FINANCIAL MANAGEMENT
1. Introduction to financial management
Financial Management can be defined as the management of the finances of a business / organisation
in order to achieve financial objectives. Taking a commercial business as the most common
organisational structure, the key objectives of financial management would be to:
• Create wealth for the business
• Generate cash, and
• Provide an adequate return on investment bearing in mind the risks that the business is taking and the
resources invested. There are three key elements to the process of financial management:
(a) Financial Planning
Management need to ensure that enough funding is available at the right time to meet the needs of the
business. In the short term, funding may be needed to invest in equipment and stocks, pay employees
and fund sales made on credit. In the medium and long term, funding may be required for significant
additions to the productive capacity of the business or to make acquisitions.
(b) Financial Control
Financial control is a critically important activity to help the business ensure that the business is meeting
its objectives. Financial control addresses questions such as:
• Are assets being used efficiently?
• Are the businesses assets secure?
• Do management act in the best interest of shareholders and in accordance with business rules?
(c) Financial Decision-making
The key aspects of financial decision-making relate to investment, financing and dividends:
• Investments must be financed in some way – however there are always financing alternatives that can
be considered. For example it is possible to raise finance from selling new shares, borrowing from banks
or taking credit from suppliers
• A key financing decision is whether profits earned by the business should be retained rather than
distributed to shareholders via dividends. If dividends are too high, the business may be starved of
funding to reinvest in growing revenues and profits further.
2. The basic principles of financial management
There are ten principles that form the basics of FINANCIAL MANAGEMENT. These can be called as
the foundation of finance that plays significant role in decision making made by financial managers.
PRINCIPLE 1: The risk return trade off- investors would not take additional risk unless they expect to
be compensated with additional return.
PRINCIPLE 2: Time Value of Money - a dollar received today is worth more than a dollar received a
year from now.
PRINCIPLE 3: CASH, not profits is KING - it is cash flows not profits that are actually received by the
firm and can be reinvested.
PRINCIPLE 4: Incremental Cash Flows- It's only what changes that counts. The incremental cash flow
is the difference between the cash flows if the project is taken on versus what they will be if the project
is not taken on.
PRINCIPLE 5: The Curse of Competitive Markets-Why it's hard to find exceptionally profitable
projects.
PRINCIPLE 6: Efficient Capital Markets-the markets are quick and the prices are right. An efficient
market is characterized by a large number of profit-driven individuals who act independently.
PRINCIPLE 7: The Agency Problem-a problem resulting from conflicts of interest between the
manager/agent and the stockholder.
PRINCIPLE 8: Taxes Bias Business Decisions
PRINCIPLE 9: All Risk is not Equal-some risk can be diversified away, and some cannot.
PRINCIPLE 10: Ethical Behavior is doing the right thing, and ethical dilemmas are everywhere in
finance.
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3. Introduction to working capital
The net working capital of a business is its current assets less its current liabilities
Current Assets include:
- Stocks of raw materials
- Work-in-progress
- Finished goods
- Trade debtors
- Prepayments
- Cash balances
Current Liabilities include:
- Trade creditors
- Accruals
- Taxation payable
- Dividends payable
- Short term loans
Every business needs adequate liquid resources in order to maintain day-to-day cash flow. It needs
enough cash to pay wages and salaries as they fall due and to pay creditors if it is to keep its workforce
and ensure its supplies. Maintaining adequate working capital is not just important in the short-term.
Sufficient liquidity must be maintained in order to ensure the survival of the business in the long-term as
well. Even a profitable business may fail if it does not have adequate cash flow to meet its liabilities as
they fall due. Therefore, when businesses make investment decisions they must not only consider the
financial outlay involved with acquiring the new machine or the new building, etc, but must also take
account of the additional current assets that are usually involved with any expansion of activity.
Increased production tends to engender a need to hold additional stocks of raw materials and work in
progress. Increased sales usually mean that the level of debtors will increase. A general increase in the
firm’s scale of operations tends to imply a need for greater levels of cash.
4. Working Capital Needs of Different Businesses
Different industries have different optimum working capital profiles, reflecting their methods of doing
business and what they are selling.
• Businesses with a lot of cash sales and few credit sales should have minimal trade debtors.
Supermarkets are good examples of such businesses;
• Businesses that exist to trade in completed products will only have finished goods in stock. Compare
this with manufacturers who will also have to maintain stocks of raw materials and work-in-progress.
• Some finished goods, notably foodstuffs, have to be sold within a limited period because of their
perishable nature.
• Larger companies may be able to use their bargaining strength as customers to obtain more favourable,
extended credit terms from suppliers. By contrast, smaller companies, particularly those that have
recently started trading (and do not have a track record of credit worthiness) may be required to pay their
suppliers immediately.
• Some businesses will receive their monies at certain times of the year, although they may incur
expenses throughout the year at a fairly consistent level. This is often known as “seasonality” of cash
flow. For example, travel agents have peak sales in the weeks immediately following Christmas.
Working capital needs also fluctuate during the year
The amount of funds tied up in working capital would not typically be a constant figure throughout the
year. Only in the most unusual of businesses would there be a constant need for working capital funding.
For most businesses there would be weekly fluctuations. Many businesses operate in industries that have
seasonal changes in demand. This means that sales, stocks, debtors, etc. would be at higher levels at
some predictable times of the year than at others. In principle, the working capital need can be separated
into two parts: • A fixed part, and • A fluctuating part
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The fixed part is probably defined in amount as the minimum working capital requirement for the year.
It is widely advocated that the firm should be funded in the way shown in the diagram below:
The more permanent needs (fixed assets and the fixed element of working capital) should be financed
from fairly permanent sources (e.g. equity and loan stocks); the fluctuating element should be financed
from a short-term source (e.g. a bank overdraft), which can be drawn on and repaid easily and at short
notice.
5. Working Capital Cycle
As an introduction to the working capital cycle, here is a quick reminder of the main types of cash
inflow and outflow in a typical business:
Inflows
Outflows
Cash sales to customers
Purchasing finished goods for re-sale
Receipts from customers who were allowed
to buy on credit (trade debtors)
Purchasing raw materials and other components
needed for the manufacturing of the final product
Interest on bank and other balances
Paying salaries and wages and other operating
expenses
Proceeds from sale of fixed assets
Purchasing fixed assets
Investment by shareholders
Paying the interest on, or repayment of loans
Paying taxes
Cash flow can be described as a cycle:
• The business uses cash to acquire resources (assets such as stocks)
• The resources are put to work and goods and services produced. These are then sold to customers
• Some customers pay in cash (great), but others ask for time to pay. Eventually they pay and these
funds are used to settle any liabilities of the business (e.g. pay suppliers)
• And so the cycle repeats
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Hopefully, each time through the cash flow cycle, a little more money is put back into the business than
flows out. But not necessarily, and if management don’t carefully monitor cash flow and take corrective
action when necessary, a business may find itself sinking into trouble.
The cash needed to make the cycle above work effectively is known as working capital.
Working capital is the cash needed to pay for the day to day operations of the business.
In other words, working capital is needed by the business to:
• Pay suppliers and other creditors
• Pay employees
• Pay for stocks
• Allow for customers who are allowed to buy now, but pay later (so-called “trade debtors”)
What is crucially important, therefore, is that a business actively manages working capital. It is the
timing of cash flows which can be vital to the success, or otherwise, of the business. Just because a
business is making a profit does not necessarily mean that there is cash coming into and out of the
business.
There are many advantages to a business that actively manages its cash flow:
• It knows where its cash is tied up, spotting potential bottlenecks and acting to reduce their impact
• It can plan ahead with more confidence. Management are in better control of the business and
can make informed decisions for future development and expansion
• It can reduce its dependence on the bank and save interest charges
• It can identify surpluses which can be invested to earn interest
SOURCES OF FINANCE
1. Managing Business Cash Flows - An Introduction
In an ideal world, a business will experience a consistently positive cash flow – i.e. the amount of cash
coming into the business (cash inflow) is greater than the cash going out of the business (cash outflows)
This would allow a business to build up cash reserves with which to plug cash flow gaps, seek expansion
and reassure lenders and investors about the health of the business.
However, it is important to note that income and expenditure cash flows rarely occur together, with
inflows often lagging behind.
An important aim of effective financial management must be to speed up the inflows and slow down the
outflows.
Cash inflows
The main cash inflows are:
• payment for goods or services from customers
• receipt of a bank loan
• interest on savings and investments
• shareholder investments
• increased bank overdrafts or loans
Cash outflows
The main cash outflows are:
• purchase of stock, raw materials or tools
• wages, rents and daily operating expenses
• purchase of fixed assets - PCs, machinery, office furniture, etc
• loan repayments
• dividend payments
• income tax, corporation tax, VAT and other taxes
• reduced overdraft facilities
Many of the regular cash outflows, such as salaries, loan repayments and tax, have to be made on fixed
dates. A business must always be in a position to meet these payments, to avoid large fines or a
disgruntled workforce.
To improve everyday cash flow a business can:
• ask customers to pay sooner
• chase debts promptly and firmly
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•
•
•
•
•
use factoring
ask for extended credit terms with suppliers
order less stock but more often
lease rather than buy equipment
improve profitability
Cash flow can also be improved by increasing borrowing (lending), or by putting more money into the
business. This is acceptable for coping with short-term downturns or to fund growth in line with the
business plan, but shouldn't form the basis of day-to-day cash flow management.
2. Introduction to Raising Business Finance
When a company is growing rapidly, for example when contemplating investment in capital equipment
or an acquisition, its current financial resources may be inadequate. Few growing companies are able to
finance their expansion plans from cash flow alone. They will therefore need to consider raising finance
from other external sources. In addition, managers who are looking to buy-in to a business
("management buy-in" or "MBI") or buy-out (management buy-out" or "MBO") a business from its
owners may not have the resources to acquire the company. They will need to raise finance to achieve
their objectives. There are a number of potential sources of finance to meet the needs of a growing
business or to finance an MBI or MBO:
- Existing shareholders and directors funds
- Family and friends
- Business angels
- Clearing banks (overdrafts, short or medium term loans)
- Factoring and invoice discounting
- Hire purchase and leasing
- Merchant banks (medium to longer term loans)
- Venture capital
A key consideration in choosing the source of new business finance is to strike a balance between equity
and debt to ensure the funding structure suits the business. The main differences between borrowed
money (debt) and equity are that bankers request interest payments and capital repayments, and the
borrowed money is usually secured on business assets or the personal assets of shareholders and/or
directors. A bank also has the power to place a business into administration or bankruptcy if it defaults
on debt interest or repayments or its prospects decline. In contrast, equity investors take the risk of
failure like other shareholders, whilst they will benefit through participation in increasing levels of
profits and on the eventual sale of their stake. However in most circumstances venture capitalists will
also require more complex investments (such as preference shares or loan stock) in additional to their
equity stake. The overall objective in raising finance for a company is to avoid exposing the business to
excessive high borrowings, but without unnecessarily diluting the share capital. This will ensure that the
financial risk of the company is kept at an optimal level.
(i) Business Plan
Once a need to raise finance has been identified it is then necessary to prepare a business plan. If
management intend to turn around a business or start a new phase of growth, a business plan is an
important tool to articulate their ideas while convincing investors and other people to support it. The
business plan should be updated regularly to assist in forward planning.
There are many potential contents of a business plan. The European Venture Capital Association
suggests the following:
- Profiles of company founders directors and other key managers;
- Statistics relating to sales and markets;
- Names of potential customers and anticipated demand;
- Names of, information about and assessment of competitors;
- Financial information required to support specific projects (for example, major capital investment or
new product development);
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- Research and development information;
- Production process and sources of supply;
- Information on requirements for factory and plant;
- Magazine and newspaper articles about the business and industry;
- Regulations and laws that could affect the business product and process protection
(patents, copyrights, trademarks).
The challenge for management in preparing a business plan is to communicate their ideas clearly and
succinctly. The very process of researching and writing the business plan should help clarify ideas and
identify gaps in management information about their business, competitors and the market.
(ii) Types of Finance - Introduction
A brief description of the key features of the main sources of business finance is provided below.
Venture Capital
Venture capital is a general term to describe a range of ordinary and preference shares where the
investing institution acquires a share in the business. Venture capital is intended for higher risks such as
start up situations and development capital for more mature investments. Replacement capital brings in
an institution in place of one of the original shareholders of a business who wishes to realise their
personal equity before the other shareholders. There are over 100 different venture capital funds in
Nigeria and some have geographical or industry preferences. There are also certain large industrial
companies which have funds available to invest in growing businesses and this 'corporate venturing' is
an additional source of equity finance.
Grants and Soft Loans
Government, local authorities, local development agencies and the European Union are the major
sources of grants and soft loans. Grants are normally made to facilitate the purchase of assets and either
the generation of jobs or the training of employees. Soft loans are normally subsidised by a third party so
that the terms of interest and security levels are less than the market rate. There are over 350 initiatives
from the Department of Trade and Industry alone so it is a matter of identifying which sources will be
appropriate in each case.
Invoice Discounting and Invoice Factoring
Finance can be raised against debts due from customers via invoice discounting or invoice factoring,
thus improving cash flow. Debtors are used as the prime security for the lender and the borrower may
obtain up to about 80 per cent of approved debts. In addition, a number of these sources of finance will
now lend against stock and other assets and may be more suitable then bank lending. Invoice
discounting is normally confidential (the customer is not aware that their payments are essentially
insured) whereas factoring extends the simple discounting principle by also dealing with the
administration of the sales ledger and debtor collection.
Hire Purchase and Leasing
Hire purchase agreements and leasing provide finance for the acquisition of specific assets such as cars,
equipment and machinery involving a deposit and repayments over, typically, three to ten years.
Technically, ownership of the asset remains with the lessor whereas title to the goods is eventually
transferred to the hirer in a hire purchase agreement.
Loans
Medium term loans (up to seven years) and long term loans (including commercial mortgages) are
provided for specific purposes such as acquiring an asset, business or shares. The loan is normally
secured on the asset or assets and the interest rate may be variable or fixed. The Small Firms Loan
Guarantee Scheme can provide up toN250, 000 of borrowing supported by a government guarantee
where all other sources of finance have been exhausted.
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Mezzanine Debt
This is a loan finance where there is little or no security left after the senior debt has been secured. To
reflect the higher risk of mezzanine funds, the lender will charge a rate of interest of perhaps four to
eight per cent over bank base rate may take an option to acquire some equity and may require repayment
over a shorter term.
Bank Overdraft
An overdraft is an agreed sum by which a customer can overdraw their current account. It is normally
secured on current assets, repayable on demand and used for short term working capital fluctuations.
The interest cost is normally variable and linked to bank base rate.
Completing the finance-raising
Raising finance is often a complex process. Business management need to assess several alternatives and
then negotiate terms which are acceptable to the finance provider. The main negotiating points are often
as follows:
- Whether equity investors take a seat on the board
- Votes ascribed to equity investors
- Level of warranties and indemnities provided by the directors
- Financier's fees and costs
- Who bears costs of due diligence.
