BAFIN MODULE 1: INTRODUCTION TO
Also, too much
FINANCIAL MANAGEMENT
Financial management starts with a plan. This
applies to both individuals and companies. It is
not enough to have cash and other resources
today. Such resources if not managed
properly can be wiped out. Hence financial
management is a must.
From the perspective of a corporation,
financial management deals with
decisions that are supposed to maximize the
value of shareholders wealth. This means
maximizing the market value of the shares of
stocks represent the form of ownership in a
corporation.
The changes in the price of a stock can be
a confluence of many factors:
 Profitable operation
 Nature of the business
 Prospects of the business
 Projected earnings
 Timeframe for the realization of such
projected earnings
 Ability to meet maturing obligations
 Appropriate capital structure
 Dividend policies
 Investing decisions
 Management and market sentiment
While profits significantly affect the price of
stock, finance literature states that profit
maximization should not be the overriding
objective of company’s management, but
shareholder’s wealth maximization. Profits can
be maximized by taking more risks, for
example borrowing more to finance expansion
and generate more revenues. While more
borrowings can increase profitability, it can
also expose the company to more risks and
may even result in operating losses if some
external shocks occur and adversely affect the
company’s operations.
Shareholder’s wealth maximization takes into
account the risk return trade off of
management decisions and the prospects of a
company. For closely held corporations, the
concept of shareholder’s wealth maximization
maybe more difficult to apply as there is no
market price of the stock to look at.
Nevertheless, the management
should still be aware of the variables that
influence the price of the stock because new
investors may join the company or the
controlling stockholders may decide to list the
shares in the Philippine stock exchange in the
future. When these opportunities come, the
factors which are considered relevant in
appropriately valuing a stock will be applied.
SHAREHOLDER’S WEALTH MAXIMIZATION
Maximizing shareholder’s wealth
through maximization of stock price should be
the overriding objective of management as it
covers the different facets of operating a
company and it considers the different
stakeholders in the organization. Stakeholders
are not limited to the stockholders of the
company. Stakeholders also include
management employees, suppliers,
customers, creditors, regulatory agencies, and
the community where the company operates.
For a longer and sustainable operations, the
interest of these different stakeholders has to
be borne in mind.
The stock holders have to be happy
with their investments in the company so that
they will be encouraged to invest more. More
investments mean more jobs can be created.
While profitability is a major drive for
increasing the value of stock, there are other
factors that influence share prices. There are
many reasons why profit maximization should
not be the overriding objective of a company.
One reason as cited previously is that the
company may need to borrow more just so it
can increase sales or augment production
capacity. While borrowing is not necessarily
bad, too much too much of it exposes the
company to bankruptcy risk.
focus on profits may force management to
consider inferior raw materials for production.
While this may improve profits in the short run,
this may have adverse repercussions in the
long run. Management may also defer
important repairs and maintenance just to
show better profits in the current accounting
period. Again, deferring such repairs and
maintenance may impair the efficiency of the
production facilities in the long run.
Maximizing shareholder’s wealth
motivates members of top management to
develop a longer perspective for the company
that they manage. With this objective in mind,
management will try to make their customers
happy by providing good products and
services at reasonable prices. To achieve this,
management may have to innovate, invest in
technology and be more efficient in their
production and operation. Management may
also need to consider setting aside a certain
percentage of income to research and
development to further improve, and possibly
expand the company’s existing product and
service offerings.
The interest of the employees has to
be considered in managing a company.
Chances are happy employees mean more
productive employees. If employees are
happy in the workplace and they have sense
of belonging in the company, they will protect
the interest of the company. In Filipino culture,
it is called malasakit. A close translation to
English will probably be solicitude or empathy.
Unhappy employees can damage the
reputation of the company or they may do
something that will taint the image of the
company.
Paying suppliers and creditors on time
is a good business practice that will improve
relationships with these parties. It is important
that management take care of suppliers to
ensure good quality of materials at reasonable
prices. Good relationships with creditors
enhance the probability of getting credit facilities
especially during times of emergencies.
