HOLY CROSS COLLEGE OF CALINAN, INC.

Davao-Bukidnon, National Highway, Calinan, Davao City

SECOND TERM, FIRST SEMESTER

SY 2025-2026

A WORKBOOK IN FM 1: FINANCIAL MANAGEMENT

KISSAH A. NERI, CPA, MBA

AUTHOR
Mobile No.: 09464019370
E-mail add: kissahneri@[Link]

ARAH ME P. HERNANDEZ, MBA

Instructor
Mobile No.: 09389697459
E-mail add:
arahernandez093962@[Link]
2
 i

HOLY CROSS COLLEGE OF CALINAN, INC. VISION AND MISSION

VISION
Holy Cross College of Calinan, Inc. is a Christ-centered, Marian, and Filipino
evangelizing school. It envisions to form resilient, ecologically sensitive, and globally
competent individuals through a culture of excellence shaped by the transformative
Rivierian education, responsive and dedicated to the call of the Church and broader
society.

MISSION:

Thus, we take it upon ourselves to:

1. provide transformative education rooted in the Rivierian values;
2. form Christ-centered, resilient, and globally competent individuals who are
academically excellent, socially responsible and stewards of God’s creation; and
3. prepare the youth and other stakeholders through holistic formation and a culture
of excellence to serve and contribute meaningfully to Church and society.

COURSE DESCRIPTION

Financial Management is an introductory finance course designed to make

students understand basic finance concepts. The course involves studies on decision-
making and utilizing financial resources available to the firm from the perspective of the
manager.

The course emphasizes the understanding of finance theory and a working

knowledge of the financial environment in which the firm operates in order to develop
appropriate financial strategies. Hence, it covers the whole range of basic finance
concepts, economics and financial environment, financial statement analysis, risk
analysis, and the valuation process.

COURSE OUTLINE

Number of Hours Content

5 Unit 1. An Overview of Financial Management
What is Finance?
Jobs in Finance
Forms of Business Organization
The Main Financial Goal: Creating Value for Investors
Stockholder-Manager Conflicts
Stockholder-Debtholder Conflicts
Balancing Shareholder Interests and the Interests of Society
Business Ethics
10 Unit 2. Financial Markets and Institutions
The Capital Allocation Process
Financial Markets
 ii

Financial Institutions
The Stock Market

12 Unit 3. Financial Statements, Cash Flow and Taxes

Financial Statements and Reports
The Balance Sheet
The Income Statement
Statement of Cash Flows
Statement of Stockholders’ Equity
Uses and Limitations of Financial Statements
Free Cash Flow
MVA and EVA
Income Taxes

13 Unit 4. Analysis of Financial Statements

Ratio Analysis
Liquidity Ratios
Asset Management Ratios
Debt Management Ratios
Profitability Ratios
Market Value Ratios
The DuPont Equation
Potential Misuses of ROE
Using Financial Ratios to Assess Performance
Uses and Limitations of Ratios

14 Unit 5. Time Value of Money

Time Lines, Future and Present Values
Annuities and Perpetuities
Uneven Cash Flows
Semiannual and Other Compounding Periods

Total No. of Hours: 54

 iii

Table of Contents

Unit 1. An Overview of Financial Management

Lesson 1.1 What is Finance?
Lesson 1.2 Jobs in Finance
Lesson 1.3 Forms of Business Organization
Lesson 1.4 The Main Financial Goal: Creating Value for Investors
Lesson 1.5 Stockholder-Manager Conflicts
Lesson 1.6 Stockholder-Debtholder Conflicts
Lesson 1.7 Balancing Shareholder Interests and the Interests of Society
Lesson 1.8 Business Ethics

Unit 2. Financial Markets and Institutions

Lesson 2.1 The Capital Allocation Process
Lesson 2.2 Financial Markets
Lesson 2.3 Financial Institutions
Lesson 2.4 The Stock Market
Lesson 2.5 The Market for Common Stock
Lesson 2.6 Stock Markets and Returns
Lesson 2.7 Stock Market Efficiency

Unit 3. Financial Statements, Cash Flow and Taxes

Lesson 3.1 Financial Statements and Reports
Lesson 3.2 The Balance Sheet
Lesson 3.3 The Income Statement
Lesson 3.4 Statement of Cash Flows
Lesson 3.5 Statement of Stockholders’ Equity
Lesson 3.6 Uses and Limitations of Financial Statements
Lesson 3.7 Free Cash Flow
Lesson 3.8 MVA and EVA
Lesson 3.9 Income Taxes

Unit 4. Analysis of Financial Statements

Lesson 4.1 Ratio Analysis
Lesson 4.2 Liquidity Ratios
Lesson 4.3 Asset Management Ratios
Lesson 4.4 Debt Management Ratios
Lesson 4.5 Profitability Ratios
Lesson 4.6 Market Value Ratios
Lesson 4.7 The DuPont Equation
Lesson 4.8 Potential Misuses of ROE
Lesson 4.9 Using Financial Ratios to Assess Performance
Lesson 4.10 Uses and Limitations of Ratios

Unit 5. Time Value of Money

Lesson 5.1 Time Lines, Future and Present Values
 iv

Lesson 5.2 Finding the Interest Rate (I) and Number of Years (N)
Lesson 5.3 Annuities and Perpetuities
Lesson 5.4 Uneven Cash Flows
Lesson 5.5 Semiannual and Other Compounding Periods
Lesson 5.6 Comparing Interest Rates
Lesson 5.7 Fractional Time Periods
Lesson 5.8 Amortized Loans
 1

UNIT
1 AN OVERVIEW OF FINANCIAL MANAGEMENT

TARGET GOAL FOR THE UNIT

o Point out ways on how managers can maximize the wealth of the firm. (AP)
o Examine techniques that firms use to mitigate potential conflicts between
stockholders and managers, and between stockholders and bondholders. (AN)

VALUES DESIRED: Perseverance, patience and teamwork

LESSON 1.1 WHAT IS FINANCE?

I. LEARNING OUTCOMES
 Define finance. (R)
 Explain the role of finance. (U)

II. INPUT

What is Finance?

Finance is defined by Webster’s Dictionary as “the system that includes the

circulation of money, the granting of credit, the making of investments, and the
provision of banking facilities”. Finance has many facets, which makes it difficult to
provide one concise definition. The discussion in this section will give you an idea of what
finance professionals do and what you might do if you enter the finance field after
you graduate.

Areas of Finance

Finance consists of three interrelated areas:

(1) financial management
(2) capital markets
(3) investments

Financial Management
 This is also called as corporate finance.
 Focuses on decisions relating to how much and what types of assets to acquire,
how to raise the capital needed to purchase assets, and how to run the firm so as
to maximize its value.
 The same principles apply to both for-profit and not-for-profit organizations, and
as the title suggests, much of this book is concerned with financial management.
 2

Capital Markets
 These relate to the markets where interest rates, along with stock and bond prices,
are determined.
 Also studied here are the financial institutions that supply capital to businesses.
 Banks, investment banks, stockbrokers, mutual funds, insurance companies, and
the like bring together “savers” who have money to invest and businesses,
individuals, and other entities that need capital for various purposes.
 Governmental organizations such as the Federal Reserve System, which
regulates banks and controls the supply of money, and the Securities and
Exchange Commission (SEC), which regulates the trading of stocks and bonds in
public markets, are also studied as part of capital markets.

Investments
 These relate to decisions concerning stocks and bonds and include a number of
activities:
1. Security analysis deals with finding the proper values of individual securities
(i.e., stocks and bonds).
2. Portfolio theory deals with the best way to structure portfolios, or “baskets,” of
stocks and bonds. Rational investors want to hold diversified portfolios in order
to limit risks, so choosing a properly balanced portfolio is an important issue for
any investor.
3. Market analysis deals with the issue of whether stock and bond markets at any
given time are “too high,” “too low,” or “about right.” Included in market analysis
is behavioral finance, where investor psychology is examined in an effort to
determine whether stock prices have been bid up to unreasonable heights in a
speculative bubble or driven down to unreasonable lows in a fit of irrational
pessimism.

Although we separate these three areas, they are closely interconnected. Banking
is studied under capital markets, but a bank lending officer evaluating a business’ loan
request must understand corporate finance to make a sound decision. Similarly, a
corporate treasurer negotiating with a banker must understand banking if the treasurer is
to borrow on “reasonable” terms. Moreover, a security analyst trying to determine a
stock’s true value must understand corporate finance and capital markets to do his or her
job. In addition, financial decisions of all types depend on the level of interest rates; so,
all people in corporate finance, investments, and banking must know something about
interest rates and the way they are determined.

Finance Within an Organization

Most businesses and not-for-profit organizations have an organization chart similar

to the one shown in Figure 1. The board of directors is the top governing body, and the
chairperson of the board is generally the highest-ranking individual. The CEO comes next
 3

but note that the chairperson of the board often also serves as the CEO. Below the CEO
comes the chief operating officer (COO), who is often also designated as a firm’s
president. The COO directs the firm’s operations, which include marketing,
manufacturing, sales, and other operating departments. The chief financial officer (CFO),
who is generally a senior vice president and the third-ranking officer, is in charge of
accounting, finance, credit policy, decisions regarding asset acquisitions, and investor
relations, which involves communications with stockholders and the press.

If the firm is publicly owned, the CEO and the CFO must both certify to the SEC
that reports released to stockholders, and especially the annual report, are accurate. If
inaccuracies later emerge, the CEO and the CFO could be fined or even jailed. This
requirement was instituted in 2002 as a part of the Sarbanes-Oxley Act. The act was
passed by Congress in the wake of a series of corporate scandals involving now-defunct
companies such as Enron and WorldCom, where investors, workers, and suppliers lost
billions of dollars due to false information released by those companies.

Sarbanes-Oxley Act A law passed by Congress that requires the CEO and CFO
to certify that their firm’s financial statements are accurate.

Figure 1. Finance Within the Organization

Finance Versus Economics and Accounting

Finance, as we know it today, grew out of economics and accounting. Economists

developed the notion that an asset’s value is based on the future cash flows the asset will
provide, and accountants provided information regarding the likely size of those cash
flows. People who work in finance need knowledge of both economics and accounting.
Figure 1 illustrates that in the modern corporation, the accounting department typically
 4

falls under the control of the CFO. This further illustrates the link among finance,
economics, and accounting.

LESSON 1.2 JOBS IN FINANCE

I. LEARNING OUTCOMES
 Identify the various types of jobs in finance. (R)

II. INPUT

Finance prepares students for jobs in banking, investments, insurance,

corporations, and government. Accounting students need to know marketing,
management, and human resources; they also need to understand finance, for it affects
decisions in all those areas. For example, marketing people propose advertising
programs, but those programs are examined by finance people to judge the effects
of the advertising on the firm’s profitability. So, to be effective in marketing, one
needs to have a basic knowledge of finance. The same holds for management—
indeed, most important management decisions are evaluated in terms of their
effects on the firm’s value.

It is also worth noting that finance is important to individuals regardless of

their jobs. Some years ago, most employees received pensions from their employers
upon retirement, so managing one’s personal investments was not critically
important. That’s no longer true. Most firms today provide “defined contribution” pension
plans, where each year the company puts a specified amount of
money into an account that belongs to the employee. The employee must decide
how those funds are to be invested—how much should be divided among stocks, bonds,
or money funds—and how much risk they’re willing to take with their
stock and bond investments. These decisions have a major effect on people’s lives,
and the concepts covered in this book can improve decision-making skills.

