Introduction to PEHAA
Basics of Corporate Finance
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CONTENT
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Role and objective function of corporate finance within an
organization
Basic Corporate Finance Principles
Cash flow and Capital Budgeting Approaches and Decision
Rules
Financial management framework in a public enterprise
Main principles and rules of financial management in an SOE
The anatomy of financial statements and how to read them
Financial statement Analysis
Mergers and Acquisitions
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Role and objective function of corporate finance within
an organization
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FUNCTIONS OF CORPORATE FINANCE
• Determine funding
requirements
• Investment
profitability of
investment decisions
• Determine when to
distribute dividends
or investment back
in business
• Choose for debt/
equity or a mix of
both
Capital
Budgeting
Capital
Structure
Dividend
Distribution
Working
Capital
Requirements
• Managing capital for
day-to-day
operations
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FUNCTIONS OF CORPORATE FINANCE
 Planning finances: Here is where the comprehensions are
made use of to determine the finances of the company
effectively. Decisions need to be taken on how much
finance is needed, how it will be sourced, where it will be
invested, would the investment bring in profits, how much
is anticipated profits and such to decide on a firm plan-ofaction.
 Capital raising: This is a vital stage highlighting the
importance of corporate finance and decisions taken here
will involve assessment of company assets four sources to
fund investments. To raise enough capital a company may
decide to sell shares, issue debentures and shares, take
bank loans, ask creditors to invest etc
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FUNCTIONS OF CORPORATE FINANCE
 Investments: Investments can be either on working capital
or fixed assets. Fixed capital is utilised for financing the
purchase of machinery, infrastructure, buildings,
technological upgrades and property. However, working
capital is required four day to day activities like rawmaterial purchases, running expenses of the company,
salaries and overheads and bills.
 Risk management and financial monitoring: Persistently
keep an eye on the investments is required. Riskmanagement aims to reduce and mitigate the undertaken
risks of investments and forms a part of the on-going
monitoring process.
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ACTIVITIES OF CORPORATE FINANCE
 Investments & Capital Budgeting : Investing and capital
budgeting is one the activities in corporate finance that
includes planning where to place the company’s long-term
capital assets in order to generate the highest riskadjusted returns. This mainly consists of deciding whether
to pursue an investment opportunity through extensive
financial analysis. Financial modelling, also falling under
Investing and capital budgeting as one the activities in
corporate finance, is used to estimate the economic
impact of an investment opportunity and compare
alternative projects. An analyst with often use Internal
Rate of Return (IRR) in conjunction with Net Present Value
(NPV) to compare projects and pick the optimal one.
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ACTIVITIES OF CORPORATE FINANCE
 Capital Financing: This is one of the core activities in corporate
finance and includes decisions on how to optimally finance the
capital investments through the business’ equity, debt, or a mix
of both. Long-term funding four major capital expenditures or
investments may be obtained from selling company stocks or
issuing debt securities in the market through investment banks.
Balancing the two sources – equity and debt, should be closely
managed as one of the activities in corporate finance because
having too much debt may increase the risk of default in
repayment, while depending too heavily on equity may dilute
earnings and value four original investors.
 Dividends & Return of Capital: Dividends & Return of Capital
requires the corporate finance professionals within the
company to decide whether to retain a business’s excess
earnings four future investments and operational requirements
or to distribute the earnings to shareholders in the form of dividends
or share buybacks.
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Basic Corporate Finance Principles (Financing;
Investment; and Dividend principles)
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FINANCING, INVESTMENT, DIVIDEND
PRINCIPLES
Investment Definition: An investment is an asset or item acquired with
the goal of generating income or appreciation. Appreciation refers to an
increase in the value of an asset over time. When an individual
purchases a good as an investment, the intent is not to consume the
good but rather to use it in the future to create wealth.
Financing Definition: Financing is the process of providing funds for
business activities, making purchases, or investing. Financial institutions,
such as banks, are in the business of providing capital to businesses,
consumers, and investors to help them achieve their goals.
Dividend Definition: A dividend is the distribution of a company's
earnings to its shareholders and is determined by the company's board
of directors. Dividends are often distributed quarterly and may be paid
out as cash or in the form of reinvestment in additional stock.
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Basic Corporate Finance Concepts
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CAPITAL BUDGETING PROCESS
To identify
Investment
Opportunities
Gathering of
the Investment
Proposals
Review of
Performance
Capital Budgeting
Process
Decision
Making
Process in
Capital
Budgeting
Implementation
Capital Budget
Preparations &
Appropriations
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CAPITAL BUDGETING
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The process of identifying, evaluating, planning, and financing
capital investment projects of an organization.
Capital budgeting is defined “as the firm’s formal
process for the acquisition and investment of capital.
It involves firm’s decisions to invest its current funds
for addition, disposition, modification and replacement
of fixed assets”.
“Capital budgeting is long term planning for making and
financing proposed capital outlays”- Charles T. Horngreen.
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CAPITAL BUDGETING
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Capital budgeting involves capital investment projects which
require large sum of outlay and involve a long period of time –
longer than the usual cut-off of one year or normal operating
cycle.
“Capital budgeting consists in planning development of
available capital for the purpose of maximizing the long term
profitability of the concern” – Lynch
The main features of capital budgeting are
Potentially large anticipated benefits
A relatively high degree of risk
Relatively long time period between the initial outlay
and the anticipated return.
- OsterYoung
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CAPITAL BUDGETING
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The success and failure of business mainly depends on how the
available resources are being utilized.
Main tool of financial management
All types of capital budgeting decisions are exposed to risk and
uncertainty.
They are irreversible in nature.
Capital rationing gives sufficient scope for the financial
manager to evaluate different proposals and only viable project
must be taken up for investments.
Capital budgeting offers effective control on cost of capital
expenditure projects.
It helps the management to avoid over investment and
under investments.
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CHARACTERISTICS OF CAPITAL
INVESTMENT DECISIONS
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Capital investment decisions usually require relatively large
commitments of resources.
Most capital investment decisions involve long-term
commitments.
Capital investment decisions are more difficult to reverse
than short-term decisions.
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Working Capital: The Elements
THE ELEMENTS OF WORKING CAPITAL
current assets
current liabilities
Major elements:
Inventories
Accounts receivable
Cash (in hand and at bank)
Major elements:
Short term loans
Accounts payable
working capital
current assets
- current liabilities = working capital
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WHY IS WORKING CAPITAL
IMPORTANT?
Working capital...
 Is used to keep the organisation running on a day-to-day
basis
 Represents a net investment in short-term assets
 Defines the liquidity of the business (whether or not the
business is solvent in the short term)
 Directly related to the cash flow from operating activities.
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WORKING CAPITAL: THE BUSINESS
CYCLE
Cash: Start. Company
pays for raw materials
Purchases
1
9
Cash: End. Customer
pays for product or service
2
Collections
8
Current Assets
Materials
Inventory
3
7
4
Operating Cycle
Production
5
Accounts
Receivable
6
Sales
Finished
Inventory
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WORKING CAPITAL
(CASH CONVERSION) CYCLE
TIMELINE - Working Capital Cycle
Jan
Feb
March
April
May
Creditors
62 Days
Raw Materials
25 days
Work in
Progress
30 days
Finished Goods
19 days
Debtors
•69 Days
Financing Gap
•81 Days
Purchase
Collection
Day
0
|
Sale
Da
y
62
Payment
|
Day
74
|
Day
143
|
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CASH CONVERSION CYCLE
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MANAGEMENT OF WORKING CAPITAL
Debtor Receivables Collection Days
= Average Trade Debtors X 365
Credit Sales
 A decrease indicate:
- A recent large
payment received
just before balance
sheet date
- Improved control of
receivables;
- Urgent need for
cash.
NB: -If average figure is not
available, use the balance sheet
figure instead
- If credit sales not available, use
the sales figure
X Increase may indicate:
- Poor control of receivables by
the Company (e.g. failure to
issue invoices in a timely
manner; failure to pursue
overdue debts);
- Relaxation of credit terms to
attract new business or as a
result of competition;
- A significant overdue payment
or many customers struggling to
pay
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WORKING CAPITAL RATIOS
Inventory Turnover Days (i.e. Inventory days) NB: If average figure is not
= Average Inventory
X 365
available, use the balance
Cost of Goods Sold (COGS)
sheet figure instead
 Decrease may indicate
- A recent delivery just
before the balance sheet
was created
- Inventory selling more
quickly;
- A rundown of inventories
because of a need to
generate cash;
- Improved inventory control
by the business
X Increase may indicate
- Inability to sell inventory,
e.g. out of date/poor
quality;
- Failure to manage
inventory levels;
- Large contract due
requiring a build up of
inventory;
- Planned inventory build up
due to change in policy.
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WORKING CAPITAL RATIOS
Creditor Payment Days:
Average Trade Creditors X 365
Cost of Goods (Inventory) bought on credit

