CHAPTER 11 - UNDERSTANDING FINANCIAL STATEMENTS

General Objectives of Financial Statements

1. Providing Information for Economic Decisions
2. Providing Information About Financial Position
3. Providing Information About Performance of an Enterprise
4. Providing Information About Changes in Financial Position
Broad Classes of Users That Demand Financial Accounting Information
1. Managers and Employees
2. Investors and Analysts
3. Creditors and Suppliers
4. Shareholders and Directors
5. Regulatory and Tax Agencies
6. Customers and Potential Strategic Partners
7. Other Decision Makers
Sources of Information about Business Enterprise
1. The audited annual report
2. The unaudited quarterly or interim reports
Constraints on Relevant and Reliable Information
1. Timeliness
2. Balance Between Benefit and Cost
3. Balance Between Qualitative Characteristics
4. True Fair View or Fair Presentation
4 financial statements:
1.

Statement of financial position

2.

Statement of comprehensive income

3.

Statement of stockholders equity

4.

Statement of cash flows

Articulation - the four financial statements are linked with each other and linked across time
Statement of Financial Position - reports a company's financial position at a point in time, the
company's resources (assets) namely, what the company owns and also the sources of financing
Two Ways a Company Can Finance it's Asset
1. Owner Financing - can raise money from shareholders
2. Nonowner Financing - can also raise money from banks or other creditors and suppliers
Equity - owner claims on asset

Liabilities - nonowners claim on asset

Accounting Equation - (assets = liabilities + owner's equity)
Owner (or equity) Financing - includes resources contributed to the company by it's owners
along with any profit retained by the comoany
Nonowner (creditor or debt) Financing - borrowed money
Working Capital - also known as current assets
Net Working Capital - difference between current assets minus current liabilities
Net Operating Working Capital - difference between current assets and non-interest bearing
current liabilities
Statement of Comprehensive Income - reports on a company's performance over a period of
time and lists amounts for revenues, expenses and other comprehensive income
Statement of Stockholders' Equity - reports on changes in key types of equity over a period of
time
Statement of Cash Flows - reports the change (either an increase or decrease) in a company's
cash balance over a period of time

CHAPTER 12- ANALYSIS OF FINANCIAL STATEMENTS

Financial Statement Analysis - the process of extracting information from financial statements to
better understand a company's current and future performance and financial condition
Some Questions about a Company's Business Environment
1. Life Cycle
2. Outputs
3. Buyers
4. Inputs
5. Competition
6. Financing
7. Labor
8. Governance
9. Risk
Financial Ratio - comparison in fraction, proportion, decimal or percentage of two significant
figures taken from financial statements

Ratio can be categorized as Follows :

1. Liquidity Ratios - gives us an idea of the firm's ability to pay off debts that are maturing
within a year or within the next operating cycle
2. Asset Management Ratios - gives us an idea of how efficiently the firm is using it's asset
3. Debt Management Ratios - tell us how the firm has financed it's assets as well as the
firm's ability to repay it's long-term debt
4. Profitability - give us an idea of how profitability the firm is operating and utilizing it's
assets
5. Market Book Ratios - gives us an idea of what investors think about the firm and it's
future prospects
Financial Ratios
1. Liquidity Ratios - measure the firm's ability to meet cash needs as they arise
2. Activity Ratios - measure the liquidity of specific assets and efficiency in managing assets
3. Leverage Ratios - measure the extent of a firm's financing, with debt relative to equity
and it's ability to cover interest and other fixed charges
4. Profitability Ratios - measure the overall performance of the firm and it's efficiency
managing assets, liabilities and equity
I. Analysis of Liquidity or Short-Term Solvency
1) Current Ratio - measure of short-term debt-paying ability
2) Acid-Test (Quick) Ratio - a much more rigorous test of a company's ability to meet it's shortterm debts
3) Cash Flow Liquidity Ratio - considers cash flow from operating activities (from the statements
of cash flows) in addition to the truly liquid assets, cash and marketable securities
II. Analysis of Asset Liquidity and Asset Management Efficiency
1) Accounts Receivable Turnover - roughly measures how many times a company's accounts
receivable have been turned into cash during the year
2) Average Collection Period - helps evaluate the liquidity of accounts receivable and the firm's
credit policies
3) Inventory Turnover - measures the efficiency of the firm in managing and selling inventory
4) Average Sales Period
5) Fixed Asset Turnover - assessing management's effectiveness in generating sales from
invesetments in fixed assets particularly for a capital I intensive firm