Compliance with the requirements of
regulatory agencies also ensures more
smooth operations. Noncompliance may result
in suspension of operations or unnecessary
penalties. Disruption in operation as a result of
noncompliance with regulatory requirements
may also taint the image of the company
which may have adverse effect effects not just
on the operations but also on the cost of
financing as well.
Supporting the community where the company
operates, its whatever capacity it can,
increases the company’s chances of
continuous operations in the area. Hiring
employees from the community promotes
employees support for the company. The
company can also help in some civic oriented
activities like planting trees in the area. Philex
mining corporation is an example of a
company which has reforested more than
2,500 hectares of land across ITOGON and
TUBA, BENGUET. For this, the company has
won several awards, some of which were
given by the Philippine Mine Safety and
Environmental association. In 2014, PHILEX
also joined forces with the National Power
Corporation to reforest about 500 hectares of
land around San Roque dam’s critical
watershed area. Philex has also established
Adopt a School Program where the company
helps in the renovation of schools in their host
and neighboring communities. In its mining
area, the company also provides free private
elementary education through Philex Mines
Elementary School. It has also awarded
several scholarships to students in their host
communities.
BAFIN MODULE 2: OVERVIEW OF
FINANCIAL SYSTEM
The financial system makes the savers and
users of funds.
SAVERS
A. Households B. Individuals
C. Corporations D. Government agencies
FINANCIAL INTERMEDIARIES
a. Banks
b. Insurance companies
c. Stock exchange
d. Stock brokerage firm
e. Mutual funds
f. Other financial institutions
USERS OF FUNDS
(BORROWERS.INVESTORS)
a. Households
b. Individuals
c. Corporations/companies
d. Government agencies
Savings can come from households,
individuals, companies, government
agencies, or any other entity whose cash
inflows are greater than them cash outflows.
The financial system through financial
intermediaries provides a mechanism by
which these savings can be channeled to
users of funds, borrowers and investors.
Some of the financial instruments issued by
the users of funds such as the
shares of stocks and corporate bonds of
publicly listed companies and the
debt securities issued by the national
government can be traded. The
financial market provides a system for the
trading of these securities. The
Philippine Stock Exchange (PSE) offers
facilities for the trading of shares
of publicly listed companies.
A company can become publicly listed through
an initial public offering
(IPO) where shares will be offered to many
investors. The offering of the
shares will be coursed through an investment
bank which will underwrite
the offering of the shares. Corporate bonds
and government debt securities can be traded
through the Philippine Dealing and Exchange
Corporation (PDEX).
The same entities can be savers and users of
funds. One entity may have
savings today but may be needing funds in the
future, for example for
expansion.
BANKS
Banks provide mechanism where savers can
put their excess funds through deposits.
Banks give the depositors interest on the
money deposited to them. To cover for the
interest given to depositors, banks lend the
money to borrowers after performing a credit
investigation. Some of the deposits can be
invested in some financial instruments like
government securities and corporate bonds.
Banks can also serve as conduits of investors
in buying and selling both government
securities and corporate bonds. Banks have to
be regulated by the Bangko Sentral ng
Pilipinas because they take deposits, and
there is public interest involved.
INSURANCE COMPANIES
Insurance companies offer different products.
Insurance products can be broadly
categorized into life insurance products and
non-life insurance products. Life insurance
products protect the insured from loss of life
while non-life insurance products protect the
insured from the loss of or damage to
properties. In exchange for the protection, the
insured pays premium to the insurance
companies. These premiums are used to fund
claims. Generally, the cash collected from the
premiums may cover more than claims for
most periods. Hence, the excess cash can be
invested by insurance companies. There are
guidelines in investing that insurance
companies have to follow to ensure that they
have enough cash when claims are made.
Insurance companies are regulated by the
insurance commission.
STOCK EXCHANGE
The Philippine Stock Exchange (PSE)
provides a system for the trading of
equity securities of publicly listed companies.
