Finance Peer Responses/Reflection #4

· Respond to 3 posts listed below. Advance the conversation; provide a real-world application and experiential examples;

· Conceptually discuss your key [most significant] learning insight or take-away from the selected forum topic comments.

· Responses should be a minimum of 150-250 words , supported by at least one reference outside of the textbook (use academic journals), either supporting or refuting the position of the author of the forum topic response or peer response.

Topic #1: Financial Leverage and the firm

 

Salama (2008) defined financial leverage as the degree to which a firm uses fixed-income securities that fall under the category of debt and preferred equity. The more financing of debt a company uses, the higher of the degree is the companies financial leverage. In other words financial leverage is the measure of how much the firm relies on debt. Many times firms use financial leverage to increase production volume which hopefully equates to an increase in sales and ultimately earnings of a company. Financial leverage can also be used to magnify shareholders earnings. When looking at financial leverage it is accepted that a high degree of financial leverage means high interest payments for the company. A company having interest payments is overall detrimental the bottom line of the company. The paper further defines the accepted formula for determining financial leverage. In this case the formula is referred to as the degree of financial leverage or the DFL. This formula measures the percent change in earnings per share over the percent change in EBIT. 

Financial leverage is an imperative aspect of financial management. In order for a firm to be at maximum value and for shareholders returns to be at maximum value the management much arrive at a proper mixture of debt and equity (Schauten and Spronk, 2006). It is often the case that earnings per share of a firm can be increased through the practice of financial leverage. This is typically due to the fact the tax on the cost of debt is less than the return on the investing of the borrowed money. It is though common to find that as the debt ratio or the debt/equity ratio increases there can be a negative reflection for the company. As a result of this every firm must over the interest cost of debt if they see a return on equity start to decrease.

That being said when a company decides to practice financial leverage there is an assumed risk. Schauten and Spronk (2006) discussed the fact that as with any case taking on debt always brings about a higher level of risk purely due to the fact that income from the company must be used to pay back the debt the company owes even if revenue for the company drops. One of the major factors that goes into this is return on equity or ROE that effects the common stock owners of the company. The return on investment is a measure of the firms’ capability of generating profits from all units of shareholders equity. The ROE is the primary indicator of how well a company is doing at using investment funds to generate positive earnings and growth for the company. The return on investment is determined by dividing the net income after tax by the shareholders equity. This is deemed to be positive financial leverage for a company when the return on investment increases. Companies do have to be careful though not to be over leveraged, which in this situation the amount that is borrowed is much higher than the amount that company has the ability to earn. When this happens it can effect the companies ability to become solvent in the case of downfall. This also can drive a company into premature bankruptcy as it may be the only option to be able to pay of debts that they owe through leveraging of the company. This is a primary reason that companies must be very careful of the financial leveraging their company is doing and keep a watchful eye on the economic environment around them.

One of the newer concepts that is being brought to light is the subject of diversification on financial leverage. Diversification as defined by Salama (2012) is reduction of non-systematic risk by investment in a variety of assets and markets. Recently firms have increased their foreign investments with some firms having over 50% of their business involved in foreign assets. The problem is that Negi (2012) stated that biased corporate finance theory is suggestive of diversification actually destroying value as it often diminishes the benefits of specialization within the firm, which is against the idea of financial leverage. The idea that global diversification is the way to go stems from the fact it is leveraging a company against multiple economies. So for instance if the US market fails, the Chinese market may not. The jury though appears to still be out on if there is a positive impact when global diversification is used. Salama (2008) looked into the statistics from multiple companies ones that use global diversification and ones that do not and found a mixed bag of results. For some companies that made careful financial leverage choices on the global market they saw either a return in revenue or at least met a break even point they previously were not able to make. On the other hand companies that picked poor global markets to invest in often saw harsh downturns in revenue which in some cases even caused bankruptcy of the business.

Overall financial leverage is a useful process in expanding a business. It can improve the resources that a company has available and often present a more attractive option to stock holders. When the formulas are used correctly and good investments are made companies often see a positive return on the use of financial leverage. It is though a risky behavior for companies as it does often rely on the success of other businesses and other markets. Companies often have to go through in depth analysis to make sure that that the rewards outweigh the risk of the investment.

