QUESTION 1 (15 Marks)

You have been appointed as a Finance Manager of a company outsourcing

information technology services:
(a) Describe your main functions as a Finance Manager.
A financial manager is responsible of the financial section of an organization. A financial
manager processes financial report, coordinate investment activities, develops strategies for the
sort term and long-term financial goals for the organization. The main responsibility of the
financial manager is to monitor the organization’s finances and assists directors in decision
making. However, in today’s world financial management is not only the acquiring of funds but
also plays an important role in collection, management and utilization of funds. There are
different functions of a financial manager in an organization which are as follow:
Capital Investment Decision:
This includes the decision of allocating funds to long term assets which would bring profits in
the future. The investment decision determines the amount of assets held by the company, the
assets composition and the business risk perceived by the supplier of capital. The importance of
investment decision is that the return form the investment exceeds company’s rate of return on
capital.
Financing Decision:
Financial decision is another important function performed by the financial manager. The
financial manager should decide on the sources of money supply. The company must maintain
an optimal mix of equity and debt capital also known as capital structure.
Dividend Decision:
The financial manager should make a dividend policy to determine whether dividend should be
distributed or not and how much should be distributed.
Liquidity Decision:
Liquidity is a company's ability to convert its assets to cash in order to pay its liabilities when
they are due. Current assets should be managed efficiently as it affects the liquidity of the
company and to safeguard from insolvency.
Financial Forecasting:
It is the estimation of the financial requirement and development of the finance structure.
Financial manager should ensure cash inflows and outflows are continuous and uninterrupted for
the smooth running of the company. Hence forecasting should be made on the technical changes,
the capital market and funds necessary for investment.
Analysis and appraisal of financial performance:
Financial manager should perform different financial analysis in order to appraise financial
performance such as ratio analysis, break-even analysis and many more.
Advising Executives:
Financial manager should also advise top management about the financial position of the
organization. His advice is crucial on financial problems and should provide different financial
alternatives.
Procurement of fund:
The financial manager should how much fund should be raised and from which source. He
should also consider the cost of raising funds and its impact on shareholders money, creditors,
employees and society at large.
Apart from these the finance manager has other responsibilities like maintaining the financial
health of the organization, protection and safety of financial documents and making incentive
schemes such as insurance and pension.
(b) What guidelines would you propose to your CEO for effective cash
management?
Cash management consists of the operational and banking processes associated with the
collection, accumulation, holding and distribution of cash. When it comes to financial
management cash is king. The lag between paying suppliers and the time you collect money
from customers, is the problem and the solution is effective cash management. In other words,
cash management means delaying outgoing of cash and encouraging debtors to pay money back
as rapidly as possible. There are different guidelines that can be used for effective cash
management. These can be listed as below:
Measuring Cash Flow
An accurate cash flow projection can help the company to troubleshoot problem well before it
happens. Cash flow projection is normally done for a quarter of for a whole year. Cash flow
plans give an idea what is going to happen in the future. A company can starts it cash flow
projection by adding cash on hand and other cash that will be received from other sources. In
doing so, the company will gather information from salespersons, creditors and finance
department. The company should also take into consideration the amount of cash outflows. In
other words, the company should know its expenditures like, salaries, rent, utilities, debt
payments, advertising and cash dividends. It can be difficult to prepare a cash flow projection but
at the same time it is very important. Cash flow projection ranks next to business mission and
objectives business must do to plan for the future.
Improving Receivables
If a company gets paid for sales instantly, cash flow problem would never happen.
Unfortunately, this is not the case. However, a company can improve cash flow by managing
cash receivables. This is to improve the speed by materials are turned into products, inventory
into receivables and cash. There are certain techniques the company can adopt for doing this:
 It can offer discounts to customers who pay their bills quickly
 At the time of order, ask customers to make deposit payments
 Get rid of old inventory
 Track accounts receivable to identify and avoid slow payment
Managing Payables
When a company is growing, it should watch out on its expenses carefully. Whenever, expenses
are growing faster than sales, the company should examine costs carefully and try to cut or
control the costs. The following can help to manage payables effectively:
 Take advantage of credit payment terms. If payments are due in 30 days, do not pay in 15
days.
 Make payments on the last day due by using electronic funds. This will allow the
company to make use of funds as long as possible.
  A company should communicate its financial situation to its suppliers if ever it needs a
payment delay.
 Choosing lowest price supplier does not mean it will be beneficial for the company. At
times, more flexible payment terms can improve cash flow.
Always Keep Buffer Money
Once the company has found its breakeven point, it should always ensure that it has enough cash
when needed. The best practiced id to have three months’ worth cash handy. It can be in terms of
personal funds, overdraft or revolving credit facility.
Surviving Shortfalls
Sooner or later the company might itself short of money. The key in managing a short of money
is to become aware of the problem as early as possible. Bankers are cautious with business who
need money today itself. They prefer to give money beforehand. When a company is short of
money it means that it has fail to plan and bankers will not be ready to help.
QUESTION 2 (15 Marks). The CEO of a Management company, where you
have been recruited as a Finance Manager, has requested you to carry out the
financial analysis of the latest audited accounts of a client firm. Describe how
would you proceed with this exercise. You may wish to substantiate your
answer with the help of the following types of ratios:
(a) Liquidity Ratios:
Liquidity ratios is used to measure the ability of an organization to pay off its short-term
obligations. These ratios compare the liquid assets to the amount of the current liabilities
stated in the company’s balance sheet. The higher the ratio the better the ability of the
company to pay off its obligations on time. Examples of liquidity ratios are:
Current ratio:
Current ratio compares the current assets to the current liabilities. It is calculated as follows:
Current Ratio = Current Assets
Current Liabilities
Company A has the following information listed on its balance sheet:
Current Assets = $50,000
Current Liabilities = $25,000
Current Ratio = Current Assets / Current Liabilities
So, if
the Current Ratio = $50,000 ÷ $25,000, then
the Current Ratio = 2
Quick Ratio:
Quick ratio is the same as current ratio but excludes inventory. It is also known as acid ratio.
Therefore, the remaining assets should be convertible into cash within a short period of
time.
Quick Ratio = Current Assets – Inventories
Current Liabilities
 (b) Activity Ratios:
Activity ratios is a set of financial ratios that measure the effective of a business to convert its
assets into sales or cash. Activity ratios help to evaluate a business operating efficiency by
analyzing inventories, fixes assets and account receivables. It also indicates how to utilize the
components of the balance sheet. There are different types of activity ratios which are as follows:
Inventory Turnover Ratio:
There is certain business that hold inventory and the activity ratio shows how many times
inventory has been sold during an accounting period. It is calculated as
Inventory Turnover Ratio = Cost of goods sold
Average cost of inventory
For example, the cost of goods sold by company X is $10000 and the inventory cost is $5000.
The inventory turnover ratio is 10000 / 5000 = 2, which means that inventory has been sold twice
in the account period.

