Financial management I

Lecture Power point

By: Getahun Deribe Tesfaye

E-mail: [email protected]
Phone No: 0933650777

Haramaya University
Academic year 2022
CHAPTER ONE
INTRODUCTION TO FINANCIAL MANAGEMENT
1.1General Overview of financial management
Financial management is concerned with the creation,
maintenance and maximization of economic value or wealth
through the application accounting theories and concepts in
management decision making.
As a management process is on decision making with
an eye toward creating and maximizing wealth. The
decisions involved are financial decisions such as
when to introduce a new product ,when to invest in
new assets ,when to replace existing assets ,when to
borrow from banks ,when to issue stocks or
bonds ,when to extend credit to a customer and how
much cash to maintain
we study financial management under the
assumptions of capital markets, in the context of
corporate form of business organizations and under
the guidance of the basic principles that form the
A.4Existence of well-developed capital markets
Financial management is studied under the assumption that there
is capital market and capital exchange in the business
environment concerned with free and competitive interaction and
reasonable costs and prices like any commodity market .This
interaction in a well-developed capital market exists between the
corporation and financial markets in the following manner.
Initially, the corporation raises capital in the financial markets by
selling securities –stocks and bonds .Secondly, the corporation
then invests this in return generating assets or new projects.
Thirdly, the cash flow from those assets is either reinvested in the
corporation, given back to the investors, paid to government in
the form of taxes.
B. The context of corporate form of business organizations
Financial management is studied in the context of a corporate
form of business organization and its decisions due to the
following characteristics and advantages of a corporation.
I. Basic characteristics
- Separate legal existence
- Limited liability
- Ownership possession and transfer through stocks.
- Separation of ownership from management
- Indefinite life time
- Double taxation
- Ability to issue shares.
II. Advantages
1. Ease of raising capital/ mobilization of huge amount of capital
2. Existence of secondary capital markets /resale markets/.A secondary
market is a security market in which previously stocks are resold or
exchanged while primary stock markets are markets in which stocks are
exchanged when they are first issued.
3. A corporate entity is a self-perpetuating entity
4. Corporations have a better chance of growth due to their ability for
easy raise of Capital.
C. Basic principles that form the basis for financial management
1. The risk –return trade-off
-In financial decision making, we don’t take additional risk
unless we expect to be compensated with additional return
that is, investors demand a high return for taking additional risks.
. –The risk– return relationship will be a key concept in the
valuation of stocks and bonds and proposal of new projects for
acceptance.
2. The time value of money –A dollar received today is worth
more than a dollar to be received in the future .The time value of
money is the opportunity cost of passing up the earning potential
of a dollar today.
3. Cash –Not profits –is a king
In measuring wealth or value, we will consider cash flows, not
accounting profits, because it is the cash flows, not profits
that are actually received by the firm, relevant for decision
making and can be reinvested .Accounting profits on the other
hand, appear when they are earned rather than when the money
is actually in hand.
4. Incremental cash flows – It is only what changes that counts.
In making business decisions in creating wealth ,we only consider
incremental cash flow which is the difference between the cash
5. The curse of competitive markets – why it is hard to find
exceptionally profitable projects? If an industry is generating
large profits, new entrants usually attracted .The additional
competition and added capacity can result in profits being driven
down to the required rate of return, then some participants in the
market drop out, reducing capacity and competition.

