Financial management notes by m.riaz khan 03139533123 (1)

Comprehensive Notes
For Students of BBA, MBA & M.com
Prepared By:
Muhammad Riaz Khan
Government College of Management Sciences Peshawar
Contact: +923139533123 (mriazkhan91@yahoo.com)

Financial Management
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Prepared By: Muhammad Riaz Khan (M.com GCMS Peshawar) Mob#+923139533123
ACKNOWLEDGEMENT
I am very grateful to Almighty ALLAH who enabled me to complete
notes on FINANCIAL MANAGEMENT. I have taken efforts for
completion of these Notes. However, it would not have been possible
without the kind support and help of many individuals. I would like to
extend my sincere thanks to all of them.
I am highly indebted to Sir Mr. Jawad Anwar (Lecturer at PIMS
Peshawar) and Sir Imtiaz Ali (Lecturer at GCMS Peshawar) for their
guidance and constant supervision as well as for providing necessary
information regarding these notes & also for their support in completing it.
I would like to express my gratitude towards my Parents & Friends
for their kind co-operation and encouragement which help me in completion
of these notes.
My thanks and appreciations also go to my dearest colleagues Mr.
Adnan Khan and Tauseef Ullah in preparing such notes who have
willingly helped me out with their abilities.
Muhammad Riaz Khan

Comprehensive Notes
COURSE OUTLINE
Part – I
1. An Overview of Financial
Management
i) Careers in Finance
ii) How are Companies Organized
iii) Finance in the Organizational
Structure of the Firm
iv) The Goals of the Corporation
v) Business Ethics and Social
Responsibility
vi) Agency Relationships
2. Financial Statement, Cash Flows
and Taxes
i) A Brief History of Accounting
and Financial Statements
ii) Financial Statements and Reports
iii) The Balance Sheet
iv) The Income Statement
v) Statement of Retained Earnings
vi) Net Cash Flow
vii)Statement of Cash Flows
viii) Modifying Accounting Data for
Managerial Decisions
ix) MVA and EVA
x) Depreciation
3. Analysis of Financial Statements
i) Ratio Analysis
ii) Liquidity Ratios
iii) Asset Management Ratios
iv) Debt Management Ratios
v) Profitability Ratios
vi) Market Value Ratios
vii)Trend Analysis, Common Size
Analysis, and Percent Change
Analysis
viii) Tying the Ratios Together
ix) Comparative Ratios and
“Benchmarking”
x) Uses and Limitations of Ratio
Analysis
xi) Problems with ROE
xii)Looking Beyond the Numbers
4. Financial Planning and
Forecasting Financial
Statements
i) Strategic Plans
ii) Operating Plans
iii) The Financial Plan
iv) Computerized Financial Planning
Models
v) Sales Forecasts
vi) Financial Statement Forecasting:
The Percent of Sales Method
vii)The AFN Formula
viii) Forecasting Financial
Requirements When the Balance
Sheet Ratios Are Subject to
Change
ix) Other Techniques of Forecasting
Financial Statements
Part – II
5. The Financial Environment
i) The Financial Markets
ii) Financial Institutions
iii) The Stock Market
iv) The Cost of Money
v) Interest Rate Levels
vi) The Determinants of Market
Interest Rates
vii)The Term Structure of Interest
Rates
viii) What Determines the Shape of
the Yield Curve?
ix) Using the Yield Curve to
Estimate Future Interest Rates
x) Investing Overseas
xi) Other Factors That Influence
Interest Rate Levels
xii)Interest Rates and Business
Decisions
6. Risk and Return
i) Investment Returns

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ii) Stand-Alone Risk
iii) Risk in Portfolio Context
iv) Calculating Beta Coefficient
v) The Relationship between Risk
and Rates of Return
vi) Physical Assets versus Securities
vii)Some Concerns about Beta and
the CPM
viii) Volatility versus Risk
7. Portfolio Theory and Asset Pricing
Models
i) Measuring Portfolio Risk
ii) Efficient Portfolios
iii) Choosing the Optimal Portfolio
iv) The Capital Asset Pricing Model
v) The Capital Market Line and
Security Market Line
vi) Calculating Beta Coefficient
vii)Empirical Tests of the CAPM
viii) Arbitrage Pricing Theory
ix) The Fama-French Three-Factor
Model
x) An Alternative Theory of Risk
and Return: Behavioral Finance
Part – III
8. The Cost of Capital
i) The Weighted Average Cost of
Capital
ii) Cost of Debt
iii) Cost of Preferred Stock
iv) Cost of Common Stock
v) The CAPM Approach
vi) Dividend-Yield-plus-Growth
Rate, or DCF Approach
vii)Comparison of the CAPM, DCF,
and Bond-Yield-plus-Risk-
Premium Methods
viii) Composite, or Weighted
Average, Cost of Capital, WACC
ix) Adjusting the Cost of Capital for
Risk
x) Estimating Project Risk
xi) Using the CAPM to Estimate a
Project’s Risk-Adjusted Cost of
Capital
xii)Techniques for Measuring Beta
Risk
xiii) Adjusting the Cost of Capital
for Flotation Costs
xiv) Some Problem Areas in Cost of
Capital
xv) Four Mistakes to Avoid
9. Corporate Valuation and Value-
Based Management
i) Overview of Corporate Valuation
ii) The Corporate Valuation Model
iii) Value-Based Management
iv) Corporate Governance and
Shareholders Wealth
10. Capital Structure Decisions
i) The Target Capital Structure
ii) Business and Financial Risk
iii) Determining the Optimal Capital
Structure
iv) Capital Structure Theory
v) Checklist for Capital Structure
Decisions
vi) Variations in Capital Structure
11. Distributions to Shareholders:
Dividends and Repurchases
i) Dividend versus Capital Gains
ii) Dividend Policy Issues
iii) Dividend Stability
iv) Establishing the Dividend Policy
in Practice
v) Dividend Reinvestment Plans
vi) Summary of Factors Influencing
Dividend Policy
vii)Overview of the Dividend Policy
Decision
viii) Stock Dividends and Stock
Splits
ix) Stock Repurchases
Part – IV
12. Initial Public Offerings,
Investment Banking, and
Financial Restructuring
i) The Financial Life Cycle of a
Startup Company

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ii) The Decision to Go Public Initial
Public Offerings
iii) The Process of Going Public
iv) Equity Carve-Outs: A Special
Type of IPO
v) Non-IPO Investment Banking
Activities
vi) The Decision to Go Private
vii)Managing the Maturity Structure
of Debt
viii) Zero (or Very Low) Coupon
Bonds
ix) Refunding Operations
x) Managing the Risk Structure of
Debt
13. Lease Financing
i) The Two Parties to Leasing
ii) Types of Leases
iii) Tax Effects
iv) Financial Statement Effects
v) Evaluation by the Lessee
vi) Evaluation by the Lessor
vii)Other Issues in Lease Analysis
viii) Other Reasons for Leasing
14. Current Asset Management
i) Working Capital Terminology
ii) Alternative Current Asset
Investment Policies
iii) The Cash Conversion Cycle
iv) The Concept of Zero Working
Capital
v) Cash Management
vi) The Cash Budget
vii)Cash Management Techniques
viii) Marketable Securities
ix) Inventory
x) Inventory Costs
xi) Inventory Control Systems
xii)Receivable Management
xiii) Credit Policy
xiv) Setting the Credit Period and
Standards
xv) Setting the Collection Policy
xvi) Cash Discounts
xvii) Other Factors Influencing
Credit Policy
15. Short-Term Financing
i) Alternative Current Asset
Financing Policies
ii) Advantages and Disadvantages
of Short-Term Financing
iii) Sources of Short-Term Financing
iv) Accruals
v) Accounts Payable (Trade Credit)
vi) Short-Term Bank Loans
vii)The Cost of Bank Loans
viii) Choosing a Bank
ix) Commercial Paper
x) Use of Security in Short-Term
Financing
Recommended Text:
1. Brigham, E.F. and Ehrhardt,
M.C., (2002 ), Financial
Management: Theory and
Practice (10th
Edition), HarCourt
College Publishers

6
Chapter#1
An Overview of Financial Management
Meaning of Financial Management
Financial management is concerned with the acquisition, financing, and
management of assets with some overall goal in mind.
Financial Management means planning, organizing, directing and controlling the
financial activities such as procurement and utilization of funds of the enterprise. It
means applying general management principles to financial resources of the enterprise.
Functions of Financial Management
Based on the above definition functions of the financial management can be categorized
into three major categories, these are
(A) Investment Decisions
Investment decisions are concerned with assets. Major decisions regarding investment
decisions are explained below.
1 What is the optimal firm size? It means to decide what amount of assets should
be purchased in order to keep the operations of business going and also not
increasing the size of the business.
2 What specific assets should be acquired? The exact asset required to maintain the
operations of the business.
3 What assets (if any) should be reduced or eliminated? Any asset not contributing in
the profitability of the firm should be disposed off in order to release the excess
capital.
(B) Financing Decisions
Determine how the assets (LHS of balance sheet) will be financed (RHS of balance
sheet). This means to arrange funds for purchasing assets.
1 What is the best type of financing? Means either to use debt or equity.
2 What is the best financing mix? A firm normally uses a mix of debt and equity,
financial manager decides the ratio of debt and equity which can increase the
profitability and reduce risk.
3 What is the best dividend policy (e.g., dividend-payout ratio)? Refers to the
percentage of profit to be distributed among the shareholders.
4 How will the funds be physically acquired? Means either to take loan, issue shares
debentures etc.

