OVERVIEW OF FINANCIAL MANAGEMENT

Financial Management

 means planning, organizing, directing, and controlling the financial activities such as
procurement and utilization of funds of the enterprise.
 means applying general management principles to financial resources of the enterprise.

Scope/Elements of Financial Management

1. Investment decisions

 includes investment in fixed assets (called capital budgeting). Investment in current assets
is also a part of investment decisions called working capital decisions.

2. Financial decisions

 They relate to the raising of finance from various resources which will depend upon the
decision on type of source, period of financing, cost of financing and the returns thereby.
Ibang options kung paano makakapagraise ng capital para sa business.

3. Dividend decision

 The finance manager has to make a decision with regards to the net profit distribution. Net
profits are generally divided into two:

a. Dividend for shareholders - Dividend and the rate of it has to be decided.

b. Retained profits - Amount of retained profits has to be finalized which will depend upon
expansion and diversification plans of the enterprise. Syempre hindi lahat ibibigay sa mga
shareholders.

Functions of Financial Management

1. Estimation of capital requirements:
A finance manager has to make an estimation with regards to capital requirements of the
company. This will depend upon expected costs and profits and future programs and policies of a
concern. Estimates have to be made in an adequate manner which increases the earning capacity of
an enterprise.
Kapag magtatayo ba ng milk tea shop… need ba ng 1 million pesos?
2. Determination of capital composition:
Once the estimation has been made, the capital structure has to be decided. This involves
short- term and long- term debt equity analysis. This will depend upon the proportion of equity
capital a company is possessing and additional funds which have to be raised from outside parties.
Mas okay ba ang mag-invite ng iba pang investors?
3. Choice of sources of funds:
For additional funds to be procured, a company has many choices like

a. Issue of shares and debentures

b. Loans to be taken from banks and financial institutions
c. Public deposits to be drawn like in the form of bonds.

Choice of factor will depend on relative merits and demerits of each source and period of financing.
 4. Investment of funds:
The finance manager has to decide to allocate funds into profitable ventures so that there is
safety on investment and regular returns are possible.
5. Disposal of surplus:
The net profit decision has to be made by the finance manager. This can be done in two
ways:

a. Dividend declaration - It includes identifying the rate of dividends and other benefits like
bonus.
b. Retained profits - The volume has to be decided which will depend upon expansional,
innovational, diversification plans of the company.

6. Management of cash:
Finance managers have to make decisions with regards to cash management. Cash is
required for many purposes like payment of wages and salaries, payment of electricity and water
bills, payment to creditors, meeting current liabilities, maintenance of enough stock, purchase of raw
materials, etc.
Cash is the lifeblood of the business kaya we need to manage our cash properly.
7. Financial controls:
The finance manager has not only to plan, procure and utilize the funds but he also has to
exercise control over finances. This can be done through many techniques like ratio analysis,
financial forecasting, cost, and profit control, etc.

WORKING CAPITAL MANAGEMENT CONCEPTS

Working Capital Management

 the administration and control of the company’s working capital. The primary objective is
to achieve a balance between return (profitability) and risk. It relates to the management of
short-term investment (i.e., current assets) and short-term liabilities (i.e., current
liabilities).

Working Capital

 is the firm’s investment in current assets (cash, marketable securities, accounts receivable,
inventories, and other current assets).

Net Working Capital

 is the excess of current assets over current liabilities. Effective management of working
capital will improve the firm’s overall return on investment performance.

CURRENT ASSETS - CURRENT LIABILITIES = NET WORKING CAPITAL

Objectives of Working Capital Management

 To make sure each type of working capital investment is productive in

(1) generating income for the business, MAJOR PURPOSE

(2) reducing the amount of investment needed to support sales and production, and
 (3) both generating income and reducing the amount of investment needed to support sales
and production. BEST CHOICE

Working Capital Financing Policies

1. Conservative (Relaxed) Policy – operations are conducted with too much working capital;
involves financing almost all asset investment with long-term capital.
NATATAKOT KAPUSIN YUNG OWNERS KAYA MALAKI ANG WORKING CAPITAL
NILA.
Advantages:

 reduces risk of liquidity

 eliminates the firm’s exposure to fluctuating loan rates and potential unavailability of short
credit

Disadvantage:

 less profitable because of higher financing cost NAKATENGGA YUNG PERA

2. Aggressive (Restricted) Policy – operations are conducted on a minimum amount of working

capital; uses short-term liabilities to finance, not only temporary, but also part or all of the
permanent current asset requirement.
Advantage:

 increases return on equity (profitability) by taking advantage of the cost differential between
long-term and short-term debt

Disadvantages:

 exposure to risk arising from low working capital position

 puts too much pressure on the firm’s short-term borrowing capacity so that it may have
difficulty in satisfying unexpected needs for funds

3. Matching Policy (also called self-liquidating policy or hedging policy) – matching the maturity of
a financing source with specific financing needs.

 short-term assets are financed with short-term liabilities

 long-term assets are funded by long-term financing sources

4. Balanced Policy – balances the trade-off between risk and profitability in a manner consistent
with its attitude toward bearing risk.

Deciding on an Appropriate Working Capital Policy

The amount of net working capital that a company should have depends on the amount of risk it is
willing to take. The primary consideration therefore is the trade-off between returns (profitability)
and risk (risks of illiquidity) associated with:

1. Asset Mix Decision – appropriate mix of current and noncurrent assets.

2. Financing Mix Decision – appropriate mix of short-term and long-term liabilities to finance
current assets.

Risk Return Trade-off

 The greater the risk, the greater is the potential for larger returns. STOCKS AND
BANKS
 More current assets lead to greater liquidity but yield lower returns (profit).
 Fixed assets earn greater returns than current assets. KAYA KAPAG KUMIKITA ANG
COMPANY, NAGPAPAGAWA NG MGA FACTORIES ETC.
 Long-term financing has less liquidity risk than short-term debt, but has a higher explicit
cost, hence, lower return.

Components of Working Capital

1. Cash and Marketable Securities - CURRENT ASSETS

2. Accounts Receivable - CURRENT ASSETS
3. Inventories - CURRENT ASSETS
4. Short-term Financing - CURRENT LIABILITIES
 CASH MANAGEMENT
Cash management is one of the key areas of working capital management. Apart from the fact that it
is the most liquid current asset, cash is the common denominator to which all current assets can
be reduced because the other major liquid assets, which are receivables and inventory, get eventually
converted into cash.
Motives/Reasons for Holding Cash

a. Transaction Motives - refers to the holding of cash to meet routine cash requirements to
finance the transactions which affirm carries on in the ordinary course of business ARAW-
ARAW NA NEEDS
b. Precautionary Motives - motive of holding cash implies the need to hold cash to meet the
unpredictable obligations. BIGLAANG INSTANCES OR EXTRA GANERN
c. Speculative Motives - refers to the desire of a firm to take advantage of opportunities which
present themselves at unexpected moments and which are typically outside the normal course
of business. KUNG MAY NAKARESERVE NA CASH AT MAY DUMATING NA
OPPORTUNITY
d. Compensating/Contractual Motives - another motive to hold cash balances is to compensate
banks for providing certain services and loans.

Objectives of Cash Management

1. To meet the cash disbursement needs (payment schedule) BABAYARAN IN THE

FUTURE, SALARIES, UTILITIES GANERN
2. To minimize funds committed to cash balances KAILANGAN BA TALAGA NG
MALAKING CASH BALANCE SA COMPANY OR HINDI LANG SIYA NAIINVEST
NG MAAYOS?

