| Debt Ratios Debt ratios are calculated to assess that how much a firm is using financial leverage for profit maximization with the combination of total assets. These also reflect that how much the firm has the ability to service debt to make the payments required on a scheduled basis over the life of debt. In debt ratios, coverage ratios also measure the bank’s ability to pay certain fixed charges. Total Liabilities Debt Ratio = Total Assets 1. Time Interest Earned Ratio It is also called the Interest Coverage Ratio, measures the firm’s ability to make contractual interest payments. Greater the ratio means that firm is better position to make fulfill its interest obligations.  Earning Before Interest and Taxes Time interest Earned Ratio = Interest Amount Earning before income and taxes includes the total interest income and non-interest income, after deducting non-interest expense during the year(s). Interest amount includes interest payments made on deposits (current, saving, fixed) and investments. 2. Fixed Payment Coverage Ratio The fixed payment coverage ratio was used to measure the firm’s ability to meet all fixed-payment obligations, such as interest and principal, lease payments, and preferred stock dividends. Earning before interest and taxes + Lease payments FPCR = Interest+ Lease Payment+ (Principal) x (1/1-T) T = Tax rate applicable to bank income. (1/1-T) = The term included to adjust the after tax principal amount of borrowing and lease payments back to before tax equivalent. |
Debt Ratios Caluculation
Investment Risk and Return
Investment Risk and Return
Risk means uncertainty. In investment risk, when there is uncertainty attached with the outcomes of investment opportunity. In global markets there are lot of risk attached with the securities that can negatively affect the return of an investment opportunity.
There are basically two types of risks:
1. Systematic Risks These risks occur inside the organization that can affect the profits of the organization. such as inefficiency of the management, labor unavailability or strikes. We say this risk as controllable because this can be controlled to some extent by the executives.
2. Unsystematic Risks This type of risk exist outside the organization and are more worse than systematic risks. Such as political factors, competitors strategies, material unavailability, etc. This is also called uncontrollable because it cannot be controlled by the management of the firm.
The return on investment varies from company to company depending upon the nature of organizations and their basic objectives. If the organization is for charitable purposes it will require the non-profit return.
The return may in different forms like increase of sales volume, increase in the firm marketability, increase in customers loyalty. And also return may be positive or negative. This depends upon the risk associated with the investment opportunities.
Risk and return both go side by side in investment opportunities. The most spoken business slogan is "Higher the risk higher the return". Means investing in most risky portfolio (set of diversified investment opportunities) will yield the higher return as compared to the risk free assets. But in portfolio management when we combine different investment opportunities to composite the portfolio and we want higher return with minimum risk. For this purpose we add a risk free asset in our portfolio.
Risk means uncertainty. In investment risk, when there is uncertainty attached with the outcomes of investment opportunity. In global markets there are lot of risk attached with the securities that can negatively affect the return of an investment opportunity.
There are basically two types of risks:
1. Systematic Risks These risks occur inside the organization that can affect the profits of the organization. such as inefficiency of the management, labor unavailability or strikes. We say this risk as controllable because this can be controlled to some extent by the executives.
2. Unsystematic Risks This type of risk exist outside the organization and are more worse than systematic risks. Such as political factors, competitors strategies, material unavailability, etc. This is also called uncontrollable because it cannot be controlled by the management of the firm.
The return on investment varies from company to company depending upon the nature of organizations and their basic objectives. If the organization is for charitable purposes it will require the non-profit return.
The return may in different forms like increase of sales volume, increase in the firm marketability, increase in customers loyalty. And also return may be positive or negative. This depends upon the risk associated with the investment opportunities.
Risk and return both go side by side in investment opportunities. The most spoken business slogan is "Higher the risk higher the return". Means investing in most risky portfolio (set of diversified investment opportunities) will yield the higher return as compared to the risk free assets. But in portfolio management when we combine different investment opportunities to composite the portfolio and we want higher return with minimum risk. For this purpose we add a risk free asset in our portfolio.
Capital Budgeting
Capital Budgeting
Capital budgeting is the process of evaluating and selecting long-term investments opportunities that are parallel with the firm's objectives. And to fulfill these objectives different investment opportunities are evaluated and then finally one is selected. And, firm generally made capital expenditure in earning assets that could increase their earning capacity.
Following are the key motives for capital expenditures:
1. Expansion The most common motive is the expansion of firm's operations. And in this firms generally acquire fixed assets because only fixed assets can increase the earning capacity.
2. Replacements When the machinery of the firm outdates then replacements decisions are made. Replacements are also made when the firm reaches maturity and its growth slows.
3. Renewal This is the alternative of replacements. This involves rebuilding, overhauling or retrofitting an existing fixed asset. Basis difference is that in replacement we replace the whole asset but in renewal we only replace the a part of asset.
4. Other If firm make expenditure other that above mentioned that it will fall in this category.
Steps in Capital Budgeting
Different authors present different approaches in capital budgeting process. But the basic logic is same:
1. Screening and Selection of Investments Among different investment opportunities we generally evaluate and select the investment opportunity by using Capital Budgeting techniques (DCF and Non DCF).
2. Capital Budget Proposal A budget is proposed in which it is discussed that what will our key expenditure? What will be the total cost of investment? When cash flows will occur?
3. Budget Approval and Authorization The proposed budget is presented to the top management for approval and top management make authorization and gives the directions that from when these funds will be generated, some time internally and some time externally.