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(C) Asset Management Decisions
1 How do we manage existing assets efficiently? Efficiently means to maximize
their productivity and overall contribution to profits.
2 Financial Manager has varying degrees of operating responsibility over assets.
3 Greater emphasis is made on current asset management than fixed asset
management.
Objectives of Financial Management
The financial management is generally concerned with procurement, allocation and
control of financial resources of a concern. The objectives can be-
1. To ensure regular and adequate supply of funds to the concern.
2. To ensure adequate returns to the shareholders which will depend upon the earning
capacity, market price of the share, expectations of the shareholders?
3. To ensure optimum funds utilization. Once the funds are procured, they should be
utilized in maximum possible way at least cost.
4. To ensure safety on investment, i.e., funds should be invested in safe ventures so
that adequate rate of return can be achieved.
To plan a sound capital structure-There should be sound and fair composition of capital
so that a balance is maintained between debt and equity capital.
The Goals of Corporations
Corporate goals are defined as those specific ambitions or quantifiable targets that
are set by an organization of which it commits to so as to achieve its corporate mission
and objectives. The goals must define a mark that can be specifically measured over a
period of time. The Goal of Corporations refers to the maximizing of profits while
managing the financial risks of the firm. This refers to the main purpose of a corporation
which is to maximize shareholder value in order for the investors to gain from the
corporation. This applies in capital finance where capital is raised for creating,
developing, growing or acquiring businesses.
Several examples of corporate goals can be used for inspiration for your own business.
Profit maximization
Goals reflect general statements about what the business wants to achieve.
Improving profitability is a common corporate goal. The goal statement usually includes
details about the business and aligns its actions with the company mission and values. For

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example, actions might include developing new markets, products or services. Other
examples include reducing unnecessary costs, changing suppliers or raising prices. Stated
simply, the goal must be clearly understood by all employees. It must also be flexible
enough. If market conditions change, the goal can be adjusted.
Efficiency
Corporate goals typically reflect a commitment to improve existing operations.
This includes striving for excellence. It also involves producing results through effective
teamwork and using technology to innovate. Successful corporate leaders realize that
they have to be vigilant about reducing product errors, waste and customer
dissatisfaction. Corporate goals may also specify planned methods or strategies. For
example, to reduce product errors, a business might set a goal of implementing a Six
Sigma initiative, a quality management technique.
Expansion
Increasing market share is common corporate goal. This often involves targeting
new audiences, such as younger customers. Reaching out to a new demographic may also
involve using new marketing techniques. For example, a small business can promote its
products and services using social media technology. A company can expand its market
presence by designing, developing and delivering new products.
Satisfaction
Corporate leaders recognize that employee satisfaction contributes to
productivity. Corporate goals related to employees typically demonstrate a commitment
to the workforce. Programs may include training courses, events and resources. These
allow employees to develop professional skills and enhance collaboration. For example, a
common goal strives to create a culture based trust and respect for all. This improves
employee retention rates, reduces absenteeism and increases employee morale.
Sustainability
Corporate goals usually demonstrate a commitment to the community. A business
has a responsibility to be an asset, not a liability. For example, a company may aspire to
improve the environmental performance of the tools and technology used in its facilities,
by its customers and by its suppliers. Short-term goals address today’s problems and
long-term goals prepare for the future.

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Business Ethics and Social Responsibility
What is Business Ethics?
The concept has come to mean various things to various people, but generally it's
coming to know what it right or wrong in the workplace and doing what's right -- this is
in regard to effects of products/services and in relationships with stakeholders.
Business ethics is the behavior that a business adheres to in its daily dealings with
the world. The ethics of a particular business can be diverse. They apply not only to how
the business interacts with the world at large, but also to their one-on-one dealings with a
single customer.
Many businesses have gained a bad reputation just by being in business. To some
people, businesses are interested in making money, and that is the bottom line. It could be
called capitalism in its purest form. Making money is not wrong in itself. It is the manner
in which some businesses conduct themselves that brings up the question of ethical
behavior.
Good business ethics should be a part of every business. There are many factors to
consider. When a company does business with another that is considered unethical, does
this make the first company unethical by association? Some people would say yes, the
first business has a responsibility and it is now a link in the chain of unethical businesses.
Many global businesses, including most of the major brands that the public use,
can be seen not to think too highly of good business ethics. Many major brands have been
fined millions for breaking ethical business laws. Money is the major deciding factor
Social Responsibility:
Social responsibility and business ethics are often regarding as the same concepts.
However, the social responsibility movement is but one aspect of the overall discipline of
business ethics. The social responsibility movement arose particularly during the 1960s
with increased public consciousness about the role of business in helping to cultivate and
maintain highly ethical practices in society and particularly in the natural environment.
Social responsibility is an ethical theory that an entity, be it an organization or individual,
has an obligation to act to benefit society at large. Social responsibility is a duty every
individual has to perform so as to maintain a balance between the economy and the
ecosystems.
Agency Relationships in Financial Management
 Management acts as an agent for the owners (shareholders) of the firm.
 An agent is an individual authorized by another person, called the principal, to act
in the latter’s behalf.

10
 Agency Theory is a branch of economics relating to the behavior of principals and
their agents.
 Principals must provide incentives so that management acts in the principals’ best
interests and then monitor results.
 Incentives include stock options, perquisites, and bonuses.
Shareholders and managers have divergent goals. The Shareholders goal is to maximize
shareholder value while the manager's goals are Job security, Power, status, and
compensation etc. Thus, managers may have the incentive to take actions that are not in
the best interest of the shareholders. Because managers usually own only a small interest
in most large corporations, potential agency conflicts are significant
Managerial compensation:
The compensation package should be designed to meet two objectives: one is to
attract and retain capable managers; two is to align managers' actions with the interest of
shareholders.
 Performance shares: Management receives a certain number of shares if the
company achieves predefined performance benchmarks.
 Executive stock options: Management is granted an option to buy stock at a
stated price within a specified time period.
Agency Problems: Shareholders (Through Managers) Vs. Creditors:
Managers are the agent of both shareholders and creditors. Shareholders
empower managers to manage the firm. Creditors empower managers to use the loan.
Though employed by shareholders managers work in the best interest of shareholders,
They deprive creditors in two different ways,
 By investing in riskier projects they maximize the profits which on turn is
received by the shareholders and creditors bear only risk for them
 By increasing dent the company increases leverage and in turn the risk of
insolvency is increased but creditors get nothing as risk premium.
To protect themselves against shareholders, creditors often include restrictive covenants in
debt agreements. In the long-run, a firm that deals unfairly with creditors may impair the
shareholders' interest because the firm may
 lose access to the debt markets or
 Be saddled with high interest rates and restrictive covenants.
*End of Chapter*

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Chapter#2
Financial Statements, Cash Flow and
Taxes
Financial Statements Definition:
Summary report that shows how a firm has used the funds entrusted to it by
its stockholders (shareholders) and lenders, and what is its current financial position. The
three basic are the (1) balance sheet, which shows firm's assets, liabilities, and net
worth on a stated date; (2) income statement (also called profit & loss account), which
shows how the net income of the firm is arrived at over a stated period, and (3) cash flow
statement, which shows the inflows and outflows of cash caused by the
firm's activities during a stated period.
Basic Financial Statements
A business is a financial entity separate from its owners. Each business must keep
financial records. Financial statements have generally agreed-upon formats and follow
the same rules of disclosure. This puts everyone on the same level playing field, and
makes it possible to compare different companies with each other, or to evaluate different
year's performance within the same company. There are three main financial statements:
 Income Statement
 Balance Sheet
 Statement of Cash Flows
Each financial statement tells its own story. Together they form a comprehensive
financial picture of the company, the results of its operations, its financial condition, and
the sources and uses of its money. Evaluating past performance helps managers identify
successful strategies, eliminate wasteful spending and budget appropriately for the future.
Armed with this information they will be able to make necessary business decisions in a
timely manner
There are 5 types of Accounts.
 Assets
 Liabilities
 Owners' Equity (Stockholders' Equity for a corporation)

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 Revenues
 Expenses
All the accounts in an accounting system are listed in a Chart of Accounts. They are
listed in the order shown above. This helps us prepare financial statements, by
conveniently organizing accounts in the same order they will be used in the financial
statements.
The Balance Sheet lists the balances in all Assets, Liability and Owners' Equity
accounts.
The Income Statement lists the balances in all Revenue and Expense accounts.
The Balance Sheet and Income Statement must accompany each other in order to
comply with GAAP. Financial statements presented separately do not comply with
GAAP. This is necessary so financial statement users get a true and complete financial
picture of the company.
All accounts are used in one or the other statement, but not both. All accounts are
used once, and only once, in the financial statements. The Balance Sheet shows account
balances at a particular date. The Income Statement shows the accumulation in the
Revenue and Expense accounts, for a given period of time, generally one year. The
Income Statement can be prepared for any span of time, and companies often prepare
them monthly or quarterly.
It is common for companies to prepare a Statement of Retained Earnings or a
Statement of Owners' Equity, but one of these statements is not required by GAAP.
These statements provide a link between the Income Statement and the Balance Sheet.
They also reconcile the Owners' Equity or Retained Earnings account from the start to the
end of the year.

