Capital Markets, Behavioral Finance, Banking PDF

Capital Markets I. CAPITAL MARKETS A. Stock Markets The stock market is where the prices of firms’ stocks are established. Because the primary goal of financial managers is to maximize their firms’ stock prices, knowledge of the stock market is important to anyone involved in managing a busines...

Capital Markets I. CAPITAL MARKETS A. Stock Markets The stock market is where the prices of firms’ stocks are established. Because the primary goal of financial managers is to maximize their firms’ stock prices, knowledge of the stock market is important to anyone involved in managing a business. 1. Physical Location Stock Exchanges 2. Over-The-Counter (OTC) Formal organizations having tangible physical A large collection of brokers and dealers, connected locations that conduct auction markets in designated electronically by telephones and computers, that (“listed”) securities. 2 Basic Types provides for trading in unlisted securities. Physical location exchanges are tangible entities. of Market Procedures Although the stocks of most large companies trade on Each of the larger exchanges occupies its own the NYSE, a larger number of stocks trade off the building, allows a limited number of people to trade on exchange in what was traditionally referred to as the its floor, and has an elected governing body – its over-the-counter (OTC) market. board of governors. Dealer Markets – A dealer market includes all facilities needed to conduct security transactions, but the transactions are not made on the physical location exchanges. The dealer market system consists of: The relatively few dealers who hold inventories The thousands of brokers who act as agents The computers, terminals, and electronic 1 of these securities and who are said to "make a 2 in bringing the dealers together with 3 networks that provide a communication link market" in these securities; investors; and between dealers and brokers. Copyright © CPACE Philippines®. All rights reserved. 05 I. CAPITAL MARKETS B. Equity Valuation The main purpose equity valuation is to estimate the value of a firm or its security. A key assumption of any fundamental value technique is that the value of the security (in this case an equity or a stock) is driven by the fundamentals of the firm’s underlying business at the end of the day. There are a number of different methods of valuing a company with one of the primary ways being the comparable (or comparables) approach. Comparables Approach. A company’s equity value should bear some resemblance to other equities in a similar class. This entails comparing a company’s equity to competitors or other firms in the same sector. Discounted Cash Flow. A company’s equity value is determined by the future cash flow projections using net present value. This approach is most useful if the company has strong data to support future operating forecasts. Precedent Transactions. A company’s equity depends on historical prices for completed M&A transactions involving similar companies. This approach is only relevant if similar entities have been recently valued and/or sold. Asset-Based Valuation. A company’s equity value is determined based on the fair market value of net assets owned by the company. This method is most often used for entities with a going concern, as this approach emphasizes outstanding liabilities determining net asset value. Book-Value Approach. A company’s equity value is determined based on its previous acquisition cost. This method is only relevant for companies with minimal growth that might have undergone a recent acquisition. Copyright © CPACE Philippines®. All rights reserved. 06 I. CAPITAL MARKETS C. Capital Structure The term capital refers to investor- A firm’s capital structure is typically The optimal capital structure is the supplied funds—debt, preferred stock, defined as the percentage of each type mix of debt, preferred stock, and common stock, and retained earnings. of investor supplied capital, with the total common equity that maximizes the Accounts payable and accruals are not being 100%. stock’s intrinsic value. The capital included in our definition of capital structure that maximizes the intrinsic because they are not provided by value also minimizes the weighted investors—they come from suppliers, average cost of capital (WACC). workers, and taxing authorities as a result of normal operations, not as investments by investors. Copyright © CPACE Philippines®. All rights reserved. 07 Behavioral Finance II. BEHAVIORAL FINANCE Behavioral Finance is the study of various psychological factors that can affect financial markets. Behavioral finance typically encompasses five main concepts: Self-attribution: Emotional gap: This refers to a tendency to make choices The emotional gap refers to decision-making based on overconfidence in one’s own based on extreme emotions or emotional strains knowledge or skill. Self-attribution usually Mental accounting: such as anxiety, anger, fear, or excitement. stems from an intrinsic knack in a particular Mental accounting refers to the propensity for Oftentimes, emotions are a key reason why area. Within this category, individuals tend to people to allocate money for specific people do not make rational choices. rank their knowledge higher than others, even purposes. when it objectively falls short. Herd behavior: Anchoring: Herd behavior states that people tend to mimic Anchoring refers to attaching a spending level to a the financial behaviors of the majority of the herd. certain reference. Examples may include Herding is notorious in the stock market as the spending consistently based on a budget level or cause behind dramatic rallies and sell-offs. rationalizing spending based on different satisfaction utilities. Copyright © CPACE Philippines®. All rights reserved. 09 II. BEHAVIORAL FINANCE A. Emotion and Investing Some Biases Revealed by Behavioral Finance. Breaking down biases further, many individual biases and tendencies have been identified for behavioral finance analysis. Some of these include: Confirmation Bias Experiential Bias Confirmation bias is when investors have a bias This occurs when investors’ memory of recent events toward accepting information that confirms their makes them biased or leads them to believe that the already-held belief in an investment. If information event is far more likely to occur again. For this reason, surfaces, investors accept it readily to confirm that it is also known as recency bias or availability bias. they’re correct about their investment decision—even if the information is flawed. Loss Aversion Familiarity Bias Loss aversion occurs when investors place a greater The familiarity bias is when investors tend to invest in weighting on the concern for losses than the pleasure what they know, such as domestic companies of from market gains. In other words, they’re far more locally owned investments. As a result, investors are likely to try to assign a higher priority to avoiding not diversified across multiple sectors and types of losses than making investment gains. As a result, investments, which can reduce risk. Investors tend to some investors might want a higher payout to go with investments that they have a history or have compensate for losses. If the high payout isn’t likely, familiarity with. they might try to avoid losses altogether even if the investment’s risk is acceptable from a rational standpoint. Copyright © CPACE Philippines®. All rights reserved. 10 II. BEHAVIORAL FINANCE B. Behavioral Finance and Investment Strategy C. Behavioral Finance and Capital Markets Market Timing and Technical Analysis Asset bubbles and market crashes are largely a matter of timing. If you could anticipate a bubble and invest just before it began and divest just before it burst, you would get maximum return. That sort of precise timing, however, is nearly impossible to achieve. To time events precisely, you would constantly have to watch for new information, and even then, the information from different sources may be contradictory, or there may be information available to others that you do not have. Taken together, your chances of profitably timing a bubble or crash are fairly slim. The efficient market hypothesis (EMH) says that at any given time in a highly liquid market, stock prices are efficiently valued to reflect all the available information. Market timing – an asset allocation strategy. However, many studies have documented long-term historical phenomena in securities markets that contradict the efficient market hypothesis and cannot be captured plausibly in models based on perfect investor rationality. The EMH is generally based on the belief that market participants view stock prices rationally based on all current and future intrinsic and external factors. When studying the stock market, behavioral finance takes the view that markets are not fully efficient. This allows for the observation of how psychological and social factors can influence the buying and selling of stocks. The understanding and usage of behavioral finance biases can be applied to stock and other trading market movements on a daily basis. Broadly, behavioral finance theories have also been used to provide clearer explanations of substantial market anomalies like bubbles and deep recessions. While not a part of EMH, investors and portfolio managers have a vested interest in understanding behavioral finance trends. These trends can be used to help analyze market price levels and fluctuations for speculation as well as decision-making purposes. Copyright © CPACE Philippines®. All rights reserved. 