FINC 301: INTRODUCTION TO
BUSINESS FINANCE
2020/2021
Professor Godfred A. Bokpin
BSc Admin (Accounting), MPhil (Finance),
PhD (Economics)
Email: gabokpin@ug.edu.gh
COURSE DESCRIPTION AND
OBJECTIVES

As an introductory finance course, it offers an overview of the
finance function from the perspective of the corporate financial
manager. Specifically, this course will cover: (i) the role of the
finance manager and a working knowledge of financial
markets, (ii) corporate financial concepts such as the time
value of money, financial statement analysis, sources of
financing to a firm, and (iii) some basic decision making
frameworks, namely, working capital management and shortterm financing. This course also introduces students to the
nature and workings of financial markets and their use by
corporations and investors.
Course Overview



No matter how brilliant a business idea is,
without funding, it cannot generate wealth.
On the other hand, given that financial resources
are limited, these resources must always be
utilized in the most efficient manner given the
goals of the firm.
This course seeks to situate the finance function
within the broader organizational setting and
outline its role in achieving stellar financial
performance.
Slide 3
Concept of Finance




Finance as a subject is thought to relate to three areas of studies
constituting Economics, Accounting and Mathematics. An
understanding of the basic relationship is necessary for the finance
student. Finance theory is a set of concepts that help think through
resource allocation over time. Finance may then be looked at as the
study of allocation of scarce resources over time. Finance can be
understood as an extension of economics, but studying finance is not
identical to studying economics
Finance can be said to be applied economics or economics of time
and risk
Finance concerns more about valuation reflecting passage of time and
risk or a science of valuation
Finance also involves decision making including: investment,
financing and working capital management/dividend policy decisions
Course Objectives

You will learn how to use financial management for problem-solving and decisionmaking in your personal life and professional role as managers, financial analysts etc.
Specifically, on successful completion of this subject, students would be able to:
– Explain the various decision roles of a financial manager
– Diagnose the financial health of an organization, prepare financial analysis
reports and offer appropriate financial advice
– Determine the relevant components that drive profits for a business venture.
– Determine the growth potential of an organization based on its funding capacity
– Select the appropriate funding method for an organization’s growth agenda
– Determine the appropriate balance between working capital management and
firm performance
– Make simple investment decisions by applying the time value of money concept
TGBTG
Slide 5
Overview of Corporate Financial
Management and the Financial Environment


Effective financial management is the defining characteristic between successful
firms and failed firms. Finance plays a critical role in business and society. This
session seeks to introduce students to the financial manager’s role and the financial
management decisions. It also exposes students to the competing goals to the
ultimate goal of value maximization.
At the end of this session, students should be able to:
– Differentiate between the financial implications of the different forms of
business organization
– Explain the basic types of financial management decisions and the role of the
financial manager
– Explain the goal of financial management
– Illustrate the agency problem and the role of corporate governance.
– Identify the various types of financial markets, transactions and financial
institutions
Session Objectives
At the end of the session, the student will
1. Explain the decision roles of the finance
manager
2. Identify the various forms and implications of
business organizations available
3. Explain the concept of financial markets and
related issues
4. Explain the concept of wealth maximization,
agency and governance
Slide 7
Session Outline
The key topics to be covered in the session are as follows:




Topic 1 - The Various Forms of Business Organizations
Topic 2 - The Role and Goal of the Finance Manager
Topic 3 -Ownership versus control of corporations and
Agency Issues
Topic 4 - Financial Markets
Slide 8
FORMS OF BUSINESS
ORGANIZATION
In Practice, businesses can be setup using any one of
the following forms of business organizations:
– Sole proprietorship
– Partnership
– Corporation (center of our financial management
sessions)
 Which form of business organisation is dominant
in Ghana and why
 What kind of support do they need to excell
 Are these support mechanisms available & working
Sole Proprietorship




A business that is organized as a sole proprietorship has a
single owner who usually provides all the capital from
personal resources.
Banks, friends and relatives are the primary sources available
to the sole proprietor for raising borrowed funds.
A sole proprietor is personally liable for all the debts of the
business.
For tax purposes in most settings, all income of the business
is treated as the proprietor's personal income and taxed at tax
rates applicable to personal income.
The Sole Proprietorship


