business finance slide

© Angkasa Training Centre, 2010

BUSINESS FINANCE

1


Chapter 1: The World of Finance

• Finance is the process by which money is transferred among businesses, individuals and governments through the process of financing and investing

• It also can be defined as the application of the principles of financial economist to an inter-related set of monetary problems.

2


1.1 Importance of Financial Statements

• Financial statements are formal records of the financial activities of a business, person, or other entity which provide an overview of a business or person's financial condition in both short and long term.

• four basic financial statements:1. Balance Sheet2. Income Statement3. Statement of Retained Earnings4. Statement of Cash Flow

3


1.2 Understanding Profit and Loss Accounts

• represents a summary of the firm’s operating results over a period, normally for 1-year period.

IIFC Products BhdIncome Statement for year ended Dec 31, 2009 (in RM`000)

Net Sales 1,500Cost of Goods Sold 750Gross Profits 750Operating expenses 30Depreciation Expense 180Earnings before interest and tax (EBIT) 540Interest expense 40Earnings before tax 500Taxes (40%) 200Earnings after tax (Net Income) 300Preferred stock dividend 7Earnings available to common stock holders (EACS) 293Common Stock dividends 200Addition to Retained Earnings 93

4


1.3 Understanding Balance Sheet

• presents a quantitative summary statement of a company’s financial position at a given point in time, including assets, liabilities and shareholders’ equity or net worth.

IIFC Products BhdBalance Sheet for year ended Dec 31, 2009

Current Assets Current LiabilitiesCash 108,000 Account Payable 178,200Marketable Securities 103,500 Notes Payable 4,050Accounts Receivable 124,200 Accruals 21,330Inventories 9,000 Total Current Liabilities 203,580Total Current Assets 344,700 Long Term Debt 202,500Net Fixed Assets 306,000 Total Liabilities 406,080Total Assets 650,700 Shareholders' equity

Preferred Stock 40,000Common Stock 64,620Retained Earnings 140,000Total liabilities and shareholders' equity 650,700

5


Chapter 2: Analysis of Financial Statement

• Financial analysis is the assessment of a firm’s past, present and anticipated future financial performance

• helps an individual to check whether a business is doing better this year than it was last year, or whether it is doing better or worse than other companies in the same industries

6


2.1 Assessing Financial Health

• company will be considered as “financially healthy” when its performance outperformed other companies in the same industry and also outperformed the industry’s benchmark

• The principal tool of financial analysis is financial ratios.

7


2.2 The Basics Financial Ratios

• Financial ratios are divided into five main categories:1. liquidity ratios

2. efficiency/activity ratios

3. leverage ratios

4. profitability ratios

5. market value ratios

8


Liquidity Ratios

• show a firm’s ability to meet its short term financial obligations. In other words, they show whether the firm has the resources to pay its creditors when payments are due

a. Current RatioCurrent Ratio = Current Assets_

Current Liabilities= 344,700 203,580= 1.69 times

9


Liquidity Ratios

b. Quick/Acid Test Ratio

Quick/Acid Test Ratio

= Current Assets – Inventories

Current Liabilities

= 344,700 – 9,000

203,580

= 1.65 times

10


Efficiency/Activity Ratios

• measure how effectively the firm is managing its assets in generating sales. They show the amount of sales generated for every dollar of assets investment

a. Inventory Turnover Ratio Inventory Turnover Ratio

= Cost of Goods Sold (COGS) Inventories

= 750,000 9,000= 83.33 times

11



b. Average Collection Period (ACP)

Average Collection Period (ACP)

= ____Account Receivable____

Annual Credit Sales/360 days

= ___124,200___

1,500,000/360

= 29.80 days

12



c. Fixed Asset Turnover

Fixed Asset Turnover

= _____Sales_____

Net Fixed Assets

= 1,500,000

306,000

= 4.9 times

13



d. Total Asset Turnover

Total Asset Turnover

= ___Sales__

Total Assets

= 1,500,000

650,700

= 2.3 times

14


Leverage Ratios

• measure the level of debt or borrowings in a firm. They tell us whether the company depends more on the debt financing or equity financing. They also highlight the ability of the firm to honour its medium and long term debt commitments in terms of repayment of the principal as well as the interest charges

a. Debt Ratio Debt Ratio = _Total Debt_

Total Assets= 446,080 650,700= 0.6855 @ 68.55%

15


Leverage Ratios

b. Debt to Equity Ratio

Debt to Equity Ratio

= _Total Debt_

Total Equity

= 446,080

204,620

= 2.18

16


Leverage Ratios

c. Times Interest Earned / Interest Coverage Ratio

Times Interest Earned

= Earnings Before Interest and Tax (EBIT)