11 Interest Rates III. INTEREST RATES Companies raise capital in two main forms: debt and equity. In a free economy, capital, like other items, is allocated through a market system, where funds are transferred and prices are established. The interest rate is the price that lenders receive, and borrowers pay for debt capital. Similarly, equity investors expect to receive dividends and capital gains, the sum of which represents the cost of equity. A. The Determinants of Market Interest Rates The Real Risk-Free Rate of Interest, R* - the rate of interest that Liquidity Premium (LP) - a premium added to the equilibrium would exist on default-free US Treasury if no inflation were interest rate on a security if that security cannot be converted expected. to cash on short notice and at close to its “fair market value.” The Nominal, or Quoted, Risk-Free Rate of Interest - the rate of Interest Rate Risk - the risk of capital losses to which investors interest on a security that is free of all risk; rRF is proxied by the are exposed because of changing interest rates. T-bill rate or the T-bond rate; rRF includes an inflation premium. Inflation Premium (IP) - a premium equal to expected inflation Maturity Rate Premium - a premium that reflects interest that investors add to the real risk-free rate of return. rate risk. Default Risk Premium (DRP) - the difference between the Reinvestment Rate Risk - the risk that a decline in interest rates interest rate on a US Treasury bond and a corporate bond will lead to lower income when bonds mature and funds are of equal. reinvested. Copyright © CPACE Philippines®. All rights reserved. 13 III. INTEREST RATES People use money as a medium of exchange. When money is used, its value in the The Cost of Money future, which is affected by inflation, comes into play. The higher the expected rate of inflation, the larger the required dollar return. Interest rate paid to savers depends on: Time Preferences for Production Consumption – The 1 the rate of return that producers expect to earn on invested capital Opportunities – The preferences of investment opportunities consumers for current 2 savers’ time preferences for current versus future consumption in productive (cash- consumption as generating) assets. opposed to saving for future consumption. 3 the riskiness of the loan, and 4 the expected future rate of inflation. 4 Most Fundamental Factors Affecting the Producers’ (borrowers) expected returns on their business investments set an upper Cost of Money limit to how much they can pay for savings, while consumers’ time preferences for consumption establish how much consumption they are willing to defer and hence how much they will save at different interest rates. Higher risk and higher inflation also lead to higher interest rates. Risk – In a financial Interest Rate Levels market context, the Inflation – The amount by chance that an which prices increase Term Structure of Interest Rates – the relationship between investment will provide a over time. long-term and short-term rates. low or negative return. Long-term rates primarily reflect long-run expectations for inflation. Short-term rates are responsive to current economic conditions. Copyright © CPACE Philippines®. All rights reserved. 14 III. INTEREST RATES Term Structure of Interest Rates The relationship between bond yields and maturities. It describes the relationship between long- and short-term rates. The term structure is important to corporate treasurers deciding whether to borrow by issuing long- or short-term debt and to investors who are deciding where to buy long- or short-term bonds. Yield Curve – a graph showing the relationship between bond yields and maturities. Yield Yield Yield Maturity Maturity Maturity Normal Yield Curve – an upward-sloping Inverted (Abnormal) Yield Curve – a Humped Yield Curve – a yield curve where interest rates on yield curve. downward-slopping yield curve. intermediate-term maturities are higher than rates on both short- and long-term maturities. B. Interest Rate Risk Interest Rate Risk – is the risk of capital Reinvestment Rate Risk – the risk that a Maturity Risk Premium (MRP) – a premium losses to which investors are exposed decline in interest rate will lead to lower income that reflects interest rate risk. because of changing interest rates. when bonds mature and funds are reinvested. Copyright © CPACE Philippines®. All rights reserved. 15 III. INTEREST RATES C. Interest Rate Derivatives The Real Risk-Free Rate of Interest, R* Is the interest rate that would exist on a risk-less security if no inflation were expected. It may be thought of as the rate of interest on short-term U.S. Treasury securities in an inflation-free world. The real risk-free rate is not static—it changes over time, depending on economic conditions, especially on (1) the rate of return that corporations and other borrowers expect to earn on productive assets and (2) people’s time preferences for current versus future consumption. Borrowers’ expected returns on real assets set an upper limit on how much borrowers can afford to pay for funds, whereas savers’ time preferences for consumption establish how much consumption savers will defer—hence, the amount of money they will lend atdifferentt interest rates. The Nomimal, or Quoted, Risk-Free Rate of Interest, rRF = r* + IP The rate of interest on a security that is free of all risk; rRF is proxied by the T-bill rate of the T-bond rate; rRF includes an inflation premium. To be strictly correct, the risk-free rate should be the interest rate on a totally risk-free security—one that has no default risk, maturity risk, no liquidity risk, no risk of loss if inflation increases, and no risk of any other type. If the term risk-free rate is used without the modifiers real or nominal, people generally mean the quoted (or nominal) rate; and we follow that convention in this book. Therefore, when we use the term risk-free rate, rRF, we mean the nominal risk-free rate, which includes an inflation premium equal to the average expected inflation rate over the remaining life of the security. Inflation Premium (IP) A premium equal to expected inflation that investors add to the real risk-free rate of return. Default Risk Premium (DRP) The risk that a borrower will default, which means the borrower will not make scheduled interest or principal payments, also affects the market interest rate on a bond: The greater the bond’s risk of default, the higher the market rate. Liquidity Premium (LP) A “liquid” asset can be converted to cash quickly at a "fair market value." Real assets are generally less liquid than financial assets, but different financial assets vary in their liquidity. Because they prefer assets that are more liquid, investors include a liquidity premium (LP) in the rates charged on different debt securities. Copyright © CPACE Philippines®. All rights reserved. 16 III. INTEREST RATES D. Monetary Policy Monetary policy is a set of tools used by a nation’s central bank to control the overall money supply and promote economic growth and employ strategies such as revising interest rates and changing bank reserve requirements. Types of Monetary Policy Contractionary – is policy that increases interest rates and Expansionary – during times of slowdown or a recession, an limits the outstanding money supply to slow growth and expansionary policy grows economic activity. By lowering decrease inflation, where the prices of goods and services in interest rates, saving becomes less attractive, and consumer an economy rise and reduce the purchasing power of money. spending and borrowing increase. Goals of Monetary Policy Inflation Unemployment Exchange Rates Contractionary monetary policy is used to An expansionary monetary policy decreases The exchange rates between domestic and temper inflation and reduce the level of money unemployment as a higher money supply and foreign currencies can be affected by monetary circulating in the economy. Expansionary attractive interest rates stimulate business policy. With an increase in the money supply, the monetary policy fosters inflationary pressure and activities and expansion of the job market. domestic currency becomes cheaper than its increases the amount of money in circulation. foreign exchange. Copyright © CPACE Philippines®. All rights reserved. 