Total Assets Turnover Ratio:

It calculates net sales compared to total assets. It shows the ability of a business to generate
revenue from its assets.
Total assets turnover ratio = Sales
Average total assets
For example, the revenue generated by company Y in a year is $8 billion. The total assets at the
beginning of the year was $1 billion and at the end pf the year is $2 billion.
Average total assets = ($1 billion + $2 billion) / 2 = $1.5 billion
Hence, the total assets turnover ratio = $ 8 billion / $1.5 billion = 5.33
Fixed Assets Turnover Ratio:
It measures the efficiency of a business to utilize its fixes assets to generate revenue. It focuses
only on the fixed assets of the business.
Fixed Assets Turnover Ratio = Net Sales
Average Fixed assets

OR

Fixed Assets Turnover Ratio = Net Sales

Gross fixed assets – Accumulated depreciation
Let’s take an example:
Let us consider two independent companies X and Y that manufactures office furniture and

distribute it to the sellers as well as customers in various regions of the USA. The following

information for both the companies is available:

From the above table, the following can be calculated,

Based on the above information calculate the fixed assets turnover ratio for both the companies.

Also, compare and determine which company is more efficient in using its fixed assets?

As per the question,

Average net fixed asset for Company X = (Opening net fixed assets + Closing net fixed assets) /2
The average net fixed asset for Company Y=(Opening net fixed assets + Closing net fixed

asset)/2

Therefore,

Fixed asset turnover ratio for Company X = Net sales / Average net fixed assets
So, from the above calculation Fixed asset turnover ratio for company X will be:

Fixed asset turnover ratio for Company Y = Net sales / Average net fixed assets
So, from the above calculation Fixed asset turnover ratio for company Y will be:

Therefore, company Y generates a sales revenue of $3.34 for each dollar invested in fixed assets
as compared to company X which generates a sales revenue of $3.19 for each dollar invested in
fixed assets. Based on the above comparison, it can be said that Company Y is slightly more
efficient in utilizing its fixed assets.
Accounts Receivables Turnover Ratio:
It determines how good a business is in managing its creditors and debtors. To calculate the
accounts receivables turnover ratio, only the credit sales are taken into consideration and not the
cash sales. A higher ratio indicates that creditors are paying on time and helps to maintain the
cash flow and payments of debtors are also made on time. It shows a healthy business model.
Accounts Receivables Turnover Ratio = Net credit sales
Average accounts receivables
For instance:
Gigs Inc. has the following information –

 Net Credit Sales – $500,000

 Accounts Receivables (Opening) – $40,000

 Accounts Receivables (Closing) – $60,000

First, we will find out the average accounts receivables (net).