Meeting Payments Schedule

Firms have to make payments of cash on a continuous and regular basis to suppliers of goods,
employees and so on. A basic objective of cash management is to meet the payment schedule, that is,
to have sufficient cash to meet the cash disbursement need of the firm.
The importance of sufficient cash to meet the payment schedule can hardly be overemphasised. The
advantages of adequate cash are:

1. It prevents insolvency or bankruptcy arising out of the inability of a firm to meets its
obligations
2. The relationship with the bank is not strained
3. It helps in fostering goods relations with trade creditors and suppliers of raw materials, as
prompt payment may help their own cash management
4. A cash discount can be availed of if payment is made within the due date
5. It leads to a strong credit rating which enables the firm to purchase goods on favorable terms
and to maintain its line of credit with banks and other sources of credit
 6. To take advantage of favorable business opportunities that may be available periodically
7. The firm can meet unanticipated cash expenditure with a minimum strain during emergencies

Minimizing Funds Committed to Cash Balances

In minimizing cash balances, two conflicting aspects have to be reconciled. A high level of cash
balances will ensure prompt payment together with all the advantages. But it also implies that large
funds may remain idle, as cash is a non-coming asset and the firm will have to forego profits. A low
level of cash balances, on the other hand, may mean failure to meet the payment schedule. The aim
of cash management therefore should have an optimal amount of cash balances.
Managing Cash Inflow PUMAPASOK NA PERA
Reducing Float can Speed Up Cash Receipts

1. Mail Float: length of time from the moment a customer mails a check until the firm begins
to process it. PAANO KUNG MALAYO PA YUNG PINANGGGAGALINGAN.
2. Processing Float: the time required by a firm to process a check before it can be deposited
in a bank. KELAN PA MADEDEPOSIT YUNG CHEKE SA BANKO?
3. Transit float: time required for a check to clear through the banking system and become
usable funds. NAGBABAYAD NG CHEKE AT UNDERGO PA NG CLEARANCE.
KAHIT NARECEIVE NA YUNG CHEKE SYEMPRE DI PA MAGAGAMIT YUNG
CASH NA EQUIVALENT NOON.
4. Disbursing float: occurs because funds are available in a firm’s bank account until its
payment check has cleared through the banking system.

Lockbox System
Instead of mailing checks to the firm, customers mail checks to a nearby Post Office Box. A
commercial bank collects and deposits the checks. This reduces mail float, processing float and
transit float.

1. Traditional Lockbox: A post office box maintained by a firm’s bank that is used as a
receiving point for customer remittances.
2. Electronic Lockbox: A collection service provided by a firm’s bank that receives electronic
payments and accompanying remittance data and communicates this information to the
company in a specified format.

Preauthorized Checks (PACs)

Arrangement that allows firms to create checks to collect payments directly from customer
accounts. This reduces mail float and processing float.
Depository Transfer Checks (DTCS)
Moves cash from local banks to concentration bank accounts. Firms avoid having idle cash in
multiple banks in different regions of the country. BAKA KASI MAMAYA MAG-OOPEN PA
TAYO NG ACCOUNTS SA AREA NG CUSTOMERS NATIN.

Wire Transfers
Moves cash quickly between banks. Eliminates transit float.

Managing Cash Outflow LUMALABAS NA PERA

Zero Balance Accounts (ZBAs)
Different divisions of a firm may write checks from their own ZBA. Division accounts then have
negative balances. Cash is transferred daily from the firm’s master account to restore the zero
balance. Allows more control over cash outflows.
Payable-Through Drafts (PTDs)
Allows the firm to examine checks written by the firm’s regional units. Checks are passed on to the
firm, which can stop payment if necessary.
Remote Disbursing
Firm writes checks on a bank in a distant town. This extends the disbursing float. FAVORABLE
SA ATIN KAPAG NAG EXTEND YUNG FLOAT KASI OUT FLOW EH

Determining Cash Needs

Baumol Model
The optimal amount of short-term securities sold to raise cash will be higher when annual cash
outflows are higher and when the cost per sale of securities is higher. Conversely, the initial cash
balance falls when the interest is higher.
The purpose of this model is to determine the minimum cost amount of cash that a financial manager
can obtain by converting securities to cash, considering the cost of conversion and the counter
balancing cost of keeping idle cash balances which otherwise could have been invested in marketable
securities. The total cost associated with cash management, according to this model has 2 elements
(i) cost of converting marketable securities into cash (ii) the lost opportunity cost. The conversion
costs are incurred each time marketable securities are converted into cash.

Cash Budget
Cash budget is a device to help a firm to plan and control the use of cash. It is a statement showing
the estimated cash inflows and outflows over the planning horizon. The net cash position of a firm
as it moves from one budgeting sub period to another is highlighted by the cash budget.

Marketable Securities
Marketable securities are highly liquid, short-term, interest-earning government, and non
government money market instruments. They can be easily converted to cash.
Reasons for Holding Marketable Securities

1. They serve as a substitute for cash balances.

2. They are held as a temporary investment where a return is earned while funds are
temporarily idle.
3. They are built up to meet known financial requirements such as tax payments, maturing bond
issues and so on.

Factors Influencing the Choice of Marketable Securities

1. Risks such as financial risk (uncertainty of expected returns due to changes in issuer’s ability
to pay) and interest rate risk (uncertainty of expected returns due to changes in interest rates).
MAY RISK DAHIL SYEMPRE INVESTMENT SIYA
2. Maturity. SHORT TERM
 3. Yield or returns on securities. KAHIT PAPANO AY KUMIKITA NAMAN SIYA
4. Marketability/liquidity risk (ability to transform securities into cash).

Types

1. Treasury Bills - short term securities issued by the government.

2. Bankers Acceptances - short term securities used in international trade, sold on discount
basis. Short-term promissory trade notes for which a bank (by having “accepted” them)
promises to pay the holder the face amount at maturity.
3. Negotiable Certificates of Deposits (CDs) - short-term securities issued by banks. A large-
denomination investment in a negotiable time deposit at a commercial bank or savings
institution paying a fixed or variable rate of interest for a specified period of time.
4. Commercial Paper - short-term unsecured “IOUs” sold by large reputable firms to raise cash.
5. Repurchase Agreements - an investor acquires short-term securities subject to a commitment
from a bank to repurchase the securities on a specific date.
6. Money Market Mutual Funds - a pool of money market securities, divided into shares,
which are sold to investors.

RECEIVABLE MANAGEMENT
ACCOUNTS RECEIVABLE MANAGEMENT

Accounts receivables are generated when a firm offers credit to its customers. The first thing that
needs to be addressed when establishing a credit policy is to set the standards by which a firm is
judged in determining whether or not credit will be extended. MAGTATAKA TAYO BAKIT ANG
LAKI NG SALES NATIN PERO MABABA ANG CASH YUN PALA AY PINAPAUTANG NG
PINAPAUTANG SA MGA CUSTOMERS.
Factors to Consider for Accounts Receivable Policy -
1. Credit Standards 5C’s
Character - customers’ willingness to pay - GOOD PAYER BA?
Capacity - customers’ ability to generate cash flows MAY PAMBAYAD BA?
Capital - customers’ financial sources
Conditions - current economic or business conditions LUGE NA PALA
Collateral - customers’ asset pledged to secure debt PLAY SAFE
2. Credit Terms
This defines the credit period (2/10, N/30) and discount offered for customers prompt payment.
The following costs associated with the credit terms must be considered: cash discounts, credit
analysis and collections costs, bad debts losses and financing cost.
3. Collection Program
Shortening the average collection period may preclude too much investment in receivable (low
opportunity cost) and too much loss due to delinquency and defaults. The same could also result in
loss of customers if harshly implemented. KAPAG MASYADONG MAHIGPIT, BAKA UMALIS
ANG CUSTOMERS. AYUSIN ANG DEBT COLLECTION PROGRAM.

