FINMAN2 Reviewer Managerial Finance is the science of

managing financial resources in a firm so as to

TOPICS maximize the value of the firm while on the other
1. Introduction to Financial Management side managing the financial risks.
2. Preparing and Analyzing Statements Financial management is such a managerial
3. Forecasting and AFN process which is concerned with the planning and
4. Managing Working Capital control of financial resources.
5. Managing Short-term Credits Financial management was started as a
6. Cost of Capital separate subject of study in the 20th century.
7. Capital Budgeting : Concepts, Techniques,
Cash Flows and Risk Considerations In the initial years of its development,
8. Leverage and Capital Structure and Dividend financial management was concerned only with
Payout Policy collection of funds for business.
But according to the modern viewpoint,
not only collection of funds but also their proper
Financial management typically covers various utilization are the basic functions of financial
aspects of managing an organization's finances to management.
achieve its financial goals and optimize its In present times, financial management
financial performance. analyses all financial problems of a business.
Financial management is part of a larger
TOPIC 1: INTRODUCTION TO FINANCIAL discipline called Finance which is a body of facts,
MANAGEMENT principles and theories relating to raising and
using money by individuals businesses and
government.
INTRODUCTION
Financial Management, also referred as Financial management refers to the
managerial finance, corporate finance, and functions involved in the management of financial
business finance. resources.
Financial management provides as These functions are fund procurement,
essential foundation for understating the role and working capital management, capital budgeting,
significance of financial management in an and capital structure designing of an organization.
organization. It includes controlling and maintaining the
It covers the basic principles and concepts financial assets of an organization.
that guide financial decision- making. In addition, it determines the future
Financial management is the process of strategies related to expansion, diversification,
planning, organizing, controlling, and monitoring joint venture, and mergers and acquisitions.
an organization’s financial resources to achieve Financial management may be defined as
its goals and objectives effectively. planning, organizing, directing and controlling the
It involves managing the funds and financial activities of an organization.
resources available to the organization to
optimize performance and generate value for
stakeholders.
According to Guthman and Dougal,
financial management means, “The activity
Financial Management is a branch of
concerned with the planning, raising, controlling
economies concerned with the generation and
and administering of funds used in the business.”
allocation of scarce resources to the most efficient
It is concerned with the procurement and
user within the economy (or the firm).
utilization of funds in the proper manner.
The allocation of these resources is done
through a market pricing system.
Financial management involves the
A firm requires resources in form of funds
management of the finance function.
raised from investors.
It is concerned with the planning,
The funds must be allocated within the
organizing, directing and controlling the financial
organization to projects that will yield the highest
activities of an enterprise.
return.
Financial Management is a discipline
Financial Management influences all
concerned with the generation and allocation of
segments of corporate activity, for both profit-
scarce resources (usually funds) to the most
oriented firms and non-profit firms.
efficient user within the firm (the competing
It is involved in a range of activities like
projects) through a market pricing system (the
acquisition of funds, the allocation of resources,
required rate of return).
and the tracking of financial performance.
 Therefore, it has acquired a vital role in 1. Estimation of capital requirements: A
every type of organization. finance manager has to make estimation with
regards to capital requirements of the company.
In business, financial management is the This will depend upon expected costs and
practice of handling a company's finances in a profits and future programmes and policies of a
way that allows it to be successful and compliant concern. Estimations have to be made in an
with regulations. adequate manner which increases earning
capacity of enterprise.
Financial Management means planning,
organizing, directing and controlling the financial
activities such as procurement and utilization of 2. Determination of capital
funds of the enterprise. composition: Once the estimation have been
It means applying general management made, the capital structure have to be decided.
principles to financial resources of the enterprise. This involves short- term and long- term debt and
equity analysis.
Scope/Elements of Financial Management This will depend upon the proportion of
1. Investment decisions includes investment in equity capital a company is possessing and
fixed assets (called as capital budgeting). additional funds which have to be raised from
Investment in current assets are also a part of outside parties.
investment decisions called as working capital
decisions.
2. Financial decisions - They relate to the 3. Choice of sources of funds: For
raising of finance from various resources which additional funds to be procured, a company has
will depend upon decision on type of source, many choices like-
period of financing, cost of financing and the a. Issue of shares and debentures
returns thereby. b. Loans to be taken from banks and
3. Dividend decision - The finance manager financial institutions
has to take decision with regards to the net profit c. Public deposits to be drawn like in form
distribution. Net profits are generally divided into of bonds.
two: Choice of factor will depend on relative
a. Dividend for shareholders - Dividend and merits and demerits of each source and period of
the rate of it has to be decided. financing.
b. Retained profits - Amount of retained
profits has to be finalized which will depend
upon expansion and diversification plans of 4. Investment of funds: The finance
the enterprise. manager has to decide to allocate funds into
profitable ventures so that there is safety on
investment and regular returns is possible.
Objectives of Financial Management
The financial management is generally 5. Disposal of surplus: The net profits
concerned with procurement, allocation and decision have to be made by the finance
control of financial resources of a concern. manager. This can be done in two ways:
The objectives can be- a. Dividend declaration - It includes
1. To ensure regular and adequate supply of identifying the rate of dividends and other
funds to the concern. benefits like bonus.
2. To ensure adequate returns to the shareholders b. Retained profits - The volume has to be
which will depend upon the earning capacity, decided which will depend upon
market price of the share, expectations of the expansional, innovational, diversification
shareholders. plans of the company.
3. To ensure optimum funds utilization. Once the
funds are procured, they should be utilized in 6. Management of cash: Finance manager
maximum possible way at least cost. has to make decisions with regards to cash
4.To ensure safety on investment, i.e, funds management.
should be invested in safe ventures so that Cash is required for many purposes like
adequate rate of return can be achieved. payment of wages and salaries, payment of
5.To plan a sound capital structure-There should electricity and water bills, payment to creditors,
be sound and fair composition of capital so that a meeting current liabilities, maintainance of
balance is maintained between debt and equity enough stock, purchase of raw materials, etc.
capital.
7. Financial controls: The finance manager
Functions of Financial Management has not only to plan, procure and utilize the funds
but he also has to exercise control over finances. Managerial finance is concerned with the
This can be done through many duties of the financial manager working in
techniques like ratio analysis, financial business.
forecasting, cost and profit control, etc. Financial managers administer the
financial affairs of all types of businesses –
Finance and Business private and public, large and small, profit seeking
The field of finance is broad and dynamic. and not for profit.
Finance influence everything that firms do, They perform such varied tasks as
from hiring personnel to building factories to developing a financial plan or budget, extending
launching new advertising campaigns. credit to customers, evaluating proposed large
Even if you don’t see yourself pursuing a expenditures, and raising money to fund the firm’s
career in finance, you‘ll find that an understanding operations.
of a few key ideas in finance will help make you Legal Forms of Business Organization
smarter consumer and wise investor with your One of the most basic decisions that all
own money. businesses confront is how to choose a legal form
of organization.
This decision has very important financial
WHAT IS FINANCE? implication because how business is organized
Finance can be defined as the science legally influences the risk that the firm’s owner
and art of managing money. must bear, how the firm can raise money, and
At the personal level, finance is concerned how the firm’s profits will be taxed.
with individuals’ decisions about how much of The three most common legal forms of
their earnings they spend, how much they save, business organization are:
and how they invest their savings. 1. Sole proprietorship
In a business context, finance involves the 2. Partnership
same types of decisions: 3. Corporation
how firms raise money from investors,
how firms invest money in an attempt to earn a Corporations Stockholders
profit, and how they decide whether to reinvest The owners of a corporation, whose
profits in the business or distribute them back to ownership, or equity, takes the form of either
investors. common stock or preferred stock.

