CFMS Coverage Topic & Reviewer PDF

CERTIFIED FINANCIAL MANAGEMENT SPECIALIST (CFMS) Review Material Center for Professional Advancement and Continuing Education, Inc. 2024 This material is not for sale. 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. 2 Basic Types of Market Procedures: 1. Physical Location Stock Exchanges - Formal organizations having tangible physical locations that conduct auction markets in designated (“listed”) securities. - Physical location exchanges are tangible entities. Each of the larger exchanges occupies its own building, allows a limited number of people to trade on its ﬂoor, and has an elected governing body – its board of governors. 2. Over-The-Counter (OTC) - A large collection of brokers and dealers, connected electronically by telephones and computers, that provides for trading in unlisted securities. - Although the stocks of most large companies trade on the NYSE, a larger number of stocks trade o_ the exchange in what was traditionally referred to as the over- the-counter (OTC) market. 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: 1. The relatively few dealers who hold inventories of these securities and who are said to "make a market" in these securities; 2. The thousands of brokers who act as agents in bringing the dealers together with investors; and 3. The computers, terminals, and electronic networks that provide a communication link between dealers and brokers. 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 di_erent 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. C. Capital Structure The term capital refers to investor-supplied funds—debt, preferred stock, common stock, and retained earnings. Accounts payable and accruals are not included in our deﬁnition of capital because they are not provided by investors—they come from suppliers, workers, and taxing authorities as a result of normal operations, not as investments by investors. A ﬁrm’s capital structure is typically deﬁned as the percentage of each type of investor- supplied capital, with the total being 100%. The optimal capital structure is the mix of debt, preferred stock, and common equity that maximizes the stock’s intrinsic value. The capital structure that maximizes the intrinsic value also minimizes the weighted average cost of capital (WACC). II. BEHAVIORAL FINANCE Behavioral Finance is the study of various psychological factors that can a_ect ﬁnancial markets. Behavioral ﬁnance typically encompasses ﬁve main concepts: Mental accounting: Mental accounting refers to the propensity for people to allocate money for speciﬁc purposes. Herd behavior: Herd behavior states that people tend to mimic the ﬁnancial behaviors of the majority of the herd. Herding is notorious in the stock market as the cause behind dramatic rallies and sell-o_s. Emotional gap: The emotional gap refers to decision-making based on extreme emotions or emotional strains such as anxiety, anger, fear, or excitement. Oftentimes, emotions are a key reason why people do not make rational choices. Anchoring: Anchoring refers to attaching a spending level to a certain reference. Examples may include spending consistently based on a budget level or rationalizing spending based on di_erent satisfaction utilities. Self-attribution: This refers to a tendency to make choices based on overconﬁdence in one’s own knowledge or skill. Self-attribution usually stems from an intrinsic knack in a particular area. Within this category, individuals tend to rank their knowledge higher than others, even when it objectively falls short. 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 o Conﬁrmation bias is when investors have a bias toward accepting information that conﬁrms their already-held belief in an investment. If information surfaces, investors accept it readily to conﬁrm that they’re correct about their investment decision-even if the information is ﬂawed. Experiential Bias o This occurs when investors’ memory of recent events makes them biased or leads them to believe that the event is far more likely to occur again. For this reason, it is also known as recency bias or availability bias. Loss Aversion o Loss aversion occurs when investors place a greater weighting on the concern for losses than the pleasure from market gains. In other words, they’re far more likely to try to assign a higher priority to avoiding losses than making investment gains. As a result, some investors might want a higher payout to compensate for losses. If the high payout isn’t likely, they might try to avoid losses altogether even if the investment’s risk is acceptable from a rational standpoint. Familiarity Bias o The familiarity bias is when investors tend to invest in what they know, such as domestic companies of locally owned investments. As a result, investors are not diversiﬁed across multiple sectors and types of investments, which can reduce risk. Investors tend to go with investments that they have a history or have familiarity with. B. Behavioral Finance and Investment Strategy 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 di_erent 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. Market timing – an asset allocation strategy. C. Behavioral Finance and Capital Markets The e_icient market hypothesis (EMH) says that at any given time in a highly liquid market, stock prices are e_iciently valued to reﬂect all the available information. However, many studies have documented long-term historical phenomena in securities markets that contradict the e_icient 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 e_icient. 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. 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 o The Real Risk-Free Rate of Interest, R* - the rate of interest that would exist on default- free US Treasury if no inﬂation were expected. o The Nominal, or Quoted, Risk-Free Rate of Interest – the rate of interest on a security that is free of all risk; rRF is proxied by the T-bill rate or the T-bond rate; rRF includes an inﬂation premium. o Inﬂation Premium (IP) – a premium equal to expected inﬂation that investors add to the real risk-free rate of return. o Default Risk Premium (DRP) – the di_erence between the interest rate on a US Treasury bond and a corporate bond of equal o Liquidity Premium (LP) – a premium added to the equilibrium interest rate on a security if that security cannot be converted to cash on short notice and at close to its “fair market value.” o Interest Rate Risk – the risk of capital losses to which investors are exposed because of changing interest rates. o Maturity Rate Premium – a premium that reﬂects interest rate risk. o Reinvestment Rate Risk – the risk that a decline in interest rates will lead to lower income when bonds mature and funds are reinvested. The Cost of Money 4 Most Fundamental Factors A_ecting the Cost of Money: 1. Production Opportunities – The investment opportunities in productive (cash- generating) assets. 2. Time Preferences for Consumption – The preferences of consumers for current consumption as opposed to saving for future consumption. 3. Risk – In a ﬁnancial market context, the chance that an investment will provide a low or negative return. 