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Managerial Finance
Managerial Finance
Lecture 1st
The Main Outlines:
1. Definition of Finance.
2. Financial Activities/Decisions and the Role of the Financial
Manager.
3. The Goal of the Firm.
4. The Main Principles of Finance.
The first view or perspective states that the primary activities of the financial
manager, (in addition to ongoing involvement in financial analysis and
planning), are making investment decisions and making financing
decisions.
In turn, investment decisions can be classified in two groups: short
investment decisions (related to current assets) and long investment
decisions (related to long term assets).
In general, investment decisions totally related to the left-hand side of the
balance sheet.
Through making investment decisions, the financial managers exercise the
following financial activities:
Determine both the mix and the type of assets found on the firm's
balance sheet.
Determine the best chances to invest a firm’s funds so as to create a
high level of expected return so maximizing the wealth of shareholders
(the business’s owners). s
Determine the appropriate mix of short-term and long-term financing.
Deciding which individual short-term sources are best at a certain point
in time.
Deciding which individual long-term sources are best at a certain point in
time.
Determine the appropriate mix of long-term financing to maximize the
value of the firm (capital structure decisions).
Determine the financial requirements (additional financing needs).
Profit Maximization
• According to this goal, management only looks for maximizing profits.
• But the question here is: what kind of profits need to be maximized;
earnings before interest and taxes (EBIT), earnings per share (EPS) or net
profits (NI)…
• There is common agreement to maximize the Earnings per Share (EPS)
and applying the following criterion:
Accrual accounting recognizes the revenue earned at the time of sale and expenses
incurred by the company. Its examples include sales of goods on credit, where
sales will be recorded in the books of account on the date of sale irrespective of
whether it is on credit or cash.
Ratio analysis: -
5 Essential Financial Ratios for Every Business
The common financial ratios every business should track are 1) liquidity ratios 2)
leverage ratios 3)efficiency ratio 4) profitability ratios and 5) market value ratios.
1) Liquidit
y ratios
Companies
use liquidity
ratios to
measure
working
capital performance – the money available to meet your current, short-term
obligations .
Simply put, companies need liquidity to pay their bills. Liquidity ratios measure a
company’s capacity to meet its short-term obligations and are a vital indicator of its
financial health. Liquidity is different from solvency, which measures a company’s
ability to pay all its debts. In the sporting world, Italian football club Lazio faces a
now-infamous liquidity ratio preventing it from signing new players. Italian clubs
are required to communicate their liquidity indicator to the football authorities
twice a year. This indicator cannot be any lower than a certain threshold set by the
football authorities.
There are different forms of liquidity ratio.
Current ratio: Current Assets / Current Liabilities
The current ratio measures how a business’s current assets, such as cash, cash
equivalents, accounts receivable, and inventories, are used to settle current
liabilities such as accounts payable.
Quick ratio (Acid-test ratio): (Current Assets – Inventories – Prepaid Expenses) /
Current Liabilities
Also known as the acid-test ratio, the quick ratio measures how a business’s more
liquid assets, such as cash, cash equivalents, and accounts receivable can cover
current liabilities. This ratio excludes inventories from current assets. A quick ratio
of 1 is considered the industry average. A quick ratio below 1 shows that a
company may not be in a position to meet its current obligations because it has
insufficient assets to be liquidated. (Acid test refers to a quick and simple test gold
miners used to determine whether samples of metal were true gold or not. Acid
would be added to a sample; if it dissolved, it wasn’t gold. If it stood up to the acid,
it likely was). From a great real example on the Street.com see how Apple’s Quick
Ratio stacks up:
Quick Ratio Example: Apple (NASDAQ: AAPL)
The following figures are as of March 27th, 2021, and come from Apple’s balance
sheet. Numbers are in millions of dollars.
Cash and cash equivalents: $38,466
Accounts receivable: $18,503
Marketable securities: $31,368
Current liabilities: $106,385
QR = Liquid Assets / Current Liabilities
QR = ($38,466 + $18,503 +$31,368) / $106,385
QR = $88,337 / $106,385
QR = 0.83
Based on this calculation, Apple’s quick ratio was 0.83 as of the end of March
2021. This number could be higher if more assets were included in its calculations.
Cash ratio: Cash and cash equivalents / Current Liabilities
The cash ratio measures a business’s ability to use cash and cash equivalent to pay
off short-term liabilities. This ratio shows how quickly a company can settle
current obligations.
2) Leverage ratios
Companies often use short and long-term debt to finance business operations.
Leverage ratios measure how much debt a company has. Molson Coors Beverage
Co. , the maker of Coors Light and Miller Lite beer for instance, had been saddled
with debt, after an acquisition in the industry according to the Wall Street Journal.
