Kinnaird College for Women

Pre-mid Assignment 1
Corporate finance
Course instructor: Ma’am Fizza abbas

Date of Submission: 19th September, 2019

Submitted by:
ASMA NASEER
BSc. Accounting & Finance
Fall Semester V
F17BACT008
1- Choose 1 corporation from current economy in Pakistan

2- Comment on working capital and asset management of that business

3- Liquidity analysis

4- Final concluding remarks if business is managing efficiently or not (risk, leverage, dol, dfl,
debt analysis)
Contents
WORKING CAPITAL MANAGEMENT: ................................................................................ 8
Gross working capital: ................................................................................................................. 8
Networking capital: ...................................................................................................................... 8
Liquidity analysis: ........................................................................................................................... 9
Current ratio: ................................................................................................................................ 9
Quick ratio: ................................................................................................................................. 9
Conclusion Liquidity, profitability and risk analysis:................................................................... 10
Asset management: ....................................................................................................................... 10
Asset management ratios: ......................................................................................................... 11
Fixed asset turnover: ................................................................................................................. 11
Asset turnover ratio: .................................................................................................................. 11
Account payable turnover ratio:................................................................................................ 12
Inventory turnover ratio: ........................................................................................................... 13
Receivables turnover ratio: ....................................................................................................... 13
Operating cycle: ........................................................................................................................ 14
Conclusion of asset management of PSO: .................................................................................... 14
Debt and leverage analysis: .......................................................................................................... 15
Debt ratio: ................................................................................................................................. 15
Degree of operating leverage: ................................................................................................... 15
Operating leverage and risk: ..................................................................................................... 16
Degree of Financial Leverage ................................................................................................... 16
Financial leverage and risk ....................................................................................................... 16
Interest coverage ratio:........................................................................................................... 17
Risk management: ......................................................................................................................... 17
Conclusion: ................................................................................................................................... 18
WORKING CAPITAL MANAGEMENT:
Working capital consists of two main components i.e. current asset and current liabilities.
Working capital management shows how efficiently a firm manages its current asset in
accordance to its current liabilities. The primary function of working capital management is to
maintain enough cash flow to meet the obligation of short term debt and short term operating
cost. It works for balancing the ratio of current asset and current liability.

Working capital can be divided into two categories

 Net working capital

 Gross working capital

Gross working capital:

Gross working capital is company’s total amount of current assets. It consist of cash on hand,
account receivables, inventory and short term investments. It does not include liabilities so, it
only offers a limited description about company’s financial status.

Networking capital:
Networking capital is the dollar difference between current assets and current liabilities.

Net Working Capital = (Current Assets) – (Current Liabilities)

A positive networking capital shows the firm’s stability and so it has enough funds to meet its
current liabilities and invest in other activities. A net zero networking capital means a company
is only able to meet its current financial obligations and a negative networking capital means that
a company has deficit funding and it needs to borrow money to remain solvent.

In 2018, Pakistan state oil ltd total current assets were 378,103,557 and total current liabilities
were 286,944,833. So, the total networking capital was:

378,103,557 – 286,944,833 = 91,158,724

In 2018, the PSO ltd had a positive total networking capital. Positive working capital means that
company is able to meet its current financial obligations and is working efficiently so, there is no
such need to raise capital in order to meet its current obligations.

Liquidity analysis:

Current ratio:
Current ratio is obtained by dividing current asset to current liabilities. It is used to measure the
percentage of firm’s current asset to its short term liabilities. This ratio shows whether the
company has sufficient current assets to meet its short term liabilities.

Current ratio = (current assets) / (current liabilities)

The current ratio should be more than 1 and less than 2. More than 2 is a bad indicator and it
shows that company is not using its current assets efficiently. If the ratio is less than 1 it shows
that a company has weaker liquidity.

Net working capital ratio of PSO in 2018 was:

378,103,557 / 286,944,833 = 1.3

In 2018, the total networking capital ratio of PSO was less than 2 and more than 1 i.e. 1.3. So, it
shows that the company is in a good position and it is using its current assets efficiently.

Quick ratio:
Quick ratio shows the firm ability to meet its current liability with its most liquid asset.

Quick ratio = (current asset – inventories) / current liabilities

(378,103,577 – (239,981 + 81,615,455)) / 286,944,833 = 1.03

Inventories include stock in trade & stores, spare parts and loose tools.
In 2018, company’s quick ratio was 1.03. Quick ratio less than 1 indicates that a company does
not have enough liquid assets to meet its current liability. If the quick ratio is highly less than its
current ratio it then indicates that current assets are
dependent on inventory. PSO ltd had a quick ratio
of 1.03 which is more than 1 that is a good
indicator for the firm’s liquidity and it shows that
firm can get rid of its current liabilities instantly.