4. Inﬂation – The amount by which prices increase over time. People use money as a medium of exchange. When money is used, its value in the future, which is a_ected 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: (1) the rate of return that producers expect to earn on invested capital (2) savers’ time preferences for current versus future consumption (3) the riskiness of the loan, and (4) the expected future rate of inﬂation. Producers’ (borrowers) expected returns on their business investments set an upper 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 di_erent interest rates. Higher risk and higher inﬂation also lead to higher interest rates. Interest Rate Levels Short-term rates are responsive to current economic conditions. Long-term rates primarily reﬂect long-run expectations for inﬂation. Term Structure of Interest Rates – the relationship between long-term and short-term 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. Normal Yield Curve – an upward-slopping yield curve. Inverted (Abnormal) Yield Curve – a downward-slopping yield curve. Humped Yield Curve – a yield curve where interest rates on 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 losses to which investors are exposed because of changing interest rates. Maturity Risk Premium (MRP) – a premium that reﬂects interest rate risk. Reinvestment Rate Risk – the risk that a decline in interest rate will lead to lower income when bonds mature and funds are reinvested. C. Interest Rate Derivatives The Real Risk-Free Rate of Interest, R* o 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 a_ord 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 at di_erent interest rates. The Nomimal, or Quoted, Risk-Free Rate of Interest, rRF = r* + IP o 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. o 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. o 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) o A premium equal to expected inﬂation that investors add to the real risk free rate of return. Default Risk Premium (DRP) o The risk that a borrower will default, which means the borrower will not make scheduled interest or principal payments, also a_ects the market interest rate on a bond: The greater the bond’s risk of default, the higher the market rate. Liquidity Premium (LP) o A “liquid” asset can be converted to cash quickly at a "fair market value." Real assets are generally less liquid than ﬁnancial assets, but di_erent 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 di_erent debt securities. 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 limits the outstanding money supply to slow growth and decrease inﬂation, where the prices of goods and services in an economy rise and reduce the purchasing power of money. Expansionary – during times of slowdown or a recession, an expansionary policy grows economic activity. By lowering interest rates, saving becomes less attractive, and consumer spending and borrowing increase. Goals of Monetary Policy Inﬂation - Contractionary monetary policy is used to temper inﬂation and reduce the level of money circulating in the economy. Expansionary monetary policy fosters inﬂationary pressure and increases the amount of money in circulation. Unemployment - An expansionary monetary policy decreases unemployment as a higher money supply and attractive interest rates stimulate business activities and expansion of the job market. Exchange Rates - The exchange rates between domestic and foreign currencies can be a_ected by monetary policy. With an increase in the money supply, the domestic currency becomes cheaper than its foreign exchange. 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 a_ect 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 o_er 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. o “Normal” Yield Curve – an upward-sloping yield curve. o Inverted (“Abnormal”) Yield Curve – a downward-sloping yield curve. o Humped Yield Curve – a yield curve where interest rates on intermediate-term maturities are higher than rates on both 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. 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 A_ect Inﬂation? In general, rising interest rates curb inﬂation while declining interest rates tend to speed inﬂation. When interest rates decline, consumers spend more as the cost of goods and services is cheaper because ﬁnancing is cheaper. Increased consumer spending means an increase in demand and increases in demand increases prices. Conversely, when interest rates rise, consumer spending and demand decline, money-ﬂows reverse, and inﬂation is somewhat tempered. How Do Interest Rates A_ect Stocks? In general, rising interest rates hurt the performance of stocks. If interest rates rise, that means individuals will see a higher return on their savings. This removes the need for individuals to take on added risk by investing in stocks, resulting in less demand for stocks. 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 e_ect on the economy. Some sectors may react quickly, such as the stock market, while the e_ect 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. 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 Corporations are permitted to reduce taxable income by certain necessary and ordinary business expenditures. All current expenses required for the operation of the business are fully tax-deductible. Investments and real estate purchased with the intent of generating income for the business are also deductible. A corporation can deduct employee salaries, health beneﬁts, tuition reimbursement, and bonuses. In addition, a corporation can reduce its taxable income by deducting insurance premiums, travel expenses, bad debts, interest payments, sales taxes, fuel taxes, and excise taxes. Tax preparation fees, legal services, bookkeeping, and advertising costs can also be used to reduce business income. Special Considerations A central issue relating to corporate taxation is the concept of double taxation. Certain corporations are taxed on the taxable income of the company. If this net income is distributed to shareholders, these individuals are forced to pay individual income taxes on the dividends received. Instead, a business may register as an S corporation and have all income pass-through to the business owners. As S corporation does not pay corporate tax, as all taxes are paid through individual tax returns. Advantages of a Corporate Tax Paying corporate taxes can be more beneﬁcial for business owners than paying additional individual income tax. Corporate tax returns deduct medical insurance for families as well as fringe beneﬁts, including retirement plans and tax-deferred trusts. It is easier for a corporation to deduct losses, too. A corporation may deduct the entire amount of losses, while a sole proprietor must provide evidence regarding the intent to earn a proﬁt before the losses can be deducted. Finally, proﬁt earned by a corporation may be left within the corporation, allowing for tax planning and potential future tax advantages. 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. 