Formulas for calculating Finance

BUSINESS FINANCE

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Table of Contents
Chapter 1: The World of Finance
1.0

4

Introduction 4
1.1.

Importance of Financial Statements 4

1.2.

Understanding Profit and Loss Accounts

1.3.

Understanding Balance Sheet 6

Chapter 2 : Analysis of Financial Statement
2.0

2.1.

Assessing Financial Health

9

2.2.

The Basics Financial Ratios

9

2.3.

Trend Analysis and Industry Comparisons 16

18

Introduction 18
3.1.

Why Money Has Time Value 18

3.2.

Measuring the Time Value of Money 18

3.3.

The Present Value of a Single Amount

3.4.

Working with Annuities

3.5.

Special Time Value of Money Problems

19

25

Chapter 4 : Capital Budgeting Decision Methods
4.0

9

Introduction 9

Chapter 3 : The Time Value of Money
3.0

5

29

31

Introduction 31
4.1.

The Capital Budgeting Process

4.2.

Capital Budgeting Decision Methods32

4.3.

Capital Rationing

4.4.

Risk and Capital Budgeting 41

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Chapter 5 : Capital Structure Basics 42
5.0

Introduction 42
5.1.

Breakeven Analysis and Leverage

5.2.

Leverage

5.3

Capital Structure Theory

42

44
46

Chapter 6 : Working Capital Policy 47
6.0

Introduction 47
6.1.

Managing Working Capital

6.2.

Why Business Accumulate Working Capital 48

6.3.

Liquidity Versus Profitability 49

6.4.

Establishing the Optimal Level of Current Assets

49

6.5.

Managing Current Liabilities: Risk and Return

51

6.6.

Three Working Capital Financing Approaches

52

6.7.

Working Capital Financing and Financial Ratios

54

Chapter 7 : Managing Cash
7.0

48

56

Introduction 56
7.1.

Cash Management Concept 56

7.2.

Determining the Optimal Cash Balance

7.3.

Forecasting Cash Needs

7.4.

Managing the Cash Flowing In and Out of the Firm 58

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Chapter 1: The World of Finance

1.0

Introduction
Finance is the process by which money is transferred among businesses, individuals
and governments through the process of financing and investing. It also can be defined
as the application of the principles of financial economist to an inter-related set of
monetary problems.

1.1. Importance of Financial Statements
Financial statements are formal records of the financial activities of a business, person,
or other entity. Financial statements provide an overview of a business or person's
financial condition in both short and long term. All the relevant financial information
of a business enterprise, presented in a structured manner and in a form easy to
understand, is called the financial statements. There are four basic financial statements:
1.

Balance sheet: also referred to as statement of financial position or condition,
reports on a company's assets, liabilities, and Ownership equity at a given
point in time.

2.

Income statement: also referred to as Profit and Loss statement (or a "P&L"),
reports on a company's income, expenses, and profits over a period of time.
Profit & Loss account provide information on the operation of the enterprise.
These include sale and the various expenses incurred during the processing
state.

3.

Statement of retained earnings: explains the changes in a company's retained
earnings over the reporting period.

4.

Statement of cash flows: reports on a company's cash flow activities,
particularly its operating, investing and financing activities

These financial statements are importance to the stakeholders of a company in order to
assess the company’s financial health. Financial analysis will be carried out in order to
evaluate a company’s performance. The assessment will be done to determine the
company’s past, present and anticipated future financial performance.

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1.2. Understanding Profit and Loss Accounts

Profit and Loss accounts (P&L) is also known as Income Statement. A firm’s income
statement represents a summary of the firm’s operating results over a period, normally
for 1-year period.
IIFC Products Bhd
Income Statement for year ended Dec 31, 2009 (in
RM`000)
Net Sales
Cost of Goods Sold
Gross Profits
Operating expenses
Depreciation Expense
Earnings before interest and tax (EBIT)
Interest expense
Earnings before tax
Taxes (40%)
Earnings after tax (Net Income)
Preferred stock dividend
Earnings available to common stock holders (EACS)
Common Stock dividends
Addition to Retained Earnings

1,500
750
750
30
180
540
40
500
200
300
7
293
200
93

Table 1.1 Income Statement of IIFC Products Bhd

The above table presents IIFC Products Bhd’s income statement. The 2009 statement
begins with Net sales; the total RM amount of sales during the period, from which cost
of goods sold, is deducted. The resulting gross profits of RM 750,000 represent the
amount remaining to satisfy operating, financial and tax costs.
Operating expenses include selling expense, general and administrative expense,
leasing expense and depreciation expense are deducted from gross profits to get the
operating profit. Operating profit or earnings before interest and tax (EBIT) represent
the profits earned from producing and selling products, without considering financial
and tax costs.
Interest expense, which is the financial cost, will be subtracted from operating profits
to find net profit before tax. Taxes then is calculated at the appropriate tax rates (in the

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example, the company has a 40% tax bracket) and deducted to determine the net
profits after tax.
Any preferred stock dividend must be subtracted from net profit after tax to arrive at
earnings available to common stockholders. This is the amount earned by the firm on
behalf of the common stockholders during the period. The earning available to
common stockholders will then be divided into two portions: common stock dividend
and addition to retained earnings.

1.3. Understanding Balance Sheet
Balance sheet presents a quantitative summary statement of a company’s financial
position at a given point in time, including assets, liabilities and shareholders’ equity
or net worth. The first part of a balance sheet shows all the productive assets a
company owns and the second part shows all the financing methods (such as liabilities
and shareholders’ equity).
IIFC Products Bhd
Balance Sheet for year ended Dec 31, 2009
Current Assets
Cash
Marketable

Current Liabilities
108,000 Account Payable

178,200

Securities
Accounts Receivable
Inventories
Total Current

103,500 Notes Payable
124,200 Accruals
9,000 Total Current Liabilities

4,050
21,330
203,580

Assets
Net Fixed Assets
Total Assets

344,700 Long Term Debt
306,000 Total Liabilities
650,700 Shareholders' equity

202,500
406,080

Preferred Stock
Common Stock
Retained Earnings
Total liabilities and

40,000
64,620
140,000

shareholders' equity

650,700

Table 1.2 Balance Sheet of IIFC Products Bhd
The above table presents IIFC Products Bhd’s balance sheet. The statement balances
the firm’s assets (what it owns) against its financing, which can be either debt (what it
owes) or equity (what was provided by owners). The firm’s assets are further subdivided into current assets (expected to be converted into cash within one year or less)
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and fixed asset. The same situation applies to the firm’s liabilities, which are divided
into current liabilities (expected to be paid within one year or less) and long term
liabilities.
As is customary, the assets and liabilities are listed from the most liquid to the least
liquid. Liquidity depend on how easy the assets or liabilities can be converted into
cash.

Current Assets
The components of current assets are cash and other assets that are consumable or
convertible to cash in a relatively short time less than 1 year. It represents working
capital of the firm that provides support for day-to-day operation
1. Marketable securities: very liquid short term investments, such as Treasury Bills
and Certificate of deposit held by the firm. Since they are very liquid, marketable
securities are viewed as a form of cash. They are also known as “near cash”
money
2. Account receivable: represent the total money owed to the firms by its customers
on credit sales made to them
3. Inventories: include raw materials, work in progress (partially finished goods)
and finished goods held by the firm.
Fixed Assets
Fixed assets such as equipment, lands and buildings are acquires for long-term use
and cannot easily converted into cash within a short period without losing its value.
1. Net Fixed assets: represent the difference between gross fixed assets (the original
cost of all long term assets owned by the firm) and accumulated depreciation
(total expense recorded for the depreciation of fixed assets)
Current Liabilities
Current liabilities are obligations due and payable within a period of 1 year or less
1. Account payable: amounts owed by the firm for credit purchases that they made.
2. Notes payable: outstanding short term loans

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3. Accruals: amounts owed for services for which a bill may not or will not be
received. For example taxes due the government and wages due employees.
Long Term Debt
Long term debt is debt due or payable beyond 1-year period
1. Long term debt: represents debt for which payment is not due in the current year.
For example is bond, term loan, debentures and mortgage.
Shareholders’ Equity
Represents ownership positions in the firm:
1. Preferred stock: also called preferred shares, preference shares, or simply
preferreds, is a special equity security that resembles properties of both an equity
and a debt instrument and is generally considered a hybrid instrument
2. Common Stock: a form of corporate equity ownership. The common stockholders
are the owners of the firm
3. Retained Earnings: the cumulative total of all earnings that have been retained and
reinvested in the firm since its inception.