Interest Expense

= 540,000

40,000

= 13.5 times

17


Profitability Ratios

• measure how effectively the firm uses its assets to make profits. Profitability ratios show the profits earned for every single dollar of sales made or the profits earned for every investment in assets made.

a. Gross Profit Margin (GPM)

Gross Profit Margin (GPM)

= Gross Profit

Sales

= _750,000_

1,500,000

= 50%

18



b. Operating Profit Margin

Operating Profit Margin

= Earnings Before Interest and Tax (EBIT)

Sales= _540,000_

1,500,000

= 36%

19



c. Net Profit Margin

Net Profit Margin

= Earnings Available to Common Stockholders

Sales

= _293,000_

1,500,000

= 19.53%

20



d. Return on Assets (ROA)

Return on Assets (ROA)


Total Assets

= _293,000_

650,700

= 45.03%

21



e. Return on Equity (ROE)

Return on Equity (ROE)


Total Equity

= _293,000_

204,620

= 143.19%

22


Market Value Ratios

• relate a firm’s stock price to its earnings and book value per share. They give the management an indication of what investors think of the firm’s past performance and future

prospect.

a. Earnings Per Share (EPS)

Earnings Per Share


Number of ordinary shares issued

= _293,000_

200,000

= RM1.465

23


Market Value Ratios

b. Dividend Per Share (DPS)

Dividend Per Share

= _______Ordinary Dividends_______

Number of Ordinary Shares Issued

= _200,000_

200,000

= RM1.00

24


Market Value Ratios

c. Dividend Payout Ratio (DPR)

Dividend Payout Ratio

= _Dividend Per Share_

Earnings Per Share

= _RM1.00_

RM1.465

= 0.68

25


Market Value Ratios

d. Price/Earnings Ratio

Price/Earnings Ratio

= _Market Price Per Share_

Earnings Per Share

= _RM25.00_

RM1.465

= 17.06 times

26


2.3 Trend Analysis and Industry Comparisons

1. Trend analysis• It is also known as time series analysis, which evaluates

performance of the company over time. • Comparisons are made between current to past performance using

ratios to assess the company’s progress.

2. Cross sectional• This analysis involves the comparison of different companies’

financial ratios at the same point in time. • Ratios of other companies within the same industry are needed in

order to analyze the performance of the company. • Analysts are often interested in how well a company has performed

in relation to other companies in the same industry.

27


Chapter 3 : The Time Value of Money

• means a dollar received today is worth more than the same dollar received in the future.

• crucial in financial management as it will enable us to further understand how stocks and bonds are valued, how to decide on the capital budgeting and many more.

28


3.1 Why Money Has Time Value

• In investment, the more time taken, the more interest you may earn

• investors would be compensated for his waiting time in making their investment due to their willingness to forgo their current consumption in expectation of future earnings

29


3.2 Measuring the Time Value of Money

• a single sum of money or a series of equal, evenly-spaced payments or receipts promised in the future can be converted to an equivalent value today.

• Conversely, you can determine the value to which a single sum or a series of future payments will grow to at some future date

• Time Value of Money can be further subdivided into two;

1. Present Values (PV)

2. Future Values. (FV)

30


3.3 The Present Value of a Single Amount

Future Value and Compounding

• future value is the value to be received in the future, given a value today

Example 1:

Find the future value of RM7, 000 to be invested for 4 years at 10% compounded annually.

