Finance Pointers
Finance Pointers
1. Jobs In Finance
• Investment Banker – Helps an organization to raise capital by selling bonds or equity, and advises differentclients on
a variety of financial opportunities depending on the nature of the business this finance person isinvolved in.
• Chief Financial Officer (CFO) – Leads and manages the overall financial dealings of the company. Trackingprofit and
loss, then strategizing how to make the company more profitable are the main tasks of CFOs. Management
experience is needed to direct staff on how to maximize the finances of the company, which may include various
departments or divisions.
• Finance Director – Instead of having a CFO, a finance director helps the company in managing its financialoperations.
Strategic planning, mergers and acquisitions, forecasting, budgeting, and financial modeling arethe expected skills
for this job.
• Controller – Directs a company’s accounting practices. The responsibilities of controllers include the development
of profit and loss statements, balance sheets, financial prospectuses, and the preparation of reports that predict
the financial performance of the organization.
• Trader – Works closely with portfolio managers, buying and selling securities based on their requests.
• Financial Examiner – Checks if the company is compliant with laws, regulations governing financial, securities
institutions, and financial and real estate transactions
• Portfolio Manager – Often works at investment management firms and oversees a fund or group of funds, makes
investment decisions, and tracks trends.
3. Conflicts on stockholders and Debtholders; Conflicts can also arise between stockholders and debtholders.
• Debtholders, which include the company’s bankers and its bondholders, generally receive fixed payments
regardless of how well the company does,
• While, stockholders do better when the company does better.
• This situation leads to conflicts between these two (2) groups, to the extent that stockholders are typically more
willing to take on riskier projects.
a. Investment banks traditionally help companies raise capital. They (1) help corporations design securities with
features that are currently attractive to investors, (2) buy these securities from the corporation, and (3)resell them
to savers. Because the investment bank generally guarantees that the firm will raise the needed capital, the
investment bankers are also called underwriters.
b. Commercial banks, such as Citibank and JP Morgan Chase, are the traditional “department stores of finance”
because they serve a variety of savers and borrowers. Historically, commercial banks were the major institutions
that handled checking accounts. Today, several other institutions also provide checking services and significantly
influence the money supply. Note too that the larger banks are generally part of financial services corporations.
c. Financial services corporations are large conglomerates that combine many different financial institutionswithin a
single corporation. Most financial services corporations started in one area but have now diversifiedto cover most
of the financial spectrum. For example, Citigroup owns Citibank (a commercial bank), an investment bank, a
securities brokerage organization, insurance companies, and leasing companies.
d. Credit unions are cooperative associations whose members are supposed to have a common bond, suchas being
employees of the same firm. Members’ savings are loaned only to other members, generally for auto purchases,
home improvement loans, and home mortgages. Credit unions are often the cheapest source of funds available to
individual borrowers.
e. Pension funds are retirement plans funded by corporations or government agencies for their workers and
administered primarily by the trust departments of commercial banks or by life insurance companies. Pension
funds invest primarily in bonds, stocks, mortgages, and real estate.
f. Life insurance companies take savings in the form of annual premiums; invest these funds in stocks, bonds, real
estate, and mortgages; and make payments to the beneficiaries of the insured parties. In recentyears, life insurance
companies have also offered a variety of tax-deferred savings plans designed to provide benefits to participants
when they retire.
g. Mutual funds are corporations that accept money from savers and then use these funds to buy stocks, long-term
bonds, or short-term debt instruments issued by businesses or government units. These organizations pool funds
and thus reduce risks by diversification. They also achieve economies of scale in. analyzing securities, managing
portfolios, and buying and selling securities. Different funds are designed tomeet the objectives of different types
of savers. Hence, there are bond funds for those who prefer safety, stock funds for savers who are willing to accept
significant risks in the hope of higher returns, and money market funds that are used as interest-bearing checking
accounts.
h. Exchange-traded funds (ETFs) are similar to regular mutual funds and are often operated by mutual fund
companies.
i. Hedge funds
• are also similar to mutual funds because they accept money from savers and use the funds to buy various
securities, but there are some important differences. While mutual funds (and ETFs) are registered and
regulated by the Securities and Exchange Commission (SEC),
• hedge funds are largely unregulated. This difference in regulation stems from the fact that mutual funds
typically target small investors, whereas hedge funds typically have large minimum investments and are
marketed primarily to institutions and individuals with high net worth.
• Hedge funds received their name because they traditionallywere used when an individual was trying to
hedge risks.
Remember:
✓ Stocks of corporations not listed and therefore not traded in the stock exchange but registered and licensed bythe
Securities and Exchange Commission (SEC) for sale to the public are only available in the so-called over- the-counter
(OTC) market.
