Introduction to Finance 3.

Accounting – focuses Finance within an Organization

on recording, classifying,
What is finance? summarizing, and Board of Directors
interpreting financial
- Webster’s dictionary transactions. It’s about
defines finance as “the historical data and Chief Executive Officer (CEO)
system that includes the reporting the financial
circulation of money, the health of an entity.
granting of credit, the Key Ares: Financial
making of investments, reporting (income
and the provision of statements, balance
banking facilities” sheets, cash flow Chief Operating Chief Financial Officer
statements), auditing, Officer (COO) (CFO)
Areas of Finance taxation, managerial
1. Financial Management accounting,
2. Capital Markets bookkeeping.
3. Investments 4. Economics – studies
how societies allocate Marketing, Production, Accounting, Treasury,
Finance vs Economics vs scarce resources to Human Resources, and Credit, Legal, Capital
Accounting satisfy unlimited wants other operating Budgeting and Investor
and needs. It provides departments Relations
1. Finance – deals with the the theoretical
management of money framework for
and other valuable understanding market
assets. It’s forward- behavior, supply and
looking, focusing on demand, and the broader
decision-making related economic environment.
to investments, Key Areas:
fundraising, and risk Microeconomics
management to (individual and firm
maximize wealth. behavior),
Key Areas: Capital macroeconomics
budgeting, corporate (aggregate economic
finance, investments, activity), econometrics,
financial markets, risk economic policy, market
management, financial structures.
planning.
Goal of Financial
Management in maximizing their own wealth;
therefore managers might pay
The main goal of financial themselves excessive salaries.
management is to create value
for its investors 1. Stockholder-
debtholder conflicts –
Determinants of Value debtholders generally
receive a fixed payment
1. Intrinsic Value – regardless of how well
estimate of a stock’s the company does. This
“true” value based on led to stockholders
accurate risk and returns. typically more willing to
2. Market Price – stock take risky projects.
value based on
perceived but possibly Financial Markets
incorrect information as The economy depends on a
seen by marginal strong financial system.
investors - History shows that a
strong financial system is
Challenges to FM Goal a necessary ingredient
for a growing a
1. Having a short-run prosperous economy.
focus – Example: Wells Comapanies raising
Fargo implemented capital to finance capital
incentives to reward expenditures and
employees for signing up investors saving to
customers to new accumulate funds for
accounts. Unfortunately, future use require well-
to obtain bonuses some functioning financial
employees created fake markets and institutions.
accounts or signed up
customers for
unauthorized credit
cards.
2. Stockholder-Manager
Conflicts – managers
might be more interested
The Capital Allocation
Process Major Market Instruments