6. Efficient capital markets – capital markets are

efficient and the prices are right.
An efficient (informational efficiency) capital market is
a market in which the values of all assets and
securities at any instant in time fully reflect all
available public information. Such markets
characterized by the existence of a large number of
profit driven individuals acting independently.
7. The Agency problem – Managers won’t work for owners unless it’s
in their best interest. It is the problem resulting from conflicts of
interest between the managers (agents of the stockholders) and
the stockholders.
8. Taxes bias business decision: In incremental cash
flow analysis, the cash flow to be considered should be
after- tax incremental cash flows to the firm as a whole.
9. All risks are not equal – Some risks can be
diversified away, and some cannot. Risk diversification
is the process of reducing risk through increasing the
alternatives of risk full investment and other business
decisions.
10. Ethical behavior is doing the right thing and
ethical dilemmas are everywhere in the business.
1.2 Finance as the area of study
Finance, in general, consists of three interrelated areas: (1)
Money and capital markets, which deal with securities
markets and financial institutions; (2) investments, which
focus on the decision of investors, both individuals and
institutions, as they choose among securities for their
investment portfolios; and (3) financial management or
"business finance" which involves the actual management
of business firms.
1) Money and Capital Markets: Most of the
finance professionals go to work for financial
institutions, including banks, insurance
companies, investment companies, credits and
savings associations.
Investments: The three major functions in
the investment area are (1) sales of
securities (2) the analysis of individual
securities, and (3) determining the
optimal mix of securities for a given
investor.
Generally, the investment decision is
concerned with managing the firm’s by
allocating and utilizing funds wisely with
in the firm. It is determining the total
birr amount
Financial management: - Financial management or
managerial finance is the focus of this material.
Financial management is important in all
types of businesses, including banks, and
other financial institutions as well as
other form of businesses. Financial
management is also important in
governmental operations, from schools to
hospitals and from zonal administrative
levels to states administrative levels and
even beyond that.
 The Central Role of Capital:
Capital, as you know, is essential for the operation of any
form business and financial management may be defined
in terms of the relationship between capital and the
business firm.
Initial capital/funds of the newly formed firm
consist of funds secured from the owners of
the firm in the form of equity capital and
from the creditors in the form of both short-
term and long-term loans.
An existing firm may finance itself by
retaining part of its earnings (plough- back of
profit or reinvestment) in addition to the two
sources indicated
The capital of the firm, whether it is generated internally
from operations or provided by owners and creditors,
constitutes the sources of the firm’s capital and recorded on
the right-hand side of the balance sheet as liabilities and
owners' equity.
The acquired assets constitute the uses of the
capital of the firm and are listed in the left-
hand side of the balance sheet (i.e assets).
The balance sheet of the firm is thus contains
both the uses and sources of the capital of the
firm.
Financial Management and Capital
Capital sources and uses must be carefully
managed if the firm needs to be profitable for
its financiers. Financial management is the
specialized business function that deals with
this problem.
In general, financial management can be
defined as the management of capital
sources and uses so as to attain the desired
goals of the firm (i.e. maximization of
shareholders' wealth).
A Firm’s capital consists of items of value that are
owned and used and items that are used but not
owned. For example, the office space that a business
firm has rented for doing business and the bank
loans that the firm has taken to finance its
Capital sources are those items found on the right-hand
side of the balance sheet (i.e., the liabilities and equity
section as indicated earlier.) Examples of the use of the
capital of the firm are receivables, inventories, and fixed
assets. As an area of study, financial management is
concerned with two distinct functions. These are: (1) the
financing function, and (2) the investing function.
The financing function describes the management of
the sources of capital. The investing function, on the
other hand, concentrates on the type, size and
percentage composition of capital uses. It deals with
the question "how much of the total capital provided
by the financing sources should be invested in
receivables, marketable securities, inventories, and
fixed assets?" The specialized set of management
duties and responsibilities that center on the
financing and investing functions are referred to as
 It is very important for you at this point to distinguish