Credit Management
Credit management strategically defines the quality of accounts receivable collections. Credit and
collection have a direct relationship. If credit standards are high, the rate of collection is expected
to be high, and vice-versa.
Credit processes precede collection activities. Generally, it is a choice of offering and implementing
a set of stiff credit criteria to have a high collection rate or a set of lax credit criteria coupled with
high collection costs. However, creative managers can still develop a mix model in managing their
receivables and collection to optimize sales and collections. There are several variables of credit
management such as discount rate, discount time, credit period, credit cap (limit), credit class, and
credit assessment.
Collection Management
Operationally, collection management starts from the date the merchandise is sold to credit
customers. Complete and reliable records and corroborating documents should be maintained to
ensure an efficient basis of collection. Billings and collection policies are interrelated processes to
complete a collection cycle.
IMPORTANTE ITO LALO NA KUNG MARAMI TAYONG CUSTOMERS KAYA MINSAN
MAYROONG ISANG TAO OR DEPARTMENT NA NAKA-TOKA DITO.
Receivable Portfolio Analysis
Receivable portfolio (i.e., “receivable spread) refers to the strategy of spreading investments in
receivables over a customer base. It gives an impression of whether the management is strict or lax
in imposing its receivable policies and whether the management is conservative and aggressive in
its receivable investment. Receivable should also be tracked down – per customer, customer group,
customer receivable age, and customer balances. This is done in relation with the goal of speeding up
the collection of receivables.
Aging of Accounts Receivable
Aging of accounts receivables classifies the accounts to their number of days outstanding. It has the
following advantages:

 It tracks down receivable balances.

 It serves as an analysis sheet to study receivable balances according to their “age” as either
current account or past due account.
  It gives an idea of which accounts are “moving” and which are “not moving” by doing a
supplemental analysis of the long past due accounts.
 It is a reasonable technique of estimated doubtful accounts expense.

INVENTORY MANAGEMENT
Inventory management is directly linked to the operating goal of giving the best service to customers.
When a customer calls for a sales order, delivery must be done at the fastest possible time at the
lowest possible costs. Traditionally, companies maintain a large stock of inventories to meet the
challenge of serving customers on time. JOLLIBEE ETC AT HINDI PRE-ORDER.
Objectives

1. Reduce inventories while maintaining customer service levels and quality. The firm can
free needed cash to finance both internal and external growth.
2. To establish production and inventory control.

Inventory Planning and Control

Inventories provide a cushion to smooth out the differences in the time and location of demand and
supply for a product. The purpose of inventory planning and control is to determine the optimum
level of inventory necessary to minimize costs.
*The EOQ Model
The economic order quantity (EOQ) refers to the units of materials that should be purchased to
minimize total relevant inventory costs. Total relevant inventory costs include the sum of ordering
and carrying costs. Total relevant inventory costs do not include the purchase price in the analysis
because the unit purchase price remains the same regardless of the order quantity the business places.
=Ordering costs (WALA PA SAYO) include those spent in placing an order, waiting for an order,
inspection and receiving costs, setup costs, and quantity discounts lost.
Cost per order = Total ordering costs / No. of orders
Total ordering costs = Cost per order x No. of orders
No. of orders = Annual demand / order size
Annual demand represents the annual need or requirements of the business. Order size refers to the
number of units or amount purchased per order batch.
=Carrying costs (NASA IYO NA) are those spent in holding, maintaining, or warehousing
inventories such as warehouse and storage costs, handling and clerical costs, property taxes and
insurance, deterioration and shrinkage of stocks, obsolescence of stocks, interest, and return on
investment (e.g., lost return on investment tied up in inventory).
Carrying cost per unit = Total carrying costs / Average inventory
Total carrying costs = Carrying cost per unit x Average inventory
Average inventory = Order size / 2
also,
 Carrying cost per unit = Unit cost x Carrying cost ratio
Carrying cost ratio = Carrying cost per unit / Unit cost

=Economic order quantity is the point where the total ordering costs equal the total carrying cost.
Also, at this point the total inventory cost is at its minimum.

______________
EOQ = √ 2 x D x O ÷ C

D = demand annually for the product; O = Order cost per order placed;
C = carrying cost annually per unit of the product in inventory.

=Reorder point refers to the inventory level where a purchase order should be placed.
=Lead time refers to the waiting time from the date the order is placed until the date the delivery is
received. Lead time quantity represents the normal usage during the lead time period. Normal usage
means the average usage of inventory during a period (i.e., annual demand / working days in a year).
KELAN DARATING YUNG STOCK SA SUPPLIER?
=Safety stock is set to serve as a margin in case of variations in normal usage and normal lead time.
Hence, there is a safety stock for variation in usage and a safety stock for variations in time.
RESERBA

Reorder point = Lead time quantity + Safety stock quantity

where:
Lead time quantity = normal usage x normal lead time
Safety stock = safety stock (in usage) + safety stock (in time)
Safety stock (in usage) = (Maximum usage – Normal usage) x Normal lead
time
Safety stock (in time) = (Maximum lead time – Normal lead time) x
Normal usage
and;
Maximum inventory level = Safety stock quantity + Order size

=Stock-out (Shortage) Costs include those costs incurred when an item is out of stock. These
include the lost contribution margin on sales plus lost customer goodwill. MASISIRA TAYO SA
KANILA.
 SHORT-TERM FINANCING
Short term finance refers to financing needs for a small period normally less than a year. In
businesses, it is also known as working capital financing. This type of financing is normally needed
because of uneven flow of cash into the business, the seasonal pattern of business, etc. In most cases,
it is used to finance all types of inventories, accounts receivables etc. At times, only specific one-
time orders of business are financed.
Why Do Firms Need Short-Term Financing?

 Cash flow from operations may not be sufficient to keep up with growth-related financing
needs.
 Firms may prefer to borrow now for their inventory or other short-term asset needs rather
than wait until they have saved enough. LUMAKI YUNG ORDER PERO WALA PA
TAYONG CAPITAL PAMBILI KAYA NEED MUNA NATIN HUMIRAM SA IBA
 Firms prefer short-term financing instead of long-term sources of financing due to:
 easier availability MAHABA PROCESS SA BANKS
 usually has lower cost (remember yield curve)
 matches need for short term assets, like inventory