Its CFO Tracey Joubert signaled to the market the company’s plans “reduce its
leverage ratio to below 3 times by the end of this year.” The types of leverage ratio
to consider are:
Debt ratio: Total Debt / Total Assets
The debt ratio measures the proportion of debt a company has to its total assets. A
high debt ratio indicates that a company is highly leveraged.
Debt to equity ratio: Total Debt / Total Equity
The debt-to-equity ratio measures a company’s debt liability compared to
shareholders’ equity. This ratio is important for investors because debt obligations
often have a higher priority if a company goes bankrupt.
Interest coverage ratio: EBIT / Interest expenses
Companies generally pay interest on corporate debt. The interest coverage ratio
shows if a company’s revenue after operating expenses can cover interest
liabilities.
3) Efficiency ratios
Efficiency ratios show how effectively a company uses working capital to generate
sales. For instance an analyst reported that Seattle-based bank Washington
Federal’s company’s efficiency ratio was 58.65%, down from 59.02% recorded a
year ago. A fall in efficiency ratio indicates improved profitability. There are
several ways to analyze efficiency ratios:
Asset turnover ratio: Net sales / Average total assets
Companies use assets to generate sales. The asset turnover ratio measures how
much net sales are made from average assets.
Inventory turnover: Cost of goods sold / Average value of inventory
For companies in the manufacturing and production industries with high inventory
levels, inventory turnover is an important ratio that measures how often inventory
is used and replaced for operations.
Days sales in inventory ratio: Value of Inventory / Cost of goods sold x (no. of
days in the period)
Holding inventory for too long may not be efficient. The day sales in inventory
ratio calculates how long a business holds inventories before they are converted to
finished products or sold to customers.
Payables turnover ratio: Cost of Goods sold (or net credit purchases) / Average
Accounts Payable
The payables turnover ratio calculates how quickly a business pays its suppliers
and creditors.
Days payables outstanding (DPO): (Average Accounts Payable / Cost of Goods
Sold) x Number of Days in Accounting Period (or year)
This ratio shows how many days it takes a company to pay off suppliers and
vendors. A lower days payables outstanding implies that a business is letting go of
cash too quickly and may not be taking advantage of longer credit terms. On the
other hand, when the DPO is too high, it means a company delays paying its
suppliers, which can lead to disputes.
Receivables turnover ratio: Net credit sales / Average accounts receivable
Accounts receivables are credit sales made to customers. It is important that
companies can readily convert account receivables to cash. Slow paying customers
reduce a business’s ability to generate cash from their accounts receivable.
The receivables turnover ratio helps companies measure how quickly they turn
customers’ invoices into cash. A high receivables turnover ratio shows that a
company quickly generates cash from accounts receivables.
4) Profitability ratios
A business’s profit is calculated as net sales less expenses. Profitability
ratios measure how a company generates profits using available resources over a
given period. Higher ratio results are often more favorable, but these ratios provide
much more information when compared to results of similar companies, the
company’s own historical performance, or the industry average. Some of the most
common profitability ratios are:
Gross margin: Gross profit / Net sales
The gross margin ratio measures how much profit a business makes after the cost
of goods and services compared to net sales. Comparing companies can be
illustrative – such as finding that Home Depot has a 33.6% gross profit margin
versus Walmart’s 25.1%.
Operating margin: Operating income / Net sales
The operating margin measures how much profit a company generates from net
sales after accounting for the cost of goods sold and operating expenses.
Return on assets (ROA): Net income / Total assets
Companies use the return on assets ratio to determine how much profits they
generate from total assets or resources, including current and noncurrent assets.
Return on equity (ROE): Net income / Total equity
Shareholders’ equity is capital investments. The return on equity measures how
much profit a business generates from shareholders’ equity. For instance a
company with a declining ROE could be seen as having more risk than a company
in the same industry with an increasing ROI.
5) Market Value ratios
Market value ratios are used to measure how valuable a company is. These ratios
are usually used by external stakeholders such as investors or market analysts but
can also be used by internal management to monitor value per company share.
Earnings per share ratio (EPS): (Net Income – Preferred Dividends) / End-of-
Period Common Shares Outstanding
The earnings per share ratio, also known as EPS, shows how much profit is
attributable to each company share.
Price earnings ratio (P/E): Share price / Earnings per share
The PE ratio is a key investor ratio that measures how valuable a company is
relative to its book value earnings per share.
Book value per share ratio: (Total Equity – Preferred Equity) / Total shares
outstanding
A company’s common equity is what common shareholders own after all liabilities
and preference shares have been settled from total assets.
The book value per share measures the value per share for common equity owners
based on the balance sheet value of assets less liabilities and preference shares.
Dividend yield ratio: Dividend per share / Share price
The dividend yield ratio measures the value of a company’s dividend per share
compared to the market share price.
When companies pay out dividends to shareholders, the value of dividends
received for each share owned is known as the dividend per share. Shareholders
and analysts compare the dividend per share to the company’s share price using the
dividend yield ratio.
