Ratio and Financial Statement Analysis - Assignment Example

Financial ment Analysis: Ratios and Financial ment Analysis Insert of Executive Summary Financial management is the planning organizing, directing and controlling the financial activities of an enterprise; the application of management principle of the financial resources of the business. The main objectives of financial management are to ensure the availability and regular supply of funds to the enterprise, to ensure optimal use of funds by prioritizing the projects that funds should be allocated to due to the constraint of funding availability, to have a robust and sound capital structure and to ensure that investors have reasonable and adequate returns to their investment (Parrino & Kidwell, 2009). Concepts that have been used include annuity which is a series of constant cash flows that occurs at the end of each period called a term, perpetuity which is a financial asset that does not have a maturity period but keep making payments indefinitely, compounding which is finding the future value of one or more cash flows, discounting which is determining the present value of one or more future cash flows. Financial decisions are made based on future value or present value. Future value is what one or more cash flows are worth at the end of the period while the present value measures the worth of one or more cash flows to be received in the future are worth today. The effective annual interest rate which is the annual growth rate that takes into account compounding. These concepts are fully covered in the paper while handing the questions. Financial management ratios are an area of expertise that every manager in any financial position should get acquainted with. They are useful in helping him to make sound financial decisions on the source of funds, the investment option to undertake and the financial prudence needed in the running of a business entity. Keywords: annuities, compounding, perpetuity, future value, present value, effective annual interest rate Main Body What the time value of money is and why it is so important in the field of finance: The question that comes to mind is what the value of a future cash flow is today. The time value of money is the value of the stream of future cash flows today. Money has a time value since a dollar held today is worth more than a dollar to be received in the future. If you had the money today, you would have probably invested it and earned interest thus time value of money is the opportunity cost of foregoing todays consumption. Time value of money is important in the field of fiancé because before investment decisions are made there is required that a comparison be made between the value funds invested today and the value of expected future cash inflows. The decision to make the investment should only be arrived at if the amount of future cash inflows exceeds the cost of the investment that is the initial cash outlay. In making financial decisions, which is concerned with the designing of the optimal capital structure and sourcing cheap funds for the business (Koh & Fong, 2012). Time value of money is used here especially when comparing the cost of different sources of finances. The effective rate of interest of each source of funds is calculated based on the time value of money. The concept of future value, including the meaning of principal amount, simple interest, and compound interest, and be able to use the future value formula to make business decisions: future value; financial decisions are evaluated on a future value basis or a present value basis. The future value is the value of a cash flow at a later date or after a specified period of time. The present value on the other hand is the current worth of a stream of cash flows to be received in the future. The principal is the amount of the initial investment; it is the amount on which the interest is going to be paid. Simple interest is the amount of interest paid on the principal amount only. The amount of money earned on simple interest remains constant from period to period. Compound interest comprises of simple interest and interest on the simple interest that is reinvested into the business. The higher the interest rate the higher the investment will grow for future value (Weaver, 2011). Compound interest can be calculated more than semiannually or quarterly or it can be continuous compounding. The more frequently an investment is compound the higher the return it will generate. The future value formula is given as Vt =P0 (1+ r)t where the(1+ r)n is the future value factor . Whereby n is the time period of the investment. The concept of present value and how it relates to future value, and be able use the present value formula to make business decisions: The present value is the value of one or more cash flows future cash flows today that is at time zero. The concept of present value is used to set prices in financial markets. The prices of financial assets are the discounted values of an expected stream of future earnings. Calculating the present value involves discounting future cash flows back to the present at an appropriate discounting rate (Moles & Kidwell, 2011). Discounting, adjusts the cash flows for the time value of money. The present value factor is the inverse of the future value factor1 / (1+ r)n . The present value formula is given by P0 = Vt (1 / (1+ r)t ) where P0 is the present value and Vt is the future value. The lower the interest rates the higher the amount of present value. Why the concept of compounding is not restricted to money, and be able to use the future value formula to make business decisions: Any changes that are observed over time in the physical or social sciences follow a compound growth rate pattern (Moles, Parrino, & Kidwell, 2011). The future value formula can be used in calculating these growth rates. The formula can adjust to anything other than money if the amount is put in number form then it can be compounded using the compounding formula. Why cash flows occurring at different times must be discounted to a common date before they can be compared, and be able to compute the present value: When making financial decisions you’ll need to know the amount of future cash flows all at time zero. When you have a cash flow starting from different time periods, you’ll need to discount them to a common date so that they are comparable in the same period of time in order to make a sound financial decision (Matthew, 2011). Explain what perpetuity is and how it is used in business, and be able to calculate the value of perpetuity: perpetuity is a financial asset that does not have a maturity period but keep making payments indefinitely. Perpetuities are also called consoles especially in Canada and the UK. Perpetuities are calculated using PV for perpetuity = C/rc is the coupon while r is the interest rate. Perpetuity applies in bonds and equity. Some markets have perpetual bonds where the cash flows from the initial investment are perpetual in nature. Growing annuities and perpetuities, as well as their application in business, and be able to calculate their value: Annuities are a series of constant cash flows at the end of each term. This is where you invest a fixed amount on a periodic basis over a number of years. It can also be a situation where you pay a fixed amount of loan at the end of every month until the total amount is paid off such as loans and mortgages (Vyuptakesh, 2011). Growing annuities are cash flows that increase year to year. An example of a growing annuity is a growing business whose cash flows increase every year. The calculation of annuities is given by the following formula. The growth in perpetuities is when a cash flow stream features constantly growing annuities forever. A growing perpetuity can be used to estimate a retirement amount using annual income and inflation. It can be gotten by Why the effective annual interest rate (EAR) is the appropriate way to annualize interest rates, and be able to calculate EAR: Effective annual interest rate is the annual growth rate that takes into account compounding. It adjusts the annualized interest rate for the time value of money. The effective annual interest rate is greater than the nominal interest rate. The effective interest rate is preferred because it gives the actual and true cost of borrowing and lending. The EAR is arrived at by EAR = (1 + Quoted rate/m)m – 1. How to calculate the present value of an ordinary annuity: The present value of an annuity is the sum of all the present values of all the periodic payments (Kidwell, Blackwell, Whidbee, & Sias, 2011). It is the amount to be invested now In order to earn a future stream of income. It is a series of periodic payments, discounted at the current interest rates. This is the situation in car loan or mortgage loan. The loan itself is the present value of that future stream of income. It is calculated using the following formula PVA = P ((1 - (1+ r)-n) /r) Reference Kidwell, D. S., Blackwell, D. W., Whidbee, D. A., & Sias, R. W. (2011). RicFinancial Institutions, Markets, and Money, Eleventh Edition. New York: John Wiley & Sons . Koh, B., & Fong, W. (2012). Personal Financial Planning. New Jersy: FT Press. Matthew, B. (2011). Economics. London: A-Z GuideProfile Books. Moles, P. P., & Kidwell, D. S. (2011). Corporate finace. New York: John Weiy and Sons. Parrino, R., & Kidwell, D. S. (2009). Fundamentals of Corporate Finance . New York: John. Vyuptakesh, S. (2011). Fundamentals of Financial Management, Third Edition. India, Delhi: Pearson Education Publishers. Weaver, S. (2011). The Essentials of Financial Analysis. New York: McGraw-Hill. Read More