lecture -introduction and ratios(1-5)(sem2)

8/3/2019 LECTURE -Introduction and Ratios(1-5)(Sem2)

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LECTURE 1

INTRODUCTION


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Business Finance

Relates to the study of how financial resources(assets) are obtained and used effectively in theaccomplishment of firms objective,

The role of business finance has evolved overthe years from the a descriptive study(procurement of funds) to a normative field (management of assets, allocation of capital andvaluation of firm in the overall market place)


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Economic environment and finance

Raising finance to fund business operation is animportant role for finance managers

It is essential that the firms funding requirementare put into overall economic context

Economic sectors are divided into Personal (household) Business Public (government)

Foreign (international trade) Finance match need of borrower (deficit unit) and

lender (surplus unit)


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Financial Intermediaries (sectors)

Businesses that exist to match the needs of borrower(personal and business sector) and lenders (personalsector).

Financial intermediaries seen as providing the followingservices: Collect small savings and pool them into larger amount Transform short term deposit into long term loans Spread the risk of small depositors by investing into wide

enterprises Reduce transaction cost of borrowers and lenders

Once funds are attracted, it purchases financial assets

from other economic unit (enterprises) to generate returnon the invested fund.

i.e. Insurance company ,pension fund, unit trust, financecompanies, commercial banks, merchant banks


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Objective of Business Firm

Maximize return

Whos return? Community at large

Employees

shareholders

firms objective is to maximize shareholders wealth bymaximizing the firms value

Firms value is reflected in the movement of the share

price This objective is affected by two factors rate of return earned on the shares (future earning

Risk attached to earning that return (uncertainty)


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Risk and Return

All decisions making involves future earning. Suchearnings are always associated with certain degree ofuncertainty.

The future earning are known as return and the

uncertainty associated with the return is known as risk.

Risk refers not to the possibility of total loss but thelikelihood of actual return varying form forecast

Risk and return has a liner positive relationship, wherehigher risk is associated with higher expected return..(we will discuss this in detail later)


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How to achieve the firms

objective?

To achieve firms objective (maximizeshareholders wealth), 3 types of decisionsshould be considered by the finance

manager

Investment decision

Financing decision

Dividend decision


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Role of a finance manager

Uses the information provided byaccountant to make decisions involvingfinance

Plan the financial objective of a firm

Determine the capital structure

Plan and control use of funds for long term

investment Plan and control the use of funds for short

term investment


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Exercise

1. How are risk and return related?

2. What is the role of financialintermediaries ?


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LECTURE 2

INTRODUCTION PART 2


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Capital market and Money market

Capital market is a form of financial market thattrades long term securities (shares, loan stock,bonds)

Also known as stock exchange

Capital market can be categorized into primarymarket secondary market

Money market trades short term financialinstruments such as commercial paper,

negotiable certificates of deposit, bankersacceptance and treasury bill.


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Primary Market

Market in which new securities are traded

IPO (initial public offering) is the first time acompanys share is sold to the public

Seasonal new issue refers to offering of newshare by company that already has ordinaryshares traded in the market


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Secondary Market

Market in which shares previously issuedby the firm is traded. Total stock offinancial assets are unaffected by such

transaction


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Public offering and Private

Placement

Public offering takes place in a financial marketin which both individual and institutionalinvestors have the opportunity to acquiresecurities. The issuing firm and investors doesnot meet face to face.

Private Placement takes place in a more

personal manner, in which only a limited numberof investor have the opportunity to purchase aportion of the shares. The issuing firm andinvestor develop a face to face transaction.


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Exercise

1.Explain what is a financial market. How isan economy worse off without them?

