FMDFINA Reviewer

TABLE OF CONTENTS

● Overview of Financial Management

● Financial Statements and Ratio Analysis
● Financial Planning
● Risk, Return, and CAPM
● Cost of Capital
● Capital Budgeting Techniques

OVERVIEW OF FINANCIAL MANAGEMENT

Finance
- Study of how people and businesses evaluate investements and raise capital to
fund them.

- The art and science of managing money.

Financial Management
- Refers to the maintenance and creation of economic wealth.

Investment Decisions

- Purchase of real assets

- Refers to Capital budgeting decisions
- Decisions to invest in tangible or intangible assets.
- Also called the investment decision.
- Also called capital expenditure or CAPEX decisions.
- Involved managing assets already in place and deciding when to shut down
or dispose of assets when they are no longer profitable.

Financing Decisions
 - Sale of securities and other financial assets
- Can add value however it can also destroy value if you made a mistake.
- Includes meeting its obligation to bank, bondholders and stockholders that
have contributed financing in the past.
- Shareholders are equity investors who contribute equity in financing.

Capital Structure

- The choice between debt and equity financing.

- Capital refers to the firm’s sources of long term financing.

Financing decisions vs Investment Decisions

- Investment decisions are more important than financing decisions

because it is crucial for growth and profitability.
- Financing decisions may not add as much value as compared to a good
investment decisions.

Finance in Practice
- “The Rise and Stall of Convergence in Accounting Standards”
Variety of Stakeholders for Public Companies:
- Shareholders
- Bondholders
- Bankers
- Suppliers
- Employees
- Management

Kinds of business Organization

1. Sole proprietorship
 2. Partnership
a. General partnership
b. Limited partnership & Limited Liability Company
3. Corporation

Financial Goal of the Corporation

Shareholders want these three things:
1. Maximize current wealth
2. To transform wealth into most desirable time pattern of
consumption.
3. To manage risk characteristics of chosen consumption plan.

Basic Principles of Financial Management:

1. Corporate finance is all about maximizing value.
2. The opportunity cost of capital sets the standards for investments.
3. A safe dollar is worth more than a risky dollar.
4. Smart investment decisions create more value than smart financing
decisions.
5. Good governance matters.

FINANCIAL STATEMENTS AND RATIO ANALYSIS

Financial Statement
- Gives a summary of what occurred to the firm after a specified time period. It
represents the company's performance throughout a particular period of time.

Major Financial Statements:

1. Balance Sheet
- It is a financial statement that shows a company's assets, liabilities, and
shareholder equity at a certain period in time.
- Components:
❖ Currents Assets: Cash, Accounts Receivable, and Inventories
 ❖ Non-current Assets: Patent, Goodwill, Copyright, and Trademark
❖ Current Liabilities: Accounts Payable, Accrued Expenses, and
Notes Payable
❖ Long-term Debt
❖ Equity or Capital

2. Income Statement
- Also known as the statement of profit and loss
- Reflects the summary of operations for the specific period
- Components:
❖ Gross Sales
➢ Result from transactions involving sale or rendering of
goods or services in exchange for money.
❖ Cost of Goods Sold
➢ The direct cost of the product or service that is
subsequently sold or rendered.
❖ Gross profit
➢ The difference between the net sales and cost of goods
sold.
❖ Operating Expense
➢ Indirect expenses which may include administrative and
selling expenses.
❖ Operating Income
➢ Summary of day to day operations of the firm taken from
the gross profit minus the operating expenses (EBIT).
 3. Cash Flow Statements
- Depicts the changes that occurred between the beginning and ending
balance sheets as a result of operations
4. Statement of Retained Earnings
- Shows the detailed presentation of the stockholder’s equity.

Financial Ratios
- Ratio Analysis requires “calculating and interpreting financial ratios to analyze
and monitor the firm’s performance.”

