Unit 2 The Financial Environment

UNIT

THE FINANCIAL ENVIORNMENT

FINANCIAL MARKETS
A financial market is any mechanism for trading financial assets or claims. There is
no physical market-place, transactions being conducted via telephone or computer.
Its main financial markets are as follows:
(1)

(2)
(3)

The money market channel wholesale funds, usually less than one year, from
lenders to borrowers. The market is largely dominated by the major banks and
other financial institutions. Referring to short-term lending and borrowing
purposes
The securities or capital market deals with long-dated securities such as
shares and loan stock
The foreign exchange market is a market for buying and selling one currency
against another. Deals are either on a spot basis (for immediate delivery) or on
a forward basis (for future delivery).

The financial markets provide mechanisms through which the corporate financial
manager has access to a wide range of source of finance and instruments.
Capital markets have two important functions:

Primary Market
- providing new capital for
business and other activities.
Example share issuing, or
loans.

Secondary Market
trading existing securities

Financial markets promote savings and investment by providing mechanisms

whereby the financial requirements of lenders (suppliers of funds) and borrowers
(users of funds) can be met. Financial intermediaries (financial institutions)
collecting funds from savers to lend to their corporate and other customers through
money and capital markets, or directly through loans, leasing and other forms of
financing.
The role of financial intermediaries:

Re-packaging Finance. Gathering small amounts of savings from a large

number of individuals and turn them into larger bundles for lending to
businesses.
Risk Reduction. Placing small sums from numerous individuals in large,
well-diversified investment portfolios.
Liquidity Transformation. Bringing together short-term savers and longterm borrowers.
Cost Reduction. Minimizing transaction costs by providing convenient and
relatively inexpensive services for linking small savers to larger borrowers.

Are financial markets efficient?

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Unit 2 The Financial Environment

In an efficient stock market, current market prices fully reflect available

information and it is impossible to outperform the market consistently, except
by luck
The measure of efficiency is seen in the extent and speed with which the
market reflects new information in the share price.

Efficient Market Hypothesis (EMH)

Information can be classifies as historical, current or forecast. Only current or

historical information is certain in its effect on price
Different amounts of financial information are available to different groups of
people
There is unequal access to the information, which may affect a companys
share price
If you are one of the well-informed, this gives you the opportunity to keep one
step ahead of the market
Three levels of market efficiency, EMH:

The Weak Form of

the EMH states that
current share price
fully reflect ALL
information
contained in past
price movements.
If this level of
efficiency holds,
there is no value in
trying to predict
future price
movement by
analyzing trends in
past price
movements.
Efficient stock
market prices will
fluctuate more or
less randomly, any
departure from
randomness being
too expensive to
determine. Share
price are said to
follow a random
walk

The semi-strong
form of the EMH
states that current
market prices
reflect not only all
past price
movements, but
ALL publicly
available
information. In
other words, there
is no benefit in
analyzing existing
information, such
as that given in
published
accounts, dividend
and profits
announcement,
appointment of a
new chief
executive or
product
breakthrough, after
the information has
been released. The
stock market has
already captured
this information in
the current share
price

The strong form of

the EMH state that
current market
prices reflect all
relevant
information even
if privately held.
The market price
reflects the true
or intrinsic value of
the share based on
the underlying
future cash flows.
The implications of
such a level of
market efficiency
are clear: no one
can consistently
beat the market
and earn abnormal
returns. Few would
go so far as to
argue that stock
markets are
efficient at this
level

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Unit 2 The Financial Environment

You will have noticed that as the EMH strengthens, the opportunities for profitable
speculation reduce. Competition between well-informed investors drives share prices
to reflect their intrinsic values.

Using the published information

Financial managers and investors need to study the performance of the shares of
their company, both against the appropriate sector as a whole and also against
competitors within the sector. Two performance statistics that are most commonly
reported are the dividend yield and price:earning ratio.

Dividend yield

Price:earning (P:E) ratio

This is the gross, or pre-tax,

dividends of the companies in the
sector in the last year as a
percentage of the total value of
the sector.

The P:E ratio is a much-used

performance indicator. It is the
share price divided by the current
earnings per share.

Taxation and Financial Decisions

Few financial decisions are immune from taxation considerations. Corporate and
personal taxation affects both the cash flows received by companies and the
dividends income received by shareholders. Consequently, financial managers need
to understand the tax consequences of investment and financing decisions. Taxation
may be important in two key areas of financial management:
(1)

Raising Finance. There are clear tax benefits in raising finance by issuing
debt rather than capital. Interest on borrowings attracts tax relief, thereby
reducing the companys tax bill, while a dividend payment on equity capital
does not attract tax relief. The tax system is thereby biased in favour of debt
finance.

(2)

Investment in Fixed Assets. Spending on certain types of fixed asset

attracts a form of tax relief termed capital allowances. This is intended to
stimulate certain types of investment, such as in industrial plant and
machinery. The taxation implications of an investment decision can be very
important.