These equity securities are
common stocks and preferred stocks. An
individual who wants to invest
and trade in the stock market cannot go
directly to PSE to buy and sell
stocks. He has to open an account with an
accredited stock brokerage firm where he can
channel his buy and sell orders of equity
securities.
STOCK BROKERAGE FIRMS
Investing in the stock market has to be
coursed through stock brokerage
firms. At present, there are on line brokers and
live brokers. With on line
brokers, one can trade in the stock market
through the internet. COL
Financial and BPI Trade are two of the o line
brokers in the Philippines. To trade on line,
one must have an account and deposit with
the on line
broker.
With live brokers, one needs a
telephone to call brokers and place orders.
Settlement of the transaction can be arranged
with the broker. Live brokers normally have
their messengers who deliver confirmation
receipts as well as collect and deliver checks.
Confirmation receipts are forms of evidence
regarding the executed buy or sell transaction
that a client placed with his broker.
MUTUAL FUNDS
Mutual funds provide opportunities for big and
small investors to invest in financial
instruments which they would not have
considered on their own, or they may have
considered but do not have the time or the
expertise to do it. These include investments
in the stock market, bonds, treasury notes and
other money market instruments like treasury
bills.
With mutual funds, investments are pooled
and the funds are invested by professional
managers for a fee. The fees are a small
percentage of the funds invested.
Mutual cater to different investment objectives.
There are mutual funds
which are limited only to stocks while others
are restricted to fixed income instruments like
bonds and treasury notes. Others provide a
combination of both stocks and fixed income
instruments.
It must be noted that when one invests in
mutual fund, he becomes a part owner of that
fund. To invest in a mutual fund, he has to buy
shares of the mutual fund and the buying
shares depend on the net assets value (NAV)
of that fund when the purchase is made. Note
that the net asset value of a mutual fund
changes every day as the value of the
financial instruments where the funds are
invested also changes.
Because NAV changes, an investor in mutual
fund can also lose as the NAV can fall before
the NAV when the investment was made.
However, because the fund is managed by
professionals, positive returns are expected
over time. How much one gains from investing
in mutual funds may also depend on the
investment horizon of the investor.
OTHER FINANCIAL INSTITUTIONS
Other financial institutions include pension
funds like Government service insurance
system (GSIS) and social security system
(SSS), investment banks and credit unions
among others.
FINANCIAL INSTRUMENTS
Financial instruments are generally classified
into two major categories:
a. Equity securities – include common
stocks and preferred stocks
b. Debt securities
COMMON STOCK AND PREFERRED
STOCK
Most company have only common stocks in
their stockholder’s equity but some companies
have both common stocks and preferred
stocks. PLDT and GLOBE have both common
stocks and preferred stocks in their
stockholders’ equity.
A preferred stock has priority over
common stocks in terms of claim over the
assets of the company. This means that if a
company is to be liquidated and its assets
have to be distributed, no asset will be
distributed to common stockholders unless all
the claims of the preferred stockholders have
been given.
Preferred stockholders also have
priority over common stockholders in cash
dividend declaration. No cash dividends will
be given to common stockholders unless all
the dividends due to preferred are paid first.
If the preferred stockholders have
preference over common stockholders in
terms of claims over the assets of the
company and in cash dividend declaration,
why would an investor be willing to become a
common stockholder?
There are benefits in being a common
stockholder. Common stockholders are the
real owners of the company. Being residual
owners, the growth potential of their
investment is unlimited. If an investor has
identified a good common stock, its value can
multiply overtime.
Unlike preferred stocks, the dividend per
share for common stocks is not fixed. A common
stock investor can receive more cash dividends
during period of unusual profitability. But during
periods of unprofitable operations, both preferred
stockholders and common stockholders may not
receive dividends. The company is not obligated
to pay dividends if it
is not in a position to do so. For cumulative
preferred stockholders, unpaid dividends can
accumulate and no cash dividends will be paid to
common stockholders unless all dividends in
arrears for prepaid stockholders are paid.
