An Introduction to the financial tools in measuring Liquidity and Profitability

An Introduction to the pecuniary tools in measuring Liquidity and Profit capacityTools that ar important in observe business atomic number 18 liquidity and favour adequate to(p)ness. Liquidity refers to solvency meaning how quickly assets support be converted to silver while the income program line measures the fiscal feat of an entity through measuring improvemen postponeness. The main financial documents of a compevery measures profit king and liquidity, the statement of comprehensive income measures profitability whilst liquidity is measured by the statement of financial position.Liquidity is measured by comparing the on-going assets and contemporary liabilities of an entity. Current assets atomic number 18 resources of a business maturing in spite of appearance a class whilst current liabilities be the piffling line obligations of a business maturing within a year. Therefore, when measuring liquidity we measure the ability of an entity to cover its short term ob ligations with its current resources which includes inventory, Debtors, notes in the bank and petty bullion amongst different resources. If a regular puke cover its current obligations with its current resources twice it is considered liquid meaning it jakes cover its current obligations with some difficulties and any ratio slight than that is considered illiquid meaning the entity forget face difficulties in settling its current obligations which is not a good sign for any entity.Profitability is measured by matching revenue for a intent with expenses for that consequence. Revenue is the proceeds an entity receives from selling its products from its core business activities. Whilst expenses ar those cost incurred during a period in the process of generating sales revenue. Examples of expenses include electricity, rent, depreciation, salaries and reward e.t.c. The excess of revenues over expenses gist the business is bankable whilst the vice versa inwardness its m aking a loss. Profitability is measured in the income statement, and in summation to cash items it also considers non cash items much(prenominal) as depreciation. As a result profitability is not a true reflection of the cash gene postd by the business given the fact that it is drawn on an assemblage basis. gradeling LtdThe guild is faced with disagreements between both departments which are the history and finance cater. The accounting staff believes that if the phoner is profitable it should be able to make for its obligations whilst the finance staff disagrees. The elaboration in the above paragraphs has explained profitability and liquidity and differences tush be identified from the explanations. That is profitability appearance the ability of the stiff to cover its operational expenses with its operational revenue and this includes cash and non cash items and hence can not measure the ability of a starchy to pay its obligations. On the opposite hand liquidity me asures the ability of a unfluctuating to cover its obligations with its resources and hence a perfect measure of the ability of the firm in covering its financial obligations. Hence, a profitable firm can be illiquid i.e. can face liquidity take exceptions in concourse its obligations.ConclusionThe financial managers staff is right in advocating for party budget cut in order to reduce their financial obligations given the challenge they are faced with. On the other hand the accounting staff are wrong in thinking that a profitable firm implies liquidity as these are two different things as was discussed in the previous paragraphs. interrogate 2 fountainhead 33.1.1. Debt RatioAdebt ratio compares a corporations impartdebt to its total assets. Debt consists of the sum of moneys borrowed or owing to creditors. The ratio is used to gain a general idea as to the enume score of leverage or debt being used by a company. A low percentage office that the company is slight dependent on debt or leverage i.e. money borrowed from and/or owed to others. The lower the proportion, the less leverage a company is using and the stronger its equity position. This is so because the lower the chances that the company testament be liquidated to fit out the debt obligations. In general, the gameer the ratio, the to a greater extent jeopardy that company is considered to conduct taken on. Debt ratio is mensural by the pastime formulaFor the companies under discussion their debt ratios are as followsPelican written report Ltdwoodland Forest Ltd lakh0/ curtilage00005000000/1000000010%50% wood Forest Ltd has got a broad(prenominal) ratio of 50% compared to the ratio of Pelican paper Ltd of 10%. This means that Timberland has a high financial fortune as it is financed by debt more than Pelican. The more debt compared to equity a company has, which is signalled by a high debt ratio, the more leveraged it is and the insecurityier it is considered to be.3.1.2. quantify pursuit take in RatioA metric used to measure a companys ability to meet its debt obligations. It is calculated by taking a companys earnings ahead spare- beat activity and valuatees (EBIT) and dividing it by the total interest payable on bonds and other contractual debt. It is unremarkably quoted as a ratio and indicates how many times a company can cover its interest charges on a pre- assess basis. Failing to meet these obligations could force a company into bankruptcy. The ratio is calculated as followsTimes Interest Earned=Earnings before interest and taxes/interestFor the two companies their respective ratios are as followsPelican writing LtdTimberland Forest Ltd6250000/1000006250000/50000062.5 times12.5timesPelican Paper Ltd