Types/Sources
As we understood why we need short-term financing, there are various sources of short-term
financing for a business. Each type of short-term finance has different characteristics and can be used
in different situations. Some of those are explained below:
Trade Credit
It is the credit extended by the account’s payables. We would classify this credit into 2 types – free
trade credit and paid trade credit. After a particular no. of days as per payment terms, the supplier
charges interest on the delay of payment. So, the period before this is free trade credit and after that is
paid trade credit.
It’s quite obvious that the free trade credit should be as much as possible because it is free of cost.
How much is free trade credit extended to a customer? It depends upon the creditworthiness of the
buyer, discipline maintained in payment commitments, the bulk of the business, etc. Higher you rate
on these factors, higher would be the free trade credit available to your business.
Paid trade credit is definitely a type of short-term financing but on the priority list, it would be quite
below. In short, it should be selected only when another financing is not available. The reason for not
opting for it is its high-interest cost.
Short-Term Loans
Short term loans can be availed from banks and other financial institutions. Banks extend these
loans after careful study of the business, its working capital cycle, past track record etc. Once
availed, these loans are repaid either in small instalments or may be paid in full at the end of the
period. This depends on the terms of the loan. It is advisable to use these loans for financing
permanent working capital needs. There are other alternatives to fund the temporary working capital
needs. For more refer Working Capital Loans.
Business Line of Credit
A business line of credit, a type of short-term financing, is most appropriate for temporary working
capital needs. In this type of financing, an amount is approved by the issuing bank or financial
institution. Within the limit of this amount, the business can make payment and keep depositing once
payment from customers is received. It works like a revolving credit and the best part of this is the
interest is charged on the utilized amount only and not on the approved amount. The business has the
flexibility to deposit unused amounts to save on interest costs. This way it becomes a very cost-
effective financing option.
Invoice Discounting
Invoice discounting is another source of short-term finance where the receivable invoices can be
discounted with the financial institutes or banks or any third party. Discounting invoices means
the bank will pay you the money at the time of discounting and collect the money from your
customer when the bill becomes due.
Factoring
Factoring is also a similar arrangement like invoice discounting where the accounts receivables of a
business are sold to a third party at a price which is lower to the realisable value of the accounts
receivable. This purchasing party is commonly known as a factor. These factoring services are
provided by both banks and other financial institutions. There are many types of factoring like with
recourse or without recourse etc.
= Accounts Receivable as Collateral
A pledge is a promise that the borrowing firm will pay the lender any payments received from the
accounts receivable collateral in the event of default. Since accounts receivable fluctuate over time,
the lender may require certain safeguards to ensure that the value of the collateral does not go below
the balance of the loan. So, normally a bank will only loan you 70 -75% of the receivable
amount. Accounts receivable can also be sold outright. This is known as factoring.
Inventory as Collateral
A major problem with inventory financing is valuing the inventory. For this reason, lenders will
generally make a loan in the amount of only a fraction of the value of the inventory. The fraction will
differ depending on the type of inventory. If inventory is long lived, i.e. lumber, they (lender or a
customer) may loan you up to 75% of the resale value. If inventory is perishable, i.e., lettuce,
you will not get much.
Short-Term versus Long-Term Financing
The most important difference between the two types of financing is the time period, the purpose
and the cost of financing.

1. The time period is simple to understand. Short-term financing is normally for less than a
year and long-term could even be for 10, 15 or even 20 years.
2. The purposes are totally different for both types of financing. Short-term financing is
normally used to support the working capital gap of a business whereas the long term is
required to finance big projects, PPE, etc.
3. The third thing is the cost of financing which is higher in case of short-term and
comparatively lower in case of long-term barring abnormal economic conditions.
1. FINANCIAL STATEMENT ANALYSIS
Financial Statement Analysis is defined as the process of identifying financial strengths and
weaknesses of the firm by properly establishing relationship between the items of the balance sheet
and the profit and loss account.
There are various methods or techniques that are used in analyzing financial statements, such as
comparative statements, schedule of changes in working capital, common size percentages, funds
analysis, trend analysis, and ratios analysis.
Financial statements are prepared to meet external reporting obligations and also for decision making
purposes. They play a dominant role in setting the framework of managerial decisions. But the
information provided in the financial statements is not an end in itself as no meaningful conclusions
can be drawn from these statements alone. However, the information provided in the financial
statements is of immense use in making decisions through analysis and interpretation of financial
statements.
Tools and Techniques of Financial Statement Analysis

1. Horizontal and Vertical Analysis

Horizontal Analysis or Trend Analysis

Comparison of two or more year’s financial data is known as horizontal analysis, or trend analysis.
Horizontal analysis is facilitated by showing changes between years in both peso and percentage
form.
Trend Percentage
Horizontal analysis of financial statements can also be carried out by computing trend percentages.
Trend percentage states several years’ financial data in terms of a base year. The base year equals
100%, with all other years stated in some percentage of this base.
Vertical Analysis
Vertical analysis is the procedure of preparing and presenting common size statements. Common size
statement is one that shows the items appearing on it in percentage form as well as in peso form.
Each item is stated as a percentage of some total of which that item is a part. Key financial changes
and trends can be highlighted by the use of common size statements.

2. Ratios Analysis

The ratios analysis is the most powerful tool of financial statement analysis. Ratios simply means one
number expressed in terms of another. A ratio is a statistical yardstick by means of which
relationship between two or various figures can be compared or measured. Ratios can be found out
by dividing one number by another number. Ratios show how one number is related to another.
Profitability Ratios
Profitability ratios measure the results of business operations or overall performance and
effectiveness of the firm. Some of the most popular profitability ratios are as under:

 Gross profit ratio (GP ratio)is the ratio of gross profit to net sales expressed as a percentage.
It expresses the relationship between gross profit and sales.

Formula: Gross Profit Ratio = (Gross profit / Net sales) × 100

Analysis:
Gross profit ratio may be indicated to what extent the selling prices of goods per unit may be reduced
without incurring losses on operations. It reflects efficiency with which a firm produces its products.
As the gross profit is found by deducting cost of goods sold from net sales, higher the gross profit
better it is. There is no standard GP ratio for evaluation. It may vary from business to business.
However, the gross profit earned should be sufficient to recover all operating expenses and to build
up reserves after paying all fixed interest charges and dividends.

 Net profit ratio is the ratio of net profit (after taxes) to net sales. It is expressed as percentage.

Formula: Net Profit Ratio = (Net profit / Net sales) × 100

Analysis:
NP ratio is used to measure the overall profitability and hence it is very useful to proprietors. The
ratio is very useful as if the net profit is not sufficient, the firm shall not be able to achieve a
satisfactory return on its investment. This ratio also indicates the firm’s capacity to face adverse
economic conditions such as price competition, low demand, etc. Obviously, higher the ratio the
better is the profitability. But while interpreting the ratio it should be kept in mind that the
performance of profits also be seen in relation to investments or capital of the firm and not only in
relation to sales.

 Operating ratio is the ratio of cost of goods sold plus operating expenses to net sales. It is
generally expressed in percentage.

Formula: Operating Ratio = [(Cost of goods sold + Operating expenses) / Net sales] × 100
Analysis:
Operating ratio shows the operational efficiency of the business. Lower operating ratio shows higher
operating profit and vice versa. An operating ratio ranging between 75% and 80% is generally
considered as standard for manufacturing concerns. This ratio is considered to be a yardstick of
operating efficiency but it should be used cautiously because it may be affected by a number of
uncontrollable factors beyond the control of the firm. Moreover, in some firms, non-operating
expenses from a substantial part of the total expenses and in such cases operating ratio may give
misleading results.

