fm 1-3
fm 1-3
Financial management can also be d ef ined as a d ecision making process concerned wit h
planning f or raising, and ut ilizing f und s in a manner t hat achieves t he goal of a f irm.
There are many specif ied business f unct ions perf ormed by a business unit . These includ e
market ing, prod uct ion, human resource management , and f inancial management . Financial
management is one of t he import ant f unct ions of a f irm. I t is a specif ied business f unct ion t hat
d eals wit h t he management of capit al sources and uses of a f irm.
The primary f unct ion of account ing is t o gat her and present f inancial d at a. Finance, on t he ot her
hand , is primarily concerned wit h f inancial planning, cont rolling and d ecision-making. The
f inancial manager evaluat es t he f inancial st at ement s provid ed by t he account ant by applying
ad d it ional d at a and t hen makes d ecisions accord ingly.
1
to the required rate of return, then some participants in the market drop out, reducing
capacity and competition.
6. Efficient capital markets – capital markets are efficient and the prices are right. An
efficient capital market is a market in which the values of all assets and securities at any
instant in time fully reflect all available public information. Such markets characterized
by the existence of a large number of profits –driven individuals acting independently.
7. The Agency problem – Managers won’t work for owners unless it’s in their best interest.
It is the problem resulting from conflicts of interest between the managers (agents of
the stockholders) and the stockholders.
8. Taxes bias business decision
In incremental cash flow analysis, the cash flow to be considered should be after- tax
incremental cash flows to the firm as a whole.
9. All risks are not equal – Some risks can be diversified away, and some cannot be. Risk
diversification is the process of reducing risk through increasing the alternatives of
risky investment and other business decisions.
10. Ethical behavior is doing the right thing and ethical dilemmas are everywhere in the
business.
I n general, t he f unct ions of f inancial management includ e t hree major d ecisions a f irm must
make. These are:
I nvest ment d ecisions
Financing d ecisions
D ivid end d ecisions
They d eal w it h allocat ion of t he f irm’s scarce f inancial resources among compet ing uses. These
d ecisions are concerned wit h t he management of asset s by allocat ing and ut ilizing f und s wit hin
t he f irm. Specif ically, t he invest ment d ecisions includ e:
i) D eterm ining the asset m ix or com position: - d et ermining t he t ot al amount of t he
f irm’s f inance t o be invest ed in current and f ixed asset s.
ii) D eterm ining the asset type: - d et ermining which specif ic asset s t o maint ain wit hin
t he cat egories of current and f ixed asset s.
2
iii ) Managing the asset structure, i.e., maint aining t he composit ion of current and f ixed
asset s and t he t ype of specif ic asset s und er each cat egory.
The invest ment d ecisions of a f irm also involve working capit al management and capit al
bud get ing d ecisions. The f ormer ref ers t o t hose d ecisions of a f irm af f ect ing it s current asset s and
short – t erm liabilit ies. The lat er, on t he ot her hand , involves long – t erm invest ment d ecisions
like acquisit ion, mod if icat ion, and replacement of f ixed asset s.
Financing Decisio ns
The f inancing d ecisions d eal wit h t he f inancing of t he f irm’s invest ment s, i.e., d ecisions whet her
t he f irm should use equit y or d ebt f und s in ord er t o f inance it s asset s. They are also concerned
wit h d et ermining t he most appropriat e composit ion of short – t erm and long – t erm f inancing. I n
simple t erms, t he f inancing d ecisions d eal w it h d et ermining t he best f inancing mix or capit al
st ruct ure of t he f irm.
The d ivid end d ecisions ad d ress t he quest ion how much of t he cash a f irm generat es f rom
operat ions should be d ist ribut ed t o owners in t he f orm of d ivid end s and how much should be
ret ained by t he business f or f urt her expansion. There are t rad e of f s on t he d ivid end policy of a
f irm. On t he one hand , paying out more d ivid end s will make t he f irm t o be perceived st rong and
healt hy by invest ors ; on t he ot her hand , it will af f ect t he f ut ure growt h of t he f irm. So t he
d ivid end d ecision of a f irm should be analyzed in relat ion t o it s f inancing d ecisions.
Areas of Finance
What is exactly managerial finance or finance in general? What are the major responsibilities
and duties of managers of finance? In order to answer these questions, you need to understand
the areas that finance covers. Finance, in general, consists of three interrelated areas: (1) Money
and capital markets, which deal with securities markets and financial institutions; (2)
investments, which focus on the decision of investors, both individuals and institutions, as they
choose among securities for their investment portfolios; and (3) financial management or
"business finance" which involves the actual management of business firms. The career
opportunities within each field are many and varied, but managers of finance must have
knowledge of all the three areas if they are to perform their jobs well.
3
1) Money and Capital Markets: - Most of the finance professionals go to work for financial
institutions, including banks, insurance companies, investment companies, credits and savings
associations. For you to succeed in doing such jobs you need a knowledge of the factors that
cause interest rates to rise and fall, the regulations to which financial institutions are subjected,
and the various types of financial instruments such as bonds, shares, mortgages, certificates of
deposits and so on. You also need a general knowledge of all aspects of business administration,
because the management of financial institutions involves accounting, marketing, personnel
management, computer science as well as financial management. An ability to get people to do
their job (i.e. people skills) is very critical.
2) Investments: - Finance graduates who go into investment areas generally work for
brokerage houses in the sales of securities or as security analysts. Others work for banks
and insurance companies in the management of investment portfolios, or they work for
financial consulting firms which advise individual investors or pension funds on how to
invest their funds. The three major functions in the investment area are (1) sales of
securities (2) the analysis of individual securities, and (3) determining the optimal mix of
securities for a given investor.
Generally, the investment decision is concerned with managing the firm by allocating and
utilizing funds wisely with in the firm. It is determining the total birr amount
The types of jobs encountered in financial management range from decisions regarding plant
expansion to choosing what types of securities to issue to finance the expansion. Financial
managers also have the responsibility for deciding the credit terms under which customers
may buy, how much inventory the company should carry, how much cash to keep on hand
whether to acquire other company (merger analysis) and how much of the firms earnings to
retain in the business versus payout as dividends.
Regardless of which specific area of finance you are emphasizing on, you need knowledge of
all the three areas (i.e. money and capital market, investments, and financial management).
For example, a banker lending to businesses cannot do the job properly without a good
understanding of financial management, because he or she must be able to judge how well
the businesses are operating. In the same way, company's financial managers need to know
what their bankers consider important and how investors are likely to judge their company's
performance and thus determine their stock prices.
4
The Central Role of Capital and Goal of the Firm
Capital, as you know, is essential for the operation of any form of business and financial
management may be defined in terms of the relationship between capital and the business
firm. A business firm, whether it is a newly established or an existing one, must obtain a
certain amount of capital to finance itself in order to produce and sell goods and services to
its customers. Initial capital/funds of the newly formed firm consist of funds secured from
the owners of the firm in the form of equity capital and from the creditors in the form of both
short-term and long-term loans. An existing firm may finance itself by retaining part of its
earnings (plough- back of profit or reinvestment) in addition to the two sources indicated.
The capital of the firm, whether it is generated internally from operations or provided by
owners and creditors, constitutes the sources of the firm’s capital and recorded on the right -
hand side of the balance sheet as liabilities and owners' equity.
The acquired capital is, thus used to employ personnel, to obtain offices and other
manufacturing facilities, inventories, and other assets. The capital is also used for producing
goods and services to meet customers' demands. The acquired assets constitute the uses of
the capital of the firm and are listed in the left-hand side of the balance sheet (i.e assets). The
balance sheet of the firm is thus contains both the uses and sources of the capital of the firm.
The balance sheet records these values at the particular point in time. To complete the
balance sheet, the firm records the results of its operations during a given period of time,
such as a year in its income statement. The income statement, as you know, lists the firms
revenues generated, expenses incurred, and profit earned over a span of time and provides a
measure of the ability of the firm to manage its capital sources and uses. These two financial
statements (balance sheet and income statement) picture a firm as an entity that finances
itself with capital from various sources and puts this capital into various uses in order to
generate the desired amount of revenues and profits. Capital sources and uses must be
carefully managed if the firm needs to be profitable for its financiers. Financial management
is the specialized business function that deals with this problem.
In general, financial management can be defined as the management of capital sources and
uses so as to attain the desired goals of the firm (i.e maximization of shareholders' wealth). A
Firm’s capital consists of items of value that are owned and used and items that are used but
not owned. For example, the office space that a business firm has rented for doing business
and the bank loans that the firm has taken to finance its operations are items of values that the
business firm can use but doesn't own. Capital sources are those items found on the right-
hand side of the balance sheet (i.e., the liabilities and equity section as indicated earlier.)
Examples of the use of the capital of the firm are receivables, inventories, and fixed assets.
The problems and opportunities that financial managers face and the business decisions they
are required to make entirely depend on the purposes or goals of their organizations. Profit
seeking organizations should actually behave in a way they maximize the wealth of their
shareholders. It is very important for you at this point to distinguish between wealth
maximization and profit maximization as goals of business firms. There are two ways in
which the wealth of shareholders changes. These are: (1) Through changing dividend
5
payments, and (2) through the change in the market price of common shares. Hence, the
change in shareholder’s wealth of business firms may be calculated as follows:
1. Multiply the dividend per share paid during the period by the number of shares
owned.
2. Multiply the change in shares price during the period by the number of shares owned.
3. Add the dividends and the change in the market value computed in steps 1 and 2 to
obtain the change in the shareholder’s wealth during the period.
In order to maximize the wealth of shareholders, a business firm must seek to provide the largest
attainable combination of dividends per share and stock price appreciation. But the problem is
that while a business firm may have some degree of freedom in setting its dividend policy that is
in accordance with wealth maximization goal, it can not influence the prices of shares, which are
basically set by the interaction of buyers and sellers in the securities/stocks markets. Stock
prices tend to reflect the perception of the stockholders on the ability of the business firm to earn
profits and the degree of risks that the business firm assumes in generating its profit. The
ultimate risk that the business firm usually faces is the probability that it will fail or go bankrupt.
In such an event, the owners/shareholders of the business firm would see their investment
becoming worthless; and the creditors would likely see that at least some portion of their loans
go unpaid. These events have impacts on the market prices of shares which in turn have impacts
on the objective of business firm that is wealth maximization of shareholders.
Profit-maximization, on the other hand, is a traditional micro economics theory of business firms
which was historically considered as the goal of the firm. Profit maximization stresses on the
efficient use of financial/capital resources of the firm. Profit maximization as a goal of the
business firm ignores however, many of the real world complexities that financial managers try
to address in their decisions. Profit maximization largely functions as a theoretical goal in which
economists use it to prove how firms behave rationally to increase profit. When finance was
emerged as a separate area of study, it has retained profit maximization which is the new
concept, profit maximization looks at the total company profit rather than profit per share. Profit
maximization doesn't deal with the company's dividends as either a return to shareholders or the
impact of dividend policy on stock prices.
In the more applied discipline of financial management, however, firms must deal every day with
two major factors: These are uncertainty and timing of returns.
Wealt h maximizat ion means maximizat ion of t he value of a f irm. Hence w ealt h maximizat ion is
also called value maximizat ion or net present value (NPV) maximizat ion.
