Notes: Prepared By: University: Date: Part

:

Financial Management Nauroz Khan Abasyn University Peshawar 22/02/2009 (2-2)

Inventory turnover Ratio:
A ratio showing how many times a company's inventory is sold and replaced over a period.

Although the first calculation is more frequently used, COGS (cost of goods sold) may be substituted because sales are recorded at market value, while inventories are usually recorded at cost. Also, average inventory may be used instead of the ending inventory level to minimize seasonal factors. Inventory for whole year: = Inventory x 360 days ----------------------------------(COGS)

Operating Cycle VS Cash Cycle:
Operating cycle and cash cycle are two important components of working capital management. Together they determine the efficiency of a firm regarding working capital management. Operating cycle refers to the delay between the buying of raw materials and the receipt of cash from sales proceeds. In other words, operating cycle refers to the number of days taken for the conversion of cash to inventory through the conversion of accounts receivable to cash. It indicates towards the time period for which cash is engaged in inventory and accounts receivable. If an operating cycle is long, then there is lower accessibility to cash for satisfying liabilities for the short term. Operating cycle takes into consideration the following elements: accounts payable, cash, accounts receivable, and inventory replacement. The following formula is used for calculating operating cycle: Operating cycle = age of inventory + collection period Cash cycle is also termed as net operating cycle, asset conversion cycle, working capital cycle or cash conversion cycle. Cash cycle is implemented in the financial assessment of a commercial enterprise. The more the figure is increased, the higher is the period for which the cash of a commercial entity is engaged in commercial activities and is inaccessible for other functions, for instance investments. The cash cycle is interpreted as the number of days between the payment for inputs and getting cash by sales of commodities manufactured from that input.

The fundamental formula that is applied for the calculation of cash conversion cycle is as follows: Cash cycle = (Average Stockholding Period) + (Average Receivables Processing Period) - (Average Payables Processing Period) Here Average Receivables Processing Period (in days) = Accounts Receivable/Average Daily Credit Sales Average Stockholding Period (in days) = Closing Stock/Average Daily Purchases Average Payable Processing Period (in days) = Accounts Payable/Average Daily Credit Purchases. A short cash cycle reflects sound management of working capital. On the other hand, a long cash cycle denotes that capital is occupied when the commercial entity is expecting its clients to make payments.

Profitability Ratio:
Profitability ratios are used to assess a business' ability to generate earnings as compared to expenses over a specified time period. Gross Profit Ratio: = Gross Profit ---------------------------- x 100 Total Sale Net Profit ------------------------------- x 100 Sale

Net Profit Ratio:

=

Investment Ratio:
Formula = Net Profit ------------------ x 100 Total Asset

Return on Equity:
The amount of net income returned as a percentage of shareholders equity. Return on equity measures a corporation's profitability by revealing how much profit a company generates with the money shareholders have invested. ROE is expressed as a percentage and calculated as: Return on Equity = Net Income/Shareholder's Equity Net income is for the full fiscal year (before dividends paid to common stock holders but after dividends to preferred stock.) Shareholder's equity does not include preferred shares.

Trend Analysis:
An aspect of technical analysis that tries to predict the future movement of a stock based on past data. Trend analysis is based on the idea that what has happened in the past gives traders an idea of what will happen in the future. There are three main types of trends: short-, intermediate- and long-term. Trend analysis tries to predict a trend like a bull market run and ride that trend until data suggests a trend reversal (e.g. bull to bear market). Trend analysis is helpful because moving with trends, and not against them, will lead to profit for an investor. Growth: Current – Previous -------------------------------- x 100 Previous

Trend Analysis can do by: = Base Year Compare with the Rest of Years.

(a): Common Size Analysis:
Formula = Entity -----------------Total Entity

Indicates the proportion of an asset/liability/expense is as a function of total assets / liabilities / revenue.
Things to remember

Compares what proportion that an expense reduces sales, especially useful when comparing previous years. It is also useful when comparing similar companies of different sizes to see if they have the same financial structure.

(b): Index Analysis:
Indexes are essential for fast and efficient access to the data of the database. Since it is very important for database system functionality. Indexes are used for special table scans and are important for performance.