Kinds of Ratio Analysis

1. Cross-Sectional Analysis
- Compares the company’s data vs its main competitors or industry data 2.
2. Time-Series Analysis
- Evaluates the company’s performance from a specific time period.
- All data should be developed and recorded in the same manner.
3. Combined Analysis
- A combination of Cross-sectional and Time-series analysis.

Limitations of Financial Ratios

- Ratios can indicate signs (but not sources) of the problem.
- One ratio can’t be used to determine complete performance
- Seasonality effects should be considered.
- Inflation can affect values.
- The bias to use audited Financial statements
- The need to utilize data that used the same methodology

Classification of Financial Ratios

Liquidity Efficiency Leverage Profitability Market Value

1. Net 1. Asset 1. Long - 1. Operating 1. Price /
Working Turnover Term Margin Earnings
Capital Ratio Debt 2. Profit Ratio
to Total 2. Inventory Ratio Margin or 2. Market /
- Assets Turnover 2. Long Net Profit Book
2. Current 3. Average Term Margin Ratio
Ratio Days in Debt - 3. Return on
3. Quick Inventory Equity Total
(Acid - 4. Receivables Ratio Assets
Test) 3. Total 4. Basic
Ratio Debt Earned
4. Cash Ratio Power
Ratio 4. Times - Ratio
Interest 5. Return on
Earned Common
5. Cash Equity
Coverage

1. Liquidity
❖ The ability of the company to satisfy its short-term liabilities.
❖ Answers the question: “How liquid is the firm?”
❖ A firm is financially liquid if it is able to pay its bills on time.
❖ The higher the ratio, the more liquid the business is.

2. Efficiency
❖ The ability of the company to generate sales.

3. Leverage
❖ The ability of the company to satisfy its long term obligations.
❖ Also known as equity multiplier
❖ The lower the ratio, the less leveraged the company is.

4. Profitability
❖ The capability of the company to generate income.
 5. Market Value
❖ How investors value the firm in terms of Market Price per share (MPS)

Liquidity Ratios
Ratio Formula

Net Working Capital to Total Assets Ratio

Current Ratio

Quick (Acid - Test) Ratio

Cash Ratio

1. Net-Working-Capital-to-Total-Assets Ratio
a. Current assets are also known as working capital.
b. Having a higher amount of current assets is ideal.
2. Current ratio
a. Expressed in times of coverage.
b. Standard benchmark is 2.0
3. Quick (Acid-test) Ratio
a. This ratio excludes inventory and other less liquid portions of current
assets.
b. Expressed in times of coverage.
c. Standard benchmark is 1.0
 4. Cash Ratio
a. This ratio measures if the cash and marketable securities that the company
has are enough to cover its current liabilities.
b. This is a very conservative measure of liquidity.
Efficiency Ratios
Ratio Formula

Asset Turnover Ratio

Inventory Turnover

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Average Days in Inventory

Receivables Turnover

Average Collection Period

Ratio Alternative Formula

Asset Turnover Ratio

Inventory Turnover

Average Days in Inventory

Receivables Turnover

Average Collection Period

5. Asset Turnover ratio

a. Shows how much revenue is generated from assets.
6. Inventory Turnover
a. Shows how fast the company replenishes its inventory.
7. Average days in Inventory
a. Shows how long a number of days the company keeps their inventory. i.
Shorter days or potential stock-outs might make the customer tryout the
products of competitors.
i. Longer days show the obsolescence of the product.

8. Receivables Turnover
a. Quicker payments for Accounts receivable translates to a high Accounts
Receivables turnover.
 b. Measured in number of times.
9. Average Collection Period
a. Make use of credit sales and not cash sales.
i. Shorter number of days or being able to quickly collect receivables
can show that customers may be pressured to pay.
ii. Longer number of days can show that the company may be too lax
in collecting receivables.
b. Measured in number of days.
Note: The number of days would vary in the analysis of what is good or bad depending
on the industry of the company.

