Ratio Analysis: Understanding the language: Session I-B
Concept Title: Understanding the language – ii
Concept Description: Explains basic terms used in finance
Every firm maintains a certain cash balance to carry out day-to-day transactions. However, if the firm has too much idle cash, it is missing the returns that it can earn on investing the money appropriately.
To maximize profits, many firms invest in marketable securities where they earn interest or dividends without experiencing a substantial impact on their liquidity position. Marketable, in this context, refers to how soon a security can be sold before its actual maturity date without experiencing a substantial loss in its value. Marketable securities are short-term financial instruments or securities that can be traded with relative ease for cash without any significant transaction costs. Following are some examples:
- Commercial Paper: Short-term, low risk, promissory notes that companies with good credit rating issue. Corporations sell Commercial Paper directly to investors, with the promise that the investor will receive the principal amount and interest on maturity.
- Certificates of deposits (CDs): CDs are issued by commercial banks and allow their owners to receive interest and the amount deposited.
- Treasury Bills: The government issues Treasury Bills to finance its budget deficit. These bills are considered risk free, as the government issues them.
Debt or Leverage is what a firm owes to outsiders. External funds are acquired in order to finance assets. It is usually expressed relative to equity and sometimes relative to assets.
Why is leverage important?
First, the level of debt determines the interest expense a business has to bear before it can pass on its earnings to its shareholders. Interest expense is a fixed cost. A business has to make interest payments irrespective of the level of production or the level of generated profits.
Second, leverage increases the upside as well as the downside for a business. In profitable situations, the use of leverage increases the Return on Equity and in non-profitable situations; it decreases the Return on Equity. Higher leverage leads to higher risk.
Ultimately, it boils down to a tradeoff between the beneficial impact of leverage (the ability to earn more returns) and the risk enhancing effect of leverage (the impact on fixed costs due to interest payments). Businesses fail miserably when they fail to understand this tradeoff.
When a firm takes on leverage, it takes on creditors. All existing creditors are interested in whether you will be able to pay them back. Potential creditors, however, are also interested in whether the business has the ability to take on more debt.
So, the existing level of debt in a firm is a valuable indicator for a potential creditor, along with profitability and other financial indicators, about whether the firm is worth lending to or not.
Debt: Explanations and Types
Debt can be of two types:
Short-term: The maturity date of obligations ranges from a few weeks to a full year. Examples of this type of debt are bank loans, overdrafts and line of credit facilities.
Long-term debt: The maturity of loans is beyond one year. Various instruments are available in this category. Some of these are:
- Term loans are a contract where the borrower agrees to pay the lender interest and principal at specific dates.
- Bonds are similar to terms loans. The only difference between the two is that they advertised and offered to a larger group of investors.
The term “stakeholders” refers to all those individuals and institutions that have a particular interest in and/or association with a company. There are various stakeholders that a business has:
- Customers – this group is interested whether a business can consistently provide quality goods and services at an adequate price.
- Employees – they want to be compensated adequately for the work they perform and would like to keep their jobs in the long run.
- Owners – this group has invested a great deal of time and money in the enterprise and are interested in receiving adequate returns on their investment.
- Suppliers – want to sell their products to the business and earn a profit on sales.
- Creditors – lend money to the business and want to be repaid.
- Government – wants to collect taxes and maintain a clean and healthy environment while protecting the rights of various parties.
At some time or the other, all these stakeholders become a source of financing for the business. For example, by providing goods and services on credit, a supplier finances a part of the business for a short period.
However, the difference between the rest of the stakeholders and creditors is that other constituents may become creditors in support of their primary goals. Whereas, for a lender, being a creditor is the primary goal, while other stakeholders’ primary goals are different.
Managerial efficiency (ME)
By Managerial Efficiency (ME) we mean that decisions taken by the management should lead to desired results and should also help in improving the financial health of the company. Is the management creating value or destroying value? Is the management making the right decisions about its operations? Analysis performed to assess the managerial efficiency of a business will look at the profitability and productivity ratios of a business and compare them with those of the competition, industry standards and accepted market norms.
Any decisions taken to improve managerial efficiency will focus on improving the profitability and productivity of the business and theoretically speaking should be independent of how the business is funded (capital structure and leverage).
Unlike Managerial Efficiency, Fundamental analysis focuses on the inherent value in a business. The question to answer in Fundamental Analysis is whether a business is trading too cheaply or too expensively in the market as compared to other players, particularly competitors.
Analysts use Fundamental Analysis for valuation and investment decisions. Hence, it focuses more on liquidity and valuation issues rather than productivity and profitability.