Being the residual owners of the company,
common stockholders have voting rights, a
privilege generally not available to preferred
stockholders. This means that if one has
enough common shares in a company, he can
nominate a director in the board of directors. If
this happens, then he can influence the major
decisions made by a company as such major
decisions are approved by the board.
DEBT SECURITIES
The treasury bonds and treasury bills issued
by the national treasury are of forms of
indebtedness of the national government. The
treasury bills which are in the tenors of 91
days, 182 days, and 360 days are auctioned
at the national treasury every Monday to
accredited dealers. These are eventually
formed out to both institutional investors on
Wednesdays.
Occasionally, the national treasury also
issues retail treasury bonds. A small investor can
participate in these retail treasury bonds. These
are normally in multiples of 5,000. Coupon
interest on these retail treasury
bonds are paid quarterly for treasury bonds,
coupon interest is paid semi
annually.
Some publicly listed companies have
also started issuing corporate bonds. The
tenors are usually 5 years, 7 years and 10
years.
PLDT and MERALCO are the other
big publicly listed companies which issued
corporate bonds recently. Corporate bonds
offer slightly higher interest rates than
government securities.
Interest on investment to debt
securities is subject to 20% final tax. For
bank deposits with tenors of at least 5 years
tax rate is zero percent.
In terms of claims over the assets of a
company, bondholders have preference over
preferred stocks and common stocks. Also
interest due to them, just like bank creditors,
has to be paid first before dividends are
given to preferred and common stockholders.
BAFIN MODULE 3.1
ORGANIZATIONAL CHART AND THE
ROLES OF THE VP FOR FINANCE
BOARD OF DIRECTORS
The Board of directors is the highest policy
making body in a corporation. The boards
primary responsibility is to ensure that
corporation is operating to serve the best
interest of the stockholders. The members of
the board who are called directors are elected
by the stockholders. The ability to elect a
director in the board is contingent on the
number of shares owned and the number of
directors in the board.
To illustrate assume that there are ten
directors in the board. If a stockholder owns
10% of the voting shares of the company then
this stockholder can elect one director in the
board. This is the reason why some investors
want to own the majority shares of a company
if they want control over that company.
Owning majority of the shares means having
the right to elect majority of the directors in the
board.
The following are among the
responsibilities of the board of directors:
1. Setting policies on investments , capital
structure and dividends
2. Approving company’s strategies , goals
and budgets
3. Appointing and removing members of the
top management including the president
4. Determining top management’s
compensation
5. Approving the information and other
disclosures reported in the financial
statements
PRESIDENT
The roles of a president in a corporation may
vary from one company to another . Among
the responsibilities of a president are the
following :
1. Overseeing the operations of a company
and ensuring that the strategies as
approved by the board are implemented
as planned
2. Performing all areas of management
planning, organizing, staffing, directing
and controlling
3. Representing the company in
professional, social and civic activities
The president cannot manage the company
on his own , especially when the corporation
has become too big. To assist him are the vice
presidents of different functional areas :
finance, sales and marketing production and
administration .
VP FOR SALES AND MARKETING
The following are among the responsibilities of
VP for Sales and Marketing
1. Formulating marketing strategies and
plans
2. Directing and coordinating company sales
3. Performing market and competitor
analysis
4. Analyzing and evaluating the
effectiveness and cost of marketing
methods applied
5. Conducting or directing research that will
allow the company to identify new
marketing opportunities , for example
variants of the existing products /services
already offered in the market
6. Promoting good relationships with
customers and distributors
VP FOR PRODUCTION
The following are among the responsibilities of
VP for Production:
1. Ensuring production meets customer
demands
2. Identifying production technology /process
that minimizes production cost and makes
the company cost competitive
3. Coming up with a production plan that
maximizes the utilization of the company’s
production facilities
4. Identifying adequate and competitively
priced raw materials suppliers
VP FOR ADMINSITRATION
The following are among the responsibilities of
VP for Administration
1. Coordinating the functions of
administration , finance and sales and
marketing departments
2. Assisting other departments in hiring
employees
3. Providing assistance in payroll
preparation
4. Determining the location and the
maximum amount of office space needed
by the company
5. Identifying means, processes or systems
that will minimize the operating costs of
the company
VP FOR FINANCE
Functions of VP for FINANCE
 FINANCING
 INVESTING
 OPERATING
 DIVIDEND POLICIES
FINANCING DECISIONS
Financing decisions include making decisions
as to how to finance long term investments
and working capital which deals with the day
to day operations of the company.