During the finance-raising process, accountants are often called to review the financial aspects of the
plan. Their report may be formal or informal, an overview or an extensive review of the company's
management information system, forecasting methods and their accuracy, review of latest management
accounts including working capital, pension funding and employee contracts etc. This due diligence
process is used to highlight any fundamental problems that may exist.
3. Sources of Finance for SMEs
Often the hardest part of starting a business is raising the money to get going. The entrepreneur might
have a great idea and clear idea of how to turn it into a successful business. However, if sufficient
finance can’t be raised, it is unlikely that the business will get off the ground.
Raising finance for start-up requires careful planning. The entrepreneur needs to decide:
• How much finance is required?
• When and how long the finance is needed for?
• What security (if any) can be provided?
• Whether the entrepreneur is prepared to give up some control (ownership) of the start-up in
return for investment?
The finance needs of a start-up should take account of these key areas:
• Set-up costs (the costs that are incurred before the business starts to trade)
• Starting investment in capacity (the fixed assets that the business needs before it can begin to
trade)
• Working capital (the stocks needed by the business –e.g. r raw materials + allowance for
amounts that will be owed by customers once sales begin)
• Growth and development (e.g. extra investment in capacity)
One way of categorising the sources of finance for a start-up is to divide them into sources which are
from within the business (internal) and from outside providers (external).
(i) Internal sources
The main internal sources of finance for a start-up are as follows:
Personal sources
These are the most important sources of finance for a start-up, and we deal with them in more detail in a
later section.
Retained profits
This is the cash that is generated by the business when it trades profitably – another important source of
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finance for any business, large or small.
Note that retained profits can generate cash the moment trading has begun. For example, a start-up
sells the first batch of stock forN5, 000 cash which it had bought forN2, 000. That means that retained
profits areN3, 000 which can be used to finance further expansion or to pay for other trading costs and
expenses.
Share capital – invested by the founder
The founding entrepreneur (/s) may decide to invest in the share capital of a company, founded for the
purpose of forming the start-up. This is a common method of financing a start-up. The founder
provides all the share capital of the company, retaining 100% control over the business. The advantages
of investing in share capital are covered in the section on business structure. The key point to note here
is that the entrepreneur may be using a variety of personal sources to invest in the shares. Once the
investment has been made, it is the company that owns the money provided. The shareholder obtains a
return on this investment through dividends (payments out of profits) and/or the value of the business
when it is eventually sold. A start-up company can also raise finance by selling shares to external
investors – this is covered further below.
(ii) External sources
Loan capital
This can take several forms, but the most common are a bank loan or bank overdraft.
A bank loan provides a longer-term kind of finance for a start-up, with the bank stating the fixed
period over which the loan is provided (e.g. 5 years), the rate of interest and the timing and amount of
repayments. The bank will usually require that the start-up provide some security for the loan, although
this security normally comes in the form of personal guarantees provided by the entrepreneur. Bank
loans are good for financing investment in fixed assets and are generally at a lower rate of interest that a
bank overdraft. However, they don’t provide much flexibility.
A bank overdraft is a more short-term kind of finance which is also widely used by start-ups and small
businesses. An overdraft is really a loan facility – the bank lets the business “owe it money” when the
bank balance goes below zero, in return for charging a high rate of interest. As a result, an overdraft is a
flexible source of finance, in the sense that it is only used when needed. Bank overdrafts are excellent
for helping a business handle seasonal fluctuations in cash flow or when the business runs into shortterm cash flow problems (e.g. a major customer fails to pay on time).
Two further loan-related sources of finance are worth knowing about:
Share capital – outside investors
For a start-up, the main source of outside (external) investor in the share capital of a company is friends
and family of the entrepreneur. Opinions differ on whether friends and family should be encouraged to
invest in a start-up company. They may be prepared to invest substantial amounts for a longer period of
time; they may not want to get too involved in the day-to-day operation of the business. Both of these
are positives for the entrepreneur. However, there are pitfalls. Almost inevitably, tensions develop with
family and friends as fellow shareholders.
Business angels are the other main kind of external investor in a start-up company. Business angels are
professional investors who typically investN10k -N750k. They prefer to invest in businesses with high
growth prospects. Angels tend to have made their money by setting up and selling their own business –
in other words they have proven entrepreneurial expertise. In addition to their money, Angels often
make their own skills, experience and contacts available to the company. Getting the backing of an
Angel can be a significant advantage to a start-up, although the entrepreneur needs to accept a loss of
control over the business.
You will also see Venture Capital mentioned as a source of finance for start-ups. You need to be
careful here. Venture capital is a specific kind of share investment that is made by funds managed by
professional investors. Venture capitalists rarely invest in genuine start-ups or small businesses (their
minimum investment is usually overN1m, often much more). They prefer to invest in businesses which
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have established themselves. Another term you may here is “private equity” – this is just another term
for venture capital.
A start-up is much more likely to receive investment from a business angel than a venture capitalist.
Personal sources
As mentioned earlier, most start-ups make use of the personal financial arrangements of the founder.
This can be personal savings or other cash balances that have been accumulated. It can be personal debt
facilities which are made available to the business. It can also simply be the found working for nothing!
The following notes explain these in a little more detail.
Savings and other “nest-eggs”
An entrepreneur will often invest personal cash balances into a start-up. This is a cheap form of finance
and it is readily available. Often the decision to start a business is prompted by a change in the personal
circumstances of the entrepreneur – e.g. redundancy or an inheritance. Investing personal savings
maximises the control the entrepreneur keeps over the business. It is also a strong signal of commitment
to outside investors or providers of finance. Re-mortgaging is the most popular way of raising loanrelated capital for a start-up. The way this works is simple. The entrepreneur takes out a second or
larger mortgage on a private property and then invests some or all of this money into the business. The
use of mortgaging like this provides access to relatively low-cost finance, although the risk is that, if the
business fails, then the property will be lost too. .
Borrowing from friends and family
This is also common. Friends and family who are supportive of the business idea provide money either
directly to the entrepreneur or into the business. This can be quicker and cheaper to arrange (certainly
compared with a standard bank loan) and the interest and repayment terms may be more flexible than a
bank loan. However, borrowing in this way can add to the stress faced by an entrepreneur, particularly
if the business gets into difficulties.
Credit cards
This is a surprisingly popular way of financing a start-up. In fact, the use of credit cards is the most
common source of finance amongst small businesses. It works like this. Each month, the entrepreneur
pays for various business-related expenses on a credit card. 15 days later the credit card statement is
sent in the post and the balance is paid by the business within the credit-free period. The effect is that
the business gets access to a free credit period of aroudn30-45 days!
(iii) Overdraft Financing
Overdraft financing is provided when businesses make payments from their business current account
exceeding the available cash balance. An overdraft facility enables businesses to obtain short-term
funding - although in theory the amount loaned is repayable on demand by the bank.
There are several important factors to consider when assessing the appropriateness of an overdraft as a
source of funding for SME's:
- The amount borrowed should not exceed the agreed limit ("facility"). The amount of the facility made
available is a matter for negotiation with the bank;
- Interest is charged on the amount overdrawn - at a rate that is above the Bank Base Rate. The bank
may also charge an overdraft facility fee;
- Overdrafts are generally meant to cover short-term financing requirements - they are not generally
meant to provide a permanent source of finance
- Depending on the size of the overdraft facility, the bank may require the SME to provide some security
- for example by securing the overdraft against tangible fixed assets, or against personal guarantees
provided by the directors
The amount of an overdraft at any one time will depend on the cash flows of the business, the timing of
receipts and payments, seasonal trends in the sales and so on. This can be illustrated using the data
below. In the example cash flow statement given below, the SME generates a positive overall cash flow
in a full year. However, due to the timing of sales receipts compared with supplier payments, the
business needs to fund a temporary overdraft during the year: In the example below, the business
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requires a maximum overdraft facility ofN75, 000 in July. Thereafter, the overdraft balance reduces as
sales receipts exceed cash payments.
If the business finds that an overdraft facility appears to be becoming a long-term feature of the business,
the
bank
may
suggest
converting
the
overdraft
into
a
medium-term
loan.
Comparison of Bank Overdrafts and Bank Loans
The key advantages of overdrafts and loans in certain business situations:
Advantages of an overdraft over a loan
Customer only pays interest when overdrawn
Bank has flexibility to review and adjust the level of the overdraft facility, perhaps on a short-term basis
Overdraft can be effectively be used as a medium-term loan – the facility is simply renewed each time
the bank comes to review it. Being part of short-term debt, the overdraft balance is not normally
included in calculations of the business’ financial gearing
Advantages of a loan over an overdraft
Business and bank know precisely what the repayments of the loan will be and how much interest is
payable and when. This makes cash flow planning more predictable
The loan is committed – the business does not have to worry about the loan being withdrawn whilst it
complies with the terms of the loan
(iv) Time value of money.
The time value of money is money's potential to grow in value over time. Time value of money is the
concept that the value of a naira to be received in future is less than the value of a naira on hand today.
One reason is that money received today can be invested thus generating more money. Another reason is
that when a person opts to receive a sum of money in future rather than today, he is effectively lending
the money and there are risks involved in lending such as default risk and inflation. Default risk arises
when the borrower does not pay the money back to the lender. Inflation is the rise in general level of
prices. Time value of money principle also applies when comparing the worth of money to be received
in future and the worth of money to be received in further future. In other words, TVM principle says
that the value of given sum of money to be received on a particular date is more than same sum of
money to be received on a later date.
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Few of the basic terms used in time value of money calculations are:
Present Value
When a future payment or series of payments are discounted at the given rate of interest up to the
present date to reflect the time value of money, the resulting value is called present value.
Read further: Present Value of a Single Sum of Money and Present Value of an Annuity
Future Value
Future value is amount that is obtained by enhancing the value of a present payment or a series of
payments at the given rate of interest to reflect the time value of money.
Read further: Future Value of a Single Sum of Money and Future Value of an Annuity
Interest
Interest is charge against use of money paid by the borrower to the lender in addition to the actual
money lent.
Read further: Simple vs. Compound Interest
Application of Time Value of Money Principle
There are many applications of time value of money principle. For example, we can use it to compare
the worth of cash flows occurring at different times in future, to find the present worth of a series of
payments to be received periodically in future, to find the required amount of current investment that
must be made at a given interest rate to generate a required future cash flow, etc. Because of this
potential, money that's available in the present is considered more valuable than the same amount in the
future.
For example, if you were given N100 today and invested it at an annual rate of only 1%, it could be
worth N101 at the end of one year, which is more than you'd have if you received N100 at that point. In
addition, because of money's potential to increase in value over time, you can use the time value of
money to calculate how much you need to invest now to meet a certain future goal. Many financial
websites and personal investment handbooks help you calculate these amounts based on different
interest rates. Inflation has the reverse effect on the time value of money. Because of the constant
decline in the purchasing power of money, an uninvested naira is worth more in the present than the
same uninvested naira will be in the future.
What Does Time Value of Money Mean?
The idea that money available today is worth more than the same amount of money in the future, based
on its earnings potential. This principle asserts that money can earn interest and grow, and so any
amount of money is worth more the sooner a person has it so that that person can put it to use now rather
than later. This is also referred to as present discounted value. Everyone knows that money deposited in
a savings account will earn interest. Because of this, the sooner it starts earning interest, the better. For
example, assuming a 5% interest rate, a N100 investment today will be worth N105 in one year (N100
multiplied by 1.05). Conversely, N100 received one year from now is worth only N95.24 today (N100
divided by 1.05), assuming a 5% interest rate.
Time Value of Money Practice Problems and Solutions
1) Jim makes a deposit ofN12, 000 in a bank account. The deposit is to earn interest annually at the rate
of 9 percent for seven years.
a) How much will Jim have on deposit at the end of seven years?
P/Y = 1, N = 7, I = 9, PV = 12,000, PMT = 0 ⇒ FV =N21, 936.47
b) Assuming the deposit earned a 9 percent rate of interest compounded quarterly, how much would he
have at the end of seven years?
P/Y = 4, N = 7 × 4 = 28 ⇒ FV =N22, 374.54
c) In comparing parts (a) and (b), what are the respective effective annual yields? Which alternative is
better?
Because interest in compounded annual in part (a), the effective annual rate is the same as the nominal
rate: EARA = 9%. In part (b), EARB = (1 + i/m) m – 1 = 1.02254 – 1 = 9.31%.
11
This can be also solved using the TI BAII+ using the Interest Conversion worksheet. Simply press [2 nd]
[I Conv] (the second function of the 2 key) to bring up this worksheet. When the screen says NOM =
press [9] and [Enter]. Then arrow up and make sure that [C/Y] reads 4 compounding periods per year; if
not, press [4] and [Enter]. Finally arrow up to the EFF screen and press [CPT] to compute the effective
annual rate.
Alternative (b) is preferred because it compounds your interest more frequently. Thus you get to earn
“interest on your interest” sooner.
2) John is considering the purchase of a lot. He can buy the lot today and expects the price to rise toN15,
000 at the end of 10 years. He believes that he should earn an investment yield of 10 percent annually on
this investment. The asking price for the lot isN7, 000. Should he buy it? What is the annual yield
(internal rate of return) of the investment if John purchases the property forN7, 000 and is able to sell it
10 years later forN15, 000?
P/Y = 1, N = 10, I = 10, PMT = 0, FV = 15,000 ⇒ PV = −N5, 783.15. Because the present value of this
investment is less than theN7, 000 asking price for the lot, John should not buy it.
To solve for the internal rate of return enter PV = − 7,000 and compute I = 7.92%.
3) An investor can make an investment in a real estate development and receive an expected cash return
ofN45, 000 after six years. Based on a careful study of other investment alternatives, she believes that an
18 percent annual return compounded quarterly is a reasonable return to earn on this investment. How
much should she pay for it today?
P/Y = 4, N = 6 × 4 = 24, I = 18, PMT = 0, FV = 45,000 ⇒ PV = −N15, 646.66.
4) Suppose you have the opportunity to make an investment in a real estate venture that expects to pay
investorsN750 at the end of each month for the next eight years. You believe that a reasonable return on
your investment should be 17 percent compounded monthly.
a) How much should you pay for the investment?
P/Y = 12, N = 8 × 12 = 96, I = 17, PMT = 750, FV = 0 ⇒ −N39, 222.96.
b) What will be the total sum of cash you will receive over the next eight years? This can be solved by
setting I = 0, PV = 0, and computing FV = −N72, 000. Notice that the sign of this solution is negative
because the payments have been entered as positive values.
c) Why is there such a large difference between (a) and (b)?
The difference between the answers in parts (a) and (b) represents the foregone interest that results from
receiving the payments in the future, rather than today.
5) Walt is evaluating an investment that will provide the following returns at the end of each of the
following years: year 1,N12,500; year 2,N10,000; year 3,N7,500; year 4,N5,000; year 5,N2,500; year
6,N0; and year 7,N12,500. Walt believes that he should earn an annual rate of 9 percent on this
investment. How much should he pay for this investment?
This can be solved using the irregular cash flow worksheet:
CF0 = 0
C01 = 12,500
C02 = 10,000
C03 = 7,500
C04 = 5,000
C05 = 2,500
C06 = 0
C07 = 12,500
12
Set I = 9 and solve for NPV =N37, 681.
