Question 1 The financial manager needs your help in analyzing the financial position of the company.

He generated the following ratio ba sed on the companys financial statements. Analyze the ratio using both trend and cross-sectional analyses. Highlight important strengths and weaknesses of the company and recommend suggestions to improve the companys financial position. 2009 1.54 0.62 2010 1.47 0.67 2011 1.55 0.61 2012 1.33 0.56 TREND INDUSTRY AVERAGE 2012 1.20 0.66 CONCLUSION Good Below Average

A 1 2 B 3 4 5 C 6 7 D 8 9 10

Liquidity Ratio Current Ratio Quick Ratio Asset Utilization Inventory Turnover Average Collection Period Total Asset Turnover Debt Utilization Debt Ratio Time Interest Earned Profitability Gross Profit Margin Net Profit Margin Return On Assets

3.60 33.00 2.35

3.84 38.00 2.20

2.88 47.00 1.80

2.56 65.00 1.50

8.22 33.00 2.72

Below Average Below Average Below Average

0.48 45.40

0.56 33.00

0.59 14.10

0.66 12.20

0.62 12.90

Slightly More Debt Below Average

0.44 0.18 0.43

0.37 0.15 0.32

0.32 0.07 0.13

0.32 0.06 0.09

0.28 0.08 0.21

Good Below Average Below Average

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Answer Financial position also referred to as balance sheet, reports on companys assets, liabilities and ownership equity at given point of time. Analyzing and understanding financial position of the company will give better frame of mind to further assess profit and loss statements. To analyze the financial position of the company, analysis on ratios generated will be divided into 4 primary categories; a) Liquidity ratios Liquidity ratio is also known as solvency ratios, its measure the ability of company to meet its short term obligation from liquidation of its current assets as they come due. Current Ratio is a liquidity ratio that measures company's ability to pay its debt over the next 12 months or its business cycle. From every ringgit of its current liabilities in 2011 and 2012, the company has between RM1.55 and RM1.33 of current assets available to cover the liabilities. Current ratios shows ups and downs trend from 2009-2011 but within acceptable range and even better than industry average of 1.20. Quick ratio effectively assesses the same aspect as current ratio but more stringent test. Quick ratio or acid-test measures ability of the company to use its near cash or quick assets to extinguish or retire its current liabilities immediately, thus stocks are excluded as its assumed to be the most illiquid among the current assets. Quick ratio less than 1 indicate that company would not be able to repay all its debts by using its most liquid assets. Even though company current ratio was better than industry average, quick ratio was vice versa i.e. lower than industry average (0.56 versus 0.66) in 2012. The low quick ratio probably indicate a very low figure after taking off the value of inventories but leaving in the very high amounts owed to trade creditors. b) Assets utilization ratios The asset utilization ratio measures management's ability to make the best use of its assets to generate revenue. These ratios serve as a guide to critical factors concerning the use of the firm's assets, inventory, and accounts receivable collections in day-to-day operations. Asset utilization ratios are especially important for internal monitoring concerning performance over multiple periods, serving as warning signals or benchmarks from which meaningful conclusions may be reached on operational issues. Inventory turnover measure the inventory management efficiency of a business. Inventory turnover of 2.46 in 2012 indicate that the company turn its inventory only 2.46 times in a year which is way below industry average (8.22). Inventory turnover also showed a declining trend from 2009 (3.60) to 2012 (2.46), indicates inefficiency in controlling inventory levels that may be an indication of over-stocking which may pose risk of obsolescence and increased inventory holding costs. Average collection period measure how long on the average it takes to collect a receivable after a sale has been made. In 2012, the company took about 65 days to collect cash after sale was made, indicate that the company did not collect its receivables as quickly as the industry average, 33 days.
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The increased trend of debtors turnover period from 33 (2009) to 65 (2012) was also less favourable which reflected the company accounts receivables are not as liquid or are not being converted to cash as quickly as in the past. The average collection period should however be compared with the firm's credit policy to see how well the company is doing, it is acceptable if this activity ratio is the same or lower than companys credit term. Total asset turnover measures the efficiency in which the total assets (current and fixed) have been employed to generate sales. Downward trend of total asset for the past 4 years of analysis (2.35 in 2009 versus 1.50 in 2012) shows the more sluggish of the companys sales, this may relate to a less favourable trend of inventory turnover and average collection period or could be due to fixed assets sitting idle instead of being used to their full capacity. All of these issues could lower the total asset turnover ratio. A low turnover than the industry average (33 versus 65) in 2012 may indicate poor management of the company's assets or idle assets. c) Debt Utilization ratios Debt utilization ratios are used to evaluate the firm's debt position with regard to its asset base and earning power, which measure the prudence of the debt management policies of the firm. 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 assets. Increase trend in debt ratio (0.48 in 2009 to 0.66 in 2012) signify that the more companys assets are finance through debt rather than equity. The higher the ratio, the greater the risk associated with the companys operation as higher portion of company's assets are claimed by its creditor. The company debt ratio was slightly below the industry average (0.66 versus 0.62) indicate that this industry is more capital intensive which need to rely more on debt to finance its assets. Times interest earned indicates how many times the interest expenses are covered by the net operating income (EBIT) of the company. It is a long-term solvency ratio that measures the ability of a company to pay its interest charges as they become due. It is computed by dividing the income before interest and tax by interest expenses. Times interest earned ratio of 12.2 times in 2012 indicates that interest expenses of the company are 12.2 times covered by its EBIT. Even though showed declining trend (45.4 in 2009 to 12.2 in 2012), this ratio was still good and almost similar to industry average i.e.12.9. d) Profitability ratios Profitability ratios measure the ability of the company to earn an adequate return on sales, total assets and invested capital. In other word, this ratio assesses the degree of profitability in relation to sales and investment. Gross profit margin shows how efficiently a business is using its materials and labours in the production process and gives an indication of the pricing, cost structure, and production efficiency of your business. The company gross profit margin shows a declining trend from year 2009 to 2012 with 0.44 to 0.32 respectively but slightly higher than the industry average in 2012 (0.28). This trend indicates that the industry itself might have a high cost pressure or high competition resulting to mark down in sales price or higher cost of sales.
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Unlike the gross profit which measures the operating efficiency of the business, net profit margin measures the overall efficiency of the business. It shows the margin left for the equity and preference shareholders i.e. the owners. The company net profit margin shows the declining trend (0.18 in 2009 to 0.06 in 2012) and lower than the industry average in 2012 (0.08). The profitability declining trend was parallel with the declining trend of gross profit margin. In addition, it could also result from inefficiency of the company in turning its revenue into actual profit. Return on assets ration measure the effectiveness in which assets have been employed to make profits. The company return on assets was deteriorating from one to another year being analyze (0.43 in 2009 to 0.09 in 2012) and even lower than the industry average of 0.21 (2012). The declining trend of ROA was due to decrease in operating profit. In 2011, the company could probably increase its investment in assets which moves its ROA lower than the industry in the corresponding years (2012). Overall, the company financial position shows an unfavourable trend within four years being analyze. Possible conclusion could be the industry itself is in the unfavourable trend due to intense competition which affects the assets utilization ratio and liquidity. Furthermore, the company position even worse than industry average although both recorded the same declining trend in term of managing its assets which reflected in lower inventory turnover and higher average collection period. On the other hand, the company recorded good debt service ability signifies a favourable times interest earned even though in a declining trend. Recommendations to improve the companys financial position are as follows:i) Managing its inventory