The VP for Finance is also
responsible for determining the appropriate
capital structure of the company, that is how
much of the total assets should be financed by
debt and equity. This responsibility is crucial
because if the company is aggressively
financed, that is , it is heavily financed by debt,
the company becomes vulnerable to adverse
economic conditions which may result in
higher volatility in earnings. The company can
get bankrupt because of too much debt.
Capital structure decisions vary from one
company to another. It is affected by the
stability of cash flows , extent of fixed
operating expenses and variable expenses.
Companies which are capital intensive and
are characterized by high fixed operating
expenses such as utility and mining
companies are supposedly more
conservatively financed. This means, these
companies have to be financed more by
equity. These companies have to generate
high levels of revenues before they can cover
their expenses. If these companies are heavily
financed by debt, then interest expense adds
up to the already high fixed operating
expenses. This would mean higher revenues
for profits to be made .
INVESTING DECISIONS
To minimize the probability of failure , long
term investments have to be supported by a
capital budgeting analysis which is among the
responsibilities of a finance manager. Capital
budgeting analysis is a technique used to
determine the financial viability of a long term
investment. This requires forecasting the cost
of investment and the streams of cash flow
expected to be generated from the
investment. The investment can only be
considered if it satisfies certain financial
parameters that are to the top management.
This function of a finance manager is crucial.
Many companies which suffered financial
distress went through an aggressive
expansion heavily financed by debt. Among
the local companies which suffered a major
setback because of aggressive expansion are
Metro Pacific Corporation with respect to their
Fort Bonifacio Global City development project
and Belle Resources as regards their initial
venture in the casino business. Both
companies implemented these expansions
right after the 1997 Asian financial crisis.
OPERATING DECISIONS
Operating decisions deal with the daily
operations of the company . The role of the
VP for finance is determining how to finance
working capital such as accounts receivable
and inventories . Should the company finance
these two accounts substantially by short term
sources of financing or through long term
sources of financing .
The decision regarding the financing
of these working capital accounts depends on
the appetite of top management for risk. If the
company is more aggressive , then these
accounts receivable and inventories can be
substantially financed by short term sources.
Short term sources of funds are
cheaper . interest on short term loans is
generally lower than the interest on long term
loans. Using short term loans can boost the
profitability of a company.
While financing through short term
sources of financing may minimize the
financing cost of the company , this has a
trade off . financing working capital accounts
mostly through short term sources may
expose the company to a liquidity problem
where obligations are already due but the
company does not have sufficient cash to pay
for the obligations.
A more conservative management will
opt to finance working capital accounts mostly
through long term sources.
DIVIDEND POLICIES
Some investors buy stocks because of the
dividends they expect to receive from the
company. Non declaration of dividends may
disappoint these investors. PLDT and Globe
are two of the Philippine listed companies
which have generously distributed cash
dividends for the last five years.
Two conditions must exist before a
company can declare cash dividends. First,
the company must have enough retained
earnings to support cash dividend declaration.
When cash dividends are declared , the
 retained earnings of a company go down to
the extent of such declaration . second the
company must have cash. How much cash
dividend a company declares is within the
purview of the VP for Finance?
There are several factors considered in
declaring cash dividends.
1. Availability of investment opportunities
2. Access to long term sources of funds
3. Capital structure
BAFIN MODULE 3.2
REVIEW OF FS PREPARATION, ANALYSIS
AND INTERPRETATION
BASIC FINANCIAL STATEMENTS
1. STATEMENT OF FINANCIAL POSITION
The statement of financial position
provides information regarding the liquidity position
and capital structure of a company as of a given
date. Liquidity – refers to the ability of a company
to pay maturing obligations. The current assets of a
company are compared with its current liabilities to
determine its paying capacity. Generally assets
which are expected to be converted to cash within
one year such as accounts receivable and
inventories are classified as current assets.