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. What Percent of Income is Taxed? The percent of your income that is taxed depends on how much you earn and your ﬁling status. In theory, the more you earn, the more you pay. How Can I Calculate Income Tax? To calculate income tax, you’ll need to add up all sources of taxable income earned in a tax year. The next step is calculating your adjusted gross income (AGI). Once you have done this, 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 e_icient. 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. 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 o_set overall capital gains. According to the IRS, short and long-term capital losses must ﬁrst be used to o_set capital gains of the same type. In other words, long-term losses o_set long-term gains before o_setting short-term gains. Short-term capital gains, or earnings from assets owned for less than one year, are taxed at ordinary income rates. What Are Basic Tax Planning Strategies? Some of the most basic tax planning strategies include reducing your overall income, such as by contributing to retirement plans, making tax deductions, and taking advantage of tax credits. How Do High-Income Earners Reduce Taxes? There are many ways to reduce taxes that are not only available to high-income earners but to all earners. These include contributing to retirement accounts, contributing to health savings accounts (HSAs), investing in stocks with qualiﬁed dividends, buying muni 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 o_setting capital gains with capital losses. 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 e_ects 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. 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 di_erent views of a company’s activities and performance. o Balance Sheet - The balance sheet is a report of a company’s ﬁnancial worth in terms of book value. It is broken into three parts to include a company’s assets, liabilities, and shareholder equity. Short-term assets such as cash and accounts receivable can tell a lot about a company’s operational e_iciency; liabilities include the company’s expense arrangements and the debt capital it is paying o_; and shareholder equity includes details on equity capital investments and retained earnings from periodic net income. The balance sheet must balance assets and liabilities to equal shareholder equity. This ﬁgure is considered a company’s book value and serves as an important performance metric that increases or decreases with the ﬁnancial activities of a company. o Income Statement - The income statement breaks down the revenue that a company earns against the expenses involved in its business to provide a bottom line, meaning the net proﬁt or loss. The income statement is broken into three parts that help to analyze business e_iciency at three di_erent points. It begins with revenue and the direct costs associated with revenue to identify gross proﬁt. It then moves to operating proﬁt, which subtracts indirect expenses like marketing costs, general costs, and depreciation. Finally, after deducting interest and taxes, the net income is reached. Basic analysis of the income statement usually involves the calculation of gross proﬁt margin, operating proﬁt margin, and net proﬁt margin, which each divide proﬁt by revenue. Proﬁt margin helps to show where company costs are low or high at di_erent points of the operations. o Cash Flow Statement - The cash ﬂow statement provides an overview of the company’s cash ﬂows from operating activities, investing activities, and ﬁnancing activities. Net income is carried over to the cash ﬂow statement, where it is included as the top line item for operating activities. Like its title, investing activities include cash ﬂows involved with ﬁrm-wide investments. The ﬁnancing activities section includes cash ﬂow from both debt and equity ﬁnancing. The bottom line shows how much cash a company has available. o Free Cash Flow and Other Valuation Statements - Companies and analysts also use free cash ﬂow statements and other valuation statements to analyze the value of a company. Free cash ﬂow statements arrive at a net present value by discounting the free cash ﬂow that a company is estimated to generate over time. Private companies may keep a valuation statement as they progress toward potentially going public. o Financial Performance - Financial statements are maintained by companies daily and used internally for business management. In general, both internal and external stakeholders use the same corporate ﬁnance methodologies for maintaining business activities and evaluating overall ﬁnancial performance. 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 di_erent 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: This includes asset turnover, quick ratio, receivables turnover, days to sales, debt to assets, and debt to equity. Income Statement: This includes gross proﬁt margin, operating proﬁt margin, net proﬁt margin, tax ratio e_iciency, and interest coverage. Cash ﬂow: This includes cash and earnings before interest, taxes, depreciation, and amortization (EBITDA). These metrics may be shown on a per-share basis. Comprehensive: This includes return on assets (ROA) and return on equity (ROE), along with DuPont analysis. 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 di_erent 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 historical data. Usually, the purpose of horizontal analysis is to detect growth trends across di_erent time periods. Second, vertical analysis compares items on a ﬁnancial statement in relation to each other. For instance, an expense item could be expressed as a percentage of company sales. Finally, ratio analysis, a central part of fundamental equity analysis, compares line-item data. Price-to-earnings (P/E) ratios, earnings per share, or 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 e_iciently it generates proﬁts and shareholder value. For instance, gross proﬁt margin will show the di_erence 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 di_erent ratios, with di_erent ones used to examine di_erent 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. We divide the ratios into ﬁve categories. 1. Liquidity ratios, which give an idea of the ﬁrm's ability to pay o_ debts that are maturing within a year. 2. Asset management ratios, which give an idea of how e_iciently the ﬁrm is using its assets. 3. Debt management ratios, which give an idea of how the ﬁrm has ﬁnanced its assets as well as the ﬁrm's ability to repay its long-term debt. 4. Proﬁtability ratios, which give an idea of how proﬁtably the ﬁrm is operating and utilizing its assets. 5. Market value ratios, which give an idea of what investors think about the ﬁrm and its future prospects. 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 e_ects on ROE. Finally, market value ratios tell us what investors think about the company and its prospects. All of the ratios are important, but di_erent 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 e_icient 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. 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. 