This business is normally owned and run by one person(in
numbers) and typically has few, if any, employees
Advantages
–
–
–
–
–

No formal charter required (easy to create)
Less or possibly no regulation
Significant tax savings
Minimal organizational costs
Profits and control not shared with others
Disadvantages
–
–
–
–
Limited ability to raise large sums of money
Unlimited liability for the owner
Limited to the life of the owner
Usually no tax deductions for employees health, life or disability insurance
Slide 11
Partnership




A partnership is an agreement between two or more persons
to operate a business (2-20 for Ghana).
The partners are "jointly and severally" responsible for the
debts of the partnership.
A partnership is not taxed as a business. Instead, the income
of the business is allocated to the partners and each partner's
share of the income is taxed as if it were income from a
proprietorship.
In general a partnership interest cannot be sold without the
consent of the other partners.
The Partnership


Advantages
– Minimal organizational effort and costs
– Easy to raise capital
Disadvantages
– Unlimited liability for the individual partners
– Limited ability to raise large sums of money
– Dissolved upon the death or withdrawal of any of
the partners
Slide 13
The Corporation

Corporation is a legal entity separate from its owners
– Owners are known as stockholders/shareholders,
– Ownership is evidenced by the possesion of shares or stocks
– Most important of all the business organizations in terms of



Total sales, Assets ,Profits, Contribution to national income
Has many of the legal powers individuals have such as the ability
to enter into contracts, own assets, and borrow money
The corporation is solely responsible for its own obligations. Its
owners are not personally liable for any obligation the
corporation enters into.
Slide 14
The Corporation

Advantages
– Unlimited life
– Limited liability for its owners, as long as no personal guarantee on a
business-related obligation such as a bank loan or lease
– Ease of transfer of ownership through transfer of stock
– Ability to raise large sums of capital

Disadvantages
– Difficult and costly to establish, as a formal charter is required
– Subject to double taxation on its earnings and dividends paid to
stockholders
– Bankruptcy, even at the corporate level, does not discharge tax
obligations
Slide 15
Limited Liability Company



Ownership interest is called "equity" which is
represented by "shares".
A limited liability company is an independent legal
entity.
A limited liability company is a taxable entity and
pays tax on its taxable income at the corporate tax
rate. Dividends are taxed in the hands of
shareholders as their personal income. Thus the
limited liability company is subject to "double
taxation".
Limited Liability Company
Many limited liability companies are "private"
or "closely held" in the sense that they do not
issue shares to the public. Companies that can
legally issue shares to the public are called
"public companies".
 One of the advantages of the limited liability
company is that it can raise capital by
borrowing and issuing additional shares

The Corporation


Advantages
– Unlimited life
– Limited liability for its owners, as long as no personal guarantee on
a business-related obligation such as a bank loan or lease
– Ease of transfer of ownership through transfer of stock
– Ability to raise large sums of capital
Disadvantages
– Difficult and costly to establish, as a formal charter is required
– Subject to double taxation on its earnings and dividends paid to
stockholders
– Bankruptcy, even at the corporate level, does not discharge tax
obligations
Slide 18
The Finance Function: Financial
Manager
FINANCE FUNCTIONS IN A COMPANY
I. PLANNING
III. ADMINISTRATION OF FUNDS
– Long and Short-term corporate plans
– Manage cash; Manage investments
– Budgeting for capital expenditures and
– Make banking arrangements
operations
– Receive, keep and disburse the firm’s money
– Sales forecasting
– Credit and Collection management
– Performance evaluation
– Management of provident/pension funds
– Pricing
IV. ACCOUNTING AND CONTROL
– Economic appraisal
– Establishment of accounting policies
– Analysis of acquisitions and disinvestments,
– Development and reporting of accounting
etc.
II. PROVISION OF CAPITAL
– Establish and execute plans to acquire
capital
PROTECTION OF ASSETS
– Provision of insurance coverage
– Assure protection of business assets
and loss prevention through internal
and external auditing
– Real estate management
–
–
–
–
–
–
data
Cost standards
Internal auditing
Systems and procedures (accounting)
Government reporting
Report and interpretation of results of
operations to management
Comparison
of
performance
with
operating plans and standards
FINANCE FUNCTIONS IN A COMPANY
Finance Function
Finance Function
VI. TAX ADMINISTRATION
VIII. EVALUATION AND CONSULTING
– Establishment and administration
– Consultation and advice to other
of tax policies and procedures
corporate executives on company policy,
operations, objectives and effectiveness
– Relations with tax agencies
thereof
– Preparation of tax reports
IX.
MANAGEMENT
INFORMATION
– Tax planning
SYSTEMS
– Development and use of electronic data
VII. INVESTOR RELATIONS
processing facilities
– Establishment and maintenance of
– Development and use of management
liaison with investment community
information systems
– Establishment and maintenance of
– Development and use of systems and
communications with company
procedures
stockholders
– Counseling with analysts - public
financial information
The Responsibilities of the Finance
Manager

