Introduction to corporate finance

Q1. (a): Profitability Ratios

Gross Profit Margin

2006: 28.05%

2007: 22.68%

2008: 24.32%


The Gross Profit Ratio tells us the profit of a business makes on its cost of sales or cost of good sold. The performance was better in 2006, as it was 28.05%. The percentage decreased 5.37% in 2007 which is not good as they have less profit for their activities that take place in the service. But 2008 performance was again better, as it was 24.32%.


The Gross Profit Margin shows how well the business is managing its purchase of stock. If it is high figure it shows that the business is doing well as it is controlling the cost of its purchases. The negative aspect about this ratio is that it provides figures that may mislead Spectrum e.g. if Spectrum do not know the difference between net and gross profit margin as many people get mixed with these two figures. I have used this ratio for Spectrum and I found out that their Gross Profit Margin for 2006 was 28.05%, in 2007 it was 22.68% and in 2008 it was 24.32%. By looking at their Gross Profit Margin, I found out their Gross Profit Margin decreased bye 5.37%, which means that the performance of Spectrum has gone down. In 2006 Spectrum's sales figure was £21,015 and in 2007 their sales figure was £27,450. This means that the sales are not the reason of why their Gross Profit Ratio has decreased, as you can see that their sales have increased from £6,435. The reason why their Gross Profit ratio figure has decreased in 2007 is because in 2006 their cost of sales was £15,120 and in 2007 it was £21,225 which means that the cost of sales has increased bye £6,105.

This ratio can improve Spectrum Gross Profit margin by increasing the sales revenue and Spectrum can do this by selling as much as possible. Spectrum could advertise more in order to make more sales.

By looking at their Gross Profit Margin, I found out their Gross Profit Margin has increased by 1.64%, which means that the performance of Spectrum has gone up. The reason why their Gross Profit ratio figure has increased in 2008 is because in 2007 their cost of sales was £21,225 and in 2008 it was £16,575 which means that the cost of sales has decreased by £4,650, and the main reason why cost of sale of Spectrum was less as compare with 2007 just because in 2008 they had cheap material. Material cost was decreased by 19.77% in 2008. Appendix 1

Net Profit Margin

2006: 8.72%

2007: 8.09%

2008: 10.85%


In 2007, the business was profitable but the profit fell compared to the previous year it was 8.09%. Their expenses have increased due to the difference. The directors have taken a larger salary, but 2008 performance was again better, the profit up as compared to previous year it was 10.85%.


Net Profit Margin provides information on the relationship between the net profits, which is the profit when all the expenses have been subtracted (gross profit - expenses) and the sales revenue has been made by Spectrum. I have used this ratio for Spectrum and I have found out that in 2006 their Net Profit Margin was 8.72% and in 2007 it was 8.09%. This tells me that the performance of Spectrum has gone down as compared to 2006. Spectrum's Net Profit has fallen down by 0.63% from 2006 to 2007. Again Spectrum's sales figure is not the reason of why their Net Profit Margin ratio figure has decreased. The reason why their Net Profit Margin ratio has decreased in 2007 is because their Net Profit has decreased as in 2006 their new Profit was £552 and whereas in 2007 it was £836. This tells me that Spectrum's expenses have increased. This is the reason why their Profit Margin ratio has decreased in 2007.

By decreasing some of the expenses Spectrum can increase their Profit back up and this can make their cash flow healthier. This ratio can improve Spectrum Net Profit Margin by raising the sales revenue and by selling more. Spectrum will also need to ensure that they are keeping their sundries expenses, utility bills and drawings are kept minimum. So that they can save money and can spend on important things such as stock. They can also improve their gross and net profit by advertising more but they need to make sure that they are not spending to much money on advertising. Spectrum can do this by advertising where their market audience is.