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 – This section reports the amount of cash from the income statement that was originally reported on an accrual basis. A few of the items included in this section are accounts receivable, accounts payable, and income taxes payable. If a client pays a receivable, it would be recorded as cash from operations. Changes in current assets or current liabilities (items due in one year or less) are recorded as cash ﬂow from operations. Cash Flow From Investing – This section records the cash ﬂow from capital expenditures and sales of long-term investments like ﬁxed assets related to plant, property, and equipment. Speciﬁc items might include vehicles, furniture, buildings, or land. Other expenditures that generate cash outﬂows could include business acquisitions and the purchase of investment securities. Cash inﬂows come from the sale of assets, businesses, and securities. Investors typically monitor capital expenditures used for the maintenance of, and additions to, a company’s physical assets to support the company’s operation and competitiveness. In short, investors want to see whether and how a company is investing in itself. Cash Flow From Financing – Debt and equity transactions are reported in this section. Any cash ﬂows that include payment of dividends, the repurchase or sale of stocks, and bonds would be considered cash ﬂow from ﬁnancing activities. Cash received from taking out a loan or cash used to pay down long-term debt would also be recorded here. For investors who prefer dividend-paying companies, this section is important because, as mentioned, it shows cash dividends paid. Cash, not net income, is used to pay dividends to shareholders. Cash Flow Analysis A company's cash ﬂow is the ﬁgure that appears at the bottom of the cash ﬂow statement. It might be labeled as "ending cash balance" or "net change in cash account." Cash ﬂow is also considered to be the net cash amounts from each of the three sections (operations, investing, ﬁnancing). One can conduct a basic cash ﬂow analysis by examining the cash ﬂow statement, determining whether there is net negative or positive cash ﬂow, pinpointing how the outﬂows compare to inﬂows, and draw conclusions from that. However, there is no universally-accepted deﬁnition of cash ﬂow. For instance, many ﬁnancial professionals consider a company's net operating cash ﬂow to 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. Operating Cash Flow/Net Sales This ratio, which is expressed as a percentage of a company's net operating cash ﬂow to its net sales, or revenue (from the income statement), tells us how many dollars of cash are generated for every dollar of sales. There is no exact percentage to look for, but the higher the percentage, the better. It should also be noted that industry and company ratios will vary widely. Investors should track this indicator's performance historically to detect signiﬁcant variances from the company's average cash ﬂow/sales relationship along with how the company's ratio compares to its peers. It is also essential to monitor how cash ﬂow increases as sales increase since it's important that they move at a similar rate over time. 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 e_icient 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.3 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. 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 Positive cash ﬂow is always the goal. When it continues over a number of consecutive periods, it demonstrates that a company is capable of healthy operations and can grow successfully. However, keep an eye out for positive investing 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. Negative Cash Flow Negative cash ﬂow may indicate something other than ﬁnancial trouble. For instance, investing cash ﬂow might be negative because a company is spending money on assets that improve operations and the products it sells. Free Cash Flow Having free cash ﬂow is a great advantage. It's the cash ﬂow available after paying operating expenses and purchasing needed capital assets. A company can use its free cash ﬂow to pay o_ debt, pay dividends and interest to investors, and more. 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. 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. 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? The three types of cash ﬂow are cash ﬂows from operations, cash ﬂows from investing, and cash ﬂows from ﬁnancing. How Do You Calculate Cash Flow Analysis? A basic way to calculate cash ﬂow is to sum up ﬁgures for current assets and 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. 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 a_ected 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 di_erence 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 a_ects or might a_ect 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. What Is Financial Modeling Used for? A ﬁnancial model is used for decision-making and ﬁnancial analysis by people inside and outside of companies. Some of the reasons a ﬁrm might create a ﬁnancial model include the need to raise capital, grow the business organically, sell or divest business units, allocate capital, budget, forecast, or value a business. What Information Should Be Included in a Financial Model? To create a useful model that's easy to understand, you should include sections on assumptions and drivers, an income statement, a balance sheet, a cash ﬂow statement, supporting schedules, valuations, sensitivity analysis, charts, and graphs. What Types of Businesses Use Financial Modeling? Professionals in a variety of businesses rely on ﬁnancial modeling. Here are just a few examples: Bankers use it in sales and trading, equity research, and both commercial and investment banking, public accountants use it for due diligence and valuations, and institutions apply ﬁnancial models in private equity, portfolio management, and research. How Is a Financial Model Validated? Errors in ﬁnancial modeling can cause expensive mistakes. For this reason, a ﬁnancial model may be sent to an outside party to validate the information it contains. Banks and other ﬁnancial institutions, project promoters, corporations seeking funds, equity houses, and others may request model validation to reassure the end-user that the calculations and assumptions 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. 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: o Tracking cash ﬂow o Evaluating assets and liabilities o Analyzing shareholder equity o Measuring 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 e_ective 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 e_ectively companies pay down debt and generate revenue. 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 e_iciency in reporting and ensures regulatory compliance with other standards. 