Degree 04 Financial Management - Commonwealth of Learning

FINANCIAL MANAGEMENT

Financial Management Dr. Gaofetoge Ntshadi Ganamotse Adeelah Tariq Rapelang D.Sekatle Commonwealth of Learning Edition 1.0. ____________________

Commonwealth of Learning© 2013 Any part of this document may be reproduced without permission but with attribution to the Commonwealth of Learning using the CC‐BY‐SA (share alike with attribution). http://creativecommons.org/licenses/by‐sa/4.0

Commonwealth of Learning 4710 Kingsway, Suite 2500 Burnaby, British Columbia

Canada V5H 4M2 Telephone: +1 604 775 8200

Fax: +1 604 775 8210 Web: www.col.org

E‐mail: [email protected]

ACKNOWLEDGEMENTS

These training materials have drawn so much from the available literature. The

commonwealth of learning extends its gratitude to the many authors who have made their

materials available through online or print publication. Many thanks to Mr. Sekatle, who has

initiated the writing of these materials.

Financial Management Page | i

TABLE OF CONTENTS

Table of Contents ........................................................................................................................................... i

COURSE OVERVIEW....................................................................................................................................... 1

Course Introduction .................................................................................................................................. 1

Course Goals ............................................................................................................................................. 1

Course Description .................................................................................................................................... 2

Required Readings .................................................................................................................................... 4

Assignments and Projects ......................................................................................................................... 5

Assessment Methods ................................................................................................................................ 5

Course Schedule ........................................................................................................................................ 5

STUDENT SUPPORT ....................................................................................................................................... 6

Academic Support ..................................................................................................................................... 6

How to Submit Assignments ..................................................................................................................... 6

Technical Support ..................................................................................................................................... 6

UNIT ONE ‐ INTRODUCTION TO FINANCIAL MANAGEMENT ........................................................................ 7

Unit 1 Introduction ................................................................................................................................... 7

Unit 1 Objectives ....................................................................................................................................... 7

Unit 1 Readings ......................................................................................................................................... 7

Unit 1 Assignments and Activities ............................................................................................................. 7

Topic 1.1 Finance and Forms of Business ................................................................................................. 8

Topic 1.1 Introduction ........................................................................................................................... 8

Topic 1.1 Objectives .............................................................................................................................. 8

Finance .................................................................................................................................................. 8

FORMS OF BUSINESS OWNERSHIP ....................................................................................................... 9

Topic 1.1 Summary ............................................................................................................................. 12

Topic 1.2 CONCEPTS and Principles of Financial Management .............................................................. 13

Topic 1.2 Introduction ......................................................................................................................... 13

Topic 1.2 Objectives ............................................................................................................................ 13

Financial management ........................................................................................................................ 13

The Finance Function and its Organization ......................................................................................... 14

Financial Management and Economics .............................................................................................. 15

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Financial Management and Accounting ............................................................................................. 15

Role of the Financial Manager ............................................................................................................ 16

Topic Summary ................................................................................................................................... 18

Unit 1 References ................................................................................................................................ 19

Unit 1 – Summary ................................................................................................................................... 20

Assignments and Activities ................................................................................................................. 20

Summary ............................................................................................................................................. 20

Next Steps ........................................................................................................................................... 20

UNIT Two ‐ FINANCIAL INSTITUTIONS AND MARKETS ................................................................................ 21

Unit 2 Introduction ................................................................................................................................. 21

Unit 2 Objectives ..................................................................................................................................... 21

Unit 2 Readings ....................................................................................................................................... 21

Unit 2 Assignments and Activities ........................................................................................................... 21

Topic 2.1 Financial Institutions ............................................................................................................... 22

Introduction ........................................................................................................................................ 22

Objectives............................................................................................................................................ 22

Major Customers of Financial Institutions .......................................................................................... 22

Commercial Banks ............................................................................................................................... 23

Mutual Funds ...................................................................................................................................... 26

Securities Firms ................................................................................................................................... 27

Insurance Companies .......................................................................................................................... 27

Pension Funds ..................................................................................................................................... 28

Savings institutions ............................................................................................................................. 28

Finance companies.............................................................................................................................. 29

Comparison of the Key Financial Institutions ..................................................................................... 29

Consolidation of Financial Institutions ................................................................................................ 30

Globalization of Financial Institutions ................................................................................................. 30

Topic Summary ................................................................................................................................... 31

Topic 2.2 FINANCIAL Markets ................................................................................................................. 32



Types of Markets ................................................................................................................................. 32

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Types of Market Securities.................................................................................................................. 35

Topic Summary ................................................................................................................................... 45

Unit 2 – References ............................................................................................................................. 47

Unit 2 – Summary ................................................................................................................................... 47


Summary ............................................................................................................................................. 47

Next Steps ........................................................................................................................................... 47

UNIT THREE ‐ FINANCIAL STATEMENTS ...................................................................................................... 48


Unit 3 Objectives ..................................................................................................................................... 48

Unit 3 Readings ....................................................................................................................................... 48


Topic 3.1 STATEMENTS of Comprehensive Income and Financial Position ............................................ 50



Components of the Statement Comprehensive Income .................................................................... 50

Two Statements .................................................................................................................................. 50

Components of the Statement of Financial Position (Balance sheet) ................................................ 57

Topic 3.2 Analysis of the Financial Statements ....................................................................................... 62



Introduction to Ratio Analysis ............................................................................................................. 62

Liquidity Measures .............................................................................................................................. 64

Profitability Measures ......................................................................................................................... 66

Efficiency Ratios .................................................................................................................................. 68

Investment Ratios ............................................................................................................................... 71

TOPIC SUMMARY ................................................................................................................................ 72

Topic 3.3 Statement of Cash Flows ......................................................................................................... 75

Topic 3.3 Introduction ........................................................................................................................ 75


Cash flows ........................................................................................................................................... 75

Presentation of the cash flow statement (ias 7) ................................................................................. 76

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Analyzing the Cash Flow of a Business ................................................................................................ 80

Unit 3 References ................................................................................................................................ 83

Unit 3 ‐ Summary .................................................................................................................................... 85


Summary ............................................................................................................................................. 85

Next Steps ........................................................................................................................................... 85

UNIT FOUR ‐ FINANCIAL PLANNING ............................................................................................................ 86


Unit 4 Objectives ..................................................................................................................................... 86

Unit 4 Readings ....................................................................................................................................... 86


Topic 4.1 – Introduction to Financial Planning ....................................................................................... 87

Topic 4.1 Introduction ........................................................................................................................ 87


Strategic Financial Plans ...................................................................................................................... 87

Operating Financial Plans .................................................................................................................... 87

Summary ............................................................................................................................................. 88

Topic 4.2 ‐ Cash Budgets for Cash Planning ............................................................................................ 89



What is a Cash Budget ........................................................................................................................ 89

The Sales Forecast ............................................................................................................................... 89

Preparing the Cash Budget ................................................................................................................. 90

Cash Receipts ...................................................................................................................................... 91

Cash Disbursements ............................................................................................................................ 93

Net Cash Flow, Ending Cash, Financing and Excess Cash .................................................................... 94

Evaluating the Cash Budget ................................................................................................................ 95

Managing the Uncertainty in the Cash Budget ................................................................................... 95

Summary ............................................................................................................................................. 96

Topic 4.3 Pro Forma Financial Statements: A Tool For Profit Planning .................................................. 97



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Pro Forma Financial Statements ......................................................................................................... 97

Preceding Year’s Financial Statements ............................................................................................... 97

Sales Forecast ...................................................................................................................................... 99

Preparing the Pro Forma Statements ................................................................................................. 99

Pro forma Income Statement ............................................................................................................. 99

Types of Costs and expense Consideration ...................................................................................... 100

Pro Forma Balance Sheet .................................................................................................................. 100

Evaluating the Pro Forma Statements .............................................................................................. 103

Topic 4. Summary ............................................................................................................................. 103

Unit 4 – References ........................................................................................................................... 104

Unit 4 – Summary ................................................................................................................................. 104

Assignments and Activities ............................................................................................................... 104

Summary ........................................................................................................................................... 105

Next Steps ......................................................................................................................................... 106

UNIT FIVE ‐ SHORT TERM FUNDS MANAGEMENT .................................................................................... 107

Unit 5 Introduction ............................................................................................................................... 107

Unit 5 Objectives ................................................................................................................................... 107

Unit 5 Readings ..................................................................................................................................... 107

Unit 5 Assignments and Activities ......................................................................................................... 107

Topic 5.1 – Working Capital Management ........................................................................................... 108

Topic 5.1 Introduction ....................................................................................................................... 108

Topic 5.1 Objectives ......................................................................................................................... 108

Working Capital and Net Working Capital ........................................................................................ 108

The Goals of Working Capital Management ..................................................................................... 109

Cash and motives for holding cash ................................................................................................... 109

Reasons for Holding Cash Balances .................................................................................................. 109

Cash Flow Cycle ................................................................................................................................. 110

The cash conversion cycle ................................................................................................................. 110

Cash conversion cycle’s funding requirements ................................................................................ 111

Permanent versus seasonal funding needs ...................................................................................... 111

Aggressive versus conservative funding strategy ............................................................................. 112

Topic 5.1 Summary ........................................................................................................................... 112

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Topic 5.2 – Inventory Management ...................................................................................................... 114


Topic 5.2 Objectives .......................................................................................................................... 114

Inventory: An overview ..................................................................................................................... 114

Level versus Seasonal Production ..................................................................................................... 114

ABC inventory system ....................................................................................................................... 115

Economic Ordering Quantity ............................................................................................................ 115

Carrying Costs ................................................................................................................................... 115

Deriving Economic Ordering Quantity Formula ................................................................................ 117

Total costs for inventory ................................................................................................................... 118

Safety Stock and Stock outs .............................................................................................................. 119

Just‐in‐Time (JIT) Inventory Management ........................................................................................ 119

Topic 5.2 Summary ........................................................................................................................... 120

Topic 5.3 – Current Liabilities Management ......................................................................................... 121


Topic 5.3 Objectives .......................................................................................................................... 121

Accounts Payable Management ....................................................................................................... 121

Role of Accounts payable in cash conversion cycle .......................................................................... 121

Credit terms ...................................................................................................................................... 122

Effects of stretching accounts payable ............................................................................................. 125

.......................................................................................................................................................... 125

Accruals ............................................................................................................................................. 125

Sources of Un secured short term financing: ................................................................................... 125

Commercial Bank loans ..................................................................................................................... 126

Loan Interest Rates ........................................................................................................................... 126

Fixed rate and floating rate ............................................................................................................... 126

Computing interest ........................................................................................................................... 126

The single payment notes ................................................................................................................. 127

Lines of credit .................................................................................................................................... 128

Interest rate: ..................................................................................................................................... 129

Operating change restrictions........................................................................................................... 129

Compensating balances .................................................................................................................... 129

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Annual cleanups ................................................................................................................................ 130

Revolving credit agreement .............................................................................................................. 130

Commercial paper ............................................................................................................................. 131

Interest rate on commercial paper ................................................................................................... 131

Secured short term financing............................................................................................................ 132

Characteristics of secured short term financing ............................................................................... 132

Collateral and terms .......................................................................................................................... 132

Accounts receivable as collateral ...................................................................................................... 133

Pledging accounts receivable ............................................................................................................ 133

Factoring accounts receivable .......................................................................................................... 134

Inventory as collateral....................................................................................................................... 135

Floating inventory liens ..................................................................................................................... 135

Trust receipt inventory loans ............................................................................................................ 135

Warehouse receipt loans .................................................................................................................. 136

Topic Summary ................................................................................................................................. 136

Unit 5 – References ........................................................................................................................... 137

Unit 5 – Summary ................................................................................................................................. 137

Assignments and Activities ............................................................................................................... 137

Summary ........................................................................................................................................... 138

FINAL ASSIGNMENT/MAJOR PROJECT ...................................................................................................... 139

COURSE SUMMARY ................................................................................................................................... 140

Topics Learned ...................................................................................................................................... 140

Application of Knowledge and Skill ....................................................................................................... 143

Course Evaluation ................................................................................................................................. 144

COURSE APPENDICES ................................................................................................................................ 145

Appendix 1 – Solution to topic 3.2 (Financial Analysis) .................................................................. 146

Appendix 2: Unit Four Assignment’s Solution ................................................................................. 149

Financial Management Page | 1

COURSE OVERVIEW

COURSE INTRODUCTION

Financial management is an introductory course which provides the applied and realistic

view of financial management for today’s’ entrepreneurs. It is the basis of fundamental

concepts of business finance, investment and an understanding of financial calculations. It

sets a ground understanding of the elements of Financial Management in an Enterprise by

describing the corporation and its operating environment. The contents of this course

provide the understanding, knowledge and essential skills; any manager should have when

considering proposing project and assessing its financial viability and impact on the

business.

The course integrates elements of financial accounting and financial management. The

financial accounting focuses on key financial statements such as Income Statements,

Balance Sheets, and Cash Flow Statements, and their roles in the measurement of

performance through the use of financial and non‐financial measures. Whereas, the

financial Management focuses on decision making associated with designing, implementing

and managing an enterprise. This course will help entrepreneurs to support accounting, risk

management, improve operational planning, controls and decision making. Entrepreneurs

will be able in order to impede the misuse of funds, maximize the profit and wealth of the

business in Long Run. In addition to this, the course along with other courses, e.g., business

plan development, operations management etc, in program provides the basis for further

studies related to finance which are important to most managerial people.

This course assumes that the students have prior accounting knowledge as it is designed to

build on the introduction to business accounting, business planning and management

accounting courses. However, the course can also be taken by those who have basic

practical accounting knowledge.

COURSE GOALS

Upon completion of the financial management course you will be able to:

Page | 2 Financial Management

1. Understand the nature of finance management and the theoretical and conceptual

underpinning of the frameworks for the financial management

2. Identify the nature, characteristics and use of financial statements as financial reporting

system

3. Distinguish between financial and non‐financial performance measurement.

4. Use the relevant costs for decision making, particularly pricing.

5. Highlight the issues in the determination of the cost of products or services and activities

and the implications for cost control and pricing.

6. Analyze the relationships between activity cost, volumes and profit, and their role for

planning and decision making

7. Make important financing and investment decisions by establishing working capital

policies

8. Recognize the impact of management decisions on the financial health of a business

9. Employ effective financial management techniques to maximize profit and wealth of the

business.

10. Understand the financial planning process, including strategic and short‐term financial

plans.

COURSE DESCRIPTION

To meet the above course objectives, the course is divided into 5 units. A general overview

of financial management is introduced in Unit 1. Financial institutions and markets are

covered in unit 2. The different types of financial statements are examined in unit 3, Unit 4

covers the different areas of financial planning whilst unit 5 covers financial decision

making. The valuation and capital budgeting issues are covered in unit 6. Each of the units is

further subdivided into topics, see the list below. Assessment of learning is provided at the

end of each topic and a summative assessment of each unit if given at the end of each unit:


Unit 1: Introduction to Financial Management

Topic 1.1: Finance and Forms of Business

Topic 1.2: Concepts and Principles of Management

Unit 2 Financial Markets and Institutions

Topic 2.1: Financial Institutions

Topic 2.2: Financial Markets

Unit 3 Financial Statements

Topic 3.1: Statements of Comprehensive Income and Financial Position

Topic 3.2: Analysis of the Financial Statements

Topic 3.3: Statement of Cash flows

Unit 4: Financial Planning

Topic 4.1: Introduction to Financial Planning

Topic 4.2 Cash Budgets for Cash Planning

Topic 4.3 Pro‐forma Financial Statements: A tool for Profit Planning

Unit 5: Financial Decision Making

Topic 5.1: Working Capital Management

Topic 5.2: Inventory Management

Topic 5.3: Current Liabilities Management


REQUIRED READINGS

Materials relating to financial Management can be found on the web, as well as in the

Library:

1. Geoffrey, A. Hirt, Bartley R. Danielsen Stanley B. Block (2009) Foundations of Financial

Management. McGraw Hill. ISBN: 0073363774 / 0‐07‐336377‐4

2. Brigham F. Eugene and Houston F. Joel (2012) Fundamentals of Financial management.

South‐ Western, Cengage Learning, Ohio IBN 13: 978‐0‐538‐47712‐3

3. Chandra Prassana (2010) Fundamentals of Financial Management. Tata McGraw Hill.

New Delhi in

http://books.google.co.uk/books?id=osy4UMOgpG4C&printsec=frontcover&dq=fUNDAME

NTALS+OF+FINANCIAL+MANAGEMENT,&hl=en&sa=X&ei=yJN_UZnaBMX5PLrDgdAD&sqi=2

&ved=0CFIQ6AEwAw accessed 24/04/13

4. Firer, C.; Ross, S.; Westerfield, R. and Jordan, B. (2004). Fundamentals of

Corporate Finance. McGraw Hill, New York.

