Introduction To Financial Analysis - Instructor

Risk Management Prepared by: Muhammad Mobeen Ajmal
Lecturer
Introduction to Financial and Credit Risk

Group No:
Sr. Name Roll Number Effort Signature Marks
Marks Allotment
Sr Criteria Marks Marks
1 Timely Submission Date of Submission (Days) 15
Homework 1
Homework 2
Homework 3
Homework 4
Final
2 Complete Submission (No. of Incomplete Pages) 20
Homework 1
Homework 2
Homework 3
Homework 4
Final
3 Correct Submission (Final) (Random x pages) 10
4 Attachments (Write Serial Number behind each attachment) 20
Gold Pledge 5
Guarantee 5
Indemnity 5
Restrictive Clause 5
5 Originality(Final) (Random x pages) 10

6 Cases Correctness 25
Pakistan Steel Mills 10
Shark 5
Pidilite Industries 10
Attachments and Cases 45
Submission, correctness and completeness 55
Total Marks 100
Introduction Last Updated: 25-10-22 1 of 126

Lecturer
Notes:
1) If plagiarism is found then two submission will get zero marks. One of the person doing the
plagiarism and the other of the person facilitating plagiarism.
2) If a book is lost, you will not get marks for previous timely submissions.
3) Please attach the attachments in order so that I do not miss any of your attachment. Name the
attachment from the names given in the above list.
4) If four or more people have the same attachment, the attachments mark will be halved. I don’t
care how the attachment reached other people when you found it and only shared it with one of your
friends.
5) Select a different contract/document/financial for each attachment task. Thus, to get all six Balance
Sheet associated Marks, you should have Balance Sheet of three companies.
6) Select a different Balance Sheet for each attachment task. Thus, to get all six Balance Sheet associated
Marks, you should have Balance Sheet of three companies.
7) The homework will only be checked in the first fifteen minutes from the start of the class.
8) For those who submit the work late, you will not only loose the timely submission marks but also
get 70% of the correctness marks and 70% of completeness marks to be fair with those who solved
and submitted before I shared the solution. I will share the solution in each class.
9) For homework, an incomplete page is a page in which a question is unanswered. All the tasks with
missing information must be answered. If you don’t understand the question, ask and write clear "??"
on the question.
10) Even after the homework is checked, you should continue answering and completing the book
since I will recheck the book at the time of final submission.
11) For Final submission, an incomplete page is a page in which a question is unanswered. All the
tasks with missing information must be answered. Since you have ample time before the final
submission to visit my office, there will be no provision for not understanding the material in final
submission.

Lecturer
Financial Risk and Its Types
Financial Risk
Financial Risk is one of the major concerns of every business across fields and geographies.
The possibility of losing money in a business venture or investment is referred to as financial risk. In
other words, financial risk is a danger that can translate into the loss of capital. It relates to the odds
of money loss.
In case of a financial risk, there is a possibility that a company’s cash flow might prove insufficient to
satisfy its obligations.
Risk
Risk can be referred to like the chances of having an unexpected or negative outcome. Any action or
activity that leads to loss of any type can be termed as risk. There are different types of risks that a
firm might face and needs to overcome.
Risk implies the extent to which any chosen action or an inaction that may lead to a loss or some
unwanted outcome. The notion implies that a choice may have an influence on the outcome that exists
or has existed. However, in financial management, risk relates to any material loss attached to the
project that may affect the productivity, tenure, legal issues, etc. of the project.
Systematic Risk
Systematic risk is uncontrollable by an organization and macro in nature.
Systematic risk refers to the risk inherent to the entire market or market segment. Systematic risk,
also known as “undiversifiable risk,” “volatility” or “market risk,” affects the overall market, not
just a particular stock or industry.

Lecturer
Unsystematic Risk
Unsystematic risk is controllable by an organization and micro in nature.
Unsystematic risk refers to risks that are not shared with a wider market or industry. Unsystematic
risks are often specific to an individual company, due to their management, financial obligations, or
location. Unlike systematic risks, unsystematic risks can be reduced by diversifying one's
investments.
Ex Indicate whether the following are systematic risks or unsystematic risks
1 Covid 19 Systematic
2 The Food and Drug Administration (FDA) banning a specific drug that a Unsystematic
company sells
3 The 2008 financial crisis Systematic
4 A security breach could expose confidential information about customers or Unsystematic
other types of key proprietary data to criminals.
5 Entering into a flawed partnership with another firm Unsystematic
6 Terrorist activities Systematic
7 Airline industry employees went on strike Unsystematic
8 Global inflationary pressures Systematic
9 Management inefficiency and inability to set internal controls Unsystematic
10 Increase in the market interest rate by SBP Systematic

Lecturer
Systematic Risk and Its Types
Systematic risk is due to the influence of external factors on an organization. Such factors are normally
uncontrollable from an organization's point of view. It is a macro in nature as it affects a large number of
organizations operating under a similar stream or same domain. It cannot be planned by the organization.
Systematic risk is indicative of a larger factor that affects either the entire market or a sector of the
market. This type of risk includes natural disasters, weather events, inflation, changes in interest rates,
even socioeconomic issues like war or even terrorism.
The types of systematic risk are depicted and listed below.
Systematic Risk
Purchasing
Power/ Market risk Interest Rate Risk
Inflationary Risk
Purchasing Power/ Inflationary Risk

Purchasing power risk is also known as inflation risk. It is so, since it emanates (originates) from the
fact that it affects a purchasing power adversely. It is not desirable to invest in securities during an
inflationary period.
The risk that inflation reduces the value of an investment. Bonds are particularly susceptible to
purchasing power risk.
Inflation occurs when prices generally rise. Inflation occurs naturally, but unexpected rises in inflation
can be devastating to bonds as well as the economy.
Bonds are subject to the risks of inflation due to their fixed coupons. When an investor purchases a
bond, they receive a fixed amount of interest over the life of the bond. If prices of everything from milk
to cars to real estate rise, the fixed amount of interest now has less purchasing power (buys less).
An inflation premium is the part of prevailing interest rates that results from lenders compensating for
expected inflation by pushing nominal interest rates to higher levels.
Purchasing
Power Risk
Demand Cost Inflation

Inflation Risk Risk

Risk Management Inflation Risk Risk Prepared by: Muhammad Mobeen Ajmal
Lecturer
Demand Inflation Risk
Demand inflation risk arises due to increase in price, which result from an excess of demand over
supply. It occurs when supply fails to cope with the demand and hence cannot expand anymore. In
other words, demand inflation occurs when production factors are under maximum utilization.
There are five primary causes of demand-pull inflation:

1. A growing economy: When consumers feel confident, they spend more and take on more debt. This
leads to a steady increase in demand, which means higher prices.
2. Increasing export demand: A sudden rise in exports forces an undervaluation of the currencies
involved.
3. Government spending: When the government spends more freely, prices go up.
4. Inflation expectations: Companies may increase their prices in expectation of inflation in the near
future.
5. More money in the system: An expansion of the money supply with too few goods to buy makes
prices increase.
Example: Assume the economy is in a boom period, and the unemployment rate falls to a new
low. Interest rates are at a low point, too. The federal government, seeking to get more gas-guzzling cars
off the road, initiates a special tax credit for buyers of fuel-efficient cars. The big auto companies are
thrilled, although they didn't anticipate such a confluence of upbeat factors all at once. Demand for many
models of cars goes through the roof, but the manufacturers literally can't make them fast enough. The
prices of the most popular models rise, and bargains are rare. The result is an increase in the average
price of a new car.
Ex Indicate whether the increase of the following variables would lead to increased demand
inflation risk for the bonds.
Sr Change in Quantity Shift in Demand Curve Demand Inflation
Variable Demanded (Right or Left) Risk Increase
1 Wealth Increase Right Increase
2 Expected Relative
return Increase Right Increase
3 Relative Liquidity Increase Right Increase
4 Relative Risk Decrease Left No
5 Credit Availability Increase Right Increase

Lecturer
Cost Inflation Risk
Cost-push inflation occurs when overall prices increase (inflation) due to increases in the cost of
wages and raw materials. Cost-push inflation can occur when higher costs of production decrease
the aggregate supply (the amount of total production) in the economy.
Since the demand for goods hasn't changed, the price increases from production are passed onto
consumers creating cost-push inflation.
Unexpected causes of cost-push inflation are often natural disasters, which can include floods,
earthquakes, fires, or tornadoes. If a large disaster causes unexpected damage to a production facility and
results in a shutdown or partial disruption of the production chain, higher production costs are likely to
follow. A company might have no choice but to increase prices to help recoup some of the losses from a
disaster. Although not all natural disasters result in higher production costs and therefore, wouldn't lead
to cost-push inflation.
Other events might qualify if they lead to higher production costs, such as a sudden change in
government that affects the country’s ability to maintain its previous output. However, government-
induced increases in production costs are more often seen in developing nations.
Example: The Organization of the Petroleum Exporting Countries (OPEC) is a cartel that consists of 13
member countries that both produce and export oil. In the early 1970s, due to geopolitical events, OPEC
imposed an oil embargo on the United States and other countries. OPEC banned oil exports to targeted
countries and also imposed oil production cuts. What followed was a supply shock and a quadrupling of
the price of oil from approximately $3 to $12 per barrel.2 Cost-push inflation ensued since there was no
increase in demand for the commodity. The impact of the supply cut led to a surge in gas prices as well
as higher production costs for companies that used petroleum products.
Ex Indicate whether the increase of the following variables would lead to increased cost push
inflation risk for the bonds.
Sr Change in Quantity Shift in Supply Curve (Right Cost Push Inflation
Variable Supplied or Left) Risk Increase
1 World Oil Prices Decrease
No (since (Import
demand of No No
2 Depreciating Prices increase,
Exchange Rate quantity supplied Left Increase
3 Tax Increase Left Increase

Lecturer
Interest Rate Risk

Interest-rate risk arises due to variability in the interest rates from time to time. It particularly affects
debt securities as they carry the fixed rate of interest.
Interest rate risk is the potential for investment losses that can be triggered by a move upward in the
prevailing rates for new debt instruments. If interest rates rise, for instance, the value of a bond or
other fixed-income investment in the secondary market will decline. The change in a bond's price
given a change in interest rates is known as its duration.
Interest Rate
Risk
Reinvestment
Price Risk
Rate Risk
Price Risk
Price risk arises due to the possibility that the price of the shares, commodity, investment,
etc. may decline or fall in the future.
Real Asset Prices and Interest Rate
The prices of real asset depend on the interest rate. The higher the interest rate offered by bank, the
people would sell the real assets and then invest in the bank to earn the higher interest rate. Thus, as
more people sell, the price of the real asset would decrease.
As more people make deposits, the supply of credt would be more than the demand for credit, forcing
the interest rate to decrease. Once the interest rate decrease, real assets will once again become
attractive and their demand and prices would increase.

Lecturer
Financial Asset Prices and Interest Rate
Ex Consider a consol bond with face value of $100. The quoted annual rate of the bond is 10%.
What is the Price of the consol bond if the market interest rate is as given in the table:
A perpetual bond, also known as a "consol bond" or "perp," is a fixed income security with no
maturity date. The price of a consol bond with market interest rate or required rate of r% and coupon
payment of C is given by:
C
Price =
r
Market Interest Rate 8% 9% 10% 11%
Coupon C 10 10 10 10
Price 125.00 111.11 100.00 90.91
Ex Consider a 5 year zero coupon bond with face value of $100. What is the Price of the consol
bond if the market interest rate is as given in the table:
A zero-coupon bond, also known as an accrual bond, is a debt security that does not pay interest but
instead trades at a deep discount, rendering a profit. The price of a zero coupon bond with market
interest rate or required rate of r% of n years to maturity and face value FV is given by:
FV
Price =
(1 + r)𝑛
FV 100 100 100 100
Price 68.06 64.99 62.09 59.35
Ex Consider a 10 year zero coupon bond with face value of $1200. What is the Price of the
consol bond if the market interest rate is as given in the table:
FV 1200 1200 1200 1200
Price 810.68 670.07 555.83 462.65

Lecturer
Reinvestment Risk
It refers to the risk of change in the interest rate, which may lead to the non-availability of the
opportunity to reinvest in the current investment rate. Reinvestment rate risk results from fact that
the interest or dividend earned from an investment can't be reinvested with the same rate of
return as it was acquiring earlier. It is further divided into two parts –
1 Duration Risk – It refers to the risk arising from the probability of unwilling pre-payment or
extension of the investment beyond the predetermined time period.
2 Basis Risk – It refers to the risk of not experiencing the exact opposite behaviour to interest rate
changes in the securities with inverse features.
To compensate investors for taking on more risk, the expected rates of return on longer-term
securities are typically higher than rates on shorter-term securities. This is known as the maturity
risk premium.
Ex Three investors invest in the same 15 year bond but with different holding period intention:
a When Melvin holds the security till maturity, why is there no market price risk?
At maturity, the price of the bond is equal t the face value and independent of the interest rate.
b When Leonard holds the security for long period, why is there market price risk
insignificant?
As time approaches maturity, the price of the bond approaches the face value. Thus the price risk
reduces close to maturity.
c When Sally holds the security for short period, why is there a significant market price risk?
As time approaches maturity, the price of the bond approaches the face value. Thus the price risk
reduces close to maturity.

Lecturer
d When Melvin holds the security till maturity, why is there reinvestment risk?
Where will the coupon paayments be invested? Will they be invested at a rate similar to the 15 years bonds quoted rate or
lower? Will the issuer be able to call back the loan in which case will the reinvestment be at the same rate or lower?
b When Leonard holds the security for long period, why is there a significant reinvestment
risk?
Where will the coupon paayments be invested? Will they be invested at a rate similar to the 15 years bonds quoted rate or
lower? Will the issuer be able to call back the loan in which case will the reinvestment be at the same rate or lower?
c When Sally holds the security for short period, why is there an insignificant reinvestment
rate risk?
When the intention is short term holding the interest rate do not change much during this period so the
interest rate risk is low.
Ex Complete the table
Risk Description Reinvestment Risk Feature
or Price Risk
Risk over future The classic risk related to underlying interest Reinvestment Probability of breach
interest payments rates such as KIBOR. of convenant of debt
or receipts for faculty
investors
For example property, transport, utilities, Price Ability to raise prices
private equity and infrastucture etc. The cost over a time period
Risk of future of future capital may require price increases on
Capital Purchases traded goods
Risk over value of Applies to investors with bond portfolios. Price Probability of breach
fixed rate of convenant in deby
instrument facility
A refinancing risk applying to the next time a Reinvestment Average time until comaplete
refiances or time until next
Margin Risk margin is set for the borrower. refinance.
Leveraged transactions will have high levels of Price Probability of breach
Firms with high financial risk from high dents implying high of convenant in deby
financial risk interest rate risk. facility

Lecturer
Market Risk
Market risk is associated with consistent fluctuations seen in the trading price of any particular shares
or securities. That is, it arises due to rise or fall in the trading price of listed shares or securities in
the stock market. Market risk is the risk of losses in positions arising from movements in market
variables like prices and volatility.
The market risk premium (MRP) is the difference between the expected return on a market
portfolio and the risk-free rate.
There are several standard markets which can increase market risk including:
Equity Risk: the risk that share prices will change.
Commodity Risk: the likelihood that a commodity price, such as that of a metal or grain, will change.
Currency Risk: the probability that foreign exchange rates will change.
Interest Rate Risk: the risk that interest rates will go up or down.
Inflation Risk: the risk that overall rises in prices of goods and services will undermine the value of
money, and probably adversely impact the value of investments.
MarketRisk
Absolute Relative Volatility

Risk Risk Risk
Risk ManagementRisk Risk Risk
Prepared by: Muhammad Mobeen Ajmal
Lecturer
Absolute Risk
The risk of something is the odds of it taking place. The absolute risk of something happening is the
odds of that happening over a stated time period.
For e.g., if a coin is tossed, there is fifty percentage chance of getting a head and vice-versa.
Example: About 90% of startups fail. 10% of startups fail within the first year. Across all industries,
startup failure rates seem to be close to the same. Failure is most common for startups during years two
through five, with 70% falling into this category.
Relative Risk
The relative risk (also called the risk ratio ) of something happening is where you compare the odds
for two groups against each other. Relative risk is the assessment or evaluation of risk at different
levels of business functions.
For e.g. a relative-risk from a foreign exchange fluctuation may be higher if the maximum sales
accounted by an organization are of export sales.
Example: Compared to family firms, the non family firms have 30% more chances of default under a
crisis.
Ex Indicate whethere the following are types of Relative Risk or Absolute Risk?
1 People who do not smoke have 0.5% chance of getting a cancer Absolute
2 Smokers are 20 times more likely to get cancer compared to non smokers. Relative
3 The firms which give collateral are 85% less likely to default compared to Relative
firms which do not give collateral.
4 35% of the companies which aply for bank loan manipulate their financial Absolute
statements.
Ex A company with a high debt load has a 40% chance of going bankrupt in the next five years.
The average for comparable companies of the same size is a risk of 0.5% over the five years.
a What is the absolute risk of default of a high debt company?

A company with a high debt load has a 40% chance of going bankrupt in the next five years.
b What is the relative risk of default of a high debt company compared to low debt companies?
Probability of default of high debt company 40%

Probability of default of low debt company 0.50%
Relative Risk 80.00
High debt companies are 80 times more likely to default compared to their peers.
Ex A company which imports raw material for production has 75% chance of costs significantly
increasing when the local currency depreciates. The average for comparable companies of
the same size is a risk of 35%.
a What is the relative risk of cost increasing for an importer compared to a non importer.
Relative Risk 2.14
Importer companies are 2.14 times more likely to increase costs compared to their peers.

Lecturer
Volatilty Risk
Volatility risk is of a change in the price of securities as a result of changes in the volatility of a risk-
factor. For e.g. it applies to the portfolios of derivative instruments, where the volatility of its underlying
is a major influence of prices.
John is an investor. His portfolio primarily tracks the performance of the S&P 500 and John wants to
add the stock of ABC Corp. Before adding the stock to his portfolio, he wants to assess the directional
relationship between the stock and the S&P 500.
John does not want to increase the unsystematic risk of his portfolio. Thus, he is not interested in owning
securities in the portfolio that tend to move in the same direction.
John can calculate the variance between the stock of ABC Corp. and S&P 500 by following the steps
below:
First, John obtains the figures for both ABC Corp. stock and the S&P 500.
The data is summarized below:
S&P ABC
x y
𝑥 − 𝑥ҧ 𝑥 − 𝑥ҧ 2 𝑦 − 𝑦ത 𝑦 − 𝑦ҧ 2
Year
2013 1692 68 1692 2862864 68 4624

2014 1978 102 1978 3912484 102 10404
2015 1884 110 1884 3549456 110 12100
2016 2151 112 2151 4626801 112 12544
2017 2519 154 2519 6345361 154 23716
෍ ⬚Total 10,224 546 10224 21296966 546 63388
Find the average

n = 5
2044.80
σ𝑥 10,224.00
𝑥ҧ = =
𝑛𝑥 5
109.20
σ𝑦
𝑦ത == 546
=
𝑛𝑦
5
Find the sample variance
𝑠𝑥2 = ######### = 5,324,241.50

4

Lecturer
𝑠𝑦2 =
63388.00
= 15847
4
Find the standard deviation
𝑠𝑥 = 𝑠𝑥2 .
5324241.5 = 2307.43
𝑠𝑦 = 𝑠𝑦2
.
15847 = 125.88
a Which stock has more deviation in prices?
b Which stock has more volatility risk?
Ex The graphs of returns of stock and bonds is shown.
a Which of Stock or Bond has more volatility risk?

Stocks.

Lecturer
Ex The graphs of returns of Jakarta Stock Index (JSE) is shown.
a Is the volaitility risk constant over time?

