FINANCIAL STATEMENT ANALYSIS Net income

Return on Equity=
Total common equity
Why are ratios useful?
- Ratios standardize numbers and EBIT (1−T )
facilitate comparisons Return on Invested Capital=
Total invested capital
- Ratios are used to highlight weaknesses
and strengths Effects of Debt on ROA & ROE
- Ratio comparisons should be made - Holding assets constant, if debt
through time and with competitors increases;
o Industry analysis o Equity declines
o Benchmark (peer) analysis o Interest expense increases –
o Traded analysis which leads to a reduction in net
income
current assets - ROA declines due to the reduction in net
Current ratio=
current liabilities income
- ROE may increase or decrease since
current asset−inventories both net income and equity decline
Quick ratio=
current liabilities
Problems with ROE
Sales - ROE and shareholder wealth are
Inventory turnover =
Inventories correlated but problems can arise when
ROE is the sole measure of
Receivables performance
DSO=
Average Sales Per Day o ROE does not consider risk
o ROE does not consider the
Receivables amount of capital invested
Annual sale divide 365 - Given these problems, reliance on ROE
may encourage managers to make
Sales investments that do not benefit
¿ AssetsTurnover = Assets ¿
Net ¿ shareholders. As a result, analysts have
looked to develop other performance
Sales measures such as EVA
Total Assets Turnover=
Total Assets
Price Price
=
Total Debt Earning Earnings per share
Debt ¿ capital ration=
Total invested capital
Market price
Market book ratios=
EBIT Book value per share
¿−Interest−Earned Ratio=
Interest
THE DUPONT EQUATION
EBIT
Operating Margin=
Sales ROE=Profit margin x TATO x Equity multiplier

Net income Sales Assets

Profit Margin= ROE= ¿ x x Total
Sales Sales Total Assets Equity

EBIT
Basic Earning Power=
Total Asset

Net income POTENTIAL PROBLEMS AND LIMITATION

Returnon Assets= OF FINANCIAL RATIO ANALYSIS
Total assets
 - Comparison with industry averages is Temporary Current Assets – current assets
difficult for a conglomerate firm that that fluctuate with seasonal or cyclical variation
operates in many different divisions in sales
- Different operating and accounting Permanent Current Assets – current assets
practices can distort comparisons that a firm must carry even at the trough of its
- Sometimes it is hard to tell if a ratio is cycles.
good or bad
- Difficult to tell whether a company is on Optimal Investment Level
balance, in a strong or weak position Conservative/Relaxed – providing for a
- Average performance is not necessarily greater level of current assets
good, perhaps the firm should aim Aggressive – lean-and-mean or tight or
higher restricted; low level of current assets on hand
- Seasonal factors can distort ratios Moderate – in between conservative and
- Window dressing techniques can make aggressive
statements and ratios look better than
they actually are - Profitability varies inversely with liquidity
- Inflation has distorted many firms’ - Profitability moves together with risk
balance sheets, so analyses must be
interpreted with judgement Financing Current Assets
Hedging/Maturity Matching/Self-Liquidating
– each asset would be offset with a financing
WORKING CAPITAL MANAGEMENT instrument of the same approximate maturity;
The administration of the firm’s current assets considered as a moderate financing policy.
and the financing needed to support current Conservative Financing Policy – a portion of
assets. the temporary current assets are financed on a
- Determination of the optimal level of long-term basis
investment in current assets Aggressive Financing Policy – a portion of
- Determination of the appropriate mix of the permanent asset are financed on a short-
short-term and long-term financing used term basis
to support this investment in current
assets As a company becomes more conservative
Gross working capital – the firm’s investment with respect to working capital policy, it would
in current assets tend to have – an increase in the ratio of
Net working capital – current assets less current assets to non-current assets.
current liabilities.
Cash Conversion Cycle
Gross Working Capital: The firm’s investment CCC – the length of time funds are tied up
in current assets: can be classified according to working capital or the length of time between
components or time. paying for working capital and collecting cash
Temporary – investment in current assets that from the sale of the working capital and
varies with seasonal requirements collecting cash from the sale of the working
Permanent – investment in current assets capital
required to meet a firm’s long-term minimum Inventory Conversion Period – average time
needs required to convert raw materials into finished
goods and then to sell them
Net operating working capital (NOWC) – Average Collection Period – average time
different with net working capital since short- required to convert the firms receivable to cash
term notes payable are treated as finance cost Payables Deferral Period – average time
and thus deducted to current liabilities. between the purchase of materials and labor
Current Asset – (Current liabilities less short- and the payment of cash for them.
term notes payable)
CCC = Inventory conversion period + ACP – Average cash balance: Transaction size / 2
Payables deferral period