13
The Statement of Cash Flows is the third financial statement required by GAAP,
for full disclosure. The Cash Flow statement shows the inflows and outflows of Cash
over a period of time, usually one year. The time period will coincide with the Income
Statement. In fact, account balances are not used in the Cash Flow statement. The
accounts are analyzed to determine the Sources (inflows) and Uses (outflows) of cash
over a period of time.
There are 3 types of cash flow (CF):
Operating - CF generated by normal business operations
Investing - CF from buying/selling assets: buildings, real estate, investment portfolios,
equipment.
Financing - CF from investors or long-term creditors
The SEC (Securities and Exchange Commission) requires companies to follow
GAAP in their financial statements. That doesn't mean companies do what they are
supposed to do. Enron executives had millions of reasons ($$) to falsify financial
information for their own personal gain. Auditors are independent CPAs hired by
companies to determine whether the rules of GAAP and full disclosure are being
followed in their financial statements. In the case of Enron and Arthur Andersen, auditors
sometimes fail to find problems that exist, and in some cases might have also failed in
their responsibilities as accounting professionals.
Retained Earnings
The Retained Earnings (RE) account has a special purpose. It is used to
accumulate the company's earnings, and to pay out dividends to the company's
stockholders. Let's look at the first part of that for a moment.
At the end of the fiscal year, all Revenue and Expense accounts are closed to
Income Summary, and that account is closed to Retained Earnings. Profits increase RE;
losses will decrease RE. So the RE account might go up or down from year to year,
depending on whether the company had a profit or loss that year.
The changes in the RE accounts are called "Changes in Retained Earnings" and
are presented in the financial statements. This information can be included in the Income
Statement, in the Balance Sheet, or in a separate statement called the Statement of
Changes in Retained Earnings. Each company can decide how to present the information,
but it must be presented in one of those three places.
Most financial statements today include a Statement of Retained Earnings. Some
companies prepare a Statement of Stockholders' Equity to give a more comprehensive
picture of their financial events. This statement includes information about how many

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shares of stock were outstanding over the year, and provides other valuable information
for large companies with a complex capital structure. The changes in RE are included in
the Stockholders' Equity statement.
Net Cash Flow:
Net cash flow refers to the difference between a company's cash inflows and
outflows in a given period. In the strictest sense, net cash flow refers to the change in a
company's cash balance as detailed on its cash flow statement.
How it works/Example:
Net cash flow is also known as the "change in cash and cash equivalents." It is
very important to note that net cash flow is not the same as net income, free cash flow,
or EBITDA.
You can approximate a company's net cash flow by looking at the period-over-
period change in cash on the balance sheet. However, the statement of cash flows is a
more insightful place to look. Net cash flow is the sum of cash flow from operations
(CFO), cash flow from investing (CFI), and cash flow from financing (CFF).
Let's look at the 2010 cash flow statement for Wal-Mart (NYSE: WMT) as
presented by Yahoo! Finance. At the bottom of the cash flow statement, we see that the
change in cash and cash equivalents is calculated to be $632 million. This means that
when the cash flow from operations, cash flow from investing, and cash flow from
financing is added up, Wal-Mart added $632 million to its cash balance in 2010.

15
Dividends
Dividends are payments companies make to their stockholders. These must be
made from earnings. Since we record accumulated earnings in the RE account, all
dividends must come out of that account. There are several types of dividends, but they
all must come from Retained Earnings. In order to pay dividends, the RE account MUST
have a positive, or Credit, balance.
If the RE account has a Debit balance, we would call that a Deficit, and the
company would not be able to pay dividends to its stockholders. Deficits arise from
successive years of posting losses in excess of profits.
Market Value Added (MVA)
 Market value added represents the difference in the total value of the firm and the
total capital supplied by the investors.
 MVA measures the performance of the managers from the creation of the
company till current year, because it compares the par value of share with the
current market value means the total increase in the firm share till date.
 Share holders wealth is maximized by maximizing the difference in market value
of the stock and the amount of wealth supplied by the shareholders.
MVA = Market value of stock – Equity capital supplied by shareholders.
Or = (Shares outstanding) (Stock Price – Total Common Equity
Or MVA = Total Market value – Total investor supplied capital
 Greater the market value more efficiency and more profitable the firm is
Economic Value Added (EVA)
 Economic value added is the difference between after tax profits of the firm and
the total dollar cost of capital. EVA is the value created by the management due to
profitable operations of the business.
 Economic value added measures the firm efficiency in the current year only that
how much the firm earned more than its cost of capital
EVA = NOPAT – Cost of capital required for operations
EVA = (Operating capital) (ROIC – WACC)
Where ROIC is Return on invested capital and WACC is the weighted average cost of
capital
And NOPAT is net operating profit after tax
 Positive EVA means firm is generating more profit than its cost and additional
investment will increase the value of the firm

16
 The EVA shows the true economic profit of the business greater the value
more profitable the firm is.
Free Cash flows
 Free cash flow is the amount of cash remaining after the company makes
investment in assets that are necessary for the firms operations, or the cash which
is left over from the investment in assets.
 In other words free cash flow is the amount of cash available for distribution to all
investors that is shareholders and debt holders.
 So the value of the company is directly related to the amount of free cash flow
generated
Uses of free cash flow
Following are the uses of free cash flows
1. To pay interest to debt holders
2. To repay or redeem bonds
3. Pay dividend to shareholders
4. To repurchase some of its stock
5. Buy short term investments
Calculating free cash flows
Free cash flows can be calculated using the following equations
FCF = NOPAT – Net investment in operating assets
Where net investment in operating assets means net increase in both current and fixed
assets
Or FCF = Operating cash flow – Gross investment in operating capital
Where Operating cash flow = NOPAT + Depreciation
And Gross investment in operating capital = Net investment in operating assets +
Depreciation
What Is Depreciation?
Depreciation is the process by which a company allocates an asset's cost over the
duration of its useful life. Each time a company prepares its financial statements, it
records a depreciation expense to allocate a portion of the cost of the buildings, machines
or equipment it has purchased to the current fiscal year. The purpose of recording
depreciation as an expense is to spread the initial price of the asset over its useful life. For
intangible assets - such as brands and intellectual property - this process of allocating
costs over time is called amortization. For natural resources - such as minerals, timber
and oil reserves - its called depletion.
End of Chapter

17
Chapter#3
Financial Statement Analysis
Financial statement analysis can be referred as a process of understanding the risk and
profitability of a company by analyzing reported financial info, especially annual and
quarterly reports.
Reasons for Analysis
Financial statements analysis may be carried out by either internal or external users.
What do internal users use it for?
Internal users (Management) analyze financial statements for the following reasons.
• Evaluating the financial statements
• Planning according to the past performance.
• And controlling company operations
What do external users use it for?
• To check long term solvency for Investment decisions
• Creditors to check the liquidity for Credit decisions
• Investors for Valuation for investment decisions.
• Government for regulations and tax purposes.
Advantages of financial statement analysis
The different advantages of financial statement analysis are listed below:
 The most important benefit if financial statement analysis is that it provides an
idea to the investors about deciding on investing their funds in a particular
company.
 Another advantage of financial statement analysis is that regulatory authorities
like IASB can ensure the company following the required accounting standards.
 Financial statement analysis is helpful to the government agencies in analyzing
the taxation owed to the firm.
 Above all, the company is able to analyze its own performance over a specific
time period.

18
Ratio Analysis
Quantitative analysis of information contained in a company’s financial
statements. Ratio analysis is based on line items in financial statements like the
balance sheet, income statement and cash flow statement; the ratios of one item – or a
combination of items - to another item or combination are then calculated. Ratio
analysis is used to evaluate various aspects of a company’s operating and financial
performance such as its efficiency, liquidity, profitability and solvency.
Ratio analysis can be made by
• Comparing one company to another
• Comparing one year with another year of the same company
• Comparing one company with the industry
Following are the different categories of financial ratios.
(A)Liquidity: Can we make required payments as they fall due?
(B) Asset management: Do we have the right amount of assets for the level of
sales?
(C)Debt management: Do we have the right mix of debt and equity?
(D)Profitability: Do sales prices exceed unit costs, and are sales high enough as
reflected in PM, ROE, and ROA?
(E) Market value: Do investors like what they see as reflected in P/E and M/B
ratios?
These ratios are now explained below
(A) Liquidity Ratios.
• Liquidity ratios measure the ability of the company that whether it can pay its
short term obligations or not.
• This is done by comparing a company's most liquid assets (or, those that can be
easily converted to cash), its short-term liabilities.
• In general, the greater the coverage of liquid assets to short-term liabilities the
better as it is a clear signal that a company can pay its debts that are coming due
in the near future and still fund its ongoing operations.
• Short term creditors and suppliers are more interested in these ratios.
Liquidity ratios can be measured using two ratios these are
1 Current ratio
2 Quick/ liquid. Acid test ratio
Current Ratio
 The current ratio is a popular financial ratio used to test a
company's liquidity (also referred to as its current or working capital position)
by deriving the proportion of current assets available to cover current
liabilities.

