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HANDOUTS ON FUNDAMENTALS OF a.

2) Determine how much funding will


FINANCIAL MANAGEMENT 1 be required in the future, and what
Chapter 6: Financial Statements would be the nature of such needs,
Analysis including any seasonal component to
(Reference: Van Horne and John M. the needs.
Wachowicz, Fundamentals of Financial b) Analysis of the financial condition
Management, 13th edition) and profitability of the firm
b.1.) Analytical tools used to address
1) Introduction the first concern include sources and
a) To make rational decisions in uses of funds statements, statements
keeping with the objectives of the of cash flow, and cash budgets. Such
firm, the financial manager must have tools used to assess the financial
analytical tools. condition and performance of the firm
b) The firm itself and outside are financial ratios.
providers of capital creditors and c) Analysis of the business risk of the
investors all undertake financial firm
statement analysis. c.1) Business risk relates to the risk
The type of analysis varies according inherent in the operations of the firm.
to the specific interests of the party Some companies are in highly volatile
involved. lines of business and/or may be
c) Trade creditors are primarily operating close to their break-even
interested in the liquidity of a firm. point.
Their claims are short term, and the c.2) Other companies are in very
ability of the firm to pay these claims stable lines of business and/or find
quickly is best judged by an analysis themselves operating far from their
of the firms liquidity. break-even point.
d) The claims of bondholders are long 3) All the three factors mentioned in
term. They are more interested in the the framework should be considered
cash-flow ability of the firm to service jointly and used in determining the
debt over a long period of time. They financial needs of the firm.
may evaluate this ability by analyzing a) The greater the funds
the capital structure of the firm, the requirements, the greater the total
major sources and uses of funds, the financing that will be necessary.
firms profitability over time, and b) The nature of the needs for funds
projections of future profitability. influences the type of financing that
e) Investors in a companys common should be used.
stock are principally concerned with c) The firms level of business risk
present and expected future earnings also strongly affects the type of
as well as with the stability of these financing that should be used.
earnings about a trend line. As a c.1) The greater the business risk, the
result, investors usually focus on less desirable debt financing usually
analyzing profitability. They would becomes relative to common stock
also be concerned with the firms financing. In other words, equity
financial condition insofar as it affects financing is safer in that there is no
the ability of the firm to pay dividends contractual obligation to pay interest
and avoid bankruptcy. and principal, as there is with debt.
f) Internally, management also c.2) A firm with a high degree of
employs financial analysis for the business risk is generally ill advised to
purpose of internal control and to take on considerable financial risk as
better provide what capital suppliers well.
seek in financial condition and d) The financial condition and
performance from the firm. performance of the firm also influence
2) Framework for financial analysis the type of financing that should be
a) Analysis of the funds needs of the used.
firm d.1) The greater the firms liquidity,
a.1) Focus on the trend and seasonal the stronger the overall financial
component of a firms fund condition; and the greater the
requirements. profitability of the firm, the more risky

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the type of financing that can be indications, financial statements are
incurred. That is, debt financing generally more accurate and clearer
becomes more attractive with than they were in the past. But the
improvements in liquidity, financial world is dynamic, and a new
condition, and profitability. accounting problem surfaced in 2007.
Big banks, most notably Citigroup,
PART 2: owned many risky but high-yielding
Chapter 3: Financial Statements subprime mortgages. The banks
(Reference: Brigham, Eugene, invented a complex legal procedure
Fundamentals of Financial that they called a structured
Management, 12th edition) investment vehicle (SIV) to conceal
the fact that they held all of these
1) Introduction risky mortgages. They correctly feared
The financial statements presented in that people wouldnt want to do
a typical business with a risky bank. But when
companys annual report look quite the subprime market fell apart in
official. They are signed by the firms 2007, the banks had to acknowledge
top executives and are certified by a their losses, which ran into many
Big Four accounting firm, so one billions of dollars. It turns out that the
would think that they must be banks had tried to avoid writing down
accurate. That may not be true, their mortgages; but a newly formed
though, for three reasons: legitimate organization set up by the Big Four
misjudgments in valuing assets and accounting firms, called the Center for
measuring costs, flexible accounting Audit Quality, took a hard line and
rules that result in differently reported forced the writedowns. 2) Financial
results for similar companies, and Statements and Reports The annual
outright cheating. report is the most important report
One blatant example of cheating that corporations issue to
involved WorldCom, which reported stockholders, and it contains two
asset values that exceeded their true types of information.2 First, there is a
value by about $11 billion. This led to verbal section, often presented as a
an understatement of costs and a letter from the chairperson, which
corresponding overstatement of describes the firms operating results
profits. Enron is another example. during the past year and discusses
That company overstated the value of new developments that will affect
certain assets, reported those artificial future operations. Second, the report
value increases as profits, and provides these four basic financial
transferred the assets to subsidiary statements:
companies to hide the true facts. 1. The balance sheet, which shows
Enrons and WorldComs investors what assets the company owns and
eventually learned what was who has claims on those assets as of
happening, the companies were a given datefor example, December
forced into bankruptcy, their top 31, 2008.
executives went to jail, the accounting 2. The income statement, which
firm that audited their books was shows the firms sales and costs (and
forced out of business, and millions of thus profits) during some past period
investors lost billions of dollars. After for example, 2008.
the Enron and WorldCom blowups, 3. The statement of cash flows, which
Congress passed the Sarbanes-Oxley shows how much cash the firm began
Act (SOX), which required companies the year with, how much cash it
to improve their internal auditing ended up with, and what it did to
standards and required the CEO and increase or decrease its cash.
CFO to certify that the financial 4. The statement of stockholders
statements were properly prepared. equity, which shows the amount of
The SOX bill also created a new equity the stockholders had at the
watchdog organization to help make start of the year, the items that
sure that the outside accounting firms increased or decreased equity, and
were doing their job. From all the equity at the end of the year.

