Financial Management

Financial Management
1) Why is the examination of only the balance sheet and income statement not adequate in evaluating a firm?
Balance Sheet - a reflection of its financial condition at a particular time. Results of financial flows are recorded in
the capital structure, the size of the trust funds and assets, accumulated depreciation. The balance represents the
greatest interest for all users of financial information, since he shows the dependence of the enterprise on external
sources of financing and debt, the state of relations with suppliers and customers, the direction of investment and
sources of financing. Balance data indicate than a company, as it has suppliers and creditors, that is a pure or equity.
Any business operation leads to a change in the balance, and if possible, it is possible to observe a daily compilation
of the dependence of events held in the enterprise and financial condition. Balance is the comparison of assets and
liabilities of the company, ie, funds and real estate companies with obligations in relation to its owners and creditors.
Profit and Loss Statement describes the results of the organization's activities for the period and shows how she got
the profits and losses (by matching income and expenses).
Profit and loss account, together with the balance sheet is an important source of information for the comprehensive
analysis of profit.
The information provided in the report, to evaluate changes in revenues and expenses during the reporting period
compared with the previous, to analyze the composition, structure and dynamics of the gross profit margin, return on
sales, net profit, as well as to identify factors of formation of the final financial result. Summarizing the results of
the analysis, it is possible to identify untapped opportunities to increase profit organization, improve its profitability.
The information provided in the statement of profit and loss, allowing all interested users to conclude how effective
the activities of the organization and how justified and profitable investment in its assets.
In the world practice uses several variants of the profit and loss account, classification is summarized in Fig. 1. It is
possible to allocate the following reasons for the classification:
approach to the classification of expenses:
location indicators;
a process for preparing the financial result;
method of disclosure of the difference between revenues and expenditures.
2. Explain the difference between liquidity risk and credit risk?

Liquidity risk refers to the chance that an entity will have insufficient cash flow to meet its obligations. This can be
caused by the undesirability of an asset in the marketplace, such as a company's products or fixed assets set for
liquidation.
Credit risk is the risk of loss due to non-payment of debts owed by an entity. Credit risk may be compounded by
liquidity risk.
While you don't usually have the chance to pick between types of risk with a single entity, it is important to look at
the factors that may increase the level of risk you face. While a firm may presently be liquid, and able to meet its
obligations, the wise investor looks forward to predict future market conditions that may adversely impact a firm's
ability to meet its obligations.
3. Explain the meaning of operating leverage?
Leverage The use of fixed costs in an attempt to increase (or lever up) profitability.
Operating leverage The use of fixed operating costs by the firm.
Financial leverage The use of fixed financing costs by the firm.
Operating leverage is present any time a firm has fixed operating costs regardless of volume.
In the long run, of course, all costs are variable. Consequently, our analysis necessarily involves the short run. We
incur fixed operating costs in the hope that sales volume will produce revenues more than sufficient to cover all
fixed and variable operating costs. One of the more dramatic examples of an effect of operating leverage is the
airline industry, where a large proportion of total operating costs is fixed. Beyond a certain break-even load factor,
each additional passenger essentially represents straight operating profit (earnings before interest and taxes, or
EBIT) to the airline.
It is essential to note that fixed operating costs do not vary as volume changes. These costs include such things as
depreciation of buildings and equipment, insurance, part of the overall utility bills, and part of the cost of
management. On the other hand, variable operating costs vary directly with the level of output. These costs include
raw materials, direct labor costs, part of the overall utility bills, direct selling commissions, and certain parts of
general and administrative expenses.
One interesting potential effect caused by the presence of fixed operating costs (operating leverage) is that a change
in the volume of sales results in a more than proportional change in operating profit (or loss). Thus, like a lever used
to magnify a force applied at one point into a larger force at some other point, the presence of fixed operating costs
causes a percentage change in sales volume to produce a magnified percentage change in operating profit (or loss).
(A note of caution: remember, leverage is a two-edged sword just as a companys profits can be magnified, so too
can the companys losses.)
This magnification effect is illustrated in Table 16.1. In Frame A we find three different firms possessing various
amounts of operating leverage. Firm F has a heavy amount of fixed operating costs (FC) relative to variable costs
(VC). Firm V has a greater dollar amount of variable operating costs than of fixed operating costs. Finally, Firm 2F
has twice the amount
of fixed operating costs as does Firm F. Notice that, of the three firms shown, Firm 2F has (1) the largest absolute
dollar amount of fixed costs and (2) the largest relative amount of fixed costs as measured by both the (FC/total
costs) and (FC/sales) ratios.
Each firm is then subjected to an anticipated 50 percent increase in sales for next year. Which firm do you think will
be more sensitive to the change in sales: that is, for a given percentage change in sales, which firm will show the
largest percentage change in operating profit (EBIT)? (Most people would pick Firm 2F because it has either the
largest absolute or the largest relative amount of fixed costs. Most people would be wrong.)
Earlier, we said that one potential effect of operating leverage is that a change in the volume of sales results in a
more than proportional change in operating profit (or loss). A quantitative measure of this sensitivity of a firms
operating profit to a change in the firms sales is called the degree of operating leverage (DOL). The degree of
operating leverage of a firm at a particular level of output (or sales) is simply the percentage change in operating
profit over the percentage change in output (or sales) that causes the change in profits. Thus, DOL= percentage
change in operating profit (EBIT)/ Percentage change in output (or sales)
The sensitivity of the firm to a change in sales as measured by DOL will be different at each level of output (or
sales). Therefore, we always need to indicate the level of output (or sales) at which DOL is measured as in DOL at
Q units.
Operating leverage refers to the phenomenon whereby a small change in sales triggers a relatively large change in
operating income (or EBIT).
The degree of operating leverage, or DOL, measures the magnitude of the operating leverage effect. The degree of
operating leverage is the percent change in EBIT divided by the percent change in sales: DOL=%
EBIT/%
Sales
A DOL greater than 1 show, that the firm has an operating leverage. That is, when sales changes by some
percentage, EBIT will change by a greater percentage.
We may also find the DOL by using only numbers found in the base-year income statement.
DOL= (Sales VC)/ (Sales-VC-FC)
Operating leverage occurs because of fixed costs in the operations of the firm. A firm with fixed costs in the
production process will see its EBIT rise by a larger percentage than sales when unit sales are increasing. If unit
sales drop, however, the firms EBIT will decrease by a greater percentage than does its sales.
Whenever fixed costs are greater than zero, DOL is greater than 1, indicating a leverage effect. The larger the
amount of fixed costs, then, the greater the leveraging effect.
1) Explain what determines a companys return on assets.ROA

2) What is the difference between systematic and unsystematic risk?
The first part, systematic risk, is due to risk factors that affect the overall market such as changes in the nations
economy, tax reform by Congress, or a change in the world energy situation. These are risks that affect securities
overall and, consequently, cannot be diversified away. In other words, even an investor who holds a well-diversified
portfolio will be exposed to this type of risk.
The second risk component, unsystematic risk, is risk unique to a particular company or industry; it is independent
of economic, political, and other factors that affect all securities in a systematic manner. A wildcat strike may affect
only one company; a new competitor may begin to produce essentially the same product; or a technological
breakthrough may make an existing product obsolete. For most stocks, unsystematic risk accounts for around 50
percent of the stocks total risk or standard deviation. However, by diversification this kind of risk can be reduced
and even eliminated if diversification is efficient. Therefore not all of the risk involved in holding a stock is relevant,
because part of this risk can be diversified away. The important risk of a stock is its unavoidable or systematic risk.
Investors can expect to be compensated for bearing this systematic risk. They should not, however, expect the
market to provide any extra compensation for bearing avoidable risk. It is this logic that lies behind the capital-asset
pricing model.
Total risk= Systematic risk + Unsystematic risk
4. Explain what determines a companys return on assets.ROA