To maintain its inventory levels to match required production or sales volume or simply to reduce production of slow moving items. Regular stock takes should be performed to indentify obsolete, damaged and slow moving items. ii) Improves debtor collection period

To assess and review its customers financial statements and only extended credit term to those good track record and performance. Cash term should be the only option for new customers. In addition, the company should check and develop good credit control system. iii) Assets strip The key to improving the total asset turnover ratio is to asset strip, i.e. to get rid unproductive assets which are not contributing towards income generation of the company. If the company decides to maintain these unproductive assets, then measure should be taken to increase the revenue generated from the assets.

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iv) Increase in paid up capital As a last resort, the company should be able to improve its financial position by simply increase paid up capital, i.e. invest more in the company. However, increasing paid up capital does not resolve the underlying problem facing by the company but only to show the shareholders commitment in getting the business better position. Question 2 (a) Explain agency problem. How can this problem be resolved by market forces? What are the consequences of such solutions to shareholders? Answer Agency problem is a conflict of interest between a company's management and the company's stockholders. The manager, acting as the agent for the shareholders, or principals, is supposed to make decisions that will maximize shareholder wealth. However, it is in the manager's own best interest may differ from the principal's best interests which is to maximize his own wealth. There are two factors in market forces to prevent or minimize agency problems; i. Behaviour of security market participants

One market force is major shareholders, particularly large institutional investors, such as mutual funds, life insurance companies, and pension funds. These holders of large block of a firms stock have begun in recent years to exert pressure on management to perform. When necessary they exercise their voting rights as stockholders to replace underperforming management. ii. Hostile takeovers

Another market force is the threat of takeover by another firm that believes that it can enhance the firms value by restructuring its management, operations, and financing. The constant threat of takeover tends to motivate management to act in the best interest of the firms owners by attempting to max imize share price. Question 2 (c) ESME Company wants to evaluate its cash flow position in the year 2012 to determine its sources and use of cash. Prepare the cash flow statement of the company using the data provided below and analyze its cash flow from the aspect of operation, investment and financing activities.