No
b Circle the periods in which the volatility risk is high.
c In which period is the volatility risk maximum?
10150No
Ex The graphs of returns of Jakarta Stock Index (JSE) is shown.
a Is the volaitility risk constant over time?

No
b Circle the periods in which the volatility risk is low.
c Box the periods in which the volatility risk is high.

Lecturer
Unsystematic Risk and Its Types

Unsystematic risk is due to the influence of internal factors prevailing within an organization.
Such factors are normally controllable from an organization's point of view.
It is a micro in nature as it affects only a particular organization. It can be planned, so that
necessary actions can be taken by the organization to mitigate (reduce the effect of) the risk.
Unsystematic risk is also known as idiosyncratic risk, diversifiable risk, and controllable risks.
The types of unsystematic risk are depicted and listed below.
Unsystematic
Risk
Business Risk Operational

Credit Risk
Risk
Business risk
Business risk is also known as liquidity risk. It is so, since it emanates (originates) from the sale and
purchase of securities affected by business cycles, technological changes, etc.
The meaning of asset and funding liquidity risk is as follows:
1. Asset liquidity risk is due to losses arising from an inability to sell or pledge assets at, or near, their
carrying value when needed. For e.g. assets sold at a lesser value than their book value.
2. Funding liquidity risk exists for not having an access to the sufficient-funds to make a payment on
time. For e.g. when commitments made to customers are not fulfilled as discussed in the SLA (service
level agreements).
Credit risk
Financial risk is also known as credit risk. It arises due to change in the capital structure of the
organization. The capital structure mainly comprises of three ways by which funds are sourced for the
projects.
These are as follows:
1. Owned funds. For e.g. share capital.
2. Borrowed funds. For e.g. loan funds.
3. Retained earnings. For e.g. reserve and surplus.
The meaning of types of financial or credit risk is as follows:

1. Exchange rate risk is also called as exposure rate risk.
2. Recovery rate risk
3. Sovereign risk is associated with the government.
4. Settlement risk

Lecturer
Operational risk
Operational risks are the business process risks failing due to human errors. This risk will change from
industry to industry. It occurs due to breakdowns in the internal procedures, people, policies and systems
. The types of operational risk are depicted and listed below.

The meaning of types of operational risk is as follows:
1. Model risk
2. People risk
3. Legal risk
4. Political risk
The operational Risks of Banks

defined by BASEL II

Lecturer
Some Preliminary Definitions

Financial Statements
Financial statements are written records that convey the business activities and the financial performance
of a company.
Financial statements are often audited by government agencies, accountants, firms, etc. to ensure
accuracy and for tax, financing, or investing purposes.
The Financial Statements are:

1. Statement of financial position (balance sheet).
2. Statement of profit or loss and other comprehensive income (Income Statement or Statement of
Comprehensive Income)
3. Statement of changes in equity for the period (Statement of retained earnings).
4. Statement of cash flows for the period.
5. Notes, comprising a summary of significant accounting policies and other explanatory notes.
1. Statement of Financial Position (Balance Sheet)

Primary Equation
Assets =Liabilities+Equity

Lecturer
The Balance Sheet of Lucky Cement is shown:

Lecturer
2. Statement of profit or loss and other comprehensive income (Income Statement
or Statement of Comprehensive Income)
Primary Equation
Revenue-Expenses=Profits
The Income Statement of Lucky Cement is Shown

Lecturer
3. Statement of changes in equity for the period (Statement of retained earnings).

Primary Equation
Changes in Equity=Additional Contributed Capital+Revenue-Expenses-Withdrawals
The Statement of Changes in Equity of Lucky Cement is Shown

Lecturer
Primary Equation
Change in Cash=Cash from Operation+Cash from Investing+ Cash from Financing
The Statement of Cashflows(Direct) of Lucky Cement is Shown

Lecturer
The Statement of Cashflows(Indirect) of Lucky Cement is Shown

Lecturer
3e. Notes
The first page of notes of Lucky Cement is Shown

Lecturer
Exercise: Indicate in which financial statements each item would most likely appear; Income
Statement, Balance Sheet, Statement of Changes in Equity or Cashflow Statement.
1 Assets Balance Sheet
2 Cash from investing activities Cashflow
3 Total Liability and Equity Balance Sheet
4 Revenue Income Statement
5 Expenses Income Statement
6 Withdrawals Changes in Equity
7 Cash from operating activities Cashflow
8 Net decrease or increase in cash Cashflow
9 Net Income Income Statement
Exercise: Indicate in which financial statements each item would most likely appear; Income
Statement, Balance Sheet, Statement of Changes in Equity or Cashflow Statement.
1 Factory Balance Sheet
2 Cash received from sale of land Cashflow
3 Loan taken from bank Balance Sheet
4 Sale of Apples Income Statement
5 Manufacturing expenses Income Statement
6 Cash dividends given by shareholders Cashflow
7 Cash received from sale of apples Cashflow
8 Cash received from the bank loan Cashflow
9 Distribution Expenses Income Statement
Exercise: What is the value of the following for lucky cement in 2021?
1 Total assets $ 156,368,062,000
2 Total Equity $ 113,200,258,000
3 Total Liabilities $ 43,167,804,000
4 Total Equity and liabilities $ 156,368,062,000
5 Net Income $ 14,070,189,000
6 Net Sales $ 62,940,805,000
7 Dividends $ -
8 Cash flow from operating activities $ 12,492,631,000
9 Cash flow from financing activities $ 4,022,095,000
Exercise: Listed below are some items found in the financial statements of Tony Gruber Co.
Indicate in which financial statement(s) the following items would appear.
1 Service revenue. Income Statement
2 Equipment Balance Sheet
3 Advertising Expense Income Statement
4 Accounts Receivable Balance Sheet
5 Owner's Capital Balance Sheet
6 Salaries and Wages Payable Balance Sheet

Lecturer
Value of Equity of the Firm

Book Value
Book value is the net value of a firm's assets found on its balance sheet, and it is roughly equal to the
total amount all shareholders would get if they liquidated the company.
Book value is the accounting value of the company's assets less all claims senior to common equity
(such as the company's liabilities). The term book value derives from the accounting practice of
recording asset value at the original historical cost in the books.
While the book value of an asset may stay the same over time by accounting measurements, the market
value of a company collectively can grow from the accumulation of earnings generated through asset
use. Since a company's book value represents the shareholding worth, comparing book value with
the market value of the shares can serve as an effective valuation technique when trying to decide
whether shares are fairly priced.
As the accounting value of a firm, book value has two main uses:
1. It serves as the total value of the company's assets that shareholders would theoretically receive if a
company was liquidated.
2. When compared to the company's market value, book value can indicate whether a stock is under- or
overpriced.
Ex Use the Lucky Cements Financial Statements to find the ratio for 2020 and 2021?
2021 2020
Book Value of Assets
Book Value of Liabilities
Book Value of Equity
Book Value of PPE
Limitations of Book Value

Timing issue: One of the major issues with book value is that companies report the figure quarterly
or annually. It is only after the reporting that an investor would know how it has changed over the
months.
Adjustments and their impact: Book valuation is an accounting concept, so it is subject to

adjustments. Some of these adjustments, such as depreciation, may not be easy to understand and
assess. If the company has been depreciating its assets, investors might need several years of financial
statements to understand its impact. Additionally, depreciation-linked rules and accounting practices can
create other issues. For instance, a company may have to report an overly high value for some of its
equipment. That could happen if it always uses straight-line depreciation as a matter of policy.
Claims: Book value does not always include the full impact of claims on assets and the costs of
selling them. Book valuation might be too high if the company is a bankruptcy candidate and
has liens against its assets. What is more, assets will not fetch their full values if creditors sell them in a
depressed market at fire-sale prices.
Value of intangibles: The increased importance of intangibles and difficulty assigning values for them
raises questions about book value. As technology advances, factors like intellectual property play larger
parts in determining profitability. Ultimately, accountants must come up with a way of consistently
valuing intangibles to keep book value up to date.

Lecturer
Market Value
Market value is the company's worth based on the total value of its outstanding shares in the market,
which is its market capitalization.
Market value tends to be greater than a company's book value since market value captures
profitability, intangibles, and future growth prospects.
Market value—also known as market cap—is calculated by multiplying a company's outstanding shares
by its current market price.
Market Cap = Number of Shares Outstanding X Market Price per Share
As the market price of shares changes throughout the day, the market cap of a company changes
so as well. On the other hand, the number of shares outstanding almost always remains the same. That
number is constant unless a company pursues specific corporate actions. Therefore, market value
changes nearly always occur because of per-share price changes.
Ex Use the Lucky Cements Financial Statements to find the ratio for 2020 and 2021? The
company's share were trading for Rs. 511.69 in 2021 and Rs 498.32 in 2020. The share
information is given below:
2021 2020
Number of Shares Outstanding
Share Price
Market Capitalization
Market Value of Equity
Limitations of Market Value

Perception vs Reality: While market cap represents the market perception of a company's valuation,
it may not necessarily represent the real picture. It is common to see even large-cap stocks moving 3
to 5 percent up or down during a day's session. Stocks often become overbought or oversold on a short-
term basis, according to technical analysis.
Herd Behaviour of Investors: Long-term investors also need to be wary of the occasional manias and
panics that impact market values. Market values shot high above book valuations and common sense
during the 1920s and the dotcom bubble. Market values for many companies actually fell below their
book valuations following the stock market crash of 1929 and during the inflation of the 1970s.
Relying solely on market value may not be the best method to assess a stock’s potential.

Lecturer
Book Value Greater Than Market Value
It is unusual for a company to trade at a market value that is lower than its book valuation. When that
happens, it usually indicates that the market has momentarily lost confidence in the company. It
may be due to business problems, loss of critical lawsuits, or other random events. In other words,
the market doesn't believe that the company is worth the value on its books. Mismanagement or
economic conditions might put the firm's future profits and cash flows in question.
Value investors actively seek out companies with their market values below their book valuations.
They see it as a sign of undervaluation and hope market perceptions turn out to be incorrect. In this
scenario, the market is giving investors an opportunity to buy a company for less than its stated net
worth. However, there is no guarantee that the price will rise in the future.
Market Value Greater Than Book Value

The market value of a company will usually exceed its book valuation. The stock market assigns a
higher value to most companies because they have more earnings power than their assets. It
indicates that investors believe the company has excellent future prospects for growth, expansion,
and increased profits. They may also think the company's value is higher than what the current book
valuation calculation shows.
Profitable companies typically have market values greater than book values. Most of the companies in
the top indexes meet this standard. Growth investors may find such companies promising. However, it
may also indicate overvalued or overbought stocks trading at high prices.
Book Value Equals Market Value

Sometimes, book valuation and market value are nearly equal to each other. In those cases, the
market sees no reason to value a company differently from its assets.
Remember:
Compare Market Price per share with book value per share.
Compare Market Cap with the total book value of equity.
Ex Use the Lucky Cements Financial Statements and other information to find the ratio for
2020 and 2021?
2021 2020
Number of Shares Outstanding
Book Value per share
Market Value per Share
a Compare the Book Value of Equity with Market Cap.

Lecturer
Market to Book (P/B)
The price-to-book (P/B) ratio is a way to compare market value and book value. It is equal to the price
per share divided by the book value per share.
Price to Book ratio can show daily change: For example, a company has a P/B of one when the book
valuation and market valuation are equal. The next day, the market price drops, so the P/B ratio becomes
less than one. That means the market valuation is less than the book valuation, so the market might
undervalue the stock. The following day, the market price zooms higher and creates a P/B ratio greater
than one. That tells us the market valuation now exceeds book valuation, indicating potential
overvaluation. However, the P/B ratio is only one of several ways investors use book value.
If a P/B ratio is less than one, the shares are selling for less than the value of the company's assets.
This means that, in the worst-case scenario of bankruptcy, the company's assets will be sold off and the
investor will still make a profit.
Failing bankruptcy, other investors would ideally see that the book value was worth more than the
stock and also buy in, pushing the price up to match the book value. That said, this approach has
many flaws that can trap a careless investor.

Lecturer
The Traps of B/V
A price-to-book ratio under 1.0 typically indicates an undervalued stock, although some value
investors may set different thresholds such as less than 3.0.
If it's obvious that a company is trading for less than its book value, you have to ask yourself why
other investors haven't noticed and pushed the price back to book value or even higher. The P/B
ratio is an easy calculation, and it's published in the stock summaries on any major stock research
website.
The answer could be that the market is unfairly battering the company, but it's equally probable
that the stated book value does not represent the real value of the assets. Companies account for
their assets in different ways in different industries, and sometimes even within the same industry. This
muddles book value, creating as many value traps as value opportunities.
Companies Suited to Book Value Plays

Critics of book value are quick to point out that finding genuine book value plays has become
difficult in the heavily-analysed U.S. stock market. Oddly enough, this has been a constant refrain
heard since the 1950s, yet value investors continue to find book value plays.
The companies that have hidden values share some characteristics:
They are old. Old companies have usually had enough time for assets like real estate to appreciate
substantially.
They are big. Big companies with international operations, and thus with international assets, can
create book value through growth in overseas land prices or other foreign assets.
They are ugly. The third class of book value buys is the ugly companies that do something dirty or
boring. The value of wood, gravel, and oil go up with inflation, but many investors overlook
these asset plays because the companies don't have the dazzle and flash of growth stocks.
Cashing in on Book Value
Even if you've found a company that has true hidden value without any claims on it, you have to
wait for the market to come to the same conclusion before you can sell for a profit. Corporate
raiders or activist shareholders with large holdings can speed up the process, but an investor can't always
depend on inside help. For this reason, buying purely on book value can actually result in a loss,
even when you're right!
If a company is selling 15% below book value, but it takes several years for the price to catch up, then
you might have been better off with a 5% bond. The lower-risk bond would have similar results over the
same period.
Ex Use the Lucky Cements Financial Statements and other information to find the ratio for
2020 and 2021?
2021 2020
Price to Book
a Compare the Book Value of Equity with Market Cap.

Lecturer
Current vs Non Current Assets

Current Assets
Current assets are all the assets of a company that are expected to be sold or used as a result of
standard business operations over the next year. Current assets include cash, cash equivalents,
accounts receivable, stock inventory, marketable securities, pre-paid liabilities, and other liquid assets
Ex Nishat Mills Current assets can be seen from the Financials.
a What is the value of current assets of Nishat Mills in 2021?

40676368000
b Why is cash a current asset? If a company wants, it can keep the cash for ages.
The current assets are expected to be used in a year, it is not necessary that they will be used within a year. They are expected to give
benefit in the next one year but if the company wants, they can hold the asset and take the benefit after one year.
b What are trade debts? What is the value of trade debts?

The trade debts are accounts receivable, which is money owed by the customers for credit purchases and
their value is 4326780,000Rs

Lecturer
Ex Lucky Cements Current assets can be seen from the Financials.
Non Current Assets

Noncurrent assets are a company's long-term investments for which the full value will not be
realized within the accounting year. They are typically highly illiquid, meaning these assets cannot
easily be converted into cash.
Exa Lucky Cements Non Current assets can be seen from the Financials.
mple
Question
Rank the following assets from Most Liquid(1) to Least Liquid(9).
Asset Rank Asset Rank Asset Rank
Cash and Bank Balance 1 Accrued Return 3 Property 9
Short term investments 2 Trade Debts 4 Cars 8
Long Term Investments 7 Stores and Spares 6 Stock in trade 5
Ex Why are deposits assets? Differentiate between long term deposits and short term deposits?
Explain why one is current asset and another is non current asset?
When you place you money with another organization as security, it is an asset as you can get benefits from this money and later
you will be returned this money. Long term deposits will be returned after at least one year while short term deposits will be
returned within a year. Since the short term deposits are returned within a year, they are a current asset.
Ex Is your security deposit with the university a non current deposit or a current deposit?
If the deposit is to be returned after a few years, then it is non current. It will give benefit and security for
many years.

Lecturer
Ex In the year of your graduation, would the security deposit with the university be a non
current deposit or a current deposit?
Since the deposit will be returned within a year, it will be current deposit.
Exa Nishat Mills Non Current assets can be seen from the Financials.
mple
List current and non current assets which are common in both Lucky Cement and Nishat Mills.
Current Assets Non current Assets

Cash and Bank Balance Property Plant Equipment
Other receivables Long term investments
Stock in trade Long term loans
Stores and Spares Long term deposits
Trade Debts
Short term deposits and prepayments
a Why are intangible assets non current asset?
Most intangible assets are used for more than 1 year.
b Why are treasury bonds (T. Bonds) a non current assets for the company which have bought
them but Treasury Bills (T. Bills) a current asset?
T. Bills have short maturity of less than 1 years while a T. Bond is a long term government loan so it will
continue to give benefit to the company for many years.
c Are the funds held with bank current or non current?

Funds held in bank accounts may or may not be current assets depending on for how long the account is held. A current asset is any asset that is
expected to provide an economic benefit for or within one year. Funds held in bank accounts for less than one year may be considered current
assets. On the other hand some saving accounts are non current as you cannot use the money for a few years
d In which financial statement would the Current and Non current assets be found; use the
name approve by IASB.
Balance sheet or Statement of Financial Position

Lecturer
e Which assets are more illiquid; the current assets or the non current assets? Why?
The non current assets are more illiquid since they cannot be converted into cash quickly also the company
gets their benefit for a longer period of time before their value is returned to the company.
f What is cash crunch?

A "cash crunch" occurs when a company is running low enough on cash so that it starts to have an impact
on their operations. A "cash crunch" doesn't necessarily mean that a company is going bankrupt - instead,
it can simply mean that they need to convert some of their non-liquid assets into cash.
g What happens when non current assets of a company increase drastically compared to the
current assets?
A noncurrent asset is an asset that is not expected to be consumed within one year. If a company has a high
proportion of noncurrent to current assets, this can be an indicator of poor liquidity, since a large amount
of cash may be needed to support ongoing investments in noncash assets. This mean there is a possibility
that the company can have a cash crunch.
h What happens when current assets of a company increase drastically compared to the non
current assets?
Current assets earn lower return compared to non current assets. For example, Cash has no return. When
a company has many current assets then it is inefficiently holding low return current assets compared to
higher return non current assets.

Lecturer
Liquidity
Liquidity refers to the efficiency or ease with which an asset or security can be converted into ready
cash without affecting its market price. The most liquid asset of all is cash itself.
In other words, liquidity describes the degree to which an asset can be quickly bought or sold in the
market at a price reflecting its intrinsic value.
Cash is universally considered the most liquid asset because it can most quickly and easily be converted
into other assets.
Tangible assets, such as real estate, fine art, and collectibles, are all relatively illiquid.
Other financial assets, ranging from equities to partnership units, fall at various places on the liquidity
spectrum.
Example
For example, if a person wants a $1,000 refrigerator, cash is the asset that can most easily be used
to obtain it. If that person has no cash but a rare book collection that has been appraised at
$1,000, they are unlikely to find someone willing to trade them the refrigerator for their collection.
Instead, they will have to sell the collection and use the cash to purchase the refrigerator. That may be
fine if the person can wait for months or years to make the purchase, but it could present a problem if the
person only had a few days. They may have to sell the books at a discount, instead of waiting for a buyer
who was willing to pay the full value. Rare books are an example of an illiquid asset.
In the example above, the rare book collector's assets are relatively illiquid and would probably not be
worth their full value of $1,000 in a pinch.
The two main types of liquidity include market liquidity and accounting liquidity.
Ex What is a market? When do you think something is liquid in market?