Limited liability
CAREER OPPORTUNITIES IN FINANCE A legal provision that limits stockholders’
Careers in finance typically fall into one of two liability for a corporation’s debt to the amount they
broad categories: initially invested in the firm by purchasing stock.
(1) financial services and
(2) managerial finance. Common stock (Ordinary Shares)
The purest and most basic form of
corporate ownership.
Financial Services
Financial services is the area of finance
concerned with the design and delivery of advice Dividend
and financial products to individuals, `Periodic distribution of cash to the stockholders
businesses, and the government. of a firm.
It involves a variety of interesting career  Board of directors
opportunities with the areas of banking, personal Group elected by the firm’s stockholders and
financial, planning, investments, real estate, and typically responsible for approving strategic goals
insurance. and plans, setting general policy, guiding
corporate affairs, and approving major
Here are the main types of financial service: expenditures.
Banking. Banking includes handing  President or chief executive officer (CEO)
deposits into checking and savings accounts, as Corporate official responsible for managing
well as lending money to customers.... the firm’s day – to –day operations and carrying
Advisory.... out the policies established by the board of
Wealth Management.... directors.
Mutual Funds....
Insurance.
WHY STUDY MANAGERIAL FINANCE?
Managerial Finance An understanding of the concepts,
techniques, and practices will fully acquaint you maximize the wealth of the owners for whom it is
with the financial manager’s activities and being operated, or equivalently, to maximize the
decisions. stock price.
Because the consequences of most This goal translates into a straightforward
business decisions are measured in financial decision rule for managers—only take actions
terms, the financial manager plays a key that are expected to increase the share price.
operational role. Although that goal sounds simple,
People in all areas of responsibility— implementing it is not always easy.
accounting, information systems, management, To determine whether a particular course
marketing, operations, and so forth—need a basic of action will increase or decrease a firm’s share
awareness of finance so they will understand how price, managers have to assess what return(that
to quantify the consequences of their actions. is, cash inflows net of cash outflows) the action
will bring and how risky that return might be.
OK, so you’re not planning to major in Figure 1.2 depicts this process.
finance! You still will need to understand how In fact, we can say that the key variables
financial managers think to improve your chance that managers must consider when making
of success in your chosen business career. business decisions are return (cash flows) and
Managers in the firm, regardless of their risk.
job descriptions, usually have to provide financial
justification for the resources they need to do their Maximize Profit
job. It might seem intuitive that maximizing a
Whether you are hiring new workers, firm’s share price is equivalent to maximizing its
negotiating an advertising budget, or upgrading profit, but that is not always correct.
the technology used in a manufacturing process, Corporations commonly measure profits in
understanding the financial aspects of your terms of earnings per share (EPS), which
actions will help you gain the resources you need represent the amount earned during the period on
to be successful. behalf of each outstanding share common stock.
EPS are calculated by dividing the periods total
Goal of the Firm earnings available for the firm’s common
What goal should managers pursue? stockholders by the number of shares of common
There is no shortage of possible answers stock outstanding.
to this question. Profit maximization is a process business
Some might argue that managers should firms undergo to ensure the best output and price
focus entirely on satisfying customers. levels are achieved in order to maximize its
Progress toward this goal could be returns. Influential factors such as sale price,
measured by the market share attained by each production cost and output levels are adjusted by
of the firm’s products. the firm as a way of realizing its profit goals.
Others suggest that managers must first
inspire and motivate employees; in that case,
employee turnover might be the key success
metric to watch.
Clearly the goal that managers select will
affect many of the decisions that they make, so
choosing an objective is a critical determinant of
how businesses operate