Best Practices For Using Financial Ratios
Financial ratios help senior management and external stakeholders measure a
company’s performance. These best practices will drive effective decision-making.
● Compute financial ratios with accurate financial numbers
● Compare ratios across periods to identify performance trends
● Use relative competitor and industry benchmarks to measure performance
● Calculate ratios using balance sheet averages where applicable
● Interpret financial ratios correctly to support key business decisions
● Calculate and analyze ratios using the balance sheet, income statement, and cash
flow statement to get a holistic view of the business’s performance
Liquidity Ratio Analysis
It aims to determine a business’s ability to meet its financial obligations during the
short term and maintain its short-term debt-paying ability.
#1 – Current Ratio
The ratio of 1 is ideal; if current assets are twice a current liability. No issue will
be in repaying liability. However, if the ratio is less than 2, repayment of liability
will be difficult and affect the work.
Generally, one can use the current ratio to evaluate an enterprise’s short-
term solvency or liquidity position. Still, it is often desirable to know a firm’s
more immediate status or instant debt-paying ability than that indicated by the
current ratio for this acid test financial ratio. That is because it relates the
most liquid assets to current liabilities.
Or
helps to calculate actual liquidity. And for that, inventory and receivables are
excluded from current assets. In addition, some assets ban to understand better
liquidity. Ideally, the ratio should be 1:2.
#4 – Cash Ratio
If the ratio is high, then it reflects the underutilization of resources. If the ratio is
low, it can lead to a problem in the repayment of bills.
measures the relative inventory size and influences the cash available to pay
liabilities.
The receivable turnover ratio shows how often the receivable turns into cash.
The capital turnover ratio measures the effectiveness with which a firm uses its
financial resources.
Capital Turnover Ratio Formula = Net Sales (Cost of Goods Sold) / Capital
Employed
reveals the number of times the net tangible assets turns over during a year. The
higher the ratio better it is.
Asset Turnover Ratio Formula = Turnover / Net Tangible Assets
indicates whether or not working capital has been utilized effectively in sales. Net
Working Capital signifies the excess of current assets over current liabilities.
Net Working Capital Turnover Ratio Formula = Net Sales / Net Working
Capital
The Cash Conversion Cycle is the total time taken by the firm to convert its cash
outflows into cash inflows (returns).
Cash Conversion Cycle Formula = Receivable Days + Inventory Days –
Payable Days
This financial ratio measures profitability concerning the total capital employed in
a business enterprise.
Return on Investment formula = Profit Before Interest and Tax / Total Capital
Employed
EPS derives by dividing the company’s profit by the total number of shares
outstanding. It means profit or net earnings.
Earnings Per Share Formula = Earnings After Taxation – Preference
Dividends / Number of Ordinary Shares
Before investing, the investor uses all the above ratios to maximize profit and
analyze risk. He can easily compare and predict a company’s future growth
through ratios. It also simplifies the financial statement.
Business Risk Ratios
we measure how sensitive the company’s earnings are concerning its fixed costs
and the assumed debt on the balance sheet.
Total leverage is the percentage change in net profit relative to its sales. The total
leverage measures how sensitive the net income is to the change in sales.
It helps to measure the extent of equity to repay debt. One may use it for long-term
calculations.
#19 – Interest Coverage Ratio Analysis
signifies the ability of the firm to pay interest on the assumed debt.
Higher interest coverage ratios imply the greater ability of the firm to pay
off its interests.
If interest coverage is less than 1, then EBITDA is insufficient to pay off
interest, implying finding other ways to arrange funds.
tells us whether the operating income is sufficient to pay off all obligations related
to debt in a year.
Debt Service Coverage Formula = Operating Income / Debt Service
Stability Ratios
It is used with a long-term vision and to check the company’s stability in the long
run.
use to know whether the company is having good fun or not to meet the long-term
business requirement.
The ideal ratio is 0.67. If the ratio is less than 1, one can use it to purchase fixed
assets.
If the ratio increases, profit increases and reflects the business expansion. If the
ratio decreases, trading is loose.
Coverage Ratios
use to calculate dividends needed to pay to investors or interest to the lender. The
higher the cover, the better it is.
#24 – Fixed Interest Cover
Examples
For calculation of current ratio, let us assume the following for ABC ltd:
Importance
Assessment.
Comparison.
Trend.
Credit analysis.
Problem identification – The financial ratios in accounting.
Management decision.
Limitations
Lack of proper context .
Past data .
Variation in accounting methods .
Window Dresssing .
Lack of non-financial consideration .
The inflation effect .
Managerial Finance
Lecture 4th
The Financial Inclusion
Managerial Finance
Lecture 5th
Capital Budgeting Cash Flows and Techniques
Managerial Finance
Lecture 6th
Risk Management