The purpose of this assignment is to identify different financial management concepts such as Ratio analysis, Investment appraisal techniques and financial theories. Based on these concepts investors, individuals and businesses will able to making their investment and day to day decisions.
Here there will a section, it will get discuss about stock investments. As we knowledge seekers and investors we exactly should know whether the current economic situation is good for purchase stocks or sell stocks. Therefore we have to analyze the stock market and identify risks and returns of stocks for each situation. However we are not going to talk more details regarding this in the report.
Also another important financial management concept is annuity and perpetuity and their significance. As we are future managers we would have to carry financial analysis on financial performance and financial position of an organization. Therefore the easiest way to carried out this is ratio analysis.
This evaluation is done with the purpose of determining the suitability for the investment by a business. Usually the main purpose of financial analysis is to analyze the stability, liquidity, solvency and profitability of a business. Under this report it will be mentioned. Thus I think that we will be able to get much knowledge about financial management concepts and how do they assist us in our life cycle.
6.1. Calculation of ratios on AB’s Gift Company.
(current asset/Current liability)
= 1.82 times
= 2.05 times
(Current asset-inventory/current liability)
|= 55450 – 20650|
= 1.42 times
|= 69500 – 26800|
= 1.12 times
|= 92750 – 31000|
= 1.36 times
|Stock turn over|
( cost of sales / average inventory)
= 5.47 times
= 4.78 times
= 4.56 times
|Cash conversion cycle|
(DSO + DIO – DPO)
|= 64 +71 -96|
= 39 days
|= 72 + 77 -109|
= 40 days
|= 38 + 80 -117|
= 1 day
|Gross profit margin|
(Gross profit/ sales *100)
|Net profit margin|
( PBIT/(Total Assets-Current Liabilities)*100)
|Debt to equity ratio|
(Debt equity/owner’s equity)
DSO – Days of Sales Outstanding
DIO – Days of Inventory Outstanding
DPO – Days of Purchases Outstanding
(Opening stock + Closing stock)/2
( Receivables/Credited Sales)*365
= 64 days
= 72 days
= 38 days
|DIO = 365|
= 71 days
= 77 days
= 80 days
|DPO = Acc: Payables|
(Cost of Sales/365)
= 96 days
= 109 days
= 117 days
6.2 company’s financial performance and stability
According to AB’s Gift Company they used only GP margin, Net Profit margin and ROCE ratios to analyze the financial performance of the company during those three years. The Gross profit margin in 2012 is 48.74% that in 2013 is 52.12% and in 2014 is 59.84%.It has been increased year by year. This is because either selling price of a unit has raised year by year or the cost per unit has reduced year by year.
If we consider about net profit margin ratio it has been increased year by year, at roughly in 2013 net profit margin has been increased by 4% than previous year, and also on 2014 the net profit margin is 17% and previous year (2013) it was 15% that mean it increased by 2 %. Reason behind that, although cost of sales and other expenses was increase sales revenue has been increased at higher parentage than those above expenses.
ROCE is the co-efficient of profitability and efficiency. Return on capital employed has significantly improved to 30.62% in 2014 from 13.62% in 2012.This is because the profitability and efficiency both have improved together during these three years. As such the entire profitability has improved significantly following reasons.
Generally accepted ratio of current ratio is 2:1.Therefore we can see this accepted ratio in the company excluding 2013.Also the quick ratio can be accepted. The liquidity position has improved significantly.
Also the debt to equity ratio is concerned with a company’s long term stability. How much the company owes in relation to its size whether it is getting into heavier debt or improving its situation and whether its debt burden seems heavy or light? According to the above calculations the company has carried out balanced debt equity ratio.
7.1 CAPM Model and types of risks
The capital asset pricing model (CAPM) is a model that describes the relationship between systematic risk and expected return per asset, particularly stocks. The general idea behind CAPM is that investors need to be compensated in two ways, those are time value of money and risk.
In finance, the capital asset pricing model is an empirical model used to determine a theoretically appropriate required rate of return of an asset, if that asset is to be added to an already well-diversified portfolio, given that asset’s non diversifiable risk.
The CAPM formula is as follows.