Maximize Shareholder Wealth

Finance teaches that managers’ primary
goal should be to maximize the wealth of the
firm‘s owners – the stockholders.
The simplest and best measure of
stockholder wealth is the firm’s share price.
Managers should take actions that
increase the firm’s share price.
A common misconception is that when
firms strive to make their shareholders happy,
they do so at the expense of other constituencies
such as customers, employees, or suppliers.
Therefore, we argue that the goal of the
firm, and also of managers, should be to But does profit maximization lead to the
highest possible share price? drop as many well-informed investors sell the
For at least three reasons the answer is stock in anticipation of lower future cash flows.
often no. In this case, the earnings increase was
First, timing is important. An investment accompanied by lower future cash flows and
that provides a lower profit in the short run may therefore a lower stock price.
be preferable to one that earns a higher profit in
the long run. Risk
Second, profits and cash flows are not Profit maximization also fails to account
identical. The profit that a firm reports is simply an for risk – the chance that actual outcomes
estimate of how it is doing, an estimate that is may differ from those expected.
influence by many different accounting choices A basic premise in managerial finance is
that firms make when assembling their finance that trade-off exists between return (cash flow)
reports. and risk.
Cash flow is a more straightforward Return and risk are, in fact, the key
measure of the money flowing into and out of the determinants of share piece, which represents
company. the wealth of the owners in the firm.
Companies have to pay their bills with Cash flow and risk affect the share price
cash, not earnings, so cash flow is what matters differently:
most to financial managers. Holding risk fixed, higher cash flow is generally
Third, risk matters a great deal. A firm that associated with a higher share price.
earns a low but reliable profit might be more In contrast, holding cash flow fixed, higher
valuable than another firm with profits that risk tend to result in a lower share price because
fluctuate a great deal (and therefore can be very the stockholders do not like risk.
high or very low at different times). For example, Apple’s CEO Steve Job,
took a leave of absence to battle a serious health
issue, and the firm’s stock suffered as a result.
Timing This occurred not because of any near-
Because the firm can earn a return on term cash flow reduction but in response to firm’s
funds it receives, the receipt of funds sooner increased risk – there’s a chance that the firm’s
rather then latter is preferred (Rotor and Valve lack of near-term leadership could result in
example). reduce future cash flows.
In spite of the fact that the total earnings Simply put, the increased risk reduced the
from Rotor are smaller than those from Valve, firm’s share prices.
Rotor provides much greater earnings per share In general, stockholders are risk averse –
in the first year. The larger returns in year 1 could that is, they must be compensated for bearing
be reinvested to provide greater future earnings. risk.
The larger returns in year 1 could be reinvested to In other words, investors expect to earn
provide greater future earnings. higher returns on riskier investments, and they will
accept lower returns on relatively safe
Cash Flows investments.
Profits do not necessarily result in cash
flows available to the stockholders. The Stakeholders
accounting assumptions and techniques that a Although maximization of shareholder
firm adopts can sometimes allow a firm to show a wealth is the primary goal, many firms broaden
positive profit even when its cash outflow exceeds their focus to include the interests of stakeholders
its cash inflows. as well as shareholders.
Furthermore, higher earnings do not Stakeholders are groups such as
necessarily translate into a higher stock price. employees, customers, suppliers, creditors,
Only when earnings increases are owners, and others who have direct economic link
accompanied by increased future cash flows is a to the firm.
higher stock price expected. A firm with a stakeholder focus
For example, a firm with a high-quality consciously avoids actions that would prove
product sold in a very competitive market could detrimental to stakeholders.
increase its earnings by significantly reducing its The goal is not to maximize stakeholder
equipment maintenance expenditures. well-being but to preserve it.
The firm’s expenses would be reduced, The stakeholders view does not alter the
thereby increasing its profits. goal of maximization shareholder wealth.
But if the reduced maintenance results in Such view is often considered part of the
lower product quality, the firm may impair its firm’s “social responsibility”.
competitive position, and its stock price could It is expected to provide long-run benefit to
shareholders by maintaining positive relationships d. Lowering personal liabilities of the
with stakeholders. company
Such relationships should minimize e. Manipulating revenues and sales figures
stakeholder turnover, conflicts, and litigation.
Clearly, the firm can better achieve its goal Examples of Creative Accounting
of shareholder wealth maximization by fostering  The company raises invoices before the
cooperation with its other stakeholders, rather end of the accounting year to inflate its
than conflict with them. sales figures, but the actual transaction
occurs on the post date. It is an example
where the company attempts to show the
THE ROLE OF BUSINESS ETHICS boosted revenue figures.
Business Ethics  The company sometimes gives loans to
Business ethics are the standards of their known person to willfully hide the
conduct or moral judgement that apply to persons transactions made during the year.
engage in commerce.  The company arbitrarily increases an
Violations of these standards in finance asset’s useful life to get rid of the
involve a variety of actions: “creative accounting,” higher depreciation charged.
earnings management, misleading financial
forecasts, insider trading, fraud, excessive 2. Earning management
executive compensation,options backdating, Earnings management is the use of
bribery, and kickbacks. accounting techniques to produce financial
The financial press has reported many statements that present an overly positive view of
such violations in recent years, involving such a company's business activities and financial
well-known companies as Apple and Bank of position.
America. Many accounting rules and principles
As a result, the financial community is require that a company's management make
developing and enforcing ethical standards. judgments in following these principles.
The goal of these ethical standards is to
motivate business and market participants to
adhere to both the letter and the spirit of laws and
3. Misleading financial forecasts
regulations concerned with business and
Inaccurate forecasts often come from
professional practice.
misinterpreting data or simply from the lack of
accurate information altogether. 
Most business leaders believe businesses
It can be next to impossible to create
actually strengthen their competitive positions by
accurate forecasts when your teams freely apply
maintaining high ethical standards.
their own data interpretation on what is expected
These are the followings:
at each stage of the forecasting process.
1. Creative accounting
For example, having multiple inconsistent
Creative accounting consists of accounting
interpretations of what makes a deal a qualified
practices that follow required laws and regulations
opportunity can lead to an inconsistent
but deviate from what those standards intend to
forecasting process.
accomplish.
Creative accounting capitalizes on
loopholes in the accounting standards to falsely 4. Insider trading
portray a better image of the company. Insider trading involves trading in a public
Creative accounting is a method used to company's stock by someone who has non-
make or interpret accounting policies falsely to public, material information about that stock for
misuse the accounting techniques and standards any reason. Insider trading can be either illegal or
being set by the accounting bodies. It is an legal depending on when the insider makes the
exploitation of loopholes in our accounting system trade.
and audit system after the accounts are finalized.
The purpose of doing this type of practice is to
make profits by not reporting the exact figures. 5. Fraud
A deliberate manipulation of accounting
Methods of Creative Accounting records in order to make a company's financial
performance or condition seem better than it
a. Wrong Estimation of Inventory in Stores actually is.
b. Booking less expense
c. Willfully attempting to manipulate
depreciation figures and methods 6. Option backdating
 Options backdating is a practice whereby a
firm issuing stock options to employees uses an
earlier date than the actual issue date in order to
fix a lower exercise price, making the options
more valuable.

