Foundations in Financial Management
Lecture 7: Introduction to Financial Markets
and Financial Analysis
Lecturer:
Varabott Ho
1
Reading – This Class
Textbook Chapter 8
Next Class
Overview of Financial Markets 1 & 2
Class Activities
Lecture
Quizz
Exam Practices
Discussion
2
Agenda
Banking and Financial Intermediation
Financial Markets
Financial Instruments
Financial Ratios
3
Financial Institutions
▪ Role of Central Banks and other government agencies
▪ International Financial Institutions
▪ Role of Commercial Banks - institutions that accept
deposits and make loans
▪ Role insurance companies, mutual funds, pension
funds, and investment banks
▪ Non-bank financial institutions
▪ Financial Innovation
Central Bank 1
• A central bank is an organization responsible for
managing banking activity. Within the USA the central
bank is the Federal Reserve, or 'the Fed'. Other
countries have central banks as well (ECB in Europe,
BoE in UK, BoJ in Japan). Their roles are similar, but
they may have different objectives.
Central Bank 2
1. Issues notes
2. Acts as a banker to the government
3. Manages government borrowing
4. Regulates commercial banks
5. Provides liquidity, as necessary, to banks
6. A lender of the last resort
7. Sets and manages monetary and exchange rate policy
• In the US, the central bank has three primary goals:
✔ Conduct monetary policy
✔ Supervise and regulate financial firms
✔ Provide financial services
6
The banking system 1
Financial intermediation
• Financial intermediation is the bringing together of
providers and users of finance
• Convenient means of saving money
• Aggregating amounts lent for borrowing
• Pooling reduces risk
• Maturity transformation bridging the gap between short
and long term requirements
The banking system 2
Commercial banks
• The retail (High Street) and wholesale banks are:
• Payments mechanism
• Wealth store
• Providers of funds
The banking system 3
Other financial intermediaries
• Building societies
• Finance houses
• Insurance companies
• Pension funds
• Unit trusts
• Investment trust companies
Financial Intermediation in UK
1. Finance houses: They provide medium-term installment
credit to the business and personal sectors. These are
usually owned by business sector firms or by other financial
intermediaries. They offer services similar to the clearing
banks.
2. Leasing companies: They lease capital equipment to
the business sector (operating and finance lease). They are
subsidiaries of other financial institutions.
3. Factoring companies: They provide loans to
companies secured on trade receivables, are usually bank
subsidiaries. They also buy and manage receivables.
10
Financial Intermediation in UK
4. Pension funds: They collect funds from employers and
employees to provide pensions on retirement or death.
5. Insurance companies: They use premium income from
policyholders to invest mainly in long-term assets such as
bonds, equities and property.
5. Investment trusts and unit trusts: They collect funds
by selling shares and bonds, then invest the proceeds,
mainly in the ordinary shares of other companies.
6. Building Societies : Financial institutions owned by its
members as a mutual organisation. Building societies offer
banking and related financial services, especially mortgage
lending
11
Banks in UK
1. Central Bank: The Bank of England
2. Primary Banks: also referred to as commercial banks,
retail banks (“high street banks”), or clearing banks
3. Secondary Banks: consists of investment banks and
foreign banks, do not the clearing by themselves
Example of Largest UK Retail Banks
HSBC
Royal Bank of Scotland
Lloyds TSB
Halifax Bank of Scotland
Barclays 12
Benefits of Financial
Intermediaries
1. Expert advice – financial intermediaries can advise their
customers on financial matters: on the best way of investing their
funds and on alternative ways of obtaining finance.
2. Expertise in channeling funds – financial intermediaries have
the specialist knowledge to be able to channel funds to those areas
that yield the highest return
3. Maturity transformation – many people and firms want to
borrow money for long periods of time, and yet many depositors wan
to be able to withdraw their deposits on demand or at short notice.
4. Risk transformation –Financial intermediaries, by lending to
large numbers of people, are willing to risk the odd case of default.
13
Agenda
Banking and Financial Intermediation
Financial Markets
Financial Instruments
Financial Ratios
14
Financial Markets 1
Financial Instruments & Markets Overview
Securitization Money Market
Hybrid Security Corporate Bond
Credit Derivative Government Bond
Futures Exchange High Yield
Forward Common
Swaps Stock
Options Preferred
OTC Stock
Commodity
Market Exchange
Real Estate Rate
Insurance Currency
Reinsurance
Financial markets 2
Money markets are operated by banks/financial
institutions
• They provide means of trading, lending and borrowing in
the short-term
Main money market instruments
• Deposits
• Bills
• Commercial paper
• Certificates of deposit
Financial markets 3
• Capital markets are markets for trading in long-term
financial instruments, in particular shares and bonds
• They enable organisations to raise new finance,
investors to realise investments and companies to
merge/takeover
Stock markets, which provide financing through the
issue of shares or common stock:
• Primary Market: Sale of new shares
• Secondary Market: Sale of existing shares
Bond markets, the buying and selling of bonds of
corporations and various government bodies.
Financial markets 4
Commodity markets are markets where raw or primary
products are exchanged. These raw commodities are traded
on regulated exchanges, in which they are bought and sold in
standardized contracts.