Net profit Margin ratio has increased in 2008 is because their net profit has increased as in 2008 their new profit was £994 and whereas in 2007 it was £836, this tells me that Spectrum's expenses have decreased. This is the reason why their profit margin ratio has increased in 2008. Appendix 1

ROCE (Return On Capital Employed)

2006: 21.24%

2007: 28.45%

2008: 40.44%


ROCE is a ratio that indicates the efficiency and profitability of a company's capital investments. This is good as the return on capital employed has increased in 2007 and 2008, which is good for business as it is better. ROCE is refers to payments back to capital owners of a business. So if the number increases it means that the business is getting their payments on time which is good for the business. Appendix 1

Leverage Ratio


A Leverage Ratio measure's a company's ability to meet its financial commitments and its financing methods (debt or equity). It is an important measure to consider because an investor can figure out where their invested money is going and how much of it will be reinvested to create a return.


The debt to assets ratio measures the percentage of assets that are financed by debt. It also measures the amount of risk a company is taking in case of a debt-load. In this case, about 47.14% of assets are being finance by debt, which is good when compared to previous years 2006 was 63.12% and 2007 was 62.80%. The company is relying less on debt and therefore paying less interest out to third parties. The debt to equity ratio measures the proportion of assets that are being financed by debt and equity. Once again the percentages have been decreasing from 171.17% in 2006 to 90.14% in 2008. This confirms the debt to asset ratio, the company is using less debt to finance its assets and therefore spending less on paying interests on loans to third parties. The money is staying in the company by shareholder's money is being invested and the return going back to shareholders. Long term debt to equity same as debt equity, the interest coverage ratio measures the ease with which a company can pay interest payments on its outstanding debt. Its 28.76% in 2008 which means company's interest coverage ratio increased significantly which means it can pay off all its interest payments with ease when required, it was 74.62% in 2006 and 73.25% in 2007 so in 2008 its better then previous years. Additionally, this ties into our previous ratios where the company's debts had decreased and they would therefore have to pay less interest. The company is therefore generating a sufficient amount of revenues to cover its interest payments. Appendix 1

Current Ratio

2006: 1.84

2007: 2.12

2008: 2.88


The current ratio in 2006 was £1.84 to every £1, in 2007 it was £2.12 to every £1 and in 2008 it was 2.88. The current ratio shows us the current idea of the money that the business needs to pay back. This is progress for Spectrum as in 2006 they had to pay less back but now in 2007 and 2008 they are paying more.


This ratio shows how many assets a Spectrum has compared to liabilities, in other words how easily it would be able to pay its creditors. If the figure is just over 1 then the business may be in a difficult position for payment as it current assets would be virtually to its liabilities. It is considered good to have a figure of between 1.5 and 2, so that the business can be sure it can pay its liabilities easily. A figure higher than 2 would not be good as the money should be placed elsewhere to improve the business. The figures for Spectrum show me that the business is doing well in 2008 and 2007 compared to 2006. The amount of assets in 2008 and 2007 has increased. In 2006 the current ratio shows that for every £1 Spectrum owes they owned £1.84 but in 2007 the figure was £2.12 and in 2008 the figure was £2.88. Another reason why their business is not performing well is because of their current liabilities. In 2006 the current liabilities figure was £4,770 and in 2007 it was £4,307 and in 2008 it was £1,916. This shows me that the business is in dept as Spectrum owes more money in 2006. The figures had dropped and their business was not as healthy.

Therefore this could be harder for Spectrum to pay their bills and other expenses, which are necessary for their business. In 2007 and 2008 the performance of their business was good as they could pay all their expenses. Spectrum improved the performance of their business by improving the ratio. Appendix 1

Advantages of Ratios

Ratio analysis is an important and old technique of financial analysis. These are the following advantages of Ratio.

