TUT 2 – CLM FINANCIAL STATEMENT ANALYSIS Question 1 What characteristics should a business have before it can be considered to be financially sound? A sound business possesses the following characteri[.]
TUT – CLM: FINANCIAL STATEMENT ANALYSIS Question 1: What characteristics should a business have before it can be considered to be financially sound? A sound business possesses the following characteristics: - The business has adequate liquidity so it can meet short-term obligations easily when they fall due and avoid the risk of becoming insolvent Two principal ratios that are commonly used to judge the liquidity position of any business are: current ratio and quick ratio - The business is run efficiently: how efficiently the business has used its assets Basic efficiency ratios include the inventory turnover ratio (shows the efficiency of management of inventory ) and the average collection period ( shows the efficiency in collection of receivables) - The business is run profitably: The gross profit-sales ratio & The net profit-sales ratio - The proprietor’s stake in the business is high; alternatively, the business is not burdened with too much debt Question 2: What are the various types of financial ratio that lenders use in analysing the financial position of a firm? - Liquidity ratios: refers to the ability of a firm to meet its short-term obligations Liquidity is an important aspect to be watched in any business Two principal ratios that are commonly used to judge the liquidity position of any business are: + The current ratio: The current ratio is the ratio of current assets to current liabilities Current assets include cash, marketable securities, debtors, closing stock (ending inventory), loans and prepaid expenses Current liabilities are borrowings for the short term, trade creditors, accrued expenses and provisions The ratio could fluctuate between 1.5 and 2, which is not a concern + The quick ratio: Another measure of liquidity is the quick ratio, also called the acid test ratio It is much the same as the current ratio except that inventory is excluded from its calculation The quick ratio is a ratio of quick assets to current liabilities Quick assets include all current assets except inventory (raw material, work in process and finished goods) Selling of inventory may be a difficult process and the lender wants to ensure the business can meet current liabilities out of quick assets alone (current assets other than inventory) If the ratio is unity (equal to 1), then the business can easily meet the current liabilities out of its quick assets - Efficiency ratios: the efficiency ratios measure how efficiently the business has employed its assets These ratios are based on the relationship between the level of activity (represented by sales or the cost of goods sold) and the levels of various assets Efficiency ratios are also called turnover ratios, activity ratios or asset management ratios The important efficiency ratios are: + The inventory turnover ratio: shows the efficiency of management of inventory A high ratio would indicate that the inventory is fast moving and that the products of the business are in high demand The higher the ratio, the better it is It means that the inventory management of the business is very efficient + The average collection period: shows the efficiency in collection of receivables A business that is efficient in debt collection will face fewer liquidity problems If the average collection period calculated by the above formula is less than the credit term generally allowed by the firm, then the debt collection of the firm can be regarded as efficient - Profitability ratios: A financially sound business is likely to be a profitable business The two popular profitability ratios are the gross profit-sales ratio (This is the ratio ofgross profit to net sales, where gross profit is defined as the difference between net sales and the cost of goods sold The higher the ratio, the better it is The ratio measures the pricing and production cost control aspect The firm may have less control over pricing, because the market decides price, but it can control the costs The ratio should be compared with the ratio of other firms in the industry) and the net profit-sales ratio (This ratio captures the profitability of the firm when all the costs (including the administrative costs) are considered The higher the ratio, the better it is The ratio provides a valuable understanding of the costand-profit structure of the firm.) - Leverage ratios: Financial leverage means the use of debt finance Leverage ratios help US assess the risk arising from the use of debt capital It has been found that if a positive financial leverage could be established, then debt capital is a preferred source of finance Analysis of financial leverage generally uses two types of ratio: structural ratios and coverage ratios The structural ratios are the debt-equity ratio, the proprietary ratio and the debt-assets ratio, while the coverage ratios are the interest coverage ratio and the fixed charges coverage ratio + The debt-equity ratio This ratio shows the proportion of amount borrowed by the firm compared with the proprietor’s own investment in the business It is a ratio of debt to the equity of the firm The debt consists of all liabilities of the firm, whether short term or long term, and the equity consists of capital and reserves => The lower the ratio, the better it is + The interest coverage ratio: The interest coverage ratio is the ratio of earnings before interest and taxes on debt interest It shows whether the firm has sufficient resources to cover the interest portion of the debt In the case of a firm having financial difficulties, the bank may postpone the repayment instalment but would insist on, at least, payment of the interest on the debt If a firm is unable to pay even the interest, then it is in serious financial difficulty => The higher the ratio, the better it is + The fixed charges coverage ratio: This ratio is the ratio of earnings before interest and taxes plus depreciation to interest on the loan and the loan repayment instalment It is used to measure the debt servicing capacity of the firm Question Explain the advantages and limitations of financial statements analysis - Advantages in lending decision making - The limitations are that: benchmarking can be difficult; window dressing may occur; it is hard to obtain a future view; and this type of analysis ignores non-financial information Question What is break-even analysis? Why should a lender be interested in break-even analysis? => Break-even analysis is a concept from cost accounting It is a useful concept, not only for the firm but also for the lender who is trying to assess the performance and prospects of the firm It is therefore discussed here in detail Break-even analysis involves calculation of the break-even point and the margin of safety Question What is the difference between indexed analysis and common-size analysis? => When firms are of different sizes it is hard to compare them unless their financial statements are expressed in a common form. To create such a common form all the components of the statement of financial position and income statement are expressed as a percentage of total assets and total revenue respectively A common size statement is a cross-sectional analysis, that is, it refers to a particular period or year only, and compares firms at that point in time. Question What is discounted cashflow? What are the various discounted cashflow methods? => Discounted cashflow techniques are often used to analyse project finance proposals There are three discounted cashflow techniques: the net present value (often abbreviated as NPV), the internal rate of return (often abbreviated as IRR) and the benefit-cost ratio (also called the profitability index) Question What is 'creative accounting’? Explain by giving examples Question Which ratios loan officers generally use in credit assessment? Question Imagine the current assets and current liabilities of a firm are $3200 and $2000 respectively How much can the firm borrow on a short-term basis without reducing the current ratio below 1.5? - Curent ratio= 3200/2000=1.6 - If firm borrow: (3200+x)/(2000+x)= x=