17 III. INTEREST RATES Tools of Monetary Policy Open Market Operations: In open market operations (OMO), the Federal Reserve Bank buys bonds from investors or sells additional bonds to investors to change the number of outstanding government securities and money available to the economy as a whole. The objective of OMOs is to adjust the level of reserve balances to manipulate the short-term interest rates and that affect other interest rates. Interest Rates: The central bank may change the interest rates or the required collateral that it demands. In the U.S., this rate is known as the discount rate. Banks will loan more or less freely depending on this interest rate. Reserve Requirements: Authorities can manipulate the reserve requirements, the funds that banks must retain as a proportion of the deposits made by their customers to ensure that they can meet their liabilities. Lowering this reserve requirement releases more capital for the banks to offer loans or buy other assets. Increasing the requirement curtails bank lending and slows growth. E. Yield Curve A graph showing the relationship between bond yields and maturities. The yield curve changes in position and in slope over time. Humped Yield Curve – a yield curve where Yield Yield Yield “Normal” Yield Curve – an upward- Inverted (“Abnormal”) Yield Curve – a interest rates on intermediate-term sloping yield curve. downward-sloping yield curve. maturities are higher than rates on both Maturity Maturity Maturity short- and long-term maturities. What Determines the Shape of the Yield Curve? Because maturity risk premiums are positive, if other things were held constant, long-term bonds would always have higher interest rates than short-term bonds. Copyright © CPACE Philippines®. All rights reserved. 18 III. INTEREST RATES F. Inflation and Interest Rates Interest rates tend to move in the same direction as inflation but with lags, because interest rates are the primary tool used by central banks to manage inflation. In the U.S. the Federal Reserve targets an average inflation rate of 2% over time by setting a range of its benchmark federal funds rate, the interbank rate on overnight deposits. Higher interest rates are generally a policy response to rising inflation. Conversely, when inflation is falling and economic growth slowing, central banks may lower interest rates to stimulate the economy. How Changes in Interest Rates Affect Inflation? In general, rising interest rates curb inflation while declining interest How Do Interest Rates Affect Stocks? rates tend to speed inflation. When interest rates decline, consumers In general, rising interest rates hurt the performance of stocks. If interest spend more as the cost of goods and services is cheaper because rates rise, that means individuals will see a higher return on their financing is cheaper. Increased consumer spending means an increase savings. This removes the need for individuals to take on added risk by in demand and increases in demand increases prices. Conversely, investing in stocks, resulting in less demand for stocks. when interest rates rise, consumer spending and demand decline, money-flows reverse, and inflation is somewhat tempered. The Bottom Line Interest rates influence stocks, bond interest rates, consumer and business spending, inflation, and recessions. However, there is often a lag in the timing between an interest rate change and its effect on the economy. Some sectors may react quickly, such as the stock market, while the effect on other sectors such as mortgages and auto loans can take longer to be felt. By adjusting the federal funds rate, the Fed helps keep the economy in balance over the long term. Understanding the relationship between interest rates and the U.S. economy will allow investors to understand the big picture and make better investment decisions. Although the relationship between interest rates and the stock market is fairly indirect, the two tend to move in opposite directions. As a general rule of thumb, when the Federal Reserve cuts interest rates, it causes the stock market to go up; when the Federal Reserve raises interest rates, it causes the stock market to go down. But there is no guarantee as to how the market will react to any given interest rate change. Copyright © CPACE Philippines®. All rights reserved. 19 Income and Business Taxation IV. INCOME AND BUSINESS TAXATION A. Corporate Taxation What is a Corporate Tax? Corporate taxes are collected by the government as a source of income. It is based on taxable income after expenses have been deducted. Corporate Tax Deductions Special Considerations Advantages of a Corporate Tax Corporations are permitted to reduce taxable income A central issue relating to corporate taxation is the Paying corporate taxes can be more beneficial for by certain necessary and ordinary business concept of double taxation. Certain corporations are business owners than paying additional individual expenditures. All current expenses required for the taxed on the taxable income of the company. income tax. Corporate tax returns deduct medical operation of the business are fully tax-deductible. If this net income is distributed to shareholders, these insurance for families as well as fringe benefits, Investments and real estate purchased with the intent of individuals are forced to pay individual income taxes including retirement plans and tax-deferred trusts. It is generating income for the business are also deductible. on the dividends received. Instead, easier for a corporation to deduct losses, too. A corporation can deduct employee salaries, health a business may register as an S corporation and have A corporation may deduct the entire amount of benefits, tuition reimbursement, and bonuses. In all income pass-through to the business owners. As S losses, while a sole proprietor must provide evidence addition, a corporation can reduce its taxable income by corporation does not pay corporate tax, as all taxes regarding the intent to earn a profit before the losses deducting insurance premiums, travel expenses, bad are paid through individual tax returns. can be deducted. Finally, profit earned by a debts, interest payments, sales taxes, fuel taxes, and corporation may be left within the corporation, excise taxes. Tax preparation fees, legal services, allowing for tax planning and potential future tax bookkeeping, and advertising costs can also be used to advantages. reduce business income. The Bottom Line The corporate tax rate is a tax levied on a corporation's profits, collected by a government as a source of income. It applies to a company's income, which is revenue minus expenses. In the U.S., the federal corporate tax rate is a flat rate of 21%. States may also impose a separate corporate tax on companies. Companies often seek to lower their corporate tax obligations through taking advantage of deductions, loopholes, subsidies, and other practices. Copyright © CPACE Philippines®. All rights reserved. 21 IV. INCOME AND BUSINESS TAXATION B. Individual Taxation Individual Income Tax Also referred to as personal income tax. This type of income tax is levied on an individual’s wages, salaries, and other types of income. This tax is usually a tax that the state imposes. Because of exemptions, deductions, and credits, most individuals do not pay taxes on all of their income. While a deduction can lower your taxable income and the tax rate used to calculate your tax, a tax credit reduces your income tax obligation. Tax credits help reduce the taxpayer’s tax obligation or amount owed. They were created primarily for middle- income and lower-income households. How Can I Calculate Income Tax? What Percent of Income is Taxed? To calculate income tax, you’ll need to add up all sources of The percent of your income that is taxed depends on how much taxable income earned in a tax year. The next step is calculating you earn and your filing status. In theory, the more you earn, the your adjusted gross income (AGI). Once you have done this, more you pay. subtract any deductions for which you are eligible from your AGI. The Bottom Line All taxpayers pay federal income tax. Depending on where you live, you may have to pay state and local income taxes, too. The U.S. has a progressive income tax system, which means that higher-income earners pay a higher tax rate than those with lower incomes. Most taxpayers do not pay taxes on all of their income, thanks to exemptions and deductions. C. Tax Planning and Optimization Tax planning is the analysis of a financial situation or plan to ensure that all elements work together to allow you to pay the lowest taxes possible. A plan that minimizes how much you pay in taxes is referred to as tax efficient. Tax planning should be an essential part of an individual investor's financial plan. Reduction of tax liability and maximizing the ability to contribute to retirement plans are crucial for success. Copyright © CPACE Philippines®. All rights reserved. 