Professional Documents
Culture Documents
– Semester I
Tutorial Prepared by
Sanjeewa Guruge
B.Sc. Accountancy (Special) - 1st Class (USJ)
M.Sc. Investments (UK)
FCA, FCMA
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Working Capital Management
Objectives
Working capital refers to the firm’s investment in short-term assets (cash, marketable
securities, accounts receivable and inventories). Net working capital is the difference
between a firm’s current assets and its current liabilities. Often, short-term financial
management is called working capital management. These terms mean the same thing.
What type of questions fall under the general heading of short-term finance? To name
just a very few;
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Short-term
Fluctuating
Current Assets
Permanent
Current Assets Long-term
Fixed Assets
Fixed assets should be financed long-term, either equity or long-term debt, since the
assets are long-lived and need financing for a long period of time. The current assets
can be broken down into two portions, permanent current assets and fluctuating current
assets. The permanent current assets represent base levels of inventories, receivables,
etc., that will always be on hand. The fluctuating current assets represent the seasonal
build-ups that occur, such as inventories before Christmas and receivables after
Christmas. The fluctuating current asset levels should be financed short-term since we
don’t want to pay financing charges all year if we only need the money for a four-month
period.
While the permanent current assets are, individually, short-lived assets, as a category
they are always there (hence, permanent) and will always need to be financed. Thus,
the permanent current assets should also be financed long-term, just like the fixed
assets. While it is possible to finance some of our permanent needs using short-term
debt, it is risky to do so. (Such financing is described as an “aggressive” working capital
financing policy– aggressive being associated with risky.)
Probably a bigger risk is the inability to roll over the short-term debt every year.
You may have a bad year and find that lenders are unwilling to refund the debt
(forcing you to default).
Of course, some companies take the opposite approach – they will finance some of their
seasonal needs of the fluctuating current assets with long-term financing. This is a
conservative approach, but the financing is there when it is needed – but it costs money
during those times when it is not needed.
Life insurance companies and pension funds, on the other hand, have liabilities that are
many years in the future. They would prefer to make longer term loans so that there
isn’t the need to reinvest the money every year.
Cash
Cash is probably the least productive asset you can have. Not only it does not earn
anything, it actually loses purchasing power as a consequence of inflation. So why do
firms hold cash? The three Keynsian motives for holding cash balances are;
While cash is necessary to cover the transactions motive, the precautionary and
speculative motives can be covered with the near money (or near cash) of marketable
securities.
In order to maximize your cash balances, you can do one of two things; either accelerate
the inflow of funds (ask for an advance on your salary) or delay the outflow of funds
(postpone paying the phone bill until next month). But why would we want to maximize
our cash holdings if it is the least productive asset? Because idle cash, either sitting in a
checking account or tied-up in accounts receivable is extremely costly.
Can you invest money for one day? Absolutely. In fact, for a large enough amount of
money, someone will meet you at the bank on Sunday in order to accept your deposit.
Marketable Securities
Marketable securities are a way of holding cash but with the attribute of earning
interest. Market securities have three characteristics:
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1. Short-term maturity (less than one year, or “money market instruments”
2. High marketability
3. Virtually no risk of default
Commercial paper
Commercial paper is the promissory notes of a major national firms. Most of the
firms that issue commercial paper sell it directly to investors (insurance
companies, money market funds, pension funds) although sometimes it will be
sold through investment bankers.
Banker’s Acceptances
A banker’s acceptance is a time draft that evolves from international
export/import financing. An exporter is paid by a time draft issued by a foreign
bank. Since the draft is not payable until some future date (1-3 months,
typically) the company that receives it will often sell it to its local bank at a
discount. The local bank bundles the discounted drafts (banker’s acceptances)
and then resells them in the money markets.
Accounts Receivable
Accounts receivable are generated when a firm offers credit to its customers. The first
thing that needs to be addressed when establishing a credit policy is to set the standards
by which a firm is judged in determining whether or not credit will be extended. There
is what’s known as the 5 Cs of credit:
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Once the credit standards have been set, the terms of credit need to be established.