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 di_er 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. Who regulates banks? Being a heavily regulated industry worldwide, bank regulation varies from country to country, but all countries have some form of regulation in place to ensure the stability of their banking systems. Typically, there is more than one regulatory agency per country. Regulations typically come from both government agencies and central banks. In the United States, bank regulation is primarily the responsibility of four federal agencies: the O_ice of the Comptroller of the Currency, the Federal Deposit Insurance Corporation insuring deposits, the Federal Reserve System regulating state-chartered banks, and the Consumer Financial Protection Bureau. Other countries have similar agencies that oversee their banking systems. For example, in Canada bank regulation is handled by the O_ice 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. Why is regulation important? Banking is an essential part of the global economy, and bank regulation is a critical tool for ensuring the stability and e_iciency of the banking sector. Bank regulation protects consumers by ensuring that banks maintain adequate capital levels, disclose risks inherent in their business activities, and follow sound risk management practices. Regulation is also important because it promotes ﬁnancial stability by limiting the ability of banks to engage in activities that could lead to a systemic crisis. In addition, bank regulation helps to ensure that banks can serve as reliable sources of credit for businesses and households. Overall, bank regulation plays a vital role in ensuring the safety and soundness of the banking sector. Why are banks highly regulated? Banks are highly regulated for a variety of reasons. First and foremost, banks deal with large amounts of money, which makes them a prime target for crime. In addition, banks play a crucial role in the economy, and their failure could have devastating consequences. Additionally, banks act as intermediaries between borrowers and lenders, helping to allocate capital to its most productive uses. Without bank regulation, banks would be free to engage in risky behavior that could lead to bank failures and a ﬁnancial crisis. To prevent this, regulators must monitor banks’ activities 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 laws, and its lending practices. By regulating banks, authorities can help to prevent bank failures and protect the economy. What are some examples of banking regulations? Bank regulation is the process by which a government or other institution supervises the activities of banks. Common bank regulations include reserve requirements, which dictate how much money banks must keep on hand; capital requirements, which dictate how much money banks can lend; and liquidity requirements, which dictate how easily banks can convert their assets into cash. In addition, bank regulators often impose restrictions on bank activities, such as limitations on lending to related parties or investments in certain types of assets. By ensuring that banks follow these and other regulations, bank regulators help to protect depositors and maintain the stability of the banking system. 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. 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. 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 a_ect 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 e_ectiveness. 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 Banks must create a risk identiﬁcation process across the organization in order to develop a meaningful risk management program. Note that it’s not enough to simply identify what happened; the most e_ective risk identiﬁcation techniques focus on root cause. This allows for identiﬁcation of systemic issues so that controls can be designed to eliminate the cost and time of duplicate e_ort. Assessment & Analysis Methodology Assessing risk in a uniform fashion is the hallmark of a healthy risk management system. It’s important to be able to collect and analyze data to determine the likelihood of any given risk and subsequently prioritize remediation e_orts. Mitigate Risk mitigation is deﬁned as the process of reducing risk exposure and minimizing the likelihood of an incident. Top risks and concerns need to be continually addressed to ensure the bank is fully protected. Monitor Monitoring risk should be an ongoing and proactive process. It involves testing, metric collection, and incidents remediation to certify that the controls are e_ective. It also allows for addressing emerging trends to determine whether or not progress is being made on various initiatives. Connect Creating relationships between risks, business units, mitigation activities, and more paints a cohesive picture of the bank. This allows for recognition of upstream and downstream dependencies, identiﬁcation of systemic risks, and design of centralized controls. Eliminating silos eliminates the chances of missing critical pieces of information. Report Presenting information about how the risk management program is going – in a clear and engaging way – demonstrates e_ectiveness and can rally the support of various stakeholders at the bank. Develop a risk report that centralizes information and gives a dynamic view of the bank’s risk proﬁle. ERM Software for Banks The best way to begin the process of developing a sound banking risk management plan is by using enterprise risk management software. At LogicManager, we transform how you think about risk. Our platform is designed to alleviate the pain points in your bank’s ERM processes so that you can focus on aligning and achieving operational and strategic goals. Logic Manager’s risk management software for banks and expert advisory services provide a risk-based framework and methodology to accomplish all of your governance activities, while simultaneously revealing the connections between those activities and the goals they impact. Risk Management in Banking Conclusion Whether you are managing risks deﬁned by the OCC, CFPB, FDIC, or any of the other many regulatory agencies, it’s important to think of risk management in banking as helping you accomplish more than just compliance. LogicManager’s solutions are designed to meet the needs of your unique and dynamic industry. C. Financial Institutions and Markets Financial institutions are organizations like banks, credit unions, and investment companies that help people manage and grow their money. Financial markets are places where people can buy and sell things like stocks, bonds, and commodities, in order to make investments and trade with each other. What are ﬁnancial institutions? In our world of money and ﬁnance, there are special organizations that help us save, invest, and manage our money. These organizations are called ﬁnancial institutions. They include banks, credit unions, insurance companies, and brokerage ﬁrms. Financial institutions play a big role in our lives, helping us do things like save for college, buy a car, or even start a business. What are ﬁnancial markets? Imagine you want to buy or sell things like stocks, bonds, or other ﬁnancial assets. To do this, you need a place where buyers and sellers can come together to trade these assets. That place is called a ﬁnancial market. There are di_erent types of ﬁnancial markets, such as stock markets, bond markets, and money markets. These markets are essential for the smooth functioning of our economy and play a key role in helping