A Financial Health Check using Ratios

Accountants and bank managers have formulated dozens of financial ratios to help
diagnose the financial health of the business, its position, performance and
prospects.
(a)
(1)

[b]

Profit margin
(i) Gross profit margin
(ii Net profit margin
)
Return on Capital employed
Asset turnover
Debtor days
Stockholding period
Supplier credit days
Current ratio
Quick ratio
Gearing ratio

Profitability
Ratios

(2)

Activity Ratios

(a)
(b)
(c)
(d)

(3)

Liquidity and
Financing
Ratios

(a)
(b)
(c)

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Unit 2 The Financial Environment

(4)

Investors Ratios

(d)

Interest cover

(a)
(b)
(c)
(d)
(e)
(f)

Return on shareholders funds

Dividend per share
Earning per share (EPS)
Dividend cover
Price: Earnings ratio (P:E)
Dividend yield

WORKING CAPITAL MANAGEMENT

What is Working Capital?

The firms total investment in current assets or assets which it

expects to be converted into cash within a year or less

Net Working Capital = Current Assets Current Liabilities

Frequently when the term working capital is used it is actually

intended to net working capital.

Business needs adequate resources to maintain day-to-day cash flow (short-term

management).

Sufficient liquidity must be maintained in order to ensure the survival of the

business in the long-term as well.
In other words, working capital management is to ensure that sufficient liquid
resources are maintained.

What is Sufficient?

Not too much of money but just nice to meet payment, not too little
of money but some of them are used to do other investment (to earn
more money)

A balance between the requirement to minimise the risk of

insolvency (able to pay) and to maximise the return on assets (fully
utilise the available funds)

Working Capital Management

The administration of the firms current assets and the financing

needed to support current assets

In short, to maintain the optimum level for current assets and

current liabilities.

The ideal current ratio is generally accepted to be 2:1 (that is, out of all of the
current assets, half is financed by current liabilities and the other half from
long-term liabilities)
The ideal quick ratio is 1:1, these liquidity ratios are a guide to the risk of cash
flow problems and insolvency

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Unit 2 The Financial Environment

However, these ratios also vary according to the nature of the companys
business. For example, does service company have lots of inventory? What
about manufacturing company?
Two situations that should not happen:
(1)

Overcapitalisation

Lots of current assets but little bills, excessive working capital

Too much current assets funds are held to carry current assets, should
have invested elsewhere to get better return

Long-term funds are unnecessarily the tied up

(2)

This could be shown through:

Sales/working capital
Liquidity ratios
Turnover period for stock and debtors, too often.

Overtrading

Contrast with overcapitalisation

Where a business tries to do too much too quickly with little long-term
capital

Dangerous will have liquidity problem, does not have enough capital to
provide cash to pay its debts as they fall due

Solutions to reduce the degree of over-trading:

New capital could be injected
Control over stock and debtors
Abandon plans like increase sales and fixed assets purchases, until
build up its capital base with retained profits

Symptoms of over-trading are as follow:

A rapid increase in turnover
A rapid increase in current assets and fixed assets
A small increase in proprietors capital, but increase in trade
creditors, bank overdraft
Decrease in current ratio and quick ratio, increase debt-to-totalassets ratio.

Meaning and consequences of overtrading:

Overtrading is the condition of a business which enters into
commitments in excess of its available short-term resources.
This can arise due to the time lag (between paying for materials
or labour and receiving money from debtors) even if the
company is trading profitably if is has a long cash operating
cycle.
The consequences of overtrading will be an increase in the level of
the bank overdraft. When this begins to get dangerously high
then other step tends to be taken to reduce or defer cash outlays
such as delaying payment to creditors and putting off necessary

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Unit 2 The Financial Environment

maintenance or advertising or new expenditure.

Ultimately
stocks and production will be reduced so that customer demand
cannot be satisfied.
Cash Conversion Cycle (CCC)

Also know as Working Capital Style, Operating Cash Cycle or Trading

Cycle

CCC = Stock Turnover in days + Debtors collection period Creditors payment period

If the turnover period for stocks and debtors lengthen, or the payment period to
creditors shorten:
The operating cycle will lengthen
The investment in working capital will increase

TUTORIAL
U N I T

QUESTION 1
(a)

The following information relates to Pearl Bhd.

Year ended 30 June

Sales
Cost of Sales
Purchases
Debtors

2003
(RM000)
300
240
160
38

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2004
(RM000)
350
288
194
43

Unit 2 The Financial Environment

Creditors
Raw Material Stocks
Work in Progress
Finished Goods Stocks

24
40
22
48

35
75
39
53

Required:
Calculate the projected change in working capital cycle between 2003 and 2004
positions.
(b)

You are the company secretary of Paper Malaysia Bhd a large manufacturing company.
The financial director has recently resigned following the disclosure of same financial
irregularities and you are temporarily helping to sort out the company finances.
Your examination of the financial position reveals that some 30% of the total net assets
of RM10 million comprise debtors. You consider from cash flow projections that the
company is likely to be short of funds in the next three months. You also consider that
the management of debtors has been neglected such that too much cash is locked up in
the debtors accounts.
The managing director has asked you to prepare a brief report for the next Board
meeting. The current return on capital is 12%.

