i.e., Preferred shares (Has a characteristic similar of both common stock and bonds)

What is the objective of this topic?

- To maximize the market value of the firm through an appropriate mix of long-term sources of funds

FMGT 1013 – Financial Management | 1

What is the difference between FINANCIAL STRUCTURE and CAPITAL STRUCTURE?
- The financial structure of a company is the composition of its sources of financing, i.e., Short-Term and
Long-Term
- Financial structure consists of:
1. current liabilities;
2. long-term debt;
3. retained earnings and common and preferred equity
(in other words, everything on the balance sheet except for assets).

Therefore, CAPITAL STRUCTURE = Financial Structure – Current Liabilities

After knowing the different sources of long-term financing, we are now ready to discuss the associated COST OF
BORROWING or USING these funds. In Finance language, we call it COST OF CAPITAL (Capital in this
perspective represents all sources of long-term financing.)

Cost of Capital
 The rate of return that a business enterprise must offer on its securities in order to maintain its market value
 The rate of return, that must be received by the firm on its investment projects, to attract investors for
investing capital in the firm and to maintain its market value.
 The cost of using funds; it is also called
 Hurdle rate
 Required rate of return
 Cut-off rate
 A weighted average cost of various capital components, i.e. sources of finance, employed by the firm such
as equity, preference or debt.

Importance of Cost of Capital

 It helps in evaluating the investment options, by converting the future cash flows of the investment avenues
into present value by discounting it.
 It is helpful in capital budgeting decisions regarding the sources of finance used by the company.
 It is vital in designing the optimal capital structure of the firm, wherein the firm’s value is maximum, and the
cost of capital is minimum.
 It can also be used to appraise the performance of specific projects by comparing the performance against
the cost of capital.
 It is useful in framing optimum credit policy, i.e. at the time of deciding credit period to be allowed to the
customers or debtors, it should be compared with the cost of allowing credit period.

Computation of Cost of Capital

Source Capital Cost of Capital

Creditors Long-term debt After-tax rate of interest
Stockholders:
Preferred Preference shares Preference dividends per share
Current market price or net issuance price

Common Common or ordinary shares Capital Asset Pricing Model (CAPM) or

Dividend Growth Model (DGM)

Computation of Cost of Long-term Debt

 The minimum rate of return required by suppliers of debt.
 The cost of debt is the effective interest rate a company pays on its debts. It’s the cost of debt, such as bonds
and loans, among others. The cost of debt often refers to before-tax cost of debt, which is the company's
cost of debt before taking taxes into account. However, the difference in the cost of debt before and after
taxes lies in the fact that interest expenses are deductible.

Example: Jervi Corporation is planning to issue P20M bonds at an effective interest rate of 10%. The company pays
income tax at a rate of 30%. What is the cost of debt capital?

The cost of debt is equal to the after-tax rate of interest. Cost of debt = 10% x (1-0.30) = 7%
Since interest expense is tax-deductible, the debt is calculated on an after-tax basis.

Computation of Cost of Ordinary Shares

The cost of common stock is common stockholders’ required rate of return. Companies can raise new common
equity in two ways: by a new common stock issue or by retaining and reinvesting previous earnings.
 Ordinary equity share does not represent a contractual obligation to make specific payments thus making it
more difficult to measure It costs more than the cost of bonds or preferred share.
 Business firms raise equity capital externally through the sale of new ordinary equity shares and internally
through retained earnings.

FMGT 1013 – Financial Management | 2

  Retained earnings represent the portion of accumulated after tax profits that the firm has not distributed to
its shareholders, thus is reinvested in itself
 Cost of existing ordinary equity share is the same as the cost of retained earnings. No adjustment is made
for flotation cost
 The cost of new ordinary equity share is higher than the cost of retained earnings because of the flotation
costs involved in selling new ordinary shares which reduce the proceeds to the firm.

Two Methods:
1. CAPITAL ASSET PRICING MODEL (CAPM)
The cost of equity is more complicated since the rate of return demanded by equity investors is not as clearly
defined as it is by lenders. The cost of equity is approximated by the capital asset pricing model as follows:

The risk-free rate (RF) is the rate of return an investor could receive on an investment in a riskless asset,
approximated by the return on very short-term Philippine Treasury bills.

The market rate of return (RM) represents the required return on the average stock in the market, approximated
by a benchmark index such as the S&P 500.