 Expense ratios indicate the relationship of various expenses to net sales. The operating ratio
reveals the average total variations in expenses. But some of the expenses may be increasing
while some may be falling. Hence, expense ratios are calculated by dividing each item of
expenses or group of expense with the net sales to analyze the cause of variation of the
operating ratio. The ratio can be calculated for individual items of expense or a group of
items of a particular type of expense like cost of sales ratio, administrative expense ratio,
selling expense ratio, materials consumed ratio, etc. The lower the operating ratio, the larger
is the profitability and higher the operating ratio, lower is the profitability. While interpreting
expense ratio, it must be remembered that for a fixed expense like rent, the ratio will fall if
the sales increase and for a variable expense, the ratio in proportion to sales shall remain
nearly the same.

Formula: Particular Expense = (Particular expense / Net sales) × 100

 Return on assets is the ratio of annual net income to average total assets of a business during
a financial year. It measures efficiency of the business in using its assets to generate net
income. It is a profitability ratio.

Formula:

ROA Annual Net Income

=

Average Total Assets

Analysis:
Return on assets indicates the number of cents earned on each peso of assets. Thus higher values of
return on assets show that business is more profitable. This ratio should be only used to compare
companies in the same industry. The reason for this is that companies in some industries are most
asset-insensitive i.e. they need expensive plant and equipment to generate income compared to
others. Their ROA will naturally be lower than the ROA of companies which are low asset
insensitive. An increasing trend of ROA indicates that the profitability of the company is improving.
Conversely, a decreasing trend means that profitability is deteriorating.
  Return on equity or return on capital is the ratio of net income of a business during a year to
its stockholders' equity during that year. It is a measure of profitability of stockholders'
investments. It shows net income as percentage of shareholder equity.

Formula:

ROE Annual Net Income

=

Average Stockholders' Equity

Analysis:
Return on equity is an important measure of the profitability of a company. Higher values are
generally favorable meaning that the company is efficient in generating income on new investment.
Investors should compare the ROE of different companies and also check the trend in ROE over
time. However, relying solely on ROE for investment decisions is not safe. It can be artificially
influenced by the management, for example, when debt financing is used to reduce share capital
there will be an increase in ROE even if income remains constant.

 Dividend yield ratio is the relationship between dividends per share and the market value of
the shares. Shareholders are real owners of a company and they are interested in real sense in
the earnings distributed and paid to them as dividend. Therefore, dividend yield ratio is
calculated to evaluate the relationship between dividends per share paid and the market value
of the shares.

Formula: Dividend Yield Ratio = Dividend Per Share / Market Value Per Share

Analysis:
This ratio helps as intending investor knows the effective return he is going to get on the proposed
investment.

 Dividend payout ratio is calculated to find the extent to which earnings per share have been
used for paying dividend and to know what portion of earnings has been retained in the
business.

Formula: Dividend Payout Ratio = Dividend per Equity Share / Earnings per Share

Analysis:
The payout ratio and the retained earnings ratio are the indicators of the amount of earnings that have
been ploughed back in the business. The lower the payout ratio, the higher will be the amount of
earnings ploughed back in the business and vice versa. A lower payout ratio or higher retained
earnings ratio means a stronger financial position of the company.
  Earnings per share ratio (EPS Ratio) is a small variation of return on equity capital ratio and
is calculated by dividing the net profit after taxes and preference dividend by the total
number of equity shares.

Formula: Earnings per share (EPS) Ratio = (Net profit after tax − Preference dividend) / No. of
equity shares (common shares)

Analysis:
The earnings per share is a good measure of profitability and when compared with EPS of similar
companies, it gives a view of the comparative earnings or earnings power of the firm. EPS ratio
calculated for a number of years indicates whether or not the earning power of the company has
increased.

 Price earnings ratio (P/E ratio)is the ratio between market price per equity share and earnings
per share. The ratio is calculated to make an estimate of appreciation in the value of a share
of a company and is widely used by investors to decide whether or not to buy shares in a
particular company.

Formula: Price Earnings Ratio = Market price per equity share / Earnings per share

Analysis:
Price earnings ratio helps the investor in deciding whether to buy or not to buy the shares of a
particular company at a particular market price. Generally, higher the price earnings ratio the better it
is. If the P/E ratio falls, the management should look into the causes that have resulted into the fall of
this ratio.
Liquidity Ratios:
Liquidity ratios measure the short-term solvency of financial position of a firm. These ratios are
calculated to comment upon the short-term paying capacity of a concern or the firm’s ability to meet
its current obligations. Following are the most important liquidity ratios.

 Current ratio may be defined as the relationship between current assets and current liabilities.
This ratio is also known as “working capital ratio“. It is a measure of general liquidity and is
most widely used to make the analysis for short term financial position or liquidity of a firm.
It is calculated by dividing the total of the current assets by total of the current liabilities.

Formula: Current Ratio = Current Assets / Current Liabilities Or

Current Assets:Current Liabilities
Analysis:
Current ratio matches current assets with current liabilities and tells us whether the current assets are
enough to settle current liabilities. Current ratio below 1 shows critical liquidity problems because it
means that total current liabilities exceed total current assets. General rule is that higher the current
ratio better it is but there is a limit to this. Abnormally high value of current ratio may indicate
existence of idle or underutilized resources in the company.
  Liquid ratiois also termed as “Liquidity Ratio “, “Acid Test Ratio” or “Quick Ratio“. It is the
ratio of liquid assets to current liabilities. The true liquidity refers to the ability of a firm to
pay its short-term obligations as and when they become due.

Formula: Liquid Ratio = Liquid Assets / Current Liabilities

Analysis:
The quick ratio/acid test ratio is very useful in measuring the liquidity position of a firm. It measures
the firm’s capacity to pay off current obligations immediately and is more rigorous test of liquidity
than the current ratio. It is used as a complementary ratio to the current ratio. Liquid ratio is more
rigorous test of liquidity than the current ratio because it eliminates inventories and prepaid expenses
as a part of current assets. Usually a high liquid ratio is an indication that the firm is liquid and has
the ability to meet its current or liquid liabilities in time and on the other hand a low liquidity ratio
represents that the firm’s liquidity position is not good. As a convention, generally, a quick ratio of
“one to one” (1:1) is considered to be satisfactory.

Absolute liquidity is represented by cash and near cash items. It is a ratio of absolute liquid assets to
current liabilities. In the computation of this ratio only the absolute liquid assets are compared with
the liquid liabilities. The absolute liquid assets are cash, bank and marketable securities. It is to be
observed that receivables (debtors/accounts receivables and bills receivables) are eliminated from the
list of liquid assets in order to obtain absolute4 liquid assets since there may be some doubt in their
liquidity.

Formula: Absolute Liquid Ratio = Absolute Liquid Assets / Current Assets

This ratio gains much significance only when it is used in conjunction with the current and liquid
ratios. A standard of 0.5: 1 absolute liquidity ratio is considered an acceptable norm. That is, from the
point of view of absolute liquidity, fifty cents worth of absolute liquid assets are considered sufficient
for one-peso worth of liquid liabilities. However, this ratio is not in much use.

 Working capital is a measure of liquidity of a business. It equals current assets minus current
liabilities.

Formula:

Working Capital = Current Assets − Current Liabilities

Analysis:
If current assets of a business at the point in time are more than its current liabilities the working
capital is positive, and this tells that the company is not expected to suffer from liquidity crunch in
near future. However, if current assets are less than current liabilities the working capital is negative,
and this communicates that the business may not be able to pay off its current liabilities when due.
Activity Ratios:
Activity ratios are calculated to measure the efficiency with which the resources of a firm have been
employed. These ratios are also called turnover ratios because they indicate the speed with which
assets are being turned over into sales. Following are the most important activity ratios:

 Inventory turnover is the ratio of cost of goods sold by a business to its average inventory
during a given accounting period. It is an activity ratio measuring the number of times per
period; a business sells and replaces its entire batch of inventory again.