19
 The concept behind this ratio is to ascertain whether a company's short-term
assets (cash, cash equivalents, marketable securities, receivables and
inventory) are readily available to pay off its short-term liabilities (notes
payable, current portion of term debt, payables, accrued expenses and taxes).
 In theory, the higher the current ratio, the better. the company liquidity is
Formula
Shows that the company has 2.6 of current assets to pay off 1 re of current liability.
Quick ratio
• Quick ratio compares quick assets with current liabilities.
• It further refines the current ratio by measuring the amount of the
most liquid current assets there are to cover current liabilities.
• The quick ratio is more conservative than the current ratio because it excludes
inventory and other current assets, which are more difficult to turn into cash.
• Therefore, a higher ratio means a more liquid current position.
Formula
Quick Ratio = Quick Asset/ Current Liabilities
Or
It shows that company have 1.3 of quick assets to pay current liabilities of Re 1
(B) Asset Management Ratios
Asset Management Ratios attempt to measure the firm's success in managing its assets to
generate sales. These ratios shows that how efficiently a company is using their assets
Following are the asset management ratios.

20
Inventory Turnover Ratio
• The Inventory Turnover and Days' Inventory Ratios measure the firm's
management of its Inventory.
• Inventory turnover means the speed through which old inventory is replaced with
new one.
• In general, a higher Inventory Turnover Ratio is indicative of better performance
since this indicates that the firm's inventories are being sold more quickly.
Formula Sales/ inventory
300000/50000 = 6 times
Which shows that we the company’s old inventory is replaced 6 times annually
Receivable management ratio- The days of sales outstanding Ratio
• Days of sales outstanding also called the average collection period refers to the
days in which account receivables are collected.
• This ratio measures the ability of an organization that how efficiently company is
their credit sales and receivables
• it shows the days during which money is tied up due to credit sales
• More quickly the debts are recovered more fund will be available for the
organization and hence will show efficiency
Formula
DSO (in times) = Sales/receivables
DSO (in days) = receivables/ average daily sales
Or = receivables * 365/ annual sales
= 20000 * 365/ 200000
= 36.5 days
Shows that it takes 36.5 days for an average debtor to be collected
Fixed assets turnover Ratio
• This ratio shows that how efficiently the firm uses their fixed assets.
• Greater the fixed assets turnover greater is their efficiency.
Formula
Sales/Net fixed Assets

21
Total Assets Turnover ratio
• Shows the turnover of total assets with respect of sales.
• Shows the efficiency of total assets, that how much of revenue is generated by
total assets
• Greater turnover shows that assets produce greater sales with respect to their
value.
Formula
Sales/ Total Assets
(C) Debt Management Ratio
• Debt management ratios show how the firm is financed and how better the firm
van pay their long term debt and interest payment.
• Investors, creditors and banks are often interested in calculating these ratios
• Three important debt management ratios are
Total Liabilities to total assets ratio
• This ratio compares total liabilities of the firm with total assets
• Shows the percentage of assets purchased by taking liabilities
• Higher the ratio greater will be the leverage, which shows that most of the assets
are financed through debt.
• If most assets are financed through debt solvency risk will be high and will be less
attractive for investors and long term creditors.
Formula
Total liabilities/ Total assets
= 150,000/250,000
= 0.6 or 60%
Which means that 60% of the assets are financed through liabilities?
Times Interest earned Ratio
• Shows the firm’s ability that whether the firm can pay their fixed interest charges
or not? In other words it compares the firm’s profits with fixed interest charges,
• Banks and other financial institutes which grant loan to the organization are
interested in this ratio.
• This ratio shows that what amount of profit is available for payment of one dollar
of interest, greater the ratio more profit is available, better is the ability to service
debt
Formula

22
= 200000/10000 =20
Which means that the company has 20 Rs of profit to pay I Re of interest?
Earnings before interest tax depreciation and amortization (EBITDA) Ratio
 Interest coverage ratio does not fully explain the firm’s ability to service debt
because interest is not the only payment which a company makes but it also has to
pay some portion of its loan and also lease payment
 Similarly EBIT is not the total cash available for all these payments
 EBITDA is used to find the amount of free cash flow available for payment of
interest, repayment of principle amount and also lease installment.
 Greater the ratio means more free cash is available for payment of the above
payments.
Formula:
NPBITDA + Lease payments/Interest expense Principle Payment Lease payment
(D) Profitability ratios
 These ratios, much like the operational performance ratios, give users a good
understanding of how well the company utilized its resources in generating profit
and shareholder value.
 The long-term profitability of a company is vital for both the survivability of the
company as well as the benefit received by shareholders.
Profit margin to sales
 Profit margin to sales compares net profit available to shareholders for
distribution with sales.
 Net profit available for shareholders is the absolute profit from which all types of
expenses, taxes and preference dividend has been deducted
 To a large degree, it is the quality, and growth, of a company's earnings that drive
its stock price.
 Theatrically greater the profit margin ratio greater will be the performance of the
business, or more profitable the business is.
Formulas:
Net profit margin ratio = Profit available for shareholders/ sales
Basic Earning Power Ratio
 This ratio shows the basic or raw earning capacity of the assets of the business

23
 This ratio is calculated by taking EBIT (earnings before interest and tax), which
shows that tax effects and interest is not taken into consideration.
Formula
Basic Earning power = EBIT/ Total Assets
Return on Total Assets
 Return on total assets is calculated by comparing Net profit available for
shareholders with total assets
 This ratio shows the final earning power and final earning capacity of the business
 Greater the ratio more profitable the business is and more efficiently the business
is utilizing its resources
Formula
Return on Total assets = Net profit available for shareholders/ Total asset
Return on Equity:
 This ratio indicates how profitable a company is by comparing its net
income to its average shareholders' equity.
 The return on equity ratio (ROE) measures how much the shareholders
earned for their investment in the company.
 The higher the ratio percentage, the more efficient management is in
utilizing its equity base and the better return is to investors.
Formula:
(E) Market Value Ratios
Market Value Ratios relate an observable market value, the stock price, to book values obtained
from the firm's financial statements.
Price-Earnings Ratio (P/E Ratio)
 The Price-Earnings Ratio is calculated by dividing the current market price per share of
the stock by earnings per share (EPS). (Earnings per share are calculated by dividing net
income by the number of shares outstanding.)
 The P/E Ratio indicates how much investors are willing to pay per dollar of current
earnings. As such, high P/E Ratios are associated with growth stocks. (Investors who are
willing to pay a high price for a dollar of current earnings obviously expect high earnings
in the future.)

24
 In this manner, the P/E Ratio also indicates how expensive a particular stock is. This
ratio is not meaningful, however, if the firm has very little or negative earnings.
Where
Market-to-Book Ratio
 The Market-to-Book Ratio relates the firm's market value per share to its book value per
share.
 This shows the amount of money an investor is willing to pay to get 1 rupee ownership in
that company
 Since a firm's book value reflects historical cost accounting, this ratio indicates
management's success in creating value for its stockholders.
 Greater the ratio more interested the investors are in your company and will show greater
growth in the shares.
Where
Book value per share = Total equity/ total outstandding shares,
Retention Ratio:
The proportion of earnings kept back in the business as retained earnings. The retention ratio
refers to the percentage of net income that is retained to grow the business, rather than being paid
out as dividends. It is the opposite of the payout ratio, which measures the percentage of earnings
paid out to shareholders as dividends.
On a per-share basis, the retention ratio can be expressed as (1 – Dividends per share / EPS).

25
The retention ratio is 100% for companies that do not pay dividends, and is zero for companies
that pay out their entire net income as dividends.
Also known as “plowback ratio.”
Trend Analysis, Common Size Analysis and Percent Change Analysis
Trend Analysis
Trend analysis Is one of the tools for the analysis of the company’s monetary statements for the
investment purposes. Investors use this analysis tool a lot in order to determine the financial
position of the business. In a trend analysis, the financial statements of the company are
compared with each other for the several years after converting them in the percentage. In the
trend analysis, the sales of each year from the 2008 to 2011 will be converted into percentage
form in order to compare them with each other. In order to convert the figures into percentages
for the comparison purposes, the percentages are calculated in the following way:
Trend analysis percentage = (figure of the previous period – figure of the current period)/total of
both figures
The percentage can be found this way and if the current-year percentages were greater than
previous year percentage, this would mean that current-year result is better than the previous year
result.
Common‐Size Analysis
Common‐size analysis (also called vertical analysis) expresses each line item on a single year's
financial statement as a percent of one line item, which is referred to as a base amount. The base
amount for the balance sheet is usually total assets (which is the same number as total liabilities
plus stockholders' equity), and for the income statement it is usually net sales or revenues. By
comparing two or more years of common‐size statements, changes in the mixture of assets,
liabilities, and equity become evident. On the income statement, changes in the mix of revenues
and in the spending for different types of expenses can be identified.
Percentage Change Analysis
A percent change analysis shows how two items changed as a percentage from one period to
another period. Used on a balance sheet, a percent change analysis shows how a balance sheet
account changes from year to year, or quarter to quarter. The balance sheet accounts are assets,

26
liabilities and stockholders' equity. Percent change analysis is important for managers and
investors to see how a company is growing or retracting from year-to-year.
DuPont Analysis:
DuPont analysis is an extended analysis of a company's return on equity. It concludes that a
company can earn a high return on equity if:
1. It earns a high net profit margin;
2. It uses its assets effectively to generate more sales; and/or
3. It has a high financial leverage
Formula
According to DuPont analysis:
Return on Equity = Net Profit Margin × Asset Turnover × Financial Leverage
Return on Equity =
Net Income
×
Sales
×
Total Assets
Sales Total Assets Total Equity
Analysis
DuPont equation provides a broader picture of the return the company is earning on its equity. It
tells where a company's strength lies and where there is a room for improvement.
DuPont equation could be further extended by breaking up net profit margin into EBIT margin,
tax burden and interest burden. This five-factor analysis provides an even deeper insight.
ROE = EBIT Margin × Interest Burden × Tax Burden × Asset Turnover × Financial Leverage
Return on Equity =
EBIT
×
EBT
×
Net Income
×
Sales
×
Total Assets
Sales EBIT EBT Total Assets Total Equity
*End of Chapter*