7. Bribery and kickbacks

Considering Ethics Robert A. Cooke, a
noted ethicist, suggests that the following
questions be used to assess the ethical viability of
a proposed action.
1. Is the action arbitrary or capricious? Does
it unfairly single out an individual or group?
2. Does the action violate the moral or legal
rights of any individual or group?
3. Does the action conform to accepted moral
standards?
4. Are there alternative courses of action that
are less likely to cause actual or potential harm?
Clearly, considering such questions before
taking an action can help to ensure its ethical
viability
TOPIC 2 - PREPARING AND ANALYZING
Today, many firms are addressing the
FINANCIAL STATEMENTS
issue of ethics by establishing corporate ethics
policies.
The Four Key Financial Statements
A major impetus toward the development
The four key financial statements required
of ethics policies has been the Sarbanes-Oxley
by the SEC for reporting to shareholders are:
Act of 2002.
1. Income statements
Frequently, employees are required to
2. Balance sheet
sign a formal pledge to uphold the firm’s ethics
3. Statement of stockholders’ equity
policies.
4. Statement of cash flows
Such policies typically apply to employee
actions in dealing with all corporate stakeholders,
Preparing and analyzing financial
including the public.
statements is a crucial aspect of financial
management for businesses and organizations.
Ethics and Share Price
These statements provide a snapshot of a
An effective ethics program can enhance
company's financial performance, position, and
corporate value by producing a number of
cash flows, helping stakeholders make informed
positive benefits.
decisions.
It can reduce potential litigation and
The most common financial statements
judgment costs, maintain a positive corporate
include the balance sheet, income statement, and
image, build shareholder confidence, and gain the
cash flow statement.
loyalty, commitment, and respect of the firm’s
It is important to note that preparing and
stakeholders.
analyzing financial statements require a good
Such actions, by maintaining and
understanding of accounting principles and
enhancing cash flow and reducing perceived risk,
practices.
can positively affect the firm’s share price.
Many businesses hire accountants or
Ethical behavior is therefore viewed as
financial professionals to ensure accurate and
necessary for achieving the firm’s goal of owner
reliable financial reporting.
wealth maximization.

Income Statement
The income statement provides a financial
summary of the firm’s operating results during a
specific period.
The most common are income statements
covering a 1-year period period ending at a
specific date, ordinarily December 31 of the
calendar year. cash dividend paid, with the change in retained
Many large firms, however, operate on a earnings between the start and the end of that
12-month financial cycle, or fiscal year, that ends year.
at a time other than December 31.
Operating profit is often called earnings
before interest and taxes or EBIT.

Any preferred stock dividend must be

subtracted from net profits after taxes to arrive at
earnings available for common stockholders.
The actual cash dividend per share (DPS),
which is the peso amount of cash distributed
during the period on behalf of each outstanding
share of common stock.
Statement of cash flows
The statement of cash flows is a summary
of the cash flows over the period of concern.
The statement provides insight into the
firm’s operating, investment, and financing cash
flows and reconciles them with changes in its
cash and marketable securities during the period.
a. Indirect Method
The indirect method for the preparation of the
statement of cash flows involves the adjustment
of net income with changes in balance sheet
Balance Sheet accounts to arrive at the amount of cash
The balance sheet presents a summary generated by operating activities.
statement of the firm’s financial position at a given
time.
The statement balances then firm’s assets
(what it owns) against its financing, which can be
either debt (what it owes) or equity (what was
provided by owners).
Retained earnings represent the
cumulative total of all earnings, net of dividends,
that have been retained and reinvested in the firm
since its inception.
It is important to recognize that retained
earnings are not cash but rather have been
utilized to finance the firm’s assets. Notes to the Financial Statements
Included with published financial
statements are explanatory notes keyed to the
relevant accounts in the statements.
These notes to the financial statements
provide detailed information on the accounting
policies, procedures, calculations, and
transactions underlying entries in the financial
statements.
Common issues addressed by these notes
include revenue recognition, income taxes,
breakdowns of fixed asset accounts, debt and
lease terms and contingencies.
Statement of Retained Earnings
The statement of retained earnings is
abbreviated form of the statement of stockholders Using Financial Ratios
equity. The information contained in the four basic
Unlike the statement of stockholders’ financial statements is of major significant to a
equity, which shows all equity accounts variety of interested parties who regularly need to
transactions that occurred during a given year, have relative measures of the company’s
the statement of retained earnings reconciles the performance.
net income earned during a given year and any Relative is the key word here, because the
analysis of financial statements is based on the of a given ratio.
use of ratios or relative values. More important is the interpretation of the
Relative value is a method of determining ratio value.
an asset's worth that takes into account the value A meaningful basis for comparison is
of similar assets. needed to answer such questions as “ Is it too
This is in contrast with absolute value, high or to low?” and “ Is it good or bad.
which looks only at an asset's intrinsic value and Two types of ratio comparisons can be
does not compare it to other assets. made, cross-sectional and time – series.
Cross-sectional analysis involves the
comparison of different firms’ financial ratios at
Financial ratios offer entrepreneurs a way the same point in time.
to evaluate their company's performance and Analysis are often interested in how well a
compare it other similar businesses in their firm has performed in relation other firms in its
industry. industry.
Ratios measure the relationship between Frequently, a firm will compare its ratio
two or more components of financial statements. values to those of a key competitor or group of
They are used most effectively when results over competitors that it wishes to emulate.
several periods are compared. This type of cross-sectional analysis,
Ratios are extremely valuable as called benchmarking has become very popular.
analytical tools, but they have limitations.
They can indicate areas of strength and Benchmarking
weakness, but do not provide answers. A type of cross-sectional analysis in which
the firm’s ratio values are compared to those of a
key competitor or group of competitors that it
To be most effective, they should be used wishes to emulate.
in combination with other elements of financial Benchmarking is a process where you
analysis. measure your company’s success against other
Also, please note that there is no one similar companies to discover if there is a gap in
definitive set of key financial ratios, no uniform performance that can be closed by improving
definition for all ratios, and no standard which your performance.
should be met for each ratio. Studying other companies can highlight
Each situation should be evaluated with what it takes to enhance your company’s
the context of the particular firm, industry and efficiency and become a bigger player in your
economic environment. industry.
Comparison to industry averages is also
Ratio analysis involves methods of popular.
calculating and interpreting financial ratios to
analyze and monitor the firm’s performance.
The basic inputs to ratio analysis are the
firm’s income statement and balance sheet.
Ratio analysis of a firm’s financial
statements is of interest to stockholders,
creditors, and the firm’s own management.
Both current and prospective shareholders
are interested in the firm’s current and future level
of risk and return, which directly affect share
prices.