Capital Budgeting: Make decisions on what long term investments
should be undertaken by organization (Business Entity)?
– Involves planning and managing a firms long-term investments.
– Evaluate the size, timing and risk of future cash flows and select profitable investments for
the firm

Capital Structure: Decide where the organization (Business Entity)
will get funds to pay for long term investments?
– How much should the firm borrow
– What are the least expensive sources of funds available for the firm


Working Capital Management: Decisions on how organization
(Business Entity) should manage everyday (Short-term) financial
activities?
– Day to day receipt and disburstment of cash to ensure that the
firm has enough recources to continue its operation without costly
interruptions
Dividend Policy: Decide how much of the organization’s profits
should be distributed to owners?
Slide 22
The Goal of Financial Management

Stock holder wealth maximization
– Modern managerial finance theory operates on the
assumption that the primary aim of the firm is to
maximize the wealth of its stock holders.
• Alternative Goals of Financial Management




Profit maximization
Managerial reward maximization
Behavioral goals and
Social responsibility
Slide 23
The Goal of Financial Management

Stock holder wealth maximization
– Modern managerial finance theory operates on the
assumption that the primary aim of the firm is to
maximize the wealth of its stock holders.
• Alternative Goals of Financial Management




Profit maximization
Managerial reward maximization
Behavioral goals and
Social responsibility
Slide 24
Slide 25
Wealth Maximization


How can the financial manager affect stockholder’s wealth
maximization?
By influencing the
– Present and future earnings per share (EPS)
– Size, timing and the risk of these earnings
– Dividend policy
– Manner of financing the firm
In essence, how excellently the financial manager executes
these functions determine the ultimate success of the
business.
Slide 26
Exercise 1_Session 1

Discuss the advantages and disadvantages of
pursuing Managerial reward maximization,
behavioral goals and social responsibility as goals
of the finance function in an organisation.
Slide 27
Topic Three
OWNERSHIP VERSUS CONTROL
OF CORPORATIONS AND
AGENCY ISSUES
Slide 28
Separation of Ownership & Control




a situation in which the owners of a business do not manage it or
control it. This applies particularly in large publicly-owned companies.
It can also apply to smaller family-owned companies where the
business is run by managers.
This separation of ownership and management gives rise to an
agency relationship: when one or more persons(principals) employ
one or more other persons (agents) to perform some task.
Primary agency relationship exist between
– Shareholders and managers
– Managers and creditors

These relationships are major source of agency problems
Slide 29
PRINCIPAL-AGENT PROBLEM






In economic terms, the manager’s mandate will be to maximize owner’s
wealth.
That is, there is now a SEPARATION OF OWNERSHIP from
MANAGEMENT
This gives rise to a Principal-Agent relationship
Management need not know anything about shareholder tastes or
consumption preferences. His/Her task is to maximize the value of
investment.
However, owners run the risk that managers may look after their own
interest at the expense of owners who provide the funds.
The potential that this may happen is referred to as the, PRINCIPALAGENT PROBLEM or AGENCY PROBLEM
30
Agency Problem