(RM – RF), or the difference between the market’s required rate of return and the risk-free rate, is the risk premium
for the market, or the systematic risk premium. The risk premium for the market is included in the required rate
of return for a security or portfolio of securities. The market risk premium measures the additional return over and
above the risk-free rate that investors demand in order to move investments into the stock market in general (not
to any specific security).

The beta coefficient (β) represents the correlation between the historical returns of a given stock vs. the historical
return of the market as a whole or the average stock in the market as represented by some index of market
activity such as the S&P 500. The beta coefficient of a stock is a measure of the sensitivity of the investment’s
returns to changes in the market’s returns.
Example: If the price of an individual stock rises 10% and the stock market 15%, the beta is 1.5

Beta (β) is used in the CAPM formula to estimate risk, and the formula would require a public company's own
stock beta. For private companies, a beta is estimated based on the average beta of a group of similar, public
firms. Analysts may refine this beta by calculating it on an unlevered, after-tax basis. The assumption is that a
private firm's beta will become the same as the industry average beta.

CAPM (Cost of equity) = Rf + β(Rm−Rf)

where:
Rf=risk-free rate of return
Rm=market rate of return

β = Beta coefficientβ(RM – RF), or the beta coefficient for a particular security multiplied by the market risk
premium, is the risk premium for that particular security. It is the risk premium that investors require to purchase
that stock.

Example: Assume a beta of 1.5, a market rate of return of approximately 16% and an expected risk-free rate
of 12%, what is the cost of equity?
CAPM (Cost of equity) = Rf + β(Rm−Rf)
= 12% + 1.5(16%-12%
= 18%

2. THE DIVIDEND GROWTH MODEL

The Dividend (Gordon) Growth Model (also called the Dividend Discount Model or Constant Growth Model) uses
the dividends per share, the expected growth rate of the dividends, and the market price of the share in order to
estimate the cost of retained earnings as a percentage of the market value. For the company to support a decision
not to distribute its profits, it must be able to generate a greater return than the amount calculated by the dividend
plus a growth rate in the level of dividends paid.

The Dividend Growth Model incorporates a very important assumption—that the dividend will increase by the
same percentage each year.

FMGT 1013 – Financial Management | 3

Computation of Cost of Preference Shares

The cost of preference share capital is apparently the dividend which is committed and paid by the company.
 No tax adjustment is made when calculating the cost of preferred stock because preferred dividends are not
deductible; no tax savings are associated with preferred share.

WEIGHTED AVERAGE COST OF CAPITAL

 The weighted average cost of capital (WACC) is a calculation of a firm's cost of capital in which each category
of capital is proportionately weighted. All sources of capital, including common stock, preferred stock, bonds,
and any other long-term debt, are included in a WACC calculation.
 A firm’s WACC increases as the beta and rate of return on equity increase because an increase in WACC
denotes a decrease in valuation and an increase in risk.

Steps in the calculation of WACC:

Step 1: Calculating Costs of the Components of Capital Structure

This step is the individual computation of cost of each type of long-term financing which was discussed above.

FMGT 1013 – Financial Management | 4

Step 2: Assessing the Firm’s Capital Structure

 After the component costs have been calculated, the next step is to assess the firm’s capital structure to
determine the appropriate weighting (as a percentage of total capital) to be assigned to each component. A
firm’s capital structure is the mixture of capital that it uses to finance its assets. A proration based on each
component’s market value in order to get the weight for each component.
 In assessing the capital structure of a firm, we always use the market values of the various components, not
the book values. There are problems wherein market values are not given or a few of the components have
given market values. In such cases and for academic discussions, proration based on BOOK VALUES are
allowed. However, if the market values of all the components are given, proration should be based on market
values.

FMGT 1013 – Financial Management | 5

Step 3: Calculating the Weighted Average Cost of Capital

The final step in calculating the overall cost of capital is to use the proportion each component of capital
represents of the total market value of the capital and the cost of each component to find the weighted average
rate. We have calculated the cost of each component as follows:
Debt (after-tax) 5.20%
Preferred stock 3.90%
Common stock 8.33% ***

Using the individual component costs, we calculated and the proportion of each type of capital to the total
market value of the capital as the weighting, the weighted average cost of capital is:
(0.052 × 0.32) + (0.039 × 0.102) + (0.0833 × 0.578) = 0.069 or 6.9%

***Note: The Cost of Common stock used in the computation is based on Dividend Growth Model.
For academic problems, the use of DGM or CAPM depends on the given information.