Conclusion Liquidity, profitability and risk analysis:

One of the major objectives of the working capital management is to ensure liquidity. Lenders
prefer firms with a large number of current assets over current liabilities. Liquidity has an inverse
relation with profitability and risk. The liquidity ratio (current ratio & quick ratio) of most
current financial report of PSO shows that company is liquid because its net working capital is
more than 1 (1.03) which is a good sign of liquidity. However, an increase in current ratio can
be observed in comparison with past trends. Current ratio is increased due to increase in current
asset. Quick ratio has decreased from its past trend, although it is still more than 1 which is a
good sign for the liquidity of the firm. When there is more liquidity there is more risk and when
there is less liquidity the risk is also less.

Asset management:
Asset management refers to the management of people’s assets. The term also applies to dealing
with other organizations or companies investments. Assets include either intangible or intangible
assets.

 Intangible assets are things we cannot touch such as intellectual property, goodwill,
financial assets, or human capital.
 Tangible assets, on the other hand, are things we can touch and include buildings, land,
computers, or office equipment.

In accounting and finance, an asset is anything with an economic value that we can own.
Asset management ratios:
Asset management ratios are used to check whether a company is managing its assets efficiently
or not. Asset management ratios are computed for different assets. Common examples of asset
turnover ratios include fixed asset turnover, inventory turnover, accounts payable turnover ratio,
accounts receivable turnover ratio, and cash conversion cycle. These ratios provide important
insights into different financial areas of the company and its highlights its strengths and
weaknesses.

Fixed asset turnover:

Fixed asset turnover ratio compares the sales revenue a company to its fixed assets. This ratio
tells us how effectively and efficiently a company is using its fixed assets to generate revenues.
This ratio indicates the productivity of fixed assets in generating revenues. It is obtained by
dividing the sales revenue with total fixed asset:

Fixed Asset Turnover Ratio = Sales Revenue / Total Fixed Assets

An increasing trend in fixed assets turnover ratio is good for company because it means that the
company has less money tied up in fixed assets for each unit of sales. A decrease trend in fixed
asset turnover may mean that the company is over investing in the property, plant and
equipment.

In 2018, the fixed asset turnover ratio of PSO was 182. An increase can be shown in fixed asset
turnover ratio from the past trends. It has been increased due to the increase in the gross sales
revenue.

Asset turnover ratio:

Asset turnover is a financial ratio that measures the efficiency of a company and the use of its
assets to product sales. It is a measure of how efficiently management is using the assets at its
disposal to promote sales. The ratio helps to measure the productivity of a company's assets.

Asset turnover = Revenue / Average total assets

 In days = 365 / Asset turnover

High asset turnover ratios are desirable because they mean that the company is utilizing its assets
efficiently to produce sales. The higher the asset turnover ratios, the more sales the company is
generating from its assets. Low asset turnover ratios mean inefficient utilization of assets. Low
asset turnover ratios mean that the company is not managing its assets wisely. They may also
indicate that the assets are obsolete. Companies with low asset turnover ratios are likely to be
operating below their full capacity.

In 2018, the total asset turnover ratio of PSO was 3.28. The total asset turnover ratio of PSO in
2018 shows that company is efficiently utilizing its assets. The asset turnover ratio has increased
from the past trend by 10% which is a good sign for the company.

Account payable turnover ratio:

Accounts payable turnover ratio that shows how fast a company pays off its creditors. An
accounts payable turnover ratio measures the number of times a company pays its suppliers
during a specific accounting period. Accounts-payable turnover is calculated by dividing the
total amount of purchases made on credit by the average accounts-payable balance for any given
period.

Accounts payable turnover ratio = Total purchases / Average accounts payable

Days Payable Outstanding (DPO) = 365 /AP turnover ratio

A high ratio means there is a relatively short time between purchase of goods and services and
payment for them. Conversely, a lower accounts payable turnover ratio usually signifies that a
company is slow in paying its suppliers. A company wants to slow down its cash payment so,
they can make the use of money they already have. High payable turnover is not always good for
the company likewise the lowest payable turnover ratio is also not good for the company.