The agency problem is a conflict of interest inherent
in any relationship where one party is expected to act in
another's best interests.
In business/corporate finance, the agency problem
usually refers to a conflict of interest between a
company's management and the company's
shareholders.
– For E.g. Managers take decisions which are not in
line with the goal of maximizing stock holders
wealth
– Managers work less eagerly and benefit themselves
in terms of salaries and perks
Slide 31
Agency Costs and Corporate Governance



Agency costs are thus the tangible and intangible
expenses borne by shareholders because of
disagreement between shareholders and managers or
the self-serving actions of managers.
These costs can be explicit, out-of-pocket expenses
– E.g. the costs of auditing financial statements to
verify their accuracy
Or more implicit ones
– e.g. Reduced stock price.
Slide 32
Corporate Governance



In order to minimize this agency problems and its
associated costs, a corporate governance system is
instituted.
Corporate governance is typically explained as the
manner in which firms are governed.
The most visible mode of corporate governance is the
corporate board of directors, which is a group of persons
acting as representatives of a firm’s shareholders and responsible
for establishing corporate management related policies and
making decisions on major company issues.
 In
essence, the expertise and integrity of the board determines how
successful a firm will be.
Slide 33
Topic Four
FINANCIAL MARKETS
Slide 34
Financial Markets Explained


A financial market is a broad term describing any
marketplace where buyers and sellers participate in
the trade of assets such as equities, bonds, currencies
and derivatives.
The importance of financial markets for the
development of a country's economy cannot be
overemphasized. Financial market gives strength to
economy by making finance available at the right
place.
Slide 35
Financial Markets & Corporate
Governance

Market for financial securities
– Money Markets and Capital Markets
– Suppliers of funds
– Users of funds
– Financial securities/assets/vehicles/instruments
– Intermediaries
– Regulators

Efficient financial markets allow for efficient
allocation of resources from units with surpluses
to units in need
36
The Classification of Financial Markets


There are different ways of classifying financial markets. One way is to
classify financial markets by the type of financial claim.
– The Debt market is the financial market for fixed claims of debt
instruments and
– the Equity market is the financial market for residual claims or
equity instruments.
A second way is to classify financial markets by the maturity if claims.
– The market for short-term financial claims is referred to as Money
Market and
– the market for long-term financial claims is called as Capital
market. Traditionally, the cutoff between short-term and long-term
financial claims has been one year – though the dividing line is
arbitrary, it is widely accepted.

Since short-term financial claims are invariably debt claims, the money
market is the market for short-term debt instruments. The capital market
is the market for long-term instruments and equity instruments.
Slide 37



A third way to classify financial markets is based on whether the claims
represent new issues or outstanding issues.
– The market where issuers sell new claims is referred to as the Primary
market and
– the market where investors trade outstanding securities is called the
Secondary market.
A fourth way to classify financial markets is by the timing of delivery.
– A Cash or Spot market is one where the delivery occurs immediately and
– a Forward or Futures market is one where the delivery occurs at a predetermined time in future.
A fifth way to classify financial markets is by the nature of its organizational
structure.
– An Exchange-traded market is characterized by a centralized organization
with standard procedures.
– An Over-the counter market is a decentralized market with customized
procedures.
Slide 38
Cash flows to and from the
firm
Slide 39
Financial Markets issues
 Risk - return tradeoff/risk that determines
returns.
 Time value of money.
 Focus on Cash - not
profits
 Incremental cash flows
count.
 The curse of competitive
markets.
 Efficient capital markets.
 The agency problem.
 Taxes bias business
decisions.
 All risk is not equal.
 Ethical dilemmas are
everywhere in finance
 All cash flows occur at
the year end
 Rates are always quoted
per annum.
FINANCIAL STATEMENT ANALYSIS
41
LEARNING OBJECTIVES
1. Describe and discuss financial
performance evaluation by internal and
external users.
2. Describe and discuss the standards for
financial performance evaluation.
3. State the sources of information for
financial performance evaluation.
42
LEARNING OBJECTIVES
(continued….)
4. Identify Tools and Techniques of
Performance Evaluation.
5. Discuss Major Categories of Accounting
Ratios.
6. Discuss Significance and Limitations of
Ratio Analysis.
43
Financial Performance Evaluation by
Internal and External Users
OBJECTIVE 1
Describe and discuss financial
performance evaluation by internal
and external users.
44
The Purpose of Accounting:
Financial Information
Financial analysis is a process of selecting, evaluating,
and interpreting financial data, (along with other pertinent
information) with the purpose of formulating an
assessment of a company’s present and future financial
condition and performance
Financial Statement Analysis is the process of identifying
financial strength and weakness of a business by establishing
relationship between the elements of balance sheet and
income statement.
The focus is typically on the financial statements, as they
are a disclosure of a financial performance of a business
entity but other reports are also important

