Financial Management and Working Capital Turnover - Assignment Example

Financial Management

Question one

Current ratio is defined as and it determines how easy a firm can settle its short-term debts via its current assets. Only companies with current ratio of greater than one are in a positon to settle their short-term debts through their current assets. As far as leverage is concerned, ABC is less leveraged as it is in a position to settle its short-term debts easily as depicted by its high current ratio of 3 compared to 1.8 of its competitor XYZ. With 3 and 1.8 times more current assets that current liabilities respectively, ABC and XYZ are in a position to clear their short-term loans since they all have a current ratio of greater than one. Further analysis will be looked into using the follow ratios:

Working capital turnover

By definition, working capital turnover is defined as while working capital is defined as From the current ratio analysis, it follows that ABC has a huge working capital compared to XYZ. Remember current ratio is a function of current assets to current liabilities in which ABC has a ratio of 3 while XYZ has 1.8 signifying that ABC has more current assets than XYZ. Nevertheless, factoring in working capital turnover, it is clear that ABC exhibits a low working capital turnover compared to XYZ. This is also true from the fact that both firms exhibit the same level of sales. With XYZ having a higher working capital turnover than ABC, XYZ is more efficient in producing sales from its working capital: short-term assets and liabilities despite the fact that ABC has a huge deposit of working capital compare to XYZ. In terms of financial performance and considering this ratio, XYZ is more active in utilizing the little working capital it has to make sales and produce more money even after paying its bills and other expenses (Singh, 2015).

Total asset turnover

When a company wants to know the rate at which it is able to make sales from its total assets, it compares the net sales made to the average total assets, that isIt has been established that both companies have the same level of fixed assets and sales. Irrespective of the fact that ABC has a current ratio of greater than 2 while XYZ has less than 2, the ability to generate sales from the fixed assets is the same for both companies. From a financial perspective, none has a greater ability than the other.

Return on asset (ROA)

The purpose of any asset owned by a company is to make a profit to the company. After a given financial period, a company determines how much profit a particular asset has made by calculating the net income generated by that asset over the given time frame. By definition, return on asset is defined by ABC and XYZ enjoy similar levels of net income and asset distribution. For this reason, the two companies are enjoying an equal ability to earn from the capital invested. Every company ventures into business with the belief of generating profits and revenue from its assets. With an equal ability to make profits from their assets, none of the companies is better than the other in terms of activity, profitability and financial performance.

Return on equity (ROE)

There are numerous ways of raising capital for a company and shareholder’s contribution is one of them. For every investment made by a shareholder, they expect dividend at the end of a defined financial year. In order to determine the profitability of the investment made by shareholders, return on investment (ROE) is usually utilized (Heikal, Khaddafi & Ummah, 2014). Mathematically, ROE is defined as ROE indicates how much income is generated by each dollar invested by a shareholder. A ROE of 2 would indicate that for each dollar invested by a shareholder, it produces two dollars as net income. Shareholder’s equity is derived from subtracting liabilities from assets, that is From the available facts, both firms have the same level of fixed assets and amount of current liabilities. An analysis of ROE will clearly reveal that the returns on shareholders’ investment in the two companies is the same. None profits brings more profit to shareholder than the other.

Debt/total assets

This is a financial leverage indicator ratio that shows the percentage of assets that are in financing by creditors or debt. The general formula defining this ratio is

The lower the ratio, the stable the company as a higher ratio indicates that a huge percentage of the company’s assets is financed by creditors hence the company is more leveraged and at a higher financial risk. A number of long-term debts carried by the firms are the same and none of them carries short-term debts. By having a fixed level of assets also, company ABC and XYZ have equal debt/total assets ratio. This implies that whatever percentage of assets that are being financed by creditors in each firm, it is similar in both of them.

The financial analysts argue that ABC is doing better than XYZ financially owing to the fact that it has a current ratio greater than the required minimum threshold. From a financial performance perspective, all firms exhibit similar liquidity, profitability, and leverage level as revealed by the total asset turnover, return on assets and return on equity and debt / total assets ratios. Furthermore, company XYZ seems to be more active compared to ABC when one compares their working capital turnover. While company ABC has more working capital than XYZ, XYZ efficiently and effectively utilizes the little working capital it has generating more sales that ABC.

Question two

The debt/equity, is a liquidity ratio that seeks to find the total debt accompany owes to its creditors to the total equity it owes to its shareholder. A computation of this ratio will indicate how much financing comes from creditors and investors respectively. A higher ratio will indicate that a huge chunk of financing comes from credit (bank loans) than from shareholders and vice versa. Debt refers to both the long-term and the short-term loans while equity constitutes the cash shareholders pay when a company sells its stock and any profit not paid out as dividends, otherwise referred to as retained earnings (Heikal, Khaddafi & Ummah, 2014). Given the fact that none of the companies is intending to borrow or issue additional stock and the existing debts does not have to be paid over the next three years, the debt to equity ratio for company ABC will increase while that for company XYZ will decrease within three years respectively.

As mentioned above, a shareholder’s equity is a function of the stocks/shares and a number of dividends owned. ABC pays 100% of its net income (retained earnings) as dividends and has no plan on buying back shares. While there is no intention of borrowing by this company, it is true to say that its model is completely unsustainable as it has 0% retained earnings for growth and development. Whenever dividends are paid and no shares are bought back by the company, shareholder’s equity greatly reduces with time. Consequently, the debt to equity ratio increases owing to the fact that the value of the denominator (equity) decreases while that of the numerator (debt) remains constant.

Likewise, for company XYZ, the debt to equity ratio also increases. Nevertheless, compared to company ABC, XYZ’s debt to equity ratio increases by a half annually. This is explained by the fact that only 50% of its net income goes into paying dividends to shareholders. It has only been mentioned that the only variables that remain constant for the two firms are the operating income, debt repayment, plan to purchase back shares and their intention to increase their borrowing. Since asset acquisition has not been mentioned, it may be assumed that the remaining 50% net income will be used for growth and development and even purchase of new assets for firm XYZ. Addition of more assets has a positive effect as far as reduction of the debt to equity ratio is concerned.

In summary, all factors held constant for the two companies, ABC’s debt to equity ratio will be twice (300%:150%) that of XYZ within a period of three years. From a financial analysis perspective, investors will be “seen” to have funded less of their assets to company ABC compared to XYZ within three years.

Question three

XYZ’s 8 year-bond at a coupon rate of 6% will have a higher market yield compared to ABC’s 10 year-bond at a similar coupon rate. The amount of interest rate to be paid on a bond is affected by the duration of time of the bond under the hands of the bondholder. This is explained by the fact that the more a bondholder has the bond, the numerous the number of risks he/she is will encounter (Becker & Ivashina, 2015). For this case study, it is assumed that the bonds from the two companies were equal in value and were issued at similar par values. ABC issued its bond three years back which means seven years are due before maturity while XYZ’s bond only needs four years to mature. The prevailing yield to maturity of the bonds is 8% compared to the respective coupon rate of 6% for each bond.

Yield to maturity is the expected internal rate of return a bondholder expects from bond if it were to be sold on the market. As far as bonds, yield to maturity and coupon rates are concerned, if the coupon rate is above the yield to maturity then the bond will trade above its par value and this will be more beneficial to the bondholder. On the other hand, if the coupon rate is below the yield to maturity, the bold will trade below its par value and the bondholder will not make a lot of profit. Market value is basically the value of which something can be traded at that particular time.

An investor holding ABC’s bond will have to wait for seven more years earning a coupon interest of 6% while one holding XYZ’s bond will have to wait only for four years in order to enjoy the prevailing yield to maturity of 8% being enjoyed in the market. Given the fact that both bonds have identical coupon rate, the one with a shorter maturity period will yield a higher market value and for this reason, it is XYZ’s eight-year bond.

Question four

Beta is a numeric value that measures how the stock of a particular company fluctuates with respect to the market. A beta of more than one indicates a riskier stock while a beta of less than one indicates a less volatile stock. Through capital asset pricing model (CAPM), the expected returns from a particular stock can be calculated and the data used to inform investors on what to invest in. Note that, at market value, beta is always equal to 1 and this usually used as a threshold for determining the volatility of an asset. Given the fact that the external market conditions are the same, the following factors may have contributed to their differences in the value of beta:

• Net earnings
• Company events
• Dividends
• Buybacks and stock splits

Net earnings

The price of a stock is greatly influenced by the net earnings made by a company. Investors to a particular firm are always interested in know how much profit a firm accrues in a given financial year so that they can make a decision of investing or not (Zacks Investment Research, 2017). The value of a stock is directly proportional to earnings. From the financial analysis above, it has been shown that company XYZ is efficient in utilizing its short-term assets better than company ABC. With this difference, it follows that XYZ makes more profit compared to ABC and this is reflected in their beta value.

Dividends

Declaration of dividends on a stock generally affects the prices of stocks. When a dividend is declared on the stock, it may catch the attention of investors increasing demand and hence its price. However, this is usually short-lived. While ABC has a 100% policy on dividend payout, the true value of their dividend may be less than the 50% payable by XYZ. When the declared dividend is too low, a substantial decline in the prices of stock will be experienced hence the beta of that stock.

Buyback and stock splits

In an attempt to buy back shares and reduce the price of shares, a company may split shares owned by investors into smaller portions. In this instance, ABC may have split its shares and recalled some of them leading to a drop in their prices affecting the overall beta in comparison that company XYZ.

Company news and events

When a company produces a faulty product, launches it into the market and then recalls, the level of stock may fall. This incident may raise the concern of investors over the company’s short-term earning compelling them to sell the stocks they have at a lower value. On the other hand, if a company announces that they will be launching a better product in the market, prices for its stock will increase hence its beta value (Zacks Investment Research, 2017). While it is not indicated, it may be assumed that recent events and news from the two firms may have happened against ABC and for XYZ hence the disparity in beta value.

Question five

The current ratio is a liquidity ratio which is used to evaluate the readiness and ability of a firm to settle its current liabilities through its current assets. Before using the current ratio as a measure of financial performance of a company, management ought to take the market standards into consideration as taking into account the current ratio as a standalone number can be misleading. Is most cases, financing from lending institutions and banks usually advance credit to company’s whose current ratio is greater than 1 but less than 2. With a high current ratio, it may also imply that a company is not fully utilizing its resources (current assets) or it is reserving more of its assets and not being put up for a profitable venture. Secondly, a high current ratio implies that the company has excess cash at hand or retained profits and for this reason, not in need of credit advance. Having understood the impacts of having a high current ratio, the manager of ABC can reduce it by employing the following approaches.

• Increasing short term-loans,
• Spending more cash optimally,
• Amortizing prepaid expenses and,
• Reduce working capital cycle.

Increasing short-term loans

One of the easiest ways of reducing current ratio is to increases current liabilities (eFinanceManagement, 2017). It has been noted above that none of the companies have short-term debts and this may be the reason why ABC records such a huge current ratio. The manager should, therefore, increases its proportion of short-term debts while keeping the proportion of long-term debt small. From question two, it was assumed that there is no necessity of the companies to pay their existing debts within a period of three years. Well, while this may give room for planning and reduce the loan burden, reducing the duration taken to repay long-term debts is an appropriate measure of increasing the current portion of the current liabilities.

Short-term debts are usually associated with huge interest rates. Such interest on a firm reduce the net income and profit margins and may dwindle the growth rate of a firm.

Spending more cash optimally

The company should spend more of the current asset, cash at hand, as it will reduce the current ratio (eFinanceManagement, 2017). There are a couple of constructive ways in which the company can spend the extra cash it has. One, ABC can spend a proportion of its cash is settling a portion of the long-term debt it owes to its debtors. Moreover, the cash can be converted into a fixed asset by using it to purchase a fixed asset. Net income is most retained as profit. Since ABC has a 100% policy when it comes to paying dividends to shareholders, it can increase ROE and reward its shareholders well. This will motivate them to pump more money into the business.

This move is not associated with any risk since it involves plowing back the profits made into the profitability of the firm. The cash is either used to settle debts, increase more fixed assets and reward shareholders well.

Amortizing prepaid expenses

A prepaid expense is an expense paid for before it is consumed. These are expenses that are fundamental for the running of a firm for instance insurance premiums. An entity is usually required to pay premiums before it benefits from the insurance packages. As far as the balance sheet is concerned, these expenses are usually regarded as current assets. If these expenses are amortized over a long period of time, they reduce consequently reducing current assets and hence current ratio (eFinanceManagement, 2017). The manager of ABC should find for amortizable prepaid expenses in his farm and clear them.

Reduce working capital cycle

The time it takes to convert current assets and current liabilities into cash is usually referred to as a working capital cycle. On the other hand, working capital is simply the difference between current assets and liabilities respectively. A leaner working capital cycle is an approach meant to control current assets or reduce it all together while increasing current liabilities (eFinanceManagement, 2017). In a working capital cycle, a couple of variables have to be controlled for the process to be efficient: cash, receivable, payable and inventory. It is true to argue that inventory turnover may not be as quick as expected and for this reason, a company may have to raise capital through short-term loans for the process of production. In the end, the ratio will reduce owing to the reduction in current assets and increase in current liabilities. The risk with this approach is that it is greatly influenced by the market as far as inventory is concerned. The company may end up borrowing excessive short-term debts reducing its current ratio below the acceptable value.