QUESTION 2
XY Sdn Bhd
Profit and Loss Account for the year ended 31 December 2002
RM
Sales
less: Cost of Sales
Opening Inventory
add: Purchases

RM
452,000

125,000
341,000
466,000
143,000

less: Closing Inventoy

323,000
Gross Profit

129,000

Net Loss

3,000

Balance Sheet as at 31 December 2002

RM
Current Assets
Debtors
Inventory

RM

163,000
143.000
306,000

Non-Current Assets (Net Book Value)

Motor Vehicle
Fixture
Freehold premises at valuation

52,000
25,000
280,000
257,000
663,000

Total Assets
Capital and Reserves
Ordinary Share Capital
Retained Profits

100,000
158,000
258,000

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Unit 2 The Financial Environment

Non-Current Liabilities
Loans

120,000

Current Liabilities
Trade Creditors
Bank Overdraft

145,000
140,000
285,000
663,000

Bank Overdraft

Required:
(a) Calculate the current ratio and quick ratio an explain why the management of this
company should be concerned about its liquidity position
(b) Explain the term Operating Cash Cycle
(c) Calculate the Operating Cash Cycle for this company (assume a 360 days year).

QUESTION 3
The following are extracts of Balance Sheet and Income Statement of Big Shop Sdn Bhd:
2002
RM

2003
RM

Current Assets:
Stocks
Debtors
Balance at Bank

1,200
1,000
1,800

1,400
600
1,000

Current Liabilities

3,400

2,300

Owners Equity

4,500

3,500

14,000
8,000
4,200

10,000
6,000
2,800

Sales
Cost of Goods Sold
Net Profit

(a)

Calculate the following ratios for each year (assuming a 365 day year):
(i) Current ratio
(ii) Quick ratio
(iii) Gross profit margin
(iv) Net profit margin
(v) Debtors collection period (in days)
(15 marks)

(b)

Using the above calculated ratios, comment on the profitability and liquidity of
Big Shop Sdn Bhd.
(5 marks)
TOTAL 20 MARKS

QUESTION 4
The following details have been extracted from the accounts of EmEnO Sdn Bhd for the last
three years.

Turnover (Sales)
Gross Profit
Net Profit
Fixed Assets
Stock
Debtors
Creditors
Cash at Bank
Bank Overdraft

2002
(RM000)
100
33
15
64
4
8
5
5
-

2002
(RM000)
103
34
15
72
4
11
6
6

2004
(RM000)
108
35.6
15
68
4
15
6
5

Required:
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Unit 2 The Financial Environment

(a)

Calculate, for each of the three years:

(i) Gross profit percentage
(ii) Net profit percentage
(iii) Quick ratio

(b)

Comment briefly on the ratios given and those that you have calculated in (a) above.

(6 marks)
(14 marks)
TOTAL 20 MARKS

QUESTION 5
Deron Sdn Bhd makes a range of products, all of which follow a similar production process
and have the same cost structure. The products are made in batches that are started at the
beginning of the month and are completed and taken into finished goods stock at the end of
the month. There is no work-in-progress at the end of any month.
Currently sales are RM0.3 million a month and produce a contribution of 40 sen per RM1 of
sales. Variable raw material costs account for 20 sen per RM1 of sales. Fixed costs are
RM120,000 per month of which RM30,000 is depreciation. The companys only variable
costs are production costs.
Currently trade debtors take one month to pay, trade creditors for raw materials are paid one
month after purchase and the other variable costs are paid during the month of production. At
the end of each month the company has sufficient raw material stock to meet the following
months production and enough finished goods stock to meet the following months sales.
The company has decided to expand its production and sales volumes by 50%. To generate
the increased demand, the selling price will be reduced by 10% and trade debtors will be
allowed to pay two months after the sale. Since neither the usage, nor the cost per product of
raw materials and other variable costs will be affected by the proposed expansion, the
contribution per RM1 of sales will fall to 30 sen. The changes to sales volume, price and
payment period will commence with sales made from 1st December 2004.
The companys balance at bank at 1st October 2004 is expected to be RM70,000.

Required:
Prepare the companys cash budgets for each of the months of October 2004, November
2004, December 2004. January 2005 and February 2005.
[Note: To have the necessary finished stock in place fore 1st December, it will be necessary
to increase production during November, and to have the required raw material stock in place
for 1st November it will be necessary to increase purchases during October.
TOTAL 25 MARKS

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