Chapter 3 Financial Statement Analysis.doc

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Management and Organizational Studies
Management and Organizational Studies 2310A/B

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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