Financial activity of a company

Theme: Financial activity of a company• Questions:

• Finance and financial relations of a company. Financial management.

• Financial sources of a company. • Financial statements and the system of financial

indicators (liquidity ratios, profitability ratios, solvency ratios).

• Fiscal pressure at the level of a company. The impact of taxation on the financial results of a company(essay)

• Finance of a company means a system of monetary relations, related to the creation, use, distribution and redistribution of monetary funds of a company.

• Finance fulfills basically two functions: distribution and control.

• The most important goal of the distribution function is to create and use effectively the income and assets of the enterprise.

• Control function of finance can be realized through reporting on financial performance.

• The finance of a company is based on the following principles:

• autonomy in the field of financial and economic activity;

• self-financing of the activities and development;

• self investing; • reserving funds in order to prevent the risks; • the use of borrowed funds on the base of

financial stability, commitment to the State (taxes and duties) and partners (contracts).

Financial management

• Financial management refers to the efficient and effective management of money (funds) in such a manner as to accomplish the objectives of the organization

• Financial management is the management of the financial relations of the company.

• Financial management is carried out through the financial mechanism, combining forms, methods, means, legal, regulatory and information provision.

• Financial management should ensure satisfactory state of a company, which is characterized by a set of indicators.

• Financial relations include relations with:• counteragents regarding revenue generation and

utilization of funds;• partners regarding the distribution of profit from joint

ventures, purchases (sales) of securities, receiving interest, dividends, etc.;

• customers in accordance with the treaties and regulations; • the banking system's regarding cash-settlement service,

obtaining and repaying loans, provision of temporarily free funds;

• insurance companies about property insurance, transactions, etc.;

• the Government looking to taxation; distribution of productive transfers.

FINANCIAL MARKET

MARKET PATICIPANTS

Suppliers

Debtors

Government

Creditors

Customers

Financial relations

• Financial management is important functional area of management.

• All other functional areas such as production, management, marketing, personnel management, etc. depends on the Financial management.

• Efficient financial management is required for survival, growth and success of the company or firm.

• Many firms have failed because their managers did not pay enough attention to finances.

Scope of Financial Management

• The scope of financial management includes the following five 'A's.

• Anticipation : Financial management estimates the financial needs of the company.

• Acquisition : It collects finance for the company from different sources.

• Allocation : It uses this collected finance to purchase fixed and current assets for the company.

• Appropriation : It divides the company's profits among the shareholders, banks, etc. It keeps a part of the profits as reserves.

• Assessment : It also controls all the financial activities of the company

Financial management consists of all those activities that are concerned with obtaining money and using it effectively.

Effective financial management begins with determination of the firm’s financing needs.

Money is needed both to start a business and to keep it going.

Short-term financing needs Long-term financing needs– Monthly expenses Business start-up costs– Current inventory needs New-product development– Speculative production Lon-term marketing activities– Short-term promotional needs Expansion of facilities– Cash-flow problem Replacement of capital assets– Unexpected emergencies Mergers and acquisitions

• Proceeding from the necessity to implement the financial relations each company need to attract the financial resources

• through their own sources (internal), and • through borrowing money for short – term or long – term,

and • through government subsidies or grants (external sources).

• Internal sources of financing:• Retained profit (profit kept by company for future activity);• Selling assets ( money raised by selling off an asset no

longer needed);• The authorized capital of the company;• Reserve funds, and so on.

External sources of the financing

• Equity financing ( money received from the sales of common and preferred stocks);

• Debt financing:• A). money obtained through short-term and long-

term borrowing;• B). Money obtained through issuing corporate

bonds (large corporation);• Government and other financial institutions’

subsiding.

• There are at least two reasons why equity financing is attractive to large corporations;

• The corporation need not to repay money obtained from the sale of stock, and it need not repurchase the shares of stock at a later date;

• A corporation is under no legal obligation to pay dividends to stockholders.

• There are two types of stock: common and preferred. Each type has advantages and drawbacks as a means of long-term financing.

FINANCIAL RESOURCES OF A FIRM

Short-term banking loans

Owned capital

Long-term banking loans

Banking loans’ repaid interest

Taxes

Repaid dividends

TR/profit

Financing of non-productive sphere Investments Financing of

current activity

Repaid dividends

Sources and movement of the financial resources of a company

FINANCIAL ACTIVITY= (financial statements/

information/calculations)

Investment activity

Stock market transactions

Credit operations

Repaid Dividends

Accounting can be viewed as a system for transforming financial data into useful financial information. The financial statements based on the accounting equation, that shows the relationship among the firm’s assets, liabilities and owners’ equity. Assets are the things of value that a firm’s owns

(cash, inventories, equipment, building, patents) Liabilities are the firm’s debt and obligations –

what it owes to others Owners’ equity is the difference between a

firm’s assets and its liabilities – what would left over the firm’s owners, if its assets were used to pay off its liabilities

Current and long-term liabilities

Accounts payable are short-term obligations that arise as a result of making credit purchases

Notes payable are obligations that have been secured with promissory notes

Salaries payable and taxes payable are expenses that have been incurred during the current accounting period but will be paid in the next accounting period

Long-term liabilities are debt that need not be repaid at least one year

The standard form of the accounting equation:

Assets = Liabilities + Owners’ equity

Implementation of this equation begins with the recording of the firm’s day-to-day financial transactions.

A balance sheet (or statement of financial position) is a summary of a firm’s assets, liabilities and owners’ equity accounts at a particular time. It shows the monetary amounts that enter into the accounting equation.

On a balance sheet assets are listed in order, from the most liquid to the least liquid.

A firm’s balance sheet provides a “picture” of

the firm at a particular time.

Its income statement summarizes its

operations during one accounting period. Both

can be used to answer a variety of questions

about the firm’s ability to do business and stay

in business, its profitability, its value as an

investment, and its ability to repay its debs.

Northeast Art supply, inc. Balance sheet (December 31, 1998)

ASSETS

Current assets

LIABILITIES AND OWNERS’ EQUITY

Current liabilities• cash $ 59.000 Accounts payable $ 35.000

• marketable 10.000securities

Notes payable $ 25.000

• accounts 40.000receivable

Salaries payable 4.000

(–) allowance for 2.000debtful accounts

Taxes payable 6.000

• notes receivable 32.000 Total current liabilities: 70.000

• merchandise 41.000inventoryprepaid expenses 2.000

Total current assets: 182.000

Northeast Art supply, inc. Balance sheet (December 31, 1998)Fixed assets Long-term liabilities

• Delivery equipment 110.000

• mortgage payable on store equipment 40.000

(–) accumulated depreciation 20.000

Total long-term liabilities: 40.000

• furniture and storeequipment 62.000

Owners’ equity• Common stock,

10.000 shares at $15,Par value 150.000

(–) accumulateddepreciation 15.000

• Retained earnings(reinvested) 80.000

Total fixed assets: 137.000 Total owners’ equity: 230.000

Intangible assets Total liabilities and owners’ equity $ 340.000

• Patents 6.000

• Good-will 15.000

Total intangible assets: 21.000Total assets $ 340.000

Northeast Art supply, Inc.Income statement for Year ended, December 31, 1998

Revenues• Gross sales (TR) $ 465.000· (–) less sales returns and allowances 9.500· (–) less sales discounts 4.500

Net sales 451.000

Cost of goods sold· Beginning inventory (January, 1998) 40.000· Purchases inventory (January, 1998) 11.000

Net purchases 335.000· Cost of goods available for sale 375.000· (–) less ending inventory (December 31, 1998) 41.000· Cost of goods sold 334.000

Gross profit on sales 117.000Operating expenses• Selling expenses

Sales salaries 30.000Advertising 6.000Sales promotion 2.500Depreciation – store equipment 3.000Miscellaneous selling 1.500Total selling expenses 43.000

General expenses• Office salaries 18.500• Rent 8.500• Depreciation – delivery equipment 4.000• Depreciation – office furniture 1.500• Utilities expense 2.500• Miscellaneous expenses 500

Total general expenses 36.500TOTAL OPERATING EXPENSES 79.500

Net income from operations 37.500(–) less interest expense 2.000Net income before taxes 35.500(–) less income taxes 5.325Net income (net profit) after taxes 30.175

Accounting and Finance• Types of Information:• Profit and Loss Account –

the revenue and costs of a business over a time period

• Balance Sheet – the assets and liabilities of a business at a specific point in time– Use these sources to give ratios –

the relationship between different aspects of the business

Financial Ratios

A financial ratio is a number that shows the relationship between two elements of a firm’s financial statements.

Types of the financial ratios:

Profitability ratios a measure of how much profit its activities generate(theme 10)

Short-term financial ratios (liquidity ratios) – ability of a business to meet its debts

Long-term debt ratios indicate the degree to which a firm’s operations are financed to borrowing

Ratio Analysis• Return on equity or on capital employed

(ROCE)or on investment– A measure of the efficiency of the firm in using its

capital to generate profit. – A ROCE of 15% suggests that the firm uses every

$1 of capital to generate profits of 15c

Ratio Analysis• Example:• Assume two firms produce identical products

and have identical capital structures:– Firm A – Capital Assets = $1,000,000 – Profit = $250,000– Firm B – Capital Assets = $1,000,000– Profit = $100,000

• Easy to see in this instance that firm A is the more efficient as every $1 of capital generates 25c in profit whereas for Firm B, every $1 of capital only generates 10c profit

• ROCE allows us to have a measure of efficiency for firms with different capital structures

Ratio Analysis

Net Profit ROCE = ----------------------------------- x100 Owners’ Equity

Generally – the higher the ratio, the more effective the firm is in using its capital assets

• Earnings per share= Net Profit available to equity shareholders

Number of issued equity shares

The average profit earned per ordinary share

• Dividends per share= Dividends paid to equity shareholders

Number of issued equity shares

The average dividend received per ordinary share

Ratio Analysis• Liquidity Ratios(short-term financial ratios):

– Look at the ability of a firm to meet its expenditure and how much cash is tied up in the business available to pay for that expenditure

– Careful management of its income and expenditure is important to its cash flow and its ultimate long term survival

• More firms fail through cash flow problems than any other reason

Liquidity Ratios

• Working Capital – having sufficient funds at the right time to be able to meet liabilities– Working capital management

is crucial to the success of a firm

Working capital = the difference between current assets and current liabilities

Liquidity Ratios• The Current Ratio – the proportion

of current assets to liabilities.– A current ratio of 2:1 means the firm

has sufficient liquidity to cover its liabilities twice over

– A current ratio of 0.75:1 would suggest that the firm is unable to meet its liabilities and could be in a weak financial position

• A ratio below 1 does not mean the firm will collapse but it will be in a vulnerable position

Liquidity Ratios• Acid Test Ratio or quick ratio = (Current Assets - Stocks) : Current Liabilities, or(Cash + marketable securities + accounts receivables + notes

receivable )/ Current LiabilitiesThe Acid Test Ratio is a measure of the firm’s ability to pay

current liabilities quickly – with the cash, marketable securities, and receivables.

It gives a clear and quick indication of the state of the firm’s liquid assets.

Comparing the Current ratio and the Acid Test ratio therefore gives an indication of the relative size of the stock holdings of a firm.

Long term debt ratios• They indicate the degree to which a firm’s operations are

financed to borrowing.• Debt to assets ratio indicates the extent to which the firm’s

borrowing is backed by its assets. It is calculated by dividing total liabilities By total assets:

• Debt-to-assets ratio= total liabilities/total assets

• For ex. Ratio of 32% means that slightly less than 1/3 of the assets of a firm are financed by creditors.

• Debt-to-equity ratio compares the amount of financing provided by creditors with the amount provided by owners:

• Debt-to-equity ratio = Total liabilities/owner’s equity

• A ratio of 48% means that creditors have provided about 48 cents of financing for every dollar provided by owners

Summary of financial Ratios for Northeast Art Supply

Ratio FormulaNortheast

Art Supply

Overall Business average

Profitability ratios

• Net profit margin 6,7% 4% - 5%

• Return of equity 13% 12% - 15%

• Earnings per share $ 3,02 per share

Short-term financial ratios

• Working capital Current assets less current liabilities $ 112.00

• Current ration2,6 2,0

• Acid-test ratio 1,99 1.0

Ratio FormulaNortheast

Art Supply

Overall Business average

Activity Rations

• Account receivable turnover

11,9 –

• Inventory turnover 8,2 9

Long-term debt rations• Debt-to-assets

ratio 32% 33%

• Debt-to-equity ratio 48% 33% -

50%

Ratio Analysis• Limitations of Ratio Analysis:

– Usefulness dependent on the accuracy of the figures – Enron, Parmalat?

– Only a part of the jig-saw – needs other information to make full judgement

– What has happened in the past is not necessarily a pointer to what will happen in the future!

– Statistics always have a limitation in that it depends when they are used and how they are used.

– No two businesses are fully comparable as the differences between them will always influence the performance of the business

– Ratios do not always reflect the degree of ‘intuition’/’genius’ that may influence the performance of a businessThe Crooked E – ironic logo of

Enron. Statistics do have their limitations!Source: reubing, stock xchng