6) Total Asset Turnover - measure of the efficiency of management to generate sales and thus earn
more profit for the firm
III. Analysis of Leverage : Debt Financing and Coverage
1) Debt Ratio - measures proportion of all assets that are financed with debt
2) Debt to Equity Ratio - measures the riskiness of the firm's capital structure in terms of
relationship between the funds supplied by creditors and investors
3) Times Interest Earned Ratio - most common measure of the ability of a firm's operations to
provide protection to long-term creditors
4) Fixed Charge Coverage - measures the firm's coverage capability to cover not only interest
payments but also the fixed payment associated with leasing which must be met annually
IV. Operating Efficiency and Profitability
1) Gross Profit Margin - shows relationship between sales and the cost of products sold
2) Operating Profit Margin - measure of overall operating efficiency and incorporates all the
expenses associated with ordinary or normal business activities
3) Net Profit Margin - measures profitability after considering all revenue and expenses
4) Cash Flow Margin - measures the ability of the firm to translate sales to cash to enable it to
service debt, pay dividends or invest in new capital assets
5) Return on Investment on Assets (ROA) and Return on Equity (ROE) - both measure the
overall efficiency of the firm in managing it's total investment in assets and in generating return to
shareholders
Other Ratios used to Measure Returns to Investors
1) Earnings Per Share (EPS)
2) Price Earnings Ratio (P/E)
3) Dividend Payout Ratio
4) Dividend Yield
DuPoint Equation - formula that shows that the rate of return on equity on equity can be found as

the product of profit margin, total asset turnover and the equity multiplier
3 Components of DuPont Disaggregation Analysis on ROE
1. Profit Margin - amount of profit that the company earns from each peso of sales
2. Asset Turnover - a productivity measure that reflects the volume of sales that a company
generates from each peso invested in assets
3. Financial Leverage - measures the degree to which the company finances it's assets with
debt rather than equity
Return on Assets - measures the return on investment for the company without regard to how it is
financed
Joint Focus of ROA
1. Profitability - measured by the profit margin (Net income Sales)
a) Gross Profit Margin (Gross Profit Sales) - measures the gross profit (Sales less
Cost of Goods Sold) for each sale.
b) Expense Management - managers focus on reducing manufacturing and
administrative overhead expenses to increase profitability
2. Productivity - refers to the volume of sales resulting from invested in aassets

CHAPTER 13 - CASH FLOW ANALYSIS

Statement of Cash Flows - a financial statement that shows the firm's cash flows over a given
period of time
The statement of cash flows provide the means of measuring a busines firm's:
a) Financial Liquidity - which refers to the "measures to cash" of assets and liabilities
b) Financial Flexibility - refers that a company's ability to respond and adapt to financial
adversity and unexpected needs and opportunities
Current Cash Debt Coverage Ratio (FL) - indicates whether the company can pay off it's
current liabilities from it's operations in a given year
Cash Debt Coverage Ratio (FF) - indicates a company's ability to repay it's liabilities from net
cash provided by operating activities, without having to liquidate the assets employed in it's
operations
Free Cash Flow - amount of discretionary cash flow a company has
Cash - include cash and cash equivalents
Cash Equivalents - consist of short-term, highly liquid investments

Classification of Cash Flow Activities

1. Operating Activities
2. Investing Activities
3. Financing Activities
Calculating Cash Flow From Operating Activities
1. Direct Method
2. Indirect Method