Financial Performance Evaluation


Financial performance evaluation, also called financial
statement analysis, comprises all the techniques employed
by users of financial statements to show important
relationships in the financial statements and the trend in
those numbers over time.
Users of financial statements fall into two broad
categories: internal users and external users. Users of
financial statement may be classified into those with
direct financial interest and indirect financial interest
46
Financial Statement Analysis:
Players in the Communication Process…
Management
Preparation
CFO, CEO, Accounting Staff
Guided by GAAP
Management
Accounting
input
Independent Auditors
Verification
Partners, Managers, Staff
Guided by GAAS
Information
Intermediaries
Government
Regulators
Financial analyst/services
SEC,GSE
Analysis and Advice
Verification
Guided by Code.
Guided by SEC regs.
Users
Analysis and Decision
Investors, Lenders, etc.
47
Public
companies only
Financial Statement Analysis:
Common Objectives
1.
2.
Assessing the historical operating performance and
financial health of a supplier, customer, or competitor.
To understand the economics of a firm in order to
forecast its future profitability and risks
– Profitability is an increase in wealth
– Risk is the probability that a specific level of
profitability will not be achieved.
48
Financial Statement Analysis:
Common Objectives (Cont)
3.
An assessment of future profitability and risks is often meant
to provide a basis for
– making an investment in a firm’s common/ordinary or preferred
stock.
– extending credit (short or long-term)
– valuing a firm in settings such as an IPO, an acquisition candidate,
in court-directed bankruptcy hearings, or in liquidation actions.
– forming an opinion on a client’s financial statements with respect
to whether the client is a “going concern.”
– assessing whether combinations in an industry might generate
unreasonable (monopoly) returns, thus prompting antitrust action
by government regulators.
49
The Users of Accounting Information
DECISION MAKERS
Management
Various
functional
areas in
Organizations
Those with
Direct Financial
Interest
Those with
Indirect
Financial
Interest
Owners
Government
Creditors
Agencies
Labour Unions
Public
50
Internal User
Management is an internal user



Management’s primary objective is to increase the
wealth of the owners or stockholders of the
business.
Management’s main responsibility is to carry out
plans to achieve the financial performance
objectives.
Management develops monthly, quarterly, and
annual reports that compare actual performance
with objectives for key financial measures.
51
External Users
Creditors make loans in various forms.
 Investors buy shares, from which they
hope to receive dividends and an increase
in value.
 Both groups face risks and for both the
goal is to achieve a return that makes up
for the risk.

52
Others Users of Financial
Information



Government and its Agencies
Employees and Trade Unions
Company’s Publics
53
Standards for Financial Performance
Evaluation (Benchmarking)
OBJECTIVE 2
Describe and discuss the standards for
financial performance evaluation.
54
Standards for Financial Performance
Evaluation (Benchmarking)
The general standards of comparison include:
 Company’s own set of data
– Past data
– Future data
 Inter-firm comparison (Benchmarking against a
competitor etc)

Industry Average
55
Sources of Information
OBJECTIVE 3
State the sources of information for
financial performance evaluation.
56
Reports Published by the Company