5. International Accounting Standards Board (2009) Presentation of Financial

statements in http://www.iasplus.com/en/standards/standard5 accessed 23rd April

2013

6. International Accounting Standards Board (2009) International Financial Reporting

Standard for Small and Medium-sized Entities (IFRS for SMEs) in

http://eifrs.iasb.org/eifrs/sme/en/IFRSforSMEs2009.pdf accessed 25/04/2013

7. Subramanyam, K.R. and Wild John. J (2009) Financial Statement analysis, 10TH Edition

McGraw‐Hill Irwin, New York. –in http://highered.mcgraw‐

hill.com/sites/dl/free/0073379433/597452/Subramanyam_fsa_sample_Ch01.pdf accessed

23/04/2013

8. Stolowy, H. And Lebas, Michel J. (2002) Corporate Financial Reporting – A Global

Perspective. Thomson Learning. London.

9. Dyson, John R. (2010) Accounting for non accounting Students. Pearson Education

Limited. Harlow. In http://web.kku.ac.th/chrira/Non%20Acct.%20Dyson.pdf accessed

26/04/2013

10. Gitman, Lawrence J. And Chad J. Zutter (2012) Principles of managerial finance, 13th Ed.

P. cm. The Prentice Hall


11. Lorenzo P, Argentina and Allende, Sarria (2010) Working Capital Management, Oxford

University press Inc.

12. Brealey, R.A; Myers, S.C; Allen, F. (2006) Principles of corporate finance, 6th Ed.

dandelon.com

13. Gitman, Lawrence J. (2002) Principles of managerial finance, 10th Ed. P. cm. The

Prentice Hall

14. Sagner, James (2011), Essentials of Working Capital Management, John Wiley and sons.

Inc

15. Gitman, Lawrence J. Web Chapter Financial Markets and Institutions available at

http://wps.aw.com/wps/media/objects/5448/5579249/FinancialMarketsandInstitutions.pd

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ASSIGNMENTS AND PROJECTS

Assessment of learning for this course will be done through end of topic activities, end of

unit activities and one major end of course assignment. The end of topic activity is designed

to reinforce the students learning at the end of the topic whilst the end of unit tests the

attainment of the course objective in relation to a specific unit. The end of course

assessment requires the student to consolidate all the knowledge and skills acquired from

the course. This will be developed by the respective institutions.

ASSESSMENT METHODS

The end of topic and end of unit assessments could be used for seminar activities by your

institution. For the course assessment, participating universities could provide their

students with financial statements from companies for students to work with and advise

management for these companies accordingly. This could either be a group project or

individual project depending on the assessment structure of the participating universities.

An end of year examination could also be given to the students.

COURSE SCHEDULE

This course is designed to be completed within 12 to 16 weeks of the final year of a degree

in entrepreneurship programme.


STUDENT SUPPORT

ACADEMIC SUPPORT

The course assumes that the participating institutions would have within their structures,

some means of supporting student learning. The module assumes that besides the normal

lectures, student learning will be facilitated through use of seminars, designed to accord

the students’ time to work through the activities either as a group or as individuals. Also, it

is assumed that personal tutorials will be arranged to give students a chance to reinforce

their learning through a one to one intervention as needed by students.

The student handbook, developed by the respective institutions, will provide information

with regards to access of resources, e.g. library, lecturer and/or facilitators.

HOW TO SUBMIT ASSIGNMENTS

Submission of assignments is to be in line with the policies and guidelines of the respective

participating institutions. These should be included in the course handbook, to facilitate

motivation of student learning.

TECHNICAL SUPPORT

Where appropriate, the participating institutions should avail the course lecture slides in

online sites such as blackboard or Moodle. Such information to be provided in the course

handbook.


UNIT ONE ‐ INTRODUCTION TO FINANCIAL MANAGEMENT

UNIT 1 INTRODUCTION

The unit provides a general overview of the concept of financial management. The students

are introduced to financial management, the concepts and principles used within the scope

of the subject. The important concepts are defined.

UNIT 1 OBJECTIVES

Upon completion of this unit, the students will be able to:

1. Differentiate between different forms of businesses and explain the finance implications

for each.

2. Explain the concepts and principles of financial management

UNIT 1 READINGS

To complete this unit, you are required to read the following chapters:

1. Geoffrey, A. Hirt, Bartley R. Danielsen Stanley B. Block (2009)

2. Brigham, F. Eugene and Houston, F. Joel (2012) ‐ Chapter 1

3. Chandra Prassana (2010) Chapter 1

UNIT 1 ASSIGNMENTS AND ACTIVITIES

While crude end of topic assessment id provided in this course to assess student learning.

The end of the participating universities will develop end of unit assessment is to be

designed by the participating institutions.


TOPIC 1.1 FINANCE AND FORMS OF BUSINESS

TOPIC 1.1 INTRODUCTION

When deciding on which form of ownership to go for, entrepreneurs look for different

considerations, such as suitability, legality and tax implications. There are three main forms

of; sole proprietorship, partnership and the company; however there is an extension to the

company which is the close corporation. Each of these has advantages and disadvantages.

The most influencing factor to decisions of ownership is the country’s respective company

law/laws of incorporation. The nature of the business and the founding structure of the

business calls for careful management of the finances to lead to the achievement of the

aspirations of the owners, which is growth. Efficient management of finance entails,

acquiring and investing the financial resources of an organisation profitably. This topic

introduces financial management by explaining the forms of businesses and implications for

finance and the concepts and principles of financial management

TOPIC 1.1 OBJECTIVES

Upon completion of this Topic you will be able to:

1. Explain the nature of finance

2. To explain the forms of businesses and finance implications

FINANCE

Finance is known as the art and science of managing money finance is broad and dynamic

field and it directly affects the lives of every person and every organization. Every individual

and organization earns or raises money and spends or invests money. Finance is concerned

with the process, institutions, markets, and instruments involved in the transfer of money

among individuals, businesses, and governments. Basic principles of finance, such as those

in this course, can be universally applied in business organizations of different types.


FORMS OF BUSINESS OWNERSHIP

There are three most common legal forms of business organization, the sole proprietorship,

the partnership and the corporation. However some other specialized forms of business

also exist. Among the business organizations, the large number of businesses are sole

proprietorships. However, corporations are significantly dominant with respect to receipts

and net profits.

SOLE PROPRIETORSHIP

A sole proprietorship is a business founded and owned by one person. It is the simplest

form of business to start and enjoys less government regulation. In real life there are more

sole proprietorships than any other type of business businesses that later become large

corporations start out as small sole proprietorships.

The advantages are the owner of a sole proprietorship keeps all the profits, there is only

one person to make decision hence quickening the decision making process, there is also no

conflict on decisions made. Flexibility is enhanced and there is total responsibility and

ownership of tasks to be carried out. Above all the owner takes all the profits. However

disadvantages are; the owner has unlimited liability for business debt, meaning that

creditors can look to the proprietor’s personal assets for payment. Because there is no

distinction between personal and business income, all business income is taxed as personal

income, there is no sharing of ideas on decision making which might lead to less efficient

solutions. The owner might be overloaded and overworked because he has no one to help.

The life of a sole proprietorship is limited to the owner’s life span and therefore has no

continuity; above all the amount of capital can be raised by a sole is minimal to the extent

of his savings. This limits the business from exploiting new opportunities. Ownership of a

sole proprietorship may be difficult to transfer since this requires the sale of the entire

business to a new owner, (Firer et al., 2004)

PARTNERSHIP

A partnership is a kind of a business whereby two or more owners join together as partners

to co‐own the business. The partners share in gains or losses and contribute capital, and are

responsible for achieving the goals of the organisation. We will have to understand that for

partnership to start, there are certain arrangements and agreements entered into, such as,


all partners might be liable for the debts of an organisation (have unlimited liability for all

partnership debt) this happens in a general partnership1

Because partners do things together, in should be tabulated in their partnership agreement

as to how they contribute as well and their profit/loss sharing ratios. The agreement might

be informal oral agreement, however it is advisable that it be formalised in pen and paper

for ease of conflict resolution. In a limited partnership, one or more partners will be

involved actively in running the business, thereby having unlimited liability, while some of

the partners will not participate in the running of the business (sleeping partners). A limited

partner’s liability for business debts is limited to the amount that partner contributes to the

partnership.

The advantages of a partnership are that; it is easy to form and inexpensive, the same as a

sole proprietorship. The capital contributed can be quite substantial as compared to a sole

trader; there could be a wide array of ideas in decision making and work may be shared

among active partners. However a partnership also has its disadvantages; its lifespan is

limited, because when a partner dies the partnership has to be dissolved. Transfer of

ownership by a general partner is not easy because the partnership has to be dissolved and

new one must be formed. Because partners act for and on behalf of the partnership,

decisions taken by partners render other partners liable.

Starting a partnership means people intend to work together for a common good, it goes

without saying that some will be charged with certain responsibilities for and on behalf of

other partnership, for it to be successful, it should be based upon trust and honesty. A

written agreement is very important especially if it spells out clearly the rights and duties of

the partners; it helps solve misunderstandings later on. Firer et al. (2004) argue that the

primary disadvantages of sole proprietorships and partnerships as forms of business

organization are (1) unlimited liability for business debts on the part of the owners, (2)

limited life of the business, and (3) difficulty of transferring ownership. These three

disadvantages add up to a single, central problem: The ability of such businesses to grow

can be seriously limited by an inability to raise cash for investment.

1 http://www.myownbusiness.org/s4/


CORPORATION

The corporation is the most important form (in terms of size) of business organization in

most countries. It is considered a legal “person” separate and distinct from its owners, and

it has many of the rights, duties, and privileges of an actual person. Corporations can

borrow money and own property, can sue and be sued, and can enter into contracts. A

corporation can even be a general partner or a limited partner in a partnership, and a

corporation can own stock in another corporation (Firer et al, 2004).

Starting a corporation is by far strenuous, lengthy and more complicated than starting the

other forms of business organization, this is because it requires the preparation of the

memorandum of association as well the articles of incorporation, which are quite

comprehensive documents. According to the Company Laws of various countries the

articles of incorporation must contain a number of things, including the corporation’s

name, its intended life (which can be forever), its business purpose, and the number of

shares that can be issued2.

The bylaws are rules describing how the corporation regulates its own existence. For

example, the bylaws describe how directors are elected. The bylaws may be amended or

extended from time to time by the stockholders. In a large corporation, the stockholders

and the managers are usually separate groups. The stockholders elect the board of

directors, who then select the managers. Management is charged with running the

corporation’s affairs in the stockholders’ interests. In principle, stockholders control the

corporation because they elect the directors. As a result of the separation of ownership and

management, the corporate form has several advantages. Ownership (represented by

shares of stock) can be readily transferred, and the life of the corporation is therefore not

limited. The corporation borrows money in its own name. As a result, the stockholders in a

corporation have limited liability for corporate debts. The most they can lose is what they

have invested. The relative ease of transferring ownership, the limited liability for business

debts, and the unlimited life of the business are the reasons why the corporate form is

superior when it comes to raising cash. If a corporation needs new equity, it can sell new

shares of stock and attract new investors. The number of owners can be huge; larger

corporations have many thousands or even millions of stockholders.

2 http://highered.mcgraw‐hill.com/sites/dl/free/0072946733/301389/Ross_Sample_ch01.pdf


TOPIC 1.1 SUMMARY

This topic has highlighted the importance of financial management for the various forms of

business. Whilst financial management is deemed important for all forms of companies,

there are differences in the requirements for financial management depending on the type

of ownership of the business.

Self‐Reflection Question

How is the finance function organised in the different forms of companies?


TOPIC 1.2 CONCEPTS AND PRINCIPLES OF FINANCIAL MANAGEMENT


Managers, be they of a for‐profit or not‐for‐profit companies or those managing large or

small firms, constantly have to make finance related decisions. The main aim of such

decisions is to generate value to the owners of the business through the operations of the

company. People who are responsible for such role in a company are said to be performing

a financial management role. This topic introduces the students to the concept of financial

management. The main focus of financial management, the role of the finance manager

and the decisions facing those charged with the financial management responsibilities are

articulated.


At the end of the topic, the learners will be able to:

1. Define financial management

2. Explain the nature of the finance function

3. Explain the role of a financial manager in an organisation

FINANCIAL MANAGEMENT

Financial management is concerned with decisions on assets acquisition, generation of the

required capital to acquire the necessary assets as well as decisions on how to maximize.

Shareholders/owners value through the operations of the firm. As such, financial managers

have to think about answering these basic questions;

1. What long term investments should we take on? The kind of buildings, materials,

machinery and equipment needed.

2. Where will the long term finances to pay for the investments are acquired from? This

will involve as to whether the entrepreneur will rely on savings from the profits made,

borrow from external sources or engage in more owners to contribute the capital.


3. How do we intend to manage the day to day financial activities? Such as collecting from

customers and paying suppliers, as well as making any disbursements concerning the

business.

Assuming the manager is the entrepreneur, these are not the only questions that s/he will

have to answer; they may not be exhaustive, however these are some of the most

important. Financial management therefore deals with a wide range of issues as such;

simply put; the acquisition of funds into the business and how to invest those funds in the

best possible manner to ensure organizational growth as well increasing the owners,

wealth. In this case we can believe in an organisation someone charged with these

responsibility is fit to be called the “Financial Manager”, let us now look at what the

Financial Manager is.

THE FINANCE FUNCTION AND ITS ORGANIZATION

People in different areas of responsibility within the business interact with finance

personnel and procedures to get their jobs done. In order to make useful forecasts and

effective decisions, financial personnel must be willing and able to talk to individuals in

other areas of the firm. Financial management function can be broadly described by taking

into consideration its role within the organization, its relationship to economics and

accounting, and the primary activities of the financial manager.

The size and importance of the financial management function depend on the size of the

firm. Financial management can be performed by the accounting department in small firms.

Whereas, a separate finance department linked directly to the company president or CEO

through the chief financial officer (CFO) is required in medium to large firms. The lower

portion of the organizational chart in Figure 1.1 represents the structure of the finance

function in a usual medium‐to‐large‐size firm.

The treasurer focus tends to be more external and is commonly responsible for handling

financial activities, such as financial planning and fund raising, making capital expenditure

decisions, managing cash, managing credit activities, managing the pension fund, and

managing foreign exchange. The controller focus more internal and typically handles the


accounting activities, such as corporate accounting, tax management, financial accounting,

and cost accounting.

FINANCIAL MANAGEMENT AND ECONOMICS

Financial managers must have an understanding of the economic framework such as

different levels of economic activity and changes in economic policy. The financial

managers need to use economic theories as guidelines for efficient business operation e.g.

supply‐and‐demand analysis, profit‐maximizing strategies, and price theory etc. The most

important economic principle used in financial management is marginal analysis, which

helps managers to make financial decisions and take actions, only when the added benefits

exceed the added costs.

FINANCIAL MANAGEMENT AND ACCOUNTING

Financial management and accounting activities of a business are closely related and are

not easily distinguishable. In small firms the controller often carries out the finance

function, and in large firms many accountants are closely involved in various finance

activities. However, there are two basic differences between finance and accounting; one is

related to the emphasis on cash flows and the other to decision making.

EMPHASIS ON CASH FLOWS

The accounting function primarily develops and reports data for measuring the

performance of the firm, and assessing its financial position. The accountant uses

standardized and generally accepted principles to prepare financial statements on accrual

basis.

On the other hand, the primary emphasis of financial manager is on the inflow and outflow

of cash i.e. cash flows. The financial manager maintains solvency of the business by

planning the cash flows necessary to satisfy its obligations and to acquire assets needed to

achieve the goals of the business. Regardless of its profit or loss, cash basis are used to

recognize the revenues and expenses only with respect to actual inflows and outflows of

cash to make sure that a business must have a sufficient flow of cash to meet its obligations

as they come due.


Example:

In accounting terms Bamboo limited is profitable, but in terms of actual cash flow it is

a financial failure. Its lack of cash flow resulted from the uncollected account

receivable in the amount of 110,000. Without adequate cash inflows to meet its

obligations, the firm will not survive, regardless of its level of profits. As the example

shows, the financial manager must look beyond financial statements to obtain insight

into existing or developing problems because the accrual accounting data do not fully

describe the conditions of a business. However, accountants are sensitive to the

importance of cash flows, and financial managers use and understand accrual‐based

financial statements. By concentrating on cash flows, the financial managers should

be able to avoid insolvency and achieve the financial goals.

DECISION MAKING

The second key difference between finance and accounting is related to decision making.

Accountants devote their attention to the collection and presentation of financial data. On

the other hands, the attention of financial managers is devoted to evaluate the accounting

statements, develop additional data and make decisions on the basis of their assessment of

the associated risks and returns. This does not mean that accountants never make decisions

or that financial managers never gather data. Rather, the primary focuses of accounting and

finance are distinctly different.

ROLE OF THE FINANCIAL MANAGER

In addition to financial analysis and planning, the financial manager’s primary activities

include making investment decisions and making financing decisions. Investment decisions

determine the mix and the type of assets held by the business. Financing decisions

determine the mix and the type of financing used by the business. These types of decisions

can be viewed in terms of the firm’s balance sheet, as shown in Error! Reference source not

found.. However, the decisions are actually made on the basis of their cash flow effects on

the overall value of the firm.


Figure 1: The decisions made by finance managers

Source: Gitman et al. (2012)

As mentioned above, as companies grow and become owned by increased numbers of

individuals/organizations (shareholders), the owners are not directly involved in the day to

day decision making but employ managers to represent their interests and make decisions

on their behalf. Therefore the financial Manager would be expected to answer the

questions raised above.