between wealth maximization and profit maximization
as goals of business firms.
There are two ways in which the wealth of shareholders
changes. These are: (1) Through changing dividend
payments, and (2) through the change in the market price
of common shares.
In order to maximize the wealth of shareholders, a
business firm must seek to provide the largest
attainable combination of dividends per share and
stock price appreciation
Profit-maximization, on the other hand, is a
traditional micro economics theory of business firms
which was historically considered as the goal of the
firm. Profit maximization stresses on the efficient
use of financial/capital resources of the firm.
Profit maximization as a goal of the business firm ignores however,
many of the real world complexities that financial managers try to
address in their decisions. Profit maximization largely functions as
a theoretical goal in which economists use it to prove how firms
behave rationally to increase profit. When finance was emerged as a
separate area of study, it has retained profit maximization which is
the new concept, profit maximization looks at the total company
profit rather than profit per share. Profit maximization doesn't deal
with the company's dividends as either a return to shareholders or
the impact of dividend policy on stock prices.
In the more applied discipline of financial management, however,
firms must deal every day with two major factors: These are
uncertainty and timing of returns.
Uncertainty of Returns:
Profit maximization as the goal of business firms ignores uncertainty and risks in
order to present the theory more easily. Projects and investment alternatives are
compared by examining their expected values or weighted average profits. Whether
or not one project is riskier than another doesn't enter these calculations; economists
do discuss risk, but tangentially. In reality projects differ a great deal with respect to
the risk characteristics, and disregarding this difference can result in incorrect
decisions.
Example
There is no variability that is associated with the possible
outcomes of producing and selling plastic combs because demand
for this product is stable. If things go well (optimistic), poorly
(pessimistic), or as expected, the profit will still be the same
10,000 Birr. With that of the electric combs however the range of
possible profit figures varies from 20,000 Birr if things go well
(optimistic), to 10,000 Birr if things go as expected, or to the
profit figure of zero if things go wrong (pessimistic). Here, if you
look at just the expected profit figure of 10,000 Birr, it is the same
for both projects and you conclude that both projects are
equivalent. They are not, however. The returns (profit figures)
associated with electric combs involve a much greater degree of
uncertainty or risk.
Timing of Returns: Another problem with profit maximization as
the goal of business firm is that it ignores the timing of the returns
from projects.
Example
Therefore, the real-world factors of uncertainty and
timing of returns force financial managers to look
beyond a simple profit maximization as the goal of the
business firm. These limitations of profit
maximization as the goal of business firms leads us to
the maximization of the more robust goal of the
business firm, that is, maximization of shareholders
wealth.
 Maximization of Shareholder's Wealth:
We have chosen maximization of shareholder's wealth that is
maximization of the total market value of the existing
shareholders' common stock because the effect of all financial
decisions is reflected through these prices. The shareholders
react to poor investment or dividend decisions by causing the total
value of the firm's stock to fall and they react to good decisions by
pushing the price of the stock up.
The market price of the business firm’s stock reflects the value of
the firm as seen by its owners. The wealth maximization as the
goal of business firm takes into account uncertainty or risk, time,
and any other factors that are important to the owners of the firm.
Thus, again, the framework of maximization of shareholders'
wealth allows for a decisions environment that includes the
complexities and complications of the real-world
The Agency Problem
While the goal of the business firm will be maximization of
shareholders' wealth, in reality the agency problem may interfere with
the implementation of this goal. The agency problem is the result of a
separation of the management and the ownership in firms. For
example, a large business firm may be run by professional managers
who have little or no ownership position in the firm, owners being the
shareholders. As the result of this separation between the decision
makers and owners, managers may make decisions that are no in line
with goal of business firm, or the interest of owners, that is
maximization of shareholders' wealth. Professional managers may
attempt to benefit themselves in terms of salary and promotions at the
expense of shareholders
According to stakeholder theory: the goal of business firm is not only limited
to profit and wealth maximization it also includes and concerns the following:
1. Profit maximization
2. Stockholder wealth maximization

