A. Role of Senior Financial advisor

Question 1

Profitability Ratios :

ROCE

Answer 1

Operating Profit (PBIT) / Capital Employed

Question 2

Profitability Ratios : Capital Employed

Answer 2

Equity + LT liabilities
Non current assets + net current assets
Total assets - current liabilities

Question 3

Profitability Ratios :

1. Gross margin
2. Net Margin

Answer 3

GP margin= Gross Profit/Sales

NP Margin= Net Profit/Sales

Question 3

Profitability Ratios : ROE

Answer 3

Profit After Tax - Preference dividends/Shareholders’ Funds (Ordinary shares + Reserves)

Question 4

Profitability Ratios : RI

Answer 4

Profit After Tax - (Operating Assets x Cost of Capital)

Question 5

What are Efficiency ratios?

Answer 5

These are measures of utilisation of Current & Non-current Assets of an organisation.

Question 6

Efficiency ratio: Asset Turnover

Answer 6

Sales/Capital Employed

Question 7

Efficiency ratio: ROCE

Answer 7

Margin X Asset Turnover

Question 8

Efficiency ratio:

1. Receivables Days
2. Payables Days
3. Inventory Days

Answer 8

1. Receivables Days = (Receivables Balance / Credit Sales) x 365
2. Payables Days = (Payable Balance / Credit Purchases) x 365
3. Inventory Days. = (Inventory / Cost of Sales) x 365

Question 9

What are profitability ratios?

Answer 9

These are measures of value added being generated by an organisation

Question 10

What are liquidity and gearing ratios?

Answer 10

Liquidity Ratios measure the extent to which an organisation is capable of converting assets into cash and cash equivalents.

On the other hand, Gearing Ratios measure the dependence of an organisation on external financing as against shareholder funds.

Question 11

Liquidity ratios :

1. Current Ratios
2. Quick Ratio

Answer 11

1. Current Ratios = Current Assets / Current Liabilities

2. Quick Ratio = (Current Assets – Inventory) / Current Liabilities

Question 12

Gearing ratios :

1. Financial Gearing
2. Operational gearing

Answer 12

1. Financial Gearing
   = Debt/Equity
   = Debt/(Debt + Equity)
2. Operational gearing
   = Contribution / PBIT

Question 13

What are investor’s ratios?

Answer 13

These ratios measures return on investment generated by stakeholders.

Question 14

Investors ratios :

1. Dividend Cover
2. Dividend Yield

Answer 14

1. Dividend Cover = Profit After Tax / Total Dividend

2. Dividend Yield = Dividends per share / Share price

Question 15

Investors ratios :

1. Interest Cover
2. Interest yield

Answer 15

1. Interest Cover = PBIT / Interest

2. Interest yield = (coupon rate / market price) x 100%

Question 16

Investors ratios :

1. Earnings Per Share
2. PE Ratio

Answer 16

1. Earnings Per Share = Profit After Tax and preference dividends / Number of Shares
2. PE Ratio =. Share Price / EPS

Question 17

Ratios aren’t always comparable. What are the factors affecting comparability? How to compare ratios ?

Answer 17

1. Different accounting policies
2. Different accounting dates
3. Different ratio definitions
4. Comparing to averages
5. Possible deliberate manipulation (creative accounting)
6. Different managerial policies

Compare ratios with :

• Industry averages
• Other businesses in the same business
• With prior year information

Question 18

What are the dangers associated with high gearing?

Answer 18

The higher a company’s gearing, the more the company is considered risky.An acceptable level is determined by comparison to companies in the same industry.
A company with high gearing is more vulnerable to downturns in the business cycle because the company must continue to service its debt regardless of how bad sales are.
A greater proportion of equity provides a cushion and is seen as a measure of financial strength.

The best-known examples of gearing ratios include:

• debt-to-equity ratio = (total debt / total equity),
• interest cover = (EBIT / total interest),
• equity ratio = (equity / assets),
• debt ratio = (total debt / total assets)

Dangers associated with high gearing:

1. Need to cover high fixed costs, may tempt companies to increase sales prices and lose sales to competition
2. Risk of non-payment of a fixed cost and litigation
3. Risk of unsettling shareholders by having no spare funds for dividends
4. Risk of lower credit rating
5. Risk of unsettling key creditors

Question 19

What is operational gearing?

Answer 19

Operating gearing is a measure which seeks to investigate the relationship between the fixed operating costs and the total operating costs.

• In cases where a business has high fixed costs as a proportion of its total costs, the business is deemed to have a high level of operational gearing.
  Potentially this could cause business problems as it relies on continuing demand to stay afloat.

-If there is a fall in demand, the proportion of fixed costs to revenue becomes even greater. It may turn profits into serious losses.

Normally, businesses cannot themselves do a great deal about the operational gearing, as it may be typical and necessary in the industry, such as the airline business.

The normal equation used is: =
Fixed operating costs / Total operating costs

In this sense total operating costs include both fixed and variable operating costs.

Question 20

How is interest cover better gearing ratio?

Answer 20

Interest cover is a measure of the adequacy of a company’s profits relative to interest payments on its debt.

The lower the interest cover, the greater the risk that profit (before interest) will become insufficient to cover interest payments.