Inventory conversion period = Inventory /

COGS per day

ACP or DSO = Receivables / Sales per day or

Sales/365

Payables deferral period = Payables /

Purchase per day or COGS/365

Cash and Securities Management

Motives for Holding Cash
Transactionary – meet payments, such as
purchases, wages, taxes and dividends arising
in the ordinary course of business
Precautionary – maintain a safety cushion or
buffer to meet unexpected cash needs
Speculative – take advantage of temporary
opportunities, such as sudden decline in the
price of a raw material; not a frequent motive

Cash balances maintained:

- Transaction balance
- Compensating balance: requirement
for the firm to maintain a certain amount
of demand deposits to compensate a
bank for services provided.

Baumol Model determine optimum cash

balance under conditions of certainty, minimize
fixed costs of transactions and opportunity cost
of holding cash balances.

Concept of Float
Book balance is not equal to bank balance

Transaction costs: Number of transactions x

cost per transaction

Number of transactions: Annual cash

requirement / Transaction size

Opportunity costs: Average cash balance x

opportunity cost rate
Hastening Cash Receipts Slowing Down Cash Payments
Reducing Collection Float Using float - dollar difference between the
- Earlier billing: can also use pre- balance shown in a firm’s (or individual’s)
authorized debit checkbook balance and the balance on the
- Lockbox system – post office box bank’s books; positive if disbursement float is
maintained by a firm’s bank that is used greater than collection float.
as a receiving point for customer Controlling disbursements
remittances; eliminates processing float; Payable through draft – a check-like
improved collections instrument that is drawn against the payor and
- Cash concentration – movement of not against a bank
cash from lockbox or field banks into the Zero balance account – a corporate checking
firm’s central cash pool residing in a account in which a zero balance is maintained;
concentration bank requires a master (parent) account from which
- Wire transfers – generic term for funds are drawn to cover negative balances or
electronic funds transfer using two-way to which excess balances are sent.
communications system.
Marketable Securities Portfolio
Ready cash: Optimal balance of marketable
securities held to take care of probable
deficiencies in the firm’s cash account
Controllable cash: marketable securities held
for meeting controllable outflows such as taxes
and dividends
Free Cash: marketable securities that is set
aside to service neither the cash account nor
the firm’s controllable outlays.

Variables in Security Selection

Safety: likelihood of getting back the principal
originally invested
Marketability: ability to sell a significant
volume of securities in a short period of time in
the secondary market without significant price
concession
Yield: interest and/or appreciation or principal
provided by the security
- Bond equivalent yield = (Face amount –
purchase price) / Purchase price *
(365/Days to maturity)
- Equivalent Annual Yield = ( 1 + BEY/
(365/DTM))^(365/DTM)
Maturity: life of the security

Money Market Instruments

Treasury bills: short-term noninterest-bearing
obligations of the Bureau of Treasury issued a
discount and redeemed at maturity for full face
value.
Repurchase agreements – agreements to buy
securities (usually treasury bills) and to resell
them at a specified higher price at a later date.
Banket’s Acceptances – short-term - Opportunity savings on reduction in
promissory trade notes for which a bank (by receivables as a result of proposed cash
having “accepted” them) promises to pay the discounts
holder the face amount at maturity; sold on a Costs
discounted basis - Opportunity cost on investment in
Commercial paper – short-term, unsecured additional receivables
promissory notes, generally issued by large - Opportunity cost on increased
corporation (unsecured corporate IOUs); sold receivables as a result of lengthening
on a discounted basis the credit period
Negotiable certificate of Deposit – large- - Cost of cash discounts provided
denomination investment in a negotiable time - Incremental bad debt losses.
deposit at a commercial bank or savings
institution paying a fixed or variable rate of Analyzing Credit Applicants
interest for a specified time period Obtaining information
- Financial statements
- Credit ratings and reports
- Bank checking
- Trade checking
- Company’s own experience
Analyze information
- Sequential investigation
- Credit scoring system: System that
assigns numerical scores to various
characteristics related to
creditworthiness
Make Credit Decision
- Line of credit: limit to the amount of
credit extended to an account