 

References:

 

Negi, P., Sankpal, S., Mathur, G., & Vaswani, N. (2012). Impact of financial leverage on the payoffs to stockholders and market value. IUP Journal of Accounting Research & Audit Practices, 11(1), 35-46. Retrieved from http://search.proquest.com.proxy.davenport.edu/docview/1019956952?accountid=40195

 

Salama, M. F. (2008). Diversification strategies, financial leverage, and excess value: The role of information asymmetry and corporate governance (Order No. 3320184). Available from Accounting & Tax. (304417910). Retrieved from http://search.proquest.com.proxy.davenport.edu/docview/304417910?accountid=40195

 

Schauten M and Spronk J (2006), "Optimal Capital Structure: Reflections on Economic and Other Values", ERIM Report Series Reference No. ERS-2006-074-F&A, Retrieved from SSRN http://ssrn.com/abstract=968852.

Topic #2: Types of Market Efficiency

            The stock market is very busy with buying and selling occurring on a daily basis. People expect to get a fair price for their stock and the efficient market hypothesis explains how the capital market remains fair.  It states that,”…the price of an asset reflects all relevant information that is available about the intrinsic value of the asset” (Jones & Netter, 2008).  This ensures that stocks are not being sold at higher prices with knowledge that the price of the stock is going to drop in the near future.  Similarly, it also safeguards against people buying a lot of stock at a low price with the knowledge that the price is going to rise soon.  But how does this hypothesis relate to the real world capital market?  With an imperfect society there are bound to be some variances in which the market does not respond to all information immediately.  This is explained with different types of efficiency.  The three types are the weak form, semi strong form and the strong form each of which will be discussed below.

            The weak form of efficiency is based off of the last observed price plus the expected return plus a random error.  It reflects all past publicly available information (Boundless, 2014).  Future stock prices cannot be projected solely based off of past prices though.  Let’s look at an example to better understand this concept.  Say an investor is following the stock prices of a company and notices that their prices tend to rise on Monday and fall on Friday.  The investor decides to invest when the price is low on a given Friday and expects to have gained money on Monday.  However, the Monday after the investor buys the stocks the price has fallen instead of risen.  This would be an example of a weak form market.  The investor was unable to earn a return based off of past stock price patterns.  If stock prices followed a cyclical pattern, people would always know exactly when the best time to sell and the best time to buy would be and it would essentially all cancel out.  However, not all markets follow the weak form.  There is also a form that contains more information than the weak form and it is called the semi strong form.

            The semi strong form of efficient market reflects all public information including accounting statements in addition to historical price information (Ross & Westerfield & Jaffe, 2013).  This form implies that stock prices rapidly adjust to the new public information.  For example, a company releases information that they are experiencing increased earnings.  An investor would then want to buy stock right away since it is expected that stock prices will go up from this new information.  However, in a semi strong form since the prices of stock change immediately with new information the investor will actually be buying the new price of stock, which has already taken into consideration the increased earnings.   Many investors seek the help of investment analysts which track trends of a company and help advise for the peak times of selling and buying.  However, with the semi strong form, since any changes that are to be made public are reflected in the price of the stock immediately the investment analysts are not given any advantage over the average investor.  Essentially, in a semi strong form market investors cannot use any published public information to predict future prices (Piper, 2009). 

            The last form of efficient market is the strong form.  This form encompasses an even broader knowledge of information including the past price of the stock, published information that could affect the stock as well as unpublished information, which makes it different and more inclusive than the semi strong form of market.  If all information affecting the price of the stock were immediately reflected in the price of the stock then this would protect against insider trading.  For example, an oil company has just received news that one of the oil tankers has run aground.  An investor with stock invested in this company gets ahold of the news before it goes public and decides to sell their stock.  Under the strong form market the price of the stock will have already dropped before the investor can sell their stock even though the information was not made public yet.  Although this sounds like a perfect way to maintain fair trading prices it is not always portrayed this way in the United States market.    