Total Asset Turnover:
The amount of sales generated for every dollar's worth of assets. It is calculated by dividing sales in dollars by assets in dollars. Also known as the Asset Turnover Ratio.

Earning Power Ratio:
A company's ability to generate a sustainable, and likely growing, stream of earnings that provides cash flow. Formula: Asset x Net Profit

Working Capital:
A measure of both a company's efficiency and its short-term financial health. The working capital ratio is calculated as: Positive working capital means that the company is able to pay off its short-term liabilities. Negative working capital means that a company currently is unable to meet its short-term liabilities with its current assets (cash, accounts receivable and inventory). Also known as "net working capital", or the "working capital ratio".

Gross Working Capital:
Cash and short-term assets expected to be converted to cash within a year. Businesses use the calculation of gross working capital to measure cash flow. Gross working capital does not account for current liabilities, but is simply the measure of total cash and cash equivalent on hand. Gross working capital tends not to add much to the business' assets, but helps keep it running on a day-to-day basis.

Working Capital Management:
Working capital management involves the relationship between a firm's short-term assets and its short-term liabilities. The goal of working capital management is to ensure that a firm is able to continue its operations and that it has sufficient ability to satisfy both maturing short-term debt and upcoming operational expenses. The management of working capital involves managing inventories, accounts receivable and payable, and cash. A managerial accounting strategy focusing on maintaining efficient levels of both components of working capital, current assets and current liabilities, in respect to each other. Working capital management ensures a company has sufficient cash flow in order to meet its short-term debt obligations and operating expenses. Sale -------------------- = Profit Asset

Classification of Working Capital:
Working capital may be classified in to two ways: (a): On the basis of concept. (b): On the basis of time. On the basis of concept working capital can be classified as gross working capital and net working capital. On the basis of time, working capital may be classified as: Permanent or fixed working capital: Permanent or fixed working capital is minimum amount which is required to ensure effective utilization of fixed facilities and for maintaining the circulation of current assets. Every firm has to maintain a minimum level of raw material, work- in-process, finished goods and cash balance. This minimum level of current assts is called permanent or fixed working capital as this part of working is permanently blocked in current assets. As the business grow the requirements of working capital also increases due to increase in current assets. Temporary or variable working capital: Temporary or variable working capital is the amount of working capital which is required to meet the seasonal demands and some special exigencies. Variable working capital can further be classified as seasonal working capital and special working capital. The capital required to meet the seasonal need of the enterprise is called seasonal working capital. Special working capital is that part of working capital which is required to meet special exigencies such as launching of extensive marketing for conducting research, etc. Note: Temporary working capital differs from permanent working capital in the sense that is required for short periods and cannot be permanently employed gainfully in the business.

Hedging Techniques:
Hedging is a process by which risk is reduced; however, I'll emphasize that unless you liquidate a position, all risk cannot be eliminated. Hedging can reduce most risk, but as you will see, sometimes you wind up trading one risk for another. Also, recognize that hedging is typically a short-term strategy to protect long-term positions. It may also be utilized to complete an arbitrage transaction. However, you never want to apply a long-term hedging strategy to a short-term position, as that would be costly and add more risk in the long run.

Cash Management:
Cash management is a broad term that covers a number of functions that help individuals and businesses process receipts and payments in an organized and efficient manner.

Motives For With Holding Cash In Hand:

(a): Transaction Motives:
The motive that consumers have to hold money for their likely purchases in the immediate future or daily expenses.

(b): Speculative Motives:
A desire to hold cash for the purpose of being in a position to exploit any attractive investment opportunity requiring a cash expenditure that might arise. We develop a simple framework for analyzing corporate risk management decisions when managers have a directional prediction on future price levels. The optimal hedging strategy with "a view" retains a partial exposure and requires rebalancing. This can help explain the active trading behavior of some managers.

(c): Precautionary Motives:
A desire to hold cash in order to be able to deal effectively with unexpected events that require cash outlay. The precautionary demand for liquidity can cause an agent to respond to a risk by holding more money.

Collection of Cash: (Speed It Up)
The purpose of this policy is to establish effective cash collection, deposit and disbursement procedures to maximize cash availability. Therefore, collection, deposit and disbursement procedures are the main factors in achieving maximum fund availability and investment goals.

