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Chapter 4

FIN 3715 Chapter Notes - Chapter 4: Inventory Turnover, Financial Statement Analysis, Asset Turnover


Department
Finance
Course Code
FIN 3715
Professor
A L L
Chapter
4

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Chapter 4 Evaluating a Firm’s Financial Performance
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Chapter 4 Evaluating a Firm’s Financial Performance
Learning objectives
The purpose of financial analysis
Evaluate a company's performance
The purpose of financial analysis
Financial statement analysis provides a useful tool for evaluating business performance, which can
be used not only by financial managers but also by investors, lenders, suppliers, employees, and
customers.
Through the use of financial ratios, managers can:
Identify deficiencies in the firm’s performance and take corrective action;
Evaluate employee performance and determine incentive compensation;
Compare the financial performance of the firm’s different divisions;
Prepare, at both the firm and division levels, financial projections, such as those associated
with the launch of a new product;
Understand the financial performance of the firm’s competitors;
Evaluate the financial condition of a major supplier.
While the stakeholders can use financial ratios:
to decide whether or not to make a loan to the company;
to determine the firm’s creditworthiness;
to decide whether or not to invest in a company;
to decide whether or not to grant credit terms to a company.
Evaluate a company's performance
In order to evaluate company’s performance we use financial ratios which answer to important
questions about a firm’s operations:
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Chapter 4 Evaluating a Firm’s Financial Performance
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1 - How liquid is the firm?
To answer this question, we should consider different ratios; therefore we should compare current
assets that can be converted easily in cash with current liabilities:
A higher ratio means greater liquidity.
While the acid-test ratio keeps in consideration items that are more liquid: cash and accounts
receivable (without for example inventory), giving a more stringent measure of liquidity than the
current ratio:
A higher ratio means greater liquidity.
Another prospective to know if the company has enough liquidity is represented by the ratio that
measures how many days on average it takes to collect receivables:
A longer (shorter) period means a slower (faster) collection of receivables and that the receivables
are of lesser (greater) quality.
The same results can be achieved with the following ratio, which measures how often accounts
receivable are rolled over during a year:
Moreover to know the quality of the inventory, we consider this ratio:
It measures how many days a firm’s inventories are held on average before being sold.
The more (less) days required, the lower (higher) the quality of the inventory.
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