Lecturer
Market Liquidity
Market liquidity refers to the extent to which a market, such as a country's stock market or a city's real
estate market, allows assets to be bought and sold at stable, transparent prices.
In the example above, the market for refrigerators in exchange for rare books is so illiquid that, for all
intents and purposes, it does not exist.
The determinants of Market Liquidity
The stock market, on the other hand, is characterized by higher market liquidity. If an exchange has
a high volume of trade that is not dominated by selling, the price a buyer offers per share (the bid price)
and the price the seller is willing to accept (the ask price) will be fairly close to each other.
Investors, then, will not have to give up unrealized gains for a quick sale.
When the spread between the bid and ask prices tightens, the market is more liquid, when it grows
the market instead becomes more illiquid.
Markets for real estate are usually far less liquid than stock markets.
The liquidity of markets for other assets, such as derivatives, contracts, currencies, or commodities, often
depends on their size, and how many open exchanges exist for them to be traded on.
Market liquidity depends, among other things, on the overall risk appetite of investors and on the
funding constraints faced by financial intermediaries.
The risk appetite of market makers—a bank or financial intermediary that stands ready to buy or sell
financial assets—affects their inclination to trade. .
Changes in bank business models may also affect their willingness and ability to make markets

Lecturer
1. Depth
Market depth is a measure of the volume of securities being traded, as well as the effect that orders have
on market price:
If a market is “deep”, there are many shares being traded. A large order would not have a significant
effect on the market price.
If a market is “shallow” there are fewer shares being traded. A large order would have a significant
effect on the market price.
Volume of trade
Volume of trade is the total quantity of shares or contracts traded for a specified security. It can be
measured on any type of security traded during a trading day.
Ex Suppose the stocks are Apple, AT&T, and Verizon. Let us assume the first trader buys
1,000 shares of Apple and sells 500 shares of AT&T. The other trader sells 1,000 shares of
Apple and sells 500 shares of Verizon to the first trader. What is the total trading volume for
the day?
Total shares of AT&T traded 500
Total shares of Verizon Traded 500
Total shares of Apple Traded 1000
Total share volume 2000
Ex Look at the graph and answer the following questions:

Period of high trading volume 500
Month in which the market was deepest 500
Periods of low trading volume 1000
Month in which the market was shallowest 2000

Lecturer
Average daily trading volume (ADTV) is the average number of shares traded within a day in a given
stock. Daily volume is how many shares are traded each day, but this can be averaged over a number
of days to find the average daily volume.
When average daily trading volume (ADTV) increases or decreases dramatically, it signals that there
has been a substantial shift in how people value or view the asset.
Usually, higher average daily trading volume means that the security is more competitive, has
narrower spreads and is typically less volatile.
The higher the trading volume is for a security, the more buyers and sellers there are in the market
which makes it is easier and faster to execute a trade.
Without a reasonable level of market liquidity, transaction costs are likely to become higher (due to
larger spreads).
Ex Indicate whether the following are True or False
1 Company A's share are traded more often in the last five days
compared to the shares of Company B. This implies that the
False (A has higher ADTV)
Average Daily Trade volume of company A's share is less than the
ADTV of Company's B's Shares.
2 Company A's share are traded more often in the last five days
compared to the shares of Company B. This implies that A's shares True (A has more liquidity)
are more liquid than B's share.
3 More liquidity implies that the transaction cost to trade the shares
False( Lower)
will be higher.

Lecturer
2. Width
Market width refers to the bid-ask spread. This is the difference between the offer price and the asking
price of an asset:
If the gap is “wide”, there is a big difference between the price that sellers are asking and the price
buyers are willing to pay. It is more difficult to complete these types of transactions.
If the gap is “narrow”, there is a small difference between the price sellers are asking and the price
buyers are willing to pay. It is easier to complete these types of transactions.
Spread
The spread refers to the difference between two prices, rates, or yields. In one of the most common
definitions, the spread is the gap between the bid and the ask prices of a security or asset, like a
stock, bond, or commodity. This is known as a bid-ask spread. The spread is one measure of market
width.
Bid Price: the price at which a market-maker or dealer is prepared to buy securities or other assets.
Ask Price: the lowest price at which a seller will sell the stock.
The bid price will almost always be lower than the ask or “offer,” price.
Certain markets are more liquid than others and that should be reflected in their lower spreads.
Ex
The GBP to USD bid price is 1.3089 while the ask price is 1.3091. What is the spread?
Bid Price 1.3089
Ask Price 1.3091
Spread 0.0002
Ex A stock is trading at $9.95 / $10. What is the spread?
Bid Price 9.95
Ask Price 10
Spread 0.05
Ex You visit your favourite crypto exchange and see that the lowest asking price is $55,000, and
the highest bidding price is $53,000. What is the spread?
Bid Price 53000
Ask Price 55000
Spread 2000
Ex Bank ABC charges customers 4% interest for car loans and pays out interest to depositors
for holding their money at a rate of 1.75%. What is the interest- spread?
Bid Price 1.75%
Ask Price 4%
Spread 2.2500%
Ex The yield on a high-yield bond index was 8.5%, while the yield on the 10-year U.S. Treasury
was 2%. What is the yield spread?
Treasury Yield 2.00%
Index Yield 9%
Spread 6.5000%

Lecturer

Lecturer
3. Resilience
Market resilience refers to the speed at which prices return to previous levels following a large
transaction.
Regardless of the activities of market makers, other factors such as search costs in the marketplace and
investor characteristics also affect market liquidity.
A positive development has been the emergence of electronic trading platforms, which has probably
made it easier and cheaper for buyers, and sellers of financial instruments to interact.
Likewise, more trade transparency in bond markets has improved liquidity. Large scale asset purchases
by central banks, despite a generally positive effect on market liquidity, have reduced the
availability of certain securities.

1 Understanding market liquidity resilience, i.e. the capacity of
liquidity to absorb shocks, of United States Treasuries is crucial TRUE
from a financial stability standpoint.
2 Impaired market liquidity makes securities trading more difficult by
TRUE
increasing funding costs.
3 The concept of liquidity resilience is linked to the inability of False(Its linked to the ability to
market liquidity to withstand shocks. withstand shock)
4
In a non-resilient market, a state of high liquidity can suddenly
TRUE
transform into one of low liquidity in response to a shock
5 Although low liquidity is a leading indicator of low liquidity

resilience during periods of financial stress, in normal times, higher
TRUE
liquidity levels can support the illusion of resilient liquidity and
induce excessive risk taking.
6 The conventional liquidity resilience measure is the speed of
TRUE
recovery of the liquidity level after one shock
7 If prices quickly bounce back following a large order, a market is
TRUE
seen to be resilient and functioning well.
8 Episodes of sudden, unforeseen loss of liquidity – for example, in
the equity and Treasury markets – suggests that structural changes
TRUE
(such as the spread of high-frequency algorithmic trading) are now a
source of fragility.
9 Financial markets have been affected by a number of structural
changes over the past few years. Innovation has generated a broad
trend towards fast, electronic trading. And necessary regulation
implemented in response to the global financial crisis has
TRUE
discouraged them from market making as principal. These
developments, alongside occasional bursts of volatility associated
with short-term illiquidity, have led to concerns that market
liquidity may have become more fragile.

Lecturer
Accounting Liquidity
Accounting liquidity measures the ease with which an individual or company can meet their
financial obligations with the liquid assets available to them—the ability to pay off debts as they
come due.
In investment terms, assessing accounting liquidity means comparing liquid assets to current
liabilities, or financial obligations that come due within one year.
There are a number of ratios that measure accounting liquidity, which differ in how strictly they
define "liquid assets." Analysts and investors use these to identify companies with strong liquidity. It is
also considered a measure of depth.

Lecturer
Measuring Accounting Liquidity
Financial analysts look at a firm's ability to use liquid assets to cover its short-term obligations.
Generally, when using these formulas, a ratio greater than one is desirable.
Ratios as a measure of liquidity

For different industries and differing legal systems the use of differing ratios and results would be
appropriate. For instance, in a country with a legal system that gives a slow or uncertain result a
higher level of liquidity would be appropriate to cover the uncertainty related to the valuation of assets.
A manufacturer with stable cash flows may find a lower quick ratio more appropriate than an Internet-
based start-up corporation.
How to improve liquidity of a company?
Liquidity of a bank
Liquidity is a prime concern in a banking environment and a shortage of liquidity has often been a
trigger for bank failures.
Holding assets in a highly liquid form tends to reduce the income from that asset (cash, for example, is
the most liquid asset of all but pays no interest) so banks will try to reduce liquid assets as far as
possible. However, a bank without sufficient liquidity to meet the demands of their depositors risks
experiencing a bank run. The result is that most banks now try to forecast their liquidity requirements
and maintain emergency standby credit lines at other banks. Banking regulators also view liquidity as a
major concern.

Lecturer
Current Ratio
The current ratio is the simplest and least strict. It measures current assets (those that can reasonably be
converted to cash in one year) against current liabilities. Its formula would be:
A good current ratio is between 1.2 to 2, which means that the business has 2 times more current assets
than liabilities to covers its debts.
A current ratio below 1 means that the company doesn't have enough liquid assets to cover its short-term
liabilities.
2021 2020
Current Assets
Current Liabilities
Current Ratio
a Interpret the ratio for 2021?
b Interpret the ratio for 2020?
c Has the ratio improved over time? What does it indicate?
d If the current ratio of Lucky Cement is less than the industry average, what would it indicate
about the companies
e What if the ratio is extremely high compared to the industry average?
Ex Indicate whether the following would increase the current ratio of the company or not?
Bonds Increas Vehicles No
Land No Long term loans issued No
Real Estate No Long term investments No
Treasury Bills Increas Frequently Traded Stocks Increase
Art No Infrequently traded stocks No
Modarbahs Increas Mutual Funds Increase

Lecturer
Quick Ratio (Acid-test ratio)
The quick ratio, or acid-test ratio, is slightly more strict. It excludes inventories and other current
assets, which are not as liquid as cash and cash equivalents, accounts receivable, and short-term
investments. The formula is:
A variation of the quick/acid-test ratio simply subtracts inventory from current assets, making it a bit
more generous:
Generally, quick ratios between 1.2 and 2 are considered healthy.

If it's less than one, the company can't pay its obligations with liquid assets. If it suffers an interruption,
it may find it difficult to raise the cash to pay its creditors.
If it's more than two, the company isn't investing enough in revenue-generating activities.
2021 2020
Cash and bank balance
Short term investments
Accounts Receivable (Trade Debt)
Current Liabilities
Quick Ratio
d If the ratio of Lucky Cement is much more than the industry average, what would it indicate
about the companies

Lecturer
Cash Ratio
The cash ratio is the most exacting of the liquidity ratios. Excluding accounts receivable, as well as
inventories and other current assets, it defines liquid assets strictly as cash or cash equivalents.
More than the current ratio or acid-test ratio, the cash ratio assesses an entity's ability to stay solvent
in the case of an emergency—the worst-case scenario—on the grounds that even highly profitable
companies can run into trouble if they do not have the liquidity to react to unforeseen events.
Creditors prefer a high cash ratio, as it indicates that a company can easily pay off its debt. Although
there is no ideal figure, a ratio of not lower than 0.5 to 1 is usually preferred.
2021 2020
Cash and bank balance
Current Liabilities
Cash Ratio
d If the ratio of Lucky cement is much less than the industry average, what would it indicate
about the companies
e
How would you increase the cash ratio of a company?

Lecturer
Operating Cashflow Ratio
The operating cash flow ratio can be calculated by dividing the operating cash flow by current
liabilities. This indicates the ability to service current debt from current income, rather than
through asset sales.
The operating cash flow ratio is a measure of the number of times a company can pay off current
debts with cash generated within the same period. A high number, greater than one, indicates that
a company has generated more cash in a period than what is needed to pay off its current
liabilities.
An operating cash flow ratio of less than one indicates the opposite—the firm has not generated
enough cash to cover its current liabilities. To investors and analysts, a low ratio could mean that
the firm needs more capital.
However, there could be many interpretations, not all of which point to poor financial health. For
example, a firm may embark on a project that compromises cash flows temporarily but renders
substantial rewards in the future.
The operating cash flow ratio assumes cash flow from operations will be used to pay those current
obligations (i.e., current liabilities). The current ratio, meanwhile, assumes current assets will be
used.
2021 2020
Cash flow from operations
Current Liabilities
Cash Ratio
d If the ratio of Lucky Cement is much less than the industry average, what would it indicate
about the companies

Lecturer
Net Working Capital
Working capital, also known as net working capital (NWC), is the difference between a
company’s current assets—such as cash, accounts receivable/customers’ unpaid bills, and inventories of
raw materials and finished goods—and its current liabilities, such as accounts payable and debts. It's a
commonly used measurement to gauge the short-term health of an organization.
Why Is Working Capital Important?

Working capital is important because it is necessary for businesses to remain solvent. In theory, a
business could become bankrupt even if it is profitable. After all, a business cannot rely on paper
profits to pay its bills—those bills need to be paid in cash readily in hand. Say a company has
accumulated $1 million in cash due to its previous years’ retained earnings. If the company were to
invest all $1 million at once, it could find itself with insufficient current assets to pay for its current
liabilities.
Is Negative Working Capital Bad?

Yes, it is bad if a company's current liabilities balance exceeds its current asset balance. This means
the company does not have enough resources in the short-term to pay off its debts, and it must get
creative on finding a way to make sure it can pay its short-term bills on time.
How Can a Company Improve Its Working Capital?

A company can improve its working capital by increasing its current assets. This includes saving
cash, building higher inventory reserves, prepaying expenses especially if it results in a cash
discount, or closely considering which customers to extend credit to (in an attempt to reduce its bad
debt write-offs).
A company can also improve working capital by reducing its short-term debts. The company can
avoid taking on debt when unnecessary or expensive, and the company can strive to get the best
credit terms available. The company can be mindful of spending both externally to vendors and
internally with what staff they have on hand.
2021 2020
Current Assets
Current Liabilities
Net Working Capital

Lecturer
Working Capital to Debt Ratio
The working capital to debt ratio is a metric used in investment analysis that reflects a company's
ability to pay off its total debt with only its working capital.
The higher the ratio value, the more positive a feature this capability becomes for any business you
may wish to invest in, since it’s generally considered a sign of good financial health.
By comparing a firm’s working capital with the amount of its total debt, you can determine just
how quickly and easily that organization could liquidate its cashable assets to repay its debt
obligations, should it ever become necessary.
Even though such a drastic step would only be considered under the most extreme circumstances, since
it would effectively eliminate all of a company’s working capital (WC), the working capital to total debt
ratio is still considered a highly significant measure of debt coverage.
2021 2020
Current Assets
Current Liabilities
Net Working Capital
Total Debt
Net Working Capital to Total Debt
about the companies
e If the ratio of Lucky Cement is much less than the industry average, what would it indicate
about the companies

Lecturer
Working Capital Turnover
Working capital turnover is a ratio that measures how efficiently a company is using its working
capital to support sales and growth. Also known as net sales to working capital, working capital
turnover measures the relationship between the funds used to finance a company's operations and
the revenues a company generates to continue operations and turn a profit.
A high turnover ratio shows that management is being very efficient in using a company’s short-term
assets and liabilities for supporting sales. In other words, it is generating a higher dollar amount of
sales for every dollar of working capital used.
In contrast, a low ratio may indicate that a business is investing in too many accounts receivable and
inventory to support its sales, which could lead to an excessive amount of bad debts or obsolete
inventory.
To gauge just how efficient a company is at using its working capital, analysts also compare working
capital ratios to those of other companies in the same industry and look at how the ratio has been
changing over time. However, such comparisons are meaningless when working capital turns negative
because the working capital turnover ratio then also turns negative.
2021 2020
Net Working Capital
Total Revenue
Working Capital Turnover
about the companies

Lecturer
Working capital management commonly involves monitoring cash flow, current assets, and current
liabilities through ratio analysis of the key elements of operating expenses, including working capital
turnover, the collection ratio, and inventory turnover ratio.
Working capital management helps maintain the smooth operation of the net operating cycle, also
known as the cash conversion cycle (CCC)—the minimum amount of time required to convert net
current assets and liabilities into cash. When a company does not have enough working capital to
cover its obligations, financial insolvency can result and lead to legal troubles, liquidation of
assets, and potential bankruptcy.
To manage how efficiently they use their working capital, companies use inventory management and
keep close tabs on accounts receivables and accounts payable. Inventory turnover shows how many
times a company has sold and replaced inventory during a period, and the receivable turnover ratio
shows how effectively it extends credit and collects debts on that credit.
Ex Indicate whether the following would increase or decrease the NWC?

1 The company buys a factory Decrease (Cash Decrease vs a Fixed Asset increas
2 The company bought inventory on cash No effect(Cash Decrease vs Inventory increase of
3 The company sold inventory on credit Increase (Inventory decreased by small amount, A
4 Owner invested money in the firm Increase (Cash increase, equity increase)
5 Take a loan from a bank Increase (Cash increase and Loan Liability increas
6 Pay dividends Decrease (Cash Decrease vs equity increase)

1 A higher NWC is always better FALSE
TRUE. Paying interest is an outflow of cash,
2 Paying Interest Expense decreases current ratio. a decrease of CA while CL did not change
Increase (Inventory decreased by small
3 The cash conversion cycle is the minimum time required to turn net
amount, Accounts Receivable Increased by
working capital into cash. larger amount)
4 Bankruptcy and liquidation happen when a company cannot pay its
Increase (Cash increase, equity increase)
debt in the short run.
5 Restructure requires change in management. FALSE
6 Operating expenses include the cost to produce the inventory and

FALSE
then sell it.
Ex Indicate which of the following would increase working capital turnover.

1 Shorten Operating Cycles. An increased cash flow generates
Increase
working capital.
2 Financing Fixed Assets with Working Capital. ... Decrease
3 Perform Credit Checks on New Customers. Increase
4 Utilize Trade Credit Insurance. Increase
5 Increase Unnecessary Expenses. Decrease
6 Increase Bad Debt. Decrease
7 Find Additional Bank Finance. Increase
6 Pay cash dividends Decrease

Lecturer
Defensive Interval Ratio
The defensive interval ratio (DIR) is a financial liquidity ratio that indicates how many days a
company can operate without needing to liquidate its assets.
The defensive interval ratio is calculated by dividing the company’s current assets by its daily
expenditures, as indicated below:
where
Defensive assets = cash + marketable securities + net receivables
Daily operational expenses = (annual operating expenses – noncash charges) / 365

Many analysts believe that the defensive interval ratio DIR is a better liquidity ratio to use than the
classic quick ratio or current ratio. This is because the DIR measures a company’s short-term
liquidity in regard to its daily expenditures.
Also, the defensive interval ratio DIR provides analysts with a number of days, rather than a ratio of
the company’s assets to liabilities. This makes it easier to interpret as a measure of liquidity. Knowing
that a company can remain liquid for “X” number of days without tapping into its long-term assets is an
easily grasped point of reference Many analysts believe that the DIR is a better liquidity ratio to use than
the classic quick ratio or current ratio. This is because the DIR measures a company’s short-term
liquidity in regard to its daily expenditures.
Daily Operational expenses refers to the per day operating expense (Cost of Sales, Operating expenses)
but excluding non-cash items such as depreciation.
Analysts consider DIR to be a more useful liquidity ratio than quick ratio or current ratio due to the fact
that it compares assets to expenses rather than comparing assets to liabilities.
Ex Use the following information to find the defensive ratio.