5Cs of Credit
Character: borrower’s wiliness to honor
obligations
RECEIVABLES MANAGEMENT
Capacity: borrower’s ability to generate cash
Credit and collection policies
to meet obligations
Credit standard: minimum quality of
Capital: borrower’s net worth and the
creditworthiness of a credit applicant that is
relationship of net worth to debt
acceptable to the firm
Collateral: borrower’s security for the loan
Credit period: total length of time over which
Conditions: borrower’s purpose for entering
credit is extended to a customer to pay a bill
into a loan
Cash discount: percent reduction in sales or
Focus on AR are on the first three Cs
purchase price allowed for early payment of
invoices.
I
Seasonal dating: credit terms that encourage
the buyer of seasonal products to take delivery
before the peak sales period and to defer
payment until after the peak sales period.

Cost-Benefit Analysis: Change in credit

policy
Benefits:
- Profitability of additional sales
 Inventory Management - Small lot sizes
- Efficient receiving and material handling
- Strong management commitment.

Short-Term Financing
Types of Short-term financing
Spontaneous
- Trade credit
- Accrued expenses
Negotiated
- Money market credit
- Bank loans
- Receivable factoring

Order Point
- Quantity to which inventory must fall in
order to signal that an order must be
places to replenish an item
- Lead time: length of time between the
placement of an order for an inventory
item and when the time is received in
inventory
- Safety stock: inventory stock held in
reserve as a cushion against uncertain
demand (or usage) and replenishment
lead time
Order point = Ave. Lead time x Ave. Daily
Usage + Safety Stock

Other Inventory Management Concepts

ABC method of inventory control: controls
expensive inventory items more closely than
less expensive items
Supply chain management: managing the
process of moving goods, services and
information from suppliers to an end customers
Just in time system: inventories are required
and inserted in production at the exact times
they are needed; pulling inventories as-needed
instead of pushing inventories as produced

Requirements for a JIT System

According to General Motors, the following
are needed to make a Just in time system
work: Money Market Credit
- Geographical concentration Commercial paper – short-term, unsecured
- Dependable quality promissory notes, generally issued by large
- Manageable supplier network corporations
- Controlled transportation system
- Manufacturing flexibility
Letter of credit – promise from a third party holds specifically identified
(usually a bank) for payment in the event that inventory and proceeds from its
certain conditions are met sale in trust for the lender.
Banker’s acceptance – short-term promissory o Terminal warehouse receipt:
trade notes for which a bank (by having receipt for the deposit of goods in
‘accepted’ them) promises to pay the holder a public warehouse that a lender
the face amount at maturity holds as collateral for a loan
o Field warehouse receipt: receipt
Bank Loans for goods segregated and stored
- Can either be unsecured or secured on the borrower’s premises (but
- Line of credit: informal arrangement under the control of an
between a bank and its customer independent warehousing
specifying the maximum amount of company) that a lender holds a
credit the bank will permit the firm to collateral for a loan.
owe at any one time Receivable Factoring
- Revolving credit agreement: formal, - Selling of receivables to a financial
legal commitment to extend credit up to institution, the factor, usually without
a max amount over a stated period of recourse
time - Factor usually charges a factoring fee
- Prime rate: short-term interest rate for bearing credit risk and servicing the
charged by banks to large, creditworthy receivables
customers - In addition, interest may be charged hen
- Payment of Interest Rates the firm takes a cash advance before
o Collect basis: interest paid at the receivables are due.
maturity
o Discount: interest is deducted
from the initial loan; results in a
higher effective interest rate

Compensating Balance
- Demand deposits maintained by a firm
to compensate a bank for services
provided credit lines or loans
- Commitment fee: fee charged by the
lender for agreeing to hold credit
available

Secured Loans
- Can be backed by either receivables or
inventories
- Inventory-backed loans
o Floating lien: general or blanket,
lien against a group of assets
without the assets being
specifically identified
o Chattel mortgage: lien on
specifically identified personal
properly backing a loan
o Trust receipt: security device
acknowledging that the borrower