6) A loan ofN50, 000 is due 10 years from today. The borrower wants to make annual payments at the
end of each year into a sinking fund that will earn interest at an annual rate of 10 percent. What will the
annual payments have to be? Suppose that the borrower will make monthly payments that earn 10
percent interest, compounded monthly. How much will he pay annually into the fund?
With annual compounding: P/Y = 1, N = 10, I = 10, PV = 0, FV = 50,000 ⇒ PMT = −N3, 137.27.
With monthly compounding: P/Y = 12, N = 10 × 12 = 120, ⇒ PMT = − 244.09.
These are monthly payments, so the total annual payment will be 244.09 × 12 =N2, 929.04.
7) The Dallas Development Corporation is considering the purchase of an apartment project forN100,
000. They estimate that they will receiveN15, 000 at the end of each year for the next 10 years. At the
end of the 10th year, the apartment project will be worth nothing. If Dallas purchases the project, what
will be its internal rate of return? If the company insists on a 9 percent return compounded annually on
its investment, is this a good investment?
P/Y = 1, N = 10, I = 9, PMT = 15,000, FV = 0 ⇒ PV = −N96, 264.87. Based on the NPV rule, this is a
poor investment because the present value of future cash flows is less than the required investment
ofN100, 000.
Alternatively, you could enter PV = −N100, 000 and solve for I = 8.14%. Because the IRR of this
investment is less than the 9% hurdle rate, Dallas should not invest in this project.
8) Suppose you depositN5, 000 into an account earning 4 percent interest, compounded monthly.
a) How many years will it take for your account to be worthN7, 500?
P/Y = 12, PV = −5,000, I = 4, PMT = 0, FV = 7,500 ⇒ N = 121.84, or 10.15 years.
b) Suppose in addition to the initialN5, 000 deposit, you will make monthly contributions ofN50. How
many years will it take for the account to grow toN7, 500 in this case?
PMT = −50 ⇒ N = 35.39 or 2.95 years.
c) How does your answer change if you make quarterly deposits ofN150 rather than monthly
contributions ofN50? Explain the reason for any difference in your answer from part b. Maintain the
assumption that interest compounds monthly.
P/Y = 4, C/Y = 12, PMT = −150 ⇒ N = 11.83 or 2.96 years.
The time it takes to saveN7, 500 rises just a bit because you are no longer earning interest on new
investments until the end of each quarter, rather than each month.
9) Consider an investment that will payN680 per month for the next 15 years and will be worthN28, 000
at the end of that time. How much is this investment worth to you today at a 5.25 percent discount rate?
P/Y = 12, N = 15 × 12 = 180, I = 5.25, PMT = 680, FV = 28,000 ⇒ PV = −97,351.34.
10) You currently oweN18, 000 on a car loan at 9.5 percent interest. If you make monthly payments
ofN576.59 per month, how long will it take you to fully repay the loan?
P/Y = 12, I = 9.5, PV = 18,000, PMT = −576.59, FV = 0 ⇒ N = 36
11) You have just borrowedN10, 000 and will be required to make monthly payments ofN227.53 for the
next five years in order to fully repay the loan. What is the implicit interest rate on this loan?
P/Y = 12, N = 5 × 12 = 60, PV = 10,000, PMT = −227.53, FV = 0 ⇒ I = 13%
12) Your uncle has given you a bond that will payN500 at the end of each year forever into the future. If
the market yield on this bond is 8.25 percent, how much is it worth today?
This type of investment is known as perpetuity. The formula for its value is
PV = PMT / r = 500 / 0.0825 = 6,060.61.
13
13) Suppose you have an investment that is expected to generate aN20, 000 cash flow next year and that
this is expected to increase by 5 percent per year forever into the future.
a) If your required rate of return on this investment is 18 percent, how much is it worth to you today?
This is a growing perpetuity. The formula for its value is
PV = PMT. =
r− g
= 153,846.15
20,000
0.18 − 0.05
b) Suppose now that you do not know how fast the cash flows will grow in the future, but that you
expect them to grow at a constant rate. Suppose also that this investment is currently priced atN200, 000.
If the required rate of return is still 18 percent, how fast does the market expect the annual cash flows to
grow? Rearrange the growing perpetuity formula to solve for the growth rate:
g=r
- PMT = 0.18 − 20,000
PV
=
0.18 - 0.10 = 0.08 or 8 percent
200,000
14) You are considering the purchase of an investment that is expected to generate cash flows ofN15,
000 per year for the next five years. After that, cash flows are expected in increase at the rate of 5
percent per year for the indefinite future. Thus, in year 6 the cash flow will beN15, 750, etc. How much
is this investment worth to you today if your required return is 15 percent?
First, calculate the value of the investment at the end of year 5 using the formula for a growing
perpetuity:
V5 = CF6 =
15,750
= 157,500
r– g
0.15 − 0.05
Next use this as the future value and use your time value of money keys to calculate the value as of date
0 (today). P/Y = 1, N = 5, I = 15, PMT = 15,000, FV = 157,500 ⇒ PV = −128,587.66.
______ 1. What is the future value ofN3, 500 deposited for 12 years at 5 percent interest, compounded
annually?
A.N6, 285.50
B.N3, 679.07
C.N55, 709.94
D.N6, 369.47
P/Y = 1, N = 12, I = 5, PV = 3,500, PMT = 0; solve for FV
______ 2. What is the internal rate of return on an investment that costsN2, 000 and returnsN32 per
month for the next 15 years?
A. The IRR cannot be calculated for this investment
B. 1.48%
C. 17.86%
D. 14.13%
P/Y = 12, PMT = 32, PV = -2,000, FV = 0, N = 15 × 12 = 180; solve for I
______ 3. What is the internal rate of return of an investment with the following cash flows?
n
$
0
(1,000)
1
300
2
300
3
300
4
200
5
100
14
A. The IRR cannot be calculated for this investment
B. 10.00%
C. 15.23%
D. 7.48%
CF0 = -1,000, C01 = 300, F01 = 3, C02 = 200, F02 = 1, C03 = 100,
F03 = 1; solve for IRR
______ 4. If your discount rate is 12%, what is the NPV of the investment from the last?
question?
A.N0.00
B. ($55.25)
C.N200.00
D. ($95.60)
With all the same entries, solve for NPV with I = 12
______ 5. True or FALSE: Assuming the same positive discount rate and the same number of years over
which they will be received, aN1,200 annuity with annual payments has a larger present value than
aN100 annuity with monthly payments. The reason is “sooner is better than later.” The total payments
you
receive is the same under both annuities ($1,200 per year), but you get some of your money sooner with
the monthly annuity. You could put this in an account and earn interest on it, making it worth more to
you thanN1, 200 at the end of each year.
______ 6. How much should you pay for an investment that paysN1, 500 per year for the next three
years and thenN2, 000 per year for the following two years?
Assume a discount rate of 15% per year?
A.N8, 500.00
B.N5, 562.70
C.N6, 338.15
D.N10, 000.00
CF0 = 0, C01 = 1,500, F01 = 3, C02 = 2,000, F02 = 2; solve for NPV with I = 15
______ 7. Consider an eight-year investment costingN55, 000. It is expected to payN3, 000 per year in
each of the next five years andN15, 000 per year in the last three years. If the required discount rate is 12
percent, what is the net present value of this investment?
A.N86, 257.28
B. ($23,742.72)
C.N5, 000
D.N60, 000.00
CF0 = -55,000, C01 = 3,000, F01 = 5, C02 = 15,000, F02 = 3; solve for
NPV with I = 12
______ 8. What is the internal rate of return of the investment in the last question?
A. The IRR cannot be calculated for this investment
B. 1.47%
C. 14.7%
D. 12.0%
With the same entries as above, solve for IRR
______ 9. What is the annual debt service on aN1.2 million 30-year mortgage at 6.75%
interest with monthly payments?
A.N40, 518
B.N7, 783
15
C.N94, 286.59
D.N93, 398
Annual debt service is simply 12 times the monthly payment.
Enter PV = 1,200,000, P/Y = 12, N = 30 × 12 = 360, I = 6.75, FV = 0; solve for PMT and multiply the
result by 12.
______ 10. In class we said that “cash is king” in finance. Which of the following things
is NOT true about this king?
A. More is better than less
B. Sooner is better than later
C. Certain is better than uncertain
D. STRAIGHT IS BETTER THAN CROOKED
4. Business Angels
Business Angels
Business owners often report that company finance ofN10, 000 toN250, 000 can be very difficult to
obtain - even from traditional sources such as banks and venture capitalists. Banks generally require
security and most venture capital firms are not interested in financing such small amounts. In these
circumstances, companies often have to turn to "Business Angels".
Business angels are wealthy, entrepreneurial individuals who provide capital in return for a proportion of
the company equity. They take a high personal risk in the expectation of owning part of a growing and
successful business.
Businesses Suitable for Angel Investment
Businesses are unlikely to be suitable for investment by a business angel unless certain conditions are
fulfilled.
(1) The business needs to raise a reasonably modest amount (typically betweenN10, 000 toN250, 000,
and is willing to sell a shareholding in return for financing. Equity finance of overN250, 000 is usually
provided by venture capital firms rather than business angels. The exceptions are when several business
angels invest together in a syndicate or when business angels co-invest alongside venture capital funds.
The sums raised can easily exceedN250, 000. Raising finance in the form of equity (shares) strengthens
the business' balance sheet. Banks (or other lenders) may then be willing to provide additional debt
finance.
(2) The owners and managers of the business are willing to develop a personal relationship with a
business angel. This is important. Typically, business angels want hands-on involvement in the
management of their investment, without necessarily exercising day-to-day control. This relationship
can be a positive one for the business. A business angel with the right skills can strengthen a business
by, for example, offering marketing and sales experience.
(3) The business can, and is prepared to offer the business angel the possibility of a high return (usually
an expected average annual return of at least 20%–30% per annum). Most of this return will be realised
in the form of capital gains over a period of several years.
(4) The business can demonstrate a strong understanding of its products and markets. Some business
angels specialise by providing "expansion finance" for businesses with a proven track record, or in
particular sectors. This enables an already successful business to grow faster. Business angels are also a
significant source of start-up and early-stage capital for companies without a track record. A business
plan based on convincing market research is essential.
(5) The business has an experienced and professional management team - as a minimum with strong
product and sales skills. If there are weaknesses in the existing management team, a business angel can
often provide the missing skills or introduce the business to new management.
(6) The business can offer the business angel the possibility of an ‘exit’. Even if the business angel has
no plans to realise the investment by any particular date, the angel will want the option to be available.
The most common exits are:
16
- A trade sale of the business to another company.
- Repurchase of the business angel’s shares by the company.
- Purchase of the business angel’s shares by the company’s directors or another investor.
Finding an angel
Many contacts are made informally. For example: personal friends and family; wealthy business
contacts; major suppliers and clients of the business. Investors can also be found by approaching formal
angel networking organisations. Many of the most active business angels use these networks to find out
about interesting investment opportunities.
5. Introduction to Venture Capital
Venture capital
Venture Capital is a form of "risk capital". In other words, capital that is invested in a project (in this
case - a business) where there is a substantial element of risk relating to the future creation of profits and
cash flows. Risk capital is invested as shares (equity) rather than as a loan and the investor requires a
higher “rate of return" to compensate him for his risk.
The main sources of venture capital in Nigeria are venture capital firms and "business angels" - private
investors. Separate Tutor2u revision notes cover the operation of business angels. In these notes, we
principally focus on venture capital firms. However, it should be pointed out the attributes that both
venture capital firms and business angels look for in potential investments are often very similar.
What is venture capital?
Venture capital provides long-term, committed share capital, to help unquoted companies grow and
succeed. If an entrepreneur is looking to start-up, expand, buy-into a business, buy-out a business in
which he works, turnaround or revitalise a company, venture capital could help do this. Obtaining
venture capital is substantially different from raising debt or a loan from a lender. Lenders have a legal
right to interest on a loan and repayment of the capital, irrespective of the success or failure of a
business. Venture capital is invested in exchange for an equity stake in the business. As a shareholder,
the venture capitalists return is dependent on the growth and profitability of the business. This return is
generally earned when the venture capitalist "exits" by selling its shareholding when the business is sold
to another owner. Venture capital originated in the late 18th century, when entrepreneurs found wealthy
individuals to back their projects on an ad hoc basis. This informal method of financing became an
industry in the late 1970s and early 1980s when a number of venture capital firms were founded. There
are now over 100 active venture capital firms in the UK, which provide several billion pounds each year
to unquoted companies mostly located in the UK.
What kinds of businesses are attractive to venture capitalists?
Venture capitalists prefer to invest in "entrepreneurial businesses". This does not necessarily mean small
or new businesses. Rather, it is more about the investment's aspirations and potential for growth, rather
than by current size. Such businesses are aiming to grow rapidly to a significant size. As a rule of thumb,
unless a business can offer the prospect of significant turnover growth within five years, it is unlikely to
be of interest to a venture capital firm. Venture capital investors are only interested in companies with
high growth prospects, which are managed by experienced and ambitious teams who are capable of
turning their business plan into reality.
For how long do venture capitalists invest in a business?
Venture capital firms usually look to retain their investment for between three and seven years or more.
The term of the investment is often linked to the growth profile of the business. Investments in more
mature businesses, where the business performance can be improved quicker and easier, are often sold
sooner than investments in early-stage or technology companies where it takes time to develop the
business model.
Where do venture capital firms obtain their money?
17
Just as management teams compete for finance, so do venture capital firms. They raise their funds from
several sources. To obtain their funds, venture capital firms have to demonstrate a good track record and
the prospect of producing returns greater than can be achieved through fixed interest or quoted equity
investments. Most venture capital firms raise their funds for investment from external sources, mainly
institutional investors, such as pension funds and insurance companies.
Venture capital firms' investment preferences may be affected by the source of their funds. Many funds
raised from external sources are structured as Limited Partnerships and usually have a fixed life of 10
years. Within this period the funds invest the money committed to them and by the end of the 10 years
they will have had to return the investors' original money, plus any additional returns made. This
generally requires the investments to be sold, or to be in the form of quoted shares, before the end of the
fund.
Venture Capital Trusts (VCT's) are quoted vehicles that aim to encourage investment in smaller unlisted
(unquoted and quoted companies) companies by offering private investors tax incentives in return for a
five-year investment commitment. The first were launched in 1995 and are mainly managed by venture
capital firms. If funds are obtained from a VCT, there may be some restrictions regarding the company's
future development within the first few years.
What is involved in the investment process?
The investment process, from reviewing the business plan to actually investing in a proposition, can take
a venture capitalist anything from one month to one year but typically it takes between 3 and 6 months.
There are always exceptions to the rule and deals can be done in extremely short time frames. Much
depends on the quality of information provided and made available.
The key stage of the investment process is the initial evaluation of a business plan. Most approaches to
venture capitalists are rejected at this stage. In considering the business plan, the venture capitalist will
consider several principal aspects:
- Is the product or service commercially viable?
- Does the company have potential for sustained growth?
- Does management have the ability to exploit this potential and control the company through the growth
phases?
- Does the possible reward justify the risk?
- Does the potential financial return on the investment meet their investment criteria?