2. Distinguish capital market and moneymarket?

3. Distinguish primary market and secondarymarket.


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LECTURE 3

INTRODUCTION PART 3


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Legal form of business firm

1. Sole proprietorship a business own by singleperson

Advantage

Easily establish with few complications Minimal organizational cost

Does not have to share profit or control with others

Disadvantage

Unlimited liability

Owner must absorb all losses

Equity capital limited to the owners personal investment

Business terminates immediately upon death of owner


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Legal form of Business Firm

2. Partnership an association of two ormore individuals coming together as co-owners to operate a business for profit.There are 2 types of partnership

i) General partnership advantage

Minimal organizational requirements

Negligible government regulations

disadvantage All partners have unlimited liability

Difficult to raise large amounts of capital

Partnership dissolve by the death or withdrawal of ageneral partner


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Partnership -cont

ii) Limited partnership Advantage

For limited partners, liability is limited to the amount ofcapital invested

Withdrawal or death of a limited partner does not affect

continuity of the business Stronger inducement in raising capital

Disadvantage There must be at least one general partner who has

unlimited liability in the partnership

Limited partners may not participate in the managementof the business

More expensive to organize than general partnership, asa written agreement is mandatory


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Legal form - cont

3. Corporation legal entity having the power topurchase and sell, own assets, incur liabilitywhile existing separately from its owners.Ownership is evidence by shareholdings.

Advantage Limited liability of owners Ease of transferability of ownership

Death of owner does not result in the discontinuity ofbusiness operation

Ability to raise large amount of capital Disadvantage

Most difficult and expensive form of business

Control of firm is not guaranteed by ownership of shares


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Sources of finance

1. Long term financing Ordinary share Preference share Debenture or loan stock Bonds

Term loan2. Short term financing Bank finance Trade credit Hire purchase

Leasing Factoring Bills of exchange


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Exercise

1. The shareholders are owners of alimited company but the position of ashareholder differs from that of a sole

trader Discuss.


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LECTURE 4

BUSINESS OBJECTIVES


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Business Objectives

Although most finance studies assume theobjective of maximization of shareholderswealth it is important that in real worldcompanies may be working toward other

objective:

1. Maximization of profit2. Maximization of the return on capital employed

3. Survival4. Long term stability5. Growth6. Maximization satisfaction of interested parties

(employees, creditors, public and others)

M i i i f fi


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Maximization of profit vs.

Maximization of shareholders wealth

Maximization of profit Suboptimal decision for shareholders The use of profit as a measure of return is misleading in that

profit could be increased through external financing (acquisition)which will dilute the equity and eventually decrease earning pershare

The use of EPS also not an appropriate objective in that it doesnot represent the actual income of the shareholders. It onlyrepresent investors share of income according to accountingformula.

Ignore timing of return (earning) and uncertainty (risk)

Maximization of shareholders wealth Means maximization of firms value, max share price

Takes into account present and future earning (return) per share,timing, duration and risk of the earning

Takes into account dividend yield and capital gain

Efficient allocation of resources in the society


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Agency Theory Relationship between various interested parties in the firm

Agency relationship occur when one party (principle) employsanother party (the agent) to perform a task on their behalf

Example: Manager agents for shareholders, employees agents ofmanagers and manager and shareholders agents of creditors

Conflict of interest may exist in most of these agent-principlerelationship known as agency theory: Employees may desire high wages for shorter hours while management

might require lower unit cost Creditors prefer less risky investment decisions made by managers,

unlike shareholders Managers may make decision not in the best interest of shareholders.

Managers might seek to max their welfare.

Paying themselves high salary and perks Provide themselves with large decision making power Increase opportunities for promotions Reduce risk through diversification Defend acquisition and takeover


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How to reduce agency problem

(shareholder manager)? audit/monitor mangers decision. The cost ofmonitoring and the cost of sub optimal decision forshareholders are known as agency cost.

Design remuneration package for managers whichwould motivate managers to take decisions whichare consistent with the objective

Managers compensation should be linked to changesin the shareholders wealth

Time horizon of managers decision should match thatof shareholders

Shareholders and managers attitude toward riskshould be encouraged to be similar


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Exercise

1. Why are investment and financingdecision important to a firm?

2. Why is profit maximization considered

incomplete as a business objective3. Discuss the problem that might exist in

the relationship between shareholder

and manager and how to overcome theproblem.


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LECTURE 5

FINANCIAL STATEMENT


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Basic Financial Statement

Income statement Reports the results from operating the business for a

period of time, such as a year

Balance sheet Provides a snapshot of the firms financial position at

a specific point in time, presenting its assets, liabilitiesand capital

Cash flow statement Provides an insight to the sources and uses of cash

over a period. The income statement measures profitfor a period on accrual basis rather than cash basis.