ROA tells you what earnings were generated from invested capital (assets). ROA for public companies can vary
substantially and will be highly dependent on the industry. This is why when using ROA as a comparative measure,
it is best to compare it against a company's previous ROA numbers or the ROA of a similar company.
The assets of the company are comprised of both debt and equity. Both of these types of financing are used to fund
the operations of the company. The ROA figure gives investors an idea of how effectively the company is converting
the money it has to invest into net income. The higher the ROA number, the better, because the company is earning
more money on less investment. For example, if one company has a net income of $1 million and total assets of $5
million, its ROA is 20%; however, if another company earns the same amount but has total assets of $10 million, it
has an ROA of 10%. Based on this example, the first company is better at converting its investment into profit.
When you really think about it, management's most important job is to make wise choices in allocating its resources.
Anybody can make a profit by throwing a ton of money at a problem, but very few managers excel at making large
profits with little investment.
Things to Remember
The ROA is often referred to as ROI
We add the interest expense to ignore the costs associated with funding those assets.
Return on assets (ROA) is calculated by:
Return on Assets is usually represented as a percentage, and represents the Net Income the company was able to
generate based on the amount of Assets it owns.
In other words, it tells potential investors the amount of money management is able to make with the assets that it
has. The higher a companys Return on Assets the better.
The figures needed to determine a companys Return on Assets are found on the companys balance
sheet and income statement.
Use of Return on Assets (ROA) Analysis
To get a better idea of why return on assets is so important, consider two companies:
Company A has $1 million in Net Income.
Company B has $1 million in Net Income.
From this, both companies look to be the same.
However now consider:

Company A has a total of $10 million in Assets.
Company B has a total of $100 million in Assets.
Company A has a Return on Assets of 10%, while company by has a Return on Assets of only 1%.
This tells potential investors that the management of company A is more efficient in making money with its assets.
However it is important to note that when comparing the Return on Assets of different companies, ensure that the
companies are in the same industry. A software company will have a significantly different return on assets than a
railroad company.
Benefits Using Return on Assets:
Recall in our definition of Return on Equity (ROE):

This means that as a company takes on more debt its liabilities increase, which reduces Shareholder Equity, which
will increase ROE. Now obviously, if a company is taking on way too much debt that is not good but its ROE
number will look amazing.
Return on equity does not take into account the companys liabilities (debt), and therefore companies with high
amounts of debt can lead investors astray in their fundamental analysis.
But Return on Assets takes into account a companys liabilities. Recall the fundamental balance sheet equation:
Assets = Liabilities + Shareholder Equity.
As a company takes on more debt, lets say in the form of a loan, its assets will also increase (because the company
receives cash or other assets in exchange for the loan).
Therefore, Return on Assets also takes into account managements ability to efficiently use its assets (such as
equipment) along with financing (such as debt or bond issues).
For a company with no liabilities, its ROA and ROE numbers will be exactly the same. Where the numbers start to
diverge is when the company begins to take on debt.
Looking at ROA in combination with a companys ROE can help tell a better story of the true efficiency of a
companys management. When ROE is very high, but ROA is very low it may be a sign that the company is not
using its financing wisely.
5. What is the difference between systematic and unsystematic risk?

pricing model.
6.Define and contrast the terms working capital and net working capital.
There are two major concepts of working capital net working capital and gross working capital. When accountants
use the term working capital, they are generally referring to net working capital, which is the dollar difference
between current assets and current liabilities.
This is one measure of the extent to which the firm is protected from liquidity problems.
From a management viewpoint, however, it makes little sense to talk about trying to actively manage a net
difference between current assets and current liabilities, particularly when that difference is continually changing.
Financial analysts, on the other hand, mean current assets when they speak of working capital. Therefore, their focus
is on gross working capital. Because it does make sense for the financial manager to be involved with providing
the correct amount of current assets for the firm at all times, we will adopt the concept of gross working capital. As
the discussion of working capital management unfolds, our concern will be to consider the administration of the
firms current assets namely, cash and marketable securities, receivables, and inventory and the financing
(especially current liabilities) needed to support current assets .
7. Distinguish between the dividend payout ratio and the dividend per share.
The dividend-payout ratio determines the amount of earnings that can be retained
in the firm. Retaining a greater amount of current earnings in the firm means that fewer
dollars will be available for current dividend payments. The value of the dividends paid to
stockholders must therefore be balanced against the opportunity cost of retained earnings lost
as a means of equity financing.
The dividend payout ratio is the amount of dividends paid to stockholders relative to the amount of total net income
of a company. The amount that is not paid out in dividends to stockholders is held by the company for growth. The
amount that is kept by the company is called retained earnings.
Net income shown in the formula can be found on the company's income statement.
This formula is used by some when considering whether to invest in a profitable company that pays out dividends
versus a profitable company that has high growth potential. In other words, this formula takes into consideration
steady income versus reinvestment for possible future earnings, assuming the company has a net income.
Dividend-payout ratio
Annual cash dividends divided by annual earnings; or, alternatively, dividends per share divided by earnings per
share. The ratio indicates the percentage of a companys earnings that is paid out to shareholders in cash.
Dividend policy is an integral part of the firms financing decision. The dividend-payout ratio
determines the amount of earnings that can be retained in the firm as a source of financing.
However, retaining a greater amount of current earnings in the firm means that fewer dollars
will be available for current dividend payments. A major aspect, then, of the dividend policy
of the firm is to determine the appropriate allocation of profits between dividend payments
and additions to the firms retained earnings. But also important are other issues pertaining
to a firms overall dividend policy: legal, liquidity, and control issues; stability of dividends;
stock dividends and splits; stock repurchase; and administrative considerations.
For example: ABC company paid a total of $237,000 in dividends over the last year of which there was a special one
time dividend totalling $59,250. ABC has 2 million shares outstanding so its DPS would be ($237,000$59,250)/2,000,000 = $0.0889 per share.
Dividends are a form of profit distribution to the shareholder. Having a growing dividend per share can be a sign
that the company's management believes that the growth can be sustained.
8. Explain the conflicts of interest that can arise between owners and managers (agency problem).
An agency relationship occurs when a principal hires an agent to perform some duty. A conflict, known as an
"agency problem," arises when there is a conflict of interest between the needs of the principal and the needs of the
agent.
In finance, there are two primary agency relationships:
Managers and stockholders
Managers and creditors
1. Stockholders versus Managers
If the manager owns less than 100% of the firm's common stock, a potential agency problem between
mangers and stockholders exists.
Managers may make decisions that conflict with the best interests of the shareholders. For example,
managers may grow their firms to escape a takeover attempt to increase their own job security. However, a
takeover may be in the shareholders' best interest.
2. Stockholders versus Creditors
Creditors decide to loan money to a corporation based on the riskiness of the company, its capital structure
and its potential capital structure. All of these factors will affect the company's potential cash flow, which is
a creditors' main concern.
Stockholders, however, have control of such decisions through the managers.
Since stockholders will make decisions based on their best interests, a potential agency problem exists
between the stockholders and creditors. For example, managers could borrow money to repurchase shares
to lower the corporation's share base and increase shareholder return. Stockholders will benefit; however,
creditors will be concerned given the increase in debt that would affect future cash flows.
Motivating Managers to Act in Shareholders' Best Interests

There are four primary mechanisms for motivating managers to act in stockholders' best interests:
Managerial compensation
Direct intervention by stockholders
Threat of firing
Threat of takeovers
1. Managerial Compensation
Managerial compensation should be constructed not only to retain competent managers, but to align managers'
interests with those of stockholders as much as possible.
This is typically done with an annual salary plus performance bonuses and company shares.
Company shares are typically distributed to managers either as:

o
Performance shares, where managers will receive a certain number shares based on the company's
performance
Executive stock options, which allow the manager to purchase shares at a future date and price.
With the use of stock options, managers are aligned closer to the interest of the stockholders as
they themselves will be stockholders.
2. Direct Intervention by Stockholders

Today, the majority of a company's stock is owned by large institutional investors, such as mutual funds and
pensions. As such, these large institutional stockholders can exert influence on mangers and, as a result, the firm's
operations.
3. Threat of Firing
If stockholders are unhappy with current management, they can encourage the existing board of directors to change
the existing management, or stockholders may re-elect a new board of directors that will accomplish the task.
4. Threat of Takeovers
If a stock price deteriorates because of management's inability to run the company effectively, competitors or
stockholders may take a controlling interest in the company and bring in their own managers.
In the next section, we'll examine the financial institutions and financial markets that help companies finance their
operations.
9. Explain the meaning of financial leverage?