In structuring its investment, the venture capitalist may use one or more of the following types of share
capital:
Ordinary shares
These are equity shares that are entitled to all income and capital after the rights of all other classes of
capital and creditors have been satisfied. Ordinary shares have votes. In a venture capital deal these are
the shares typically held by the management and family shareholders rather than the venture capital firm.
Preferred ordinary shares
These are equity shares with special rights. For example, they may be entitled to a fixed dividend or
share of the profits. Preferred ordinary shares have votes.
Preference shares
These are non-equity shares. They rank ahead of all classes of ordinary shares for both income and
capital. Their income rights are defined and they are usually entitled to a fixed dividend (e.g. 10%
fixed). The shares may be redeemable on fixed dates or they may be irredeemable. Sometimes they may
be redeemable at a fixed premium (e.g. at 120% of cost). They may be convertible into a class of
ordinary shares.
Loan capital
Venture capital loans typically are entitled to interest and are usually, though not necessarily repayable.
Loans may be secured on the company's assets or may be unsecured. A secured loan will rank ahead of
unsecured loans and certain other creditors of the company. A loan may be convertible into equity
shares. Alternatively, it may have a warrant attached which gives the loan holder the option to subscribe
18
for new equity shares on terms fixed in the warrant. They typically carry a higher rate of interest than
bank term loans and rank behind the bank for payment of interest and repayment of capital.
Venture capital investments are often accompanied by additional financing at the point of investment.
This is nearly always the case where the business in which the investment is being made is relatively
mature or well-established. In this case, it is appropriate for a business to have a financing structure that
includes both equity and debt.
Other forms of finance provided in addition to venture capitalist equity include:
- Clearing banks - principally provide overdrafts and short to medium-term loans at fixed or, more
usually, variable rates of interest.
- Merchant banks - organise the provision of medium to longer-term loans, usually for larger amounts
than clearing banks. Later they can play an important role in the process of "going public" by advising
on the terms and price of public issues and by arranging underwriting when necessary.
- Finance houses - provide various forms of instalment credit, ranging from hire purchase to leasing;
often asset based and usually for a fixed term and at fixed interest rates.
Factoring companies - provide finance by buying trade debts at a discount, either on a recourse basis
(you retain the credit risk on the debts) or on a non-recourse basis (the factoring company takes over the
credit risk).
Government and Nigerian Commission sources - provide financial aid to companies, ranging from
project grants (related to jobs created and safeguarded) to enterprise loans in selective areas.
Mezzanine firms - provide loan finance that is halfway between equity and secured debt. These facilities
require either a second charge on the company's assets or are unsecured. Because the risk is
consequently higher than senior debt, the interest charged by the mezzanine debt provider will be higher
than that from the principal lenders and sometimes a modest equity "up-side" will be required through
options or warrants. It is generally most appropriate for larger transactions.
Making the Investment - Due Diligence
To support an initial positive assessment of your business proposition, the venture capitalist will want to
assess the technical and financial feasibility in detail.
External consultants are often used to assess market prospects and the technical feasibility of the
proposition, unless the venture capital firm has the appropriately qualified people in-house. Chartered
accountants are often called on to do much of the due diligence, such as to report on the financial
projections and other financial aspects of the plan. These reports often follow a detailed study, or a one
or two day overview may be all that is required by the venture capital firm. They will assess and review
the following points concerning the company and its management:
- Management information systems
- Forecasting techniques and accuracy of past forecasting
- Assumptions on which financial assumptions are based
- The latest available management accounts, including the company's cash/debtor positions
- Bank facilities and leasing agreements
- Pensions funding
- Employee contracts, etc.
The due diligence review aims to support or contradict the venture capital firm's own initial impressions
of the business plan formed during the initial stage. References may also be taken up on the company
(e.g. with suppliers, customers, and bankers).
6. Sources of Equity Finance
Equity is the term commonly used to describe the ordinary share capital of a business.
Ordinary shares in the equity capital of a business entitle the holders to all distributed profits after the
holders of debentures and preference shares have been paid.
(i) Ordinary (equity) shares
Ordinary shares are issued to the owners of a company. The ordinary shares of companies typically have
a nominal or 'face' value (usually something likeN1 or 5Op, but shares with a nominal value of 1p, 2p or
2Sp are not uncommon).
19
However, it is important to understand that the market value of a company's shares has little (if any)
relationship to their nominal or face value. The market value of a company's shares is determined by the
price another investor is prepared to pay for them. In the case of publicly-quoted companies, this is
reflected in the market value of the ordinary shares traded on the stock exchange (the "share price").
In the case of privately-owned companies, where there is unlikely to be much trading in shares, market
value is often determined when the business is sold or when a minority shareholding is valued for
taxation purposes.
In your studies, you may also come across "Deferred ordinary shares". These are a form of ordinary
shares, which are entitled to a dividend only after a certain date or only if profits rise above a certain
amount. Voting rights might also differ from those attached to other ordinary shares.
Why might a company issue ordinary shares?
A new issue of shares might be made for several reasons:
(1) The company might want to raise more cash
For example might be needed for the expansion of a company's operations. If, for example, a company
with 500,000 ordinary shares in issue decides to issue 125,000 new shares to raise cash, should it offer
the new shares to existing shareholders, or should it sell them to new shareholders instead?
- Where a company sells the new shares to existing shareholders in proportion to their existing
shareholding in the company, this is known as a "rights issue".
(2) The company might want to issue new shares partly to raise cash but more importantly to
'float' its shares on a stock market.
When a company is floated, it must make available a minimum proportion of its shares to the general
investing public.
(3) The company might issue new shares to the shareholders of another company, in
order to take it over
There are many examples of businesses that use their high share price as a way of making an offer for
other businesses. The shareholders of the target business being acquired received shares in the buying
business and perhaps also some cash.
There are three main methods of raising equity:
(1) Retained profits: i.e. retaining profits, rather than paying them out as dividends. This is the most
important source of equity
(2) Rights issues: i.e. an issue of new shares. After retained profits, rights issues are the next most
important source
(3) New issues of shares to the public: i.e. an issue of new shares to new shareholders. In total in
Nigeria, this is the least important source of equity finance
(ii) Rights Issues
A rights issue is an issue of new shares for cash to existing shareholders in proportion to their
existing holdings.
A rights issue is, therefore, a way of raising new cash from shareholders - this is an important source of
new equity funding for publicly quoted companies.
Why issue shares to existing shareholders?
Legally a rights issue must be made before a new issue to the public. This is because existing
shareholders have the “right of first refusal” (otherwise known as a “pre-emption right”) on the new
shares.
By taking these pre-emption rights up, existing shareholders can maintain their existing percentage
holding in the company.
However, shareholders can, and often do, waive these rights, by selling them to others. Shareholders can
also vote to rescind their pre-emption rights.
20
How are the shares sold in a rights issue priced?
The price at which the new shares are issued is generally much less than the prevailing market price for
the shares. A discount of up to 20-30% is fairly common.
Why would a business offer new shares at a price well below the current share price?
The main reason is to make the offer relatively attractive to shareholders and encourage them either to
take up their rights or sell them so the share issue is "fully subscribed".
The price discount also acts as a safeguard should the market price of the company's shares fall before
the issue is completed. If the market share price were to fall below the rights issue price, the issue would
not have much chance of being a success - since shareholders could buy the shares cheaper in the market
than by taking up their rights to buy through the new issue.
Do existing shareholders have to take up their rights to buy new shares?
In a word - no.
Shareholders who do not wish to take up their rights may sell them on the stock market or via the firm
making the rights issue, either to other existing shareholders or new shareholders. The buyer then has the
right to take up the shares on the same basis as the seller
Other factors to consider in rights issues
In addition to the price at which a rights issue is offered, there are several other factors that need to be
considered:
Issue Costs
Rights issues are a relatively cheap way of raising capital for a quoted company since the costs of
preparing a brochure, underwriting commission or press advertising involved in a new issue of shares is
largely avoided. However, it still costs money to complete a rights issue. Issue costs are often estimated
at around 4% on equity funds raised of aroundN2 million raised. However, as many of the costs of the
rights issue are fixed (e.g. accountants and lawyers fees) the % cost falls as the sum raised increases.
Shareholder reactions
Shareholders may react badly to firms continually making rights issues as they are forced either to take
up their rights or sell them. They may sell their shares in the company, driving down the market price
Control
Unless large numbers of existing shareholders sell their rights to new shareholders there should be little
impact in terms of control of the business by existing shareholders
Unlisted companies
Unlisted companies often find rights issues difficult to use, because shareholders unable to raise
sufficient funds to take up their rights may not have available the alternative of selling them where the
firm's shares are not listed. This could mean that the firm is forced to rely on retained profits as the main
source of equity, or seek to raise venture capital or take on debt.
(iii) New Share Issues & Flotation
There are three main ways of raising equity finance:
- Retaining profits in the business (rather than distributing them to equity shareholders);
- Selling new shares to existing shareholders (a "rights issue")
- Selling new shares to the general public and investing institutions
This revision note outlines the process involved in the third method above.
How significant are new issues of shares?
Issues of new shares to the public account for around 10% of new equity finance.
Whilst not significant in the overall context of equity financing, when new issues do occur, they are
often large in terms of the amount raised.
21
New issues are usually used at the time a business first obtains a listing on the Stock Exchange. This
process is called an Initial Public Offering (“IPO”) or a “flotation”.
Methods
The process of a stock market flotation can apply both to private and nationalised share issues. There are
also several methods that can be used. These methods are:
• An introduction
• Issue by tender
• Offer for sale
• Placing, and
• A public issue
In practice the “offer for sale” method is the most common method of flotation. There is no restriction
on the amount of capital raised by this method.
The general procedures followed by the various methods of flotation are broadly the same. These
include
- Advertising, e.g. in newspapers
- Following legal requirements, and Stock Exchange regulations in terms of the large volumes of
information which must be provided. Great expense is incurred in providing this information, e.g.
lawyers, accountants, other advisors.
Why issue new shares on a stock exchange?
The following are reasons why a company may seek a stock market listing:
(1) Access to a wider pool of finance
A stock market listing widens the number of potential investors. It may also improve the company's
credit rating, making debt finance easier and cheaper to obtain.
(2) Improved marketability of shares
Shares that are traded on the stock market can be bought and sold in relatively small quantities at any
time. Existing investors can easily realise a part of their holding.
(3) Transfer of capital to other uses
Founder owners may wish to liquidate the major part of their holding either for personal reasons or for
investment in other new business opportunities.
(4) Enhancement of company image
Quoted companies are commonly believed to be more financially stable. A stock exchange listing may
improve the image of the company with its customers and suppliers, allowing it to gain additional
business and to improve its buying power.
(5) Facilitation of growth by acquisition
A listed company is in a better position to make a paper offer for a target company than an unlisted one.
However, the owners of a private company which becomes a listed plc (public company) must accept
that the change is likely to involve a significant loss of control to a wider circle of investors. The risk of
the company being taken over will also increase following listing.
7. Sources of medium term finance for investment in capital assets
The acquisition of assets - particularly expensive capital equipment - is a major commitment for many
businesses. How that acquisition is funded requires careful planning. Rather than pay for the asset
outright using cash, it can often make sense for businesses to look for ways of spreading the cost of
acquiring an asset, to coincide with the timing of the revenue generated by the business.
The most common sources of medium term finance for investment in capital assets are Hire Purchase
and Leasing. Leasing and hire purchase are financial facilities which allow a business to use an asset
over a fixed period, in return for regular payments. The business customer chooses the equipment it
requires and the finance company buys it on behalf of the business.
Many kinds of business asset are suitable for financing using hire purchase or leasing, including:
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- Plant and machinery
- Business cars
- Commercial vehicles
- Agricultural equipment
- Hotel equipment
- Medical and dental equipment
- Computers, including software packages
-Office equipment
(i) Hire purchase
With a hire purchase agreement, after all the payments have been made, the business customer becomes
the owner of the equipment. This ownership transfer either automatically or on payment of an option to
purchase fee.
For tax purposes, from the beginning of the agreement the business customer is treated as the owner of
the equipment and so can claim capital allowances. Capital allowances can be a significant tax incentive
for businesses to invest in new plant and machinery or to upgrade information systems.
Under a hire purchase agreement, the business customer is normally responsible for maintenance of the
equipment.
(ii) Leasing
The fundamental characteristic of a lease is that ownership never passes to the business customer.
Instead, the leasing company claims the capital allowances and passes some of the benefit on to the
business customer, by way of reduced rental charges.
The business customer can generally deduct the full cost of lease rentals from taxable income, as a
trading expense.
As with hire purchase, the business customer will normally be responsible for maintenance of the
equipment.
There are a variety of types of leasing arrangement:
Finance Leasing
The finance lease or 'full payout lease' is closest to the hire purchase alternative. The leasing company
recovers the full cost of the equipment, plus charges, over the period of the lease.
Although the business customer does not own the equipment, they have most of the 'risks and rewards'
associated with ownership. They are responsible for maintaining and insuring the asset and must show
the leased asset on their balance sheet as a capital item.
When the lease period ends, the leasing company will usually agree to a secondary lease period at
significantly reduced payments. Alternatively, if the business wishes to stop using the equipment, it may
be sold second-hand to an unrelated third party. The business arranges the sale on behalf of the leasing
company and obtains the bulk of the sale proceeds.
Operating Leasing
If a business needs a piece of equipment for a shorter time, then operating leasing may be the answer.
The leasing company will lease the equipment, expecting to sell it second hand at the end of the lease, or
to lease it again to someone else. It will, therefore, not need to recover the full cost of the equipment
through the lease rentals. This type of leasing is common for equipment where there is a wellestablished second hand market (e.g. cars and construction equipment). The lease period will usually
be for two to three years, although it may be much longer, but is always less than the working life of the
machine. Assets financed under operating leases are not shown as assets on the balance sheet. Instead,
the entire operating lease cost is treated as a cost in the profit and loss account.
Contract Hire
Contract hire is a form of operating lease and it is often used for vehicles.
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The leasing company undertakes some responsibility for the management and maintenance of the
vehicles. Services can include regular maintenance and repair costs, replacement of tyres and batteries,
providing replacement vehicles, roadside assistance and recovery services and payment of the vehicle
licences.
Advantages & disadvantages of leasing
As we discussed in our introduction to asset finance, the use of hire purchase or leasing is a popular
method of funding the acquisition of capital assets. However, these methods are not necessarily suitable
for every business or for every asset purchase. There are a number of considerations to be made, as
described below:
Certainty
One important advantage is that a hire purchase or leasing agreement is a medium term funding facility,
which cannot be withdrawn, provided the business makes the payments as they fall due.
The uncertainty that may be associated with alternative funding facilities such as overdrafts, which are
repayable on demand, is removed.
However, it should be borne in mind that both hire purchase and leasing agreements are long term
commitments. It may not be possible, or could prove costly, to terminate them early.
Budgeting
The regular nature of the hire purchase or lease payments (which are also usually of fixed amounts as
well) helps a business to forecast cash flow. The business is able to compare the payments with the
expected revenue and profits generated by the use of the asset.