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Answer ESME Bhd Statement of Cash Flows (RM000) For the Year Ended December 31, 2012 Cash Flow from Operating Activities Net profits after taxes Depreciation Increase in account receivable Increase in inventories Increase in account payable Increase in accruals Cash provided by operating activities Cash Flow from Investment Activities Increase in gross fixed assets Cash provided by investment activities Cash Flow from Financing Activities Increase in note payable Increase in long term debt Dividends paid Cash provided by financing activities Net increase in cash and cash equivalents Cash and cash equivalents at the beginning of year Cash and cash equivalents at the end of the year Cash flow analysis The statement of cash flows reveals how a company spends its money (cash outflows) and where the money comes from (cash inflows). It is divided into 3 sections i.e. i) operations; ii) investing and iii) financing activities of the business. i) Cash flow from operating activities

861.00 230.00 (716.00) (583.00) 232.00 141.00 165.00 (534.00) (534.00) 300.00 365.00 (300.00) 365.00 (4.00) 342.00 338.00

This is the key source of a company's cash generation. In this section of the cash flow statement, net income (income statement) is adjusted for non-cash charges and the increases and decreases to working capital items - operating assets and liabilities in the balance sheet's current position. ESME Company (ESME) recorded positive cash inflow of RM165,000 from operating activities despite an increased in account receivable and inventories which reflected an increase in net working capital requirement. Negative aggregate (i.e. application of cash) of RM926,000 indicates an increase in amount of net working capital needed by ESME in the financial year.

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ii)

Cash flow from investing activities

This provides information about cash flow implications on non day-to-day strategic decisions. Investing transactions generate cash outflows, such as capital expenditures for plant, property and equipment, business acquisitions and the purchase of investment securities. Inflows come from the sale of assets, businesses and investment securities. Negative cash flow of RM534,000 from investing activities suggested that ESME might acquired additional fixed assets in 2012. For investors, the most important item in this category is capital expenditures. It's generally assumed that this use of cash is a prime necessity for ensuring the proper maintenance of, and additions to, a company's physical assets to support its efficient operation and competitiveness. iii) Cash flow from financing activities

Cash Flow from financing debt and equity transactions dominate this category. Companies continuously borrow and repay debt. The issuance of stock is much less frequent. Here again, for investors, particularly income investors, the most important item is cash dividends paid. Its cash, not profits, that is used to pay dividends to shareholders. ESME generated positive cash flow from financing activities reflected by activity of sourcing additional fund through issuance of note payable and obtained long term debt. Additional long term debt is consistent with negative cash flow of RM534,000 from investing activity, it suggested that ESME obtained the long term financing to partly financed for acquiring of additional fixed assets. Cash dividend was paid during financial year 2012 but this amount relatively low as compared to retained earning recorded by ESME. Question 3 (a) Discuss corporate governance and its role in maximizing shareholders wealth. Answer Corporate governance refers to the set of systems, principles and processes by which a company is governed. They provide the guidelines as to how the company can be directed or controlled such that it can fulfil its goals and objectives in a manner that adds to the value of the company and is also beneficial for shareholder in the long term. It is based on principles such as conducting the business
with all integrity and fairness, being transparent with regard to all transactions, making all the necessary disclosures and decisions, complying with all the laws of the land, accountability and responsibility towards the stakeholders and commitment to conducting business in an ethical manner.

Fundamentally, there is a level of confidence that is associated with a company that is known to have good corporate governance. The presence of an active group of independent directors on the board contributes a great deal towards ensuring confidence in the market. Corporate governance have a pivotal roles in maximizing shareholders wealth in which could be achieved as follows:i) Good corporate governance is known to be one of the criteria that investors are increasingly depending on when deciding on which companies to invest in. It is also known to have a positive influence on the share price of the company.
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ii)

Having a clean image on the corporate governance front could also make it easier for companies to source capital at more reasonable costs. It benefited shareholder in a way that less dependency on shareholders fund on further investment and expansion.

iii) Well-executed corporate governance should be similar to a police departments internal affairs unit, weeding out and eliminating problems with extreme prejudice and this will protect shareholders to their best interest as well as their wealth In order to rebuild the trust of the individual shareholders, employees and the public at large, a company must focus less on maximizing shareholder value in the short-term and more on optimizing shareholder value through building strong relationships with all the stakeholders.

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