Cash Float:
Cash float is the time between when you authorize a bank to disperse funds from your bank account and when it actually leaves your account.

Slow Down Payment:
At the time of payment slowdown the payment and pay it lately through which you can get a lot of benefits.

Credit Policies:
Guidelines addressing how a company evaluates potential customers who wish to buy on credit. Guidelines include credit terms that specify discounts, interest rates, and credit limits. Selling on credit means offering credit directly to your customers, not simply allowing them to use credit cards. It can be both a positive and a negative addition to your business. The positive side is obvious - the likelihood of increased business and convenience for customers. The negative side is the time consuming, but absolutely necessary, set up procedures and the very real possibility of that the customer will not pay.

Credit Applicant Analysis:
(a): Sources of Information i.e. financial statement etc. (b): Credit Rating Report. (c): Bank checking. (d): Trade Checking. (e): Companies Own Experience.

Credit Analysis:
Credit analysis is the method by which one calculates the creditworthiness of a business or organization. The audited financial statements of a large company might be analyzed when it issues or has issued bonds. Or, a bank may analyze the financial statements of a small business before making or renewing a commercial loan. The term refers to either case, whether the business is large or small. Credit analysis involves a wide variety of financial analysis techniques, including ratio and trend analysis as well as the creation of projections and a detailed analysis of cash flows. Credit analysis also includes an examination of collateral and other sources of repayment as well as credit history and management ability. In Short: (The process of evaluating an applicant's loan request or a corporation's debt issue in order to determine the likelihood that the borrower will live up to his/her obligations).

The "Five C's" of Credit Analysis:
Regardless of where you seek funding - from a bank, a local development corporation or a relative - a prospective lender will review your creditworthiness. A complete and thoroughly documented loan request (including a business plan) will help the lender understand you and your business. The "Five C's" are the basic components of credit analysis. They are described here to help you understand what the lender looks for.

The 5C's are:
1. Capacity to repay is the most critical of the five factors; it is the primary source of repayment - cash. The prospective lender will want to know exactly how you intend to repay the loan. The lender will consider the cash flow from the business, the timing of the repayment, and the probability of successful repayment of the loan. Payment history on existing credit relationships - personal or commercial- is considered an indicator of future payment performance. Potential lenders also will want to know about other possible sources of repayment. 2. Capital is the money you personally have invested in the business and is an indication of how much you have at risk should the business fail. Interested lenders and investors will expect you to have contributed from your own assets and to have undertaken personal financial risk to establish the business before asking them to commit any funding.

3. Collateral or guarantees are additional forms of security you can provide the lender. Giving a lender collateral means that you pledge an asset you own, such as your home, to the lender with the agreement that it will be the repayment source in case you can't repay the loan. A guarantee, on the other hand, is just that someone else signs a guarantee document promising to repay the loan if you can't. Some lenders may require such a guarantee in addition to collateral as security for a loan. 4. Conditions describe the intended purpose of the loan. Will the money be used for working capital, additional equipment or inventory? The lender will also consider local economic conditions and the overall climate, both within your industry and in other industries that could affect your business. 5. Character is the general impression you make on the prospective lender or investor. The lender will form a subjective opinion as to whether or not you are sufficiently trustworthy to repay the loan or generate a return on funds invested in your company. Your educational background and experience in business and in your industry will be considered. The quality of you references and the background and experience levels of your employees will also be reviewed.

Credit Line:
An arrangement in which a bank or vendor extends a specified amount of unsecured credit to a specified borrower for a specified time period also called line of credit (LOC). An arrangement between a financial institution, usually a bank and a customer that establishes a maximum loan balance that the bank will permit the borrower to maintain. The borrower can draw down on the line of credit at any time, as long as he or she does not exceed the maximum set in the agreement.

Outsourcing:
Process of awarding a contract or otherwise entering into an agreement with a third party, usually a supplier, to perform services that are currently being performed by an organization's employees. Organizations "outsource" elements of their operations for one or both of the following reasons. (1) The service can be performed cheaper, faster, or better by a third party. (2) The service (for example, janitorial services) is not a core business functions contributing to the revenue growth and technical expertise of the organization. Accordingly, management does not want to focus time and attention on it.