R* = kRF + β (kM – kRF)
kRF = the rate of return for a risk-free security
kM = the broad market’s expected rate of return
β = beta of the asset
There are some assumptions in CAPM model in relating to all investor’s point of view
- Aim to maximize economic utilities (Asset quantities are given and fixed)
- Investors are rational and risk averse
- Broadly diversified across a range of investment
- Investors are price takers (cannot influence prices)
- Investors can lend and borrow unlimited amounts under the risk free rate of interest
There are some advantages of the CAPM model. The CAPM has several advantages over other methods of calculating required return, explaining why it has remained popular for more than forty years.
- It considers only systematic risk, reflecting a reality in which most investors have diversified portfolios from which systemic risk has been essentially eliminated
- It generates a theoretically-derived relationship between required return and systematic risk which has been subject to frequent empirical research and testing
- It is generally seen as a much better method of calculating the cost of equity than the divided growth model in that it explicitly takes on to account a company’s a level of systematic risk relative to the stock market as a whole
- It is clearly superior to the WACC in providing discount rates for use in investment appraisal
Also there are some disadvantages in CAPM model. The CAPM suffers from a number of disadvantages and limitations that should be noted in a balanced discussion of this important theoretical method.
Types of risks associated with stock markets
There are two types of risks associated with stock market those are,
- Systematic risk
- Unsystematic risk
Systematic risk influences a large of assets. A significance political event, for example, could affect several of the assets in portfolio. It is virtually impossible to protect yourself against this type of risk. The systemic inherent to the entire market or an entire market segment. systematic risk, also known as “diversifiable risk”, “volatility” or “market risk” affects the overall market, not just a particular stock or industry. This type of risk is both unpredictable and impossible to completely avoid. It cannot be mitigated through diversification, only thought hedging or by using the right assets allocation strategy.
As an example putting some assets in bonds and other assets in stocks can mitigate systematic risk because and interest rate shift that makes bonds less valuable will tend to make stokes more valuable, and vice versa, thus limiting the overall change in the portfolio’s value from systematic changes. Interest rate changes, inflation, recessions and wars. All represent source of systematic risk because that affect the entire market. Systematic risk underlies all other investment risk.
Whereas this type of risk affects a bond range of securities, unsystematic task affect a very specific a group of securities or an individual securities.
Company or industry specific hazard that is inherent in each investment. Unsystematic risk also known as “nonsystematic risk”, “specific risk”, “diversifiable risk” or “residual risk”, can be reduce through divercification.by owing stocks in different companies and in different industries, as well as by owning other type of securities such as treasuries and municipal securities, investors will be less affected by an event or decision that has a strong impact on the company, industry or investment types. As a example unsystematic risk include a new competitor a regulatory change or management change and product recall. Another example is the risk that airline industry employees will go on strike. This risk primarily affects the airline industry, airline companies with whom the airline do business. It does not affect the entire market system so it is an unsystematic risk.
7.2 Calculation of rate of return based on CAPM.
R* = kRF + B (kM – kRF)
R* = kRF + B (kM – kRF)
In the B&S has a higher expected return than A&T, we can say the reason for that, when all other factors that are affect to the expected return, are constant, β value is higher in B&S than A&T. (β = index of systemic risk) because higher risk gives give higher return.
8.1 Annuity and perpetuities
An annuity is a series of equal payments at regular intervals, grantees for a fixed number of years or the life time of one or more individuals. Similar to a pension, the money is paid out of an investment contract under which the annuitant deposits certain sums with an annuity guarantor. The amount paid back includes principals and the interests, either or both of which may be tax exempt. An annuity is not an insurance policy but a tax shelter.
There are two types of annuities
- Ordinary annuity
- Annuity due
An ordinary annuity has the flowing characteristics,
- The payment are always made at the end of the each interval
- The interest rate compounds at the same interval as the payment interval
For calculating the ordinary due the following formula should be used,
PV value of annuity = R* [1 – (1 + i)]/i
Sn value of annuity= R[(1+i)^n-1] / i
- i is the interest rate per compounding period.
