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An Introduction to the financial tools in measuring Liquidity and Profitability

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Any opinions, findings, conclusions or recommendations expressed in this material are those of the authors and do not necessarily reflect the views of UK Essays.

Published: Mon, 5 Dec 2016

Tools that are important in monitoring business are liquidity and profitability. Liquidity refers to solvency meaning how quickly assets can be converted to cash while the income statement measures the financial performance of an entity through measuring profitability. The main financial documents of a company measures profitability and liquidity, the statement of comprehensive income measures profitability whilst liquidity is measured by the statement of financial position.

Liquidity is measured by comparing the current assets and current liabilities of an entity. Current assets are resources of a business maturing within a year whilst current liabilities are the short term obligations of a business maturing within a year. Therefore, when measuring liquidity we measure the ability of an entity to cover its short term obligations with its current resources which includes inventory, Debtors, cash in the bank and petty cash amongst other resources. If a firm can cover its current obligations with its current resources twice it is considered liquid meaning it can cover its current obligations with few difficulties and any ratio less than that is considered illiquid meaning the entity will face difficulties in settling its current obligations which is not a good sign for any entity.

Profitability is measured by matching revenue for a period with expenses for that period. Revenue is the proceeds an entity receives from selling its products from its core business activities. Whilst expenses are those costs incurred during a period in the process of generating sales revenue. Examples of expenses include electricity, rent, depreciation, salaries and wages e.t.c. The excess of revenues over expenses means the business is profitable whilst the vice versa means its making a loss. Profitability is measured in the income statement, and in addition to cash items it also considers non cash items such as depreciation. As a result profitability is not a true reflection of the cash generated by the business given the fact that it is drawn on an accrual basis.

Yearling Ltd

The company is faced with disagreements between two departments which are the accounting and finance staff. The accounting staff believes that if the company is profitable it should be able to pay for its obligations whilst the finance staff disagrees. The elaboration in the above paragraphs has explained profitability and liquidity and differences can be identified from the explanations. That is profitability means the ability of the firm to cover its operational expenses with its operational revenue and this includes cash and non cash items and hence can not measure the ability of a firm to pay its obligations. On the other hand liquidity measures the ability of a firm to cover its obligations with its resources and hence a perfect measure of the ability of the firm in covering its financial obligations. Hence, a profitable firm can be illiquid i.e. can face liquidity challenges in meeting its obligations.

Conclusion

The financial manager’s staff is right in advocating for party budget cut in order to reduce their financial obligations given the challenge they are faced with. On the other hand the accounting staff are wrong in thinking that a profitable firm implies liquidity as these are two different things as was discussed in the previous paragraphs.

Question 2

Question 3

3.1.1. Debt Ratio

A debt ratio compares a company’s total debt to its total assets. Debt consists of the amounts borrowed or owing to creditors. The ratio is used to gain a general idea as to the amount of leverage or debt being used by a company. A low percentage means that the company is less dependent on debt or leverage i.e. money borrowed from and/or owed to others. The lower the proportion, the less leverage a company is using and the stronger its equity position. This is so because the lower the chances that the company will be liquidated to meet the debt obligations. In general, the higher the ratio, the more risk that company is considered to have taken on. Debt ratio is calculated by the following formula:

For the companies under discussion their debt ratios are as follows:

Pelican Paper Ltd

Timberland Forest Ltd

1000000/10000000

5000000/10000000

10%

50%

Timberland Forest Ltd has got a high ratio of 50% compared to the ratio of Pelican Paper Ltd of 10%. This means that Timberland has a high financial risk as it is financed by debt more than Pelican. The more debt compared to equity a company has, which is signalled by a high debt ratio, the more leveraged it is and the riskier it is considered to be.

3.1.2. Times Interest earned Ratio

A metric used to measure a company’s ability to meet its debt obligations. It is calculated by taking a company’s earnings before interest and taxes (EBIT) and dividing it by the total interest payable on bonds and other contractual debt. It is usually quoted as a ratio and indicates how many times a company can cover its interest charges on a pre-tax basis. Failing to meet these obligations could force a company into bankruptcy. The ratio is calculated as follows:

Times Interest Earned=Earnings before interest and taxes/interest

For the two companies their respective ratios are as follows:

Pelican Paper Ltd

Timberland Forest Ltd

6250000/100000

6250000/500000

62.5 times

12.5times

Pelican Paper Ltd has a high times interest earned ratio of 62.5times compared to Timberland’s of 12.5times. This means Pelican has a high ability to cover its debts compared to Timberland as reflected by the number of times they can cover their interest obligations with available earnings.

Conclusion

Timberland has a high financial risk reflected by a high debt ratio and a lower time interest earned ratio.

