Financial Management

Dr. Eslam Abd El-Hamid

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 ACTIVITY RATIO ANALYSIS – CONT’D

✔ ACTIVITY RATIOS:
▪ To Calculate the Activity Ratios we need to get several items from Financial Statement:
a. Revenues & Cost Of Goods Sold from Income Statement.
b. Beginning & Ending Inventory from Balance Sheet.
c. Beginning & Ending Customer Receivables from Balance Sheet.
d. Beginning & Ending Supplier Payable from Balance Sheet.
e. The number of days for the period (Period = 360 days / Period = 90 days)

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 ACTIVITY RATIOS ANALYSIS – CONT’D

INVENTORY TURNOVER Inventory Turnover = COGS ÷ Average Inventory

*Average Inventory = (Beginning Inventory + Ending Inventory ) ÷ 2

▪ Inventory Turnover is a ratio showing how many times a company’s is sold and
replaced over a period.

DAYS INVENTORY DIO = (Average Inventory ÷ COGS) / 360

OUTSTANDING “DIO” *Average Inventory = (Beginning Inventory + Ending Inventory ) ÷ 2

▪ DIO measures the average number of days the company holds its inventory before
selling it. The ratio measures the number of days funds are tied up in inventory

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 ACTIVITY RATIOS ANALYSIS – CONT’D

DSO = (Average Receivables ÷ Revenues) / 360

DAYS SALES OUTSTANDING
“DSO” *Average Receivables = (Beginning Receivables + Ending Receivables ) ÷ 2

▪ DSO measures the number of days the company takes to collect its sales, it can be
used to assess the company’s credit policy.

DPO = (Average Payables ÷ COGS) / 360

DAYS PAYABLE
OUTSTANDING “DPO” *Average Payables = (Beginning Payables + Ending Payables ) ÷ 2

▪ DPO measures the average number of days the company takes to pay its bills from
trade suppliers

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 ACTIVITY RATIOS ANALYSIS – CONT’D

CCC = DIO + DSO – DPO

CASH CONVERSION CYCLE ▪ CCC as a stand alone number does not mean very much, it should be used to track
“CCC”
the company over a period of time & to compare the company to its competitors
▪ CCC reflects the effect of company’s selling / purchasing policy, production process
& their effect on cash cycle
▪ CCC used to determine & match the company’s required short term facilities
(working capital facilities) in terms of tenor & amount

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 ACTIVITY RATIOS ANALYSIS – CONT’D
❑ Example:
ITEM Company "A" Company "B"
▪ Kindly Compute the following for each
Section From Balance Sheet
company and then compare: Current Assets Average Average
✔ DIO
✔ DSO Customer Receivables 4,500,000 1,500,000
Inventory 2,550,000 1,250,000
✔ DPO
✔ CCC Current Liabilities: Average Average
Suppliers Payables 2,550,000 1,875,000

Section From Income Statement Y-14 Y-15

Revenues 30,600,000 18,000,000
Cost Of Goods Sold 30,600,000 15,000,000

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 WORKING CAPITAL & THE CASH CONVERSION CYCLE
❑ WORKING CAPITAL :
✔ Is the cash required to finance the day to day operations of the business to be able to:
▪ To pay your Suppliers when invoices come due
▪ Allow your customers to buy now and pay later
▪ To pay employees and other creditors
✔ In other words it is the length of time it take to convert business current assets (inventory and sales
receivables) and current liabilities (suppliers payables) into cash and it is measured by the cash
conversion cycle which is composed of:
▪ Days Sales Outstanding “DSO”; average time taken to collect the customers receivables.
▪ Days Inventory Outstanding “DIO”; average time taken to produce business inventory and convert it
into sales.
▪ Days Payable Outstanding “DPO”; average taken to pay your suppliers.

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 WORKING CAPITAL & THE CASH CONVERSION CYCLE

OPERATING CYCLE “OC”:

OPERATING CYCLE “OC”:

OC = DIO + DSO
OC = 60 + 40 = 100 Days

CASH CONVERSION CYCLE “CCC” :

CASH CONVERSION CYCLE “CCC”:

CCC = OC - DIO
CCC = 100 - 35 = 65 Days

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 WORKING CAPITAL & THE CASH CONVERSION CYCLE
✔ Working Capital Optimization is not only the function of the Finance Department, it is a cross functional
process where it affects different departments of the organization where the main objective is to:
▪ Keep minimum cash tied up in the working capital cycle
▪ Preserve sufficient cash to cover business due payments
▪ Have an efficient and effective service level
PERFORMANCE DEPARTMENT IN
MEANING DRIVEN BY
INDICATOR CHARGES
▪ Sales ▪ Payment Terms
Days Sales Outstanding How long does it take to
▪ Finance ▪ Invoice Issuance Timeline
“DSO” collect your receivables?
▪ Credit ▪ Collection Effectiveness
▪ Sales
▪ Inventory Policies
Days Inventory Outstanding How long does it take to ▪ Production
▪ Forecast Accuracy
“DIO” consume the inventory? ▪ Supply Chain &
▪ Distribution Effectiveness
Distribution
How long does it take to pay ▪ Procurement ▪ Payment Terms
Days Payables Outstanding
your payables? ▪ Finance ▪ Payment Discounts
“DPO”
▪ Payment Methods

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 CASE 6 – FINANCIAL ANALYSIS

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 BUDGETING – SETTING UP ASSUMPTIONS

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 THE DEFINITION:

✔The Budgeting is the process of identifying, gathering, summarizing, and

communicating Financial and Non-Financial information about an
organization's future activities, in order to accomplish the business long
term plans.
✔A Budget is a commitment for planed activities and resources acquisition
&/or uses.