Leverage The use of fixed costs in an attempt to increase (or lever up) profitability.
Operating leverage The use of fixed operating costs by the firm.
Financial leverage The use of fixed financing costs by the firm.
Financial leverage involves the use of fixed cost financing. Interestingly, financial leverage is acquired by choice,
but operating leverage sometimes is not. The amount of operating leverage (the amount of fixed operating costs)
employed by a firm is sometimes dictated by the physical requirements of the firms operations. For example, a steel
mill by way of its heavy investment in plant and equipment will have a large fixed operating cost component
consisting of depreciation. Financial leverage, on the other hand, is always a choice item. No firm is required to have
any long-term debt or preferred stock financing. Firms can, instead, finance operations and capital expenditures from
internal sources and the issuance of common stock. Nevertheless, it is a rare firm that has no financial leverage. Why,
then, do we see such reliance on financial leverage?
Financial leverage is employed in the hope of increasing the return to common shareholders. Favorable or positive
leverage is said to occur when the firm uses funds obtained at a fixed cost (funds obtained by issuing debt with a
fixed interest rate or preferred stock with a constant dividend rate) to earn more than the fixed financing costs paid.
Any profits left after meeting fixed financing costs then belong to common shareholders. Unfavorable or negative
leverage occurs when the firm does not earn as much as the fixed financing costs. The favorability of financial
leverage, or trading on the equity as it is sometimes called, is judged in terms of the effect that it has on earnings
per share to the common shareholders. In effect, financial leverage is the second step in a two-step profitmagnification process. In step one, operating leverage magnifies the effect of changes in sales on changes in
operating profit. In step two, the financial manager has the option of using financial leverage to further magnify the
effect of any resulting changes in operating profit on changes in earnings per share. In the next section we are
interested in determining the relationship between earnings per share (EPS) and operating profit (EBIT) under
various financing alternatives and the indifference points between these alternatives.
A quantitative measure of the sensitivity of a firms earnings per share to a change in the firms operating profit is
called the degree of financial leverage (DFL). The degree of financial leverage at a particular level of operating
profit is simply the percentage change in earnings per share over the percentage change in operating profit that
causes the change in earnings per share. Thus, DFL= percentage change in earning per share (EPS)/ Percentage
change in operating profit (EBIT)
Financial leverage is the additional volatility of a firms net income caused by the presence of fixed-cost funds
(such as fixed rate dept) in the firms capital structure. The degree of financial leverage (DFL) is the % change in
net income divided by the % change in EBIT. DFL=%

NI/%
EBIT
The Alternate Method of Calculating DFL: DFL=EBIT/ (EBIT-I)
The DFL will be greater than 1 if interest expense is greater than zero.
10. Explain what determines a companys return on equity. ROE
Return on equity (ROE) is a measure of profitability that calculates how many dollars of profit a company
generates with each dollar of shareholders' equity. The formula for ROE is:
ROE = Net Income/Shareholders' Equity
ROE is sometimes called "return on net worth."

How it works/Example:
Let's assume Company XYZ generated $10 million in net income last year. If Company XYZ's
shareholders' equity equaled $20 million last year, then using the ROE formula, we can calculate Company XYZ's
ROE as:
ROE = $10,000,000/$20,000,000 = 50%
This means that Company XYZ generated $0.50 of profit for every $1 of shareholders' equity last year, giving
the stock an ROE of 50%.
Why it Matters:
ROE is more than a measure of profit; it's a measure of efficiency. A rising ROE suggests that a company is
increasing its ability to generate profit without needing as much capital. It also indicates how well a company's
management is deploying the shareholders' capital. In other words, the higher the ROE the better. Falling ROE is
usually a problem.
However, it is important to note that if the value of the shareholders' equity goes down, ROE goes up. Thus, writedowns and share buybacks can artificially boost ROE. Likewise, a high level of debt can artificially boost ROE;
after all, the more debt a company has, the less shareholders' equity it has (as a percentage of total assets), and the
higher its ROE is.
Some industries tend to have higher returns on equity than others. As a result, comparisons of returns on equity are
generally most meaningful among companies within the same industry, and the definition of a "high" or "low" ratio
should be made within this context.
11. How do gross profits, operating profits, and net income differ?
Gross Profit - the difference between the net income from sales and cost of sales.
Cost of sales, in addition to production costs, also includes the value of co-payments: property tax; a tax on owners
of motor vehicles; payment for land; excise tax, etc. Accordingly, gross profit decreased by the fees and charges.
Operating Profit- it is the balance sheet profit, corrected for the difference between other operating revenues and
operating expenses.
Other operating income includes income from operating activities of the enterprise other than income (revenue)
from sales of products (which has already been included in the gross income):
income from rental property;
Income from operating margin rate;
income from the sale of current assets (excluding financial investments);

recoveries of amounts previously written-off assets and the like.
Operating costs include the costs of maintaining the operating activities of the enterprise, namely:
administrative costs (general expenses associated with the management and maintenance of enterprise);
distribution costs (storage costs, sales, production, advertising, delivery of products to consumers, etc.);
other operating expenses (Cost of inventories, bad debts, loss from operations in currency exchange rates, losses
from devaluation of stocks imposed economic sanctions and other expenses that arise in the ordinary course of the
company (with the exception of expenses included in the cost of production)).
Operating income is a reflection of the effectiveness of core business and shows how successful the company is
production, excluding the effect of other factors.
Profit from ordinary activities - an operating profit corrected by the amount of financial income and financial costs .
Profit from ordinary activities is a taxable profit (taxable income).
Financial income: Income from investments in other companies; dividends; interest on loans; income from nonoperating exchange differences and other.
Financial expenses: interest payments for the loan capital; losses from the write-down of financial investments and
fixed assets; Other losses and expenses that are not related to operating activities.
Net profit (Net Income) - is the profit that goes to the company after the payment of income tax. Net profit for the
company uses its discretion in two ways:
Accumulation Fund (reinvested profit) is used in the development of production, the creation of a reserve fund,
investing in other companies.
The consumption fund is used to pay the owners, shareholders, staff material incentives for performance, solution of
social problems, charity.
The profit of each company is formed from the following sources:
Gain on sale of products (services) - is the profit from operating activities of the enterprise. This view displays the
result of profit from operating activities of the enterprise market and its profile. Gain on sale is the difference
between the proceeds from sales (excluding value added tax and excise duty) and the total cost of production.
Gain on sale of property - a company's profit from the sale of tangible assets (fixed assets, inventories) and
intangible assets, securities, etc. Gain on sale of property is determined as the difference between the sale price and
the book (residual) value of the object sold.
Profit from extraordinary operations - profit from this joint venture enterprises, the interest on the acquired shares,
fines that are paid by other companies for breach of contractual obligations, income from ownership of debt
obligations, royalties, etc.
Please note the different sources offer other definitions of balance profit and unified regulation or opinions on this
point. So be careful using the term, try using other, more standardized. Here are some additional definitions:
Balance sheet profit - a profit from operations and non-operating.