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Chapter 2 : Analysis of Financial Statement

2.0

Introduction

Financial analysis is the assessment of a firm’s past, present and anticipated future
financial performance. The analysis is made based on the firm’s financial statements
(i.e balance sheet, income statement, statement of cash flow and statement of retained
earnings). It involves looking at historical performance to estimate future performance.
It allows comparison of the company’s performance overt time as well as its
performance in comparison with its competitor in the same industry. Financial analysis
helps an individual to check whether a business is doing better this year than it was
last year, or whether it is doing better or worse than other companies in the same
industries.

2.1. Assessing Financial Health
A company’s financial health can be assessed by looking at its financial statements. The
company will be considered as “financially healthy” when its performance
outperformed other companies in the same industry and also outperformed the
industry’s benchmark. The need to identify a company’s strengths and weaknesses is a
must so that it can capitalize on this strength and take remedial and corrective actions
to improve its weaknesses. The principal tool of financial analysis is financial ratios.

2.2. The Basics Financial Ratios
Financial

ratios

are

divided

into

five

main

categories;

liquidity

ratios,

efficiency/activity ratios, leverage ratios, profitability ratios and market value ratios. To
illustrate how these ratios are calculated and interpreted, we will refer to the balance
sheet and income statement of IIFC Products Bhd in table 1.1 and 1.2 from previous
chapter.

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1. Liquidity Ratios
Liquidity ratios show a firm’s ability to meet its short term financial obligations.
In other words, they show whether the firm has the resources to pay its creditors
when payments are due.

The higher the ratios, the easier for the firm to meet its obligations. Among the
commonly used ratios are:

a. Current Ratio
Current Ratio

Current Assets_
=

Current Liabilities

=

344,700
203,580

=

1.69 times

Having a ratio of 1.69 times means, for every RM1 of current liabilities, the
firm has RM1.69 of current assets as back up.

b. Quick/Acid Test Ratio
Quick/Acid Test Ratio

Current Assets – Inventories
= Current Liabilities
= 344,700 – 9,000
203,580
= 1.65 times

This ratio indicates whether a firm has enough current assets to cover its
current liabilities without selling its inventories. Based on the above
calculation, the firm still has RM1.65 for every RM1 of liabilities that they
have, without having to sell its inventory.

2. Efficiency/Activity Ratios

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These ratios measure how effectively the firm is managing its assets in generating
sales. They show the amount of sales generated for every dollar of assets
investment
a. Inventory Turnover Ratio
Inventory Turnover Ratio

Cost of Goods Sold (COGS)
=

Inventories

= 750,000
9,000
= 83.33 times
This ratio indicates how many times the inventory is sold and replaced in a
year. The higher the ratio, the faster the stock is being sold, the more efficient
the firm in managing its inventories. Based on the calculation above, the firm
manages to sell its inventories 83.33 times per year. It shows that the company
is efficient in managing its inventory.

b. Average Collection Period (ACP)
Average Collection Period (ACP)

____Account Receivable____
= Annual Credit Sales/360 days
= ___124,200___
1,500,000/360
= 29.80 days

This ratio indicates the number of days taken by a firm to collect its account
receivable from its debtors. The shorter the days, the more effective the firm
in managing its account receivable. IIFC Product Bhd takes 29.8 days to
collects its debts.

c. Fixed Asset Turnover

_____Sales_____

Fixed Asset Turnover

= Net Fixed Assets
= 1,500,000
306,000
= 4.9 times

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This ratio measures the firm’s efficiency in utilizing its plant, equipment and
other fixed assets in generating sales. The above calculation shows that the
firm turnover its fixed assets 4.9 times a year.

d. Total Asset Turnover

___Sales__

Total Asset Turnover

= Total Assets
= 1,500,000
650,700
= 2.3 times

This ratio indicates the firm’s efficiency in managing its assets to generate
sales. The above calculation shows that the firm turnover its total assets 2.3
times a year. The higher a firm’s total assets turnover, the more efficiently its
assets have been used.

3. Leverage Ratios
The term leverage of gearing refers to the use of borrowed capital or loans. Leverage
ratios measure the level of debt or borrowings in a firm. They tell us whether the
company depends more on the debt financing or equity financing. They also
highlight the ability of the firm to honour its medium and long term debt
commitments in terms of repayment of the principal as well as the interest charges.
a. Debt Ratio
Debt Ratio

_Total Debt_
=

Total Assets

=

446,080
650,700

=

0.6855 @ 68.55%

Based on the above calculation, the firm shows that 68.55% of its assets is financed by
debt, while the balance are finance by shareholders’ equity. This shows that the
company is highly dependent on debt. Creditors and financial institutions will prefer
a company with a lower debt ratio.

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b. Debt to Equity Ratio

_Total Debt_

Debt to Equity Ratio

= Total Equity
= 446,080
204,620
= 2.18

This ratio measures the relative funds provided by creditors as compared to owners
or net worth in the firm’s capital structure. Ratio more than 1 means creditors
provide more funds compared to owner.

c. Times Interest Earned @ Interest Coverage Ratio
Times Interest Earned

= Earnings Before Interest and Tax (EBIT)
Interest Expense
= 540,000
40,000
= 13.5 times

This ratio measures the firm’s ability to cover its interest charges out of its operating
profits. The higher the ratio, the higher is the firm’s ability to fulfill interest
obligations. Based on the above calculation, the firm is able to pay its interest
obligations 13.5 times with the amount of operating profits that it has.

4. Profitability Ratios
These ratios measure how effectively the firm uses its assets to make profits.
Profitability ratios show the profits earned for every single dollar of sales made or the
profits earned for every investment in assets made.
a.

Gross Profit Margin (GPM)
Gross Profit Margin (GPM)

Gross Profit
=

Sales

= _750,000_
1,500,000
= 50%

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The above calculation shows that the firm manages to generate RM0.50 of gross profit
for every RM1 of sales made. It shows the efficiency of the company in controlling its
cost of goods sold.
b.

Operating Profit Margin
Operating Profit Margin

Earnings Before Interest and Tax (EBIT)
=

Sales

= _540,000_
1,500,000
= 36%
The above calculation shows that the firm manages to generate RM0.36 of operating
profit for every RM1 of sales made
c.

Net Profit Margin
Net Profit Margin

Earnings Available to Common Stockholders
=

Sales

= _293,000_
1,500,000
= 19.53%
The above calculation shows that the firm manages to generate RM0.1953 of net
profit for every RM1 of sales made
d. Return on Assets (ROA)

Return on Assets (ROA)

Earnings Available to Common Stockholders
=

Total Assets

= _293,000_
650,700
= 45.03%
This ratio also known as Return on Investments (ROI). It indicates the ability of the
firm to generate profits out of the firm’s investments in assets. The above calculation
shows that for every RM1 of total assets that the firm has, it will be able to generate
RM0.4503 of profits.

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e.

Return on Equity (ROE)

Earnings Available to Common Stockholders

Return on Equity (ROE) =

Total Equity

= _293,000_
204,620
= 143.19%

ROE measures the profit earned by common stockholders from their investment in
the firm. Based on the above calculation, for every RM1 of investment the
shareholders made, it will be able to generate RM1.43 of return to them.

5. Market Value Ratios
These ratios relate a firm’s stock price to its earnings and book value per share. They
give the management an indication of what investors think of the firm’s past
performance and future prospect. Market ratios are the result of the firm’s overall
performance.
Given that IIFC Products Bhd’s ordinary shares issued is 200,000 shares and its
current market share price is RM25.
a. Earnings Per Share (EPS)
Earnings Per Share

Earnings Available to Common Stockholders
=

Number of ordinary shares issued

= _293,000_
200,000
= RM1.465
This ratio indicates the profit earned per unit of issued share. The above calculation
shows that IIFC Products Bhd’s shareholders are getting RM1.465 for each share held
in the firm

b. Dividend Per Share (DPS)
Dividend Per Share

_______Ordinary Dividends_______
= Number of Ordinary Shares Issued
= _200,000_
200,000
= RM1.00

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This ratio indicates the total amount of dividend received by ordinary shareholders
for each unit of ordinary share held. Based on the above calculation, it shows that the
shareholder will receive RM1 of dividend of each share that they have.
c. Dividend Payout Ratio (DPR)

_Dividend Per Share_

Dividend Payout Ratio

=

Earnings Per Share

= _RM1.00_
RM1.465
= 0.68
Dividend payout ratio indicates the proportion of earnings that is distributed as
dividends to shareholders. The above calculation shows that the firm distributes 68%
of its earnings to the shareholders and retained 32% of the balance for reinvestment
and other purposes.

d. Price/Earnings Ratio
Price/Earnings Ratio

_Market Price Per Share_
=

Earnings Per Share

= _RM25.00_
RM1.465
= 17.06 times
This ratio measures the amount that investors are willing to pay for each dollar of a
firm’s earnings. The 17.06 shows that the investors were paying RM17.06 for each RM1
of earnings.