The firm’s creditors are interested Analyst have to be very careful when
primarily in the short-term liquidity of the company drawing conclusions from ratio comparisons.
and its ability to make interest and principal It’s tempting to assume that if one ratio for
payments. a particular firm is above the industry norm, this is
A secondary concern of creditors is the a sign that the firm is performing well, at least
firm’s profitability; they want assurance that the along the dimension measured by the ratio.
business is heathy.
Management uses ratios to monitor the However, ratios may be above or below
firm’s performance from period to period. the industry norm for both positive and negative
reasons, and it is necessary to determine why a
TYPES OF RATIO COMPARISON firm’s performance differs from its industry peers.
Ratio analysis is not merely the calculation Thus, ratio analysis on its own is probably
most useful in lighting areas for further ability to satisfy its short-term obligations as they
investigation. come due.
Liquidity refers to the solvency of the firm’s
overall financial position.- the ease with which it
Time-Series Analysis can pay its bills.
Time-series analysis evaluates Because a common precursor to financial
performance over time. distress and bankruptcy is low or declining
Comparison of current to past liquidity, these ratios can provide early signs of
performance, using ratios, enables analysts to cash flow problems and impending business
assess the firm’s progress. failure.
Developing trends can be seen by using The two basic measures of liquidity are
multiyear comparisons. the current ratio and the quick (acid-test) ratio.
Any significant year-to-year changes may
be symptomatic of a problem, specially if the a. CURRENT RATIO
same trend is not an industry-wide phenomenon. The current ratio, one of the most
commonly cited ratios, measures the firm’s ability
Combined Analysis to meet its short-term obligations. It is express as
The most informative approach to ratio follows:
analysis combines cross-sectional and time-
series analyses. Current ratio = Current assets ÷ Current liabilities
A combine view makes it possible to
assess the trend in the behavior of the ratio in A higher current ratio indicates a greater
relation to the trend for the industry. degree of liquidity.
How much liquidity a firm needs depends
on a variety of factors, including the firm’s size, its
access to short-term financing sources like bank
credit lines, and the volatility of its business.
The more predictable a firm’s cash flows
the lower the acceptable current ratio.

b. QUICK (ACID-TEST) RATIO

The quick (acid-test) ratio is similar to the
Cautions About Using Ratio Analysis current ratio except that it excludes inventory,
1. Ratios that reveal large deviations from the which is generally the least liquid current assets.
norm merely indicate the possibility of a problem. The quick ratio is calculated as follows:
2. A single ratio does not generally provide
sufficient information from which to judge the
overall performance of the firm. Current assets – Inventory
3. The ratios being compared should be Quick ratio =
calculated using financial statements dated at the Current liabilities
same point in time during the year.
4. It is preferably to use audited financial As with the current ratio, the quick ratio
statements for ratio analysis. level that a firm should strive to achieve depends
5. The financial data being compared should largely on the nature of the business in which it
have been developed in the same way. operates.
6. Results can be distorted by inflation, which The quick ratio provides a better measure
can cause the book value of inventory and of overall liquidity only when a firm’s inventory
depreciable assets to differ greatly from their cannot be easily be converted into cash.
replacement values. If inventory is liquid, the current ratio is a
preferred measure of overall liquidity.
Categories of Financial Ratios
Financial ratios can be divided for Activity Ratios
convenience into five basic categories: Activity ratios measure the speed with
1. Liquidity ratios which various accounts are converted into sales
2. Activity ratios or cash-inflows or outflows.
3. Debt ratios Activity ratios measures how efficiently the
4. Profitability ratios business is running. We often call this as “Assets
5. Market ratios Management Ratio” i.e. how efficiently the assets
of the company is being used by the management
Liquidity ratios to generate maximum possible revenue.
The liquidity of a firm is measured by its
 in relation to the firm’s credit terms.
In a sense, activity ratios measure how
efficiently a firm’s operate along a variety of c. AVERGE PAYMENT PERIOD
dimensions such as inventory management, The average payment period or average
disbursement, and collections. age of accounts payable is the average amount of
A number of ratios are available for time needed to pay accounts payable.
measuring the activity of the most important It is calculated in the same manner as the
current accounts, which, include inventory, average collection period:
accounts receivable, and accounts payable.
The efficiency with which total assets are Accounts Payable
used can also be assessed.
Average payment period=
Average Purchases per day

Accounts Payable
a. INVENTORY TURNOVER Average payment period=
Inventory turn over commonly measures Annual Purchases
the activity or liquidity, of a firm’s inventory. It is 365
calculated as follows:

Inventory turnover = Cost of goods sold ÷ Inventory

Or The difficulty in calculation the average
Sales ÷ Inventories payment not available in published financial
statements.
The resulting turnover is meaningful only Ordinarily, purchases are estimated as a
when it is compared with that of other firms in the given percentage of cost of goods sold. The ratio
same industry or to the firm’s past inventory is meaningful only in relation to the average credit
turnover. terms extended to the firm.
An inventory turnover of 20 would not be
unusual for a grocery store, whose goods are
highly perishable and must be sold quickly, d. TOTAL ASSET TURNOVER
whereas an aircraft manufacturer might turn its The total asset turnover indicates the
inventory just four times per year. efficiency with which the firm uses its assets to
Another inventory activity ratio measures generate sales. Total asset turnover is calculated
how many days of inventory the firm has on hand. as follows:
Inventory turnover can be easily converted
into an average age of inventory by dividing in Total asset turnover = Sales ÷ Total assets
into 365 days.
The value can also be viewed as the
average number of days’ sales in inventory. Generally, the higher a firm’s total asset
turnover, the efficient its assets have been used.
b. AVERAGE COLLECTION PERIOD This measure is probably of greatest interest to
The average collection period, or average management because it indicates whether the
age of accounts receivable, is useful in evaluating firm’s operations have been financially efficient.
credit and collection policies. Debt Ratios
Simply put, the average amount of time The debt position of a firm indicates the
needed to collect accounts receivable. amount of other people’s money being used to
It is arrived at by dividing the average daily generate profits.
sales into the accounts receivable balance: In general, the financial analyst is most
concerned with long-term debts because these
Accounts Receivable commit the firm to a stream of contractual
Average collection period=
Average Sales per day payments over the long run.
The more debt a firm has, the greater its
risk of being unable to meet its contractual debt
payments.
Accounts Receivable In general, the more debt a firm uses in
Average collection period= relation to its total assets, the greater, the greater
Annual Sales
its financial leverage.
365

Financial leverage is the magnification of

risk and return through the use of fixed-cost
The average collection is meaningful only financing, such as debt and preferred stock.
 The more fixed-cost debt a firm uses, the
greater will be its expected risk and return.
Financial leverage is the use of borrowed
money (debt) to finance the purchase of assets
with the expectation that the income or capital
gain from the new asset will exceed the cost of
borrowing.
Financial leverage is the use of debt to
buy more assets.
Leverage is employed to increase the
return on equity.
However, an excessive amount of financial
leverage increases the risk of failure, since it
a. DEBT RATIO
becomes more difficult to repay debt.
The debt ratio measures the proportion of
With increase debt comes greater risk as
total assets finance by the firm’s creditors.
well as larger potential return.
The higher this ratio, the greater the
amount of other people’s money being used to
There are two general types of debt generate profits.
measures: A debt ratio measures the amount of
1. Measures of the degree of indebtedness leverage used by a company in terms of total debt
2. Measures of the ability to service debts to total assets.
This ratio varies widely across industries,
such that capital-intensive businesses tend to
have much higher debt ratios than others.
The degree of indebtedness measures the
From a pure risk perspective, debt ratios
amount debt relative to other significant balance
of 0.4 or lower are considered better, while a debt
sheet amounts.
ratio of 0.6 or higher makes it more difficult to
A popular measure of the degree of
borrow money.
indebtedness is the debt ratio.
The second type debt measure, the ability
While a low debt ratio suggests greater
to service debts, reflects a firm’s ability to make
creditworthiness, there is also risk associated with
the payments required on a schedule basis over
a company carrying too little debt.
the life of a debt.
While a low debt ratio suggests greater
The term to service debts means to pay
creditworthiness, there is also risk associated with
debts on time.
a company carrying too little debt.
The firm’s ability to pay certain fixed
The ratio is calculated as follows:
charges is measure using coverage ratios.
Debt ratio = Total liabilities ÷ total assets
Typically, higher coverage ratios are
preferred (especially by the firm’s lenders), but a
The higher the debt ratio, the greater the
very high ratio might indicate that the firm's
firm’ s degree of indebtedness and the more
management is too conservative and might be
financial leverage it has.
able to earn higher returns by borrowing more.
In general, the lower the firm’s coverage
b. TIMES INTEREST EARNED RATIO
rations, the less certain it is to be able to pay fixed
The times interest earned ratio,
obligations.
sometimes called the interest coverage ratio
If a firm is unable to pay these obligations,
measures the firm’s ability to make contractual
its creditors may seek immediate repayment
interest payments.
which in most instances would force a firm into
The higher its value, the better able the
bankruptcy.
firm is to fulfill its interest obligations.
Two popular coverage ratios are the times
The Times Interest Earned (TIE)
interest earned ratio and the fixed-payment
ratio measures a company's ability to meet its
coverage ratio.
debt obligations on a periodic basis.
This ratio can be calculated by dividing a
company's EBIT by its periodic interest expense.

Times interest earned ratio = Earnings before

interest and taxes ÷ Interest expense

Earnings before interest and taxes (EBIT)

is the same as operating profit. Common –size income statements are
especially useful in comparing performance
across years because it is easy to see if certain
c. FIXED-PAYMENT COVERAGE RATIO categories of expenses are trending up or down
The fixed payment coverage ratio as a percentage of the total volume of business
measures the firm’s ability to meet all fixed- that then company transacts.
payment obligations, such as loan interest and
principal, lease payments and preferred stock
dividends.
As is true of the times interest earned
ratio, the higher this value the better. The formula
for the fixed-payment coverage ratio is

