Finance Assignment
Jagger
MBA655Period2Part2.pptx
MBA 655 Period 2 Part 2
Chapter 13 and 14 Ratio Analysis
Andrew root
Principles
Wisdom and understanding > technical skills
Cash cycle ratios
Example
Chapters 13 – Cash is king
Production cycle + Accounts receivable cycle – Payment cycle = Cash conversion cycle i.e. the number of days between when a firm incurs an outflow to start production until it receives payment on a credit sale.
So if a firm can shorten its production cycle or its collection cycle, or both, while keeping its payment cycle constant or lengthened, it can shorten the number of days that it would typically have to finance its operations for, thereby reducing its financing costs and increasing its profits.
Thus, shortening the cash conversion cycle essentially requires the efficient management of receivables (credit policy), inventory, and payables.
Chapters 13 – Cash conversion cycle
The production cycle and the collection cycle together make up the operating cycle, so the cash conversion cycle can also be calculated as follows:
Cash conversion cycle = Operating cycle – Payment cycle.
Chapters 13 – Production cycle
Average collection cycle = 365/AR turnover rate.
Average accounts receivable =
Chapters 13 – Collection cycle
AP turnover = CGS / Average AP
Chapters 13 – Payment cycle
Average accounts payable = (beginning AP + ending AP)/2
Average payment cycle = 365/AP turnover rate.
Example.
John Gray is really concerned that his company’s working capital is not being managed efficiently. He decides to take a look at the firm’s operating and cash conversion cycles to see what’s going on. Using the data provided below, help John measure his firm’s collection, production, payment, operating, and cash conversion cycles respectively.
Cash sales $350,000
Credit sales $600,000
Total sales $950,000
Cost of goods sold $600,000
Ending Balance Beginning Balance
Accounts receivable $45,000 $32,000
Inventory $22,000 $9,000
Accounts payable $6,000 $5,000
Chapters 13 – Cash conversion cycle
First, we calculate the average values of the 3 accounts:
Average A/R ($45,000 + $32,000)/2 = $38,500
Average inventory$(22,000+9000)/2 = $15,500
Average A/P ($6,000 + $5,000)/2 = $5,500
Next, we calculate the turnover rates of each
A/R Turnover = Credit Sales/Avg. A/R $600,000/$38,500 15.58
Inventory Turnover = Cost of Goods Sold/Avg. Inv $600,000/$15,500 = 38.71
A/P Turnover = Cost of Goods Sold/Avg. A/P = $600,000/$5,500 = 109.09
Finally we calculate the collections cycle, the production cycle, and the payment cycle by dividing each of the turnover rates into 365 days, respectively.
Chapters 13 – Cash conversion cycle
Collection cycle = 365/A/R Turnover 365/15.58 23.43 days
Production cycle = 365/Inv. Turnover365/38.71 9.43 days
Payment cycle = 365/A/PTurnover365 / ``````````````````````````109.093.35 days
So the firm’s operation cycle = Collection cycle + Production cycle =23.43+9.43 = 32.86 days
Cash conversion cycle = Operating cycle – payment cycle = 32.86-3.35 29.51 days. So on average, the firm has to finance its credit sales for about 30 days.
Chapters 13 – Cash conversion cycle
Chapters 14 – Ratios and Performance
Principles
Orderly and systematic
Ratios
Performance
Example
Financial ratios are relationships between different accounts from financial statements—usually the income statement and the balance sheet—that serve as performance indicators
Being relative values, financial ratios allow for meaningful comparisons across time, between competitors, and with industry averages.
Chapters 14 – Ratios and Performance
5 key areas of a firm’s performance can be analyzed using financial ratios:
Liquidity ratios: Can the company meet its obligations over the short term?
Solvency ratios: (also known as financial leverage ratios): Can the company meet its obligations over the long term?
Asset management ratios: How efficiently is the company managing its assets to generate sales?
Profitability ratios: How well has the company performed overall?
Market value ratios: How does the market (investors) view the company’s financial prospects?
Can also conduct a Du Pont analysis which involves a breakdown of the return on equity into its three components, i.e. profit margin, turnover, and leverage.
Chapters 14 – Ratios and Performance
Measure a company’s ability to cover its short-term debt obligations in a timely manner:
3 key liquidity ratios include: The current ratio, quick ratio, and cash ratio.
Chapters 14 – Liquidity
Chapters 14 – Solvency
Measure how efficiently a firm is using its assets to generate revenues or how much cash is being tied up in other assets such as receivables and inventory.
Equations 14.7 – 14.11 can be used to calculate 5 key asset management ratios.
Chapters 14 – Asset management ratios
Profitability ratios such as net profit margin, returns on assets, and return on equity, measure a firm’s effectiveness in turning sales or assets into profits.
Chapters 14 – Profitability ratios
Used to gauge how attractive or reasonable a firm’s current price is relative to its earnings, growth rate, and book value.
Chapters 14 – Market value ratios
Involves breaking down ROE into three components of the firm:
operating efficiency, as measured by the profit margin (net income/sales);
asset management efficiency, as measured by asset turnover (sales/total assets); and
financial leverage, as measured by the equity multiplier (total assets/total equity).
Equation 14.19 shows that if we multiply a firm’s net profit margin by its total asset turnover ratio and its equity multiplier, we will get its return on equity.
Chapters 14 – DuPont disaggregation
Cogswell has better operational efficiency, i.e. it is better able to move sales dollars into income, but Spritzer is more efficient at utilizing its assets, and since it uses more debt, it is able to get more of its earnings to its shareholders.
Although these 14 ratios are not the only ones that can be used to assess a firm’s performance, they are the most popular ones.
It is important to look at the overall picture of the firm in all 5 areas and accordingly reach conclusions or make recommendations for changes.
Chapters 14 – DuPont example ni/sales * sales/assets * assets/equity