 Average Accounts Receivables (net) = ($40,000 + $60,000) / 2 = $50,000.

By using the formula of Accounts receivables turnover, we get

 Accounts Receivables Turnover= Net Credit Sales / Average Accounts Receivables

 Or, Accounts Receivables Turnover= $500,000 / $50,000 = 10 times.

Therefore, accounts receivables turnover ratio is use for

 Accounts Receivables turnover is an efficiency ratio. It is used to see how many times

accounts receivables have been collected during a fiscal year.

  A higher Accounts receivables turnover is healthy for a company. It denotes that the time

interval between the credit sales and the receipt of money is lower. And that means the

firm is quite efficient in collecting the accounts receivables.

 On the other hand, a lower Accounts receivables turnover is not good enough for a

company. It indicates that the time interval between the credit sales and the receipt of

money is higher. And as a result, there’s always a risk of not receiving the due amount.

 When an investor looks at the Accounts receivables turnover, she needs to know how

efficient the firm is in collecting the due amount. If there’s any risk in delaying or not

receiving the payment, it may directly affect the cash flow of the company.

(c) Debt Ratios:

Debt ratio is a solvency ratio that measures a company’s total liabilities as a percentage of its
total assets. In other words, debt ratio shows the ability of a company to pay its liabilities with its
assets. It also measures the financial leverage of the company. It is calculated as below
Debt Ratio = Total Liabilities
Total Assets
As many solvency ratios, a lower ratio is more favorable than a higher one. A lower debt ratio
normally implies a more stable business. Each industry has its own benchmarks but 0.5 is
considered as a reasonable ratio. A ratio of 1 implies that the total liabilities equals the total
assets which means the company will have to all its assets to pay its liabilities.
For instance, if company Z has a total asset of $100000 and a total liability of $25000 the debt
ratio will be
$25000 / $100000 = 0.25
This means that company Z has 4 times as many assets as its liabilities. This is quite a low ratio
and means that the company will be able to pay back its liabilities.
 (d) Profitability Ratios:
Profitability ratio compare income statement accounts to evaluate the company’s ability to
generate profits from its operations. It focusses o the return on investment from inventory
and other assets. In other words, profitability ratio helps to judge whether companies are
making enough profit from its assets. The different types of profitability ratios are:

Gross Margin Ratio:

It compares the gross margin of a company to the net sales and shows how profitable the
company sells its inventory. Gross margin ratio only considers the cost of the goods sold.
Gross margin ratio = Gross margin / Net sales
Assume Jack’s Clothing Store spent $100,000 on inventory for the year. Jack was able to sell this
inventory for $500,000. Unfortunately, $50,000 of the sales were returned by customers and
refunded. Jack would calculate his gross margin ratio like this.

As you can see, Jack has a ratio of 78 percent. This is a high ratio in the apparel industry. This
means that after Jack pays off his inventory costs, he still has 78 percent of his sales revenue to
cover his operating costs.

Profit Margin Ratio:

It is also known as return on sale ratio or gross profit ratio that shows what percentage of
sales are left after all expenses are paid. It also measures how effectively a company can
convert sales into net income.
Profit Margin Ratio = Net income / Net sales
Trisha’s Tackle Shop is an outdoor fishing store that selling lures and other fishing gear to the
public. Last year Trisha had the best year in sales she has ever had since she opened the business
10 years ago. Last year Trisha’s net sales were $1,000,000 and her net income was $100,000.

Here is Trisha’s return on sales ratio.

As you can see, Trisha only converted 10 percent of her sales into profits. Contrast that with this
year’s numbers of $800,000 of net sales and $200,000 of net income.

This year Trisha may have made less sales, but she cut expenses and was able to convert more of
these sales into profits with a ratio of 25 percent.

Example
Charlie’s Construction Company is a growing construction business that has a few contracts to
build storefronts in downtown Chicago. Charlie’s balance sheet shows beginning assets of
$1,000,000 and an ending balance of $2,000,000 of assets. During the current year, Charlie’s
company had net income of $20,000,000. Charlie’s return on assets ratio looks like this.

As you can see, Charlie’s ratio is 1,333.3 percent. In other words, every dollar that Charlie
invested in assets during the year produced $13.3 of net income. Depending on the economy, this
can be a healthy return rate no matter what the investment is.

Investors would have to compare Charlie’s return with other construction companies in his
industry to get a true understanding of how well Charlie is managing his assets.

Return on Assets Ratio (ROA):

ROA measures how efficiently a company can manage its assets to produce profits during a
period. This ratio helps a company to know how well it can convert its investment in assets
into profits.
ROA = Net income / Average total assets

Return on Capital Employed (ROCE):

ROCE is a profitability ratio that measures how efficiently a company can generate profits
from its capital employed by comparing net operating profit to capital employed.
ROCE = Net operating profit / Employed capital
References:
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