module1 financial ratios & present value

7/30/2019 Module1 Financial Ratios & Present Value

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INTRODUCTION TO THE WORLD OFFINANCE

MODULE 1


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Important Business Activities2

ProductionMarketingFinance


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All business activities involve acquisition and useof funds.Finance function makes money available to meetthe costs of production and marketing operations.

Why Finance Matters?3


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Money marketCapital market

Primary market Secondary market

Various Financial Market &Instruments

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Long term funds -Equity andBorrowed

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Shares represent ownership rights of their holders.Shareholders are owners of the company. Sharescan of two types:

Equity Shares Preference Shares

Loans, Bonds or Debts : represent liability of the

firm towards outsiders. Lenders are not owners of the company. These provide interest tax shield .


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Equity and Preference Shares6

Equity Shares are also known as ordinary shares . Do not have fixed rate of dividend. There is no legal obligation to pay dividends to equity

shareholders.Preference Shares have preference for dividend

payment over ordinary shareholders.

They get fixed rate of dividends. They also have preference of repayment at the time of

liquidation.


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Finance Functions7

Finance functions or decisions can be divided asfollows

Long-term financial decisions

Long-term asset-mix or investment decision or capital budgeting decisions. Capital-mix or financing decision or capital structure and

leverage decisions. Profit allocation or dividend decision

Short-term financial decisions Short-term asset-mix or liquidity decision or working

capital management.


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Finance Managers Role 8

Raising of FundsAllocation of FundsProfit PlanningUnderstanding Capital Markets


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Financial Goals9

Profit maximization (profit after tax)Maximizing earnings per share

Wealth maximization


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Financial Statement Analysis10


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Financial Statements

Financial statements provide information aboutthe financial activities and position of a firm.

Important financial statements are: Balance sheet Profit & Loss statement Cash flow statement

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Balance Sheet

Balance sheet indicates the financial condition of a firm at a specific point of time. It containsinformation about the firms : assets, liabilities

and equity.Assets are always equal to equity and liabilities:

Assets = Equity + Liabilities

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Assets

Assets are economic resources or propertiesowned by the firm.There are two types of assets:

Fixed assets Current assets

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Current Assets

Current assets (liquid assets ) are those whichcan be converted into cash within a year i.e.accounting period or operating cycle of the

business (time taken to convert raw material into finished goods, sell them and convert debtorsinto cash) . Current assets include:

Cash Tradable (marketable) securities Debtors (account receivables) Stock of raw material Work-in-process Finished goods

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Fixed Assets

Fixed assets are long-term assets. Normallyrecorded at cost price.

Tangible fixed assets are physical assets like land,

machinery, building, equipment. Their cost is allocatedover their useful lives by depreciation. Intangible fixed assets are the firms rights and claims,

such as patents, copyrights, goodwill etc. Their cost isallocated over their useful lives by amorization.

Gross block represent all tangible assets at acquisitioncosts.

Net block is gross block net of depreciation.

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Liabilities

Liability is a firms obligation to pay cash or provide goods or services in the future.

Two types of liabilities are: Current liabilities Long-term liabilities

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Current Liabilities

Current liabilities are payable within a year inthe normal course of business.They include:

Accounts payable (creditors) Outstanding expenses Advances from customers Provision for tax Provision for dividend

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Long-term Liabilities

Long-term liabilities are the obligations or debts payable in a period of time greater than theaccounting period.

They include - Debentures, bonds, and securedlong-term loans from financial institutions.

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Shareholders Funds or EquityShare capital is owners contribution. As liabilities arethe claims of outside parties, equity represents ownersclaims against the business entity.

Shareholders equity has two parts: (i) paid-up share capital, and (ii) reserves and surplus (retained earnings)

representing undistributed profits.

Paid-up share capital and reserve and surplustogether are called net worth .

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Gujarat Narmada Valley FertilizersCompany Balance Sheet as on 31March


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Sources of Funds

It is the sum of net worth or equity (E) and borrowing/debt (D), both long and short term.This is also called as Capital Employed. It do

not include current liabilities. CE = Net Worth + Borrowing = E + D

Net current assets (NCA) is the difference between current assets (CA) and currentliabilities (CL):

NCA = CA CL

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Application of Funds

It includes Net fixed assets, net current assets,investment and other assets.Net current assets (NCA) is the difference

between current assets (CA) and currentliabilities (CL):

NCA = CA CL

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Balance Sheet Relationship

Sources of Funds are equal to application of funds. It means capital employed finances its netassets.

Capital Employed = Net Assets

Note: Contingent liabilities are written as a noteto the balance sheet as they are not the actual

liabilities.

