UNIT 3.

Basic Financial Concepts

If you owe your bank a hundred pounds, you have a problem. If you owe it a million pounds, it has a problem! John Maynard Keynes Individuals, as well as organizations, need some techniques in order to manage and improve their financial affairs. When we talk about finance, what we immediately have in mind is the difference between income and expenditure; if the difference is not satisfactory, we regularly think at some investments or extra working hours, which is also a kind of investment, but a human capital consuming one. If income expenditure ! we can invest the excess income at the "tock #xchange $% buy different kinds of assets by means of a mutual fund etc. If income & expenditure ! we can raise capital by borrowing it from friends 'in case you have good ones(, from commercial banks, by selling equity claims $% working extra hours) In the first case we are the *#+,#%, while in the second, we are the -$%%$W#%. In both, we need a .I+/+0I/* I+1#%2#,I/%3.

LENDER

BORROWER

FINANCIAL INTERMEDIARY (suc as !an"#

1he lender receives interest, the borrower pays a higher interest than the lender receives, and the financial intermediary gets the difference. 1hat is the way, commercial banks, for example, mainly survive, by the

difference 4 spread 4 margin between the interest received on deposits and the interest given for credits. -anks are thus intermediating money flows from different unknown lenders and borrowers. -ut finance is not only used by individuals, also by governments and businesses 'corporate finance(; we may also add non5profit organizations, schools etc. 6sing the appropriate financial instruments, all of them may achieve their goal. /n example of corporate finance is7 a company may decide to sell stocks to institutional investors, who in turn sell them to the public.
I+"1I161I$+/* I+=#"1$%"

Investment banks 0redit unions

<ension funds 2utual funds -anks

*ife insurance companies

-anks -uilding societies

If we buy one stock of 8 company /+, ! the company is selling 9:: stocks ! we become 9;9:: owner of that company /+, we own 9;9:: of anything on the asset side of the balance sheet. In return for the stock, the company receives cash, used to expand the business. 1he process is called equity financing. $o%e !asic &inancial concepts' (. )e*e +ou a*e as"e, to esta!lis - et e* t e &ollo-in. state%ents a*e t*ue o* &alse. Moti/ate t en +ou* c oice' A,0uste, 1*esent 2alue 'A12( is the +et present value '+<=( of a pro>ect if financed only by debt plus the present value '<=( of any financing benefits.

Financial inst*u%ents exist only within the context of financial markets and varies according to the risk taken. Cas inst*u%ents include only credits and deposits. De*i/ati/e inst*u%ents can be divided into exchange traded derivatives and over5the5counter derivatives. De&ault means failure to make required debt payments on a timely basis Ratio means one value divided by another. Li3ui,it+ *atio provides information about a company@s ability to meet its short5term financial obligations; this information is needed especially by those who are interested in getting extended credit from the firm. Asset tu*no/e* *atio indicates how efficiently the firm is using its resources Financial le/e*a.e *atio indicates the long term solvency of the firm; it measures the extent to which the firm is using long5term debt. Len,e* o& last *eso*t is a term usually used when the 0entral -ank extends credit to those commercial banks on the verge of illiquidity. 1he 0entral -ank acts, in this case, as lender of last resort to commercial banks. O&&s o*e !an"s are banks located in areas with low taxation and regulation. 2any offshore banks are public banks. / !uil,in. societ+ is a financial institution, owned by its members, that offers different services, especially mortgage lending. Matu*it+ is the date on which an asset becomes due for payment.