31


Formulae

FV = PV (1 + i )n

where;

PV = Present Value of the future sum of money

FV = Future Value of an investment at the end of n years

i = annual discount rate

n = number of years before payment is received

32


FV = PV (1 + i )n

= 7, 000 ( 1+0.1)4

= 10,248.70

or

FV = PV (FVIFI,n)

= PV (FVIF10%,4)

= 7, 000 (1.464)

= 10,248.00

33


Example 2:

Find the future value of RM7, 000 to be invested for 4 years at 10% compounded semi annually

n = 4 years x 2 times per year

= 8

i = 10% per annum / 2 times a year

= 5%

34


FV = PV (1 + i )n

= 7, 000 ( 1+0.05)8

= 10,342.19

or

FV =PV (FVIF5%,8)

= 7, 000 (1.477)

= 10,339.00

35


Example 3:

Find the future value of RM7, 000 to be invested for 4 years at 10% compounded quarterly

FV = PV (1 + i )n

= 7, 000 ( 1+0.025)16

= 10,391.54

36


Example 4:

Find the future value of RM7, 000 to be invested for 4 years at 10% compounded monthly.

FV = PV (1 + i )n

= 7, 000 ( 1+0.1/12)48

= 10,425.48

37


Example 5:

Find the future value of RM7, 000 to be invested for 4 years at 10% compounded daily.

FV = PV (1 + i )n

= 7, 000 ( 1+0.1/365)4x365

= 10,442.20

38


Present Value and Discounting

• The present value is the value today of a sum of money to be received in the future.

Example 1:

What is the present value of RM5, 000 to be received 3 years from today if the required rate of return is 8% compounded annually?

39


Formulae

PV = __FV__

(1+i)n

where;

PV = Present Value of the future sum of money

FV = Future Value of an investment at the end of n years


n = number of years before payment is received

40


PV = __FV__

(1+i)n

= __5, 000__

(1+ 0.08)3

= 3,969.16

or

PV = FV (PVIFI,n)

= FV (PVIF8%,3)

= 5, 000 (0.7938)

= 3,969.00

41


Example 2:

What is the present value of RM5, 000 to be received 3 years from today if the required rate of return is 8% compounded semi annually?


= 6


= 4%

42


PV = __FV__

(1+i)n

= __5, 000__

(1+ 0.04)6

= 3,951.57

or

PV = FV (PVIF4%,6)

= 5, 000 (0.7903)

= 3,951.50

43


Example 3:

What is the present value of RM5, 000 to be received 3 years from today if the required rate of return is 8% compounded quarterly?


= 12


= 2%

44


PV = __FV__

(1+i)n

= __5, 000__

(1+ 0.02)12

= 3,942.47

or

PV = FV (PVIF2%,12)

= 5, 000 (0.7885)

= 3,942.50

45


Example 4:

What is the present value of RM5, 000 to be received 3 years from today if the required rate of return is 8% compounded monthly?

PV = __FV__

(1+i)n

= __5, 000__

(1+ 0.1/12)36

= 3,708.70

46


Example 5:

What is the present value of RM5, 000 to be received 3 years from today if the required rate of return is 8% compounded daily?

PV = __FV__

(1+i)n

= __5, 000__

(1+ 0.1/365)3x365

= 3,704.24

47


3.4 Working with Annuities

• An annuity is a series of equal payments made at fixed intervals for a specific number of periods

• divided into two main types:

1. Ordinary annuity: payments made at the end of each period (i.e payment of Astro bills)

2. Annuity due: payment made at the beginning of each period (i.e rental payments)

48


Future Value of an Ordinary Annuity

FVA = PMT (1+i )n - 1

i

where:

FVA = the total future value at the end of n periods

PMT = the equal payments made for each period


n = number of payments made

Or

FVA = PMT (FVIFA I,n)

49


Future Value of an Annuity Due

FVAD = PMT (1+i )n – 1 (1+i) i

where:

FVA = the total future value at the end of n periods




Or

FVA = PMT (FVIFA I,n) (1+i)

50


Present Value of an Ordinary Annuity

PVA = PMT (1+i )n – 1

i (1+i)n

where:

PVA = the total present value of n annuity




Or

PVA = PMT (PVIFAi,n)

51


Present Value of an Annuity Due

PVAD = PMT (1+i )n – 1 (1+i)

i (1+i)n

where:

PVA = the total present value of n annuity




Or

PVA = PMT (PVIFAi,n)(1+i)

52


Chapter 4: Capital Budgeting Decision Methods

• The purpose of this chapter is to evaluate and decide whether to purchase new equipment, the acquisition of property or acquisition of another company. Therefore the best project can give a maximum return from the company’s investment.

