The finance manager has the main goal of increasing the value of the stock of the company. This is what the stakeholders of the company consider to be sound financial management.
The investors are concerned about the returns on their investment. When the value of the stock increases, the market share price also increases. However, as much as the focus is on profit maximization, the manager cannot make unethical or illegal decisions.
The profit-making decisions should be ethical and responsible. There are other goals of the finance manager that enable him to accomplish the main goal and ensure business continuity.
The finance manager should consider the competition in the industry and lay strategies on how the company can survive and thrive. It is about beating the competition and maximizing the shares or the market size.
The manager should ensure that the high share value or market price of the stock is steadily maintained each year. His role also includes the management of costs since with inefficiency the profit margin of the company will be low. There are certain decisions that the finance manager is concerned with.
The manager wants to strategize on the long-term assets that the company should invest in in order for the company to get the highest returns. This involves capital budgeting.
The financial resources are limited therefore the manager needs to analyze the project’s return with the firm’s expected rate of return. The finance manager is also concerned with the financing decisions.
How is the firm going to finance its capital projects? The capital structure is mainly made up of debt and equity. There are certain risks in the company using higher levels of debt to finance its projects due to the high interest payments on the liabilities or loans.
The finance manager works to come up with an optimum capital structure or debt/equity ratio. The finance manager has to make decisions concerning the short-term operating cash flows. There is usually a time lag between the timing of the cash inflows and the outflows.
The timing of these transactions may not be known with certainty. It is therefore the responsibility of the finance manager to manage these gaps in cash flows. This short-term management of the cash flows is directly related to the net working capital.
The net working capital refers to the current assets less current liabilities.
There are several responsibilities of the finance manager. He is in charge of maintaining the profitability of the company. The manager gets involved in the budgeting and forecasting processes of the company. The actual and budgeted costs are compared and the variances analyzed and investigated.
The manager analyzes the dynamic and often turbulent market conditions in the industry and uses forecasting tools in the strategic planning of the company.
The finance manager ensures that the books of account and other financial records are maintained. These are the documents required in the preparation of the financial statements. The manager is tasked with the responsibility of ensuring that the financial statements are accurate.
Financial Ratios: Current ratio
This is a ratio used to analyze the ability of the company to settle short-term obligations. It is calculated as follows:
2009 Current ratio = current assets/current liabilities =450,000,000/200,000,000 = 2.25
2010 Current ratio = current assets/current liabilities =580,000,000/325,000,000 = 1.785
2011 Current ratio = current assets/current liabilities =725,000,000/500,000,000 = 1.45
The liquidity ratios of the company are low for both 2010 and 2011. It is recommended that the appropriate liquidity ratio be 2:1. The 2011 liquidity ratio is lower than the 2010 ratio showing it has a higher risk than the year before when it comes to settling short-term obligations.
Acid Test Ratio
This ratio measures the ability of the firm to settle its short-term liabilities without selling its stocks or inventories. It is a stricter ratio than the current ratio.
2010 Acid Test ratio = current assets- inventory/current liabilities = 450,000,000 – 250,000,000/ 200,000,000 = 1.0
2010 Acid Test ratio = current assets- inventory/current liabilities = 580,000,000 – 285,000,000/ 325,000,000 = 0.91
2011 Acid Test ratio = current assets- inventory/current liabilities =725,000,000- 325,000,000/500,000,000 = 0.8
The 2011 acid-test ratio is lower than the 2010 ratio showing the liquidity levels reduced. When it comes to both current and acid test ratios the company should ensure they invest more time in cash management.
This involves someone strategically analyzing the working capital of the company to ensure that the right balance is maintained. It is the comparison of the liquidity of the company and its profitability. The company should not have excess cash so that it cannot invest however at the same time it should not insufficient cash holdings such that it cannot settle its short term obligations.
Accounts receivable turnover
The ratio is used to analyze the suitability of the credit policy of the organization.
2010 accounts receivable turnover = sales/average accounts receivable = 1,500,000,000/150,000,000 = 10
2010 accounts receivable turnover = sales/average accounts receivable
Average accounts receivable= opening + closing accounts receivable/2 = 150,000,000+ 230,000,000/2 = 190,000,000
Accounts receivable turnover = 1,800,000,000/190,000,000 = 9.47
2011 Average accounts receivable= opening + closing accounts receivable/2 = 230,000,000+ 330,000,000/2 = 280,000,000
Accounts receivable turnover = 2,160,000,000/280,000,000 = 7.71
The accounts receivable turnover of the company reduced in 2010 and 2011 which is not advisable since it shows low ability to convert debtors into sales. The management should take steps to ensure that the accounts receivable turnover is increased.