Leverage Ratios
Ratio Formula

Long-term Debt Ratio

Long-term Debt-Equity

Total Debt Ratio

Times-Interest Earned Ratio

Cash Coverage
10. Long-term Debt Ratio
a. Shows how much of the company’s equity can cover long-term debt
b. Compares a company’s long-term debt to its total capitalization (total
long-term capital).
i. Total capitalization is the sum of Long-term Debt and equity
c. The lower the ratio, the better
11. Long-term Debt-Equity Ratio
a. Shows how much of the firm’s assets are funded by liabilities.
b. Compares long-term debt to equity
c. The lower the ratio, the better
12. Total Debt Ratio
a. Measures the proportion of assets that were financed by debt
b. Investors are hesitant on lending to firms with very high debt ratios.
c. The lower the ratio, the better
13. Times-Interest Earned Ratio (Interest coverage ratio)
a. Shows how much of the company’s income can cover financial
obligations.
b. Measures how well a company has its interest obligations covered
c. The higher the ratio, the better. Standard benchmark is < 2.5.
d. Earnings Before Interest & Taxes (EBIT)
i. Also known as the operating income.
ii. Measures a company’s ability to generate profit from its operations on
an accrual basis.
iii. An adjusted version of net income.
14. Cash Coverage
a. A variation of Times Interest Earned ratio
b. Useful for companies with a huge number of depreciation expense
c. Depreciation expense formula (eg.): Accumulated depreciation 2022 -
Accumulated depreciation 2021
d. The higher the ratio, the better
Profitability Ratios
Ratio Formula

Operating Margin

Profit Margin or Net

Return on Total Assets

Basic Earning Power (BEP) Ratio

Return on Common

15. Operating Margin

a. Identifies how a company is performing with respect to its operations
before the impact of interest expenses is considered
16. Net Profit Margin
a. Shows how much net income the firm generated from its sales.
b. The higher the ratio, the better
17. Return on Assets (ROA)
a. Shows how much net income the firm generated from its assets.
b. The measure of profit per dollar of assets
c. The higher the ROA, the better
18. Basic Earning Power (BEP) Ratio
 a. Shows how much net operating income the firm generated out of its total
assets.
19. Return on Common Equity (ROE)
a. Shows how much income the firm generated from its equity.
b. Also known as return on book equity
c. The higher the ROE, the better
Notes:
- Net Income = Net Income After Taxes - Preferred Stock Dividends
- Common Equity = Common Stock Equity
- Accounts related to common equity: Common stock, Paid-in Capital in Excess of
Par, Retained Earnings

Market Value Ratios

Ratio Formula

Price/Earnings (P/E)Ratio

Market/Book (M/B) Ratio

*Earnings per Share (EPS)

*Book Value per Share (BVP)

20. Price/Earnings Ratio

a. How much in number of times are common stockholders willing to pay for
earnings per share.
21. Market/Book Ratio
 a. How much in number of times are investors willing to pay for book value
per share.
i. Decreases BVP if the buyback price is above current BVP
ii. Increases BVP if the buyback price is below current BVP

FINANCIAL PLANNING
Overview of Financial Planning

● Financial Planning provides road maps for guiding, coordinating, and controlling the
firm’s actions to achieve its objectives.
● Long-term (Strategic) Financial Plan
○ 5-year plans are the norm but it can cover “2 to 10 years.”
○ Factors in CAPEX, sources of asset funding, forecasted investments, etc.
● Short-term (Operating) Financial Plan
○ Normally ranges from 1-2 years
○ Needs the projected sales and other information
○ Involves the preparation of budgets and projected F/S