53


4.1 The Capital Budgeting Process

The process of capital budgeting involved four steps which is as follow :1. Estimates the cash flows after tax from

investment.

2. Consider the risk involved associated to the investment.

54


Cont.

3. Choose the best methods to evaluate the project ; non-discounted method and discounted method.

4. Make a best decision to ensure those investments provides a positive return to the company’s value. The decision is based on mutual exclusive investment and/or independent investment.

55


Capital Budgeting Decision Methods

• 2 cash flow methods :

• Non-discounted cash flow

• Discounted cash flow method

56


Non-discounted cash flow

• This method does not consider the time value of money in calculating and analyze the capital investment. Under this method, there are two techniques that commonly used by Financial Manager to calculate and evaluate the best investment i.e. Average Rate of Return and Payback Period.

57


The Accounting Rate of Return (ARR)

• This method is to measures the average on profitability of proposed capital investment as the ratio of average net income after tax to the average investment.

• ARR = Average Net Income After Tax

Average Investment

58


The Payback Period

• The payback period method focuses on the time value of money and uses cash flow after tax, instead of net profit in evaluating an investment. This method use to measure the length of time that the company needs to consider to recover back the cost of investment. Thus, payback occurs when the total of cash inflows equal to the initial investment :

59


Payback period (When the cash flows are an annuity)

= IO / Average CF

Payback period (When the cash flows are mixed stream)

= (Yr – 1) + [ (IO – Cum. inflow before Yr.) ]

Cash inflow in Yr.

60


Example

• Shasha Farzana is the Financial Manager for RIDZ Sdn Bhd. She needs to considering the potential investment for company i.e. Project A and Project B which can maximize the company’s return.

61


Cont.

• The below table shows the detail of each projects :

62

Year Project A Project B1 RM2,500 RM2,5002 RM2,500 RM7003 RM2,500 RM3,300

Total Inflow RM7,500 RM6,500Initial Outlay RM5,000 RM5,000


Discounted cash flow method

• Discounted cash flow method considers the time value of money in the analysis. This method support the goal of the firm i.e. to maximize the shareholders’ wealth.

• There are three common techniques in discounted cash flow ; net present value, internal rate of return and profitability index.

63


Net Present Value (NPV)

• This technique among the common techniques and is widely used in analyzing the best investment for company. NPV is the present value of an investment’s annual cash flows less the initial outlay. It can be expressed as follows :

64


Cont.

• NPV (mixed stream cash flows) =

= [ PV1 + PV2 + … + PVn ] - IO

(1 + i)1 (1 + i)1 (1 + i)n

• NPV (an annuity)• = PV [ 1 – 1 ]

(1 + i)n - IO

i

65


Profitability Index (PI)

• Profitability index measures the ratio of present value of cash flow to the cost of investment. This index can be expressed as follows :

PI = [ PV1 + PV2 + … + PVn ]

(1 + i)1 (1 + i)1 (1 + i)n

-----------------------------------------

Initial Outlay

66


Internal Rate of Return (IRR)

• IRR is the discount rates that cause the NPV to equal zero. Therefore, IRR is when NPV is equates to zero :

IRR = Σ [ CFATt / (1 + IRR)t ] – IO

67


Capital Rationing

• Capital rationing is referring to placing a limit on the dollar size of the capital budget. There are three basic principles for imposing a capital-rationing constraint.

68


Example

• Company ABC has a budget constraint of RM4 million and there are four projects available. The table below is the information for each of proposed projects :

69

Project Initial Outlay (RM)

NPV (RM)

AA 2.0 million 0.8 millionBB 1.0 million 0.4 millionCC 1.2 million 0.6 millionDD 1.8 million 0.9 million


Chapter 5 : Capital Structure Basics

• Capital structure is the mix or combination of firm’s permanent long term financing including firm’s debt, preferred stock and common stock.