22 IV. INCOME AND BUSINESS TAXATION Tax planning covers several considerations. Considerations include timing of income, size, and timing of purchases, and planning for other expenditures. Also, the selection of investments and types of retirement plans must complement the tax filing status and deductions to create the best possible outcome. Tax planning covers several considerations. Considerations include timing of income, size, and timing of purchases, and planning for other expenditures. Also, the selection of investments and types of retirement plans must complement the tax filing status and deductions to create the best possible outcome. Tax Planning vs. Tax Gain-Loss Harvesting Tax gain-loss harvesting is another form of tax planning or management relating to investments. It is helpful because it can use a portfolio's losses to offset overall capital gains. According to the IRS, short and long-term capital losses must first be used to offset capital gains of the same type. In other words, long-term losses offset long-term gains before offsetting short-term gains. Short-term capital gains, or earnings from assets owned for less than one year, are taxed at ordinary income rates. How Do High-Income Earners Reduce Taxes? There are many ways to reduce taxes that are not only available to What Are Basic Tax Planning Strategies? high-income earners but to all earners. These include contributing Some of the most basic tax planning strategies include reducing to retirement accounts, contributing to health savings accounts your overall income, such as by contributing to retirement plans, (HSAs), investing in stocks with qualified dividends, buying muni making tax deductions, and taking advantage of tax credits. bonds, and planning where you live based on favorable tax treatments of a specific state. The Bottom Line Tax planning involves utilizing strategies that lower the taxes that you need to pay. There are many legal ways in which to do this, such as utilizing retirement plans, holding on to investments for more than a year, and offsetting capital gains with capital losses. Copyright © CPACE Philippines®. All rights reserved. 23 Financial Analysis and Reporting V. FINANCIAL ANALYSIS AND REPORTING A. Financial Statements Analysis Financial statement analysis is the process of analyzing a company’s financial statements for decision-making purposes. External stakeholders use it to understand the overall health of an organization and to evaluate financial performance and business value. Internal constituents use it as a monitoring tool for managing the finances. How to Analyze Financial Statements The financial statements of a company record important financial data on every aspect of a business’s activities. As such, they can be evaluated on the basis of past, current, and projected performance. In general, financial statements are centered around generally accepted accounting principles (GAAP) in the United States. These principles require a company to create and maintain three main financial statements: the balance sheet, the income statement, and the cash flow statement. Public companies have stricter standards for financial statement reporting. Public companies must follow GAAP, which requires accrual accounting. Private companies have greater flexibility in their financial statement preparation and have the option to use either accrual or cash accounting. Several techniques are commonly used as part of financial statement analysis. Three of the most important techniques are horizontal analysis, vertical analysis, and ratio analysis. Horizontal analysis compares data horizontally, by analyzing values of line items across two or more years. Vertical analysis looks at the vertical effects that line items have on other parts of the business and the business’s proportions. Ratio analysis uses important ratio metrics to calculate statistical relationships. Copyright © CPACE Philippines®. All rights reserved. 25 V. FINANCIAL ANALYSIS AND REPORTING Types of Financial Statements Companies use the balance sheet, income statement, and cash flow statement to manage the operations of their business and to provide transparency to their stakeholders. All three statements are interconnected and create different views of a company’s activities and performance. Balance Sheet Income Statement Cash Flow Statement The balance sheet is a report of a company’s The income statement breaks down the revenue The cash flow statement provides an overview of financial worth in terms of book value. It is broken that a company earns against the expenses the company’s cash flows from operating activities, into three parts to include a company’s assets, involved in its business to provide a bottom line, investing activities, and financing activities. Net liabilities, and shareholder equity. Short-term assets meaning the net profit or loss. The income income is carried over to the cash flow statement, such as cash and accounts receivable can tell a lot statement is broken into three parts that help to where it is included as the top line item for about a company’s operational efficiency; liabilities analyze business efficiency at three different operating activities. Like its title, investing activities include the company’s expense arrangements and points. It begins with revenue and the direct costs include cash flows involved with firm-wide the debt capital it is paying off; and shareholder associated with revenue to identify gross profit. It investments. The financing activities section equity includes details on equity capital then moves to operating profit, which subtracts includes cash flow from both debt and equity investments and retained earnings from periodic indirect expenses like marketing costs, general financing. The bottom line shows how much cash a net income. The balance sheet must balance costs, and depreciation. Finally, after deducting company has available. assets and liabilities to equal shareholder equity. interest and taxes, the net income is reached. Basic This figure is considered a company’s book value analysis of the income statement usually involves and serves as an important performance metric the calculation of gross profit margin, operating that increases or decreases with the financial profit margin, and net profit margin, which each activities of a company. divide profit by revenue. Profit margin helps to show where company costs are low or high at different points of the operations. Copyright © CPACE Philippines®. All rights reserved. 26 V. FINANCIAL ANALYSIS AND REPORTING Free Cash Flow and Other Valuation Statements Financial Performance Companies and analysts also use free cash flow statements and other Financial statements are maintained by companies daily and used internally valuation statements to analyze the value of a company. Free cash flow for business management. In general, both internal and external statements arrive at a net present value by discounting the free cash flow stakeholders use the same corporate finance methodologies for that a company is estimated to generate over time. Private companies may maintaining business activities and evaluating overall financial performance. keep a valuation statement as they progress toward potentially going public. When doing comprehensive financial statement analysis, analysts typically use multiple years of data to facilitate horizontal analysis. Each financial statement is also analyzed with vertical analysis to understand how different categories of the statement are influencing results. Finally, ratio analysis can be used to isolate some performance metrics in each statement and bring together data points across statements collectively. Below is a breakdown of some of the most common ratio metrics: Balance sheet: Income Statement: Cash flow: Comprehensive: This includes asset turnover, This includes gross profit margin, This includes cash and earnings before This includes return on assets quick ratio, receivables turnover, operating profit margin, net profit interest, taxes, depreciation, and (ROA) and return on equity days to sales, debt to assets, margin, tax ratio efficiency, and amortization (EBITDA). These metrics (ROE), along with DuPont and debt to equity. interest coverage. may be shown on a per-share basis. analysis. Copyright © CPACE Philippines®. All rights reserved. 27 V. FINANCIAL ANALYSIS AND REPORTING What are the advantages of financial statement analysis? The main point of financial statement analysis is to evaluate a company’s performance or value through a company’s balance sheet, income statement, or statement of cash flows. By using a number of techniques, such as horizontal, vertical, or ratio analysis, investors may develop a more nuanced picture of a company’s financial profile. What are the different types of financial statement analysis? Most often, analysts will use three main techniques for analyzing a company’s financial statements. First, horizontal analysis involves comparing Second, vertical analysis compares items on a Finally, ratio analysis, a central part of fundamental historical data. Usually, the purpose of financial statement in relation to each other. equity analysis, compares line-item data. Price-to- 1 horizontal analysis is to detect growth trends 2 For instance, an expense item could be 3 earnings (P/E) ratios, earnings per share, or across different time periods. expressed as a percentage of company sales. dividend yield are examples of ratio analysis. What is an example of financial statement analysis? An analyst may first look at a number of ratios on a company’s income statement to determine how efficiently it generates profits and shareholder value. For instance, gross profit margin will show the difference between revenues and the cost of goods sold. If the company