Balance sheet profit - a profit from ordinary activities, financial results of the operating and non-operating and
extraordinary circumstances.
12. How does the statement of cash flows relate to the income statement?
Complementing the balance sheet and income statement, the cash flow statement (CFS), a mandatory part of a
company's financial reports since 1987, records the amounts of cash and cash equivalents entering and leaving a
company. The CFS allows investors to understand how a company's operations are running, where its money is
coming from, and how it is being spent. Here you will learn how the CFS is structured and how to use it as part of
your analysis of a company
The Structure of the CFS
The cash flow statement is distinct from the income statement and balance sheet because it does not include the
amount of future incoming and outgoing cash that has been recorded on credit. Therefore, cash is not the same as net
income, which, on the income statement and balance sheet, includes cash sales and sales made on credit. (For
background reading, see Analyze Cash Flow The Easy Way.)
Cash flow is determined by looking at three components by which cash enters and leaves a company: core
operations, investing and financing,
Operations
Measuring the cash inflows and outflows caused by core business operations, the operations component of cash flow
reflects how much cash is generated from a company's products or services. Generally, changes made in
cash, accounts receivable, depreciation, inventory and accounts payable are reflected in cash from operations.
Cash flow is calculated by making certain adjustments to net income by adding or subtracting differences in
revenue, expenses and credit transactions (appearing on the balance sheet and income statement) resulting from
transactions that occur from one period to the next. These adjustments are made because non-cash items are
calculated into net income (income statement) and total assets and liabilities (balance sheet). So, because not all
transactions involve actual cash items, many items have to be re-evaluated when calculating cash flow from
operations.
For example, depreciation is not really a cash expense; it is an amount that is deducted from the total value of an
asset that has previously been accounted for. That is why it is added back into net sales for calculating cash flow.
The only time income from an asset is accounted for in CFS calculations is when the asset is sold.
Changes in accounts receivable on the balance sheet from one accounting period to the next must also be reflected in
cash flow. If accounts receivable decreases, this implies that more cash has entered the company from customers
paying off their credit accounts - the amount by which AR has decreased is then added to net sales. If accounts
receivable increase from one accounting period to the next, the amount of the increase must be deducted from net
sales because, although the amounts represented in AR are revenue, they are not cash.
An increase in inventory, on the other hand, signals that a company has spent more money to purchase more raw
materials. If the inventory was paid with cash, the increase in the value of inventory is deducted from net sales. A
decrease in inventory would be added to net sales. If inventory was purchased on credit, an increase in accounts
payable would occur on the balance sheet, and the amount of the increase from one year to the other would be added
to net sales.
The same logic holds true for taxes payable, salaries payable and prepaid insurance. If something has been paid off,
then the difference in the value owed from one year to the next has to be subtracted from net income. If there is an
amount that is still owed, then any differences will have to be added to net earnings. (For mroe insight,
see Operating Cash Flow: Better Than Net Income?)
Investing
Changes in equipment, assets or investments relate to cash from investing. Usually cash changes from investing are
a "cash out" item, because cash is used to buy new equipment, buildings or short-term assets such as marketable
securities. However, when a company divests of an asset, the transaction is considered "cash in" for calculating cash
from investing.
Financing
Changes in debt, loans or dividends are accounted for in cash from financing. Changes in cash from financing are
"cash in" when capital is raised, and they're "cash out" when dividends are paid. Thus, if a company issues a bond to
the public, the company receives cash financing; however, when interest is paid to bondholders, the company is
reducing its cash.
From this CFS, we can see that the cash flow for FY 2003 was $1,522,000. The bulk of the positive cash flow stems
from cash earned from operations, which is a good sign for investors. It means that core operations are generating
business and that there is enough money to buy new inventory. The purchasing of new equipment shows that the
company has cash to invest in inventory for growth. Finally, the amount of cash available to the company should
ease investors' minds regarding the notes payable, as cash is plentiful to cover that future loan expense.
Of course, not all cash flow statements look this healthy, or exhibit a positive cash flow. But a negative cash flow
should not automatically raise a red flag without some further analysis. Sometimes, a negative cash flow is a result
of a company's decision to expand its business at a certain point in time, which would be a good thing for the future.
This is why analyzing changes in cash flow from one period to the next gives the investor a better idea of how the
company is performing, and whether or not a company may be on the brink of bankruptcy or success. (For
information on cash flow accounting, see Cash Flow On Steroids: Why Companies Cheat.)
Tying the CFS with the Balance Sheet and Income Statement
As we have already discussed, the cash flow statement is derived from the income statement and the balance sheet.
Net earnings from the income statement is the figure from which the information on the CFS is deduced. As for the
balance sheet, the net cash flow in the CFS from one year to the next should equal the increase or decrease of cash
between the two consecutive balance sheets that apply to the period that the cash flow statement covers. (For
example, if you are calculating a cash flow for the year 2000, the balance sheets from the years 1999 and 2000
should be used.)
Conclusion
A company can use a cash flow statement to predict future cash flow, which helps with matters in budgeting. For
investors, the cash flow reflects a company's financial health: basically, the more cash available for business
operations, the better. However, this is not a hard and fast rule. Sometimes a negative cash flow results from a
company's growth strategy in the form of expanding its operations.
By adjusting earnings, revenues, assets and liabilities, the investor can get a very clear picture of what some people
consider the most important aspect of a company: how much cash it generates and, particularly, how much of that
cash stems from core operations.
14. State the primary objective of financial management.
Financial management is the responsibility of planning, directing, organizing and controlling a companycapital
resources. Small business owners typically complete this function because they are responsible for all company
resources. Larger business organizations may have a financial or accounting manager to handle this business
function. Financial management has several objectives in a business. Most of the objectives serve in a support
capacity to provide business owners with relevant information on the companybusiness operations.
State the purpose of financial management is to improve the well-being of society through the adoption of effective
financial decision-making in the implementation of the State's functions with the goals and objectives of social and
economic development of the country. This aim finds its expression in the growth of the financial cost of public
goods appropriate volume and quality. This means that the adoption of financial management decisions on the
formation and use of public financial resources and income should be directed to the full satisfaction of public needs
at the given or smaller amounts of public expenditure.
The purpose of public financial management is specified by its following tasks:
-providing activities of public authorities and the government to provide public goods necessary and sufficient
financial resources;
is the effective use of public financial resources (revenues) for all activities related to the State's functions, with the
production and distribution of public goods;
-providing growth tax profit (the difference between tax revenues and tax expenditures) with an acceptable level of
tax risks;
-Increase the collection of state tax and non-tax revenues in relation to their planned parameters;
-Increase the effectiveness of public expenditure on the basis of program-target method of science-based regulation
and standardization;
-minimizatsiya fiscal risks for given values of government revenues and expenditures;
-providing the stability and balance of public and municipal finance;
- The effective management of public debt and the budget deficit (surplus);
- Effective management of public financial reserves;
- The management of public financial flows, including state targeted programs based budgeting;
-increase the efficiency and effectiveness of state financial control
.
15. What are examples of money market securities? Provide at least three examples. Describe them.
Money market securities sometimes are called cash equivalents, or just cash for short. The
money market is a sub-sector of the fixed-income market. It consists of very short-term debt
securities that are highly marketable. Many of these securities trade in large denominations
and are out of the reach of individual investors. Money Market Mutual Funds, however, are
easily accessible to small investors. These mutual funds pool the resources of many
investors and purchase a wide variety of money market securities on their behalf. Most
commonly traded money-market instruments include:
Treasury Bills: Government debt security with a maturity that is less than one year. Treasury bills are
issued through a competitive bidding process at a discount from par. This means they do not pay fixed interest
payments like most bonds do.
Certificates of Deposits (CDs): A savings certificate entitling the bearer to receive interest. A CD bears a
maturity date, a specified interest rate, and can be issued in any denomination. CDs are generally issued by
commercial banks.
Commercial Paper: An unsecured, short-term loan issued by a corporation, typically for financing
accounts receivable and inventories. It is usually issued at a discount reflecting prevailing market interest rates.
Bankers Acceptances: A short-term credit investment created by a non-financial firm and guaranteed by a
bank. Acceptances are traded at discounts from face value in the secondary market. Bankers' acceptances are very
similar to T-bills and are often used in money market funds.
Eurodollars: U.S. dollar-denominated deposits at foreign banks or foreign branches of American banks. By
locating outside of the United States, Eurodollars escape regulation by the Federal Reserve Board.
Repurchase Agreement (Repos): A form of short term borrowing for dealers in government securities. The
dealer sells the government securities to investors, usually on an overnight basis, and buys them back the following
day. For the party selling the security (and agreeing to repurchase it in the future) it is a repo; for the party on the
other end of the transaction (buying the security and agreeing to sell in the future) it is a reverse repurchase
agreement.
Federal Funds: Funds deposited to regional Federal Reserve Banks by commercial banks, including funds
in excess of reserve requirements. These non-interest bearing deposits are lent out at the Fed funds rate to other
banks unable to meet overnight reserve requirements.
Brokers Call: The interest rate relative to which margin loans are quoted. Also known as the call loan rate.
An important measure that differentiates money market securities from capital market securities is the time to
maturity. Money market securities, essentially, have maturity period of one year or less.
16. What are some of the disadvantages of a sole proprietorship? A partnership? A limited liability company (LLC)?
: The sole proprietorship is the oldest form of business organization. As the title suggests, a
single person owns the business, holds title to all its assets, and is personally responsible for all of its debts. A
proprietorship pays no separate income taxes. The owner merely adds any profits or subtracts any losses from the
business when determining personal taxable income.
This business form is widely used in service industries. Because of its simplicity, a sole proprietorship can be
established with few complications and little expense. Simplicity is its greatest virtue. Its principal shortcoming is
that the owner is personally liable for all business obligations. If the organization is sued, the proprietor as an
individual is sued and has unlimited liability, which means that much of his or her personal property, as well as the
assets of the business, may be seized to settle claims. Another problem with a sole proprietorship is the difficulty in
raising capital. Because the life and success of the business is so dependent on a single individual, a sole
proprietorship may not be as attractive to lenders as another form of organization. Moreover, the proprietorship has
certain tax disadvantages. Fringe benefits, such as
medical coverage and group insurance, are not regarded by the Internal Revenue Service as expenses of the firm and
therefore are not fully deductible for tax purposes. A corporation often deducts these benefits, but the proprietor
must pay for a major portion of them from income left over after paying taxes. In addition to these drawbacks, the
proprietorship form makes the transfer of ownership more difficult than does the corporate form. In estate planning,
no portion of the enterprise can be transferred to members of the family during the proprietors lifetime. For these
reasons, this form of organization does not afford the flexibility that other forms do.
A partnership is similar to a proprietorship, except there is more than one owner. A partnership, like a
proprietorship, pays no income taxes. Instead, individual partners include their share of profits or losses from the
business as part of their personal taxable income. One potential advantage of this business form is that, relative to a
proprietorship, a greater amount of capital can often be raised. More than one owner may now be providing personal
capital, and lenders may be more agreeable to providing funds given a larger owner investment base.
In a general partnership all partners have unlimited liability; they are jointly liable for the obligations of the
partnership. Because each partner can bind the partnership with obligations, general partners should be selected with
care. In most cases a formal arrangement, or partnership agreement, sets forth the powers of each partner, the
distribution of profits, the amounts of capital to be invested by the partners, procedures for admitting new partners,
and procedures for reconstituting the partnership in the case of the death or withdrawal of a partner. Legally, the
partnership is dissolved if one of the partners dies or withdraws. In such cases, settlements are invariably sticky,
and reconstitution of the partnership can be a difficult matter.
In a limited partnership, limited partners contribute capital and have liability confined to that amount of capital;
they cannot lose more than they put in. There must, however, be at least one general partner in the partnership,
whose liability is unlimited. Limited partners do not participate in the operation of the business; this is left to the
general partner(s). The limited partners are strictly investors, and they share in the profits or losses of the partnership
according to the terms of the partnership agreement. This type of arrangement is frequently used in financing real
estate ventures.
Corporations
Because of the importance of the corporate form in the United States, the focus of this book is on corporations. A
corporation is an artificial entity created by law. It can own assets and incur liabilities. In the famous Dartmouth
College decision in 1819, Justice Marshall concluded that
a corporation is an artificial being, invisible, intangible, and existing only in contemplation
of the law. Being a mere creature of law, it possesses only those properties which the
charter of its creation confers upon it, either expressly or as incidental to its very existence.
The principal feature of this form of business organization is that the corporation exists legally separate and apart
from its owners. An owners liability is limited to his or her investment. Limited liability represents an important
advantage over the proprietorship and general partnership. Capital can be raised in the corporations name without
exposing the owners to unlimited liability. Therefore, personal assets cannot be seized in the settlement of claims.
Ownership itself is evidenced by shares of stock, with each stockholder owning that proportion of the enterprise
represented by his or her shares in relation to the total number of shares outstanding. These shares are easily
transferable, representing another important advantage of the corporate form. Moreover, corporations have found
what the explorer Ponce de Leon could only dream of finding unlimited life. Because the corporation exists apart
from its owners, its life is not limited by the lives of the owners (unlike proprietorships and partnerships). The
corporation can continue even though individual owners may die or sell their stock.
Because of the advantages associated with limited liability, easy transfer of ownership through the sale of common
stock, unlimited life, and the ability of the corporation to raise capital apart from its owners, the corporate form of
business organization has grown enormously in the twentieth century. With the large demands for capital that
accompany an advanced economy, the proprietorship and partnership have proven unsatisfactory, and the
corporation has emerged as the most important organizational form.
A possible disadvantage of the corporation is tax related. Corporate profits are subject to double taxation. The
company pays tax on the income it earns, and the stockholder is also taxed when he or she receives income in the
form of a cash dividend. (We will take a closer look at taxes in the next section.2) Minor disadvantages include the
length of time to incorporate and the red tape involved, as well as the incorporation fee that must be paid to the state
in which the firm is incorporated. Thus, a corporation is more difficult to establish than either a proprietorship or a
partnership.
: Sole Proprietorship Advantages 1. The proprietor is the sole business decision-maker.2. The
proprietor receives all income from business. 3. Income from the business is taxed once, at the individual taxpayer
level. Disadvantages 1. The proprietor is liable for all debts of the business (unlimited liability). 2. The
proprietorship has a limited life. 3. There is limited access to additional funds.
General Partnership Advantages1. Partners receive income according to terms in partnership agreement. 2. Income
from business is taxed once as the partners personal income. 3. Decision-making rests with the general partners
only. Disadvantage 1. Each partner is liable for all the debts of the partnership. 2. The partnerships life is
determined by agreement or the life of the partners. 3. There is limited access to additional funds.
Corporation Advantages 1. The firm has perpetual life. 2. Owners are not liable for the debts of the firm; the most
that owners can lose is their initial investment. 3. The firm can raise funds by selling additional ownership interest.
4. Income is distributed in proportion to ownership interest. Disadvantages 1. Income paid to owners is subjected to
double taxation. 2. Ownership and management are separated in larger organizations.
17. What distinguishes a partnership from individual entrepreneurship?