4. Implementation Following the approval and authorization the expenditures are made and project is implemented.
5. Evaluation and control Once the project is implemented the results are monitored and matched with the objectives of the firm.
Capital budgeting is the process of evaluating and selecting long-term investments opportunities that are parallel with the firm's objectives. And to fulfill these objectives different investment opportunities are evaluated and then finally one is selected. And, firm generally made capital expenditure in earning assets that could increase their earning capacity.
Following are the key motives for capital expenditures:
1. Expansion The most common motive is the expansion of firm's operations. And in this firms generally acquire fixed assets because only fixed assets can increase the earning capacity.
2. Replacements When the machinery of the firm outdates then replacements decisions are made. Replacements are also made when the firm reaches maturity and its growth slows.
3. Renewal This is the alternative of replacements. This involves rebuilding, overhauling or retrofitting an existing fixed asset. Basis difference is that in replacement we replace the whole asset but in renewal we only replace the a part of asset.
4. Other If firm make expenditure other that above mentioned that it will fall in this category.
Steps in Capital Budgeting
Different authors present different approaches in capital budgeting process. But the basic logic is same:
1. Screening and Selection of Investments Among different investment opportunities we generally evaluate and select the investment opportunity by using Capital Budgeting techniques (DCF and Non DCF).
2. Capital Budget Proposal A budget is proposed in which it is discussed that what will our key expenditure? What will be the total cost of investment? When cash flows will occur?
3. Budget Approval and Authorization The proposed budget is presented to the top management for approval and top management make authorization and gives the directions that from when these funds will be generated, some time internally and some time externally.
4. Implementation Following the approval and authorization the expenditures are made and project is implemented.
5. Evaluation and control Once the project is implemented the results are monitored and matched with the objectives of the firm.
Time Value of Money
Time Value of Money
Financial managers and investors are always confronted with the opportunities to earn positive rates of return on their funds. And we always know that in every single investment opportunity their are always number of cash flows (inflows or outflows). And these cash flows are either same or vary from time to time. We also know that every time there is the uncertainty in the outcomes of returns and inflation is increasing day by day. And it greatly affect the value of money. So, the sensitive financial managers and investors keep close eye on it.
In time value of money we use two inverse concepts:
1. Future Value
2. Present Value
Future value simply means that what will the future value of the present investment opportunity. For example, we keep $1000 in treasury and we forget. After some months when we find it and evaluate its worth we say that this is $1000. But actually when we use time value concept its worth has been decreased because if we had invested that $1000 in any investment opportunity we got some return and obviously, it will be greater than $1000.
Present value simply means that what is the present value of the future cash flow from an investment opportunity. We generally find the present value of the future cash flow. Because, we know that dollar today is worth more than dollar tomorrow. The logical matter behind the present value is same as behind the future value.
Above mentioned both techniques are used in capital budgeting decisions. In which we evaluate different investment opportunities and made decisions on the basis of present and future values. But one thing should be clear that both present and future value concepts are used in Discounted Cash Flow (DCF) techniques.
Financial managers and investors are always confronted with the opportunities to earn positive rates of return on their funds. And we always know that in every single investment opportunity their are always number of cash flows (inflows or outflows). And these cash flows are either same or vary from time to time. We also know that every time there is the uncertainty in the outcomes of returns and inflation is increasing day by day. And it greatly affect the value of money. So, the sensitive financial managers and investors keep close eye on it.
In time value of money we use two inverse concepts:
1. Future Value
2. Present Value
Future value simply means that what will the future value of the present investment opportunity. For example, we keep $1000 in treasury and we forget. After some months when we find it and evaluate its worth we say that this is $1000. But actually when we use time value concept its worth has been decreased because if we had invested that $1000 in any investment opportunity we got some return and obviously, it will be greater than $1000.
Present value simply means that what is the present value of the future cash flow from an investment opportunity. We generally find the present value of the future cash flow. Because, we know that dollar today is worth more than dollar tomorrow. The logical matter behind the present value is same as behind the future value.
Above mentioned both techniques are used in capital budgeting decisions. In which we evaluate different investment opportunities and made decisions on the basis of present and future values. But one thing should be clear that both present and future value concepts are used in Discounted Cash Flow (DCF) techniques.
DuPont System Of Analysis (EXTENDED)
DuPont System (Extended)
We use extended DuPont system because it provides the additional insights into the effect of financial leverage. The concept and use of the model is the same as the basic DuPont system except for a further breakdown of components.
Combining the Operating profit margin and total asset turnover;
EBIT Net Sales EBIT
X =
Net Sales Total Assets Total Assets
To consider the negative effect of financial leverage, we deduct the interest expense;
EBIT Interest EBT
_ =
Total Assets Total Assets Total Assets
To find the positive effect of financial leverage, we will get;
EBT Total Assets EBT
X =
Total Assets Common Equity Common Equity
Finally to reach on ROE, we multiply the tax retention rate;
EBT Income Tax EBT
X 1- =
Common equity EBT Common Equity
In summary, we use the following five components in extended DuPont system of analysis;
EBIT
1. = Operating profit margin
T. Revenue
T. Revenue
2. = Total asset turnover
Total Assets
Interest
3. = Interest expense rate
Total Assets
Total Assets
4. = Financial leverage multiplier
Common Equity
income Tax
5. 1- = Tax retention rate
EBT
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