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Profit & Loss Statement

Profit & Loss statement provides informationabout a firms:

revenues, expenses, and Profitability

It is a flow statement

It is a measure of firms profitability, solvency andliquidity.

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Nature of Revenues

Revenue is the amount received or receivablewithin the accounting period from the sale of thefirms goods or services.

Operating revenue is the one that arises from mainoperations of the firm i.e. sale of finished goods,and the revenue arising from other activities iscalled non-operating revenue i.e. sale of oldequipment.

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Nature of Expenses

Expense is the amount paid or payable within theaccounting period for generating revenue.

Examples : raw material consumed, salary and wages, power and fuel, repairs and maintenance, rent, selling andmarketing expenses, administrative expenses.

Expenses are expired costs and capitalexpenditures represent un-expired costs andappear as assets in balance sheet.

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Concepts of Profit

Gross profit = sales cost of goods sold (CGS) CGS = raw material consumed + manufacturing expenses of goods

that have been soldPBDIT = Profit before dep., interest and tax = sales expenses, except

dep., interest and taxOperating profit (OP), OP = GP OEXP DEP. It is also known asPBIT. It measures firms operative performance without regard to firmssources of financing. PBIT = Profit before interest and tax= PBDIT DEPPBT = Profit before tax = PBIT InterestPAT = Profit after tax = PBT TaxNet operating profit after tax (NOPAT)= PBIT (1 Tax rate)

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Gujarat Narmada Valley Fertilizers Company LtdProf i t & Lo ss Acco un t for the year ended on 31 March


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Financial Statement Analysis29


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LEARNING OBJECTIVES

We will see how financial ratios helps in getting usefulinformation from the financial statements

Recognize the diagnostic role of financial ratios

Highlight the utility of financial ratios in credit analysis andcompetitive analysis as well as in determining the financialcapability of the firm

Understand the limitations of financial ratios

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Financial Analysis31

Financial analysis is the process of identifying thefinancial strengths and weaknesses of the firm by

property establishing relationships between the

item of the balance sheet and the profit and lossaccount.


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USERS OF FINANCIALANALYSIS

Trade creditors firms liquidity positionSuppliers of long-term debt- firms profitabilityover time so as to be able to pay their interest and principal Investors- firms earnings its present and future

profitability

Management overall growth of the company

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NATURE OF RATIOANALYSIS

Ratio analysis is a powerful tool used for financialanalysisA financial ratio is a relationship between two

accounting numbers.Ratios help to make a qualitative judgement about thefirms financial performance.

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Standards of Comparison

Time series analysisInter-firm analysisIndustry analysisProforma financial statement analysis

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Types of Financial Ratios

Liquidity ratiosLeverage ratiosActivity ratiosProfitability ratios

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LIQUIDITY RATIOS

Liquidity ratios measure a firms ability to meetits current obligations.

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Current assetsCurrent ratio =

Current liabilitiesCurrent assets Inventories

Quick ratio =Current liabilities

Cash + Marketable securitiesCash ratio =

Current liabilities


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Cont 37


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LEVERAGE RATIOS

To judge the long-term financial position of the firm, financialleverage, or capital structure ratios are calculated.

These ratios indicate mix of funds provided by owners andlenders.

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Cont 39


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ACTIVITY RATIOS

Activity ratios are employed to evaluate the efficiencywith which the firm manages and utilizes its assets.

These ratios are also called turnover ratios because theyindicate the speed with which assets are being convertedor turned over into sales.

Activity ratios, thus, involve a relationship between salesand assets.

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I T d D b


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Inventory Turnover and DebtorsTurnover

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Assets Turnover Ratios 42


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PROFITABILITY RATIOS

The profitability ratios are calculated to measurethe operating efficiency of the company.

Generally, two major types of profitability ratiosare calculated:1. profitability in relation to sales

2. profitability in relation to investment.

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Cont 44


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Cont 45


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Cont 46


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Cont 47


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Cont 48

COMPARATIVE STATEMENTS


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COMPARATIVE STATEMENTSANALYSIS

A simple method of tracing periodic changes in thefinancial performance of a company is to preparecomparative statements.

Comparative financial statements will contain itemsat least for two periods.Changes increases and decreases in incomestatement and balance sheet over a period can beshown in two ways:

(1) aggregate changes and (2) proportional changes.

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TREND ANALYSIS

In financial analysis the direction of changes over a period of years is of crucial importance.Time series or trend analysis of ratios indicates

the direction of change.This kind of analysis is particularly applicable tothe items of profit and loss account.

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Cont

For trend analysis, the use of index numbers isgenerally advocated.The procedure followed is to assign the number

100 to items of the base year and to calculate percentage changes in each items of other years inrelation to the base year. This procedure may becalled as trend-percentage method .