2.3. Trend Analysis and Industry Comparisons

Ratio analysis is not merely the calculation of the given ratio. A meaningful basis for
comparison is needed to determine the value of the company. Two types of ratio
comparisons can be made: trend analysis or also known as time series and comparative
analysis or cross sectional.

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1. Trend analysis
It is also known as time series analysis, which evaluates performance of the
company over time. Comparisons are made between current to past performance
using ratios to assess the company’s progress.
2. Cross sectional
This analysis involves the comparison of different companies’ financial ratios at the
same point in time. Unlike trend analysis, ratios of other companies within the
same industry are needed in order to analyze the performance of the company.
Analysts are often interested in how well a company has performed in relation to
other companies in the same industry.

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Chapter 3 : The Time Value of Money
3.0

Introduction
Time Value of Money (TVM) simply means a dollar received today is worth more than
the same dollar received in the future. An understanding of how time value of money
works is very crucial in financial management as it will enable us to further understand
how stocks and bonds are valued, how to decide on the capital budgeting and many
more.
Given example, during your parents’ time when they went to school, your
grandparents most likely would give them around RM0.10 as their pocket money. At
school, they would be able to buy foods and drinks with that amount of money. If you
give your children, the same amount of pocket money that your parents got (i.e
RM0.10), would your children be able to buy foods and drinks too? I bet that they
would only manage to buy a sweet.
Here we can see that, the same RM0.10, over some period of time, would value less in
the future. This situation proofs the rule of thumb which says that “a dollar received
today is worth more than the same dollar received in the future”.

3.1. Why Money Has Time Value
In reality, we could earn interest over investment period if you make an investment.
The reason is that the more time taken, the more interest you may earn. That is the
trade off between time and money.
In other words, the investors would be compensated for his waiting time in making
their investment. This is due to the fact that investors willing to forgo their current
consumption in expectation of future earnings. TVM would encourage more
investment to be done since investors are aware of the benefits of their investments.

3.2. Measuring the Time Value of Money
A key concept of TVM is that a single sum of money or a series of equal, evenly-spaced
payments or receipts promised in the future can be converted to an equivalent value

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today. Conversely, you can determine the value to which a single sum or a series of
future payments will grow to at some future date.
Time Value of Money can be further subdivided into two;
a) Present Values (PV)
b) Future Values. (FV)
There are also two situations involving TVM, which are for single cash flow and
annuity.

3.3. The Present Value of a Single Amount
Future Value and Compounding
Compound interest means interest is earned not only on the principal or initial
investment but also on the interest earned earlier. Future value of a current amount is
therefore determined by applying compound interest over a specified period of time.
To simplify, future value is the value to be received in the future, given a value today.
For example you invest RM1, 000 today in a unit trust account that is paying 4%
interest per year for 4 years, how much money will you earn in 4 years? This is what
we call as compounding.
Example 1:
Find the future value of RM7, 000 to be invested for 4 years at 10% compounded
annually.
In order to answer this question, we have two options; formulae or present value
interest factor (FVIF) table.
a.

Formulae
FV

= PV (1 + i )n

where;

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PV

= Present Value of the future sum of money

FV

= Future Value of an investment at the end of n years

i

= annual discount rate

n

= number of years before payment is received
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To answer the question;
FV

= PV (1 + i )n
= 7, 000 ( 1+0.1)4
= 10,248.70

b.

Future Value Interest Factor (FVIF) table

FV

= PV (FVIFI,n)
= PV (FVIF10%,4)
= 7, 000 (1.464)
= 10,248.00

Example 2:
Find the future value of RM7, 000 to be invested for 4 years at 10% compounded semi
annually.
In this question, the investor will receive interest twice in a year. Do take note that the
interest quoted in the question will be interest per annum. Since investors will be paid
twice a year, that means the number of times interest will be paid, n, also will change.
So does the interest on the investment.
n = 4 years x 2 times per year
=8
= 10% per annum / 2 times a year

i

= 5%
a. Formulae
FV

= PV (1 + i )n
= 7, 000 ( 1+0.05)8
= 10,342.19

b. Future Value Interest Factor (FVIF) table
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FV

=PV (FVIF5%,8)
= 7, 000 (1.477)
= 10,339.00

Example 3:
Find the future value of RM7, 000 to be invested for 4 years at 10% compounded
quarterly.
n = 4 years x 4 times per year
= 16
= 10% per annum / 4 times a year

i

= 2.5%
FV

= PV (1 + i )n
= 7, 000 ( 1+0.025)16
= 10,391.54

For this question, we cannot use the table since table only provide round numbers,
with no decimal points. The only method that can be used is only using the
formulae

Example 4:
Find the future value of RM7, 000 to be invested for 4 years at 10% compounded
monthly.
FV

= PV (1 + i )n
= 7, 000 ( 1+0.1/12)48
= 10,425.48

Example 5:
Find the future value of RM7, 000 to be invested for 4 years at 10% compounded daily.
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FV

= PV (1 + i )n
= 7, 000 ( 1+0.1/365)4x365
= 10,442.20

Present Value and Discounting
The present value is the value today of a sum of money to be received in the future.
Take for example you know that in 5 years time, you will need RM50, 000 as a down
payment of your dream house. By using the concept of time value of money, you could
determine how much money that you need to deposit today in a fixed deposit account
paying i.e 7% per year, in order for you to have RM50, 000 in 5 years. This can be
referred to as discounting.
Example 1:
What is the present value of RM5, 000 to be received 3 years from today if the required
rate of return is 8% compounded annually?
In order to answer this question, we have two options; formulae or present value
interest factor (PVIF) table.
a. Formulae
PV

= __FV__
(1+i)n

where;
PV

= Present Value of the future sum of money

FV

= Future Value of an investment at the end of n years

i

= annual discount rate

n

= number of years before payment is received

To answer the question;
PV

= __FV__
(1+i)n
= __5, 000__
(1+ 0.08)3
= 3,969.16

b. Present Value Interest Factor (PVIF) table
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PV

= FV (PVIFI,n)
= FV (PVIF8%,3)
= 5, 000 (0.7938)
= 3,969.00

There are also situations whereby the investment made is paid interest more than once
in a year. In this situation, the present value of such investment will differ than those
with annual compounding.
Example 2:
What is the present value of RM5, 000 to be received 3 years from today if the required
rate of return is 8% compounded semi annually?
In this question, the investor will receive interest twice in a year. Do take note that the
interest quoted in the question will be interest per annum. Since investors will be paid
twice a year, that means the number of times interest will be paid, n, also will change.
So does the interest on the investment.
n = 3 years x 2 times per year
=6
= 8% per annum / 2 times a year

i

= 4%
a. Formulae
PV

= __FV__
(1+i)n
= __5, 000__
(1+ 0.04)6
= 3,951.57

b. Present Value Interest Factor (PVIF) table
PV

= FV (PVIF4%,6)
= 5, 000 (0.7903)
= 3,951.50

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Example 3:
What is the present value of RM5, 000 to be received 3 years from today if the required
rate of return is 8% compounded quarterly?
= 3 years x 4 times per year

n

= 12
= 8% per annum / 4 times a year

i

= 2%
a.

Formulae
PV = __FV__
(1+i)n
= __5, 000__
(1+ 0.02)12
= 3,942.47

b.

Present Value Interest Factor (PVIF) table
PV = FV (PVIF2%,12)
= 5, 000 (0.7885)
= 3,942.50

Example 4:
What is the present value of RM5, 000 to be received 3 years from today if the required
rate of return is 8% compounded monthly?
PV

= __FV__
(1+i)n
= __5, 000__
(1+ 0.1/12)36
= 3,708.70

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For this question, we cannot use the table since table only provide round numbers,
with no decimal points. The only method that can be used is only using the formulae.
Example 5:
What is the present value of RM5, 000 to be received 3 years from today if the required
rate of return is 8% compounded daily?
PV

= __FV__
(1+i)n
= __5, 000__
(1+ 0.1/365)3x365
= 3,704.24

3.4. Working with Annuities
An annuity is a series of equal payments made at fixed intervals for a specific number
of periods. For example, depositing RM1,000 at the end of the next five years is called a
five-years annuity. Annuity is divided into two main types:
1.

Ordinary annuity: payments made at the end of each period (i.e payment of

2.