Fixed Rate Finance
In most cases the payments are fixed throughout the hire purchase or lease agreement, so a business will
know at the beginning of the agreement what their repayments will be. This can be beneficial in times of
low, stable or rising interest rates but may appear expensive if interest rates are falling.
On some agreements, such as those for a longer term, the finance company may offer the option of
variable rate agreements. In such cases, rentals or instalments will vary with current interest rates; hence
it may be more difficult to budget for the level of payment.
The Effect of Security
Under both hire purchase and leasing, the finance company retains legal ownership of the equipment, at
least until the end of the agreement. This normally gives the finance company better security than
lenders of other types of loan or overdraft facilities. The finance company may therefore be able to offer
better terms. The decision to provide finance to a small or medium sized business depends on that
business' credit standing and potential. Because the finance company has security in the equipment, it
could tip the balance in favour of a positive credit decision.
Maximum Finance
Hire purchase and leasing could provide finance for the entire cost of the equipment. There may
however, be a need to put down a deposit for hire purchase or to make one or more payments in advance
under a lease. It may be possible for the business to 'trade-in' other assets which they own, as a means of
raising the deposit.
Tax Advantages
Hire purchase and leasing give the business the choice of how to take advantage of capital allowances.
If the business is profitable, it can claim its own capital allowances through hire purchase or outright
purchase. If it is not in a tax paying position or pays corporation tax at the small company’s rate, then a
lease could be more beneficial to the business. The leasing company will claim the capital allowances
and pass the benefits on to the business by way of reduced rentals.
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FINANCIAL MARKETS
In economics, a financial market is a mechanism that allows people to buy and sell (trade) financial
securities (such as stocks and bonds), commodities (such as precious metals or agricultural goods), and
other fungible items of value at low transaction costs and at prices that reflect the efficient-market
hypothesis. Both general markets (where many commodities are traded) and specialized markets (where
only one commodity is traded) exist. Markets work by placing many interested buyers and sellers in one
"place", thus making it easier for them to find each other. An economy which relies primarily on
interactions between buyers and sellers to allocate resources is known as a market economy in contrast
either to a command economy or to a non-market economy such as a gift economy.
In finance, financial markets facilitate:
• The raising of capital (in the capital markets)
• The transfer of risk (in the derivatives markets)
• International trade (in the currency markets)
– And are used to match those who want capital to those who have it.
Typically a borrower issues a receipt to the lender promising to pay back the capital. These receipts are
securities which may be freely bought or sold. In return for lending money to the borrower, the lender
will expect some compensation in the form of interest or dividends.
In mathematical finance, the concept of a financial market is defined in terms of a continuous-time
Brownian motion stochastic process.
1. Definition
In economics, typically, the term market means the aggregate of possible buyers and sellers of a certain
good or service and the transactions between them.
The term "market" is sometimes used for what are more strictly exchanges, organizations that facilitate
the trade in financial securities, e.g., a stock exchange or commodity exchange. This may be a physical
location (like the NYSE) or an electronic system (like NASDAQ). Much trading of stocks takes place on
an exchange; still, corporate actions (merger, spinoff) are outside an exchange, while any two companies
or people, for whatever reason, may agree to sell stock from the one to the other without using an
exchange.
Trading of currencies and bonds is largely on a bilateral basis, although some bonds trade on a stock
exchange, and people are building electronic systems for these as well, similar to stock exchanges.
Financial markets can be domestic or they can be international.
2. Types of financial markets
The financial markets can be divided into different subtypes:
• Capital markets which consist of:
o Stock markets, which provide financing through the issuance of shares or common stock,
and enable the subsequent trading thereof.
o Bond markets, which provide financing through the issuance of bonds, and enable the
subsequent trading thereof.
• Commodity markets, which facilitate the trading of commodities.
• Money markets, which provide short term debt financing and investment.
• Derivatives markets, which provide instruments for the management of financial risk.
• Futures markets, which provide standardized forward contracts for trading products at some
future date; see also forward market.
• Insurance markets, which facilitate the redistribution of various risks.
• Foreign exchange markets, which facilitate the trading of foreign exchange.
The capital markets consist of primary markets and secondary markets. Newly formed (issued) securities
are bought or sold in primary markets. Secondary markets allow investors to sell securities that they hold
or buy existing securities.
3. Raising the capital
To understand financial markets, let us look at what they are used for, i.e. what
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Without financial markets, borrowers would have difficulty finding lenders themselves. Intermediaries
such as banks help in this process. Banks take deposits from those who have money to save. They can
then lend money from this pool of deposited money to those who seek to borrow. Banks popularly lend
money in the form of loans and mortgages.
More complex transactions than a simple bank deposit require markets where lenders and their agents
can meet borrowers and their agents, and where existing borrowing or lending commitments can be sold
on to other parties. A good example of a financial market is a stock exchange. A company can raise
money by selling shares to investors and its existing shares can be bought or sold.
The following table illustrates where financial markets fit in the relationship between lenders and
borrowers:
Relationship between lenders and borrowers
Lenders
Financial Intermediaries
Financial Markets
Borrowers
Interbank
Individuals
Banks
Stock
Exchange Companies
Individuals Insurance
Companies
Money
Market Central
Government
Companies Pension
Funds
Bond
Market Municipalities
Mutual Funds
Foreign Exchange
Public Corporations
3.1. Lenders
3.1.1. Individuals
Many individuals are not aware that they are lenders, but almost everybody does lend money in many
ways. A person lends money when he or she:
• puts money in a savings account at a bank;
• contributes to a pension plan;
• pays premiums to an insurance company;
• invests in government bonds; or
• invests in company shares.
3.1.2. Companies
Companies tend to be borrowers of capital. When companies have surplus cash that is not needed for a
short period of time, they may seek to make money from their cash surplus by lending it via short term
markets called money markets. There are a few companies that have very strong cash flows. These
companies tend to be lenders rather than borrowers. Such companies may decide to return cash to
lenders (e.g. via a share buyback.) Alternatively, they may seek to make more money on their cash by
lending it (e.g. investing in bonds and stocks.)
3.2. Borrowers
Individuals borrow money via bankers' loans for short term needs or longer term mortgages to help
finance a house purchase.
Companies borrow money to aid short term or long term cash flows. They also borrow to fund
modernisation or future business expansion.
Governments often find their spending requirements exceed their tax revenues. To make up this
difference, they need to borrow. Governments also borrow on behalf of nationalised industries,
municipalities, local authorities and other public sector bodies. In the UK, the total borrowing
requirement is often referred to as the Public sector net cash requirement (PSNCR). Governments
borrow by issuing bonds. Government also borrows from individuals by offering bank accounts and
Premium Bonds. Government debt seems to be permanent. Indeed the debt seemingly expands rather
than being paid off. One strategy used by governments to reduce the value of the debt is to influence
inflation.
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Municipalities and local authorities may borrow in their own name as well as receiving funding from
national governments.
Public Corporations typically include nationalised industries. These may include the postal services,
railway companies and utility companies.
Many borrowers have difficulty raising money locally. They need to borrow internationally with the aid
of Foreign exchange markets.
4. Derivative products
During the 1980s and 1990s, a major growth sector in financial markets is the trade in so called
derivative products, or derivatives for short.
In the financial markets, stock prices, bond prices, currency rates, interest rates and dividends go up and
down, creating risk. Derivative products are financial products which are used to control risk or
paradoxically exploit risk. It is also called financial economics.
5. Currency markets
Main article: Foreign exchange market
Seemingly, the most obvious buyers and sellers of currency are importers and exporters of goods. While
this may have been true in the distant past,[when?] when international trade created the demand for
currency markets, importers and exporters now represent only 1/32 of foreign exchange dealing,
according to the Bank for International Settlements.[1]
The picture of foreign currency transactions today shows:
• Banks/Institutions
• Speculators
• Government spending (for example, military bases abroad)
• Importers/Exporters
• Tourists
6. Analysis of financial markets
Much effort has gone into the study of financial markets and how prices vary with time. Charles Dow,
one of the founders of Dow Jones & Company and The Wall Street Journal, enunciated a set of ideas on
the subject which are now called Dow Theory. This is the basis of the so-called technical analysis
method of attempting to predict future changes. One of the tenets of "technical analysis" is that market
trends give an indication of the future, at least in the short term. The claims of the technical analysts are
disputed by
many academics, who claim that the evidence points rather to the random walk hypothesis, which states
that the next change is not correlated to the last change.
The scale of changes in price over some unit of time is called the volatility. It was discovered by Benoît
Mandelbrot that changes in prices do not follow a Gaussian distribution, but are rather modelled better
by Lévy stable distributions. The scale of change, or volatility, depends on the length of the time unit to
a power a bit more than 1/2. Large changes up or down are more likely than what one would calculate
using a Gaussian distribution with an estimated standard deviation.
A new area of concern is the proper analysis of international market effects. As connected as today's
global financial markets are, it is important to realize that there are both benefits and consequences to a
global financial network. As new opportunities appear due to integration, so do the possibilities of
contagion. This presents unique issues when attempting to analyze markets, as a problem can ripple
through the entire connected global network very quickly. For example, a bank failure in one country
can spread quickly to others, which makes proper analysis more difficult.
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STOCK VALUATION
In financial markets, stock valuation is the method of calculating theoretical values of companies and
their stocks. The main use of these methods is to predict future market prices, or more generally
potential market prices, and thus to profit from price movement – stocks that are judged undervalued
(with respect to their theoretical value) are bought, while stocks that are judged overvalued are sold, in
the expectation that undervalued stocks will, on the whole, rise in value, while overvalued stocks will,
on the whole, fall.
In the view of fundamental analysis, stock valuation based on fundamentals aims to give an estimate of
their intrinsic value of the stock, based on predictions of the future cash flows and profitability of the
business. Fundamental analysis may be replaced or augmented by market criteria – what the market will
pay for the stock, without any necessary notion of intrinsic value. These can be combined as "predictions
of future cash flows/profits (fundamental)", together with "what will the market pay for these profits?”
These can be seen as "supply and demand" sides – what underlies the supply (of stock), and what drives
the (market) demand for stock?
In the view of others, such as John Maynard Keynes, stock valuation is not a prediction but a
convention, which serves to facilitate investment and ensure that stocks are liquid, despite being
underpinned by an illiquid business and its illiquid investments, such as factories.
1. Fundamental criteria (fair value)
The most theoretically sound stock valuation method, called income valuation or the discounted cash
flow (DCF) method, involves discounting of the profits (dividends, earnings, or cash flows) the stock
will bring to the stockholder in the foreseeable future, and a final value on disposal.[1] The discounted
rate normally includes a risk premium which is commonly based on the capital asset pricing model.
Stocks have two types of valuations. One is a value created using some type of cash flow, sales or
fundamental earnings analysis. The other value is dictated by how much an investor is willing to pay for
a particular share of stock and by how much other investors are willing to sell a stock for (in other
words, by supply and demand). Both of these values change over time as investors change the way they
analyze stocks and as they become more or less confident in the future of stocks. Let me discuss both
types of valuations.
First, the fundamental valuation. This is the valuation that people use to justify stock prices. The most
common example of this type of valuation methodology is P/E ratio, which stands for Price to Earnings
Ratio. This form of valuation is based on historic ratios and statistics and aims to assign value to a stock
based on measurable attributes. This form of valuation is typically what drives long-term stock prices.
The other way stocks are valued is based on supply and demand. The more people that want to buy the
stock, the higher its price will be. And conversely, the more people that want to sell the stock, the lower
the price will be. This form of valuation is very hard to understand or predict, and it often drives the
short-term stock market trends.
In short, there are many different ways to value stocks. I will list several of them here. The key is to take
each approach into account while formulating an overall opinion of the stock. Look at each valuation
technique and ask yourself why the stock is valued this way. If it is lower or higher than other similar
stocks, then try to determine why. And remember, a great company is not always a great investment.
Here are the basic valuation techniques:
Earnings per Share (EPS). You've heard the term many times, but do you really know what it means.
EPS is the total net income of the company divided by the number of shares outstanding. It sounds
simple but unfortunately it gets quite a bit more complicated. Companies usually report many EPS
numbers. They usually have a GAAP EPS number (which means that it is computed using all of
mutually agreed upon accounting rules) and a Pro Forma EPS figure (which means that they have
adjusted the income to exclude any one time items as well as some non-cash items like amortization of
28
goodwill or stock option expenses). The most important thing to look for in the EPS figure is the overall
quality of earnings. Make sure the company is not trying to manipulate their EPS numbers to make it
look like they are more profitable. Also, look at the growth in EPS over the past several quarters / years
to understand how volatile their EPS is, and to see if they are an underachiever or an overachiever. In
other words, have they consistently beaten expectations or are they constantly restating and lowering
their forecasts?
The EPS number that most analysts use is the pro forma EPS. To compute this number, use the net
income that excludes any one-time gains or losses and excludes any non-cash expenses like stock
options or amortization of goodwill. Then divide this number by the number of fully diluted shares
outstanding. You can easily find historical EPS figures and to see forecasts for the next 1-2 years by
visiting free financial sites such as Yahoo Finance (enter the ticker and then click on "estimates").
By doing your fundamental investment research you'll be able to arrive at your own EPS forecasts,
which you can then apply to the other valuation techniques below. Price to Earnings (P/E). Now that
you have several EPS figures (historical and forecasts), you'll be able to look at the most common
valuation technique used by analysts, the price to earnings ratio, or P/E. To compute this figure,
take the stock price and divide it by the annual EPS figure. For example, if the stock is trading
atN10 and the EPS isN0.50, the P/E is 20 times. To get a good feeling of what P/E multiple a stock
trades at, be sure to look at the historical and forward ratios.
Historical P/Es are computed by taking the current price divided by the sum of the EPS for the last four
quarters, or for the previous year. You should also look at the historical trends of the P/E by viewing a
chart of its historical P/E over the last several years (you can find on most finance sites like Yahoo
Finance). Specifically you want to find out what range the P/E has traded in so that you can determine if
the current P/E is high or low versus its historical average.
Forward P/Es are probably the single most important valuation method because they reflect the future
growth of the company into the figure. And remember, all stocks are priced based on their future
earnings, not on their past earnings. However, past earnings are sometimes a good indicator for future
earnings. Forward P/Es are computed by taking the current stock price divided by the sum of the EPS
estimates for the next four quarters, or for the EPS estimate for next calendar of fiscal year or two. I
always use the Forward P/E for the next two calendar years to compute my forward P/Es. That way I can
easily compare the P/E of one company to that of its competitors and to that of the market. For example,
Cisco's fiscal year ends in July, so to compute the P/E for that calendar year, I would add together the
quarterly EPS estimates (or actuals in some cases) for its quarters ended April, July, October and the
next January. Use the current price divided by this number to arrive at the P/E. Also, it is important to
remember that P/Es change constantly. If there is a large price change in a stock you are watching, or if
the earnings (EPS) estimates change, be sure to recompute the ratio.