has a higher gross profit margin than its competitors, this may indicate a positive sign for the company. At the same time, the analyst may observe that the gross profit margin has been increasing over nine fiscal periods, applying a horizontal analysis to the company’s operating trends. B. Ratio Analysis Ratios help us evaluate financial statements. For example, at the end of 2015, Allied Food Products had $860 million of interest-bearing debt and interest charges of $88 million, while Midwest Products had $52 million of interest-bearing debt and interest charges of $4 million. Which company is stronger? The burden of these debts and the companies' ability to repay them can best be evaluated by comparing each firm's total debt to its total capital and comparing interest expense to the income and cash available to pay that interest. Ratios are used to make such comparisons. We calculate Allied's ratios for 2015 using data from the balance sheets and income statements given in Tables 3.1 and 3.2. We also evaluate the ratios relative to food industry averages, using data in millions of dollars.' As you will see, we can calculate many different ratios, with different ones used to examine different aspects of the firm's operations. You will get to know some ratios by name, but it's better to understand what they are designed to do than to memorize names and equations. Copyright © CPACE Philippines®. All rights reserved. 28 V. FINANCIAL ANALYSIS AND REPORTING We divide the ratios into five categories. 1. Liquidity ratios, which give an 2. Asset management ratios, 3. Debt management ratios, 4. Profitability ratios, which give 5. Market value ratios, which idea of the firm's ability to pay which give an idea of how which give an idea of how the an idea of how profitably the give an idea of what investors off debts that are maturing efficiently the firm is using its firm has financed its assets as firm is operating and utilizing its think about the firm and its within a year. assets. well as the firm's ability to repay assets. future prospects. its long-term debt. Satisfactory liquidity ratios are necessary if the firm is to continue operating. Good asset management ratios are necessary for the firm to keep its costs low and thus its net income high. Debt management ratios indicate how risky the firm is and how much of its operating income must be paid to bondholders rather than stockholders. Profitability ratios combine the asset and debt management categories and show their effects on ROE. Finally, market value ratios tell us what investors think about the company and its prospects. All of the ratios are important, but different ones are more important for some companies than for others. For example, if a firm borrowed too much in the past and its debt now threatens to drive it into bankruptcy, the debt ratios are key. Similarly, if a firm expanded too rapidly and now finds itself with excess inventory and manufacturing capacity, the asset management ratios take center stage. The ROE is always important; but a high ROE depends on maintaining liquidity, on efficient asset management, and on the proper use of debt. Managers are, of course, vitally concerned with the stock price; but managers have little direct control over the stock market's performance, while they do have control over their firm's ROE. So ROE tends to be the main focal point. Copyright © CPACE Philippines®. All rights reserved. 29 V. FINANCIAL ANALYSIS AND REPORTING C. Cash Flow Analysis Cash flow analysis is an important aspect of a company’s financial management because it underscores the cash that’s available to pay bills and make purchases—generally, money it needs to run and grow the business. Companies, investors, and analysts examine cash flow for various reasons, including for insight into a company’s financial stability and health and to inform decisions about possibly investing in a company. Why Cash Flow Analysis is Important Cash is important to every business. Having enough money to pay the bills, purchase needed assets, and operate a business to make a profit is vital to a company's success and longevity. A company must understand how well it is generating cash and how much it has. That way, it can take corrective action, if needed. When you track your finances, including where cash comes from and where it goes, you can place yourself in a better position to plan business activities and company operations that lead to profits and growth. Cash flow analysis examines the cash that flows into and out of a company—where it comes from, what it goes to, and the amounts for each. The net cash flow figure for any period is calculated as current assets minus current liabilities. Ongoing positive cash flow points to a company that is operating on a strong footing. Continued negative cash flow may indicate a company is in financial trouble. A company’s cash flows can be determined by the figures that appear on its statement of cash flows. Copyright © CPACE Philippines®. All rights reserved. 30 V. FINANCIAL ANALYSIS AND REPORTING Cash Flow Statement Before it can analyze cash flow, a company must prepare a cash flow statement that shows all cash inflows that it receives from its ongoing operations and external investment sources, as well as all cash outflows that pay for business activities and investments during a given quarter. The three distinct sections of the cash flow statement cover cash flows from operating activities (CFO), cash flows from investing (CFI), and cash flows from financing (CFF) activities. Cash Flow From Operations Cash Flow From Investing Cash Flow From Financing This section reports the amount of cash from the This section records the cash flow from capital Debt and equity transactions are reported in this income statement that was originally reported on expenditures and sales of long-term investments section. Any cash flows that include payment of an accrual basis. A few of the items included in like fixed assets related to plant, property, and dividends, the repurchase or sale of stocks, and this section are accounts receivable, accounts equipment. Specific items might include vehicles, bonds would be considered cash flow from payable, and income taxes payable. If a client furniture, buildings, or land. Other expenditures financing activities. Cash received from taking pays a receivable, it would be recorded as cash that generate cash outflows could include out a loan or cash used to pay down long-term from operations. Changes in current assets or business acquisitions and the purchase of debt would also be recorded here. For investors current liabilities (items due in one year or less) investment securities. Cash inflows come from who prefer dividend-paying companies, this are recorded as cash flow from operations. the sale of assets, businesses, and securities. section is important because, as mentioned, it Investors typically monitor capital expenditures shows cash dividends paid. Cash, not net used for the maintenance of, and additions to, a income, is used to pay dividends to company’s physical assets to support the shareholders. company’s operation and competitiveness. In short, investors want to see whether and how a company is investing in itself. Copyright © CPACE Philippines®. All rights reserved. 31 V. FINANCIAL ANALYSIS AND REPORTING Cash Flow Analysis Operating Cash Flow/Net Sales A company's cash flow is the figure that appears at the bottom of the cash This ratio, which is expressed as a percentage of a company's net operating flow statement. It might be labeled as "ending cash balance" or "net change in cash flow to its net sales, or revenue (from the income statement), tells us how cash account." Cash flow is also considered to be the net cash amounts from many dollars of cash are generated for every dollar of sales. each of the three sections (operations, investing, financing). There is no exact percentage to look for, but the higher the percentage, the One can conduct a basic cash flow analysis by examining the cash flow better. It should also be noted that industry and company ratios will vary statement, determining whether there is net negative or positive cash flow, widely. Investors should track this indicator's performance historically to pinpointing how the outflows compare to inflows, and draw conclusions from detect significant variances from the company's average cash flow/sales that. relationship along with how the company's ratio compares to its peers. However, there is no universally-accepted definition of cash flow. For instance, It is also essential to monitor how cash flow increases as sales increase since many financial professionals consider a company's net operating cash flow to it's important that they move at a similar rate over time. be the sum of its net income, depreciation, and amortization (non-cash charges in the income statement).1 While often coming close to net operating cash flow, this interpretation can be inaccurate, and investors should stick with using the net operating cash flow figure from the cash flow statement. While cash flow analysis can include several ratios, the following indicators provide a starting point for an investor to measure the investment quality of a company's cash flow. Copyright © CPACE Philippines®. All rights reserved. 