LESSON 1.3 FORMS OF BUSINESS ORGANIZATION

I. LEARNING OUTCOMES
 Differentiate the forms of business. (U)

II. INPUT

The basics of financial management are the same for all businesses, large or
small, regardless of how they are organized. Still, a firm’s legal structure affects its
operations and thus should be recognized.
There are four main forms of business organizations:
(1) Proprietorships
(2) Partnerships
(3) Corporations
 5

(4) Limited liability companies (LLCs) and limited liability partnerships (LLPs)

In terms of numbers, most businesses are proprietorships. However, based on the

dollar value of sales, more than 80% of all business is done by corporations. Because
corporations conduct the most business and because most successful businesses
eventually convert to corporations, we focus on them in this course. Still, it is important to
understand the legal differences between types of firms.

Proprietorship

An unincorporated business owned by one individual. Going into business as a

sole proprietor is easy—a person begins business operations.

Advantages:
1. They are easy and inexpensive to form.
2. They are subject to few government regulations.
3. They are subject to lower income taxes than are corporations.

Limitations:
1. Proprietors have unlimited personal liability for the business’ debts, so they can
lose more than the amount of money they invested in the company. You might
invest P10,000 to start a business but be sued for P1 million if, during company
time, one of your employees runs over someone with a car.
2. The life of the business is limited to the life of the individual who created it, and to
bring in new equity, investors require a change in the structure of the business.
3. Because of the first two points, proprietorships have difficulty obtaining large sums
of capital; hence, proprietorships are used primarily for small businesses.

However, businesses are frequently started as proprietorships and then converted

to corporations when their growth results in the disadvantages outweighing the
advantages.

Partnership

A partnership is a legal arrangement between two or more people who decide to

do business together. Partnerships are similar to proprietorships in that they can be
established relatively easily and inexpensively.
Moreover, the firm’s income is allocated on a pro rata basis to the partners and is
taxed on an individual basis. This allows the firm to avoid the corporate income tax.
However, all of the partners are generally subject to unlimited personal liability, which
means that if a partnership goes bankrupt and any partner is unable to meet his or her
pro rata share of the firm’s liabilities, the remaining partners will be responsible for making
good on the unsatisfied claims.

Corporation
 6

A corporation is a legal entity created by a state, and it is separate and distinct

from its owners and managers. It is this separation that limits stockholders’
losses to the amount they invested in the firm—the corporation can lose all of its money,
but its owners can lose only the funds that they invested in the company.
Corporations also have unlimited lives, and it is easier to transfer shares of stock
in a corporation than one’s interest in an unincorporated business. These factors
make it much easier for corporations to raise the capital necessary to operate large
businesses.
A major drawback to corporations is taxes. Most corporations’ earnings are
subject to double taxation—the corporation’s earnings are taxed, and then when
its after-tax earnings are paid out as dividends, those earnings are taxed again
as personal income to the stockholders.

Limited Liability Corporations (LLC) and Limited Liability Partnership (LLP)

A limited liability company (LLC) is a popular type of organization that is a hybrid

between a partnership and a corporation.

A limited liability partnership (LLP) is similar to an LLC. LLPs are used for
professional firms in the fields of accounting, law, and architecture, while LLCs are used
by other businesses.

Similar to corporations, LLCs and LLPs provide limited liability protection, but they
are taxed as partnerships. Further, unlike limited partnerships, where the general partner
has full control of the business, the investors in an LLC or LLP have votes in proportion
to their ownership interest.

When deciding on its form of organization, a firm must trade off the advantages of
incorporation against a possibly higher tax burden. However, for the following reasons,
the value of any business other than a relatively small one will probably be maximized if
it is organized as a corporation:

1. Limited liability reduces the risks borne by investors, and, other things held
constant, the lower the firm’s risk, the higher its value.
2. A firm’s value is dependent on its growth opportunities, which are dependent on
its ability to attract capital. Because corporations can attract capital more easily
than other types of businesses, they are better able to take advantage of growth
opportunities.
3. The value of an asset also depends on its liquidity, which means the time and effort
it takes to sell the asset for cash at a fair market value. Because the stock of a
corporation is easier to transfer to a potential buyer than is an interest in a
proprietorship or partnership, and because more investors are willing to invest in
stocks than in partnerships (with their potential unlimited liability), a corporate
investment is relatively liquid. This too enhances the value of a corporation.
 7

LESSON 1.4 THE MAIN FINANCIAL GOAL: CREATING VALUE FOR INVESTORS

I. LEARNING OUTCOMES
 Explain the links between stock price, intrinsic value, and executive compensation.
(U)

II. INPUT

In public corporations, managers and employees work on behalf of the

shareholders who own the business, and therefore they have an obligation to pursue
policies that promote stockholder value. While many companies focus on maximizing a
broad range of financial objectives, such as growth, earnings per share, and market
share, these goals should not take precedence over the main financial goal, which is to
create value for investors.
If a manager is to maximize stockholder wealth, he or she must know how that
wealth is determined. Throughout this course, we shall see that the value of
any asset is the present value of the stream of cash flows that the asset provides
to its owners over time. Thus, stock price maximization requires us to take a long-run
view of operations. At the same time, managerial actions that affect a company’s
value may not immediately be reflected in the company’s stock price.

Determinants of Value

Figure 2 illustrates the situation. The top box indicates that managerial actions,
combined with the economy, taxes, and political conditions, influence the level
and riskiness of the company’s future cash flows, which ultimately determine the
company’s stock price. As you might expect, investors like higher expected cash
flows, but they dislike risk; so, the larger the expected cash flows and the lower the
perceived risk, the higher the stock’s price.

The second row of boxes differentiates what we call “true” expected cash flows
and “true” risk from “perceived” cash flows and “perceived” risk. By “true,” we mean the
cash flows and risk that investors would expect if they had all of the information that
existed about a company. “Perceived” means what investors expect, given the limited
information they have.
 8

Figure 2. Determinants of Intrinsic Values and Stock

The third row of boxes shows that each stock has an intrinsic value, which is an
estimate of the stock’s “true” value as calculated by a competent analyst who has the best
available data, and a market price, which is the actual market price based on perceived
but possibly incorrect information as seen by the marginal investor. Not all investors
agree, so it is the “marginal” investor who determines the actual price.

When a stock’s actual market price is equal to its intrinsic value, the stock is in
equilibrium, which is shown in the bottom box in Figure 2. When equilibrium
exists, there is no pressure for a change in the stock’s price. Market prices can—
and do—differ from intrinsic values; eventually, however, as the future unfolds,
the two values tend to converge.

Intrinsic Value

Actual stock prices are easy to determine—they can be found on the Internet and
are published in newspapers every day. However, intrinsic values are estimates, and =
different analysts with different data and different views about the future form different
estimates of a stock’s intrinsic value. Indeed, estimating intrinsic values is what security
analysis is all about and is what distinguishes successful from unsuccessful investors.
Investing would be easy, profitable, and essentially riskless if we knew all stocks’ intrinsic
values—but, of course, we don’t. We can estimate intrinsic values, but we can’t be sure
that we are right. A firm’s managers have the best information about the firm’s future
 9

prospects, so managers’ estimates of intrinsic values are generally better than those of
outside investors. However, even managers can be wrong.

Intrinsic value is a long-run concept. Management’s goal should be to take actions

designed to maximize the firm’s intrinsic value, not its current market price. Note, though,
that maximizing the intrinsic value will maximize the average price over the long run, but
not necessarily the current price at each point in time. For example, management might
make an investment that lowers profits for the current year but raises expected future
profits. If investors are not aware of the true situation, the stock price will be held down
by the low current profit even though the intrinsic value was actually raised. Management
should provide information that helps investors make better estimates of the firm’s
intrinsic value, which will keep the stock price closer to its equilibrium level. However,
there are times when management cannot divulge the true situation because doing so
would provide information that helps its competitors.

Consequences of Having a Shor-run Focus

Ideally, managers adhere to this long-run focus, but there are numerous
examples in recent years where the focus for many companies shifted to the short run.
Perhaps most notably, prior to the recent financial crisis, many Wall Street executives
received huge bonuses for engaging in risky transactions that generated short-term
profits. Subsequently, the value of these transactions collapsed, causing many of these
Wall Street firms to seek a massive government bailout.

Effective governance requires holding managers accountable for poor

performance and understanding the important role that executive compensation plays
in encouraging managers to focus on the proper objectives. For example, if a manager’s
bonus is tied solely to this year’s earnings, it would not be a surprise to discover that the
manager took steps to pump up current earnings—even if those steps were detrimental
to the firm’s long-run value. With these concerns in mind, a growing number of companies
have used stock and stock options as a key part of executive pay. The intent of structuring
compensation in this way is for managers to think more like stockholders and to
continually work to increase shareholder value.

Despite the best of intentions, stock-based compensation does not always work
as planned. To give managers an incentive to focus on stock prices, stockholders (acting
through boards of directors) awarded executives stock options that could be exercised on
a specified future date. An executive could exercise the option on that date, receive stock,
immediately sell it, and earn a profit. The profit was based on the stock price on the option
exercise date, which led some managers to try to maximize the stock price on that specific
date, not over the long run. That, in turn, led to some horrible abuses. Projects that looked
good from a long-run perspective were turned down because they would penalize profits
in the short run and thus lower the stock price on the option exercise day. Even worse,
some managers deliberately overstated profits, temporarily boosted the stock price,
exercised their options, sold the inflated stock, and left outside stockholders “holding the
bag” when the true situation was revealed.
 10

LESSON 1.5 STOCKHOLDER-MANAGER CONFLICTS

I. LEARNING OUTCOMES
 Explain the links between stock price, intrinsic value, and executive compensation.
(U)

II. INPUT

It has long been recognized that managers’ personal goals may compete with
shareholder wealth maximization. In particular, managers might be more interested in
maximizing their own wealth than their stockholders’ wealth; therefore, managers might
pay themselves excessive salaries.

Effective executive compensation plans motivate managers to act in their

stockholders’ best interests. Useful motivational tools include:
(1) reasonable compensation packages
(2) firing of managers who don’t perform well
(3) the threat of hostile takeovers

Compensation Packages

Compensation packages should be sufficient to attract and retain able managers,

but they should not go beyond what is needed. Compensation policies need to be
consistent over time. Also, compensation should be structured so that managers are
rewarded on the basis of the stock’s performance over the long run, not the stock’s price
on an option exercise date. This means that options (or direct stock awards) should be
phased in over a number of years so that managers have an incentive to keep the stock
price high over time.

When the intrinsic value can be measured in an objective and verifiable manner,
performance pay can be based on changes in intrinsic value. However, because intrinsic
value is not observable, compensation must be based on the stock’s market price—but
the price used should be an average over time rather than on a specific date.

Direct Stockholder Intervention

Years ago, most stock was owned by individuals. Today, however, the majority of
stock is owned by institutional investors such as insurance companies, pension funds,
hedge funds, and mutual funds, and private equity groups are ready and able to step in
and take over underperforming firms. These institutional money managers have the clout
to exercise considerable influence over firms’ operations.

Given their importance, they have access to managers and can make suggestions
about how the business should be run. In effect, institutional investors such as CalPERS
(California Public Employees’ Retirement System, with $300 billion of assets) and TIAA-
 11

CREF (Teachers Insurance and Annuity Association-College Retirement Equities Fund,

a retirement plan originally set up for professors at private colleges that now has more
than $600 billion of assets) act as lobbyists for the body of stockholders. When such large
stockholders speak, companies listen. For example, Coca-Cola Co. revised its
compensation package after hearing negative feedback from its largest stockholder,
Warren Buffett.

Managers’ Response

If a firm’s stock is undervalued, corporate raiders will see it as a bargain and will
attempt to capture the firm in a hostile takeover. If the raid is successful, the target’s
executives will almost certainly be fired. This situation gives managers a strong incentive
to take actions to maximize their stock’s price. In the words of one executive, “If you want
to keep your job, never let your stock become a bargain.”