  1. Accounting ratio help to major profitability of the business, ratio tells the whole story of changes in the earning capacity of the business. Profitability shows the actual performance of the company.
  2. Ratios highlight the factors associated with successful and unsuccessful company.
  3. It helps planning and forecasting, ratios can assist management, Ratio analysis help the outsiders like shareholders, creditors, debenture-holders, bankers to know about profitability to pay them interest and dividend etc.
  4. Ratio analysis also makes comparison of the performance of different divisions of the company. Accounting ratios are helpful in deciding about their efficiency in the past and compare it to future.
  5. Ratio analysis helps in investments decisions in the case of investors and lending decisions in the case of bankers etc.
  6. Ratio analysis helps to workout in operating efficiency of the company with the help of various turnover ratios. All turnover ratios are worked out to evaluate the performance of the company in the utilising the resources.

Shortcoming or Limitations of Ratios

Though ratios are simple to calculate and easy to understand, there are certain limitations or shortcoming of the ratio analysis techniques and they should keep in mind while using interpreting financial statements.

  1. Different company apply different accounting policies, therefore the ratio of one company can not always compare with other companies. Some companies may value the closing stock on LIFO basis and some other companies will use FIFO basis.
  2. Accounting ratios are based on data drawn from accounting records. In case data is correct, then only the ratios will be correct. For example if the valuation of stock is based on higher price, the price of the concern will be inflated and it will indicate a wrong financial position.
  3. Ratios are alone not adequate. Ratios are only indicators, they cannot be taken as final regarding good or bad financial position of the business.
  4. Price level changes often make the comparison of figures difficult over a period of time, in such case ratio analysis may not clearly indicate the trend in solvency. Therefore, it is necessary to make proper adjustment for price-level changes before any comparison.
  5. Ratio analysis are costly technique and can be use by big companies, small companies are not able to afford it.
  6. Not only industries differ in their nature, but also the companies of similar business widely differ in their size. There are no standard ratios, which are universally accepted for comparison purposes. As such, the significance of ratio analysis technique is reduced.

Financial and Non-financial Techniques

In this part we will discuss about financial and non-financial techniques, which are as follows.

  1. Profitability (Financial)
  2. Activity Ratio (Financial)
  3. Benchmarking (Non Financial)
  4. Customer Service (Non Financial)

Profitability Ratio (Financial)

We used profitability ratio for Spectrum Company, profitability ratio is a class of financial metric that are used to assess a business's ability to generate earnings as compared to its expense. We had checked that how Spectrum Company managers are good in generating profit. We use Profitability ratio to check how company is doing. Having higher value relative to a competitor's ratio from previous period is indicative that the company is doing well.

Activity Ratio (Financial)

Activity ratios show how efficiently a company has managed liabilities and short-term assets. Spectrum Company will try to turn their production into cash or sales as fast as possible because this will generally lead to higher revenues, but it is common for the year end value to be used in order to obtain figures for comparative purposes.

Benchmarking (Non Financial)

Spectrum Company will check its cost, cycle time, productivity, or quality to another that is widely considered to be an industry. Benchmarking provides a snapshot of the performance, Spectrum Company would use benchmarking for better performance of business and will help to understand in relation to a standard. Spectrum Company would try to make good quality to make a best performance using a specific indicator in resulting in a metric performance that is then compared to others.

Customer Service (Non Financial)

Spectrum Company would

Q1. (b): Agency Theory

Agency theory is the financial economics that looks at conflicts between people with different interests in the same assets. The conflicts between,

Shareholders and managers of companies

Agency Theory is the theory that covers the conflicts between agent of the firm and the principal of the firm, the agents are the managers and the principal are the stockholders, there will be a conflict if the goal of the agents managers are not consists with the goal of the stockholders and that goal is basically maximization of the stockholders wealth, And if there is conflict between this goals you will see will be agency cost and those cost could involved millions of dollar in under performance of the firm.

Spectrum Company is very diverse group of companies and Spectrum company's shares are owned by institutional investors, they have the power to influence the board of directors. There may be a conflict of interest between the board and the institutional investors management as they Spectrum companies management don't take that much risk while diversifying their business in India and other country. Institutional investors take the higher risk rather than normal companies.