Liabilities which are expected to be settled or paid
within one year are classified as current liabilities.
2. INCOME STATEMENT
 The income statement provides information
regarding the revenues or sales , expenses
and net income of a company over a given
accounting period. The accounting period
maybe for a month , a quarter, or a year. The
income reported by a company is not that
useful if the accounting period is not stated . In
analyzing earnings performance , a
comparison with the previous periods and with
other companies , especially those coming
from the same industry is a must. Such
comparison will not be made possible without
knowing the accounting periods covered in the
statement of profit or loss.
 In analyzing statement of profit or loss ,it is
important to identify how much of the income
comes from core business and how much
comes from the non core business. Core
business refers to the main business of a
company.
3. STATEMENT OF CASH FLOWS
 The statement of cash flows provides an
explanation regarding the change in cash
balance from one accounting period to
another. The cash flow are also classified
into three main categories : operating ,
investing and financing
 The statement of cash flows is very
important financial statement because it
provides information regarding the quality of
earnings of a company as shown in the cash
flows from operating activities. In this section
, the income reported from statement of
profit or loss which is based on accrual
principle is converted to cash. This is very
important piece of information found in this
financial report because a company may
have so much reported net income , but if
such income is not translated into cash ,
then that income is useless. One cannot use
net income to pay debt or to pay the salaries
of the employees. Cash is needed.
 The cash flows from investing activities
provide information regarding the future
directions of the company. This section
shows how much investment the company is
making a given accounting period.
Expansions allow companies to grow.
However, that expansion or investment are
not always good especially when
management has undertaken them too
aggressively and are also financed
aggressively.
 To find out if a company, which is
undergoing expansion, will potentially
encounter liquidity problems in the future, an
examination of the third section of the
statement of cash flows has to be made.
The cash flow from financing activities
provide information whether there is a
proper matching of investing and financing
activities. An expansion which will take a
longer period of time to realize the benefits
warrants a more patient source of financing
such as equity.
STATEMENT OF CHANGES IN
STOCKHOLDER’s EQUITY
This financial statement provides information that
explains the changes in the stockholder’s equity
from one accounting period to another.
The changes may be due to the following.
1. Profit or loss for the accounting period
2. Cash dividend declaration
3. Issuance of new shares of stocks
4. Other transactions that affect the stockholders
equity such as other comprehensive income,
treasury stocks and revaluation of assets.
NOTES TO FINANCIAL STATEMENTS
The notes to financial statements are integral part
of the financial statements. Among the additional
information that the notes to financial statements
provide are the following:
1. Brief description of the company. Information
may include the nature of business of the
company and the owners behind the company
2. Summary of significant accounting policies .
this I very important because the existing
generally accepted accounting principles
provide alternative accounting policies to
companies . it is therefore important to find out
what specific accounting policies are used by
the company.
3. Breakdown of amounts found in the financial
statements. The company’s property, plant and
equipment account may have too many
components. Putting all the details on the face
of the balance sheet may make the balance
sheet long . an alternative presentation is to
provide a single amount on the face of the
balance sheet for PPE for the breakdown of
PPE can be presented in the notes to financial
statements .
PROCESS TAKEN IN PREPARING FINANCIAL
STATEMENTS
1. Analyzing business transactions
2. Recording in the journals
3. Posting to ledger accounts
4. Preparing the unadjusted trial balance
5. Making the adjusting entries
6. Preparing the adjusted trial balance
7. Preparing the financial statements
8. Making the closing entries
9. Post closing trial balance
 ACTIVITY :
Prepare the income statement for 2021` and
statement of financial position as of December 31,
2021 of XYZ Company.