The roles and responsibilities of the Financial Manager are usually associated with the top

officer of an organization for example, the Financial Director or the Chief Finance Officer.

The adoption of organizational structure highlighting the financial activities within a firm is

shown in Figure 2.


Figure 2: An organisational structure highlighting the role of the financial manager


The activities controlled by the financial director include managing the firm’s cash and

credit, the financial planning and capital expenditure, also the record keeping of side of the

company, this includes cost and management accounting, and management information

systems, (Firer et al.,2004).

TOPIC SUMMARY

Financial management forms and important part of every business and should be carried

out by competent managers. The three areas of corporate financial management we have

described—capital budgeting, capital structure, and working capital management—are very

broad categories. Each includes a rich variety of topics, and we have indicated only a few of

the questions that arise in the different areas. The chapters ahead contain greater detail.

Chairman of the Board

Managing Director

Human Resources Director

Marketing Director

Financial Director (Responsible for

Financial Management)

Treasurer

Capital Expenditure Manager

Credit Manager

Foregin Exchange Manager

Finacial Palnning and Fund‐RAising

Manager

Cash Manager Pension Fund Manager

Controller

Tax Manager Cost Accounting

Manger

Corporate Accounting Manager

Finasncial Accounting Manager

Operations Director



In your own words, describe the responsibilities that Financial Managers are charged

with in an organisation and the kind of decisions that they have to make, your answer

should reflect on the discussion above.

UNIT 1 REFERENCES

1. Geoffrey, A. Hirt, Bartley R. Danielsen Stanley B. Block (2009) Foundations of Financial

Management. McGraw Hill. ISBN: 0073363774 / 0‐07‐336377‐4

2. Brigham, F. Eugene and Houston, F. Joel (2012) Fundamentals of Financial management.

South‐ Western, Cengage Learning, Ohio, ISBN 13: 978‐0‐538‐47712‐3

3. Chandra Prassana (2010) Fundamentals of Financial Management. Tata McGraw Hill.

New Delhi in

http://books.google.co.uk/books?id=osy4UMOgpG4C&printsec=frontcover&dq=fUNDAME

NTALS+OF+FINANCIAL+MANAGEMENT,&hl=en&sa=X&ei=yJN_UZnaBMX5PLrDgdAD&sqi=2

&ved=0CFIQ6AEwAw accessed 24/04/13


UNIT 1 – SUMMARY

ASSIGNMENTS AND ACTIVITIES

The end of topic assignments have been employed to assess student learning for this unit.

Further activities could be incorporated in the students’ assignments that are to be

developed by the respective participating institutions.

SUMMARY

The topics covered in this unit underscore the importance of financial management for the

various forms of companies. The roles of finance managers in an organisation have been

outlined. The financial decisions the managers have to make in order to realise value to

stakeholders from the operations of the company call for managers to be more analytical in

the performance of their day to day finance activities. These issues are covered in the units

that follow.

NEXT STEPS

Having understood the basics of financial management, we shall now explore more

important avenues in an organisation, remember that activities of an organisation are

recorded and reported, we will therefore look at the various reports and how they are used

in an organisation to make economic sense.


UNIT TWO ‐ FINANCIAL INSTITUTIONS AND MARKETS

UNIT 2 INTRODUCTION

Financial institutions are responsible to channel the savings of individuals, businesses and

governments into loans or investments. Financial institutions serve its users as the main

source of funds. Majority of individuals and businesses rely heavily on funds from financial

institutions, in the form of loans for their financial support. They are regulated by

regulatory guidelines from governments and are required to operate within these

guidelines. Financial markets are the intermediaries that facilitate an efficient transfer of

resources from severs to who need for them. The financial markets are responsible to

contribute in economic development by providing channels for allocation of savings to

investment.

UNIT 2 OBJECTIVES

Upon completion of this unit you will be able to:

1. Explain how financial institutions serve as intermediaries between investors and

firms.

2. Explain various types of financial institutions and how they work.

3. Provide an overview of financial markets.

4. Explain how investors and business firms trade money market and capital market

securities in the financial markets in order to satisfy their needs.

5. Identify the major securities exchanges.

6. Understand derivative securities and explain why investors and firms use them.

7. Describe the role of foreign exchange market.

UNIT 2 READINGS


Gitman, Lawrence J. Web Chapter Financial Markets and Institutions available at


f


(a) Identify the major financial institutions present in your country and explain the major

services offered by them. (Hint: Identify minimum 2 and maximum of 4 institutions.)

(b) Identify a major organized securities exchange in your country and explain how it is

different from a organized securities exchange in a foreign country. (Hint: Difference on the

basis of number and type of requirements to be listed on a securities exchange for trading.)


TOPIC 2.1 FINANCIAL INSTITUTIONS

INTRODUCTION

Financial institutions are the intermediaries and channel the savings of individuals,

businesses and governments into loans or investments. With trillions dollar worth of

financial assets under the control of financial institutions, they are regarded as major

players in the financial marketplace. They frequently serve businesses and individuals as the

main source of funds. Some financial institutions lend the money, accepted from

customers’ savings deposits, to other customers or to businesses that needs them.

Generally, many individuals and businesses rely heavily on funds, in the form of loans, from

institutions for their financial support. The government establishes regulatory guidelines for

financial institutions and these institutions are required to operate within these guidelines.

OBJECTIVES

Upon completion of this topic you will be able to:

1. Understand how different financial institutions serve as intermediaries between

investors and firms.

2. Identify different types of financial institutions and the services provided by them.

MAJOR CUSTOMERS OF FINANCIAL INSTITUTIONS

The major suppliers and the major demanders of funds to and from financial institutions

are individuals, businesses and government. The large portion of funds in financial

institutions are provided by the individual consumers’ savings. Individuals not only are the

suppliers of the funds to financial institutions but are also the demanders of funds from

financial institutions in the form of loans. Although, the net suppliers for financial

institutions are individuals, as a group the amount of money saved by individuals is more

than what they borrow. Also, businesses primarily deposit some of their funds in checking

accounts with various commercial banks or financial institutions. Businesses also borrow

funds from financial institutions like individuals, but businesses are considered as the net

demanders of funds. The amount of money borrowed by businesses is more than what is

saved by them.

Governments are another customer of financial institutions. They maintain deposits of tax

payments, temporarily idle funds and Social Security payments in commercial banks.

Governments do not borrow funds directly from financial institutions, although they

indirectly borrow from them by selling their debt securities to various institutions. The

government is another net demander of funds like businesses and typically borrows more

than what it saves.

There are different types of financial institutions and few most important financial

institutions that facilitate the flow of funds from investors to business firms are commercial


banks, mutual funds, security firms, insurance companies and pension funds. A detailed

discussion of each of these financial institutions can be found below.

COMMERCIAL BANKS

Deposits from savers are accumulated by commercial banks and are used to provide credit

to businesses, individuals and government agencies. Thus they provide service to the

investors who desire to invest funds in the form of deposits. Commercial banks provide

personal loans to individuals and commercial loans to business firms by using the deposited

funds. The deposited funds are also used to purchase debt securities issued by business

firms or government agencies. Commercial banks serve as a key source of credit to facilitate

expansion of businesses. In the past, commercial banks were the only dominant direct

lenders to businesses. However, in recent years other types of financial institutions have

begun to advance more loans to the businesses. The objective of the commercial banks are

to generate earnings for their owners which is similar to most other types of business firms.

Generally, the commercial banks generate earnings by receiving a higher return by using

their funds as compared to the cost they incur from obtaining deposited funds. The paid

average annual interest rate on the obtained deposits is usually lower than the rate of

return earned on the funds. For example, a bank may pay an average annual interest rate of

3 percent on the obtained deposits and may receive a return of 8 percent on the invested

funds as loans or as investments in securities. Commercial banks can charge a higher rate of

interest on high risk loans, however, with higher risk loans they are more exposed to the

possibility that these loans will default.

The traditional and very important function of commercial banks are accepting deposits

and using those funds for loans or to purchase debt securities. In addition to this function,

banks now perform many additional functions as well. In particular, commercial banks

generate fees by providing services such as foreign exchange, traveller’s cheques, personal

financial advising, insurance and brokerage services. In short, the commercial banks are

able to offer customers one stop shopping experience.

SOURCES AND USES OF FUNDS AT COMMERCIAL BANKS

Mainly, most of the funds of commercial banks are obtained by accepting deposits from

investors (customers). These customers of commercial banks are usually individuals, but

some of them are firms and government agencies that have excess cash. Some of these

deposits are held at banks for very short periods, such as a month or less than a month.

Commercial banks also able to attract deposits for longer time periods by offering

certificates of deposit, which specify a minimum deposit level e.g. 2,000 and a particular

maturity time frame (such as 1 year or so). Because most of the commercial banks offer

certificates of deposit with various different maturities, they effectively diversify the times

at which the deposits are withdrawn by investors.


Deposits at commercial banks are insured up to a certain amount by an independent

agency to maintain stability and public confidence e.g. Federal Deposit Insurance

Corporation (FDIC) in United States. It guarantee the safety of depositor's accounts in

member banks. The insurance of deposits helps to reduce the fear of depositors about the

possibility of a bank’s failure. Therefore, it decreases the possibility that all depositors will

try to withdraw their deposits from banks simultaneously. As a result the banking system

can efficiently facilitates the flow of funds from savers to borrowers.

Most of the funds of commercial banks are either used to provide loans or to purchase debt

securities. In both of the cases they serve as creditors that provide credit to those

borrowers who need funds. Commercial banks provide commercial loans to businesses,

make personal loans to individuals and purchase debt securities issued by business firms or

government agencies. Most business firms rely heavily on commercial banks as a source of

funds. Some of the commonly known means by which commercial banks extend credit to

businesses are term loans, lines of credit and investment in debt securities issued by firms.

Term loans are provided by banks for a medium‐term to finance the investment of a

business in machinery or buildings. For example, consider a manufacturer of toy trucks that

plans to produce toys and sell them to retail stores. The manufacturer will need funds to

purchase the machinery for producing toy trucks, to make lease payments on the

manufacturing facilities and to pay its employees. With the passage of time, the business

will generate cash flows that can be used to cover mentioned expenses. However, there is a

time lag between the cash outflow (expenses) and cash inflow (revenue). This time lag

occurs because of the difference in time when the business must cover these expenses and

when it receives revenue. The term loan enables the business to cover its expenses until a

sufficient amount of revenue is generated.

The term loan on an average lasts for a medium‐term, greater than 3 years and less than 10

years, such as 4 to 8 years. The rate of interest charged by the bank to the business firm for

this type of loan depends on the interest rates prevailing in the market at the time the loan

is provided. The adjustment in the rate of interest changed on term loans is made

periodically e.g. annually, to reflect movements or changes in market interest rates.

Another form of credit provided by commercial banks to businesses is a line of credit. Line

of credit allows the business to access a specified amount of funds over a specified period

of time. This form of credit provided by commercial is especially useful when the business is

uncertain about the amount of borrowings needed over a given period. For example, if the

toy truck manufacturer in the previous example was unsure about its expenses in the near

future, it has an option to obtain a line of credit and borrow only the amount that it

needed. Once a line of credit is approved, it enables the business to acquire funds quickly.

Line of credit is explained in greater detail later in the text.

Commercial banks also invest in debt securities e.g. bonds that are issued by the business

firms. The arrangement with a business who sell the security to a commercial bank is


typically less personalized as compared to when a bank extends a term loan or a line of

credit. For example, it may be just one of thousands of investors who invest in a particular

debt security issued by a business firm. However, we recognize that credit provided by a

commercial bank to business firms goes beyond the direct loans that it provides to business

firms, because it also includes all the securities purchased that were issued by business

firms.

COMMERCIAL BANKS AS FINANCIAL INTERMEDIARIES

Commercial banks play a number of roles as financial intermediaries. First and foremost

role of a commercial bank is to repackage the deposits received from investors into loans

that are provided to business firms. In this manner, small size deposits by individual

investors can be consolidated and channelled in the form of large size loans to business

firms. It is difficult for the individual investors to achieve this by themselves because they

do not have sufficient information about the business firms that need funds.

Second, banks employ credit analysts to assess the creditworthiness of businesses that wish

to borrow funds. Individual investors who deposit funds in commercial banks are generally

not capable of performing this task and would prefer that the commercial bank play this

role.

Third, commercial banks are able to pool the funds and have so much money to lend that

they can diversify loans across several borrowers. In this manner, the commercial banks

increase their ability to absorb individual defaulted loans by reducing the risk that a

substantial portion of the loan portfolio will default. As the lenders, they accept the risk of

default. Many individual investors prefer to let the bank serve on their behalf because they

would not be able to absorb the loss of their own deposited funds. In the event of a

commercial bank closure due to excessive amount of defaulted loans, the deposits of each

investor are insured up to certain amount by the independent agency e.g. FDIC in United

States. Therefore the commercial bank is a mean by which funds can be channelled from

small investors to businesses without the investors having to engage themselves in the role

of lender.

Fourth, since the late 1980s some of the commercial banks have been authorized to place

the securities that are issued by business firms by serving as financial intermediaries. Such

banks who act as financial intermediaries may facilitate the flow of funds to businesses by

finding investors who are willing to purchase the debt securities issued by the these

businesses. Therefore, they enable firms to obtain borrowed funds even though they do not

provide the funds themselves.

REGULATION OF COMMERCIAL BANKS

The banking system is regulated by the Reserve System often known as the central bank of

the country. The central bank is responsible for controlling the amount of money in the

financial system. It influences the operations that banks conduct by imposing regulations on


activities of banks. Some commercial banks are members of the central bank and are

therefore subject to additional rules and regulations.

Commercial banks are regulated by various regulatory agencies. For example in United

States first, they are regulated by the Federal Deposit Insurance Corporation, the insurer for

depositors. The FDIC wants to ensure that banks do not take excessive risk that could result

in failure because it is responsible for covering deposits of banks. The FDIC would not be

able to cover the deposits of all the depositors, in case several large banks failed, and this

could result in a major banking crisis. Those commercial banks that apply for a federal

charter are known as national banks and they are subject to regulations of the Comptroller

of the Currency. As all national banks are required to be members of the Federal Reserve,

they are also subject to Federal Reserve regulations. Alternatively, banks can apply for a

state charter.

The common philosophy of regulators who monitor the banking system is to encourage

competition among banks so that customers will be charged reasonable prices for the

services that are offered by banks. In order to maintain the stability of the financial system,

regulator organization also attempt to limit the risk of banks.

MUTUAL FUNDS

Mutual funds are the financial institutions that sell shares to individuals and generate

funds. They pool these generated funds and use them to invest in securities. Mutual funds

can be classified into three broad categories.

1. Money market mutual funds

2. Bond mutual funds

3. stock mutual funds

Money market is known for trading short term securities. Money market mutual funds

collect and pool the proceeds from individual investors to invest in money market i.e. short‐

term securities issued by business firms and other financial institutions. Bond mutual funds

collect and pool the proceeds from individual investors to invest in bonds, where as the

stock mutual funds collect and pool the proceeds from investors to invest in stocks.

Investment companies owns the mutual funds. Many of these companies e.g. Fidelity

International have created various types of money market mutual funds, bond mutual

funds and stock mutual funds in order to be able to satisfy various different preferences of

investors.

ROLE OF MUTUAL FUNDS AS FINANCIAL INTERMEDIARIES

The mutual funds finance new investment by firms, when they use money from investors to

invest in newly issued debt or equity securities. On the other hand, when the mutual funds

invest in debt or equity securities already held by investors, they are just transferring

ownership of the securities among investors. Mutual funds enable individual investors to


hold diversified portfolios or combinations of debt securities and equity securities by

pooling small investments of individual investors.

Mutual funds are also helpful to the individuals who prefer to let them make their

investment decisions for them. The returns to individual investors who invest in mutual

funds are tied to the returns earned by the mutual funds on their investments. To

determine which debt securities to purchase, money market mutual funds and bond mutual

funds conduct a credit analysis of the firms that have issued or will be issuing those debt

securities. Stock mutual funds have specific investment objectives (e.g. growth in value or

high dividend income) and to satisfy these specific objectives they invest in stocks. Stock

mutual funds have potential for a high return, given the risk level of stock.

The reason that mutual funds usually have billions of dollars to invest in securities, they use

large amount of resources to make their investment decisions. In general, each mutual fund

is managed by one or more portfolio managers. These managers are responsible for the

purchase and sale of securities in the portfolio of funds. These managers have a detailed

information about the business firms that issue the securities in which they can invest. It is

possible that after making an investment decision, mutual funds can sell any securities that

are not expected to perform well. On the other hand, if a mutual fund has made a large

investment in a particular security, the portfolio managers of mutual fund may try to

improve the performance of the security rather than sell it. For example, a mutual fund may

hold more than a million shares of a particular stock that has performed poorly. Rather than

making a decision to sell the stock, the mutual fund may attempt to influence the

management of the business firm that issued the security in order to boost the

performance of the firm. These efforts should have a favourable effect on the stock price

of the firm.