The annual report of a company is an important source
of financial information.
The main parts of an annual report are:
– Management's analysis of the past year's operations.
– The financial statements.
– The notes to the statements, including the principal
accounting procedures used by the company.
– The auditors' report.
– A summary of past operations.
57
Tools and Techniques of Performance
Evaluation
OBJECTIVE 4
Apply horizontal analysis, trend
analysis, and vertical analysis and
Ratio Analysis to financial
statements.
58
Tools and Techniques of
Financial Performance Evaluation



Few numbers are very significant when
looked at individually.
It is the relationship between various
numbers or their change from year to year
that is important.
The tools of financial performance
evaluation are intended to show
relationships and changes.
59
Horizontal Analysis
Horizontal analysis is the process of computing changes in like
items from one year to another
Horizontal analysis begins with the computation of changes from the
previous year to the current year. The base year is the first year
considered.
Then dividing the cedi amount of change by the base period
amount.
Horizontal analysis uses both cedi amounts and percentages.
Percentage Change = 100 x
(
)
Amount of Change
Base Year Amount
60
Financial Statement Analysis: Horizontal
Analysis Tool
Increase (Decrease)
1998
Sales
1997
Amount
Percent
9.5%
$18,284
$16,701
$1,583
3,141
3,205
(64)
Net income
Prepared by F. AboagyeOtchere & J.K. Otieku
61
(2.0%)
Financial Statement Analysis:
Trend Analysis Tool

A form of horizontal analysis that examines more than a
two- or three-year period
– Use a selected base year whose amounts are set equal to
100 percent
– Compute trend percentages, each item for following years
is divided by the corresponding amount during the base
year
– Trend analysis is important because it may point to basic
changes in the nature of a business.
Trend % =
Any year $
Base year $
62
Financial Statement Analysis:
Trend Analysis Tool (Cont)
(in millions)
1998
Net Sales
$18,284
Cost of products sold
4,856
Gross profit
13,428
1997
1996
1995
1994
1993
$16,701
4,464
12,237
$15,065
3,965
11,100
$13,767
3,637
10,130
$11,984
3,122
8,862
$11,413
3,029
8,384
The resulting trend percentages follow:
1998
1997
1996
1995
1994
1993
Net sales
160%
Cost of products sold 160
Gross profit
160
146%
147
146
132%
131
132
121%
120
121
105%
103
106
100%
100
100
Sales, cost of products sold, and gross profit have trended
upward at almost identical rates throughout the five-year period
63
Vertical Analysis




Percentages are used to show the relationship of the
different parts to a total in a single statement.
The analyst sets a total figure in the statement equal to
100% and computes each component’s percentage of that
total.
The statement of percentages is called a common-size
statement.
Vertical analysis is useful for comparing the importance of
specific components in the operation of a business and
changes in the components from one year to the next.
64
Financial Statement Analysis:
Vertical Analysis Tool


Vertical analysis of a financial statement reveals the
relationship of each statement item to a specified base,
which is the 100% figure
Every other item on the financial statement is then
reported as a % of that base (common-size ratios)
– When an income statement is analyzed vertically, net
sales is usually the base
– Vertical analysis of balance sheet amounts are shown as
a percentage of total assets
Vertical analysis % =
Each income statement item
Net Sales
65
Financial Statement Analysis:
Vertical Analysis Tool (Cont)
FINC 301 COMPANY
Income Statement (Adapted)
Years Ended December 31, 1998 and 1997
Dollar amounts in millions
Net sales
$18,284 100.0% $16,701 100.0%
Cost of products sold
4,856
26.6
4,464
26.7
Gross profit
13,428
73.4
12,237
73.3
Operating expenses :
Marketing, selling,
and administrative
4,418
24.2
4,173
25.0
Advertising and products
promotion
2,312
12.6
2,241
13.4
Research and development 1,577
8.6
1,385
8.3
Special charge
800
4.4
Provision for restructuring
201
1.1
225
1.3
Other
(148)
(0.8)
(269)
(1.5)
Earnings before income taxes 4,268
23.3
4,482
26.8
Provision for income taxes
1,127
6.1
1,277
7.6
Net earnings
$ 3,141
17.2%66 $ 3,205
19.2%
Ratio Analysis




The way to compare companies of different sizes is to use standard
measures
Financial ratios are standard measures that enable analysts to compare
companies of different sizes
A Financial Ratio is a relationship between two accounting figures
expressed mathematically.
Ratios are guides or shortcuts that are useful in:
– Evaluating a company’s financial position and operations.
– Making comparisons with results in previous years or
with other companies.