To und erst and and appreciat e t he essence of wealt h maximizat ion, we need t o consid er t he
various st akehold ers in a given corporat ion. St akehold ers are all ind ivid uals or group of
ind ivid uals w ho have a d irect or ind irect int erest in t he f irm. They includ e st ockhold ers, d ebt ors,
managers, employees, cust omers, government al agencies and ot hers. But among t hese, managers
should give priorit y t o st ockhold ers. I n f act , t he overrid ing premise of f inancial management is
6
t hat a f irm should be managed t o enhance t he well-being or wealt h of it s exist ing common
st ockhold ers. St ockhold ers’ w ellbeing d epend s on bot h current and expect ed d ivid end payment s
and market price of t he f irm’s common st ock.
Wealt h maximizat ion as a d ecision crit erion is consid ered t o be an id eal goal of a f irm in
f inancial management . There are several reasons why wealt h maximizat ion d ecision crit erion is
superior t o ot her crit eria. First , it has an exact measurement unlike prof it maximizat ion. I t
d epend s on cash f lows (inf low s and out f lows). Second , wealt h maximizat ion as a d ecision
crit erion consid er t he qualit y as well as t he t ime pat t ern of benef it s. Third , it emphasizes on t he
long-t erm and sust ainable maximizat ion of a f irm’s common st ock price in t he f inancial market .
Fourt h, wealt h maximizat ion gives a recognit ion t o t he int erest of ot her st akehold ers and t o t he
societ al welf are on t he long-t erm basis.
Technically, wealt h maximizat ion as a d ecision rule involves a comparison of value t o cost .
Thus, an act ion t hat has a d iscount ed value t hat exceed s it s cost can be said t o creat e value and
such act ion should be und ert aken. Whereas an act ion wit h less d iscount ed value t han cost
red uces wealt h and , t heref ore, should be reject ed . The d iscount ed value is a value which t akes
risk and t iming of benef it s int o account .
Uncertainty of Returns:
Profit maximization as the goal of business firms ignores uncertainty and risks in order to
present the theory more easily. Projects and investment alternatives are compared by examining
their expected values or weighted average profits. Whether or not one project is riskier than
another doesn't enter these calculations; economists do discuss risk, but tangentially. In reality
projects differ a great deal with respect to the risk characteristics, and disregarding this
difference can result in incorrect decisions.
To better understand the implication of ignored risks, let us look at two mutually exclusive
investment alternatives (that is, only one of the two can be accepted). The first project involves
the use of existing plant to produce plastic combs, a product with an extremely stable demand.
The second project uses existing plant to produce electric vibrating combs. The latter products
may catch on and do well, but it could also fail. The optimistic, pessimistic, and expected
production outcomes are given as follows:
Profit figures
Plastic Comb Electric Com
Optimistic outcome $10,000 $20,000
Expected outcome 10,000 10,000
Pessimistic Out come 10,000 0
7
There is no variability that is associated with the possible outcomes of producing and selling
plastic combs because demand for this product is stable. If things go well (optimistic), poorly
(pessimistic), or as expected, the profit will still be the same 10,000 Birr. With that of the
electric combs however the range of possible profit figures varies from 20,000 Birr if things go
well (optimistic), to 10,000 Birr if things go as expected, or to the profit figure of zero if things
go wrong (pessimistic). Here, if you look at just the expected profit figure of 10,000 Birr, it is
the same for both projects and you conclude that both projects are equivalent. They are not,
however. The returns (profit figures) associated with electric combs involve a much greater
degree of uncertainty or risk.
The goal of profit maximization, however, ignores uncertainty (risk) and considers these projects
equivalent in terms of desirability as it refers only to the expected profit figures from t he
projects.
Timing of Returns: Another problem with profit maximization as the goal of business firm is
that it ignores the timing of the returns from projects. To illustrate, let us reexamine our plastic
comb versus electric comb investment decisions. This time, let us ignore risk and say that each
of these projects is going to return a profit of 10,000 Birr during the first year (year 1) but it is
after one year before the electric comb can go into production, while the plastic comb can begin
production immediately. The timing of the profit from these projects is as follow:
Profit figures
Plastic Comb Electric Comb
Year 1 $10,000 $0
Year 2 0 10,000
In this case the total profits from each project are the same, but the timing of earnings from the
investments differs. As we will see later on in the chapter of "the time value" of money, money
has a definite time value. Thus, the plastic comb project is the better of the two. The 10,000 Birr
profit from project during year 1 could be invested in the saving account that earns an interest of
5 percent per annum. At the end of the second year the money would have grown to 10,500 birr
as opposed to the 10,000 Birr profits to be reported at the end of the second year for the electric
comb project. Since investment opportunities are available for the money on hand, we are not
indifferent to the timing of the returns (profits) from these investment opportunities. Given
equivalent cash flows from profits, we want the cash flows to occur sooner rather than later.
Therefore, the financial manager must always consider the possible timing of returns (profits) in
financial decision making.
Therefore, the real-world factors of uncertainty and timing of returns force financial managers to
look beyond simple profit maximization as the goal of the business firm. These limitations of
profit maximization as the goal of business firms leads us to the maximization of the more robust
goal of the business firm, that is, maximization of sharehold ers wealth.
In formulating the goal of maximization of shareholder's wealth, we are doing nothing more than
modifying the goal of profit maximization to deal with the complexities of the operation
8
environment. We have chosen maximization of shareholder's wealth that is maximization of the
total market value of the existing shareholders' common stock because the effect of all financial
decisions is reflected through these prices. The shareholders react to poor investment or
dividend decisions by causing the total value of the firm's stock to fall and they react to good
decisions by pushing the price of the stock up. Obviously, there are some series practical
problems in direct use of this goal and evaluating the reaction to various financial decisions by
examining changes in the firm's stock value. Many things affect stock prices. To employ wealth
maximization as the goal of your business firm, you need not consider every stock price change
to be the market interpretation of the worth of you decision. Other factors such as economic
expectations, also affect stock price movements. What you do focus on is the effect that your
decision should have on the stock price if everything elsewhere held constant. The market price
of the business firm’s stock reflects the value of the firm as seen by its owners. The wealth
maximization as the goal of business firm takes into account uncertainty or risk, time, and any
other factors that are important to the owners of the firm. Thus, again, the framework of
maximization of shareholders' wealth allows for a decisions environment that includes the
complexities and complications of the real-world.
While the goal of the business firm will be maximization of shareholders' wealth, in reality the
agency problem may interfere with the implementation of this goal. The agency problem is the
result of a separation of the management and the ownership in firms. For example, a large
business firm may be run by professional managers who have little or no ownership position in
the firm, owners being the shareholders. As the result of this separation between the decision
makers and owners, managers may make decisions that are no in line with goal of business firm,
or the interest of owners, that is maximization of shareholders' wealth. Professional managers
may attempt to benefit themselves in terms of salary and promotions at the expense of
shareholders. The exact significance of this problem is difficult to measure. However, while it
may interfere with the implementation of the goal of maximization of shareholders' wealth, in
some firms, it does not affect the goal's validity. The costs associated with the agency problem
are also difficult to measure, but occasionally we can see the effect of this problem in the
marketplace. For example, if the market feels that the management of business firm in damaging
shareholders' wealth, we might see a positive reaction in the stock price to the removal of that
management.
9
1) Determining the Size and Growth Rate:
The size of the business firm is measured by the value of its total assets. If the book values are
used the size of the firm is equal to the total assets as indicated in the balance sheet. When this
method of size determination is used, the growth rate of the business firm is measured by the
yearly percentage change in the book values of all the items in the assets section of the balance
sheet.
As the student of financial management, you should be able to understand that business firm that
is large and growing fast and larger doesn't necessarily produce increasing earnings.
As indicated earlier, assets represent investments or uses of capital that the business firm makes
in seeking to earn a rate of return for its owners. The most common asset categories are cash,
inventories, and fixed assets. However, financial institutions, such as banks and insurance
companies, have somewhat different asset categories. They may list loans and advances and
negotiable securities as assets. The percentage composition of the assets of the firm is computed
as ratio of the book value of each asset to total book values of all assets. The choices of the
percentage composition of assets item affect the level of business risk. The asset structure
decision relate to what products and services the business firm should produce. The financial
manager is directly involved in decisions related to the assets structure that makes business firm
more successful in a way it will maximize the wealth of shareholders.
The wealth maximizing assets structure can be described in either of the following ways:
1) The asset structure that yields the largest profits for a given level of exposures to
business risk, or
2) The asset structure that minimizes exposure to business risk that is needed to generate
the desired profits.
In both of the cases (i.e. 1 and 2), the financial manager should recognize that the asset structure
of the business firm is the major determinant of the overall risk-return profile of the firm.
When the business firm finances its investment by using debt capital, the business firm and its
shareholders face added risks along with the possibility of added returns. The added risk is the
10
possibility that the firm may face difficulty to repay its debts as they mature. Stock prices react
to the manner of financing of business firm, as well as, to the subsequent ability or inability of
the firm to manage its capital structure. The added returns come from the ability of the firm to
earn the rate of return higher than the interests and related financing costs of using liabilities.
The added returns may be paid as dividends and/or reinvested in the firm to generate more
profits. This in effect would maximize the wealth of shareholders of the business firm.
Finance becomes a separate area of study around 1900 for the first time. Since that time, the
duties and responsibilities of the financial managers have undergone continuous change, and
expected to change in the future as well. The two main reasons for the ongoing change in the
functions of finance are (1) the continuous growth and increasing diversity of the national and
international economy, and (2) the time to time development of new analytical tools that have
been adopted by financial managers.
Up to 1900, finance was considered as a part of applied economics. The 1890s and 1900s were
the periods of major corporate mergers and consolidations in the American economy. These
mergers and consolidations were gradually transmitted to other economies all over the world.
These activities required unprecedented amount of financing. The management of the capital
structure of companies that had been formed as a result of mergers and consolidations become an
important task, and finance was emerged as distinct functional area of business management.
The major technological innovations of the 1920s created entirely new industries such as radio
and broadcasting stations. These new industries produce not only large quantities of output but
also earned high profit margin. Financial management was found to be important in dealing with
problems related to planning and controlling the liquidity of the newly emerged industries of
that time.
The stock market crash of 1929 and the subsequent economic depression occurred in the
American economy resulted in the worst economic conditions that occurred in the 20th century.
Bankruptcy, reorganization,, and mere survival become major problems for many corporations.
The capital structure which was dominated by debt aggravated the solvency and liquidity
problems of companies. Financial management is additionally responsible for the planning of
the rehabilitation and survival of the business firm.
These cdays, a large number of people are employed and work in manufacturing and service
industries that didn't exist before. Much of this rapid economic growth occurred because the
increased rate of technological advancement. The computerization process in almost all of these
industries is an example of the extent to which our economy has become dependent on new
technologies. cAs new industries have arisen and as older industries have sought ways to adapt to
the rapidly changing technologies, finance has become increasingly analytical and decision
11
oriented. This evolution of the finance function has been influenced by the development of
computer science, operations research and isometrics as tools for financial management
functions.
To summarize, the evolution of finance functions contains the following three important points:
1. Finance is relatively new as a separate business management function.
2. Financial management, as it is presently practiced, is decision oriented and uses
analytical tools such as quantitative and computerized techniques, economics, and
managerial accounting:
3. The continuing rapid pace of economic development virtually guarantees that the
finance function will not only continue to develop but also have to accelerate its pace
of development to keep up with the complex problems and opportunities that
corporate manger are facing.