3. Managerial reward maximization: when the firms make a profit management

give a bonus for their employees.
4. Behavioral goal: change employees mind to think for the advancement of the
organization.
5. Social responsibility: keep the environment in well manner. Avoid environmental
pollutions.

The Objective of Financial Management

The financial manager uses the overall company's goal of
shareholders' wealth maximization which is reflected through the
increased dividend per share and the appreciations of the prices of
shares in formulating financial policies and evaluating alternative
course of operation. In order to do so, this overall goal of wealth
maximization needs to be related to take the following specific
objectives of financial management into account. These are:
1) Financial management aims at determining how large the business
firm should be and how fast should it grow.
2) Financial management aims at determining the best percentage
composition of the firm's assets (asset portfolio decision, or
decisions related to capital uses).
3) Financial management also aims at determining the best percentage
composition of the firm's combined liabilities and equity decisions
related to capital sources).
1) Determining the Size and Growth Rate:
The size of the business firm is measured by the value of its total assets. If the
book values are used the size of the firm is equal to the total assets as indicated in
the balance sheet. When this method of size determination is used, the growth
rate of the business firm is measured by the yearly percentage change in the book
values of all the items in the assets section of the balance sheet.
As the student of financial management, you should be able to understand that
business firm that is large and growing fast and larger doesn't necessarily produce
increasing earnings.
2) Determining Assets Composition (Portfolio):
As indicated earlier, assets represent investments or uses of
capital that the business firm makes in seeking to earn a rate of
return for its owners. The most common asset categories are
cash, account receivable inventories, and fixed assets.
However, financial institutions, such as banks and insurance
companies, have somewhat different asset categories. They
may list loans and advances and negotiable securities as assets.
3) Determining the Composition of Liabilities and Equity
As it was stated, liabilities and equity are the sources of capital of the business
firms. They are the financing sources that business firms use to make investment
in various types of assets.
The most common financing sources are accounts and notes payable, accruals for
items such as taxes, wages, loans and debt securities of various maturity dates,
common stocks, preferred stocks and retained earnings. Here again, banks and
insurance companies might secure funds from liability accounts such as time
deposits, demand deposit, and saving deposits.
Financial management decisions
Finance functions or decisions include:
 Investment or long-term asset mix decision
 Financing or capital mix decision
 Dividend or profit allocation decision
 Liquidity or short-term asset mix decision
Investment decisions
 Investment decisions or capital budgeting involves the decision of allocation of capital
or commitment of funds to long term assets that would yield benefits in the future.
 Investment process should be evaluated in terms of both expected return and risk
Financing decisions
 Financing decisions is the second important function to be performed by the finance
manager
 Deals with when, where, and how to acquire funds to meet the firm’s investment
needs
 The mix of debt and equity is known as the firm’s capital structure. The financial
manager must strive to obtain the best financing mix or the optimum capital
structure for his or her firm.
 The firm’s capital structure is considered to be optimum when the market value of
shares is maximized.
 The use of debt affects the return and risk of shareholders, it may increase the return
on equity funds but it always increases risk. A proper balance will have to be struck
between return and risk.
Dividend decisions
 The financial manager must decide whether the firm should distribute all profits
or retain them or distribute a portion and retain the balance
 Like the capital structure policy, the dividend policy should be determined in
terms of its impact on the shares holders’ value. The optimum dividend policy
is one that maximizes the market value of the firm’s shares.
Liquidity decisions
 Current assets must be managed efficiently for safeguarding the
firm against the dangers of illiquidity and insolvency.
 An investment in current assets affects the firm’s profitability,
liquidity and risk. A conflict exists between liquidity and
profitability while managing current assets. Example, if the firm
does not invest sufficient funds in current assets, it may become
illiquid. But it would lose profitability as idle current assets would
not earn anything. Therefore, a proper tradeoff must be achieved
between profitability and liquidity.
 In order to ensure that neither insufficient nor unnecessary funds
are invested in current assets, the financial manager should develop
sound techniques of managing current assets.
Financial manager should estimate firm’s needs for current assets and
make sure that funds would be made available when needed.
 End of the
chapter

Thank You
 Chapter - 2
Financial Analysis and Planning
Financial analysis is the process of selection, evaluation and
interpretation financial data, along with other pertinent information,
to assist in investment and other financial decisions.
It is a diagnostic tool of analysis that can help
management to identify the strength and weakness of
the firm so that corrective actions can be taken
starting from planning, and also to consider the
strength of the company as a motive for
competitiveness and growth.
Financial analysis and its application in business can
be viewed from different perspectives .From the
investor’s view point financial analysis is a tool for
predicting the future performance of the firm on which
the investment decision related to this firm can be
made. For the creditor financial analysis is used to
Approaches to financial analysis
Based on the information required for financing and investing
decisions, the approaches of financial analysis include:
I. A comparison of the performance of a firm with the performance
of other firms in the same industry (industry/vertical analysis)
II. Evaluation of the performance or position of a given firm
overtime. (trend/horizontal analysis)
III.Adjusting the financial statements of a firm to a common size
financial statement.
Ratio Analysis: The first step in undertaking
financial statements analysis is to read and
understand the financial statement and their
accompanying notes with care.