3.2

3.2.1. Operating Profit margin

Operating profit margin is the proportion of operating profit to Sales revenue for that period. Operating profit margin indicates how effective a company is at controlling the costs and expenses associated with their normal business operations. A high ratio means a high profitability whilst a lower means less profitable. The ratio is calculated as follows:

Operating profit margin = operating profit/sales

The respective ratios for the two companies are as follows:

Pelican Paper Ltd

Timberland Forest Ltd

6250000/25000000

6250000/25000000

25%

25%

The companies has the same ratios and this implies that they are equally good in managing their costs and expenses hence profitability based on this ratio.

3.2.2. Net Profit Margin

The ratio measures the percentage of profit available to ordinary shareholders to Sales. This number is an indication of how effective a company is at cost control. The higher the net profit margin is, the more effective the company is at converting revenue into actual profit. The net profit margins are a good way to compare companies in order to gauge which ONES are relatively more profitable. The ratio is calculated by the following formula:

Net profit margin = Earnings available for ordinary share holders/sales

The respective ratios of the two companies are as follows:

Pelican Paper Ltd

Timberland Forest Ltd

3690000/25000000

3450000/25000000

14.76%

13.80%

Pelican has a high ratio compared to Timberland which means a high profitability based on this ratio. Therefore Pelican is profitable than Timberland.

3.2.3. Return on Total Assets

Measures profit in proportion to total assets, in other words the effectiveness of management utilising the available assets in generating profits. A high ratio means greatest effectiveness and profitability. The ratio is calculated as follows:

Return on total assets = Earnings available for ordinary shareholders/Total assets

For the two companies the respective ratios are as follows:

Pelican Paper Ltd

Timberland Forest Ltd

3690000/10000000

3450000/10000000

36.90%

34.50%

Pelican has a high ratio compared to Timberland’s hence high profitability.

3.2.4. Return on common equity

Measures the return earned on the ordinary shareholder’s investment in the firm. The amount of net income returned as a percentage of shareholders equity. Return on equity measures a corporation’s profitability by revealing how much profit a company generates with the money shareholders have invested.  

ROE is expressed as a percentage and calculated as:

Return on Equity = Net Income/Shareholder’s Equity

Net income is for the full fiscal year (before dividends paid to common stock holders but after dividends to preferred stock.) Shareholder’s equity does not include preferred shares.

The two companies’ ratios are as follows:

Pelican Paper Ltd

Timberland Forest Ltd

3690000/9000000

3450000/5000000

41%

69%

Pelican has a lower return on equity compared to Timberland and based on this ratio Timberland is more profitable compared to Pelican.

3.3.

Timberland has become more profitable because of the larger debt. Debt has a fixed interest payment and its tax allowed meaning it is tax deductable and as a result a high debt means a high interest payment and lower tax hence increased profits.

3.4.

The risks undertaken by Timberland investors are basically financial risks which include the liquidity risk, interest rate risk and credit risk.

Question 4

Item

Change(Rands)

inflow(I)/outflow(o)/neither(N)

Cash

+100

I

Trade and other payables

-1000

O

Short term borrowing

+500

I

Long-term borrowing

-2000

O

Inventory

+200

O

Non-current assets

+400

O

Trade receivables

-700

I

Net profit

+600

 

Depreciation

+100

N

Repurchase of shares

+600

O

Cash dividends

+800

I

Sale of shares

+1000

I

Question 5

5.1.

Year

Cashflow

PVIF(5%)

PV

1

800

0.95

761.90

2

900

0.91

816.33

3

1000

0.86

863.84

4

1500

0.82

1234.05

5

2000

0.78

1567.05

Present Value of mixed cash flows

5243.17

5.2.

The amount that can be paid at most is 5 243.17

5.3.

Present Value of the mixed cash flows at 7% is as follows:

Year

Cashflow

PVIF(5%)

PV

1

800

0.93

747.66

2

900

0.87

786.09

3

1000

0.82

816.30

4

1500

0.76

1144.34

5

2000

0.71

1425.97

Present Value of mixed cash flows

4920.37

An opportunity cost of 7% implies that the investor will be prepared to pay less now and earn the same return as the one who pays more at 5% return.

Question 6

6.1. Risk Averse

Describes of an investor who, when faced with two investments with same or a similar expected return and different risks, will prefer the one with the lower risk. Given the trade off between risk and return its means risk averse investors will always lose on a potential of earning higher returns as investments with lower risks tend to have lower returns.

6.2. Risk indifferent

This describes investors who overlook purposely risk when deciding between investments. They are also called risk neutral investors and they are mainly concerned with an investment expected return.