Increase may indicate
- Company unable to pay bills on
time;
- Taking advantage of extended
terms;
- Deferring payments to preserve
cash.
- A large invoice received just before
the date of the balance sheet.
NB: -If average figure is not
available, use the balance sheet
figure instead
- If purchases on credit not
available, use cost of goods sold

Decrease may indicate
- Paying early to get
discounts; Pressure
from accounts
- A large payment
made just before the
date of the balance
sheet
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WORKING CAPITAL RATIOS CAN BE
EXPRESSED IN ‘DAYS’ OR AS ‘TURNOVER’
Cash Tied Up in Inventory
Inventory Turnover = Cost of Goods Sold
Average Inventory
Inventory Days = Average Inventory
Cost of Goods Sold
x 365
Cash Tied Up in Receivables
Receivables(debtor) Turnover = Credit Sales _________
Average Trade Debtors
Receivables Days =Average Trade Debtors x 365
Credit Sales
Cash Belonging to Creditors Held in by the Business
Payables (creditor) Turnover = Cost of Goods bought on credit
Average Trade
Creditors
Payables Days =Average Trade Creditors _____ x 365
Cost of Goods Bought on Credit
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CASH CONVERSION (WORKING
CAPITAL) CYCLE : CCC
CCC= Inventory days + Receivable days – Payables days.
** This is the net days that funds are held up in inventories and
trade counterparties**
 Usually, a short CCC means greater liquidity, which translates
into less of a need to borrow, more opportunity to realize price
discounts with cash purchases for raw materials, and an
increased capacity to fund the expansion of the business into
new product lines and markets.
 Conversely, a longer CCC increases an Company's cash needs
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WORKING CAPITAL RATIOS
Net Working Assets (NWA) to Sales
= (Receivables + Inventory – Account Payable ) x 100
Sales
 This is an efficiency ratio. It indicates how the main components
of working capital are being managed in relation to sales. If the
ratio is increasing, it may indicate that the Company is
mismanaging its key working assets.
 Careful management often results in a fall of this ratio. As sales
increase the ratio should remain the same if NWA are being
managed successfully.
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OVERTRADING
 Definition: Conducting more business than the Company's working
capital can normally sustain thus placing serious strain on cash flow
and risking collapse or insolvency.
 There comes a point when increased sales volumes are no longer
sustainable.
a) Possible Signs of Overtrading (i) A large increase in sales or current
assets or current liabilities with little increase in owners’ equity. (ii)
Taking longer credit or giving longer credit.(iii) Gross and net profit
margin falling (caused by an effort to raise cash to pay bills). (iv) If
outside finance provided by loans and suppliers exceeds the owners’
equity (net assets)
b) Dangers of Overtrading : Cash flow becomes tighter and production
levels inevitably fall once loan facilities are fully drawn. This can result in
a fall in profitability and a lack of liquidity to pay overheads as they fall
due. In serious cases this will result in business failure.
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EXERCISE: MAX LTD’S WORKING
CAPITAL RATIOS
Calculate Max Ltd’s
 Inventory Turnover and Inventory days
 Receivables (debtor) turnover and days
 Account payables (creditor) turnover and days
 Cash conversion cycle
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EXERCISE: CALCULATE MAX LTD’S
WORKING CAPITAL RATIOS

Inventory Turnover and
Inventory days

Receivables (debtor) turnover
and days

Account payables (creditor)
turnover and days

Cash conversion cycle 30
Managing Working Capital
CALCULATING WORKING CAPITAL REQUIREMENT:
Urban fashion
Sales
COGS
Receivables
Inventory
Payables
Year 1
100,000
70,000
38 Days 10,328
75 Days 14,384
Year 2
110,000
77,000
11,362
15,822
24,712
6,712
26,671
7,384
18,000
18%
18,000
19,800
18%
18,000
35 Days
Net working capital requirement
Percent of annual sales
Financed by: Owner's equity
Retained profit Year 2 assume 1% of
sales
Shortfall
1,100
700
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31
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Managing Working Capital
CASH FLOW STATEMENTS
Sources and uses of cash
Sources:
Uses:
 Increase in a liability