Growth Rate. Valuations rely very heavily on the expected growth rate of a company. For starters, you
can look at the historical growth rate of both sales and income to get a feeling for what type of future
growth that you can expect. However, companies are constantly changing, as well as the economy, so
don't rely on historical growth rates to predict the future, but instead use them as a guideline for what
future growth could look like if similar circumstances are encountered by the company. To calculate
your future growth rate, you'll need to do your own investment research. The easiest way to arrive at this
forecast is to listen to the company's quarterly conference call, or if it has already happened, then read a
press release or other company article that discusses the company's growth guidance. However,
remember that although companies are in the best position to forecast their own growth, they are not
very accurate, and things change rapidly in the economy and in their industry. So before you forecast a
growth rate, try to take all of these factors into account.
And for any valuation technique, you really want to look at a range of forecast values. For example, if
the company you are valuing has been growing earnings between 5 and 10% each year for the last 5
years but suddenly thinks it will grow 15 - 20% this year, you may want to be a little more conservative
29
than the company and use a growth rate of 10 - 15%. Another example would be for a company that has
been going through restructuring. They may have been growing earnings at 10 - 15% over the past
several quarters / years because of cost cutting, but their sales growth could be only 0 - 5%. This would
signal that their earnings growth will probably slow when the cost cutting has fully taken effect.
Therefore you would want to forecast earnings growth closer to the 0 - 5% rate than the 15 - 20%. The
point I'm trying to make is that you really need to use a lot of gut feel to make a forecast. That is why the
analysts are often inaccurate and that is why you should get as familiar with the company as you can
before making these forecasts.
PEG Ratio. This valuation technique has really become popular over the past decade or so. It is better
than just looking at a P/E because it takes three factors into account; the price, earnings, and earnings
growth rates. To compute the PEG ratio (a.k.a. Price Earnings to Growth ratio) divide the Forward P/E
by the expected earnings growth rate (you can also use historical P/E and historical growth rate to see
where it's traded in the past). This will yield a ratio that is usually expressed as a percentage. The theory
goes that as the percentage rises over 100% the stock becomes more and more overvalued, and as the
PEG ratio falls below 100% the stock becomes more and more undervalued. The theory is based on a
belief that P/E ratios should approximate the long-term growth rate of a company's earnings. Whether or
not this is true will never be proven and the theory is therefore just a rule of thumb to use in the overall
valuation process.
Here's an example of how to use the PEG ratio. Say you are comparing two stocks that you are thinking
about buying. Stock A is trading at a forward P/E of 15 and expected to grow at 20%. Stock B is trading
at a forward P/E of 30 and expected to grow at 25%. The PEG ratio for Stock A is 75% (15/20) and for
Stock B is 120% (30/25). According to the PEG ratio, Stock A is a better purchase because it has a lower
PEG ratio, or in other words, you can purchase its future earnings growth for a lower relative price than
that of Stock B.
Return on Invested Capital (ROIC). This valuation technique measures how much money the
company makes each year per dollar of invested capital. Invested Capital is the amount of money
invested in the company by both stockholders and debtors. The ratio is expressed as a percent and you
should look for a percent that approximates the level of growth that you expect. In its simplest
definition, this ratio measures the investment return that management is able to get for its capital. The
higher the number, the better the return.
To compute the ratio, take the pro forma net income (same one used in the EPS figure mentioned above)
and divide it by the invested capital. Invested capital can be estimated by adding together the
stockholders equity, the total long and short term debt and accounts payable, and then subtracting
accounts receivable and cash (all of these numbers can be found on the company's latest quarterly
balance sheet). This ratio is much more useful when you compare it to other companies that you are
valuing.
Return on Assets (ROA). Similar to ROIC, ROA, expressed as a percent, measures the company's
ability to make money from its assets. To measure the ROA, take the pro forma net income divided by
the total assets. However, because of very common irregularities in balance sheets (due to things like
Goodwill, write-offs, discontinuations, etc.) this ratio is not always a good indicator of the company's
potential. If the ratio is higher or lower than you expected, be sure to look closely at the assets to see
what could be over or understating the figure.
Price to Sales (P/S). This figure is useful because it compares the current stock price to the annual sales.
In other words, it tells you how much the stock costs per dollar of sales earned. To compute it, take the
current stock price divided by the annual sales per share. The annual sales per share should be calculated
by taking the net sales for the last four quarters divided by the fully diluted shares outstanding (both of
these figures can be found by looking at the press releases or quarterly reports). The price to sales ratio is
useful, but it does not take into account any debt the company has. For example, if a company is heavily
30
financed by debt instead of equity, then the sales per share will seem high (the P/S will be lower). All
things equal, a lower P/S ratio is better. However, this ratio is best looked at when comparing more than
one company.
Market Cap. Market Cap, which is short for Market Capitalization, is the value of all of the company's
stock. To measure it, multiply the current stock price by the fully diluted shares outstanding. Remember,
the market cap is only the value of the stock. To get a more complete picture, you'll want to look at the
Enterprise Value.
Enterprise Value (EV). Enterprise Value is equal to the total value of the company, as it is trading for
on the stock market. To compute it, add the market cap (see above) and the total net debt of the
company. The total net debt is equal to total long and short term debt plus accounts payable, minus
accounts receivable, minus cash. The Enterprise Value is the best approximation of what a company is
worth at any point in time because it takes into account the actual stock price instead of balance sheet
prices. When analysts say that a company is a "billion dollar" company, they are often referring to its
total enterprise value. Enterprise Value fluctuates rapidly based on stock price changes.
EV to Sales. This ratio measures the total company value as compared to its annual sales. A high ratio
means that the company's value is much more than its sales. To compute it, divide the EV by the net
sales for the last four quarters. This ratio is especially useful when valuing companies that do not have
earnings, or that are going through unusually rough times. For example, if a company is facing
restructuring and it is currently losing money, then the P/E ratio would be irrelevant. However, by
applying an EV to Sales ratio, you could compute what that company could trade for when it's
restructuring is over and its earnings are back to normal.
EBITDA. EBITDA stands for earnings before interest, taxes, depreciation and amortization. It is one of
the best measures of a company's cash flow and is used for valuing both public and private companies.
To compute EBITDA, use a company’s income statement, take the net income and then add back
interest, taxes, depreciation, amortization and any other non-cash or one-time charges. This leaves you
with a number that approximates how much cash the company is producing. EBITDA is a very popular
figure because it can easily be compared across companies, even if all of the companies are not
profitable.
EV to EBITDA. This is perhaps one of the best measurements of whether or not a company is cheap or
expensive. To compute, divide the EV by EBITDA (see above for calculations). The higher the number,
the more expensive the company is. However, remember that more expensive companies are often
valued higher because they are growing faster or because they are a higher quality company. With that
said, the best way to use EV/EBITDA is to compare it to that of other similar companies.
1.1. Approximate valuation approaches
Average growth approximation: Assuming that two stocks have the same earnings growth, the one
with a lower P/E is a better value. The P/E method is perhaps the most commonly used valuation method
in the stock brokerage industry. By using comparison firms, a target price/earnings (or P/E) ratio is
selected for the company, and then the future earnings of the company are estimated. The valuation's fair
price is simply estimated earnings times target P/E. This model is essentially the same model as
Gordon's model, if k-g is estimated as the dividend payout ratio (D/E) divided by the target P/E ratio.
Constant growth approximation: The Gordon model or Gordon's growth model is the best known of a
class of discounted dividend models. It assumes that dividends will increase at a constant growth rate
(less than the discount rate) forever. The valuation is given by the formula:
.
And the following table defines each symbol:
31
Symbol Meaning
Units
estimated stock price
$ or € orN
last dividend paid
$ or € orN
discount rate
%
the growth rate of the dividends
%
Limited high-growth period approximation: When a stock has a significantly higher growth rate than
its peers, it is sometimes assumed that the earnings growth rate will be sustained for a short time (say, 5
years), and then the growth rate will revert to the mean. This is probably the most rigorous
approximation that is practical.
While these DCF models are commonly used, the uncertainty in these values is hardly ever discussed.
Note that the models diverge for
and hence are extremely sensitive to the difference of dividend
growth to discount factor. One might argue that an analyst can justify any value (and that would usually
be one close to the current price supporting his call) by fine-tuning the growth/discount assumptions.
2. Market criteria (potential price)
Some feel that if the stock is listed in a well organized stock market, with a large volume of transactions,
the listed price will be close to the estimated fair value. This is called the efficient market hypothesis.
On the other hand, studies made in the field of behavioural finance tend to show that deviations from the
fair price are rather common, and sometimes quite large.
Thus, in addition to fundamental economic criteria, market criteria also have to be taken into account
market-based valuation. Valuing a stock is not only to estimate its fair value, but also to determine its
potential price range, taking into account market behaviour aspects. One of the behavioural valuation
tools is the stock image, a coefficient that bridges the theoretical fair value and the market price.
3. Keynes's view
In the view of noted economist John Maynard Keynes, stock valuation is not an estimate of the fair
value of stocks, but rather a convention, which serves to provide the necessary stability and liquidity for
investment, so long as the convention does not break down.
Certain classes of investment are governed by the average expectation of those who deal on the
Stock Exchange as revealed in the price of shares, rather than by the genuine expectations of the
professional entrepreneur. How then are these highly significant daily, even hourly, revaluations
of existing investments carried out in practice?
In practice, we have tacitly agreed, as a rule, to fall back on what is, in truth, a convention. The
essence of this convention – though it does not, of course, work out so simply – lies in assuming
that the existing state of affairs will continue indefinitely, except in so far as we have specific
reasons to expect a change.
Nevertheless the above conventional method of calculation will be compatible with a
considerable measure of continuity and stability in our affairs, so long as we can rely on the
maintenance of the convention. …
Thus investment becomes reasonably 'safe' for the individual investor over short periods, and
hence over a succession of short periods however many, if he can fairly rely on there being no
breakdown in the convention and on his therefore having an opportunity to revise his judgment
and change his investment, before there has been time for much to happen. Investments which
are 'fixed' for the community are thus made 'liquid' for the individual.
32
FINANCIAL STATEMENTS
1. Introduction to Financial Accounting
There are two main forms of accounting information:
(1) Financial Accounts, and
(2) Management Accounts
Financial Accounts - A Definition
Financial accounts are concerned with classifying, measuring and recording the transactions of a
business. At the end of a period (typically a year), the following financial statements are prepared to
show the performance and position of the business:
Profit and Loss
Account
Also known as the income statement. Describing the trading performance of the
business over the accounting period
Balance Sheet
Statement of assets and liabilities at the end of the accounting period (a
"snapshot") of the business
Cash Flow
Statement
Describing the cash inflows and outflows during the accounting period
Notes to the
Accounts
Additional details that have to be disclosed to comply with Accounting Standards
and the Companies Act
Directors' Report
Description by the Directors of the performance of the business during the
accounting period + various additional disclosures, particularly in relation to
directors' shareholdings, remuneration etc
Financial accounts are geared towards external users of accounting information. To answer their needs,
financial accountants draw up the profit and loss account, balance sheet and cash flow statement for the
company as a whole in order for users to answer questions such as: - "Should I invest my money in this
company?" - "Should I lend money to this business?" - "What are the profits on which this company
must pay tax?"
Company Law Requirements for Financial Accounts
Every Company registered under the Companies Act is required to prepare a set of accounts that give a
true and fair view of its profit or loss for the year and of its state of affairs at the year end. Annual
accounts for Companies Act purposes generally include:
- A directors’ report
- An audit report
- A profit and loss account
- A balance sheet
- A statement of total recognised gains and losses
- A cash flow statement
- Notes to the accounts
If the company is a "parent company", (in other words, the company also owns other companies subsidiaries) then "consolidated accounts" must also be prepared. Again there are exceptions to this
requirement (see consolidated accounts).
Comparative figures should also be given for almost all items and analysis given in the yearend financial
statements. Exceptions to this rule are given individually. For example, there is no requirement to give
comparative figures for the notes detailing the movements in the year on fixed asset or reserves
balances.
2. Income Statement
The income statement is a historical record of the trading of a business over a specific period
(normally one year). It shows the profit or loss made by the business – which is the difference
between the firm’s total income and its total costs.
The income statement serves several important purposes:
33
•
Allows shareholders/owners to see how the business has performed and whether it has made an
acceptable profit (return)
• Helps identify whether the profit earned by the business is sustainable (“profit quality”)
• Enables comparison with other similar businesses (e.g. competitors) and the industry as a whole
• Allows providers of finance to see whether the business is able to generate sufficient profits to
remain viable (in conjunction with the cash flow statement)
• Allows the directors of a company to satisfy their legal requirements to report on the financial
record of the business
The structure and format of a typical income statement is illustrated below:
Example Business Ltd
Income Statement
20X1
20X0
Year Ended 31 December
£'000
£'000
Revenue
21,450
19,780
Cost of sales
13,465
12,680
Gross profit
7,985
7,100
Distribution costs
3,210
2,985
Administration expenses
2,180
1,905
Operating profit
2,595
2,210
Finance costs
156
120
Profit before tax
2,439
2,090
Tax expense
746
580
Profit attributable to shareholders
1,693
1,510
The lines in the income statement can be briefly described as follows:
Category
Explanation
Revenue
The revenues (sales) during the period are recorded here. Sometimes referred to as
the “top line” – revenue shows the total value of sales made to customers
Cost of sales
The direct costs of generating the recorded revenues go into “cost of sales”. This
would include the cost of raw materials, components, goods bought for resale and
the direct labour costs of production.
Gross profit
The difference between revenue and cost of sales. A simple but very useful
measure of how much profit is generated from everyN1 of revenue before
overheads and other expenses are taken into account. Is used to calculate the gross
profit margin (%)
34
Distribution &
administration
expenses
Operating costs and expenses that are not directly related to producing the goods or
services are recorded here. These would include distribution costs (e.g. marketing,
transport) and the wide range of administrative expenses or overheads that a
business incurs.
Operating profit
A key measure of profit. Operating profit records how much profit has been made
in total from the trading activities of the business before any account is taken of
how the business is financed.
Finance
expenses
Interest paid on bank and other borrowings, less interest income received on cash
balances, is shown here. A useful figure for shareholders to assess how much
profit is being used up by the funding structure of the business.
Profit before tax
Calculated as operating profit less finance expenses
Tax
An estimate of the amount of corporation tax that is likely to be payable on the
recorded profit before tax
Profit
attributable to
shareholders
The amount of profit that is left after the tax has been accounted for. The
shareholders then decide how much of this is paid out to them in dividends and
how much is left in the business (“retained earnings” in the equity section of the
balance sheet)
3. Profit quality
One of the issues to consider when looking at the income statement is to look at whether the reported
profit is “high quality” or “low quality”. What is the difference?
A high quality profit is one which can be repeated or sustained. In other words the profit does not
contain any unusual one-off items of income or profit which shareholders cannot reasonably expect the
business achieve in the following year. A low quality profit is one which it is difficult to repeat. The
profit is likely to benefit from one or more “exceptional items” which will not repeat. Examples of
exceptional items include:
• One-off profits on selling major items of property, plant and equipment (e.g. selling a piece of
land)
• Income from a significant insurance claim
• Profits from selling business units or brands
4. Balance Sheet
A balance sheet is a statement of the total assets and liabilities of an organisation at a particular date usually the last date of an accounting period. The balance sheet is split into two parts:
(1) A statement of fixed assets, current assets and the liabilities (sometimes referred to as "Net
Assets")
(2) A statement showing how the Net Assets have been financed, for example through share capital and
retained profits.