In 2018, the account payable turnover ratio of PSO was 8.83 and the payable turnover ratio in
days was 41. According to financial statement of 2018 the creditor’s turnover has decreased
primarily due to increase in trade payable as at reporting date on account of increase in
international oil prices which was partially offset by increase in purchases during the year. The
decrease in payment is not bad for the company as there is no default in payments.
Inventory turnover ratio:
Inventory turnover is a measure of the number of times inventory is sold or used in a given time
period such as one year. This ratio is important because gross profit is earned each time
inventory is turned over. Inventory turnover is calculated by dividing the cost of goods sold by
the inventory level ((beginning inventory + ending inventory)/2):

Inventory turnover = Cost of goods sold / Inventory

Days inventory outstanding = 365 / Inventory turnover

The inventory turnover ratio must be judged in relation to the past trends and expected future
ratios of the firm, industry average or both. High inventory is good for company but sometimes it
shows the HAND TO MOUTH existence of the company i.e. it’s maintaining a low level of
inventory and incurring frequent stock outs. Low level of inventory turnover ratio indicates the
slow-moving, excessive or obsolete items in inventory.

In 2018, the inventory turnover ratio of PSO was 12.46 and the day’s turnover was 29. The
inventory turnover has decreased as compared to the past trend. As per the financial statements
the inventory turnover has decreased primarily due to increase in inventory by 23.0% mainly due
to increase in international oil prices which was partially offset by 19.0% increase in gross sales
revenue.

Receivables turnover ratio:

The receivable turnover ratio shows the company's debt collection, the number of times average
receivables are turned over during a year. This ratio determines how quickly a company collects
outstanding cash balances from its customers during an accounting period.

Receivables turnover ratio = Net receivable sales / accounts receivables

Accounts Receivable in days= 365 / Receivables Turnover Ratio

In 2018, the receivables ratio of PSO was 5.24. An increase can be shown from the past trend of
two years in the inventory turnover ratio i.e. 2017 & 2016 but, the inventory turnover ratio was
more back then in 2015, 2014 & 2013. The increase in receivable turnover ratio is good sign for
the company. The higher the value of receivable turnover the more efficient is the management
& better the company is in terms of collecting their accounts receivables. Similarly, low
receivable turnover ratio shows inefficient management of debtors or less liquid debtors. But in
some cases too high ratio can indicate that the company's credit lending policies are too tight
which is not good for a company.

Operating cycle:
The cash conversion cycle (Operating Cycle) is the length of time between a firm's purchase of
inventory and the receipt of cash from accounts receivable. It is the time required for a business
to turn purchases into cash receipts from customers. It also shows how efficiently the company is
managing its working capital. It is calculated by

Operating cycle = Inventory receivables in days + receivable turnover in days

Cash conversion cycle = ITD + RTD – PTD

In 2018, the operating cycle of PSO was 58.00 which have been decreased over the past. As per
the financial statement the operating cycle has decreased by 17.2% primarily due to increase in
creditor days on account of increase in trade payables. The lower the cash conversion cycle, the
more healthy a company generally is. Businesses attempt to shorten the cash conversion cycle by
speeding up payments from customers and slowing down payments to suppliers.

Conclusion of asset management of PSO:

The overall turnover ratios of receivable, inventory, fixed asset, asset turnover, payable turnover
& operating cycle shows that company is efficiently maintaining its assets and is in a good
position. However, the inventory turnover ratio has decreased from the past trend but, it is not
considered bad for the company as it was partially offset by the increase in the gross sales
revenue.

Debt and leverage analysis:

Debt ratio:
Debt ratio is a ratio that indicates the proportion of a company's debt to its total assets. It shows
how much the company relies on debt to finance its assets. The higher the ratio, the greater the
risk associated with the firm's operation. The debt ratio is calculated by dividing total liabilities
(i.e. long-term and short-term liabilities) by total assets:

Debt ratio = Liabilities / Assets

286,944,833 / 402,562,332 = 0.71

The optimal debt ratio is determined by the same proportion of liabilities and equity as a debt-to-
equity ratio. If the ratio is less than 0.5, most of the company's assets are financed through
equity. If the ratio is greater than 0.5, most of the company's assets are financed through debt.
Each industry has its own bench mark for debt but, maximum normal value is 0.6-0.7. However,
the debt ratio of 1 is not good for company it indicates that a company would have to sell all of
its assets in order to pay off its liabilities. The debt ratio of PSO in 2018 was 0.7 which is
between the normal maximum values of debt ratio.

Degree of operating leverage:

The Degree of Operating Leverage (DOL) is the leverage ratio that sums up the effect of an
amount of operating leverage on the company’s earnings before interests and taxes (EBIT). If the
degree of operating leverage is high, it means that the earnings before interest and taxes would
be unpredictable for the company, even if all the other factors remain the same.