The following transactions were incurred by XYZ
Company
January 2021
a. Incorporators invested 12.5 million cash in a newly
organized corporation., XYZ Company . the par
value of the share is 1
b. XYZ Company bought land and building for 6
million cash. The value of the building which has a
remaining useful life of 20 years is 4 million. A full
year depreciation for the building can be
recognized in 2021.
c. XYZ company bought fixtures to be used in the
operation of the business for 600,000. These are
depreciable over 10 years.
d. XYZ company bought office equipment for
500,000. These are depreciated over five years.
e. XYZ Company bought two transportation vehicle for
1.1.million. These are depreciated over five years.
Transactions for 2021
a. Bought merchandise worth 18 million , 1.5 million of
which remained unpaid in December 31, 2021.
b. Sold merchandise for 20 million . The average cost
of the merchandise sold is 75 % of the sales.
Twenty percent of the sales remained uncollected
as of December 31, 2021.
c. Paid salaries of employees amounting to 1.25
million .
d. Total utilities incurred for the year is 280,000.
250,000 of which was paid during the year.
e. Other operating expenses which were paid in cash
amounted to 350,000.
f. Tax rate is 30 %. Seventy percent of the tax due for
the year was paid in 2021. The balance was paid in
the first quarter of 2022.
BAFIN MODULE 4: FINANCIAL
STATEMENT ANALYSIS
•There are different users of financial
statements. Financial statement analysis can
be used by managers, equity investors,
creditors, regulators, labor unions ,
employees, the public and potential investors
and creditors. Financial statement analysis is
used for investment and credit decisions. It is
also used for regulating companies such as
what the Energy Regulatory Commission does
for power distribution companies and other
energy companies.
•Financial statement analysis is definitely used
by management for monitoring performance
and for identifying strategies to further improve
the company’s operations.
FINANCIAL RATIOS
A. PROFITABILITY RATIOS
The following ratios are used to measure the
profitability of a company
1. Return on equity (ROE)
ROE is a profitability measure that should be
of interest to stock market investors. It
measures the amount of net income earned in
relation to stockholder’s equity. ROE is
computed as follows:
ROE = NET INCOME/STOCKHOLDER’s EQUITY
2. Return on assets (ROA )
Return on assets measures the ability of a
company to generate income out of its
resources. The formula is
ROA = (Operating income /total assets ) x 100%
3. Gross profit margin
The formula for computing gross profit margin
is Gross profit margin = (Gross profit /sales) x
100%
 Gross profit margin is a profitability ratio
that measures the ability of the company
to cover its cost of goods sold from its
sales .
 If the manager of a company wants to
improve its gross profit margin, two things
can be done: 1. Raise prices 2.Find ways
to bring down production costs.
For trading or merchandising
companies, find a supplier which can sell
finished goods to the company at low prices.
Both approaches are not easy to do .
Raising prices is possible if your company is
the only seller or provider of this product in the
area. If there are may sellers, however raising
prices can make your products appear
relatively more expensive and buyers may go
to companies who offer their products at
cheaper prices.
The second approach which is to
bring down production costs may not also be
easy to achieve because this may require
investment in technology. It may also require
identifying cheaper sources of raw materials.
Trying to make the production more efficient
can also help.
OPERATING PROFIT MARGIN
Operating profit margin measures the amount
of income generated from the core business of
a company. It is computed as the difference
between revenues and the sum of cost of
revenues or sales and operating expenses.
The formula for computing profit margin ratio
is Operating profit margin = (Operating income
/sales) x 100%
NET PROFIT MARGIN
Net profit margin measures how much net
profit a company generates for every peso of
sales or revenues that it generates. The
formula for computing net profit margin is
Net profit margin = (Net income /Sales) x 100%
LIQUIDITY RATIOS
Liquidity ratios measures the ability of a
company to pay maturing obligations from its
current assets. Two commonly used liquidity
ratios are the current ratio and the acid test
ratio or sometimes called quick assets ratio.
