Capital markets,

market efficiency and

ratio analysis
FINANCIAL INTERMEDIARIES AND FINANCIAL
MARKETS
 Capital/Financial
Marketsmarkets are
• Financial institutions and
procedures that facilitate transactions in
all types of financial claims.
• Allocate savings to the best
investments. Financial market provides
a forum in which suppliers of funds and
demanders of funds can transact business
directly.
• Consist of money market and capital
market. Transactions in short term
marketable securities take place in
the money market while transactions
in long-term securities take place in the 3
Why Capital Markets
Exist?
• Capital markets facilitate the transfer of capital (i.e. financial) assets
from one owner to another.
• They provide liquidity. Liquidity refers to how easily an asset can be
transferred
without loss of value.
• The transaction price in the market provides a measure of the value of
the asset.
Importance of Financial
Markets
• Without financial markets (and financial
assets), savings of economic units must be
accumulated in the form of real assets.
• Cannot transfer savings from one party
to the other who need the funds. Less
capital formation and great innovative
ideas cannot be financed. The rate of
economic growth is slower and the
wealth of the economy as a whole is lesser.
• Usually, an investment bank or a
financial intermediary link the providers
(suppliers) and users (demanders) of
finance together.
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 Financial
Institutions
• Financial institutions are intermediaries that
channel the savings of
individuals, businesses, and governments into loans or
investments.
• The key suppliers and demanders of funds are individuals,
businesses, and governments.
• In general, individuals are net suppliers of funds, while
businesses and governments are net demanders of funds.

6
Internal and external finance
Internal finance:
• Retained
earnings
•Efficiency
savings External
finance:
• Equity
• Debt
• Leasing
 Sources of
Finance
• Internal vs. External Source of Financing – greater
reduce the need for external financing that are
profits
more
expensive. Pecking Order Theory of Financing: cost of
internal equity < cost of debt < cost of external equity
• Changes in market and economics conditions affect the
precise ways
corporate funds will be raised.
- E.g. when interest rates are increasing, lesser debt
financing
-E.g. when stock market in bear for a long period,
lesser equity financing
 NEW
Sources of Finance
& Types of
Securities
• Ordinary shares (issue to general investing
public vs. rights issue) – external equity
• Retained earnings – internal equity
• Preference shares
• Corporate Bonds / Loan Stock / Debentures
• Convertibles
• Warrants
• Bank borrowings
• Lease and Hire Purchase
Internal and external
finance (continued)
Balance between sources is influenced
by:
• company attitude to risk and return;
• availability and amount of retained
earnings;
• access to capital markets;
• costs of different sources of finance;
• dividend policy;
• investment opportunities;
• historical position.
Financial assets
• Gilts
• Treasury bills
• Preference shares
• Ordinary Equity
• Bonds
• Loan stock and
debentures
• Convertibles
• Warrants
Primary and secondary
markets
Primary market: for new issues of
shares Secondary market: ‘second-
hand market’
• Increases liquidity of shares
• Generates pricing information
• Barometer of corporate
performance
Stock Exchange markets:
• Full market
• Alternative investment market
(AIM)
What is market efficiency?
• Operational efficiency (low transaction costs)

• Informational efficiency (low cost, access)

• Pricing efficiency (prices of shares reflect all relevant

available information)

• Allocational efficiency (funds go to most

efficient/profitable companies)

• Market efficiency concerned with pricing

efficiency
 Perfect capital
•
market
No taxes or transaction costs
• Free entry and exit
• Many buyers and sellers
• Participants are utility maximisers
• Information is costless and freely
available
Perfect versus efficient market
• Market does not have to be perfect to be efficient.
Requirements for efficient market:
• Low transaction costs/taxes
• Informational efficiency, i.e. information available at
low cost
• No one participant dominates the market
 ‘Beating’ the market
Two approaches for investors attempting to beat the market:
• Chartism/technical analysis: drawing charts and using
regression analysis to predict prices based on past
trends.
• Fundamental analysis: using financial data to predict ‘fair’
price of share – using accounts, share pricing models and so
on.
 Efficient market
hypothesis
‘The price of a security fully and fairly reflects all available and
relevant information’ – Fama, 1970.
Academics define three ‘strengths’ of market efficiency
and test the market using empirical data.
 NEW
Three Forms of Capital
Market Efficiency
Strong Form
(All information affecting the asset’s value)