When must the customer pay? If they pay early, will they receive a discount? If they
pay late, do they get charged a penalty?
While the whole purpose of extending credit is to increase sales and, thus, gross profits,
the expected increase in gross profits must be compared with the costs associated with
extending credit to customers. These costs include
Competitors will respond very quickly to a change in price. How many times have we
seen the claims that “We will meet or beat any advertised price”? A change in credit
policy, on the other hand, is a more subtle means of competing for customers and one
that the competition will not necessarily respond to. In fact, many firms base their
business on easy credit. How many times have we seen the advertisements where they
tell us “Good credit? Bad credit? No credit? We don’t care!” Of course, these firms will
have larger bad debt expenses and larger financing costs, etc. Obviously, they will also
need to have higher prices (higher gross profit margins) in order to cover these costs.
Inventories
Inventories (raw materials, work-in-process, finished goods) make up a large portion of
most firm’s current assets, and for many, total assets. As such, the extent to which a
firm efficiently manages its inventories can have a large influence on its profitability.
Thus, keeping abreast of inventory policy is critical to the profitability (and value) of the
firm.
Several factors influence the amount of inventory that a firm maintains. The most
important of these include
Level of sales – typically, the more sales a firm has, the more inventory it
holds
Length of time and technical nature of the production process – The longer it
takes to produce finished goods inventories from raw materials, the larger the
amount of finished goods that a firm will typically hold (a safety stock).
Durability vs. Perishability – If an inventory item is highly perishable, such
as fresh vegetables, a small amount will be held. Similarly, fashions of
clothes and car styles are “perishable” and will result in smaller inventories
than durable goods such as tools and hardware.
Costs – Cost of holding inventories as well as costs of obtaining inventories
will influence inventory sizes.
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Inventory costs can be broken down into three major categories:
A. Ordering Costs
1. Fixed costs – stocking, clerical
2. Shipping costs – often fixed
3. Missed quantity discounts – an opportunity cost
B. Carrying Costs
1. Time value of money tied-up in inventories
2. Warehousing costs
3. Insurance
4. Handling
5. Obsolescence, breakage, “shrinkage”
C. Stock-out Costs
1. Lost sales
2. Loss of goodwill
3. Special shipping costs
Ideally, we want to balance these costs against each other so that our total costs are
minimized.
Trade Credit
The major source of short-term financing for firms is that of trade credit. While it is an
account payable on our balance sheet, it is an account receivable on the balance sheet of
our supplier.
For example, 2/10 net 30 means that if you pay within the first ten days, you can deduct
2% from the bill; otherwise the full amount of the bill is due within 30 days. Discounts
are offered by suppliers to keep their A/R balances down and minimize the funds that
are tied-up.
Not taking the discount can be a very expensive means of financing. For example,
suppose we do not pay within the first ten days. Then, if we pay on the thirtieth day, we
have paid 2% (approximately) for an additional twenty days’ use of the funds (the first
ten days were free anyway). Since there are 18 twenty-day periods in a year, this is
approximately
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2% * 18 = 36%
Actually, the cost is a little higher since we are paying 2% on top of the 98% we would
otherwise have to pay:
2% 360days
* 36. 7%
98% 20days
Commercial Banks
The second major source of short-term financing for firms is commercial banks. A firm
wants to establish a close relationship with its bank and obtain a line of credit. In order
to get a credit line, you will want to show them your income statements, balance sheets,
financial ratios, etc. The bank will then allow a certain amount of credit with a set rate
of interest (usually prime plus). This can be renegotiated every year. In fact,
commercial banks’ bread and butter is their business accounts and they are very
competitive with one another in trying to attract corporate clients. The amount of the
credit line is typically tied to the amount of accounts receivable that the firm has and
sometimes to the amount of inventories that it holds.