CURRENT RATIO
The formula for computing current ratio is
Current ratio = Current assets / current liabilities
ACID TEST OR QUICK ASSET RATIO
The formula is Quick asset ratio = (Cash t
current accounts receivable t short term
marketable securities) / current liabilities
The quick asset ratio is a stricter measure of a
company’s liquidity position. Common to both
current ratio and the quick asset ratio is the
accounts receivable. The real test of a
company’s ability to meet its maturing
obligations largely depends on the quality of
its receivables. Even if a company has a high
quick asset ratio, a company is not assured
that no liquidity problems will arise if the
collection of accounts receivable takes too
long.
LEVERAGE RATIOS
Leverage ratios shows the capital structure of
a company, that is how much of the total
assets of a company is financed by debt and
how much is financed by stockholder’s equity.
Leverage ratios can also be used to measure
the company’s ability to meet long term
obligations.
A question may be raised as to what
an appropriate capital structure is, that is a
combination of debt and equity for a company.
The capital structure of a company is
influenced by the following factors;
 Nature of business
 Stage of business development
 Macroeconomic conditions
 Prospects of the industry and expected
growth rates
 Bond and stock market conditions
 Financial flexibility
 Regulatory environment
 Taxes
 Management style
The following are the leverage ratios:
1. DEBT RATIO
Debt ratio measures how much of the total
assets are financed by liabilities. The formula
is DEBT RATIO = Total liabilities/ Total
assets
2. DEBT TO EQUITY RATIO
Debt to equity ratio is a variation of the debt
ratio. A debt to equity ratio of more than one
means that a company has more liabilities as
compared to stockholder’s equity. The formula
is Debt to equity ratio = Total liabilities
/total stockholder’s equity
3. INTEREST COVERAGE RATIO
Interest coverage ratio provides information if
a company has enough operating income to
cover interest expense. The formula is
Interest coverage ratio = Earnings before
interest and taxes / Interest expense
EFFICIENCY RATIOS OR TURNOVER RATIOS
Efficiency ratios . otherwise known as turnover
ratios are called as such because they
measure the management’s efficiency in
utilizing the assets of the company . The
following are the efficiency ratios :
Total assets turnover ratio measures the
company’s ability to generate revenues for
every peso of asset invested . It is an indicator
of how productive the company is in utilizing
its resources. The formula is Asset turnover
ratio = Sales / Total Assets
1. FIXED ASSET TURNOVER RATIO
If a company is heavily invested in property ,
plant and equipment or fixed assets, it pays to
know how efficient the management of these
assets is. This can be applied to companies
which are characterized by high PPE such as
utility companies like telecom companies,
power generation , distribution companies and
water distribution companies. It can also be
applied to manufacturing companies. The
formula is Fixed asset turnover ratio = Sales
/PPE
2. ACCOUNTS RECEIVABLE TURNOVER
RATIO
Accounts receivable turnover ratio measures
the efficiency by which accounts receivable
are managed. A high accounts receivable
turnover ratio means efficient management of
receivables. Accounts receivable turnover
ratio = Sales / Accounts receivable
3. INVENTORY TURNOVER RATIO
Inventory turnover ratio measures the
company’s efficiency in managing its
inventories. Trading and manufacturing
companies and companies that are dealing
with highly perishable products and those that
are prone to technological obsolescence must
pay close attention to this ratio to minimize
losses. The formula is Inventory turnover
ratio = Cost of sales /inventories
4. ACCOUNTS PAYABLE TURNOVER
RATIO
The accounts payable turnover ratio provides
information regarding the rate by which trade
payables are paid. Any operating company will
prefer to have a longer payment period for its
accounts payable but this should be done only
with the concurrence of the supplier.
The formula is as follows: Accounts payable
turnover ratio = Cost of sales /trade
accounts payable
5. OPERATING CYCLE AND CASH
CONVERSION CYCLE
By adding the average collection period and
days inventories, the operating cycle can be
computed. This operating cycle covers the
period from the time the merchandise is
bought to the time the proceeds from the sale
are collected. Managers of companies will
prefer to have a short operating cycle as
compared to long one.
OPERATING CYCLE = Day’s inventories
plus days receivables