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Example: Hindustan


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Example: HindustanManufacturing Company

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INTER-FIRM ANALYSIS

The analysis of the financial performance of all firmsin an industry and their comparison at a given pointof time is referred to the cross-section analysis or

the inter-firm analysis .To ascertain the relative financial standing of a firm,its financial ratios are compared either with itsimmediate competitors or with the industry average.

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industry: Inter-firm

Comparison Market Share55

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UTILITY AND LIMITATIONS OFRATIO ANALYSIS


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UTILITY OF RATIO ANALYSIS

the ability of the firm to meet its current obligations;the extent to which the firm capital structure has beenfinanced by borrowed funds;

the efficiency with which the firm is utilizing its assetsin generating sales revenuethe overall operating efficiency and performance of thefirm.

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Diagnostic Role of Ratios

Profitability analysisAssets utilizationLiquidity analysisStrategic Analysis

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CAUTIONS IN USING RATIO


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CAUTIONS IN USING RATIOANALYSIS

Standards for comparisonCompany differencesDifferent definitions of variablesChanging situationsHistorical data

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Present & Future value


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Present & Future valuebasics

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Time Preference for Money

Time preference for money is an individuals preference for possession of a given amount of money now, rather than the same amount at somefuture time.Three reasons may be attributed to the individuals time preference for money:

risk... uncertainty abt future cash receipts preference for present consumption over future... becoz of

risk of not enjoying future consumption that may be caused by death or illness or inflation

investment opportunities... they can put present cash toearn additional cash

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Required Rate of Return

The time preference for money is generallyexpressed by an interest rate. An individual willrequire a rate of return which compensates him for

time and is called as risk-free rate . He would also demand compensation for assuming

risk, which is called risk premium .The investors required rate of return is:

Risk-free rate + Risk premium .

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Required Rate of Return

Would an investor want Rs. 100 today or after one year?

Cash flows occurring in different time periods are not comparable.

It is necessary to adjust cash flows for their differences in timing and risk.

Example : If preference rate =10 percent

An investor can invest if Rs. 100 if he is offered Rs 110 after one year.

Rs 110 is the future value of Rs 100 today at 10% interest rate.

Also, Rs 100 today is the present value of Rs 110 after a year at 10%

interest rate. If the investor gets less than Rs. 110 then he will not invest. Anything

above Rs. 110 is favourable.

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Time Value Adjustment

Two most common methods of adjusting cashflows for time value of money:

Compounding the process of calculating future values of cash flows and

Discounting the process of calculating present values of cash flows.

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Future Value

Compounding is the process of finding the future values of cash flows by applying the concept of compound interest.

Compound interest is the interest that is received on theoriginal amount (principal) as well as on any interest earned

but not withdrawn during earlier periods.Simple interest is the interest that is calculated only on theoriginal amount (principal), and thus, no compounding of interest takes place.

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Future Value66


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Future Value: Example68


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Future Value of an Annuity69

Future Value of an Annuity:


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Future Value of an Annuity:Example

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Sinking Fund71


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Example


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Present Value

Present value of a future cash flow (inflow or outflow) is the amount of current cash that is of equivalent value to the decision-maker.Discounting is the process of determining presentvalue of a series of future cash flows.The interest rate used for discounting cash flows isalso called the discount rate .

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Present Value of a Single


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Present Value of a SingleCash Flow

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l


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Example75

l f


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Present Value of an Annuity76

Capital Recovery and Loan


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Capital Recovery and LoanAmortisation

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E l


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Example78

L A i i S h d l


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Loan Amortisation Schedule79

End Payment Interest Principal Outstaof Year Repayment Balance

0 10,0001 3,951 900 3,051 6,9492 3,951 625 3,326 3,6233 3,951 326 3,625* 0

P V l f P i


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Present Value of Perpetuity80

Present Value of a Perpetuity:


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p yExample

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Present Value of an Uneven


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Periodic SumIn most instances the firm receives a stream of uneven cash flows. Thus the present value factorsfor an annuity cannot be used.

The procedure is to calculate the present value of each cash flow and aggregate all present values.

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PV of Uneven Cash Flows:


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Example83

Present Value of Growing


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gAnnuities

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E l


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Example85

E l


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Example86

V l f A it D


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Value of an Annuity Due87

Future Value of An Annuity:


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yExample

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Example


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Example

The present value of Re 1 paid at the beginning of each year for 4 years is

1 3.170 1.10 = Rs 3.487

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Multi Period Compounding


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Multi-Period Compounding90

Effective Interest Rate:


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Example91

module1 financial ratios & present value

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