Another type of credit line is referred to as a revolving line of credit. With a revolving
line of credit, the bank provides a written agreement guaranteeing loans up to a certain
amount. The firm will pay a normal rate of interest on the amounts of funds that it
borrows plus a commitment fee. Unlike a regular line of credit which can be changed, a
revolving line of credit guarantees that the bank will always make the amount available
if needed. Additionally, a revolving line of credit will often be extended jointly by
several banks when the amounts used are larger than a single bank can (or wants to)
handle alone.
Types of Loans
Loans come in a variety of shapes. A simple loan requires that the firm maintain a non-
interest-bearing account at the bank. While compensating balances are not used as
much as they have been in the past, they are still encountered frequently.
Suppose a bank offers a one-year loan for $100,000 at an 8% rate of interest with a
compensating balance of 20%. Then,
$100,000 loan
Less: 20,000 compensating balance
$ 80,000 net proceeds
At the end of one year, the firm repays the bank $88,000. $8,000 is interest on the loan
and the other $80,000 (with the $20,000 in the compensating balance for a total of
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$100,000) is the principal. Thus, the firm has effectively paid $8,000 interest on the use
of $80,000 for an annual rate of interest of 10%.
Alternatively, the bank may offer a discounted loan where the interest is deducted up-
front. Using our same example,
$100,000 loan
Less: 8,000 interest
$ 92,000 net proceeds
At the end of the year, the firm repays the $100,000 of principal (since the interest was
paid up-front). Effectively, the firm paid $8,000 of interest for the use of $92,000 of
funds for a rate of interest of 8.7% on the loan.
Of course, your banker is there to help you and may express concern that the need to
come up with $100,000 at the end of the year could be difficult. He/she may suggest,
instead, an interest add-on loan where the amount of interest is added to the principal
and then repaid in a series of installments. Our example loan would then required that
monthly payments of $9,000 be made ($100,000 principal + $8,000 interest =
$108,000/12 months = $9,000 per month).
$100,000
Average
Owed
12 months
As an approximation, the amount of the loan that was outstanding during the year was,
on average, only $50,000. The $8,000 of interest thus represents an approximately 16%
rate of interest on the average amount of the loan.
0 1 - - - - - - - - - - - - - - - - - 11 12
Of course, if you were the bank, the cash flows would be the same, only the signs would
be reversed. So as a bank officer, how would you determine the rate of interest that you
were earning on this investment?
The true cost of debt of any loan is the internal rate of return between what you receive
and what you have to pay back. Suppose we use our calculators and determine the IRR
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of this interest add-on loan. We determine that the IRR is 1.2%. But remember that
this is 1.2% per month. Using simple interest, 1.2%*12 = 14.4% annual rate of interest.
Pledging of Accounts Receivable – This is the most common form. A lender will loan
up to 80% of the amount of the invoice. Upon payment, the borrower has
“pledged” to use the proceeds to reduce the amount of the loan. If the customer
does not pay the invoice, the borrower is still obligated to repay the loan.
Securities Loans
A borrower can pledge their inventories of securities of another company (bonds, notes
payable) as collateral for a loan as well. Thus, if you hold a note payable from a
creditworthy firm, many lenders will loan money against it. (This is similar, in a sense,
to what happens with a margin purchase.)
In short, if a firm has assets of virtually any kind, it can use them as collateral for short-
term loans to meet its short-term cash needs.
To begin, recall that current assets are cash and other assets that are expected to
convert to cash within one year. Some of the most important items found in the current
asset section of a balance sheet are cash and cash equivalents, marketable securities,
accounts receivable and inventories.
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Analogous to their investment in current assets, firms use several kinds of short-term
debt, called current liabilities. Current liabilities are obligations that are expected to
require cash payments within one year. The major items found as current liabilities are
accounts payable, expenses payable (including accrued wages and taxes) and notes
payable.
Because we want to focus on changes in cash, we start off by defining cash in terms of
the other elements of the balance sheet. This lets us isolate the cash account and explore
the impact on cash from the firm’s operating and financing decisions. The basic balance
sheet identity can be written as;
Net working capital is cash plus other current assets, less current liabilities- that is;
If we substitutes this for net working capital in the basic balance sheet identity and
rearrange things a bit, we see that cash is;
This tells us in general terms that some activities naturally increase cash and some
activities decrease it. We can list these various activities, along with an example of each,
as follows;
Notice that our two lists are exact opposites. For example, floating a long-term bond
issue increases cash. Paying off a long-term bond issue decreases cash.