2025 2024 2023
Cash 50 60 15
Marketable Securities 20 20 20
Net Receivables 70 80 90
Defensive Assets 140 160 125
Annual Op Expenses 5000 5300 5500
Non Cash Expenses 200 250 300
Daily Operation Exp 13.15 13.84 14.25
Defensive Interval ratio 10.65 11.56 8.77

Lecturer
There is no perfect answer to the number of days over which existing assets will provide sufficient
funds to support company operations.
Analysts need to review the ratio over time to see if the defensive interval is reducing; this may
indicate that the company’s buffer of liquid assets is gradually declining in proportion to its
immediate payment liabilities.
Generally, a higher DIR is better as it provides more liquidity for the company.
However, sometimes too much liquid assets could be negative as it could imply that the company is
not employing capital efficiently to generate higher returns. Analyst need to look at this ratio from the
industry in which the company operates.
In capital intensive industries, the company might have deployed its capital in large scale projects,
which can be long-term value creative. Further, in certain industries it might be a common practice to
avail short-term loans to manage operations (like working capital loans) as it might be cheaply available.
Analyst need to be aware about all these dynamics before commenting on the DIR of a company.
2021 2020
Cash
Marketable Securities
Net Receivables
Defensive Assets
Annual Op Expenses
Cost of Sales
Distribution
Administration Expense
Annual Op Expenses
Non Cash Expenses
Depreciation
Total Non Cash Expenses

Total Operation Expenses
Daily Operation Exp
Defensive Interval ratio
a Interpret the ratio for 2021 and 2020?
b Has the ratio improved over time? What does it indicate?

Lecturer
Net Debt
Net debt shows how much cash would remain if all debts were paid off and if a company has enough
liquidity to meet its debt obligations. Net debt is calculated by subtracting a company's total cash and cash
equivalents from its total short-term and long-term debt.
If the net debt of a company is negative, this suggests the company has a significant amount of cash
and cash equivalents on its balance sheet.
Additionally, the negative balance could be an indication the company is not financed with an
excessive amount of debt.
In contrast, it could also just mean the company is holding onto more cash in comparison to debt
(e.g. Microsoft, Apple).
In instances of negative net debt, the enterprise value of these companies will be lower than
their equity value.
Recall that the enterprise value represents the value of a company’s operations – which excludes any
non-operating assets.
Therefore, companies that have accumulated large cash reserves will have a higher equity value than
enterprise value.
2021 2020
Current Liabilities
Non current Liabilities
Total Debt
Cash and Cash Equivalents
Net Debt
d If the Total debt does not increase next year, by how much should Cash and Cash
Equivalents grow so that the Net debt becomes negative?
d What does negative Net debt mean?

Lecturer
Net Debt to EBITDA Ratio
The net debt-to-EBITDA ratio is a debt ratio that shows how many years it would take for a
company to pay back its debt if net debt and EBITDA are held constant. Is a ratio measuring the
amount of income generated and available to pay down debt before covering interest, taxes,
depreciation, and amortization expenses. Debt/EBITDA measures a company's ability to pay off its
incurred debt.
A high ratio result could indicate a company has a too-heavy debt load.
Banks often include a certain debt/EBITDA target in the covenants for business loans, and a
company must maintain this agreed-upon level or risk having the entire loan become due
immediately.
It is used by credit rating agencies to assess a company's probability of defaulting on issued debt,
and firms with a high debt/EBITDA ratio may not be able to service their debt in an appropriate
manner, leading to a lowered credit rating.
Some industries are more capital intensive than others, so a company's debt/EBITDA ratio should
only be compared to the same ratio for other companies in the same industry. In some industries, a
debt/EBITDA of 10 could be completely normal, while in other industries a ratio of three to four is
more appropriate.
2021 2020
Earning before taxes (EBT)
Add Income Tax (Tax)
Earning before interest and taxes(EBIT)
Add Depreciation
Add Amortization (A)
Earning before interest and taxes,
Depreciation and Amortization
(EBITDA)
Net Debt
Net Debt to EBITDA
d If the Net Debt to EBITDA turnover is decreasing, what does it indicate?

Lecturer
Risky Asset Conversion Ratio
The term risky asset conversion ratio refers to a measure that assesses the proportion of assets that
may be difficult to convert into cash. The risky asset conversion ratio is useful to lenders that want a
more accurate assessment of a company's assets
Risky Assets
Risky Asset Conversion Ratio =
Total Assets
Risky assets are those assets not readily converted into cash, less applicable depreciation or
amortization.
Examples of risky assets include intangible assets and equipment that has been customized by the
company to accommodate their operating requirements or production processed
The risky asset conversion ratio provides the investor-analyst with information in terms of the ability
of a company to liquidate certain assets. The value of these risky assets is then divided by the total
assets of the company to determine the proportion of assets that might not be as valuable as shown
on the company's balance sheet. The types of assets that fall into the "risky" category include
intangible assets in addition to equipment and machinery that has been customized by the company and
may be difficult to sell in the event of liquidation.
Ex The CFO of Company ABC would like to better understand the value of the company's
assets since their revenue forecast indicates it may be a difficult fiscal year for the company.
She asked her team to calculate the company's risky asset conversion ratio to determine the
proportion of assets not easily converted into cash. Her team categorized the following assets
as risky and indicated the value of these assets (net of depreciation or amortization):
intangible assets ($3,500,000), customized plant equipment and machinery ($12,750,000).
Company ABC's total assets were $125,000,000. The analysts reported the company's risky
assets as:
Risky Assets 16250000
Total Assets 125000000
Risky Assets Conversion Ratio 0.13
a Interpret the ratio?
Company ABC's CFO was relieved to find only 13% of the company's assets could not be readily
converted into cash in the event of liquidation. This information will help the CFO negotiate with
lenders if the company's revenue forecast is accurate and the company experiences a contraction in sales.
Ex Use the Lucky Cements Financial Statements to estimate the ratio for 2020 and 2021?
2021 2020
Risky Assets
Total Assets
Risky Asset Conversion Ratio
Interpret the ratio

Lecturer
How to Enhance Liquidity of a Business
Here are five ways to improve your liquidity ratio if it's on the low side:
1. Control overhead expenses. There are many types of overhead that you may be able to reduce -- such
as rent, utilities, and insurance -- by negotiating or shopping around. You can also look at where you
expend time and energy. One example: If your company has a paper trail, going digital can save you
time and money that's now spent submitting and accepting paper checks.
2. Sell unnecessary assets. Eliminating items such as surplus business equipment can provide a small
sum of capital and reduce the average cost of equipment maintenance.
3. Change your payment cycle. Talk to your vendors about opportunities for discounts if you pay early,
which can save you hundreds to thousands of dollars. On the flip side, you can consider offering your
customers discounts for submitting payments ahead of schedule.
4. Look into a line of credit. A line of credit could help you cover gaps in cash flow due to payment
schedules. Some business lines of credit offer access to up to $100,000 per year, with no annual fee for
the first year. If you're considering this, compare terms before choosing a lender to work with.
5. Revisit your debt obligations. If you have short-term debt, switching to long-term debt can require
smaller monthly payments and give you more time to pay off the sum. On the flip side, switching long-
term debt to short-term debt may mean higher monthly payments, but it can also mean that your debt
will be paid off more quickly. Also consider options like debt consolidation and loan refinancing, which
may help lower monthly payments now, while also saving you money in the long-term.

Lecturer
Ex Indicate whether the following are true or false and underline the incorrect word in the
sentence.
1 If the current ratio is 0.7, the company has is low liquidity status which will
failure to fulfill financial obligation. For this reasons, we have to take the T
steps of enhancing our liquidity.
2 Convert saving deposits it into fixed deposit, as fixed deposits give more
T
interest and thus you will get 9% interest on this fund.
3 You can increase the transport cost if you use public transport like rail or
F (decrease)
bus instead of using your own car or other vehicle.
4 If you have decided to enhance your liquidity, you have to decrease your
T
expenses.
5 You have to try to minimize the use of your all assets. F (maximize)
6 Sell your all wastages and all your less efficient assets. It will give you
T
more liquidity.
7 If you can give more discount to your debtors (such as 2/10, n/30), at that
time, your account receivables will convert in cash faster and thus your F (increase)
liquidity would decrease
8 Paying creditors quickly decrease the liquidity however if the company gets
more discounts from the creditors for timely payment, then liquidity would T
increase
9 Paying creditors quickly decrease the liquidity however if the company gets
more discounts from the creditors for timely payment, then liquidity would
increase T
10 Liquidity increases if the company get less discounts and have to pay more
F(decreases)
money.
11 Increasing the daily sales will increase liquidity T
12 When a company uses its working capital for the owners personal use, the
F(decreases)
liquidity increases.
13 A company should pay more dividends to increase liquidity of the
F(less)
company.
14 A high net debt to EBITDA ratio will result in company getting a better
F(worse)
Credit Rating.
15 A Net Debt to EBITDA ratio can be decreased by switching short term debt
F(Not change)
with long term debt.
16 A Net Debt to EBITDA ratio can be decreased by increasing the
F(Not change)
depreciation expense of the company
17 A Net Debt to EBITDA ratio can be decreased by increasing the profit
T
margin of the company
18 The risky asset conversion ratio increases as the number of marketable
F(decreases)
securities held by the firm increases
19 The risky asset conversion ratio decreases when the firm gets more
F(Increases)
customized assets t0 facilitate production
20 Increasing the daily sales will increase risky asset conversion ratio F(decreases)

Lecturer
Solvency
Solvency is the ability of a company to meet its long-term debts and financial obligations. Solvency
can be an important measure of financial health, since its one way of demonstrating a company’s
ability to manage its operations into the foreseeable future.
The quickest way to assess a company’s solvency is by checking its shareholders’ equity on the balance
sheet, which is the sum of a company’s assets minus liabilities.
Many companies have negative shareholders’ equity, which is a sign of insolvency. Negative
shareholders’ equity insinuates that a company has no book value, and this could even lead to
personal losses for small business owners if not protected by limited liability terms if a company must
close. In essence, if a company was required to immediately close down, it would need to liquidate all of
its assets and pay off all of its liabilities, leaving only the shareholders’ equity as a remaining value.
Carrying negative shareholders’ equity on the balance sheet is usually only common for newly
developing private companies, start-ups, or recently offered public companies. As a company
matures, its solvency position typically improves.
However, certain events may create an increased risk to solvency, even for well-established
companies. In the case of business, the pending expiration of a patent can pose risks to solvency, as it
will allow competitors to produce the product in question, and it results in a loss of associated royalty
payments. Further, changes in certain regulations that directly impact a company’s ability to continue
business operations can pose an additional risk. Both businesses and individuals may also experience
solvency issues should a large judgment be ordered against them after a lawsuit.

Lecturer
Ex The Equity and Liability Portion of the Pakistan Refinery Limited is shown. (Values in
thousands of Rs)
a What are the assets of Pakistan Refinery Limited in 2020?

35452348000
b What is the equity of Pakistan Refinery Limited in 2020?
-174853000
c Why is the equity of the company negative?
Heavy accumulated losses of 18 b Rs.
When studying solvency, it is also important to be aware of certain measures used for managing
liquidity. Solvency and liquidity are two different things, but it is often wise to analyse them
together, particularly when a company is insolvent.
A company can be insolvent and still produce regular cash flow as well as steady levels of working
capital.
Solvency Ratios
Solvency ratio levels vary by industry, so it is important to understand what constitutes a good ratio
for the company before drawing conclusions from the ratio calculations. Ratios that suggest lower
solvency than the industry average could raise a flag or suggest financial problems on the horizon.

Lecturer
Total liabilities to equity
The ratio focuses on all the money that the company owes and compare it to all the money put in by
the share holders.
2021 2020
Total Liabilities
Total Equity
Total Liabilities to Equity
Difference between Debt and Liabilities

A liability is a legally binding obligation payable to another entity. Liabilities are incurred in order to
fund the ongoing activities of a business. Examples of liability accounts are trade payables, accrued
expenses payable, and wages payable.
Debt is an amount owed for funds borrowed. The lender agrees to lend funds to the borrower upon a
promise by the borrower to pay interest on the debt, usually with the interest to be paid at regular
intervals. A person or business acquires debt in order to use the funds for operating needs or capital
purchases. Examples of debt accounts are short-term notes payable and long-term debt.
1) The main difference between liability and debt is that liabilities encompass all of one’s financial
obligations, while debt is only those obligations associated with outstanding loans. Thus, debt is a
subset of liabilities.
2) In addition, debt obligations require the debtor to pay back the principal on the loan plus
interest, whereas there is no interest payment associated with most other types of liabilities.
3) A third difference is that most liabilities are short-term in nature and so appear in the current
liabilities section of the balance sheet, whereas debt may be reported in both the current liabilities
and long-term liabilities sections of the balance sheet, depending on when loan payments are due.
4) Finally, most liabilities are measured with liquidity ratios to see if they can be paid when due,
while debt is measured with leverage ratios to see if a firm is at risk of becoming insolvent.

Lecturer
Debt to equity
A business's debt-to-equity ratio, or D/E ratio, is a measure of the extent to which a company can
cover its debt. It is calculated by dividing a company's total debt by its total shareholders' equity. The
higher the D/E ratio, the more difficult it may be for the business to cover all of its liabilities.
This financial tool gives an idea of how much borrowed capital (debt) can be fulfilled in the event of
liquidation using shareholder contributions. It is used for the assessment of financial leverage and
soundness of a firm and is typically calculated using previous fiscal year's data.
A low debt-equity ratio is favourable from investment viewpoint as it is less risky in times of
increasing interest rates. It therefore attracts additional capital for further investment and expansion of
the business.
Debt must be repaid or refinanced, imposes interest expense that typically can’t be deferred, and
could impair or destroy the value of equity in the event of a default. As a result, a high D/E ratio is
often associated with high investment risk; it means that a company relies primarily on debt financing.
Debt-financed growth may serve to increase earnings, and if the incremental profit increase
exceeds the related rise in debt service costs, then shareholders should expect to benefit.

Lecturer
However, if the additional cost of debt financing outweighs the additional income that it generates,
then the share price may drop. The cost of debt and a company’s ability to service it can vary with
market conditions. As a result, borrowing that seemed prudent at first can prove unprofitable later
under different circumstances.
Changes in long-term debt and assets tend to affect D/E ratio the most because the numbers involved
tend to be larger than for short-term debt and short-term assets. If investors want to evaluate a
company’s short-term leverage and its ability to meet debt obligations that must be paid over a year or
less, they can use other ratios.
What counts as a “good” debt-to-equity (D/E) ratio will depend on the nature of the business and its
industry. Generally speaking, a D/E ratio below 1 would be seen as relatively safe, whereas values of 2
or higher might be considered risky. Companies in some industries, such as utilities, consumer
staples, and banking, typically have relatively high D/E ratios. Note that a particularly low D/E ratio may
be a negative, suggesting that the company is not taking advantage of debt financing and its tax
advantages.
Utility stocks often have especially high D/E ratios. As a highly regulated industry making large
investments typically at a stable rate of return and generating a steady income stream, utilities borrow
heavily and relatively cheaply. High leverage ratios in slow-growth industries with stable income
represent an efficient use of capital.
If a company has a negative D/E ratio, this means that it has negative shareholder equity. In other
words, the company’s liabilities exceed its assets. In most cases, this would be considered a sign of high
risk and an incentive to seek bankruptcy protection.
Interest Bearing Debt means the total amount of outstanding indebtedness of the Companies for
borrowed money (including, without limitation, bank debt, equipment debt, capital lease obligations,
bank overdrafts and any other indebtedness for borrowed money).
2021 2020
Total Liabilities
Long term loans
Trade and other Payables
Current Maturity of Long term debt
Short term borrowings
Total interest bearing debt
Total Equity
Debt to Equity

Lecturer
Debt to capital
The debt-to-capital ratio is a measurement of a company's financial leverage. The debt-to-capital ratio
is calculated by taking the company's interest-bearing debt, both short- and long-term liabilities
and dividing it by the total capital.
Investors use the debt-to-capital metric to gauge the risk of a company based on its financial
structure. A high ratio indicates that the company is extensive using debt to finance its operations;
whereas, a low metric means the company raises its funds through current revenues
or shareholders. Likewise, creditors use this measurement to assess whether the company is suitable for
a loan or is too leveraged to afford one.
2021 2020
Total Equity
Total Capital employed
Debt to capital
d Would this ratio be higher or lower for a bank compared to Lucky Cement.
Higher.

Lecturer
As with any financial metric, this can’t be analysed in a vacuum. A high ratio does not always mean a
bad thing. Look at utility companies for instance. They often carry high levels of debt because their
operations are capital intensive. This translates into a higher debt-to-capital ratio, but it doesn’t
mean they will be insolvent soon. Utility companies have an extremely steady base of customers and as
such their revenues are consistent. This means they are able to meet their obligations without worrying
about downturns in revenues.
Contrast this with new, expanding companies. These companies might not have established customer
bases, but they still need to finance their day to day operations. They may have steady sales at the
moment, but this is not a guarantee like with the utility companies. Eventually, the new company sales
could level off or simply decrease leaving fewer funds to service its debt. A high debt to capital
ratio for this company would indicate risk.
If the debt-to-capital ratio is greater than 1, the company has more debt than capital. This company is
extremely risky. If any more liabilities are acquired without an increase in earning, the company
might go bankrupt.
On the other hand, if the ratio is less than 1, the debt levels are manageable and the firm is
considered less risky to invest or loan to given other factors are taken into consideration.
Ex Explain the relationship between Debt to Equity and Debt to Capital. Also explain how
increase in one will inadvertently lead to an increase in the other.
1
Ex A firm has Debt to total capital of 50%, what is the debt to equity of the firm?
Debt to Total Capital 50%
Percentage of Equity 50%
Debt to Equity 1.00
Ex A firm has Debt to total capital of 90%, what is the debt to equity of the firm?
Percentage of Equity 10%
Debt to Equity 9.00
Ex A firm has Debt to Equity of 0.4, what is the debt to Total Capital of the firm?
Debt to Equity 0.40
Ex A firm has Debt to Equity of 2.4, what is the debt to Total Capital of the firm?
Debt to Equity 2.40

Lecturer
General Rule of Thumb for Debt to Equity Ratio
Convert the rule of thumb of Debt to Equity to Debt to Total Capital

Debt to Equity Debt to Total Capital Rule
0.5 or less 0.333 or less Low risk
0.5 to 1 0.333 to 0.500 Reasonable
1 to 2 0.500 to 0.667 Typical
2 to 5 0.667 to 0.833 Proceed with Caution
5 or more 0.833 or more Need extra caution
Ex The Lehman Brothers Financing portion of Balance Sheet is give. Use it to answer the
following question.
a Google it: What was Lehman Brother's primary business?
Lehman Brothers was a global financial firm that provided investment banking, trading,
brokerage, and other services. It was the fourth-largest investment bank in the United States. Its
collapse is regarded as deepening the 2008 financial crisis and is considered one of its defining
moments.
b Google it: What happened to Lehman Brothers in 2008 financial crisis?

Lehman Brothers filed for bankruptcy on September 15, 2008. Hundreds of employees, mostly dressed in
business suits, left the bank's offices one by one with boxes in their hands. It was a sombre reminder that
nothing is forever—even in the richness of the financial and investment world.
At the time of its collapse, Lehman was the fourth-largest investment bank in the United States with
25,000 employees worldwide. It had $639 billion in assets and $613 billion in liabilities.
c Calculate the Total Liabilities to Equity Ratio and Interpret it?
d Calculate the Total Debt to Equity Ratio and Interpret it?

Lecturer
e Calculate the Total Debt to Total Capital ratio and Interpret it?
f Do you think, it was reasonable for Lehman Brothers to take on so much risk?

Lecturer
Enterprise Value
Enterprise value (EV) is the sum of a company's market cap and its net debt. To compute the EV, total
debt—both short- and long-term—is added to a company's market cap, then cash and cash equivalents
are subtracted.
Enterprise Value =
Excess Cash is broadly connotes the amount of cash over and above what a business requires to
fulfil its daily operational cash requirements beyond what the company needs to perform its daily
operations. Thus, excess cash occurs only when the total cash of the business is larger than total current
liabilities. The formula for calculating excess cash is:
Because excess cash is always less than cash, applying excess cash, rather than just cash in the equation,
increases the enterprise value
It is typical for companies to hold cash balances in the form of deposits or marketable securities for the
amounts that can exceed what they need for operating needs. Such extra cash on a balance sheet is
commonly referred to as excess cash. Excess cash is a nonoperating asset with a much lower risk profile
compared to operating capital.
2021 2020
Cash and Cash Equivalents
Total Current Liabilities
Total Current Assets
Total Current Non Cash Assets
Excess Cash
Net Debt
Market Cap
Enterprise Value
a Interpret the value for 2021?
b Has the value increased? If so, what does it indicate?
c Has the excess cash for the firm increased, what is its impact?