27
Chapter#4
Financial Planning and Forecasting
Financial Planning - Definition, Objectives and Importance
Definition of Financial Planning
Financial Planning is the process of estimating the capital required and determining its
competition. It is the process of framing financial policies in relation to procurement,
investment and administration of funds of an enterprise.
Objectives of Financial Planning
Financial Planning has got many objectives to look forward to:
a. Determining capital requirements- This will depend upon factors like cost of
current and fixed assets, promotional expenses and long- range planning. Capital
requirements have to be looked with both aspects: short- term and long- term
requirements.
b. Determining capital structure- The capital structure is the composition of capital,
i.e., the relative kind and proportion of capital required in the business. This
includes decisions of debt- equity ratio- both short-term and long- term.
c. Framing financial policies with regards to cash control, lending, borrowings, etc.
d. A finance manager ensures that the scarce financial resources are maximally
utilized in the best possible manner at least cost in order to get maximum returns
on investment.
Importance of Financial Planning
Financial Planning is process of framing objectives, policies, procedures, programmes
and budgets regarding the financial activities of a concern. This ensures effective and
adequate financial and investment policies. The importance can be outlined as-
1. Adequate funds have to be ensured.
2. Financial Planning helps in ensuring a reasonable balance between outflow and
inflow of funds so that stability is maintained.
3. Financial Planning ensures that the suppliers of funds are easily investing in
companies which exercise financial planning.
4. Financial Planning helps in making growth and expansion programmes which
helps in long-run survival of the company.

28
5. Financial Planning reduces uncertainties with regards to changing market trends
which can be faced easily through enough funds.
6. Financial Planning helps in reducing the uncertainties which can be a hindrance to
growth of the company. This helps in ensuring stability and profitability in
concern.
Forecasting Financial Statements
Introduction:
Financial Forecasting describes the process by which firms think about and
prepare for the future. The forecasting process provides the means for a firm to express
its goals and priorities and to ensure that they are internally consistent. It also assists the
firm in identifying the asset requirements and needs for external financing.
For example, the principal driver of the forecasting process is generally the sales
forecast. Since most Balance Sheet and Income Statement accounts are related to sales,
the forecasting process can help the firm assess the increase in Current and Fixed Assets
which will be needed to support the forecasted sales level. Similarly, the external
financing which will be needed to pay for the forecasted increase in assets can be
determined.
Strategic Planning:
Strategic planning provides the vision, direction and goals for the business.
Strategic planning is an organization's process of defining its strategy, or direction, and
making decisions about allocating resources to pursue this strategy. In order to determine
the direction of the organization, it is necessary to understand its current position and the
possible avenues through which it can pursue a particular course of action. A financial
forecast is an estimate of future financial outcomes for a company. Using historical
internal accounting and sales data, in addition to external market and economic
indicators, a financial forecast is an economist's best guess of what will happen to a
company in financial terms over a given time period—which is usually one year.
Operating Plans:
Operational planning is a subset of strategic work planning which describes short-
term ways of achieving milestones and explains how. The strategic plan will be put into
operation during a given operational period. An operational plan draws directly from
agency and program strategic plans to describe agency and program missions and goals,
program objectives, and program activities.
Like a strategic plan, an operational plan addresses four questions:
 Where are we now?
 Where do we want to be?

29
 How do we get there?
 How do we measure our progress?
The Financial Plans:
Financial planning is the process of meeting your life goals through the proper
management of your finances. Life goals can include buying a home, saving for your
child’s education or planning for retirement. The financial planning process involves the
following steps:
 Gathering relevant financial information
 Setting life goals
 Examining your current financial status
 Coming up with a financial strategy or plan for how you can meet your goals
 Implementing the financial plan
 Monitoring the success of the financial plan, adjusting it if necessary
Using these steps, you can determine where you are now and what you may need in the
future in order to reach your goals.
Financial planning is a systematic approach whereby the financial planner helps the
customer to maximize his existing financial resources by utilizing financial tools to
achieve his financial goals. Financial planning is simple mathematics. There are 3 major
components:
 Financial Resources (FR)
 Financial Tools (FT)
 Financial Goals (FG)
When you want to maximize your existing financial resources by using various financial
tools to achieve your financial goals, which is financial planning.
Financial Planning: FR + FT = FG
Computerized Financial Planning Model:
The financial plan describes the practice's financial strategy, projects the strategy's
future effect on the practice, and establishes goals by which the practice's manager can
measure subsequent performance. The act of putting together a financial plan is called the
financial planning process. It is a process that consists of analyzing the practice;
projecting future outcomes of decisions that have to be made regarding finances,
investments, and day to day operations; deciding which alternatives to undertake; and
measuring performance against goals that are established in the financial plan.
Computer financial planning models can aid the practice manager in projecting
future outcomes of various financial, investment, and operational decisions. These
models can be created inexpensively by non-computer programmers with the aid of
computer software on the market today. The financial planning process for a hypothetical

30
practice was summarized, and the financial model used to test out various alternatives
available to the practice was described
Sales Forecasts:
Sales forecasting is estimating what a company's future sales are likely to be
based on sales records as well as market research. The information used in them must be
well organized and may include information on the competition and statistics that affect
the businesses' customer base. Companies try to forecast sales in hopes of identifying
patterns so that revenue and cash flow can be maximized.
Before the forecasting process begins, marketing, sales, or other managers should
determine how far ahead the estimate should be done. Short-term forecasting is a
maximum of three months and is often effective for analyzing budgets and markets.
Intermediate forecasting is between a period of three months and two years and may be
used for schedules, inventory and production. Long-term forecasting is for a minimum of
two years and is good for dealing with growth into new markets or new products. Sales
forecasts should be conducted regularly and all results need to be measured so that future
methods can be adjusted if necessary.
Basically, sales forecasting is analyzing all parts of a business from total
inventory to the strengths and weaknesses of salespeople. Managers must think about
changes in customer sales or other changes that could affect the estimated figures. They
must be competitive when assessing the competition and how they can surpass others in
the marketplace to better meet the needs of the target market.
Financial Statement Forecasting Methods
To forecast financial data, corporate leadership and department heads rely on
various methods and tools. These include appraisal methodologies, such as vertical and
horizontal analyses, as well as financial ratios, such as net profit margin and return on
equity. Forecasted financial information is also known as pro forma or projected
accounting information.
Following are some methods of forecasting Financial Statements
Statistical Forecasting
 Statistical forecasting enables department heads to project financial statements based on
assumptions and internally derived factors. For example, supervisors may review the
state of the economy and take government-published GDP metrics to estimate how much
the company might grow sales in the future -- say, in one, two or 10 years. Gross
domestic product, or GDP, is the total market value of goods and services produced
within a nation's borders during a given period.

31
Ratio Method
 In ratio analysis, a company uses previously calculated metrics to forecast financial
statement data. Financial ratios indicate everything from efficiency and profitability to
solvency and liquidity. Examples include net profit margin, asset-turnover ratio and
return on equity, or ROE. A company may, for example, forecast income data for each of
the next five years by multiplying current-year sales by the current-year ROE. The firm
then may adjust the final number by including material cost and labor expense
projections.
Vertical Method
 Vertical analysis means a company sets a financial statement item as a numerical standard and
compares other items with the benchmark. For example, a company may set total sales as the
benchmark for income statement forecasts. The business then may calculate that material costs
amounted to a certain percentage -- say, 50 percent -- of total sales over the last 12 months. Using
this proportion, accountants may extrapolate by setting material costs at 50 percent of total sales
for the next five years.
Horizontal Method
 In horizontal analysis, the goal is to review financial data year over year, giving analytical
prominence to the study of historical information. For example, a business may analyze its sales
data over a five-year period and determine that the average revenue-growth rate is 11 percent.
The organization then may use the same number to forecast that sales will grow 11 percent for
each of the next five or 10 years.
*End of Chapter*

32
Chapter#5
Financial Environment
Introduction:
Financial environment is the outcome of a range of functions of the economy on
all financial outcomes of an area or a country. It includes forex markets, bond markets,
stock markets and commodity markets.
Financial Markets
 A market is a venue where goods and services are exchanged.
 A financial market is a place where individuals and organizations wanting to
borrow funds/capital are brought together with those having a surplus of funds.
Types of Financial markets:
Some Financial markets are as follows
1-Real/tangible/Physical assets Markets and Financial Asset Market
Real assets are tangible assets that determine the productive capacity of an
economy, that is, the goods and services its members can create. These include land,
buildings, machines, and knowledge that can be used to produce goods and services.
Other common examples of investments in Real Assets are paintings, antiques, precious
metals and stones, classic cars etc.
While Financial Asset Market refers to that market where financial assets are
dealt. Financial Assets, (Assets in the form of paper) or more commonly known
as Securities, include stocks, bonds, unit trusts etc. In essence, financial assets or
securities represent legal claim on future financial benefits.
2-Spot Markets and Future Markets:
The spot market is where securities (e.g. shares, bonds, funds, warrants and
structured products) and goods (e.g. commodities) are traded. In spot market goods are
delivered on the same day or within a few days In other words, the transaction takes
place immediately or within a short period of time (T+3; transactions are usually settled
three working days after they take place).
Future market transactions are transactions in which the price, number and
delivery date of the traded securities are agreed when the transaction is concluded but