Astro bills)
Annuity due: payment made at the beginning of each period (i.e rental
payments)

Future Value of an Ordinary Annuity
Example:
If you make a deposit of RM500 at the end of each period for five years in a bank which
pays 10% interest per year, how much will you have at the end of five years?
To answer this question, we can either use a formulae or the table
a.

Formulae
FVA

= PMT (1+i )n - 1
i

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where:
FVA = the total future value at the end of n periods
PMT = the equal payments made for each period
i

= annual discount rate

n

= number of payments made

FVA = 500 (1+0.1)5 – 1
0.1
= RM3, 052.55

b.

Future Value Interest Factor Annuity (FVIFA) table
FVA = PMT (FVIFA I,n)
= 100 (FVIFA10%,5)
= 500 (6.1051)
= RM3,052.55

Future Value of an Annuity Due
Example:
If you make a deposit of RM500 at the beginning of each period for five years in a bank
which pays 10% interest per year, how much will you have at the end of five years?
a. Formulae
FVAD = PMT (1+i )n – 1 1+i
i
where:
FVA = the total future value at the end of n periods
PMT = the equal payments made for each period

FVAD

i

= annual discount rate

n

= number of payments made

= 500 (1+0.1)5 – 1 1+0.1
0.1
= RM 3,357.81

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b. Future Value Interest Factor Annuity (FVIFA) table
FVA = PMT (FVIFA I,n) (1+i)
= PMT (FVIFA10%,5)(1+0.1)
= 500 (6.1051)(1+0.1)
= RM3,357.81

Present Value of an Ordinary Annuity
Example:
Suppose a firm expects to receive future car loans payments of RM100 per year for the
next five years from one of its customers. The first payment is due one year from today.
The interest imposed on the debt is 5% per year. How much money does the customer
owe to the firm?
a. Formulae
PVA

= PMT (1+i )n – 1
i (1+i)n

where:
PVA = the total present value of n annuity
PMT = the equal payments made for each period
i

= annual discount rate

n

= number of payments made

PVA = 100 (1+0.05)5 – 1
0.05(1+0.05)
= RM432.94
b. Present Value Interest Factor Annuity (PVIFA) table
PVA = PMT (PVIFAi,n)
= 100 (PVIFA5%,5)
= 100 (4.3295)
= RM432.95

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Business Finance

Present Value of an Annuity Due
Example:
Suppose a firm expects to receive future car loans payments of RM100 per year for the
next five years from one of its customers. The first payment is due today. The interest
imposed on the debt is 5% per year. How much money does the customer owe to the
firm?
a. Formulae
PVAD = PMT (1+i )n – 1 1+i
i (1+i)n
where:
PVA = the total present value of n annuity
PMT = the equal payments made for each period

PVAD

i

= annual discount rate

n

= number of payments made

= 100 (1+0.05)5 – 1 1+0.05
0.05(1+0.05)
= RM454.60

b. Present Value Interest Factor Annuity (PVIFA) table
PVA = PMT (PVIFAi,n)(1+i)
= 100 (PVIFA5%,5)(1+0.05)
= 100 (4.3295)(1.05)
= RM454.60

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3.5. Special Time Value of Money Problems

Problem 1
Hasan currently has RM10, 000 that he can use to purchase inventory for his custom
T-shirt shop. His supplier says RM10, 000 is not enough for the current shipment but
that he will agree to sell a similar load of T-shirts in one year for RM10, 800 or in two
years for RM11, 500. Hasan can invest his money for one year at an annual interest
rate of 6% or for two years at an annual rate of 7%. Which choice can Hasan afford?
Option 1: Invest for one year @ 6%
FV

= RM10,000 (1+0.06)1
= RM10,600

Hassan cannot afford to buy the T-shirt in one year time since the supplier will charge
him for RM10,800
Option 2: Invest for two years @ 7%
FV

= RM10,000 (1+0.7)2
= RM11,449

Hassan also cannot afford to buy the T-shirt in two years time since the supplier will
charge him for RM11,500 whereas his investment could only be RM11,449.

Therefore, Hassan cannot afford either one of the options given by the supplier to
him.

Problem 2
Kassim and Haini want to make a down payment of RM25, 000 on a condominium
when they retire in three years. If they can earn 8% on their investments, how much
money do they need to invest today to have enough for the down payment?

PV
Shaliza/PBF

= __25,000__
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Business Finance

(1+0.08)3
= RM19, 845.81
Therefore, they need to invest RM19, 845.81 today for them to be able to get RM25,000
in three years time.

Problem 3
Your firm is planning to invest $25,000 per year in equal annual end-of-the-year cash
flows to fund an employee retirement plan. If the investments are expected to earn
8% per year, how much will the account be worth in 20 years?
FVA

= PMT (1+i )n - 1
i
= 25,000 (1+0.08)20 – 1
0.08
= RM1, 144, 049.11

Problem 4
The average annual cost of higher education at a public university is approximately
$12,000 per year. If we assume those costs are lump sum beginning-of-the-year
payments, and the appropriate cost of capital is 7%, what is the present value cost of
four years of higher education?
PVA

= Pmt (1+i )n – 1 1+i
i(1+i)
= 12,000 _(1+0.07)4 – 1_ 1+0.07
0.07(1+0.07)
= RM43, 491.78

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Chapter 4 : Capital Budgeting Decision Methods
4.0

Introduction
When the company needs to decide whether to invest in a new project, the financial
manager has to focus on company’s cash flow and cost involved to be used to evaluate
the investments. Thus, the financial manager has to determine the relevant revenues
and expenditures, that is the cash inflow and cash outflow, so that it may establish the
maximum return to the company in those investments.
The purpose of this chapter is to evaluate and decide whether to purchase new
equipment, the acquisition of property or acquisition of another company. Therefore
the best project can give a maximum return from the company’s investment.
4.1. The Capital Budgeting Process

The process of capital budgeting involves the calculation of incremental cash flows
against the investment decision and thus evaluate the cost involved in the projects.
The process of capital budgeting involved four steps which is as follow :
a. Estimates the cash flows after tax from investment.
b. Consider the risk involved associated to the investment.
c. Choose the best methods to evaluate the project ; non-discounted method and
discounted method.
d. Make a best decision to ensure those investments provides a positive return to the
company’s value. The decision is based on mutual exclusive investment and/or
independent investment.
Mutual exclusive investment decision refer to a decision on choosing the best
project (only 1 project) which gives the positive result to the company while
independent investment is refer to the decision of choosing more than 1 project as
long as that project give the highest value to the company.
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4.2. Capital Budgeting Decision Methods
The capital budgeting process can be determined by using 2 cash flow methods i.e.
Non-discounted cash flow and discounted cash flow method.
4.2.1 Non-discounted cash flow method
This method does not consider the time value of money in calculating and
analyze the capital investment. Under this method, there are two techniques that
commonly used by Financial Manager to calculate and evaluate the best
investment i.e. Average Rate of Return and Payback Period.
The following is the example which will be used to calculate all the techniques.
Shasha Farzana is the Financial Manager for RIDZ Sdn Bhd. She needs to
considering the potential investment for company i.e. Project A and Project B
which can maximize the company’s return. The below table shows the detail of
each projects :
Year

Project A

Project B

1

RM2,500

RM2,500

2

RM2,500

RM700

3

RM2,500

RM3,300

Total Inflow

RM7,500

RM6,500

Initial Outlay

RM5,000

RM5,000

The Accounting Rate of Return (ARR)
This method is to measures the average on profitability of proposed capital
investment as the ratio of average net income after tax to the average investment.
ARR

=

Average Net Income After Tax
Average Investment

Where :
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Average Net Income After Tax

=

Σ Net Income / n

Average Investment

=

(IO + SV) / 2

Where :
IO
:
SV
:
n
:
Illustration 1;

Initial Investment
Estimated salvage value of the investment
Number of years

Refer to example above, calculate the average rate of return for both
projects and decides the project to be invested when the minimum
average rate of return is 80%.
ARRA

=
=
=

ARRB

=
=
=

[ (2,500 + 2,500 + 2,500) / 3 years]
[ (5,000 + 0) / 2]
(2,500 / 2,500) X 100
100%
[ (2,500 + 700 + 3,300) / 3 years]
[ (5,000 + 0) / 2]
(2,167 / 2,500) X 100
87%

As an investment criterion, the highest average rate of return is favorable
as its represents a greater return on average. Therefore;


Independent project : The company should accept both projects since
the rate of returns are above than the minimum average rate of return.



Mutually exclusive project : The company should adopt Project A
only as it gives the highest return than Project B.