businesses and governments raise money. Why do we need ﬁnancial institutions and markets? Financial institutions, like banks and credit unions, can be really helpful. They help you manage your money, build your credit, and get more money over time. Here are some ways they can beneﬁt you: Imagine two friends, Alex and Jamie. They both work hard and make the same amount of money. But there's a big di_erence in how they handle their money. Alex saves money under the mattress, has no bank account, and cashes their paycheck at a local check-cashing place. Jamie, on the other hand, has a bank account and uses ﬁnancial institutions and markets for his own beneﬁt. Everyday needs Alex always carries cash because they don't have a bank account. This can be risky and inconvenient. When they need to pay a bill, Alex has to go to the post o_ice or the store to pay in person. Jamie, however, has a bank account, which makes it easy to pay bills online or with a debit card. Plus, if Jamie ever loses his wallet, he can contact the bank to cancel the card and protect his money. Saving money Since Alex keeps all their money under the mattress, they don't earn any interest on their savings. This means that if Alex saves $1,000 for a year, it will still be worth only $1,000. Jamie, however, has a savings account at a bank. This account earns interest, so if Jamie saves $1,000 for a year, he might earn $30 in interest, making the total $1,030. Investing Both Alex and Jamie want to grow their money, but they have very di_erent approaches. Alex doesn't know much about investing, so they stick to saving money under the mattress. Jamie, on the other hand, knows that investing can help him build wealth faster. Jamie uses ﬁnancial institutions and markets to invest in stocks or bonds, which can potentially provide higher returns than just saving money in a bank account. Safety and protection Alex's method of keeping money under the mattress is not only outdated, but it's also risky. If there's a ﬁre or a burglary, Alex could lose all their savings. Jamie's money, on the other hand, is protected by the bank's security measures and federal insurance. Even if the bank gets robbed or if the bank goes out of business, Jamie's money is insured up to by the Federal Deposit Insurance Corporation (FDIC). Access to loans In the future, both Alex and Jamie might need to borrow money, maybe for college or to buy a car. Alex will have trouble getting a loan because they don't have a bank account or a credit history. Jamie, however, has a relationship with a bank and has built a credit history by using a credit card responsibly. This makes it easier for Jamie to get a loan with a good interest rate. As you can see, ﬁnancial institutions and markets play a crucial role in our lives and, if you take advantage of them, you can make your money work for you. How do we use ﬁnancial institutions and markets? Let's look at some examples of ﬁnancial institutions and markets and how they serve di_erent saving and investing needs. Banks Banks are a popular choice for people who want to save money in a secure place and earn interest. They also provide loans and credit cards to help people ﬁnance large purchases, like homes and cars. Banks may also o_er investment products and services, such as stocks and mutual funds. In reality, your bank might be a one-stop- shop, where you can take care of all your ﬁnancial needs. Lenders Lenders are institutions that lend money to people and businesses. While most banks and credit unions do this, there are some companies who only lend money and do not provide any other services, like checking or savings account. They charge interest on the borrowed amount, which is their main source of income. Credit unions Credit unions are similar to banks, but they are member-owned and you typically have to qualify to become a member. For example, there are teacher credit unions, or town credit unions (you have to live in a certain town to be a member). Credit unions usually o_er better interest rates on savings and lower interest rates on loans. They also provide a range of ﬁnancial services, just like banks. Brokerage ﬁrms and investment companies These companies help people invest their money in stocks, bonds, and other ﬁnancial assets. They often charge fees or commissions for their services. For example, you might open an account with a brokerage ﬁrm to invest in a stock or mutual fund. Insurance companies Insurance companies provide protection against ﬁnancial losses due to accidents, natural disasters, and other unexpected events. They collect premiums from policyholders and use the money to pay out claims when needed. For example, you might buy homeowners insurance to protect your house from damage due to a ﬁre. Financial advisers Some ﬁnancial institutions, like ﬁnancial advisers and wealth managers, provide advice to help people make informed decisions about saving, investing, and managing their money. They may charge fees for their services, or earn commissions based on the products they recommend. Financial markets Financial markets are where ﬁnancial trades happen, but most people don't actually go there to trade stocks, bonds, or other securities. Instead, they rely on ﬁnancial institutions, like banks or investment ﬁrms, to act on their behalf. So even though you might buy stocks or invest in a mutual fund, you're not actually the one making the trades- the ﬁnancial institution is doing that work for you. Stock markets Stock markets are places where people can invest in shares of companies, like Apple or Amazon. They allow investors to buy and sell stocks, which represent ownership in the company, and potentially earn proﬁts as the company grows. Bond markets Bond markets are where people can invest in bonds, which are loans made to companies or governments. Investors who buy bonds receive regular interest payments and get their principal amount back when the bond matures. Money markets Money markets are a type of ﬁnancial market where people can invest in short-term debt securities, like Treasury bills and certiﬁcates of deposit. Conclusion Understanding ﬁnancial institutions and markets is essential for making smart decisions about saving and investing your money. By exploring the di_erent types and functions of these organizations, you can identify the best options for your needs and preferences. Whether you're saving for a rainy day, investing in your future, or borrowing money for a big purchase, ﬁnancial institutions and markets are there to help you achieve your ﬁnancial goals. D. Bank Operations and Management Banking Operations and Management Banking system is a crucial component of the global economy accounting for trillions in assets worldwide. Banks are just one part of the world of ﬁnancial institutions, standing alongside investment banks, insurance companies, ﬁnance companies, investment managers and other companies that proﬁt from the creation and ﬂow of money. As ﬁnancial intermediaries, banks stand between depositors who supply capital and borrowers who demand capital. Given the importance in economy and individual wealth that rests on banks, it is also among the most stringently regulated