How do companies and 1. Treasury bills

individual raise capital? 2. Commercial paper
3. Negotiable Certificates of
1.Direct transfers Deposit (CDs)
Business ---------------- Savers 4. Consumer credit
5. Money market mutual
2. Indirect Transfers through funds
investment Bankers 6. Treasury notes and
Business – Investment Banks – Savers bonds
7. Mortgages
3. Indirect Transfers through a
8. State and local bonds
Financial Intermediary
Business – Financial Intermediary – Savers 9. Corporate bonds
10. Leases
Types of Financial Markets 11. Preferred stocks
12. Common stocks
1. Physical Asset Markets
vs Financial Asset
Markets
2. Spot Markets vs Future
Markets
3. Money Markets vs
Capital Markets
4. Primary Markets vs
Secondary Markets
5. Private Markets vs Public
Markets
Financial analysis involves: of financial position. Showing Liquidity Ratios Profitability Ratios
 Comparing the firm’s performance to changes in percentage form helps
that of other firms in the same to gain a feel of how unusual the Measures of short-term debt-paying ability Measures of the income or operating
industry. changes might be. success of an enterprise for a given period
 Evaluating trends in the firm’s Liquid Asset – trades in an active market of time. How much profitable a firm is
financial position over time. Common-size Statements (Vertical and thus can be quickly converted to cash operating and utilizing its assets.
Analysis) at the going market price.
What is the purpose of Financial a. Operating Margin – measures
Statement Analysis? The process of comparing figures in the Two of the most liquidity ratios are… operating income or EBIT per dollar
 To assist the statement users in financial statements of a single period a. Current Ratio of sales; operating income divided
predicting the future. (unlike in horizontal analysis, where b. Quick or Acid Test Ratio by sales
statements for at least two accounting b. Profit Margin – measures net
Three techniques are commonly used to periods are required). Current Ratio income per dollar of sales; net
make comparisons and to detect trends: Expresses the relationship of current income divided by sales
1. Peso and percentage changes in the Involves converting the figures in the assets to current liabilities. It is a widely c. Return on Assets (ROA) –
financial statement items statements to a common base. This is used measure for evaluating a company’s measures the rate of the return on
2. Common-size statements accomplished by expressing all the liquidity and short-term debt-paying ability. the firm’s assets; net income
3. Ratios figures in the statements as a percentage divided by total assets
of an important item, such as total assets 𝑪𝒖𝒓𝒓𝒆𝒏𝒕 𝑨𝒔𝒔𝒆𝒕𝒔 d. Return on Equity (ROE) –
𝑪𝒖𝒓𝒓𝒆𝒏𝒕 𝑹𝒂𝒕𝒊𝒐 =
Peso and Percentage Changes in (in the balance sheet) and total or net 𝑪𝒖𝒓𝒓𝒆𝒏𝒕 𝑳𝒊𝒂𝒃𝒊𝒍𝒊𝒕𝒊𝒆𝒔 measures the rate of return on
Financial Statement (Horizontal sales (in the income statement). As a common stockholder’s investment;
Analysis) result, all the figures in the statements Quick Asset/Acid Test Ratio net income divided by ordinary
would be expressed not in peso but in Relates to cash, short-term investments, shareholders equity
Financial statements are placed side-by- percentage terms. These “converted” and net receivables to current liabilities. e. Return on Investment (ROI) –
side and two types of comparisons can be statements are called common-size This ratio indicates a company’s measures the total return that the
made. statements, 100 percent statements or immediate liquidity. It is important company has provided for the
component size. complement to the current ratio. investors; after-tax operating
A. Trend percentages restate a time income divided by total invested
series of financial data in terms of a Financial Statement Ratios 𝑸𝒖𝒊𝒄𝒌 𝑨𝒔𝒔𝒆𝒕 𝒐𝒓 𝑨𝒄𝒊𝒅 𝑻𝒆𝒔𝒕 𝑹𝒂𝒕𝒊𝒐 = 𝑪𝒖𝒓𝒓𝒆𝒏𝒕 𝑨𝒔𝒔𝒆𝒕𝒔 − 𝑰𝒏𝒗𝒆𝒏𝒕𝒐𝒓𝒊𝒆𝒔
capital
base year. Particularly when plotted 𝑪𝒖𝒓𝒓𝒆𝒏𝒕 𝑳𝒊𝒂𝒃𝒊𝒍𝒊𝒕𝒊𝒆𝒔
f. Earnings per share – measures
against time. This approach allows A ratio expresses the mathematical the amount of net income earned
the analyst to quickly gauge the rate relationship between one quantity and by common shares
and direction of change. another as either a percentage, rate, or  Basic Earnings per share
B. The difference (increase or proportion. Ratios can be classified as: 𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒 − 𝑃𝑟𝑒𝑓𝑒𝑟𝑟𝑒𝑑 𝑆ℎ𝑎𝑠𝑟𝑒 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑠
decrease) between two statements =
𝑊. 𝐴𝑣𝑒. 𝐶𝑜𝑚𝑚𝑜𝑛 𝑆ℎ𝑎𝑟𝑒𝑠 𝑂𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔
can be shown in separate columns A. Liquidity Ratios  Diluted Earnings per share
in both peso and percentage forms. B. Profitability Ratios =
𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒 − 𝑃𝑟𝑒𝑓𝑒𝑟𝑟𝑒𝑑 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑠, 𝑛𝑜𝑛 𝑐𝑜𝑛𝑣𝑒𝑟𝑡𝑖𝑏𝑙𝑒
C. Solvency Ratios 𝑊. 𝐴𝑣𝑒. 𝐶𝑜𝑚𝑚𝑜𝑛 𝑆ℎ𝑎𝑟𝑒𝑠 𝑂𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔 𝑎𝑛𝑑 𝐶𝑜𝑛𝑣𝑒𝑟𝑡𝑖𝑏𝑙𝑒 𝑂𝑆