SECURITIES FIRMS

Securities firms are financial institutions that include investment banks, investment

companies and brokerage firms. Securities firms serve as financial intermediaries in various

different ways. First, they play an investment banking role by placing securities i.e. stocks

and debt securities, issued by business firms or government agencies. More precisely, they

find investors who want to purchase these securities. Second, securities firms at times serve

as investment companies by creating, marketing and managing investment portfolios. A

mutual fund is an example of an investment company. Finally, securities firms may play a

role as brokerage firm. In a brokerage firm role it helps investors to purchase securities or

to sell securities that they previously purchased.

INSURANCE COMPANIES

Financial institutions that provide various types of insurance for their customers are known

as insurance companies. The various types of insurance for their customers include life

insurance, property and liability insurance and health insurance. They periodically receive

payments from their policyholders which are known as premiums. These payments are


then pooled and invested until these funds are needed to pay off claims of policyholders.

Insurance companies normally use the funds to invest in debt securities issued by firms or

government agencies. They also invest heavily in stocks issued by business firms. This way

they help to finance corporate expansion.

Insurance companies also employ portfolio managers. These managers invest the funds

that result from pooling the premiums of their customers. An insurance company may have

one or more bond portfolio managers who determine which bonds or debt security to

purchase, and one or more stock portfolio managers who determine which stocks to

purchase. The main objective of the portfolio managers is to earn a higher return on the

portfolios for a given level of risk. In this manner, the return on the investments not only

targets to cover future insurance payments to policyholders but also targets to generate a

sufficient profit, which provides a return to the owners of insurance companies. The

performance of insurance companies is greatly dependent on the performance of their

bond and stock portfolios.

Like mutual funds, insurance companies also tend to purchase securities in large blocks, and

they normally have a large stake in several different firms. Thus the insurance companies

closely monitor the performance of firms in which they have invested. Sometimes they

attempt to influence the management of a firm to improve the performance of the firm and

therefore improve the performance of the securities in which they have invested.

PENSION FUNDS

Pension funds are financial institutions that receive payments from employees and/or their

employers on behalf of the employees, and then invest these proceeds for the benefit of

the employees. The received payments of pension funds are called contributions. They

typically invest in debt securities or bonds issued by business firms or government agencies

and in equity securities or stock issued by firms. Like other financial institutions pension

funds also employ portfolio managers to invest and manage funds that result from pooling

the employee or employer contributions. They have bond portfolio managers to purchase

bonds and stock portfolio managers to purchase stocks. The reason pension funds make

large investments in debt securities or in stocks issued by firms, they closely monitor the

firms in which they invest. Same as mutual funds and insurance companies, pension funds

may periodically attempt to influence the management of those firms to improve the

performance of the firm.

SAVINGS INSTITUTIONS

Savings institutions are financial institutions that also serve as an important intermediary.

They are also known as thrift institutions or savings and loan associations. Savings

institutions accept deposits from individuals and use the majority of these deposited funds

to provide mortgage loans to individuals. The participation of savings institutions is critical

in financing the purchases of homes by individuals. They also serve as intermediaries

between investors and business firms by lending these funds to firms.


FINANCE COMPANIES

Finance companies mainly generate funds by issuing debt securities or bonds. Finance

companies lend the funds to individuals or firms in need of these funds. The lending of

finance companies are focused on small businesses. When extending these loans, they are

exposed to a higher level of risk than commercial banks that borrowers will default on or

will not pay back their loans. Therefore, the finance companies charge a relatively high

interest rate as compared to commercial banks.

COMPARISON OF THE KEY FINANCIAL INSTITUTIONS

A brief comparison of the most important types of financial institutions that provide

funding to firms is shown in Figure. The financial institutions differ from each other in the

manner they obtain funds, but they are similar in terms of providing credit to business

firms by purchasing debt securities or bonds the firms have issued. All of the mentioned

financial institutions except commercial banks and savings institutions also provide equity

investment by purchasing equity securities issued by business firms.

Figure 3: How Financial Institutions Provide Financing for Firms


Securities firms does not appear in Figure 1 because they are not as important in actually

providing the funds needed by business firms. However, they play an essential role in

facilitating the flow of funds from financial institutions to business firms. In fact, each arrow

in the figure representing a flow of funds from financial institutions to business firms may


have been facilitated by a securities firm that was hired by the business firm to sell its debt

or equity securities e.g. bonds or stock. Securities firms sometimes also sell the debt and

equity securities to individual investors. This results in some funds flowing directly from

individuals to business firms without first passing through a financial institution.

CONSOLIDATION OF FINANCIAL INSTITUTIONS

In recent years there has been a great deal of consolidation among financial institutions. As

a result of this consolidation a single financial conglomerate may own every type of

financial institution. Various financial conglomerates offer all different types of services

including commercial banking services, investment banking services, brokerage services,

mutual funds and insurance services. They also have a pension fund and manage the

pension funds of other companies as well. An example of a financial conglomerate is

Citigroup Incorporation. It offers commercial banking services through its Citibank unit,

insurance services through its Travelers’ insurance unit, and investment banking and

brokerage services through its Salomon Smith Barney unit.

In recent years, the trend of mergers and acquisitions has made it possible for many

commercial banks to expand their offerings of financial services by acquiring or merging

with other financial intermediaries that offer other financial services. Some banks even

serve in advisory roles for businesses that are considering the acquisition of other business

firms. As a result, the bank expansion is mainly focused on services that were traditionally

offered by securities firms. In general, the expansion of banks into these services has

facilitated the competition and it is expected to increase the competition among financial

intermediaries. This increased competition therefore has led to lower the price that

individuals or business firms pay for these services.

GLOBALIZATION OF FINANCIAL INSTITUTIONS

In recent years, financial institutions not only have diversified their services but also have

expanded internationally. This global expansion of financial institutions was stimulated by

various factors. First and foremost, the expansion of multinational corporations (MNCs)

encouraged commercial banks to expand and serve the foreign subsidiaries. Second, the

commercial banks may have more flexibility to offer securities services and other financial

services outside the parent country, where fewer restrictions are imposed on commercial

banks. Third, large commercial banks acknowledged that they could take advantage of their

global image by establishing branches in foreign countries/cities.

Financial institutions located in foreign countries are responsible for the facilitation of the

flow of funds between investors and the business firms based in that country. During the

1997–1998 period, a large number of Asian firms were performing poorly and were cut off

from funding by local as well as foreign banks. Before this time, some banks had been

willing to extend loans to these Asian firms without determining requirement and feasibility

of funding. The crisis helped realize some foreign banks that they should not extend credit

to firms just based of their good performance during the mid‐1990s. In addition to that, the


crisis also caused Asian firms to realize their dependence on banks to run their businesses.

As a result, Asian firms are now expanding more cautiously, because they have to justify

their request for additional funding (credit) from banks.

TOPIC SUMMARY

Financial institutions channel the flow of funds between investors and business firms.

Individuals deposit funds at financial institutions such as commercial banks, they purchase

shares of mutual funds, they purchase insurance protection with insurance premiums and

they make contributions to pension plans. All of these financial institutions provide credit to

business firms by purchasing debt securities. In addition to this, all of the above motioned

financial institutions except commercial banks purchase stocks issued by business firms.


1. Distinguish between the role of a commercial bank and that of a mutual fund.

2. Which type of financial institution do you think is most critical for firms?


TOPIC 2.2 FINANCIAL MARKETS


Financial markets facilitate an efficient transfer of resources from those (individual or

business firms, government) who have idle resources to others (individual or business firms,

government) who have a pressing need for them is achieved through. More precisely,

financial markets provide channels for allocation of savings to investment. These provide a

variety of assets to savers as well as various forms in which the investors can raise funds

and thereby decouple the acts of saving and investment. The savers of the resources or

funds and investors are constrained not by their individual abilities, but by the ability of

economy to invest and save respectively. Therefore, the financial markets contribute to

economic development to the extent that the latter depends on the rates of savings and

investment.



1. Provide an overview of financial markets.

2. Explain how firms and investors trade money market and capital market securities

in the financial markets in order to satisfy their needs.

3. Describe the major securities exchanges.

4. Describe derivative securities and explain why firms and investors use them.

5. Describe the foreign exchange market.

TYPES OF MARKETS

A market is a place where a buyer and seller interacts and make exchange of goods.

Financial markets are very important for business firms and investors because they

facilitate the transfer of funds between the investors who wish to invest and firms that

need to obtain funds. Therefore, in a financial market the investors are the sellers the fund

obtainers are the buyers and the different type of funds are regarded as goods. Second,

financial markets can accommodate the needs of business firms who wish to invest their

temporarily excess funds/savings. Third, they can accommodate the needs of investors who

wish to liquidate their investments with the intention of spending the proceeds or investing

them in alternative investments.

PRIMARY MARKETS VERSUS SECONDARY MARKETS

Primary market is a market where debt and equity securities are issued by firms. Primary

market facilitates the issuance of new securities. The offering of stock to the public for the

very first time is referred as an initial public offering (IPO). Any offering of stock by the firm

afterwards is known as a secondary offering. Securities can be sold in the so‐called

secondary market, by investors to other investors after they have been issued for the first

time. A secondary market is one that facilitates the trading of existing securities.


The distinction between the primary market and the secondary market can be made with

the help of following example.

PUBLIC OFFERING VERSUS PRIVATE PLACEMENT

The non‐exclusive sale of securities to the general public is known as public offering. More

precisely, business firms raise funds in the primary market by issuing securities through a

public offering. The initial public offering (IPO) and the secondary offering by Kenton Co. in

the earlier example were public offerings. A public offering is usually conducted with the

help of a securities firm (a financial institution) that provides investment banking services.

This securities firm may advise the issuing firm on the size and the price of the offering. It

may also agree to place the offering with investors and may even be willing to underwrite

the offering, which means that it guarantees the dollar amount to be received by the

issuing firm.

As an alternative to a public offering, business firms can issue securities through a private

placement. Private placement is the sale of new securities directly to an investor or group

of investors. A new offering of securities is often worth 40 to 100 million or may be more

than that, thus only institutional investors e.g. pension funds and insurance companies, can

afford to invest through private placements. The major advantage of a private placement is

that it avoids fees charged by securities firms for placing the stock. However, some business

Example – Primary Market versus Secondary Market

Kenton Co. was established in July 1991. It enjoyed success as a private limited

business firm for more than 10 years, but it could not grow as desired because of a

limitation on the amount of loans it could obtain from commercial banks. Kenton

needed a large equity investment from other firms to expand its business. On

March 14, 2002, With the help of a securities firm, it engaged in an initial public

offering. it issued 1 million shares of stock at an average price of 30 per share. Thus

the company raised a total of 30 million. Later the investors in Kenton’s stock

decided to sell the stock. They then used the secondary market to sell the stock of

Kenton Limited to other investors. The secondary market activity does not directly

affect the amount of funds available to Kenton has to support its expansion

because Kenton gets no additional funds when investors sell their shares in the

secondary market. Kenton’s expansion over the next several years was successful,

and it decided to expand further. By this time, the stock price of Kenton Limited

was near 60 per share. On June 8, 2010, Kenton issued another 1 million shares of

stock as a secondary offering. The new shares were sold at an average price of 60,

and generated 60 million for Kenton to pursue its expansion plans. After that date,

some of the new shares as well as IPO shares were traded in the secondary market.


firms prefer to pay for the advising and underwriting services of a securities firm over a

private placement.

MONEY MARKETS VERSUS CAPITAL MARKETS

Money markets are the financial markets that facilitate the flow of short‐term funds only.

By short term we mean funds with maturities of 1 year or less than 1 year. The securities

that are traded in money markets are referred to as money market securities. To obtain

funds for a short period of time, business firms commonly issue money market securities

for purchase by investors. Business firms may also consider purchasing money market

securities with temporarily available cash. Similarly, investors purchase money market

securities with funds that they may soon need for other more profitable investments in the

near future.

In contrast to money markets, financial markets that facilitate the flow of long‐term funds

i.e. the funds with maturities of more than 1 year are known as capital markets. The

instruments that are traded in capital markets are referred to as securities. As stocks do not

have maturities and can provide long‐term funding, thus they are classified as capital

market securities. Business firms generally issue stocks and bonds to finance their long‐

term investments in corporate operations. These securities are purchased by institutional

and individual investors who have funds that they wish to invest for a long time.

INTERNATIONAL CAPITAL MARKETS

BOND MARKETS

Eurobond market is the oldest and largest international bond market where corporations

and governments normally issue bonds i.e. Eurobonds, denominated in dollars. For

example, A U.S. Corporation might issue bonds denominated in dollars that would be

purchased by investors in any of the European countries. Eurobond market is appreciated

by issuing firms and governments because it allows them to attract a much large number of

investors than would generally be available in the local market.

Foreign bond market is another international market which is for long‐term debt securities.

A foreign bond is a type of bond issued by a foreign corporation (MNC) or government and

is denominated in the investor’s home currency and sold in the investor’s home market. A

bond issued by a U.S. company that is denominated in pound sterling and sold in United

Kingdom is an example of a foreign bond. As compared to Eurobond market, the foreign

bond market is much smaller but many issuers have found this to be an attractive way of

tapping debt markets in Japan, Germany, Switzerland and the United States.


INTERNATIONAL EQUITY MARKET

Finally, there is a recently emerged vibrant international equity market. This market has

made it possible for many corporations to sell blocks of shares to investors in a number of

different countries at the same time. These market facilities enable the corporations to

raise far large amounts of capital than they can raise in any single national market.

International equity sales plays an essential role for governments who wants to sell state‐

owned companies to private investors, because the companies being privatized are often

extremely large.

TYPES OF MARKET SECURITIES

Securities are generally classified in two different types namely, money market securities or

capital market securities.

KEY MONEY MARKET SECURITIES

Money market securities are highly liquid securities, which means that a major loss in their

value, they can be easily converted into cash without. This is very important to business

firms and investors who may need to sell the money market securities on a moment’s

notice in order to use their funds for other more profitable purposes. The money market

securities used by firms and investors mainly includes Treasury bills, commercial paper,

negotiable certificates of deposit and foreign money market securities.

TREASURY BILLS

To explain the treasury bills in the text U.S treasury bills are considered as example. U.S.

Treasury issues treasury bills as short‐term debt securities. Treasury bills are issued on

every Monday in two maturities, i.e. 13 weeks and 26 weeks, whereas, Treasury bills with

one year maturity are issued once a month. An auction process is used by the Treasury

when issuing the securities and competitive bids are submitted by 1:00 p.m. eastern time

on every Monday. Firms and investors who are willing to pay the average accepted price

paid by all competitive bidders can also submit non‐competitive bids. The Treasury always

has a plan for amount of money to be raised every Monday. First, it accepts the highest

competitive bids and continues accepting the lower bids until it has obtained the amount of

desired funds.

The par value which is the principal to be paid at maturity on Treasury bills is minimum

10,000, but the treasury bill purchased by firms and institutional investors typically have a

much higher par value. Treasury bills they are sold at a discount from the par value when

they are issued. The difference between the par value and the discount is the return of

investor. Treasury bills do not pay coupon or interest payments but instead pay a yield

equal to the percentage difference between the sale price and the purchase price.

Firms and investors who wish to have quick access to funds if needed are the common

demanders of Treasury bills. Treasury bills are highly liquid because there is an active


secondary market in which previously issued Treasury bills are sold. Treasury bills are

perceived as free from the risk of default because they are backed by the federal

government and regarded as risk‐free security. Therefore, the rate of return that can be

earned from investing and holding a Treasury bill until maturity is commonly referred to as

a risk‐free rate. Investors are sure about the exact return they can earn by holding a

Treasury bill until maturity.

Example – Treasury Bills

Marcos Ltd. purchased a 1‐year Treasury bill with a par value of 200,000 and paid

188,000 for it. If it holds the Treasury bill until maturity, then the return for the period

will be equal to 6.38% [(200,000‐188,000) ÷ 188,000]

The return is uncertain if Marcos Ltd plans to hold the Treasury bill for 60 days and

then sell it in the secondary market. The return will depend on the selling price of the

Treasury bill in the secondary market 60 days from now. Assume that Marcos Ltd

expects to sell the Treasury bill for 190,000. Therefore its expected return over this

time period would be equal to 1.064% [(190,000‐188,000) ÷ 188,000]

Returns earned by investing in money market securities are generally measured on an

annualized basis. It can be done by multiplying the return by 365 (days in a year)

divided by the number of days the investment is held by the investor. In the given

example, the expected annualized return is equal to 6.47%. 190,000 188,000188,000 36560

In the given example there is uncertainty because the investor firm is not planning to

hold the Treasury bill until maturity. If Marcos Ltd planned to take a risk‐free position

for the 60 days period, it could purchase a Treasury bill in the secondary market with

60 days remaining until maturity. For example, suppose that Marcos Ltd could

purchase a Treasury bill that had 60 days until maturity and had a par value of

200,000 and a price of 198,000. The annualized yield that would be earned in this case

is equal to 6.14%. 200,000 198,000198,000 36560


COMMERCIAL PAPER

A short‐term debt security issued by well‐known and creditworthy firms is referred to as

commercial paper. It provides the business firm an alternative to a short‐term loan from a

bank. Some of the business firms issue their commercial paper directly to investors whereas

others rely on financial institutions to facilitate the placement of the commercial paper with

investors. The minimum denomination of a commercial paper is 200,000, although

multiples of 1 million is the more common denominations. Typically, the maturities are

between 20 and 45 days but they can be as long as 270 days.