Note that the price managers should be trying to maximize is not the price on
a specific day. Rather, it is the average price over the long run, which will be maximized
if management focuses on the stock’s intrinsic value. However, managers
must communicate effectively with stockholders (without divulging information
that would aid their competitors) to keep the actual price close to the intrinsic
value. It’s bad for stockholders and managers when the intrinsic value is high but the
actual price is low. In that situation, a raider may swoop in, buy the company
at a bargain price, and fire the managers. To repeat our earlier message:
Managers should try to maximize their stock’s intrinsic value and then
communicate effectively with stockholders. That will cause the intrinsic value to be
high and the actual stock price to remain close to the intrinsic value over time.

Because the intrinsic value cannot be observed, it is impossible to know whether

it is really being maximized. Managers can use these valuation models to analyze
alternative courses of action and thus see how these actions are likely to impact the firm’s
value. This type of value-based management is not precise, but it is the best way to run
a business.

LESSON 1.6 STOCKHOLDER-DEBTHOLDER CONFLICTS

I. LEARNING OUTCOMES
 Discuss why stockholder-debtholder conflicts arise. (U)

II. INPUT

Conflicts can also arise between stockholders and debtholders. Debtholders,

which include the company’s bankers and its bondholders, generally receive fixed
payments regardless of how well the company does, while stockholders do better when
the company does better. This situation leads to conflicts between these two groups,
to the extent that stockholders are typically more willing to take on risky projects.
 12

Another type of stockholder–debtholder conflict arises over the use of additional

debt. The more debt a firm uses to finance a given amount of assets, the riskier the firm
becomes. For example, if a firm has $100 million of assets and finances them with $5
million of bonds and $95 million of common stock, things have to go terribly badly before
the bondholders suffer a loss. On the other hand, if the firm uses $95 million of bonds and
$5 million of stock, the bondholders suffer a loss even if the value of the assets declines
only slightly.

Bondholders attempt to protect themselves by including covenants in the

bond agreements that limit firms’ use of additional debt and constrain managers’
actions in other ways.

LESSON 1.7 BALANCING SHAREHOLDER INTERESTS AND THE INTERESTS

OF SOCIETY

I. LEARNING OUTCOMES
 Discover ways on how to balance shareholder interest and the society. (APP)

II. INPUT

To understand how corporate managers, balance the interests of society and

shareholders, it is helpful to first look at those issues from the perspective of a
sole proprietor. Most managers understand that maximizing shareholder value does not
mean that they are free to ignore the larger interests of society.

From a broader perspective, firms have a number of different departments,

including marketing, accounting, production, human resources, and finance. The
finance department’s principal task is to evaluate proposed decisions and judge
how they will affect the stock price and thus shareholder wealth.

Interestingly, some companies have taken more explicit steps to recognize the
broader needs of society. A fairly small but rapidly growing number of companies
have become certified as “B” or “benefit” corporations. While these companies are
still focused on making a profit, they are committed to putting other stakeholders
such as employees, customers, and their communities on an equal footing with
shareholders. In order to qualify as a B corporation, the company must subject
itself to an annual audit in which its practices regarding social responsibility corporate
governance, and transparency are reviewed.

LESSON 1.8 BUSINESS ETHICS

I. LEARNING OUTCOMES
 Discuss the importance of business ethics and the consequences of unethical
behavior. (U)
 13

II. INPUT

The word ethics is defined in Webster’s dictionary as “standards of conduct or

moral behavior”. Business ethics can be thought of as a company’s attitude and conduct
toward its employees, customers, community, and stockholders (Brigham & Houston,
2019).

High standards of ethical behavior demand that a firm treat each party that it deals
with in a fair and honest manner. A firm’s commitment to business ethics can be
measured by the tendency of the firm and its employees to adhere to laws and regulations
relating to such factors as product safety and quality, fair employment practices, fair
marketing and selling practices, the use of confidential information for personal gain,
community involvement, bribery, and illegal payments to obtain business.

Consequences of Unethical Behavior

 Bankruptcy (e.g. Enron and Worldcom Scandal)
 Damaging blow to reputation (e.g. General Motors on issue about ignition switches)

How Should Employees Deal with Unethical Behavior?

According to Brigham and Houston (2019), the desire for stock options, bonuses,
and promotions drives managers to take unethical actions such as fudging the books to
make profits in the manager’s division look good, holding back information about bad
products that would depress sales, and failing to take costly but needed measures to
protect the environment.

These issues are often tricky and judgment comes into play when deciding on what
action to take and when to take it. If a lower-level employee thinks that a product should
be pulled, but the boss disagrees, what should the employee do? If an employee decides
to report the problem, trouble may ensue regardless of the merits of the case. If the alarm
is false, the company will have been harmed, and nothing will have been gained. In that
case, the employee will probably be fired. Even if the employee is right, his or her career
may still be ruined because many companies (or at least bosses) don’t like “disloyal,
troublemaking” employees.

Further, employees can be “stuck between a rock and a hard place,” that is, doing
what they should do and possibly losing their jobs versus going along with the boss and
possibly ending up in jail. This discussion shows why ethics is such an important
consideration in business and in business schools—and why we are concerned with it.
(Brigham & Houston, 2019, p. 23).
 14

UNIT
2 FINANCIAL MARKETS AND INSTITUTIONS

TARGET GOAL FOR THE UNIT

o Point out the importance of financial markets and institutions in the economy. (AP)
o Differentiate various types of financial markets, institutions and stock markets. (AN)
o Develop a simple understanding of behavioral finance. (AP)

VALUES DESIRED: Perseverance, patience and teamwork

LESSON 2.1 THE CAPITAL ALLOCATION PROCESS

I. LEARNING OUTCOMES
 Explain the capital allocation process. (U)

II. INPUT

Businesses, individuals, and governments often need to raise capital. People and
organizations with surplus funds are saving today in order to accumulate funds for some
future use. Those with surplus funds expect to earn a return on their investments, while
people and organizations that need capital understand that they must pay interest to
those who provide that capital.

Transfer of funds in three ways according to Brigham and Houston (2019):

1. Direct transfers of money and securities.

 This occurs when a business sells its stocks or bonds directly to savers,
without going through any type of financial institution.
 This procedure is used mainly by small firms, and relatively little capital is
raised by direct transfers.

2. Transfer through underwriters.

 An underwriter facilitates the issuance of securities.
 The company sells its stocks or bonds to the investment bank, which then sells
these same securities to savers.
 The businesses’ securities and the savers’ money merely “pass through” the
investment bank.
 There is a risk involved in the investment banks since it buys and holds
securities for a period of time and may not be able to resell the securities to
savers.
 This transaction is also called as primary market transaction.
 15

Figure 3. Diagram of the Capital Formation Process for Business

3. Transfer through a financial intermediary.

 Intermediaries may be banks, insurance companies or mutual funds.
 Intermediary obtains funds from savers in exchange for its securities.
 The intermediary uses this money to buy and hold businesses’ securities, and
the savers hold the intermediary’s securities.
 Intermediaries literally create new forms of capital—in this case, certificates of
deposit, which are safer and more liquid.
 The existence of intermediaries greatly increases the efficiency of money and
capital markets.

Often the entity needing capital is a business (and specifically a corporation), but
it is easy to visualize the demander of capital being a home purchaser, a small business,
or a government unit.

In a global context, economic development is highly correlated with the level and
efficiency of financial markets and institutions. It is difficult, if not impossible, for an
economy to reach its full potential if it doesn’t have access to a well-functioning financial
system. In a well-developed economy like that of the United States, an extensive set of
markets and institutions has evolved over time to facilitate the efficient allocation of
capital. To raise capital efficiently, managers must understand how these markets and
institutions work, and individuals need to know how the markets and institutions work to
earn high rates of returns on their savings (Brigham & Houston, 2019).
 16

LESSON 2.2 FINANCIAL MARKETS

I. LEARNING OUTCOMES
 Identify the different types of financial markets. (R)
 Discuss the importance of financial markets in the economy. (U)

II. INPUT

FINANCIAL MARKETS

A financial market is a market where buyers and sellers trade commodities,

financial securities, foreign exchange, and other freely exchangeable items (fungible
items) and derivatives of value at low transaction costs and at prices that are determined
by market forces.

Types of Markets

Brigham and Houston (2019) provided the following classification of markets.

1. Physical asset markets versus financial asset markets.

 Physical asset markets are for products such as wheat, autos, real estate,
computers and machinery.
 Financial asset markets deal with stocks, bonds, notes and mortgages. This
also deals with derivative securities whose values are derived from changes
in the prices of other assets.

2. Spot markets versus futures markets.

 Spot markets are markets in which assets are bought or sold for “on-the-
spot” delivery
 Futures markets are markets in which participants agree today to buy or sell
an asset at some future date. Such a transaction can reduce, or hedge, the
risks faced by the parties.
3. Money markets versus capital markets.
 Money markets are the markets for short-term, highly liquid debt securities.
 Capital markets are the markets for intermediate- or long-term debt and
corporate stocks.

4. Primary markets versus secondary markets.

 Primary markets are the markets in which corporations raise new capital.
 Secondary markets are markets in which existing, already outstanding
securities are traded among investors.
- Secondary markets also exist for mortgages, other types of loans, and
other financial assets.
 17

- The corporation whose securities are being traded is not involved in a

secondary market transaction and thus does not receive funds from such
a sale.

5. Private markets versus public markets.

 Private markets, where transactions are negotiated directly between two or
more parties. Because these transactions are private, they may be
structured in any manner to which the relevant parties agree.
 Public markets, where standardized contracts are traded on organized
exchanges.
- Bank loans and private debt placements with insurance companies are
examples of private market transactions.
- These securities must have fairly standardized contractual features
because public investors do not generally have the time and expertise to
negotiate unique, non-standardized contracts.

Note: A healthy economy is dependent on efficient funds transfers from people who are
net savers to firms and individuals who need capital. Without efficient transfers, the
economy could not function. It is essential that financial markets function efficiently—
not only quickly, but also inexpensively.

LESSON 2.3 FINANCIAL INSTITUTIONS

I. LEARNING OUTCOMES
 Identify the different types of financial institutions. (R)
 Discuss the importance of financial institutions in the economy. (U)

II. INPUT

FINANCIAL INSTITUTIONS

Large businesses in developed economies find it more efficient to enlist the

services of a financial institution when it comes time to raising capital.

Major Categories of Financial Institutions according Brigham and Houston (2019):

1. Investment banks.
- An organization that underwrites and distributes new investment
securities and helps businesses obtain financing.
- They are called underwriters because they generally guarantees that the
firm will raise the needed capital.
 18

 Help corporations design securities with features that are currently

attractive to investors,
 buy these securities from the corporation, and
 resell them to savers

2. Commercial banks.
- The traditional department store of finance serving a variety of savers
and borrowers.
- Provides savings and checking services and influences the money
supply of a country.

3. Financial services corporations.

- These are large conglomerates that combine many different financial
institutions within a single corporation.
- Most financial
- The services corporations started in one area but have now diversified to
cover most of the financial spectrum. Ex. an investment bank, a securities
brokerage organization, insurance companies, and leasing companies

4. Credit unions.
- These are cooperative associations whose members are supposed to
have a common bond, such as being employees of the same firm.
- Members’ savings are loaned only to other members, generally for auto
purchases, home improvement loans, and home mortgages.
- Often the cheapest source of funds available to individual borrowers.

5. Pension funds.
- These are retirement plans funded by corporations or government
agencies for their workers and administered primarily by the trust
departments of commercial banks or by life insurance companies.
- Invests primarily in bonds, stocks, mortgages and real estate.
6. Life insurance companies.
- Take savings in the form of annual premiums; invest these funds in
stocks, bonds, real estate, and mortgages; and make payments to the
beneficiaries of the insured parties.
- In recent years, life insurance companies have also offered a variety of
tax-deferred savings plans designed to provide benefits to participants
when they retire.