The credit policies should be reviewed and aging analysis carried out. The company should not hold a lot of its assets in accounts receivable. This money needs to be used in investment and other profit making activities. However, a ratio that is too high may show that the company has a restrictive credit policy where it may affects the sales and profits of the company.
Average collection period
This ratio shows the time it takes for the company to receive its payments from its debtors. It is calculated by multiplying the number of days in a period and the average accounts receivable and dividing by the sales.
2009 ratio = 365* 150,000,000/1,500,000,000= 36.5
2010 ratio = 365* 190,000,000/1,800,000,000= 38.53
2011 ratio= 365* 280,000,000/ 2,160,000,000 = 41.31
A lower ratio is preferred because the company needs money to settle its obligations in terms of interest expenses and operating expenses. In 2011, the ratio increased compared to the 2010 ratio. The average collection period needs to shortened for the debtors and the company to continually carry out an aging analysis.
Solvency
These are ratios that analyze the financial stability of a company in terms of the repayment of short-term and long-term debt
Solvency ratio
In most industries, it is considered wise that a company maintains a percentage of 20%. The lower the ratio, the lower the probability of a company is to meet its obligations. It is calculated as a percentage, comparing the after-tax profit of the company less non-cash depreciation expense compared to the short-term and long-term obligations of the company as follows:
Solvency ratio = After-tax profit /short-term + Long-term liabilities*100%
2009 ratio = 93,880,000/450,000,000*100 = 20.86%
2010 ratio = 101,280,000 / 656,120,000*100 = 15.43%
2011 ratio = 120,150,000/ 1,050,740,000*100% = 11.434%
The solvency of the company is quite low and has been decreasing over the three years. It is not advisable to maintain at that level.
Debt-equity ratio
This ratio is used by analysts to investigate what portion of the equity has been financed through debt or equity. It is calculated as follows:
Total liabilities/stockholder’s equity
2009 debt/equity ratio = 450,000,000/ 550,000,000 = 0.82
2010 debt/equity ratio = 656,120,000/ 643,880,000 = 1.09
2010 debt/equity ratio = 1,050,740,000/843,260,000 = 1.246
This shows that a higher proportion of the company equity have been financed through debt through the three years. This affects earnings because additional interest payments may be volatile. The management needs to ensure that the company has a better debt equity ratio.
Debt-asset ratio
This ratio is used by analysts to investigate what portion of the assets has been financed through debt or equity. It is calculated as follows:
Total liabilities/total assets
2009 debt/equity ratio = 450,000,000/1,000,000,000 = 0.45
2010 debt/equity ratio = 656,120,000/1,300,000,000 = 0.504
2010 debt/equity ratio = 1,050,740,000/1,894,000,000 = 0.555
This shows that a higher proportion of the company assets have been financed through debt through the three years. This affects earnings because additional interest payments may be volatile. The management needs to ensure that the company has a better debt asset ratio.
Times interest earned
It shows how many times a company can pay its interest obligations with its pre-tax profit.
No. of times interest earned ratio = EBIT/Interest
2009 ratio = 170,000,000/30,000,000 = 5.67
2009 ratio = 190,000,000/40,000,000 = 4.75
2009 ratio = 270,000,000/85,000,000 = 3.18
This shows that the company’s ratio has been decreasing over the three years. The company could cover its interest payments more times in 2009 than in 2011.
Activity Ratios
These are the financial ratio used to measure the ability of a company to convert several of its accounts into cash or sales.
Inventory turnover
This shows the frequency that the company converts its inventory into sales. It is calculated by dividing the sales by the inventory.
2009 ratio = 1,500,000,000/ 250,000,000 = 6
2010 ratio = 1,800,000,000/ 285,000,000 = 6.32
2011 ratio = 2,160,000,000/ 325,000,000 = 6.65
A low inventory turnover is not encouraged as it shows that the company is holding excess inventory. It shows that it has poor sales. The increasing company ratios show that the company has been getting stronger sales over the years.
Fixed Asset turnover
This measures the ability of the company to use its fixed assets to generate revenue for the company. It is calculated by dividing the sales with the fixed assets.
2009 ratio = 1,500,000,000/ 550,000,000 = 2.73
2010 ratio = 1,800,000,000/ 720,000,000 = 2.5
2011 ratio = 2,160,000,000/ 1,169,000,000 = 1.85
The ratio has been decreasing over the years showing that the company was more efficient in 2009 when it comes to fixed asset turnover.