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Those activities that that decrease cash are called uses of cash. Looking back our list, we
see that sources of cash always involve increasing a liability (or equity) account or
decreasing an asset account. This makes sense because increasing a liability means that
we have raised money by borrowing it or by selling an ownership interest in the firm. A
decrease in an asset means that we have sold or otherwise liquidated as asset. In either
case, there is a cash inflow.
Uses of cash are just the reverse. A use of cash involves decreasing a liability by paying
it off, or increasing asset by purchasing something. Both of these activities require that
the firm spend some cash.
The primary concern in short-term finance is the firm’s short-run operating and
financing activities. For a typical manufacturing firm, these short-run activities might
consist of the following sequence of events and decisions.
Event Decision
Buying raw materials How much inventory to order?
Paying cash Whether to borrow or draw down cash balances?
Manufacturing the product What choice of production technology to use?
Selling the product Whether credit should be extended to a customer?
Collecting cash How to collect?
These activities create patterns of cash inflows and outflows. These cash flows are both
unsynchronized and uncertain. They are unsynchronized because, for example, the
payment of cash for raw materials does not happen at the same time as the receipt of
cash from selling the product. They are uncertain because future sales and costs cannot
be precisely predicted.
We can start with a simple case. One day, call it day 0, we purchase $ 1,000 worth of
inventory on credit. We pay the bill 30 days later, and after 30 more days, someone buys
the $1,000 in inventory for $1,400. Our buyer does not actually pay for another 45 days.
We can summarize these events chronologically as follows.
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The operating cycle
There are several things to notice in our example. First, the entire cycle, from the time
we acquire some inventory to the time we collect the cash, takes 105 days. This is called
the operating cycle.
As we illustrate, the operating cycle is the length of time it takes to acquire inventory,
sell it and collect for it. This cycle has two distinct components. The first part is the time
it takes to acquire and sell the inventory. This period, a 60-day span in our example, is
called the inventory period. The second part is the time it takes to collect on the sale, 45
days in our example. This is called the accounts receivable period.
Based on our definitions, the operating cycle is obviously just the sum of the inventory
and accounts receivable periods.
What the operating cycle describes is how a product moves through the current asset
accounts. The product begins life as inventory, it is converted to receivable when it is
sold, and it is finally converted to cash when we collect from the sale. Notice that, at
each step, the asset is moving closer to cash.
The second thing to notice is that the cash flows and other events that occur are not
synchronized. For example, we don’t actually pay for the inventory until 30 days after
we acquire it. The intervening 30-day period is called the accounts payable period. Next,
we spend cash on Day 30, but we don’t collect until Day 105. Somehow, we have to
arrange to finance the $1,000 for 105 – 30 = 75 days. This period is called the cash cycle.
Therefore, the cash cycle is the number of days that pass before we collect the cash from
a sale, measured from when we actually pay for the inventory. Notice that, based on our
definitions, the cash cycle is the difference between the operating cycle and the accounts
payable period.
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The above figure depicts the short-term operating activities and cash flows for a typical
manufacturing firm by way of a cash flow time line. As shown, the cash flow time line
presents the operating cycle and the cash cycle in graphical form. The need for short
term financial management is suggested by the gap between the cash inflows and the
cash outflows. This is related to the lengths of the operating cycle and the accounts
payable period.
The gap between short-term inflows and outflows can be filled either by borrowing or by
holding a liquidity reserve in the form of cash or marketable securities. Alternatively,
the gap can be shortened by changing the inventory, receivable and payable periods.