32 V. FINANCIAL ANALYSIS AND REPORTING Free Cash Flow Free cash flow (FCF) is often defined as the net operating cash flow minus capital expenditures. Free cash flow is an important measurement since it shows how efficient a company is at generating cash. Investors use free cash flow to measure whether a company might have enough cash, after funding operations and capital expenditures, to pay investors through dividends and share buybacks. To calculate FCF from the cash flow statement, find the item cash flow from operations— also referred to as "operating cash" or "net cash from operating activities"—and subtract capital expenditures required for current operations from it. You can go one step further by expanding what's included in the free cash flow number. For example, in addition to capital expenditures, you could include dividends for the amount to be subtracted from net operating cash flow to arrive at a more comprehensive free cash flow figure. This figure could then be compared to sales, as shown earlier. As a practical matter, if a company has a history of dividend payments, it cannot easily suspend or eliminate them without causing shareholders some real pain. Even dividend payout reductions, while less injurious, are problematic for many shareholders. For some industries, investors consider dividend payments to be necessary cash outlays similar to capital expenditures. It's important to monitor free cash flow over multiple periods and compare the figures to companies within the same industry. If free cash flow is positive, it should indicate the company can meet its obligations, including funding its operating activities and paying dividends. Copyright © CPACE Philippines®. All rights reserved. 33 V. FINANCIAL ANALYSIS AND REPORTING Comprehensive Free Cash Flow Coverage You can calculate a comprehensive free cash flow ratio by dividing the free cash flow by net operating cash flow to get a percentage ratio. Again, the higher the percentage, the better. What Cash Flow Analysis Can Tell You Cash flow analysis can lend insight into the financial vibrancy or financial instability of a company and its prospect as a good investment. Bear in mind these points when analyzing cash flow: Positive Cash Flow Negative Cash Flow Free Cash Flow Positive cash flow is always the goal. When it Negative cash flow may indicate something Having free cash flow is a great advantage. It's continues over a number of consecutive periods, other than financial trouble. For instance, the cash flow available after paying operating it demonstrates that a company is capable of investing cash flow might be negative because a expenses and purchasing needed capital assets. healthy operations and can grow successfully. company is spending money on assets that A company can use its free cash flow to pay off improve operations and the products it sells. debt, pay dividends and interest to investors, and However, keep an eye out for positive investing more. cash flow and negative operating cash flow. This could mean trouble ahead if, for instance, cash flowing from the sale of investments is being used to pay operating expenses. Operating Cash Flow Margin The operating cash flow margin ratio compares cash from operating activities to sales revenue in a particular period. A positive margin shows that a company is able to convert sales to cash and can indicate profitability and earnings quality. Copyright © CPACE Philippines®. All rights reserved. 34 V. FINANCIAL ANALYSIS AND REPORTING Limitations of Cash Flow Analysis The cash flow statement presents past data. It might not be a big help on its own to analysts and investors who want to properly size up a company as an investment. For example, cash flow data that shows investments made point to an outflow (that could contribute to a negative cash flow). But those investments may result in future positive cash flow, profits, and major growth. It doesn't depict a company's net income because it doesn't include non-cash items. The income statement must be examined to determine these. It doesn't present a full picture of a company's liquidity, just the cash available at the end of one period. How Cash Flow Is Accounted For There are two forms of accounting that determine how cash moves within a company's financial statements. They are accrual accounting and cash accounting. Accrual Accounting Accrual accounting is used by most public companies. It reports revenue as income when it's earned rather than when the company receives payment. Expenses are reported when incurred, even though no cash payments have been made. For example, if a company records a sale, the revenue is recognized on the income statement, but the company may not receive cash until a later date. From an accounting standpoint, the company would be earning a profit and pay income taxes on it. However, no cash would have been exchanged. The transaction would likely involve an outflow of cash initially, since it costs money for the company to buy inventory and manufacture the product to be sold. It's common for businesses to extend terms of 30, 60, or even 90 days for a customer to pay the invoice. The sale would be an accounts receivable with no impact on cash until collected. Cash Accounting Cash accounting is an accounting method in which payment receipts are recorded in the period they are received, and expenses are recorded in the period in which they are paid. In other words, revenues and expenses are recorded when cash is received and paid, respectively. A company's profit is shown as net income on the income statement. Net income is the bottom line for the company. However, because of accrual accounting, net income doesn't necessarily mean that all receivables were collected from customers. From an accounting standpoint, the company might be profitable, but if receivables become past due or uncollected, the company could run into financial problems. Even profitable companies can fail to adequately manage their cash flow, which is why a cash flow statement is a critical tool for analysts and investors. Copyright © CPACE Philippines®. All rights reserved. 35 V. FINANCIAL ANALYSIS AND REPORTING What Is Cash Flow Analysis? Cash flow analysis is the process of examining the amount of cash that flows into a company and the amount of cash that flows out to determine the net amount of cash that is held. Once it's known whether cash flow is positive or negative, company management can look for opportunities to alter it to improve the outlook for the business. What Are the 3 Types of Cash Flows? How Do You Calculate Cash Flow Analysis? The three types of cash flow are cash flows from operations, cash flows from A basic way to calculate cash flow is to sum up figures for current assets and investing, and cash flows from financing. subtract from that total current liabilities. Once you have a cash flow figure, you can use it to calculate various ratios (e.g., operating cash flow/net sales) for a more in-depth cash flow analysis. The Bottom Line If a company's cash flow is continually positive, it's a strong indication that the company is in a good position to avoid excessive borrowing, expand its business, pay dividends, and weather hard times. Free cash flow is an important evaluative indicator for investors. It captures all the positive qualities of internally produced cash from a company's operations and monitors the use of cash for capital expenditures. Copyright © CPACE Philippines®. All rights reserved. 36 V. FINANCIAL ANALYSIS AND REPORTING D. Financial Modeling What is Financial Modeling? Financial Modeling is the process of creating a summary of a company’s expenses and earning in the form of a spreadsheet that can be used to calculate the impact of a future event of decision. A financial model has many uses for company executives. Financial analysts most often use it to analyze and anticipate how a company’s stock performance might be affected by future events or executive decisions. Example of Financial Modeling The best financial models provide users with a set of basic assumptions. For example, one commonly forecasted line item is sales growth. Sales growth is recorded as the increase (or decrease) in gross sales in the most recent quarter compared to the previous quarter. These are the only two inputs a financial model needs to calculate sales growth. The financial modeler creates one cell for the prior year's sales, cell A, and one cell for the current year's sales, cell B. The third cell, cell C, is used for a formula that divides the difference between cells A and B by cell A. This is the growth formula. Cell C, the formula, is hard-coded into the model. Cells A and B are input cells that can be changed by the user. In this case, the purpose of the model is to estimate sales growth if a certain action is taken or a possible event occurs. Of course, this is just one real-world example of financial modeling. Ultimately, a stock analyst is interested in potential growth. Any factor that affects or might affect that growth can be modeled. Also, comparisons among companies are important in concluding a stock purchase. Multiple models help an investor decide among various competitors in an industry. Copyright © CPACE Philippines®. All rights reserved. 