Cash Budget

● Cash Budget represents the firm’s planned inflows and outflows of cash. ● Sales
Forecast is vital to the company’s short-term plans. It may be based on external and/or
internal data.
● Sample: Cash Budget
● GHI Company’s sales for January and February were PHP 65,000 and PHP
75,000, respectively. Projected sales for March, April, and May are PHP 75,000,
PHP 85,000, PHP 95,000, respectively. It has a cash balance of PHP 10,000 on
March 1 and would be maintaining a minimum cash balance of PHP 10,000.
Construct a cash budget for March to May considering the following:
● The firm’s cash sales are 40%, 50% are collected a month later, and 10%
are collected 2 months after the sale.
 ● It has other income of PHP 4,000 monthly.
● Its projected cash purchases are PHP 40,000, PHP 60,000, and PHP
70,000 for March to May, respectively.
● Salaries, based on the previous month’s revenue, are 40%.
● Taxes amounting to PHP 5,000 are due in March.
● Solution: Cash Budget
● Cash Receipts:

● Cash Disbursements:

● Cash Budget:

Profit Planning

● Profit Planning depends on ACCRUAL principles to estimate the company’s F/S.

● Requirements in Constructing Projected F/S
● Past F/S
● Projected Sales
 ● Limitations of the Pro Forma Statements
● The past strongly affects the future
● Some accounts can have specific amounts

Pro Forma I/S

● The Pro Forma I/S may be constructed using the PERCENT-OF-SALES METHOD.
● The key accounts that are computed as a percentage of sales are
● Cost of Goods Sold (CGS)
● Operating Expenses (OPEX)
● Interest Expense
● Formula:

● Sample: Pro Forma I/S

● JKL Company will construct its forecasted I/S for 2022. It projected that sales =
PHP 2,000,000, interest expense = PHP 50,000. Other information (2021 data):
● Sales = PHP 1,500,000
● CGS = PHP 900,000 (where: fixed cost = PHP300,000, variable cost =
PHP 600,000)
● OPEX = PHP 150,000 (where: fixed cost = PHP60,000, variable cost =
PHP 90,000)
● Interest Expense = PHP 50,000
● Tax Rate = 30%
● Solution: Pro Forma I/S
 ● Version 1: Projected I/S (amounts are in PHP)

● Version 2: Projected I/S (amounts are in PHP)

Pro Forma B/S

● The Judgmental Approach is a method for constructing the projected B/S wherein the
amounts of the accounts are forecasted and the company’s “external financing is used as a
balancing, or ‘plug’ figure.”
● Sample: Pro Forma B/S
● MNO Company will construct its projected B/S for 2022. Forecasted sales are
PHP 5,000,000. Other information:
● Cash will be PHP 70,000.
● M/S will be PHP 10,000.
 ● A/R will be 20% of sales.
● Inventories will be 30% of sales.
● An equipment amounting to PHP 150,000 will be purchased. Depreciation
for 2022 will be PHP 30,000.
● A/P will be 15% of sales.
● Net profit margin will be 5% (it will give out PHP 75,000 in dividends).
● Other B/S accounts will have no changes.
● B/S accounts (2021 data):
● Accruals = PHP 100,000
● Other CL = PHP 60,000
● Net F/A = PHP 700,000
● CS = PHP 300,000
● LTD = PHP 250,000
● RE = PHP 290,000
● Solution: Pro Forma B/S

Sustainable Growth Rate

● Formula:
● g = RR * ROE
● where: Retention Rate = 1-Dividends Declared/Net Earnings
● Sample: Sustainable Growth Rate
● PQR Company earned PHP 25,000,000 and reinvested PHP 15,000,000 back into
 the firm. According to its B/S, its common equity accounts are valued at
PHP120,000,000. Calculate its sustainable growth rate.
● Solution: Sustainable Growth Rate

RISK, RETURN, AND CAPM

● Risk: In finance, it refers to a chance or possibility of financial losses or that an actual

return will differ from an expected return
● Returns:
○ Expected Return: the return an investor expects to earn on an asset given its
price, growth potential, etc.
○ Required Return: the return an investor requires on an asset given its risk and
market interest rates.