4. C ose t e co**ect ,e&inition &o* eac o& t e ite%s in italics' money supply 1he total supply of money put in circulation in a given country@s economy by its 0entral -ank

1he total supply of money put in circulation in a given country@s economy at a given time

velocity 1he number of times a given currency changes hands in a specific time period, usually measured by C,< divided by money supply 1he number of times a given currency changes hands in a specific time period, usually measured by C+< divided by money supply currency board / monetary authority which is required to maintain an exchange rate with a foreign exchange. 1he conventional aims of a central bank must be subordinated to the exchange rate target / monetary authority which is required to maintain an exchange rate with a foreign currency. 1he conventional aims of a central bank must be subordinated to the exchange rate target reserve requirements /mount of liquid assets that commercial and investment banks hold in cash or deposit with 0entral -anks, usually at a very low interest /mount of liquid assets that commercial banks hold in cash or deposit with 0entral -anks, usually at a very low interest mutual fund / mutual fund is a form of investing money together with other people to participate in a wider range of investments, but the costs of doing so are supported by the national government / mutual fund is a form of investing money together with other people to participate in a wider range of investments and to share the costs of doing so stock life insurance company / life insurance company owned by shareholders who share in its earnings

 tax

/ life insurance company owned by policyholders who share in its earnings / fee charged by a government on a product, income, or activity / quota levied by a government on a product, income or activity

tariff / tax imposed on a product when it is imported into a country / tax imposed on a product when it is exported from a country duty / tax on both imports and exports / tax on imports / tax on exports

crowding out It theoretically occurs when governments expand their borrowing, by issuing bonds, more to finance increased expenditure or tax cuts in excess of revenue It theoretically occurs when investment banks expand their borrowing, by issuing bonds, more to finance increased expenditure or tax cuts in excess of revenue foreign exchange (currency or F !"#$ It includes trading between large banks, central banks, currency speculators, multinational corporations, governments and other financial markets and institutions. It includes trading >ust between central banks, multinational corporations and governments the nominal exchange rate It is the rate at which only a government can trade the currency of one country for the currency of another 9:

It is the rate at which an organization can trade the currency of one country for the currency of another balance sheet It shows a company@s financial condition at a specific point in time, including assets, liabilities and net worth It shows a company@s financial condition at a specific point in time, including assets and liabilities profit and loss account It is a record of a company@s trading activities over a period of time It is a record of a company@s financial position at a moment in time

3. Co%plete t e -o*,s !elo- to %atc t e .i/en %eanin.s' / market for the trading of companies@ stocks sE E E E mE E E E E .inancing a company through the sale of stocks in a company eE E E E E f E E E E E E E 1hey are generally viewed as safer investments than stocks bE E E E 1hey are bonds that are rated below investment grade by the credit rating agencies >E E E bE E E E ,ollar deposits in a 6.". bank branch or a non56.". bank located outside the 6nited "tates eE E E E E E E E E dE E E E E E "hort5term debt obligations of a national government that are issued to mature in F to 9G months. tE E E E E E E bE E E E It is a standardized contract to buy or sell a certain underlying instrument at a certain date in the future, at a pre5 set price 99

fE E E E E E cE E E E E E E It is an agreement between two parties to buy or sell an asset at a pre5agreed future point in time. 1herefore, the trade date and delivery date are separated fE E E E E E cE E E E E E E It is the difference between the buying and selling price of the same stock or currency transaction bE E ;oE E E E sE E E E E It is a person or a firm, which quotes a buy and sell price in a financial instrument or commodity hoping to make a profit on the difference mE E E E E mE E E E

5. T e*e a*e ,i&&e*ent in/est%ent c oices !elo-. Ma*" t e% as ) ( i. #6 M (%e,iu%# o* L (lo-# *is" 0ommon stocks, types of securities that represents ownership in a corporation 0orporate bonds, characterized by high yields "ecurities traded on Wall "treet *ong5term buy5and5hold securities, where individuals do no try to time the markets "ecurities that are traded below their true value "witching among mutual fund asset classes in an attempt to profit from the changes in their market outlook .ixed5income securities "ecurities that pay a high level of dividends or coupon payments 1reasury bills 2edium5term treasury notes Index funds