70


• Different companies may imply different optimal structure. The objectives of capital structure are as follows :– Investment decision– Financing decision– Dividend policy decision

71


Breakeven Analysis and Leverage

• Breakeven analysis is focus on the relationship between sales volume and profitability, which has a direct relationship to the firm’s total cost structure.

72


Break Even Point

• Also known as a cost-volume analysis which is finding the level of sales where operating profit or net income before interest and tax equals to zero that is the total revenues equal to total cost. EBIT is;

EBIT= Q (P – V) – FCWhere ;• Q : Sales quantity (in unit)• P : Price per unit• V : Variable cost per unit• FC : Fixed cost

73


Sales Break Even

• It involves the same formula except the sales break even uses contribution margin (CM). The sales break even can be calculated as follows :

CM = 1 – Variable cost ratio

= 1 – (V / P)

74


Cash Break Even (CBE)

• It concern with the sales level in order to meet operating cash requirement. This is because cash receipts and expenditure do not correspond directly with the sales and expenses as per income statement. In CBE, non-cash expenses such as depreciation are not included as it will overstate the CBE. The CBE can be computed as follows;

75


Cont.

• CBE (in unit) = (FC – depreciation)

(P – V)

• CBE (in RM) = (FC – depreciation)

[ 1 - (V / P)

76


Break Even Margin

• This technique is used to calculate the margin of safety when the level of sales is known. This relates to the firm’s current sales level to break even point and thus it will measures the risk on how much the sales can be decline before meet the break even point which result in negative operating earnings.

77


Cont.

• Break even margin (BEM) can be computed using the following formula :

BEM = S0 – BE (in RM) / S0

78


Leverage

• Leverage implies the usage of fixed costs in a business to firm’s earnings. The leverage is included the operating leverage and financial leverage.

• Operating leverage is the fixed operating costs which is appear in the firm’s income statement.

79


Cont.

• Financial leverage relates to the financial sources which carry fixed financing charges that the company willing to bear in order to maximize their returns on shareholders’ wealth. The combination between operating leverage and financial leverage known as the total leverage.

80


Degree of Operating Leverage (DOL)

• DOL is the percentage change in a firm’s operating profit due to the change in sales volume.

• The formula to calculate DOL is as follows:

DOL = Percentage chg. in operating profit

Percentage change in sales

81


Degree of Financial Leverage (DFL)

• DFL is defined as the percentage of change in EPS as the result from percentage change in EBIT. The level of financial leverage can be determined by applying the following formula :

82


Cont.

• DFL = % change in EPS____

% change in operating profit

• DFL= ________EBIT_______

EBIT – 1 – Preferred divd.

/ (1 – Tax)

83


Example

Company Syarikat Mama

Syarikat Mimi

Syarikat Mumu

Sales (RM) 5,500 9,750 5,000Operating cost :Fixed cost (RM)

1,000 7,000 3,500

Variable cost (RM)

3,500 1,500 1,000

Operating profit 1,000 1,250 500Fixed cost 0.22 0.82 0.78

84


Cont.

• The above illustration, it shows that Syarikat Mimi has the highest percentage of fixed cost of 0.82. This is requires a large amount of sales in this company as compared to Syarikat Mama and Mumu in recovering the total costs and thus able to make a highest profit.

85


Capital Structure

• This capital structure theory assumes that there is an optimal capital structure, whereby when a company increases the amount of debt in capital structure, the weighted average cost of capital (WACC) will be reduced. The WACC will increase when the company has more debt. This is due to the required return by investors will increase and thus reduced the debt fund.

86


Chapter 6 : Working Capital Policy

1. Inventory Management• The Economic Order Quantity (EOQ) model will

determine the optimal order size for an inventory item and therefore helps to minimize the inventory costs.

• Other system of inventory also may be used such as the ABC Approach, Materials Requirement Planning (MRP) Approach and Just-In-Time (JIT) Approach

87


2. Account Receivable Management• starts with the process of credit Selection whereby

the customers will be evaluated using the 5C’s of credit before any credit sales is granted.