Importance of ratio analysis

  Both lenders and potential lenders use financial ratios
to evaluate loan applications from borrowing
companies.
 Investors use financial ratios to assess the future tale of
the companies to make investment decision
 Managers make use of financial ratios in order to judge
the performance of their companies and to control the
. day-to-day operation of their companies.
 Owners make use of financial ratios to evaluate
whether their companies are maximizing their wealth
or not.
The Basic Financial Ratios
Financial ratios can be designed to measure almost any
aspect of the performance of the company.
In general, financial analysts use ratios as one tool in
identifying areas of strengths and weaknesses in the
company. Financial ratios, however, tend to identify
symptoms rather than the problems classing symptoms. A
financial ratio whose value is judged to be "different" or
usually high or low may help identify a significant event
but doesn't provide enough information that helps to
identify the reasons for the occurrence of the event. The
financial ratios are judged to be high, or low, or acceptable
when they are compared with standards.
Standard ratios could be:
1. Industry standards: these are standard ratios computed for
companies operating in the same industry. For example, average
ratio standards can be developed for textile industry.
2. Management plans: these are financial ratios that the
management of a give company set as goals. These are plans of
the company and standards against which actual financial ratios are
compared.
3. Historical standards: these are financial ratios developed from the
historical records of the company over say the last 10 years.
Historical standards are, therefore, the average financial ratios for
the company for the last 10 years. These ratios can also be used as
standards against which you compare the computed ratios to judge
them of high, low or acceptable.
Types of Financial Ratios:
The most common financial ratios used for financial analysis
include: liquidity, activity (asset management), debt management
(leverage), profitability ratios and market value ratio
1. Liquidity Ratios
Liquidity ratios measure the ability of business firm to pay its
current liabilities and current portion of long-term debts as they
mature. Liquidity ratios assume that current assets are the principal
sources of cash for meeting current liabilities and current portion of
long-term loans. There are two most widely used liquidity ratios.
These are the current and quick or acid ratios.
Current Ratio:
The current ratio is computed by dividing current
assets by current liabilities. The current ratios for
Addis Manufacturing Company for 1992 and 1993 are
the following:
Current Ratio = Current asset
Current liability
Current Ratio (for 1992) = 35,000/17,900 = 1.96
Current Ratio (for 1993) = 40,000/18,000
=2.22 times
The larger the current ratio, the less the difficulty that
the company faces in paying its obligations at the
right time. In many cases lenders frequently require
the current ratio of the borrowing company to remain
at or above 2.0 time as a condition for grading or
continuing the commercial and industrial loans. This
standard of 2.0 times is an arbitrarily selected figure
and many financial analysts feel that the liquidity
position of the company should be questioned if the
current ratio of the company falls below 2.0 times.
This is because of the fact that all current assets
cannot be easily converted back to cash. It is very
difficult to collect accounts receivable in full.
It is very difficult of sell all the inventories. Short-
term prepayments are unlikely to be convert to
cash. If the less liquid assets constitute significant
portion of the total current asset, you may need
current ratio that is even greater than 2.0 times.
The current ratios of Addis manufacturing Company
show that the company has 1.96 Birr in current
assets for each Birr of current liabilities during
1992 and 2.22 Birr in current assets for each Birr of
current liabilities during 1993. It is very difficult to
say this ratios are high or low as we don’t have
industry standard, or management plan or
Interpretation: can be of two type according to the result after
comparing with the standards.
 Low ratio-suggests that a firm may face difficulty in paying its
short term obligations.
 High ratio- indicates that too much capital is tied up in current
assets and a firm may be sacrificing some return.