Derivatives markets provide standardized forward contracts
to buy or sell a particular commodity or financial instrument at
a predetermined price in the future.
Insurance markets, which facilitate the redistribution of
various risks.
Foreign exchange markets exist wherever one currency is
traded for another. It is the largest market in the world, in
terms of cash value traded 18
Stock Market Listing
Offer for Sale: Issue of shares to the public is managed
by an investment bank which often underwrites the share
price (=> IPO).
Prospectus Issue: The company issues shares directly
to the public (rare).
Placing: The investment bank arranges for shares to be
sold directly to a small number of people (not to the public)
Introduction: Shares are not traded in the market, but a
price is shown in the market.
19
Agenda
Banking and Financial Intermediation
Financial Markets
Financial Instruments
Financial Ratios
20
Financial Instruments 1
–Fixed Income
•A form of a loan issued by a corporation or government.
•Can be bought and sold in financial markets
•Bond market and money market
–Stocks or Equity
•The holder owns a small piece of the firm and entitled to part of
its profits.
•Firms sell stocks to raise money.
–Both stocks and bonds [securities]
•Represent a claim to a stream of payments [cash flows] in the
future
•Bonds—Interest payment and face value at maturity
•Stocks—Dividends and sales price when sold
Financial Instruments 2
– Debt Markets
• Short-term (maturity < 1 year) Money Market
• Long-term (maturity > 1 year) Fixed Income Market
– Equity Markets
• Primary Market - New security issues sold to initial buyers
• Secondary Market - Securities previously issued are bought
and sold
• Stock Exchanges e.g., New York Stock Exchange, London
Stock Exchange
– Derivatives Markets
• Futures
• Options
Financial Instruments 3
– Futures contracts.
• An agreement between two parties to exchange a fixed
quantity of a commodity or an asset at a fixed price on a
set future date.
• A price is always specified.
– Options
• Derivative instruments whose prices are based on the
value of an underlying asset.
• Give the holder the right, not obligation, to buy or sell a
fixed quantity of the asset at a pre-determined price on
either a specific date or at any time during a specified
period.
Stock Market Index 1
• Bloomberg
• Americas
✔ Dow Jones Index
✔ S&P 500 Index
✔ NASDAQ Index
Stock Market Index 2
Dow Jones Industrial Average
Stock Market Index 3
• Major World Stock Exchanges
Agenda
Banking and Financial Intermediation
Financial Markets
Financial Instruments
Financial Ratios
27
Financial Ratios
Financial ratios provide information about
financial performance:
1. Profitability
2. Shareholder Investment
3. Efficiency Ratios
4. Liquidity Ratios
5. Capital Structure or Gearing
1. Profitability Ratios
• ROCE = PBIT/(Assets – Current Liabilities)
• ROCE = PBIT/(Equity + Long Term Debt)
• ROE = Net Profit/Equity
• Gross Profit Margin = Gross Profit/Sales
• Net Profit Margin = Net Profit/Sales
2. Shareholder Investment Ratios
• Dividend Cover = Profit/Dividends
• P/E Ratio = Market Price per Share / EPS
• Dividend Pay Out Ratio = Dividend per Share / EPS
• Dividend Yield = Dividend per Share / Share Price
29
3. Efficiency Ratios
• Receivables period = Receivables/Sales x 365
• Accounts payable period = Payables/Cost of Sales x 365
• Inventory turnover period = Inventory/Cost of Sales x 365
4. Liquidity Ratios
• Current ratio = Current Assets/Current Liabilities
• Quick ratio = (Cur. Assets – Inventory)/Cur. Liabilities
30
5. Capital Structure or Gearing
• Gearing = Debt/Equity
• Debt ratio = Total Liabilities / Total Assets
• Interest cover = PBIT/Interest
31
ROCE: Return on Capital
Employed
Profit before interest and tax (PBIT)
x 100%
Total assets less current liabilities
• Capital Employed” = the sum of shareholders' equity and debt
liabilities
• It can be simplified as (Total Assets – Current Liabilities).
• A higher ROCE indicates more efficient use of capital.
• ROCE should be higher than the company’s capital cost; otherwise
it indicates that the company is not employing its capital effectively
and is not generating shareholder value.
32
Limitations of Financial
Statement Analysis
1. There is no standard definition of ratios
2. Past information may not predict future performance
3. Ending numbers may not represent average numbers
4. Comparisons may not be appropriate (the company is
different from others in the industry)
5. Ratios are affected by accounting policy (e.g., not
revaluing assets results in a higher ROCE; Undervalued
assets will increase gearing)
6. Inflation can increase profitability ratios
33
Examples of Investors Ratios
1. Earnings per share (EPS):
[Profit after interest, taxation and preferred dividends] /
the number of ordinary shares in issue.
EPS is a measurement of the profit earned by the company
for each share in issue.
2. P/E ratio = Current share price / annual EPS
4. Dividend yield = Dividend Per Share / current share price.
Example: if the annual dividend per share is 15 cents and
the share price is $4, the dividend yield is (15/400) × 100%
= 3.75%
34
End of Lecture
35