Commercial paper is not as liquid as Treasury bills are, because commercial paper does not

have an active secondary market to resell it. Therefore, the investors who purchase

commercial paper usually plan to hold it until maturity. Commercial papers are issued at

discount and do not pay coupon or interest payments like Treasury bills. The total expected

return to investors is based exclusively on the difference between the selling and the

buying price. There is a possibility that the firm that issued commercial paper will default on

its payment at maturity, therefore, investors require a higher return on commercial paper

as compared to return expected from risk‐free (Treasury bills) securities with a similar

maturity.

NEGOTIABLE CERTIFICATES OF DEPOSIT

Debt securities, which are issued by financial institutions to obtain short‐term funds, are

referred to as negotiable certificate of deposit (NCD). The minimum denomination of a

negotiable certificate of deposit (NCD) is typically 100,000, but the 1 million denominations

are more common. Commonly NCDs have maturities of 10 days to 365 days (1 year). Unlike

the other money market securities discussed earlier, negotiable certificate of deposits

(NCDs) do provide interest payments. The secondary market for NCDs exists, but it is not

very active as the secondary market for Treasury bills. Investors require a return on a

negotiable certificate of deposit that is slightly above the return on Treasury bills with a

similar maturity because of the risk that the financial institution issuing a NCD will default

on its payment at maturity.

FOREIGN MONEY MARKET SECURITIES

Foreign money markets are assessable to firms and investors who wish to borrow or invest

funds for short‐term periods. Short‐term securities such as commercial papers can be

issued by business firms in foreign markets, assuming that they are perceived as

creditworthy in those foreign markets. Firms and investors can also attempt to borrow

short‐term funds in foreign currencies by issuing short‐term securities denominated in

those currencies. The major reason for a firm or an investor to borrow in foreign money

markets is to obtain funds in a currency that matches its cash flows. For example, European

subsidiary of IBM may borrow Euros which is the currency for 11 different European

countries either from a bank or by issuing commercial paper to support its European

operations, and it will use future cash inflows in Euros to pay off this debt at maturity.


Investors may invest in foreign short‐term securities because they have future cash

outflows in those currencies. For example, say a firm has excess funds that it can invest for

three months. If it needs Canadian dollars to purchase exports in 3 months, it may invest in

a 3‐month Canadian money market security (such as Canadian Treasury bills) and then use

the proceeds at maturity to pay for its exports. Alternatively, an investor may purchase a

foreign money market security to capitalize on a high interest rate. Interest rates vary

among countries, which causes some foreign money market securities to have a much

higher interest rate than others. However, investors are subject to exchange rate risk when

investing in securities denominated in a different currency from what they need once the

investment period ends. If the currency denominating the investment weakens over the

investment period, then the actual return that investors earn may be less than what they

could have earned from domestic money market securities.

KEY CAPITAL MARKET SECURITIES

Bonds and stocks are the major capital market securities.

BONDS

Bonds are long‐term debt securities and are used by business firms and governments.

Business firms and governments issue bonds to raise large amounts of long‐term funds.

Bonds are distinguished by their issuer and can be classified as Treasury bonds, municipal

bonds or corporate bonds.

TREASURY BONDS

Treasury bonds are a mean of obtaining funds for a long‐term period and are issued by the

United States Treasury. The treasury bonds normally have maturities ranging between 10 to

30 years. As discussed previously, the Treasury issues short‐term debt securities in the form

of Treasury bills and medium‐term debt securities in the form of Treasury notes. Their

maturities range between 1 and 10 years.

The minimum denomination of Treasury bonds is 1,000, but more common denominations

are much larger. The federal government in United States borrows most of its funds by

issuing Treasury securities. Treasury bonds have an active secondary market, so it is easier

for investors to sell Treasury bonds at any time. The interest on Treasury bonds are paid to

the investors who hold them, in the form of coupon payments every 6 months or semi‐

annually. Investors who invest in treasury bonds earn a return in the form of these coupon

payments as well as in the difference between the selling and the purchase price of the

bond.

A Treasury bond with a par value of 1,000,000 and a 6 percent coupon rate pays 60,000 per

year, which is divided into 30,000 after the first six month period of the year and another

30,000 in the second six month period of the year. Interest earned by investors on Treasury

bonds is exempt from state and local income taxes.


Treasury bonds are backed by the federal government, therefore, the return to an investor

who holds these bonds until maturity is known with certainty. The coupon payments on

holding a treasury bond are known with certainty, and so is the payment at maturity which

is the par value. As a result, the return that is expected to be earned on a Treasury bond is

commonly referred to as a long‐term risk‐free rate. The annualized return guaranteed on a

10‐year bond today provides the annualized risk‐free rate of return over the next 10 years,

whereas, the annualized return that is promised on a 20‐year Treasury bond provides the

annualized risk‐free rate of return over the next 20 years. If investors want to earn a risk‐

free return over a specific period that is not available on newly issued Treasury bonds, then

in that case they can purchase a Treasury bond available in the secondary market with a

time remaining until maturity that matches their desired investment period.

Municipal Bonds Municipal bonds, in United States, are the type of bonds issued by

municipalities to support their expenditures. They are commonly classified into one of two

categories.

The two common types are the General obligation bonds and the revenue bonds. General

obligation bonds are a mean to provide investors with interest and principal payments that

are backed by the municipality’s ability to tax. On the other hand, revenue bonds are a

mean to provide investors with interest and principal payments by using funds generated

from the project financed with the proceeds of the bond issue. For instance, a municipality

may issues revenue bonds to build a toll way. To make interest and principal payments to

the investors who purchased these revenue bonds, municipality would be using proceeds

received in the form of tolls. The minimum denomination of these types of bonds is 5,000;

however larger denominations are more common.

The interest on municipal bonds is paid on a semi‐annual (6 months) basis. The interest paid

on these bonds is generally exempt from federal income taxes and may even be exempt

from state and local income taxes. This feature of municipal bonds is very attractive and

enables municipalities to obtain funds at a low cost. Because the investors tend to be more

concerned with the after‐tax return, they are willing to accept a lower pre‐tax return on

municipal bonds. A secondary market for Municipal bonds does exist, but that secondary

market is less active than the secondary market for Treasury bonds. As a result, municipal

bonds are less liquid as compared to Treasury bonds that have a similar term to maturity.

Corporate Bonds Corporations issue corporate bonds to finance their investment in long‐

term assets, such as buildings and machinery. The standard denomination of corporate

bonds is 1,000, but at times other denominations are issued as well. Corporate bonds

issued in high volume have more active secondary market. Similar to the municipal bonds

there is less active secondary market for corporate bonds than there is for Treasury bonds;

therefore, corporate bonds are less liquid than Treasury bonds with a similar term to

maturity. Corporate bonds have maturities of normally ranging between 10 and 30 years,


Example – International Bond

A microprocessor manufacturer just issued a 20 ‐ year bond with 12% coupon

interest rate and a 1,000 par value. It pays interest on a semi‐annual basis.

Investors who invest in this bond have a contractual right to receive (1) annual

interest of 120 (12% × 1000), distributed at the end of each 6 months as 60

(1/2 × 120) for 20 years, and also (2) at the end of year 20, the 1,000 which is

the par value.

but at times they have maturities of 50 years or more. For instance, in past Coca‐Cola

Company and Disney issued bonds with maturities of 100 years.

INTERNATIONAL BONDS

Many business firms issue bonds in the international markets e.g. firms in United States can

issue bonds in Eurobond market. Issuing bonds in Eurobond market serves issuers and

investors in bonds denominated in a variety of currencies. For instance, General Motors

may consider, issuing a dollar‐denominated bond to investors in the Eurobond market or

issuing a bond denominated in Japanese yen to support its business operations in Japan.

Investors from United States may purchase bonds denominated in other currencies in the

Eurobond market that are paying higher coupon rates than dollar‐denominated bonds. But

these investors will be subject to exchange rate risk if, in the future, they plan to convert

the coupon and principal payments into dollars.

STOCKS

An equity security which represents ownership interest in the issuing firm is regarded as

Stock. Bonds are issued by both governments and businesses, but stock is issued only by

business firms. The two available types of stock are common stock and preferred stock.

COMMON STOCK

Shares of common stock are units of ownership interest, or equity in a business firm. A

return is earned by common stockholders either in the form of dividends, by realizing gains

through increases in share price or both.

PREFERRED STOCK

It is a special form of ownership in a business firm. Preferred stock has features of both a

bond and common stock. A fixed periodic dividend is promised to preferred stockholders

and this fixed dividend must be paid prior to any dividends payment to the common

stockholders. In other words, preferred stockholders have priority over common

stockholders when the dividends of the business firms are disbursed.

INTERNATIONAL STOCKS

Large business firms commonly issue stock in international equity markets. These firms

may be able to easily sell all of their stock offering by placing some of the offered stock in


foreign markets, if there is not sufficient demand in the home country. In addition to this,

by selling some of their newly issued stock in foreign markets firms may be able to increase

their global name recognition in countries where they conduct business.

Investors usually invest in stocks issued by foreign firms because of the belief that price of a

particular foreign stock is undervalued in the foreign market. Another belief is that a foreign

country has much greater potential economic growth as compared to the home country.

Investors may also invest in foreign stocks to achieve international diversification. To the

extent that most stocks of firms are highly influenced by the economy of the country,

Investors can reduce their exposure to potential weakness in the economy by investing in

foreign firms’ stocks whose performance is insulated from economic conditions of home

country.

SECURITIES EXCHANGE

Securities exchange is a marketplace where business firms (sellers of securities) can raise

funds through the sale of new securities and investors (purchasers of securities) can

maintain liquidity by being able to resell them easily when required. Securities exchanges

are commonly known as “stock markets”. The label “stock market” is somewhat misleading

because bonds, common stock, preferred stock and a variety of other investment

instruments are traded on these exchanges. The securities exchanges are classified into two

major types i.e. the organized securities exchange and the over‐the‐counter market.

ORGANIZED SECURITIES EXCHANGES

Tangible organizations that act as secondary markets where outstanding securities are

resold are referred to as organized securities exchanges. The largest organized exchange in

the United States is the New York Stock Exchange (NYSE). In Canada, the largest organized

exchange is the Toronto Stock Exchange. Major European examples of organized securities

exchanges include the Amsterdam Stock Exchange, London Stock Exchange, Paris Bourse

and the Frankfurt Stock Exchange. Nigerian Stock Exchange, JSE Limited, are the examples

in Africa. In Asia, examples include the Singapore Exchange, the Tokyo Stock Exchange,

the Hong Kong Stock Exchange, the Shanghai Stock Exchange and the Bombay Stock

Exchange. In Latin America, there are such exchanges as the BM&F Bovespa and the BMV.

Australia has a national stock exchange, the Australian Securities Exchange. The regional

securities exchange also exist, e.g. in United States, the Chicago Stock Exchange and the

Pacific Stock Exchange (located in Los Angeles and San Francisco).

Majority of organized exchanges are modeled after the New York Stock Exchange (NYSE).

The New York Stock Exchange (NYSE) accounts for approximately 90 percent of the total

annual dollar volume of shares traded on organized exchanges. An individual or a business

firm must own a ‘seat’ on the exchange to make transactions on the ‘floor’ of the securities

exchange. Most of the seats on the securities exchange are owned by brokerage firms. To

be listed on an organized exchange for trading, a firm must file an application and meet a


number of requirements. For example, to be eligible for listing on a securities exchange, a

firm must have at certain number of stockholders, each owning certain number of shares, a

certain minimum amount of shares of publicly held stock, a certain demonstrated before

taxes earning power at the time of listing and a certain before taxes earning power for each

of the preceding time interval (2 year or so), required net tangible assets, and a certain

amount in market value of publicly traded shares.

Transactions are made on the floor of the exchange through an auction process. By making

transaction we mean trading and the goal of trading is to give both purchasers and sellers

the best possible deal by filling buy orders (orders to purchase securities) at the lowest

possible price and sell orders (orders to sell securities) at the highest possible price. The

common procedure for placing and executing an order can be explained by a simple

example.

An order, either to buy or to sell, can be executed in seconds once it is placed, thanks to

modern sophisticated telecommunications devices. Information on the daily trading of

securities is reported in various media, including financial publications.

THE OVER‐THE‐COUNTER EXCHANGE

Intangible market for the purchase and sale of securities not listed by the organized

exchanges are referred to as over‐the‐counter (OTC) exchange or market. Traders known as

dealers match the forces of supply and demand for securities to determine the market price

of over‐the‐counter (OTC) securities. For example, in United States OTC dealers are linked

with the purchasers and sellers of securities through the National Association of Securities

Dealers Automated Quotation System (NASDAQ), which is a sophisticated

telecommunications network.

Example – Organized Securities Exchanges

Norman Blake, who has an account with one of the financial management and

advisory companies, wishes to purchase 100 shares of the IBM Corporation at the

prevailing market price. Norman calls her account executive, Howard Kohn of

financial management and advisory company, and places his order. Howard

immediately has the order transmitted to the headquarters of the financial

management and advisory company, which immediately forwards the order to the

clerk of financial management and advisory company on the floor of the securities

exchange. The clerk dispatches the order to one of the seat holders of firm (IBM

Corporation), who goes to the appropriate trading post, executes the order at the

best possible price and returns to the clerk. The clerk then wires the execution price

and confirmation of the transaction back to the brokerage office. Howard, is then

given the relevant information, who passes it along to Norman. To complete the

transaction Howard then does certain paper work.


The OTC dealer provides current “bid prices” and “ask prices” on thousands of actively

traded OTC securities. The highest price offered by a dealer to purchase a given security is

referred to as bid price, and the lowest price at which the dealer is willing to sell the

security is referred to as the ask price. As a result, the dealer adds securities to his/her

inventory by purchasing them at the bid price and in order to earn profit from the spread

between the bid and ask prices, the dealer sells securities from his or her inventory at the

ask price. The trading in OTC market is different from auction process on the organized

securities exchanges. The prices at which OTC securities are traded in the OTC market are a

result of both competitive bids and negotiation. Besides creating a secondary (re‐sale)

market for outstanding securities, the OTC market also acts like a primary market in which

all new public issues are sold.

DERIVATIVE SECURITIES MARKETS

Derivative Securities are financial contracts whose values are derived from the value of

underlying financial assets (e.g. securities). Derivative securities are also called derivatives.

The value of each derivative security tends to be related to the value of the underlying

financial asset in a manner that is understood by business firms and investors. As a result,

derivative securities allow individual investors and business firms to take positions in the

securities on the basis of their expectations of movements in the underlying financial

assets. Specially, investors usually speculate on expected movements in the value of the

underlying financial asset without having to actually purchase the financial asset. In

majority of cases, a speculative investment in the derivative can generate a much higher

return as compared to the same investment in the underlying financial asset. On the other

hand, this type of investment will also result in a much higher level of risk for the investors.

Derivative securities are not just used to take speculative positions but also to hedge or

reduce exposure to risk. For instance, business firms that are negatively affected by interest

rate movements can take a particular position in derivative securities that can balance the

effects of movements in interest rate. Derivative securities can reduce its risk by reducing

the exposure of a firm to some external force. Derivative securities are used by some of the

investors to reduce the risk of their investment portfolio. For example, the investors can

take a particular position in derivatives to protect themselves against an anticipated

temporary decline in the bonds or the stocks they own. Derivative securities are only traded

on special exchanges and through sophisticated telecommunications systems. Financial

institutions, for example, commercial banks and securities firms match up buyers and

sellers to facilitate the trading of derivative securities.

THE FOREIGN EXCHANGE MARKET

The market that allows for the purchase and sale of currencies to facilitate international

purchases of products, services and securities is regarded as foreign exchange. The foreign

exchange market is not based in a single location but is composed of large banks which


exist around the world. The banks serve as intermediaries between the buyer (investors or

business firms) and the seller of specific foreign currency. There are two major components

of foreign exchange market a spot market and a forward market.

SPOT MARKET

Spot market is a major component of the foreign exchange market and facilitates the

immediate exchange of currencies. The existing exchange rate at which one currency can be

immediately exchanged for another currency is known as the spot exchange rate or spot

rate. For example, in past years, the Canadian dollar’s value has ranged between 0.60 and

0.80 U.S dollars. Alternatively, 1 Canadian dollar = 0.60 U.S dollars or 1 U.S dollar = 1.66

Canadian dollar. When business firms purchase foreign supplies or acquire a firm in a

foreign country and when investors invest in foreign securities, they normally use the spot

market to obtain the currency needed for the transaction.

Exchange rates were almost fixed during the Bretton Woods era (1944 to 1971). They could

only change by 1 percent from an initially established rate. To maintain stable exchange

rates, central banks of countries intruded by exchanging their currency on reserve for other

currencies in the foreign exchange market. The boundaries of exchange rates were

expanded to be 2.25 percent from the specified value by 1971, but this still restricted

exchange rates from changing significantly over period of time.

During the year 1973, the boundaries were abolished. This was the result of pressure on

some currencies to adjust their values because of large differences between the demand

and the supply of a specific currency. For example if the flow of trade and investing

between the United States and a given country changes, the U.S. demand and the supply of

that foreign currency for sale (exchanged for dollars) will also change.