9G

UNIT 5. Rea,in. a Balance $ eet

!eading furnishes the mind only with materials of knowledge. It is thinking that makes what we read ours John Locke (. Rea, t e &ollo-in. te7t an, ans-e* t e 3uestions' Who and what is the balance sheet relevant forH What would be the main difference between accounts payable and accounts receivableH What financial ratios can be calculated by reading a balance sheetH 4. Matc t e &ollo-in. te*%s -it t ei* co**espon,ent e7planations' in/ento*+6 &i7e, assets6 cu**ent lia!ilities6 *etaine, ea*nin.s6 cu**ent assets6 accounts *ecei/a!le6 o-ne*8s e3uit+6 intan.i!le assets6 accounts pa+a!le 1hey have a life span of one year or less, meaning they can easily be converted into cash. 1hey are typically paid within one year or less and are therefore paid with current assets. -ecause current assets pay for them, the ratio between the two is important7 a company should have enough of the former to cover the latter. 1hey have a life span of over one year. ,epreciation is calculated and deducted from these types of assets. 1he initial amount of money invested into a business. 1hey are the short5term obligations owed to the company from clients. It represents the amount of materials currently available for production. What the company owes to suppliers for buying raw materials or retail products on credit. While these assets are not physical in nature, they are often the resources that can make or break a company. 9F

1he percentage of net earnings not paid out as dividends, but kept by the company to be reinvested in its core business or to pay debt. It is recorded under shareholders@ equity on the balance sheet.

/ !alance s eet reveals a company@s assets, liabilities and owner@s equity, also called net worth. 1he balance sheet provides all the necessary information to shareholders, those people who contribute with their money to the internal financing of a company, in exchange for dividends. 1he balance sheet is divided into two parts7 assets % liabilities & owners' equity /ssets are what a company uses for its production process, while liabilities are obligations to be paid to outside parties. $wners@ equity, referred to as shareholders@ equity in a <*0, is the amount of money initially invested into the company plus any retained earnings. %etained earnings are calculated as following7 !etained earnings (!"$ % (eginning retained earnings & )et income * + ,ividends In most cases, companies retain earnings in order to invest them in, for example, buying new machinery or spend the money on research and development. If beginning %# I +et income J ,ividends %#, then the company is registering a deficit. / balance sheet represents a specific period 'usually one day( and is most usually calculated on the last day of a company@s fiscal year, ,ec F9.
ASSETS Current assets cash and cash equivalent accounts receivable inventory Raw materials Work-in-progress WI!" #inished goods $ank accounts %hecks LIABILITIES Current liabilities Dividends payable Accounts payable Interest payment on long-term debt Taxes payable Owners equity

9K

ASSETS &tocks T-bills Fixed assets or tangible assets 'achinery %omputers $uilding (and Intangible assets !atent %opyright )oodwill #ranchises and licenses (easing

LIABILITIES

If, at the end of the fiscal year, a company decides to reinvest its net earnings into the company, the retained earnings will be restated from the income statement into the balance sheet. net earnings & retained earnings % total net worth .or a balance sheet to be functional, total assets on the left side have, at least, to equal total liabilities plus owner@s equity on the right side. A !alance s eet7 It is also a support for the financial ratios to be calculated It helps an investor to realize how liquid a company is and to analyze its growth potential It shows how profits are used to finance the company@s operations and whether the company has enough cash for growth It points to the inventory levels, whether they are stagnant or in progress, if debt is paid or to be paid It shows what cash value would shareholders receive in case of bankruptcy It shows what is the value of current assets, those assets which can be easily converted into cash.