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These statements are related to one accounting standards, normally results
another; and taken together, they in financial statements that convey
provide an accounting picture of the what is generally understood as a true
firms operations and financial and fair view of such information.
position. The quantitative and verbal 2) Linkage of Financial Statements
materials are equally important. The a) The four financial statements are
firms financial statements report linked with each other and linked
what has actually happened to its across time.
assets, earnings, and dividends over b) The statement of financial position
the past few years, whereas and statement of comprehensive
managements verbal statements income are linked via retained
attempt to explain why things turned earnings. Retained earnings are
out the way they did and what might updated each period and reflect
happen in the future. cumulative income that has not yet
been distributed to shareholders.
Chapter 11: Understanding c) There is an order to financial
Financial Statements statements preparation:
Chapter 12: Analysis of Financial (c.1) A company prepares its income
Statements statement using the statement of
(Reference: Cabrera, Ma. Elenita comprehensive income accounts. It
Balatbat, Financial Management then uses the net income number and
(Principles and Applications, vol. 1) dividend information to update the
2015 edition) retained earnings account.
1) Constraints on Relevant and (c.2) It prepares the statement of
Reliable Information financial position using the updated
a) Timeliness: In achieving a balance retained earnings account along with
between relevance and reliability, the the remaining statement of financial
overriding consideration is how best to position accounts from the trial
satisfy the economic decision making balance.
needs of users. (c.3) It prepares the statement of
b) Balance between Benefit and Cost: shareholders equity.
a pervasive constraint rather than a (c.4) It prepares the statement of
qualitative characteristic. The cash flows using information from the
benefits derived from information cash accounts and other sources.
should exceed the cost of providing it. 3. Financial statement analysis the
The evaluation of benefits and costs process of extracting information from
is, however, substantially a financial statements to better
judgmental process. understand a companys current and
c) Balance between qualitative future performance and financial
characteristics: Generally, the aim is condition. It involves
to achieve an appropriate balance Comparing the firms
among the characteristics in order to performance to that of other
meet the objective of financial firms in the same industry, and
statements. The relative importance Evaluating trends in the firms
of the characteristics in different financial position over time.
cases is a matter of professional The primary goal of financial
judgment. management is to maximize
d) True Fair View or Fair Presentation: shareholders wealth. Accounting
Financial statements are frequently data influence stock prices and such
described as showing a true and fair data can be used to see why a
view of the financial position, company is performing the way it is
performance and changes in financial and where it is heading.
position of an enterprise. Although 4. Analyzing the broader business
this framework does not deal directly environment
with such concepts, the applications a) Life cycle
of the principal qualitative
characteristics and of appropriate

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a.1) At what stage in its life is this h.2) Does a strong audit committee of
company? Is it a startup, experiencing the board exist, and is it populated
growing pains? with outsiders?
a.2) Is it strong and mature, reaping h.3) Does management have a large
the benefits of competitive portion of its wealth tied to the
advantages? companys stock?
a.3) Is it nearing the end of its life, i) Risk
trying to milk what it can from i.1) Is it subject to lawsuits from
stagnant product lines? competitors or shareholders?
b) Outputs i.2) Is it under investigation by
b.1) What products does it sell? regulators?
b.2) Are its products new, established i.3) Has it changed auditors? If so,
or dated? why?
c) Buyers i.4) Are its auditors independent?
c.1) Who are its buyers? i.5) Does it face environmental and/or
c.2) Are buyers in good financial political risks?
condition? 5. Limitations of Financial Statements
c.3) Do buyers have substantial Analysis
purchasing power? a) Information derived by the analysis
c.4) Can the seller dictate sales terms are not absolute measures of
to buyers? performance in any and all of the
d) Inputs areas of business operations. They
d.1) Who are its suppliers? are only indicators of degrees of
d.2) Are there many supply sources? profitability and financial strength of
d.3) Does the company depend on a the firm.
few supply sources with potential for b) Limitations inherent in the
high input costs? accounting data the analyst works
e) Competition with. These are brought about by
e.1) In what kind of markets does it among others: (1) variation and lack
operate? of consistency in the application of
e.2) Are markets open? Is the market accounting principles, policies and
competitive? procedures; (2) too-condensed
e.3) Does the company have presentation of data; and (3) failure to
competitive advantages? reflect change in purchasing power.
e.4) Can it protect itself from new c) Limitations of the performance
entrants? At what cost? measures or tools and techniques
e.5) How must it compete to survive? used in the analysis. Quantitative
f) Financing measurements are not absolute
f.1) Must it seek financing from public measures but should be interpreted
markets? Is it going public? relative to the nature of the business
f.2) Is it seeking to use its stock to and in the light of past, current and
acquire another company? future operations. Timing of
f.3) Is it in danger of defaulting on transactions and the use of averages
debt covenants? can also affect the results obtained in
f.4) Are there incentives to tell an applying the techniques in financial
overly optimistic story to attract lower analysis.
cost financing or to avoid default on d) Analysts should be alert to the
debt? potential for management to influence
g) Labor the outcome of financial statements in
g.1) Who are its managers+ What order to appeal to creditors, investors
are their backgrounds? Can they be and others.
trusted? Are they competent?
g.2) What is the state of employee Limitations of analysis may be
relations? Is labor unionized? overcome to some extent by finding
h) Governance appropriate benchmarks used by most
h.1) How effective is its corporate analysts such as the performance of
governance? Does it have strong and comparable components and the
independent board of directors?