Total Asset turnover
This measures the ability of the company to convert its total assets into sales. It is calculated by dividing the sales with the total assets.
2009 ratio = 1,500,000,000/ 1,000,000,000 = 1.5
2010 ratio = 1,800,000,000/ 1,300,000,000 = 1.38
2011 ratio = 2,160,000,000/ 1,894,000,000 = 1.14
The ratio has been decreasing over the years showing that the company was more efficient in 2009 when it comes to total asset turnover.
Profitability
Profit margin
This shows the amount or percentage of sales that the company is able to convert into income. It helps the financial analysts in analysis to determine which company is more efficient than another in terms of controlling its costs. It is calculated by dividing net profit by the sales.
2009 ratio = 93,880,000/1,500,000,000= 6.26%
2010 ratio = 101,280,000/1,800,000,000 = 5.63%
2011 ratio = 120,150,000/2,160,000,000 = 5.56%
The company performed poorly in this area as the rate has been decreasing. The company performed better in 2009 as it had a higher profit margin than in 2011.
Return on assets
It is an indication of how efficient the company is in utilizing its assets to generate earnings. It is ratio of net income to total assets.
2009 ratio = 93,880,000/1,000,000,000= 9.388%
2010 ratio = 101,280,000/1,300,000,000 = 7.79%
2011 ratio = 120,150,000/1,894,000,000 = 6.434%
The company performed poorly in this area as the rate has been decreasing. The company performed better in 2009 as it had a higher return on assets than in 2011.
Return on owners’ equity
This is a profitability ratio that shows the returns the company has generated using the shareholder’s funds. It is calculated by dividing the net income with the stock-holder’s equity.
2009 ratio = 93,880,000/550,000,000= 17.07%
2010 ratio = 101,280,000/720,000,000 = 14.07%
2011 ratio = 120,150,000/1,169,000,000 = 10.28%
The company performed poorly in this area as the rate has been decreasing. The company performed better in 2009 as it had a return on equity than in 2011..
Comparison of company’s ratio and industry ratios
There are some industry ratios that have been provided that can be used to analyze the profitability, liquidity, solvency and activity ratios of the company. The industry ratios on profit margin have increased over the three years from 5.75% to 5.81%. This shows that the other companies in the industry were able to earn higher margins on average over the years.
The AED Company’s profit margin however decreased over the three years from 6.26% to 5.56%. The company is not able to control its costs well compared to other companies.
The industry return on assets ratio also improved favorably from 8.22% to 8.48%. Companies on average were able to utilize their assets to generate higher sales. The AED return on assets in 2009 was quite high at 9.388% higher than the average at that time at 8.22%.
However as the years have gone by, the ratio has reduced to 6.434%. Return on equity industry ratios also shot up during the three years to stand at 14.16% in 2011. The AED Company’s return on equity ratio had been higher in 2009 at 17.07% while the industry’s was at 13.26%. However as other companies ratios on average improved the AED ratio decreased significantly to 10.28%.
The industry’s receivables turnover ratios decreased in 2010 but however it picked up in 2011. The companies in the industry had generally decided to extend the credit period to their customers in 2010 but in 2011, they again tightened the credit period.
The AED Company similarly in 2010 extended its credit period since the receivable turnover ratio decreased from 10 to 9.47. However in 2011, as companies tightened their credit policies, the AED Company did not take any such action. In fact it extended the credit period even more as the accounts receivable turnover decreased to 7.71.
These credit practices are confirmed by the ratios of the average collection period where the AED average collection period increased from 36.5 days to 41days. The fixed assets turnover in the industry generally declined from 2.75 to 2.20. This shows that there were challenges in the whole industry in terms of the fixed assets utilization. The AED ratio has also decreased from 2.73 to 1.85.
The industry total asset turnover fluctuated during the three years. It first decreased in 2010 then picked up in 2011. In overall though it increased during the three years since in 2009 it was at 1.43 but in 2011 it was at 1.46. The AED company ratio for total assets turnover decreased during the three years from 1.5 to 1.14. It performed poorly compared to other companies in the industry.
In terms of liquidity, the industry current and quick ratios fluctuated in the three years. Both ratios decreased in 2010 but however picked up in 2011 to surpass the 2009 ratios. The current ratio was above 2 which is the recommended measure in most industries.