            There are instances by which insider trading occurs.  Basically, an investor receives information about a company, either good or bad, that is going to affect the price of the stock before anyone else knows about it.  By having the information ahead of time the investor can sell their stock if the future looks bleak or buy shares if the future looks profitable.  This is illegal and punishable by fines or even jail time.  One high profile case was that of Martha Stewart who used insider information to her advantage.  In 2001 she was told to sell all of her 3,928 shares in ImClone Systems because the company was expected to go under (Grigoriadis, 2012).  She did as she was advised and avoided a loss of $45,000.  However, it was only a matter of time until it was discovered that she had evaded this loss due to insider information.  She was tried and punished with a fine and a five-month jail sentence.  Unfortunately, she is not the only case of insider trading.  There have been many others and there will continue to be more in the future. 

            The stock market is a very busy entity with dollars upon dollars being traded each day. The market, by nature, aims at being efficient and creating an equal trading space for everyone.  The different forms of market efficiency represent different levels of information used to determine the price of a stock.  The market aims to make trading fair for everyone even though there are instances where unfair transactions are made.

           

References

Boundless. (3 Jul. 2014). In The Efficient Market Hypothesis. Retrieved Jan. 26, 2015 from https://www.boundless.com/finance/textbooks/boundless-finance-textbook/security-market-efficiency-and-returns-9/market-efficiency-85/the-efficient-market-hypothesis-365-7276/

Grigoriadis. (1 Apr. 2012). In Insider Trading-Not a Good Thing. Retrieved Jan. 26, 2015 from http://nymag.com/news/features/scandals/martha-stewart-2012-4/

Jones, S. and Netter, J. (2008). In Efficient Capital Markets. Retrieved Jan. 26, 2015 from http://www.econlib.org/library/Enc/EfficientCapitalMarkets.html

Piper, M. (19 Nov. 2009). In Efficient Market Hypothesis: Strong, Semi-Strong, and Weak. Retrieved Jan. 26, 2015 from http://www.obliviousinvestor.com/efficient-market-hypothesis-strong-semi-strong-and-weak/

Ross, S. A. and Westerfield, R. W. and Jaffe, J. (2013). Corporate finance. New York, NY: McGraw-Hill/Irwin.

Topic #3: Cash Management

Cash management is a concept that comprises the majority of a financial manager’s function within an organization. It involves the collection, application and disbursement of a company’s liquid cash. With the primary objective focused on managing the cash in a way that maximizes the availability of cash on hand in order to reduce the risk of becoming over-leveraged. The cash on hand is available cash that is not tied up in assets or inventory, but is available to pay bills and utilize. This is involves monitoring and directing cash balances, cash flow, and investment strategies. This is the most important function of financial managers and where they provide value is by ensuring that the company has cash to pay it’s bills and does so in a timely manner. Otherwise, the company would become over-leveraged and end up in bankruptcy. 

Aside from the obvious goal to prevent bankruptcy, the value of efficient cash management also increases profitability and reduces risk for a company (Dotsey, 1984). The efficiency of this function is extremely necessary for start up businesses and businesses that are expanding. Proper cash management can make or break their success. Even an established business can be subject to cash management problems regardless of whether they have plenty of customers, and offer a good product or service against their competitors. The business operation does not necessarily mean that the cash flow is managed properly and a seemingly successful company may not be prepared for unanticipated expenses. Having cash flow problems does not allow for a safety net and reduces the ability to come up with cash for growth. Whether this be securing loans, growing products/services, or hiring new talent. All of this requires a good cash flow position. 

Businesses will have expenses when producing products and providing services; in many cases the expense is incurred before the payments are received. Additionally, staff wages are consistently reducing funds and other business expenses - seen or unseen arise. Therefore, careful management and planning for these fluctuations in cash flow are essential for ensuring that timing and amounts in and out are in balance. Also allowing a cushion for times when there are downturns. Thus, optimal cash management involves making realistic projections, creating good billing and collection systems, monitoring accounts receivable, and disbursement of funds; all while functioning under established budgetary restrictions (Dotsey, 1984). 