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average performance of several total current
companies in the same industry. liabilities
6. Financial Ratio Analysis a.2) Acid-test ratio or quick ratio a
a) Financial ratio is a comparison in more severe test of immediate
fraction, proportion, decimal or solvency; test of ability to meet
percentage of two significant figures demands from current assets.
taken from financial statements. Acid test ratio or quick ratio =
b) It expresses the direct relationship total quick assets / total current
between two or more quantities in the liabilities
statement of financial position and Total quick assets: cash +
statement of comprehensive income marketable securities + accounts
of a business firm. receivable
c) The ratios are categorized as a.3) Working Capital to total assets
follows: indicates relative liquidity of total
c.1) Liquidity ratios give us an idea assets and distribution of resources
of the firms ability to pay off debts employed.
that are maturing within a year or Working capital to total assets
within the next operating cycle. =
These ratios are necessary if the firm Working Capital / Total Assets
is to continue operating. Working capital = current assets
c.2) Asset management ratios give current
us an idea of how efficiently the firm is Liabilities
using its assets. Good asset b) Ratios used to evaluate asset
management ratios are necessary for liquidity and management efficiency
the firm to keep its costs low and thus, b.1) Trade receivable turn-over
its net income high. velocity of collection of trade accounts
c.3) Debt management ratios tell us and notes; test of efficiency of
how the firm has financed its assets collection.
as well as the firms ability to repay its Trade receivable turn-over = net
long-term debt. These indicate how credit sales /
risky the firm is and how much of its Average trade receivable (net)
operating income must be paid to b.1b) Average collection period or
bondholders rather than stockholders. number of days sales uncollected
c.4) Profitability ratios give us an evaluates the liquidity of accounts
idea of how profitability the firm is receivable and the firms credit
operating and utilizing its assets. policies.
These ratios, combine the asset and Average collection period or
debt management categories and number of days sales uncollected
show their effects on return on equity. = 360 days / receivable turnover
c.5) Market book ratios - these ratios or accounts receivable / net
which consider the stock price, give us sales/360
an idea of what investors think about b.2) Inventory turnover measures
the firm and its future prospects. efficiency of the firm in managing and
These tell us what investors think selling inventories
about the company and its prospects. Finishes goods inventory = Cost
7. Summary of most commonly used of goods sold / average finished
ratios: their formulas and basic goods inventory
significance c) Ratios used to evaluate long-term
a) Ratios used to evaluate short-term financial position or stability/leverage
financial position (short-term solvency c.1) Debt ratio shows proportion of
and liquidity) all assets that are financed with debt.
a.1) Current ratio primary test of Debt ratio = total liabilities / total
solvency to meet current obligations assets
from current assets as a going c.2) Equity ratio indicates proportion
concern; measure of adequacy of of assets provided by owners.
working capital. Reflects financial strength and caution
Current ratio = total current to creditors.
assets/

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Equity ratio = total equity / total
assets
c.3) Debt to equity ratio measures
debt relative to amounts of resources
provided by owners.
Debt to equity ratio = total
liabilities / total equity
c.4) Fixed assets to long-term
liabilities reflects extent of
investment in long-term assets
financed from long-term debt.
Fixed assets to long-term
liabilities = fixed assets (net) /
total long-term liabilities
d) Ratios used to measure
profitability and returns to investors
d.1) Gross profit margin measures
profit generated after consideration of
cost of products sold.
Gross profit margin = gross
profit / net sales
d.2) Operating profit margin
measures profit generated after
consideration of operating costs.
Operating profit margin =
operating profit / net sales
d.3) Net profit margin (rate of return
on net sales measures profit
generated after consideration of all
expenses and revenues
Net profit margin = net profit /
net sales