The spot rates of most currencies changes because of the continuous change in demand

and supply conditions for a given currency. Therefore, most investors and business firms

that will need or receive foreign currencies in the future are exposed to fluctuations in

exchange rate.

FORWARD MARKET

The forward market is responsible to facilitate the foreign exchange transactions that

involve exchange of currencies in future. The specified or quoted exchange rate at which

one currency can be exchanged for another currency on a specific date in future is known

as the forward rate. For most widely traded currency, the quote for forward rate is typically

close to the spot rate quote at a given point in time. Most of the commercial banks that

play role in the spot market also participate in the forward market by accommodating

requests of individual investors and business firms. They provide quotes to individual

investors or business firms who wish to buy or sell a specific foreign currency at a future

point in time.


Individual investors or business firms who make use of the forward market negotiate with a

commercial bank for a forward contract. The forward contract specifies the amount of a

specific currency that will be exchanged in future, the exchange rate (the forward rate) at

which that currency will be exchanged and the future date on which the specific exchange

will take place. Forward contract can be in the form of ‘buying the currency forward’ or

‘selling the currency forward’. A business firm can involve in a forward contract by ‘buying

the currency forward’, if it anticipates the requirement of foreign currency in the future. On

the other hand, if the firm anticipates receiving a foreign currency in future, it can involve in

a forward contract in which it ‘sells the currency forward’.

TOPIC SUMMARY

All types of business firms in need of short term funds issue commercial paper as a means

of obtaining funds. These firms also invest in the other forms of money market securities

(e.g. Treasury bills) when they have temporarily available funds. Investors invest in all the

kinds of securities discussed above. If investors wish to invest their funds for a very short

time period, they usually focus on the money market securities. Whereas, when they can

Example – Spot and forward Market

Charlie Co., a business firm in United States, expects to receive 200,000 Euros at

the end of each of the next 3 months from exporting products to a Germen firm.

The spot rate of the euro is 1.20 and the forward rate of the euro is also 1.20 for

each of the next 3 months. Charlie Co. anticipates that the value of euro will

decrease to 1.12 in 3 months. If Charlie Co. decides not to use a forward contract

then it will be converting the Euros received into dollars at the spot rate that exists

in 3 months. A comparison of the cash flows that is expected to occur in 3 months

is as follows.

TABLE 1: A comparison of expected Cash flows

Choices Exchange Rate Expected Cash Inflows

1. Use the spot

market

The spot rate in 3 months

is expected to be 1.12. €200,000 × 1.12 = 224,000

2. Use the forward

market

The 3‐month forward

rate is 1.20 €200,000 × 1.20 = 240,000

The comparison shows that Charlie Co. expects to receive 16,000 higher cash

inflows as a result of hedging with a forward contract. Thus Charlie Co. decides to

negotiate a forward contract to sell €200,000 forward. Instead of an exporter, if

Charlie Co. were an investor and anticipated to receive Euros in the future, it could

have been feasible to use a forward contract in the same manner.


invest their funds for long periods they choose capital market securities. Although, the

money market securities provide a relatively low expected return, but are highly liquid and

generate a positive return until the investor decides to use funds somewhere else. On the

other hand, the capital market securities offer higher returns, but their expected returns

are subject to a higher degree of risk. Capital markets aid in the exchange of long‐term

securities, therefore they help to finance the long‐term growth of government agencies and

business firms. In the capital markets, institutional investors play a major role in supplying

funds. Commercial banks, insurance companies, pension funds and bond mutual funds are

major investors for bonds in the primary markets and secondary markets. Whereas,

insurance companies, pension funds and stock mutual funds are major investors for stocks

in the primary and secondary markets.

Self‐Reflection Questions

1. Distinguish between the roles of primary and secondary markets.

2. Distinguish between money and capital markets.

3. How can corporations use international capital markets to raise funds?

4. Why are derivative securities purchased by investors?

5. Distinguish between the spot market and forward market for foreign exchange

6. What is the meaning of the term risk free rate?

7. Explain why the firm that issues a corporate bond must promise investors a higher

return than that available on a treasury security that has the same maturity.

8. How does stock differ from bonds in terms of ownership privileges?

9. How does the stock exchange facilitate the exchange of stocks?

10. How does OTC market differ from the organized securities exchange?


UNIT 2 – REFERENCES

Frederic S Mishkin and Stanley Eakins (2012), Financial Markets and Institutions, Global 7th

edition, Person Education as Prentice Hall Limited

Gitman, Lawrence J. Web Chapter Financial Markets and Institutions available at


f

Madura, Jeff (2012), Financial Markets and Institutions, 10th edition, South‐West, Cengage

Learning Limited

UNIT 2 – SUMMARY


The assignment and activities covered in the unit will enable the students to clearly

visualize the role of financial institutions and markets and in what respect they are different

from one country to another.

SUMMARY

The unit describes in detail how financial institutions serve managers of firms as

intermediaries between investors and business firms. It highlights the various types of

financial institutions and how they work. Provides an overview of financial markets and

explains how investors and businesses trade money market and capital market securities in

the financial markets in order to satisfy their needs. It sheds light on the major securities

exchanges, derivative securities and foreign exchange market and explains why investors

and business firms use them. The roles of financial managers, financial markets and

investors in channelling financial flows of funds are summarized in the table.

Table 2: Channelling financial Flow of Funds

Role of Financial Managers Role of Financial Markets Role of Investors

Financial managers make

financing decisions that

require funding from

investors in the financial

markets.

The financial markets provide

a forum in which firms can

issue securities to obtain the

funds that they need and in

which investors can purchase

securities to invest their funds.

Investors provide the

funds that are to be

used by financial

managers to finance

corporate growth.

NEXT STEPS

Having understood the types and roles of financial institutions and markets the next unit

will explore the financial statements. Also, ratio analysis are highlighted in the next unit.


UNIT THREE ‐ FINANCIAL STATEMENTS

UNIT 3 INTRODUCTION

Business transactions are recorded, summarized and reported by the use of different kinds

of financial statements, each serving a different purpose. Financial statements are prepared

in order to reflect on the activities of an organisation, to measure performance, to

benchmark and compare against other organisations. Financial statements are the primary

communication tool to stakeholders of an organisation. This course primarily focus on three

financial statements, namely; the statement of comprehensive income, the balance sheet

and cash flow statements. It is through these reports that the progress of an organization

can be measured and corrective action be taken, if there are deviations from the goals of

the business. Therefore, whilst the financial planning course has introduced the student to

preparation of financial statements, in this course the student is introduced to the use of

financial statements as a financial reporting system that could help management and

shareholders to assess the financial position of the business. As a result, this unit introduces

the students to the three types of financial statements. Also, the students are equipped

with the skills to analyse each type of the financial statements. Specific objectives of the

unit are outlined below.

UNIT 3 OBJECTIVES


1. Tell the difference between the various financial statements

2. Analyse and interpret the different financial statements

UNIT 3 READINGS

To complete this unit you are required to read the following book chapters:

Stolowy, H. And Lebas, Michel J. (2002) Corporate Financial Reporting – A Global

Perspective. Thomson Learning. London. – Chapters 2 and 3


Subramanyam, K.R. and Wild John. J (2009) Financial Statement analysis, 10TH Edition,

McGraw‐Hill Irwin, New York. – Chapter 1 in http://highered.mcgraw‐

hill.com/sites/dl/free/0073379433/597452/Subramanyam_fsa_sample_Ch01.pdf accessed

23/04/2013

IFRS (2012) Illustrative Financial Statements. KPMG. In

http://www.kpmg.com/Global/en/IssuesAndInsights/ArticlesPublications/IFRS‐illustrative‐

financial‐statements/Documents/IFRS‐illustrative‐financial‐statements‐2012.pdf accessed

29/04/2013


To reinforce the students’ learning during the course seminars, the participating institutions

could avail published financial statements of a local organisation. The students could be

assigned to work in groups to analyse and interpret the different financial statements.

Another activity could be a multiple choice test designed to examine the student’s

understanding of the component parts of the different types of financial statements. The

end of topic questions are provided to assess student learning for the respective topics.


TOPIC 3.1 STATEMENTS OF COMPREHENSIVE INCOME AND FINANCIAL POSITION


The performance of a company should be measured overtime to judge as to whether the

company is achieving its goals and delivering value to its shareholders. Also, the

performance of the company could be measured by making a comparison with other similar

companies, which could be complicated due to different sizes of companies and disparity of

their operations. To do so, the company’s financial statements i.e. the balance sheet, the

income and cash flow statement, which result from the financial accounting process, are

analysed using financial ratios. The analysis of financial statements using ratios is termed

financial analysis. This topic explores the components of the financial statements.


Upon completion of this topic the students will be able to:

1. Describe the component elements found in the statements comprehensive income and

financial position

COMPONENTS OF THE STATEMENT COMPREHENSIVE INCOME

The statement of comprehensive income is based on the business transactions that have

been recorded for a specific period, usually 12 months. It includes profit or loss for that

period plus other comprehensive income recognised in that period. However, an entity has

a choice of presenting two statements or a single statement of comprehensive income.

TWO STATEMENTS

Where the company presents two statements, the first statement is the income

statement (profit and loss), the bottom line of which is profit or loss. This approach

is consistent with some International Financial Reporting Standards (IFRSs) (see IAS

1.89) that permit for some components to be excluded from profit or loss and

instead to be included in other comprehensive income. The second is the

statement of comprehensive income, which begins with the profit or loss from the

income statement bottom line.


Figure 4: Presentation of two statements

The components of each of the two statements are outlined below.

COMPONENTS OF THE PROFIT AND LOSS

The income statement (profit or loss) is based on the business transactions that have been

recorded for a specific period, usually 12 months. The International Accounting

Standards (IAS) regulation number 1.88 stipulates that all items of income and

expense recognized in a period must be included in profit or loss unless a standard

or an interpretation requires otherwise. As a result of the 2003 revision to IAS 1, the

Standard is now using 'profit or loss' rather than 'net profit or loss' as the

descriptive term for the bottom line of the income statement.

The profit and loss statement allows for the business to analyse how the income

(profit or loss) for the period was created. The statement records the resources

consumed and the revenue generated from serving the customers during a specific

period. The profit and loss statement does not reflect the financial position of the

firm, but tells us how profitable the transactions for serving the customers were.

The bottom line of the income statement starts the other comprehensive income

PROFIT AND LOSS STATEMENT

Operating income – operating expenses = PROFIT OR LOSS

STATEMENT OF OTHER COMPTREHENSIVE INCOME

Profit and loss + other non operating income


TABLE 3: EXAMPLE OF THE COMPONENTS OF PROFIT AND LOSS STATEMENT

ABC Corporation

For the Year Ended December 31, 2007

Sales Revenue 2,900,000 Revenue Section

Cost of Goods Sold 1,750,000

Gross Profit (Margin) 1,150,000

Operating Expenses:

General & Administrative Expenses 140,000 Operating Expenses:

Selling Expenses 80,000 Note: Expenses are on the left with the total on the right.

Amortization of Intangible Assets 25,000

Write off of Goodwill 17,500

Restructuring Costs 420,000

Loss from Inventory Write‐Down 130,000

Total Operating Expenses 812,500

Operating Income 337,500

Other Income (Expense): Other Income (expense) includes items that relate to operations but are not part of operations. Note: If there is a single item it is places on the right. Multiple items are placed on the left with the total on the right.

Interest Income 75,000

Interest Expense (42,500)

Gain on Sale of Operating Assets 78,200

Loss on Sales of Operating Assets (8,250)

102,500

Income From Continuing Operations Before Income Tax Expense

23,500,000

Income Tax Expense @ 40% 9,400,000 Income Tax from continuing operations is shown as a separate line item.

Income before Extraordinary Items 14,100,000

Discontinued Operations:

Operating Income (loss)from Discontinued Operation Net of 40% tax

4,000,000

Discontinued Operations usually have two components. The first is the gain (loss) from part year operations.

Loss (Gain)on Sale of Discontinued Operations Assets Net of 40% tax

(15,000,000

)

The second is the gain (loss) from the sale of the assets.

Loss (Gain) on Discontinued Operations (11,000,000) Both are always net of Income Tax.

Income Before Extraordinary Items 3,100,000

Extraordinary Items:

Gain from Early Sale of Bonds Net of 40% Tax

12,000,000

Extraordinary Items are items that are not expected to happen frequently but have a major (Material) impact on the current year’s operations. Items are report net of income tax

Loss From Flood Damage Net of 40% Tax (3,000,000)

Gain (Loss) from Extraordinary Operations 9,000,000

Profit or (loss) 12,100,000

Source: extracted from

(http://studentweb.usq.edu.au/home/W0054016/Pages/Financial_Acct_Folder/Ex

ample_Comprehensive_Income_Statement.htm)


COMPONENTS OF THE STATEMENT OF COMPREHENSIVE INCOME IN A TWO STEP APPROACH

In a two statement approach, the comprehensive statement starts with the bottom

line of the profit and loss statement. The components of the comprehensive income

should include:

changes in revaluation surplus

actuarial gains and losses on defined benefit plans recognised in accordance with

gains and losses arising from translating the financial statements of a foreign operation

gains and losses on re‐measuring available‐for‐sale financial assets

The effective portion of gains and losses on hedging instruments in a cash flow hedge.

(IFRSs, 2013)

Table 4: Example of statement of comprehensive income

Profit or (loss) 12,100,000

Other Comprehensive Income (Loss):

Comprehensive Income is from non‐owner transactions. The gains and losses are outside the control of the owner. Items are reported net of income tax.

Foreign currency translation adjustment loss, net of 40% tax (3,900,000)

Unrealized gains on investment securities, net of 40% tax 4,200,000

Total Other Comprehensive Income (Loss) 300,000

Comprehensive Income 12,400,000

Source: extracted from


ample_Comprehensive_Income_Statement.htm )


SINGLE STATEMENT OF COMPREHENSIVE INCOME

The single statement of comprehensive income combines the components of the income

statement and the statement of other comprehensive income, as highlighted in FIGURE 5

and example below.

Figure 5: Presentation of a single statement of comprehensive income

The International Accounting Standards (See IAS 1) stipulate for the minimum items in the

statement of comprehensive income to include the following:

a) revenue

b) finance costs

c) share of the profit or loss of associates and joint ventures accounted for using the

equity method

d) tax expense

e) a single amount comprising the total of (i) the post‐tax profit or loss of discontinued

operations and (ii) the post‐tax gain or loss recognised on the disposal of the assets

or disposal group(s) constituting the discontinued operation

f) profit or loss

g) each component of other comprehensive income classified by nature

h) share of the other comprehensive income of associates and joint ventures

accounted for using the equity method

i) total comprehensive income

STATEMENT OF COMPREHENSIVE INCOME

Profit and loss

Other comprehensive income

TOTAL COMPREHENSIVE INCOME


j) The following items must also be disclosed in the statement of comprehensive

income as allocations for the period

k) profit or loss for the period attributable to non‐controlling interests and owners of

the parent

l) total comprehensive income attributable to non‐controlling interests and owners of

the parent

m) Additional line items may be needed to fairly present the entity's results of

operations.

n) No items may be presented in the statement of comprehensive income (or in the

income statement, if separately presented) or in the notes as 'extraordinary items'.

o) The AIS also requires for disclosure of the following, if material, either in the

statement of comprehensive income or in the notes.

p) write‐downs of inventories to net realisable value or of property, plant and

equipment to recoverable amount, as well as reversals of such write‐downs

q) restructurings of the activities of an entity and reversals of any provisions for the

costs of restructuring

r) disposals of items of property, plant and equipment

s) disposals of investments

t) discontinuing operations

u) litigation settlements

v) other reversals of provisions

The IAS further stipulates that the expenses in the profit or loss statement be categorised

for analysis either by nature (raw materials, staffing costs, depreciation, etc.) or by function

(cost of sales, selling, administrative, etc). Where the expenses are categorised by function,

the IAS, additional information on the nature of expenses must be disclosed, for example –

at a minimum depreciation, amortisation and employee benefits expense. Below is an

example of the Statement of Comprehensive Income. )


Table 5: Example of a single statement of comprehensive income

Statement of Income and Comprehensive Income

For the Year Ended December 31, 2007

Sales Revenue 2,900,000

Cost of Goods Sold 1,750,000

Gross Profit 1,150,000

Operating Expenses:

General & Administrative Expenses 140,000

Selling Expenses 80,000

Amortization of Intangible Assets 25,000

Write off of Goodwill 17,500

Restructuring Costs 420,000

Loss from Inventory Write‐Down 130,000

Total Operating Expenses 812,500

Operating Income 337,500

Other Income (Expense):

Interest Income 75,000

Interest Expense (42,500)

Gain on Sale of Operating Assets 78,200

Loss on Sales of Operating Assets (8,250)

Total Other Operating Income(Expense) 102,500

Income From Continuing Operations Before Income Tax Expense

23,500,000

Income Tax Expense @ 40% 9,400,000

Income before Extraordinary Items 14,100,000

Discontinued Operations:

Operating Income (loss)from Discontinued Operation Net of 40% tax

4,000,000

Loss (Gain)on Sale of Discontinued Operations Assets Net of 40% tax

(15,000,000)

Loss (Gain) on Discontinued Operations

(11,000,000)

Income Before Extraordinary Items 3,100,000

Extraordinary Items:

Gain from Early Sale of Bonds Net of 40% Tax 12,000,000

Loss From Flood Damage Net of 40% Tax (3,000,000)

Gain (Loss) from Extraordinary Operations 9,000,000

Net Income 12,100,000

Other Comprehensive Income (Loss):

Foreign currency translation adjustment loss, net of 40% tax

(3,900,000)

Unrealized gains on investment securities, net of 40% tax

4,200,000

Total Other Comprehensive Income (Loss)

Financial Management Page| 57

300,000

Comprehensive Income 12,400,000

Earnings Per Share (1,000,000 shares issued and Outstanding)

Income (loss) From Continuing Operations 14.10

Loss (Gain) on Discontinued Operations (11.00)

Gain (Loss) from Extraordinary Operations 9.00

Other Comprehensive Income (Loss) 0.30

Comprehensive Income Per Share 12.40

Source:


ample_Comprehensive_Income_Statement.htm )

COMPONENTS OF THE STATEMENT OF FINANCIAL POSITION (BALANCE SHEET)

The balance sheet statement provides an up to date statement of the financial

position or net worth of the company for a given period. As stipulated by the

International Financial Reporting Board, the statement of financial position (balance

sheet) presents and classifies the resources (assets), the obligations to external

parties (liabilities to creditors) and equity to share holders for a certain period.