Credit rating agencies:
A credit rating agency (CRA) is a company that assigns credit ratings for issuers of certain types of debt obligations as well as the debt instruments themselves. In some cases, the servicers of the underlying debt are also given ratings. In most cases, the issuers of securities are companies, special purpose entities, state and local governments, non-profit organizations, or national governments issuing debt-like securities (i.e., bonds) that can be traded on a secondary market. A credit rating for an issuer takes into consideration the issuer's credit worthiness (i.e., its ability to pay back a loan), and affects the interest rate applied to the particular security being issued.

Uses of ratings:
Credit ratings are used by investors, issuers, investment banks, broker-dealers, and governments. For investors, credit rating agencies increase the range of investment alternatives and provide independent, easy-to-use measurements of relative credit risk; this generally increases the efficiency of the market, lowering costs for both borrowers and lenders. This in turn increases the total supply of risk capital in the economy, leading to stronger growth. It also opens the capital markets to categories of borrower who might otherwise be shut out altogether: small governments, startup companies, hospitals, and universities.

History of Credit Rating Agencies:
However rating agencies only started in 1907 (Moody’s to be precise) but US already had a kicking bond market. The main cos that issued bonds were railroad companies. So who managed these bond issues then? He said there were three agencies: One is the credit-reporting (not rating) agency. Another is the specialized financial press. A third is the investment banker. In a sense, the bond-rating agency innovated by Moody in 1909 represents a fusion of functions performed by these three institutions that preceded it.

SEC (security and exchange commission):
Securities and Exchange Commission: an independent federal agency that oversees the exchange of securities to protect investors. A government regulatory agency that oversees and enforces the securities laws of the Pakistan, publishes rules and guidance for the securities industry, and provides investor education. SEC Overview: The U.S. Securities and Exchange Commission (the SEC) states that its mission "is to protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation." SEC Mission: The principal way that the SEC fulfills its mission is by creating and enforcing regulations that set the standards for the public disclosure of financial information by public companies. Its main areas of enforcement activity are:
• • •

Insider trading Accounting fraud False or misleading investment information

SEC Reach: The oversight exercised by the SEC extends to all categories of participants in the securities markets, primarily:
• • • •

Securities exchanges Securities brokers and dealers Investment advisors Mutual funds

Capital Budgeting Techniques:
The process in which a business determines whether projects such as building a new plant or investing in a long-term venture are worth pursuing. Oftentimes, a prospective project's lifetime cash inflows and outflows are assessed in order to determine whether the returns generated meet a sufficient target benchmark. Also known as "investment appraisal". Popular methods of capital budgeting include net present value (NPV), internal rate of return (IRR), discounted cash flow (DCF) and payback period. Understand the payback period (PBP) method of project evaluation and selection, including its: (a) calculation; (b) acceptance criterion; (c) advantages and disadvantages; and (d) focus on liquidity rather than profitability. • Understand the three major discounted cash flow (DCF) methods of project evaluation and selection – internal rate of return (IRR), net present value (NPV), and profitability index (PI). • Explain the calculation, acceptance criterion, and advantages (over the PBP method) for each of the three major DCF methods. • Define, construct, and interpret a graph called an “NPV profile.” • Understand why ranking project proposals on the basis of the IRR, NPV, and PI methods “may” lead to conflicts in rankings. • Describe the situations where ranking projects may be necessary and justify when to use either IRR, NPV, or PI rankings. • Understand how “sensitivity analysis” allows us to challenge the singlepoint input estimates used in traditional capital budgeting analysis. • Explain the role and process of project monitoring, including “progress reviews” and “post-completion audits.”

Net present value is the current value of future cash flows—calculated by dividing each future cash flow by the compounded interest rate, and then adding up all of the discounted cash flows. You can create a spreadsheet (for situations where cash flows or the interest rates used are different from year to year) or use a financial calculator (if the cash flow and interest rate is constant throughout the period). The formula is: NPV = CF0 + CF1/(1+r) + CF2/(1+r)2 + CF3/(1+r)3 ... Where CF 1 is the cash flow the investor receives in the first year, CF2 the cash flow the investor receives in the second year etc. and r is the discount rate.

Sign up to vote on this title
UsefulNot useful