Lecturer
Enterprise value (EV) is the total value of a company, defined in terms of its financing. It includes
both the current share price (market capitalization) and the cost to pay off debt (net debt, or debt
minus cash). Combining these two figures helps establish the company’s enterprise value, indicating
the neighbourhood you need to be in to buy the company.
Enterprise value is a financing calculation—the amount you would need to pay to those who have
a financial interest in the firm. That means everyone who owns equity (shareholders) and everyone
who has loaned it money (lenders). So if you’re buying the company, you have to pony up for the
stock and then pay off the debt, but you get the company’s cash reserves upon acquisition.
Because you receive that cash, it means you paid that much less to buy the company. That’s why
you add the debt but subtract the cash when you calculate an acquisition target’s enterprise value.
Ex Relationship between Market Value and Enterprise Value.

Consider two companies with the following information given. Then answer the questions:
All vales are in billion of Rs.
Company A Company B
Market Cap 10 10
Interest bearing debt 2 1
Excess Cash 1 2
Enterprise Value 11 9
a Which company has higher market value of equity?
Both companies have the same value
b Which company has a higher acquisition value?
The Enterprise Value of A is higher since it has more debt

Lecturer
c Why does debt increase the value of the company?
To buy the company, the acquirer has to buy the equity and the debt.
d Why does excess cash holding decrease the enterprise value?

you get the company’s cash reserves upon acquisition. Because you receive that cash, it means you
paid that much less to buy the company.
e If the company A had also issued preferred shared of Rs 1 Billion, would it impact the
enterprise value?
Yes, since the preferred shareholders had to be paid, the enterprise value would increase.
f If the company A had also issued preferred shared of Rs 1 Billion, what would be the
enterprise value?
12
g Company B is a family holding, i.e. most of the company's shares are with the members of
the same family, would this impact the enterprise value?
No. Since the family members are owners of the firm they will be treated like other shareholders
h Can enterprise value be negative?

Since at worst market value can be zero, and the debt must be positive, it is unlikely that the
enterprise value is negative
i Can excess cash be negative?
At worst excess cash will be zero
g Company B is a subsidiary firm of Company C. To increase Company B's Enterprise Value,

Company C, gave it a debt of Rs 2 million in cash. Do you think this action will increase the
enterprise value of company B?
No. Since the additional net debt from this action is zero, there would be no impact of this action
on enterprise value of B.
g Company B is a subsidiary firm of Company C. To increase Company B's Enterprise Value,

Company C, gave it a debt of Rs 2 million in form of land and building. Do you think this
action will increase the enterprise value of company B?
Since the value of debt has increased and the market value of equity and excess cash has not
changed, the enterprise value will increase.

Lecturer
Case Pakistan Steel Mills

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Lecturer

Lecturer
a Assuming the book value of PSM equity is equal to the market value of the PSM's equity,
what was the Enterprise Value of PSM in 2006:
Market Value of Equity 22,083,783.00
Interest Bearing Debt 8,592,715.00
Excess Cash 10,923,631.00
Enterprise Value 19,752,867.00
b What is the value of 75% of the firm, based on the enterprise value calculated above:

Share Percentage sold 75%
Value of 75% PSM 14,814,650.25
c Just based on Enterprise Value calculated on the basis of book value of equity, do you think
that the deal would have been acceptable?
Yes, since a firm vale of 14 million was being sold for 362 million, it was an exceptional deal.
d Why is the book value of equity not a good measure for market value of equity?
The book value is based on historical costs of the assets and the liabilities. Land and other such
assets appreciation is not captured by the book value. In the balance sheet note that the land is
stated at much lower than the current market value. So, the equity which is the difference between
assets and liabilities is much lower.
e Since PSM was not a listed company, the market value of the company is not readily
available. For this purpose, an analyst suggested that the market value of the company could
be equal to the market value of the assets less the market value of the liabilities the company
has. After just considering the market value of different assets and liabilities and ignoring all
benefits from synergies, the analyst reached a market cap of 501 million for PSM. Use this
market Cap, to find the enterprise value:
Market Value of Equity 501,000,000.00

Interest Bearing Debt 8,592,715.00
Excess Cash 10,923,631.00
f What is the value of 75% of the firm, based on the enterprise value calculated above:

Share Percentage sold 75%
Value of 75% PSM 374,001,813.00
g Just based on Enterprise Value calculated on the basis of market value of individual parts,
do you think that the deal would have been acceptable.
No, the deal sold a firm worth 374 million for on 362 million.

Lecturer
Debt to Enterprise Value
Debt to Enterprise value capture the percentage of debt in a firms portfolio. So higher debt to
enterprise value firms have higher percentage of debt in their capital structure compared to
companies with lower debt to enterprise value.
a If the debt to enterprise value of Pakistan Synthetic Limited on 22 Sep 22 was 0.33 and the
debt of the company was 3.65 billion, what was the enterprise value of PSL? Assume the
company did not have excess cash.
Debt to Enterprise Value 0.33
Debt (in billion) 3.65
Enterprise Value (in billion) 11.06
b If the debt to enterprise value of Pakistan Telecommunication Authority on 22 Sep 22 was
1.12 and the debt of the company was 148.37 billion, what was the enterprise value of PTA?
Assume the company did not have excess cash.
Debt to Enterprise Value 1.12
Debt (in billion) 148.37
Enterprise Value (in billion) 132.47
c For a company with the given market cap and excess cash, find the impact of changes in debt
level on the Debt to Enterprise Ratio.
Company A B C D
Book Value of Equity 120 120 120 120
Market Cap 200 200 200 200
Excess Cash 55 5 5
Debt 100 150 200 250
Enterprise Value 295 345 395 445
Debt to EV 0.339 0.435 0.506 0.562
Debt to Equity 0.833 1.250 1.667 2.083
d What is the relationship between debt and debt to enterprise value.
Keeping all else constant, as the debt increases so does the det to enterprise value increases. This is
because the numerator and denominator both increase.
e Why is debt to equity always more than debt to enterprise?
Debt to equity only focuses on the percentage of debt compared to equity while enterprise value
captures all sources of funding thus debt is much smaller component of the denominator.
f Corporate debt has soared to record levels, and investment professionals are worried. As an investment analyst, which
companies would you recommend, the one with higher Debt to Enterprise value or those with lower debt to enterprise
value? Why?
Interest rates have risen since much of this debt was incurred, so refinancing will increase interest expense, reducing profit margins and cash flow.
As the economy decelerates, perhaps heading into recession, corporate revenue growth will slow, raising debt service burdens for leveraged firms.
Goldman Sachs had recommended stocks with strong balance sheets (low debt). They now prefer companies that are reducing debt aggressively.

Lecturer
Debt to tangible net worth
Debt to Tangible Net Worth Ratio – a ratio indicating the level of creditors’ protection in case of
the firm’s insolvency by comparing company’s total liabilities with shareholder’s equity (excluding
intangible assets, such as trademarks, patents etc.).
This is a more conservative indicator comparing to debt to equity ratio, because intangible assets
not always have value when a company is going through the process of liquidation. For instance, if
the trademark is not planned for use by any of other firms, its value would equal zero. In this case funds
obtained from intangible assets sale can't be used for covering the liabilities to creditors. Eliminating
intangible assets from computation is very important for analysts in terms of measuring the real
debt-paying ability of a firm.
or alternatively it can be stated as
Generally, excess of the debt to tangible net worth ratio value over 1 means than company's creditors
aren't well protected, and in case of firm's insolvency they would only recover a part of the principal
and interest belonging to them.
Lower than 1 ratio indicates the situation when creditors can expect receiving all the amount in full
(principal plus interest).
2021 2020
Shareholders Equity
Intangible Assets
Tangible Net Worth
Debt to Tangible Net Worth
b Has the ratio increased? If so, what does it indicate?
c Are the lenders of lucky cement protected?
d If the tangible net worth ratio of lucky cement was greater than 1, how could it have been
reduced?
By repaying loans or by investing more in tangible assets

Lecturer
Financial Leverage vs Proprietary Ratio
The Financial Leverage ratio captures the impact of all obligations, both interest-bearing and non-
interest-bearing. This Ratio aims to determine how much of the business assets belong to the
Shareholders of the company rather than the Debt holders /Creditors. Accordingly, if Equity
Shareholders fund the majority of the assets, the business will be less leveraged than the majority of
the assets funded by Debt (in that case, the business will be more leveraged). The higher the ratio, the
higher the leverage and the higher the financial risk on the heavy debt obligation taken to finance
the business’s assets.
The proprietary ratio establishes the relationship between Shareholders’ funds and the business’s
total assets. It indicates how much shareholder funds have been invested in the business’s assets. The
higher the ratio, the lesser the leverage, and comparatively less is the financial risk on the part of
the business. Conversely, it can be calculated by taking the inverse of the Financial Leverage Ratio.
𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠 𝐸𝑞𝑢𝑖𝑡𝑦

𝐹𝑖𝑛𝑎𝑛𝑐𝑖𝑎𝑙 𝐿𝑒𝑣𝑒𝑟𝑎𝑔𝑒 = 𝑃𝑟𝑜𝑝𝑟𝑖𝑒𝑡𝑎𝑟𝑦 𝑅𝑎𝑡𝑖𝑜 =
𝐸𝑞𝑢𝑖𝑡𝑦 𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠
Financial Leverage Proprietary Ratio

Ratio indicates low Financial Risk Low High
Ratio indicates high Financial Risk High Low
Ex A company has Proprietary Ratio of 0.75, what is the Financial Leverage?

1.333333333
2021 2020
Shareholders Equity
Total Assets
Financial Leverage
Proprietary Ratio
a Interpret the financial leverage ratio for 2021?
b Interpret the proprietary ratio for 2021?
c Has the financial leverage ratio increased? If so, what does it indicate?
d Are the lenders and creditors of lucky cement protected?
e How can the financial leverage ratio be decreased?

By repaying loans or by investing more in tangible assets

Lecturer
Debt to EBITDA
Debt/EBITDA—earnings before interest, taxes, depreciation, and amortization—is a ratio measuring

the amount of income generated and available to pay down debt before covering interest, taxes,
depreciation, and amortization expenses. Debt/EBITDA measures a company's ability to pay off its
incurred debt. A high ratio result could indicate a company has a too-heavy debt load.
Banks often include a certain debt/EBITDA target in the covenants for business loans, and a
company must maintain this agreed-upon level or risk having the entire loan become due immediately.
This metric is commonly used by credit rating agencies to assess a company's probability of
defaulting on issued debt, and firms with a high debt/EBITDA ratio may not be able to service their
debt in an appropriate manner, leading to a lowered credit rating.
A declining debt/EBITDA ratio is better than an increasing one because it implies the company is
paying off its debt and/or growing earnings. Likewise, an increasing debt/EBITDA ratio means the
company is increasing debt more than earnings.
Depreciation and amortization are non-cash expenses that do not really impact cash flows, but
interest on debt can be a significant expense for some companies. Banks and investors looking at the
current debt/EBITDA ratio to gain insight on how well the company can pay for its debt may want to
consider the impact of interest on debt-repayment ability, even if that debt will be included in new
issuance.
2021 2020
Interest Bearing Debt
EBITDA
Debt to EBITDA
c Based on the ratio, is the firm increasing debt level compared to its cash generating
potential?

Lecturer
Times interest Earned (Interest Coverage Ratio)
The times interest earned (TIE) ratio is a measure of a company's ability to meet its debt obligations
based on its current income. The formula for a company's TIE number is earnings before interest and
taxes (EBIT) divided by the total interest payable on bonds and other debt.
The result is a number that shows how many times a company could cover its interest charges with
its pre-tax earnings.
TIE is also referred to as the interest coverage ratio.
Obviously, no company needs to cover its debts several times over in order to survive. However, the
TIE ratio is an indication of a company's relative freedom from the constraints of debt. Generating
enough cash flow to continue to invest in the business is better than merely having enough money to
stave off bankruptcy.
As a rule, companies that generate consistent annual earnings are likely to carry more debt as a
percentage of total capitalization. If a lender sees a history of generating consistent earnings, the firm
will be considered a better credit risk.
Utility companies, for example, generate consistent earnings. Their product is not an optional expense
for consumers or businesses. Some utility companies raise a considerable percentage of their capital by
issuing debt.
Start-up firms and businesses that have inconsistent earnings, on the other hand, raise most or all of
the capital they use by issuing stock. Once a company establishes a track record of producing reliable
earnings, it may begin raising capital through debt offerings as well.
2021 2020
EBIT
Finance Cost
Times Interest Earned
c Do you expect lucky cement to have consistent or inconsistent earnings? Why?

Old established company in a country with growing construction business so consistent earnings
are expected.
d Do you expect Lucky cement to have more Debt in its Capital Structure than a Start-up like
Uber or Airlift? If so, why?
Yes, banks will give more cheaper loan to Lucky Cement.

Lecturer
Ex
Excel Industries have been facing liquidity crunches, and recently it has received an order for $65
million to be completed in four years, but they lack funds to fulfil the order. They will receive a
quarter of the contract value in the first year. The Debt to Equity Ratio (DE) is 2.50 already, and it
wants to borrow more to fulfil the order. However, the Bank has asked the company to maintain a
DE ratio maximum of 3 and Times Interest Earned Ratio at least 2, and at present, it is 2.5. It
currently pays $12 million as interest, and if the new borrowing puts up additional pressure of $4
million interest, would the firm be able to maintain the Bank’s condition?
a Without, the additional loan, what is the EBIT of the company?
Times Interest Earned 2.50
Interest Expense 12,000,000.00
EBIT 30,000,000.00
b With additional loan, what would be the new Interest Expense?
Interest Expense before new loan 12,000,000.00
Additional Interest Expense 4,000,000.00
Interest Expense after new loan 16,000,000.00
c With additional loan, what would be the new Times Interest Earned, assuming the earnings
did not change?
EBIT 30,000,000.00
d
If the order is achieved, then the firm will get additional EBIT of 10% of the contract value.
EBIT before new contract 30,000,000.00
Additional EBIT 1,625,000.00
EBIT with contract 31,625,000.00
e
With additional loan, and the contract, what would be the new Times Interest Earned?
EBIT 31,625,000.00
f
Can the company achieve the desired Times Interest Earned if they get the contract?
Barely, the times interest earned is less than 2 but since it is close to 2, they might still get the loan
but they will have to put at least additional collateral to get the loan.
g
If the company originally had debt of 35 million, what was the equity of the company?
Debt 35,000,000.00
Debt to Equity 2.50
Equity 14,000,000.00
g With additional debt of 11 million, is the desired debt to equity ratio achieved?
Debt 46,000,000.00
Debt to Equity 3.29

Lecturer
Ex Use the following graphs answer the questions?
a Which of the three companies is the most insolvent?

Ford Motors
b Comment on Tesla's Debt to Equity over time and suggest if the solvency position of Tesla is
improving or not?
Tesla's DE decreased significantly from 2015 to 1017 and then it increased but not to the levels of
2016. In general, Teslas, DE has decreased indicating a lower reliance on debt.
c Why do you think Ford Motors relied heavily on Debt while General motors kept low debt
level?
Some companies focus more on debt financing like ford motors while others like general motors prefer to raise more equity. While
Ford Debt burden is higher, they keep their equity levels low and still try to capture the booming market share by taking new loans.
Because of Fords Track record of paying its debt and generating Free Cash flow it is able to raise new debt easily. '
a Why does Tesla have a negative Times Interest Earned in 2017? Is it even possible?
Yes when EBIT is negative, times interest earned is negative. So in 2017 and 2018, Tesla was
making huge losses.

Lecturer
b If Tesla could not earn the interest, why did it not go bankrupt in 2017?
Since its operations were making losses, Tesla borrowed more money and also raised more equity
even to pay the interest expense.
c Is Tesla's Times Interest Earned Improving? What does this indicate?
This indicate that Tesla has more free cash and thus can easily pay its interest and even then have
money for other activities.
a Why does Tesla have a negative Working Capital? Is it even possible?

When the current liabilities are more than the current assets, the working capital will be negative.
b If the net working capital is negative, how is Tesla still operating?
Tesla will have to take long term loans or raise equity to operate. Thus for their day to day business, they have to take
non current loan and financing options. This is harmful for the company in the long run.
c Is Tesla's Net Working Capital Improving? What does this indicate?
Tesla has low liquidity, its current assets are much less than its current liabilities and Tesla might
not be able to pay its short term obligations.
a General Motors have almost the same Debt to Equity Ratio of Tesla but its debt is many
times more than Tesla? How is this possible?
It’s a much bigger company with many times the equity as compared to Tesla.

Lecturer
Altman Z Score
The Altman Z-score is the output of a credit-strength test that gauges a publicly traded manufacturing
company's likelihood of bankruptcy.
The Altman Z-score, is based on five financial ratios that can be calculated from data found on a
company's financial statements. It uses profitability, leverage, liquidity, solvency, and activity to predict
whether a company has a high probability of becoming insolvent.
𝐴𝑙𝑡𝑚𝑎𝑛 𝑍 𝑠𝑐𝑜𝑟𝑒
𝑊𝑜𝑟𝑘𝑖𝑛𝑔 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝐴𝑐𝑐𝑅𝑒𝑡𝑎𝑖𝑛𝑒𝑑 𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝐸𝐵𝐼𝑇
= 1.2 + 1.4 + 3.3
𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠 𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠 𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠
⬚
⬚
𝑀𝑎𝑟𝑘𝑒𝑡 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝐸𝑞𝑢𝑖𝑡𝑦 𝑆𝑎𝑙𝑒𝑠
+ 0.6 + 0.999
𝐵𝑜𝑜𝑘 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠 𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠
The working capital/total assets ratio, is a measure of the net liquid assets of the firm relative to the
total capitalization. Liquidity and size characteristics are explicitly considered. Ordinarily, a firm
experiencing consistent operating losses will have shrinking current assets in relation to total
assets.
Retained earnings is the account which reports the total amount of reinvested earnings and/or losses of
a firm over its entire life. The account is also referred to as earned surplus. It should be noted that the
retained earnings account is subject to "manipulation" via corporate quasi-reorganizations and stock
dividend declarations. The retained earnings to total assets is a measure of cumulative profitability
over time is what I referred to earlier as a “new” ratio. The age of a firm is implicitly considered in
this ratio. For example, a relatively young firm will probably show a low RE/TA ratio because it has
not had time to build up its cumulative profits. Therefore, it may be argued that the young firm is
somewhat discriminated against in this analysis, and its chance of being classified as bankrupt is
relatively higher than that of another older firm, ceteris paribus. But, this is precisely the situation in the
real world. The incidence of failure is much higher in a firm’s earlier years. In addition, the RE/TA
ratio measures the leverage of a firm. Those firms with high RE, relative to TA, have financed their
assets through retention of profits and have not utilized as much debt.
Earnings Before Interest and Taxes/Total Assets (EBIT/TA) ratio is a measure of the true
productivity of the firm’s assets, independent of any tax or leverage factors. A firm’s ultimate
existence is based on the earning power of its assets. Furthermore, insolvency in a bankrupt sense occurs
when the total liabilities exceed a fair valuation of the firm’s assets with value determined by the earning
power of the assets.
Equity is measured by the combined market value of all shares of stock, preferred and common, while
liabilities include both current and long term. Market Value of Equity/Book Value of Total Liabilities
(MVE/TL) ratio shows how much the firm’s assets can decline in value (measured by market value of
equity plus debt) before the liabilities exceed the assets and the firm becomes insolvent. This ratio adds
a market value dimension which most other failure studies did not consider.