7. Mutual funds.
- These are corporations that accept money from savers and then use
these funds to buy stocks, long-term bonds, or short-term debt
instruments issued by businesses or government units.
 19

- These organizations pool funds and thus reduce risks by diversification.

- They also achieve economies of scale in analyzing securities, managing
portfolios, and buying and selling securities.
- Different funds are designed to meet the objectives of different types of
savers.

8. Exchange traded funds (ETFs).

- Similar to regular mutual funds and are often operated by mutual fund
companies.
- ETFs buy a portfolio of stocks of a certain type and then sell their own
shares to the public.
- ETF shares are generally traded in the public markets, so an investor
who wants to invest in the market can buy shares in an ETF that holds
stocks in that particular market.

9. Hedge funds.
- Also similar to mutual funds because they accept money from savers and
use the funds to buy various securities, but there are some important
differences.
o Mutual funds (and ETFs) are registered and regulated by the SEC.
o Hedge funds are largely unregulated.
- The difference in regulation derives from the fact that mutual
funds typically target small investors, whereas hedge funds
usually have large minimum investments and are marketed
primarily to institutions and individuals with high net worth.
- Hedge funds received their name because they traditionally were used
when an individual was trying to hedge risks.

10. Private equity companies.

- Organizations that operate much like hedge funds, but rather than
purchasing some of the stock of a firm, private equity players buy and
then manage entire firms.
- Most of the money used to buy the target companies is borrowed.
 20

LESSON 2.4 THE STOCK MARKET

I. LEARNING OUTCOMES
 Explain how the stock market operates. (U)
 Differentiate various types of stock markets. (AN)
 Explain how the stock market has performed in recent years. (U)

II. INPUT

THE STOCK MARKET

The stock market refers to the collection of markets and exchanges where regular
activities of buying, selling, and issuance of shares of publicly-held companies take place
(Chen, 2020).

It is the most active secondary markets and the most important one to financial
managers where the prices of firms’ stock are established (Brigham & Houston, 2019).

Types of Stock Markets:

1. Physical location exchanges
2. Electronic dealer-based markets or the Over-the-counter (OTC) markets

Physical Location Stock Exchanges

Physical location exchanges are tangible entities. Each of the larger exchanges
occupies its own building, allows a limited number of people to trade on its floor, and has
an elected governing body—its board of governors (Brigham & Houston, 2019).

 Most of the larger investment banks operate brokerage departments. They

purchase seats on the exchanges and designate one or more of their officers as
members.
 The exchanges are open on all normal working days, with the members meeting
in a large room equipped with telephones and other electronic equipment that
enable each member to communicate with his or her firm’s offices throughout the
country.
 Like other markets, security exchanges facilitate communication between buyers
and sellers.
 The exchanges operate as auction markets. The exchange members with “sell
orders” offer the shares for sale, and they are bid for by the members with “buy
orders”.

Over-the-counter (OTC) Markets

 21

An OTC is a large collection of brokers and dealers, connected electronically by

telephones and computers that provides for trading in unlisted securities (Brigham &
Houston, 2019).
 Some brokerage firms maintain an inventory of stocks and stand prepared to make
a market for them. These “dealers” buy when individual investors want to sell, and
they sell part of their inventory when investors want to buy. The inventory of
securities was kept in a safe, and the stocks, when bought and sold, were literally
passed over the counter.

 Today, this is referred to as dealer markets.

- A dealer market includes all facilities that are needed to conduct security
transactions, but the transactions are not made on the physical location
exchanges.
- The dealer market system consists of:
(1) relatively few dealers who hold inventories of these securities and
who are said to “make a market” in these securities,
(2) thousands of brokers who act as agents in bringing the dealers
together with investors, and
(3) computers, terminals, and electronic networks that provide a
communication link between dealers and brokers.
- The dealers who make a market in a particular stock quote the price at
which they will pay for the stock (the bid price) and the price at which they
will sell shares (the ask price).
- Each dealer’s prices, which are adjusted as supply and demand
conditions change, can be seen on computer screens across the world.
- The bid-ask spread, which is the difference between bids and ask prices,
represents the dealer’s markup, or profit.
- The dealer’s risk increases when the stock is more volatile or when the
stock trades infrequently.

THE MARKET FOR COMMON STOCK

 Closely Held Corporation

- A corporation that is owned by a few individuals who are typically
associated with the firm’s management.

 Publicly Owned Corporation

- A corporation that is owned by a relatively large number of individuals
who are not actively involved in the firm’s management.

Types of Stock Market Transactions

 22

1. Outstanding shares of established publicly owned companies that are

traded: the secondary market.
- The market for outstanding shares or used shares is the secondary
market.
- The company receives no new money when sales occur in this market.

2. Additional shares sold by established publicly owned companies: the

primary market.
- These are new shares issued by the corporation. And thus, occur in a
primary market.

3. Initial public offerings made by privately held firms: the IPO market.
- Whenever stock in a closely held corporation is offered to the public for
the first time, the company is said to be going public.
- The market for stock that is just being offered to the public is called the
initial public offering (IPO) market.

STOCK MARKETS AND RETURNS Note: You may also visit

google finance website at
Stock Market Reporting [Link]
finance.
Up until a few years ago, the best source of stock
quotations was the business section of daily newspapers. One problem with newspapers,
however, is that they report yesterday’s prices. Now it is possible to obtain quotes
throughout the day from a wide variety of Internet sources. One of the best is Yahoo!’s
[Link] (Brigham & Houston, 2019).
 23

Figure 4. Stock Quote for Twitter, Inc. August 14, 2020

Stock Market Efficiency

To begin this section, consider the following definitions:

Unlocking of Terms
1. Market price: The current price of a stock.
2. Intrinsic value: The price at which the stock would sell if all investors
had all knowable information about a stock.
3. Equilibrium price
- The price that balances buy and sell orders at any given time.
- When a stock is in equilibrium, the price remains relatively stable
until new information becomes available and causes the price to
change.
4. Efficient market: A market in which prices are close to intrinsic values
and stocks seem to be in equilibrium.

According to Brigham and Houston (2019), when markets are efficient, investors
can buy and sell stocks and be confident that they are getting good prices. When markets
are inefficient, investors may be afraid to invest and may put their money “under the
pillow,” which will lead to a poor allocation of capital and economic stagnation. From an
economic standpoint, market efficiency is good.

There is an “efficiency continuum,” with the market for some companies’ stocks
being highly efficient and the market for other stocks being highly inefficient. The key
factor is the size of the company—the larger the firm, the more analysts tend to follow it
and thus the faster new information is likely to be reflected in the stock’s price. Also,
different companies communicate better with analysts and investors, and the better the
communications, the more efficient the market for the stock. In an inefficient market, it
might be possible to purchase the company’s stock at a low price and then be able to turn
around and sell it at a higher price making a profit. This is called arbitrage (Brigham &
Houston, 2019 pp. 53-54).
 24

Behavioral Finance Theory

The efficient markets hypothesis (EMH) remains one of the cornerstones of

modern finance theory. It implies that, on average, asset prices are about equal to their
intrinsic values. The logic behind the EMH is straightforward. If a stock’s price is “too low,”
rational traders will quickly take advantage of this opportunity and buy the stock, pushing
prices up to the proper level. Likewise, if prices are “too high,” rational traders will sell the
stock, pushing the price down to its equilibrium level.

Although the logic behind the EMH is compelling, many events in the real world
seem inconsistent with the hypothesis, which has spurred a growing field called
behavioral finance. Rather than assuming that investors are rational, behavioral finance
theorists borrow insights from psychology to better understand how irrational behavior
can be sustained over time.

Key points in behavioral finance theory:

1. It is often difficult or risky for traders to take advantage of mispriced assets.
2. Deals with why mispricings can occur in the first place.

These experiments suggest that investors and managers behave differently in

down markets than they do in up markets, which might explain why those who made
money early in the stock market bubble continued to invest their money in the market
even as prices went ever higher. Other evidence suggests that individuals tend to
overestimate their true abilities (Brigham & Houston, 2019, pp.55).

Conclusions about Market Efficiency

According to Brigham and Houston (2019), if the stock market is efficient, it is a

waste of time for most people to seek bargains by analyzing published data on stocks.
That follows because if stock prices already reflect all publicly available information, they
will be fairly priced, and a person can beat the market only with luck or inside information.
So rather than spending time and money trying to find undervalued stocks, it would be
better to buy an index fund designed to match the overall market as reflected in an index.

However, if we worked for an institution with billions of dollars, we would try to find
undervalued stocks or companies because even a small undervaluation would amount to
 25

a great deal of money when investing millions rather than thousands. Also, markets are
more efficient for individual stocks than for entire companies; so for investors with enough
capital, it does make sense to seek out badly managed companies that can be acquired
and improved.

However, even if markets are efficient and all stocks and companies are fairly
priced, an investor should still be careful when selecting stocks for his or her portfolio.
Most importantly, the portfolio should be diversified, with a mix of stocks from various
industries along with some bonds and other fixed-income securities.
 26

UNIT
3 FINANCIAL STATEMENTS, CASH FLOW AND TAXES

TARGET GOAL FOR THE UNIT

o Prepare a complete set of financial statement in good form. (Cre)

VALUES DESIRED: Perseverance, patience and teamwork

LESSON 3.1 FINANCIAL STATEMENTS AND REPORTS

I. LEARNING OUTCOMES
 Describe financial reports. (R)
 Explain why financial reports are needed by the users. (U)

II. INPUT

A BRIEF HISTORY OF ACCOUNTING AND FINANCIAL STATEMENTS

Thousands of years ago, individuals (or families) were self-contained in the sense
that they gathered their own food, made their own clothes, and built their own shelters.
Then specialization began—some people became good at making pots, others at making
arrowheads, others at making clothing, and so on.

As specialization began, so did trading, initially in the form of barter. At first, each
artisan worked alone, and trade was strictly local. Eventually, though, master craftsmen
set up small factories and employed workers, money (in the form of clamshells) began to
be used, and trade expanded beyond the local area. As these developments occurred, a
primitive form of banking began.

When the first loans were made, lenders could physically inspect borrowers’ assets
and judge the likelihood of the loan’s being repaid. Eventually, though, lending became
more complex—borrowers were developing larger factories, traders were acquiring fleets
of ships and wagons, and loans were being made to develop distant mines and trading
posts. Also, some investments were made on a share-of-the-profits basis, and this meant
that profits (or income) had to be determined. At the same time, factory owners and large
merchants needed reports to see how effectively their own enterprises were being run,
and governments needed information for use in assessing taxes. For all these reasons,
a need arose for financial statements, for accountants to prepare those statements, and
for auditors to verify the accuracy of the accountants’ work.

The economic system has grown enormously since its beginning, and accounting
has become more complex. However, the original reasons for financial statements still
apply: Bankers and other investors need accounting information to make intelligent
 27

decisions, managers need it to operate their businesses efficiently, and taxing authorities
need it to assess taxes in a reasonable way (Ballada & Ballada, 2014).

FINANCIAL STATEMENTS AND REPORTS

Annual Report

According to Brigham and Houston (2019) an annual report is a report issued

annually by a corporation to its stockholders. It contains basic financial statements as well
as management’s analysis of the firm’s past operations and future prospects.