Individual business
Individual entrepreneurs are individuals engaged in entrepreneurial activities without a legal entity and in the
absence of a legal entity. The types of individual enterprise is private enterprise and joint ventures.
Private entrepreneurship by one citizen alone on the basis of the property belonging to him by right of ownership, as
well as by virtue of a law allowing the use and (or) disposal of property.
Joint business carried out a group of citizens (private entrepreneurs) on the basis of the property belonging to them
by right of common ownership, as well as by virtue of a law allowing joint use and / or disposal of the property.
Individual entrepreneurship based on private ownership (private business), carried out under the financial
responsibility.
Individual entrepreneur pays less than the amount of taxes and, in most cases, at lower rates than the entity. An
individual entrepreneur is obliged to pay contributions to pension funds for themselves and employees.
The size of the tax rates depend on the tax regime in which the entrepreneur operates. In carrying out activities
based on entrepreneur patent income is taxed at a rate of 3 percent. When working on the basis of a simplified
declaration income is taxed at a rate of 3 to 7 percent depending on its sum.
Accounting of individual entrepreneur in the case of a patent and the simplified declaration is much simpler
accounting of the legal entity. In the patent it is practically non-existent. This advantage allows individual
entrepreneur to maintain accounting records independently without hiring an accountant. However, the possibility of
applying the simplified declaration established for legal persons, but then, in most cases, already require receiving
an accountant to work.
18. What is meant by exchange risk and political risk?