Lecturer
The capital-turnover ratio, Sales to total assets, is a standard financial ratio illustrating the sales
generating ability of the firm’s assets. It is one measure of management’s capacity in dealing with
competitive conditions.
A score below 1.8 means it's likely the company is headed for bankruptcy, while companies with
scores above 3 are not likely to go bankrupt.
Investors can use Altman Z-scores to determine whether they should buy or sell a stock if they're
concerned about the company's underlying financial strength. Investors may consider purchasing a
stock if its Altman Z-Score value is closer to 3 and selling or shorting a stock if the value is closer to
1.8.
Altman Z score and 2008 Financial Crisis

In 2007, the credit ratings of specific asset-related securities had been rated higher than they
should have been. The Altman Z-score indicated that the companies' risks were increasing
significantly and may have been heading for bankruptcy.
Altman calculated that the median Altman Z-score of companies in 2007 was 1.81. These companies'
credit ratings were equivalent to a B. This indicated that 50% of the firms should have had lower ratings,
were highly distressed and had a high probability of becoming bankrupt. Altman's calculations led him
to believe a crisis would occur and there would be a meltdown in the credit market.
2021 2020
Total Assets
Working Capital
WC/TA
Accumulated Retained Earnings
RE/TA
EBIT
EBIT/TA
Sales
Sales/TA
Market Cap
Altman Z Score

Lecturer
Ex Suppose a company has the following information
Values in million
Current Assets 60 Accumulated retained earnings till previous year 8
Current Liabilities 35 Sales 87
Fixed Assets 100 COGS and SG&A 40
Net Income 10 P/E Multiple 8
Dividends 2 Total Liabilities 120
a Use the information to find the following
Working Capital 25 Retained Earnings for the year 8
Total Assets 160 Market Capitalization 80
EBIT 47 Accumulated Retained Earnings 16
b Use the information to find the Altman Z score
WC/TA 0.1563 EBIT/TA 0.29375
S/TA 0.5438 Market to Book 2
RE/TA 0.1 Altman Z Score 3.04
c How likely is that the company will default in the coming few periods?
Since Altman Z score is more than 3, it is unlikely that the company will default.
Ex: Find the Altman Z score of the following companies and then answer the questions:
Indus Indus Ravi Ravi Jhelum Jhelum
Working Capital to Total Assets 42% 0.504 25% 0.3 32% 0.384
Retained Earnings/ Total Assets 20% 0.28 14% 0.196 12% 0.168
EBIT/ Total Assets 7% 0.231 1% 0.033 2% 0.066
Market / Book 3.00 1.80 1.50 0.90 2.00 1.20
Sales/ Total Assets 20% 0.1998 10% 0.1 15% 0.14985
Altman Z Score 3.015 1.529 1.968
a Which of the three companies is:
Is least likely to default Indus
Is most likely to default Ravi
b If the score of a company is in the area of ignorance, suggest 2 practical methods to increase
it
Increase sales, pay less dividends, decrease costs, improve perception of company
c
Indicate whether the following would increase the Altman Z score of the company or not:
1 Buy more fixed assets No (Cash will decrease, current assets decrease, working capital will decrease while total assets wil
2 Raise more equity funding Yes (Working capital increases, equity increases)
3 Pay off short term debt No effect (Working capital does not change, while TA decrease)
4 Decrease the distribution expenses Yes (Increases EBIT)
17 Pay off long term debt Yes (TA decrease and amount of debt decrease)

Lecturer
Operating Cycle
An Operating Cycle (OC) refers to the days required for a business to receive inventory, sell the
inventory, and collect cash from the sale of the inventory. This cycle plays a major role in
determining the efficiency of a business.
The OC offers an insight into a company’s operating efficiency. A shorter cycle is preferred and
indicates a more efficient and successful business. A shorter cycle indicates that a company is able to
recover its inventory investment quickly and possesses enough cash to meet obligations. If a company’s
OC is long, it can create cash flow problems.
Ways a company can reduce its operating cycle:

Lecturer
Inventory Turnover and Days in Inventory
Inventory turnover is a financial ratio showing how many times a company turned over
its inventory relative to its cost of goods sold (COGS) in a given period.
COGS
Inventory Turnover =
Average Inventory
Days in Inventory: A company can then divide the days in the period, typically a fiscal year, by the
inventory turnover ratio to calculate how many days it takes to sell its inventory, on average.
365
Days in Inventory =
Inventory Turnover
The inventory turnover ratio can help businesses make better decisions on pricing,
manufacturing, marketing, and purchasing. It is one of the efficiency ratios measuring how
effectively a company uses its assets.
Average value of inventory is used to offset seasonality effects. It is calculated by adding the value of
inventory at the end of a period to the value of inventory at the end of the prior period and dividing the
sum by 2.
Inventory at Start of year + Inventory at end of year

Average Inventory =
2
Cost of goods sold (COGS) is also known as cost of sales. Analysts use COGS instead of sales in the
formula for inventory turnover because inventory is typically valued at cost, whereas the sales figure
includes the company’s mark-up. Some companies may use sales instead of COGS in the calculation,
which would tend to inflate the resulting ratio.
Inventory turnover measures how often a company replaces inventory relative to its cost of sales.
Generally, the higher the ratio, the better.
In general a small number of days in inventory is preferable.
A low inventory turnover ratio (high number of days in inventory) might be a sign of weak sales or
excessive inventory, also known as overstocking. It could indicate a problem with a retail
chain’s merchandising strategy, or inadequate marketing.
A low inventory turnover ratio (high number of days in inventory) can be an advantage during
periods of inflation or supply chain disruptions, if it reflects an inventory increase ahead of supplier
price hikes or higher demand. Retail inventories fell sharply in the first year of the COVID-19 pandemic,
leaving the industry scrambling to meet demand during the ensuing recovery.
A high inventory turnover ratio (low number of days in inventory), on the other hand, suggests
strong sales.
A high inventory turnover ratio (low number of days in inventory), unfortunately , it could be the
result of insufficient inventory. As problems go, ensuring a company has sufficient inventory to
support strong sales is a better problem to have than needing to scale down inventory because
business is lagging.

Lecturer
The speed with which a company can turn over inventory is a critical measure of business
performance.
Retailers that turn inventory into sales faster tend to outperform comparable competitors. The
longer an inventory item remains in stock, the higher its holding cost, and the lower the likelihood that
customers will return to shop.
The fast fashion business is an example. Competitors including H&M and Zara typically limit runs
and replace depleted inventory quickly with new items. Slow-selling items equate to higher holding
costs. There is also the opportunity cost of low inventory turnover; an item that takes a long time to
sell delays the stocking of new merchandise that might prove more popular.
A decline in the inventory turnover ratio may signal diminished demand, leading businesses to reduce
output.
Inventory turnover is an especially important piece of data for maximizing efficiency in the sale of
perishable and other time-sensitive goods. Examples include groceries, fashion, autos, and
periodicals.
An overabundance of cashmere sweaters may lead to unsold inventory and lost profits, especially as
seasons change and retailers restock accordingly.
Such unsold stock is known as obsolete inventory, or dead stock.
The inventory-to-says ratio is the inverse of the inventory turnover ratio, with the additional distinction
that it compares inventories with net sales rather than the cost of sales.
Average Inventory
Inventory to Sales =
Net Sales
A higher ratio may mean you have strong sales or keep low inventory numbers.
2021
COGS
Net Sales
Inventory 2021
Inventory 2020
Average Inventory
Inventory Turnover
Days in Inventory
Inventory to Sales
a Interpret the inventory turnover ratio for 2021?
b Interpret the days in inventory ratio for 2021?
c Interpret the inventory to sales ratio for 2021?

Lecturer
Challenges when using inventory turnover
Challenge # 1: Comparison
The first challenge associated with inventory turnover is comparison. It’s important to remember that
any time you want to compare your inventory turnover with that of another business, it must be on a
level playing field. In other words, there’s no use comparing your retail operation with a business
that sells completely different products. Inventory turnover ratios are relative. For example, high-
price items like cars can, by nature, be slower to leave the warehouse whereas fashion items and
perishable goods move off the shelves much faster.
Challenge # 2: Management
The way you manage your warehouse can have a direct effect on your inventory turnover. Even if
demand is high, if your warehouse is inefficient and struggling to move goods off the shelves
quickly enough, your inventory turnover ratio is going to suffer as a result.
Challenge # 3: Seasonality
For some items, demand is led by the seasons. In other words, demand is not going to be steady all
year round. Depending on the product, the high-demand season might be in winter, fall, summer, or
spring. For example, if you’re a retailer specializing in Christmas trees, then yup, you guessed it, your
sales are going to spike in December. Your inventory turnover ratio will undoubtedly be impacted by
seasonal demand. As such, it is essential to track and fully understand your seasonal demand patterns.
Challenge # 4: High-cost items

As mentioned above, higher-cost items tend to move off the shelves more slowly. Customers tend to
do their research and take their time before investing in big-ticket items like cars and electronics. As
such, a lower inventory turnover is likely. You need to do your research and be sure that these items are
worth the potential wait on the warehouse shelf. After all, nobody wants an expensive product when it’s
obsolete.
Challenge # 5: Over-ordering
Excess inventory (overstocking) is the enemy of profit and efficiency. If you bulk-buy too many items,
your inventory turnover ratio is going to suffer. With all the capital tied up in bulk inventory, it could
take a very long time to get that money back. In general, it’s better for retailers to reduce their carrying
costs by resisting the urge to buy in bulk, even where there are economies of scale or discounts to be
had. If those products aren’t going to shift, those potential savings from the manufacturer could be
meaningless.
Challenge # 6: Inaccurate data
If you’re not tracking your inventory accurately then your inventory turnover ratio isn’t going to
be accurate, either. Having precise inventory data at your fingertips is absolutely essential. And the
best—and easiest—way to achieve this is by using an inventory management system to track and analyse
all of your inventory-related data in a single place.
Ex Indicate whether the following would increase inventory turnover:
1 Offering promotions to increase sales Yes(Offer promotions to deplete inventory by increasing sales. Beyond clearing
inventory, discounts can be an effective way to drive customer loyalty, boost
2 Just in Time Inventory System Yes (Buy less stock, more often. By purchasing inventory to meet a month’s demand, rather than th
3 Negotiate Discounts with Suppliers Yes( Negotiate discounts with your manufacturer or supplier. If you’ve built a strong rapport with y
4 Encourage Pre-orders Yes (Pre-orders can be a beneficial tool for businesses looking to gauge demand, generate exciteme
5 Engage a third party logistic provider (3PL) Yes( Inventory management would improve at a slight increase in COGS)

Lecturer
Accounts Receivable Turnover and Days in receivable
The accounts receivables turnover ratio measures the number of times a company collects its
average accounts receivable balance. It is a quantification of a company's effectiveness in collecting
outstanding balances from clients and managing its line of credit process.
Net Sales
Receivables Turnover =
Average Receivables
Accounts Receivable Days (A/R days) is the average time a customer takes to pay back a business
for products or services purchased. It helps companies estimate their cash flow and plan for short-term
future expenses.
365
Days in Receivables =
Receivable Turnover
Accounts receivable are effectively interest-free loans that are short-term in nature and are extended by
companies to their customers. If a company generates a sale to a client, it could extend terms of 30 or 60
days, meaning the client has 30 to 60 days to pay for the product.
The receivables turnover ratio measures the efficiency with which a company is able to collect on its
receivables or the credit it extends to customers. The ratio also measures how many times a
company's receivables are converted to cash in a certain period of time. The receivables turnover
ratio is calculated on an annual, quarterly, or monthly basis.
The numerator of the accounts receivable turnover ratio is net credit sales, the amount of revenue
earned by a company paid via credit. This figure exclude cash sales as cash sales do not incur
accounts receivable activity. Net credit sales also incorporates sales discounts or returns from
customers and is calculated as gross credit sales less these residual reductions.
However, since the credit sales of all companies is not easily available, the proxy used is net sales.
It is important that the calculation uses a consistent timeframe. Therefore, the net credit sales should
only incorporate a specific period (i.e. net credit sales for the second quarter only). Should returns
happen in a future period, this figure should be included in the calculation as it relates to the activity
being analysed.

Lecturer
Average value of receivables is used to offset seasonality effects or other timing effects. This is
usually calculated as the average between a company's starting accounts receivable balance and ending
accounts receivable balance.
A/R at Start of year + A/R at end of year

Average Receivables =
2
Companies with more complex accounting information systems may be able to easily extract its
average accounts receivable balance at the end of each day. The company may then take the average of
these balances; however, it must be mindful of how day-to-day entries may change the average. Similar
to calculating net credit sales, the average accounts receivable balance should only cover a very specific
time period.
A high receivables turnover ratio (low days in receivable) can indicate that a company’s collection of
accounts receivable is efficient and that it has a high proportion of quality customers who pay their
debts quickly.
A high receivables turnover ratio (low days in receivable) might also indicate that a company operates
on a cash basis.
A high receivable turnover ratio (low days in receivable) can also suggest that a company is
conservative when it comes to extending credit to its customers. Conservative credit policies can be
beneficial since they may help companies avoid extending credit to customers who may not be able
to pay on time.
On the other hand, having too conservative a credit policy may drive away potential customers.
These customers may then do business with competitors who can offer and extend them the credit they
need. If a company loses clients or suffers slow growth, it may be better off loosening its credit
policy to improve sales, even though it might lead to a lower accounts receivable turnover ratio.
A low receivables turnover ratio (high days in receivable ratio) isn't a good thing. That's because it
may be due to an inadequate collection process, bad credit policies, or customers that are not
financially viable or creditworthy. A low turnover ratio typically implies that the company should
reassess its credit policies to ensure the timely collection of its receivables. However, if a company with
a low ratio improves its collection process, it might lead to an influx of cash from collecting on old
credit or receivables.
In some cases, though, low ratios does not mean that the problem is only with the credit system.
There could be other issues in the company. For example, if the company's distribution division is
operating poorly, it might be failing to deliver the correct goods to customers in a timely manner. As a
result, customers might delay paying their receivables, which would decrease the company’s receivables
turnover ratio.
Ex Indicate whether the following would increase receivable turnover:
1 Offering longer credit period to increase sales No( If the credit period is longer, the customers will pay
later and thus the days in receivable would increase)
2 Increasing the credit discount if customers pay within credit Yes (Customers have more advantage to pay)
period.
3 Engage collection agency Yes (they will collect the money and thus the receivables will decrease)
4 Yes (A/R will decrease )

Factoring: Sell Accounts Receivable to third party at a
discount

Lecturer
Importance of Receivables Turnover Ratio
The accounts receivable turnover ratio communicates a variety of useful information to a company. The
ratio tells a company:
1) How well a company is collecting credit sales? As a company processes receivable balances faster,
it gets its hand on capital faster.
2) What collateral opportunities a company may have? Some lenders may use accounts receivable as
collateral; with strong historical accounts receivable activity, a company may have greater opportunities
to borrow funds.
3) When it might be able to make large capital investments? A company can project what cash it will
have on hand in the future when better understanding how quickly it will convert receivable balances to
cash.
4) How sufficiently a company is evaluating the credit of clients? If a company's accounts receivable
turnover ratio is low, this may be an indicator that a company is not reviewing the creditworthiness of its
clients enough. Slower turnover of receivables may eventually lead to clients becoming insolvent and
unable to pay.
5) How it is performing over time? When analysing financial ratios of a single company over time, that
company can better understand the trajectory of its accounts receivable turnover.
6) How it is performing compared to its competitors? When analysing financial ratios of several
different but similar companies, a company can better understand whether it is an industry-leader or
whether it is falling behind.
2021
Net Sales
Receivables 2021
Receivables 2020
Average Receivables
Receivable Turnover
Days in Receivable
a Interpret the receivable turnover ratio for 2021?
b Interpret the days in receivable ratio for 2021?
Ex Use the following data to find the Days in Receivable

20XX
Net Sales $ 2,000
Percentage of Sales in Credit 70%
Average Receivables $ 50
Days in Receivable 13.04

Lecturer
Receivable Ageing Report
Accounts receivable aging is a periodic report that categorizes a company's accounts receivable
according to the length of time an invoice has been outstanding. It is used as a gauge to determine
the financial health and reliability of a company's customers.
An AR collections aging report provides important data on customer payment behaviors and the
effectiveness of crediting/collection functions. Running an AR collections report regularly (usually
weekly or monthly) helps you understand what to expect from customers in terms of payments.
Ex Mitchelle Foods Trade Debts Ageing Report is shown.
a Answer the following questions

1 The amount due for more than 1 year 11,430,281.00
2 Amount due for more than a month but less than 2months 30,269,619.00
3 Amount due for more than three months 13,506,431.00
4 Loss Expected from amount overdue for a month 192,859.00
5 Loss Expected from amount overdue for a year 11,430,281.00
Ex Beparwah Incs Ageing Report is given. Find the value for Provision for Doubtful Debt?
Receivable Uncollectable percentage
Age of the receivable Loss Allowance
Balance expected
1 296,400 Not yet due 2% 5,928
2 177,800 1-30 days due 4% 7,112
3 58,000 31-90 days due 32.00% 18,560
4 7,600 Over 90 days due 82% 6,232
Provision for Doubtful Debt 37,832

Lecturer
The main reasons for a company to track accounts receivable aging.
1. The first is to keep track of overdue or delinquent accounts so that the company can continue to
pursue old debts. These may be sold to collections, pursued in court, or simply written off.
2. The second reason is so that the company can calculate the number of accounts for which it does
not expect to receive payment. Using the allowance method, the company uses these estimates to
include expected losses in its financial statement.
3. Accounts receivable are derivations of the extension of credit. If a company experiences
difficulty collecting accounts, as evidenced by the accounts receivable aging report, problem
customers may be required to do business on a cash-only basis. Therefore, the aging report is helpful
in laying out credit and selling practices.
4. Accounts receivable aging reports are also required for writing off bad debts. Tracking delinquent
accounts allows the business to estimate the number of accounts that they will not be able to collect. It
also helps to identify potential credit risks and cash flow issues.
5. Companies will use the information on an accounts receivable aging report to create collection
letters to send to customers with overdue balances. Accounts receivable aging reports may be mailed
to customers along with the month-end statement or a collection letter that provides a detailed account of
outstanding items. Therefore, an accounts receivable aging report may be utilized by internal as well as
external individuals
Ex On 31 July 2022, Quisp Concludes that a customer 2345$ receivable is uncollectable and
that this account should be written off. What impact would this have on the net Income of
the company??
Increase/Decrease
Bad Debts Expense Increase
Impact on sales No Effect
Impact on Net Income Decrease
Ex The accounts receivable ageing schedule for seven clients of a company are shown.
Sr Client Balance Not due 1-30 30-60 61-90 More 90
1 Buffalo 4,700 4,700
2 Hen 2,900 2,900
3 Guigas 6,300 600 1,200 4,500
4 Alad 9,930 9,400 350 120 60
5 Dami 22,100 22,100
6 Guni 12,225 75 150 12,000
7 Vin 8,712 12 8,700
Subtotal 66,867 25,600 15,387 5,000 8,820 12,060
1 Which Client has the worst paying behaviour Guni has not paid about
2 What percent of Vins money is due for more than 2 months 1.00
3 Which customer has paid all the dues on time Dami
4 Why is the company still giving credit to Guigas? Maybe they had a fight
5 Percent of total receivables are past due for 3 months 0.18

Lecturer
Factoring
Factoring, receivables factoring or debtor financing, is when a company buys a debt or invoice from
another company. Factoring is also seen as a form of invoice discounting in many markets and is very
similar but just within a different context. In this purchase, accounts receivable are discounted in
order to allow the buyer to make a profit upon the settlement of the debt. Essentially factoring
transfers the ownership of accounts to another party that then chases up the debt.
Factoring therefore relieves the first party of a debt for less than the total amount providing them
with working capital to continue trading, while the buyer, or factor, chases up the debt for the full
amount and profits when it is paid. The factor is required to pay additional fees, typically a small
percentage, once the debt has been settled. The factor may also offer a discount to the indebted party.
Factoring is a very common method used by exporters to help accelerate their cash flow. The process
enables the exporter to draw up to 80% of the sales invoice’s value at the point of delivery of the goods
and when the sales invoice is raised.
Forfaiting (note the spelling) is the purchase of an exporter's receivables – the amount that the importer
owes the exporter – at a discount by paying cash. The purchaser of the receivables, or forfaiter, must
now be paid by the importer to settle the debt. This is a common process used for speeding up the cash
flow cycle and providing risk mitigation for the exporter on 100% of the debts value.
As the receivables are usually guaranteed by the importer's bank, the forfaiter frees the exporter from
the risk of non-payment by the importer. When a forfaiter purchases the exporter’s receivables directly
from the exporter then it is referred to as a primary purchase. The receivables technically then become a
form of debt instrument that can be sold on the secondary market as bills of exchange or promissory
notes, this is known as a secondary purchase.

