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BU121 week 8.docx

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Wilfrid Laurier University
Laura Allan

BU121 March 5 2013  Formulas are given on the final exam (but aren’t labelled or grouped so we have to know which is which)  Current ratio = average current assets/average current liabilities = 1.37  Should be >2, <4  You should have more than twice the current assets than current liabilities so you can have enough funds available to pay the bills (so it can cover the timing difference)  If you have more than 4 times the current assets of liabilities, your return is lower (you could be using those assets to invest)  Use averages because there can be dramatic differences from one period to the next  Current assets are found on the balance sheet (average is this year’s assets plus last year’s assets divided by 2)  Acid Test/Quick Ratio = Average current assets – Average inventories Average current liabilities = .62  Should be >1  Take out inventories because they are less liquid  NWC (Net working capital) to Total Assets Ratio = Average current assets – Average current liabilities Average total assets = 14.7%  The higher the % the greater the liquidity (want to be liquid to cover costs, but don’t want it to be too liquid because the assets could be invested to get a better return somewhere else) 1 BU121 March 5 2013  What does this information tell you about the company?  Why did it happen?  From the balance sheet: o We’re dealing with the aftermath of a big investment (this doesn’t happen all the time) o Receivables are going up (we made the sales but we need the cash) o Inventory is also going up Conversion Period Ratios  Measure the average time in days required for non-cash current assets and selected current liabilities to create or demand cash  If you have receivables that come in really fast, you probably only give credit to people who can pay you back fast (but this means you’re making less sales; you have to balance it out)  Non-cash current assets will eventually create cash, but current liabilities demand cash (how fast can we convert assets into cash) o The faster assets can be converted into cash, the greater the liquidity (other things being equal) Operating Cycle Measures the time it takes to purchase raw materials, assemble a product, book the sale, and collect on it. 2 BU121 March 5 2013 Measuring Conversion Times  Inventory-to-Sale Conversion Period = Average inventory Cost of goods sold/365 = 112.9 days  Sale-to-Cash Conversion Period (days of sales outstanding or average collection period) = Average receivables Net sales/365 = 57.1 days  Inventory-to-Sale + Sale-to-Cash conversion period = Average Operating Cycle = 170 days  Purchase-to-Payment Conversion Period = Average payables + Average accrued liabilities Cost of goods sold/365 = 76.8 days  Inventory-to-Sale + Sale-to-Cash – Purchase-to-Payment conversion period = Cash Conversion Cycle (C ) = 93.2 days 3 BU121 March 5 2013  That means that you don’t have cash coming in to cover bills for these 93 days  You need to pay bills with external sources for 3 months because you don’t have the cash  The number of days of operation that must be externally financed  Should be as close to 0 as possible (want to sustain ourselves)  Try to develop relationships with suppliers and customers to line up when payments are due and when receivables come in Interpreting Conversion Trends  What does this information tell you about the company?  Why did it happen?  How is this related to the net cash burn rate?  We’re paying suppliers faster (purchase-to-payment has decreases) but this increases C 3 because normally you would be subtracting the purchase-to-payment o Maybe we’re getting a discount for paying faster  We made the decision to buy more inventory (probably stocking up more than we need to; not bad if we’re stocking up in the anticipation of sales)  Sale to cash period has gone up – people are taking longer to pay A/R o We may be granting more people credit and this means increased sales (slower is okay but we don’t want to give credit to bad customers who never pay)  Cash burn has to do with the inventory we’re investing in (inventory appears to be higher than it needs to be; the problem is that we seem to be building inventory with no relation to higher sales) Leverage  Considers how the firm acquired external financing (to support the longer C )  Magnifying return by increasing risk  Considering how we finance growth or a shortfall  Measures the extent to which the firm has used debt and its ability to meet its debt obligations  What is the benefit of using debt vs. equity?  Interest vs. dividends (what stockholders want)  Debt costs you interest, equity costs you dividends  Dividends are not an expense on the income statement (you calculate them from net income)  Interest can be deducted as an expense before taxes, so the earnings you pay taxes for are lower 4 BU121 March 5 2013  Dividends cannot be deducted from taxes (don’t have to pay dividends, but want to entice shareholders to stay with me)  Risk/return tradeoff  Control vs. legal recourse  Debt doesn’t make you give up control (you don’t have to give up a part of your company)  Debt holders have legal recourse if it goes south (they can come after you to reclaim their investment)  Equity gains control of your company but you have no legal recourse if it is a bad investment for them Example:  Currently each firm has $1,000,000 in common stock outstanding, and each needs to finance an additional $1,000,000… A B Difference 10% bonds equity with 10% dividend EBIT $1,000,000 $1,000,000 - Interest 100,000 0 100,000 EBT 900,000 1,000,000 - Taxes @ 50% 450,000 500,000 -50,000 EAT $450,000 $500,000 50,000  interest cost $100,000 - tax savings $50,000 = real interest $50,000 / $1,000,000 debt = 5%, not 10% -- lower cost of capital  if return on capital is 15%:  A 15% return - 5% cost = 10% overall  B 15% return - 10% cost = 5% overall  But what about B’s greater net profit?  The $450,000 looks smaller but it’s a 45% return  B made more but the investors had to invest $2 million (25% return)  Summary:  low degree of leverage: ○ lower risk but higher cost of capital = lower return  high degree of leverage: ○ higher risk but lower cost of capital = higher return  Equity may look better and generate more profits but you must look at profits in relation to the equity invested. Even though it shows more profit, it costs more than debt.  Equity is less risky than debt so it will yield a lower return  Debt has a lower cost of capital because of the tax deductibility of the interest 5 BU121 March 5 2013  Total Debt-to-Total Assets = average total liabilities / average total assets = 61.38%  Equity Multiplier = average total assets / average owners’ equity OR 1 / (1- total debt-to-total assets) = 2.59 ½ of assets supported by debt vs. equity  Debt-to-Equity = average total debt / average owners’ equity OR TD-to-TA / (1 – TD-to-TA)  Current Liabilities-to-Total Debt = Average current liabilities / Average total liabilities = 64.88% (Can the venture pay the debt?)  Interest Coverage = EBITDA / interest = 3.2x My earnings to cover the interest could drop to 1/3 and I’d still be able to cover payments Are they trending upwards at a good rate? (Can I cover the debt with the actual funds available to cover it?)  Fixed Charges Coverage = EBITDA + lease payments Interest + lease payments + [debt repayments/(1-tax rate)] = 1.87x Interpreting Leverage Ratio Trends - If ability to cover payments has gone down, risk has gone up - They’re taking on more debt but their earning haven’t gone up relatively 6 BU121 March 5 2013 - The payments that have to be made soon have increased (If new ventures can even get loans, the lenders will want to get the payments in quicker) – more current liabilities Profitability and Efficiency - Measure how efficiently a venture controls it expenses and uses it assets - Accounting-based measures of profitability are a standard starting point for examining venture value - Entrepreneurs don’t focus on profit, they focus on cash; but eventually want to increase value - No mathematical formula to calculate value (no pattern, judgment) - Angel investors look for free cash flow (cash that will be generated after bills are paid; risk; and the time value of money, can I get a better return somewhere else? How long will it take?) - Gross Profit Margin = (net sales – cost of goods sold) / net sales = 33.33%  The cost of the sale is about 66% - Operating Profit Margin = EBIT / net sales =
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