In terms of cash collection, the objective of setting up an efficient system is to minimize the time it takes for a business to collect funds owed to it for providing a product or service. Specifically, focusing on the time it takes between providing a product/service to having the cash available for use. The time may be increased by factors such as customer delays making a payment, the time it takes for mail, processing time, and what is termed “bank float” (Kroll, 2006). Processing time can refer to any amount of time it takes (or number of hands the payment goes through) in order to get the funds to the bank. Bank float refers to the time the bank holds the funds (pending funds) until they release this amount to be available for use. These activities (and sometimes more) increase the time spent awaiting funds to become available. Time waiting for money usually translates to a loss in the ability to make more money with these funds; which is essentially a loss and where the phrase “time is money” is applicable. If a business is struggling, the time delays can cause great stress on the business. Therefore, the ability to reduce time waiting for funds is an important component of efficient cash management. Recently, automated payments and deposits have significantly improved businesses’ ability to receive and deposit funds more quickly. However, maintaining effective billing and collection procedures are important functions to successful cash management. 

There is a term in finance called the Cash Conversion Cycle (CCC). This term is used to describe the amount of time from producing a product or service to the time when money is received and in the account from the customer. During this time (cycle) the funds are not available for use by the company (Maysami, 2010). This period helps financial managers determine if they will need to borrow funds to stay afloat (Maysami, 2010). Then, managers can monitor monitor these cycles and how much interest will be paid for borrowing funds. The goal being to determine how the cycle can be shortened to the extent that cost of borrowing funds can be reduced or eliminated. The CCC comprises three other financial concepts: Inventory conversion period (ICP), Payable deferral period (PDP), and Receivable conversion period (RCP) (Maysami, 2010). ICP = length of time between purchase of materials/production of goods or services and sale to customer; PDP = time from purchase of materials on credit and cash payments for accounts payable; RCP = time from sale of product/service to customer on credit to time when cash received in accounts receivable (Maysami, 2010). Therefore the CCC formula is: 

CCC = ICP + RCP - PDP (Maysami, 2010)

An example illustrated by Maysami states: “If a company takes 35 days from the time the orders are made to receive and process materials into the final product, the ICP = 35 days; then 25 days after materials are received the company pays for them, the PDP = 25 days; finally, the firm receives cash payment for the sale in 30 days, the RCP = 30 days; the CCC = 35+30-25 or 40 days” (Maysami, 2010). 

Therefore, based upon the number of days determined by the CCC, financial managers can figure out if funds must be borrowed and if so what interest will be incurred (Maysami, 2010). In continuing to use this, managers can work on shortening this duration to reduce interest costs or eliminate them, as previously mentioned. 

In addition to collecting cash, the funds collected must be distributed to the correct accounts and bill payments made. Therefore, the business must also be aware of the costs incurred to handle, transfer, and pay funds (Kroll, 2006). Electronic services and systems cost money or may charge fees. Thus, these costs must be taken into consideration in handling a business’s cash. The convenience and time saved must be justified. Otherwise, alterations in how the money is handled and payments are made must be revised. 

Cash management also means making sure funds are available at the proper times so that financial obligations are met. Timing and balancing funds available plays a large role in cash management as illustrated above by use of the CCC. Successful cash managers utilize additional tools and formulas to monitor their cash flow. Many look at their “cash to assets ratio,” and may factor in assets, inventory, loan notes, etc. The higher their liquidity measures, the better the cash flow is being managed. However, being careful that there is not too much cash sitting idle that could be used for investments or growth. 

If a company is consistently showing poor liquidity, then it may be necessary for a company to take actions not limited to borrowing money; like streamlining high cost areas, increasing revenue and cutting spending in order to improve their financial position (Kroll, 2006). Financial managers have this information and should proactively conduct financial analyses if the business is experiencing poor cash flow (Maysami, 2010). Then, they may use this to revise budgets, make adjustments where necessary, and create more effective financial management plans. 

References: 

Dotsey, M. (1984). An investigation of cash management practices and their effects on the demand for money. Economic Review.

Kroll, K. (2006). Best practices in cash management: Information and automation are key. Business Finance, 12(2), 17-20.

Maysami, R. C. (2010). Understanding and controlling cash flow. Financial management series. Retrieved November, 12.