37 V. FINANCIAL ANALYSIS AND REPORTING What Is Financial Modeling Used For? What Information Should Be Included in a Financial Model? A financial model is used for decision-making and financial analysis by people To create a useful model that's easy to understand, you should include inside and outside of companies. Some of the reasons a firm might create a sections on assumptions and drivers, an income statement, a balance sheet, a financial model include the need to raise capital, grow the business organically, cash flow statement, supporting schedules, valuations, sensitivity analysis, sell or divest business units, allocate capital, budget, forecast, or value a charts, and graphs. business. How Is a Financial Model Validated? What Types of Businesses Use Financial Modeling? Errors in financial modeling can cause expensive mistakes. For this reason, a Professionals in a variety of businesses rely on financial modeling. Here are financial model may be sent to an outside party to validate the information it just a few examples: Bankers use it in sales and trading, equity research, and contains. Banks and other financial institutions, project promoters, both commercial and investment banking, public accountants use it for due corporations seeking funds, equity houses, and others may request model diligence and valuations, and institutions apply financial models in private validation to reassure the end-user that the calculations and assumptions equity, portfolio management, and research. within the model are correct and that the results produced by the model are reliable. The Bottom Line Financial modeling is a set of numerical techniques used to forecast a company's future growth. Based on the information in a company's income statement, balance sheet, and estimates of future economic conditions, analysts can create sophisticated projections of an investment's future performance. Copyright © CPACE Philippines®. All rights reserved. 38 V. FINANCIAL ANALYSIS AND REPORTING E. Financial Reporting and Disclosure What is Financial Reporting? Definition, Types and Importance Financial reporting is a crucial process for companies and investors, as it provides key information that shows financial performance over time. Government and private regulatory institutions also monitor financial reporting to ensure fair trade, compensation and financial activities. Typically, you record financial activities on several key statements, which others can use for review. In this article, we discuss what financial reporting is, why it's important, what financial statements are common and who uses and monitors these documents. What is financial reporting? Financial reporting is the process of documenting and communicating financial activities and performance over specific time periods, typically on a quarterly or yearly basis. Companies use financial reports to organize accounting data and report on current financial status. Financial reports are also essential in the projections of future profitability, industry position and growth, and many financial reports are available for public review. There are several primary statements to use when reporting financial data, and the information you include in these documents fulfills several key objectives of financial reporting: Tracking Evaluating assets Analyzing Measuring cash flow and liabilities shareholder equity profitability Importance of financial reporting Monitors income and expense - Tracking income and expenses is another important process that financial reporting supports. Monitoring financial documentation is necessary for effective debt management and budget allocation and provides insight into key areas of spending. Monitoring income and expenses ensures companies track debts regularly to remain transparent in competitive markets. Therefore, financial reporting gives you documentation methods to track current liabilities and assets. Accurate financial documentation is also necessary to measure important metrics, including debt-to-asset ratios, which investors use to evaluate how effectively companies pay down debt and generate revenue. Copyright © CPACE Philippines®. All rights reserved. 39 V. FINANCIAL ANALYSIS AND REPORTING Ensures Compliance - Financial reporting encompasses specific processes that companies follow to comply with mandatory accounting regulations. Each document you use to evaluate financial activities comes under the review of several financial regulatory institutions. This makes accurate documentation crucial to ensure all financial reports comply with tax regulations and financial reporting criteria. Accurate financial reporting also simplifies tax, valuation and auditing processes, reducing the time to complete necessary financial obligations and further validating financial compliance. Communicates Essential Data - Key shareholders, executives, investors and professionals all rely on current financial data to make decisions, plan budgets and monitor performance. The importance of open communication and transparency is necessary to support funding, investment opportunities and financial review. Many investors and creditors rely on the information companies communicate in financial documentation to assess profitability, risk and future returns. Supports Financial Analysis and Decision-Making - Financial reporting is crucial for performing analysis to support business decisions. Using financial statements improves accountability and supports the analysis of critical financial data. Documents like the income statement and balance sheet provide real-time information that you can use to track historical performance, identify key areas of spending and create forecasts more accurately. With better-developed data models and detailed financial analysis, reporting helps businesses evaluate current activities and make decisions for future growth. Who Regulates Financial Reporting Regulatory entities, including the SEC, IRS and Financial Accounting Standards Board (FASB) establish standards that outline protocols and required practices relating to financial activities and documentation. The SEC is responsible for overseeing capital markets and sets forth regulations for investment activities in stock markets. Depending on the type of business, capital market activity and funding, the SEC requires public companies and market participants to disclose financial information regularly for investors to review. The FASB is a private regulatory entity that establishes and monitors the Generally Accepted Accounting Principles (GAAP). The GAAP provides a framework for financial processes that supports efficiency in reporting and ensures regulatory compliance with other standards. Copyright © CPACE Philippines®. All rights reserved. 40 Banking and Financial Institutions VI. BANKING AND FINANCIAL INSTITUTIONS A. Banking Regulation What is Bank Regulation? Banking regulation imposes various requirements, restrictions, and guidelines on banks. Although legal requirements differ from country to country, banking regulations pursue similar objectives, such as reducing systemic risk by, for example, creating unfavorable trading conditions for banks or preventing bank fraud. What is the main purpose of bank regulation? Bank regulation is the process of setting and enforcing rules for banks and other financial institutions. The main purpose of bank regulation is to protect consumers, ensure the stability of the financial system, and prevent financial crime. Banking regulations are also designed to promote safe and sound banking practices by ensuring banks have enough capital to cover their risks, preventing them from engaging in unfair or deceptive practices, and ensuring that consumers have access to information about their rights and options. For example, regulations may ban certain types of fees or limit the amount of interest that banks can charge on loans. By promoting competition, bank regulation helps to keep prices low for consumers and spurs innovation in the banking sector. Furthermore, bank regulators also supervise the activities of banks and enforce compliance with regulations. By doing so, bank regulators help to ensure that banks operate in a safe and sound manner and that consumers are protected from fraud and abuse. Copyright © CPACE Philippines®. All rights reserved. 