has a high times interest earned ratio of 62.5times compared to Timberlands of 12.5times. This means Pelican has a high ability to cover its debts compared to Timberland as reflected by the number of times they can cover their interest obligations w ith operable earnings.ConclusionTimberland has a high financial endangerment reflected by a high debt ratio and a lower time interest earned ratio.3.23.2.1. run Profit marginOperating profit margin is the proportion of run profit to Sales revenue for that period. Operating profit margin indicates how telling a company is at absolute the costs and expenses associated with their normal business operations. A high ratio means a high profitability whilst a lower means less profitable. The ratio is calculated as followsOperating profit margin = operating profit/salesThe respective ratios for the two companies are as followsPelican Paper LtdTimberland Forest Ltd6250000/250000006250000/2500000025%25%The companies has the equal ratios and this implies that they are equally good in managing their costs and expenses hence profitability based on this ratio.3.2.2. Net Profit MarginThe ratio measures the percentage of profit easy to unexceptional shareholders to Sales. This number is an indication of how effective a company is at cost control. The higher(prenominal)(prenominal) the net profit margin is, the more effective the company is at converting revenue into actual profit. The net profit margins are a good way to compare companies in order to venture which ONES are relatively more profitable. The ratio is calculated by the following formulaNet profit margin = Earnings available for run-of-the-mine share holders/salesThe respective ratios of the two companies are as followsPelican Paper LtdTimberland Forest Ltd3690000/250000003450000/2500000014.76%13.80%Pelican has a high ratio compared to Timberland which means a high profitability based on this ratio. Therefore Pelican is profitable than Timberland.3.2.3. Return on Total AssetsMeasures profit in proportion to total assets, in other words the effectiveness of management utilising the available assets in generating profits. A high ratio means greatest effectiveness and profitability. The ratio is calculated as followsReturn on total assets = Earnings available for unexceptional shareholders/Total assetsFor the two companies the respective ratios are as followsPelican Paper LtdTimberland Forest Ltd3690000/100000003450000/1000000036.90%34.50%Pelican has a high ratio compared to Timberlands hence high profitability.3.2.4. Return on common equityMeasures the revert earned on the ordinary shareholders investment in the firm. The amount of net income fadeedas a percentageof shareholders equity.Return on equitymeasures a corporations profitabilityby revealing how muchprofit a company generateswith the money shareholders assume invested.ROE is expressed as a percentage and calculated asReturn on Equity = Net Income/Shareholders EquityNet income is for the sound fiscal year (before dividends pay to common stock holders but by and by dividends to selectred stock.) Shareholders equity does not include preferred shares.The two companies ratios are as followsPelican Paper LtdTimberland Fores t Ltd3690000/90000003450000/500000041%69%Pelican has a lower return on equity compared to Timberland and based on this ratio Timberland is more profitable compared to Pelican.3.3.Timberland has become more profitable because of the larger debt. Debt has a refractory interest payment and its tax allowed meaning it is tax deductable and as a result a high debt means a high interest payment and lower tax hence increased profits.3.4.The hazards undertaken by Timberland investors are rudimentaryally financial put on the lines which include the liquidity risk, interest rate risk and credit risk.Question 4ItemChange(Rands)inflow(I)/outflow(o)/neither(N)Cash+100ITrade and other payables-1000OShort term borrowing+500Isemipermanent borrowing-2000OInventory+200ONon-current assets+400OTrade receivables-700INet profit+600Depreciation+100NRepurchase of shares+600OCash dividends+800ISale of shares+1000IQuestion 55.1.YearCashflowPVIF(5%)PV18000.95761.9029000.91816.33310000.86863.84415000.821234 .05520000.781567.05 stand for Value of mixed cash flows5243.175.2.The amount that can be paid at most is 5243.175.3. get Value of the mixed cash flows at 7% is as followsYearCashflowPVIF(5%)PV18000.93747.6629000.87786.09310000.82816.30415000.761144.34520000.711425.97Present Value of mixed cash flows4920.37An opportunity cost of 7% implies that the investor will be prepared to pay less now and earn the same return as the one who pays more at 5% return.Question 66.1. Risk AverseDescribes of an investor who, when faced with two investments with same or a similar expect return and different risks, will prefer the one with the lower risk. given up the trade off between risk and return its means risk antipathetic investors will always pull away on a potential of earning higher returns as investments with lower risks guide to put one across lower returns.6.2. Risk indifferentThis describes investors who overlook purposely risk when deciding between investments. They are also called ri sk neutral investors and they are mainly concerned with an investment expected return.6.3. Risk seekingDescribes investors who are willing to take additional risks for investments that have relatively low expected return. This contrasts with a typical investor mentality risk aversion. They tend to take higher risks in an effort to earn higher returns. They are also termed risk lovers.6.4.Financial managers are beat out described as risk averse as they always seek to minimise risk when they make financial decisions.Question 