 A reasonable higher (moderate)the ratio,

- the larger the amount of birr availability in current assets per birr
of current liability
- the more the firm’s liquidity position
- the greater the safety of funds of short term creditors (i.e. less risk
to creditors)
 A very lower current ratio results opposite from current ratio out
lined as above. A low current ratio could be improved by:
-long term borrowing to increase current assets
-liquidating current liabilities using long term financing
 A very high current ratio may indicate,
-excessive cash due to poor cash management
-excessive A/R due to poor credit management
-excessive inventories due to poor inventory management
- A firm is not making full use of its current borrowing
capacity
Therefore, a firm should have a reasonable current ratio.
Quick Ratio:
Quick ratio is sometimes called the acid test ratio. It
serves the same general purpose as that of the
current ratio but more stringent as it exclude less
liquid current assets like inventory from current
assets. It considers only quick current assets such as
cash, marketable securities, and account receivables.
This is done because inventories, prepaid expenses
and supplies cannot easily be converted back to cash.
Thus the quick (acid-test) ratio measures the ability of
the company to pay its current liabilities by converting
its most liquid assets to cash which is easier.
The quick ratio is computed by subtracting
inventories, prepaid expense and supplies from
current assets and dividing the remainder by total
current liabilities. for Addis Manufacturing Company
the quick ratios are:
If the company wants to pay the entire amount of its current
liabilities by using its quick assets (i.e current assets minus the sum
of inventories, prepaid expenses and supplies), its quick assets should
be equal to or greater than its current liabilities. Thus the Company's
quick ratio should be 1.0 times or more than that. In the case of
Addis Manufacturing Company, the quick assets of 91 cents are
available to meet each Birr or current liabilities. This implies that the
quick assets are not enough to settle all the current obligations.
Unless the company converts the non-quick current assets to the
extent they provide cash that is enough to pay the remaining 9 cents
for each Birr of current liabilities, the company will face difficulty in
meeting its obligation. The current ratio of 1.08 times for 1993, on
the other hand, implies that the company has 1.08 Birr of quick
assets for each Birr of current liabilities. Again, the company is in
good liquidity position during 1993 compared to 1992.
2. Activity/turnover Ratios
Activity ratios measure the degree of efficiency with which the
company utilizes its resources. It can also be called as efficiency
or asset utilization ratio. Efficiency is equated with rapid resource
turnovers. Some activity ratios concentrate on individual assets
such as inventory, or accounts receivable while others look at the
overall company performance, or activity. The following activity
ratios are discussed for Addis Manufacturing Company, which is
an ideal company considered for an illustrative purpose.
I. Inventory turnover ratio: This ratio is meaningful for
companies like Addis Manufacturing Company which hold
inventories of different kinds. (it could be merchandise, raw
material, processed goods and so on). These ratio measures the
number of times per year that the company sells its inventory.
It is computed by dividing the Birr amount of costs of goods
sold by the Birr amount of inventory at the closing date of the
accounting period. for Addis Manufacturing Company, the
inventory turnover ratios are:
In general, high inventory turnover may be taken as a sign of good
inventory management. Other things being the same, higher
inventory turnover ratios computed for Addis Manufacturing
Company indicate that the company was able to sell its inventories
4.44 times and 4.39 time during 1992 and 1993 E.C respectively.
The performance/efficiency of the company in selling its
inventories was nearly the same during the two years you cannot
say the inventory turnover ratios for Addis Company show good or
bad performance, or high efficiency or low efficiency as long as
you don't have standard inventory turnover ratio to compare with.
Average age of inventory (AAI): The number of days inventory is
kept before it is sold to customers.
AAI = 360 days
Inventory turnover
For Addis Manufacturing:
AAI (1992) = 360/4.44 = 81 days
AAI (1993) = 360/4.39 = 82 days
Interpretation: - ABC carries its inventory for 81 days in 1992
and for 82 days in 1993before they are converted to cash.
ii. Total Assets Turnover Ratio: - It measures the relationship
between a birr of sales and a birr of assets, usually on the yearly
basis. Basically the company wants to generate as much birr as
possible in the form of sales per a birr of an investment it made in
assets. The asset turnover ratio is a measure of the overall activity
of the company. It is computed by dividing the total net sales of
the company by its total assets on the closing date of the
accounting period. For Addis Manufacturing, the total turnover
ratios are:
The total assets turnover ratio of 1.55 times during 1992 implies that the
company was able to generate 1.55 Birr for a single birr it has invested in its
assets during the year.
During 1993, on the other hand, the company was able to make a net sales of
1.46 birr for each birr it has invested in the total assets. Though the total
volume of sales is greater during 1993, the assets turnover ratios show that the
company was efficient in generating higher net sales per birr of investment in
asset in 1992 than in 1993. The decrease in the asset turnover ratio in 1993
may indicate a decrease in the utilization of the assets for generating the
desired sales revenue.
iii. Account receivable turnover: measures the liquidity of a firm’s
accounts receivable. That is, it indicates how many times or how
rapidly A/R is converted into cash during a year. Financial analysts
apply two tools to judge the quality or liquidity of A/R.
 A/R turnover
 Collection period

A/R turnover = Net credit sales (Total sales)