The primary purpose of ratios is to point out areas needing further
investigation.
67
Major Categories of Ratios
OBJECTIVE 5
Discuss major categories of
Accounting ratios.
68
Financial Statement Analysis:
Ratio Analysis

The ratios used to make business decisions may be
classified broadly as follows:
– Ratios that measure the company’s ability to pay or the
risks of not meeting current liabilities [liquidity ratios]
– Ratios that measure the company’s ability to sell
inventory, collect receivables, etc [activity ratios]
– Ratios that measure the company’s ability to pay or the
risks of not meeting long-term debt [solvency ratio]
– Ratios that measure the company’s profitability
– Ratios used to analyze the company’s shares as an
investment [investment ratios]
69
Evaluating Liquidity


Liquidity is a company's ability to pay bills when they are
due and to meet unexpected needs for cash.
All ratios that relate to liquidity involve working capital
or some part of it.
– Current ratio: measures short-term debt-paying
ability.
– Quick ratio: measures short-term debt-paying ability.
– Acid-Test ratio: measures short-term debt-paying
ability.
70
Analysis of Risk and Liquidity
• Factors that affect risk of a firm
–
–
–
Economy-wide factors such as inflation
Industry-wide factors such as competition
Firm-specific factors such as potential for a labour strike
• Questions or issues on liquidity
a) Can the firm pay short-term obligations like workers' wages?
That is, what are measures of short term risk?
b) Can the firm pay long-term obligations like debt? That is, what
are long-term measures of risk?
Prepared by F. Aboagye-Otchere & J.K.
Otieku
71
Liquidity Ratio
Current Ratio = Current Assets
Current Liabilities
Quick Ratio =
Current Assets - Stock
Current Liabilities
Acid-Test Ratio =
Cash + cash Equivalents
Current Liabilities
72
Working Capital Financing Policy

Working capital financing policies may include
– Moderate: Match the maturity of the assets with the
maturity of the financing.
– Aggressive: Use short-term financing to finance
permanent assets.
– Conservative: Use permanent capital for permanent
assets and temporary assets.
73
Evaluating Profitability



Profitability reflects a company's ability to earn a satisfactory income.
A company's profitability is closely linked to its liquidity because
earnings ultimately produce cash flow.
Profitability ratios include:
– Profit margin: measures net income produced by each sales cedi.
– Asset turnover: measures how efficiently assets produce sales.
– Return on assets: measures overall earning power.
– Return on equity: measures profitability of shareholder investments.
74
Profitability Ratios
Return on Assets =
Net Income
Total Assets
Profit Margin =
Net Income
Net Sales
Asset Turnover =
Net Sales
Average Total Assets
Return on Equity =
Net Income
Stockholders’ Equity
Evaluating Activity Ratios


Activity ratios measure how efficient a firm is at
using the firm's resources.
Activity ratios include:
– Rate of Stock Turnover
– Average Collection period
– Average Payment Period
– Fixed Assets Turnover
76
Activity Ratios
Rate of Stock Turnover =
Cost of Sales
Average Stock
Average Collection Period = Receivables * 360 Days
Credit Sales
Average Payment Period = T. Creditors * 360 Days
Credit Purchases
Prepared by F. AboagyeOtchere & J.K. Otieku
77
Activity Ratios
Rate of Stock Turnover =
Cost of Sales
Average Stock
Average Collection Period = Receivables * 360 Days
Credit Sales
Average Payment Period = T. Creditors * 360 Days
Credit Purchases
Fixed Assets Turnover =
Fixed Assets
Evaluating Long-Term Solvency


Long-term solvency has to do with a
company's ability to survive for many years.
The aim of long-term solvency analysis is to
detect early signs that a company is headed for
financial difficulty.
Early signs that a company is on the road to
bankruptcy include:
– Declining profitability and liquidity ratios.
– Unfavorable debt to equity ratio.
– Unfavorable interest coverage ratio.
79
Long-Term Solvency
Debt to Equity Ratio =
Longterm Liabilities
Stockholders’ Equity

Measures capital structure and leverage.