Lecturer
Ex An owner-operator is looking to solve their cash flow problems and decides to work with a
factoring company. Their factoring company offered the owner-operator a flat rate- a 97%
cash advance with a 3% fee. What would the owner receive for Rs 2300,000 receivables for
the month?
Factor 97%
Receivables 2,300,000
Cash Received 2,231,000
Fees paid 69,000
Ex A non-trucking B2B business starts working with a factoring company. Their contract states
the factoring company charges a 3% fee for the first 30 days of the factoring contract, after
which a smaller fee (say, .5%) is added on every 10 days past the initial 30 that the invoice(s)
remain unpaid. What would the owner receive for Rs 2300000 receivables for the month of
which ten percent are unpaid 30 days after the due date?
Within Month After 30 days Total
Factor 97% 96.50%
Receivables 2,070,000 230,000 2,300,000
Cash Received 2,007,900 221,950 2,229,850
Fees paid 62,100 8,050 70,150
Ex List three factors which will decrease the fees percentage of the factoring agreement?
actoring rates may vary, but can be approximated by answering these questions:

Lecturer
Accounts Payable Turnover and Days in Payable
The accounts payable turnover ratio is a short-term liquidity measure used to quantify the rate at which
a company pays off its suppliers. Accounts payable turnover shows how many times a company pays
off its accounts payable during a period.
Purchases
Payables Turnover =
Average Payables
Days payable outstanding (DPO) is a financial ratio that indicates the average time (in days) that a
company takes to pay its bills and invoices to its trade creditors, which may include suppliers,
vendors, or financiers.
365
Days in Payable =
Payable Turnover
Purchases are the goods purchased from the suppliers. It does not differentiate between credit
purchases since it is not given in the financials. Purchases is found by first subtracting beginning
inventory from ending inventory and then adding the cost of goods sold to the difference between the
ending and beginning inventories.
Purchases = COGS + (Ending Inventory − Beginning Inventory)

Average value of payables is used to offset seasonality effects or other timing effects. This is usually
calculated as the average between a company's starting accounts payables balance and ending accounts
payables balance.
A/P at Start of year + A/P at end of year

Average Payables =
2
Investors can use the accounts payable turnover ratio to determine if a company has enough cash or
revenue to meet its short-term obligations. Creditors can use the ratio to measure whether to
extend a line of credit to the company.
A decreasing turnover ratio indicates that a company is taking longer to pay off its suppliers than in
previous periods. The rate at which a company pays its debts could provide an indication of the
company's financial condition. A decreasing ratio could signal that a company is in financial
distress. Alternatively, a decreasing ratio could also mean the company has negotiated different
payment arrangements with its suppliers.
When the turnover ratio is increasing, the company is paying off suppliers at a faster rate than in
previous periods. An increasing ratio means the company has plenty of cash available to pay off its
short-term debt in a timely manner. As a result, an increasing accounts payable turnover ratio could be
an indication that the company managing its debts and cash flow effectively.
However, an increasing ratio over a long period could also indicate the company is not reinvesting
back into its business, which could result in a lower growth rate and lower earnings for the
company in the long term. Ideally, a company wants to generate enough revenue to pay off its accounts
payable quickly, but not so quickly the company misses out on opportunities because they could use that
money to invest in other endeavours.

Lecturer
2021
Cost of Goods Sold
Inventory 2021
Inventory 2020
Purchases
Payable 2021
Payable 2020
Average Payables
Payable Turnover
Days in Payable
a Interpret the Payable turnover ratio for 2021?
b Interpret the days in payable ratio for 2021?
Ex Use the following data to find the Days in payable

20XX
Net Sales $ 2,000
Cost of Goods Sold $ 900
Change in Inventory $ 360
Purchases $ 1,260
Percentage of Purchases in Credit 70%
Average Payables $ 50
Ex During FY 2020, a company’s total credit purchases for funds owed to creditors and
suppliers was $1 million. However, the company received credits for adjustments and
returned inventory amounting to $100,000. The company had a total AP balance of $80,000
in Jan 1, 2020 and ends the year on Dec. 31, 2019 with outstanding AP of $120,000.
Calculate the payable turnover ratio
2021
Gross Credit Purchases 1000000
Purchase Returns 100000
Net Credit Purchases 900000
Payable 2019 80000

Payable 2020 120000
Average Payables 100000
Payable Turnover 9
Days in Payable 40.55555556

Lecturer
Operating Cycle
An Operating Cycle (OC) refers to the days required for a business to receive inventory, sell the
inventory, and collect cash from the sale of the inventory.
Operating Cycle = Days in Inventory + Days in Receivables

This cycle plays a major role in determining the efficiency of a business. It can also help determine its
efficiency and how smoothly operations are running. Though a company's operating cycle depends on
the industry, knowing its operating cycle is useful when comparing itself to competitors. Additionally, a
business’s operating cycle might ultimately determine whether or not investors take an interest in the
company.
The OC offers an insight into a company’s operating efficiency. A shorter cycle is preferred and
indicates a more efficient and successful business. A shorter cycle indicates that a company is able
to recover its inventory investment quickly and possesses enough cash to meet obligations.
If a company’s OC is long, it can create cash flow problems.
2021
Days in Receivable
Days in Inventory
Operating Cycle
a Interpret the Operating Cycle for 2021?
Ex Company XYZ ins industry A has the following information. On average it takes a company
27 days to use the procured Raw Materials. Once operation starts, the average work in
process conversion period is 13 days. The finished goods are held for average 9 days. The
customers on average pay within 15 days. What is the operating cycle of the company?
Days
Days in Raw Material 27
Days in WIP inventory 13
Days in finished goods 9
Days in Inventory 49
Days in Receivable 15
Operating Cycle 64
Ex The following information is available about the industry A. The days in inventory is 62
days while the days in receivables are 12 days. What is the operating cycle of the industry?
Days
Operating Cycle 74

Lecturer
Cash Conversion Cycle
The cash conversion cycle (CCC) is a metric that expresses the time (measured in days) that it takes for
a company to convert its investments in inventory and other resources into cash flows from sales.
Also called the net operating cycle or simply cash cycle, CCC attempts to measure how long each net
input dollar is tied up in the production and sales process before it gets converted into cash
received.
This metric takes into account how much time the company needs to sell its inventory, how much
time it takes to collect receivables, and how much time it has to pay its bills.
The CCC is one of several quantitative measures that help evaluate the efficiency of a company’s
operations and management. A trend of decreasing or steady CCC values over multiple periods is a
good sign, while rising ones should lead to more investigation and analysis based on other factors.
One should bear in mind that CCC applies only to select sectors dependent on inventory management
and related operations.
2021
Days in Receivable
Days in Inventory
Operating Cycle
Days in Payable
Cash Conversion Cycle
a Interpret the Cash Conversion Cycle for 2021?
Ex Indicate whether the following would decrease cash conversion cycle of a company:
Increase (Since the days in receivable will increase as
1 Offer extended credit terms extended period is offered t them)
2 Split the invoice amount into smaller amounts and charge Decrease as days in receivables will decrease
more frequently
3 Just in Time Inventory System Decrease as the Days in Inventory would decrease
4 Adopt lean manufacturing to reduce inventory's Decrease as days in inventory would decrease
3 Have a mix of global and local raw materials Decrease as days in inventory would decrease as global raw materials hav
4 Increase the frequency of payment to buyers Increase since days in Payable would increase

Lecturer
Ex Company XYZ ins industry A has the following information. On average it takes a company
13 days to use the procured Raw Materials. Once operation starts, the average work in
process conversion period is 6 days. The finished goods are held for average 14 days. The
customers on average pay within 22 days. The company pays its suppliers after 10 days.
What is the Cash Conversion cycle of the company?
Days
Days in Raw Material 13
Days in WIP inventory 6
Days in finished goods 14
Days in Payable 10
Cash Conversion Cycle 45
Cash Conversion Cycle can be negative:
A negative cash conversion cycle means that inventory is sold before you have to pay for it. Or, in
other words, your vendors are financing your business operations. A negative cash conversion cycle is a
desirable situation for many businesses
A good cash conversion cycle is a short one. If your CCC is a low or (better yet) a negative number,
that means your working capital is not tied up for long, and your business has greater liquidity.
Ex In 2012 Apple had 22.75 days in receivables, 5.13 days in inventory and 85.12 days in
payable. Calculate the cash conversion cycle? Interpret the answer.
Cash Conversion Cycle -57.24
hat basically means they are getting paid by their customers long before they pay their suppliers.
Essentially this is an interest free way to finance their operations by borrowing from their
suppliers.

Lecturer
Ex Use Customers Cash to Finance your Start-up

Lecturer
a
Explain why each of the financing models will result in a negative Cash Conversion Cycle?
Match Maker
Deposit
Subscription
Standardize and Resell
Scarcity
Ex The Balance Sheet and Income Statement of Gymshark for 2019 is given
Ben Francis came up with the idea of starting his own business while working as a teenager for his
granddad. In 2011 when Ben Francis was a 19-year old student at Birmingham Aston University, he
developed the first version of the Gymshark website. He started the business with his school friend
Lewis Morgan. In 2012, Morgan and Francis were keen to work in the fitness industry, and they started
using the Gymshark website to dropship fitness supplements.
Drop shipping is where you take customers’ orders but don’t keep the products in stock. This meant that
the duo acted as middlemen to the fitness market and sold products without a need to take on additional
cost or risk of buying stock themselves. After a while, Francis realized the profit margins of this business
were too low, and there was no future potential in the industry. The money they got from drop shipping
and what Francis saved while working as a Pizza Hut deliveryman was used to purchase a sewing
machine and screen printer. They used this equipment to start creating their fitness wear.
Gymshark’s step in the right direction started with BodyPower Expo, a top fitness trade show. At the end
of 2012, Francis discovered BodyPower, and he tried to bring Gymshark into the show. Francis emptied
his bank account to acquire space on the trade show floor to achieve this. He worked hard with his
friends to develop the Luxe fitted tracksuit and built a brand name. Eventually, all his efforts paid off as
the product spiked Gymshark’s growth. Gymshark received the highest order quantity they had ever
received.
Once Francis got back from the trade show, he put products online, and that was where everything
changed. Gymshark had more traffic and sales in less than an hour than they ever had before. The
company made over $42000 in a single day which was far beyond the $400 they usually make in a day.
Following this, Ben and his team started off scaling the company.

Lecturer

Lecturer
a Which Financing model did Ben and friend his friend start with then they started the
business?
Match Marker Model
b What was the benefit of going to the Trade Show Body Power Expo for the company?
Match Marker Model The company made over $42000 in a single day which was far beyond the
$400 they usually make in a day.
c How did raising the money from customers effect their Cash Conversion Cycle
The Cash Conversion Cycle was negative as they were using the customers money to finance the
operations.
d Calculate the Cash Conversion Cycle for 2019?

Revenue (most recent year) $176,164,068
Cost of Goods Sold (most recent year) $58,588,348
Beginning Inventory $12,071,070
Ending Inventory $22,536,369
Beginning Accounts Payable $20,019,877
Ending Accounts Payable $32,373,131
Beginning Accounts Receivable $6,676,669
Ending Accounts Receivable $12,002,392
Inventory Turnover $19
Receivable Turnover $3
Payable Turnover $3
Days in Inventory 19.35
Days in Payable 138.47
Cash Conversion Cycle (11.32)
e Comment on the days in Payable vs Days in Receivable of the business?
f What is the amount of Cash as a percentage of Net Assets held by Gym Shark? Is Gymshark
inefficiently using the cash?
g Does Gymshark's business model justify the large cash holding? Why or why not?

Lecturer
A Glossary of Credit Risk Related Terms

Odds
Odds provide a measure of the likelihood of a particular outcome. They are calculated as the ratio of the
number of events that produce that outcome to the number that do not.
Odds also have a simple relation with probability: the odds of an outcome are the ratio of the
probability that the outcome occurs to the probability that the outcome does not occur. In mathematical
terms, where {p} is the probability of the outcome:
a What is the odd that the Company will default given that the probability the company will
default is 20%.
Probability of default 20%
Probability of non default 80%
Odd of default 0.25
b What is the odd that the Company will require a collateralized loan given that the
probability the company will not require the collateralized loan is 35%.
Probability of collateralized loan 65%
Probability of not collateralized loan 35%
Odd of collateralized loan 1.86
c Write a formula for p in terms of the odds M:

M=p/(1-p)>>M(1-p)=p>>M-Mp=p>>M=p+Mp>>M=p(1+M)>>p=M/(1+m)
d If the odd of bad debt is 1: 7, what is the probability that a bad debt will be created?
Odd of bad debt 1/7
probability of bad debt 13%
probability of bad debt not occurring 88%
e If the odd of bad debt is 1: 32, what is the probability that a bad debt will be created?
Odd of bad debt 0.0312500
probability of bad debt 0.0303030
probability of bad debt not occurring 0.9696970

Lecturer
Secured vs Unsecured Loans
Unsecured Loans – An unsecured loan is a loan that doesn't require any type of collateral. Instead of
relying on a borrower's assets as security, lenders approve unsecured loans based on a borrower’s
creditworthiness. Examples of unsecured loans include personal loans, student loans, and credit cards.
Secured loans – These are also known as Asset-backed loans. These are collateralized by other
financial or real assets. Secured loans are business or personal loans that require some type of collateral
as a condition of borrowing. A bank or lender can request collateral for large loans for which the money
is being used to purchase a specific asset or in cases where your credit scores aren’t sufficient to qualify
for an unsecured loan. Secured loans may allow borrowers to enjoy lower interest rates, as they present a
lower risk to lenders.
Ex Indicate whether the following are secured or unsecured loans?

1 Credit Cards Unsecured
2 House Mortgage Secured
3 Loan taken from a Pawnshop Secured
4 A life insurance loan lets you borrow money against a life insurance policy
Secured
using its cash value as collateral
5 Car Loan Secured
6 A revolving loan is a loan that has a credit limit that can be spent, repaid,
Unsecured
and spent again.
Ex Indicate whether the following are secured or unsecured loans?

1 A readyline facility Unsecured
2 Mudarbah Contract Secured
3 Student loan Unsecured
4 A payday loan is a type of short-term borrowing where a lender will extend
Unsecured
high-interest credit based on your income.
5 Working capital finance Secured
6 Cash credit loans is a loan provided against adequate security in the form of
Unsecured
assets or stock.

Lecturer
Collateral
The term collateral refers to an asset that a lender accepts as security for a loan. Collateral may take
the form of real estate or other kinds of assets, depending on the purpose of the loan. The collateral acts
as a form of protection for the lender. That is, if the borrower defaults on their loan payments, the lender
can seize the collateral and sell it to recoup some or all of its losses.
Collateralization
Collateralization is the use of a valuable asset as collateral to secure a loan. If the borrower defaults
on the loan, the lender may seize and sell the asset to offset their loss.
Hair cut
Haircut is the difference between the market value of the asset used as collateral and the loan
amount. .
For instance, you used a piece of land with a market value of $50,000 as collateral, but the bank gave
you a loan of $40,000 on this. In this case, the difference of $10,000 (or 20%) is the haircut
The amount of haircut largely depends on the lender’s perception of the risk related to the fall in the
value of the asset. A general rule of thumb is lower the haircut, the safer the loan is, and vice versa.
Also, a lower haircut allows for more leverage. The reduction (or the haircut) is expressed in the
form of a percentage.
Ex Mr. A wants to borrow some amount by keeping his stocks as collateral. He keeps stock
worth $ 400 as collateral, but the lender only provides him with $280 loan.
Asset Value 400.00
Loan Value 280.00
Hair Cut (Value) 120.00
Hair Cut (% of asset value) 30%

Lecturer
Lien
A lien is a claim or legal right against assets that are typically used as collateral to satisfy a debt. A
creditor or a legal judgment could establish a lien. A lien serves to guarantee an underlying
obligation, such as the repayment of a loan. If the underlying obligation is not satisfied, the creditor
may be able to seize the asset that is the subject of the lien. There are many types of liens that are used to
secure assets.
Example: SBP defines Lien as:
Ex Complete the table for the following Liens

Type of Lien Typically filed by General or Voluntary or
Specific Involuntary
assets
Tax Lien IRS, FBR, Government Agency General Involuntary
Mortgage Lien Bank Specific Voluntary
Mechanics Lien Contractor/Supplier (If you hire someone to work on your propertySpecific
and fail to pay them according to the terms of your agreement, they
Involuntary
Judgement Lien General
Civil Court ( A judicial lien is created when a court grants a creditor an interest in the debtor'sInvoluntary
property, after a court judgment.)
Ex Under the Roshan Apna Ghar Scheme, SBP offered two schemes to Non resident Pakistanis
to invest and make a home in Pakistan. The rate charged on two schemes is shown. Explain
what do you think is the difference between the two alternatives and why the Non-Lien
Based Financing Scheme has higher interest?
Lien Based Financing: The NRPs can obtain house finance facility against lien on their RDA deposit balances or Naya Pakistan Certificates. Banks can
finance up to 99% of the property value for purchase or construction of house; for renovation of house, financing is capped up to 40% of the property value.
No mortgage of property, equitable or registered, is required against lien based financing facility. The borrower will sign all the financing documents
digitally, physical presence is not mandatory even for execution of sale or transfer deed. The borrower will however, nominate any person in Pakistan to
complete the sale or purchase formalities and get the property transferred in the borrower’s name.

Lecturer
Hypothecation
Hypothecation occurs when an asset is pledged as collateral to secure a loan. The owner of the asset
does not give up title, possession, or ownership rights, such as income generated by the asset. However,
the lender can seize the asset if the terms of the agreement are not met. Hypothecation is different from a
mortgage, lien, or assignment.
Hypothecation in real estate is most often associated with mortgage loans. A rental property, for
example, may undergo hypothecation as collateral against a mortgage issued by a bank. While the
property remains collateral, the bank has no claim on rental income that comes in; however, if the
landlord defaults on the loan, the bank may seize the property by initiating a foreclosure proceeding.
The use of hypothecation in real estate agreements can offer some reassurance to lenders who may
want to mitigate risk when loaning money. If the borrower doesn't pay for any reason, the bank can
potentially recoup some of its losses if it's able to foreclose and then resell the property later.

Lecturer
Hypothecation can also work in favour of borrowers. By entering into this type of agreement,
borrowers may find it easier to obtain mortgage loans with a smaller down payment or lower credit
score requirements. They may also be able to qualify for more favourable interest rates because the
lender is assuming less risk.
Ex Indicate whether the following are following are collateral or hypothecation?