CHAPTER 14 - OPERATING AND FINANCIAL LEVERAGE

Leverage - represents the use of fixed costs items to magnify the form's results
CVP ANALYSIS
Cost-Volume-Profit (CVP) Analysis - helps the managers to understand the relationship among
cost, volume and profit
It is affected by the following elements:
a) Selling prices
b) Sales volume
c) Unit variable costs
d) Total fixed costs
e) Mix of products sold
Contribution Margin Per Unit or Marginal Income Per Unit - the excess of unit selling price
over unit variable cost and the amount each unit sold contributes toward:
1. Covering fixed cost
2. Providing operating profit
Formula:
CM per unit = unit selling price - unit variable cost
Contribution Margin Ratio - shows how the contribution margin will be affected by a given
peso change in total sales
CVP ANALYSIS FOR BREAKEVEN PLANNING
Break-Even Point - the level of sales volume where total revenues and total expenses are equal,
that is, there is neither profit or loss
It can be computed as follows:
Sales Mix - refers to the relative proportions in which a company's products are sold
Example:

Operating Leverage - a measure of how sensitive net operating income is to a given percentage
change in peso sales
Example:
Degree of Operating Leverage - a measure, at a given level of sales, of how a percentage change
in sales volume will affect profits
Formula:
Degree of Operating Leverage (Alternative Approach) - percentage change in operating
income that occurs as a result of a percentage change in units sold
Formula:
LIMITATIONS OF ANALYSIS
Financial Leverage - reflects the amount of debt used in the capital structure of the firm
* Operating leverage affects the left-hand side of the statement of financial position while
Financial leverage affect the right-hand side.
IMPACTS OF EARNINGS
Degree of Financial Leverage (DFL) - percentage change in earnings (EPS) that occurs as a
result of a percentage change in earnings before interest and taxes (EBIT).
Formula:
Degree of Combined Leverage (DCL) - use the entire income statement and shows the impact if
a change in sales or volume on bottom-line earnings per share
Formula:
Degree of Combined Leverage (DCL) - shows the impact of a change in sales or volume on
bottom-line earnings per share
Formula:

CHAPTER 15 - FINANCIAL FORECASTING FOR STRATEGIC GROWTH

Long-Range Planning - a means of systematically thinking about the future and anticipating
possible problems before they occur
Financial Planning - formulates the way in which financial goals are to be achieved
Financial Plan - a statement of what is to be done in the future

Planning Horizon - first dimension of of planning process that must be established

Aggregation - involves the determination of all of the individual projects together with the
investment required that the firm will undertake
- second dimension of planning process
Elements of Financial Planning Models
1. Economic Environment Assumptions
2. Pro forma Statements
3. Asset Requirements
4. Financial Requirements
5. Additional Funds Needed (AFN)
6. Sales Forecast
Determinants of Growth
1. Profit Margin
2. Dividend Policy
3. Financial Policy
4. Total Asset Turnover
Steps in the Projected Financial Statement Method
1. Forecast the income statement
2. Forecast the statement of financial position
3. Raising the additional funds needed
4. Consider financing feedbacks

CHAPTER 16 REQUIREMENTS

FORECASTING

SHORT-TERM

(OPERATING)

FINANCIAL

Financial Planning - involves making projections of sales, income and assets based on alternative
production and marketing strategies
Financial Control - moves on the implementation phase dealing with the feedback and
adjustment process that is required:
a) To ensure that plans are followed
b) To modify existing plans in response to changes in the operating environment
Production Budget - presents a detailed analysis of the required investments to support the
forecasted sales level
Budgeting - act of preparing a budget
Budget - a financial plan of the resources needed to carry out tasks and meet financial goals

- a description in quantitative terms of a desired future result

Budgetary Control - use of budgets to control a firm's activities
Purpose of Budget
1. Defining broad objectives and goals
2. Coordinating the activities of organization
3. Allocating resources
4. Communicating management's approved plans
5. In recovering and preparing for potential bottleneck
6. Motivating managers
7. Setting a standard
Types of Budget
A. Operating Budget
1. Cost of sales budget
2. Selling and administrative expenses budget
3. Financial expense budget
4. Budgeted income statement
a) Sales budget
b) Production budget
materials cost budget
Direct labor cost budget
Factory overhead budget
Inventory levels
B. Financial Budget
1. Budgeted statement of financial position
2. Cash budget
3. Budgeted statement of sources and uses of funds
C. Capital/Invetment Budget
Sales Budget - showing what products will be sold in what quantities at what prices, is the
foundation on which all other short-term budgets are built
Factors to be Considered in Sales Forecast
1. Past sales volume
2. General economic and industry conditions
3. Relationship of sales to economic indicators
4. Relative product profitability
5. Market research studies and competition
6. Pricing, advertising and other promotion policies
7. Production capacity
8. Quality of sales force
9. Seasonal variation