Further, it contains two types of information. First, there is a verbal section, often
represented as a letter from the chairperson, which describes the firm’s operating results
during the past year and discusses new developments that will affect future operations.
Second, the report provides these four basic financial statements:

1. The balance sheet – which shows what assets the company owns and who has
claims on those assets as of a given date—for example, December 31, 2018.
2. The income statement – which shows the firm’s sales and costs (and thus profits)
during some past period—for example, 2018.
3. The statement of cash flows, which shows how much cash the firm began the
year with, how much cash it ended up with, and what it did to increase or decrease
its cash.
4. The statement of stockholders’ equity, which shows the amount of equity the
stockholders had at the start of the year, the items that increased or decreased
equity, and the equity at the end of the year.

These statements are related to one another, and, taken together, they provide an
accounting picture of the firm’s operations and financial position.

The quantitative and verbal materials are equally important. The financial
statements report what has actually happened to assets, earnings, and dividends over
the past few years, whereas the verbal statements attempt to explain why things turned
out the way they did.
 28

LESSON 3.2 THE BALANCE SHEET

I. LEARNING OUTCOMES
 Discuss the balance sheet and its uses. (U)
 Compute balance sheet figures. (APP)

The Balance Sheet

 The balance sheet is a “snapshot” of a firm’s position at a specific point in time.
 Figure 5 shows the layout of a typical balance sheet. The left side of the statement
shows the assets that the company owns, and the right side shows the
firm’s liabilities and stockholders’ equity, which are claims against the firm’s assets.
 As Figure 5, assets are divided into two major categories:
o current assets and fixed, or long-term, assets. Current assets consist of
assets that should be converted to cash within one year, and they include
cash and cash equivalents, accounts receivable, and inventory. Long-term
assets are assets expected to be used for more than one year; they include
plant and equipment in addition to intellectual property such as patents and
copyrights. Plant and equipment is generally reported net of accumulated
depreciation.
 The claims against assets are of two basic types—liabilities (or money the
company owes to others) and stockholders’ equity. Current liabilities consist of
claims that must be paid off within one year, including accounts payable, accruals
(total of accrued wages and accrued taxes), and notes payable to banks and other
short-term lenders that are due within one year. Long-term debt includes bonds
that mature in more than a year.
 Stockholders’ equity can be thought of in two ways. First, it is the amount
that stockholders paid to the company when they bought shares the company sold
to raise capital, in addition to all of the earnings the company has retained
over the years: Stockholders’ equity = Paid-in capital + Retained earnings
 The retained earnings are not just the earnings retained in the latest year—
they are the cumulative total of all of the earnings the company has earned and
retained during its life. Stockholders’ equity can also be thought of as a residual:
Stockholders’ equity = Total assets - Total liabilities
 29

Figure 5. The Balance Sheet

Working capital
 Current assets are often called working capital because these assets “turn over”;
that is, they are used and then replaced throughout the year.
 If we subtract current liabilities from current assets, the difference is called
net working capital: Net working capital = Current assets - Current liabilities
 Current liabilities include accounts payable, accruals, and notes payable to
the bank.
 Financial analysts often make an important distinction between net working capital
(NWC) and net operating working capital (NOWC). NOWC differs from NWC in
two important ways. First, NOWC makes a distinction between cash that is used
for operating purposes and “excess” cash that is being held for other purposes.
 Second, when looking at a company’s current liabilities, analysts distinguish
between its “free” liabilities (accruals and accounts payable) and its interest-
bearing notes payable. These interest-bearing liabilities are typically treated as a
financing cost, rather than an operating cost, which explains why they are not
included as part of the company’s operating current liabilities.
 30

LESSON 3.3 THE INCOME STATEMENT

I. LEARNING OUTCOMES
 Discuss the income statement and its uses. (U)
 Compute income statement figures. (APP)

II. INPUT

Income statements
 Reports summarizing a firm’s revenues, expenses, and profits during a reporting
period, generally a quarter or a year.

Earnings per share (EPS)

 Earnings per share (EPS) is often called “the bottom line,” denoting that of all
items on the income statement, EPS is the one that is most important to
stockholders.
 A typical stockholder focuses on the reported EPS, but professional security
analysts and managers differentiate between operating and non-operating income.

Operating Income
 Earnings from operations before interest and taxes (i.e., EBIT).

Operating income (or EBIT) = Sales revenues - Operating costs

Different firms have different amounts of debt, different tax carrybacks and
carryforwards, and different amounts of non-operating assets such as marketable
securities. These differences can cause two companies with identical operations to
report significantly different net incomes.

Depreciation
 The charge to reflect the cost of assets depleted in the production process.
Depreciation is not a cash outlay.

Amortization
 A noncash charge similar to depreciation except that it represents a decline in
value of intangible assets.

EBITDA
 An acronym for earnings before interest, taxes, depreciation, and amortization.
 31

LESSON 3.4 STATEMENT OF CASH FLOWS

I. LEARNING OUTCOMES
 Discuss the statement of cash flows and its uses. (U)
 Compute net cash flow figures. (APP)

II. INPUT

Statement of Cash Flows

A report that shows how items that affect the balance sheet and income statement
affect the firm’s cash flows.

The company’s cash position as reported on the balance sheet is affected by

different factors which includes the following:

1. Cash flow. Other things held constant, a positive net cash flow will lead to more
cash in the bank. However, as we discuss below, other things are generally not
held constant.
2. Changes in working capital. Net working capital, is defined as current assets
minus current liabilities. Increases in current assets other than cash, such as
inventories and accounts receivable, decrease cash, whereas decreases in these
accounts increase cash.
3. Fixed assets. If a company invests in fixed assets, this will reduce its cash
position. On the other hand, the sale of fixed assets will increase cash.
4. Security transactions. If a company issues stock or bonds during the year, the
funds raised will enhance its cash position. On the other hand, if it uses cash to
buy back outstanding debt or equity, or pays dividends to its shareholders, this will
reduce cash.

The statement of cash flows is separated into three categories:

1. Operating activities: includes net income, noncash expenses (depreciation and

amortization), and changes in current assets and current liabilities other than cash
and short-term debt.

2. Investing activities: includes investments in or sales of fixed assets (noncurrent

assets).

3. Financing activities: includes cash raised during the year by issuing short-term
debt, long-term debt, or stock. Also, since dividends paid or cash used to buy back
outstanding stock or bonds reduces the company’s cash, such transactions are
included here.
 32

Cash Flows from Operations

 This is the first section of the cash flow statement;
 It includes transactions from all operational business activities;
 This begins with net income then reconciles all noncash items;
 It is the company’s net income but in cash version (Hayes, 2020).

Cash Flows from Investing

 This is the second section of the cash flow statement;
 It is the result of investment gains and losses;
 This section also includes cash spent on property, plant, and equipment
 This section is where analysts look to find changes in capital expenditures (capex).
(Hayes,2020)

Cash Flows from Financing

 It is the last section of the cash flow statement;
 The section provides an overview of cash used in business financing;
 It measures cash flow between a company and its owners and its creditors, and
its source is normally from debt or equity;
 These figures are generally reported annually on a company's 10-K report to
shareholders;
 Analysts use the cash flows from financing section to determine how much money
the company has paid out via dividends or share buybacks;
 It is also useful to help determine how a company raises cash for operational
growth (Hayes, 2020).

Read more about this topic at [Link]

See additional sample income statement at [Link]
 33

TABLE 1. Allied Food Products: Statement of Cash Flows for 2018

(Millions of Dollars)

LESSON 3.5 STATEMENT OF STOCKHOLDERS’ EQUITY

I. LEARNING OUTCOMES
 Discuss the statement of stockholders’ equity and its uses. (U)
 Compute stockholders’ equity figures. (APP)

II. INPUT

Statement of Stockholders’ Equity

 A statement that shows by how much a firm’s equity changed during the year and
why this change occurred.
 34

 “Retained earnings” represents a claim against assets, not assets per

se. Stockholders allow management to retain earnings and reinvest them in the
business, use retained earnings for additions to plant and equipment, add to
inventories, and the like. Companies do not just pile up cash in a bank account.
Thus, retained earnings as reported on the balance sheet do not represent cash
and are not “available” for dividends or anything else.

Hayes (2020) pointed out important details about stockholders’ equity:

 Stockholders' equity refers to the assets remaining in a business once all liabilities
have been settled.
 This figure is calculated by subtracting total liabilities from total assets;
alternatively, it can be calculated by taking the sum of share capital and retained
earnings, less treasury stock.
 A negative stockholders' equity may indicate an impending bankruptcy.

Paid-in Capital

 Investors contribute their share of (paid-in) capital as stockholders, which is the

basic source of total stockholders' equity.
 The amount of paid-in capital from an investor is a factor in determining his/her
ownership percentage.

Retained Earnings

 Retained earnings are a company's net income from operations and other
business activities retained by the company as additional equity capital.
 They represent returns on total stockholders' equity reinvested back into the
company.
 Retained earnings accumulate and grow larger over time.
 Accumulated retained earnings may exceed the amount of contributed equity
capital and can eventually grow to be the main source of stockholders' equity.

Treasury Shares
 35

 These are “share buybacks”.

 Shares bought back by companies become treasury Note:
Contra accounts
shares, and their dollar value is noted in the treasury
are subtracted in
stock contra account.
computing the total
 Treasury shares continue to count as issued shares, but
shareholders’
they are not considered to be outstanding and are thus
equity.
not included in dividends or the calculation of earnings
per share (EPS).
 Treasury shares can always be reissued back to stockholders for purchase when
companies need to raise more capital.
 If a company doesn't wish to hang on to the shares for future financing, it can
choose to retire the shares.
Read more about this topic at [Link]
[Link]
See additional sample income statement at [Link]

TABLE 2. Allied Food Products: Statement of Stockholders’ Equity

Dec. 31, 2018(Millions of Dollars)

LESSON 3.6 USES AND LIMITATIONS OF FINANCIAL STATEMENTS

I. LEARNING OUTCOMES
 Explain the uses and limitations of FS. (U)

II. INPUT

Financial statements provide a great deal of useful information. You can inspect
the statements and answer a number of important questions such as these: How large is
the company? Is it growing? Is it making or losing money? Is it generating cash through
its operations, or are operations actually losing cash?
 36

At the same time, investors need to be cautious when they review financial
statements. Although companies are required to follow GAAP, managers still
have a lot of discretion in deciding how and when to report certain transactions.

Consequently, two firms in exactly the same situation may report financial
statements that convey different impressions about their financial strength. Some
variations may stem from legitimate differences of opinion about the correct way
to record transactions. In other cases, managers may choose to report numbers in
a manner that helps them present either higher or more stable earnings over time.
As long as they follow GAAP, such actions are legal, but these differences make it
difficult for investors to compare companies and gauge their true performances.
In particular, watch out if senior managers receive bonuses or other compensation
based on earnings in the short run—they may try to boost short-term reported
income to boost their bonuses.

Unfortunately, there have also been cases where managers disregarded GAAP
and reported fraudulent statements. One blatant example of cheating involved
WorldCom, which reported asset values that exceeded their true value by about $11
billion. This led to an understatement of costs and a corresponding overstatement of
profits. Enron is another high-profile example. It overstated the value of
certain assets, reported those artificial value increases as profits, and transferred
the assets to subsidiary companies to hide the true facts. Enron’s and WorldCom’s
investors eventually learned what was happening, and the companies were forced
into bankruptcy. Many of their top executives went to jail, the accounting firm
that audited their books was forced out of business, and investors lost billions of
dollars.

After the Enron and WorldCom fiascos, Congress in 2002 passed the Sarbanes-
Oxley Act (SOX), which required companies to improve their internal auditing standards
and required the CEO and CFO to certify that the financial statements were properly
prepared. The SOX bill also created a new watchdog organization to help make sure that
the outside accounting firms were doing their jobs.