 Decrease in an asset
 Increase in an asset
 Increase in equity
 Decrease in equity
 Profit from operations
 Loss from operations
Decrease in a liability
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Managing Working Capital
REMEMBER….. THE WORKING CAPITAL CYCLE
Time-line example
Raw Materials
Work in Progress
Finished Goods
Accounts Receivable
Total
Less
Payables
Total
55 Days
78,000
19 Days
69 Days
25,000
207,000
143 Days 310,000
62 Days
82,000
81 Days 228,000
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Managing Working Capital
REMEMBER……TIMELINE OF THE WORKING CAPITAL CYCLE
January
February
March
April
May
Creditors
62 days
Raw Materials
25 days
Work in Progress Finished Goods
30 days
19 days
Debtors
69 days
Financing Gap
81 days
Day 0:
Purchase
Day 62:
Payment
Day 74:
Sale
Day 143:
Collection
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Managing Working Capital
TIMELINE – WORKING CAPITAL CYCLE
January
February
March
Creditors
62 days
Raw Materials
25 days
Work in Progress Finished Goods
30 days
19 days
Effective management of terms of
April
May
trade can improve the finance
gap.
Poor management will worsen it.
Debtors
69 days
Financing Gap
81 days
Day 0:
Purchase
Day 62:
Payment
Day 74:
Sale
Day 143:
Collection
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Managing Working Capital
EXAMPLE
The effect of a growth in sales on working capital
Year 1
000's
Ratio
1,000
100,000
COGS
800
70,000
Gross Profit
200
10,328
Gross Profit%
20%
14,384
Inventory
87.7
40 days
109.6
40 days
98.6
45 days
Sales
Receivables
Payables
Planned growth in
sales of 40%
The terms of trade will
stay the same
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Managing Working Capital
EXAMPLE
The effect of a growth in sales on working capital
when the terms of trade stay the same
Year 1
Year 2
Growth
Each element of
working capital grew
by 40%
000's
Ratio
000's
1,000
100,000
1,400
COGS
800
70,000
1,120
Gross Profit
200
10,328
280
Gross Profit%
20%
14,384
20%
Inventory
87.7
40 days
122.8
40 days
40%
109.6
40 days
153.4
40 days
40%
98.6
45 days
138.0
45 days
40%
Sales
Receivables
Payables
Ratio
If the terms of trade
stay the same the
elements of working
capital will grow in
harmony with sales
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Managing Working Capital
EXAMPLE
The effect of a growth in sales on working capital
when the terms of trade change
Year 1
000's
Sales
Year 2
Ratio
000's
Growth
OR
Ratio
Growth
Ratio
1,000
1,400
COGS
800
1,120
Gross Profit
200
280
Gross Profit%
20%
20%
Inventory
87.7
40 days
122.8
40 days
40%
154.4
50 days
74%
109.6
40 days
153.4
40 days
40%
172.6
45 days
57%
98.6
45 days
138.0
45 days
40%
168.8
55 days
71%
Receivables
Payables
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Managing Working Capital
EXAMPLE
Effect of a growth in sales on working capital when the terms of trade change
Year 1
000's
Sales
Year 2
Ratio
000's
Growth
OR
Ratio
Growth
Ratio
1,000
1,400
COGS
800
1,120
Gross Profit
200
280
Gross Profit%
20%
20%
Inventory
87.7
40 days
122.8
40 days
40%
154.4
50 days
74%
109.6
40 days
153.4
40 days
40%
172.6
45 days
57%
98.6
45 days
138.0
45 days
40%
168.8
55 days
71%
Receivables
Payables
If the terms of trade change the
elements of working capital do
not grow in harmony with sales
A change in the terms of trade
is not caused by a growth of
sales. There must be another
reason
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Cash flow and Capital Budgeting Approaches and
Decision Rules
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USES OF BREAK-EVEN ANALYSIS
 Determine at what level of sales the business is able to
cover its fixed costs
 Determine level of profits at various possible levels of sales
 Helps to make a decision whether to increase price or sales
volumes
 If sales fall, at what level does the company make a loss
 If the business borrows to make investments, how much
must sales increase to cover the additional debt service
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BREAK-EVEN POINT
Breakeven
Gross profit
52%
Fixed costs
Profits
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Using Break-Even Point Analysis
First step – understand the nature of costs
Fixed costs
Variable costs:
Not directly related to
sales / output
Vary directly with sales / output
Care, some are a bit of both!
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FINANCIAL ANALYSIS
Using break-even analysis
Sales
3000000
2500000
Profit
Margin of
safety
Total costs
2000000
Break-even
1500000
Loss
1000000
Fixed costs
500000
Most recent trading year
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Uses of Break-Even Analysis: Recap
 Determines at what level of sales the business is able to cover its
fixed costs
 Determines level of profits for various levels of sales
 Helps to make a decision whether to increase the price or sales
volumes
 If sales fall, at what level does the company make a loss
 If the business borrows to make investments, how much must
sales increase to cover the additional debt service
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BREAK-EVEN ANALYSIS
Using break-even analysis: What does it tell us about the business?
Low break-even point:
Profitable at low sales (safety)
High break-even point:
 The opposite
Low investment type of business
 Most of cost is variable (can be turned off)
 Flexible and responsive
 Dependant on external suppliers
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USING BREAK-EVEN ANALYSIS
 Consider where the break-even point occurs：
 High break-even – the business very vulnerable
 Normal break-even - the business is less vulnerable
 Low break-even - the business is not vulnerable
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PRESENT VALUE
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NET PRESENT VALUE
 The difference between the market value of a project and its
cost
 Discounted Cash Flow (DCF) Valuation:
– The first step is to estimate the expected future cash flows.
– The second step is to estimate the required return for
projects of this risk level.
– The third step is to find the present value of the cash flows
and subtract the initial investment.
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NPV – DECISION RULE
 If the NPV is positive, accept the project
 A positive NPV means that the project is expected to add
value to the firm and will therefore increase the wealth of the
owners.
 Since our goal is to increase owner wealth, NPV is a direct
measure of how well this project will meet our goal.
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COMPUTING NPV FOR THE
PROJECT
 You are looking at a new project and you have estimated the
following cash flows:
– Year 0: CF = -165,000
– Year 1: CF = 63,120;
– Year 2: CF = 70,800;
– Year 3: CF = 91,080;
 Your required return for assets of this risk is 12%.
 NPV = 63,120/(1.12) + 70,800/(1.12)2 + 91,080/(1.12)3 –
165,000 = 12,627.42
 Do we accept or reject the project?
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DECISION CRITERIA TEST - NPV
 Does the NPV rule account for the time value of money?
 Does the NPV rule account for the risk of the cash flows?
 Does the NPV rule provide an indication about the increase in
value?
 Should we consider the NPV rule for our primary decision
criteria?
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NET PRESENT VALUE
Investment Returns
Original Investment
100,000
Rate
Year 1
100,000
20%
20,000
Year 2
100,000
20%
20,000
Year 3
100,000
20%
20,000
Year 4
100,000
20%
20,000
Year 5
100,000
20%
20,000
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NET PRESENT VALUE
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NET PRESENT VALUE
 The closing balance should be 248,832 if compound interest is used. If a
flat rate is used the balance will be only 200,000 - a significant difference! If
you introduced flat rates in your bank it would not be long before the
complaints started to roll in! As illustrated above if the return is 20,000 each
year, the rate falls dramatically and in the last year it is only 9.6%.
 This makes it difficult to assess the true value of future incomes, i.e.
project returns which are usually stated in today's values. This means that
future incomes must be adjusted to take account the time value of money.
This can be achieved by calculating the cost of the capital used in the
investment and adjusting the return. The method commonly used is net
present value.
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NET PRESENT VALUE

The term present value refers to the present value of an amount of money that
will be received at some time in the future. So, if you expect to receive EUR 1,191
three years from now what will it be worth in today's values? The present value of this
EUR 1,191 is equal to the amount of money now that you must invest so that you will
get EUR 1,191 at the end of the three-year period. When the interest rate is known,
you can then determine how much you must invest.

Present values can be calculated by discounting. The formula for Present value is:

Where:

P0 = Present value at time

Pn = Principal value at the end of any year n

i = interest rate, also known as the discount rate

n = duration of the period, number of years
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NET PRESENT VALUE
 As an example, assume you will receive an amount of EUR 1,191 three
years from now. What is the
 present value of this EUR 1,191 when the interest rate or the discount rate
is at 6% per year?
 In this case when: I = 0.06; P3 = 1,191 and n = 3 years
 Present Value = P0= 1,191/(1+0.06)3
 Therefore, the present value is EUR 1,000.
 In the same way, it is possible to discount the future incomes for an
investment. A business is planning to
 make an investment of EUR 100,000. The total costs for production using
the machine are expected to be
 EUR 5,000 each year. The incomes generated by the machine are expected
to be EUR 30,000 and therefore the net annual cash flow is expected to be
EUR 25,000 (see Table 4-6: Example - incomes
 generated by an investment of 100,000 (1)).
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NET PRESENT VALUE
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NET PRESENT VALUE
59
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NET PRESENT VALUE
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INTERNAL RATE OF RETURN
 Definition: IRR is the return that makes the NPV = 0
 Decision Rule: Accept the project if the IRR is greater than
the required return
 This is the most important alternative to NPV
– Often used in practice
– Intuitively appealing
– Based entirely on the estimated cash flows and is
independent of interest rates found elsewhere
 Compute using trial and error process
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NPV VS. IRR
 NPV and IRR will generally give us the same decision
 Exceptions
– Non-conventional cash flows – cash flow signs change
more than once – may be several IRRs
– Mutually exclusive projects
• Initial investments are substantially different
• Timing of cash flows is substantially different
 Whenever there is a conflict between NPV and another
decision rule, you should always use NPV
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TIME VALUE OF MONEY - NET
PRESENT VALUE
 The value of money decreases over time. This is because of
interest. For example, EUR 1,000 invested for
 one year at an interest rate of 5% would be worth EUR 1,050
after 12 months.
 That means that an investor would expect higher incomes in
future years from the same investment.
 So, in this example EUR 1,050 earned in one year’s time has only
the same value as EUR 1,000 income earned today.
 Clearly, the effects of inflation should also be considered.
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TIME VALUE OF MONEY - NET
PRESENT VALUE
 The value of money decreases over time. This is because of
interest. For example, EUR 1,000 invested for one year at an
interest rate of 5% would be worth EUR 1,050 after 12 months.
 That means that an investor would expect higher incomes in
future years from the same investment.
 So, in this example EUR 1,050 earned in one year’s time has only
the same value as EUR 1,000 income earned today.
 Clearly, the effects of inflation should also be considered.
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Financial management framework in a public enterprise
65
EFFICIENT PUBLIC FINANCE
MANAGEMENT
66
UNDERSTANDING THE PUBLIC SECTOR
FINANCIAL MANAGEMENT CYCLE
67
UNDERSTANDING THE PUBLIC SECTOR
FINANCIAL MANAGEMENT CYCLE
 It is essential than in the past for there to be effective
implementation processes for public sector financial
management and service delivery.
 This is a continuous process of planning, implementation,
evaluation, audit and improvement based on the outcomes –
in other words, as a financial management cycle in which:
 Earlier steps lead logically to later steps during the financial
year
 At the end of the process internally (and, from the auditors,
externally) evaluation and review whether or not what was
planned was actually delivered and how it might be done
better in future.
68
UNDERSTANDING THE PUBLIC SECTOR
FINANCIAL MANAGEMENT CYCLE
The key stages in the cycle are:
 Budgeting and service planning – what the organization plans to do
and how it allocates the necessary resources to make service
delivery possible. This is based on a combination of corporate
objectives and resources and project and activity budgeting and
planning i.e. where top-down meets bottom-up
 Operational performance management – ensuring that planned
service outcomes are actually achieved
 Budgetary control and integrated financial management –
confirming that planned service outcomes are achieved within
allocated budget
 Evaluation – internal review of how processes and outcomes can be
improved
 Audit – external verification and also independent advice on how
processes and outcomes can be improved.
69
Main principles and Rules of financial management in
an SOE
70
TOOLS FOR FINANCIAL MANAGEMENT
IN STATE OWNED COMPANIES
A. Tools For Financial
Planning
B. Tools for Financial
Implementation
C. Tools for Financial
Reporting and Analysis
1. Revenue Forecasting
7. Financial Performance
Monitoring
9. Financial Reporting and Analysis:
The Statement of Net Assets and the
Statement of Net Position
2. Resource Development
Analysis
8. Cash Management:
Determining the Optimal Cash
Balance
10. Financial Reporting and Analysis:
Statement of Activities
3. Cost Estimation
11. Financial Reporting and Analysis:
Fund-Level Statements
4. Cost Comparison
12. Financial Conditional Analysis
5. Incremental Cost Analysis
13. Debt Capacity Analysis
6. Cost-Benefit Analysis
14. Financial Risk Assessment: Analysing
the Risk of Revenue Loss
71
1 REVENUE FORECASTING
 Revenue forecasting helps financial planning.
 Because revenue determines service capacity, accurate
revenue forecasting allows for a good understanding of an
organization’s ability to provide services.
 Forecasting is also a process through which managers learn
about their communities and organizations
 The Delphi technique is probably the most popular qualitative
tool. It is a process in which a group of experts are individually
questioned about their perceptions of future events that will
affect the revenue flows.
72
1 REVENUE FORECASTING
 Quantitative forecast tools vary from simple smoothing
techniques to sophisticated causal modeling
 Using the simple moving average (SMA) technique, we calculate
the arithmetic average of revenues in previous forecast periods
(“years” in this case) and use it as the forecast.
 SMA is very simple to understand and easy to use. But it has a
major drawback—it weighs all previous revenues equally in
averaging. In other words, it treats the revenue from ten years
ago as if it is as important as last year’s revenue. Common sense
says that we should place more weight on the more recent
revenue.
 The exponential smoothing (EXS) technique assigns different
weights to data of different periods.
73
1 REVENUE FORECASTING
Utility Taxes in city XXXX
Year
Revenues ($)
1
842,387
2
1,665,430
3
1,863,296
4
2,063,103
5
2,905,717
6
2,994,785
7
3,281,836
8
3,766,661
9
3,907,110
10
4,063,555
11
?
Licenses, Permits, and Fees in city XXXX
Year
Revenues ($)
1
13,717,979
2
14,369,907
3
16,232,768
4
15,693,711
5
17,684,099
6
18,276,037
7
20,289,136
8
?
Franchise Taxes in city XXXX
Year
Revenues ($)
1
12,442,000
2
12,427,000
3
13,091,000
4
13,743,000
5
14,306,000
6
15,089,000
7
15 257 000
8
16,749,000
9
?
74
2 RESOURCE DEVELOPMENT ANALYSIS
 Resource development analysis (RDA) applies to a fiscal condition where a
significant revenue increase or expenditure cut is needed for a large
revenue shortage foreseeable in the near future. Revenue shortages
result from one of three conditions—a significant expenditure increase, a
significant revenue loss, or both.
 It is important to note that RDA is necessary for large and persistent
revenue shortages that could severely hinder an organization’s service
quality and affect its financial viability. Small, temporary, or incremental
revenue shortages may be dealt with by using financial reserves or other
established financial practices, and RDA may not be necessary. For
example, the shortage caused by annual employee salary raises to offset
inflation can be covered by allocating a certain percentage of the budget
for the increase, and no specific justification or analysis is needed. RDA
consists of several steps:
75
2 RESOURCE DEVELOPMENT ANALYSIS
 Understanding the issue. In this step, a revenue shortage and
possible causes of it are specified.
 Estimating the amount of the revenue shortage.
 Developing revenue options. Possible revenue options to
deal with the shortage are developed.
 Assessing revenue options. Pros and cons of each revenue
option are analyzed.
 Making decisions. Finally, a decision on which revenue
option(s) is most feasible is made.
76
2 RESOURCE DEVELOPMENT ANALYSIS
 Estimating Revenue Loss
 Revenue loss is the amount of revenue decline between two
fiscal periods. For example, if $500 is collected this year and
only $400 is available for the next year, the revenue loss is
$100. Revenue loss can be broadly defined as:
 Revenue Amount Before the Loss – Revenue Amount After
the Loss.
 Estimating Expenditure Growth
77
2 RESOURCE DEVELOPMENT ANALYSIS
 Estimating Purchase Prices (or Cost). The focus of this
estimation is on the purchase prices of expenditure
(expense) elements such as personnel, operating, and
capital expenditures.
 Estimation Based on Demographics. Expenditure growth is
often caused by increasing public demand for services, and
public demand can be measured by population growth.
 Estimation Based on Comparable Scenarios. This method is
particularly useful when little reliable information on
purchase prices or demographics is available. The essence of
the method is to develop comparable spending scenarios.
78
2 RESOURCE DEVELOPMENT ANALYSIS
 DEVELOPING REVENUE OPTIONS
 Once the amount of a revenue shortage is determined, potential sources
should be identified to cover the shortage. A common strategy to deal
with the shortage is to cut spending. Spending cuts can effectively reduce
the revenue shortage. Nevertheless, it will affect services and people.
Also, it is often politically risky for public officials. The following can be
used to increase revenues.