10. Long-term sales trends for various products

CHAPTER 17 - ADDRESSING WORKING CAPITAL POLICIES AND MANAGEMENT

OF SHORT-TERM ASSETS AND LIABILITIES
Working Capital Management - associated with short-term financial decision making
Short-Term Financial Decisions - involve cash inflows and outflows that occur within a year or
less
Long-Term Financial Decisions - involved when a firm purchases a special equipment that will
reduce operating costs over, say, the next five years
Factors Affecting the Firm's Working Capital Policy
1. The nature of operations
2. The volume of sales
3. The variation of cash flows
4. The operating cycle period
TRACING CASH AND NET WORKING CAPITAL
1. Operating Cycle - length of time in which the firm purchases or produce inventory, sell it
and receive cash
2. Cash Conversion Cycle - length of time funds are tied up in working capital or the
length of time between paying for working capital and collecting cash from the sale of
inventory
Inventory Conversion Period - average time required to purchase merchandise and
convert them into finished goods then sell them
Average Collection Period - average length of time required to convert the firm's
receivables into cash
Payables Deferred Period - average length of time between the purchase of materials
and labor and the payment of cash for them

Remedies that may be adopted to reduce the length of operating cycle period are as follows:
1. Production Management
2. Purchasing Management
3. Marketing Management
4. Credit and Collection Policies
5. External Envieonment
Alternative Policies as to the Size of Investment in Current Assets
1. Relaxed Current Asset Investment Policy - relativeley large amounts of cash, marketable
securities and inventories are carried

2. Restricted Current Asset Investment Policy - holdings of cash, securities, inventories and
receivables are minimized
3. Moderate Current Asset Investment Policy - between the relaxed and restricted policies
Cost Relevant to Investment in Current Assets
Carrying Costs - cost associated with having current assets
a) Opportunity cost
b) Explicit cost
Shortage Costs - cost associated with not having current assets
a) Opportunity cost
b) Explicit transaction fees
Relaxed Policy - most appropriate when carrying costs are low relative to shortage costs
Restricted Policy - most appropriate when carrying costs are high relative to shortage costs
Consideratiins on Broad Categories of Assets
1. Long-Term/Permanent Assets - consist of PPE and the portion of the current assets that
remain unchanged over the year
2. Fluctuating or Seasonal Assets - current assets that vary over the year due to seasonal or
cyclical needs
The following should be considered in analyzing the advantages and disadvantages of the
alternative financing policy for working capital:
1. Maturity Hedging
2. Cash Reserves
3. Relative Interest Rates
4. Availability and Costs of Alternative Financing
5. Impact on Future Sales

CHAPTER 18 - CASH AND MMRTKETABLE SECURITIES MANAGEMENT

Effective cash management generally encompasses proper management of cash flows which
entails among others the following:
a) Improving forecast of cash flows
b) Using floats
c) Synchronizing cash inflows and outflows
d) Accelerating collections
e) Controlling disbursements
f) Obtaining additional funds when and where they are needed

Reasons for holding Cash Balances

1. Transaction Favilitation
2. Precautionary Motive
3. Compliance with Creditor's Covenant
4. Investment Opportunities
Determining the Target Cash Balance
1. Cash Budget
2. Cash Break-Even Chart
3. Optimal Cash Balance using the:
a) Baumol Model
b) Miller-Orr Model
Cash Budget - tool used to present the expected cash inflows and cash outflows
Cash Break-Even Chart - shows the relationship between the company's cash needs and cash
sources
Baumol Model - balances the opportunity cost of holding cash against the transactions costs
associated with replenishing the cash account by selling off marketable securities or by borrowing
Miller-Orr Model - assumes that the distribution of daily net cash flows is normally distributed
and allows for both cash inflows and outflows
Cash Management Techniques
1. Synchronizing cash flows
2. Using floats
3. Accelerating cash collections
4. Getting available funds to where they are needed
5. Controlling disbursements
Synchronized Cash Flows - a situation in which inflows coincide with outflows thereby
permitting a firm to hold low transaction balances
Float - difference between the balance shown in a firm's books and the balance on the bank record
Disbursement Float - value of checks the firm has written but which are still being processed and
thus have not been deducted from the firm's account balance by the bank
Collections Float - amount of checks that have been received but which have not yet been
credited to the firm's account by the bank
Built in Mechanism for timely recovery from debtors:
1. Prompt billing and periodic statements

2.
3.
4.
5.
6.