Exchange Risk
1. The risk of an investment's value changing due to changes in currency exchange rates.
2. The risk that an investor will have to close out a long or short position in a foreign currency at a loss due to an
adverse movement in exchange rates. Also known as "currency risk" or "exchange-rate risk".
INVESTOPEDIA EXPLAINS 'Foreign-Exchange Risk'
This risk usually affects businesses that export and/or import, but it can also affect investors making international
investments. For example, if money must be converted to another currency to make a certain investment, then any
changes in the currency exchange rate will cause that investment's value to either decrease or increase when the
investment is sold and converted back into the original currency.
Political risk is a type of risk faced by investors, corporations, and governments. It is a risk that can be understood
and managed with reasoned foresight and investment.
Political risk analysis is rooted in the intersection between politics and business, and it deals with the probability that
political decisions, events, or conditions will significantly affect the profitability of a business actor or the expected
value of a given economic action [1] Many different meanings have been attached to the term political risk over time.
[2]
Broadly speaking, however, political risk refers to the complications businesses and governments may face as a
result of what are commonly referred to as political decisionsor any political change that alters the expected
outcome and value of a given economic action by changing the probability of achieving business objectives.
[3]
Political risk faced by firms can be defined as the risk of a strategic, financial, or personnel loss for a firm
because of such nonmarket factors as macroeconomic and social policies (fiscal, monetary, trade, investment,
industrial, income, labour, and developmental), or events related to political instability (terrorism, riots, coups, civil
war, and insurrection).[4]Portfolio investors may face similar financial losses. Moreover, governments may face
complications in their ability to execute diplomatic, military or other initiatives as a result of political risk.
A low level of political risk in a given country does not necessarily correspond to a high degree of political freedom.
Indeed, some of the more stable states are also the most authoritarian. Long-term assessments of political risk must
account for the danger that a politically oppressive environment is only stable as long as top-down control is
maintained and citizens prevented from a free exchange of ideas and goods with the outside world.
19. What is the difference between an exchange and an over-the-counter market?
Financial markets are complex organizations with their own economic and institutional structures that play a
critical role in determining how prices are establishedor discovered, as traders say. These structures also
shape the orderliness and indeed the stability of the marketplace. As holders of subprime collateralized debt
obligations and other distressed debt securities found out in the months following the August 2007 onset of
the financial turmoil that led to the global economic crisis, some types of market arrangements can very
quickly become disorderly, dysfunctional, or otherwise unstable.
There are two basic ways to organize financial marketsexchange and over the counter (OTC)although
some recent electronic facilities blur the traditional distinctions.
Trading on an exchange
Exchanges, whether stock markets or derivatives exchanges, started as physical places where trading took
place. Some of the best known include the New York Stock Exchange (NYSE), which was formed in 1792,
and the Chicago Board of Trade (now part of the CME Group), which has been trading futures contracts
since 1851. Today there are more than a hundred stock and derivatives exchanges throughout the developed
and developing world.
But exchanges are more than physical locations. They set the institutional rules that govern trading and
information flows about that trading. They are closely linked to the clearing facilities through which posttrade activities are completed for securities and derivatives traded on the exchange. An exchange centralizes
the communication of bid and offer prices to all direct market participants, who can respond by selling or
buying at one of the quotes or by replying with a different quote. Depending on the exchange, the medium of
communication can be voice, hand signal, a discrete electronic message, or computer-generated electronic
commands. When two parties reach agreement, the price at which the transaction is executed is
communicated throughout the market. The result is a level playing field that allows any market participant to
buy as low or sell as high as anyone else as long as the trader follows exchange rules.
The advent of electronic trading has eliminated the need for exchanges to be physical places. Indeed, many
traditional trading floors are closing, and the communication of orders and executions are being conducted
entirely electronically. The London Stock Exchange and the NASDAQ Stock Market are completely
electronic, as is Eurex, the worlds second-largest futures exchange. Many others, as they phase out floor
trading, offer both floor and electronic trading. The NYSE bought the electronic trading platform
Archipelago as it moves increasingly toward electronic trading. Derivatives exchanges such as the CME
Group maintain both old-style pits and electronic trading. Brazils BM&F maintained both until 2009.
Trading over the counter
Unlike exchanges, OTC markets have never been a place. They are less formal, although often wellorganized, networks of trading relationships centered around one or more dealers. Dealers act as market
makers by quoting prices at which they will sell (ask or offer) or buy (bid) to other dealers and to their
clients or customers. That does not mean they quote the same prices to other dealers as they post to
customers, and they do not necessarily quote the same prices to all customers. Moreover, dealers in an OTC
security can withdraw from market making at any time, which can cause liquidity to dry up, disrupting the
ability of market participants to buy or sell. Exchanges are far more liquid because all buy and sell orders as
well as execution prices are exposed to one another. Also, some exchanges designate certain participants as
dedicated market makers and require them to maintain bid and ask quotes throughout the trading day. In
short, OTC markets are less transparent and operate with fewer rules than do exchanges. All of the securities
and derivatives involved in the financial turmoil that began with a 2007 breakdown in the U.S. mortgage
market were traded in OTC markets.
OTC dealers convey their bid and ask quotes and negotiate execution prices over such venues as the
telephone, mass e-mail messages, and, increasingly, instant messaging. The process is often enhanced
through the use of electronic bulletin boards where dealers post their quotes. The process of negotiating by
phone or electronic message, whether customer to dealer or dealer to dealer, is known as bilateral trading
because only the two market participants directly observe the quotes or execution. Others in the market are
not privy to the trade, although some brokered markets post execution prices and the size of the trade after
the fact. But not everyone has access to the broker screens and not everyone in the market can trade at that
price. Although the bilateral negotiation process is sometimes automated, the trading arrangement is not
considered an exchange because it is not open to all participants equally.
There are essentially two dimensions to OTC markets. In the customer market, bilateral trading occurs
between dealers and their customers, such as individuals or hedge funds. Dealers often initiate contact with
their customers through high-volume electronic messages called dealer-runs that list various securities and
derivatives and the prices at which they are willing to buy or sell them. In the interdealer market, dealers
quote prices to each other and can quickly lay off to other dealers some of the risk they incur in trading with
customers, such as acquiring a bigger position than they want. Dealers can have direct phone lines to other
dealers so that a trader can call up a dealer for a quote, hang up and call another dealer and then another,
surveying several dealers in a few seconds. An investor can make multiple calls to the dealers with which
they have established a trading relationship to get a view of the market on the customer side. But customers
cannot penetrate the market among dealers.
Interdealer segments
Some OTC markets, and especially their interdealer market segments, have interdealer brokers that help
market participants get a deeper view of the market. The dealers send quotes to the broker who, in effect,
broadcasts the information by telephone. Brokers often provide electronic bulletin boards to give their clients
(the dealers) the ability to instantaneously post quotes to every other dealer in the brokers network. The
bulletin boards show bid, ask, and, sometimes, execution prices. The broker screens are normally not
available to end-customers, who, as a result, are usually not fully informed of changes in prices and the bidask spread in the interdealer market. Dealers can sometimes trade through the screen or over the electronic
system. Some interdealer trading platforms allow automated algorithmic (rule-based) trading like that of the
electronic exchanges. Otherwise the screens are merely informative, and the dealer must trade through the
broker or call other dealers directly to execute a trade. Dealers can also call the broker and other dealers
directly to post quotes and inquire about quotes that are not listed on the brokers electronic bulletin board
screens.
Advances in electronic trading platforms have changed the trading process in many OTC markets, and this
has sometimes blurred the distinction between traditional OTC markets and exchanges. In some cases, an
electronic brokering platform allows dealers and some nondealers to submit quotes directly to and execute
trades directly through an electronic system. This replicates the multilateral trading that is the hallmark of an
exchangebut only for direct participants. However dealers resist the participation of nondealers and accuse
nondealers of taking liquidity without exposing themselves to the risks of providing liquidity. Others criticize
dealers for trying to prevent competition that would compress bid-ask spreads in the market. Unlike an
exchange, in which every participant has access, these electronic arrangements can treat participants
differently based on, say, their size or credit rating. Moreover clearing and settlements of trades are still left
to the buyer and seller, unlike in exchange transactions, where trades are matched up and guaranteed by the
exchange.
OTC Markets and the Financial Crisis
The architecture of OTC markets helps explain why structured securities (which divide the risk of the
underlying assets into several slices, each of which is sold separately) faced problems during the recent
financial crisis. Credit derivatives, commercial paper, municipal bonds, and securitized student loans also
faced problems. All were traded on OTC markets, which were liquid and functioned pretty well during
normal times. But they failed to demonstrate resilience to market disturbances and became illiquid and
dysfunctional at critical times.
That led to two serious complicationsthe inability to value ones holdings and the inability to sell them:
Without liquid and orderly markets, there was no price discovery process and in turn no easy and
definitive way to value the securities. The failure of the price discovery process aggravated the problems at
banks and other financial firms during the recent crisis by making it more difficult to meet disclosure and
reporting requirements on the value of their securities and derivatives positions. Not only were there no
efficient direct market prices, there were often no benchmark prices (which are prices of assets similar to the
one being valued). As a result, the assets and positions that were once valued at market prices were instead
valued through models that sometimes were not adequately informed by benchmark prices. These valuation
problems further depressed prices of affected securities.
Dealers, facing a crunch on the funding side of their balance sheets and holding an excessive amount of
illiquid assets on the other, withdrew from the markets. The jump in volatility made it especially dangerous
and expensive for dealers to continue to make markets. Without the dealers, there was no trading, especially
in securities such as collateralized debt obligations, certain municipal securities, and credit derivatives. With
no buyers, investors could not reduce losses by trading out of losing positions and they could not sell those
positions to meet calls for more margin or collateral to pledge against loans they had taken out to buy those
instruments. This illiquidity in OTC markets contributed to the depth and breadth of the financial crisis.
The major regulatory reform initiatives under way in the United States, European Union, and other
developed financial markets are directly addressing these issues. In some cases the trading is being shifted
from OTC markets to exchange markets. In others, the post-trade clearing process of OTC trades is being
moved increasingly into clearinghouses (also known as central clearing counterparties). Trade reporting for
OTC transactions is also a part of reform efforts. The role of the dealer in OTC markets is not, however,
being explicitly addressed except through possibly higher capital requirements.
20. What is the difference between risk-tolerant and risk-averse investor?