D. Activity Ratios
 g. Cash flow margin – measures the DuPont Analysis
ability of the firm to translate sales to Solvency Ratios A formula that shows the rate of return on
cash Measures how effectively a firm manages equity can be found of profit margin, total
𝑪𝒂𝒔𝒉 𝒇𝒍𝒐𝒘 𝒎𝒂𝒓𝒈𝒊𝒏 =
𝑶𝒑𝒆𝒓𝒂𝒕𝒊𝒏𝒈 𝒄𝒂𝒔𝒉 𝒇𝒍𝒐𝒘 its debt. The use of debt will increase or asset turnover and the equity multiplier.
𝑵𝒆𝒕 𝒔𝒂𝒍𝒆𝒔 leverage up a firm’s ROE if the firms earns
more on its assets than the interest rate it ROE = ROA x Equity Multiplier
h. Dividend Yield – measures the rate
pays on debt.
of return in the investor’s common ROE = Profit Margin x Total Asset Turnover x Equity Multiplier
stock investments. a. Debt Ratio – measures the 𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒 𝑆𝑎𝑙𝑒𝑠 𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠
𝑫𝒊𝒗𝒊𝒅𝒆𝒏𝒅 𝑷𝒆𝒓 𝑺𝒉𝒂𝒓𝒆 𝑅𝑂𝐸 = 𝑥 𝑥
𝑫𝒊𝒗𝒊𝒅𝒆𝒏𝒅 𝒀𝒊𝒆𝒍𝒅 = 𝑷𝒓𝒊𝒄𝒆 𝑷𝒆𝒓 𝑺𝒉𝒓𝒆 percentage of the firm’s capital 𝑆𝑎𝑙𝑒𝑠 𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠 𝑇𝑜𝑡𝑎𝑙 𝐸𝑞𝑢𝑖𝑡𝑦
provided by debt holders
i. Dividend Payout Ratio – indicates b. Equity Ratio – measures the 𝑵𝒆𝒕 𝑰𝒏𝒄𝒐𝒎𝒆
percentage of the firm’s capital 𝑹𝑶𝑬 =
the proportion of earnings distributed 𝑻𝒐𝒕𝒂𝒍 𝑬𝒒𝒖𝒊𝒕𝒚
as dividends provided by shareholders
𝑫𝒊𝒗𝒊𝒅𝒆𝒏𝒅 𝑷𝒂𝒚𝒐𝒖𝒕 𝑹𝒂𝒕𝒊𝒐 =
𝑫𝒊𝒗𝒊𝒅𝒆𝒏𝒅 𝑷𝒆𝒓 𝑺𝒉𝒂𝒓𝒆 c. Debt to Equity Ratio – measures
𝑬𝑷𝑺 the percentage of the firm’s capital
that is financed by debt versus
j. Plowback Ratio – indicates the equity
proportion of earnings reinvested in d. Times-Interest Earned Ratio –
the business measure of the firm’s ability to
𝑫𝒊𝒗𝒊𝒅𝒆𝒏𝒅 𝑷𝒆𝒓 𝑺𝒉𝒂𝒓𝒆
𝑷𝒍𝒐𝒘𝒃𝒂𝒄𝒌 𝑹𝒂𝒕𝒊𝒐 = 𝟏 −
𝑷𝒓𝒊𝒄𝒆 𝑷𝒆𝒓 𝑺𝒉𝒂𝒓𝒆 meet its annual interest payments