The Payback Period (PB)
The payback period method focuses on the time value of money and uses
cash flow after tax, instead of net profit in evaluating an investment. This
method use to measure the length of time that the company needs to
consider to recover back the cost of investment. Thus, payback occurs
when the total of cash inflows equal to the initial investment :
Payback period (When the cash flows are an annuity)

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= IO / Average CF

Payback period (When the cash flows are mixed stream)
= (Yr – 1) + [ (IO – Cumulative cash inflow before Yr.) ]
Cash inflow in Yr.

Where :
Yr. :

Number of years to recover the initial investment; cash flow

after tax should exceed the IO
IO :

Initial investment

Illustration 2 ;
Using the above example to calculate payback period and decides the best
project to invest in when the targeted payback period is 3 years.
PPA

=
=

PPB

=
=

5,000___________
(2,500 + 2,500 + 2,500) / 3 years
2 years
(3 – 1) + [ (5,000 – 3,200) ]
3,300
2.55 years

As an investment criterion, the shortest payback period is favorable as its
represents how fast the cost could recover. Therefore;


Independent project : The company should accept both projects since
the payback period is above than the targeted payback period.



Mutually exclusive project : The company should accept Project A as
the company can get back the cost in 2 years time as compared to
Project B.

4.2.2

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Discounted cash flow method

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Business Finance

Discounted cash flow method considers the time value of money in the analysis.
This method support the goal of the firm i.e. to maximize the shareholders’
wealth.
There are three common techniques in discounted cash flow ; net present value,
internal rate of return and profitability index.
Net Present Value (NPV)
This technique among the common techniques and is widely used in analyzing
the best investment for company. NPV is the present value of an investment’s
annual cash flows less the initial outlay. It can be expressed as follows :

NPV (mixed stream cash flows) = [ PV1 + PV2 + … + PVn ] - IO
(1 + i)1 (1 + i)1
(1 + i)n
NPV (an annuity) = PV [ 1 –

Where :
PVt
i
n
IO

=
=
=
=

1 ]
(1 + i)n
i

- IO

the annual cash flow in period t
the company’s required rate of return
the project’s expected life
initial cost of investment

Illustration 3
If the marginal cost of capital for RIDZ Sdn Bhd is 10%, calculate the NPV
for both projects.
NPVA

=

=

NPVB
Shaliza/PBF

PV X [ 1 –

2,500 X [ 1 –

=

RM1,217.13

=

[

2,500

+

1 ]
(1 + i)n
i

- IO

1
]
(1 + 0.10)3
0.10

700

+

- 5,000

3,000

] - 5,000
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Business Finance

=
=
=

(1 + 0.10)1 (1 + 0.10)2 (1 + 0.10)3
[ 2,272.73 + 578.51 + 1,365.50 ] – 5,000
4,216.73 – 5,000
(RM783.27)

As an investment criterion, the basic rule for NPV to accept project with
NPV grater than zero. This is because the NPV indicates the firm earns a
greater return than or equal to required rate of return. Therefore;


Independent project : The company should accept Project A only
since the NPV is positive and more than zero and to reject Project B
which having a negative NPV.



Mutually exclusive project : The company should accept Project A
only since the NPV is positive and more than zero.

Profitability Index (PI)
Unlike NPV, profitability index measures the ratio of present value of cash
flow to the cost of investment. This index can be expressed as follows :
PI =

[ PV1 + PV2 + … + PVn
]
(1 + i)1 (1 + i)1
(1 + i)n
----------------------------------------Initial Outlay

Illustration 4
Based on above example, calculate the PI for both projects.
PIA

=

=

=
=
PIB

Shaliza/PBF

=

PV X [ 1 –

1 ]
(1 + i)n
i

- IO

2,500 X [ 1 –

1
]
(1 + 0.10)3
0.10
------------------------------------------5,000
6,217.13 / 5,000
1.2434
[ 2,500 +
700 + 3,000
]
(1 + 0.10)1 (1 + 0.10)2 (1 + 0.10)3
--------------------------------------------------Page 36

Business Finance

=

=
=

5,000
[ 2,272.73 + 578.51 + 1,365.50 ]
-----------------------------------------5,000
4,216.73 / 5,000
0.8433

The decision criterion is to accept the project if the PI is greater than or
equal to 1.00 and to reject the project if the PI is less than 1.00.
Independent project : The company should accept Project A only



since the PI is greater than zero and to reject Project B which is the PI
is lesser than 1.00.
Mutually exclusive project : The company should accept Project A



only since the PI is greater than zero.
Internal Rate of Return (IRR)
IRR is the discount rates that cause the NPV to equal zero. Therefore, IRR
is when NPV is equates to zero :
IRR

=

Σ [ CFATt / (1 + IRR)t ] – IO

To illustrate, calculate the IRR for both projects.

Illustration 5
PI (annuity)
a. Determine the PVIFAi,3 by divide the annuity with initial investment.
IO
PVIFAi,3

=
=
=

Annuity (PVIFAi,3)
5,000 / 2,500
2.000

b. Refer to PVIFA table for 2.000 for period 3. Noted that 2.000 lies
between 20% and 24%.
c. Do the interpolation to calculate IRRA.

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IRR

Percentage
20%

PVIFAi,3
2.1065

IRR

2.0000

24%

1.9813

=
=

2.1065 –
2.0000
= 0.1065

2.1065 –
1.9813
= 0.1252

20% + (0.1065 / 0.1252) (24% - 20%)
23.40%

PI (mixed stream of cash flow)
This method is more complexes and very tedious process. To illustrate,
consider the project B to calculate IRR and decide which project to be
chosen when the required rate of return in 10%.
a. Calculate the average CFAT for Project B :
Average CFATB

=
=

2,500 + 700 + 3,000
3
2,066.67

b. Determine the simulated IRR.
IO
=
Average CFATB (PVIFAi,3)
PVIFAi,3
=
5,000 / 2,066.67
=
2.4194
c. By looking at PVIFA table, 2.4194 lies between 11% and 12%.
d. It is need to adjust approximate IRR accordingly. When the cash flow
is higher in the early year, therefore the estimated IRR will move
upwards and vice-versa. For Project B, the cash flow is higher in the
later years. Thus, 12% will be the focal point of adjustment.
e. Do the trial and error to calculate the approximate IRR and using NPV
concept.
Assume i = 12%
NPVB =
=
=

[ 2,500 +
700 + 3,000
] - 5,000
1
2
3
(1 + 0.12) (1 + 0.12) (1 + 0.12)
[ 2,232.14 + 558.04 + 2,135.34 ] – 5,000
(RM74.48)

Assume i = 11%
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NPVB =
=
=

[ 2,500 +
700 + 3,000
] - 5,000
(1 + 0.11)1 (1 + 0.11)2 (1 + 0.11)3
[ 2,252.25 + 568.14 + 2,193.57 ] – 5,000
RM13.96

The above calculation showed at i = 12% gives a negative value and
when i = 11%, it gives a positive value. Therefore, the interpolation is
needed to calculate the IRR.
Percentage
11%

PVIFAi,3
13.96

IRR

0

12%

-74.48

IRR

=
=

13.96 – 0
= 13.96

13.96 –
(-74.48)
= 88.44

11% + (13.96 / 88.44) (12% - 11%)
11.16%

As decision criterion, accept the projects with IRR higher than the
required rate of return.


Independent project : The company should accept Project A and B
since the IRR is greater than the required rate of return of 10%.



Mutually exclusive project : The company should accept Project A
only since the IRR for Project A is higher than Project B.
Overall, the company should invest in Project A since all the
techniques showed that Project A is the best in term on AAR, PP, NPV,
PI and IRR.

4.3. Capital Rationing
Capital rationing is referring to placing a limit on the dollar size of the capital budget.
There are three basic principles for imposing a capital-rationing constraint.


The market condition may affect on the company’s decision to invest in a
particular project.

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

The selection of manager sometimes can give a great impact in handling a new
project especially less experience manager which can’t contributes to increase
the value of firm.



The intangible consideration for e.g. to avoid interest rate increment which may
affect the investment planning.

If the company plans to impose a capital constraint on its investment project, the
financial manager may select the project with highest NPV. In other words, the
company should select the project which provides wealth maximization to
shareholders.