More recently, a serious debate has arisen regarding the appropriate accounting
for complicated investments held by financial institutions. In the recent financial crisis,
many of these investments (particularly those related to subprime mortgages) turned out
to be worth a lot less than their stated book value. Currently, regulators and other policy
makers are struggling to come up with the best way to account for and regulate many of
these “toxic assets.”

Finally, keep in mind that even if investors receive accurate accounting data,
it is cash flows, not accounting income, that matters most.
 37

LESSON 3.7 FREE CASH FLOWS

I. LEARNING OUTCOMES
 Discuss the free cash flows. (U)

II. INPUT

Free Cash Flow (FCF)

The amount of cash that could be withdrawn without harming a firm’s ability to
operate and to produce future cash flows.
Accounting statements are designed primarily for use by creditors and tax
collectors, not for managers and stock analysts. Therefore, corporate
decision makers and security analysts often modify accounting data to meet their
needs. The most important modification is the concept of free cash flow (FCF).

Net Operating Profit After Taxes (NOPAT)

 The profit a company would generate if it had no debt and held only operating
assets.

The first term represents the amount of cash that the firm generates from its current
operations. EBIT (1 2 T) is often referred to as NOPAT, or net operating profit after
taxes. Depreciation and amortization are added back because these are noncash
expenses that reduce EBIT but do not reduce the amount of cash the company has
available to pay its investors. The second bracketed term indicates the amount of cash
that the company is investing in its fixed assets (capital expenditures) and operating
working capital in order to sustain ongoing operations.

A positive level of FCF indicates that the firm is generating more than enough
cash to finance current investments in fixed assets and working capital. By contrast,
negative free cash flow means that the company does not have sufficient internal funds
to finance investments in fixed assets and working capital, and that it will have to raise
new money in the capital markets in order to pay for these investments.

Illustration:

A company has EBIT of $30 million, depreciation of $5 million, and a 40% tax rate. It
needs to spend $10 million on new fixed assets and $15 million to increase its operating
current assets. It expects its accounts payable to increase by $2 million, its accruals to
 38

increase by $3 million, and its notes payable to increase by $8 million. The firm’s current
liabilities consist of only accounts payable, accruals, and notes payable. What is its free
cash flow?

Computation:
First, you need to determine the ∆Net operating working capital (∆NOWC):
∆NOWC = ∆Operating current assets - ∆Operating current liabilities
∆NOWC = ∆Operating current assets - (∆Current liabilities – ∆Notes payable)
∆NOWC = $15 - ($13 - $8)
∆NOWC = $15 - $5 = $10 million

Now, you can solve for free cash flow (FCF):

LESSON 3.8 MVA AND EVA

I. LEARNING OUTCOMES
 Explain the concept of market value added (MVA) and economic value added
(EVA. (U)

II. INPUT

Items reported on the financial statements reflect historical, in-the-past, values, not
current market values, and there are often substantial differences between the two.
Changes in interest rates and inflation affect the market value of the company’s
assets and liabilities but often have no effect on the corresponding book values
shown in the financial statements. Perhaps, more importantly, the market’s assessment
of value takes into account its ongoing assessment of current operations as
well as future opportunities.

Market Value Added (MVA)

 The excess of the market value of equity over its book value.
 MVA is simply the difference between the market value of a firm’s equity and the
book value as shown on the balance sheet, with market value found by multiplying
the stock price by the number of shares outstanding.

Economic Value Added (EVA)

 39

 Excess of NOPAT over capital costs.

 Companies create value (and realize positive EVA) if the benefits of their
investments exceed the cost of raising the necessary capital. Total invested capital
represents the amount of money that the company has raised from debt, equity,
and any other sources of capital (such as preferred stock).
 EVA is an estimate of a business’s true economic profit for a given year, and
it often differs sharply from accounting net income. The main reason for this
difference is that although accounting income takes into account the cost of debt
(the company’s interest expense), it does not deduct for the cost of equity capital.
By contrast, EVA takes into account the total dollar cost of all capital, which
includes both the cost of debt and equity capital.
 If EVA is positive, then after-tax operating income exceeds the cost of the capital
needed to produce that income, and management’s actions are adding value
for stockholders.
 Positive EVA on an annual basis will help ensure that MVA is also positive. Note
that whereas MVA applies to the entire firm, EVA can be determined for divisions
as well as for the company as a whole, so it is useful as a guide to “reasonable”
compensation for divisional as well as top corporate managers.

LESSON 3.9 INCOME TAXES

I. LEARNING OUTCOMES
 Discuss the relation of income taxes to finance. (U)

II. INPUT

Individuals and corporations pay out a significant portion of their income as taxes,
so taxes are important in both personal and corporate decisions. Presented in this lesson
is the summary of the income taxes for individuals and corporations. The details of our
tax laws change fairly often, but the basic nature of the tax system is likely to remain
intact.
 40

Individual Taxes

Individuals pay taxes on wages and salaries, on investment income (dividends,

interest, and profits from the sale of securities), and on the profits of proprietorships and
partnerships. The tax rates are progressive—that is, the higher one’s income, the larger
the percentage paid in taxes.
Taxable income is defined as “gross income less a set of exemptions and
deductions.”

Progressive
 A tax system where the tax rate is higher on higher incomes.

Passive Income Tax of Individuals

 Passive income for individuals includes prizes, interest, royalty, winnings,
dividends, etc.
 The passive income tax rate will depend on the nature of the passive income
earned by an individual.
 This is subject to final withholding tax.

Table 3. Income Tax Table for Individuals in the Philippines

 41

NORMAL (SCHEDULAR) TAX RATE ON INDIVIDUAL TAXPAYER

Sec. 24 (A) of NIRC (R.A. 10963)
Not over P250,000 0%
Over P250,000 but not over P400,000 20% of the excess over P250,000
Over P400,000 but not over P800,000 P30,000 + 25% of the excess over P400,000
Over P800,000 but not over P2,000,000 P130,000 + 30% of the excess over P800,000
Over P2,000,000 but not over P8,000,000 P490,000 + 32% of the excess over P2,000,000
Over P8,000,000 P2,410,000 + 35% of the excess over P8,000,000

Corporate Taxes

Corporate Income Tax

 Domestic and foreign corporations will be taxable at 30% normal income tax
(NCIT) rate based on the net taxable income.
 Starting 4th year of operation, the minimum corporate income tax (MCIT) of 2% of
the gross income will be applicable to all types of corporation doing business in the
Philippines.

Passive Income Tax for Corporations

 Passive income for corporations include interest, prizes, winnings, royalties,
dividends, etc.
 Passive income tax rate will depend on type of passive income earned by a
corporation.
 42

UNIT
4 ANALYSIS OF FINANCIAL STATEMENTS

TARGET GOAL FOR THE UNIT

o Analyze financial statements using ratios. (AN)
o Evaluate the results of financial statement analysis. (EV)

VALUES DESIRED: Perseverance, patience and teamwork

LESSON 4.1 RATIO ANALYSIS

I. LEARNING OUTCOMES
 Explain ratio analysis. (U)

II. INPUT

RATIO ANALYSIS

Gitman and Zutter (2014) defined ratio analysis as involving methods of calculating
and interpreting financial ratios to analyze and monitor the firm’s performance. He
emphasized that relative is the key word in financial statement analysis because it is
based on the use of ratios or relative values.

The basic inputs to ratio analysis are the firm’s income statement and balance
sheet. The information contained in the four basic financial statements is of major
significance to a variety of interested parties who regularly need to have relative
measures of the company’s performance.

Types of financial ratios:

1. Liquidity ratios, which give an idea of the firm’s ability to pay off debts that are
maturing within a year.
2. Asset management ratios, which give an idea of how efficiently the firm is
using its assets.
3. Debt management ratios, which give an idea of how the firm has financed its
assets as well as the firm’s ability to repay its long-term debt.
4. Profitability ratios, which give an idea of how profitably the firm is operating
and utilizing its assets.
5. Market value ratios, which give an idea of what investors think about the firm
and its future prospects.

Satisfactory liquidity ratios are necessary if the firm is to continue operating.

Good asset management ratios are necessary for the firm to keep its costs low and
 43

thus its net income high. Debt management ratios indicate how risky the firm is
and how much of its operating income must be paid to bondholders rather than
stockholders. Profitability ratios combine the asset and debt management categories and
show their effects on ROE. Finally, market value ratios tell us what investors think about
the company and its prospects.

All of the ratios are important, but different ones are more important for
some companies than for others. For example, if a firm borrowed too much in
the past and its debt now threatens to drive it into bankruptcy, the debt ratios
are key. Similarly, if a firm expanded too rapidly and now finds itself with
excess inventory and manufacturing capacity, the asset management ratios
take center stage. The ROE is always important, but a high ROE depends on
maintaining liquidity, on efficient asset management, and on the proper use
of debt. Managers are, of course, vitally concerned with the stock price, but
managers have little direct control over the stock market’s performance; they
do, however, have control over their firm’s ROE. So, ROE tends to be the main
focal point.

LESSON 4.2 LIQUIDITY RATIOS

I. LEARNING OUTCOMES
 Explain liquidity ratio. (U)
 Compute for liquidity ratios. (APP)

II. INPUT

LIQUIDITY RATIOS

The liquidity ratios help answer this question: Will the firm be able to pay off its
debts as they come due and thus remain a viable organization? If the answer is
no, liquidity must be addressed.

Liquid Asset
 An asset that can be converted to cash quickly without having to reduce the asset’s
price very much.

1. Current Ratio
 The primary liquidity ratio is the current ratio, which is calculated by
dividing current assets by current liabilities.
 It indicates the extent to which current liabilities are covered by those assets
expected to be converted to cash in the near future.
 44

 Current assets include cash, marketable securities, accounts receivable,

and inventories.
 Formula and sample computation:

 Interpretation: Allied’s current ratio is 3.2, which is well below the industry
average of 4.2. Therefore, its liquidity position is somewhat weak, but by no
means desperate.

2. Quick or Acid Test Ratio

 The second liquidity ratio is the quick, or acid test, ratio, which is
calculated by deducting inventories from current assets and then dividing
the remainder by current liabilities.
 Inventories are typically the least liquid of a firm’s current assets, and if
sales slowdown, they might not be converted to cash as quickly as
expected.
 Also, inventories are the assets on which losses are most likely to occur in
the event of liquidation. Therefore, the quick ratio, which measures the
firm’s ability to pay off short-term obligations without relying on the sale of
inventories, is important.
 Formula and sample computation:

 Interpretation: The industry average quick ratio is 2.2, so Allied’s 1.2 ratio is
relatively low. Still, if the accounts receivable can be collected, the company
can pay off its current liabilities even if it has trouble disposing of its
inventories.
 45

LESSON 4.3 ASSET MANAGEMENT RATIOS

I. LEARNING OUTCOMES
 Explain asset management ratio. (U)
 Compute for asset management ratios. (APP)

II. INPUT

ASSET MANAGEMENT RATIOS

The second group of ratios, the asset management ratios, measure how
effectively the firm is managing its assets. These ratios answer this question: Does
the amount of each type of asset seem reasonable, too high, or too low in view
of current and projected sales?

1. Inventory Turnover Ratio

 “Turnover ratios” divide sales by some asset: Sales/Various assets.
 As the name implies, these ratios show how many times the particular asset is
“turned over” during the year.
 Formula and sample computation:

 As a rough approximation, each item of Allied’s inventory is sold and restocked,

or “turned over,” 4.9 times per year.
 Turnover is a term that originated many years ago with the old Yankee peddler
who would load up his wagon with pots and pans, and then go off on his route
to peddle his wares. The merchandise was called working capital because it
was what he actually sold, or “turned over,” to produce his profits, whereas his
“turnover” was the number of trips he took each year.
 Interpretation: Allied’s inventory turnover of 4.9 is much lower than the industry
average of 10.9. This suggests that it is holding too much inventory. Excess
inventory is, of course, unproductive and represents an investment with a low
or zero rate of return. Allied’s low inventory turnover ratio also makes us
question its current ratio. With such a low turnover, the firm may be holding
obsolete goods that are not worth their stated value.