77.1. ideal diversion measures the deviation of the returns from the expected return whilst range measures the differences between the highest possible return and the lowest return of a working class. The higher the quantity deviation the higher the risk whilst the same can be said about range, therefore project A is less risky as it has the lowest standard deviation and range compared to other projects.7.2.Project A has a lower standard deviation7.3Standard deviation measures extend at which the returns are dispersed from the expected return of an asset. But it does not measure proportionately, so given different returns standard deviation will not be proper to use it as a measure of risk for purpose of comparison.7.4Coefficient of variation = Standard deviation/Expected ReturnProjectCoefficient of variationA2.9%/12%0.24B3.2%/12.5%0.26C3.5%/13%0.27D3%/12.8%0.237.5Coefficient of variation is a best measure of risk for purposes of comparison as it measures proportional deviation from the mean. Given that Grassland owners are risk averse they will choose a project with the lowest coefficient of variation which is project D based on the table above.Question 88.1Comparison of Ordinary shareholders and other providers of long term capital of the United StatesOrdinary ShareholdersOther Suppliers of long term capitalDividends to be paid are at the discretion of the companies board of directorsReceives a fixed interest whether the company made profit or not.Dividend payments are taxedInterest payments are tax deductiblePermanent form of financingThey get on withHave secondary advances to assets and income of the company.Have primary claims to income and assets of a company.Owners of the firmCreditors of the firmHave voting rightsDont have voting rights.8.2Rights offering are when ordinary shareholders are offered modern shares at a discounted price first before they become available to the public. Therefore, this offering protects a firms shareholders from dilution of their safekeeping in such a way that they are given preference to maintain their holding first by being offered proportional new shares to their holding. In that manner protected from a possible dilution if they were to be taken by new shareholders.8.3.Authorised SharesAuthorised shares quantify the maximum total shares a company can be allowed to issue. In other words it is the number of shares a company is authorised to issue highlighted in its articl es and memorandum of association. It is from this that the company can locate on the number of shares that it can issue and can just now issue at most to this amount of authorised shares otherwise it can issue less.Issued sharesIts the number of shares that has been issued and paid for and it represents part of the amount equity reflected in the statement of financial position. These also represents the amount of he authorised shares held by the public. Issued shares represents the sum of issued and treasury shares.Treasury sharesA company can decide to purchase part of the issued shares back for some reasons. If it does the shares will be held by the company and they do not participate in any thing i.e. they do not participate in voting nor receive dividends. These types of shares are the ones termed treasury shares8.4.Preference shareholders tend to have more favourable basic rights in terms of the dispersion of earnings and assets compared to ordinary shareholders. They often have features of debt instruments which makes them superior in terms of claims compared to ordinary shareholders. The claims that preference shares will be discussed in the paragraphs that followPreference shares have a fixed claim on the firms income that takes precedence over the claim of ordinary shareholders. This makes them less risk compared to ordinary shareholders as they have guaranteed income.Given that they are participative preference shares they will also have preference over ordinary shareholders in the distribution of earnings. Furthermore, if they do not receives the dividend earnings it implies the ordinary shareholders they have not as well. This then makes and shows that the ordinary shareholders are the true risk takers.In the incident of liquidation, preference shares do have a preference over ordinary shareholders in claims over assets of the firm. In other words they are paid their initial capital first before ordinary shareholders could be paid.8.5.The cumu lative future of preference shares refers to the guaranteed payment of dividends to the shares irregardless of the performance of the company. In the example of a company having less financial resources to pay for the dividend, it will be deferred and paid as and when the company realizes the resources to pay. In other words the dividends are accumulated and paid when the company can. For example, if a company is liable to pay a 10000 dividend annually for preference shares and it happens that one financial period the lack financial resources to pay the dividend they defer it to the following financial period. As a result, in the following financial period they will have to pay a dividend of 20000 which covers the 10000 for the last period and the 10000 for the current period.Question 9Valuation of shares with no dividend growth, the formula is as follows.9.1Share price = Dividend per share/cost of capital2.4/0.12R 20.009.22.4/0.2R 12.009.3The higher the risk the higher the value, a lower interest rate results in a higher value. This is so because the lower the interest rate the higher the risk of default and that risk should be compensated by an increased capital value. The reverse is also true for a higher interest rate as it has resulted in a lower capital value.