Option 1: Increasing Taxes
Option 2: Increasing User Charges
Option 3: Borrowing
Option 4: Intergovernmental Assistance
Option 5: Use of Financial Reserves
Option 6: Making Institutional or Policy Changes
Option 7: Combination of the Above Options and a Summary
79
2 RESOURCE DEVELOPMENT ANALYSIS
Example of Estimating Expenditure Growth
Year
Ten years ago
Nine years ago
Eight years ago
Seven years ago
Six years ago
Five years ago
Four years ago
Three years ago
Two years ago
Last year
Average
Total expenditure
Population
Expenditure per capita ($)
Expendisture per capita growth rate
162,491,969
162,424,561
173,379,035
185,168,296
190,753,923
197,103,191
229,163,984
229,551,667
261,833,073
258,881,807
168,456
169,675
172,019
170,780
170,307
173,122
176,373
180,462
184,639
188,013
964.64
957.27
1,007.91
1,084.25
1,120.06
1,138.52
1,299.31
1,272.02
1,418.08
1,376.94
−0.0076
0.0529
0.0757
0.033
0.0165
0.1412
−0.0210
0.1148
−0.0290
0.0418
80
2 RESOURCE DEVELOPMENT ANALYSIS
Applicability of Revenue Options According to Activity Type
Column1
Taxes
User charges
Borrowing
Intergovernmental aids
Financial reserves
Institutional/policy changes
Revenue shortage caused by
Governmental activities
Business-type activities
Applicable
Not applicable
Not applicable
Applicable
Applicable
Applicable
Applicable
Questionable
Applicable
Applicable
Applicable
Applicable
81
2 RESOURCE DEVELOPMENT ANALYSIS
The Decision-Making Matrix for Revenue Options
Ratings: 0 = Extremely unfeasible.….10 = Extremely feasible
Column1
Description
Column2
Options
1
Column3
Column4
2
3
Financial Merits
Cost of the feasibility study
Cost of the revenue design study
Cost of administration and collection
Sufficiency of revenue generated
Revenue/cost ratio
Political Merits
Elected officials’ acceptance
General public’s acceptance
Business community’s acceptance
Other interest groups’ acceptance
Legal Feasibility
Compliance with federal legal requirements
Compliance with state legal requirements
Compliance with local legal requirements
Total score
82
7 FINANCIAL PERFORMANCE
MONITORING
 A financial monitoring system serves three purposes.
 First, it provides an ongoing check on the budget. By
comparing actual financial results against budgets, it can be
determined how well financial objectives have been achieved
and whether the budget is realistic.
 Second, a monitoring system helps uncover inefficient
practices and operations.
 Third, and perhaps most important, a monitoring system
helps avoid further deterioration of financial condition.
 Financial performance monitoring is a system designed to
detect undesirable financial performance and provide possible
solutions to enhance performance.
83
7 FINANCIAL PERFORMANCE
MONITORING
Three essential elements are needed in developing an effective
financial monitoring system:
 1. Indicators that assess financial performance
 2. Techniques to detect unacceptable financial performance
 3. Techniques to diagnose causes of underperformance and to
provide suggestions for performance improvement
84
7 FINANCIAL PERFORMANCE
MONITORING
 Indicator 1: Total Revenues or Revenues Per Capita. The variations
of total revenues include total revenues by fund and revenues by
source ‘i.e., taxes, fees, charges, intergovernmental revenues’,
which indicate the level of resources available for service provision.
The percentage of a particular revenue source in total revenues can
also be monitored to assess whether an organization over relies on
the revenue
 Indicator 2: Total Expenditures or Expenditures Per Capita. One
variation of total expenditures is the expenditures by function, such
as personnel, operating, or capital expenditures. These indicators
assess the level of resources consumed for service provision. The
percentage of a particular expenditure in total expenditures can
also be monitored to identify major expenditure items.
Expenditures per capita ‘Total Expenditures/Population’ measures
the resource consumption for each individual resident.
85
7 FINANCIAL PERFORMANCE
MONITORING
 Indicator 3: Liquidity. Liquidity evaluates whether an organization
has enough cash and cash equivalents to meet its short-term
obligations. Insufficient liquidity affects an organization’s financial
viability. Excessive liquidity suggests a possible loss of investment
opportunities. One common liquidity indicator is the current ratio
‘Current Assets/Current Liabilities’.
86
7 FINANCIAL PERFORMANCE
MONITORING
 Indicator 4: Net Assets or Change in Net Assets ‘i.e., Operating Surplus or
Deficit’. Assets are what an organization owns, or more formally, the
valuable resources in an organization. They include current assets
described above and long-term ‘or noncurrent’ assets, such as land,
buildings, and equipment. Liabilities are what an organization owes to
others. In addition to current liabilities, there are long-term liabilities, such
as long-term debts. Net assets are the difference between assets and
liabilities.
 Indicator 5: Fund Equity ‘Balance’ or Fund Operating Surplus ‘or Deficit’.
Operating deficits occur when expenditures exceed revenues, which
indicates that an organization consumes more than it receives. The
constant recurrence of deficits exhausts an organization’s reserves and
puts its financial viability on the line. Deficits can occur in different funds
of an organization.
87
7 FINANCIAL PERFORMANCE
MONITORING
 Indicator 6: Borrowing Capacity. Debt issuances can be used to finance
capital improvement and occasionally short-term revenue shortages.
However, excessive debts can cause serious financial troubles. How much
debt is too much? Ratios used are: debt outstanding ratios and the debt
service ratio. One indicator that also assesses debt capacity is a
comparison of debt ‘i.e., debt outstanding’ with total assets ‘i.e., Total
Debt/Total Assets’.
 Indicator 7: Asset Allocation Efficiency. One such indicator is the total
asset turnover ‘Total Revenues/Total Assets’, which calculates the revenue
per dollar of assets. It is an indicator of asset allocation efficiency.
88
7 FINANCIAL PERFORMANCE
MONITORING
Revenues, Expenditures, and Surplus ‘Deficit’ in the Current Year ‘$’
Description
Total revenues
Total expenditures
Surplus or deficit
Actual
5,000,000
5,150,000
−150,000
Budget
4,900,000
4,600,000
300,000
Difference
100,000
−550,000
−450,000
Actual
2900000
1,100,000
1,150,000
5150000
Budget
2500000
1,000,000
1,100,000
4600000
Difference
−400,000
−100,000
−50,000
−550,000
Expenditure by Function ‘$’
Description
Personnel
Operating
Capital
Total
89
9 FINANCIAL REPORTING AND
ANALYSIS
THE STATEMENT OF NET ASSETS AND THE STATEMENT OF NET
POSITION
 Balance sheet information for a government as a whole (i.e., governmentwide) is reported in the statement of net position. The financial
statement used to report annual revenues and expenses for a government
as a whole is the statement of activities.
 We focus on the statement of net assets (net position) in this chapter and
the statement of activities in the one following.
 The following Accounting Equation describes the Net Position
 Net Position = (Assets + Deferred Outflows of Resources) − (Liabilities +
Deferred Inflows of Resources)
 Deferred outflow of resources is consumption of net assets that is
applicable to a future reporting period instead of the current period.
 Deferred inflow of resources is an acquisition of net assets that is
applicable to a future reporting period instead of the current period.
90
9 FINANCIAL REPORTING AND
ANALYSIS
THE STATEMENT OF NET ASSETS AND THE STATEMENT OF NET
POSITION
Statement of Net Position Comparison: City XXXX
Column1
Assets
Current assets
Cash 1,500,000
Accounts receivable
Inventory 690,000
Total current assets
Fixed assets
Land 3,000,000
Equipment, net
Total fixed assets
Total assets7,750,000
Deferred Outflows of Resources
Total assets + deferred outflows
Liabilities
Liabilities
Current liabilities
Accounts payable
Wages payable
Total current liabilities
Long-term liabilities
Bonds payable
Total liabilities
Deferred Inflows of Resources
Net Position
Net investment in capital assets
Unrestricted
Restricted