Earningsbefore interest ∧taxes+ Lease Payments

¿−payment coverage ratio= +{ ( Principal payments+ Preferred stoc
Interest + Lease payments
Where: Three frequently cited ratios of profitability
 T is the corporate tax applicable to the that come directly from the common-size income
firm’s income. statements are
 The term 1/(1-T) is included to adjust the 1. the gross profit margin
after tax principal and preferred stock 2. the operating profit margin
dividend payment back to before-tax 3. the net profit margin
equivalent that is consistent with the
before-tax values of all other terms. b. GROSS PROFIT MARGIN
Gross profit margin, also referred to as
Like the times interest earned ratio, the gross margin, is a measure of a company's
fixed-payment coverage ratio measures risk. The profitability.
lower the ratio, the greater the risk to both lenders Gross profit margin indicates the amount
and owners, and the greater the ratio, the lower of revenue remaining in a given accounting period
the risk. after a company pays for labor and materials,
This ratio allows interested parties to otherwise known as cost of goods sold (COGS).
assess the firm’s ability to meet additional fixed- Gross profit margin is good yardstick for
payment obligations without being driven into measuring how efficiently companies make
bankruptcy. money from products and services, because it
measures profit as a percentage of sales
revenue.
Profitability Ratios The gross profit margin measures the
There are many of measures of percentage of each sales peso remaining after
profitability. As a group, these measures enable the firm has paid for its goods.
analysts to evaluate the firm’s profits with respect The higher the gross profit margin, the
to a given level of sales, a certain level of assets, better (that is, the lower the relative cost of
or the owners’ investment. Without profits, a firm merchandise sold).
could not attract outside capital. The gross profit margin is calculated as
Owners, creditors, and management pay follows:
close attention to boosting profits because of the Sales−Cost of Goods Sold
great importance the market places on earnings. Gross Profit Margin=
Sales
Profitability ratios are a class of financial
metrics that are used to assess a business's
Gross Profit
Gross Profit Margin=
ability to generate earnings relative to its revenue, Sales
operating costs, balance sheet assets, or
shareholders' equity overtime, using data from a What is a good gross profit margin?
specific point in time. You may be asking yourself, “what is a
good profit margin?”
a. COMMON – SIZE INCOME A good margin will vary considerably by
STSTAMENTS industry, but as a general rule of thumb, a 10%
A useful tool for evaluating profitability in net profit margin is considered average, a 20%
relation to sales is the common-size income margin is considered high (or “good”), and a 5%
statement. margin is low.
Each item on this statement is expressed
as a percentage of sales.
How do you interpret gross margin?
 The ratio indicates the percentage of each a company or business segment.
peso of revenue that the company retains as Net profit margin is typically expressed as
gross profit. a percentage but can also be represented in
For example, if the ratio is calculated to be decimal form.
20%, that means for every peso of revenue The higher the firm’s net profit margin, the
generated, P0.20 is retained while P0.80 is better.
attributed to the cost of goods sold. A higher net profit margin means that a
company is more efficient at converting sales into
actual profit.
c. OPERATING PROFIT MARGIN The net profit margin is calculated as follows:
Operating Profit Margin is a profitability or
performance ratio that reflects the percentage of Net profit margin = Earnings available for
profit a company produces from its operations common stockholder ÷ Sales
before subtracting taxes and interest charges.
Operating profit margin measures the
percentage of each sales peso remaining after all What is a Good Profit Margin?
costs and expenses other than interest, taxes, You may be asking yourself, “what is a
and preferred stock dividend are deducted. good profit margin?”
It represents the “pure profits” earned on A good margin will vary considerably by
each sales peso. industry, but as a general rule of thumb, a 10%
Operating profits are “pure” because they net profit margin is considered average, a 20%
measure only the profits earned on operations margin is considered high (or “good”), and a 5%
and ignore interest, taxes and preferred stock margin is low.
dividends. A high operating profit margin is The net profit margin is a common cited
preferred. measure of the firm’s success with respect to
The operating profit margin is calculated earnings on sales.
as follows: “Good” net profit margins differ
considerably across industries.
Operating profit margin = Operating profit ÷ Sales A net profit margin of 1% or less would not
be unusual for a grocery store, whereas a net
profit margin of 10% would be low for a retail
What is good operating profit margin? jewelry store.
What constitutes a good profit margin
depends on the industry in which a company e. EARNINGS PER SHARE (EPS)
operates. Earnings per share or EPS is a common
As a general rule, a 10% operating profit metric used to carry out corporate value.
margin is considered an average performance, It can be defined as the value of earnings
and a 20% margin is excellent. per outstanding share of common stock of the
It's also important to pay attention to the company.
level of interest payments from a company's debt. EPS indicates the company's profitability
by showing how much money a business makes
What does low operating profit margin mean? for each share of its stock.
A low profit margin means that your EPS is generally of interest to present or
business isn't efficiently converting revenue into prospective stockholders and management.
profit. It represents the number of peso earned
This scenario could result from, prices that during the period on behalf of each outstanding
are too low, or excessively high costs of goods share of common stock.
sold or operating expenses. Earning per share is calculated as follows:
Low margins are determined relative to Earnings available for common stoc
Earnings per Share=
your industry and historical context within your Number of shares o f common stock o
company.
d. NET PROFIT MARGIN The higher the earnings per share of a
Net profit margin measures the company, the better is its profitability.
percentage of each sales peso remaining after all While calculating the EPS, it is advisable
costs and expenses, including interest, taxes and to use the weighted ratio, as the number of
preferred stock dividends, has been deducted. shares outstanding can change over time.
Net profit margin, or simply net
margin, measures how much net income or profit
is generated as a percentage of revenue. f. RETURN ON TOTAL ASSETS (ROA)
It is the ratio of net profits to revenues for This profitability indicator helps you
determine how your company generates its market ratios, one that focuses on earnings and
earnings and how you compare to your another that considers book value.
competitors.
The return on total assets ratio compares
a company's total assets with its earnings after a. PRICE / EARNINGS (P/E) RATIO
tax and interest. Calculation is as follows: The price/earning ratio is commonly used
to assess the owner’s appraisal of share value.
ROA = Earnings available for common The P/E ratio measures the amount that
stockholders ÷ Total assets investors are willing to pay for each peso of a firm
earnings.
How do you interpret return on assets? The level of this ratio indicates the degree
A ROA that rises over time indicates the of confidence hat investors have in the firm’s
company is doing well at increasing its profits with future performance.
each investment peso it spends. The higher the P/E ratio, the greater the
A falling ROA indicates the company might investors confidence.
have over-invested in assets that have failed to
produce revenue growth, a sign the company
may be in some trouble. How to calculate a company's P/E ratio.
This ratio is calculated by dividing a
g. RETURN ON COMMON EQUITY (ROE/ company's stock price by the company's
ROCE) earnings-per-share (EPS.) 
The return on common equity measures
the returned on the common stockholder’s P/E ratio = Market price per share of
investment in the firm. common (Stock price) ÷ Earnings per share
Generally, the owners are better off the
higher in this return.
Return on common equity is calculated as Examples:
follows: For example, if a company's share price is
currently P30 and the EPS is currently P10, the
P/E ratio would be 3.
ROE = Earnings available for common For example, if a company has earnings of
stockholders ÷ Common stock equity P10 billion and has 2 billion shares outstanding,
its EPS is P5. If its stock price is currently P120,
its PE ratio would be 120 divided by 5, which
A higher ROE signals that a company comes out to 24.
efficiently uses its shareholder's equity to
generate income. What is a good price earning ratios?
Low ROE means that the company earns A “good” P/E ratio isn't necessarily a high
relatively little compared to its shareholder's ratio or a low ratio on its own.
equity. The market average P/E ratio currently
An ROE of 15-20% is considered good. ranges from 20-25, so a higher PE above that
A value above 20% can indicate very could be considered bad, while a lower PE ratio
strong performance, but it can also be an could be considered better.
indication that company management has P/E ratio, or price-to-earnings ratio, is a
increased the business's exposure to risk by quick way to see if a stock is undervalued or
borrowing against company assets. overvalued. And so generally speaking, the lower
the P/E ratio is, the better it is for both the
business and potential investors. The metric is the
Market Ratios stock price of a company divided by its earnings
Market ratios relate the firm’s market per share.
value, as measure by its current share price, to                                                   
certain accounting values. b. MARKET /BOOK (M/B) RATIO
These ratios give insight into how M/B ratio provides an assessment of how
investors in the marketplace feel the firm is doing investors view the firm’s performance.
in terms of risk and return. they tend to reflect, on It relates the market value of the firm’s
a relative basis, the common stockholders’ shares to their book -strict accounting – value.
assessment of all aspects of the firm’s past and The book-to-market ratio identifies
expected future performance. undervalued or overvalued securities by taking
Here we consider two widely quoted the book value and dividing it by the market
value. The ratio determines the market value of a
company relative to its actual worth. investors to examine the profitability of a
To calculate the firm’s M/B ratio, we first company using information from both the income
need to find the book value per share of common statement as well as the balance sheet.
stock. The DuPont system of analysis is used to
Book value per share (BVPS) is the ratio dissect the firm’s financial statements and to
of equity available to common shareholders assess its financial condition.
divided by the number of outstanding shares. It merges the income statement and
This figure represents the minimum value balance sheet into two summary measures of
of a company's equity and measures the book profitability, return on total assets(ROA) and
value of a firm on a per-share basis. return on common equity (ROE)