● Measuring Risks: can be measured by evaluating the stock’s price ranges and its
standard deviation
○ Standard Deviation of Returns: standard deviation has a direct relationship with
risk (higher standard deviation = higher risk)
○ Beta: measure of market risks and how sensitive an individual’s stock returns to
the changes in the market.
■ = 1 average market risk
■ >1 more volatile than the market (ex. technology firms)
■ <1 less volatile in the market (ex. utilities)
● Mitigating Risks through Diversification:
○ Essentially, it is to not put all your eggs in one basket by investing in more than
one asset to reduce risk
■ Positively correlated: diversification has no effect on risk (ex. Jollibee,
Mcdo, Bounty Fresh — all poultry)
 ■ Negatively correlated: diversification has effect on risk and the portfolio is
perfectly diversified (ex. Globe, BPI, Meralco)
○ Only some risks can be diversified:

Market Risk Company-unique Risk

● Systematic risk and is nondiversifiable ● Unsystematic risk that can be reduced

● Ex. Oil prices, FOREX, etc. through diversification
● Ex. Labor force strike, oil tank bursts, etc

● Required Rate of Return

Required rate of return = Risk-free rate of return + Risk premium

COST OF CAPITAL

Refers to financial resources available for use to start, run, or expand a business.

1. Cost of Debt = % Interest Charge

2. Cost of Equity = % Expected Return

1. Weighted Average Cost of Capital (WACC)

2. After Tax Cost of Debt

Cost of Debt = kd x (1 – Tax rate)
3. Cost of Preferred stock

Kps - Cost of preferred stock

Divps - Dividends on preferred stock

Pps - Present value of Preferred Stock

(Preferred Dividend = Par / Face Value of Preferred Stock x Dividends per Preferred
Stock)

4. Cost of Common stock

CAPM Model:
Dividend Growth Model:

Kcs - Cost of Common Stock

D1 - Dividend on Period One

Pcs - Present Value of Common Stock

g - growth rate

CAPITAL BUDGETING TECHNIQUES

Terminologies:
Capital Budgeting - the process of evaluating and selecting long-term investments (acquisition of
assets) that are consistent with the firm’s goal of maximizing owner wealth. Capital Expenditure
- an outlay of funds by the firm that is expected to produce benefits over a period of time greater
than 1 year
Operating Expenditure - an outlay of funds by the firm resulting in benefits received within 1
year
Capital budgeting process - 5 distinct but interrelated steps: proposal generation, review and
analysis, decision making, implementation, and follow up
Independent projects - are projects whose cash flows are unrelated to (or independent of) one
another; the acceptance of one does not eliminate the others from further consideration

Mutually exclusive projects - are projects that compete with one another, so that the acceptance
of one eliminates from further consideration all other projects that serve a similar function.
Unlimited funds - the financial situation in which a firm is able to accept all independent projects
that provide an acceptable return
Capital rationing - the financial situation in which a firm has only a fixed number of dollars
available for capital expenditures and numerous projects compete for these dollars 3
Primary approaches to capital budgeting
1. Payback analysis
- Payback period is the amount of time required for an investment to generate cash
flows sufficient to recover its initial cost
2. Net Present Value of Discounted cash flows
- NPV is found by subtracting a projects initial investment from the present value
of its cash inflows discounted at a rate equal to the firm's cost of capital
3. Internal rate of return analysis
- it is the rate if return that the firm will earn if it invests in the project and receives
the given cash inflows
Formulas:
a. Future value/ compound interest
Future value (FV) is the value in dollars at some point in the future

FVn = Vo (l + r)n

where:
Vois the initial sum invested
r is the interest rate
n is the number of periods for which the investment is to receive interest.

Present Value

FVn = Vo (I + r)n

b. Net Present Value (NPV)

Where:
Ct = the net cash receipt at the end of year t
Io = the initial investment outlay
r = the discount rate/the required minimum rate of return on investment
n = the project/investment's duration in years.

Decision rule:

If NPV is positive (+): accept the project

If NPV is negative(-): reject the project