*** END of LESSON ***

REFERENCES

Textbooks

1. Agamata, F. (2011), Management Advisory Services, GIC Enterprises Inc.

2. Brigham, E., Houston, J. (2013), Fundamentals of financial management. Cengage Learning Asia Pte. Ltd
3. Cabrera, E. (2015) Financial Management: Principles and Applications, GIC Enterprises & Co., Inc., Manila
4. Salvador, S., Baysa, G, Gamboa, D., Geronimo, E. (2012) Fundamentals and applications of financial
management, Allan Adrian Books Inc.
5. William, J. (2015), Financial Management

Online Reference

1. https://businessjargons.com/cost-of-capital.html
2. https://medium.com/magnimetrics/understanding-the-weighted-average-cost-of-capital-wacc-948182d97e6
3. https://www.thebalancesmb.com/calculate-weighted-average-cost-of-capital-393130
4. https://www.investopedia.com/

Supplemental Readings:
1. https://investinganswers.com/dictionary/c/cost-capital
2. https://corporatefinanceinstitute.com/resources/knowledge/finance/cost-of-capital/
3. https://www.thestreet.com/investing/what-is-cost-of-capital-14814298
4. https://courses.lumenlearning.com/boundless-finance/chapter/the-basics-of-the-cost-of-capital/
5. https://www.universalclass.com/articles/business/concepts-of-cost-of-capital-in-financial-analysis.htm
6. https://www.business-case-analysis.com/cost-of-capital.html
7. https://www.cleverism.com/calculate-cost-capital-business

FMGT 1013 – Financial Management | 6

 UNIVERSITY OF SAINT LOUIS
Tuguegarao City

SCHOOL OF ACCOUNTANCY, BUSINESS and HOSPITALITY

Short Term
A.Y. 2020-2021

ONLINE LEARNING MODULE

FMGT 1013- Financial Management

Lesson 6: Capital Budgeting

This Week’s Time Table: (July 26 – July 30, 2021)

The following shall be your guide for the different lessons and tasks that you need to accomplish. Be
patient, read them carefully before proceeding to the tasks expected of you. HAVE A FRUITFUL
LEARNING EXPERIENCE 😊

Date Topics Activities or Tasks

July 26 Capital Budgeting Read your books and learning modules
July 27 A. Types and Features of Submission of Drill
Jul7 28 Investment Projects Discussion of drill
July 29 B. Measuring Investment Worth Submission of Quiz
C. Selecting the Best Mix of Projects
for a Limited Budget
D. Handling Mutually Exclusive
Investments
E. The Modified Internal Rate of
Return
F. Comparing Projects with Unequal
Lives
G. The Equivalent Annual Annuity
Approach
H. Concept of Abandonment Value
I. Real Options
J. Effect of Income Taxes on
Investment Decisions
K. Depreciation Methods
Learning Prepare a proposal on how to reduce risk in handling company resources.
Outcomes:

LEARNING CONTENT

Last week we have discussed cost of capital or the rate you are paying to obtain capital from the different
sources available. After understanding the cost of capital, the company is now ready to acquire funds that
will be used in different activities. One of which is its investment on capital assets or long-term assets.
Thus, the topic of Capital Budgeting is necessary.

We have learned in your Strategic Cost Management that budgeting means planning. In this case, we are
not planning for short term purposes but we are planning for the long term. In accounting we have the
so called revenue expenditures, which are expensed as incurred and we have these capital expenditures,
which are capitalized as asset because these expenditures will benefit the company in more than one
period. In short, these are long-term assets.

Capital Budgeting also involves decision making; decision making in the sense that the company needs to
evaluate alternatives whether to invest or not in a new asset, expand or not their current plant or to incur
large amount of renovations to their currently available property, plant and equipment. However, not like
short-term decision making, we should be very careful in evaluating capital investment decisions. Why?
Because of the following characteristics:
1. Capital investment projects involves HUGE amount of money and resources – If you make a wrong
decision, big amount money would be lost. If you recommended to the company the purchase of
an equipment worth P10M for the reason that it can generate a reasonable amount of return but
failed to achieve it, it is difficult to return the company investment of P10M.

FMGT 1013 – Financial Management | 1

 2. Capital investment projects involve long-term commitments – any defective company decision
would result in a long-term sacrifice
3. Capital investment projects are more difficult to reverse than short-term decision – you cannot
reverse any wrong decision at a click of a finger. Example, the company made a wrong decision
of investing P10M. The entity cannot just make a reversing entry of Dr. Loss, Cr. Building.
4. Capital investment projects involves much risk and uncertainty – during the course of investing or
building the project, some uncertainties may happen which may cause the company losses.

