Corporate Finance: Ch01 Introduction

Corporate finance INTRODUCTION

Corporate finance is the study of planning, evaluating and drawing decisions in the course of business. Let’s take a simple example to determine the scope of our subject. This would cover around 85% to 90% of scheme of studies of corporate finance.

Suppose you intend to kick start a business. Three up-front questions that hit our top of the head are:

• What type of investments do we need? In other words, what type of assets will be required to support the intended business?
• Where the money will come from? Sources of investments to be determined in black and white.
• How we will finance our day to day monetary matters like purchase of raw materials and payment of salaries etc.?

To answer these question let’s explore them individually for twin purpose: to know what is corporate finance and secondly, to determine the scope of the subject.

Referring to question # 1 – Types of investment or assets needed in the business: The answer to this question can be found by defining Capital Budgeting process.

Capital Budgeting:

It involves planning, analyzing and acquiring capital assets like Plant and Machinery or Land or Building. These investments take ample amount of resources and therefore, these decisions are irreversible in nature. That in turn means that once the decision is implemented it would incur heavy losses if we want to un-do it subsequently. Therefore, making investment in capital assets is a very risky process and must be handled with care and skill.

SWOT analysis is also very helpful in capital budgeting process.

SWOT stands for:

• Strengths
• Weaknesses
• Opportunities
• Threats

Strengths are connected to Opportunities and in order to tap the lucrative opportunities you need to make capital investment, which must be handled with due care and skill ensuring effective decision making. This means that type of assets to be acquired depends on the nature, need and resources of business besides some other factors. For example, a large airline industry would acquire bigger plane than a smaller airline which may opt for a relatively cheaper plane.

Taking up the second question in line, that is, “where the money will come from?”

Broadly speaking there are two potential sources for making investments. The first sources emerge from the contributions of sponsors or directors who commence the business. This portion of investment is called Capital or Equity contribution.

The other source of investment is from loans and various financial instruments and markets. Banks provide long term and short loans to the business world and this has been the most important source of business finance and is being used widely.

Other source of external financing is issuance of bonds and securities in primary and secondary markets. This process is known as Capital Structure Decisions in which it is determined that how much of the total cost shall be financed by Equity contribution and Loans.

Moving to third and last question:

To finance day to day financial needs is in fact an issue that fall within the ambit of Working Capital policies. Following are the typical questions in this context:

• What would be our purchases level for raw materials?
• Do we need to import or are locally available?
• How much finances will be needed to procure raw materials?
• What are our customers or markets?
• How many days credit to be extended to customer and taken from creditor?

FINANCIAL STATEMENTS & CORPORATE FINANCE WITH SOME IMPORTANT CONCEPTS:

There are basically three financial statements that every business entity runs periodically. It includes:

• Balance Sheet
• Income Statement
• Cash Flow

•

Balance Sheet:

This is a statement of resources controlled by and obligations to settle by an entity as on a specified date. The format of Financial Statements is governed by International Financial Reporting Standard in Kenya. However, in US these are governed by the provisions of Generally Accepted Accounting Principles (GAAP).

Balance Sheet Contents are:

1. Fixed Assets
2. Current Assets
3. Current Liabilities
4. Long Term Liabilities
5. Capital & Reserves

Assets (both fixed and current) are placed in balance sheet in the order of less liquid or illiquid to liquid. This means that current assets are more liquid than fixed assets. Then question arises “what is liquidity?” or “what is a liquid asset?”

An asset that can be converted to cash quickly and without loss of value is liquid asset. For example, prize bond is not a currency but you can get the face or par value of a prize bond when you sell the bond to any one. But this is not the case when you want to sell your motorcycle or car. Therefore, car or motor cycle is not a liquid asset but prize bond or gold are highly liquid.

Current Assets and Current Liabilities when clubbed together, give birth to another concept known as working capital.

Current assets are those that form part of the circulating capital of a business. They are replaced frequently or converted into cash during the course of trading. The most common current assets are stocks, trade debtors, and cash.

Current liabilities are those short-term liabilities which are intended to be constantly replaced in the normal course of trading activity. Current liabilities typically comprise: trade creditors, accruals and bank overdrafts.

There is another concept of Cash Cycle associated with working capital. Take a compact example to understand.