Risk aversion is a concept in economics and finance, based on the behavior
of humans (especiallyconsumers and investors) while exposed to uncertainty to attempt to reduce that uncertainty.
Risk aversion is the reluctance of a person to accept a bargain with an uncertain payoff rather than another bargain
with a more certain, but possibly lower, expected payoff. For example, a risk-averse investor might choose to put his
or her money into a bank account with a low but guaranteed interest rate, rather than into astock that may have high
expected returns, but also involves a chance of losing value.
Risk tolerance is a measure of your willingness to accept higher risk or volatility in exchange for higher potential
returns. Those with high tolerance are aggressive investors, willing to accept losing their capital in search for higher
returns. Those with a low tolerance, also called risk-averse, are more conservative investors who are more
concerned with capital preservation. The distinction is justified only by the investor's level of comfort.
A risk-tolerant investor will pursue higher potential reward investments even when there is a greater potential for a
loss. A risk-tolerant individual might not sell his stocks in a temporary market correction, while a risk averse person
might panic and sell at the wrong time. On the other end, a risk-tolerant person could be seek out high-risk
investments, even if they add little to his or her portfolio.
Risk tolerance is a measure of how much risk you can handle, but that is not necessarily the same as the appropriate
amount of risk you should take. That brings us to the second risk assessment that should be done.
21. What is the difference between unsystematic risk (firm-specific or diversifiable risk) and systematic risk (market
or non-diversifiable risk)?
pricing model.
22 . What is the distinction between the money market and the capital market?
Basically the difference between the capital markets and money markets is that capital markets are for long term
investments, companies are selling stocks and bonds in order to borrow money from their investors to improve their
company or to purchase assets. Whereas money markets are more of a short term borrowing or lending market
where banks borrow and lend between each other, as well as finance companies and everything that is borrowed is
usually paid back within thirteen months.
Another difference between the two markets is what is being used to do the borrowing or lending. In the capital
markets the most common thing used is stocks and bonds, whereas with the money markets the most common things
used are commercial paper and certificates of deposits.
Capital markets are financial markets for the buying and selling of long-term debt or equity-backed securities.
As money became a commodity, the money market became a component of the financial markets for assets
involved in short-termborrowing, lending, buying and selling with original maturities of one year or less. Trading in
money markets is done over the counterand is wholesale.
23. What is the main goal of firm? Explain.
Efficient financial management requires the existence of some objective or goal, because judgment as to whether or
not a financial decision is efficient must be made in light of some standard. Although various objectives are possible,
we assume in this book that the goal of the firm is to maximize the wealth of the firms present owners.
Shares of common stock give evidence of ownership in a corporation. Shareholder wealth is represented by the
market price per share of the firms common stock, which, in turn, is a reflection of the firms investment, financing,
and asset management decisions. The idea is that the success of a business decision should be judged by the effect
that it ultimately has on share price.
Frequently, profit maximization is offered as the proper objective of the firm. However, under this goal a manager
could continue to show profit increases by merely issuing stock and using the proceeds to invest in Treasury bills.
For most firms, this would result in a decrease in each owners share of profits that is, earnings per share would
fall. Maximizing earnings per share, therefore, is often advocated as an improved version of profit maximization.
However, maximization of earnings per share is not a fully appropriate goal because it does not specify the timing or
duration of expected returns. Is the investment project that will produce a $100,000 return five years from now more
valuable than the project that will produce annual returns of $15,000 in each of the next five years? An answer to
this question depends on the time value of money to the firm and to investors at the margin. Few existing
stockholders would think favorably of a project that promised its first return in 100 years, no matter how large this
return. Therefore our analysis must take into account the time pattern of returns.
24. What is the purpose of a statement of cash flows? Explain.
The purpose of the cash flow statement or statement of cash flows is to provide information about a company's gross
receipts and gross payments for a specified period of time.
The gross receipts and gross payments will be reported in the cash flow statement according to one of the following
classifications: operating activities, investing activities, and financing activities. The net change from these three
classifications should equal the change in a company's cash and cash equivalents during the reporting period. For
instance, the cash flow statement for the calendar year 2013 will report the causes of the change in a company's cash
and cash equivalents between its balance sheets of December 31, 2012 and December 31, 2013.
In addition to the cash amounts being reported as operating, investing, and financing activities, the cash flow
statement must disclose other information, including the amount of interest paid, the amount of income taxes paid,
and any significant investing and financing activities which did not require the use of cash.
The statement of cash flows is to be distributed along with a company's income statement and balance sheet.
25. What is the relation between a companys current ratio and its quick ratio?
Liquidity ratios are used to measure a firms ability to meet short-term obligations. They compare short-term
obligations with short-term (or current) resources available to meet these obligations. From these ratios, much
insight can be obtained into the present cash solvency of the firm and the firms ability to remain solvent in the event
of adversity.
One of the most general and frequently used of these liquidity ratios is the current ratio:
FORMULA: Current assets/Current Liabilities
The higher the current ratio, the greater the ability of the firm to pay its bills; however, this ratio must be regarded as
a crude measure because it does not take into account the liquidity of the individual components of the current
assets. A firm having current assets composed principally of cash and no overdue receivables is generally regarded
as more liquid than a firm whose current assets consist primarily of inventories.5 Consequently, we turn to a more
critical, or severe, test of the firms liquidity the acid-test ratio.
A more conservative measure of liquidity is the acid-test, or quick, ratio:
FORMULA: (Current assets-Inventory)/Current Liabilities
This ratio serves as a supplement to the current ratio in analyzing liquidity. This ratio is the same as the current ratio
except that it excludes inventories presumably the least liquid portion of current assets from the numerator. The
ratio concentrates primarily on the more liquid current assets cash, marketable securities, and receivables in
relation to current obligations. Thus this ratio provides a more penetrating measure of liquidity than does the current
ratio.
26.What is the role of diversification in the capital asset pricing model?