Profitability (Market) Ratios Activity Ratio

Measures how liquid the assets and
Price/Earnings Ratio – how much the liabilities are. Measures the number of
investors are willing to pay per unit of profit times, on average, an item of receivable,
𝑷𝒓𝒊𝒄𝒆 𝒑𝒆𝒓 𝒔𝒉𝒂𝒓𝒆 inventory or a trade payable are
𝑷 𝒐𝒓 𝑬 𝑹𝒂𝒕𝒊𝒐 = collected/paid during the period.
𝑬𝑷𝑺

Market/Book Value Ratio – how investors A. Turnover ratios – measure the

regard the company. Assessment of number of times receivables are
presumptive risk and growth. recorded and collected during the
𝑩𝒂𝒔𝒊𝒄 𝑬𝒂𝒓𝒏𝒊𝒏𝒈𝒔 𝒑𝒆𝒓 𝒔𝒉𝒂𝒓𝒆 =
𝑷𝒓𝒊𝒄𝒆 𝒑𝒆𝒓 𝒔𝒉𝒂𝒓𝒆 𝒐𝒓 𝑴𝑽 𝒑𝒆𝒓 𝒔𝒉𝒂𝒓𝒆 period.
𝑩𝒐𝒐𝒌 𝑽𝒂𝒍𝒖𝒆 𝒐𝒇 𝒄𝒐𝒎𝒎𝒐𝒏 𝒔𝒕𝒐𝒄𝒌
B. Average Age (Days Outstanding)
– average number of days during
which the company must wait
before receivables are collected
Risk, Return, and Cost of Capital 10. Operational – the risk of a change Stand-Alone Risk
(concepts only lang to) 3. Credits/Default Risk – Credit risk in value caused by the fact that
is the risk that a borrower will be actual losses, incurred from Tools in measuring stand-alone risk:
Risk unable to pay the contractual inadequate or failed internal 1. Probability distribution
- Risk refers to the probability that interest or principal on its debt processes, people and systems, or 2. Expected rates of return
actual results will differ from obligations. This type of risk is from external events, differ from 3. Historical, past realized rates of
expected results. particularly concerning to investors expected losses. return
- It encompasses uncertainty about who hold bonds in their portfolios. 4. standard deviation
future financial results and the 4. Country Risk – the risk that a Return 5. coefficient of variation
potential deviations from expected country won’t be able to honor its - Refers to the amount received on 6. sharpe ratio
outcomes, which can lead to financial commitments. investments after holding it for a
financial losses. 5. Forex Risk (Foreign-Exchange period of time in relation to initial Standard Deviation
- Investors like returns and dislike risk. Risk) – When investing in foreign investment. - measures data dispersion with
There is a fundamental trade-off countries, it’s important to consider *MAY FORMULA E2, CHECK NALAG SA regards to mean value of a dataset
between risk and return. that fact that currency exchange PIC NA NASA GC* & provides measurement regarding
rates can change the price of the investment’s volatility
Types of Risk asset as well. Expected Value of Return
6. Interest Risk – the risk that an - Amount of P/L that an investor can Coefficient of Variation and Sharpe
1. Financial Risk investment’s value will change in expect from an investment. Ratio
 Systematic – a.k.a. market the absolute level of interest rates, *MAY FORMULA E2, CHECK NALAG SA
risks, are risks that can affect the spread between two rates, in PIC NA NASA GC* Coefficient of Variation – shows the risk
an entire economic market the shape of the yield curve, or in per unit of return and it provides a more
overall or a large percentage any other interest rate relationship. Measuring Risk meaningful measure when the expected
of the total market. 7. Political – the risk an investment’s A stock’s risk can be measured in two returns on two alternatives are not the
 Unsystematic – a.k.a. specific returns could suffer because of ways: same.
risk or idiosyncratic ris, is a political instability or changes in a 1. As a stand-alone risk – risk an *MAY FORMULA E2, CHECK NALAG SA
category of risk that only country. This type if risk can stem investor would face if he or she PIC NA NASA GC*
affects an industry or from a change in government, held only one asset
particular company. It is firm- legislative bodies, other foreign 2. As a portfolio – risk an investor Sharpe Ratio – compares the asset’s
specific. policy makers, or military control. would face if the stock is part of realized return to its standard deviation