Semi-Strong Form
(All publicly available information)

Weak Form
(Information contained in
past prices)

1
8
 Weak form
efficiency
Definition:
•Security prices reflects past
information only. Implication:
• Making abnormal returns using trading
rules based on studying past share
prices is not possible.
Empirical evidence:
• Random walk hypothesis.
• Serial correlation tests, run tests and
filter tests.
 Semi-strong form
efficiency
Definition:
• Security prices reflect past information
and all publicly available information.
Implication:
• It is not possible to make abnormal
returns by studying company accounts,
and so on.
Empirical evidence:
• Stock splits.
• Anticipation of annual reports and
mergers.
 Strong form
efficiency
Definition:
• Security prices reflect all available
information, publicly available or not.
Implication:
• It is not possible to make any
abnormal returns.
Empirical evidence:
• Why is insider dealing illegal?
• Do professional analysts beat the
market?
 Implications of
•EMH
Pointless paying for expensive research.
• No point studying financial statements.
• No bargains on the stock market.
• Buy and hold strategy is best.
• Manipulation of accounts is pointless.
• Timing of new issues is not critical.
• Managers just need to focus on
making the best investment
decisions, since market capitalisation
will increase by NPV of project.
 Market efficiency?
• Empirical evidence supports semi-
strong form of efficient market
hypothesis.
• Can sophisticated investors using
expert advisors and dealing software
exploit market imperfections to make
abnormal returns?
• Efficiency is generated by the
activities of analysts who disbelieve the
hypothesis.
• What are ‘normal’ or ‘expected’ returns?
 Market efficiency?
(continued)
Anomalies in share price
behaviour:
• Calendar effects
• Size anomalies
• Value effects
•Speculative
bubbles
Behavioural
finance:
• Investors can make irrational
 Anomalie
s
• Calendar effects
-Describes the tendency of stocks to perform differently at
different times. For example, a number of researchers
have documented that historically, returns tend to be
higher in January compared to other months (especially
February).
• Size anomalies
- Smaller firms (that is, smaller capitalization) tend to
outperform larger companies. As anomalies go, the small-
firm effect makes sense. A company's economic growth is
ultimately the driving force behind its stock performance,
and smaller companies have much longer runways for
 Anomalie
• Value effects s
-Extensive academic research has shown that stocks
with below- average price-to-book ratios tend to
outperform the market.
Numerous test portfolios have shown that buying a
collection of stocks with low price/book ratios will
deliver market-beating performance.
-Although this anomaly makes sense to a point—
unusually cheap stocks should attract buyers' attention
and revert to the mean—this is, unfortunately, a relatively
weak anomaly. Though it is true that low price-to-book
stocks outperform as a group, individual performance is
idiosyncratic, and it takes very large portfolios of low price-
 Anomalie
s
• Speculative bubbles
- A speculative bubble is a sharp& steep rise in asset
prices such as shares, bonds, housing, commodities
or crypto-currencies. The bubble is usually fueled by
high levels of speculative demand which takes prices
well above fundamental values.
 Financial Ratio
Analysis
•Are our
decisions
maximizing
shareholder
wealth?
Users of ratio analysis
• Investors (financial institutions and
ordinary investors) need to make
decisions about buying and selling
company securities.
• Company managers need to assess
divisional and company performance
against previous years’ and
competitors’ performance.
• Financial institutions need to make
decisions about whether they should
provide finance to a company.
Importance of
benchmarks
Ratios must be compared with
benchmarks
• Pre-determined targets for ratios set by
the company, i.e. ROE > 16%.
• Ratios of companies of similar
size who are engaged in