These comprise the accounting equation also known as the balance sheet

equation, which is expressed as: assets = Liabilities + equity

The balance sheet can either be presented using a vertical format or a horizontal

format. The vertical format is mostly used for published accounts. According to the

International Accounting Standard 1, Current assets are cash; cash equivalent;

assets held for collection, sale, or consumption within the entity's normal operating

cycle; or assets held for trading within the next 12 months. All other assets are non‐

current.

The current liabilities are obligations that are to be settled within the entity's

normal operating cycle or due within 12 months, or those held for trading, or those

for which the entity does not have an unconditional right to defer payment beyond

12 months. Other liabilities are non‐current.


The International Accounting Standard 1 also requires that the minimum balance

sheet items should include:

(a) Property, plant and equipment

(b) Investment property

(c) Intangible assets

(d) Financial assets (excluding amounts shown under (e), (h), and (i))

(e) Investments accounted for using the equity method

(f) Biological assets

(g) Inventories

(h) Trade and other receivables

(i) Cash and cash equivalents

(j) Assets held for sale

(k) Trade and other payables

(l) Provisions

(m) Financial liabilities (excluding amounts shown under (k) and (l))

(n) Liabilities and assets for current tax, as defined in IAS 12

(o) Deferred tax liabilities and deferred tax assets, as defined in IAS 12

(p) Liabilities included in disposal groups

(q) Non‐controlling interests, presented within equity and

(r) Issued capital and reserves attributable to owners of the parent


However, additional line items may be needed to fairly present the entity's financial

position.

The International Accounting Standards further requires the following disclosures

in relation to issued share capital and reserves:

a) numbers of shares authorised, issued and fully paid, and issued but not fully paid

b) par value

c) reconciliation of shares outstanding at the beginning and the end of the period

d) description of rights, preferences, and restrictions

e) treasury shares, including shares held by subsidiaries and associates

f) shares reserved for issuance under options and contracts

g) a description of the nature and purpose of each reserve within equity

Table 6: Example of a Statement of Financial Position

31 December 20X7 31 December 20X6

ASSETS Currency unit(000

Current asset

Cash and cash equivalents 312,400 322,900

Trade receivables 91,600 110,800

Other financial assets—derivative hedging instruments

2,000 1,100

Inventories 135,230 132,500

Other current assets 23,650 11,350

Total current assets 564,880 578,650

Non‐current asset

Financial assets—investments in shares

100,150 110,770

Investments in associates 100,500 121,000

carried at fair value 60,000 71,000 carried at cost less impairment 40,500 50,000

Investments in jointly controlled entities

42,000 35,000



Investment property—carried at fair value

150,000 120,000

Property, plant and equipment—carried at cost less accumulated

Depreciation 200,700 240,020

Biological assets 70,000 75,000


Goodwill 80,800 91,200

Other intangible assets 107,070 127,560

Deferred tax assets 50,400 25,000

Total non‐current assets 901,620 945,550

Total assets 1, 466,500 1,524,200

LIABILITIES AND EQUITY

Current liabilities

Bank overdrafts 10,000 7,000

Trade and other payables 90,100 160,620

Short‐term borrowings 150,000 200,000

Current portion of bank loans 20,000 20,000

Current portion of obligations under finance leases

1,500 1,200

Current portion of employee benefit obligations

15,000 10,000

Current tax payable 23,500 40,800

Short‐term provisions 5,000 4,800

Total current liabilities 315,100 454,420

Non‐current liabilities

Bank loans 65,000 85,000

Obligations under finance leases 2,300 3,800

Environmental restoration provision

26,550 48,440

Long‐term employee benefit obligations

78,000 75,000

Deferred tax liabilities 5,800 26,040

Total non‐current liabilities 177,650 238,280

Total liabilities 492,750 692,700

Equity

Share capital 650,000 600,000

Retained earnings 243,500 161,700

Actuarial gains on defined benefit pension plan

8,200 20,100

Gains on hedges of foreign exchange risks of firm commitments

2,000 1,100

Total equity attributable to owners of the parent

903,700 782,900


Non‐controlling interests 70,050 48,600

Total equity 973,750 831,500

Total equity and liabilities 1,466,500 1,524,200

TOPIC SUMMARY

The comprehensive income statement and the statement of financial position are the basis

upon which the health of the organisation can be assessed. It was therefore important that

the learners’ be introduced to the make‐up of these statements, before they could employ

them in the financial analysis. As a result, this topic has introduced the learners to the

components of these statements as required by the International Accounting Standards

(IAS) 1.


1. What is the difference between the single step and two steps statement of

comprehensive income?

2. List the items of the statement of financial position.


TOPIC 3.2 ANALYSIS OF THE FINANCIAL STATEMENTS


Financial analysis is based on the financial statements, which have been introduced above.

Financial analysis is normally performed by organisations and business analyst to highlight

the company’s financial position. The information derived from the analysis could help the

business managers and investors to gauge the financial position of the company by

addressing questions pertaining to availability of resources for growth and for investment.

Other questions that could be addressed by financial analysis to the managers and investors

pertain to the level of profitability of the firm and generally as to whether the company

performs as was expected.


At the end of the topic the students will be able to:

1. Analyse and interpret the statement of comprehensive income and the statement of

financial position

2. Advice management on how to improve the financial position of the firm, based on the

financial analysis.

INTRODUCTION TO RATIO ANALYSIS

Businesses constantly gauge the performance of the business in terms of its management,

plans, financial situation and strategies to inform decision making. Business analysis is

therefore deemed an important exercise of the firm as it informs stakeholders about the

state of the firm. Whilst there are several types of business analysis (see FIGURE 6 below),

this course mainly focuses on financial analysis.

Ratio analysis provides ways of comparing and investigating the relationships between

different pieces of financial information. There is a wide range of financial ratios ranging

from simple to complicated computations. However, the biggest problem with ratios is that

people calculate them differently. Also, the definitions of their sources differ. It is therefore

important that when using the ratios as tools of analysis, you should be careful to


document how you calculate each ratio. When comparing your numbers to those of

another sources, be sure you know how their numbers are computed, (Firer et al, 2004).

The following questions need to be taken into consideration when analysing statements

using ratios:

1. How is the ratio computed?

2. What is the ratio intended to measure, and why might we be interested?

3. What is the unit of measurement?

4. What might a high or low value be telling us? How might such values be misleading?

5. How could this measure be improved?

Figure 6: Process of business analysis

Source: Subramanyam and Wild (2009)

Financial ratios are traditionally grouped into the following categories:

Short‐term solvency, or liquidity, ratios.

Profitability ratios

Investment ratios

Asset management, or turnover or efficiency ratios


Figure 7 below, depicts the four types of ratios. The four types of ratios are examined

below;

Figure 7: Types of Financial Ratios

Source: Dyson (2010)

LIQUIDITY MEASURES

As the name suggests, short‐term solvency ratios as a group are intended to provide

information about a firm’s liquidity, and these ratios are sometimes called liquidity

measures .The primary concern is the firm’s ability to pay its bills over the short run without

undue stress. Consequently, these ratios focus on current assets and current liabilities. For

obvious reasons, liquidity ratios are particularly interesting to short‐term creditors.

Since financial managers are constantly working with banks and other short‐term lenders,

an understanding of these ratios is essential. One advantage of looking at current assets

and liabilities is that their book values and market values are likely to be similar. Often

(though not always), these assets and liabilities just don’t live long enough for the two to

get seriously out of step. On the other hand, like any type of near‐cash, current assets and

liabilities can and do change fairly rapidly, so today’s amounts may not be a reliable guide

to the future.

The figures from the statement of financial position will be employed to illustrate

computation of the liquidity measures.


Example – Current ratio

In 2007 ,, . in 2008

,, .

CURRENT RATIO

One of the most widely used ratios is the current ratio. The ratio is represented as follows,

gives a relationship between current assets and currents liabilities, its measures as to how

much an organisation can be able to meet its short term liabilities as they fall due by the

conversion of its current assets.

Current ratio =

Because current assets and liabilities are, in principle, converted to cash over the following

12 months, the current ratio is a measure of short‐term liquidity. The above results show

that the current ratio was 1.6 times in 2007 and 1.3 in 2008, this simply shows how many

times the current liabilities are covered by the current assets.

The higher current ratio is quite favourable to the organisation and other external

stakeholders, e.g. creditors. A high current ratio means an organisation will be able to settle

its short term liabilities as they fall due, but it also may indicate an inefficient use of cash

and other short‐term assets. On normal circumstances, a current ratio of above 1 is

favourable, however this is relative to the industry, a current ratio of less than 1 would

mean that net working capital (current assets less current liabilities) is negative.

QUICK OR ACID TEST RATIO

Inventory is often the least liquid current asset. It’s also the one for which the book values

are least reliable as measures of market value since the quality of the inventory isn’t

considered.(www.mhhe.com.rwj) this is because Some of the inventory damaged,

obsolete, or lost. We know keeping large amounts of inventory is an unhealthy situation, it

compromise liquidity and show sign of problems in turning over the stock. In this case on


Example – Quick ratio

In 2007 , ,, . in 2008

, – ,, .

Example – Profit margin

In 2007 ,, , . %

calculation of the quick or acid test ratio, inventory is eliminated from the current assets,

only highly liquid assets are taken

Quick ratio (acid test ratio) =

The acid test ratio gives us the result that it is not getting better with time, the ratio in 2007

is better than in 2008. The ratio may be acceptable if it’s comfortably within 1, not

forgetting that it will differ according to industries. The ratios above show that inventory

makes only a humble part of the current asset and it is quite at a safe level.

PROFITABILITY MEASURES

Profit is believed to be the most important measure of success in an organisation.

Profitability measures as to whether the firm is employing and managing its resources and

operations efficiently. There are three commonly used measures of profitability, namely

profit margin, return on assets and return on equity. The focus in this group is on the

bottom line—net income. For illustration on these ratios, we will use figures from the

income statement and the balance sheet presented above.

PROFIT MARGIN

Companies pay a great deal of attention to their profit margin this ratio calculates net

income as a percentage of sale revenue. It measures how much profit is generated from

sales. Remember profit is the excess of sales revenue over costs and expenses.

Profit margin =

x 100


Example – Return on Assets

Gross profit Ratio = , , , , . %

Example – mark‐ up ratio 1,150,000, , . %

The ratio shows that for every unit of currency, 3.5% of that is net income. If we take a

dollar as our unit of currency, it means that for every dollar‐3.5cents are generated as net

income. In this case, the ratio may be seen as low, however it should be taken into

consideration as which other factors contribute to such figure, especially the kind of

industry the business is in. considering how low the margin is, an organisation may take on

measures to increase the ratio. Decreasing sales would not be and objective decision,

therefore it might have to maintain tight control on its costs and expenses.

ADDITIONAL RATIOS

GROSS PROFIT RATIO

Gross profit Ratio = x100

The gross profit ratio measures the extent to which the company has been successful in its

trading. The formula is as follows

MARK UP RATIO

The mark‐up ratio measures the extent to which the gross profit adds to the cost of goods

sold to generate sales. Sales activity can be realised by reducing the mark‐up. The attempt

to increase sales activity by reducing the mark‐up could harm the gross profit. However,

large volume of sales could increase the profits.

Mark up ratio =


Example – Stock turn‐over (in 2007) , , , = 12.94 times

NET PROFIT RATIO

This ratio makes an internal comparison of the net profit realised in a given period to the

sales generated in that period. Because of the different expenses that could impact the net

profit, comparison with other firms may be a challenge and would, as such, require for an

adjustment to account for such differences.

EFFICIENCY RATIOS

The efficiency ratios allow for an analysis of how efficiently the company is being managed.

To measure efficiency, comparison is made between two periods and also with external

companies. Several ratios could be employed, in this course the focus is on stock turnover,

fixed assets turnover, trade debtor collection period and trade creditor payment period.

STOCK TURNOVER RATIO

The stock turnover ratio measures the number of times the company is able to turnover its

stock, the higher the turnover, the more efficient the company is in moving its stock. A

higher stock turnover implies that the company’s funds are not tied in non‐moving stock

items. A comparison between 2 periods should an indication of the efficiency in moving

stock between periods. A between companies comparison would give an indication of

whether the company is more (less) efficient in moving its stocks relative to its customers.

Stock turnover ratio =

T

This ratio implies that the company has a little over a month’ s sales in stock.

RETURN ON ASSETS

Return on assets (ROA) is a measure of profit per dollar of assets. It can be defined several

ways, but the most common is:


Example – Return on Assets (in 2007) ,, , . %

Example – Return on Assets (in 2007) ,, . %

Example – trade creditor payment period

A company’s credit sales for 2012 amounted to 4452 million and its trade debtors for that year amounted to £394 million. The company’s credit policy is 28 days.

Debt collection period = .

Return on assets =

This ratio measures how much net income is being generated by the total assets, this

simply means how effectively are the assets being employed in order to generate net

income. It is favourable if the ratio is high, but the determining factor is in which industry is

the business in. The above ratio shows that for every unit of assets dollar,69 cents of net

income is being generated.

RETURN ON EQUITY

This the measure of how much the shareholders fared in a year (Firer et al,2004). This

actually shows how much profit has been generated by the equity invested in an

organisation. The measure is calculated as follows

Return on Equity =

TRADER DEBTOR COLLECTION PERIOD

The trade debtor collection period measures efficiency of the company in collecting from its

trade debtors. The longer collection period shows that the company takes long to collect

from its debtors, and therefore inefficient. The determination of the length of the collection

period depends of the company’s debtor collection period.

Trade debtors collection period =


Example – trade credit payment period

A company’s credit purchases for 2012 amounted to 3200 million and its trade debtors for that year amounted to 694 million. The credit terms given to the company is 50 days

Trade debtor payment period =

In this case, the company is not efficient in collecting from its debtors.

Other sources (books) use average trade debtors instead of closing trade debtors, i.e.

(Opening trade debtors + closing trade debtors).

TRADE CREDITOR PAYMENT PERIOD

Like the debt collection period, the management could be interested in finding out the

number of days it takes to pay out its creditors. Unlike the debt collection period, a longer

payment period (of course, within the credit contract), indicate the efficiency of the firm in

managing its finances. If the ratio goes beyond the agreed credit limit, this would a red flag

to indicate that the company is struggling to meet its obligations to trade creditors.

Debt collection period =

The ratio shows that the company takes more than 2 months to meet its obligations to the

trade creditors. Failure to meet credit payment terms could result in loss of credit purchase.

This could put a strain on the company’s cash position as the company is required to make

cash purchases.

Note that, the credit purchases figure is normally not provided in the published accounts.

You could calculate the cost of sales and assume that the purchases were on credit and also

that expenses have not been included in the cost of sales, unless otherwise stated, in which

case they must be excluded. Average trade creditors could be used as in the debtors

collection period above.


Example – Earnings per share , ,, , .

INVESTMENT RATIOS

The investment ratios are particularly of interest to the investors as they inform the

investors of how well their investment in the company pays off. This group of ratios covers

earnings per share, price earnings and capital gearing ratios.

EARNINGS PER SHARE

The earnings per share ratio tells the percentage of dividends that are due to the ordinary

share holders after the tax and preference share holders have been paid. The earnings are

compared to the of shares at a point in time. Using the financial statements above, the

earnings per share is calculated as:

Earnings per share =

PRICE TO EARNINGS RATIO

Share holders can compare earnings per share with their stock market price to see if there

are any gains from their investment. The price to earnings ratio assess the number of times

the market price in the earnings. This is indicative of the number of years it will take the

investor to recover their investment in shares from the earnings. A comparison of the ratio

with other companies would reveal if the investor is worse off investing in the company.

