An Introduction to the financial tools in measuring Liquidity and Profitability

An Introduction to the fiscal tools in measuring Liquidity and ProfitabilityTools that argon important in monitoring business ar liquid and favourableness. Liquidity refers to solvency meaning how quickly assets cease be converted to bills while the income statement measures the pecuniary surgical procedure of an entity through measuring profitableness. The main financial documents of a caller-out measures profitability 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 current assets and current liabilities of an entity. Current assets atomic number 18 resources of a business maturing within a year whilst current liabilities atomic number 18 the short limit obligations of a business maturing within a year. Therefore, when measuring liquidity we measure the ability of an entity to c everywhere its short term obligations with its current resou rces which includes inventory, Debtors, coin in the bank and petty cash amongst other resources. If a unassailable can cover its current obligations with its current resources twice it is considered liquid meaning it can cover its current obligations with few difficulties and any ratio less than that is considered illiquid meaning the entity result face difficulties in settling its current obligations which is not a estimable sign for any entity.Profitability is measured by matching revenue for a period with expenses for that period. Revenue is the proceeds an entity receives from selling its products from its core business activities. Whilst expenses be those embodys incurred during a period in the process of generating sales revenue. Examples of expenses include electricity, rent, depreciation, salaries and wages e.t.c. The excess of revenues over expenses elbow room the business is bankable whilst the vice versa means its making a loss. Profitability is measured in the i ncome statement, and in addition to cash items it also considers non cash items such as depreciation. As a allow for profitability is not a true reflection of the cash generated by the business given the fact that it is drawn on an accrual basis.Yearling LtdThe play along is faced with disagreements between 2 departments which argon the accounting and finance rung. The accounting staff believes that if the come with is profitable it should be able to pay for its obligations whilst the finance staff disagrees. The elaboration in the above paragraphs has explained profitability and liquidity and differences can be identified from the explanations. That is profitability means the ability of the firm to cover its useable expenses with its operational revenue and this includes cash and non cash items and hence can not measure the ability of a firm to pay its obligations. On the other hand liquidity measures the ability of a firm 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 challenges in meeting its obligations.ConclusionThe financial managers staff is right in advocating for party reckon 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.examination 2Question 33.1.1. Debt RatioAdebt ratio compares a companys totaldebt to its total assets. Debt consists of the amounts borrowed or owing to identificationors. The ratio is employ to gain a general idea as to the amount of leverage or debt being used by a company. A low percentage means that the company is less dependent on debt or leverage i.e. money borrowed from and/or owed to others. The humiliate the proportion, the less leverage a company is using and the stronger its comeliness position. This is so because the lower the chances that the company will be liquidated to meet the debt obligations. In general, the higher the ratio, the more than chance that company is considered to have lay downn on. Debt ratio is calculated by the following sayingFor the companies under discussion their debt ratios are as followsPelican Paper LtdTimberland quality Ltd1000000/100000005000000/1000000010%50%Timberland Forest Ltd has got a high ratio of 50% compared to the ratio of Pelican Paper Ltd of 10%. This means that Timberland has a high financial risk 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 riskier it is considered to be.3.1.2. Times Interest get RatioA metric used to measure a companys ability to meet its debt obligations. It is calculated by taking a companys realiseings before arouse and t axes (EBIT) and dividing it by the total please account payable on bonds and other contractual debt. It is usually quoted as a ratio and indicates how many times a company can cover its amour charges on a pre-tax basis. Failing to meet these obligations could force a company into bankruptcy. The ratio is calculated as followsTimes Interest Earned=Earnings before recreate and taxes/interestFor the two companies their respective ratios are as followsPelican Paper 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 with available earnings.ConclusionTimberland has a high financial risk reflected by a high debt ratio and a lower time interest earned ratio.3.23.2.1. Operating Profit rimOperating profit ma rgin is the proportion of operating profit to Sales revenue for that period. Operating profit margin indicates how effective a company is at controlling 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 same 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 available to ordinary shareholders to Sales. This number is an indication of how effective a company is at cost control. The higher the net profit margin is, the more effective the company is at converting revenue into actual profit. The net profit margi ns are a good way to compare companies in order to gauge which ONES are relatively more profitable. The ratio is calculated by the following formulaNet profit margin = Earnings available for ordinary 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. afford on primitive 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 follows deliver on total assets = Earnings available for ordinary shareholders/Total assetsFor the two companies the respective ratios are as followsPelican Paper LtdTimberland Forest Ltd3690000/100000003450000/1000000 036.90%34.50%Pelican has a high ratio compared to Timberlands hence high profitability.3.2.4. Return on common equityMeasures the return earned on the ordinary shareholders investment in the firm. The amount of net incomereturnedas a percentageof shareholders equity.Return on equitymeasures a corporations profitabilityby revealing how muchprofit a company generateswith the money shareholders have invested.ROE is expressed as a percentage and calculated asReturn on Equity = Net Income/Shareholders EquityNet income is for the full fiscal year (before dividends paid to common stock holders but after dividends to preferred stock.) Shareholders equity does not include preferred shares.The two companies ratios are as followsPelican Paper LtdTimberland Forest 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 arrive more profitable because of the lar ger debt. Debt has a intractable interest defrayment 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 risks undertaken by Timberland investors are basically financial risks 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+100N purchase of shares+600OCash dividends+800ISale of shares+1000IQuestion 55.1.YearCashflowPVIF(5%)PV18000.95761.9029000.91816.33310000.86863.84415000.821234.05520000.781567.05Present Value of mixed cash flows5243.175.2.The amount that can be paid at most is 5243.175.3.Present Value of the mixed cash flows at 7% is as followsYearCashflowPVIF(5%)PV18000.93747.6629000.87786.09310000.82816.30415000.761144.34520 000.711425.97Present 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 expected return and different risks, will prefer the one with the lower risk. Given the trade off between risk and return its means risk averse investors will always stick out on a potential of earning higher returns as investments with lower risks tend to have lower returns.6.2. Risk indifferentThis describes investors who overlook purposely risk when decision making between investments. They are also called risk 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 mental ity 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 best described as risk averse as they always seek to minimize risk when they make financial decisions.Question 77.1. bar warp measures the deviation of the returns from the expected return whilst range measures the differences between the highest possible return and the terminal return of a project. The higher the standard 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 analogy.7.4Coefficient of varia tion = 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 capitalOrdinary 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 matureHave secondary claims 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 right s.8.2Rights offering are when ordinary shareholders are offered new shares at a discounted price first before they become available to the public. Therefore, this offering protects a firms shareholders from dilution of their holding 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 fix the maximum total shares a company can be allowed to issue. In other words it is the number of shares a company is authorized to issue highlighted in its articles and memorandum of association. It is from this that the company can decide on the number of shares that it can issue and can only 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 r eflected 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 distribution 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 l ess 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 suit 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 cumulative future of preference shares refers to the guaranteed payment of dividends to the shares irregardless of the performance of the company. In the event 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 dividend s are accumulate 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.