Total net position
Total liabilities + deferred inflows + net position
Column2
12/31/20×4
2,000,000
560,000
250,000
2,750,000
3,000,000
2,000,000
5,000,000
8,050,000
0
7,750,000
Column3
12/31/20×3
300,000
2,550,000
2,500,000
5,500,000
0
8,050,000
3,000,000
1,300,000
4,300,000
3,000,000
1,050,000
4,050,000
1,000,000
5,300,000
0
1,500,000
5,550,000
0
1,000,000
500,000
950,000
2,450,000
7,750,000
1,000,000
1,000,000
500,000
2,500,000
8,050,000
91
10 FINANCIAL REPORTING AND
ANALYSIS: STATEMENT OF ACTIVITIES
 The financial statement that presents revenues and expenses is
called the statement of activities. Like the statement of net assets
(net position), the statement of activities presents the financial
information for a government as a whole.
 Expenses
 First, expenses are classified and presented by functions or
programs. For example, a city can present expenses in the major
service functions of public safety, transportation, education, health,
and human services.
 Revenues
 The sources of revenue are presented in the statement. In
governments, revenue sources include taxes, fees and charges,
grants, investment earnings, and other revenue sources.
92
10 FINANCIAL REPORTING AND
ANALYSIS: STATEMENT OF ACTIVITIES
Expenses, Program Revenues, Net (Expenses) Revenues, and General Revenues in the Statement of Activities: City XXXXX
Function/Program
Governmental activities
General government
Public safety
Transportation
Health and human services
Total
Business-type activities
Water
Sewer
Parking
Total
Total primary government
General revenues
Taxes
Property taxes
Sales taxes
Franchise taxes
Grants not restricted for specific programs
Investment earnings
Miscellaneous
Total general revenues
Change in net position
Net position—beginning
Net position—ending
Expenses (1)
Program revenues (2)
Net (expenses) revenues (2)−(1)
420,000
1,500,000
440,000
300,000
2,660,000
140,000
53,000
49,000
150,000
392,000
-280,000
-1,447,000
-391,000
-150,000
-2,268,000
150,000
210,000
120,000
480,000
3,140,000
180,000
300,000
60,000
540,000
932,000
30,000
90,000
-60,000
60,000
-2,208,000
1,250,000
320,000
230,000
260,000
43,000
55,000
2,158,000
-50,000
2,500,000
2,450,000
93
11 FINANCIAL REPORTING AND
ANALYSIS FUND-LEVEL STATEMENTS
 A fund is a fiscal and accounting entity in which financial transactions of
specific types of activities are recorded and reported.
 Two conditions must be met to construct a fund.
– First, a fund is a fiscal entity in which assets are set aside for liabilities
incurred in supporting specific activities of the fund. A fund reports its
own assets, liabilities, and the fund balance, which is the difference
between assets and liabilities.
– Second, a fund is an accounting entity in which the double-entry
mechanism must be used in recording transactions. The accounting
equation for a fund can be expressed as: Assets = Liabilities + Fund
Balance
 In the USA governmental funds include:
– governmental funds
– proprietary funds
– fiduciary funds
94
11 FINANCIAL REPORTING AND
ANALYSIS FUND-LEVEL STATEMENTS
Assets
Cash
Accounts receivable
Inventory
Total
Amount
225,000
84,000
0
309,000
Liabilities
Accounts payable
175,000
Due to other funds
70,000
Total
245,000
Fund balance
Reserved
13,000
Unreserved
51,000
Total
64,000
Total liabilities and fund
balance
309,000
Revenues
Property taxes
Sales taxes
Franchise taxes
Intergovernmental revenues
Investment earnings
Fees and fines
Total revenues
Expenditures
General government
Public safety
Transportation
Health and human services
Total expenditures
Excess (deficiency) of revenues over
expenditures
Other financing sources (uses)
Transfer in
Transfer out
Total other financing sources (uses)
Net change in fund balances
Fund balances—beginning
Fund balances—ending
Amount
1,150,000
320,000
230,000
300,000
38,000
24,000
2,062,000
255,150
1,317,500
311,850
296,900
2,181,400
-119,400
200,300
-100,000
100,300
-19,100
83,100
64,000
95
12 FINANCIAL CONDITION ANALYSIS
 Measuring Financial Condition
 Financial condition (also known as economic condition’ is
defined as the ability of an organization to meet its financial
obligations.
 During the process of providing goods and services, an
organization incurs financial obligations in the form of
expenses, expenditures, and debt that must be paid sooner or
later.
 If the organization can pay these obligations without incurring
much financial hardship, we say that the organization’s ability
to pay is high and the organization is in good financial
condition.
96
12 FINANCIAL CONDITION ANALYSIS
97
12 FINANCIAL CONDITION ANALYSIS
98
12 FINANCIAL CONDITION ANALYSIS
99
The anatomy of financial statements and how to read
them
100
WHAT IS PUBLIC FINANCIAL
MANAGEMENT?
A public financial management (PFM) system is a set of rules and
institutions, policies, and processes that govern the use of public
funds across all sectors, from revenue collection to monitoring of
public expenditures. PFM policies vary by country and can cover
issues related to tax law, budget management, debt
management, subsidies, and state-owned enterprises. A wellfunctioning PFM system is critical to ensuring accountability and
efficiency in the use of public financial resources, while a weak
PFM system can result in significant wastage of scarce resources
(Figure 1).
101
COMMON SIZE FINANCIAL
STATEMENTS
 One of the most useful ways for the to look at the company’s
financial statements of a small business is by using “common size”
financial statements and ratios.
 Common size statements and ratios can be developed from both
balance sheet and income statement items.
 For example, each of the items on the income statement would be
calculated as a percentage of total sales. (Divide each line item by
total sales, then multiply each one by 100 to turn it into a
percentage.)
 Similarly, items on the balance sheet would be calculated as
percentages of total assets (or total liabilities plus owners’ equity).
102
COMMON SIZE FINANCIAL
STATEMENTS
 Example: If you want to evaluate the cash position compared to the
cash position of one of the key competitors, you need more
information than, say, the business has Birr 12,000,000 and typical
competitors have Birr 22,000,000. That’s a lot less informative than
knowing that the business’s cash is equal to 7% of total assets,
while the competitor’s cash is 9% of their assets.
 Common size ratios make comparisons more meaningful
 To calculate common size ratios from the balance sheet, simply
compute every asset category as a percentage of total assets, and
every liability account as a percentage of total liabilities + equity.
103
COMMON SIZE BALANCE SHEET
104
COMMON SIZE PROFIT & LOSS
105
ETHIOPIAN AIRLINES
106
ETHIOPIAN AIRLINES
107
ETHIOPIAN AIRLINES
108
ETHIOPIAN AIRLINES
109
ETHIOPIAN AIRLINES
110
Financial statement Analysis (Ratio Analysis)
111
FINANCIAL RATIOS
 Financial Ratios are mathematical indicators that will:
 Compare Company A’s results of operations over time; e.g.
2018 -2019 - 2020
 Compare Company A’s results compared to Company B’s results
 Compare Company A’s results compared to Industry (its
competitors)
 Identify areas of strengths and weakness
112
Financial Ratios Analysis
113
WHAT CAN FINANCIAL RATIOS
MEASURE?
1. Trading Profitability
2. Operational Performance
3. Liquidity and Working Capital
4. Return(capital)
5. Cash Flow Performance
6. Risk (Debt & solvency)
114
Trading Profitability
115
TRADING PROFITABILITY
Gross Profit Margin:
Gross Profit X 100
Sales
a. What are the usual margins for the particular trade or industry?
b. Variations may be caused by:
(i) Changes in input and sales prices, e.g. price cutting, offering early
payment discounts.
(ii) Inventory losses due to mark down or pilferage.
(iii) Alterations in the basis for inventory valuations
(iv) A change in the types/numbers of products sold (product mix)
(v) Offering discounts for volume sales
(vi) Manufacturing wages
(vii) Poor buying
(viii)Poor quality control (ix) Increased competition
(ix) Failure to pass on higher production costs
116
TRADING PROFITABILITY
Operating Profit Margin:
Operating Profit (EBITDA) X 100
Sales