33
delivery and payment take place at a future time. Usually, the term "forward transaction"
is used if the time period is three days or more.
3-Money Market and Capital Market
The money market is a segment of the financial market in which financial
instruments with high liquidity and very short maturities are traded. The money market is
used by participants as a means for borrowing and lending in the short term, from several
days to just under a year.
A capital market is one in which individuals and institutions trade those securities and
instruments whose maturity is more than one year.
4-Primary Market and Secondary market
The primary market is where securities are created. It's in this market that firms
sell new stocks and bonds to the public for the first time. Or the market in which new
shares are issued
The secondary market is that market in which second hand shares and bonds are
traded. Stock exchange is the market in which one investor buys 3nd hand shares from
another investor
5-Private and Public Markets:
A private market, also known as the private market sector, is the part of a nation's
economy that is not controlled by the government. It is operated by individuals and firms
with the aim of making profits. It is the complete opposite of a public sector which is
operated by the government with the aim of providing goods and services.
Financial Institutions
Financial institutions are the organizations that are involved in providing various
types of financial services to their customers. Examples of financial institutions include;
Banks, Credit Unions, Asset Management Firms, Insurance companies and pension funds
among others.
Following are some financial institutions:
1-Commercial Banks
This is a financial institution providing services for businesses, organizations and
individuals. Services include offering current, deposit and saving accounts as well as
giving out loans to businesses. Commercial banks are defined as a bank whose main
business is deposit-taking and making loans.
2-Savings and Loan Associations

34
A savings and loan association (S&L) is a financial institution that specializes
in savings deposits and mortgage loans, and has become one of the
primary sources of mortgage loans for homebuyers today.
It offers mortgage services to people from the savings and deposits received
from private investors.
3-Mutual Savings Bank:
A Mutual Savings Bank is a financial establishment which is licensed through a
centralized or state government and provides individuals with a secure place to invest in
mortgages, credit, stocks and other securities. It is owned and operated by the depositors.
4-Credit union:
This is a mutual financial organization formed and managed by a group of people
with a common affiliation, such as employees of a company or a trade union. When you
deposit money into a credit union, you become a member and a partial owner.
5-Insurance Companies:
These are corporate entities that insure people against loss. The client pays a fee,
known as a premium, in exchange for the promise of the company to protect the client
financially in the event of certain potential misfortunes. The different t types of insurance
include life, Vehicle, health, liability and homeowners.
6-Investment Banks:
Unlike commercial banks, investment banks do not take deposits. Their focus is
assisting individuals, corporations, and governments in raising capital by underwriting
and/or acting as the client's agent in the issuance of securities. An investment bank may
also assist companies involved in mergers and acquisitions.
7-Mutual Fund Companies:
Sometimes called investment companies, these are companies that pool money
from many investors to purchase securities. Each fund invests in a different group of
securities for the investors. They serve the general public.
The Stock Exchange or Stock Market
“Stock exchanges are privately organized markets which are used to facilitate
trading in securities.”
Stock Exchange (also called Stock Market or Share Market) is one important
constituent of capital market Stock Exchange is an organized market for the purchase and

35
sale of industrial and financial security. It is convenient place where trading in securities
is conducted in systematic manner i.e. as per certain rules and regulations.
It performs various functions and offers useful services to investors and
borrowing companies. It is an investment intermediary and facilitates economic and
industrial development of a country. Stock exchange is an organized market for buying
and selling corporate and other securities. Here, securities are purchased and sold out as
per certain well-defined rules and regulations. It provides a convenient and secured
mechanism or platform for transactions in different securities. Such securities include
shares and debentures issued by public companies which are duly listed at the stock
exchange and bonds and debentures issued by government, public corporations and
municipal and port trust bodies.
Over-the-counter (OTC)
A decentralized market, without a central physical location, where market
participants trade with one another through various communication modes such as the
telephone, email and proprietary electronic trading systems. An over-the-counter (OTC)
market and an exchange market are the two basic ways of organizing financial markets.
In an OTC market, dealers act as market makers by quoting prices at which they will buy
and sell a security or currency. A trade can be executed between two participants in an
OTC market without others being aware of the price at which the transaction was
effected. In general, OTC markets are therefore less transparent than exchanges and are
also subject to fewer regulations.
What are the Bid-ask spread?
The amount by which the ask price exceeds the bid. This is essentially the
difference in price between the highest price that a buyer is willing to pay for an asset and
the lowest price for which a seller is willing to sell it.
For example, if the bid price is $20 and the ask price is $21 then the "bid-ask spread" is
$1.
The Cost of Money:
Concept of the Cost of Money
The cost of money refers to the price paid for using the money, whether borrowed
or owned. In other words the cost of money is the expectation of investor from investing
or lending money every sum of money used by corporations bears cost. The interest paid
on debt capital and the dividends paid on ownership capital are examples of the cost of

36
money. The supply of and demand for capital is the factor that affects the cost of money.
In addition, the cost of money is affected by the following factors as below:
Factors Affecting the Cost of Money
1. Production Opportunities
Production opportunities refer to the profitable opportunities for investment in
productive assets. Increase in production opportunities in an economy increases the cost
of money. Higher the production opportunities more will be the demand for money which
leads to higher cost of money.
2. Time Preference for Consumption
Time preference for consumption refers to the preference of consumers for
current consumption as opposed to future consumption. The cost of money also depends
on whether the consumers prefer to consume in current period or in future period. If the
consumers prefer to consume in current period, they spend larger portion of their earnings
in current consumption. It leads to the lower saving. Lower saving reduces the supply of
money causing the cost of money increase. Therefore, as much as the consumers give
high preference to current consumption, the cost of money will increase and vice versa.
3. Risk
Risk refers to the chance of loss. In the context of financial markets, risk means
the chance that investment would not produce promised return. The degree of risk
perceived by investors and the cost of money has positive relationship. If an investor
perceives high degree of risk from a given investment alternative, he or she will demand
higher rate of return, and hence the cost of money will increase.
4. Inflation
Inflation refers to the tendency of prices to increase over periods. The expected
future rate of inflation also affects the cost of money, because, it affects the purchasing
power of investors. Increase in rate of inflation results in decline in purchasing power of
investors. The investors will demand higher rate of return to commensurate against
decline in purchasing power because of inflation.
Interest Rate Levels
What is interest rate?
Interest rate is the rate of interest charged for the amount of money borrowed.
Banks or lending institutions usually have general guidelines for the rate they intend to
charge. Money borrowed by the bank on short term basis (such as overdraft facility) or
long term basis (debentures, mortgages or bank loans) has different interest rate.

37
These are factors that influence the level of market interest rates:
Expected levels of inflation:
Over time, as the cost of products and services increase, the value of money
decreases. Consumer will therefore have to spend more money for the same products or
services which had cost less in the previous year. As for finance lending sector,
borrowers may find it is attractive to borrow now but less attractive for lender. The value
of money now has fallen as compared to the time when they lent their money. In order to
compensate this loss, lenders have to increase the interest rate.
Demand and supply of money:
Demand and supply of money can affect interest rates. In United States, The
Federal Reserve Bank has taken a step to manipulate money supply through an open
market operation, by purchasing large volumes of government security to increase money
supply, thus reduce the interest rates, or sell large volumes of government security to
reduce money supply which will subsequently increase interest rates.
On the other hand, liquidity preference theory is linked to demand of money.
Developed by John Keynes, this theory explains how demand and supply for money
influence interest rates. It states that demand for liquidity is determined by transaction,
precaution and speculation motives.
Monetary policy and intervention by the government:
One of the government’s strategies to control the flow of money within its
consumers is by monetary policy. People will avoid borrowing money when the interest
rates are high. This in turn will reduce the money outflow and affect the country’s
revenue as consumers will not be spending unless it is necessary. In order to stimulate
growth, government may offer lower interest rates on borrowing which subsequently
attracts consumer to spend more borrowing. As a result, when the growth rate increases
rapidly to the extent that economy may face overheat problem, the government then have
to curb this by imposing higher interest rates.
General economic conditions:
Economic condition may face series its booms and slumps. The world economy
has been on the slump side since the past five years with many business closures. Banks
are unable to provide loan at lower rate as they have to cover their cost.
Apart from the above, other factors such as political and financial stability and investors’
demand for debt securities also affect interest rates. While increase in interest rates helps
consumer to save more, it is not good news for lenders and business as they lose their
revenue. Globally, this also adversely affects the world economy.