“The percentage change in a firms operating profit resulting from 1% change in output.”

The formula used for determining the Degree of Operating Leverage or DOL is as follows:

DOL = % Change in EBIT / % Change in Sales

(27,160,480 - 29,346,867 /29,346,867) / (1,056,900,563 -878,146,786 / 878,146,786)

 -7.4 / 20 = -0.37

In 2018, PSO the degree of operating leverage is -0.37.

Operating leverage and risk:

A business would benefit if the can estimate the Degree of Operating Leverage. If there is a
higher degree of operating leverage or DOL then it should be balance the with the financial
leverage in order to provide with profits to the company.

Degree of Financial Leverage

The degree of financial leverage (DFL) is the leverage ratio that sums up the effect of an amount
of financial leverage on the earning per share of a company. The degree of financial leverage or
DFL makes use of fixed cost to provide finance to the firm and also includes the expenses before
interest and taxes. If the Degree of Financial Leverage is high, the Earnings per Share or EPS
would be more unpredictable while all other factors would remain the same.

“The percentage change in the firms earing per share resulting from 1% change in
operating profit”

The Degree of Financial Leverage (DFL) can be calculated with the following formula:

DFL = % Change in EPS / % Change in EBIT

(47.42 – 55.90 /55.90) / (27,160,480 - 29,346,867 /29,346,867)

14.66/ 7.4 = 1.98

In 2018, the degree of financial ratio of PSO was 1.98. It means there will be 2% change in
operating profit due to 1% increase in the earing per share.

Financial leverage and risk

The higher the leverage of the company, the more risk it has, and a business should try and
balance it as leverage is similar to having a debt. The degree of financial leverage is useful for
figuring out the future net income in the future, which is based on the changes that take place in
the interest rates, taxes, operating expenses and other financial factors.
Interest coverage ratio:
The interest coverage ratio (ICR) is a measure of a company's ability to meet its interest
payments. Interest coverage ratio is equal to earnings before interest and taxes (EBIT) for a time
period, often one year, divided by interest expenses for the same time period. The interest
coverage ratio is a measure of the number of times a company could make the interest payments
on its debt with its EBIT. The interest coverage ratio is calculated by dividing a company's
earnings before interest and taxes (EBIT) by the company's interest expenses for the same
period.

Interest coverage ratio = EBIT / Interest

expenses

The lower the interest coverage ratio, the higher

the company's debt burden and so there is a
greater risk of bankruptcy or default. A lower
ICR means less earnings are available to meet
interest payments and that the business is more vulnerable to increases in interest rates. When a
company's interest coverage ratio is only 1.5 or lower, its ability to meet interest expenses may
be questionable. An interest coverage ratio below 1.0 indicates the business is having difficulties
generating the cash necessary to pay its interest obligations. A higher ratio indicates a better
financial health as it means that the company is more capable to meeting its interest obligations
from operating earnings.

In, 2018, the interest coverage ratio of PSO was 6.30. Increase in the interest coverage ratio is a
good sign for the company. The ratio has been increased from the past. As per the financial
statements it has been increased due to the decline in finance cost by 13.5%.

Risk management:
The Company's objective in managing risk is the creation and protection of shareholders' value.
Risk is inherent in Company's activities but it is managed through monitoring and controlling
activities which are based on limits established by the internal controls set on different activities
of the Company by the Board of Management - Oil through specific directives.. The Company’s
finance and treasury department oversees the management of the financial risk reflecting changes
in the market conditions and also the Company's risk taking activities, and provide assurance that
these activities are governed by appropriate policies and procedures and that the financial risks
are identified, measured and managed in accordance with the Company's policies and risk.

Conclusion:
In 2018, PSO Company has managed its assets and liabilities efficiently. The net sales have
been increased from the past year but, overall profit for the year has been decreased from the past
year. The decrease in the profit for the year is due to increase in the operating cost i.e.
Distribution and marketing expenses, Administrative expenses and other expenses. The net
working capital is also positive which shows that the company is able to meet its current
financial obligations and is working efficiently so, there is no such need to raise capital in order
to meet its current obligations. Operating gearing ratio and the financial leverage ratio has been
decreased due to decrease in the short term borrowings. The Company finances its operations
through equity, borrowings and management of working capital with a view to maintaining an
appropriate mix between various sources of finance to minimize risk

However, the amount of equity financing is slightly more than the debt financing. According to
the analysis of liquidity, profitability and asset management ratios, the overall position of the
company tends to be good and stable.