similar business activities.
• Average ratiosfor businesssectorin
which a company operates, i.e.
industrial norms.
• Ratios for the company from
previous years, with data adjusted for
Financial Ratio
Analysis
1. Profitability Ratios
• Measure of financial performance of a company
2. Liquidity Ratios
• Enable user to measure of financial
position of a company in the S/T
• It is including whether or not a company able
to settle its S/T obligation when they become
due
• Sometimes profitable business face financial
crisis because of overtrading
• Means that a company has invested too much
in fixed assets and inventory but too little
liquid assets and thus short of cash
 Financial Ratio
Analysis
3. Leverage Ratios
• Enable user to measure of financial position of a
company in the L/T
• Whether or not a company will be able to pay its
L/T debts as and when they become due
• A business that is unable to do so is said to be
insolvent, and will usually be forced into
compulsory liquidation by its creditors
4. Efficiency Ratios
• Measure of how efficiently the firm utilizes its assets
5.Market Ratios
• Measure of business performance and use to
screen potential investment.
We will want to answer questions
about the firm’s
Profitability Liquidity Leverage Efficiency Market
ratios ratios ratios ratios ratios/
Market based
performance
Gross Current ratio Debt ratio Total Price-to-
profit assets earnings
margin turnover (P/E)
Operating Acid test Debt to Average Market-
profit ratio equity ratio receivabl to- book
margin e (M/B)
collectio
n period
Net profit Cash ratio Time interest Inventory
margin earned holding
period
Earning Inventor
per share y
turnove
r
Return on Account
assets s
Payable
Turnove
r
5 categories of Financial
Ratios
• Liquidity, Activity (efficiency) and Leverage ratios primarily measure risks
(both operating and financing risks)
• Profitability ratios measure return
• Market ratios measure of business performance and use to screen potential
investment (exp:P/E Ratio compare the share’s price to the earnings, measure
of how expensive a stock is)
Example:
CyberDragon
Corporation
 Statement of Financial
Position (RM’000)
Cash 2,540
Marketable securities 1,800
Accounts receivable 18,320
Inventories 27,530
Total current assets 50,190
Plant and equipment 31,700
Total assets 81,890
Accounts payable 9,721
Notes payable 8,500
Accrued taxes payable 3,200
Other current liabilities 4,102
Total current liabilities 25,523
Long-term debt (bonds) 22,000
Total liabilities 47,523
Ordinary share (RM10 par) 13,000
Paid in capital 10,000
Retained earnings 11,367
Total stockholders' equity 34,367
Total liabilities & equity 81,890
Statement of Profit or
Loss
(RM’000)
Sales (all credit) 112,760
Cost of Goods Sold (85,300)
Gross Profit 27,460
Operating Expenses:
Selling (6,540)
General & Administrative (9,400)
Total Operating Expenses (15,940)
Profit before interest and taxes (PBIT) 11,520
Interest expenses (3,160)
Profit before taxes (PBT) 8,360
Taxes (40%) (3,344)
Profit after tax/ Net profit 5,016
 CyberDrag
on
Other
Information
Dividends paid on ordinary share RM2,800,000
Number of shares of issued and outstanding 1,300,000
Market price per share RM20
Book value per share *** RM26.44
Earnings per share *** RM3.86
Dividends per share *** RM2.15
 CyberDragon
Other Information
(RM’000)
• Book Value per share = Common Stock Equity
Number of common Stock outstanding
= RM34,367,000 / 1,300,000
= RM26.44
(Note: Total Stockholders’ Equity may include Preferred Stock Equity.
Thus, Common Stock Equity = Total Stockholders’ Equity minus
Preferred Stock Equity)
(Note: Common Stock Equity = Total Assets minus Total Liabilities minus
Preferred Stock Equity)
To calculate per share value of a company based on its equity available
One of the method for company to valuing another company
 CyberDrag
Other
on Information ($000)
• Earnings per share (EPS)
= Earnings attributable to common
stockholder Number of common Stock
outstanding
= RM5,016,000 / 1,300,000 = RM3.86
**measure of the return on each ordinary
share hold