Illustration 7
Company ABC has a budget constraint of RM4 million and there are four projects
available. The table below is the information for each of proposed projects :
Project
AA
BB
CC
DD

Initial Outlay (RM)
2.0 million
1.0 million
1.2 million
1.8 million

NPV (RM)
0.8 million
0.4 million
0.6 million
0.9 million

From the above table, it shows that Project DD and AA have the highest initial outlay
of RM1.8 million and RM2.0 million respectively, making a total of RM 2 million and
has the remaining balance of RM 2 million. If the projects are not detachable, then no
project will be accepted and considering project AA and DD will yield a total NPV of
RM 1.7 million. The following table is the possible combinations which can fulfill the
budget constraint.
Combination
1

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Project

Initial Outlay

NPV (RM)

AA
BB

(RM)
2.0 million
1.0 million

0.8 million
0.4 million
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Business Finance

2

BB
CC
DD

3

AA
DD

3.0 million
1.0 million
1.2 million
1.8 million
4.0 million
2.0 million
1.8 million
3.8 million

1.2 million
0.4 million
0.6 million
0.9 million
1.9 million
0.8 million
0.9 million
1.7 million

From the above combination result, it shows that combination 2 gives the highest
NPV within the capital constraint.

4.4. Risk and Capital Budgeting
Risk is referring to the degree of uncertainty or variation from the expected income
from investment.

Chapter 5 : Capital Structure Basics
5.0

Introduction

Capital structure is the mix or combination of firm’s permanent long term financing
including firm’s debt, preferred stock and common stock.

Different companies may imply different optimal structure. The objectives of capital
structure are as follows :


Investment decision



Financing decision



Dividend policy decision

These decisions have to be well-planned in order to maximize the shareholder’s wealth.
5.1. Breakeven Analysis and Leverage

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Breakeven analysis is focus on the relationship between sales volume and profitability,
which has a direct relationship to the firm’s total cost structure.


Break Even point
Also known as a cost-volume analysis which is finding the level of sales where
operating profit or net income before interest and tax equals to zero that is the
total revenues equal to total cost. EBIT is;
EBIT

=

Q (P – V) – FC

Q

:

Sales quantity (in unit)

P

:

Price per unit

V

:

Variable cost per unit

FC

:

Fixed cost

Where ;

Break even analysis can be used in profit planning.



BE (in unit)

=

(FC + Profit) / (P – V)

BE (in RM)

=

(FC + Profit) / 1 - (V / P)

Sales Break Even
It involves the same formula except the sales break even uses contribution
margin (CM). The sales break even can be calculated as follows :
CM



=

1 – Variable cost ratio

=

1 – (V / P)

Cash Break Even (CBE)
It concern with the sales level in order to meet operating cash requirement. This
is because cash receipts and expenditure do not correspond directly with the
sales and expenses as per income statement. In CBE, non-cash expenses such as
depreciation are not included as it will overstate the CBE. The CBE can be
computed as follows;

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

CBE (in unit)

=

(FC – depreciation) / (P – V)

CBE (in RM)

=

(FC – depreciation) / [ 1 - (V / P)

Break Even Margin
This technique is used to calculate the margin of safety when the level of sales is
known. This relates to the firm’s current sales level to break even point and thus
it will measures the risk on how much the sales can be decline before meet the
break even point which result in negative operating earnings. Break even
margin (BEM) can be computed using the following formula :
BEM

=

S0 – BE (in RM) / S0

5.2. Leverage

Leverage implies the usage of fixed costs in a business to firm’s earnings. The leverage
is included the operating leverage and financial leverage.
Operating leverage is the fixed operating costs which is appear in the firm’s income
statement and the financial leverage relates to the financial sources which carry fixed
financing charges that the company willing to bear in order to maximize their returns
on shareholders’ wealth. The combination between operating leverage and financial
leverage known as the total leverage.
5.2.1

Operating Leverage
It represents the firm’s fixed operating cost. Fixed cost is not vary to the
change in sales or operation. Example of such cost includes insurance, cost of
management, overhead cost and depreciation cost.
Refer to the following example of the amount of leverage used in Syarikat
Mama, Mimi and Mumu.
Illustration 1
Company
Sales (RM)

Shaliza/PBF

Syarikat Mama
5,500

Syarikat Mimi
9,750

Syarikat Mumu
5,000
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Business Finance

Operating cost :
Fixed cost (RM)
Variable cost (RM)
Operating profit
Fixed cost

1,000
3,500
1,000
0.22

7,000
1,500
1,250
0.82

3,500
1,000
500
0.78

The above illustration, it shows that Syarikat Mimi has the highest percentage
of fixed cost of 0.82. This is requires a large amount of sales in this company
as compared to Syarikat Mama and Mumu in recovering the total costs and
thus able to make a highest profit.

Assume that the sales of this three companies increased by 50%, the following
table shows the effect :
Company
Sales (RM)
Operating cost :

Syarikat Mama
8,250

Syarikat Mimi
14,625

Syarikat Mumu
7,500

1,000
5,250
2,000

7,000
2,250
5,375

3,500
1,500
1,200

Fixed cost (RM)
Variable cost (RM)
Operating profit

Assume the sales and variable cost increased by 50% but the fixed cost remain
unchanged. The result is as follows :
Company
Sales before the
change (RM)
Sales
after

Syarikat Mama
1,000

Syarikat Mimi
1,250

Syarikat Mumu
500

2,000

5,375

2,500

1,000
1,000 / 1,000

4,125
4,125 1,250

2,000
2,000 / 500

=1

= 3.3

=4

the

change (RM)
Changes (RM)
Changes (number
of times)

Syarikat Mumu is the most sensitive with the change in sales and the profit
has increased by 4 times.

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Degree of Operating Leverage (DOL)
DOL is the percentage change in a firm’s operating profit due to the change in
sales volume.
The formula to calculate DOL is as follows :
DOL

=

Percentage change in operating profit
Percentage change in sales

Based on the example above, the DOL for each of companies are as follows :
Company
Syarikat Mama
Syarikat Mimi
Syarikat Mumu

5.2.2

Change in sales (%)
50
50
50

Change in profit (%)
100
330
400

DOL
2
6.6
8

Financial Leverage
It involves the use of fixed cost financing that a company acquires by choice.
Financial leverage concerns the effect of financing decision on the owner’s
return and relationship between firm’s operating profit and earning per
share.
Degree of Financial Leverage (DFL)
DFL is defined as the percentage of change in EPS as the result from
percentage change in EBIT. The level of financial leverage can be determined
by applying the following formula :
DFL

=

Percentage change in EPS____ or
Percentage change in operating profit

DFL

=

EBIT______________
EBIT – 1 – Preferred dividend / (1 – Tax)

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5.3

Capital Structure Theory

This capital structure theory assumes that there is an optimal capital structure,
whereby when a company increases the amount of debt in capital structure, the
weighted average cost of capital (WACC) will be reduced. The WACC will increase
when the company has more debt. This is due to the required return by investors will
increase and thus reduced the debt fund.
The theory has a few assumptions:


No tax will be charge to business entity.



There are 2 types of finance availability; ordinary equity share and perpetual
debt financing.



No transaction costs



All the distributable earnings are paid as a dividend.



Business risk is constant



Earnings and dividend remain fixed.

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Chapter 6 : Working Capital Policy
6.0

Introduction

Working capital is a financial metric which represents operating liquidity available to a
business. Along with fixed assets such as plant and equipment, working capital is
considered a part of operating capital. It is calculated as current assets minus current
liabilities. If current assets are less than current liabilities, an entity has a working
capital deficiency, also called a working capital deficit.

6.1. Managing Working Capital
Decisions relating to working capital and short term financing are referred to as
working capital management. These involve managing the relationship between a
firm's short-term assets and its short-term liabilities. The goal of working capital
management is to ensure that the firm is able to continue its operations and that it has
sufficient cash flow to satisfy both maturing short-term debt and upcoming
operational expenses.
Management will use a combination of policies and techniques for the management of
working capital. These policies aim at managing the current assets (generally cash and
cash equivalents, inventories and debtors) and the short term financing, such that cash
flows and returns are acceptable. Working capital management includes;
1.

Cash management.
Identify the cash balance which allows for the business to meet day to day
expenses, but reduces cash holding costs.

2.

Inventory management.
Identify the level of inventory which allows for uninterrupted production but
reduces the investment in raw materials - and minimizes reordering costs - and
hence increases cash flow.

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3.

Debtors’ management.
Identify the appropriate credit policy, i.e. credit terms which will attract
customers, such that any impact on cash flows and the cash conversion cycle
will be offset by increased revenue and hence Return on Capital (or vice versa).

4.

Short term financing.
Identify the appropriate source of financing, given the cash conversion cycle:
the inventory is ideally financed by credit granted by the supplier; however, it
may be necessary to utilize a bank loan (or overdraft), or to "convert debtors to
cash" through "factoring".

6.2. Why Business Accumulate Working Capital
The accumulation of capital refers simply to the gathering of objects of value; the
increase in wealth; or the creation of wealth. Capital can be generally defined as assets
invested with the expectation that their value will increase, usually because there is the
expectation of profit, rent, interest, royalties, capital gain or some other kind of return.
Accumulations of capital refer to a net addition to existing wealth, or to a redistribution
of wealth. If more wealth is produced than there was before, a society becomes richer;
the total stock of wealth increases.