Failure to honor debt can result in bankruptcy, so debt is risky.

BUT debt provides flexible financing:
– It can be temporary.
– Interest is tax deductible.
– It leverages stockholders’ investments if the company earns a
return on assets greater than the cost of interest.
Long-Term Solvency
(continued…)
Interest Coverage Ratio = Income Before Income Taxes + Interest Expense
Interest Expense

Measures creditors’ protection from default on interest payments.
81
Evaluating Investment Ratios


Investment ratios are used to analyze and
evaluate a company’s shares as an investment.
Investment ratios include:
– Earnings per share
– Price-Earnings ratio (P/E ratio)
– Dividend Yield etc
82
Earnings per Share
• This ratio is the profit that is attributable to each share of
common stock.
• It would be simply the net income less preferred dividends
divided by the number of common shares.
• However, the number of common shares is complicated by
certain securities that may become (converted to) common
share. How to account for these is a complex issue.
• For example, if there are 100 common shares but 50
preferred shares that could convert to 50 common shares,
do you divide earnings by 100 or 150? The answer depends
on how likely it is that the convertible securities will
convert.
83
Earnings Per Share (Cont.)
•
•
Most companies strive to increase EPS by about 10 -15% annually
EPS does not consider the amount of assets or capital required to
generate earnings; making it of limited use in comparing two firms.
•
For investment purposes, the price to earnings ratio (P/E ratio) or
P/E multiple is preferably used
84
Price-Earnings Ratio (P/E)
• This is the return to the purchaser of a share.
– P/E = (market price of a share of stock)/(EPS)
– The PE ratio measures the market’s perception of the
quality of a company’s earnings by indicating the price
multiple the capital market is willing to pay for the
company’s earnings.
– Presumably, this ratio reflects the info provided by all
financial info. in that, the market price reflects analysts’
perceptions of the company’s growth potential, stability
and risk.
85
Price-Earnings Ratio (Cont)
»
The P/E ratio commonly serves as a useful proxy for the expected growth rate
in dividends or earnings.
– In fact, a common Wall Street rule of thumb is that the growth rate ought
to be roughly equal to the P/E ratio e.g., see Peter Lynch’s book “One Up
on Wall Street”.
– Ceterus paribus, riskier firms will have lower P/E ratios because they have
higher rates of return.

There are two types of price earnings (PE) ratios or multiples.
– The trailing PE equals the current market price per share of common stock
(CS) divided by the last year’s EPS.
– The forward PE equals the current price per share of CS divided by next
year’s forecasted EPS.
Dividend Yield


»
Dividend yield is the ratio of dividends per share of stock to the
stock’s market price per share
This ratio measures the percentage of a stock’s market value that is
returned annually as dividends
Dividend Payout ratio
– expresses the % of earnings that is distributed to shareholders
as dividends. It is calculated by dividing dividends per share by
earnings per share.
– it provides an indication of a firm’s managerial or reinvestment
strategy. A low payout suggests that a firm is retaining a large
portion of earnings for reinvestment e.g., growth industries
87
Significance and Limitations of
Ratio Analysis
OBJECTIVE 6
Discuss the significance and
limitation of ratio analysis.
88
Significance of Ratio Analysis
Ratio Analysis is a powerful tool which is
used to gauge the financial strengths and
weaknesses of a business organization
• Assess profitability
• Risk associated with an investment
decision
• Performance of management
• Control operations
89
Limitations of Ratio Analysis
There are some limitations associated with
the use of accounting ratios.
• The financial statements used are
historical in nature
• Using quantitative data to take decisions
that are qualitative
• Standard of comparison
• Skills required
90