You acquire goods or raw materials from vendors on credit. It takes time (say in days) to process or transform raw materials to finished goods, which are sold to customers on credit. Customers or Debtors are allowed a time period (in days) to settle or pay their bills and money received from debtors is used to pay off creditor, who provided goods on credit. Let’s assume you allowed your customers 30 days to pay for goods you sold to them on credit. And on the other hand you sought 35 days cushion from creditors to pay off purchases of raw materials. In this simple example you were still able to use money for 5 days before paying to creditors. This means the operating cycle is positive.

Other concepts from financial statements shall be taken up in the next hand out.

COMPARISON OF FINANCIAL STATEMENTS

Often it becomes very difficult to compare financial statements of two or more business entities due to

1. Size
2. Functional currency.

However, we can overcome these problems by utilizing two effective tools of comparison. These tools can be used for comparing performance of single entity over period of time and to compare two or more entities.

• 1. COMMON SIZE STATEMENTS
  2. RATIO ANALYSIS

1. COMMON SIZE STATEMENTS

Take the balance sheet first. Instead of putting rupee values in balance sheet, we place %age against each line item with regard to total asset. The total assets are taken as 100 and every line item relationship with total assets expressed in %age is placed against it. Take a look at the attached Common Size balance sheet.

During 2002 total assets were 60.73% of total assets and that has been increased to 62.87% of total assets in 2003. Every line-item on asset side is expressed as % of total assets. You are now in a position to compare financial statements over a period of time to know what developments have been made over time.

In common size income statement every line item is expressed as %age of sales. In other words, cost of sales, operating expenses and net income add up to 100%. Let look at the Common Size Income Statement. Cost of Sales in 2002 was 53.94% of sales, which dropped to 51.47% in 2003. This is a favorable symptom because any reduction in cost will lead to increase in profit. This is confirmed when we look at the gross profit. In 2002 GP was 46.06% of sales and that increased to 48.53% in 2003. The comparison here reveals that company has improved it performance over the year 2002.

Base Year Analysis: Common Size analysis is also known as Vertical Analysis. Base year analysis is another tool of comparing performance and is also known as Horizontal Analysis.

In this case, performance is compared over, say, five years period. The earliest year or the first year is taken as base year and every line item in the balance sheet of base year is taken as 100%. In the subsequent years amounts of every line item are expressed as %age of base year amount.

You can see the Base Year analysis example from the attached balance sheet. Comparison is being made from the year 2001 to 2006; therefore, the earliest year i.e., 2001 is labeled as base year. Total fixed assets in 2001 were Ksh. 100,000/ – expressed as 100% (cell H9: in blue font). In year 2005 the total investment in fixed assets has risen to Ksh. 155,000/-, which is 155% of base year amount (Ksh. 100,000). This means that from 2002 to 2005, 55% investment of base year amount has been injected in fixed assets and that further increased to 60% at the end of year 2006.

2) Ratios Analysis:

This is another widely acknowledged and used comparison tool for financial managers. A ratio is a relationship between two or more line items expressed in %age or number of times. Financial ratios are useful indicators of a firm’s performance and financial situation. Most ratios can be calculated from information provided by the financial statements. Financial ratios can be used to analyze trends and to compare the firm’s financials to those of other firms. In some cases, ratio analysis can predict future bankruptcy.

Financial ratios can be classified according to the information they provide.

The following types of ratios frequently are used:

1. Short Term Solvency or Working Capital ratios
2. Long term solvency ratios
3. Asset management turnover ratios
4. Profitability ratios
5. Market value ratios

Short Term Solvency or Working Capital ratios:

These ratios provide information about a firm’s ability to meet its short-term financial obligations. They are of particular interest to those extending short-term credit to the firm. Two frequently-used liquidity ratios are the current ratio (or working capital ratio) and the quick ratio.

The current ratio is the ratio of current assets to current liabilities: Current Ratio = Current Assets/Current Liabilities

Keeping the comparison purpose in our mind, you can see that in the attached balance sheet this ratio improved in 2003 over 2002. Normally, this ratio is expressed as 0.77:1meaning that current assets are 77% of current liabilities in 2002. This was improved at the end of year 2003 when our current assets were more than liabilities. The ratio in 2003 is 1.11:1.