Chapter Summary
This first chapter has provided you an introduction to finance as the area of study and to
managerial finance as an important business function. The chapter also examined the goal of the
business firm, the commonly accepted goal of profit maximization as contrasted with the more
compete goal of the maximization of shareholders' wealth. This is because of the fact that wealth
maximization goal deals with uncertainty and time in a real world environment. This goal is
found to be the proper goal of the firm. In other words, shareholders' wealth maximization
attempts to take into account both risk and return and is superior in a number of important ways
to that of the traditional economic goal of profit maximization.
Finance first appeared as a distinct area of study around 1900 and initially focused on capital
structure composition. During the great depression, bankruptcy and reorganization, finance
became an important consideration. Since 1950, finance became an important consideration.
Since 1950, finance became decision oriented with respect to both asset and capital structure
management and also became increasingly analytical in nature. The tools of the financial
manager now include accounting, economics, computer science, and quantitative analysis of
operations research.
Chapter - 2
Financial Analysis and Planning
Financial analysis is the process of selection, evaluation and interpretation of financial data,
along with other pertinent information, to assist investment and other financial decisions. It is a
diagnostic tool of analysis that can help management to identify the strength and weakness of the
firm so that corrective actions can be taken starting from planning, and also to consider the
strength of the company as a motive for competitiveness and growth. Financial analysis and its
application in business can be viewed from different perspectives .From the investor’s view point
financial analysis is a tool for predicting the future performance of the firm on which the
investment decision related to this firm can be made. For the creditor financial analysis is used to
show the liquidity and solvency of the firm, so that dependable credit decisions or making loans
in such firms can be made. But the financial manager’s primary task is the acquisition and use
funds so as to maximize the value of the firm based on right decisions made, and financial
management information are useful to make such critical decisions .
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Approaches to financial analysis
Based on the information required for financing and investing decisions, the approaches of
financial analysis include:
➢ Comparison of the performance of a firm with the performance of other firms in the
same industry
➢ Evaluation of the performance or position of a given firm overtime.
➢ Adjusting the financial statements of a firm to a common size financial statement
The data used in analyzing financial statements are contained in the financial statements
themselves such as income statement, balance sheet and statement of retained earnings. In
explaining financial statement analysis, financial statements pertaining to Addis Manufacturing
company are used throughout this chapter.
Income Statement
As you know from you previous courses, income statement measures the profitability of business
firm over a period of time. Though the income statements of many multinational companies
cover a European calendar year, Addis Manufacturing Company has adopted fiscal year that
corresponds with the Ethiopian budget year for an accounting purpose. The Ethiopian budget
year runs from Hamle 1 to Sene 30. Income Statement can also be prepared on a quarterly basis
and referred to as interim income statement. Regardless of the starting and ending dates, or the
length of the time covered, the important point is that income statement summarize the operation
of business firm over a given time interval. As it can be seen from the income statements for
Addis Manufacturing Company, the company's operations generated a flow of revenues (net
sales), expenses, and profits (net incomes) during the two reporting years.
1993 1992
Net Sales Birr 120,000 Birr 110,000
Cost of goods sold 90,000 83,000
Gross Profit 30,000 27,000
Operating Expenses:
1993 1992
Selling expenses 5,000 4,800
General and administrative expenses 8,000 7,600
Depreciation expense 1,100 800
Lease Payments 1,650 1,600
Total operating expenses 15,750 14,800
Earnings before interest and taxes 14,250 12,200
Interest expenses:
Interest on bank notes 550 700
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Interest on Other debt 3,600 3,960
Total interest expenses 4,150 4,660
Earnings before taxes 10,100 7,450
Income taxes (34%) 3,434 2,564
Net Income 6,666 4,976
Balance Sheet
A balance sheet basically summarizes the financial position of the business firm. It usually
contains two sections:
(1) The asset (i.e. uses of funds) section, and
(2) The liabilities and shareholders' equity (i.e. sources of funds) section.
The following is the comparative balance sheet for Addis Manufacturing Company, an ideal
business firm, on Sene 30, 1992 E.C. and Sene 30, 1993 E.C.
Shareholders' equity
1 Common stock, 5Birr par, 2,000,000
14
Shares authorized; 1,300,000 shares
outstanding in 1993 and 1,000,000
shares outstanding in 1992 6,500 5,000
2 Capital in excess of par 14,000 5,350
3 Retained earnings 16,500 12,750
Total shareholders' equity 37,000 23,100
Total liabilities & shareholder equity 82,000 71,000
As indicated in the above comparative balance sheet prepared for Addis Manufacturing
Company, total assets equal total liabilities and stockholders' equity. This statement shows the
mix of liabilities and equity that is used to finance company's assets. The assets of the company
are the investments it had made in profit-seeking activities. Current assets are the most liquid
assets of the company. There of one year, or less. Hence, the Birr value of current asset s is
termed as a gross working capital of the company.
As contrast to current assets, fixed asset division consists of long-term financial claims and
investments in the physical assets such as properties, plants and equipment. The liability and
shareholders' equity section of the balance sheet shows how the company is financed. Liabilities
are values of assets financed by funds from creditors. Current liabilities, as stated earlier, are to
be paid back in later years in the future. The amount of funds provided by the shareholders
directly for Addis Manufacturing company are represented by the common stock and additional
capital in excess of par portions of the shareholders' equity section of the balance sheet.
Retained earnings are part of shareholders' equity obtained as a result of the board of director’s
decision to retain portion, or entire amount of net profits of the company for reinvestment.
The accounting procedures used to generate financial statements are not primarily designed to
provide data inputs for financial statements analysis. As a consequence of this, the financial
statements may not always provide the information that the financial managers need for various
types of business decisions. For example, the assets are listed in the balance sheet at their
historical costs that do not, most of the time, reflect the current market values, or the replacement
costs of these assets. Moreover, some difficulties can be expected in interpreting financial
statement figures individually. For instance, an increase in a balance of an inventory account
could mean:
1 The individual purchases cost more than ever due to increases in prices and that the
physical inventory levels have not increased, or
2 The company is accumulating that it has been unable to sell, or
3 The company is producing, or purchasing inventories in large quantities in anticipation of
increases in the volume of sales in the future.
These clearly show how it is difficult to interpret the balance of a given account separately as it
could mean different things.
15
exhibits one important relationship that exists between the income statement (that summarizes
the operation of the company during a given time period) and the balance sheet (that summarizes
the financial position of the company on the given date). The retained earning account in the
shareholders' equity section of the balance sheet of the company is the accumulation of the net
profit of the company that have been retained over the life time of the company. Every year, the
retained earnings account is increased by an amount equal to the excess of net profit over
dividend declared and distributed during that year. Hence, the ending balance of the retained
earnings account that is computed in the statement of retained earnings links the income
statement and the balance sheet. There are in fact, many other ways in which all of these
financial statements interact with one another.
The following is the statement of retained earnings for Addis Manufacturing Company, an ideal
company, for the year ended Sene 30, 1993 E.C.
Addis Manufacturing Company
Statement of retained earnings
For the year ended Sene 30, 1993 E.C.
As you can see from the statement of retained earnings of Addis Manufacturing Company, the
retained earnings account has a balance of 12,750 Birr on Hamle 1,1992 which is the ending
balance of sene 30, 1992 carried forward. This balance wash shown in the shareholders' equity
section of the balance sheet prepared for Addis manufacturing company on sene 30, 1992. In the
same way the ending balance of the retained earnings account shown in the statement of retained
earnings for Addis manufacturing company for the year ending on Sene 30, 1993 (i.e. 16500
Birr) was reported in the shareholders' equity section of the balance sheet for that year.
Ratio Analysis:
The first step in undertaking financial statements analysis is to read and understand the financial
statement and their accompanying notes with care. This is followed by the computation of ratio
and interpreting what the ratio is to mean (i.e. undertaking ratio analysis). The use of financial
ratios to analyze financial statements is now a common practice to the extent that even
computerized financial statement analysis programs prepare financial ratios as part of their
overall analysis. Both lenders and potential lenders use financial ratios to evaluate loan
applications from borrowing companies. Investors use financial ratios to assess the future tale of
the companies to make investment with. Managers make use of financial ratios in order to judge
the performance of their companies and to control the day-to-day operation of their companies.
Owners make use of financial ratios to evaluate whether their companies are maximizing their
wealth or not.
16
weaknesses in the company. Financial ratios, however, tend to identify symptoms rather than the
problems classing symptoms. A financial ratio whose value is judged to be "different" or usually
high or low may help identify a significant event but doesn't provide enough information that
helps to identify the reasons for the occurrence of the event. The financial ratios are judged to be
high, or low, or acceptable when they are compared with standards. Standard ratios could be:
1 Industry standards, these are standard ratios computed for companies operating in the
same industry. For example, average ratio standards can be developed for textile
industry.
2 Management plans - these are financial ratios are ratios that the management of a give
company set as goals. These are plans of the company and standards against which
actual financial ratios are compared.
3 Historical standards - these are financial ratios developed from the historical records of
the company over say the last 10 years. Historical standards are, therefore, the average
financial ratios for the company for the last 10 years. These ratios can also be used as
standards against which you compare the computed ratios to judge them of high, low or
acceptable.
1. Liquidity Ratios
Liquidity ratios measure the ability of business firm to pay its current liabilities and current
portion of long-term debts as they mature. Liquidity ratios assume that current assets are the
principal sources of cash for meeting current liabilities and current portion of long-term loans.
There are two most widely used liquidity ratios. These are the current and quick or acid ratios.
Current Ratio:
The current ratio is computed by dividing current assets by current liabilities. The current ratios
for Addis Manufacturing Company for 1992 and 1993 are the following:
Current assets
17
It is very difficult to sell all the inventories. Short-term prepayments are unlikely to be
converted to cash. If the less liquid assets constitute significant portion of the total current asset,
you may need current ratio that is even greater than 2.0 times. The current ratios of Addis
manufacturing Company show that the company has 1.96 Birr in current assets for each Birr of
current liabilities during 1992 and 2.22 Birr in current assets for each birr of current liabilities
during 1993. It is very difficult to say these ratios are high or low as we don’t have industry
standard, or management plan or historical standard against we compare these current ratios. But
one can say that Addis Company is more capable in 1993 to pay its current liabilities than in
1992.
Quick Ratio:
Quick ratio is sometimes called the acid test ratio. It serves the same general purpose as that of
the current ratio but more stringent as it exclude less liquid current assets like inventory from
current assets. It considers only quick current assets such as cash, marketable securities, and
account receivables. This is done because inventories, prepaid expenses and supplies cannot
easily be converted back to cash. Thus, the quick (acid -test) ratio measures the ability of the
company to pay its current liabilities by converting its most liquid assets to cash which is easier.