✓ (OTC) This market is not a specific organization but another way of trading securities. OTCtransactions are carried out
by direct inquiries and negotiations among the buyers and sellers through the use of mail, telephone, telegraph,
Teletype, or other forms of communications.
IPO Disadvantages
• The costs associated with the process and the requirement to disclose certain information that could prove helpful to
competitors or create difficulties withvendors. Details of the proposed offering are disclosed to potential purchasers in
the form of a lengthy document known as a prospectus. Most companies undertaking an IPO do so with the assistance
of an investment banking firm acting in the capacity of an underwriter. Underwriters provide a valuable service, which
includes help with correctly assessing the value of shares (share price) and establishing a public market for shares (initial
sale) (Boundless.com, 2019).
b. Secondary market offering. According to the U.S. Financial Industry Regulatory Authority (FINRA), this is aregistered offering
of a large block of a security that has been previously issued to the public.
• The blocks being offered may have been held by large investors or institutions, and proceeds of the sale go to those
holders, not the issuing company. This is also sometimes called secondary distribution.
• A secondary offering is not dilutive to existing shareholders since no new shares are created.
• The proceeds from the sale of the securities do not benefit the issuing company in any way.
• The offered shares are privately held by shareholders of the issuing company, which may be directors or other insiders
(such as venture capitalists) who may be looking to diversify their holdings.
• Usually, however, the increase in available shares allows more institutions to take non-trivial positions in the issuing
company which may benefit the trading liquidity of the issuing company's shares (Boundless.com, 2019).
c. Transactions on secondary market. After the initial issuance, investors can purchase from other investors in the secondary
market.
• In the secondary market, securities are sold by and transferred from one investor or speculator to another.
• It is therefore important that the secondary market be highly liquid.
• As a general rule, the greater the number of investors that participate in a given marketplace, and the greater the
centralization of that marketplace, the more liquid the market (Boundless.com, 2019).
e. Stock repurchases. Also known as a share buyback, a stock repurchase is a reacquisition by a company ofits stocks.
• corporation can repurchase its stocks by distributing cash to existing shareholders in exchange for a fraction of the
company's outstanding equity; that is, cash is exchanged for a reduction in the number of shares outstanding.
• The company either retires the repurchased shares or keeps them as treasury stock, availablefor re-issuance
Remember:
o When markets are efficient, investors can buy and sell stocks and be confident that they are getting good prices.
o When markets are inefficient, on the other hand, investors may be afraid to invest and put their money “under the pillow,”
which will lead to a poor allocation of capital and economic stagnation. From an economic standpoint,market efficiency is
good.
9. Behavioral Finance Theory: EMH
• The efficient markets hypothesis (EMH) remains one of the cornerstones of modern finance theory.
• It implies that, on average, asset prices are about equal to their intrinsic values.
STRAIGHTFORWARD LOGIC:
✓ STOCK – TOO LOW. rational traders will quickly take advantage of this opportunity andbuy the stock, pushing prices up
to the proper level
✓ STOCK – TOO HIGH. rational traders will sell the stock, pushing the price down to its equilibrium level.
• Proponents of the EMH argue that these forces keep prices from being systematically wrong.
• Although the logic behind the EMH is compelling, many events in the real world seem inconsistent with the
hypothesis, which has spurred a growing field called behavioral finance. Rather than assuming that
investors are rational, behavioral finance theorists borrow insights from psychology to understand better
how irrational behavior can be sustained over time.
➢ Argue that behavioral finance’s criticism of the EMH rests on two (2) key points:
1. It is often difficult or risky for traders to take advantage of mispriced assets; and
2. It deals with why mispricing can occur in the first place. Here insights from psychology come into play.
These experiments suggest that investors and managers behave differently in down markets than they do in upmarkets, which
might explain why those who made money early in the stock market bubble continued to investtheir money in the market even
as prices went ever higher (Brigham & Houston, 2017).
The claims against assets are of two (2) basic types: liabilities (or money the company owes to others) and stockholders’
equity.
• Current liabilities consist of claims that must be paid off within one (1) year, including accounts payable, accruals
(total of accrued wages and accrued taxes), and notes payable to banks and other short-term lenders that are due
within one year.
• Long-term debt includes bonds that mature in more than a year.
• Stockholders’ equity can be thought of in two (2) ways. First, it is the amount that stockholders paid to the company
when they bought shares the company sold to raise capital, in addition to all of the earnings the company has
retained over the years.
𝑆𝑡𝑜𝑐𝑘ℎ𝑜𝑙𝑑𝑒𝑟𝑠 E’quity = 𝑃aid- In capital + Retained earnings
• The retained earnings are not just the earnings retained in the latest year - they are the cumulative total ofall of
the earnings the company has earned and retained during its life.
• Stockholders’ equity can also be thought of as a residual.