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❑ THE BUDGET MILESTONES:

STRATEGIC GOAL

• Annual Budget must reflect and be aligned with the business STRATEGIC
GOALS

BUSINESS RESOURCES
• Annual Budget, should Optimize / Organize Business Recourses to
decrease the waste & error from using them.

ROADMAP
• Annual Budget should tell (When / Where / How) to achieve your goals

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❑ THE BUDGET ADVANTAGES:
✔ Define Goals & Future Plans
Define

✔ Communicate Objectives / Expectations.

Goals
&
Future Plans
✔ Allocate Business Resources. Provide
Predictions Communicate
✔ Coordinate Departments Activities, & Provide & Plans
Control
Motivation to employees & Set Nonfinancial
BUDGET
Performance Targets.
✔ Identify Potential Difficulties / Constraints. Uncover Allocate
Bottlenecks Resources
✔ Provide Financial Predictions, & Permit control
Coordinate &
through budget-to-actual comparisons
Motivate

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❑ THE BUDGET CONTROL PHASE:

✔ Periodical Review & Compare Review

Budget
Actual-to-Budget. & Compare

✔ Determining and Investigate Variances (+ve.

&/or –ve).
✔ Feedback to Top & Operational Managers. Feedback Investigate

✔ Corrective &/Or Modified Actions (if needed).

✔ Modify Your Initial Budget.

Correction Modify

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 ASSUMPTIONS PROCESS
✔ As a next phase after the financial analysis and a step toward the
financial planning is to build up the assumptions that would move the
company from the “As Is” situation to the “To Be” situation.
✔ Setting up a valid assumptions will lead to construct a solid projected
financial statements (income statement & balance sheet) as to reach to
forecasted cash flow.
✔ Accordingly, the analyst has to build the assumption on the creditability
& reality, as it must represent the nearly achievable future.
✔ The assumptions must also match the organization strategic objectives
as to Retain and keep the alignment of the organization

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 ASSUMPTIONS PROCESS– CONT’D:
✔ The budgeting process will consists of a planned operating budget and a

financial budget. The planned operating budget helps to plan future

earnings and results in a projected income statement. The financial

budget helps management plan the financing of assets and results in a

projected balance sheet.

✔ There is an ascending path in order to build up the financial assumption.

1. First , Assumptions concern the Income Statement

2. Second, Assumptions concern the Balance Sheet

✔ By that way, we will reach to calculate the Free Cash Flow.

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 INCOME STATEMENT’S ASSUMPTIONS
✔Assumptions related to sales revenue, taking into considerations:
✔ Value and Volume
✔ Kinds of products
✔ Kinds of Clients
✔ Sales Seasonality
✔ Point of sales and geographic location
✔ Sales Trade trend (Local or Export)

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 INCOME STATEMENT’S ASSUMPTIONS–– CONT’D
✔Assumptions related to percentage of cost of goods sold to the sales revenue,
Which includes:
✔Cost of the Direct Material
✔Cost of the Direct Labor
✔Cost of Direct overheads

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 INCOME STATEMENT’S ASSUMPTIONS–– CONT’D
✔ Assumptions related to the Selling, General and Marketing Expenses,
which include:
✔The Selling Expenses and the commissions paying to sales department
✔The General and Administrative expenses, which mainly consist of the
salaries to the support activities departments.
✔The Marketing Expenses which usually consider as a percent from the
sales revenue
✔ Assumptions related to the other sources of revenue (Expense) (if there are
other non operating activities), including:
✔Interest revenue (Expenses)
✔Capital Gain (losses)

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 BALANCE SHEET’S ASSUMPTIONS
✔Assumptions related to the current assets.:
✔ The No of days holding for account receivable
✔ Calculating A/R Turnover
✔ the No of days holding for inventory
✔ Calculating inventory Turnover

✔Assumptions related to capital expenditure CAPEX (Fixed Assets):

✔ Identify the expansion plan if exist
✔ Identify the replacement plan if exist
(Any expected expansion must be link to the expected sales)

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 BALANCE SHEET’S ASSUMPTIONS–– CONT’D
✔Assumptions related to the Current Liabilities .:
✔The No of days holding for account payable
✔Calculating A/P Turnover

✔Assumptions related to the Long term Liabilities :

✔How to finance the expansion plan if exist, depending on long term debt
or equity finance.
(the degree of dependency on long term source of finance must depend
on the lowest cost of finance and the debt to equity ratio)