After knowing the characteristics of capital investment projects, we should learn the different factors that
we need to consider in evaluating it. The following are the capital investment factors that we should
consider:
1. Net cost of investment
- This includes all cost or cash outflows net of inflows or savings that is incidental to the fulfillment
of capital investment projects.
- THIS IS THE AMOUNT OF NET CASH FLOWS @ TIME ZERO.

Sample Problem 1:
The management of BIGBOY Company plans to replace a weaving machine that was acquired several
years ago at a cost of P50,000. The machine has been depreciated to its salvage value of P5,000, and it
can be sold now for P6,000. A new weaving machine can be purchased for P80,000. If a new machine is
not purchased, BIGBOY Company will spend P10,000 to repair the old machine. The cost to repair the old
machine can be deducted in the first year to compute income tax. Income tax is estimated at 30% of the
income subject to tax. The acquisition of the new machine will require additional investment in working
capital of P4,000. What is the NET COST OF INVESTMENT for decision making purposes?

Solution:
+ Acquisition cost (new weaving machine) P80,000
+ Tax on gain on sale [(6,000 – 5,000)*30%] 300
+ Increase in working capital 4,000
- Proceeds from sale of old machine (6,000)
- Avoidable repairs, net of tax (10,000*70%) (7,000)
NET COST OF INVESTMENT P71,300

2. Returns
- This refers to the expected income from the investment. This could be monetary or
nonmonetary. There are also two types of monetary returns. The first one is the Accounting Net
Income (which is geared towards profitability) and net cash inflows (which is geared towards
liquidity).
- Accounting Net Income is the amount that you’ve learned to compute since you were in your
Senior High School years. However, for Finance purposes, it is but proper to use the net cash
flows in evaluating capital decision projects. Please refer to Key Formula No. 2 for the
computation of your net cash flows. Remember that net cash flows can be NET OPERATING
CASH FLOW AFTER TAX or END OF LIFE CASH FLOWS. Operating cash flows after tax are
returns which arise from in and out of cash that is directly attributable to the capital investment.
Normally, these cash flows are ASSUMED to occur at the end of each period. On the other
hand, end of life cash flows are the net cash flow that are realized at the end of the project’s
life.

FMGT 1013 – Financial Management | 2

 3. Cost of Capital
- As discussed last week, this refers to the cost of obtaining funds or using funds for any
investment.
- This is also taken into consideration in coming up in a decision in capital budgeting. For
terminology purposes, cost of capital is also called hurdle rate, required rate of return, cut-off
rate, opportunity cost of capital, minimum rate of return, target rate of return or desired rate of
return.

Now that we have a grasp on the different concepts and factors that we will be needing in evaluating
capital investment projects, we are now ready to do CAPITAL BUDGETING
FMGT 1013 – Financial Management | 3
EVALUATING CAPITAL INVESTMENT PROJECTS
There are two broad types of capital budgeting techniques. First is those who are NOT considering the
time value of money (non-discounted cash flow methods) and those who are considering the time value
of money (discounted cash flow methods). We are going to discuss first the methods that do not consider
the time value of money

FMGT 1013 – Financial Management | 4

DISCOUNTED CASH FLOW TECHNIQUES
These are the capital investment techniques that considers the TIME VALUE OF MONEY in decision
making. Because we consider time value of money in these techniques, only NET CASH FLOWS will
be considered as our returns here.

FMGT 1013 – Financial Management | 5

CAPITAL RATIONING
Capital rationing is a situation in which management places a constraint on the total size of the firm’s
capital budget during a particular period. It is also described as the selection of the investment proposals
in a situation of constraint on availability of capital funds to maximize the wealth of the company by
selecting those projects which will maximize overall NPV.

STEPS IN CAPITAL RATIONING

(1) Rank the projects according to their profitability index
(2) Choose the combination of projects with the highest total NPV

FMGT 1013 – Financial Management | 6

 END of LESSON 1***

REFERENCES

Textbooks
1. Agamata, F. (2011), Management Advisory Services, GIC Enterprises Inc.
2. Brigham, E., Houston, J. (2013), Fundamentals of financial management. Cengage Learning Asia
Pte. Ltd
3. Cabrera, E.(2015) Financial Management: Principles and Applications, GIC Enterprises & Co., Inc.,
Manila
4. Salvador, S., Baysa, G, Gamboa, D., Geronimo, E. (2012) Fundamentals and applications of
financial management, Allan Adrian Books Inc.
5. William, J. (2015), Financial Management

Online Reference

FMGT 1013 – Financial Management | 7