High P/E ratio is indicative of a good future as the shares prices are high and the company

might be able to pay higher dividends in future. The ratio is calculated as:

Price earnings ratio =

CAPITAL GEARING RATIO

This ratio examines the extent to which the company is financed on loans (long term loans

and preference shares) relative to share holders funds. The risk associated with financing

the company from high loans is that the company will have to pay high interest and thus


reduce its ability to meet the ordinary share holders’ dividends. The other risk of relying on

high loans to finance the company is that, when the company becomes liquidated, the

ordinary share holders can only be paid after all the creditors have been paid. So if the

company is not able to pay its creditors, there is a danger that the shareholders will not be

paid.

Capital gearing ratio =

TOPIC SUMMARY

This topic has taken you through the analysis of financial statements, mainly following on

the financial statement examples given in the preceding topic. Four types of ratios have

been introduced in this topic and the formula for calculating these ratios have been

presented with examples. This should enable you to complete the topic reflection

questions presented below.


1. Calculate the appropriate liquidity, profitability, efficiency and investment ratios

for both 2011 and 2012

2. Comment on the company’s financial performance for the year ended 31st March

2012


Additional information:

1 All sales and all purchases are on credit terms.

2 The opening stock at 1 April 2010 was £20,000.

3 There were no accruals or prepayments at the end of either 2011 or 2012.

4 Assume that both the tax and the dividends had been paid before the end of the year.


5 The market price of the ordinary shares at the end of both years was estimated to

be 126p and 297p respectively.

Source: Dyson (2010, pp 233 – 238)


TOPIC 3.3 STATEMENT OF CASH FLOWS


Other than the financial position of the company, management is also concerned with the

changes in the cash account over time. The purpose of this topic is to highlight the

importance of presenting the state of affairs of the cash and cash equivalents as one of the

financial statements in a company. Because of the high liquidity of cash and cash

equivalents, the inflow and out flow of these assets need to be efficiently managed to avoid

paying out too much cash that what is coming in.


At the end of the topic, the students will be able to:

1. Distinguish the different types of cash flows

2. Prepare a cash flow statement

3. Analyse and interpret the cash flows of a business

CASH FLOWS

Cash flows are a revenue or expense stream that changes a cash account of the business

over a given period. Figure 8 illustrates the cash flows of business. It is important to note

that marketable securities, because of their highly liquid nature, are considered the same as

cash. Both cash and marketable securities represent a reservoir of liquidity that is increased

by cash inflows and decreased by cash outflows. Cash flows can be divided into three types

(1) operating, (2) investment and (3) financing.

The operating flows are directly related to sale and production of the products and services.

Investment flows are associated with purchase and sale of fixed assets and business

interests. Therefore, it is clear that the purchase transactions would result in cash outflows,

whereas sales transactions would result in cash inflows. The financing flows are a result of

debt and equity financing transactions. Incurring or repaying debt would result in a

corresponding cash inflow or outflow. Similarly, cash inflow would be the result of sale of

stock; the payment of cash dividends or repurchase of stock would result in an outflow.


Figure 8: The cash flows of a business


PRESENTATION OF THE CASH FLOW STATEMENT (IAS 7)

The requirements for the presentation of the cash flow statement is stipulated in the

international accounting standard (IAS) 7. Generally the information for the preparation of

the cash flow statement is drawn from other accounting and financial statements, such as

the manufacturing account, the trading account, the profit and loss account, the profit and

loss appropriation account and the balance sheet.

Figure 9 shows that the cash flow statement utilises information from seven sources in the

financial statements. First, manufacturing cost paid from the manufacturing account.

Secondly, cash received from customers and cash paid to suppliers from the trading

account. Thirdly, information on other cash and receipts and payments from the profit and

loss account. Fourthly, information on tax paid and dividends paid from the profit and loss

appropriation account. Fifthly, information on cash, bank balances, capital expenditure and

capital income from the balance sheet statement.


Figure 9:The interrelationship between cash flow statement and other financial statements

Source: Dyson (2010)

Given the diverse sources of information for preparation of the cash flow statement, the

statement could be prepared by using either direct or indirect or indirect methods. On one

hand, the direct method summarises all the cash book entries. On the other hand indirect

method uses information from the profit and loss and the balance sheet accounts. Dyson

(2010) gives succinct examples on this two methods, which we will use to illustrate the

difference between the two methods.

Table 7: Example for direct method


Source: Dyson (2010, pp 148 – 149)


Table 8: Example for indirect method


Source: Dyson (2010, pp 151 – 152)

ANALYZING THE CASH FLOW OF A BUSINESS

Cash flow is the primary focus of the financial manager both in managing finances and in

planning and decision making aimed at value creation of business. Important factors

affecting cash flow are any non‐cash charges e.g. depreciation. From an accounting

perspective, cash flows of a business can be summarized in the statement of cash flows.

Whereas, from a financial perspective, business often focus on both operating cash flow,

and free cash flow. Operating cash flow is used in managerial decision making and free cash

flow is closely watched by investors and other parties. In accounting terms, operating cash

flow can be defined as:

Operating Cash flow = Net profits after taxes+ Depreciation and other noncash charges

Or

OCF = NPAT + Depreciation and other noncash charges


INTERPRETATION OF CASH FLOW STATEMENT

The statement of cash flows allows the financial manager and other interested

parties to analyze the firm’s cash flow. The major categories of cash flow and the

individual items of cash inflow and outflow needs special attention to assess

whether any developments have occurred are in line with company’s financial

policies. In addition, the statement can be used to evaluate progress toward

planned goals or to check inefficiencies. For example, the increase in account

receivable and inventory results in major cash out flows, and credit or inventory

problems may be singled with this respectively. Using projected financial

statements, the financial manager can also develop a projected statement of cash

flows. This approach can be used to determine whether planned actions are

desirable in view of the resulting cash flows. An understanding of the basic financial

principles is extremely essential to the effective interpretation of the statement of

cash flows.

OPERATING CASH FLOW

Operating cash flow (OCF) of a business is generated by its normal operations of

producing and selling its output of goods or services. A variety of definitions of OCF

can be found in the financial literature. Equation introduced the simple accounting

definition of cash flow from operations. Here we refine this definition to estimate

cash flows more accurately. Unlike the earlier definition, this one excludes interest

and taxes in order to focus on the true cash flow resulting from operations without

regard to financing costs and taxes. Operating cash flow (OCF) .in financial

management terms it is defined in following equation:

Operating Cash flow = Earning before interests and taxes ‐ Taxes+ Depreciation

Or

OCF = EBIT –Taxes + Depreciation


Comparing the two Equations reveal that the major difference between the

accounting and finance definitions of operating cash flow is that the finance

definition excludes interest as an operating flow, whereas the accounting definition

in effect includes it. In the unlikely case that a firm had no interest expense, the

accounting and finance definitions of operating cash flow would be the same.

FREE CASH FLOW

The free cash flow (FCF) of a business is the amount of cash flow available to

investors—the providers of debt (creditors) and equity (owners)—after the firm has

met all operating needs and paid for investments in net fixed assets and net current

assets. Free cash flow can be defined in equation form as:

Free cash flow = Operating Cash Flow ‐Net fixed asset investment ‐ Net current

asset investment

Or

FCF = OCF – NFAI ‐ NCAI

The net fixed asset investment can be calculated as follows:

net fixed asset investment (NFAI) = Change in net fixed assets +Depreciation

Further analysis of free cash flow is beyond the scope of this introductory course.

Clearly, cash flow is the lifeblood of the business.

SUMMARY

This topic had set out to introduce you to the statement of cash flows. Specifically the

different types of cash flows have been explained. The two methods used to present the

cash flow statement have been presented and examples given for each method.



1. What are the 3 types of cash flows

2. Explain the differences and similarities between the methods of preparing a

cash flow statement

UNIT 3 REFERENCES

1. International Accounting Standards Board (2009) Presentation of Financial

statements in http://www.iasplus.com/en/standards/standard5 accessed 23rd

April 2013


McGraw‐Hill Irwin, New York. –in http://highered.mcgraw‐

hill.com/sites/dl/free/0073379433/597452/Subramanyam_fsa_sample_Ch01.pdf

accessed 23/04/2013

3. Dyson, John R. (2010) Accounting for non accounting Students. Pearson Education

Limited. Harlow. In http://web.kku.ac.th/chrira/Non%20Acct.%20Dyson.pdf accessed

26/04/2013

4. IFRS (2012) Illustrative Financial Statements. KPMG. In

http://www.kpmg.com/Global/en/IssuesAndInsights/ArticlesPublications/IFRS‐

illustrative‐financial‐statements/Documents/IFRS‐illustrative‐financial‐statements‐

2012.pdf accessed 29/04/2013

5. Stolowy, H. And Lebas, Michel J. (2002) Corporate Financial Reporting – A Global

Perspective. Thomson Learning. London. – Chapters 2 and 3


McGraw‐Hill Irwin, New York. – Chapter 1 in http://highered.mcgraw‐

hill.com/sites/dl/free/0073379433/597452/Subramanyam_fsa_sample_Ch01.pdf

accessed 23/04/2013

7. http://studentweb.usq.edu.au/home/W0054016/Pages/Financial_Acct_Folder/Exampl

e_Comprehensive_Income_Statement.htm


UNIT 3 ‐ SUMMARY


The end of topic assignment is to be developed by the participating institutions to assess

student learning for this unit. Generally the students should be required to demonstrate

their understanding of the nature of financial statements, as well as to show that they could

competently analyse and interpret the various financial statements covered in this unit.

SUMMARY

This unit has covered topics that will enable you to present and analyse three important

financial statements, namely; the statement of comprehensive income, statement of

financial position and the statement of cash flows. Examples have been provided, where

feasible to enable you to internalise the various topics. The reflective questions at the end

of each topic are designed to consolidate the student learning. Having gone through this

material, you should therefore be well equipped to tackle the end of unit assignment.

NEXT STEPS

Now that you have acquired skills and knowledge of analysis of the financial statements,

the next unit takes you a step further by introducing you to the financial planning process.


UNIT FOUR ‐ FINANCIAL PLANNING

UNIT 4 INTRODUCTION

Financial planning is an important aspect because it provides road maps for guiding,

coordinating and controlling the actions to achieve the objectives of the business. Major

aspects of the financial planning process are cash planning and profit planning. Cash

planning involves preparation of the cash budget whereas, profit planning involves

preparation of pro forma statements. The cash budget and the pro forma statements are

useful for internal financial planning as well as they are routinely required by present and

future lenders. Long‐term, or strategic, financial plans are the starting point of the financial

planning process. The strategic plans in turn help in the formulation of short‐term, or

operating, plans and budgets. Generally, the short‐term plans and budgets implement the

long term strategic objectives of a business.

UNIT 4 OBJECTIVES


1. Understand the process of financial planning, including strategic financial plans (long‐term plans) and operating financial plans (short‐term plans).

2. Discuss the process of cash planning and the preparation, evaluation and use of the cash budget.

3. Explain the simplified procedures used to prepare and evaluate the pro forma financial statements.

4. Identify the limitations of the simplified approaches to the preparation of pro forma financial statement and the common uses of these statements.

UNIT 4 READINGS


Gitman et al. (2012 or 2002), chapters 14 and 15


Self‐reflection questions are given at the end of each topic. Guidance on a comprehensive

assignment for the unit will be provided by the instructor.


TOPIC 4.1 – INTRODUCTION TO FINANCIAL PLANNING


Financial planning is an important aspect because it acts as a guide to achieve the key

objectives of the business. Cash planning and profit planning are the two major aspects of

the financial planning process. There are two main types of a financial plan which include

the strategic plans and the operating plans. Strategic (Long‐term) financial plans act as a

guide for preparing short‐term (operating) financial plans and tend to cover periods ranging

from 2 to 10 years and are updated periodically. On the other hand the operational plans

most often cover a 1 to 2 year period.



1. Understand the nature of financial planning process. 2. Identify the nature of including strategic financial plans (long‐term plans) and

operating financial plans (short‐term plans).

STRATEGIC FINANCIAL PLANS

Strategic (Long‐term) financial plans includes the planned financial actions and the

expected impact of those actions over periods ranging from 2 to 10 years. Five‐year

strategic plans are also very common and they are revised as significant new information

becomes available. Generally, businesses with high degrees of operating uncertainty,

relatively short production cycles, or both, are likely to use shorter planning horizons.

Long‐term financial plans are part of an integrated strategy which includes production and

marketing plans, and guides the businesses toward strategic goals. Those long‐term plans

consider proposed expenditure for fixed assets, research and development, marketing and

product development, capital structure, and major sources of financing. It also includes

termination of any existing projects, product lines, or lines of business; repayment or

retirement of outstanding debts; and any planned acquisitions. Such plans needs to be

supported by a sequence of annual budgets and profit plans.

OPERATING FINANCIAL PLANS

Operating(Short‐term) financial plans indicate short‐term financial actions and the expected

impact of those actions over 1 to 2 year period. Key information required to prepare the

operating financial plan is the sales forecast and various forms of operating and financial

data. Examples of short term financial plans which are also known as the output of the

process are the operating budgets, the cash budget, and pro forma financial statements.

The short term financial planning process is depicted in the Figure. sales forecast is the

starting point of the process of short‐term financial planning. Next, production plans are


developed that considers the production times and include estimates of the required raw

materials. Based on production plans, the firm can easily estimate direct labour

requirements, factory overhead, and operating expenses. Next, the firm’s pro forma

income statement and cash budget can be prepared and finally, the pro forma balance

sheet can be developed.

Figure 10: Short term Financial Planning process


SUMMARY

Strategic plans and the operating plans are the two major types of financial plan. Strategic

(long‐term) financial plans are a guide for preparing operating (short‐term) financial plans.

Long‐term plans are likely to cover periods ranging from 2 to 10 years and are always

updated periodically. Whereas, short‐term plans cover a 1 to 2 year period.


1. What is the financial planning process? Contrast strategic (long‐term) financial plans and

operating (short‐term) financial plans.

2. Which three statements result as part of the operating (short‐term) financial planning

process?

Sales

Forecast

Production

Plans

Long‐Term

Financing

Plans

Pro‐forma

Income

Statement

Pro‐forma

Balance

Sheet

Cash

Budget

Current‐Period

Balance Sheet

Fixed Asset

Outlay plan

Information needed

Output for Analysis


TOPIC 4.2 ‐ CASH BUDGETS FOR CASH PLANNING


Cash budget are based on a sales forecast and are used in the process of cash planning to

estimate short term cash surpluses and shortages. Usually, the cash budgets are prepared

for a period covering 1 year and is further divided into months. The two major components

of a cash budgets are the net cash receipts and the net cash disbursements.



1. Discuss the process of cash planning.

2. Prepare, evaluate and use the cash budget.

WHAT IS A CASH BUDGET

The cash budget, also known as cash forecast, is a statement of planned inflows and

outflows of cash of a business. It is used to estimate short‐term cash requirements of a

business, with particular attention to planning for surplus cash and for cash shortages.

Usually, the cash budget covers a 1‐year period and it is divided into smaller time intervals.

The number and type of intervals are decided on the basis of nature of the business. If the

business is seasonal and has uncertain cash flows the number of intervals are greater.

Because many businesses have a seasonal cash flow pattern, the cash budget is often

presented on a monthly basis. On the other hand, businesses with established and stable

patterns of cash flow prefers to use quarterly or annual time intervals.

THE SALES FORECAST

The important input to the process of short‐term financial planning is the sales forecast of a

business. marketing department is responsible for predicting the sales over a given period.

Based on the sales forecast, the financial manager then estimates the cash flows that will

result from forecasted sales receipts and from cost related to production, inventory, and

sales. Financial manager is also responsible to determine the level of fixed assets required

and the amount of financing, if any, needed to support the forecasted sales and production.

In practice, the most challenging aspect of forecasting is to obtain high‐quality data. An

analysis of external data, internal data, or a combination of the two may be the basis of

sales.

The observation of relationships between the sales of a business and some key external

economic indicators such as the gross domestic product, disposable personal income, and

consumer confidence are the basis of an external forecast. Forecasts containing these

indicators are easily available and a forecast of economic activity should help in predicting


future sales of the business because sales of the business are often closely related to some

characteristics of overall national economic activity.

Internal forecasts are based on a build up of sales forecasts through the sales channels of

the business. Usually, the salespeople of the business in the field are asked to estimate the

number of units of each product the business expect to sell in the given time in future. The

sales manager then collect and total the forecasts and may adjust the figures by utilizing

the knowledge of specific markets or the forecasting abilities of salespersons. Based on this

adjustments for additional internal factors such as production capabilities may be made.

the final sales forecast of the businesses are typically made by combining the external and

internal forecast data. The internal data provide information about future sales

expectations whereas, the external data offer ways to adjust the sale expectations by taking

into account general economic conditions. The nature of the product, a business offers, also

often affects the combination and types of forecasting methods to be used.

PREPARING THE CASH BUDGET

The common format of the cash budget is presented below. The individual discussion of

each of the components of cash budgets is as follows.

Table 9: Cash budget format


CASH RECEIPTS

Total inflows of cash of a business in a given financial period is regarded as Cash receipts.

The common examples of cash receipts are cash based sales, collections of accounts

receivable and other receipts of cash.

Degree 04 Financial Management - Commonwealth of Learning

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