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Production manager Setting of production schedules and Inventory, accounts payable
materials requirements
Payables manager Decisions about payment policies and Accounts payable
about whether to take discounts
Controller Accounting information about cash Accounts receivable,
flows, reconciliation of accounts payable, Accounts payable
application of payments to accounts
receivable
Examining the above table we see that selling on credit involves at least three different
entities; the credit manager, the marketing manager and the controller. Thus, there is
the potential for conflict, particularly if different managers concentrate on only part of
the picture.
In the previous example, the length of time that made up the different period were
obvious. If all we have is financial statement information, we will have to do a little
more work. We illustrate these calculations next.
To begin, we need to determine various things such as how long it takes on average, to
sell inventory and how long it takes on average to collect. We start by gathering some
balance sheet information such as the following (in thousands).
Also, from the most recent income statement, we might have the following figures (in
thousands).
First of all, we need the inventory period. We spent $ 8.2 million on inventory (cost of
goods sold). Our average inventory was $ 2.5 million. We thus turned our inventory over
$8.2/2.5 times during the year.
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Inventory turnover = Cost of goods sold
Average inventory
$ 8.2 million
=
$ 2.5 million
= 3.28 times
The result of the above calculation tells us that we bought and sold off our inventory
3.28 times during the year. This means that, on average we held our inventory for;
= 365
3.28
= 111.3 days
So, the inventory period is about 111 days. In other words, on average inventory sat for
about 111 days before it was sold.
Similarly, receivables averaged $ 1.8 million, and sales were $ 11.5 million. Assuming
that all sales were credit sales, the receivables turnover is;
Credit sales
Receivables turnover =
Average accounts receivable
$ 11.5 million
=
$ 1.8 million
= 6.4 times
If we turnover our receivables 6.4 times, then the receivables period is;
365
=
6.4
= 57 days
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The receivables period is also called the days’ sales in receivables or the average
collection period. Whatever it is called, it tells us that our customers took an average of
57 days to pay.
The operating cycle is the sum of the inventory and receivables periods;
This tells us that, on average 168 days elapse between the time we acquire inventory
and having sold it, collect for the sale.
We now need the payables period. From the information given earlier, we know that
average payables were $ 875,000 and cost of goods sold was $ 8.2 million. Our payables
turnover is;
$ 8.2 million
=
$ 0.875 million
= 9.4 times
365
=
9.4
= 39 days
Finally, the cash cycle is the difference between the operating cycle and the payable
period.
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So, on average, there is a 129-day delay between the time we pay for merchandise and
the time we collect on the sale.
You have collected the following information for the Bret & Lee Company.
Credit sales for the year just ended were $50,000, and cost of goods sold was $30,000.
a) How long does it take Bret & Lee to collect on its receivables?
b) How long does merchandise stay around before it is sold?
c) How long does it take Bret & Lee to pay its bills?
d) Calculate the operating cycle and cash cycle of the company.
Most firms have a positive cash cycle, and therefore they require financing for
inventories and receivables. The longer the cash cycle, the more financing is required.
Also, changes in the firm’s cash cycle are often monitored as an early-warning measure.
A lengthening cycle can indicate that the firm is having trouble moving inventory or
collecting on its receivables. Such problems can be masked, at least partially, by an
increased payables cycle, so both cycles should be monitored.
The link between the firm’s cash cycle and its profitability can be easily seen by
recalling that one of the basic determinants of profitability and growth for a firm is its
total asset turnover, which is defined as Sales/Total assets. The higher this ratio is, the
greater is the firm’s accounting return on assets, ROA, and return on equity, ROE.
Thus, all other things being the same, the shorter the cash cycle is, the lower is the
firm’s investment in inventories and receivables. As a result, the firm’s total assets are
lower, and total turnover is higher.
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Some aspects of Short-Term Financial Policy
The short-term financial policy that a firm adopts will be reflected in at least two ways;
If we take these two areas together, we see that a firm with a flexible policy would have
a relatively large investment in current assets, and it would finance this investment
with relatively less short-term debt. The net effect of a flexible policy is thus a relatively
high level of net working capital. Put another way, with a flexible policy, the firm
maintains a higher overall level of liquidity.