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Income Statement SALES Cost of Goods Sold GROSS PROFIT Operating Expenses

OPERATING INCOME (EBIT) Interest Expense EARNINGS BEFORE TAXES (EBT) Income Taxes EARNINGS AFTER TAXES (EAT)

Preferred Stock DividendsNET INCOME AVAILABLE TO COMMON STOCKHOLDERS


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Balance Sheet Fixed Assets Machinery & Equipment

Buildings and Land Investments & patents Current Assets Cash

Marketable Securities Accounts Receivable Inventories Prepaid Expenses

Current Liabilities Accounts Payable Accrued Expenses Short-term notes Finance By: Equity Preferred Stock

Common Stock (Par value) Paid in Capital (Share Premium) Firms Capital Structure made Retained Earnings of equity and debts Long-Term Liabilities (Debts) Long-term notes Mortgages


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Problems using accounting

information

Income measurement

Costs are not expressed in the same terms asthe revenues where there are changing prices.

Since the cost tend to be incurred before therevenue are recognized there is a tendency forcost to be understated and profit overstated.

Balance sheet values

The theoretical framework used in preparationof asset accounts tends to understate theamount of wealth invested.


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Financial ratio

Profitability ratios

Activity ratios

Liquidity ratios

Capital gearing ratios

investment ratios


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Limitation of ratios Lack of standard definition

Some accounting ratios may be defined in more thanone way. This makes it difficult to compare ratioscalculated by different accountants, for the sameratios.

Unrepresentative balance sheet figures

Balance sheet only shows a snapshot of a companysfinancial position on a single date, whereas profit andloss account covers entire accounting period.

Therefore if the assets and liabilities on the balancesheet date are not typical of the year as a whole, anyratio that combines a balance sheet figure with profitand loss figure might produce a misleading result.


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Limitation of ratios - cont

Accounting policies Accounting policies with regard todepreciation and stock valuation might be verydifferent to those of another company. Thesedifferences make it difficult to have a

meaningful comparison between companies Misinterpretation

Accounting ratios are open tomisinterpretations unless all available evidence

is taken into account. For example reduction ingross profit margin is seen as a bad sign,when in fact the company has deliberatelydropped selling price to boost sales.


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Benefit of ratios

Easily understood by all users

Useful for comparison

Remedial action can be taken onweakness revealed through ratio

Certain ratios focuses on investorsattention

f


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Profitability Ratio

Concern with the effectiveness of firm in generating profit a. Return on capital employed

Net profit before long-term interest and tax x 100% Total asset less current liabilities

b. Return on equity

Net profit after long-term interest and tax x 100%

Share capital and reserves c. Gross profit margin

Gross profit x 100% Sales

d. Net profit margin

Net profit before long-term interest and tax x 100% Sales

A i i R i


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Activity Ratios

To asses the effectiveness of firm in utilizing its asset a. Net asset turnover

Sales Total asset less current liabilities

b. Stock holding period

Stock held x 365 Stock used

c. Debtor collection period

Trade debtor x 365 Credit sales

d. Creditor payment period

Trade creditor x 365 Credit purchase

Li idi R i


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Liquidity Ratio

To assess how well the firm is managing itsworking capital

a. Current ratio Current asset

Current liabilities

b. Quick ratio Current asset less closing stock

Current liabilities

C i l i i


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Capital gearing ratios

These ratios are concern with the relativesizes of fund provided by shareholdersand by the loan creditors.

a. Debt to equity borrowing (long and short term)

total equity (share capital plus reserve)

b. Times interest covered Profit before interest and tax

Interest charges

I t t ti


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Investment ratio

- assess firms strength from the investors point of view a. Earning per share

Profit after interest and tax No of ordinary share

b. Price/ earning ratio Current market price per share Earning per share

c. Dividend yield

Dividend per share x 100% Current market price per share

d. Dividend cover

Profit after interest and tax Total dividend paid


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Exercise

1. Explain what are financial ratios, indicatethe benefits and limitation in using them

lecture -introduction and ratios(1-5)(sem2)

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