For the AED Company, both ratios deteriorated. In 2009, the current ratio and quick ratio were at good levels at 2 and 1 respectively. However in later years, they both went down. Finally, there are industry ratios provided on leverage.
Debt asset ratios increased in the industry from 38% to 40.1% showing many companies were financing more and more of their assets from debt which is not a good sign. For the AED Company, the debt asset ratio had the same increasing trend from 0.45 to 0.55.
The times interest earned ratio in the industry had an increasing trend which is a good sign. However the AED ratio decreased over the three years showing that the company needs better debt management policies.
I would not advise any potential investor to take up AED shares until they perform better in the areas of liquidity, solvency and profitability. The inflation rate played a role in affecting the profitability of companies however if on average the industry managed to get good returns then AED should look into strategies to remain competitive.
Operating and financial leverages
Operating leverage refers to the ratio between the fixed and variable costs in a company. If the fixed costs are higher than he variable costs, the company is highly leveraged. A company that is highly leveraged has the aim of generating higher returns on its investments or assets.
Another factor that is considered when it comes to the operational leverage is the sales and the margins of the company. Highly leveraged firms usually have high margins but fewer sales.
There is a danger where the company forecasts its sales wrongly. This could lead to high differences between the actual and the forecasted cash flows affecting the company’s liquidity and operating activities. Financial leverage on the other hand refers to the relationship or the ratio between the assets and the debt. It aims to analyze the percentage of assets that the company has financed using debt.
A company usually compares the interest rate and the return on the investments before taking a loan. The risk in being highly financial leveraged is that if the ROA is lower than the interest rates on the loan, the firm will find itself in a tight position. In addition, lenders are usually a bit stricter when it comes to giving loans to highly leveraged companies.
Equity is also a valuable source of financing since it is not mandatory for the company to pay cash dividends to its shareholders. However, this only refers to common shares since financing with preference shares is comparable to debt financing as it is mandatory to pay dividends to these stockholders.
There is the risk that the income will not sufficiently cover the interest obligations. This is especially true during an economic downturn where the company is wound up and the shareholders are entitled to their shares.
Working Capital Management
In a company, there are two types of assets. There are fixed assets and current assets. The fixed assets are items such as land and buildings which will take some time to liquidate while current assets refer to assets that are easy to liquidate.
Working capital management refers to the management of the current assets which includes items such as inventory, cash and accounts receivable. These are the assets that are used to settle short-term obligations.
Working capital management is crucial as it plays a role in the company’s profitability and liquidity. The firm should ensure that it maintains a moderate amount of its assets is in the current assets category. A high amount of money tied up in the current assets is not advisable as the firm will get lower returns when it comes to investments.
It will not be able to take advantage of the opportunities that arise to make profit through short-term and other long-term investments. On the other hand, if the company’s current ratio is too low, the company exposes itself to liquidity risk where it will not be able to settle its short-term obligations.
This will lead to a negative reputation as the creditors are not able to get their payments on time. It may affect the ability of the firm to secure credit facilities from its suppliers.
Working capital may also be referred to as the time lag between the purchase or expenditure of the raw material and the sale of the final products to the consumers. The management has to analyze the average collection period. The period may have to be reviewed or shortened where the company has given too much time to the debtors.
It is about analyzing inventory costs such as insurance and storage compared to the costs of stock-outs. The firm also has to take care of the payables. The firm may decide to lengthen the time it takes to settle creditor obligations by negotiating longer periods in order to maintain high liquidity.
Finance managers use the cash conversion cycle to measure whether the working capital management is at an optimal level. The cash conversion cycle refers to the difference between the days of sales outstanding and days of sales in inventory less the days of payables outstanding (Gill, Nahum and Mathur, 2).
The larger the value of the cash conversion cycle, the higher the investments in the working capital. A firm may reason that a higher cash conversion cycle is preferable as it increases profitability through higher sales. However, this practice is detrimental where the costs of holding the inventory and extending trade credit is higher than the profit to be gained.
A firm that has a lower level of current assets as a percentage of the total assets is defined as having aggressive working capital management policies. A firm however that has a high cash conversion cycle is defined as having a conservative working capital policy (Talat, 20).
Works Cited
Gill, Amarjit., Biger, Nahum and Neil Mathur. “The Relationship between Working Capital Management and Profitability: Evidence from the United States”. Business and Economics Journal, (2010): 1-9. Print.
Talat Afza. “Impact of Aggressive Working Capital Management Policy on Firms’ Profitability”. The IUP Journal of Applied Finance, 15.8(2009), 19-30. Print.