Formula for book value share c/s: The basic DuPont Analysis model is a
Common stock equity method of breaking down the original equation for
Book value per share=
Number of shares of common stock ROE
outstanding
into three components:
1. operating efficiency,
2. asset efficiency, and
Formula for M/B ratio: 3. leverage.
Operating efficiency is measured by Net
Market price per share of common stock
Profit Margin and indicates the amount of net
Market / Book Ratio=
income generated per peso of sales.
Book value per share of common stock
What does the DuPont identity tell you?
The stocks of firms that are expected to What Is the DuPont Identity?
perform well– improve profits, increase their The DuPont identity is an expression that
market share, or launch successful products – shows a company's return on equity (ROE) can
typically sell at higher M/B ratios than the stocks be represented as a product of three other ratios:
of rims with less attractive outlooks. Simply the profit margin, the total asset turnover, and the
stated, firms expect to earn high returns relative equity multiplier.
to their risk typically sell at higher M/B multiples.
Like P/E ratios are typically assessed DuPont Analysis
cross - sectionally to get a fell for the firm’s return The DuPont analysis, named after a
and risk compared to peer firms. financial model created by the chemical
manufacturer, DuPont Corporation, is a financial
framework driven by the return on equity (ROE)
ratio.
The ROE is used to assess a company’s
ability to boost returns for its investors.
The DuPont analysis is an expanded
return on equity formula, calculated by multiplying
the net profit margin by the asset turnover by the
equity multiplier.
The DuPont analysis is also known as the
DuPont identity or DuPont model.

DuPont Formula
The DuPont system first brings together
the net profit margin, which measures the firm’s
profitability on sales, with its total asset turnover,
which indicates how efficiently the firm has used
its assets to generate sales.
In the DuPont formula, the product of
these two ratios results in the return on total
assets (ROA):

DUPONT SYSTEM OF ANALYSIS ROA = Net profit margin x Total asset turnover
One of the more interesting measures of a
company's financial performance is the DuPont
Equation. Substituting the appropriate formulas into the
This model allows stock analysts and equation and simplify results in the formula given
earlier,
 Earningsavailable for common stockholders Sales Earnings available for common stockholders
ROA= x =
Sales Total Assets Total Assets

Modified DuPont Formula

The second step in the DuPont system
employs modified DuPont formula.
This formula relates the firm’s return on
total assets (ROA) to its return on common
equity (ROE).
The latter is calculated by multiplying the
return on total assets (ROA) by the financial
leverage multiplier (FLM), which is the ratio of
total assets to common stock equity:

ROE = ROA x FLM

Substituting the appropriate formulas into the

equation and simplifying results in the formula
given earlier

Earnings available for common stockholders Total Assets Earnings available for common stockho
RO E= x =
Total Sales Common stock equity Commonsto ck equity

Using of the financial leverage multiplier (FLM) to

convert the ROA into the ROE reflects the impact
of financial leverage on owners’ return.

Applying the DuPont System

The advantage DuPont system is that it
allows the firm to break its return on equity into
profit-on-sales component (net profit margin), an
efficiency-of asset-use component (total asset
turnover), and a use- of-financial-leverage
component (financial leverage multiplier). The
total return to owners therefore can be analyzed
in these important dimension.