The quick ratio is computed by subtracting inventories, prepaid expense and supplies from
current assets and dividing the remainder by total current liabilities. for Addis Manufacturing
Company the quick ratios are:
Current assets − (Pr epaid epense + Supplies + inventorie s )
Current liabiities
Quick Ratio =
35,000 − (0 + 0 + 18700 ) 16,300
= = 0.91 times
Quick Ratio (for 1992) = 17 ,900 17 ,900
40,000 − (0 + 0 + 20,500 ) 19,500
= = 1.08 times
Quick Ratio (for 1993) = 18,000 18,000
If the company wants to pay the entire amount of its current liabilities by using its quick assets
(i.e current assets minus the sum of inventories, prepaid expenses and supplies), its quick assets
should be equal to or greater than its current liabilities. Thus the Company's quick ratio should
be 1.0 times or more than that. In the case of Addis Manufacturing Company, the quick assets of
91 cents are available to meet each Birr or current liabilities. This implies that the quick assets
are not enough to settle all the current obligations. Unless the company converts the non-quick
current assets to the extent they provide cash that is enough to pay the remaining 9 cents for each
Birr of current liabilities, the company will face difficulty in meeting its obligation. The current
ratio of 1.08 times for 1993, on the other hand, implies that the company has 1.08 Birr of quick
assets for each Birr of current liabilities. Again, the company is in good liquidity position during
1993 compared to 1992.
18
2. Activity Ratios:
Activity ratios measure the degree of efficiency with which the company utilizes its resources.
Efficiency is equated with rapid resource turnovers. Some activity ratios concentrate on
individual assets such as inventory, or accounts receivable while others look at the overall
company performance, or activity. The following activity ratios are discussed for Addis
Manufacturing Company, which is an ideal company considered for an illustrative purpose.
Inventory turnover ratio: This ratio is meaningful for companies like Addis
Manufacturing Company which hold inventories of different kinds. (if could be merchandise,
raw material, processed goods and so on). These ratio measures the number of times per year
that the company sells its inventory. It is computed by dividing the Birr amount of costs of
goods sold by the Birr amount of inventory at the closing date of the accounting period. For
Addis Manufacturing Company, the inventory turnover ratios are:
Costs of goods sold
90,000
= 4.39 times
Inventory turnover (for 1993) = 20,500
In general, high inventory turnover may be taken as a sign of good inventory
management. Other things being the same, higher inventory turnover ratios computed for
Addis Manufacturing Company indicate that the company was able to sell its inventories
4.44 times and 4.39 times during 1992 and 1993 E.c respectively. The
performance/efficiency of the company in selling its inventories was nearly the same
during the two years you cannot say the inventory turnover ratios for Addis Company
show good or bad performance, or high efficiency or low efficiency as long as you don't
have standard inventory turnover ratio to compare with. Inventory turnover ratio, as a
measure of efficiency of business activities, suffers from both conceptual and
measurement problems. For example, high inventory turnover ratio could indicate the
inadequacy of inventory to meet customer demands which results in loss of sales. A low
inventory turnover ratio, on the other hand, can be caused by an increased new product
lines each of which requires some minimum inventory balances which in turn raises the
balance of overall inventory level and lowers the inventory turnover ratio. In both of
these cases, the inventory turnover ratio, if it is used alone, may lead to incorrect
conclusions. This is to mean that high inventory turnover ratio may not always be good.
A measurement problem of inventory turnover ratio emanates from the denominator used
in calculating the ratio. Since the purpose of this ratio is to measure the inventory
turnover rate, the denominator should be a measure of the average amount of inventory
that the company maintained during the year. However, in most of the cases, the figure
used as the denominator is the amount of inventory on hand at the end of the reporting
period because the average inventory balance is not easily obtainable. If the balance of
inventory at the end of the year is not a good representative of the average yearly
19
inventory as a result of seasonal and/or cyclical production and selling patterns, the
usefulness of this ratio is greatly limited.
Total Assets Turnover Ratio:- It measures the relationship between a birr of sales and a birr of
assets, usually on the yearly basis. Basically the company wants to generate as much birr as
possible in the form of sales per a birr of an investment it made in assets. The asset turnover
ratio is a measure of the overall activity of the company. It is computed by dividing the total net
sales of the company by its total assets on the closing date of the accounting period. For Addis
Manufacturing co-the total turnover ratios are:
Net Sales
Total assets turnover = Total assets
110 ,000
= 1.55 times
Total assets turnover (for 1992) = 71,000
120 ,000
= 1.46 times
Total assets turnover (for 1993) = 82,000
The total assets turnover ratio of 1.55 times during 1992 implies that the company was able to
generate 1.55 Birr for a single birr it has invested in its assets during the year. During 1993, on
the other hand, the company was able to make a net sale of 1.46 birr for each birr it has invested
in the total assets. Though the total volume of sales is greater during 1993, the assets turnover
ratios show that the company was efficient in generating higher net sales per birr of investment
in asset in 1992 than in 1993. The decrease in the asset turnover ratio in 1993 may indicate a
decrease in the utilization of the assets for generating the desired sales revenue.
Average Collection Period:- this ratio tries to measure the average number of days it takes for
the company to collect its accounts. The shorter the average collection period, the better will be
the company's activities. As you know, account receivable is resulted from credit sales. Hence,
this ratio relates the daily credit sales to its account receivable balance at the end of the reporting
period. Net sales may be used in the absence of credit sales, though it reduces the quality of the
ratio in measuring the number of days that receivables d o take before their collection. The
average collection period is computed in a two-step procedure. First, you compute the average
daily credit sales (in the absence of credit sales, you may take the average daily sales) by
dividing the 360 days into the total credit sales, or total sales. Second, you compute the average
collection period by dividing the account receivable balance at the end of the accounting period
(preferably the average account receivable if available) by daily credit sales, or daily sales in the
absence of the former. Assuming that all sales are made on account by Addis manufacturing
company, the average collection periods are:
total credit sales
360 days
Daily Credit Sales =
110 ,00
= 305 .56 birr
Daily Credit Sales (for 1992) = 360
120 ,000
= 333 .33 Birr
Daily Credit Sales (for 1992) = 360
20
When total sales are used instead of credit sales in the formula, the average collection period will
face the measurement problem because the cash sales included in the total sales do not have any
link with average collection period. Moreover, the use of the account receivable balance at the
end of the may not represent the month average of accounts receivable when there are seasonal
fluctuations. In this case, the average collection period again suffers from the measurement
problem. The average collection period requires the analyst to provide careful interpretation
even when these measurement problems are overcome, are at least recognized. An increase, or
decrease in the values of average collection period should not be used to evaluate the effort the
company puts in collecting its receivables. If the shorter average collection period during 1992
was caused by the very tight credit policy adopted during that year, it may not be more desirable
than the average collection period of 48 days achieved during 1993 under, say a liberal credit
policy. This is because the credit policies themselves can bring changes to the average collection
period. Stringent credit policy definitely reduces the average collection period. If the small
average collection period of Addis Manufacturing Company during 1992 was caused by reduced
volume of credit sales, it may not be a good indication of good credit collection condition.
Credit granting and the structuring of credit terms are major competitive tools used by the
marketing manager rather than the financial manager. Many companies are forced to set credit
policies which are comparable with the credit policy of the dominant company in the same
industry. The average collection period has to be interpreted in relation the credit term provide
to customers.
Financing ratios:- These ratios provide the basis for answering the question. Where did
the company obtain financing for its investments? The balance sheet leverage ratios
include:
1. Debt ratio or debt-asset ratio: it measures the extent to which the total assets of the
company have been financed using borrowed funds.
For Addis Manufacturing Company, the ratios are computed as follows:
total liabilities
total assets
Debt-asset ratio =
47 ,900
Debt-asset ratio (for 1992) = 71,000
45,000
= 54 .88 %
Debt-asset ratio (for 1993) = 82,000
At the end of 1992, 67.46 percent of the total assets of Addis Manufacturing Company were
financed by funds secured in the form of current and long-term liabilities. The remaining 32.54
21
percent was financed by funds contributed by shareholders and retained from the profits earned
by the company. Similarly, debt financing constitutes about 55 percent of the total assets of the
company during 1993. This leaves 45 percent of the total assets to be financing has declined
during 1993 compared to 1992 signaling good condition. Addis manufacturing company can
borrow much more money during 1993 than it could do in 1992 because the asset structure of the
company was more debt-dominated in 1992 than in 1993. Hence, lenders are willing to give
loans to the company during 1993 when debt-asset ratio is less than during 1992 when debt-asset
ratio is high.
You can't say much about the capital structure of Addis manufacturing company on the basis of
the debt-asset ratios computed above as you don't have any standard debt-asset ratio to be used
as a bench mark. In general, creditors prefer low debt-asset ratios, because the lower the ratios,
the lower the chance of losing their money upon maturity, or liquidation. The owners, on the
other hand, may want higher debt (leverage) ratios because the cost of borrowed money is
usually less than the cost of owners' funds. The debt-asset ratios calculated above for Addis
manufacturing company show that more than half of the company's assets were financed with
funds from creditors during the two years. As a result, the company may find it difficult borrow
additional funds without first raising more equity otherwise, creditors would be reluctant to lend
more money to the company with its debt-dominated capital structure.
Though creditors are willing to give loans to debt dominated borrower at higher interest rate that
commensurate with the high risk they are taking as lenders. The debit-asset ratio of 67.46 percent
for 1992 computed for Addis manufacturing company can also be interpreted as one birr of
investment in the company's assets was made up of the combination of about 67 cents of the
creditors' funds and the remaining 33 cents of the shareholders' funds. During 1993 a birr of
investment in the company's assets was made with about 55 cents of creditors' funds and the
remaining 45 cents was contributed by shareholders.
Long-Term Debt- Equity Ratio:- This ratio measures the extent to which long-term financing
sources are provided by creditors (debt-holders). The ratio is computed by dividing long-term
debts by stockholders' equity. The long-term debt to equity ratios for Addis manufacturing
company are computed as follows:-
Lont term debt
22
debt in the long-term financing. In other words the long-term financing 2.30 birr was made 1
birr from share holders' equity and 1.30 birr from long-term debt. In the same way, a single birr
in the long-term equity financing is combined with 73 cents of long-term debt financing to form
a total long-term financing of 1.73 birr during 1993. In other words, for each birr obtained from
shareholders' equity, the long-term debt holders contributed 73 cents in the long-term financing
during the year. Again, it is very difficult to conclude that the long term debt -equity ratios
computed for Addis Manufacturing Company show good or bad capital structure of the company
as long as you don't have standard long-term debt-equity ratio to be used as a point of reference.
Debt-equity ratio: This ratio expresses the relationship between the amount of the total assets
of the company financed by creditors (debt) and owners (equity). Thus, this ratio reflects the
relative claims of creditors and shareholders against the total assets of the company. This ratio
provides answer to the question: What are the proportions of debts and equity in financing in the
total assets of the company?
The debt-equity ratio is computed by dividing the total debts by the total shareholders'
equity. The debt-to-equity ratios for Addis manufacturing company are the
following:
Total debts
Coverage Ratios:- The ratios are a second category of leverage, and they are used to measure
the company’s ability to cover its financing cost (interest expense) associated with the use of
debt financing. These ratios provide the basis for answering the question of whether the
company has used to much financial leverage. The coverage ratios, most of the time for most
companies, include the following.
Time interest earned ratio (Interest coverage ratio): This ratio measures the extent to
which operating income can decline before the company is unable to meet its annual
interest costs. Failure to meet this obligation can bring legal action by the company’s
creditors, possibly resulting in bankruptcy. This ratio is determined by divid ing earnings
before interest and taxes (EBIT) by the interest charges during the year. Note that
earnings before interest and taxes (EBIT), rather than net income, is used as a numerator
in the formula because interest is paid with the pre-tax income and company’s ability of
paying interest charges is not affected by taxes.