Based on the behavior of risk-averse investors, there is an implied equilibrium relationship between risk and
expected return for each security. In market equilibrium, a security is supposed to provide an expected return
commensurate with its systematic risk the risk that cannot be avoided by diversification. The greater the systematic
risk of a security, the greater the return that investors will expect from the security. The relationship between
expected return and systematic risk, and the valuation of securities that follows, is the essence of Nobel laureate
William Sharpes capital-asset pricing model (CAPM). This model was developed in the 1960s, and it has had
important implications for finance ever since. Though other models also attempt to capture market behavior, the
CAPM is simple in concept and has real-world applicability.
Like any model, this one is a simplification of reality. Nevertheless, it allows us to draw certain inferences about risk
and the size of the risk premium necessary to compensate for bearing risk. We shall concentrate on the general
aspects of the model and its important implications. Certain corners have been cut in the interest of simplicity.
As with any model, there are assumptions to be made. First, we assume that capital markets are efficient in that
investors are well informed, transactions costs are low, there are negligible restrictions on investment, and no
investor is large enough to affect the market price of a stock. We also assume that investors are in general agreement
about the likely performance of individual securities and that their expectations are based on a common holding
period, say one year. There are two types of investment opportunities with which we will be concerned. The first is a
risk-free security whose return over the holding period is known with certainty. Frequently, the rate on short- to
intermediate-term Treasury securities is used as a surrogate for the risk-free rate. The second is the market portfolio
of common stocks. It is represented by all available common stocks and weighted according to their total aggregate
market values outstanding. As the market portfolio is a somewhat unwieldy thing with which to work, most people
use a surrogate, such as the Standard & Poors 500 Stock Price Index (S&P 500 Index).
This broad-based, market-value-weighted index reflects the performance of 500 major common stocks.
Earlier we discussed the idea of unavoidable risk risk that cannot be avoided by efficient diversification. Because
one cannot hold a more diversified portfolio than the market portfolio, it represents the limit to attainable
diversification. Thus all the risk associated with the market portfolio is unavoidable, or systematic Formula:
Re=Rf+b(Rm-Rf)
27. What is the working capital and how do companies manage it?
The management of working capital, which is taken up in this and the subsequent three
chapters, is important for several reasons. For one thing, the current assets of a typical manufacturing firm account
for over half of its total assets. For a distribution company, they
account for even more. Excessive levels of current assets can easily result in a firm realizing
a substandard return on investment. However, firms with too few current assets may incur
shortages and difficulties in maintaining smooth operations.
For small companies, current liabilities are the principal source of external financing. These
firms do not have access to the longer-term capital markets, other than to acquire a mortgage
on a building. The fast-growing but larger company also makes use of current liability financing.
For these reasons, the financial manager and staff devote a considerable portion of their
time to working capital matters. The management of cash, marketable securities, accounts
receivable, accounts payable, accruals, and other means of short-term financing is the direct
responsibility of the financial manager; only the management of inventories is not. Moreover,
these management responsibilities require continuous, day-to-day supervision. Unlike
dividend and capital structure decisions, you cannot study the issue, reach a decision, and
set the matter aside for many months to come. Thus working capital management is important,
if for no other reason than the proportion of the financial managers time that must be
devoted to it. More fundamental, however, is the effect that working capital decisions have on
the companys risk, return, and share price.
28. Which organizational forms give their owners limited liability?

A Limited liability company is an organizational form that gives their owners a limited liability
Organizing a business enterprise as a limited liability company (LLC) under the laws of the state where it operates p
rotects its owners orshareholders from personal responsibility for company debts that exceed the amount those owne
rs or shareholders have invested.
In addition, an LLC's taxable income is divided proportionally among the owners, who pay tax on their share of the i
ncome at their individualrates. The LLC itself owes no income tax.
The limited liability protection is similar to what limited partners in a partnership or investors in a traditional, or C, c
orporation enjoy.
The tax treatment is similar to that of a partnership or S corporation, another form of organization that's available for
businesses with fewerthan 75 employees. However, only some states allow businesses to use LLC incorporation.

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Financial Management

2. Explain the difference between liquidity risk and credit risk?

3. Explain the meaning of operating leverage?

1) Explain what determines a companys return on assets.ROA

4. Explain what determines a companys return on assets.ROA

The ROA is often referred to as ROI

Return on assets (ROA) is calculated by:

From this, both companies look to be the same.

However now consider:

Benefits Using Return on Assets:

Recall in our definition of Return on Equity (ROE):

Assets = Liabilities + Shareholder Equity.

5. What is the difference between systematic and unsystematic risk?

Managers and stockholders

Managers and creditors

1. Stockholders versus Managers

2. Stockholders versus Creditors

Stockholders, however, have control of such decisions through the managers.

Motivating Managers to Act in Shareholders' Best Interests

Direct intervention by stockholders

Company shares are typically distributed to managers either as:

2. Direct Intervention by Stockholders

9. Explain the meaning of financial leverage?

net income divided by the % change in EBIT. DFL=%

ROE is sometimes called "return on net worth."

income from the sale of current assets (excluding financial investments);

Balance sheet profit - a profit from operations and non-operating.

17. What distinguishes a partnership from individual entrepreneurship?

18. What is meant by exchange risk and political risk?

19. What is the difference between an exchange and an over-the-counter market?

20. What is the difference between risk-tolerant and risk-averse investor?

26.What is the role of diversification in the capital asset pricing model?

28. Which organizational forms give their owners limited liability?

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