2. Business Risk – refers to the basic 8. Counterparty – the likelihood that larger group of investments. over a specified period.
viability of a business – the question one of those involved in a *MAY FORMULA E2, CHECK NALAG SA
of whether a company will be able to transaction might default on its PIC NA NASA GC*
make sufficient sales and generate contractual obligation.
sufficient revenues to cover its 9. Liquidity – associated with an
operational expenses and turn a investor’s ability to transact their
profit. investment for cash.
Portfolio Risk Types of β Interpretation
Tools in measuring portfolio risk: Coefficient of Determination (r2) β = 1.0 Fund is
1. Capital Asset Pricing Method - Measures the % of the unexpected to
(CAPM) investment’s movement move with
2. Expected Return attributable to the movement in its benchmark
3. Portfolio Beta benchmark index; represents β < 1.0 Less volatile than
4. Portfolio Alpha correlation between examined benchmark
5. Covariance and Correlation investment & its associated (reduce portfolio
6. Coefficient of Determination benchmark risk)
7. Sharpe Ratio - High (85% to 100%) – moves β > 1.0 More volatile than
relatively in line with index benchmark (stock
Covariance and Correlation - Low (70% or less) – does not is riskier)
generally follow movements of β<0 Inversely related to
Covariance measures how two stocks or index benchmark
portfolio move together.
*MAY FORMULA E2, CHECK NALAG SA Portfolio Risk – Associated Risks CAPM
PIC NA NASA GC* 1. Diversifiable risk – part of a - Deals with the relationship
security’s risk associated with between non-
A positive covariance means that the two random events; can be eliminated diversifiable/systematic risk and
stocks tend to move together by proper diversification. Also expected return for assets,
A negative covariance means that the two company-specific or unsystematic particularly stocks.
stocks tend to move in opposite directions risk. *MAY FORMULA E2, CHECK NALAG SA
A zero covariance means that the two 2. Market risk – risk that remains in a PIC NA NASA GC*
investments are unrelated. portfolio after diversification has
eliminated all company-specific - The fundamental idea behind
Correlation is a static that measures risk. This risk is also known as CAPM is that investors expect a
degree to which two securities move in nondiversifiable or systematic or reward for both waiting and
relation to one another. Must be between beta risk worrying.
-1.0 and 1.0; expresses the strength of
relationship between two variables Portfolio Beta ad Alpha Cost of Capital
*MAY FORMULA E2, CHECK NALAG SA β is a measure of stock’s - Rate of return necessary to
PIC NA NASA GC* systematic/market risk; shows volatility maintain market value or stock
relative to market price of a firm
A positive correlation means that two β = Covariance/Variance - Cost of capital can be used for
securities move in the same direction making capital budgeting
A negative correlation means that two α is the risk relative to market or selected decisions, making long-term
securities move in the opposite direction benchmark index. Describes investment’s financing decisions and helping
A zero correlation means that the two ability to beat the market establish the optimal structure
securities have no linear relationship α = Actual Return – Expected Return
 - Often called as minimum acceptable Dividend Discounted Model (Gordon
rate of return, required rate of return, Growth Model)
hurdle rate, desired rate of return,
standard rate, cut-off rate *Formula nasa gc pic*

Source of Capital cost of capital Weighted Average Cost of Capital –

capital quality WACC
Creditors Long- After tax cost
term debt of debt - A firm’s average cost of capital
Interest x (1 – weighted to reflect that different
tax rate) sources of capital
Stockholders Preferred DPS/Issuance *Formula nasa gc pic*
– preferred stock Price or
shares Current
Market Price
Stockholders Common CAPM or
– common stock DDM
shares