Companys should be able to exercise a high level of control over
expenses and overheads.

Positive and negative trends in this ratio are usually directly
attributable to management decisions.

A Company's operating income (rather than the net profit) is often the
preferred metric for making inter-Company comparisons since it is
seen to be more reliable basis for comparing operating business
performance. This is because it ignores levels of borrowing (interest
costs), depreciation policies and differing tax charges.
117
PROFITABILITY
Profit After Tax Margin (%):
Profit After Tax (PAT) X 100
Sales

Peer Company comparisons of net profit margins can be problematic
because of different tax charges, depreciation, and interest costs.

Year-on-year comparisons for the same Company are also affected by
the same issues.

This is one of the reasons that some analysts prefer to use the
operating or pre-tax profit figures instead of the net profits for
profitability ratio calculation purposes
118
2. Operational Performance
119
OPERATIONAL PERFORMANCE
1. Sales Growth Ratio %
This year's sales – Last years Sales X 100
Last years Sales
 Are sales growing/declining? What is the reason? Remember that
sales are “price x volume”, therefore changes in sales can be due to
changes of one or even both of these variables.
 What is the impact on working capital? If sales are growing the
Company usually requires more working capital
120
OPERATIONAL PERFORMANCE
2. Profit Growth Ratio %
This year‘s PAT– Last years PAT X 100
Last years PAT