Incentives
Prompt deposit
Direct deposit to firm's bank account
Electronic depository transfer
Maintenance of regional collection office

Slowing Disbursements
1. Centralized Processing of Payables
2. Zero Balance Accounts (ZBA)
3. Delaying Payment
4. "Play the Float"
5. Less Frequent Payroll
Techniques that are available for reducing the need for precautionary balances:
1. More accurate cash budgeting
2. Lines of credit
3. Temporary investments
Reasons for Holding Marketable Securities
1. They serve as a substitute for cash balances
2. They are held as a temporary investment
3. They are built up to meet known financial requirements
Factors Influencing the Choice of Marketable Securities
1. Yield or returns on securities
2. Maturity
3. Risks
a) Default Risk - risk that the issuer of the security can not pay the principal or interest
at due dates
b) Interest Rate Risk - risk of declines in the market values of the security due to rising
rates
c) Inflation Risk - risk that inflation will reduce the "real" value of the investment
d) Marketability (liquidity) Risk - risk that securities cannot be sold at close to the
quoted market price and is closely associated with liquidity risk
e) Event Risk - probability that some event will occur and suddenly will increase a
firm's default risk
Types of Marketable Securities
1. Treasury Bills - with a maturity of one year or less, issued at a discount from face value
often called risk-free security
2. Other Short-Term Commercial Papers Issued by Finance Companies, Banks and
Other Corporations - unsecured and maturities range from a few days to 270 days
3. Negotiable Certificates of Deposit - short-term loan to commercial banks with maturities
ranging from a few weeks to several years

4. Repurchase Agreements (REPOS) - sale of government securities with an agreement to

repurchase
5. Banker's Acceptance - time draft drawn on, and accepted by a bank usually used as a
source of financing in international trade
6. Money Market Mutual Fund - an open-minded mutual fund that invests in moneymarket instruments
7. Money Market Instruments - high-grade securities characterized by a high-degree of
safety of principal and maturity of one year or less
a) Discount Paper - sells for less than it's par or face value
b) Interest-Bearing Securities - pay interest based on the par value or face value of the
security and the period of investment

CHAPTER 19 - ACCOUNTS RECEIVABLE AND INVENTORY MANAGEMENT

Two Forms of Accounts Receivable:
1. Trade or Commercial Credit - the firm extends to other firms
2. Consumer or Retail Credit - the firm extends to it's final customers
Credit Policy - a set of gguidelines for extending credit to customers
Credit policy generally covers the following variables:
1. Credit Standards - refer to the minimum financial strength of acceptable credit customer
and the amount available to different customer
a) Character - refers to the probability that the customers will pay their debts or
obligations
b) Capacity - the judgement of customers' abilities to pay
c) Capital - measured by the general financial condition of a firm
d) Collateral - represented by assets that customers may offer as security in order to
obtain credit
e) Conditions - refer to both general economic trends and special developments that
might affect customers' abilities to meet their obligations
2. Credit Terms - involve both the length of the credit period and the discount given
Credit Period - length of time buyers are given to pay for their purchases
Discounts - price reductions for early payment
3. Collection Policy - refers to the procedures the firm follows to collect past-due aaccounts
4. Delinquency and Default
Cost Associated with Investment in Accounts Receivable
1. Credit analysis, accounting and collection costs
2. Capital costs
3. Delinquency costs
4. Default costs (bad debts)