38
Determinants of market interest rates
The explanation of these determinants of interest rates is given as under:
Risk Free Interest Rate (kRF=k*+IP)
Risk free rate is one of the determinants of the interest rate. Risk free rate means
the rate of interest received if no risk is taken. Factually speaking, there is no such thing
as a risk-free rate of return because no investment can be entirely risk-free. All the
investments and securities include a certain amount of risk. A company may go bankrupt
or close down. However, if we talk about the relevant risk involved in different securities,
the government-issued securities are considered as risk-free, since the chances of default
of a government are minimal. These government issued securities provide a benchmark
for the determination of interest rates. Internationally the US T-Bills are considered as
risk free rate of return.
In Pakistan, Government of Pakistan T-Bills can be used as a proxy for risk free
rate of return, however, since Pakistan faces some sovereign risk, the T-bills would not
be considered entirely risk-free in the true sense.
Inflation (g):
The expected average inflation over the life of the investment or security is
usually inculcated in the nominal interest rate by the issuer of security to cover the
inflation risk. For instance, consider a bond with a maturity of 5 years. If the inflation rate
in Pakistan is 8 % and the bond is also offering 8% percent interest rate, the investors
would not be willing to invest in the bond since the gains from the interest rate would be
exactly offset by the inflate ion rate which is actually eroding the wealth of the investor.
To secure the investor against inflation the issuers, while quoting nominal interest rates,
add the rate of inflation to the real interest rate.
Default Risk Premium (DR):
Default risk refers to the risk that the company might go bankrupt or close down
& bonds, or shares issued by the company may collapse. Default Risk Premium is
charged by the investor, as compensation, against the risk that the company might goes
bankrupt. Companies may also default on interest payments, something not very unusual
in the corporate world. In USA, rating agencies like
Moody’s and S&P grade securities (debt and equity instruments) according to
their financial health and thus identify those companies which have a good ability to pay
off their principal lending and interest charges and those which might default on the
payments.

39
Maturity Risk Premium (MRP):
The maturity risk premium is linked to the life of that security. For example, if
you purchase the long term Federal Investment Bonds issued by the government of
Pakistan, you are assuming certain risk, because changes in the rates of inflation or
interest rates would depreciate the value of your investment. These changes are more
likely in the long term and less likely in the short term. Maturity risk Premium is linked
to life of the investment. The longer the maturity period, the higher the maturity risk
premium.
Sovereign Risk Premium (SR):
Sovereign Risk refers to the risk of government default on debt because of
political or economic turmoil, war, prolonged budget and trade deficits. This risk is also
linked to foreign exchange (F/x), depreciation, and devaluation. Now-a-days the
individuals as well as institutions are investing billions of rupees globally. If a bank
wants to invest in Pakistan, it will have to take view of Pakistan’s political, economic,
and financial environment. If the bank sees some risk involved it would be willing to lend
at a higher interest rate. The interest rate would be high since the bank would add
sovereign risk premium to the interest rate. Here it may be clarified that Pakistan is not
considered as risky as many other countries of Africa and South America.
Liquidity Preference (LP):
Investor psychology is such that they prefer easily encashable securities.
Moreover, they charge the borrower for forgoing their liquidity. A higher liquidity
preference would always push the interest rates upwards.
So summing up Quoted interest rate=k=k*+IP+DRP+LP+MRP
The above relation includes all the above factors.
The Term Structure of Interest Rates
The relationship between interest rates or bond yields and different terms or
maturities. The term structure of interest rates is also known as a yield curve and it plays
a central role in an economy. The term structure reflects expectations of market
participants about future changes in interest rates and their assessment of monetary policy
conditions.

40
In general terms, yields increase in line with maturity, giving rise to an upward
sloping yield curve or a "normal yield curve." One basic explanation for this phenomenon
is that lenders demand higher interest rates for longer-term loans as compensation for the
greater risk associated with them, in comparison to short-term loans. Occasionally, long-
term yields may fall below short-term yields, creating an "inverted yield curve" that is
generally regarded as a harbinger of recession.
What determines the shape of the yield curve?
The yield curve, also known as the "term structure of interest rates," is a graph
that plots the yields of similar-quality bonds against their maturities, ranging from
shortest to longest. (Note that the chart does not plot coupon rates against a range of
maturities -- that's called a spot curve.)
How it works/Example:
The yield curve shows the various yields that are currently being offered
on bonds of different maturities. It enables investors at a quick glance to compare the
yields offered by short-term, medium-term and long-term bonds.
The yield curve can take three primary shapes. If short-term yields are lower than long-
term yields (the line is sloping upwards), then the curve is referred to a positive (or
"normal") yield curve. Below you'll find an example of a normal yield curve:
If short-term yields are higher than long-term yields (the line is sloping downwards), then
the curve is referred to as an inverted (or "negative") yield curve. Below you'll find an
example of an inverted yield curve:

41
Finally, a flat yield curve exists when there is little or no difference between short- and
long-term yields. Below you'll find an example of a flat yield curve:
It is important that only bonds of similar risk are plotted on the same yield curve.
The most common type of yield curve plots Treasury securities because they are
considered risk-free and are thus a benchmark for determining the yield on other types
of debt.
The shape of the yield curve changes over time. Investors who are able to predict how the
yield curve will change can invest accordingly and take advantage of the corresponding
change in bond prices.
Yield curves are calculated and published by The Wall Street Journal, the Federal
Reserve, and a variety of other financial institutions.
*End of Chapter*

42
Chapter # 06
Risk and Return
What is Risk?
The probability or threat of quantifiable damage, injury, liability, loss, or any
other negative occurrence that is caused by external or internal vulnerabilities, and that
may be avoided through preemptive action.
In Finance: The probability that an actual return on an investment will be lower
than the expected return. Financial risk can be divided into the following categories:
Basic risk, Capital risk, Country risk, Default risk, Delivery risk, Economic
risk, Exchange rate risk, Interest rate risk, Liquidity risk, Operations risk, Payment
system risk, Political risk, Refinancing risk, risk, Settlement, Sovereign risk,
and Underwriting risk.
What Are the Different Types of Risk?
*Systematic Risk - Systematic risk influences a large number of assets. A significant
political event, for example, could affect several of the assets in your portfolio. It is
virtually impossible to protect yourself against this type of risk.
*Unsystematic Risk - Unsystematic risk is sometimes referred to as "specific risk". This
kind of risk affects a very small number of assets. An example is news that affects a
specific stock such as a sudden strike by employees. Diversification is the only way to
protect you from unsystematic risk.
Now that we've determined the fundamental types of risk, let's look at more
specific types of risk, particularly when we talk about stocks and bonds.
Credit or Default Risk - Credit risk is the risk that a company or individual will be
unable to pay the contractual interest or principal on its debt obligations. This type of risk
is of particular concern to investors who hold bonds in their portfolios.
Country Risk - Country risk refers to the risk that a country won't be able to honor its
financial commitments. When a country defaults on its obligations, this can harm the
performance of all other financial instruments in that country as well as other countries it
has relations with. Country risk applies to stocks, bonds, mutual funds, options and
futures that are issued within a particular country.
Foreign-Exchange Risk - When investing in foreign countries you must consider the
fact that currency exchange rates can change the price of the asset as well. Foreign-
exchange risk applies to all financial instruments that are in a currency other than your
domestic currency.

43
Interest Rate Risk - Interest rate risk is the risk that an investment's value will change as
a result of a change in interest rates. This risk affects the value of bonds more directly
than stocks.
Political Risk - Political risk represents the financial risk that a country's government
will suddenly change its policies. This is a major reason why developing countries lack
foreign investment.
Market Risk - This is the most familiar of all risks. Also referred to as volatility, market
risk is the day-to-day fluctuation in a stock's price. Market risk applies mainly to stocks
and options. As a whole, stocks tend to perform well during a bull market and poorly
during a bear market - volatility is not so much a cause but an effect of certain market
forces.
Investment Return:
A performance measure used to evaluate the efficiency of an investment or to
compare the efficiency of a number of different investments. To calculate ROI, the
benefit (return) of an investment is divided by the cost of the investment; the result is
expressed as a percentage or a ratio.
The rate of return on an
investment can be calculated as
follows:
In the above formula "gains from investment", refers to the proceeds obtained
from selling the investment of interest. Return on investment is a very popular metric
because of its versatility and simplicity. That is, if an investment does not have a positive
ROI, or if there are other opportunities with a higher ROI, then the investment should be
not be undertaken.
Return on investment, or ROI, is the most common profitability ratio. There are several
ways to determine ROI, but the most frequently used method is to divide net profit by
total assets. So if your net profit is $100,000 and your total assets are $300,000, your ROI
would be .33 or 33 percent.
Return on investment isn't necessarily the same as profit. ROI deals with the
money you invest in the company and the return you realize on that money based on the
net profit of the business. Profit, on the other hand, measures the performance of the
business. Don't confuse ROI with the return on the owner's equity. This is an entirely
different item as well. Only in sole proprietorships does equity equal the total investment
or assets of the business.
Stand Alone Risk
Standalone risk describes the danger associated with investing in a particular
instrument or investing in a particular division of a company. A typical investment
portfolio contains a wide array of instruments in which case investors are exposed to a

44
large number of risks and potential rewards. In contrast, a standalone risk is one that can
easily be distinguished from these other types of risk.
When an investor only invests in one type of stock, then his or her entire
investment returns depend on the performance of that security. If the company that issued
the stock performs well then the stock will grow in value but if the firm becomes
insolvent then the stock may become worthless. Therefore, such an investor is exposed to
standalone risk because that individual's entire investment could be lost due to the poor
performance of a single asset.
Additionally, someone who invests in a wide array of securities is also exposed to
standalone risk if that individual holds each type of instrument in a separate brokerage
account. In such situations, the investor would not lose everything if one asset dropped in
value, but each holding account would expose the investor to a different standalone risk
since each account would only hold one type of security.
Probability Distribution
A statistical function that describes all the possible values and likelihoods that a
random variable can take within a given range. This range will be between the minimum
and maximum statistically possible values, but where the possible value is likely to be
plotted on the probability distribution depends on a number of factors, including the
distributions mean, standard deviation, skewness and kurtosis. Academics and fund
managers alike may determine a particular stock's probability distribution to determine
the possible returns that the stock may yield in the future. The stock's history of returns,
which can be measured on any time interval, will likely be comprised of only a fraction
of the stock's returns, which will subject the analysis to sampling error. By increasing the
sample size, this error can be dramatically reduced.
There are many different classifications of probability distributions, including the chi
square and normal and binomial distributions.
Expected Rate of Return:
Expected return is calculated as the weighted average of the likely profits of the
assets in the portfolio, weighted by the likely profits of each asset class. Expected return
is calculated by using the following formula:

45
Written another way, the same formula is as follows: E(R) = w1R1 + w2Rq + ...+ wnRn
Example: Expected Return
For a simple portfolio of two mutual funds, one investing in stocks and the other
in bonds, if we expect the stock fund to return 10% and the bond fund to return 6% and
our allocation is 50% to each asset class, we have the following:
Expected return (portfolio) = (0.1)*(0.5) + (0.06)*(0.5) = 0.08, or 8%
Expected return is by no means a guaranteed rate of return. However, it can be used to
forecast the future value of a portfolio, and it also provides a guide from which to
measure actual returns.
Standard Deviation
Standard deviation can be defined in two ways:
1. A measure of the dispersion of a set of data from its mean. The more spread apart the
data, the higher the deviation. Standard deviation is calculated as the square root of
variance.
2. In finance, standard deviation is applied to the annual rate of return of an investment to
measure the investment's volatility. Standard deviation is also known as volatility and is
used by investors as a gauge for the amount of expected volatility.
Standard deviation is a statistical measurement that sheds light on historical volatility.
For example, a volatile stock will have a high standard deviation while a stable blue
chip stock will have a lower standard deviation. A large dispersion tells us how much the
fund's return is deviating from the expected normal returns.
Example: Standard Deviation
Standard deviation (σ) is found by taking the square root of variance:
(165)1/2
= 12.85%.
We used a two-asset portfolio to illustrate this principle, but most portfolios contain far
more than two assets. The formula for variance becomes more complicated for multi-
asset portfolios. All terms in a covariance matrix need to be added to the calculation.
Risk aversion
Risk aversion is a concept in economics and finance, based on the behavior
of humans (especially consumers and investors) while exposed to uncertainty to attempt
to reduce that uncertainty.

46
Risk aversion is the reluctance of a person to accept a bargain with an uncertain
payoff rather than another bargain with more certain, but possibly lower, expected
payoff. For example, a risk-averse investor might choose to put his or her money into
a bank account with a low but guaranteed interest rate, rather than into a stock that may
have high expected returns, but also involves a chance of losing value.
Example:
A person is given the choice between two scenarios, one with a guaranteed payoff
and one without. In the guaranteed scenario, the person receives $50. In the uncertain
scenario, a coin is flipped to decide whether the person receives $100 or nothing. The
expected payoff for both scenarios is $50, meaning that an individual who was insensitive
to risk would not care whether they took the guaranteed payment or the gamble.
However, individuals may have different risk attitudes.
Risk in a Portfolio Context
Portfolio
A collection of investments all owned by the same individual or organization.
These investments often include stocks, which are investments in individual
businesses; bonds, which are investments in debt that are designed to earn interest;
and mutual funds, which are essentially pools of money from many investors that are
invested by professionals or according to indices.
A group of investments such as stocks, bonds and cash equivalents, mutual funds,
exchange-traded funds, and closed-end funds that are selected on the basis of an
investor's short-term or long-term investment goals. Portfolios are held directly by
investors and/or managed by financial professionals.
Portfolio Return
The monetary return experienced by a holder of a portfolio. Portfolio returns can
be calculated on a daily or long-term basis to serve as a method of assessing a particular
investment strategy. Dividends and capital appreciation are the main components of
portfolio returns.
Portfolio returns can be calculated through various methodologies such as a time-
weighted and money-weighted return. However, the overall return must be compared to
the required benchmarks and risk of the portfolio as well.
Calculation Portfolio Return:
To determine the expected return on a portfolio, the weighted average expected return of
the assets that comprise the portfolio is taken.
Formula 17.4
E(R) of a portfolio = w1R1 + w2Rq + ...+ wnRn
Example:
Assume an investment manager has created a portfolio with the Stock A and Stock B.

47
Stock A has an expected return of 20% and a weight of 30% in the portfolio. Stock B has
an expected return of 15% and a weight of 70%. What is the expected return of the
portfolio?
Answer:
E(R) = (0.30) (20%) + (0.70) (15%)
= 6% + 10.5% = 16.5%
The expected return of the portfolio is 16.5%
Portfolio Risk
Portfolio risk is the possibility that an investment portfolio may not achieve its
objectives. There are a number of factors that contribute to portfolio risk, and while you
are able to minimize them, you will never be able to fully eliminate them.
Portfolio risk refers to the combined risk attached to all of the securities within the
investment portfolio of an individual. This risk is generally unavoidable because there is
a modicum of risk involved in any type of investment, even if it is extremely small.
Investors often try to minimize portfolio risk through diversification, which involves
purchasing many securities with different characteristics in terms of potential risk and
reward. There are some risks which cannot be solved through diversification, and these
risks, known as market risks, can only be lessened by hedging with contrasting
investments.
Calculating Beta Coefficient
A measure of the volatility, or systematic risk, of a security or a portfolio in
comparison to the market as a whole. Beta is used in the capital asset pricing model
(CAPM), a model that calculates the expected return of an asset based on its beta and
expected market returns.
Also known as "beta coefficient."
Beta coefficient is a measure of sensitivity of a share price to movement in the
market price. It measures systematic risk which is the risk inherent in the whole financial
system. Beta coefficient is an important input in capital asset pricing model to calculate
required rate of return on a stock. It is the slope of the security market line.
Formula
Beta coefficient is calculated as covariance of a stock's return with market returns
divided by variance of market return. A slight modification helps in building another key
relationship which tells that beta coefficient equals correlation coefficient multiplied by
standard deviation of stock returns divided by standard deviation of market returns. Beta
coefficient is given by the following formulas:
β =
Covariance of Market Return with Stock Return
Variance of Market Return
β = Correlation Coefficient ×
Standard Deviation of Stock Returns
Between Market and Stock Standard Deviation of Market Returns

48
The Relationship between Risk and Rate of Return
There are two primary concerns for all investors: the rate of return they can expect
on their investments and the risk involved with that investment. While investors would
love to have an investment that is both low risk and high return, the general rule is that
there is a more or less direct trade-off between financial risk and financial return. This
does not suggest that there is some perfect linear relationship between risk and return, but
merely that the investments that promise the greatest returns are generally the riskiest.
Low levels of uncertainty (low risk) are associated with low potential returns.
High levels of uncertainty (high risk) are associated with high potential returns.
The risk/return tradeoff is the balance between the desire for the lowest possible risk and
the highest possible return. This is demonstrated graphically in the chart below. A higher
standard deviation means a higher risk and higher possible return.
A common misconception is that higher risk equals greater return. The risk/return
tradeoff tells us that the higher risk gives us the possibility of higher returns. There are no
guarantees. Just as risk means higher potential returns, it also means higher potential
losses.
Physical assets verses securities
An item of economic, commercial or exchange value that has a tangible or
material existence. For most businesses, physical assets usually refer to cash, equipment,
inventory and properties owned by the business. Physical assets are the opposite of
intangible assets, which are non-physical assets such as leases, computer programs or
agreements.
A financial instrument that represents: an ownership position in a publicly-traded
corporation (stock), a creditor relationship with governmental body or a corporation
(bond), or rights to ownership as represented by an option. A security is a fungible,
negotiable financial instrument that represents some type of financial value. The
company or entity that issues the security is known as the issuer.
Securities are typically divided into debt securities and equities. A debt security is
a type of security that represents money that is borrowed that must be repaid, with terms
that define the amount borrowed, interest rate and maturity/renewal date. Debt securities

49
include government and corporate bonds, certificates of deposit (CDs), preferred stock
and collateralized securities (such as CDOs and CMOs).
Capital Asset Pricing Model (CAPM)
A model that describes the relationship between risk and expected return and that
is used in the pricing of risky securities.
The general idea behind CAPM is that investors need to be compensated in two
ways: time value of money and risk. The time value of money is represented by the risk-
free (rf) rate in the formula and compensates the investors for placing money in any
investment over a period of time. The other half of the formula represents risk and
calculates the amount of compensation the investor needs for taking on additional risk.
This is calculated by taking a risk measure (beta) that compares the returns of the asset to
the market over a period of time and to the market premium (Rm-rf).
Risk and the Capital Asset Pricing Model Formula
The formula for CAPM is as follows:
In this formula, Ri represents the return on a risky security i, Rf represents the risk
free rate, βi represents the beta of security i, and Rm represents the market return.
The CAPM says that the expected return of a security or a portfolio equals the
rate on a risk-free security plus a risk premium. If this expected return does not meet or
beat the required return, then the investment should not be undertaken. For example, if
Security A has an expected return of 5%, but based on the CAPM the expected
return should be 6%, then you should not buy Security A because for the same level of
risk you can find other investments with an expected return of 6%.
Using the CAPM model and the following assumptions, we can compute the
expected return of a stock: if the risk-free rate is 3%, the beta (risk measure) of the stock

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