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 INVESTMENT MANAGEMENT

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 WHAT IS AN INVESTMENT

❑ INVESTMENT; is to allocate money or other resources (time) with the expectation of future benefits.
❑ IN FINANCE; the expected future benefit from Investment is a Return.
❑ INVESTMENT RETURN; may consist of “Value Appreciation” (capital gain) and / or investment income
(net profit / dividends / interest / rent / etc…..)
❑ INVESTORS; are generally expect higher return from riskier
investments.
❑ BUSINESS; revolves around the factor of investing, through
investing money and time with the goal of

“MAXIMIZATION OF THE SHAREHOLDERS

WEALTH”
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 TIME VALUE OF MONEY
❑ TIME IS MONEY; It is the idea that money available at the
present time is worth more than the same amount in
the future due to its potential earning capacity
(mitigating future delay / inflation / risk). This core
principle of finance holds that, any amount of money
is worth more the sooner it is received
❑ FUTURE VALUE: It measures the nominal future sum of
money that a given sum of money is "worth" at a
specified time in the future assuming a certain
interest rate, or more generally “Rate of Return”.

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 FUTURE VALUE FORMULA
❑ FUTURE VALUE EQUATION: Is the present value multiplied by the

accumulation function:

FV = PV x (1+r)n
✔ FV = Future Value

✔ PV = Present Value of Investment

✔ r = Is the rate of return per period

✔ n = is the number of compounding periods

❑ SIMPLE INTEREST: Interest earned on the original investment.

❑ COMPOUND INTEREST: Interest earned on the interest generated.

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 FUTURE VALUE – CONT’D
❑ EXAMPLE: Compare $ 1,000 invested for 10% compound interest annually versus 10%
simple interest where the investment will last for three year ?

❑ SIMPLE INTEREST: ❑ COMPOUND INTEREST:

✔ Year One = 1,000 x (10%) = $ 100 ✔ Year One = 1,000 x (10%) = $ 100
✔ Year Two = 1,000 x (10%) = $ 100 ✔ Year Two = 1,100 x (10%) = $ 110
✔ Year Three = 1,000 x (10%) = $ 100 ✔ Year Three = 1,210 x (10%) = $ 121
✔ Total = 1,000 + 300 = $ 1,300 ✔ Total = 1,000 + 300 = $ 1,331

0 Y1 Y2 Y3

1,000 i=10 FV = ?
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 PRESENT VALUE FORMULA
❑ PRESENT VALUE EQUATION: Is the discounting of the future value, it is the

reverse of compounding

PV = FV
(1+r)n
✔ FV = Future Value

✔ PV = Present Value of Investment

✔ r = Is the rate of return (discounting rate) per period

✔ n = is the number of periods of compounding

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 FUTURE VALUE – COMPOUNDING PERIODS
❑ EXAMPLE: Assume that your investment is expected to generate the cash flow for the coming
four year according to the following table, can you calculate the Present Value “PV” for
these cash flow using discounting rate for 5%

ITEM FV (1+ r )n FV ÷ (1+r)n PV

Year 1 $ 10,000 (1.05)1= 1.05 = 10,000 ÷ 1.05 $ 9,524

Year 2 $ 8,000 (1.05)2= 1.1025 = 8,000 ÷ 1.1025 $ 7,256

Year 3 $ 9,000 (1.05)3= 1.1576 = 9,000 ÷ 1.1576 $ 7,775

Year 4 $ 15,000 (1.05)4= 1.2155 = 15,000 ÷ 1.2155 $ 12,341

TOTAL $ 36,895

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 PRESENT VALUE FORMULA

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 NET PRESENT VALUE “NPV”
❑ How much value is created from undertaking an investment?
✔ Step 1: Estimate the expected future cash flows.
✔ Step 2: Estimate the required return for projects of this risk level.
✔ Step 3: Find the present value of the cash flows and subtract the initial
investment to arrive at the Net Present Value.

n CFt
NPV = ∑ - INITIAL INVESTMENT
(1 + r)n
t=1

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 NET PRESENT VALUE DECISION RULE

❑ NPV > 0 MEANS:

✔ Investment is expected to add value to investors, Accept the investment

❑ NPV = 0 MEANS:
✔ Investment make no difference to investors

❑ NPV < 0 MEANS:

✔ Investment will loss value and investors must reject the investment

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 CAPITAL BUDGETING
❑ CAPITAL BUDGETING:
▪ Or investment appraisal, is the planning process used to determine whether an organization's long
term investments such as new machinery, replacement machinery, new plants, new products, and
research development projects are worth the funding of cash through the firm's capitalization structure
(debt versus equity or retained earnings)
▪ The Primary goal of the Capital Budgeting is to increase the value of the
company to the Shareholders
▪ Because the amount of capital available at any given time for new
projects is limited, management needs to use capital budgeting
techniques to determine which projects will yield the most return over
an applicable period of time.
▪ One of the most simplist appraisal techniques is Pay Back Period “PBP”

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