6.3. Risk seeking

Describes investors who are willing to take additional risks for investments that have relatively low expected return. This contrasts with a typical investor mentality – risk aversion. They tend to take higher risks in an effort to earn higher returns. They are also termed risk lovers.

6.4.

Financial managers are best described as risk averse as they always seek to minimise risk when they make financial decisions.

Question 7

7.1.

Standard deviation measures the deviation of the returns from the expected return whilst range measures the differences between the highest possible return and the lowest return of a project. The higher the standard deviation the higher the risk whilst the same can be said about range, therefore project A is less risky as it has the lowest standard deviation and range compared to other projects.

7.2.

Project A has a lower standard deviation

7.3

Standard deviation measures extend at which the returns are dispersed from the expected return of an asset. But it does not measure proportionately, so given different returns standard deviation will not be proper to use it as a measure of risk for purpose of comparison.

7.4

Coefficient of variation = Standard deviation/Expected Return

Project

Coefficient of variation

A

2.9%/12%

0.24

B

3.2%/12.5%

0.26

C

3.5%/13%

0.27

D

3%/12.8%

0.23

7.5

Coefficient of variation is a best measure of risk for purposes of comparison as it measures proportional deviation from the mean. Given that Grassland owners are risk averse they will choose a project with the lowest coefficient of variation which is project D based on the table above.

Question 8

8.1

Comparison of Ordinary shareholders and other providers of long term capital

Ordinary Shareholders

Other Suppliers of long term capital

Dividends to be paid are at the discretion of the companies board of directors

Receives a fixed interest whether the company made profit or not.

Dividend payments are taxed

Interest payments are tax deductible

Permanent form of financing

They mature

Have secondary claims to assets and income of the company.

Have primary claims to income and assets of a company.

Owners of the firm

Creditors of the firm

Have voting rights

Don’t have voting rights.

8.2

Rights offering are when ordinary shareholders are offered new shares at a discounted price first before they become available to the public. Therefore, this offering protects a firm’s shareholders from dilution of their holding in such a way that they are given preference to maintain their holding first by being offered proportional new shares to their holding. In that manner protected from a possible dilution if they were to be taken by new shareholders.

8.3.

Authorised Shares

Authorised shares quantify the maximum total shares a company can be allowed to issue. In other words it is the number of shares a company is authorised to issue highlighted in its articles and memorandum of association. It is from this that the company can decide on the number of shares that it can issue and can only issue at most to this amount of authorised shares otherwise it can issue less.

Issued shares

It’s the number of shares that has been issued and paid for and it represents part of the amount equity reflected in the statement of financial position. These also represents the amount of he authorised shares held by the public. Issued shares represents the sum of issued and treasury shares.

Treasury shares

A company can decide to purchase part of the issued shares back for some reasons. If it does the shares will be held by the company and they do not participate in any thing i.e. they do not participate in voting nor receive dividends. These types of shares are the ones termed treasury shares

8.4.

Preference shareholders tend to have more favourable basic rights in terms of the distribution of earnings and assets compared to ordinary shareholders. They often have features of debt instruments which makes them superior in terms of claims compared to ordinary shareholders. The claims that preference shares will be discussed in the paragraphs that follow;

Preference shares have a fixed claim on the firm’s income that takes precedence over the claim of ordinary shareholders. This makes them less risk compared to ordinary shareholders as they have guaranteed income.

Given that they are participative preference shares they will also have preference over ordinary shareholders in the distribution of earnings. Furthermore, if they do not receives the dividend earnings it implies the ordinary shareholders they have not as well. This then makes and shows that the ordinary shareholders are the true risk takers.

In the event of liquidation, preference shares do have a preference over ordinary shareholders in claims over assets of the firm. In other words they are paid their initial capital first before ordinary shareholders could be paid.

8.5.

The cumulative future of preference shares refers to the guaranteed payment of dividends to the shares irregardless of the performance of the company. In the event of a company having less financial resources to pay for the dividend, it will be deferred and paid as and when the company realizes the resources to pay. In other words the dividends are accumulated and paid when the company can. For example, if a company is liable to pay a 10 000 dividend annually for preference shares and it happens that one financial period the lack financial resources to pay the dividend they defer it to the following financial period. As a result, in the following financial period they will have to pay a dividend of 20 000 which covers the 10 000 for the last period and the 10 000 for the current period.

Question 9

Valuation of shares with no dividend growth, the formula is as follows.

9.1

Share price = Dividend per share/cost of capital

2.4/0.12

R 20.00

9.2

2.4/0.2

R 12.00

9.3

The higher the risk the higher the value, a lower interest rate results in a higher value. This is so because the lower the interest rate the higher the risk of default and that risk should be compensated by an increased capital value. The reverse is also true for a higher interest rate as it has resulted in a lower capital value.


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