23
The time interest earned ratios (interest coverage ratios) for Addis manufacturing
company during 1992 and 1993 are:
Earnings before int erest and taxes
Interest coverage ratio = Interest exp enses
12,200
= 2.62 times
Interest coverage ratio for 1992) = 4,660
14,250
= 3.43 times
Interest coverage ratio (for 1993) = 4,150
The time interest earned (interest coverage) ratios computed for Addis manufacturing company
reveals that the company’s earnings before interest and taxes are 2.62 times and 3.43 times
higher than the respective interest expenses of the company during 1992 and 1993 respectively.
As long as you don’t have the industry average, you cannot categorize these ratios as high or as
low. But generally speaking, the lower time interest earned ratio suggests that creditors are at
risk in receiving the interest payments that are due; the creditors may take legal action that may
result in bankrupting the company; and the company may face difficulty in raising additional
financing through debt issues as the company is under risk of paying interest charges. A larger
interest coverage ratio, on the other hand, suggests that the company has sufficient margin of
safety to cover its interest expenses; and the earnings before interest and taxes (EBIT) of the
company could decline without jeopardizing the company’s ability to make interest payments.
Fixed Charge Coverage ratio:- This ratio is similar to that of the time-interest-earned
ratio, but it is more inclusive as it recognize other fixed charges such as lease payments,
principal payments of debts, and preferred stock dividend payments. Since principal
payments of debts and preferred stock dividend payments are not tax deductibles and
paid from after tax earnings unlike interest expenses, a tax adjustment should be made for
these payments.
For example the company that is required to effect principal payments amounting to 100
birr from its earnings after taxes (assuming a tax rate of 40 percent) needs its earnings
before taxes to be ( 100 1 − 0.4), or 166.67 birr.
The fixed charges obviously include interest expenses, annual long-term lease
obligations, principal payments of long-term debts, and dividend payments for preferred
stockholders and the fixed charge coverage ratio is defined as:
EBIT + Lease payments
Pr inciple preferred
payment + preferred
int erest + lease Payment +
1 − tax rate
Fixed charge coverage ration =
As you can observe from the above equation, interest expenses and lease payments are not adjusted
for taxes because they are paid from earning before tax, while principal and preferred dividend
payments are adjusted for taxes because they are paid from the after tax earnings (net income)
24
Considering the given income tax rate of 34 percent and the principal payments of 2500 birr and
3000 birr during 1992 and 1993 respectively, the fixed charge coverage ratios for Addis
Manufacturing Company can be computed by using the above mathematical equation as follows:
12,200 + 1,600
2500 + 0
4,660 + 1,600 +
Fixed charge coverage ratio (for 1992) = 1 − 0.34
13,800
= 4,660 + 1,600 + 3,789
13,800
=1.37 times
= 10,049
14,250 + 1,650
3000 + 0
4,150 + 1,650 +
Fixed charge coverage ratio (for 1993) = 1 − 0 . 34
15,900 15,900
= = 1.45times
= 4150 + 1650 + 4 ,545 10 ,345
Addis manufacturing company is able to cover its fixed charges (interest, lease payments, and
principal payments) 1.37 times and 1.54 times using its earnings before interest and taxes during
1992 and 1993 respectively. In other words, the earnings before interest and taxes of the
company are equal to 1.37 times the fixed charges during 1992 and 1.54 time the fixed charges
during 1993.
4. Profitability Ratios:
Profitability is the net result of a number of policies and decisions. The profitability ratios
provide the overall evaluation of performance of the company and its management. These ratios
show the combined effects of liquidity, activity and average ratios on the operating result of the
company. The several ratios falling under this category are discussed in the following
paragraphs.
Gross profit margin:- the gross profit margin ratio is calculated as follows:
Gross profit margin = Gross profit
Net sales
Gross profit margin of Addis co. (for 1992) = 27,000 = 0.2455, or
110,000 24.55%
Gross profit margin of Addis co. (for 1993) = 30,000 = 0.25, or
120,000 25%
Thus, Addis manufacturing company’s gross profit constitutes 24.55 percent and 25 percent of
the company’s net sales during 1992 and 1993 respectively. These ratios reflect the company’s
mark ups on costs of goods sold as well as the ability of the company’s management to minimize
the costs of goods sold in relation to net sales. Larger gross margin ratio implies lower costs of
goods sold rate and vice versa.
Operating profit margin:- Moving down in the income statements, the next profit figure
following gross profit is the operating income (or EBIT). This operating profit figure serves as
25
the basis for computing the operating profit margin. The operating profit, as you know, is the
excess of gross profit over the total operating expenses.
Operating profit margin = Operating Income
Net sales
Operating profit margin (for 1992) = 12,200 = 0.1109, or 11.09%
110,000
Operating profit margin (for 1993) = 14,250 = 0.1188, or 11.88%
120,000
The operating profit margins reflect the company’s operating expenses as well as its costs of
goods sold. Addis manufacturing company remained with 11.09 percent and 11.88 percent of its
net sales after covering its cost of goods sold and all operating expenses during 1992 and 1993
respectively.
Net profit margin ratio:- the net profit margin on net sales measures the profitability of the
company on a per birr basis of net sales. This ratio is calculated by dividing net income by net
sale of the company for a given accounting period. The net profit margin ratios for Addis
manufacturing company are:
Net profit margin = Earnings after taxes
Net sales
Net profit margin (for 1992) = 4,976 = 0.0452, or 4.52%
110,000
Net profit margin (for 1993) = 6.666 = 0.0556
120,000
These net profit margin ratios can be interpreted in such a way that Addis manufacturing
company had earned 4.52 percent, or nearly 5 cents net income per birr of net sales it made
during 1992 and 5.56 percent or nearly 6 cents per birr of sales it made during 1993. Make sure
also that the net profit margin of the company is influenced by the amount of int erest
expenses/charges and income tax expense because net profit is an earning after interest and taxes
(EBIT).
Return on Investment (ROI) – It is also known as return on Assets (ROA). This ratio
measures the company’s profitability per birr of investment in the total assets. The ROI, or
ROA is calculated by dividing earnings after taxes by total assets. The ROIs for Addis
manufacturing company are:
Return on Investment (ROI) = earnings after taxes (net income )
Total assets
ROI (for 1992) = 4,976 = 0.0701, or 7.01%
71,000
ROI (for 1993) = 6,666 = 0.0813, or 8.13%
82,000
Thus, Addis manufacturing company generated 7.01 percent, or about 7 cents in the form of net
income out of each birr it invested in its total assets during 1992, and 8.13 percent, or about 8
cents in the form of net income out of each birr of investment in its total assets during 1993.
Whether the indicated returns on investments are good or bad depends on the industry standards,
or the management plans. But what you can say at this point is that the company’s return on
investment has shown slight improvement in 1993 compared to that of 1992.
26
5. MARKET/BOOK RATIOS:
These ratios are recently introduced into the ratio analysis. They are primarily used for
investment decisions and long-range planning and include:
Earnings per share (EPS): Expresses the profit outstanding during the reporting period. It
provides a measure of overall performance and is an indicator of the possible amount of
dividends that may be expected. The earning per share for Addis manufacturing company is
computed as follows:
Earnings per share (EPS) = Earnings after tax (net income) – Preferred dividend
Number of common shares out standing
Or (EPS) = Earnings available for common stock holders
Number of common shares outstanding
EPS (for 1992) = 4,976-0 = 4,976 = 4.98 Birr/share
1000 shares 1000 shares
EPS (for 1993) = 6,666 - 0 =6,666 = 5.13 birr/share
1,300 1,300
Addis manufacturing company has earned 4.98 Birr per share during 1992 and 5.13 Birr per
share during 1993. The earning per share has shown an increase during 1993 which shows
improved performance of the company during the year. Though, the earnings per share were
4.98 Birr and 5.13 Birr per share during 1992 and 1993 respectively, these ratios do not tell you
how much of these earnings per share is paid as dividend and how much is retained in the
business. Moreover, since you don’t have the industry average or the management plan you
cannot conclude that these earnings per share are indicators of good or bad performance.
Price-to-earnings ratio (P/E): expresses the multiple that the market prices on the company’s
earnings per share and is commonly used to assess the owner’s appraisal of share value. The
price-to-earnings ratio is computed by dividing the market price of a share by the earning per
share computed above. Assuming that at the end of 1992 and 1993 the common share of Addis
manufacturing company has a market prices of 30 Birr and 35 Birr respectively, compute the P/E
ratio of the company.
You can interpret these ratios like this: the market is willing to pay about 6 birr in 1992 and
about 7 birr in 1993 for every birr in the company’s earnings. Again the P/E ratio has shown a
slight improvement during 1993. Since the industry standard or management plan is lacking, it
is very difficult for you to categorize Addis manufacturing company as highly valued or low
valued company. But what you can say in general is that a high P/E ratio reflects the market’s
perception of the company’s growth prospects. Thus, if the investors in the stock markets
27
believe that a company’s future earnings potential is good, they are willing to pay higher prices
for the stock and further boast the P/E ratio. The problem with P/E ratio is that the market price
for a share of common stock may not be available when there is no’ stock market.
Book value per share:- is the value of each share of common stock based on the company’s
accounting records. It is computed by dividing the number of common shares outstanding into
the excess of total stock holders equity over preferred stock. The book value per share ratios
for Addis manufacturing company is computed as follows:
Book value per share = Total stock holder equity – preferred stock
Number of common shares outstanding
Book value per share (for 1992) = 23, 100 – 0 = 23,100 = 23.10
1,000 shares 1000 shares
Book value per share (for 1993) = 37,000 – 0 = 37,000 = 28.46
1,300 shares 1,300 shares
The book value of a share of common stock of Addis manufacturing company is 23 – 10 Birr in
1992 and 28.46 Birr during 1993. This shows that the book value of a share is less than the
market value of a share during the two years. Since we don’t have industry average or
management goal, we cannot say the book values per share ratios are above or below the
industry average, or management plan.
Dividends per share (DPS) : it shows the birr amount of dividends paid on a share of common
stock outstanding during the reporting period. It is determined by dividing the total cash
dividends on common shares by the number of common shares outstanding. Assuming that
Addis manufacturing company distributed a cash dividend to common shareholders of 1,900,000
Birr during 1992 and 2,600,000 Birr during 1993, the dividend per share for the two years are:
Addis manufacturing company paid 1.9 Birr dividend per common share during 1992 and 2 Birr
per common share during 1993.
Dividend payout ratio – It shows the percentage of earnings paid to shareholders. It expresses
the cash dividend paid per share as a percentage of EPS. Dividend payout ratio is computed by
dividing cash dividend per share by earnings per share. The dividend payout ratios of Addis
manufacturing company are computed as follows:
28
Earnings per share
= Total dividend to common stock
Total earnings available for common stock hold
or else
Dividend payout ratio (for 1992) = 1900 = 38.18%
4,976
Dividend payout ratio (for 1993) = 2,600 = 39%
6,666
The dividend payout ratios indicate that Addis manufacturing company paid about 38 percent of
its earnings in the form of dividends for its common shareholders during 1992 and 39 percent of
its earnings was paid in the form of dividends during 1993.
Dividend yield: it shows the rate earned by shareholders from dividends relative to the current
market price of shares. Dividend yield is computed by dividing cash dividend per share by
current market price per share. The dividend yields for Addis manufacturing company for 1992
and 1993 are:-
These are two basic approaches in analyzing a set of financial statements through the use of
financial ratios. These are the cross sectional analysis and the time series analysis. These two
approaches complement each other and both should be used as part of the analysis of financial
statements.
1. Cross-Sectional analysis:
29
This approach enables you to evaluate company’s financial conditions at a given point in time
and compare company’s current performance against that of the previous year. Under cross-
sectional analysis, you compare the ratios of your company against those of its competitors. The
first step in cross-sectional analysis of Addis manufacturing company is to evaluate its financial
position at the end of 1993.
In order to do so, the company’s financial statements are needed. The second step is to compare
the current performance of the company against that of the previous year by comparing the
financial ratios computed for 1992 and 1993 which are summarized in the following table.
Activity:
Inventory turnover --------------------------- 4.44 4.39
Total assets turnover -------------------------- 1.55 1.46
Average collection period -------------------- 39 days 48 days
Leverage:
Total debt to assets --------------------------- 67.46% 54.88%
Long term debt to equity --------------------- 130% 73%
Total debt-to-equity --------------------------- 2.07 1.22
Time interest earned --------------------------- 2.62 times 2.26 times
Fixed charges coverage ----------------------- 1.37 times 1.54 times
Comparing the liquidity ratios of 1992 and 1993 of Addis manufacturing company, both the
current ratio and quick ratio show improvement during 1993. The activity ratios of Addis
manufacturing company imply that the company was less efficient in utilizing its assets in 1993
compared to what it had done during 1993. The leverage (debt management) ratios of Addis
manufacturing company show that the capital structure has been improved during 1993
compared to that of 1992 where the capital structure had been a debt-dominated one. The
profitability ratios also suggest that the company’s performance was more profitable during 1993
than it had been in 1992. The final step in the cross-sectional analysis is comparing the financial
ratios computed for Addis manufacturing company against the average financial ratios computed
for all competing companies in the industry. The result of this comparison tells you the position
30
of Addis manufacturing company regarding its liquidity, activity, leverage and profitability.
Unfortunately we don’t have industry averages in our country to use for comparison purposes.
2. Time series Analysis: - It is the approach that is used to evaluate the performance of the
company over several years. This approach looks for three factors: (1) important trends in the
data of the company. (2) Shifts in trends, and (3) values that deviate substantially form the other
data.
1. Taken by themselves, financial ratios provide very little information that is useful.
2. Ratios seldom provide answers to questions they raise because generally they do not
identify the causes for the difficulties that the company faced.
3. Ratios can easily be misinterpreted for instance; a decrease in the value of a given ratio
doesn’t necessarily mean that something undesirable has happened.
4. Very few standards exist that can be used to judge the adequacy of a ratio or a set of
ratios. Industry average cannot be relied upon exclusively to evaluate a company’s
performance because most of the companies in an industry may perform far below the
acceptable level of performance which lowers the industry average. In some cases, the
industry average ratios may not be available at all that is the problem we encounter in the
case of Ethiopian industries.
5. Many large companies operate a number of different industries and in such cases it is
difficult to develop a meaningful set of ratios to compare against industry average. This
makes ratio analysis more useful for smaller and narrowly focused companies than for
large and multi divisional ones.
6. Inflation has severely distorted balance sheets of companies (recorded values are
usually different from ’true’, or ‘market’ value.) Again since inflation affects both
depreciation charges and inventory costs, profits are also affected. But ratios do not
take these distortions into account unless balance sheet and income statement figures
are adjusted for the effect of inflation.
7. Seasonal fluctuations can also distort the analysis of financial statements through the
31
use of ratios. These problems can be minimized by using monthly averages for
inventories and receivables when calculating turnover ratios.
8. Companies can employ ‘window dressing’ techniques to make the financial
statements look stronger. For instance, the company might borrow on a long-term
basis huge amount of cash towards the end of the accounting period for few days but
back paid in the first week of the subsequent accounting period. This action did
improve the company’s current and quick ratios and made the balance sheet of the
company look good. However, as you clearly understand, the improvement was
strictly due to the “window dressing” technique the company had employed. Under
such situation, it is highly likely to misinterpret both the current and quick ratio as
they signal good liquidity position of the company which in fact is not.
9. It is difficult to generalize whether a particular ratio is ‘good’ or ‘bad’. For example, a
high current ratio may indicate a strong liquidity position which is good, or the
availability of excess cash which is obviously bad as the excess cash is a non-earning
(idle) asset. Similarly, a high fixed asset turnover ratio may denote either a company
that uses its fixed assets efficiently, or one that is undercapitalized and can’t afford to
buy enough fixed asset whose value is used as a denominator when calculating the ratios.
- evaluat ion of a f irm’s need f or increased or red uced prod uct ive capacit y and
- evaluat ion of t he f irm’s need f or ad d it ional f inance
Generally, f inancial f orecast s are required t o run a f irm well. Their base, in almost all
circumst ances, are f orecast ed f inancial st at ement s. An accurat e f inancial f orecast is very
import ant t o any f irm in several aspect s:
Financial f orecast s are also ways f or f orecast ed f inancial st at ement s. By t heir virt ue, a f irm can
f orecast it s income st at ement , balance sheet and ot her relat ed st at ement s. Besid es, key rat ios can
be project ed . Once f inancial st at ement s and rat ios have been f orecast ed , t he f inancial f orecast
32
will be analyzed . Finally, t he f irm’s management will have an opport unit y t o make some
d ecisions bef orehand .
So, all in all, f inancial f orecast ing is a requirement f or t he invest ment , f inancing, as well as
d ivid end policy d ecisions of a f irm.
The f inancial f orecast ing process generally involves t he f ollow ing proced ures:
i) Forecast ing of sales f or t he f ut ure period
ii) D et ermining t he asset s required t o meet t he sales t arget s, and
iii) D ecid ing on how t o f inance t he required asset s.
The above t hree proced ures are very import ant in project ing t he f inancial st at ement s and key
f inancial rat ios. How ever, among t he t hree proced ures, t he f irst one, i.e, sales f orecast is t he most
crucial.
Sales f orecast is a f orecast of a f irm’s unit and birr sales f or some f ut ure period . I t is generally
based on recent sales t rend s and f orecast of t he economic prospect s of t he nat ion, region,
ind ust ry and ot her f act ors. This proced ure st art s usually by reviewing t he sales of t he recent
past s. The w hole crucial point s of a f inancial f orecast ing process lies in an accurat e f orecast of
sales. I f t his proced ure is of f , t he f irm’s prof it ably as w ell as it s value will be negat ively af f ect ed .
So in f orecast ing sales, several f act ors should be consid ered :
1. t he hist orical sales growt h pat t ern of t he f irm at bot h d ivisional and corporat e levels,
2. t he level of economic act ivit y in each of t he f irm’s market ing areas,
3. t he f irm’s probable market share,
4. t he ef f ect of inf lat ion on t he f irm’s f ut ure pricing of prod uct s,
5. t he ef f ect of ad vert ising campaigns, cash and t rad e d iscount s, cred it t erms, and ot her similar
f act ors alike on f ut ure sales,
6. ind ivid ual prod uct s’ sales f orecast s at each d ivisional level.
Forecast of sales is a base f or f orecast ing of t he f irm’s income st at ement which in t urn helps t o
project ret ained earnings. I n f orecast ing t he income st at ement assumpt ions about t he cost s, t ax
rat es, int erest charges and d ivid end s are required .
Sales f orecast s are also ground s f or d et erminat ion of t he f irm’s asset s requirement .
33
I f sales are t o increase, t hen asset s must also grow. The amount each asset account must increase
d epend s whet her t he f irm was operat ing at f ull capacit y or not . I f higher sales are project ed , more
cash will be need ed f or t ransact ions, higher sales will creat e higher receivables. Similarly, higher
sales require higher invent ory and higher plant and equipment .
Finally, t he f irm will f ace t he quest ion of f inancing it s required asset s. Some of t he required
f inance can be covered by t he increased ret ained earnings. The ret ained earnings increment will
result f rom increased sales and prof it . St ill some ot her port ion of t he f inance can be covered by
some liabilit ies which will grow by t he same proport ion w it h t hat of sales. The remaining f inance
must be obt ained f rom available ext ernal sources.
The t hird proced ure of t he f inancial f orecast ing process, i.e. f orecast of f inancial requirement s
involves again t hree sub proced ures. These are:
1. D et ermining how much money (f inance) t he f irm will need d uring t he f orecast ed period . This
will be d one based on sales and asset s f orecast .
2. D et erming how much of t he t ot al required f inance, t he f irm will be able t o generat e int ernally
d uring t he same period . There are t w o t ypes of f inance t hat will be generat ed und er normal
operat ions. The f irst is port ion of t he net income ret ained in t he f irm (ret ained earnings). The
second one is t he increase in t he f irm’s liabilit ies as a d irect and aut omat ic result of it s
d ecision t o increase sales. This f inance is called spont aneous f inance. For example, if sales
are t o increase, invent ory must increase. The increase in invent ory requires more purchases
which in t urn causes t he account s payable t o be increased . The account s payable will
increase spont aneously w it h t he increase in sales. Ot her examples includ e accruals like
salaries and wages payable and income t ax payable.
3. D et ermining t he ad d it ional ext ernal f inancial requirement s. Any balance of t he t ot al f inance
t hat cannot be met wit h normally generat ed f und s must be obt ained f rom ext ernal sources.
This f inance is called t he ad d it ional f und s need ed (AFN).
Required increase Required increase in
A FN = in asset s __ normally generat ed f und s.
34
Additional f unds needed (A FN ) are f und s t hat a f irm must raise ext ernally t hrough borrowing
(bank loans, promissory not es, bond s, et c.) or by issuing new shares of common st ock or
pref erred st ock.
35
Chapter - 3
Time value of Money
Time value of Money:
The concept of interest is one of the core ideas in financial management. Individuals, as well as,
business organizations frequently encounter situations that involve cash receipts and
disbursements over several period of time. When this happens, interest rates and int erest
payments become important considerations. Business organization deals with interest rates when
it makes both financing and investment decisions. Short-term commercial and industrial loans
may be obtained at reasonably lower interest rates while long-term investments in assets like real
estate, machinery and equipment are evaluated on the basis of the profit that the investor
(company) expects out of them. Since, such investment require the commitment of funds over
several year, the expected profits need to be measured in terms of the rates of returns which are
equivalent to the interest returns that can be received on the invested funds.
A company can, therefore, earn a rate of return on its invested funds and a rate of interest on the
funds it lent to borrowers. The key concept that under lies this is the time value of money: that a
birr today is worth more than a birr received a year from now. This is because of the fact that the
value of one birr after a year will grow to one birr and an interest earned on it for it can be
invested, or given as loans during the year. Interest is the price paid for the use of money
overtime. The rate of return/interest can be stated explicitly as it is the case for commercial and
mortgage loans provided by the commercial Bank of Ethiopia (CBE) and Construction and
Business Bank (CBB) respectively. The interest rates are explicitly expressed/stated for both
loans though the rates are subjected to changes from time to time as the CBE has done is the
recent past. Sometimes, the interest rate is implicitly applicable. For instance, if the commercial
Bank of Ethiopia (CBE) offers free checking accounts to customers who are willing to keep a
minimum balance 100 Birr in their account, there is an implicit interest rate for the checking
account opened by a given customer since the 100 Birr is tied up as long as the checking account
is active.
Certainty: - It is the most restrictive assumption. All current and future data values are assumed
to be known with certainty, or a set of techniques exists for estimating all unknown variables.
Certainty also applies to the accuracy of future events and their occurrences. This assumption is
used for simplicity since uncertainty requires the introduction of techniques that cannot be easily
understood.
Discrete Time Period: - Time is divided into yearly intervals. The time that elapses between the
last days of two consecutive years is expressed as one year. For example, year 3 is the time that
elapses from the last day of year 2 and to the last day of year 3. This assumption doesn't require
cash flows to occur on the last day of each year. What is required is that cash flows have to occur
only at points of time that are separated by one year intervals. The assumption, thus, allows us to
36
abstract from specific calendar dates and to measure time from the point at which a particular
investment or financing program begins.
Yearly Interest Computations: - interest is computed once a year and the computation is made
at the end of the year. This assumption is thus, consistent with the discrete time period
assumption made above. In reality, many situations involve monthly, daily, and even continuous
interest computation where by many commercial banks and savings and credit associations offer
daily, or continuous interest compounding on depositors' money.
Compounding Method
There are two ways of depositing payments (money) into an interest bearing account. These are
single payment and series of payments.
A birr you deposited in an interest - bearing account today worth's you more in the future
because the account earns you an interest on the money you have deposited. The process of
going from today's values, or present values (PV) to future values (FV) is called compounding.
To illustrate this, suppose you deposited 100 Birr at the Commercial Bank of Ethiopia (CBE)
that pays 5 percent interest each yea. How much would you have at the end of one year? To
begin, it is very wise to define the following terms:
In our example here, where n = 1, the future (compound) value can be calculated as follows:
FV n = FV 1 = PV + INT (interest)
= PV + PV (i)
= PV (1 + I)
= 100 (1+0.05) = 100 (1.05) = 105 Birr.
Thus, the future value (Fv) at the end of year one, Fv 1 , equals the present value (Pv) multiplied
by 1.0 plus the interest rate, so you will have 105 Birr after one year. Extending our analysis,
37
what would you end up with if you kept your 100 Birr in your bank account four five years?
Here is the time line to show the amount at the end of each year during the five years period.
Note that the value at the end of year two (n=2), 110.25 Birr, is computed as follows:
FV 2 = FV 1 (1+i)
= PV (1+i) (1+i), because FV 1 = PV 1 (1+i)
= PV (1+i)2 = 100 (1.05)2 = 110.25 Birr
Continuing the analysis, the balance at the end of year three (n = 3) is:
FV 3 = FV 2 (1+i)
= PV (1+i)2 (1+i), because FV 2 = PV (1+i)2
= PV (1+i)3
= 100 (1 + 0.05)3
= 115.76 Birr and
FV 5 = PV (1+i)5
= 100 (1 + 0.05)5 = 100 ( 1.05)5 = 127.63 Birr
In general, the future value of an initial sum at the end of n years can be found by applying the
following general equation.
Interest Table
The future value interest factor for i and n (FV1F i,n,) is defined as (1+I)n , and this factor can be
found by using a regular calculator. Interest table is the table that is constructed by using the
future value interest factors. It contains future value interest factors (FV1F i,n,) values for the
wide range of I and n values. Since the term (1+i)n is equal to the FV1Fi,n, the future value
equation for single payment can be re-written as:
FV n = PV (FV1Fi,n,)
To illustrate how to use future value interest factors (FV1F) in computing future (compound)
value of any single payment, consider our five-year, 5 percent interest rate deposit of 100 Birr in
the previous example. The future value of the 100 Birr at the end of year 5 can be determined by
looking for the FV1F5%,5 in the interest table. This is done by looking down the first column to
38
period 5, and looking across that row to the 5 percent column, where we read the value of 1.2763
which corresponds to FV1F5%,5 . This value is, then, plugged into the above equation. That is:
FV s = PV (FV1F5%,5)
FV s = 100 (1.2763)
FV s = 127.63 Birr.
Therefore, the future value at the end of years ( n=5) computed by using the future value interest
factor from the interest table, 127.63 Birr, is exactly the same as the future value we have found
by using the general future value equation for single payment.
1 It is the future value interest factor that corresponds to five periods (n=5) and interest rate
of 5 percent (i = 5%).
Other Application of future value amount of single payment:
The future value equation for single payment stated in this material can also be used to find
interest rates, as well as, members of years that will be needed for the compounded amount to
equal the desired value. Estimating the interest rate on the deposited money is a recurring
problem, when it is not explicitly stated. A useful approach is to treat the interest rate as an
implicit interest rate and found by using the interest table (future value table of single payment).
To illustrate, assume that you have invested 15,000 Birr today at a bank where it can grow to the
future value of 17,000 Birr within three years from now into the future. What is the interest rate
that the bank should pay for your account in order to fulfill your desire? To answer this
question, treat the 15,000 Birr as present value which you have deposited into an account that
pays an unknown interest rate but grows to the compound (future) amount of 17,900 Birr after
three years. Substituting these values into the future value of single payment equation, you get:
FV 3 = PV (1+i)3
17900 = 15,000 (1+i)3
17 ,900
= 1.193
(1+i)3 = FVIFi,3 = 15,000
The future value interest factor in the interest (future value of single payment table)
corresponding to the unknown interest rate (i) and a period of 3 years 9n = 3) is 1.193. Hence,
look up the three year (n=3) row and read horizontally until you find the table value (future value
interest factor) that is equal or the closest to the computed value of 1.193. There is no table
value that is exactly equal to 1.193. The table value of 1.191 is found to be the closest value to
39
1.193 and it corresponds to 6 percent. Thus, the interest that the bank actually has to pay to your
account is slightly greater than 6 percent.
Finding the number of years:- The future (compound) value of single payment equation can
be used to estimate the number of years that are required for a given amount of money deposited
at a specific interest rate to produce or desired compound amount. Assume, for example, a
deposit of 1000 Birr is made in an interest bearing account that pays 10 percent compounded
yearly. Your goal as a depositor is to collect 1,500 Birr after an unknown number of years. How
many years should you wait for the desired amount to be realized?
By substituting the values into the future value of single payment equation, you get:
Again it is possible to look up the 10 percent column in the future value interest factors (future
value) table and read vertically until you find a table value that is equal to 1.5 or closest to it.
The closest table value is 1.611, which corresponds to five years (n =5). That means if the 1000
Birr is kept in the account that pays 10 percent for five years, the resulting compounding amount
will be 1,611 Birr. This amount exceeds the desired amount of 1,500 Birr. If the 1000 Birr is
kept in the account only for four years, the table value is 1.464 Birr. Hence, the 1000 Birr has to
be kept in the account for a period slightly greater than 4 years.
We saw that an initial amount of 100 Birr invested at 5 percent per year would worth 127.63 Birr
at the end of year 5. You are definitely indifferent to the choice between 100 Birr today and
127.63 Birr at the end of the five years, and 100 Birr is defined as the present value, or PV of the
127.63 Birr that is due in 5 years of time when the interest rate or opportunity cost rate is 5
percent. In general, the present value of a cash flow due n years into the future is the amount
which, if it were on hand today, will grow to equal the future value. Since 100 Birr today would
grow to 127.63 Birr in 5 years at 5 percent interest rate, 100 Birr is the present value of 127.63
Birr due 5 years in the future.
Finding the present value of the future cash receipts, or payment is called discounting, and it
simply the reverse of the compounding process. If you know present value, PV, you compound
it to find the future value, FV. In the same way, if you know the future value, Fv, you discount it
to find the present value, PV. When discounting future value, you follow these steps.
40
Time Line. Show the cash flow on the time line
0 5% 1 2 3 4 5
Pv =? Fv5 = 127.63 Birr.
Equation:
To develop the discounting equation, we begin with the compounding equation used in the
previous section.
FV n = PV(1+I)n = Pv (FV1Fi,n )
and by solving for PV in several equivalent form, we arrive at:
FVn 1
= FVn
(1 + i ) n
(1 + i ) n
PV = substituting PV1Fi,n for
1
the term (1 + i) , are get Pv = FV (PV1 F n)
n
n i,
Hence, you can insert the figures into the present value equation inorder to determine the present
value of 100 Birr as indicated here:
1 1
(FV s ) = (127 .63)
(1 .05 )5 = (127 .63) ( 0 .78353 )
(1 + i )
n
PV = = 100 Birr
Tabular Solution:-
1
The term (1 + i ) is called the present value interest factor for i and n (PV1Fi,). The present
n
value table can be developed from the present value interest factors which are the values of
1
(1 + i) n for different values for i and. The present value interest factor for i= 5% and n=5 is
found by looking down the first column to period 5, and then moving across the row to 5%,
where the present value interest factor is read us 0.7835, so the present value of the 127.63 Birr
to be received after 5 years when the rate of interest is 5 percent is 100 Birr. That is PV = (FV s )
(PV1F5%, 5 ) = (127.63) (0.7835) = 100 Birr.
41
Other Application of Present Value of the Single Payment
With the help of present value equation and table you can solve for any one variable in the
equation when the other three variables are known:
Finding the Interest Rate: Although the term of contract may clearly state that all the relevant
cash flows, the problem of determining the interest rate, or the rate of return to the lender, or
investor may still remain unsolved. When single payments are involved, the implied interest rate
approach used for compounding problem can be adopted for use in determining the interest rate
in the present value table. To illustrate this, suppose that you have taken a loan of 1200 Birr to
day which is to be paid after three years together with its interest by making a payment of 1500
Birr. What is the rate of interest on the loan that you have taken?
To answer this question, first of all you need to identify variables which are known. In this
illustration, the present value, PV is equal to 1,200 Birr; the future value, FV is 1500 Birr, the
period of the loan, n is equal to 3 years. Then you substitute the given variables into the equation
and solve for the table value:
1
(FVn )
(1 + i )
n
Pv =
1 1 1200
(1500 )
(1 + i )3 = 1500
(1 + i )
3
1
(1 + i )3 = (PV 1Fi , 3 ) 0.08
1200 =
Looking at the year three (n=3) row in the present value table, try to locate the present value
interest factor (table value) that is equal to or closest to 0.80. The resulting table values are
0.816 corresponding 7 percent and 0.794 corresponding to 8 percent. Thus, the interest rate is
between 7 percent and 8 percent.
Finding the Number of Years:- The present value table and the present value equation for
single payment can be used to determine the number of years required for the present value to
equal its future value at a given rate of yearly compounding. For instance, how many years do
you need to wait for your deposit of 1000 Birr to grow to 1,200 Birr in a saving account that pays
interest compounding yearly at 6 percent?
To answer this question, let the 1000Birr be the present value of the future value of 1200 Birr at
an interest rate of 6 percent per year. By substituting into the present value equation for single
payment and solving for the desired table value, you get.
PV = FV n (PV1Fi,n )
1000 = 1200 (PV1F6%,n )
1000
PV1F6%,n n = =
1200
Then look at the 6 percent column in the present value table of single payment and read down the
present value interest factors till you arrive at the value that is equal of falls below the computed
42
table value. The table value that meets the stated requirement is 0.84, and it corresponds to 4
years, (n=4). Therefore, the 1000 Birr will have to be kept in the saving account for 4 years (and
compounded four times) before it grows to the desired value of 1200 Birr.