Short-term creditors prefer a high current ratio since it reduces their risk. Shareholders may prefer a lower current ratio so that more of the firm’s assets are working to grow the business. Typical values for the current ratio vary by firm and industry. For example, firms in cyclical industries may maintain a higher current ratio in order to remain solvent during downturns. One drawback of the current ratio is that inventory may include many items that are difficult to liquidate quickly and that have uncertain liquidation values. The quick ratio is an alternative measure of liquidity that does not include inventory in the current assets. The quick ratio is defined as follows:

Quick Ratio = (Current Assets – Inventory)/ Current Liabilities

This ratio also shows the investment level in inventories. Excessive investment in inventories is often considered as inefficient use of resources.

The current assets used in the quick ratio are cash, accounts receivable, and notes receivable. These assets essentially are current assets less inventory. The quick ratio often is referred to as the acid test.

Asset Turnover Ratios:

Asset turnover ratios indicate of how efficiently the firm utilizes its assets. They sometimes are referred to as efficiency ratios, asset utilization ratios, or asset management ratios. Two commonly used asset turnover ratios are receivables turnover and inventory turnover.

Receivables turnover is an indication of how quickly the firm collects its accounts receivables and is defined as follows:

Receivables Turnover = Annual Credit Sales / Accounts Receivable

The receivables turnover often is reported in terms of the number of days that credit sales remain in accounts receivable before they are collected. This number is known as the collection period.

The collection period also can be written as:

Average Collection Period = 365 / Receivables Turnover

Another major asset turnover ratio is inventory turnover. It is the cost of goods sold in a time period divided by the average inventory level during that period:

Inventory Turnover = Cost of Goods Sold/Inventory

The variations in formula of inventory turnover relates to the denominator as some financial managers take closing inventory value and other prefer to have average inventory, which we can work out by adding opening and closing inventories and dividing by 2.

The inventory turnover often is reported as the inventory period, which is the number of days worth of inventory on hand, calculated by dividing the inventory by the average daily cost of goods sold:

Inventory Period = Annual Cost of Goods Sold / Average Inventory

The inventory period also can be written as:

Inventory Period = 365/Inventory Turnover

Other asset turnover ratios include fixed asset turnover and total asset turnover.

Leverage or Long term solvency Ratios

Financial leverage ratios provide an indication of the long-term solvency of the firm. Unlike liquidity ratios that are concerned with short-term assets and liabilities, financial leverage ratios measure the extent to which the firm is using long term debt.

The debt ratio is defined as total debt divided by total assets: Debt Ratio = Total Debt/Total Assets

The debt-to-equity ratio is total debt divided by total equity:

Debt-to-Equity Ratio = Total Debt/Total Equity

Debt ratios depend on the classification of long-term leases and on the classification of some items as long-term debt or equity. The times interest earned ratio indicates how well the firm’s earnings can cover the interest payments on its debt. This ratio also is known as the interest coverage and is calculated as follows: Interest Coverage = EBIT/Interest Charges

Where EBIT = Earnings before Interest and Taxes Profitability Ratios Profitability ratios offer several different measures of the success of the firm at generating profits.

The gross profit margin is a measure of the gross profit earned on sales. The gross profit margin considers the firm’s cost of goods sold, but does not include other costs. It is defined as follows:

Gross Profit Margin = Sales – Cost of Goods Sold/Sales

Return on assets is a measure of how effectively the firm’s assets are being used to generate profits. It is defined as:

Return on Assets = Net Income/Total Assets

Return on equity is the bottom line measure for the shareholders, measuring the profits earned for each dollar invested in the firm’s stock. Return on equity is defined as follows:

Return on Equity = Net Income/Equity Market Ratios:

Earnings per Share:

This explains the portion of net income attributable to one common share. It is calculated as: EPS = net income / No. of O/S shares

P/E ratio = price per share/EPS

Market to Book Value:

= MV per share/BV per share

Use and Limitations of Financial Ratios

Attention should be given to the following issues when using financial ratios:

A reference point is needed. To be meaningful, most ratios must be compared to historical values of the same firm, the firm’s forecasts, or ratios of similar firms.

Most ratios by themselves are not highly meaningful. They should be viewed as indicators, with several of them combined to paint a picture of the firm’s situation.

Year-end values may not be representative. Certain account balances that are used to calculate ratios may increase or decrease at the end of the accounting period because of seasonal factors. Such changes may distort the value of the ratio. Average values should be used when they are available. Ratios are subject to the limitations of accounting methods. Different accounting choices may result in significantly different ratio values.