An income statement is a report that summarizes a firm’s revenues, expenses, and profits during a reporting period,
generally a quarter or a year. Net sales are shown at the top of the statement; then operating costs,interest, and
taxes are subtracted to obtain the net income available to common shareholders.
Earnings per share (EPS) is often called “the bottom line,” denoting that of all items on the income statement,EPS
is the one that is most important to stockholders. A typical stockholder focuses on the reported EPS, but
professional security analysts and managers differentiate between operating and non-operating income.
Operating income is derived from the firm’s regular core business. Moreover, it is calculated before deducting
interest expenses and taxes, which are considered to be non-operating costs. Operating income is also called
earnings before interest and taxes (EBIT).
Different firms have different amounts of debt, different tax carrybacks and carryforwards, and different amountsof
non-operating assets such as marketable securities. These differences can cause two (2) companies with identical
operations to report significantly different net incomes. For example, suppose two (2) companies haveidentical
sales, operating costs, and assets. However, one company uses some debt, and the other uses only common equity.
Despite their identical operating performances, the company with no debt (and therefore no interest expense)
would report a higher net income because no interest was deducted from its operating income. Consequently, in
comparing two (2) companies’ operating performances, it is best to focus on the operating income (Brigham &
Houston, 2017).
Liquidity ratios help users in answering the question, “Will the firm be able to pay off its debts as they come dueand thus
remain a viable organization?” If the answer is no, liquidity must be addressed (Brigham & Houston, 2017).
• Liquidity Ratios show the relationship of a firm’s cash and other current assets to its current liabilities.
• Liquid Asset is an asset that can be converted to cash quickly without having to reduce the asset’s pricevery
much.
Current Ratio – This is the primary liquidity ratio, which is calculated by dividing current assets by the current liabilities.
It indicates the extent to which current liabilities are covered by those assets expected to be convertedto cash in the near
future.
Current Assets – These include cash, marketable securities, accounts receivable, and inventories. If a company is having financial
difficulty, it typically begins to pay its accounts payable more slowly and to borrow more from its bank, both of which increase
current liabilities. If current liabilities are rising faster than current assets, the current ratio will fall; and this is a sign of possible
trouble (Brigham & Houston, 2017).
Quick (Acid Test) Ratio – This is the second liquidity ratio, which is calculated by deducting inventories from current assets and
then dividing the remainder by current liabilities.
Inventories are typically the least liquid of a firm’s current assets; and if sales slow down, they might not be converted to cash as
quickly as expected. Also, inventories are the assets on which losses are most likely to occur in the event of liquidation. Therefore,
the quick ratio, which measures the firm’s ability to pay off short- term obligations without relying on the sale of inventories, is
important (Brigham & Houston, 2017).
Inventory Turnover Ratio – “Turnover ratios” divide sales by some asset: Sales/Various assets. As the name implies,
these ratios show how many times the asset is “turned over” during the year. Here is the formula for the inventory turnover
ratio:
𝑆𝑎𝑙𝑒𝑠
𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟 𝑅𝑎𝑡𝑅𝑅𝑜 =
𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑅𝑅𝑒𝑠
Fixed Assets Turnover Ratio – This is the ratio of sales to net fixed assets to measure how effectively the firmuses its
plant and equipment.
𝑆𝑎𝑙𝑒𝑠
𝐹𝑅𝑅𝑥𝑒𝑑 𝐴𝑠𝑠𝑒𝑡𝑠 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟 𝑅𝑎𝑡𝑅𝑅𝑜 =
𝑁𝑒𝑡 𝐹𝑅𝑅𝑥𝑒𝑑 𝐴𝑠𝑠𝑒𝑡𝑠
18. Operating margin, Profit margin, return on total assets, Basic earning power
Operating Margin is calculated by dividing operating income (EBIT) by sales, gives the operating profit per peso of
sales.
Profit Margin, sometimes called the net profit margin, is calculated by dividing net income by sales.
Return on Total Assets (ROA) is the ratio of net income to total assets. This is computed by dividing netincome by total
assets.
Return on Common Equity (ROE) is the ratio of net income to common equity which measures the rate of return on
common stockholders’ investment.
Return on Invested Capital (ROIC) measures the total return that the company has provided for its investors.
ROIC differs from ROA in two (2) ways. First, its return is based on total invested capital rather than total assets.Second,
in the numerator, it uses after-tax operating income (NOPAT) rather than net income. The key difference is that net
income subtracts the company’s after-tax interest expense and therefore represents the total amount of income available
to shareholders, while NOPAT is the amount of funds available to pay both stockholders and debtholders (Brigham &
Houston, 2017).
Basic Earning Power (BEP) Ratio is calculated by dividing operating income (EBIT) by total assets.
This ratio shows the raw earning power of the firm’s assets before the influence of taxes and debt, and it isuseful when
comparing firms with different debt and tax situations (Brigham & Houston, 2017).