businesses in the world. Basic Functions: Accept Deposits / Make Loans At the fundamental level banks accept deposits from customers, raise capital from investors or lenders and then use that money to make loans, buy securities and provide other ﬁnancial services to customers. These loans are then used by individuals and organizations to expand their operations, which in turn leads to more deposited funds that make their way to banks. Provide Safety Banks also provide security and convenience to their customers. At inception, part of the primary purpose of banks was to o_er customers security for their money. This was back in a time when an individual's wealth consisted of actual gold and silver coins, but to a large extent this function is still relevant. With banks, consumers no longer need to keep large amounts of currency on hand; transactions can be treated with checks, debit cards or credit cards, instead. Many banks maintain vaults and rent out space to customers, in the form of safe deposit boxes with subsidiary services. Act as Payment Agents Banks also serve as payment agents within a country and between nations. Not only does banks issue debit cards that allow account holders to pay for goods with the swipe of a card, they can also arrange wire transfers with other institutions. Banks underwrite ﬁnancial transactions by lending their reputation and credibility to the transaction in the form of banking instruments such as checks, pay orders, demand draft etc. As payment agents, banks make commercial transactions much more convenient. Role of Banks in an Economy: Settle Payments: Every day there are millions of ﬁnancial transactions through banking channel, some conducted with paper currency, but countless done with checks, wire transfers and various types of electronic payments. Banks play a valuable role in settling these payments, ensuring that proper accounts are credited or debited, in the proper amounts and with relatively little delay. Credit Intermediation: Banks play a major role as ﬁnancial intermediaries. Banks collect money from depositors, in essence borrowing the money, and then concurrently lending it to other borrowers, generating a chain of debts. Maturity Transformation: Maturity transformation is fundamental to what banks do on a daily basis. Many investors are willing to invest on short term basis, but several projects require long-term ﬁnancial commitments. What banks do is borrow short- term, in the form of demand deposits and short-term certiﬁcates of deposit, but lend long-term. By doing this, banks transform debts with very short maturities (deposits) into credits with very long maturities (loans), and collect the di_erence in the rates as proﬁt. However, they are also exposed to the risk that short-term funding costs may rise much faster than they can recoup through lending. Money Creation: One of the most vital roles of banks is in money creation achieved through fractional reserve banking. In this system only a fraction of bank deposits are backed by actual cash-on-hand and are available for withdrawal. This is done to expand the economy by freeing up capital that can be loaned out to other parties. Role of Central Bank o Primary Functions: include issue of notes, regulation and supervision of the ﬁnancial system, bankers’ bank, lender of the last resort, banker to Government, and conduct of monetary policy o Secondary functions: include the agency functions like management of public debt, management of foreign exchange, etc. Other functions like advising the government on policy matters and maintaining close relationships with international ﬁnancial institutions. The non-traditional or promotional functions, performed by the State Bank include development of ﬁnancial framework, institutionalization of savings and investment, also provision of training facilities to bankers, and provision of credit to priority sectors. VII. FUNDAMENTALS OF CORPORATE FINANCE A. Capital Budgeting What is Capital Budgeting? Capital budgeting involves choosing projects that add value to a company. The capital budgeting process can involve almost anything, including acquiring land or purchasing ﬁxed assets like a new truck or machinery. Companies use di_erent metrics to track the performance of a potential project, and there are various methods to capital budgeting. Understanding Capital Budgeting Every year, companies often communicate between departments and rely on ﬁnancial leadership to help prepare annual or long-term budgets. These budgets are often operational, outlining how the company’s revenue and expenses will shape up over the subsequent 12 months. However, another aspect to this ﬁnancial plan is capital budgeting. Capital budgeting is the long-term ﬁnancial plan for larger ﬁnancial outlays. Capital budgeting relies on many of the same fundamental practices as any other form of budgeting. However, there are several unique challenges to capital budgeting. First, capital budgets are often exclusively cost centers; they do not incur revenue during the project and must be funded from an outside source, such as revenue from a di_erent department. Second, due to the long-term nature of capital budgets, there are more risks, uncertainty, and things that can go wrong. Capital budgeting is often prepared for long-term endeavors, then reassessed as the project or undertaking is under way. Companies will often periodically reforecast their capital budget as the project moves along. The importance in a capital budget is to proactively plan ahead for large cash outﬂows that, once they start, should not stop unless the company is willing to face major potential project delay costs or losses. Why Do Businesses Need Capital Budgeting? Capital budgeting is important because it creates accountability and measurability. Any business that seeks to invest its resources in a project without understanding the risks and returns involved would be held as irresponsible by its owners or shareholders. Furthermore, if a business has no way of measuring the e_ectiveness of its investment decisions, chances are the business would have little chance of surviving in the competitive marketplace. Companies are often in a position where capital is limited and decisions are mutually exclusive. Management usually must make decisions on where to allocate resources, capital, and labor hours. Capital budgeting is important in this process, as it outlines the expectations for a project. These expectations can be compared against other projects to decide which one(s) is most suitable. Businesses (aside from nonproﬁts) exist to earn proﬁts. The capital budgeting process is a measurable way for businesses to determine the long-term economic and ﬁnancial proﬁtability of any investment project. While it may be easier for a company to forecast what sales may be over the next 12 months, it may be more di_icult to assess how a ﬁve-year, $1 billion manufacturing headquarters renovation will play out. Therefore, businesses need capital budgeting to assess risks, plan ahead, and predict challenges before they occur. Methods Used in Capital Budgeting There is no single method of capital budgeting; in fact, companies