6.3. Liquidity Versus Profitability

A firm can increase its investment in working capital by increasing its investment in
current assets. This in turn increases the firm’s liquidity. A firm is required to maintain
a balance between liquidity and profitability while conducting its day to day
operations. Investments in current assets are expected to ensure delivery of goods or
services to the ultimate customers. A proper management of the same could result in
the desired impact on either profitability or liquidity.
Liquidity is a precondition to ensure that firms are able to meet its short-term
obligations. The 'liquidity position' in a company is measured based on the 'current
ratio' and the 'quick ratio'. The current ratio establishes the relationship between
current assets and current liabilities. Normally, a high current ratio is considered to be
an indicator of the firm's ability to promptly meet its short term liabilities. The quick
ratio establishes a relationship between quick or liquid assets and current liabilities.

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An asset is liquid if it can be converted into cash immediately or reasonably soon
without a loss of value.
A profit ratio indicates how effectively management can make profits from sales. It also
indicates how much a company has to hold up a downturn, discourage competition
and make mistakes. Potential investors are interested in dividends and appreciation in
market price of stock, so they focus on profitability ratios. Managers, on the other
hand, are interested in measuring the operating performance in terms of profitability.
Hence, a low profit margin would suggest ineffective management and investors
would be hesitant to invest in the company. Further discussion on the liquidity concept
and profitability had been discussed in the earlier chapter.

6.4. Establishing the Optimal Level of Current Assets
Management of current assets consists of the management of inventory, accounts
receivable, cash and marketable securities
1. Inventory Management
Effective management of inventory depends on the size of investment. When
inventory is managed well, the costs of inventory will be at a minimum. The
Economic Order Quantity (EOQ) model will determine the optimal order size for
an inventory item and therefore helps to minimize the inventory costs.
EOQ

=

Where:
S
= usage in units per year
O
= order cost per order
H
= holding cost per unit per period
Other system of inventory also may be used such as the ABC Approach, Materials
Requirement Planning (MRP) Approach and Just-In-Time (JIT) Approach.
2. Account Receivable Management
Account receivable must be closely monitored as it represents a large portion of
current assets. It starts with the process of credit Selection whereby the customers

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will be evaluated using the 5C’s of credit before any credit sales is granted. The
5C’s are:
Character
Capital
Conditions
Collateral
Capacity

: reliability in payments
: the customers’ debt to equity ratio
: Economic and industry conditions
: Assets available to secure the debts
: cash flow available to pay debts

Once credit sales is granted, customers shall be given a credit term which will
specify the possible discount for early repayment. For example a credit term of
“2/10 net 30” means that a customer shall be given a 2% discount if they are able to
settle their debt within 10 days, and the debt should be paid off within 30 days of
sales.
If the customers default in payment, there will be steps in collecting the ccount
receivable. Firstly, customer shall be given a reminder such as sending a duplicate
invoice or courteous letter. If the debt is still failed to be collected, second step will
be taken which the company shall make follow up sending e mail, making phone
calls or pay a visit to the debtor. Last step the company can take in collecting their
debt is by taking drastic action such as collection by attorney of employ a collection
agency on their behalf.
3. Cash Management
4. Marketable Securities

6.5. Managing Current Liabilities: Risk and Return
Liquidity is a firm's ability to meet its short-term debts, and cash is the most liquid
asset, because it can be spent immediately. Non-cash current assets, mainly receivables
and inventory, are less liquid because it may take time to turn them into cash. For
example, ratios measuring receivables collection periods and inventory turnover rates,
estimate how long it is taking to convert receivables and inventory into cash. In general
the more current assets a firm holds the greater its liquidity (measured by the current
ratio). If liquidity is, or becomes, very important managers may decide to hold
proportionately more cash and/or marketable securities (measured by the quick ratio)
than non-cash assets, receivables and inventory.

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There is always a trade-off in holding high levels of cash assets because they earn very
little return. In general, managers can only reduce the risk of becoming less liquid by
reducing the overall return on current assets, and on total assets (the ROA measure).
Another factor affecting net working capital is the firm's use of current versus longterm debt. Again, this poses the risk-return trade-off. All else being constant, the more
that managers rely on short-term debt or current liabilities to finance investment in
assets the lower will be the firm's liquidity. Think about this!
However, using current liabilities costs less (in interest) than long-term debt and is a
flexible means of funding fluctuating needs for assets.
The major disadvantage of short-term debt is that it must be repaid or 'rolled over'
more often, and any deterioration in the firm's overall financial condition may be made
worse if the firm can't refinance the short-term debt. So liquidity and longer-term
solvency are linked.
Another risk is linked to the interest rates. Every time funding arrangements are
renewed the interest rates will also be reviewed. Any change in the lender's perception
of the firm's riskiness will lead to higher interest being charged. So short-term interest
rates are likely to change more often than interest on long-term loans.
Where possible cash should be held in interest bearing accounts and drawn on only
when actually needed to pay accounts, otherwise there is an unnecessary opportunity
cost in terms of lost interest.
The following reading explains the management function of cash and marketable
securities. Note the formula for calculating optimum cash withdrawal amounts. You
don't need to learn the formula! Make brief notes of the main points.
The risk and cost factors are inversely related, in that if a company goes for a low risk
source of finance, it is related to a high cost source of finance and vice versa.
Assuming a normal yield curve (the term structure of interest rate) where the interest
rate curve is upward sloping, a short-term loan will be cheaper than a long-term
source of finance. This means that based on cost, a company may rather choose to use
short-term source of finance than a long-term source of finance.
Based on risk, short-term source of finance (e.g. bank overdraft) is assumed to
be more risky than a long-term source of finance (e.g. long-term bank loans).
Bank overdraft can technically be withdrawn on demand, at short notice, even if a
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company use short-term loan, upon maturity, it may not be renewed or it may be
renewed on unfavourable terms, unlike long-term loan where a company meeting
its loan interest payment and the terms of the loan, will not have to worry about
its withdrawal or it not being renewed as may be the case with the short-term
source of finance.

In summary:
Source of finance

Cost

Risk

Short-term

Low

High

Long-term

High

Low

6.6. Three Working Capital Financing Approaches
To discuss the three different working capital financing approach, it is important to
make distinction between permanent current assets and fluctuating working capital.
Permanent current assets are often the minimum current assets held by companies at
any

given

time.

Example

of

which

may

include

minimum

inventory

held by a company at any given time for precautionary purpose, others may
include the minimum trade receivable that are almost always outstanding,
another permanent current asset could be the minimum cash balance that
company always wish to hold for precautionary and speculative purpose. Even though
these minimum current assets a still recorded as current assets, it exhibits
characteristics similar to that of non-current assets.
Fluctuating current assets are therefore the current assets that are used continuously by
the

company

in

its

operating

activities,

such

that

before

it

reaches the minimum it takes action to replenish such current assets, such as
inventory, cash etc. with fluctuating current assets, just as it is being used, it is
always replenished by the company anytime such assets reaches re-order levels,
or return points etc, to avoid such assets going out of stocks.

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There are 3 approaches in working capital :
1.

Aggressive approach to financing working capital
The aggressive method is where a company predominantly finance all its
fluctuating current assets and most of its permanent current assets using shortterm source of finance and it is only a small proportion of its permanent current
assets that is financed using long-term source of finance.
A company that uses more short-term source of finance and less long-term
source of finance will incur less cost but with a corresponding high risk. This has
the effect of increasing its profitability but with a potential risk of facing liquidity
problem should such short-term source of finance be withdrawn or renewed on
unfavourable terms.

2.

Conservative approach to financing working capital
The other extreme method of financing working capital is where a company
decides to use mainly long-term source of finance and very little short-term source
of finance to finance its working capital. This option means that the company’s
finance is going to be relatively high cost (that is sacrificing low cost finance) but
low risk; this will make the company’s profit to be low but does not run the risk of
being faced with liquidity problem as a result of withdrawal of its source of
finance.
The conservative method is where a company predominantly finance all its
permanent current assets and most of its fluctuation current assets using longterm source of finance and it is only a small proportion of its fluctuating current
assets that is financed using short-term source of finance.

3.

Moderate approach to financing working capital
Between the two extreme approaches to financing working capital is the
moderate (or the matching or balancing) approach. This approach makes
distinction between fluctuating current assets and permanent current assets
with the suggestion that to finance working capital; short-term source of finance
should be used to finance fluctuating current assets, whiles long-term source of
finance should be used to finance permanent current assets. This matches the
source of finance with the character of the current assets.