• Dividends per share

= Dividends paid on common
stocks Number of common Stock
outstanding
= RM2,800,000 / 1,300,000 =
RM2.15
 1. Liquidity
Ratios
•Do we have enough liquid
assets to meet approaching
short-term obligations?
 Current
Ratio
current assets
current liabilities
50,190
25,523 = 1.97
Indicate as to whether a company has sufficient current assets
to meet its short term obligation
 Acid Test Ratio/ Quick
Ratio
current assets - inventories
current liabilities
50,190 - 27,530
25,523 = 0.89

Indicate as to whether a company has sufficient liquid

assets to meet its short term obligation
• Consequences of too low liquidity ratios are:
1) late payments to trade creditors, resulting
loss of cash discounts for prompt
payment and creditors withhold further
supplies
2) essential maintenance and replacement of
fixed assets are frequently postponed,
resulting in rising operating expenses
(exp: selling expenses and depreciation
expenses)
3) new investment projects are delayed,
which may reduce future growth rate of
the firm (exp: marketable securities)
• If the current ratio and acid test ratio are too
high,
anxiety over cash flows are removed, but
equally undesirable consequences are:
1) idle cash are tied up unproductively,
without
investing in potential profitable projects,
which could affect future growth of the
firm
2) unnecessarily large inventories (but
sometimes
might due to expecting price will
increase in
future), resulting in high storage
and other
carrying costs, and potential loss
in
market value of inventories that
become
2. Efficiency Ratios/ Activity
Ratios : Working Capital
Management
• Measure of how efficiently the firm utilizes its
assets
 Average Collection Period
(ACP)
accounts receivable 
365 credit sales
18,320 = 59.3 days
112,760
365
 Measure of the length of time it takes for a company’s account rec to pay what
they owe
 Short  extension of credit low, collection of a/c receivable is efficient
 Long  company should re-access their company credit policies in order to ensure the
timely collection
Accounts Receivable
Turnover
credit sales
accounts receivable
112,760
18,320 = 6.16 times

• (Note: if not stated, assume credit sales = total sales)

• Measure of how many times a credit sale is made and subsequently
collected
 Inventory Holding Period
(IHP)
Inventory 
365 COGS

27,530 = 117.80 days

365
•
85,300
Indicate the average number of days that items of inventories are held
• The shorter is better
 Inventory Turnover

cost of goods sold

inventory
85,300
27,530 = 3.10 times
• The number of times, on average the inventory is sold and replaced during the
fiscal year (3.87 months or 118 days)
• To measure the liquidity of inventory, also figure as “turnover firm”
Low inventory turnover
(Long IHP):
The firm may have too much inventories, which
is expensive because:
1) Inventories take up costly warehouse
space, storekeeper fee and insurance
2) Some inventories may become spoiled or
obsolete.
3) Higher risk of stock pilferage.
Average Payable Payment
Period (APP)

accounts payable 
365 credit
purchase
 Total Asset Turnover

sales
total assets
112,760
= 1.38 times
81,890
• Measure of how efficiently and effectively a company’s
management has utilized the assets to generate the sales
• The firm needs to figure out how to squeeze more sales dollars
out of its assets.
Fixed Asset
Turnover
sales
fixed assets
112,760
31,700 = 3.56 times
 3.Leverage
Ratios
(financing
• Measure the impact of using debt capital to finance assets.
decisions)
• Firms use debt to lever up (increase) returns on equity.
• Firms with more real assets (land and buildings) are able
to finance more of their assets with debt.
• Amount of debt a firm uses depend on
1) income record
2) amount of assets available as collateral

5
5
Debt
Ratio
total liabilities
total assets
47,523
81,890 X 100 = 58%

Can leverage make the firm more profitable?

Can leverage make the firm riskier?
 Debt-to-Equity
Ratio
Total liabilities
Total Common Equity

• High DTE indicatea companynot be able to generateenough cash to satisfy its

debt obligation
• However low DTE also indicate a company is not taking advantage of the
increased profit that financial leverage may bring
• Capital intensive industry tend to have high DTE than low capital industry
because they must buy/invest more property, plants and equipment to expand
their business
• However, lender and investors are more prefer low DTE because their interest
are better protected in the event of a business decline
• Firm with high DTE may not be able to attract additional capital
 Times Interest Earned
Ratio
operating profit
interest expense
11,520 = 3.65 times
3,160

• Shows whether a company is earning enough operating profits

before the payment of interest.
• Times interest earned ratio (also known as interest
coverage ratio) reflects the ability of operating profit (PBIT)
to cover interest expenses.
• Although generally high leverage (financed by more debt) will
increase financial risk, financing with debt could help to
reduce the firm’s cost of capital because cost of debt
capital are usually lower than cost of raising funds
through new issuance of equity shares. Cost of debt
capital is lower due to tax deductibility of interest payments
and low risk premium.
• Thus, a firm should finance by more debt capital until the
point where it can still comfortably cover its interest
payments. Therefore, usually analyze these two ratios
together.
4. Profitability
Ratios

How well are the firm’s managers maximizing

shareholder wealth? Are owners (ordinary
shareholders) and other investors receiving
an adequate return on their investment?
 Operating Profit
Margin
operating income
sales
11,520 X 100 = 10.22%
112,760

• Measure of how much of each dollar sold is available after

deducted the operating expenses. ( how much revenue left over
to cover non-
operating expenses)
 Return on Equity
(ROE)
net profit – preference share dividend
Total common equity