9L

3. Loo" at t is e7a%ple o& a !alance s eet. Fill in t e %issin. -o*,s. C oose &*o% t e &ollo-in.' patents6 o-ne*8s e3uit+6 accounts *ecei/a!le6 lan,6 capital6 accounts pa+a!le6 WI16 cu**ent assets
BALANCE $)EET '/ll figures in %$+( Assets 0ash 15bills

Total Cu**ent Assets Inventory %aw materials .inished Coods Total In/ento*+ .ong+term assets

499: L.::: L:: 9.::: A.::: 9F.L: : BGL AL: 9.G:: G.AAL F:.:: : G:.:: : 5L.::: 9.::: 5<.99 9 <4.4= :

Lia!ilities an, o-ne*s e3uit+ -urrent .iabilities ,ividend payable 1axes payable Total Cu**ent Lia!ilities .ong+term .iabilities *ong5term -ank *oan Total Lia!ilities

499: K.::: G.::: F.::: D.::: L.::: 9K.::: G:.::: GB.GAL KB.GAL

%etained #arnings Total Net Wo*t

2achinery ,epreciation 'machinery( Intangible assets

Total Lon.;te*% assets Total Assets

Total Lia!ilities > Net Wo*t

<4.4=:

5. Rea, no- t e co%plete !alance s eet a!o/e an, p*o/i,e ans-e*s to t e *e3ui*e%ents !elo-' Is the company liquid enough to pay off its debts, or it needs to take a loanH Is the company financing itself through reinvested earnings or debtH What does a low cash ratio indicateH 0alculate the debt ratio by using the balance sheet above. 0alculate the current ratio by using the balance sheet above What would a high amount of leverage indicateH 9?

UNIT :. Rea,in. a 1*o&it an, Loss Account

/(lessed is the man who expects nothing, for he shall never be disappointed/ was the ninth beatitude Alexander Pope (. Rea, t e &ollo-in. te7t an, ans-e* t e 3uestions' What is a < M * needed forH What financial ratios can be calculated by using a < M * accountH Who is mostly interested in reading a < M *H 4. Matc t e &ollo-in. te*%s -it t ei* co**espon,ent e7planations' *etu*n on capital e%plo+e, (ROCE#6 .*oss p*o&it6 inte*est co/e*6 a%o*ti?ation6 ea*nin.s pe* s a*e6 %atc in. p*inciple6 cost o& sales6 ope*atin. p*o&it6 cost p*inciple6 .oo,-ill It requires that costs should be matched to the revenues they generate. 1his means, for example, that the cost of an asset should be depreciated over its useful life rather than the entire cost being charged against profits when it is purchased. It arises when a company buys another business at a price greater than the value of its assets; the excess of the amount paid over the new asset value of the acquired business, is shown in the balance sheet of the acquiring company. Civen that it excludes many costs, including all overheads and all financing costs, it is not a good measure of how profitable a company is as a whole. It is profit given to shareholders 'after tax( divided by the number of shares in issue.

9A

It is the amount of a company@s profits that belong to a single ordinary share. It is the rate of return a business is making on the total capital employed in the business. 0apital will include all sources of funding 'shareholders funds I borrowings(, which means that the return will be prior to interest and tax. It is the equivalent of depreciation for intangible assets. It is the profit generated by a company@s operations before interest payments and tax. It measures the cost of the goods 'or services( supplied in a period. 1he cost of what a company sells is accumulated with the cost of producing or supplying it. It is a measure of the adequacy of a company@s profits relative to interest payments on its debt.

1he p*o&it an, loss account (1 @ L#, called the income statement in the 6", shows the profit or loss a company has made over a period of time. It is the most looked accounting statement and it provides the numbers needed to calculate the ratios investors look at most often7 for example <# and dividend yield are calculated using the < M *. N. B. 1he price;earnings ratio, usually abbreviated to <#, compares the price of a share to the company@s earnings 'net profit( per share. 2ature companies tend to have higher dividend yields, while young companies tend to have lower ones; *td5s don@t have a dividend yield at all because they do not pay out dividends. T e 1 @ L account6 in its s o*test &o*%6 loo"s li"e' 0otal sales + 0otal costs % 0otal profit ! !evenues * "xpenses % )et Income /ccording to the matching principle, costs and revenues are matched, so that, sales and purchases made on credit during a year, but not yet paid for, will be included in the < M * for the year. < M * provides details of costs and revenues.