- Character

- Capital

- Conditions

- Collateral

- Capacity

88


3. Cash Management

• concerned with maintaining the liquidity of the firm in order to minimize the risk of going bankrupt

• three motives of holding cash by firms:– Transaction Motive– Precautionary Motive– Speculative Motive

89


4. Marketable Securities• assets that can be quickly converted into cash. • Examples :treasury bills, commercial paper,

negotiable certificate of deposit (NCD) and Banker’s Acceptance (BA).

• rationales for holding marketable securities:

- As a substitute of cash

- As a temporary investment

90


Managing Current Liabilities: Risk and Return

Source of finance

Cost Risk

Short-term Low High

Long-term High Low

91


Three Working Capital Financing Approaches

• Aggressive approach to financing working capital

• Conservative approach to financing working capital

• Moderate approach to financing working capital

92


Aggressive approach to financing working capital

• The aggressive method is where a company predominantly finance all itsfluctuating current assets and most of its permanent current assets using short-term source of finance and it is only a small proportion of its permanent currentassets that is financed using long-term source of finance.

93


Conservative approach to financing working capital

• The conservative method is where a company predominantly finance all itspermanent current assets and most of its fluctuation current assets using long-term source of finance and it is only a small proportion of its fluctuating currentassets that is financed using short-term source of finance.

94


Moderate approach to financing working capital

• This approach makes distinction between fluctuating current assets and permanent current assets with the suggestion that to finance working capital; short-term source of finance should be used to finance fluctuating current assets, whiles long-term source of finance should be used to finance permanent current assets.

95


Working Capital Financing and Financial Ratios

• Working capital financing is essential to any growing business. It helps keep the business current and competitive in the market.

• Financial ratios can be used to analyze trends and to be compared with other firms in the same industry. In the some cases, financial ratios can predict future bankruptcy.

96


Chapter 7 : Managing Cash

• Cash is defined as coins and currency plus demand deposit account that available to meet individual’s need and is use in a daily transaction.

97


• Management of cash refer to the liquidity of a firm and thus can minimize the risk of solvency in a company. A company can become insolvent when they unable to meet its maturing liabilities due to lack of necessary liquidity to make prompt payment on its current debts.

98


• The firm has to hold cash a a few reasons:– Transaction – Precautionary – Speculation – Compensating balance

99


Forecasting Cash Needs

• Cash forecast requires four basic steps: – Estimate sales for the forecast period, a year

in this instance – Break down the annual sales figure into

monthly units to reflect any seasonal factors. – Construct pro forma income statements from

the monthly sales figures. – Translate the income statement information

into a cash forecast.

100


Preparing the Statement of Cash Flow

• Operating Cash Flow: Operating cash flow, often referred to as working capital, is the cash flow generated from internal operations. It comes from sales of the product or service of your business, and because it is generated internally, it is under your control. The company’s income statement will be converted from accrual basis to cash basis.

101


Cont.

• Investing Cash Flow : Investing cash flow is generated internally from non-operating activities. This includes investments in plant and equipment or other fixed assets, nonrecurring gains or losses, or other sources and uses of cash outside of normal operations.

102


Cont.

• Financing Cash Flow. Financing cash flow is the cash to and from external sources, such as lenders, investors and shareholders.

103


Example

• Prepare the cash flow. Given the balance sheet and profit and loss statement :

104


Balance Sheet as of 31/12/2008 and 2009

105

31/12/2008 (RM’000)

31/12/2009 (RM’000)

Cash 200 150Ac Receivable 450 425Inventory 550 625Total Current Assets 1,200 1,200Plant and Equipment 2,200 2,600Less : Accumulated Depreciation 1,000 1,200Net Plant and Equipment 1,200 1,400Total Assets 2,400 2,600

Account payable 200 150Notes payable 0 150Total Current Liabilities 200 300Bond 600 600Common stock 300 300Paid-in capital 600 600Retained Earnings 700 800Total owners’ equity 1,600 1,700Total liabilities and owner’s equity

2,400 2,600


Income Statement for the Year Ended 31st Dec 2009

106

RM’000Sales 1,450Cost of Goods Sold 850Gross Profit 600Operating Expenses 40

Depreciation 200Net Income 360Less : Interest Expenses 300

EBT 120Less : Taxes Expenses 180

Dividend 80Additional Retained Earnings 100

business finance slide

Documents