5,016
34,367 X 100 = 14.6%
Note: (NP –PSD) also known as Profit attributable to ordinary shareholders
Profit Margins and Rates of
Return
• Gross Profit Margin
= (Sales – COGS) / Sales  100%
• Operating Profit Margin
= Operating profit / Sales  100%
• Net Profit Margin
= Net profit / Sales  100%
• Return on Asset (ROA)
= Net profit / Total Assets  100%
or Operating profit/ Total Assets 
100%
• Other things being equal, the higher the
gross profit margins the better. However,
it must be noted that a firm, within its limit,
can manipulate its profit margins by setting
its pricing policy.
• A reduction in operating profit margins should
be taken seriously as it could be due to
following reasons: (a) rising COGS which are
not passed on to customers; (b) careless
stock control which lead to pilferage or
obsolescence; (c) reduction in selling price
due to competition in the product market; (d)
rising marketing or administrative expenses.
 5.Market
Ratios
Price/Earnings (P/E) ratio

= Market price per

share Earnings per
share

• P/E ratio measures the amount

that investors are willing to pay
for
each dollar of the firm’s
earnings. The higher the P/E
ratio, the higher
the degree of confidence that the investors have in the firm’s future
prospects.
• However, P/E ratio that is too high could signal that ordinary shares of
the company are overvalued in the stock market.
 5.Market
Ratios
Market/Book (M/B) ratio

= Market price per

share Book value per
share

M/B ratio relates the market value of the firm’s shares to their strict
accounting book value (historical value). Usually, book value is viewed
as the minimum value of a firm. Therefore, firms that perform well (earn
higher return relative to their risks) tend to have higher M/B ratio. If M/B
is less than one, it is usually a buy signal for investors (1/4=0.25) 0r sell
signal if more than one (6/4=1.5).
5.Market
Ratios
Dividend yield

= Dividends per share 

100% Market price per
share

Earnings yield

= Earnings per share 

100% Market price per
Both these ratios measured rate of return to shareholders, based on current
share
value
marketof shares they owned. Easier for shareholders to compare with rate
returns
of from other alternative investments.
Limitations of Financial Ratio
Analysis
Accounting policies/ treatments differ among firms.
• This may distort cross-sectional ratio analysis
between two similar firms. Examples:
depreciation method (straight line, reducing
balance, unit of production), stock valuation
method (FIFO, AVCO), treatment of purchased
goodwill, treatment of development cost etc.
• Affect all ratios that use ‘profit’ figure in the
calculation.
• Furthermore, some firms may have chosen to
revalue some of their fixed assets whereas other
firms have not do so. This may affect ratios
that use balance sheet items like ‘reserves’ and
• Many firms experienced seasonality in their
operations. Balance sheet (SOFP) items and their
corresponding ratios vary with time of the year
when the statements are prepared.
• Balance Sheet shows the company’s financial
position at one point of time (last day of
accounting period), whereas P/L shows the
company’s financial performance throughout the
accounting period.
• Using closing figures of balance sheet items in the
ratios computation may not be accurate. For
example, toy manufacturer that has financial year
ended 31st December might have much lower
inventory than toy manufacturer that has financial
year ended 30th June.
• Cross-sectional analysis between competitors in
the same industry that have different financial year-
ends might not be accurate if the industry has
• Difficult to identify the industry category to
which a firm should belongs to,
especially if the firm engages in multiple
lines of businesses. For such firm, it is difficult
to find a competitor firm that involves in
similar multiple lines of businesses for
cross- sectional analysis. Segmentation
technique is used. Can use segmentation
analysis.
• Comparing to industry average
means benchmarking to the ‘average’ firm
and not the ‘stars’ and leaders of the industry.
• Window dressing and off-balance sheet financing
can be done near the year-end to
manipulate the closing balance sheet
figures and hence distort results of
corresponding ratios.
• Non-financial information must be considered in
order to have a complete and more accurate
picture of the performance and prospects of
a company.
• Examples: (1) general industry and economic
data – Is the country’s economy in
recession or booming? Which stage of life
cycle is the product/ industry in?
• (2) Recent developments of the company’s
markets at home and abroad,
• (3) any recent acquisition or disposal of a
subsidiary?
• (4) Inherent goodwill of the company
due to advancement in technology, skilful
workforce, good atmosphere at the place
of work, highly calibre and experienced