1 House used to take the loan Collateral
2 The right to sell the house if the loan is defaulted on Hypothecation
3 Car Collateral
4 Auto-financing: To borrow money to buy a car Hypothecation
5 Inventory Secured
6
Running finance loan: Borrow money to pay salaries, buy inventories etc. Hypothecation
7 Shares of Company X used as collateral to short Company Y shares Hypothecation
8 Working finance loans Hypothecation
Exercise: Is this hypothecation?
Mortgage vs Hypothecation
Hypothecation is a charge created by a movable asset. The asset under hypothecation is usually a
movable asset like a vehicle, stocks, accounts receivables, small machines, etc.
A mortgage is a charge created over immovable property, which may include land, buildings, factory
premise, go down /warehouse, anything that is attached to the earth, or something permanently fastened
to anything that is attached to the earth. One needs to note that crops though attached to the earth, cannot
be included as “mortgaged” as they can be easily detached and sold.

Lecturer
Ex Indicate whether the contracts with the following underlying charges are Mortgages or
hypothecation contracts?
1 Car Hypothecation
2 Mortgage
3 Stores, spares and loose tools Hypothecation
4 Crops Hypothecation
5 Jewellery Hypothecation
6 Factory Secured
7 Trade Debts Hypothecation
8 Raw Material Hypothecation
9 Shares Hypothecation
10 Plaza Mortgage
Ex Indicate whether the following are true?

1 Under Mortgage, the title is in the name of lender. FALSE
2
Under Hypothecation, the title is in the name of lender. FALSE
3 A hypothecation has a longer maturity than Mortgage FALSE
4 Unlike Mortgage, under Hypothecation a bank cannot sell the underlying if
FALSE
the party defaults.
5 The loan amount given for mortgage is lower than the amount given for
FALSE
hypothecation.
Mortgage vs Hypothecation vs Pledge
A pledged asset is a valuable possession that is transferred to a lender to secure a debt or loan. A
pledged asset is collateral held by a lender in return for lending funds. Pledged assets can reduce the
down payment that is typically required for a loan as well as reduces the interest rate charged. Pledged
assets can include cash, stocks, bonds, and other equity or securities.

Lecturer
Ex Find and attach an gold loan scheme (gold used as a pledge) of any bank in Pakistan. Use
that document to answer the following questions.
a Whose property is the gold?
NBP cash and gold
b In whose possession will the gold remain?
c Is this a secured or unsecured loan?
d Because of this gold pledge, did the interest rate charged decrease?
e How is the value of the gold determined?
Weight and quality of gold to be determined by NBP's appointed schroffs
f Does the amount of loan depend on the quantity of loan?

Financing against each 10 grams of net contents of gold as follows: For One Year Financing
Rs. 70,000/ For Three Year Financing Rs. 65,000/Weight and quality of gold to be determined by
NBP's appointed schroffs
g Explain why it is a pledge instead of a Mortgage?
The goods are given to the lender by the borrower.
h Explain why it is a pledge instead of a hypothecation?
The goods are given to the lender by the borrower.
j Explain why a gold hypothecation contract is more riskier than a gold pledge?
If the gold is with the borrower, they can sell it since gold is not identified, its easily movable
and the gold documents only marginally increase its value.

Lecturer
Rehypothecation
When banks and brokers use hypothecated collateral as collateral to back their own transactions and
trades with their client’s agreement, in order to secure a lower cost of borrowing or a rebate on fees, this
is called rehypothecation. For example, the lender may use an apartment building offered as
collateral for a commercial real estate loan as collateral for a new loan. This newly created debt is
now a derivative.
Rehypothecation is regulated by the Securities and Exchange Commission. Banks and lenders must
have permission from the owner of the property or assets to do this.

Lecturer
Ex Indicate whether the contracts with the following are Hypothecation or Re-hypothecation
contracts?
1 Millat Tractor taking a loan for running finance from UBL by keeping the
Hypothecation
stock in trade as a collateral.
2 UBL takes a loan from SBP by keeping collateral of the stock in Trades
Rehypothecation
with Millat Tractors.
3 Adeel taking a loan from the broker by putting his stock portfolio as a
Hypothecation
collateral.
4 The broker taking a loan from a bank by keeping Adeel's stock portfolio as
Rehypothecation
a collateral.
5 T2 is a company which sells household items on instalments. The items can
be sold if the user does not pay the money. Then T2 uses the collaterals to Rehypothecation
gain a reduced rate loan from NBP.
Advantages of Rehypothecation
Lower Cost of Borrowing: When a borrower undertakes to let go of his asset as collateral for
rehypothecation, he tends to be awarded a certain amount of rebate or lower cost of borrowing for
the loan he has requested. Thus, the individual or entity tends to save a lot of amounts due to lower
interests and borrowing costs.
Helps Financial Institutions to Access Capital: There will be times when banks, brokers, and financial
institutions are in a crunch and need help accessing capital. At times like this, methods like
rehypothecation emerge as saviours for the occasion. By pledging the original collateral of the customer
or entity, the bank is now free to engage in additional transactions for purposes of its own with other
banks and financial institutions, thereby providing the necessary finance and capital to carry out its
operations without hindering them or coming to a significant halt.
Promotes Leverage: By engaging in trading without using own money by pledging and rehypothecation
securities, leverage is being generated in accessing capital markets.
Disadvantages of Rehypothecation
Consumers in Dark: There may be times when an individual is unaware that they have signed on to the
rehypothecation clause and the asset is being used for further rehypothecation by the entity for its
speculative purposes. The customer would not want that, and the bank would tend to act against the
consumer’s interest by misusing the asset for its speculative purposes. Securities are often misused in
this fashion.
Risk of Default: Owing to leverage and borrowing if the underlying entity defaults, it causes enormous
stress on the whole financial system. That happens to have a cumulative effect causing repercussions on
the entire economy. One default would magnify the impact owing to the significant leverage involved,
and rehypothecation tends to cause massive losses in this regard.
Misuse: There may be times when banks may often misuse the underlying pledged collateral to their
advantage and even for speculative activities.
Ex Do the original borrower gets benefit of rehypothecation?
Yes, if he agrees to rehypothecation, his interest rate is reduced by a few basis points.

Lecturer
Financial guarantee
A financial guarantee is an agreement that guarantees a debt will be repaid to a lender by another
party if the borrower defaults. Essentially, a third party acting as a guarantor promises to assume
responsibility for a debt should the borrower be unable to keep up on its payments to the creditor.
Guarantees can also come in the form of a security deposit or collateral. The types vary, ranging from
corporate guarantees to personal ones.
This agreement takes place when a guarantor agrees to take on the financial responsibility if the
original debtor defaults on their financial obligation or goes insolvent. All three parties must sign the
agreement in order for it to go into effect.
Financial guarantees act just like insurance and are very important in the financial industry. They allow
certain financial transactions, especially those that wouldn't normally take place, to go through,
permitting, for instance, high-risk borrowers to take out loans and other forms of credit. In short,
they mitigate the risk associated with lending to high-risk borrowers and extending credit during times of
financial uncertainty.
Guarantees are important because they make lending more affordable. Lenders can offer their
borrowers better interest rates and can get a better credit rating in the market. They also put investors at
ease, making them feel more comfortable because they know their investments and returns are safe.
A financial guarantee doesn't always cover the entire liability. For instance, a guarantor may
only guarantee the repayment of interest or principal, but not both.
Corporate Financial Guarantees

A financial guarantee in the corporate world is a non-cancellable indemnity. This is a bond backed by
an insurer or other secure financial institution. It gives investors a guarantee that principal and
interest payments will be made.

Lecturer
Personal Financial Guarantees
Lenders may require financial guarantees from certain borrowers before they can access credit. For
example, lenders may require college students to get a guarantee from their parents or another party
before they issue student loans. Other banks require a cash security deposit or form of collateral before
they give out any credit.
Example of a Financial Guarantee

Here's a hypothetical example to show how financial guarantees work. Let's assume that XYZ Company
has a subsidiary named ABC Company. ABC Company wants to build a new manufacturing facility and
needs to borrow $20 million to proceed.
If banks determine that company ABC has potential credit deficiencies, they may ask XYZ Company to
become a guarantor for the loan. That means that if ABC defaults, XYZ Company must repay the loan
using funds from other lines of business.
Ex Find and attach a contract of a Pakistani Company which has guarantee clause. Use that
document to answer the following questions. Support each answer by cross referring the
document.
a
Which two parties is the contract between? Write A in the document to highlight the Para.
b Who is the guarantor of the contract? Write B in the document to highlight the Para.
c What does the guarantor guarantee? Write C in the document to highlight the Para.
d What would happen if the borrower defaults?
Ex The Sub note of Long Term Loans from JDW Sugar Mills is shown:
a Who are sponsor directors of the company?

Sponsor Director means the member of the board of directors of a the company sponsor shares. ) Sponsor Shares
means 5% or more paid-up shares of a banking company, acquired by a person individually or in concert with his/her
family members, group companies, subsidiaries, and affiliates/associates.
b Can any director of the company give a guarantee?
It has now been decided that the requirement of obtaining the Directors’ personal guarantees will not be applicable in the following
cases as well: 1)Directors who are full time paid employees of the company and the position of director is held by them owing to
their professional and technical capabilities; and 2)Directors who are nominees of corporate entity/financial institution and a
guarantee has been given by the corporate entity/financial institution nominating such person as a director.
3) A director of a company who is not related to sponsors /owners of a company, having a post graduate education in business /

Lecturer
Indemnity
Indemnity is a comprehensive form of insurance compensation for damages or loss. When the term
indemnity is used in the legal sense, it may also refer to an exemption from liability for damages.
Indemnity is a contractual agreement between two parties. In this arrangement, one party agrees to
pay for potential losses or damages caused by another party.
Indemnity insurance is a type of insurance policy where the insurance company guarantees
compensation for losses or damages sustained by a policyholder.
SBP: Indemnity for the Institution from Loan Customer
Ex Find and attach any contract with indemnity clause. Use that document to answer the
following questions.
a Which two parties is the contract between? Mark Para A in contract.
b Who is the indemnifier of the contract? Mark Para B in contract.

Lecturer
c What does the indemnifier indemnify? Mark Para C in contract.
d When would the indemnity clause set in?
Ex The SMEDA "LETTER OF HYPOTHECATION FOR FIXED ASSETS" has the following
clause:
10. INDEMNIFICATION The Customer shall indemnify and keep indemnified the Bank against all
losses, damages, detriments, harms, claims, liabilities and demands, costs, charges and expenses that
may be sustained by or made against or incurred by the Bank or its agent(s) or nominee(s) in the lawful
exercise of any of the rights, powers or discretion herein contained.
a What is the Property Owner indemnifying the bank for?
b What if the charges were incurred against the fixed asset because the bank failed to pay duty
to the government? The bank placed the fixed assets on governments property. The charges
for using government space were to be borne by the bank.
Since, these are unlawful charges they will be borne by the bank.
c What if the bank failed to do its due diligence and the fixed asset was destroyed in the rain?
Since, the bank did not take proper care, the bank has to pay the charges for restoration of the
fixed asset.
Ex Why is a Life Insurance not an indemnity Contract?

An Indemnity insurance pays a loss equal to the financial loss and seeks to return the insured to
their original financial position. However, death as no return and is immeasurable.
Ex Indicate which of the following will an indemnity holder entitled to:

Sr Yes/No
1 Compensation for the damage Yes
2 Any cost that the person has to bear to defend such a suit Yes
3 Recover all damages he maybe compelled to pay in any suit on
respect of any matter to which the promise to indemnify is Yes
applied.
4 The cost of moving the asset back to the indemnifier No

Lecturer
Restrictive Covenant
A restrictive covenant is a condition that restricts, limits, prohibits, or prevents the actions of
someone named in an enforceable agreement. In bond obligations, restrictive covenants limit the
amount issuers can pay in dividends to investors. Restrictive covenants are common in real
estate deeds and leases, where they restrict how owners and tenants can use a property.
It's important to differentiate between the two main types of covenants: negative and positive. Negative
covenants are actions you can't take, while positive covenants are actions you must take. For
example, a negative covenant in real estate could prevent you from raising chickens on your property.
On the other hand, a positive covenant could require you to mow your lawn.
Restrictive covenants are commonly used to prevent a bond issuer from issuing more debt until one
or more series of bonds mature. The issuer may also be restricted from paying dividends above a
certain amount to shareholders to minimize bondholders' default risk. That's because if more
money is paid to shareholders, less is available to meet payment obligations to lenders.
Ex Indicate whether the following are negative covenants or positive covenant?

1 The company would be required to keep all its inventory insured for the
Positive
duration of the loan.
2 The issuer of the loan must disclose audit reports to creditors Positive
3 The issuer of the loan cannot give their employees and Board of Directors
Negative
salary above an ascertained threshold.
4 The employee must not share the private information of the company with Negative
5
The company must issue their financial statements at least once a year. Positive
6 The directors cannot be given bonus shares for dividend. Negative
7 The company must deposit 10% of the principal in a sinking fund. Positive
Negative covenant
A negative covenant is an agreement that restricts a company from engaging in certain actions. Think of
a negative covenant as a promise not to do something. Negative covenants are also referred to
as restrictive covenants.
For example, a covenant entered into with a public company might limit the amount of dividends the
firm can pay its shareholders.
Common restrictions placed on borrowers through negative covenants include preventing a bond issuer
from issuing more debt until one or more series of bonds have matured.
For example, the negative covenant may restrict the ability of the firm to issue additional debt.
Specifically, the borrower may be required to maintain a debt-equity ratio of no more than 1. The
lending agreement or indenture in which the negative covenant appears will also provide detailed
formulas, which may or may not conform to the Generally Accepted Accounting Principles (GAAP), to
be used to calculate the ratios and limits on negative covenants.

Lecturer
Generally, the more negative covenants exist in a bond issue, the lower the interest rate on the debt
will be since the restrictive covenants make the bonds safer in the eyes of investors.
Example: A Positive Debt covenant
Example: A Negative Debt covenant
The broad prohibition in the debt covenant is typically subject to a number of exceptions including,
but not limited to:
1) Trade payables in the ordinary course of business and certain other ordinary course obligations (such
as obligations under surety bonds and performance guarantees)
2) For borrowers with subsidiaries, intercompany debt – This allows the borrower to use
intercompany loans for internal cash management purposes. However, this exception typically only
applies to subsidiaries that have provided a guarantee of the loan, ensuring that the cash remains within
the credit group (and therefore subject to a direct claim by the lender). Intercompany debt is often
required to be subordinated.
Purchase money debt incurred in connection with the purchase of a capital asset useful in the
borrower’s business – This exception may be subject to a dollar limit.
Ex: DHA penalises residents for installing rooftop solar panels: Dawn 17/9/22
However,
Why there
is this is growing
a type unease
of violation of among DHA residents
a restrictive covenantatonthe authority’s
part of DHA? decision to send them notices
and impose fines for allegedly violating its construction laws by installing elevated steel structures for
solar panels on their rooftops.

Lecturer
Negative Covenant's in Employment Contract
Ex Indicate whether the following contracts would have negative covenants and if so, give an
example of one?
1 Employment contracts (e.g., non-compete, non-disclosure, and non-solicitation
agreements)
Employee Contract
2 Restrictive covenants typically prevent the seller of the business from:

Competing with the business sold.
Merger and Acquisition
Poaching key staff, suppliers or customers.
Contract
3 In order to achieve this, negative covenants allow the lender to:
Impose operational restrictions designed to maintain the character and cash flow of
Loan Document the borrower’s business
Restrict activities that would alter the creditworthiness and risk profile with respect
to the borrower
4 Ensuremandate
They the borrower’s continuing
owners and tenants ability
to avoidto or
repay
takethe loans actions intended to
specific
preserve the value and enjoyment of the adjoining land. Restrictive covenants are
established in a deed or a separately recorded document called a declaration of
Real Estate Document restrictive covenants. Homeowner associations (HOAs) stipulate covenants,
conditions, and restrictions (CC&Rs) to safeguard property values in the
community. Covenants are generally considered valid only if reasonable and of
5 benefit
No to all the property owners within the community.
Spot retail transaction

Lecturer
Negative Covenant's in Employment Contract
Ex Indicate whether the following issues should have a negative covenant or a positive
covenant? Why?
1 Mid- and higher-cap transactions
Negative
2 Sales of obsolete or worn-out assets
positive
3 Investments in “cash equivalents,” such as government
bonds and other low-risk, liquid investments Negative
4 Investments in assets useful in the borrower’s business

Negative
5 Merging or consolidating with another entity
Negative
6 Timely payments of Interest and Principal Positive
Ex Find and attach any contract with restrictive clauses. Use that document to answer the
following questions.
a Which two parties is the contract between? Mark Para A in contract.
b What are the negative clauses? Mark Paras B in contract.
c What can the counterparty not do for the duration of the loan?

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Risk Management Prepared by: Muhammad Mobeen Ajmal

Introduction to Financial and Credit Risk

5 Originality(Final) (Random x pages) 10

Introduction Last Updated: 25-10-22 1 of 126

Introduction Last Updated: 25-10-22 2 of 126

Financial Risk and Its Types

Introduction Last Updated: 25-10-22 3 of 126

Introduction Last Updated: 25-10-22 4 of 126

Systematic Risk and Its Types

Purchasing Power/ Inflationary Risk

Demand Cost Inflation

Introduction Last Updated: 25-10-22 5 of 126

There are five primary causes of demand-pull inflation:

Introduction Last Updated: 25-10-22 6 of 126

Introduction Last Updated: 25-10-22 7 of 126

Interest Rate Risk

Introduction Last Updated: 25-10-22 8 of 126

Introduction Last Updated: 25-10-22 9 of 126

Introduction Last Updated: 25-10-22 10 of 126

Introduction Last Updated: 25-10-22 11 of 126

Absolute Relative Volatility

a What is the absolute risk of default of a high debt company?

Probability of default of high debt company 40%

Introduction Last Updated: 25-10-22 13 of 126

2013 1692 68 1692 2862864 68 4624

Find the average

Find the sample variance

𝑠𝑥2 = ######### = 5,324,241.50

Introduction Last Updated: 25-10-22 14 of 126

Find the standard deviation

a Which stock has more deviation in prices?

b Which stock has more volatility risk?

Ex The graphs of returns of stock and bonds is shown.

a Which of Stock or Bond has more volatility risk?

Introduction Last Updated: 25-10-22 15 of 126

a Is the volaitility risk constant over time?

a Is the volaitility risk constant over time?

Introduction Last Updated: 25-10-22 16 of 126

Unsystematic Risk and Its Types

Business Risk Operational

The meaning of types of financial or credit risk is as follows:

Introduction Last Updated: 25-10-22 17 of 126

. The types of operational risk are depicted and listed below.

The operational Risks of Banks

Introduction Last Updated: 25-10-22 18 of 126

Some Preliminary Definitions

The Financial Statements are:

1. Statement of Financial Position (Balance Sheet)

Introduction Last Updated: 25-10-22 19 of 126

Introduction Last Updated: 25-10-22 20 of 126

The Income Statement of Lucky Cement is Shown

Introduction Last Updated: 25-10-22 21 of 126

3. Statement of changes in equity for the period (Statement of retained earnings).

The Statement of Changes in Equity of Lucky Cement is Shown

Introduction Last Updated: 25-10-22 22 of 126

The Statement of Cashflows(Direct) of Lucky Cement is Shown

Introduction Last Updated: 25-10-22 23 of 126

Introduction Last Updated: 25-10-22 24 of 126

Introduction Last Updated: 25-10-22 25 of 126

Introduction Last Updated: 25-10-22 26 of 126

Value of Equity of the Firm

Limitations of Book Value