- n is the number of periods
- R is the fixed periodic payment
- Regular deposits to a saving account
- monthly home mortgage payments
- Monthly insurance payments
- Pension payments
A perpetuity is an annuity that provides payments indefinitely. Since this type of annuity is unending, its sum or future value cannot be calculated. With perpetuity it is necessary to find a present value based on series of payments go on forever,
The formula for calculating the present value of perpetuity is,
A ∞ = R / i
R = the interest payment each year
I = the interest rate per payment period
- Local governments set aside monies so that fund will be available on a regular basis for cultural activities.
- The children’s charity club set up a fund redesign to provide a flow of regular payments identify to needy children.
8.2. Calculation of present value of cash flows.
PV of cash flows in 1st year = 125 / 1.115
PV of cash flows in 2nd year = 175 / (1.115^2)
PV of cash flows in next 4 years = 200* 1- (1+0.08) ^-4
= 662.43 / 1.115^2
PV of Perpetuity = 200 / 0.05
PV of total cash flows = 112.10 + 140.76 + 532.83+ 4000
Recommendations for financial performance and financial stability
In this statement, although gives favorable states about their financial performance and stability, the collection periods should be adjusted with more flexible. And also try to negotiate a better collection period with the customers get an outside leasing company to arrange leasing facility. And should be negotiate a better settlement period with the suppliers.
The overall profitability has improved and financial position has improved. Because of this better Performance, Company can reduce their production cost and so they can reduce selling price from year by year. Also the best way to raise fund is letting from financial institutions. It is cheaper than use internal sources.
Risks of stock markets.
All investors invest their money in stocks when there is a good economic situation in the country. However there are more investment options which have low risks than stocks such as government bonds, treasury bills, treasury bonds, commercial papers. Because they are secured by the central bank. Also they are issued at discounted price and interface value is paid at maturity.
As well as we explained CAPM model which used to calculate capital assets. Meanwhile we could be able to use alternative methods to calculate capital assets. From that we can identify what asset should be obtained. And what is the risk of that assets.
Also the risks of stock markets can be managed and if we have better knowledge about stock market we can make profitable investments and make profits. Therefore we can obtain knowledge from CSE and stock brokerage companies.
Finally by the end of this report I could be able to get financial knowledge about ratio analysis, theory of CAPM model and concepts of annuity and perpetuity. These concepts are more useful for every person like individuals, investors, business enterprises and so on.
If we want analyze the business performance and financial stability of a business, the ideal way is analyzing ratios. From that ratios we can identify whether the organization is profitable or not or as well as future stability of the organization. Also we would be able to evaluate whether should we want to get excess money or not. And the organization can decide where we obtain money. Is it from internal sources such as by using retained earnings or from external sources such as by bank loans and so on?
And also CAPM model is important for the decide future investment because it relating to the relationship between risk and expected return. And the time value of money should be considered when we get loan or investing for the future. Therefore for that annuity and perpetuity is important concept, because we should know about organizations investment is profitable or not
A well as in this company according to the giving statement the overall profitability and financial stability has favorable states. And by the end of this report those financial management concepts are most important for all knowledge seekers and investors.
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- Gal linger, George W., and Jerry B. Poe. Essentials of Finance: An Integrated Approach. Prentice Hall, (1995).
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- . See Marshall E. Blume, Jean Crockett, and Irwin Friend, “Stock Ownership in the United States: Characteristics and Trends,” Survey of Current Business, November 1974, p. 16.
- See Stephen A. Ross, “The Arbitrage Theory of Capital Asset Pricing,” Journal of Economic Theory, December 1976, p. 341.
- See Roger G. Ibbotson and Rex A. Sinquefeld, Stocks, Bonds, Bills, and Inflation: Historical Returns (1926–1978), second edition (Charlottesville, Virginia: Financial Analysts Research Foundation, 1979). The rates I have used are arithmetic means. Arguments can be made that geometric mean rates are appropriate for discounting longer-term cash flows.
- For an exposition of the dividend growth model, see Thomas R. Piper and William E. Fruhan, Jr., “Is Your Stock Worth Its Market Price?” HBR May–June 1981, p. 124.
- Rossi, S., Beers, T. C., & Sneden, C. 1999, in ASP Conf. Ser. 165, The Third Stromlo Symposium: The Galactic Halo, ed. B. K. Gibson, T. S. Axelrod, & M. E. Putman (San Francisco: ASP), 264
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