It is: = PBIT / Interest

It is a better measure of the gearing effect of debt on profits than gearing itself.

A value of more than 2 is normally considered reasonably safe, but companies with very volatile earnings may require an even higher level, whereas companies that have very stable earnings, such as utilities, may well be very safe at a lower level.

Similarly, cyclical companies at the bottom of their cycle may well have a low-interest cover but investors who are confident of recovery may not be overly concerned by the apparent risk.

Question 21

What are the benefits of operating leases?

Answer 21

1. Protection against obsolescence: Since it can be cancelled at short notice without financial penalty. The lessor will replace the leased asset with a more up-to-date model in exchange for continuing the leasing business.
   This flexibility is seen as valuable in the current era of rapid technological change, and can also extend to contract terms and servicing cover
2. Less commitment than a loan: There is no need to arrange a loan in order to acquire an asset and so the commitment to interest payments can be avoided, existing assets need not be tied up as security and negative effects on return on capital employed can be avoided.
   Operating leasing can therefore be attractive to small companies or to companies who may find it difficult to raise debt.
3. Cheaper than a loan: By taking advantage of bulk buying, tax benefits etc the lessor can pass on some of these to the lessee in the form of lower lease rentals, making operating leasing a more attractive proposition than borrowing.
4. Off balance sheet finance: Operating leases also have the attraction of being off-balance sheet financing, in that the finance used to acquire use of the leased asset does not appear in the balance sheet.

Question 22

Why is profit not a sufficient financial objective?

Answer 22

1. Investors care about the future
2. Investors care about the dividend
3. Investors care about financing plans
4. Investors care about risk management

For a profit-making company, maximisation of shareholder wealth is a better objective. This is measured as :
total shareholder return (dividend yield + capital gain or the dividend per share plus capital gain divided by initial share price)

Question 23

What are the types of strategic decisions to be made by the financial manager?

Answer 23

The main types of decisions that need to be made (and the main areas for consideration for the examination) are:
๏ Investment decisions : (in projects or takeovers or working capital) need to be analysed to ensure that they are beneficial to the investor. Investments can help a firm maintain strong future cash flows by the achievement of key corporate objectives. Eg. Market share, quality

๏ Sources of finance decisions: mainly focus on how much debt a firm is planning to use. The level of gearing that is appropriate for a business depends on a number of practical issues:

Life cycle - A new, growing business will find it difficult to forecast cash flows with any certainty so high levels of gearing are unwise.

Operating gearing- If fixed costs are a high proportion of total costs then cash flows will be volatile; so high gearing is not sensible.

Stability of revenue- If operating in a highly dynamic business environment then high gearing is not sensible.

Security- If unable to offer security then debt will be difficult and expensive to obtain.

๏ Decisions regarding the level of dividend to be paid to shareholders

๏ Risk management : Decisions regarding the hedging of currency or interest rate risk, project management issues

Question 24

What are the three elements to the process of financial management ?

Answer 24

1. Financial Planning :
   
   • enough funding is available at the right time to meet the needs of the business. ( Short term: invest in equipment; long term: increase production capacity)
2. Financial Control: addresses questions such as:
   
   • Are assets being used efficiently?
   • Are the businesses’ assets secure?
   • Do management act in the best interest of shareholders and in accordance with business rules?
3. Financial Decision-making: key aspects of financial decision-making relate to investment, financing and dividends.

Question 25

What are the main roles and responsibilities of a financial manager?

Answer 25

1. Investment selection and capital resource allocation
   - Ethical considerations
   - Method of investment appraisal: NPV vs IRR
   - effects on ROCE and EPS
2. Raising finance and minimising the cost of capital
   - Current gearing levels and risk appetite
   - Tax implications
   - Sources of finance and key ratios
   - Restrictions such as debt covenants
3. Distribution and retentions
   - investor preferences for cash dividends now or capital gains
   - Impact of high dividends on working capital requirements
   - Impact on share prices and shareholder wealth
4. Communication with stakeholders
   - Mission statements and strategies (Internal)
   - Credit and pricing policies (External)
5. Financial planning and control
   - Business plans and process
   - Budgets and evaluation of variances
6. Risk management
   - Risk appetite
   - How are risks identified, Analysed, Planned for and Monitored?
7. Efficient and effective use of resources.
   - Economic, efficient, effective and transparent

Question 26

What are the factors to be considered when raising finance?

Answer 26

• Gearing and financial risk
• Target capital structure
• Availability of security
• Economic expectations
• Control issues

Question 27

What are the factors considered when reducing the amount of debt by issuing equity?

Answer 27

As the proportion of debt increases in a company’s financial structure, the level of financial distress increases and with it the associated costs.
Companies with high levels of financial distress would find it more costly to contract with their stakeholders.
For example, they may have to pay higher wages to attract the right calibre of employees, give customers longer credit periods or larger discounts, and may have to accept supplies on more onerous terms.

• Less financial distress may therefore reduce the costs of contracting with stakeholders.
• Having greater equity would also increase the company’s debt capacity. This may enable the company to raise additional finance
• On the other hand, because interest is payable before tax, larger amounts of debt will give companies greater taxation benefits, known as the tax shield.
• Reducing the amount of debt would result in a higher credit rating for the company and reduce the scale of restrictive covenants