Formula:

Inventory Turnover = Cost of Goods Sold

Average Inventory

Analysis:
Inventory turnover ratio is used to measure the inventory management efficiency of a business. In
general, a higher value of inventory turnover indicates better performance and lower value means
inefficiency in controlling inventory levels. A lower inventory turnover ratio may be an indication of
over-stocking which may pose risk of obsolescence and increased inventory holding costs. However,
a very high value of this ratio may be accompanied by loss of sales due to inventory shortage.
Inventory turnover is different for different industries. Businesses which trade perishable goods have
very higher turnover compared to those dealing in durables. Hence a comparison would only be fair
if made between businesses of same industry.

 Days' inventory on hand (also called days' sales in inventory or simply days of inventory) is
an accounting ratio which measures the number of days a company takes to sell its average
balance of inventory. It is also an estimate of the number of days for which the average
balance of inventory will be sufficient. Days' sales in inventory ratio are very similar to
inventory turnover ratio and both measure the efficiency of a business in managing its
inventory.

Formula:

Days of Inventory = Number of Days in the Period

Inventory Turnover for the Period

If we substitute inventory turnover as "cost of goods sold ÷ average inventory" in the above formula
and simplify the equation, we get:
 Days of Inventory = Average Inventory × Number of Days in the Period

Cost of Goods Sold

Analysis:
Since inventory carrying costs take significant investment, a business must try to reduce the level of
inventory. Lower level of inventory will result in lower days' inventory on hand ratio. Therefore,
lower values of this ratio are generally favorable and higher values are unfavorable. However,
inventory must be kept at safe level so that no sales are lost due to stock-outs. Thus, low value of
days of inventory ratio of a company which finds it difficult to satisfy demand is not favorable. Days'
sales in inventory vary significantly between different industries. For example, business which sells
perishable goods such as fruits and vegetables have very low values of days' sales in inventory
whereas companies selling non-perishable goods such as cars have high values of days of inventory.

 Accounts receivable turnover is the ratio of net credit sales of a business to its average
accounts receivable during a given period, usually a year. It is an activity ratio which
estimates the number of times a business collects its average accounts receivable balance
during a period.

Formula:

Receivables = Net Credit Sales

Turnover Average Accounts Receivable

Analysis:
Accounts receivable turnover measures the efficiency of a business in collecting its credit sales.
Generally, a high value of accounts receivable turnover is favorable and lower figure may indicate
inefficiency in collecting outstanding sales. Increase in accounts receivable turnover overtime
generally indicates improvement in the process of cash collection on credit sales. However, a normal
level of receivables turnover is different for different industries. Also, very high values of this ratio
may not be favorable, if achieved by extremely strict credit terms since such policies may repel
potential buyers.

 Days' sales outstanding ratio (also called average collection period or days' sales in
receivables) is used to measure the average number of days a business takes to collect its
trade receivables after they have been created. It is an activity ratio and gives information
about the efficiency of sales collection activities.

Formula:
 DSO Accounts Receivable × Number of Days
=

Credit Sales

Another formula which uses the accounts receivable turnover is:

DSO Number of Days in the Period

=

Accounts Receivable Turnover

Analysis:
Since it is profitable to convert sales into cash quickly, this means that a lower value of Days Sales
Outstanding is favorable whereas a higher value is unfavorable. However, it is more meaningful to
create monthly or weekly trend of DSO. Any significant increase in the trend is unfavorable and
indicates inefficiency in credit sales collection.

 Working capital turnover ratio is an activity ratio that measures pesos of revenue generated
per peso of investment in working capital. Working capital is defined as the amount by which
current assets exceed current liabilities.

Formula:

Working Capital Turnover Ratio = Revenue

Average Working Capital

Analysis:
A higher working capital turnover ratio is better. It means that the company is utilizing its working
capital more efficiently i.e. generating more revenue using less investment.
Long Term Solvency or Leverage Ratios:
Long term solvency or leverage ratios convey a firm’s ability to meet the interest costs and payment
schedules of its long-term obligations. Following are some of the most important long-term solvency
or leverage ratios.

 Debt-to-Equity ratio Debt-to-Equity ratio is the ratio of total liabilities of a business to its
shareholders' equity. It is a leverage ratio and it measures the degree to which the assets of
the business are financed by the debts and the shareholders' equity of a business.

Formula:
 Debt-to-Equity Ratio = Total Liabilities

Shareholders' Equity

Analysis:
Lower values of debt-to-equity ratio are favorable indicating less risk. Higher debt-to-equity ratio is
unfavorable because it means that the business relies more on external lenders thus it is at higher risk,
especially at higher interest rates. A debt-to-equity ratio of 1.00 means that half of the assets of a
business are financed by debts and half by shareholders' equity. A value higher than 1.00 means that
more assets are financed by debt that those financed by money of shareholders' and vice versa. An
increasing trend in of debt-to-equity ratio is also alarming because it means that the percentage of
assets of a business which are financed by the debts is increasing.

 Times interest earned (also called interest coverage ratio) is the ratio of earnings before
interest and tax (EBIT) of a business to its interest expense during a given period. It is a
solvency ratio measuring the ability of a business to pay off its debts.

Formula:

Times Interest Earned = Earnings before Interest and Tax

Interest Expense

Analysis:
Higher value of times interest earned ratio is favorable meaning greater ability of a business to repay
its interest and debt. Lower values are unfavorable. A ratio of 1.00 means that income before interest
and tax of the business is just enough to pay off its interest expense. That is why times interest earned
ratio is of special importance to creditors. They can compare the debt repayment ability of similar
companies using this ratio. Other things equal, a creditor should lend to a company with highest
times interest earned ratio. It is also beneficial to create a trend of times interest earned ratio.
Advantages and Limitations
Financial ratio analysis is a useful tool for users of financial statement. It has following advantages:
Advantages

 It simplifies the financial statements.

 It helps in comparing companies of different size with each other.
 It helps in trend analysis which involves comparing a single company over a period.
 It highlights important information in simple form quickly. A user can judge a company by
just looking at few numbers instead of reading the whole financial statements.

Limitations
Despite usefulness, financial ratio analysis has some disadvantages. Some key demerits of financial
ratio analysis are:

1. Different companies operate in different industries each having different environmental

conditions such as regulation, market structure, etc. Such factors are so significant that a
comparison of two companies from different industries might be misleading.
2. Financial accounting information is affected by estimates and assumptions. Accounting
standards allow different accounting policies, which impairs comparability and hence ratio
analysis is less useful in such situations.
3. Ratio analysis explains relationships between past information while users are more
concerned about current and future information.
4.