2. Days Sales Outstanding

 Accounts receivable are evaluated by the days sales outstanding (DSO)
ratio, also called the average collection period (ACP).
 46

 It is calculated by dividing accounts receivable by the average daily sales to

find how many days’ sales are tied up in receivables.
 Thus, the DSO represents the average length of time the firm must wait after
making a sale before receiving cash.
 Allied has 46 days’ sales outstanding, well above the 36-day industry average:

 Formula and sample computation:

 The DSO can be compared with the industry average, but it is also evaluated
by comparing it with Allied’s credit terms. Allied’s credit policy calls for payment
within 30 days. So, the fact that 46 days’ sales are outstanding, not 30 days’,
indicates that Allied’s customers, on average, are not paying their bills on time.
This deprives the company of funds that could be used to reduce bank loans
or some other type of costly capital.
 Moreover, the high average DSO indicates that if some customers are paying
on time, quite a few must be paying very late. Late-paying customers often
default, so their receivables may end up as bad debts that can never be
collected.

3. Fixed Assets Turnover Ratio

 The fixed assets turnover ratio, which is the ratio of sales to net fixed assets,
measures how effectively the firm uses its plant and equipment.
 Formula and sample computation:

 Allied’s ratio of 3.0 times is slightly above the 2.8 industry average, indicating
that it is using its fixed assets at least as intensively as other firms in the
industry. Therefore, Allied seems to have about the right amount of fixed assets
relative to its sales.

4. Total Assets Turnover Ratio

 The final asset management ratio, the total assets turnover ratio, measures
the turnover of all of the firm’s assets, and it is calculated by dividing sales by
total assets.
 47

 Formula and sample computation:

LESSON 4.4 DEBT MANAGEMENT RATIOS

I. LEARNING OUTCOMES
 Explain debt management ratio. (U)
 Compute for debt management ratios. (APP)

II. INPUT

DEBT MANAGEMENT RATIOS

A set of ratios that measure how effectively a firm manages its debt.

The use of debt will increase, or “leverage up,” a firm’s ROE if the firm earns more
on its assets than the interest rate it pays on debt. However, debt exposes the firm
to more risk than if it financed only with equity. In this section we discuss debt
management ratios.

1. Total Debt to Total Capital

 The ratio of total debt to total capital measures the percentage of the firm’s
capital provided by debtholders.
 Formula and sample computation:

 Interpretation: Allied’s debt ratio is 47.8%, which means that its creditors have
supplied roughly half of its total funds.
 Creditors prefer low debt ratios because the lower the ratio, the greater the
cushion against creditors’ losses in the event of liquidation. Stockholders, on
 48

the other hand, may want more leverage because it can magnify expected
earnings.

2. Times Interest Earned Ratio

 The times-interest-earned (TIE) ratio is determined by dividing earnings
before interest and taxes (EBIT) by the interest charges.
 Formula and sample computation:

 The TIE ratio measures the extent to which operating income can decline
before the firm is unable to meet its annual interest costs. Failure to pay
interest will bring legal action by the firm’s creditors and probably result in
bankruptcy. Note that earnings before interest and taxes, rather than net
income, are used in the numerator. Because interest is paid with pretax
dollars, the firm’s ability to pay current interest is not affected by taxes.
 Interpretation: Allied’s interest is covered 3.2 times. The industry average is 6
times, so Allied is covering its interest charges by a much lower margin of
safety than the average firm in the industry. Thus, the TIE ratio reinforces our
conclusion from the debt ratio, namely, that Allied would face difficulties if it
attempted to borrow additional money.

LESSON 4.5 PROFITABILITY RATIOS

I. LEARNING OUTCOMES
 Explain the profitability ratios. (U)
 Compute for profitability ratios. (APP)

II. INPUT
Profitability Ratios
 A group of ratios that show the combined effects of liquidity, asset management,
and debt on operating results.

1. Operating Margin
 The operating margin, calculated by dividing operating income (EBIT) by
sales, gives the operating profit per dollar of sales.
 Formula and sample computation:
 49

 Interpretation: Allied’s 9.5% operating margin is below the industry average

of 10.0%. This subpar result indicates that Allied’s operating costs are too
high. This is consistent with the low inventory turnover and high days sales
outstanding ratios that we calculated earlier.

2. Profit Margin
 The profit margin, also sometimes called the net profit margin, is
calculated by dividing net income by sales.
 Formula and sample computation:

 Interpretation: Allied’s 3.9% profit margin is below the industry average of

5.0%, and this subpar result occurred for two reasons. First, Allied’s
operating margin was below the industry average because of the firm’s high
operating costs. Second, the profit margin is negatively impacted by Allied’s
heavy use of debt.

3. Return on Total Assets

 Net income divided by total assets gives us the return on total assets
(ROA)
 Formula and sample computation:

 Interpretation: Allied’s 5.9% return is well below the 9.0% industry average.
This is not good—it is obviously better to have a higher than a lower return
on assets. Note, though, that a low ROA can result from a conscious
decision to use a great deal of debt, in which case high interest expenses
will cause net income to be relatively low. That is part of the reason for
Allied’s low ROA.
 50

4. Return on Common Equity

 Another important accounting ratio is the return on common equity (ROE).
 Formula and sample computation:

 Stockholders expect to earn a return on their money, and this ratio tells how
well they are doing in an accounting sense.
 Interpretation: Allied’s 12.5% return is below the 15.0% industry average,
but not as far below as the return on total assets. This somewhat better
ROE results from the company’s greater use of debt.

5. Return on Invested Capital

 The return on invested capital (ROIC) measures the total return that the
company has provided for its investors.
 Formula and sample computation:

 ROIC differs from ROA in two ways. First, its return is based on total
invested capital rather than total assets. Second, in the numerator it uses
after-tax operating income (NOPAT) rather than net income.
 The key difference is that net income subtracts the company’s after-tax
interest expense and therefore represents the total amount of income
available to shareholders, while NOPAT is the amount of funds available to
pay both stockholders and debtholders.

6. Basic Earnings Power (BEP) ratio

 The basic earning power (BEP) ratio is calculated by dividing operating
income (EBIT) by total assets.
 Formula and sample computation:
 51

 This ratio shows the raw earning power of the firm’s assets before the
influence of taxes and debt, and it is useful when comparing firms with
different debt and tax situations. Because of its low turnover ratios and poor
profit margin on sales, Allied has a lower BEP ratio than the average food
processing company.

Illustration:
A company has $20 billion of sales and $1 billion of net income. Its total assets
are $10 billion. The company’s total assets equal total invested capital, and its capital
consists of half debt and half common equity. The firm’s interest rate is 5%, and its tax
rate is 40%.
1. What is its profit margin?
2. What is its ROA?
3. What is its ROE?
4. What is its ROIC?
5. Would this firm’s ROA increase if it used less leverage? (The size of the firm
does not change.)
Answer:
 52

LESSON 4.6 MARKET VALUE RATIOS

I. LEARNING OUTCOMES
 Explain the market value ratios. (U)
 Compute for market value ratios. (APP)

II. INPUT

MARKET VALUE RATIOS

These are ratios that relate the firm’s stock price to its earnings and book value
per share. The market value ratios are used in three primary ways:
a. by investors when they are deciding to buy or sell a stock;
b. by investment bankers when they are setting the share price for a new stock
issue (an IPO); and
c. by firms when they are deciding how much to offer for another firm in a potential
merger.

1. Price/Earnings Ratio
 The price/earnings (P/E) ratio shows how much investors are willing to
pay per dollar of reported profits.
 Formula and sample computation:

 Allied’s stock sells for $23.06; so, with an EPS of $2.35, its P/E ratio is 9.83x.
 P/E ratios are relatively high for firms with strong growth prospects and little
risk but low for slowly growing and risky firms.
 Interpretation: Allied’s P/E ratio is below its industry average; so, this
suggests that the company is regarded as being relatively risky, as having
poor growth prospects, or both.

2. Market/Book Ratio
 The ratio of a stock’s market price to its book value gives another indication
of how investors regard the company. Companies that are well regarded by
investors— which means low risk and high growth—have high M/B ratios.
 Formula and sample computation:
 53

 Interpretation: Investors are willing to pay less for a dollar of Allied’s book
value than for one of an average food processing company. This is
consistent with our other findings.
 M/B ratios typically exceed 1.0, which means that investors are willing to
pay more for stocks than the accounting book values of the stocks. This
situation occurs primarily because asset values, as reported by accountants
on corporate balance sheets, do not reflect either inflation or goodwill.
Assets purchased years ago at pre-inflation prices are carried at their
original costs even though inflation might have caused their actual values
to rise substantially; successful companies’ values rise above their historical
costs, whereas unsuccessful ones have low M/B ratios.

3. Enterprise Value/ EBITDA Ratio

 The ratio of a firm’s enterprise value relative to its EBITDA.
 In recent years, a lot of analysts have begun to focus intently on another
key ratio, the enterprise value/EBITDA (EV/EBITDA) ratio.
 The EV/EBITDA ratio looks at the relative market value of all the company’s
key financial claims.
 One benefit of this approach is that unlike the P/E ratio, the EV/EBITDA
ratio is not heavily influenced by the company’s debt and tax situations.
 Formula and sample computation:

 Total debt in this calculation includes long-term debt plus short-term

interest-bearing debt. In addition, for simplicity, we are assuming that
Allied’s debt is priced at par, so the market value of its debt is assumed to
equal its book value.
 This measure of enterprise value subtracts out the company’s cash
holdings. This adjustment makes it easier to compare companies with very
different levels of excess cash.
 54

 Interpretation: Allied’s EV/EBITDA ratio is significantly lower than the

industry average. This reinforces our other calculations, indicating that the
firm’s operations are not run as efficiently as they could be.

LESSON 4.7 THE DUPONT EQUATION

I. LEARNING OUTCOMES
 Explain the use of the DuPont equation. (U)

II. INPUT

DuPont Equation
 We have discussed many ratios, so it would be useful to see how they work
together to determine the ROE. For this, we use the DuPont equation, a formula
developed by the chemical giant’s financial staff in the 1920s.
 A formula that shows that the rate of return on equity can be found as the product
of profit margin, total assets turnover, and the equity multiplier. It shows the
relationships among asset management, debt management, and profitability
ratios.

Formula and sample computation:

 The first term, the profit margin, tells us how much the firm earns on its sales. This
ratio depends primarily on costs and sales prices—if a firm can command a
premium price and hold down its costs, its profit margin will be high, which will help
its ROE.
 The second term is the total assets turnover. It is a “multiplier” that tells us how
many times the profit margin is earned each year—Allied earned 3.92% on each
dollar of sales, and its assets were turned over 1.5 times each year; so, its return
on assets was 3.92% x 1.5 = 5.9%. Note, though, that this entire 5.9% belongs to
the common stockholders—the bondholders earned a return in the form of interest,
and that interest was deducted before we calculated net income to stockholders.
 55

So, the whole 5.9% return on assets belongs to the stockholders. Therefore, the
return on assets must be adjusted upward to obtain the return on equity.
 That brings us to the third term, the equity multiplier, which is the adjustment factor.
Allied’s assets are 2.13 times its equity, so we must multiply the 5.9% return on
assets by the 2.133 equity multiplier to arrive at its ROE of 12.5%.

