Lecture 6 Financial Statement Analysis

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Lecture 6Financial Statement Analysis

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Current asset policy

• Current assets cash, marketable securities,
  inventories, accounts receivable (A/R) --
  convertible to cash in normal course of current
  business cycle.
• Holding current assets has a cost -- financed by
  L/E.
• Different policies re current assets
• High liberal credit creates high A/R
• Low minimize current assets

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Risk Considerations

• Absent realization risk, firms operate at lowest
  possible levels of current assets consistent with
  sales objectives.
• Firms hold safety stocks to reduce risk of
  operational disruption meet legal obligations.
• HC firms try to minimize current assets risk
  is low. True/ false?

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Seasonal/ business cycle fluctuations

• Firms build inventories to meet periodic high
  demands or during high growth part of the
  business cycle.
• Permanent assets are needed even during low
  periods temporary assets are incremental to meet
  seasonal/ cyclical demands.

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Financing policy balancing act

• Maturity matching fixed assets matched with
  permanent capital temporary assets with
  short-term debt.
• Aggressive financing fixed assets with long-term
  capital part of permanent current assets with
  short-term debt.
• Why use aggressive financing?
• Conservative financing long-term capital funds
  all permanent assets and part of temporary
  assets.
• Why use conservative financing?

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Cash and A/R management

• Keep as little on hand as possible to maintain
  operations and meet legal commitments. Some
  techniques
• Manage float pay bills slowly/ collect
  receivables quickly
• Invest excess cash in marketable securities/
  preferred stock/ mutual funds
• Collect receivables quickly factor receivables
  if advantageous

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Inventory management

• Just-in-time inventory management
• Personnel, inventory carrying costs, storage
  costs down example St. Lukes example
• Downsides are potential for stock-outs and
  dependence on a single supplier

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Sources of short term financing

• Accruals spontaneous financing consider as
  free debt
• Accounts payable trade credit is a key source of
  financing also spontaneous
• Trade credit policy days and discounts
• Free trade credit vs. costly trade credit
• Always take free trade credit
• Bank loans notes payable

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Financial analysis

• Financial analysis focuses on financial reports
  and the derived ratios.
• In planning, analysts prepare pro forma financial
  reports to develop insights.
• Operations analysis includes some insights from
  the financial statements but industry-specific
  operating data also.

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Profitability ratios

• Total margin Net income/ Total revenue
• Return on assets (ROA) Net income/ Total
  assets
• Return on equity (ROE) Net income/ Total equity
• Return on capital employed (ROCE)
• Net profit/ (Total assets current liabilities)

Note definition of ROCE may vary slightly.
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Net profits as of net sales (2002)
Source WebMD
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Example HC companies margin2004

• Company Net Margin ROE
• of Sales
• Cyberonics 6.11 11.63
• HCA 5.30 24.21
• Eli Lily 13.06 17.49
• Quest Diagnostics 9.74 21.32
• Biogen Idec 1.13 0.36

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Liquidity Inventory turnover ratio

• revenues/ inventories

Source www.morningstar.com
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Liquidity Current ratio

• current assets/ current liabilities

Source www.morningstar.com
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Liquidity Quick ratio (acid-test)

• (current assets inventory) / current
  liabilities

Source www.morningstar.com
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All ratio tests have limits

• Companies with ratios less than 1 cannot pay
  their current liabilities and should be looked at
  with extreme caution. Furthermore, if the
  acid-test ratio is much lower than the working
  capital ratio, it means current assets are highly
  dependent on inventory. Retail stores are
  examples of this type of business.

Source www.Investopedia.com
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Liquidity debt/ equity ratio

• total debt / total equity

Source www.morningstar.com
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DuPont analysis

• ROE Tot margin x Tot asset t/over x Equity
  mult.
• Net Inc./ NI/ x Tot rev/ x
  Total assets/
• Tot equity Tot Rev Tot assets Total
  equity

What are the implications of the equation?
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Assignment

• Gapenski Ch. 16 problems 16.2a, b,c, 16.4a, b.,
  c., d, e. 16.5 a, b, c, d
• Gapenski Ch. 17 problems 17.1a, b, 17.2a,
  17.3a,b, 17.4a, b