42 VI. BANKING AND FINANCIAL INSTITUTIONS Who regulates banks? Why is regulation important? Being a heavily regulated industry worldwide, bank regulation varies from Banking is an essential part of the global economy, and bank regulation is a country to country, but all countries have some form of regulation in place to critical tool for ensuring the stability and efficiency of the banking sector. Bank ensure the stability of their banking systems. Typically, there is more than one regulation protects consumers by ensuring that banks maintain adequate regulatory agency per country. capital levels, disclose risks inherent in their business activities, and follow sound risk management practices. Regulations typically come from both government agencies and central banks. In the United States, bank regulation is primarily the responsibility of four federal Regulation is also important because it promotes financial stability by limiting agencies: the Office of the Comptroller of the Currency, the Federal Deposit the ability of banks to engage in activities that could lead to a systemic crisis. In Insurance Corporation insuring deposits, the Federal Reserve System addition, bank regulation helps to ensure that banks can serve as reliable regulating state-chartered banks, and the Consumer Financial Protection sources of credit for businesses and households. Overall, bank regulation plays Bureau. a vital role in ensuring the safety and soundness of the banking sector. Other countries have similar agencies that oversee their banking systems. For example, in Canada bank regulation is handled by the Office of the Superintendent of Financial Institutions, while in the United Kingdom it is the role of the Prudential Regulation Authority and the Financial Conduct Authority, a division of the Bank of England. In Germany, the responsibility falls to BaFin. Copyright © CPACE Philippines®. All rights reserved. 43 VI. BANKING AND FINANCIAL INSTITUTIONS Why are banks highly regulated? What are some examples of banking regulations? Banks are highly regulated for a variety of reasons. First and foremost, banks Bank regulation is the process by which a government or other institution deal with large amounts of money, which makes them a prime target for crime. supervises the activities of banks. In addition, banks play a crucial role in the economy, and their failure could have devastating consequences. Common bank regulations include reserve requirements, which dictate how much money banks must keep on hand; capital requirements, which dictate Additionally, banks act as intermediaries between borrowers and lenders, how much money banks can lend; and liquidity requirements, which dictate helping to allocate capital to its most productive uses. Without bank regulation, how easily banks can convert their assets into cash. In addition, bank regulators banks would be free to engage in risky behavior that could lead to bank failures often impose restrictions on bank activities, such as limitations on lending to and a financial crisis. To prevent this, regulators must monitor banks’ activities related parties or investments in certain types of assets. to ensure that they are sound and stable. Some of the things that are monitored include the bank's financial stability, its compliance with anti-money laundering By ensuring that banks follow these and other regulations, bank regulators help laws, and its lending practices. to protect depositors and maintain the stability of the banking system. By regulating banks, authorities can help to prevent bank failures and protect the economy. Copyright © CPACE Philippines®. All rights reserved. 44 VI. BANKING AND FINANCIAL INSTITUTIONS B. Risk Management in Banks Risk management is an essential piece of banking operations. To demonstrate why, this guide will provide an overview of risk management in banking, discuss specifically the types of risk management in commercial banks, detail risk management practices in banks, go over the process of risk management in banks, and explain how to use enterprise risk management software for banks. Risk Management in Banking Overview Just like any business, banks face a myriad of risks. However, given how important the banking sector is and the government’s stake in keeping risks in check, the risks weigh heavier than they do on most other industries. There are various types of risks that a bank may face and is important to understand how banks manage risk. Types of Risk Management in Commercial Banks Banking Risk Type #1: Credit Risk Banks often lend out money. The chance that a loan recipient does not pay back that money can be measured as credit risk. This can result in an interruption of cash flows, increased costs for collection, and more. Banking Risk Type #2: Market Risk This refers to the risk of an investment decreasing in value as a result of market factors (such as a recession). Sometimes this is referred to as “systematic risk.” Banking Risk Type #3: Operational Risk These are potential sources of losses that result from any sort of operational event; e.g. poorly-trained employees, a technological breakdown, or theft of information. Copyright © CPACE Philippines®. All rights reserved. 45 VI. BANKING AND FINANCIAL INSTITUTIONS Banking Risk Type #4: Reputational Risk Let’s say a news story breaks about a bank having corruption in leadership. This may damage their customer relationships, cause a drop in share price, give competitors an advantage, and more. Banking Risk Type #5: Liquidity Risk With any financial institution, there is always the risk that they are unable to pay back its liabilities in a timely manner because of unexpected claims or an obligation to sell long-term assets at an undervalued price. Risk Management Practices in Banks Banks must prioritize risk management in order to stay on top (and ahead) of the various critical risks they face every day. Risk management in banks also goes far beyond compliance, as banks must be on the lookout for strategic, operational, price, liquidity, and reputational risk. Staying on top of these risks demands a powerful and flexible bank risk management program. The number of individual regulatory changes that financial institutions and banks must track on a global scale has more than tripled since 2011. There are millions of proposed rules and enforcement actions across multiple jurisdictions that organizations must follow. This requires regulatory change management to be a prominent practice within any bank’s risk management program. Regulatory change management can be described in the simplest terms as “managing regulatory, policy and or procedures applicable to your organization for your industry.” Regulatory compliance can be a burdensome and costly task for financial institutions, so it is critical that organizations have the appropriate processes in place to identify changes to existing regulations as well as new regulations that impact the ability of the organization to achieve objectives. It is equally important that organizations are informed of any potential consequences or fines should they not meet the regulation. Once a regulatory change has been made, it is essential for organizations to assess how they will implement the respective changes to their current policies, processes, and training sessions. As changes are implemented, organizations should begin tracking compliance with the updated regulation going forward. Copyright © CPACE Philippines®. All rights reserved. 46 VI. BANKING AND FINANCIAL INSTITUTIONS Bonus Material: Financial Risk Assessment Template Risk Management Process in Banking Industry Having a clear, formalized risk management plan brings additional visibility into consideration. Standardizing risk management makes identifying systemic issues that affect the entire bank simple. The ideal risk management plan for a bank serves as a roadmap for improving performance by revealing key dependencies and control effectiveness. With proper implementation of a plan, banks ultimately should be able to better allocate time and resources towards what matters most. Size, brand, market share, and many more characteristics all will prescribe a bank’s risk management program. That being said, all plans should be standardized, meaningful, and actionable. The same process for defining the steps within your risk management plan can be applied across the board: Risk Identification in Banks Assessment & Analysis Methodology Banks must create a risk identification process across the organization in order to Assessing risk in a uniform fashion is the hallmark of a healthy risk management develop a meaningful risk management program. Note that it’s not enough to simply system. It’s important to be able to collect and analyze data to determine the identify what happened; the most effective risk identification techniques focus on root likelihood of any given risk and subsequently prioritize remediation efforts. cause. This allows for identification of systemic issues so that controls can be designed to eliminate the cost and time of duplicate effort. Mitigate Monitor Monitoring risk should be an ongoing and proactive process. It involves testing, metric Risk mitigation is defined as the process of reducing risk exposure and minimizing the collection, and incidents remediation to certify that the controls are effective. It also likelihood of an incident. Top risks and concerns need to be continually addressed to allows for addressing emerging trends to determine whether or not progress is being ensure the bank is fully protected. made on various initiatives. Copyright © CPACE Philippines®. All rights reserved. 47 VI. BANKING AND FINANCIAL INSTITUTIONS Connect Report Creating relationships between risks, business units, Presenting information about how the risk mitigation activities, and more paints a cohesive