Average A/R
For Addis Manufacturing the A/R turnover is calculated as follows
(assuming all sales are based on credit)
ARTO (1993) = 120,000/16,000 = 7.5 times
ARTO (1992) = 110,000/14,000* = 7.86 times
*16,000+12,000/2 avg AR
The interpretation of the result is that Addis manufacturing CO.
converted its A/R into cash 7.5 times a year in the year 1993
whereas it was 7.86 times in the year 1992.
A ratio substantially lower than the industry average may suggest
that a firm has:
 More liberal credit policy (i.e longer time credit period), poor
credit selection, and inadequate collection effort or policy
which could lead.
 A/R to be too high
 Bad debts or uncollectable Receivables
 More restrictive cash discount (i.e no or little cash discount) that
could make sales to be too low.
Note: As result of the above factors,
The firm could have poor profitability position.
The firm’s funds would be tied-up in receivable as payments by
customers are delayed.
• A ratio substantially higher than the industry average may
suggest that a firm has:
More restrictive credit policy (i.e. short term credit period)
More liberal cash discount offers (i.e. larger discount and sale
increase)
More restrictive credit selection.
More rigorous collection effort or policy
 The outcomes of a higher A/R turnover could be
Avoidance of the risk of bad debts
Increase the firms' profitability position.
Small funds tied-up in A/R
Customers pay quickly
 A reasonable High ratio is required for a firm to be efficient in
converting its A/R into cash.
If available, only credit sales should be used in the numerator as
A/R arises only from credit sales.
Average Collection Period: this ratio tries to measure the average
number of days it takes for the company to collect its account
period. The shorter the average collection period, the better the
company's activities.
The average collection period is computed in a two-
step procedure. First, you compute the average daily
credit sales (in the absence of credit sales you
computed the average daily sales) by dividing 360
days into the total credit sales, or total sales. Second,
you compute the average collection period by dividing
the account receivable balance at the end of the
accounting period (preferably the average account
receivable if available) by daily credit sales, or daily
sales in the absence of the former. Assuming that all
sales are made on account by Addis manufacturing
company, the average collection periods are:
It takes Addis Manufacturing 48 days to collect its account
receivables in the year 1993 while it take only 46 days to collect
the receivables in the year 1992.
Credit granting and the structuring of credit terms
are major competitive tools used by the marketing
manager rather than the financial manager. Many
companies are forced to set credit policies which are
comparable with the credit policy of the dominant
company in the same industry. The average
collection period has to be interpreted in relation the
credit term provide to customers.
iv. Account payable turnover: measures how rapidly creditors are
paid. That is, how rapidly or how many times A/P are paid during a
year.
A/P turnover = Net purchase/A/P

Assume for Addis Manufacturing Net purchase (on credit) is given as

36,000 for 1993 and 24,000 for 1992. Therefore, APTO will be
calculated as follows:

APTO (1993) = 36,000/7,200 = 5 times

APTO (1992) = 24,000/6000 = 4 times
Interpretation: Addis Manufacturing Co. pays its creditors 5 times a
year in 1993 and 4 times a year in 1992. This shows that the
company has a good performance in paying its creditors in 1993 than
1992. The higher the rate, the lesser risk rated by creditors.
Average payment period (APP):- measures the average length of time creditors
must wait to receive their cash or simply the average time needed by a firm to pay
its A/P to creditors or suppliers from which purchase made.

APP for Addis Manufacturing (1993) = 360 days = 72 days

5
APP for Addis Manufacturing (1992) = 360 days = 90
days
4

Interpretation: Addis Manufacturing’s creditors wait 72 days to

get their payment in 1993 and 90 days in the year 1992.
v. Fixed Asset turnover: - measures the efficiency of a
business firm with which the firm has been using its fixed
assets to generate revenue
Fixed Asset turnover = Net sales
Net fixed asset.
For Addis Manufacturing:
FATO (1993) = 120,000/42,000 = 2.86 times
FATO (1992) = 110,000/36,000 = 3.05 times
3. Debt Management or Leverage Ratios:
These ratios measure the extent to which a company finances itself with debt as
opposed to equity financing. These ratios are also called solvency or capital
structure ratios. They are also termed as financial leverage ratios. Financial
ratios provide the basis for answering two basic questions: How has the
company finance its assets? and can the company afford the level of fixed
charges associated with the use non-owners-supplied funds such as bond
interest and principal payments? The first question is answered through the use
of balance sheet leverage ratios, while the second question is answered through
the use of income statement based ratios, or simply through the use of leverage
ratios
Balance sheet leverage ratios: These ratios provide the basis for answering the
question. Where did the company obtain financing for its investments? The
balance sheet leverage ratios include:
I. Debt ratio, or debt-asset ratio: it measures the extent to which the total
assets of the company have been financed using borrowed funds.
For Addis Manufacturing Company, the ratios are computed as follows:
At the end of 1992, 67.46 percent of the total assets of Addis
Manufacturing Company was financed by funds secured in the
form of current and long-term liabilities. The remaining 32.54
percent was financed by funds contributed by shareholders and
retained from the profits earned by the company. Similarly, debt
financing constitutes about 55 percent of the total assets of the
company during 1993. This leaves 45 percent of the total assets to
be financing has declined during 1993 compared to 1992 signaling
good condition. To much debt financing is risky to the company.
Addis manufacturing company can borrow much more money
during 1992 than it could do in 1993 because the asset structure of
the company was more debt-dominated in 1992 than in 1993.
Hence, lenders are willing to give loans to the company during
1993 when debt-asset ratio is less than during 1992 when debt-
asset ratio is high.