The Companies Act requires the balance sheet to be included in the published financial accounts of all
limited companies. In reality, all other organisations that need to prepare accounting information for
external users (e.g. charities, clubs, and partnerships) will also product a balance sheet since it is an
important statement of the financial affairs of the organisation.
A balance sheet does not necessary "value" a company, since assets and liabilities are shown at
"historical cost" and some intangible assets (e.g. brands, quality of management, market leadership) are
not included.
35
Example Balance Sheet
The structure of a typical balance sheet is illustrated below:
Boston
Learning
Systems
plc 20X2
20X1
Balance Sheet at 31 December
£'000
£'000
ASSETS
Non-current assets
Goodwill and other intangible assets
150
150
Property, plant & equipment
2,450
2,100
2,600
2,250
Current assets
Inventories
1,325
1,475
Trade and other receivables
4,030
3,800
Short-term investments
250
190
Cash and cash equivalents
1,340
780
6,945
6,245
Current liabilities
Trade and other payables
2,310
2,225
Short-term borrowings
350
550
Current tax liabilities
800
650
Provisions
290
255
3,750
3,680
Net current assets
Non-current liabilities
Borrowings
Provisions
NET ASSETS
3,195
2,565
1,200
140
1,340
1,450
140
1,590
4,455
3,225
EQUITY
Share capital
500
500
Retained earnings
3,955
2,725
TOTAL EQUITY
4,455
3,225
An asset is any right or thing that is owned by a business. Assets include land, buildings, equipment and
anything else a business owns that can be given a value in money terms for the purpose of financial
reporting.
Definition of Liabilities
To acquire its assets, a business may have to obtain money from various sources in addition to its
owners (shareholders) or from retained profits. The various amounts of money owed by a business are
called its liabilities.
Long-term and Current
To provide additional information to the user, assets and liabilities are usually classified in the balance
sheet as:
- Current: those due to be repaid or converted into cash within 12 months of the balance sheet date;
36
- Long-term: those due to be repaid or converted into cash more than 12 months after the balance sheet
date;
Fixed Assets
A further classification other than long-term or current is also used for assets. A "fixed asset" is an asset
which is intended to be of a permanent nature and which is used by the business to provide the capability
to conduct its trade. Examples of "tangible fixed assets" include plant & machinery, land & buildings
and motor vehicles. "Intangible fixed assets" may include goodwill, patents, trademarks and brands although they may only be included if they have been "acquired". Investments in other companies which
are intended to be held for the long-term can also be shown under the fixed asset heading.
Definition of Capital
As well as borrowing from banks and other sources, all companies receive finance from their owners.
This money is generally available for the life of the business and is normally only repaid when the
company is "wound up". To distinguish between the liabilities owed to third parties and to the business
owners, the latter is referred to as the "capital" or "equity capital" of the company. In addition,
undistributed profits are re-invested in company assets (such as stocks, equipment and the bank balance).
Although these "retained profits" may be available for distribution to shareholders - and may be paid out
as dividends as a future date - they are added to the equity capital of the business in arriving at the total
"equity shareholders' funds". At any time, therefore, the capital of a business is equal to the assets
(usually cash) received from the shareholders plus any profits made by the company through trading that
remain undistributed.
5. Current assets
This section of the balance sheet shows the assets a business owns which are either cash, cash
equivalents, or are expected to be turned into cash during the next twelve months. Current assets are,
therefore, very important to cash flow management and forecasting, because they are the assets that a
business uses to pay its bills, repay borrowings, pay dividends and so on. Current assets are listed in
order of their liquidity – or in other words, how easy it is to turn each category of current asset into
cash. The main elements of current assets are:
Inventories
Inventories (often also called “stocks”) are the least liquid kind of current
asset. Inventories include holdings of raw materials, components, finished
products ready to sell and also the cost of “work-in-progress” as it passes
through the production process.
For the balance sheet, a business will value its inventories at cost. A profit is
only earned and recorded once inventories have been sold.
Not all inventories can eventually be sold. A common problem is stock
“obsolescence” – where inventories have to be sold for less than their cost (or
thrown away) perhaps because they are damaged or customers no longer
demand them. For these inventories, the balance sheet value should be the
amount that can be recovered if the stocks can finally be sold.
Trade and other
receivables
Trade debtors are usually the main part of this category. A trade debtor is
created when a customer is allowed to buys goods or services on credit. The
sale is recognised as revenue (income statement) when the transaction takes
place and the amount owed is added to trade debtors in the balance sheet. At
some stage in the future, when the customer settles the invoice, the trade
debtor balance converts into cash!
Most businesses operate with a reasonably significant amount owed by trade
debtors at any one time. It is not unusual for customers to take between 60-90
days to pay amounts owed, although the average payment period varies by
industry. Of course some customer debts are not eventually paid – the
customer becomes insolvent, leaving the business with debtor balances that it
37
cannot recover.
When a business is doubtful whether a customer will settle its debts it needs to
make an allowance for this in the balance sheet. This is done by making a
“provision for bad and doubtful debts” which effectively reduces the value
of trade debtors to the total amount that the business reasonably expects to
receive in the future.
Short-term
investments
Cash and
equivalents
A business with positive cash balances can either hold them in the bank or
invest them for short periods – perhaps by placing them on short-term
deposit. Such investments would be shown in this category.
cash
The most liquid form of current assets = the actual cash balances that the
business has! The bank account balance would be the main item in this
category.
6. Current liabilities
Current liabilities represent amounts that are owed by the business and which are due to be paid within
the next twelve months. Current liabilities are normally settled from the amounts available in current
assets. The main elements of current liabilities are:
Trade and other
payables
The main element of this is normally “trade creditors” – amounts owed by
a business to its suppliers for goods and services supplied. A trade creditor is
the reverse of a trade debtor. A business buys from a supplier and then pays
for those goods and services some time later – the period depends on the
length and amount of credit the supplier allows.
Short-term
borrowings
Amounts in this category represent the amounts that need to be repaid on
outstanding borrowings in the next year. For example, a business may have
a bank loan ofN2million of whichN250, 000 is due to be repaid six months
after the balance sheet date. In the balance sheet, the bank loan would be
split into two categories: N250, 000 as short-term borrowings and the
remainder (£1,750,000) in the borrowings figure in non-current liabilities.
Current tax
liabilities
This category shows the tax liabilities that the business is still to pay to the
government. This will mainly comprise corporation tax, income tax and
VAT.
Provisions
This is a category that can contain a variety of amounts due. For example, it
would include any dividends due to be paid to shareholders. More
importantly, it will also include any estimates of potential costs which the
business might incur in relation to known disputes or other issues. For
example, if the business is subject to legal claims or is planning to make
redundancies in the near future – then the likely costs of these issues needs
to be provided for in the balance sheet
Non-current liabilities
This category shows the longer-term liabilities that a business has. By “longer-term”, we mean
liabilities that need to be settled in more than one year’s time. This would include bank loans which are
not yet due for repayment.
38
RATIO ANALYSIS
1. Introduction to Ratio Analysis
In our introduction to interpreting financial information we identified five main areas for investigation of
accounting information. The use of ratio analysis in each of these areas is introduced below:
Profitability Ratios
These ratios tell us whether a business is making profits - and if so whether at an acceptable rate. The
key ratios are:
Ratio
Calculation
Comments
Gross Profit
Margin
[Gross Profit /
Revenue] x 100
(expressed as a
percentage
This ratio tells us something about the business's ability
consistently to control its production costs or to manage the
margins its makes on products its buys and sells. Whilst
sales value and volumes may move up and down
significantly, the gross profit margin is usually quite stable
(in percentage terms). However, a small increase (or
decrease) in profit margin, however caused can produce a
substantial change in overall profits.
Operating
Profit Margin
[Operating Profit /
Revenue] x 100
(expressed as a
percentage)
Assuming a constant gross profit margin, the operating profit
margin tells us something about a company's ability to
control its other operating costs or overheads.
Return on
capital
employed
("ROCE")
Net profit before tax,
interest and
dividends ("EBIT") /
total assets (or total
assets less current
liabilities
ROCE is sometimes referred to as the "primary ratio"; it tells
us what returns management has made on the resources
made available to them before making any distribution of
those returns.
Efficiency ratios
These ratios give us an insight into how efficiently the business is employing those resources invested in
fixed assets and working capital.
Ratio
Calculation
Comments
Sales /Capital Sales / Capital
Employed
employed
A measure of total asset utilisation. Helps to answer the
question - what sales are being generated by each pound's
worth of assets invested in the business. Note, when
combined with the return on sales (see above) it generates the
primary ratio - ROCE.
Sales or Profit / Sales or profit /
Fixed Assets
Fixed Assets
This ratio is about fixed asset capacity. A reducing sales or
profit being generated from each pound invested in fixed
assets may indicate overcapacity or poorer-performing
equipment.
Stock Turnover Cost of Sales /
Stock turnover helps answer questions such as "have we got
Average Stock Value too much money tied up in inventory"? An increasing stock
turnover figure or one which is much larger than the
"average" for an industry may indicate poor stock
management.
39
Credit Given / (Trade debtors
"Debtor Days" (average, if possible)
/ (Sales)) x 365
The "debtor days" ratio indicates whether debtors are being
allowed excessive credit. A high figure (more than the
industry average) may suggest general problems with debt
collection or the financial position of major customers.
Credit taken / ((Trade creditors +
"Creditor
accruals) / (cost of
Days"
sales + other
purchases)) x 365
A similar calculation to that for debtors, giving an insight into
whether a business is taking full advantage of trade credit
available to it.
Liquidity Ratios
Liquidity ratios indicate how capable a business is of meeting its short-term obligations as they fall due:
Ratio
Calculation
Comments
Current Ratio Current Assets /
Current Liabilities
A simple measure that estimates whether the business can
pay debts due within one year from assets that it expects to
turn into cash within that year. A ratio of less than one is
often a cause for concern, particularly if it persists for any
length of time.
Quick Ratio
(or "Acid
Test"
Not all assets can be turned into cash quickly or easily.
Some - notably raw materials and other stocks - must first be
turned into final product, then sold and the cash collected
from debtors. The Quick Ratio therefore adjusts the Current
Ratio to eliminate all assets that are not already in cash (or
"near-cash") form. Once again, a ratio of less than one
would start to send out danger signals.
Cash and near cash
(short-term
investments + trade
debtors)
Stability Ratios
These ratios concentrate on the long-term health of a business - particularly the effect of the
capital/finance structure on the business:
Ratio
Calculation
Comments
Gearing
Borrowing (all longterm debts + normal
overdraft) / Net
Assets (or
Shareholders' Funds)
Gearing (otherwise known as "leverage") measures the
proportion of assets invested in a business that are financed
by borrowing. In theory, the higher the level of borrowing
(gearing) the higher are the risks to a business, since the
payment of interest and repayment of debts are not
"optional" in the same way as dividends. However, gearing
can be a financially sound part of a business's capital
structure particularly if the business has strong, predictable
cash flows.
Interest cover
Operating profit
before interest /
Interest
This measures the ability of the business to "service" its
debt. Are profits sufficient to be able to pay interest and
other finance costs?
Investor Ratios
There are several ratios commonly used by investors to assess the performance of a business as an
investment:
40
Ratio
Calculation
Comments
Earnings per Earnings (profits)
share
attributable to
("EPS")
ordinary shareholders
/ Weighted average
ordinary shares in
issue during the year
A requirement of the London Stock Exchange - an
important ratio. EPS measures the overall profit generated
for each share in existence over a particular period.
PriceEarnings
Ratio ("P/E
Ratio")
Market price of share / At any time, the P/E ratio is an indication of how highly the
Earnings per Share
market "rates" or "values" a business. A P/E ratio is best
viewed in the context of a sector or market average to get a
feel for relative value and stock market pricing.
Dividend
Yield
(Latest dividend per
ordinary share /
current market price of
share) x 100
This is known as the "payout ratio". It provides a guide as to
the ability of a business to maintain a dividend payment. It
also measures the proportion of earnings that are being
retained by the business rather than distributed as dividends.
2. Interpreting Financial Information
Financial information is always prepared to satisfy in some way the needs of various interested parties
(the "users of accounts"). Stakeholders in the business (whether they are internal or external to the
business) seek information to find out three fundamental questions:
(1) How is the business trading?
(2) How strong is the financial position?
(3) What are the future prospects for the business? For outsiders, published financial accounts are an
important source of information to enable them to answer the above questions.
To some degree or other, all interested parties will want to ask questions about financial information
which is likely to fall into one or other of the following categories, and be about:
Performance Area
Key Issues
Profitability
Is the business making a profit?
How efficient is the business at turning revenues into profit?
Is it enough to finance reinvestment?
Is it growing?
Is it sustainable (high quality)?
How does it compare with the rest of the industry?
Financial efficiency
Is the business making best use of its resources?
Is it generating adequate returns from its investments?
Is it managing its working capital properly?
Liquidity and gearing
Is the business able to meet its short-term debts as they fall due?
Is the business generating enough cash?
Does the business need to raise further finance?
How risky is the finance structure of the business?
Shareholder return
What returns are owners gaining from their investment in the business?
How does this compare with similar, alternative investments in other
businesses?
41
3. Using financial statements to assess business performance
The balance sheet and income statement provide much useful information for a user of accounts to better
understand how the business is doing. Some useful analytical tasks would include:
Comparing performance over time:
A danger with just looking at one year’s results is that the numbers can hide a longer term issue in the
business. By looking at data over several years, it is possible to see whether a trend is emerging. Public
companies are required to publish a five-year summary of the income statement to help shareholders
assess trends.
Comparing performance against competitors or the industry as a whole:
Assuming that the detailed information is available, a comparison against competitors provides a useful
way for management and shareholders to assess relative performance.
Has the business’ revenues grown as fast as close competitors? How has the business performed
compared with the market as a whole?
Benchmarking against best-in-class businesses:
Comparison against other businesses who are not direct competitors can also be useful – particularly if
they help set the standard that the business aims to achieve. Care has to be taken with this, though. The
benchmark business might operate in a very different industry, with significantly different profit margins
and balance sheet norms.
Potential weaknesses in using published financial information to assess performance
It is worth remembering some of the potential problems that can arise when using the income statement
and balance sheet to assess performance. Two in particular:
• Valuing some assets and liabilities on the balance sheet involves subjective judgement. For
example, management have some discretion about what provisions they need to make for trade
debtors that may not pay or for obsolete stocks.
• Accounts are largely descriptive about what has occurred in the past – rather than explaining
why. Publicly quoted companies are required to provide much more detailed commentary on the
financial statements in the Annual Report. However, the vast majority of companies are not
publicly quoted!
4. Return on capital employed
ROCE is sometimes referred to as the "primary ratio”. It tells us what returns (profits) the business has
made on the resources available to it.
ROCE is calculated using this formula:
Example calculation:
• Operating profit =N280,000
• Capital employed =N1,400,000
• ROCE =N280,000 /N1,400,000 = 20%
The capital employed figure normally comprises:
Share capital + Retained Earnings + Long-term borrowings
(the same as Equity + Non-current liabilities from the balance sheet)
Capital employed is a good measure of the total resources that a business has available to it, although it
is not perfect.
