Principles of Finance

Contents table

Market capitalization versus book value of a company

Ratios used for analyzing performance of a company

Inventory turnover

Cash realization cycle

Net present value of a project

Capital budgeting

Stock and bond yield

Financial instruments

Cash realization cycle

Sources of funds

Procedure for issuance of bonds

Cost of capital versus capital budgeting decisions

Earnings per share versus increase in stock

Impact of issuance of additional stocks

Swot analysis of Mutare Banana Company

Business risks for Mutare Banana Company

Financial ratios

Market capitalization versus book value of a company

The worthiness of a company can be measured in several ways. In this discussion we will look at only two ways of estimating the value of a company. These two ways of estimating the company value are the book value or market capitalization. Market capitalization is the estimation of the worthiness of the company based on the prices of the shares, the perceived future state of the organization, the economic conditions of the company and the monetary situation existing in that company at the date of valuation. The share values of a company are influenced by a number of factors such as the viability of the company, the financial performance and the customer base. So the market value of the company is determined by the prices of the stocks which investors are willing to purchase or sell the shares., in other words market capitalization refers to the value that a company is given based on the price and the quantity of shares, which can be bought and sold on the stock exchange. The market capitalization can be obtained by multiplying the company’s shares by the price of the shares at that time. For example if Tanda Company has got 3000 000 shares and each share price is $10.00, then the value of Tanda Company is 3000 000 X$10.00 = $ 30 000 000.00

The book value of a company is represented by the net worth of the business. The net worth of a business is arrived at by subtracting the total liabilities from the total assets. In other words this is the value that is obtained if all the assets of a company are sold and then the liabilities are all paid out, the remaining sum of money represents the book value of an organization. This value can also be referred to as the shareholder’s equity. This can be easily obtained from the balance sheet by subtracting total liabilities from total assets.

The book value of the organization and the market capitalization can never be the same. However using the two methods of valuation is important. It can easily give an indication of whether or not there is undervaluation or overvaluation. When the market value and the book value of a company are compared and are not the same then the company is either undervalued or overvalued. Which type of the valuation method to use is determined by the stage of business development the company is in. For instance a company that is still growing has usually have a higher market capitalization, whereas a more established company has got a bigger book value. For investors the book value is more important than the market capitalization. On the other hand for the shareholders the market capitalization is of more significance, as it dictates their dividends.

Reference

Principles of Accounting, by L. M. Walther, Retrieved from: http://www.principlesofaccounting.com/chapter16/chapter16.html

R. A. Hill, Company Valuation and Takeover http://www.bookboon.com/,Cash conversion Cycle

What's the difference between book and market value? - Investopedia http://www.investopedia.com/ask/answers/183.asp

What is a Company Really Worth? Intangible Capital and the ... http://www.nber.org/papers/w14548

Explaining the Difference in Book Value and Market Capitalisation ... http://www.studymode.com/essays/Explaining-The-Difference-In-Book-Value-1153118.html

Ratios used for analyzing performance of an organization

The following ratios are essential in analyzing the performance of an organization; current ratio, quick ratio, debt-to-asset ratio, earnings per share and market capitalization. Each of these ratios has got a message that it gives to a manager or owner of a business venture. The quick ratio tells how the assets of a company can be easily turned into cash. It shows the strength of the finances of a company. Usually potential creditors use the ratio to assess the creditworthiness of such a company. It tells whether or not the company will be able to pay its financial obligations without being severely strained. A quick ratio of 1 or more is favourable and is a good indicator. A ratio of 1 means that for every dollar of current liabilities, there is a dollar of easily convertible assets into cash whereas a ratio of 3 means that for every dollar of current liabilities, there are three dollars of assets convertible into cash. So in principle the higher the ratio the stronger the finances of a company are. It is a good indicator for companies that offer goods on credit terms to that company to do so.

The quick ratio and the current ratio, both indicate how easily a company is to pay out its financial obligations. These two ratios are almost the same, except that with a quick ratio inventories are subtracted from the assets under consideration. A current ratio of between 1.5 and 3 are considered very good. A current ratio of less than 1 indicates that there are more current liabilities than current assets, which is not a good indicator of financial viability of an organization. Again, if the current ratio is too high, higher than 3 by most industries’ standards, then it means that there is a problem of management of working capital.

The debt-to-asset ratio is used to manage the debts that the company may have. It shows the extent to which the company has borrowed funds for investment. A low ratio means that the company has borrowed very little funds to invest in its business. A high ratio shows that the company has used a lot of borrowed funds for its investment. In general terms the lower the ratio the better it is for that company, since it has got very little money to pay back. It means that there is more money for expansions or for paying out as dividends. A high debt-to-asset ratio shows that there is a financial risk that the company faces. If a company has a low debt-to-asset ratio and it requires borrowing money then it can go on and do that. A company with a high debt-to-asset ratio must avoid borrowing more money. However, the best ratio is determined on an industrial level. It is best to compare debt-to-asset ratio of many firms in the industry and in the economy, before making a final decision.

Earnings per share show the performance of the firm in terms of profit. This ratio shows the profit that has been earned by the company that is going to be paid to the shareholders. This ratio is utmost significance to investors and potential investors, especially if it is shown on a time-series basis. If the EPS is decreasing on a yearly basis it means potential investors won’t come in and existing investors may pull out. If the EPS is increasing on a monthly basis then potential investors come in. It is important to compare the EPS of companies in the same industry. The EPS varies from industry to industry. Usually the industry EPS average is a very good comparison point. If the EPS is lower than the industry average investors may shun such a firm; however, if the EPS is higher than the industry average investors are more likely to come in. Both industrial comparison and trend analysis are very essential in coming with a good position of the viability of a firm by using EPS value for comparison.

Market capitalization is an important indicator of how worth the business is doing within the market. This is particularly important if the company is listed on the stock exchange. Market capitalization is a very essential assessment tool for the viability of similar companies within the same industry; this is particularly important where people are evaluating companies with a chance of merging or for acquisition purpose. A certain market capitalization is considered viable in a certain industry and economy. One cannot look at a figure and just judge the company viability using market capitalization. It is used mostly in comparison.

Reference
Definitions of 'current ratio' and meaning of 'current ratio '

www.qfinance.com/dictionary/current-ratio

Current Ratio

www.spireframe.com/define/financial-ratio/current-ratio

Earnings per Share (EPS) - ReadyRatios.com

www.readyratios.com/reference/accounting/earnings_per_share_eps.html

How Earnings per Share is Important - InvestorWords.com

www.investorwords.com/tips/614/how-earnings-per-share-is-important.html

Understanding Basic EPS and Diluted EPS in the Stock Market

beginnersinvest.about.com/od/investingglossary/a/basic-EPS-diluted-EPS-definition.htm

Inventory turnover

The inventory turnover relates to the number of times that a trader or company has bought and sold its merchandise. Inventory is a term that means the goods which a company has in stock which it intends to sell. The inventory turnover is achieved by dividing the cost of goods sold by the average inventory. The average inventory is obtained from the balance sheet. The figure which we obtain shows the number of times that the inventory has been turned over during a financial period, which is mainly a year.

Simply stated, inventory turnover = cost of sales/ average inventory for the period. If the turnover is 4, it means the inventory of that company has been turned four times during the year. If the figure is five it means that the stock has been replenished five times during the year. A low ratio means that the company’s stock was selling at a very slow rate during the year. A very low figure means that some of the stock is obsolete. It shows that the company need to manage its stock properly. This is the case where a company may be forced to reduce the prices of its goods.

Receivable turnover

The account receivable shows how easily the trader collects debts from its customers. The receivable turnover is obtained by dividing credit sales by the average receivables. The formula is: receivables =credit sales/average receivables. If the ratio is very high it means that the trader has been able to collect much of its credit sales. If the figure is very low it means that the company has difficulties in collecting its debts from its clients. The quicker the trader collects its debts the better for the viability of the company.

Reference

Effective Inventory Analysis - Lanham Associates, www.lanhamassoc.com/downloads/EIM6-Effective_Inventory_Analysis.pdf

Inventory Turnover Ratio | Stock Turnover Ratio – Accounting Tools, www.accountingtools.com/inventory-turnover-ratio

What is the inventory turnover ratio? | AccountingCoach.com Q&A

blog.accountingcoach.com/inventory-turnover-ratio-2

Do High- and Low-Inventory Turnover Retailers Respond Differently ...

www.public.kenan-flagler.unc.edu/faculty/kesavans/DemandShock.pdf

Year 2000, June thru July. Shows Inventory Items with Ratios, www.eaglebusinesssoftware.com/ebms/modules/reports/in turnover ratio.pdf

Cash realization Cycle

Cash realization cycle is an essential management tool. It shows us how effective we are at managing working capital. Working capital is the life blood of any business venture. The cash realization cycle is used in evaluating the performance of a business. Investors examine the cash realization cycle to evaluate the viability and potential of the business. Before potential investors put in their money in the business they want to know how long the cash they inject is likely to realize profit or when they can recoup the money. Equally important banks use that information to evaluate the creditworthiness of a business venture. This essay is going to explore the meaning and significance of the cash realization cycle to a firm.

The cash realization cycle refers to the period of time that elapses from the time that an investor injects some money into the business to buy inputs and perform some essential business activities and the time that the goods are sold to the time that the cash is obtained from the sale of the goods. In a production business there are a number of

Activities that are performed during this cycle; these include: buying some raw materials, producing the goods, stocking the goods and selling the goods. Since most of the goods are sold on credit, the cycle includes the time we wait until the customers pay off their credits. As for the other trading companies, the cycle begins at the point at which the traders pay the money for the acquisition of the merchandise. Then this cycle extends until the customer pays the goods and until the firm pays off its suppliers.

The cash realization cycle can be broken down into three phases namely: inventory turns in days, accounts receivable turns in days and the accounts payables.

Age inventory in days is obtained by dividing 365 days by the inventory turnover. Similarly the collection period named receivables in days is obtained by dividing the 365 by the receivable turnover. The following is the formula for the cash realization cycle:

Cash realization cycle =days inventory outstanding + days sales outstanding – days payable outstanding.

In principle the shorter the cash realization cycle the better. A short cash realization cycle indicates that the trader can get the money from his/her investment as soon as possible and therefore be able to reinvest his/her money in the business. At the end of the year he would have obtained a better return for his money. The short cash realization cycle can be achieved by having the shortest days inventory outstanding and the shortest days sales outstanding, yet having the longest days payable outstanding as possible. This analysis tells us that management must ensure that the days inventory outstanding is made as short as possible. This can be done by having a rigorous marketing effort and strategy. On the other hand days sales outstanding must be shortened by having a strong follow up on creditors so that money from sales is received as early as possible. Yet still management may delay the payment of money to its suppliers in order to lengthen the days payable outstanding. This ensures that money remain circulating in the business for a longer period.

There may be some problems in achieving the shortest cash cycle. As much as the company wants to receive the money early from the creditors, the creditors would be working harder to extend the time it keeps its cash before paying it out to its creditors. Sometimes the creditors may have poor cash flows and may only be viable if the pay off their debts in phases and in less amounts than we anticipate. In its attempt to pay late money to its suppliers the company may risk being cut off in supply by these suppliers.

Therefore the company must study the business environment carefully and must understand the domestic economy well in order to manage its cash realization cycle well. It is equally well to be conversant with the industry’s statistics so that you fit well in the nature of business. The industry may dictate the length of the cash realization cycle. The state of the national economy may also dictate the length of the cash realization cycle. So, all the various factors must be considered in evaluating the firm’s cash realization cycle.

Reference

1. Measuring the Cash Conversion Cycle in an International Supply.

(Sep 9, 2005) retrieved from: www.bus.tu.ac.th/usr/Ruth/file/C2C LRN 2005.pdf

Understanding and Using the Cash Conversion Cycle - QFINANCE .Retrieved on April 20, 2013 from:www.qfinance.com/cash-flow-management-

Net present value of a project

There are several ways in which an investor can evaluate the possibility of profitability or viability of a project. These methods include: payback period, profitability index, internal rate of return, accounting rate of return and net present value. The net present value and the internal tare of return are the most commonly used methods of evaluating an investment project. The net present value is the amount of money by which an investment is likely to grow based on the present value of money. The net present value is obtained by subtracting the initial cost of the project from the total cash inflows. There are basically three main steps in calculating the net present value. The first step is to estimate the expected future cash inflow. This is the amount of money which the investor expects to get from the project. After obtaining the estimated cash inflow the next step is to estimate the required rate of return of the project. The third and final step is to calculate the net present value. This is obtained by subtracting the expected cost of the project of the estimated cash inflow.

In short the formula for calculating the net present value is as follows:

Net present value = present value of inflows minus the present value of outflows

NPV = PV inflows – PV outflows

This process indicates the expected financial benefit from undertaking this project. Since the main reason for undertaking a project is to increase or to create wealth for the investor, it means that the potential investor would undertake a project that has the greatest positive net present value. However, by all standards you can accept any project that has got a positive net present value. A positive net present value means that the investment is expected to create more wealth to the firm or the investor. All the same, still, a net present value of zero is acceptable because it shows that there is a possibility of a return that is equal to the required rate of return. On the other hand a net present value that is less than zero is not acceptable. The reason is that it shows that the return is less than the expected rate of return. It is shows also that there is a high risk in undertaking such an investment. So, there is need to careful analyzing potential projects to ensure that you get the expected return.

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