Current asset holdings are highest with a flexible short-term financial policy and lowest
with a restrictive policy. So, flexible short-term financial policies are costly in that they
require a greater investment in cash and marketable securities, inventory and accounts
receivable. However, we expect that future cash inflows will be higher with a flexible
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policy. For example, sales are stimulated by the use of a credit policy that provide liberal
financing to customers. A large amount of finished inventory on hand enables quick
delivery service to customers and may increase sales. Similarly, a large inventory of raw
materials may result in fewer production stoppages because of inventory shortages.
A more restrictive short-term financial policy probably reduces future sales to levels
below those that would be achieved under flexible policies. It is also possible that higher
prices can be charged to customers under flexible working capital policies. Customers
may be willing to pay higher prices for the quick delivery service and more liberal credit
terms implicit in flexible policies.
Managing current assets can be thought of as involving a trade-off between costs that
rise and costs that fall within the level of investment. Costs that rise with increases in
the level of investment in current assets are called carrying costs. The larger the
investment a firm makes in its current assets, the higher its carrying costs will be. Costs
that fall with increases in the level of investment in current assets are called shortage
costs.
In a general sense, carrying costs are the opportunity costs associated with current
assets. The rate of return on current assets is very low when compared to that on other
assets.
Shortage costs are incurred when the investment in current assets is low. If a firm runs
out of cash, it will be forced to sell marketable securities. Of course, if a firm runs out of
cash and cannot readily sell marketable securities, it may have to borrow or default on
an obligation. This situation called a cash-out. A firm may lose customers if it runs out
of inventory (a stock-out) or if it cannot extend credit to customers.
An Ideal Case
We start off with the simplest possible case, an “ideal” economy. In such an economy,
short-term assets can always be financed with short-term debt, and long-term assets can
be financed with long-term debt and equity. In this economy, net working capital is
always zero.
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A growing firm can be thought of as having a total asset requirement consisting of the
current assets and long-term assets needed to run the business efficiently. The total
asset requirement may exhibit change over time for many reasons, including;
Such a firm might consider two strategies to meet its cyclical needs.
First, the firm could keep a relatively large pool of marketable securities. As the need for
inventory and other current assets began to rise, the firm would sell off marketable
securities and use the cash to purchase whatever was needed. Once the inventory was
sold and inventory holding began to decline, the firm would reinvest in marketable
securities. This approach is the flexible policy. Notice that the firm essentially uses a
pool of marketable securities as a buffer against changing current assets needs.
At the other extreme, the firm could keep relatively little in marketable securities. As
the need for inventory and other assets began to rise, the firm would simply borrow the
needed cash on a short-term basis. The firm would repay the loans as the need for assets
cycled back down. This approach is the restrictive policy.
In comparing the two strategies, notice that the main difference is the way in which the
seasonal variation in asset needs is financed. In the flexible case, the firm finances
internally, using its own cash and marketable securities. In the restrictive case, the firm
finances the variation externally, borrowing the needed funds on a short-term basis. All
else being the same, a firm with a flexible policy will have a greater investment in net
working capital.
1. Cash reserves
The flexible financing policy implies surplus cash and little short-term borrowing.
This policy reduces the probability that a firm will experience financial distress.
Firms may not have to worry as much about meeting recurring, short-run
obligations. However, investments in cash and marketable securities are zero net
present value investments at best.
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2. Maturity hedging
Most firms attempt to match the maturities of assets and liabilities. They finance
inventories with short-term bank loans and fixed assets with long-term
financing. Firms need to avoid financing long-lived assets with short-term
borrowing. This type of maturity mismatching would necessitate frequent
refinancing and is inherently risky because short-term interest rates are more
volatile that long-term rates.
References
Ross SA, Westerfield RW and Jordan BD, Fundamentals of Corporate
Finance, Ninth Edition
CFA Level 2 Book 2; Financial Reporting and Analysis and Corporate
Finance
http://www.investopedia.com
Sanjeewa Guruge
M.Sc. Investments (UK), B.Sc. Accountancy (Special) - 1st Class (USJ), FCA, FCMA
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