LESSON 4.8 POTENTIAL MISUSE OF ROE

I. LEARNING OUTCOMES
 Discuss the potential misuse of the ROE. (U)

II. INPUT

Although ROE is an important measure of performance, we know that managers

should strive to maximize shareholder wealth. If a firm takes steps that improve
its ROE, does that mean that shareholder wealth will also be increased? The
answer is “not necessarily.”
Indeed, three problems are likely to arise if a firm relies too heavily on ROE to
measure performance.
1. ROE does not consider risk.
2. ROE does not consider the amount of invested capital.
3. A focus on ROE can cause managers to turn down profitable projects.

LESSON 4.9 USING FINANCIAL RATIOS TO ASSESS PERFORMANCE

I. LEARNING OUTCOMES
 Explain how financial ratios are used to assess firm’s performance. (U)

II. INPUT

There are three approaches to assessing firm’s performance through financial

ratios.

1. Comparison to Industry Average

 One way to assess performance is to compare the company’s key ratios to
the industry averages.
 This will be useful to have a quick reference of the calculated ratios of the
industry and to identify its strengths and weaknesses.

2. Benchmarking
 It is the process of comparing a particular company with a subset of top
competitors in its industry.
 56

 The benchmarking setup makes it easy for the company to see exactly
where it stands relative to the competition.

3. Trend Analysis
 An analysis of a firm’s financial ratios over time; used to estimate the
likelihood of improvement or deterioration in its financial condition.

LESSON 4.10 USES AND LIMITATIONS OF RATIOS

I. LEARNING OUTCOMES
 Discuss the uses and limitations in the use of financial ratios. (U)

II. INPUT

As noted earlier, ratio analysis is used by three main groups:

1. Managers – use ratios to help analyze, control, and thus improve their firms’
operations
2. Credit analysts – analyze ratios to help judge a company’s ability to repay its
debts;
3. Stock analysts – are interested in a company’s efficiency, risk, and growth
prospects

Some potential problems are listed here:

1. Many firms have divisions that operate in different industries; for such companies,
it is difficult to develop a meaningful set of industry averages. Therefore, ratio
analysis is more useful for narrowly focused firms than for multidivisional ones.

2. Most firms want to be better than average, so merely attaining average

performance is not necessarily good. As a target for high-level performance, it is
best to focus on the industry leaders’ ratios. Benchmarking helps in this regard.

3. Inflation has distorted many firms’ balance sheets—book values are often different
from market values. Market values would be more appropriate for most purposes,
but we cannot generally get market value figures because assets such as used
machinery are not traded in the marketplace. Further, inflation affects asset values,
depreciation charges, inventory costs, and thus profits. Therefore, a ratio analysis
for one firm over time or a comparative analysis of firms of different ages must be
interpreted with care and judgment.
 57

4. Seasonal factors can also distort a ratio analysis. For example, the inventory
turnover ratio for a food processor will be radically different if the balance
sheet figure used for inventory is the one just before, versus just after, the
close of the canning season. This problem can be mitigated by using monthly
averages for inventory (and receivables) when calculating turnover ratios.

5. Firms can employ “window dressing” techniques to improve their financial

statements.

6. Different accounting practices can distort comparisons. As noted earlier,

inventory valuation and depreciation methods can affect financial statements
and thus distort comparisons among firms.

7. It is difficult to generalize about whether a particular ratio is “good” or

“bad.”

8. Firms often have some ratios that look “good” and others that look “bad,”
making it difficult to tell whether the company is, on balance, strong or weak.

Looking Beyond the Numbers

This is critically important for anyone making business decisions or forecasting

stock prices. However, sound financial analysis involves more than just numbers—good
analysis requires that certain qualitative factors also be considered. These factors, as
summarized by the American Association of Individual Investors (AAII), include the
following:

1. Are the company’s revenues tied to one key customer? If so, the company’s
performance may decline dramatically if that customer goes elsewhere. On
the other hand, if the customer has no alternative to the company’s products, this
might actually stabilize sales.
2. To what extent are the company’s revenues tied to one key product? Firms
that focus on a single product are often efficient, but a lack of diversification
also increases risk because having revenues from several products stabilizes
profits and cash flows in a volatile world.
3. To what extent does the company rely on a single supplier? Depending on a single
supplier may lead to an unanticipated shortage and a hit to sales and profits.
4. What percentage of the company’s business is generated overseas?
Companies with a large percentage of overseas business are often able to
realize higher growth and larger profit margins. However, overseas operations may
expose the firm to political risks and exchange rate problems.
5. How much competition does the firm face? Increases in competition tend to
lower prices and profit margins; so, when forecasting future performance, it is
 58

important to assess the likely actions of current competitors and the entry of
new ones.
6. Is it necessary for the company to continually invest in research and development?
If so, its future prospects will depend critically on the success of new
products in the pipeline. For example, investors in a pharmaceutical company
want to know whether the company has a strong pipeline of potential blockbuster
drugs and whether those products are doing well in the required tests.
7. Are changes in laws and regulations likely to have important implications
for the firm? For example, when the future of electric utilities is forecasted, it
is crucial to factor in the effects of proposed regulations affecting the use of
coal, nuclear, and gas-fired plants.
 59

UNIT
5 TIME VALUE OF MONEY

TARGET GOAL FOR THE UNIT

o Calculate for the present and future values. (APP)
o Apply time value analysis in financial management decisions. (APP)

VALUES DESIRED: Perseverance, patience and teamwork

LESSON 5.1 TIME LINES, FUTURE AND PRESENT VALUES

I. LEARNING OUTCOMES
 Discuss the use and importance of time lines. (U)
 Discuss the future and present values. (U)
 Solve for the future and present values. (APP)

II. INPUT

TIME LINES
 An important tool used in time value analysis; it is a graphical representation used
to show the timing of cash flows.
 As an illustration, consider the following diagram, where PV represents $100 that
is on hand today, and FV is the value that will be in the account on a future date:

 The intervals from 0 to 1, 1 to 2, and 2 to 3 are time periods such as years or

months. Time 0 is today, and it is the beginning of Period 1; Time 1 is one period
from today, and it is both the end of Period 1 and the beginning of Period 2; and
so forth.
 Note that each tick mark corresponds to both the end of one period and the
beginning of the next one. Thus, if the periods are years, the tick mark at Time 2
represents the end of Year 2 and the beginning of Year 3.
 Cash flows are shown directly below the tick marks, and the relevant interest
rate is shown just above the time line. Unknown cash flows, which you are trying
to find, are indicated by question marks. Here the interest rate is 5%; a single cash
outflow, $100, is invested at Time 0; and the Time 3 value is an unknown inflow.
In this example, cash flows occur only at Times 0 and 3, with no flows at Times 1
or 2.
 60

 Time lines are essential when you are first learning time value concepts, but
even experts use them to analyze complex finance problems.

FUTURE VALUES (FV)

The amount to which a cash flow or series of cash flows will grow over
a given period of time when compounded at a given interest rate.

PRESENT VALUE (PV)

- The value today of a future cash flow or series of cash flows.

Compounding
- The arithmetic process of determining the final value of a cash flow or series of cash
flows when compound interest is applied.

Approaches in solving FV and PV

1. Step-by-step approach
2. Formula approach
3. Financial calculators

Compound interest
- Occurs when interest is earned on prior periods’ interest.

Simple interest
- Occurs when interest is not earned on interest.

Formula Approach

In the step-by-step approach, we multiply the amount at the beginning of each

period by (1 + 1) = (1.05). If N=3, we multiply by (1+1) three different times,
which is the same as multiplying the beginning amount by (1+1)3. This concept
can be extended, and the result is this key equation:

FVN = PV (1 + i)N

Sample Problem:
At the beginning of your freshman year, your favorite aunt and uncle deposit
$10,000 into a 4-year bank certificate of deposit (CD) that pays 5% annual interest. You
will receive the money in the account (including the accumulated interest) if you graduate
with honors in 4 years. How much will there be in the account after 4 years?

Computation:
 61

Use the formula: FVN = PV (1 + i)N

PV = 10,000
N=4
i = 5%
FVN = PV (1 + i)N
FVN = 10,000 (1 + .05)4
FVN = 12,155.06

PRESENT VALUES (PV)

- Finding a present value is the reverse of finding a future value.

Formula:

Discounting
- The process of finding the present value of a cash flow or a series of cash flows.
- Discounting is the reverse of compounding.

LESSON 5.2 ANNUITIES AND PERPETUITIES

I. LEARNING OUTCOMES
 Discuss usage of annuities and perpetuities. (U)
 Solve for annuities. (APP)

II. INPUT

ANNUITIES
A series of equal payments at fixed intervals for a specified number of periods. A
series of equal payments at fixed intervals for a specified number of periods.
1. Ordinary (Deferred) Annuity - An annuity whose payments occur at the end
of each period.
2. Annuity Due - An annuity whose payments occur at the beginning of each period.
 62

Keep in mind that annuities must have constant payments at fixed intervals for a
specified number of periods. If these conditions don’t hold, then the payments do not
constitute an annuity.

FUTURE VALUE OF AN ORDINARY ANNUITY

Formula:

FUTURE VALUE OF AN ANNUITY DUE

Formula:

PRESENT VALUE OF AN ORDINARY ANNUITY

Formula:

PERPETUITIES
- A perpetuity is simply an annuity with an extended life.
 63

- Because the payments go on forever, you can’t apply the step-by-step approach.
However, it’s easy to find the PV of a perpetuity with a formula found by solving
equation with N set at infinity:

LESSON 5.3 UNEVEN CASH FLOWS

I. LEARNING OUTCOMES
 Solve for the present value or future values with uneven cash flows. (APP)

II. INPUT

Uneven (Non-constant) Cash Flows

- A series of cash flows where the amount varies from one period to the next.

Payment (PMT)
- This term designates equal cash flows coming at regular intervals.

Cash Flows (CF)

- This term designates a cash flow that’s not part of an annuity.

There are two important classes of uneven cash flows:

1. a stream that consists of a series of annuity payments plus an additional final lump
sum; and
2. all other uneven streams. Bonds represent the best example of the first type, while
stocks and capital investments illustrate the second type.

Here are numerical examples of the two types of flows

 64

FUTURE VALUE OF AN UNEVEN CASH FLOW STREAM

We find the future value of uneven cash flow streams by compounding rather
than discounting.

The values of all financial assets—stocks, bonds, and business capital

investments—are found as the present values of their expected future cash flows.
Therefore, we need to calculate present values very often, far more often than future
values. As a result, all financial calculators provide automated functions for finding PVs,
but they generally do not provide automated FV functions. On the relatively few occasions
when we need to find the FV of an uneven cash flow stream, we generally use the step-
by-step procedure.

Figure 6. FV of an Uneven Cash Flow

LESSON 5.4 SEMIANNUAL AND OTHER COMPOUNDING PERIODS

I. LEARNING OUTCOMES
 Solve for the values for semiannual and other compounding periods. (APP)

II. INPUT

Annual Compounding
- Compounding The arithmetic process of determining the final value of a cash flow
or series of cash flows when interest is added once a year.

Semiannual Compounding
- The arithmetic process of determining the final value of a cash flow or series of
cash flows when interest is added twice a year.

Example:
 65

For an illustration of semiannual compounding, assume that we deposit $100

in an account that pays 5% and leave it there for 10 years. First, consider again
what the future value would be under annual compounding:

How would things change in this example if interest was paid semiannually rather
than annually?
1. Convert the stated interest rate into a “periodic rate.”
2. Convert the number of years into “number of periods.”

The conversions are done as follows, where I is the stated annual rate, M is the
number of compounding periods per year, and N is the number of years:

With a stated annual rate of 5%, compounded semiannually, the periodic rate is
2.5%:

The number of compounding periods is found as:

With 10 years and semiannual compounding, there are 20 periods: