TEST BANK For Corporate Finance, 13th Edition By Stephen Ross, Randolph Weste...
Financial management
1. Financial Management
Q1) Write a note on the importance of ‘ratio analysis’
Ratio analysis is a widely used tool of financial analysis used to compare the risk and return
relationships of the firm & is defined as the systematic use of ratio to interpret the financial
statements so that the strengths and weaknesses of a firm as well as its historical performance
and current financial condition can be determined. The term ratio refers to the numerical or
quantitative relationship between two items/variables. This relationship can be expressed in
percentages, fraction & proportion of numbers. These alternative methods of expressing
items which are related to each other are for purpose of financial analysis, referred to as ratio
analysis. It should be noted that computing the ratios does not add any information not
already inherent in the above figures of profits and sales. What the ratios do is that they
reveal the relationship in a more meaningful way so as to enable equity investors;
management and lenders make better investment and credit decisions.
The rationale of ratio analysis lies in the fact that it makes related information comparable. A
single figure by itself has no meaning but when expressed in terms of related figure, it yields
significant inferences. For instance, the fact that the net profits of a firm amount to Rs 10 lacs
throws no light on its adequacy or otherwise. The figure of net profit has to be considered in
relation to other variables. How does it stand in relation to sales? What does it represent by a
way of return on total assets used or total capital employed? If therefore, net profits are
shown in terms of their relationship with items such as sales, assets, capital employed, equity
capital and so on, meaningful conclusions can be drawn regarding their adequacy.
The ratios enable the analysts to draw conclusions regarding financial operations. The use of
ratios, as a tool of financial analysis involves their comparison for a single ratio, like absolute
figures, fails to reveal the true position. For example, if in the case of a firm, the return on in
a particular year, only if the figure is related to the fact that in the preceding year the relevant
return was 12% or 18%, helps to infer whether the profitability of the firm inclined or
declined.
Ratios can be classified into five board groups
Liquidity ratios
Capital structure/leverage ratios
Profitability ratios
Activity or Efficiency ratios
Integrated analysis of ratios
Q2) Write a note on ‘liquidity and capital structure/ leverage’ ratios
Liquidity RatioThe liquidity ratios measure the ability of a firm to meet its short term
obligations and reflect the short term financial strength/solvency of a firm. The importance of
adequate liquidity in the sense of the ability of a firm to meet current/short term obligations
when they become due for payment can hardly be overstressed. Liquidity is a pre requisite for
the very survival of the firm. But from the viewpoint of utilization of funds of the firm,
liquidity implies that funds are idle or they can earn very little. A proper balance between the
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2. two contradictory requirements, that is, liquidity and profitability is required for efficient
financial management.
The ratios, which indicate the liquidity of a firm, are
Net working capital
Current ratios
Acid test or quick ratios
Super quick ratios
Turnover ratios
Defensive interval ratios
Cash flow from operation ratio
Leverage/Capital Structure Ratios helps in examining the long term solvency of the firm.
The long term lenders and creditors would judge the soundness of a firm on the basis of the
long term financial strength measured in terms of its ability to pay the interest regularly as
well as repay the installment of the principal on due dates or in on lump sum at the time of
maturity.
The leverage or capital structure ratios can be defined as financial ratios which throw light on
the long term solvency of a firm as reflected in its ability to assure the long term lenders with
regard to their long term solvency
Periodicpayment of interest during the period of the loan
Repayment of principal maturity or in predetermined installments on due dates
Accordingly there are two different but mutually dependent and interrelated types of leverage
ratios.
The ratios which are based on the relationship between borrowed funds and owners
capital, these ratios are computed from the balance sheet and hence may have many
variations such as debt equity ratio, debt assets ratio, equity assets ratio
The second type of capital structure ratios, popularly called coverage ratios are
calculated from the profit and loss account. Included in this category are interest
coverage ratio, dividend coverage ratio, total fixed charges coverage ratio, cash flow
coverage ratio and debt services coverage ratio
Q3) Write a short note working capital management
Working capital management is concerned with the problems that arise in attempting to
manage the current - assets, liabilities and the interrelationship that exists between them. The
goal of working capital management is to manage the firm’s current assets and liabilities in
such a way that a satisfactory level of working capital is maintained. This is so because if the
firm cannot maintain satisfactory level of working capital, it is likely to become insolvent and
may even be forced into bankruptcy. The current assets should be large enough to cover the
current liabilities in order to ensure reasonable margin of safety
The term current assets refer to those assets which in the ordinary course of business can be
or will be converted into cash within one year without undergoing a diminution in value and
without disrupting the operations of the firm. The major current assets are cash, marketable
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3. securities, accounts receivable and inventory. Current liabilities are those which are intended,
at their inception to be paid in the ordinary course of business within a year out of the current
assets or earnings of the concern. The basic current liabilities are accounts payable, bills
payable, bank overdraft and outstanding expenses.
Each of the current assets must be managed efficiently in order to maintain the liquidity of
the firm while not keeping too high a level of any one of them. Each of the short term sources
of financing must be continuously managed to ensure that they are obtained and used in the
best possible way. The interaction between current assets and current liabilities is therefore
the main theme of the theory of working capital management
Q4) Write a note on (a) motives for holding cash and (b) tool for cash management by a
corporate
Motives for Holding Cash the term cash with reference to cash management is used in two
senses. In a narrow sense, it is used broadly to cover currency and generally accepted
equivalents of cash like cheques, drafts and demand deposits in bank. A distinguished feature
of cash, irrespective of the form it holds is that “it has no earning power”, which defeats the
purpose of holding cash. Having said that, cash, provide a reserve pool of liquidity that
provides cash quickly when needed. There are four primary motives for maintaining cash
balance
Transaction Motive
Precautionary Motive
Speculative Motive
Compensating Motive
Transaction Motive refers to the process of holding of cash to meet routine cash
requirements to finance the transactions which a firm carries on in the ordinary course of
business, so that it can enter into a variety of transactions to accomplish its objectives which
have to be paid for in the form of cash. For example, cash payments that is to be made
towards purchases, wages, operating expenses, financial charges (like interest, taxes and
dividends). Similarly there is a regular inflow of cash to the firm from sales operations,
returns on outside investments and so on. These receipts and payments constitute a
continuous two way flow of cash. To ensure that the firm can meet its obligations when
payments become due in a situation in which disbursements are in excess of the current
receipts, it must have adequate cash balance. The requirement of cash balances between the
payments and receipts to meet routine cash needs is known as the transaction motive and
such motive refers to the holding of cash to meet anticipated obligations whose timing is not
perfectly synchronized with cash receipts
Precautionary Motive in addition to the non-synchronization of anticipated cash inflow and
outflow in the ordinary course of business, a firm may have to pay cash for purposes which
cannot be predicted or anticipated. The unexpected cash needs at short notice may be result of
Natural disaster (flood, earthquake)
Political reasons (strike)
Unexpected failure by so far perfect customers
Bills may be submitted earlier than the expected time
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4. Unexpected slowdown in collection of accounts receivable
A sudden cancellation of some order for goods
Erratic increase in the cost of raw material or distribution
The cash balances held in reserve for such random and unforeseen fluctuations in cash flows
are called as precautionary balances. In other words, precautionary motive of holding cash
implies the need to hold cash to meet certain unpredictable obligations, like a few listed
above. Precautionary cash balances helps as a cushion to meet unexpected contingencies
Speculative Motive refers to the desire of a firm to take advantage of opportunities which
present themselves at unexpected moments and which are typically outside normal course of
business. While the precautionary motive is defensive in nature, speculative motive
represents a positive and aggressive approach. Firms aim to exploit profitable opportunities
and keep cash in reserve to do so. Speculative motive helps to take advantage of
An opportunity to purchase raw materials at a reduced price on cash payment in
advance
A chance to speculate on interest rate movements by buying securities when interest
rates are expected to decline
Delay purchase or raw materials on the anticipation of decline in prices, thereby make
purchase in favorable price
Compensating Motive refers to the process of compensating banks for providing certain
services, benefits and loans. Banks provide a variety of services to business firms, such as
clearance of cheques, supply of credit information, transfer funds etc. while for some of these
services banks charge a commission or fee, and for others they seek indirect compensation.
Usually clients are required to maintain a minimum balance of cash in their bank accounts
which cannot be utilized by the firm for any transaction and will be used by the banks
themselves to earn returns – such balances are called compensating balances.
Compensating balances are also required by some loan agreements between the bank and its
customer. During periods when the supply of credit is restricted and interest rates are rising,
banks require a borrower to maintain the minimum balance in his account as a condition
precedent to the grand of loan. This is presumably to compensate the bank for a rise in the
interest rate during the period when loan will be pending
Of the four primary motives of cash balances, transaction and compensation motives forms
to be the two most important motives, since in most cases, business firms normally does not
speculate and hence need not have speculative balance and the requirement of precautionary
balances can be met out of short term borrowings.
Q5) CASE STUDY (detailed focus on the financial part of the proposal ONLY)
***The financial / non-financial information provided are assumptions only**
The Background
Company ABC has been into the business of manufacturing and selling Water
Heaters, catering to all India market.
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5. The company has an existence for the past 10 years and has been earning good profit
for the past 5 years @ 40% YoY, which is at par with the industry average for the
country.
The company is now contemplating to expand its business by diversifying itself into a
“Home Appliance” manufacturing & selling company.
In order to expand, the company is looking to raise funds from various sources for
setting up Rs 100 Crore project to manufacture a new consumer targeted appliances.
The financial part of the proposal
THE IDEAL FINANCIAL SOURCE FOR EXPANSION PROJECT
The available options have been analysed in details with its pro’s and con’s, in order to arrive
at the ideal source for the financial requirement for our expansion project.
OVERVIEW
Considering the pros and cons of Short Term and Long Term finance options, the
recommended route for our requirement is to go in Short Term. The recommendation is the
outcome of the following
The Business Perspective
Expanding and diversifying into Home Appliances has been the Corporate Strategy.
The home appliances market today is witnessing a 5% growth annual
While the demand for consumer appliances continues to grow, rising commodity
prices and exchange rate woes impact costsand the replacement cycles have shrunk
The number of new local level entrants though a small scale in size is still growing,
thereby creating a local level competition – and hence on a longer run there is a
necessity for continuous reinvention and innovation to keep abreast of the national &
local competition
The Finance Source Perspective
The positives of a Short Term option
Economical -Finance for short-term purposes can be arranged ata short notice and
does not involve any cost of rising. The amountof interest payable is also affordable.
It is, thus, relatively moreeconomical to raise short-term finance.
In contrast, if we go the Long Term route, once we are into to a long-term
agreement, it may be hard to get out of it. If interest rates drop, we will not be able to
renegotiate, however the manner we setup our financing agreement (Standard or
Floating Interest) that may be very risky as that give us a lot of downside risk if
interest rates rise.
Flexibility -Loans can be raisedas and when required. These can be paid back if not
required. Thisprovides flexibility and going forward, we need this flexibility, which
will work in advantage to the company, keeping in mind the Home Appliances
category trend in India, where there is a continuous necessity for innovation, in order
to attract & retain consumers.
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6. In contrast, if we go the Long Term route, the borrowing has to be arrived
considering the longer run requirement, which will turn out to taking too high debt. It
is not advisable &wise to take on so much debt considering that we are venturing into
a new arena
Non-interference in management - The lenders of short-termfinance cannot
interfere with the management of the borrowing. Thereby, enabling the management
to retain their freedom in decision making.
In contrast, as a part of the agreement in the Long Term route, we will have to abide
by certain terms and conditions that are laid down by the lender – which may end up
as an hindrance in decision making. Keeping in mind the fact that we are venturing in
to a new arena, which demands constant innovation, we will have to be a dynamic set
up, enabled and empowered with decision making, that are focused towards growth of
the company
Along with the above, one of the key advantages of going Short Term route is that it
May also serve long-term purposes – Enables us to keep renewing short-term credit,
e.g., cash credit is granted forone year but it can be extended upto 3 years with annual
review.After three years it can be renewed. Thus, sources of short-termfinance may
sometimes provide funds for long-term purposes. The advantage here is, unlike the Long
Term route in a Short Term route we have the scope to negotiate and renegotiate on the
interest charged; we can prepay the loans and arrive at settlements at better speeds; flexibility
to the company in many forms like for example Non-Intervention of the lender into company
decisions.
The decision to go the Short Term route has been arrived after carefully analyzing the
negatives of it. While there are the following negatives in this route, have analysed them in
detail, so that the same can be addressed by appropriate business planning methods.
The Shortcomings of Short Term finance option& the solutions
The primary shortcoming is that the repayment of the debt can at times be felt as a Fixed
Burden. Similar to other methods of borrowing, interest has to be paid on short-term loans
irrespective of profit or loss earned by the organization – but here we have the opportunity to
negotiate for better interest rates, favoring the company
Generally short-term finance is raised on the basis of security of moveable assets. In such a
case the borrowing concern cannot raise further loans against the security of these assets nor
can these be sold until the loan is cleared – we can also work option to deposit shares as a
security instead of an asset (decision to be made by the management)
Legal formalities - Sometimes certain legal formalities are to be complied with for raising
finance from short-term sources. If shares are to be deposited as security, then transfer
deed must be prepared.Such formalities take lot of time and create lot of complications – the
legal team has been appropriately briefed, so that they can be ready to handle the situation if
there is a necessity (incase if management decides to deposit shares as a security)
…….the proposal continues with the other necessary components……
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