Q1. (c): Dividend Policy

Dividend policy is company use to decide how much they have to pay dividend from the net profit. Now the company has to decide what they have to pay in terms of dividend there are three methods of paying dividends.

  1. Residual
  2. Stability
  3. Hybrid


Companies using the residual dividend policy choose to rely on internally Generated equity to finance any new projects. As a result dividend payments can come out of the residual or leftover equity only after all project capital requirements are met.


With the stability policy, companies may choose a cyclical policy that sets dividends at a fixed fraction of quarterly earnings, or it may choose a table policy whereby quarterly dividends are set at a fraction of yearly earnings. In either case, the aim of the dividend stability policy is to reduce uncertainly for investors and to provide them with income.


The final approach is a combination between the residual and stable dividend policy. Using the approach companies tend to view the debt/equity ratio as a long-term rather than a short-term goal.

Three main positions on the question are, first the Spectrum Company own shareholders, mostly they are institutional investors they will expect high dividend.

Does Dividend Policy Matter?

Its depend upon the Company management, what type of policy they chose if they will go with stability then they have to pay dividends and if they will go with the Residual then they will invest money first and from the remaining amount they will pay the dividend and its also depend upon the inventor, what they are expecting at the end u have to give a conclusion to them does dividend policy matter or not.

Q2. (a):

Tax experts for decades have bemoaned the tax code's bias toward debt or equity, interest on most corporate debt is tax deductible, while dividends payments are not. The essential question here, I think is, why do we have system that encourages corporations to take no more debt instead of equity? I can think of two reasons why the government might want to encourage debt. First, it's a nice little payback to banks of their support. Second, and more legitimacy it might help business, particularly small business, flourish. It reduces capital costs. I would be specifically concerned with small businesses that rely a lot more on debt than equity. By allowing them to deduct interest from their taxes, this makes their debt a lot less costly, allowing better profit and growth. Meanwhile, it would be great for the equity market if dividends were tax deductible instead equity investors would have better prospects for dividends, if tax deductible.

Q2. (b):

There are following three main sources of financing a public company.

  1. The capital markets: (i) The new shares issues, for example by companies acquiring a stock market listing for the first time (ii) right issues
  2. Bank borrowings
  3. Retained earnings

The capital markets

Ordinary (equity) shares to the owners of company. They have a nominal or 'face' value typically of $1 or 50 cents. The markets value of a quoted company's shares bears no relationship to their nominal value, except that when ordinary shares are issued for cash, the issue price must be equal to or be more than the nominal value of the shares.

New shares issue a company seeking to obtain additional equity funds may be, an unquoted company wishing to obtain a Stock Exchange quotation, an unquoted company wishing to issue new shares, but without obtaining Stock exchange quotation. A company which is already listed on the Stock Exchange wishing to issue additional new shares.

A Right issue provides a way of raising new share capital by means of an offer to existing shareholders, inviting them to subscribe cash for new shares in proportion to their existing holdings.

Bank Borrowings

Borrowings from banks are important source of finance to companies. Bank lending is still short-term, although medium-term lending is quite common now days.

Shot-term an overdraft, which company should keep within a limit set by the bank. Interest is charge at variable rate, on the amount which company borrowed from bank. You could take short-term loan for up to three years.

Medium-term loan are loans, which company takes up to three to ten years. The rate of interest charged on medium-term lending bank to large companies will set margin. A loan may have fixed rate interest or a variable interest rate, so that the rate of interest charged will be adjusted every three, six, nine or twelve months.

Retained Earnings

Retained Earnings is a profit, which we pay part on dividends and the remaining we keep as retain and the remaining one is called Retained Earnings. For the company, the amount of earnings retained within the business has a direct impact on amount of dividends. Profit re-invested as retained earnings is profit that could have been paid as a dividend. The major reasons for using retained earnings to finance new investments, rather than to pay higher dividends and then raise new equity for the new investments.

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