Annuities
An annuity is an equal amount of Birr payment for specified number of years. Since annuities
occur frequently in finance, such as bond interest payments, you have to be able treat them
accordingly. Although compounding and discounting of annuities can be dealt with for single
payment, these processes are time consuming, especially for longer annuities. The annuity
payments can occur at either the beginning or the end of period. If the payments are made at the
beginning of each period, the annuity is known as annuity due. If the payments, on the other
hand, occur at the end of each period, as they typically do, the annuity is called an ordinary or
deferred annuity. Since ordinary annuities are more common in finance, when the term annuity is
used in this material you should assume that the payments occur at the end of each period unless
stated, otherwise.
0 1 2 3
100 Birr 100 Birr 100 Birr
105.00 Birr = (100) (1.05)1
The time line shows each cash flow compounding and the sum of the compounded cash flows
which gives the future value of an annuity at the end of year three (n3), FCA 3 of 315.25 Birr.
Representing the single payment in a series of equal payments of an annuity with PMT
(Payment), the future value of an annuity at the end of year three (n=3), FVA 3 of 315.25 Birr.
Representing the single payment in a series of equal payments of an annuity with PMT
(payment), the future value of an annuity for n years can be designated with the following
equation:
FVA n = PMT(1+i)0 + PMT(1+i)1 + PMT(1+i)2 +----+ PMT (1+i)n
In this equation the first term (i.e. PMT (1+i)0 ) is the compounded value of the payment
at the end of last year, or year n of the annuity payments while the last term in the
equation (i.e. PMT (1+i)n-1 ) is the compounded amount of the payment made at the end of
year one (n=1). The above equation can further be simplified to:
n n −1
(1 + i )
FVA n = (PMT) ( t =1 where PMT is an annuity payment deposited, or received
at the end of each year.
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The equation can be re-written as:
(1 + i ) n − 1 n n −t
(1 + i)
By substituting for t =1
i
Using this future value of an annuity equation, the future value of the 100 Birr deposits made at
the end of each year for three years at an interest rate of 5 percent would be:
(1 + 0.05) n − 1
FVA 3 = (100) 0.05 =(100) (3.1525) = 315.25Birr
Tabular Solution:
The future value for an annuity is formed from the future value interest factor for an annuity
(1 + i ) n − 1
(FVIFA i,n ), which are the values of the term i in the above future value of annuity
equation. The future value for an annuity table contains a set of future value interest factor for
an annuity for various combination of I and n. To find an answer to 3-years, 100 Birr annuity
problem by using future value of annuity table, look down 5 percent column to the third period;
the future value interest factor for annuity (FVIFA 5%,3 ) is 3.1525. Thus, the future value of the
100 Birr annuity is 315.25 Birr.
FVA n = (PMT) (FVIFA i,n )
FVA 3 = (100) (FVIFA 5%, 3 ) = (100) (3.1525) = 315.25 Birr
A portion of the future value of annuity table
Period (n) 4% 5% 6%
1
2
3
4 3.1525*
5
6
* 3.1525 is the table value ( the future value annuity interest factor for an annuity)
corresponding
to 5 percent and 3 period. The complete future value of annuity table is included in the
appendix
to this material.
44
To illustrate interest rate computation, three equal payments of 3,000 Birr are offered in return
for 9,800 Birr to be received upon making the last annuity payment. What is the implied interest
rate? To answer this question, first identify the variables in the compounding annuity equation
that are known and plug these known values in to this equation. The compound amount of
annuity, FVA in the illustration above is 9,800 Birr and the annuity payment made at the and of
each year, PMT is 3000 Birr.
(1 + i ) n − 1
FVA n = PMT
i
(1 + i ) n − 1
9,800 = 3,000
i
(1 + i ) n − 1 9,700 (1 + i n − 1
= = 3.266
i 3,000 As indicated earlier, i
is the future value interest
factor for an annuity, FVIFA i,n for a given interest rate I and a given number of years, n. To
determine the interest rate, look up the three payment row (n=3) in the table for the table values
that is equal, or closest to 3.266. The table value corresponding to 9 percent is 3.246, and the
table value corresponding to 9 percent is 3.278. Since the computed value of 3.266 lies between
these two table values, the implied interest rate is greater than 8 percent and less than 9 percent.
Finding the Number of Payment:- If the interest rate, the size of the desired future value of an
annuity, and the size of each annuity payment are given, you can compute the number of
payments required to attain the future sum of an annuity by using the future value of an annuity
equation and table. For example, how many annual deposits of 1000 Birr each must be made into
an account that pays 6 percent interest compounded yearly in order to accumulate 5,500 Birr
immediately after the last deposit? Here, the 5,500 Birr is the future value of an annuity, and
1000 Birr is the annual payment deposited at the end of every year fill the term ends. If you
substitute the futures into the future value of an annuity equation, the desired annuity table value
will be:
(1 + i ) n − 1
FVA n = PMT
i
(1 + i ) n − 1
5500 = 1000 (FVIFA i,n ) because i is equal to FVIFA i, n.
5500
= 5 .5
FVIFA 6%, n = 1000
In order to compute the number of annual deposits to be made, look at the 6percent column in
the future value of an annuity table and read down until a table value equals, or exceeds the
computed value of 5.5. The compute value falls between 4.375 and 5.637 which correspond to 4
and 5 periods respectively. The correct answer is 5.637 or five periods (n=5) not 4.375 which
corresponds to the value of only 4 payments whose future value fall behind 5,500 Birr.
45
2 2.060 2/070 2.080 2.090 2.100
3 3.184 3.215 3.246 3.278 3.310
4 4.375* 4.440 4.506 4.573 4.641
5 5.637 + 5.751 5.866 5.985 6.105
5 4.375 is the future value interest factors for four payments of an annuity at 6 percent
interest rate.
+ 5.637 is the future value interest factor of five payments of an annuity at 6 percent interest
rate.
95.24
90.70
86.38
PVS3 =272.32
The present value of the series of payments of 100 Birr for three years annuity, PVA 3 is 272.32
Birr as shown with the help of the time line.
The same problem can be expressed by using mathematical equation. The general mathematical
equation that can be used to find the present value of an ordinary annuity is shown below:
1 2 n
1 1 1
+( PMT ) + − − − − + PMT
PVA n = (PMT) 1 + i 1+ i 1+ i
Since PMT is common for all terms, the above equation can be re-written as:
1 1 1
1 1 2 n
1
+
+ + − − − −
1 + i 1 + i 1+ i 1 + i
PVA n = (PMT)
Again the equation can be rewritten as:
n 1 t
t =1 1 + t
PVA n = (PMT)
46
The summation term in this equation is called the present value interest factor for an annuity
1
1_
(1 + i ) n , 1 − (1 + i ) − n
(PVIFA) and it equivalent to: i or i
Tabular Solution
1
−n
1−
1 − (1 + i ) (1 + i ) n
or
The term = i i
in the general equation of present value of an annuity
which is the present value interest factor for an annuity (PVIFA) is used to construct the present
value of an annuity table. The present value table of an annuity is the tabulation of the present
value interest factors for an annuity of different combinations of I and n arranged I an order
beginning with -=1% and n=1 period. Hence, the present value of an annuity equation as stated
already, can be re-written in a way it is suitable for using table values.
PVA n = (PMT) (PVIFA i,n ) where PV|IFA i,n is the present value interest factor for an annuity for
a given interest rate (i) and for a given number of years (n). To find an answer to the three-year,
100 Birr annuity problem under condiseration, simply refer to a present value of an annuity table,
which is partly shown below, and look the 5 percent column down to the third period. The
PVIFA 5%,3 is 2.7232, yielding the present value of 272.32 Birr for the three annuity payments of
100 Birr at the end of each year.
PVA 3 = (100) (PVIFA 5%,3 ) = (100) (2.72.32) = 272.32 Birr
47
4 3.465 3.387 3.312
5 4.212 4.100 3.993
* The present value interest factor for an annuity when interest rate is 5 percent for three
payments is 2.7232.
How, the can find the present value, PV of individual cash flows by using the present value
equation for single payment, and sum these values to find the present value of the entire cash
flow stream. Here is what it looks like:
0 6% 1 2 3 4 5 7
100 200 200 200 200 0 1000
48
The individual present values, as well as, the present value for the entire cash flow stream can be
computed by using this general mathematical equation:
1 2 n
1 1 1
+ CF2 + ........ + CF
PV = CF1 ( 1 + i 1 + i
n
1+ i
Where:
CF1 = the cash flow, or payment, or receipt at the end of year or period one.
CF2 = the cash flow, or payment, or receipt at the end of year, or period two.
CFn = the cash flow, or payment, or receipt at the end of year, or period n, and.
1
1
=
CF1 1 + i the value of the cash flow at the end of year one converted to the equivalent
value at the end of year zero (i.e PV of cash flow at the end of year one).
Each one of the above present values was found by suing the respective individual present value
equation. For instance, the present value of year one's cash flow was found by the present value
equation of cash flow at the end of year one (i.e. CF 1
1 1
1 1
+ (100 ) = (100 ) ( 0 .9434 ) = 94 .34
1+ i 1 .06 Birr and the present value, PV of the cash
2 2
1 1
= ( 200 )
flow at the end of year two is (CF 2 ) 1 + i 1 . 06 = (200) (00.8900) = 178 Birr,
and so on.
The present values of the cash flow stream over the 7 years can always be found by adding the
present values of individual cash flows as indicated above. However, the pattern of the cash
flow within the stream may allow you to use short-cut method. For example, the cash flows
during year two through year five are in an annuity form because the cash flows during these
years are uniform, you can use these fact and solve the same problem in a slightly different
manner but a bit simpler. That is:
0 1 2 3 4 5 6 7
100 200 200 200 200 0 1000
94.34
c693.00
658.80
0.00
665.10
49
1413.24
The cash flows during year two through year five, as it was mentioned, represent the pattern of
annuity. The present value of annuity, PVA of the cash flows at the end of year one (i.e. one
year before the first annuity payment at the end of year two) by using the mathematic equation
for the present value of an annuity that was already discussed. To remind you, how to find the
present value of these cash flows at the end of year one, it is shown below:
PVA n = (PMT) (PVIFA i,n )
PVA 4 = (200) (PVIFA 6%,4 )
PVA 4 = (200) (3.465), here 3.465 is the present value interest factor corresponding to
6 percent interest rate and four payments or cash flows. Finalizing the above computation, you
arrive at:
PVA 4 = (200) (3.465) = 693.00 Birr
After determining the present value of the four annuity payments, or cash flows of 200 Birr each
at the end of year one, you have to determine the present value of 693.00 Birr at the end of year
zero by using the mathematical equation for present value computation for single payment,
future value. That is
1
(1 + i) n
PV = (FV) . In this case, the future value is the 693.00 Birr which is the
present value of the four annuity payments during year two through year five at the end of year
one, the annual interest (discount) rate is 6 percent, and the period is only one
year (n = 1) Therefore,
1 1
1
= ( 693 ) = ( 693 ) ( 0 .9434 )
(1 + 0 .06 ) 1 .06
PV = (693)
= 653.80 Birr as it was indicated on the time-line before.
50