9B

T e .ene*al &o*% o& a 1 @ L loo"s li"e'

"ales 0ost of sales Cross profit $ther operating expenses $perating profit Interest costs <re5tax profit 1ax <rofit after tax ,ividends %etained profit #arnings per share /lso called revenues or turnover "ales5gross profit "ales 5 cost of sales /dministration, depreciation, marketing Cross profit 5 other operating expenses Interest payable 5 interest receivable $perating profit 5 Interest costs <re tax profit 5 tax <rofit after tax 5 dividends <rofit after tax divided by number of shares

1he < M * is essential for measuring the performance and efficiency of the business, such as return on capital employed and some measures of financial stability e.g. interest cover. 1he < M * is in someway quite backward looking and investors will need to consider correcting some items such as amortization of goodwill. .rom an investor@s point of view, the < M * is essential, but it can be misleading and should never be looked at in isolation. 3. a. Fill in t e %issin. -o*,s. C oose &*o% t e &ollo-in.' net inco%e6 ea*nin.s pe* s a*e6 inte*est e7pense6 net sales6 cost o& .oo,s sol, !evenues NNNNNN %ent revenue Interest revenue Total *e/enue "xpenses 9D

EEEEEEEEEEEEEEEEE NNNNNN EEEEEEEEEEEEEEEEE NNNNNN EEEEEEEEEEEEEEEEE NNNNNN EEEEEEEEEEEEEEEEE NNNNNN

NNNNNN "elling expenses /dministrative expenses NNNNNN Total e7pense Income before taxes Income taxes NNNNNN NNNNNN

EEEEEEEEEEEEEEEEE NNNNNN EEEEEEEEEEEEEEEEE NNNNNN EEEEEEEEEEEEEEEEE NNNNNN EEEEEEEEEEEEEEEEE NNNNNN EEEEEEEEEEEEEEEEE NNNNNN EEEEEEEEEEEEEEEEE NNNNNN EEEEEEEEEEEEEEEEE NNNNNN EEEEEEEEEEEEEEEEE NNNNNN

!. A&te* &illin. in6 %atc t e ite%s in t e secon, e7a%ple o& 1 @ L (t e one a!o/e# -it t e ite%s in t e &i*st e7a%ple o& 1 @ LA so%e ite%s in t e &i*st one %a+ !e inclusi/e &o* t e secon, ones. c. Inclu,e t e necessa*+ &i.u*es in t e 1 @ L a!o/e so as to p*o/i,e an a,e3uate e7a%ple o& a *eal &inancial situation. Ta"e into account t at t e co%pan+ is p*o&ita!le enou. an, co**elate t e &i.u*es -it t e ones place, in t e !alance s eet %entione, !e&o*e. 5. C oose t e *i. t ite%s &*o% t ose .i/en in !ol,' < M * indicates how net revenue isBis not transformed into net income. 1he purpose of the < M * is to show managers and investors whether the company %a,eB%a,e not or lostBnot lost money during the period being reported. < M * should help investors and creditors assessB not assess the risk of achieving future cash flows. Income statement is B is not the same as <M*. < M * isBis not use, for external reporting. < M * o&&e*sB ,oes not o&&e* relevant information to shareholders.

G:

,ecision makers fully *el+ B ,o not *el+ on the information provided by < M *.

Tas" ( Use t e secon, e7a%ple o& t e 1 @ L t at +ou a/e co%plete, to calculate t e .*oss p*o&it %a*.in an, t e net p*o&it %a*.in. Tas" 4 Use t e !alance s eet an, t e p*o&it an, loss account. Can +ou calculate ROCE &o* t e sa%e p*o,uctC Tas" 3 Assu%e t-o co%panies. Co%pan+ A as capital assets D E(9 %illion an, %a"es a p*o&it in 499< o& a*oun, E 4.: %illion. Co%pan+ B as capital assets o& E (.4 %illion. It %a"es a p*o&it in 499< o& onl+ E 599.999. W ic is t e %ost success&ul &i*%C Appl+ ROCE to &in, out t e ans-e*.

G9