Question

3. What is meant by maximizing owner’s equity value (shareholder wealth)? Why are maximizing just net income, or just profit, inappropriate goals?   (10 points)
4. Why do financial managers and investors find cash flows to be more important than accounting profit? (10 points)
5. What information does time series analysis provide for firm managers, analysts, and investors? (10 points)
6. Define the following ratios and explain their significance. (30 points)
   1. Quick ratio
   2. Average collection period
   3. Return on equity
   4. Debt ratio
   5. Profit margin

Answer 1

Shareholders’ Wealth is the Intrinsic Value or Market Value of a share of the company.

It’s the present value of the expected future earnings, whether they are in the form of dividends or the price that the sale of shares would fetch in the market.

A good economic growth strategy involves maximization of the shareholders’ wealth and not just the net profit. The reasons are :-

1. Company’s wealth can be maximized if the company’s cash outflows and inflows are planned keeping in view the risk associated with the timing. Since, shareholders’ wealth maximization takes into account these factors like ‘timing’ and ‘risk’, it’s a better measure of company’s performance.
2. It is a means of attracting more and more finance from the investors as they would be interested in keeping their money in a company whose investing and financing decisions are closer to the investors’ perception.
3. Increase in shareholders’ wealth signifies increase in market value of the firm. This way the company would be able to enjoy a better goodwill and a competitive edge over the other companies.
4. A financial and operational planning around shareholders’ growth maximization leaves more funds at disposal of the company for big capital expenditures as well as day to day working capital needs.
5. This way the credit worthiness of the company increases exponentially and it can enjoy better debt leverage.
6. Better returns can also positively impact the realizable value of the fixed tangible assets in the long run.
7. A sound market position can also help a company employ highly skilled top management with a better remuneration plan than the competitor firm.
8. It’s a protective shield against hostile take-over bids by the competitor firms.
9. It can facilitate the company in fruitful and friendly acquisition and merger bids and thus, enjoy the economies of synergistic gains.
10. Shareholders Wealth Maximization goal when corroborated with social responsibility can help a company achieve sustainable development objectives.

Investors always place a greater reliance on Cash Flows of a company than the accounting net profits for the following reasons :-

1. Cash Flows are a symbol of liquidity position of the company and how well its able to manage it’s day to day operations.
2. Cash flows if timed well i.e. by planning debtors’ credit period in sync with the creditors’ credit period, the company would be able to spare more funds for its working capital needs.
3. Lesser dependence on loans to fund long term or short term financial needs would mean lesser interest expense and consequently a better EBITDA.
4. Cash Flows have a direct impact on the shareholders’ wealth too. Greater Net Present Value of the expected net cash inflows of the future signifies a higher market value of share price of the company.
5. A good market value in turn, would fetch more funds from investors and hence, indirectly will help finance huge expansion plans without much reliance on long term debt burden.
6. To generate growth in sales, there must be adequate resources in the form of personnel, material etc, which are direct functions of optimum cash availability at the right time.
7. Cash surplus also keeps a company in a position to meet its statutory dues in time such as taxes, fines, penalties, Employee Provident Fund, Gratuity etc.
8. Emergency legal expenses can also be met with a good cash liquidity position.
9. Excess cash generated by a proper management of the gaps between payables and receivables can be invested in short term investments to generate even more income.
10. Timely settlements of the overdues from banks and financial institution with a sound cash support enables the company enjoy a good credit rating at all times.