For example, a business might lease or hire many of its production capacity (machinery, buildings etc)
which would not be included as assets in the balance sheet.
With ROCE, the higher the percentage figure, the better. The figure needs to be compared with the
ROCE from previous years to see if there is a trend of ROCE rising or falling.
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It is also important to ensure that the operating profit figure used for the top half of the calculation does
not include any exceptional items which might distort the ROCE percentage and comparisons over time.
To improve its ROCE a business can try to do two things:
• Improve the top line (i.e. increase operating profit) without a corresponding increase in capital
employed, or
• Maintain operating profit but reduce the value of capital employed
5. Asset turnover
This ratio considers the relationship between revenues and the total assets employed in a business. A
business invests in assets (machinery, inventories etc) in order to make profitable sales, and a good way
to think about the asset turnover ratio is imagining the business trying to make those assets work hard (or
sweat) to generate sales. The formula for asset turnover is:
In terms of where to get the numbers:
• Revenue obviously comes from the income statement
• Net assets = total assets less total liabilities
• The resulting figure is expressed as a “number of times per year”
The calculation can be illustrated as follows using the follow balance sheet and income statement
20X2
£’000
20X1
£’000
Revenue
21,450
19,780
Net assets
4,455
3,225
Asset turnover
4.8 times
6.1 times
How to evaluate the data in the table above?
At face-value, the asset turnover has deteriorated falling from 6.1 times per year to 4.8 times. Why
might this have occurred? The best clues appear to be in the balance sheet. The value of fixed assets
has risen by overN300, 000, the business has overN500, 000 more cash and the value of loans has
fallen. That means that net assets have risen by almost 40%. That certainly looks like good news.
However, revenues have only grown by 8%. Hence the lower asset turnover – even though the story is a
positive one!
You can see that particular care needs to be taken with the asset turnover ratio. For example:
• The number will vary enormously from industry to industry. A capital-intensive business may
have a much lower asset turnover than a business with low net assets but which generates high
revenues.
• The asset turnover figure for a specific business can also vary significantly from year to year. For
example, a business may invest heavily in new production capacity in one year (which would
increase net assets) but the revenues from the extra capacity might not arise fully until the
following year
• The asset turnover ratio takes no direct account of the profitability of the revenues generated
6. Stock turnover
Stock turnover helps answer questions such as "have we got too much money tied up in inventory"? An
increasing stock turnover figure or one which is much larger than the "average" for an industry may
indicate poor inventory management.
The stock turnover formula is:
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Calculating stock turnover can be illustrated as follows
20X2
£’000
20X1
£’000
Cost of sales
13,465
12,680
Average stock
1,325
1,475
Stock turnover
10.2 times
8.6 times
[Note: assumes the inventories at year-end were equivalent to average stock during year]
From the data above, the business has improved its stock turnover, with the ratio rising from 8.6 times to
10.2 times per year.
As a general guide, the quicker a business turns over its stocks, the better. But, it is more important to
do that profitably rather than sell stocks at a low gross profit margin or worse at a loss.
Interpreting the stock turnover ratio needs to be done with some care. For example:
• Some products and industries necessarily have very high levels of stock turnover. Fast-food
outlets turnover their stocks over several times each week, let alone 8-10 times per year! A
distributor of industrial products might aim to turn stocks over 10—20 times per year
• Some businesses have to hold large quantities and value of stock to meet customer needs. They
may have to stock a wide range of product types, brands, sizes and so on.
• Stock levels can vary during the year, often caused by seasonal demand. Care needs to be taken
in working out what the “average stock held” is – since that directly affects the stock turnover
calculation
A business can take a range of actions to improve its stock turnover:
• Sell-off or dispose of slow-moving or obsolete stocks
• Introduce lean production techniques to reduce stock holdings
• Rationalise the product range made or sold to reduce stock-holding requirements
• Negotiate sale or return arrangements with suppliers – so the stock is only paid for when a
customer buys it
The last point to remember is that stock turnover is an irrelevant ratio for many businesses in the service
sector. Any business that provides personal or professional services, for example, is unlikely to carry
significant stocks.
7. Debtor Days
The debtor days ratio focuses on the time it takes for trade debtors to settle their bills.
The ratio indicates whether debtors are being allowed excessive credit. A high figure (more than the
industry average) may suggest general problems with debt collection or the financial position of major
customers. The efficient and timely collection of customer debts is a vital part of cash flow
management, so this is a ratio which is very closely watched in many businesses.
The formula to calculate debtor days is:
Applying this formula to some example data:
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20X2
£’000
20X1
£’000
Revenue
21,450
19,780
Trade receivables
4,030
3,800
Debtor days
68.6 days
70.1 days
The data above indicates an improvement in debtor days – i.e. debtor days have fallen. That means that
the business is converting credit sales into cash slightly quicker, although it still has to wait for an
average of over two months to be paid!
The average time taken by customers to pay their bills varies from industry to industry, although it is a
common complaint that trade debtors take too long to pay in nearly every market.
Among the factors to consider when interpreting debtor days are:
• The industry average debtor days needs to be taken into account. In some industries it is just
assumed that the credit that can be taken is 45 days, or 60 days or whatever everyone else seems
(or claims) to be taking
• A business can determine through its terms and conditions of sale how long customers are
officially allowed to take
• There are several actions a business can take to reduce debtor days, including offering earlypayment incentives or by using invoice factoring
8. Creditor Days
“Creditor days” is a similar ratio to debtor days and it gives an insight into whether a business is taking
full advantage of trade credit available to it.
Creditor days estimate the average time it takes a business to settle its debts with trade suppliers. As an
approximation of the amount spent with trade creditors, the convention is to use cost of sales in the
formula which is as follows:
The calculation for creditor days can be illustrated as follows:
20X2
£’000
20X1
£’000
Cost of sales
13,465
12,680
Trade payables
2,310
2,225
Creditor days
62.6
64.1
According to the data, the business is taking slightly less time on average before it pays it suppliers.
Creditor days fell slightly from 64.1 days to 62.6 days.
In general a business that wants to maximise its cash flow should take as long as possible to pay its
bills. However, there are risks associated with taking more time than is permitted by the terms of trade
with the supplier. One is the loss of supplier goodwill; another is the potential threat of legal action or
late-payment charges
9. Liquidity ratios
There are two main liquidity ratios which are used to help assess whether a business has sufficient cash
or equivalent current assets to be able to pay its debts as they fall due. In other words, the liquidity ratios
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focus on the solvency of the business. A business that finds that it does not have the cash to settle its
debts becomes insolvent.
Liquidity ratios focus on the short-term and make use of the current assets and current liabilities
shown in the balance sheet.
Current ratio
This is a simple measure that estimates whether the business can pay debts due within one year out of
the current assets. A ratio of less than one is often a cause for concern, particularly if it persists for any
length of time. The formula for the current ratio is:
The calculation for the current ratio can be illustrated as follows:
20X2
£’000
20X1
£’000
Current assets
6,945
6,245
Current liabilities
3,750
3,680
Current ratio
1.85
1.70
At 31 December 20X2 current assets were 1.85 times the value of current liabilities. That ratio was more
than the 1.7 times at the end of 20X1, suggesting a slight improvement in the current ratio.
A current ratio of around 1.7-2.0 is pretty encouraging for a business. It suggests that the business has
enough cash to be able to pay its debts, but not too much finance tied up in current assets which could be
reinvested or distributed to shareholders.
A low current ratio (say less than 1.0-1.5 might suggest that the business is not well placed to pay its
debts. It might be required to raise extra finance or extend the time it takes to pay creditors.
Acid-test ratio
Not all assets can be turned into cash quickly or easily. Some - notably raw materials and other stocks must first be turned into final product, then sold and the cash collected from debtors. The Acid Test
Ratio (sometimes also called the “Quick Ratio”) therefore adjusts the Current Ratio to eliminate certain
current assets that are not already in cash (or "near-cash") form.
The tradition is to remove inventories (stocks) from the current assets total, since inventories are
assumed to be the most illiquid part of current assets – it is harder to turn them into cash quickly.
The formula for the acid test ratio is:
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An example calculation is shown below:
20X2
£’000
20X1
£’000
Current assets less inventories
5,620
4,770
Current liabilities
3,750
3,680
Acid test ratio
1.50
1.30
Again, the data for the business looks fine. An acid test ratio of over 1.0 is good news; the business is
well-placed to be able to pay its debts even if it cannot turn inventories into cash. Some care has to be
taken interpreting the acid test ratio. The value of inventories a business needs to hold will vary
considerably from industry to industry. For example, you wouldn’t expect a firm of solicitors to carry
much inventory, but a major supermarket needs to carrying huge quantities at any one time.
An acid test ratio for Tesco or Asda would indicate a very low figure after taking off the value of
inventories but leaving in the very high amounts owed to suppliers (trade creditors). However, there is
no suggestion that either of these two businesses has a problem being able to pay its debts!
The trick is to consider what a sensible figure is for the industry under review. A good discipline is to
find an industry average and then compare the current and acid test ratios against for the business
concerned against that average.
10. Gearing ratio
Gearing focuses on the capital structure of the business – that means the proportion of finance that is
provided by debt relative to the finance provided by equity (or shareholders).
The gearing ratio is also concerned with liquidity. However, it focuses on the long-term financial
stability of a business. Gearing (otherwise known as "leverage") measures the proportion of assets
invested in a business that are financed by long-term borrowing.
In theory, the higher the level of borrowing (gearing) the higher are the risks to a business, since the
payment of interest and repayment of debts are not "optional" in the same way as dividends. However,
gearing can be a financially sound part of a business's capital structure particularly if the business has
strong, predictable cash flows. The formula for calculating gearing is:
Long-term liabilities include loans due more than one year + preference shares + mortgages
Capital employed = Share capital + retained earnings + long-term liabilities
The gearing calculation can be calculated like this:
2012
£’000
2011
£’000
Long-term liabilities
1,200
1,450
Capital employed
5,655
4,675
Gearing ratio
21.2%
31.0%
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According to the data the gearing ratio at 31 December 2012 was 21.2%, a reduction from 31.0% a year
earlier. This was largely because the business reduced long-term borrowings byN200, 000 and added
overN1million to retained earnings.
How can the gearing ratio be evaluated?
• A business with a gearing ratio of more than 50% is traditionally said to be “highly geared”.
• A business with gearing of less than 25% is traditionally described as having “low gearing”
• Something between 25% - 50% would be considered normal for a well-established business
which is happy to finance its activities using debt.
For the above business, that would suggest that the business is relatively lowly-geared and that the
capital structure of the business is pretty safe and cautious.
It is important to remember that financing a business through long-term debt is not necessarily a bad
thing! Long-term debt is normally cheap, and it reduces the amount that shareholders have to invest in
the business. What is a sensible level of gearing?
Much depends on the ability of the business to grow profits and generate positive cash flow to service
the debt. A mature business which produces strong and reliable cash flows can handle a much higher
level of gearing than a business where the cash flows are unpredictable and uncertain.
Another important point to remember is that the long-term capital structure of the business is very much
in the control of the shareholders and management. Steps can be taken to change or manage the level of
gearing – for example:
Reduce Gearing
Focus on profit
minimisation
Increase Gearing
improvement
(e.g.
cost Focus on growth – invest in revenue growth
rather than profit
Repay long-term loans
Convert short-term debt into long-term loans
Retain profits rather than pay dividends
Buy-back ordinary shares
Issue more shares
Pay increased dividends out of retained earnings
Convert loans into equity
Issue preference shares or debentures
11. Shareholder ratios
A prime concern of shareholders is their return on investment. The returns from investing in shares of a
company come in two main forms:
• The payment of dividends out of profits
• The increase in the value of the shares (share price) compared with the price that the shareholder
originally paid for the shares
Dividend per share
One very straightforward shareholder ratio (though as we shall see – not a hugely helpful one) is
dividend per share. This shows the value of the total dividend per issued share for the financial year.
Quoted public companies usually split the annual dividend into two payments – the “interim” (paid after
six months trading) and the “final” (paid at the end of the financial year). In these cases, it is necessary
to add the two dividend payments together. The formula for dividend per share is:
Dividend per share (N) =
Total dividends paid
Number of ordinary shares in issue
To illustrate the calculation, let us assume that a firm paid out the following dividends:
• 20X9:
N460,000
• 200X8:
N240,000
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•
In both years, there were 500,000 one naira (N1) ordinary shares in issue which qualified to
receive a dividend
The dividend per share would be:
• 20X9:N460,000 / 500,000 shares =N0.92 (or 92k) per share
• 20X8:N240,000 / 500,000 shares =N0.48 (or 48k) per share
An ordinary shareholder would probably be pleased with the higher dividend per share in 20X9
compared with 20X8.
However, the problem with dividend per share is that the ratio lacks a sensible context. We don’t know:
• How much the shareholder paid for the shares – i.e. what the dividend means in terms of a return
on investment
• How much profit per share was earned which might have been distributed as a dividend
Dividend yield
Dividend yield is a better shareholder ratio to use to get a sense for the rate of return on investment. The
formula for dividend yield is:
To illustrate the calculation, consider this information:
• A firm declared the following dividend payments: 92k (20X9) and 48p (20X8)
• The average share price for 1 ordinary share of the company on the Stock Exchange during those
financial years was 1415k (20X9) and 1067k (20X8)
Using the formula, the dividend yield would be:
• 92/1415 for 20X9 = 6.5%
• 48/1067 for 20X8 = 4.5%
So the dividend yield in 20X9 increased, which is good news for shareholders since that represents an
increase in their return on investment. A dividend yield of 6.5% would seem to be a good return in a
period of low interest rates and low returns on savings accounts. What we don’t know if whether the
shareholders consider it to be an acceptable return for the perceived risk investing in the shares of the
business.
12. Limitations of ratios
Ratio analysis is widely used in practice in business. Teams of investment analysts pour over the
historical and forecast financial information of quoted companies using ratio analysis as part of their
toolkit of methods for assessing financial performance. Venture capitalists and banker use the ratios
featured here and others when they consider investing in, or loaning to businesses.
The main strength of ratio analysis is that it encourages a systematic approach to analysing performance.
However, it is also important to remember some of the drawbacks of ratio analysis
• Ratios deal mainly in numbers – they don’t address issues like product quality, customer service,
employee morale and so on (though those factors play an important role in financial
performance)
• Ratios largely look at the past, not the future. However, investment analysts will make
assumptions about future performance using ratios
• Ratios are most useful when they are used to compare performance over a long period of time or
against comparable businesses and an industry – this information is not always available
• Financial information can be “massaged” in several ways to make the figures used for ratios
more attractive. For example, many businesses delay payments to trade creditors at the end of
the financial year to make the cash balance higher than normal and the creditor days figure
higher too.
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MATHEMATICS OF FINANCE FORMULAS
Simple Interest
Compound Interest
Single deposits
Annual Compounding:
Compounded m times per year:
Continuous Compounding:
Annuities
Regular payments
Future
Value:
Present
Value:
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