may ﬁnd it helpful to prepare a single capital budget using the variety of methods discussed below. This way, the company can identify gaps in one analysis or consider implications across methods that it would not have otherwise thought about. Discounted Cash Flow Analysis Because a capital budget will often span many periods and potentially many years, companies often use discounted cash ﬂow techniques to assess not only cash ﬂow timing but also implications of the dollar. As time passes, currencies often become devalued. A central concept in economics facing inﬂation is that a dollar today is worth more than a dollar tomorrow, as a dollar today can be used to generate revenue or income tomorrow. Discounted cash ﬂow also incorporates the inﬂows and outﬂows of a project. Most often, companies may incur an initial cash outlay for a project (a one-time outﬂow). Other times, there may be a series of outﬂows that represent periodic project payments. In either case, companies may strive to calculate a target discount rate or speciﬁc net cash ﬂow ﬁgure at the end of a project. Payback Analysis Instead of strictly analyzing dollars and returns, payback methods of capital budgeting plan around the timing of when certain benchmarks are achieved. For some companies, they want to track when the company breaks even (or has paid for itself). For others, they’re more interested in the timing of when a capital endeavor earns a certain amount of proﬁt. For payback methods, capital budgeting entails needing to be especially careful in forecasting cash ﬂows. Any deviation in an estimate from one year to the next may substantially inﬂuence when a company may hit a payback metric, so this method requires slightly more care on timing. In addition, the payback method and discounted cash ﬂow analysis method may be combined if a company wants to combine capital budget methods. Throughput Analysis A dramatically di_erent approach to capital budgeting is methods that involve throughput analysis. Throughput methods often analyze revenue and expenses across an entire organization, not just for speciﬁc projects. Throughput analysis through cost accounting can also be used for operational or noncapital budgeting. Throughput methods entail taking the revenue of a company and subtracting variable costs. This method results in analyzing how much proﬁt is earned from each sale that can be attributable to ﬁxed costs. Once a company has paid for all ﬁxed costs, any throughput is kept by the entity as equity. Companies may be seeking to not only make a certain amount of proﬁt but also want to have a target amount of capital available after variable costs. These funds can be swept to cover operational expenses, and management may have a target of what capital budget endeavors must contribute back to operations. Metrics Used in Capital Budgeting When a ﬁrm is presented with a capital budgeting decision, one of its ﬁrst tasks is to determine whether or not the project will prove to be proﬁtable. The payback period (PB), internal rate of return (IRR), and net present value (NPV) methods are the most common approaches to project selection. Although an ideal capital budgeting solution is such that all three metrics will indicate the same decision, these approaches will often produce contradictory results. Depending on management’s preferences and selection criteria, more emphasis will be put on one approach over another. Nonetheless, there are common advantages and disadvantages associated with these widely used valuation methods. Payback Period The payback period calculates the length of time required to recoup the original investment. Payback periods are typically used when liquidity presents a major concern. If a company only has a limited amount of funds, it might be able to only undertake one major project at a time. Therefore, management will heavily focus on recovering their initial investment in order to undertake subsequent projects. Another major advantage of using the payback period is that it is easy to calculate once the cash ﬂow forecasts have been established. There are drawbacks to using the payback metric to determine capital budgeting decisions. First, the payback period does not account for the time value of money (TVM). Simply calculating the payback provides a metric that places the same emphasis on payments received in year one and year two. Such an error violates one of the fundamental principles of ﬁnance. Luckily, this problem can easily be amended by implementing a discounted payback period model. Basically, the discounted payback period factors in TVM and allows one to determine how long it takes for the investment to be recovered on a discounted cash ﬂow basis. Another drawback is that both payback periods and discounted payback periods ignore the cash ﬂows that occur toward the end of a project’s life, such as the salvage value. Thus, the payback is not a direct measure of proﬁtability. There are other drawbacks to the payback method that include the possibility that cash investments might be needed at di_erent stages of the project. Also, the life of the asset that was purchased should be considered. If the asset’s life does not extend much beyond the payback period, then there might not be enough time to generate proﬁts from the project. Since the payback period does not reﬂect the added value of a capital budgeting decision, it is usually considered the least relevant valuation approach. However, if liquidity is a vital consideration, then payback periods are of major importance. Internal Rate of Return The internal rate of return (or expected return on a project) is the discount rate that would result in a net present value of zero. Since the NPV of a project is inversely correlated with the discount rate—if the discount rate increases, then future cash ﬂows become more uncertain and thus become worth less in value—the benchmark for IRR calculations is the actual rate used by the ﬁrm to discount after-tax cash ﬂows. An IRR that is higher than the weighted average cost of capital suggests that the capital project is a proﬁtable endeavor and vice versa. The IRR rule is as follows: IRR > Cost of Capital = Accept Project IRR < Cost of Capital = Reject Project The primary advantage of implementing the internal rate of return as a decision- making tool is that it provides a benchmark ﬁgure for every project that can be assessed in reference to a company’s capital structure. The IRR will usually produce the same types of decisions as net present value models and allows ﬁrms to compare projects based on returns on invested capital. Despite the IRR being easy to compute with either a ﬁnancial calculator or software packages, there are some downfalls to using this metric. Similar to the payback method, the IRR does not give a true sense of the value that a project will add to a ﬁrm—it simply provides a benchmark ﬁgure for what projects should be accepted based on the ﬁrm’s cost of capital. The internal rate of return does not allow for an appropriate comparison of mutually exclusive projects; therefore, managers might be able to determine that project A and

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