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Management and Organizational Studies

Management and Organizational Studies 2310A/B

Bielman

Fall

Description

Chapter 3 Financial Statement Analysis
3.1 Using Financial Ratios
- Analysis of financial statements is based on the knowledge and use of
ratios or relative values
-Ratio Analysis – involves the methods of calculating and interpreting
financial ratios to assess the firms performance
-Numerator divided by a denominator
- Percent, multiplier, or number of days
Why Complete a Ratio Analysis?
- Planning
- Current financial position
- Company strengths and weaknesses
- Raw numbers in perspective
- Anticipate reaction of potential creditors and investors to a request
for funds
Interested Parties
- Management should be the most interested party
o Not only have to worry about the financial situation but also
critically interested in what these other interest groups think
about them
- Both present and prospective shareholders are interested in the
firm’s current and future level of risk and return
- Firm’s current and prospective creditors are primarily interested in
the liquidity of the company, current amount of debt, and the firm’s
ability to make interest and principle payments
Ratio Comparisons
Three Types:
1) Cross-Sectional Analysis: compares one company’s ratios to another
company or industry ratios
a) To be valid ratios must be calculated in the same time period
2) Time-Series Analysis: evaluates performance over time a) Comparing ratios of the most recent fiscal year to the previous three
fiscal years
3) Combined: firm can evaluate its performance over time as well as
assess its performance against the industry average
Categories of Financial Ratios
Four Categories:
1. Liquidity Ratios (measure risk)
2. Activity Ratios (measure risk)
3. Leverage Ratios (measure risk)
4. Profitability Ratios (measure return)
3.2 Analyzing Liquidity
Liquidity: the firm’s ability to satisfy its short-term obligations as they
come due
• Solvency of the firms overall financial position
Three basic measures of liquidity:
• All three liquidity measures -> higher the value, the more liquid the
firm
o Reduces firms risk since it can satisfy short term obligations
o Sacrifices profitability because:
Current assets are less profitable than fixed assets
Current liabilities are less expensive financing source
than long term funds
Net Working Capital (Not a Ratio)
- Measure of a firm’s overall liquidity (current assets only)
- Not useful for comparing with different firms, but useful for internal
control
o Often the contract under which a long term debt is incurred
specifically states a minimum level of net working capital that
the firm must maintain Protects creditors
Current Ratio
- Measures the firm’s ability to meet its short term obligations
- Indicates the dollar amount of current assets the firm has for every
dollar of current liabilities
- Rule of thumb =2 (ex. For every dollar of current liabilities, the firm
has $2 of current assets)
- The more predictable a firm’s cash flows, the lower the acceptable
current ratio
- Percentage Shrink: the percentage by which the firm’s current assets
might shrink
o Percentage Shrink = [1- 1/CR] x 100
o Ex. A current ratio of 1.85 means that the firm can still cover
its current liabilities even if its current assets shrink by 45.9
percent
- * Current ratio = 1.0, net working capital is 0. If current ratio is less
than 1.0, there will be a negative working capital
- Current ratio – compare liquidity of different firms
Quick (Acid-Test) Ratio
- Measure of liquidity calculated by dividing the firm’s current assets
minus inventory by current liabilities
- Not Inventory because…
o Illiquid
o Cannot be sold
o Typically sold on credit, and therefore becomes an A/R before
cash - Cash required to repay current liabilities will come from the most
liquid current assets
- Rule of Thumb =1
- *Quick ratio vs. current ratio depends on how liquid are the
inventories
3.3 Analyzing Activity
- Activity Ratios: measure the company’s effectiveness at managing
A/R, inventory, A/P, fixed assets and total assets
o Further analyze company’s liquidity
May have a good current ratio but may have problems
with specific current asset/liability
- Example, firm B is more liquid than Firm A
o Cash and marketable securities
o Structure of current liabilities
Average Age of Inventory
- Inventory Turnover: average number of times a company sells their
complete stock of inventory in a year
o The number of times an average item is sold in a year
o Inventory Turnover= COGS/ Inventory
High = selling inventory quickly
• But if it is extremely high there is a risk of stock
outs or lost sales
- Measures the effectiveness of the company’s management of
inventory - The average length of time inventory is held by the company
- Too High: risk of not being able to sell inventory
- Too Low: under-investment in inventory
- *Higher the inventory turnover, the lower the average age of
inventory
Average Collection Period
- Average amount of time needed to collect accounts receivable
- Useful in evaluating credit and collection policies
- Same as Age of Receivable, average amount of time needed to
collect receivable
- Ex. If the firm had extended 60 day credit terms and the 59.7 day
average collection period = excellent management of receivables
- Usual credit term is net 30 – common to “stretch” payment period
Average Payment Period
- Age of Payables, average amount of time needed to pay accounts
payable
- Ex. Avg. payment period = 95.4 days -> need to know credit terms
of the supplier (if it is net 30 than 95.4 days is VERY late = bad credit
rating)
Fixed and Total Asset Turnover
- Efficiency with which the firm uses its net fixed assets or total assets to generate sales
- The higher a firm’s fixed asset turnover, the more efficiently its fixed
assets have been used to do what they have been acquired to do—
generate sales
- Good ratio for companies with large investment in fixed assets
- * The higher the cost of the new assets the larger the denominator
and therefore the smaller the turnover ratio
o Very high turnovers together with declining assets may
suggest a company is not reinvesting in (overextending) their
assets
o Retailers and service oriented companies have high fixed asset
turnover and low total asset turnover
o Industrial and resource companies fixed and total asset
turnovers are low
- Uses the historical cost of as

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