When assessing the rate of growth consider the sales performance and
the business need for profits to fund growth, dividends, and finance
charges.
121
OPERATIONAL PERFORMANCE:
OTHER INDICATORS
3.
Sales per employee
Sales
Headcount
4.
Profit (PAT) per employee
Profit (PAT)
Headcount
5.
Value Added per employee
Value Added (Gross Profit)
Headcount
122
OPERATIONAL PERFORMANCE:
OTHER INDICATORS
6.
Fixed Assets Turnover
Sales
Fixed Assets
7. Average occupancy rate
8.
Gross profit per square meter of display
123
2. Liquidity and Working Capital Ratios
124
LIQUIDITY AND WORKING CAPITAL
 Liquidity means
 having cash and access to cash
 Sufficient cash to meet the business’s current and near-term
funding needs
 Working capital means
 Current assets minus current liabilities
 Sign of business’s ability to pay its bills and meet its other current
obligations
125
LIQUIDITY RATIOS
Current Ratio:
Cash + Bank + Marketable Securities + Debtors+ Stock
Short Term Liabilities
• This ratio identifies whether a Company's short-term assets (cash, cash
equivalents, marketable securities, receivables, inventory) are
sufficient to pay off its short-term liabilities (bills payable, current
portion of term debt, bank short term loan, accrued expenses, taxes).
• In theory, the higher the current ratio, the better--there are cases
where this can be misleading. In particular, consider the length of time
required to turn current assets (accounts receivable and inventory)
into cash – The Cash Conversion Cycle
126
LIQUIDITY RATIOS
Quick Ratio
Cash + Bank + Marketable Securities + Debtors
Liabilities
Short Term
• This ratio gives an indication of the ability of the business to pay
current liabilities from cash or near-cash items.
• In other words, whether there is a need for inventory sales to meet
urgent bills.
• The quick ratio should also be compared with the current ratio. If the
current ratio is significantly higher, it indicates that a significant
proportion of Company's current assets are inventory and/or other less
liquid items and that liquidity might be an issue
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LIQUIDITY RATIOS
Cash Ratio
Cash + Bank + Marketable Securities
Short Term Liabilities
 Why hold some assets in the form of cash?
- For day-to-day trading purposes: Some of this may need to be in
cash to pay rent, rates, fuel bills, tax, and/or interest.
- As an ‘insurance’ against cash-flow problems: It may need a cash
‘buffer’ to ensure that it does not exceed the short-term loan limit
at particular times in the year.
- To take advantage of opportunities that may arise. There may be
‘bargains’ like early payment discounts or the Company may wish
to secure short-term investments that offer high profitability.
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LIQUIDITY RATIOS
Liquid Surplus/Sales Ratio
Liquid Surplus (Current Assets-Current Liabilities) X 100 Sales
 As sales increase, the liquid surplus ought to increase in harmony with
it. The ratio ought to stay the same.
 If not, this may indicate that as sales increase the business needs to
borrow more money.
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3. Return Ratios
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RETURN RATIOS
Return on Assets (ROA)
Profit Before Tax
X 100
Average Total Assets
 An Company engaged in capital-intensive businesses (e.g. heavy
engineering), using a large asset base will have a lower ROA than noncapital intensive businesses that have a small investment in fixed assets.
 As a rule of thumb, analysts like to see that a company's ROA is no less
than 5%.
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RETURN RATIOS
Return on Equity
_
Profit Before Tax X 100
_
Average Total Shareholders Equity (Net worth)
 The higher the ratio, the better
 There is however a weakness with this ratio. It may be
disproportionately high if the Company borrows money heavily to
fund business expansion rather than use shareholders equity
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4. Debt and Solvency Ratios
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RISK AND SAFETY
Aspects to consider:
 How much money have the owners invested in the business?
 Are there any hidden reserves that would increase this figure? (e.g., a
building last valued 35 years ago).
 What is the total of net assets? Are net assets increasing or decreasing?
What has caused the increase/decrease?
 Consider the quality of the assets. Are they worth the figures stated?
 Are there any contingent liabilities? These will increase the level of
borrowings.
 Are there any permanent directors’ loans? Quasi capital??
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SOLVENCY AND LEVERAGE
Debt Ratio (%)
= Total Liabilities X 100
Total Assets
 < 60-70%
 > 70%
The higher the ratio, the more risk that Company is considered to have
taken on.
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SOLVENCY AND LEVERAGE
Gearing Ratio %
= Total Borrowing X 100
Owners’ Equity (Net Worth)
 < 100%
 > 100%
Potential Gearing Ratio %
= Total Borrowing Agreed X 100
Owners Equity (Net Worth)
Reasons for an increase in gearing:
 Borrowings have increased;
 The owners’ investment has declined, usually after losses or capital
withdrawals (e.g., dividends).
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SOLVENCY AND LEVERAGE
Interest Cover Ratio % (Profit Basis):
= Profit Before Interest Paid (PAT + Interest) X 100
Interest Paid
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EXERCISE: THOUGHTS ON MAX LTD’S
RATIOS AGAINST INDUSTRY AVERAGE
Have a look at Max Ltd’s ratios against industry averages. Type summary paragraph
summary (max 150 words) on your thoughts on the performance of the company. Post
your summary on the chat of the Teams Meeting
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RATIO ANALYSIS: ASPECTS TO
REMEMBER
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Risk or Safety
Surplus (Net Assets)
Hidden Reserves/Deficits
Gearing
Interest Cover (ICR)
Debt Service Cover (DSCR)
Ratio Analysis
Trend Analysis
Profitability
Sales
Is there a profit? From where?
Is it retained or distributed?
Gross & Net Profit Ratio
Depreciation
Director’s Remuneration
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Liquidity and Cash Flow
Cash Flow generation
Net Operating Cash Flow (NOCF)
Cash Conversion Cycle
Debtors/Creditors/Inventory
Liquid
Surplus/Deficit
Trends
Other Factors
Are the figures audited by a
reliable auditor?
Schedule of Fixed Assets
Capital Commitments
Extra ordinary items
Contingent Liabilities
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RATIOS: OVERALL QUESTIONS TO
ANSWER
 Is the business protected from unnecessary risks? (e.g. over
trading/cash flow problems)
 Is the business growing and becoming a more efficient?
 Is the business meeting its objectives (e.g., increasing sales, increasing
profits by 50%, etc.)?
 Are the performance measures up compared to the month/year
before (e.g. Is there a trend of growth/improvement in performance)?
 How liquid is the business and how solvent is it?
 How does the business compare to others:
- Competitors
- Similar businesses and
- Industry norms
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RATIOS ANALYSIS - CONCLUSION
 Alone ratios can be quite meaningless. They need to be:
 Understood;
 Consistently calculated and used;
 Compared over periods of time (trend);
 Compared to other similar businesses (benchmark);
 Compared to the industry as a whole (norms).
 Competitor and industry information is often available from:
 Customers (at branch level);
 The bank head office;
 Professional financial databases;
 Periodic industry reports.
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RATIOS: SHORTCOMINGS
 Ratios largely look at the past, not the future. It may be possible to make
assumptions about future performance using ratios;
 Inventory valuations - different Companies use different methods to value their
inventory. This can affect the accuracy of Company comparisons;
 Depreciation - Companies use different depreciation methods;
 Information about comparable businesses and an industry sector is not always
available;
 Ratios focus on numbers. They should be used in conjunction with a sound nonfinancial analysis of the factors that affect financial performance, e.g. economic
situation, level of competition, product quality, customer service etc
 Window Dressing – Financial information can be “manipulated” in several ways
to make the figures used for ratios more attractive thus unreliable for analysis.
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Mergers and Acquisitions
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DEFINITIONS
 Merger: One firm absorbs the assets and liabilities of the other firm
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in a merger. The acquiring firm retains its identity. In many cases,
control is shared between the two management teams. Transactions
were generally conducted on friendly terms.
In a consolidation, an entirely new firm is created.
Mergers must comply with applicable state laws. Usually,
shareholders must approve the merger by a vote.
Acquisition: Traditionally, the term described a situation when a
larger corporation purchases the assets or stock of a smaller
corporation, while control remained exclusively with the larger
corporation.
Often a tender offer is made to the target firm (friendly) or directly to
the shareholders (often a hostile takeover).
Transactions that bypass the management are considered hostile, as
the target firm’s managers are generally opposed to the deal.
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MERGER NEGOTIATIONS
 Friendly Acquisition:
 The acquisition of a target company that is willing to be
taken over. Usually, the target will accommodate overtures
and provide access to confidential information to facilitate
the scoping and due diligence processes.
 Hostile Takeover:
 A takeover in which the target has no desire to be acquired
and actively rebuffs the acquirer and refuses to provide
any confidential information.
 The acquirer usually has already accumulated an interest in
the target (20% of the outstanding shares) and this
preemptive investment indicates the strength of resolve of
the acquirer.
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• Target: the corporation being purchased, when there is a clear
buyer and seller.
• Bidder: The corporation that makes the purchase, when there
is a clear buyer and seller. Also known as the acquiring firm.
• Friendly: The transaction takes place with the approval of each
firm’s management
• Hostile: The transaction is not approved by the management
of the target firm.
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TYPES OF MERGERS
 Horizontal Mergers
Between competing companies
 Vertical Mergers
Between buyer-seller relation-ship companies
 Conglomerate Mergers
Neither competitors nor buyer-seller relationship
 Reverse Mergers
A reverse merger is a merger in which a private company
may go public by merging with an already public company
that often is inactive or a corporate shell.
April 2013
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SYNERGY
 The most used word in M&A is synergy, which is the idea that
by combining business activities, performance will increase,
and costs will decrease. Essentially, a business will attempt to
merge with another business that has complementary
strengths and weaknesses.
Mv (A) + Mv(B) < Mv(AB)
Financial Synergy:
 Borrow in Bulk : get better rates (borrowing interest rates)
 Save in Bulk : get better rates (deposit saving rates)
 Diversification of Risk : more companies in portfolio , less systemic risk.
 Offsetting tax losses.
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SYNERGY
 Revenue Synergy :
 Market power , larger company will attract more customers
(more brand awareness)
 Complementary products
 Reduce competition
 Bulk discounts : be able to attract better prices
 Market efficiency : one entity doing advertisements instead of
two
 Reduced fixed overhead costs : overlapping departments and
resources
April 2013
149
MERGER FINANCING
HOW THE DEAL IS FINANCED
Cash Transaction
– The receipt of cash for shares by shareholders in the
target company.
Share Transaction
– The offer by an acquiring company of shares or a
combination of cash and shares to the target company’s
shareholders.
Going Private Transaction (Issuer bid)
– A special form of acquisition where the purchaser already
owns a majority stake in the target company.
Leveraged buyouts
– In a LBO a buyer uses debt to finance the acquisition of a
company (usually LBOs are a way to take a public
company private, or put a company in the hands of the
current management, MBO).
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PURCHASE OF ASSETS & LIABILITIES
 The most common form of merger and acquisition involves
purchasing the stock of the merged or acquired concern.
 An alternative is to purchase the target company’s assets.
 If the acquirer buys all the target’s stock, it assumes the
seller’s liabilities (successor liability).
 In cases in which a buyer purchases a substantial portion of
the target’s assets, the courts have ruled that the buyer is
responsible for the seller’s liabilities (de facto merger).
April 2013
151
HISTORY OF MERGER WAVES

1st wave 1895-1905 Horizontal mergers
End with the passage and enforcement of antitrust legislation.
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2nd wave 1920-1929 Vertical mergers
Ends with stock market crash.
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3rd wave 1960-1971 Conglomerate mergers
Ends with recession and oil shocks of early 1970s.
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4th wave 1982-1989 Hostile takeovers, LBOs, MBOs
Ends with recession of late 1980s
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5th wave 1993-2000 Stock-based friendly mergers
May have ended with the burst of internet bubble
1992-1999 Strategic Mergers Very large in size and number
1998: over $1.5 trillion in deals
Driven by: Deregulation, economic forces, technology, globalization
Most done in cash (unlike 1980s)
EXAMPLES
•Deutsche
Bank –
Bankers Trust
Citicorp –
Travelers
Insurance
(Reigle –Neal
1994, Bliley
Act 1999)
AOL –
Netscape
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THANK YOU FOR YOUR
ATTENTION!
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