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6.7. Working Capital Financing and Financial Ratios
Working capital financing is essential to any growing business. It helps keep the
business current and competitive in the market. If the company has the commercial
real estate or equipment that produces an income for the business, it can obtain
working capital financing that can help pay down credit lines or accounts payable,
freeing up money for growth opportunities. Before attempting to obtain this type of
loan make sure that the company has established good business credit scores. These
credit scores will make a big difference when the lending institution is determining
whether to give your business the money that it needs to succeed.
Working capital financing can range anywhere from RM100,000 to RM2,000,000 and
more. The loan terms can range anywhere from 15 to 25 years. These loans typically are
paid back in installments with no large lump-sum payments required. This is also
known as a fully amortizing loan. Once acquired working capital financing can be used
for acquiring real estate, expanding a current facility, building a new office, purchasing
new equipment, operating expenses, or to buy out a current owner or shareholder.
All types of businesses are eligible for working capital financing. Service businesses,
manufacturers, distributors, retail stores, professionals, restaurants, and gas stations
can all benefit from these types of loans.
Meanwhile, financial ratios are useful to the company as indicator to the firm’s
performance and financial situation. Most ratios can be calculated by the given
financial statements. Financial ratios can be used to analyze trends and to be compared
with other firms in the same industry. In the some cases, financial ratios can predict
future bankruptcy.
The following types of ratios commonly used :

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

Activity ratios



Leverage ratios



Profitability ratios



Market ratios

Further discussion on financial ratios in Chapter 2 : Analyze of Financial Statement.

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Chapter 7 : Managing Cash

7.0 Introduction
In United States banking, cash management, or treasury management, is a marketing term
for certain services offered primarily to larger business customers. It may be used to describe
all bank accounts (such as checking accounts) provided to businesses of a certain size, but it
is more often used to describe specific services such as cash concentration, zero balance
accounting, and automated clearing house facilities. Sometimes, private banking customers
are given cash management services.

7.1.

Cash Management Concept

Cash is defined as coins and currency plus demand deposit account that available to meet
individual’s need and is use in a daily transaction.
Management of cash refer to the liquidity of a firm and thus can minimize the risk of
solvency in a company. A company can become insolvent when they unable to meet its
maturing liabilities due to lack of necessary liquidity to make prompt payment on its current
debts.
The firm has to hold cash a a few reasons :
1. Transaction : The amount of cash that the company needs can support day-to-day
operations. The firm must have enough cash in hand which they can make its daily
purchases of materials and pay its liabilities.
2. Precautionary : The company holds cash for a general function of predictability of a
firm’s cash inflow and outflow. The more unpredictable the cash the greater needs for
precautionary balance of cash.

3. Speculation : To take advantage of any bargain that may arise.

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4. Compensating balance : To compensate for services that they perform.

7.2.

Determining the Optimal Cash Balance

One of the important aspects in cash management is knowing the optimal cash balance. The
financial manager’s task is to maintain the cash balance (including the bank balance) at a
proper level. The company requires cash for transaction purpose in making payment of day
to day routine expenses like wages payment, payment of creditors and etc.
There is always a gap between cash inflow and cash outflow, where the firm has always to
maintain a certain cash balance in a company. But the firm has to maintain a cash balance
which is neither too small nor too high. If the firm maintains too small a balance, it may find
it difficult to make payment of day-to-day expenses and it runs out of cash.
When the cash balance has increased, it makes transaction in marketable securities become
reduces and thus transaction costs will reduce too.

7.3.

Forecasting Cash Needs

Most of us are familiar with at least one firm that has encountered serious financial
difficulties, or even faced bankruptcy, while earning a continuously larger income over time.
One factor many of these firms have in common is their failure to adequately budget future
operating expenses and to forecast future needs.
A cash forecast also serves as a control mechanism if projected figures are compared with
actual figures. If your company planned on a RM150,000 cash inflow for June but received
only RM80,000, the discrepancy will be clearly visible if you have a cash budget--though the
budget won't tell you the reasons for a problem. Maybe you weren't getting enough product
to one of your markets, or your customers might have stretched their payables. But no matter
what causes you find for the problems, a cash forecast will help you keep your fingers on
your company's pulse.
One method of preparing a cash forecast requires financial information from several prior
years and takes four basic steps:

1. Estimate sales for the forecast period, a year in this instance
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2. Break down the annual sales figure into monthly units to reflect any seasonal
factors.
3. Construct pro forma income statements from the monthly sales figures.
4. Translate the income statement information into a cash forecast.
This kind of cash projection, with monthly performance reviews and revisions, is the first
step to sound cash management. From here, owners can go on to properly time loans and
repayments, assess the impact of borrowings and investments, and fine tune the company's
cash needs for continued growth.

7.4.

Managing the Cash Flowing In and Out of the Firm

Cash flow refers to the differences between the number of dollars that came in and the
number of dollar that went out. The cash flow cycle shows how the actual net cash flows into
and out of the firm during a specified period. It concerns only with the actual movement of
the cash and as such expenses on depreciation and sales on credit do not constitute as cash
flows.
There are three main activities that explain the cash inflow and cash outflow of a business,
that is :
1. Generating cash flows from day to day business operations. It is important to
know how much cash is being generated in the normal cause of operating a
business on a daily basis, beginning with purchasing inventories on credit, selling
on credit, paying for the inventories and finally collecting on the sales made on
credit.
2. Investing in fixed assets and other long term investment. When a company
purchases or sells fixed assets like equipment and buildings, there can be
significant cash inflows and outflows.
3. Financing the business. Cash inflow and outflows occur from borrowing or
repaying debt, paying dividends and from issuing stock (equity) or repurchase
stock from shareholders.

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7.4.1

Preparing the Statement of Cash Flow
A "Cash Flow Statement" shows the sources and uses of cash and is typically
divided into three components:
Operating Cash Flow. Operating cash flow, often referred to as working
capital, is the cash flow generated from internal operations. It comes from
sales of the product or service of your business, and because it is generated
internally, it is under your control. The company’s income statement will be
converted from accrual basis to cash basis. There are two steps involved :


Add depreciation to net income since depreciation is non-cash expenses



Subtract any uncollected sales and cash payment from inventories.

Investing Cash Flow. Investing cash flow is generated internally from nonoperating activities. This includes investments in plant and equipment or
other fixed assets, nonrecurring gains or losses, or other sources and uses of
cash outside of normal operations. When a company purchase fixed assets,
such as plant and equipment, this expenditures are shown as an increase in
gross fixed assets (not the increase in the net fixed assets) in the balance sheet.
Financing Cash Flow. Financing cash flow is the cash to and from external
sources, such as lenders, investors and shareholders. A new loan, the
repayment of a loan, the issuance of stock, and the payment of dividend are
some of the activities that would be included in this section of the cash flow
statement.
Financing a business involves (1) paying dividend to the owners, (2) increase
or decrease in short term and long term debts, (3) selling shares of stock or
repurchase stock.
Refer to example below on how to prepare Statement of Cash Flow when the
Balance Sheet and Income Statement are given to you.

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Balance Sheet as of 31st Dec 2008 and 31st Dec 2009

Cash
Ac Receivable
Inventory
Total Current Assets
Plant and Equipment
Less : Accumulated Depreciation
Net Plant and Equipment
Total Assets
Account payable
Notes payable
Total Current Liabilities
Bond
Common stock
Paid-in capital
Retained Earnings
Total owners’ equity
Total liabilities and owner’s equity

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31/12/2008

31/12/2009

(RM’000)
200
450
550
1,200
2,200
1,000
1,200
2,400

(RM’000)
150
425
625
1,200
2,600
1,200
1,400
2,600

200
0
200
600
300
600
700
1,600
2,400

150
150
300
600
300
600
800
1,700
2,600

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Income Statement for the Year Ended 31st Dec 2009

Sales
Cost of Goods Sold
Gross Profit
Operating Expenses
Depreciation
Net Income
Less : Interest Expenses
EBT
Less : Taxes Expenses
Dividend
Additional Retained

RM’000
1,450
850
600
40
200
360
300
120
180
80
100

Earnings

Statement of Cash Flow For the Year Ended 31st Dec 2009

Net Income
Plus : Depreciation
Account Receivable
Inventory
Account Payable
Net Cash Flow from Operating Activities
Plant and Equipment
Net Cash Flow form Investment Activities
Dividend
Notes Payable
Net Cash Flow from Financing Activities
Net Cash Flow
Plus : Beginning Cash
Ending Cash Balance

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RM’000
180
200
25
(75)
(50)

RM’000

280
(400)
(400)
(80)
150
70
(50)
200
150

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