1. CAPITAL BUDGETING
The term capital budgeting is used to describe how managers plan significant cash outlays on
projects that have long-term implications, such as the purchase of new equipment and the
introduction of new products. This chapter describes several tools that can be used by managers to
help make these types of investment decisions.
Capital budgeting analysis can be used for any decision that involves an outlay now in order to obtain
some future return. Typical capital budgeting decisions include:
- Cost reduction decisions. Should new equipment be purchased to reduce costs?
- Expansion decisions. Should a new plant or warehouse be purchased to increase capacity and
sales?
- Equipment selection decisions. Which of several available machines should be purchased?
- Lease or buy decisions. Should new equipment be leased or purchased?
- Equipment replacement decisions. Should old equipment be replaced now or later?
Sunk Costs and Opportunity Costs
In capital budgeting analysis, sunk costs are costs which are already incurred and which need not be
reflected in the incremental cash flows used for estimation of net present value and internal rate of
return. Sunk costs are named so because they can’t be recovered.
Opportunity costs on the other hand are costs which do not necessarily involve any cash outflows but
which need to be considered because they reflect the foregone profit that could have been elsewhere.
Opportunity costs are named so because they reflect the lost opportunity to earn profit form
alternative use of the funds allocated to the project under consideration.
Capital budgeting decisions are based on current and future incremental cash flows and not any past
cash flows. Therefore, in calculating net initial investment outlay, analysts need to ignore the sunk
costs but include opportunity costs in their analysis.
Time Value of Money
The time value of money concept recognizes that a peso today is worth more than a peso a year from
now. Therefore, projects that promise earlier returns are preferable to those that promise later
returns.
The capital budgeting techniques that best recognize the time value of money are those that involve
discounted cash flows.
Net present value (NPV) of a project is the potential change in an investor's wealth caused by that
project while time value of money is being accounted for. The net present value method compares
the present value of a project’s cash inflows with the present value of its cash outflows. The
difference between these two streams of cash flows is called the net present value.
Net present value calculations take the following two inputs:

 Projected net cash flows in successive periods from the project.

 A target rate of return i.e. the hurdle rate.

Where,
Net cash flow equals total cash inflow during a period, including salvage value if any, less cash
outflows from the project during the period. Hurdle rate is the rate used to discount the net cash
inflows. Weighted average cost of capital (WACC) is the most commonly used hurdle rate.
The net present value is interpreted as follows:
If the net present value is positive, then the project is acceptable.
If the net present value is zero, then the project is acceptable.
If the net present value is negative, then the project is not acceptable.
The Internal Rate of Return (IRR) is the rate promised by an investment project over its useful life. It
is sometimes referred to as the yield on a project. The internal rate of return is the discount rate that
will result in a net present value of zero. The internal rate of return works very well if a project’s cash
flows are identical every year. If the cash flows are not identical every year, a trial-and-error process
can be used to find the internal rate of return. When using internal rate of return, the cost of capital
acts as a hurdle rate that a project must clear for acceptance.
The internal rate of return is interpreted as follows:
If the IRR is equal to or greater than the minimum required rate of return,
then the project is acceptable.
If the IRR is less than the required rate of return, then the project is
rejected.
A Profitability Index can be computed as the net present value of the project divided by the
investment required. The higher the profitability index, the more desirable the project. Profitability
index is actually a modification of the net present value method. While present value is an absolute
measure (i.e. it gives as the total peso figure for a project), the profitability index is a relative
measure (i.e. it gives as the figure as a ratio).
Other methods of making capital budgeting decisions
The Payback Method focuses on the payback period, which is the length of time that it takes for a
project to recoup its initial cost out of the cash receipts that it generates. When the annual net cash
inflow is the same every year, the formula for computing the payback period is the investment
required divided by the annual net cash inflow. When the cash flows associated with an investment
project change from year to year, the payback formula introduced earlier cannot be used. Instead, the
un-recovered investment must be tracked year by year. Accept the project only if its payback period
is less than the target payback period.

Advantages of payback period are:

1. Payback period is very simple to calculate.

2. It can be a measure of risk inherent in a project. Since cash flows that occur later in a
project's life are considered more uncertain, payback period provides an indication of how
certain the project cash inflows are.
3. For companies facing liquidity problems, it provides a good ranking of projects that would
return money early.

Disadvantages of payback period are:

1. Payback period does not take into account the time value of moneywhich is a serious
drawback since it can lead to wrong decisions. A variation of payback method that attempts
to remove this drawback is called discounted payback periodmethod.
2. It does not take into account, the cash flows that occur after the payback period.

The Accounting Rate of Return (ARR) Method (also known as the simple rate of return or the
unadjusted rate of return) does not focus on cash flows; rather it focuses on accounting net operating
income. It is the ratio of estimated accounting profit of a project to the average investment made in
the project. Accept the project only if its ARR is equal to or greater than the required accounting rate
of return. In case of mutually exclusive projects, accept the one with highest ARR.
Advantages of Accounting Rate of Return

1. Like payback period, this method of investment appraisal is easy to calculate.

2. It recognizes the profitability factor of investment.

Disadvantages of Accounting Rate of Return

1. It ignores time value of money. Suppose, if we use ARR to compare two projects having
equal initial investments. The project which has higher annual income in the latter years of its
useful life may rank higher than the one having higher annual income in the beginning years,
even if the present value of the income generated by the latter project is higher.
2. It can be calculated in different ways. Thus there is problem of consistency.
3. It uses accounting income rather than cash flow information. Thus it is not suitable for
projects which having high maintenance costs because their viability also depends upon
timely cash inflows.

Table Factor for Present Value of P1 = (1 + i) -n

Table Factor for Future Value of P1 = (1 + i) n
 1 − (1 + i)-n

Table Factor for Present Value of an Ordinary Annuity of P1=

(1 + i)n − 1

Table Factor for Future Value of an Ordinary Annuity of P1 =

1. COST OF CAPITAL
RISK AND RETURN
Generally, the higher the potential return of an investment, the higher the risk. There is no guarantee
that you will actually get a higher return by accepting more risk. The risk is the chance that an
investment's actual return will be different than expected. Risk means you have the possibility of
losing some, or even all, of your original investment. Returns are the gains or losses from a security
in a particular period and are usually quoted as a percentage. Low levels of uncertainty (low risk) are
associated with low potential returns. High levels of uncertainty (high risk) are associated with high
potential returns.

COST OF CAPITAL
The cost of capital is a term used in the field of financial investment to refer to the cost of a
company's funds (both debt and equity), or, from an investor's point of view "the shareholder's
required return on a portfolio of all the company's existing securities". It is used to evaluate new
projects of a company as it is the minimum return that investors expect for providing capital to the
company, thus setting a benchmark that a new project has to meet.
For an investment to be worthwhile, the expected return on capital must be greater than the cost of
capital. The cost of capital is the rate of return that capital could be expected to earn in an alternative
investment of equivalent risk. If a project is of similar risk to a company's average business activities
it is reasonable to use the company's average cost of capital as a basis for the evaluation. A
company's securities typically include both debt and equity; one must therefore calculate both the
cost of debt and the cost of equity to determine a company's cost of capital. However, a rate of return
larger than the cost of capital is usually required.
Cost of Debt
The cost of debt is relatively simple to calculate, as it is composed of the rate of interest paid. In
practice, the interest-rate paid by the company can be modeled as the risk-free rate plus a risk
component (risk premium), which itself incorporates a probable rate of default (and amount of
recovery given default). For companies with similar risk or credit ratings, the interest rate is largely
exogenous (not linked to the company's activities).
The cost of debt is computed by taking the rate on a risk free bond whose duration matches the term
structure of the corporate debt, then adding a default premium. This default premium will rise as the
amount of debt increases (since, all other things being equal, the risk rises as the amount of debt
rises). Since in most cases debt expense is a deductible expense, the cost of debt is computed as an
after tax cost to make it comparable with the cost of equity (earnings are after-tax as well). Thus, for
profitable firms, debt is discounted by the tax rate. The formula can be written as:
After-tax cost of debt = (Rf + credit risk rate) (1-T)
Where:
T is the corporate tax rate
Rf is the risk-free rate
The yield to maturity can be used as an approximation of the cost of capital. Yield to maturity (YTM)
is the annual return that a bond is expected to generate if it is held till its maturity given its coupon
rate, payment frequency and current market price.
Yield to maturity is essentially the internal rate of return of a bond i.e. the discount rate at which the
present value of a bond’s coupon payments and maturity value is equal to its current market price.
Yield to maturity can also be calculated using the following approximation formula:

YTM C + (F – P)/n
=

(F + P)/2

Where:
C is the annual coupon amount
F is the face value of the bond
P is the current bond price
n is the total number of years till maturity
After-tax cost of debt can be determined using the following formula:
After-Tax Cost of Debt = Pre-Tax Cost of Debt × (1 – Tax Rate)
The gross or pre-tax cost of debt equals yield to maturity of the debt. The applicable tax rate is the
marginal tax rate.
Cost of Equity
The cost of equity is more challenging to calculate as equity does not pay a set return to its investors.
Similar to the cost of debt, the cost of equity is broadly defined as the risk-weighted projected return
required by investors, where the return is largely unknown. The cost of equity is therefore inferred by
comparing the investment to other investments (comparable) with similar risk profiles to determine
the "market" cost of equity. It is commonly equated using the Capital Asset Pricing Model (CAPM)
formula.
Cost of equity = Risk free rate of return + Premium expected for risk
Cost of equity = Risk free rate of return + Beta x (market rate of return- risk free
rate of return)
Es = Rf + βs (RM-Rf)
Where:
Es - The expected return for a security
Rf - The expected risk-free return in that market (government bond yield)
βs - The sensitivity to market risk for the security
RM - The historical return of the stock market/ equity market
(RM-Rf) - The risk premium of market assets over risk free assets.
The risk-free rate is taken from the lowest yielding bonds in the particular market, such as
government bonds
The Capital Asset Pricing Model (CAPM) describes the relationship between systematic risk and
expected return for assets, particularly stocks. CAPM is widely used throughout finance for pricing
risky securities and generating expected returns for assets given the risk of those assets and cost of
capital. The goal of the CAPM formula is to evaluate whether a stock is fairly valued when its risk
and the time value of money are compared to its expected return.
Once cost of debt and cost of equity have been determined, their blend, the weighted-average cost of
capital (WACC), can be calculated. This WACC can then be used as a discount rate for a project's
projected cash flows.

Cost of Retained Earnings/Cost of Internal Equity

Note that retained earnings are a component of equity, and therefore the cost of retained earnings
(internal equity) is equal to the cost of equity as explained above. Dividends (earnings that are paid to
investors and not retained) are a component of the return on capital to equity holders, and influence
the cost of capital through that mechanism.
Expected Return
The expected return (or required rate of return for investors) can be calculated with the "dividend
capitalization model", which is

Kcs= DividendPayment/Share + GrowthRate

PriceMarket

Weighted Average Cost of Capital

The weighted average cost of capital (WACC) is the rate that a company is expected to pay on
average to all its security holders to finance its assets. The WACC is the minimum return that a
company must earn on an existing asset base to satisfy its creditors, owners, and other providers of
capital, or they will invest elsewhere. Companies raise money from a number of sources: common
equity, preferred equity, straight debt, convertible debt, exchangeable debt, warrants, options,
pension liabilities, executive stock options, governmental subsidies, and so on. Different securities,
which represent different sources of finance, are expected to generate different returns. The WACC
is calculated taking into account the relative weights of each component of the capital structure. The
more complex the company's capital structure, the more laborious it is to calculate the WACC.
Companies can use WACC to see if the investment projects available to them are worthwhile to
undertake.
The Weighted Average Cost of Capital (WACC) is used in finance to measure a firm's cost of
capital. The total capital for a firm is the value of its equity (for a firm without outstanding warrants
and options, this is the same as the company's market capitalization) plus the cost of its debt (the cost
of debt should be continually updated as the cost of debt changes as a result of interest rate changes).
Notice that the "equity" in the debt to equity ratio is the market value of all equity, not the
shareholders' equity on the balance sheet. To calculate the firm’s weighted cost of capital, we must
first calculate the costs of the individual financing sources: Cost of Debt, Cost of Preference Capital
and Cost of Equity Capital. Calculation of WACC is an iterative procedure which requires estimation
of the fair market value of equity capital.

A calculation of a firm's cost of capital in which each category of capital is proportionately weighted.
All capital sources - common stock, preferred stock, bonds and any other long-term debt - are
included in a WACC calculation. All else equal, the WACC of a firm increases as the beta and rate of
return on equity increases, as an increase in WACC notes a decrease in valuation and a higher risk.
The WACC equation is the cost of each capital component multiplied by its proportional weight and
then summing:

WACC E x Re + D x Rd x (1 - Tax)
=

T T

Where:
Re - cost of equity
Rd - cost of debt
E - market value of the firm's equity
D - market value of the firm's debt
T-E+D
E/T - percentage of financing that is equity
D/T - percentage of financing that is debt
Tax - corporate tax rate
Capital Structure
Because of tax advantages on debt issuance, it will be cheaper to issue debt rather than new equity
(this is only true for profitable firms, tax breaks are available only to profitable firms). At some point,
however, the cost of issuing new debt will be greater than the cost of issuing new equity. This is
because adding debt increases the default risk - and thus the interest rate that the company must pay
in order to borrow money. By utilizing too much debt in its capital structure, this increased default
risk can also drive up the costs for other sources (such as retained earnings and preferred stock) as
well. Management must identify the "optimal mix" of financing – the capital structure where the cost
of capital is minimized so that the firm's value can be maximized.

Illustrative Problem:
The Company went public by issuing 1,000,000 shares of common stock at P25 per share. The shares
are currently trading at P30 per share. Current risk-free rate is 4%, market risk premium is 8% and
the company has a beta coefficient of 1.2.
During last year, it issued 50,000 bonds of P1,000 par paying 10% coupon annually maturing in 20
years. The bonds are currently trading at P950. The tax rate is 30%.
Required:

1. Calculate the proportion of equity and debt in capital structure.

2. Calculate the cost of equity
3. Calculate the after-tax cost of debt
4. Calculate the weighted average cost of capital

Solution:

1. Calculating Capital Structure Weights

Current Market Value of Equity

= 1,000,000 × P30
= P30,000,000
Current Market Value of Debt
= 50,000 × P950
= P47,500,000
Total Market Value of Debt and Equity
= P30,000,000 + P47,500,000
= P77,500,000
Weight of Equity
= P30,000,000 ÷ P77,500,000
= 38.71%
Weight of Debt
= P47,500,000 ÷ P77,500,000 (or 100% − 38.71%)
= 61.29%

1. Use either the dividend discount model (DDM) or capital asset pricing model (CAPM). In the
current example, the data available allow us to use only CAPM to calculate cost of equity.

Cost of Equity
= 4% + (1.2 × 8%)
= 13.6%

1.

YTM 100 + (1,000 – 950)/20

=

(1,000 + 950)/2

= 10.51%
After-tax cost of debt = 10.51% × (1 − 30%)
= 7.36%

1. Calculating WACC
WACC = (38.71% × 13.6%) + (61.29% × 7.36%)
= 5.26% + 4.51%
= 9.77%