Marginal Analysis - performed in terms of a systematic comparison of the incremental returns

and the incremental costs resulting from a change in the firm's credit policy
Functions of Inventories
1. Pipeline or Transit Inventories - inventories which are being moved or transported from
one location to another
2. Organizational or Decoupling Inventories - inventories that are maintained to provide
each link in the productions distribution chain a certain degree of independence from the
others
3. Seasonal or Anticipation Stock - built up in anticipation of the heavy selling season
4. Batch or Lot-Size Inventories - inventories that are maintained whenever the user makes
or buys material in larger lots than are needed for his immediate purpose
5. Safety or Buffer Stock - inventories are maintained to protect the company from
uncertainties
Inventory Planning - involves the determination of what inventory quality, quantity, timing and
location should be in order to meet future business requirements
Inventory Control - the regulation of inventory within predetermined limits
Inventory Control Systems
1. Fixed Order Quantity System - each time the inventory goes down to a predetermined
level known as the record point, an order for a fixed quantity is placed
2. Fixed Reorder Cycle System - orders are made after a review of inventory levels has been
done at regular intervals
3. Optimal Replenishment System - a combination of the important control mechanisms of
the other two systems described above
4. ABC Classification System - segregation of materials for selective control is made
A items - highest possible controls
B items - normal controls
C items - simplest possible controls

CHAPTER 20 - SHORT-TERM SOURCES FOR FINANCING CURRENT ASSETS

Short-Term Financing - refers to debt originally scheduled for repayment within one year
Factors in Selecting a Source of Short-Term Funds
1. Effective cost of credit
2. Availability of credit
3. Influence
4. Additional covenants
Estimating Cost of Short-Term Credit

1. Accruals - current liabilities for services received but for which complete payments have
not been made as of the reporting date
2. Cost of Trade Credit - credit received during the discount period is sometimes called
"free trade credit"
Implicit/Hidden Costs
Opportunity Costs/Missed Cash Discounts
3. Cost of Bank Loans - can be calculated in five ways:
a) Simple Interest - the borrower receives the face value of the loan and relays the principal
and interest at maturity date
b) Discount Interest - the bank deducts the interest in advance or discounts the loan
c) Add-On Interest - interest that is calculated and added to funds received to determine the
face amount of an installment loan
d) Simple Interest with Compensating Balance
e) Discount Interest with Compensating Balance
Compensating Balance - minimum account balance that a lensing bank requires the
borrower to maintain
4. Cost of Commercial Paper
Sources of Short-Term Funds
1. Unsecured Credit vs. secured Credit
2. Accruals
3. Trade Credit
4. Short-Term Bank Loans
5. Line of Credit
6. Commercial Paper
Unsecred Credit - includes all those sources that have as their security only the lender's faith in
the ability of the borrower to repay the funds when due
Unsecured Short-Term Financing - an obligation without specific assets pledged as collateral
Collateral - asset that the borrower pledges to a lender until a loan is repaid
Secured Loans - involve the pledge of specific assets as collateral in the event the borrower
defaults in payment of principal or interest
Spontaneous Source of Short-Term Financing - sources that arise automatically from ordinary
business transaction
Nonsspontaneous Negotiated of Short-Term Financing - sources that require special effort or
negotiation
Line of Credit - these arrangements often take either of the two forms:
1. Line of Credit - an informal arrangement in which a bank agrees to lend up to a specified

maximum amount of funds during a designated period

2. Revolving Credit Arrangement - a legal commitment by the bank to extend credit up to
some maximum amount for a few months or several years
Commercial Paper - unsecured short-term promissory note sold in the money market by highly
creditworthy firms
Short-Term financing is obtainable through:
1. Pledging or assignment of accounts receivable
2. Factoring of accounts receivable
3. Inventory loans with:
a) Floating or blanket lien
b) Chattel mortgages
c) Field warehouse financing agreement
d) Terminal warehouse receipt
Pledging or Assignment of Accounts Receivable - as security for a loan obtained from either a
commercial bank or a finance company
Factoring Accounts Receivable - involves the outright sale of the firm's accounts receivable to
the finance company
Inventory Financing - some of the typical arrangements by which inventory can be used to
secure short-term financing are:
1. Blanket inventory lien
2. Trust receipt/chattel mortgage agreement
3. Warehousing
Blanket Inventory Lien - gives the lender a general lien or claim against the inventory of the
borrower
Trust Receipts/Chattel Mortgage Agreement - instrument acknowledging that the borrower
holds the inventory and proceeds from sales in trust for the lender
Warehousing - goods are physically identified, segregated and stored under the direction of an
independent warehousing company