Liquidity analysis: Length of cash cycle


 Raymond Harry Blake
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1 2. Liquidity analysis: Length of cash cycle Operating cycle of a merchandising firm: number of days it takes to sell inventory + number of days until the resulting receivables are converted to cash Acquisition of inventory Inventory storage Cash cycle: Number of days a company s cash is tied up by its current operating cycle Days payables outstanding Merchandising firm only finished goods inventory Manufacturing firm inventory held through three stages: raw material work in progress Cash collection Sale finished goods Handout Problem Set 1: Financial Ratios 7
2 ValueBased Management: Lecture 1 8
3 2. Cash cycle for Dell computers: Negative cash cycles Dell has a negative cash cycle: Dell manufactures and ships directly to its customers only after an order is received minimal inventory days Its customers pay on time low receivable collection period Dell takes its time in paying its suppliers because of its market power longer period of days in accounts payable Fiscal Year Ended 2/3/06 1/28/05 1/30/04 Days of sales in accounts receivables Days of supply in inventory Days in accounts payable (77) (73) (70) Cash cycle (44) (42) (40) Handout Problem Set 1: Financial Ratios 9
4 2. Ratios for liquidity analysis: working capital ratios Cash and cash equivalents Marketable securities Accounts receivable Inventories Prepaid expenses Current assets Current liabilities Shortterm debt Accounts payable Accrued liabilities Ratios for cash obligations Current Ratio Current Assets Current Liabilities Cash Marketable Securities Accounts Receivable Quick Ratio Current Liabilities More conservative Cash Marketable Securities Cash Ratio Current Liabilities Most conservative Cash flow from operations Cash Flow from Operations Ratio Cash Flow from Operations Current Liabilities Actual cash flows Handout Problem Set 1: Financial Ratios 10
5 2. Question 1: Calculate the cash cycle and the following liquidity ratios for Microsoft Microsoft Average no. of days inventory in stock (plus) Days of receivables outstanding Length of operating cycle (minus) Payables outstanding Length of cash cycle Current ratio Quick ratio Cash ratio Cash from operations ratio Handout Problem Set 1: Financial Ratios 11
6 3. Ratios for longterm debt and solvency analysis Debt ratios Debt to Total Capital Debt to Equity Total Debt Total Debt Total Equity (Current Long  Term) Equity) Total Capital (Debt Level of risk borne by a firm Interest coverage ratios Times Interest Earned Earnings Before Interest and Taxes (EBIT) Interest Expense Ability to meet interest payments Capital expenditure and CFOtodebt ratios Capital Expenditure Ratio CFO to Debt CFO TotalDebt Cash from Operations (CFO) CapitalExpenditures Ability to finance investments and generate cash for debt repayment Handout Problem Set 1: Financial Ratios 12
7 3. Question 1: Calculate the following debt ratios for Microsoft Microsoft Shortterm debt 0 1,000 2,000 + Longterm debt 11,921 4,939 3,746 = Total debt 11,921 5,939 5,746 + Total equity 57,083 46,175 39,558 = Total capital 69,004 52,114 45,304 Debt to equity Debt to capital Times interest earned Capital expenditure ratio Cash flow from operations(cfo) to debt All numbers in $ millions Handout Problem Set 1: Financial Ratios 13
8 Handout Problem Set 1: Financial Ratios 14
9 4. Ratios for profitability analysis: return on sales Gross (profit) margin Gross Margin Gross Profit Relationship between sales and manufacturing costs Operating margin Operating Margin Operating Income Profitability from operations Margin before Interest & Tax Margin Before Interest and Tax EBIT Independent of finance and tax position Profit margin Net income Profit Margin Net of all expenses Handout Problem Set 1: Financial Ratios 15
10 4. Ratios for profitability analysis: return on investment Return on Assets ROA EBIT Average Total Assets Net Income After  Tax Interest Cost ROA Average Total Assets Pretax Aftertax (takes into account the tax shield of debt) Return on Total Capital EBIT ROTC Average (Total Debt Stockholder's Equity) Pretax (aftertax calculation is similar to the above one) Return on Equity ROE ROE Pretax Income Average Stockholder's Equity Net Income Average Stockholder's Equity Pretax Aftertax Handout Problem Set 1: Financial Ratios 16
11 4. Question 1: Calculate the following profitability ratios for Microsoft Microsoft Gross margin (%) Operating margin (%) Profit margin (%) ROA preinterest and pretax (%) ROTC preinterest and pretax (%) ROE after tax (%) Handout Problem Set 1: Financial Ratios 17
12 Ratios: an integrated analysis Financial analysis requires a review of three interrelationships among ratios: Economic relationships: Example: Higher sales are generally associated with higher investment in working capital components such as receivables and inventory. Ratios comprising these elements should be correlated Overlap of components: Identical terms in the numerator or denominator of different ratios A term in one ratio being a subset or component of another ratio Aggregations like the total assets turnover as aggregation of inventory, accounts receivable, and fixed asset turnover Ratios as composites of other ratios, e.g., ROA = profitability x turnover Implications of these interrelationships: Disaggregation of a ratio into its components allows us to gain insights into factors affecting a firm s performance Ratio differences can highlight the economic characteristics and strategies of The same firm over time Firms in the same industry Firms in different industries Firms in different countries Handout Problem Set 1: Financial Ratios 18
13 Analysis of firm performance Disaggregation of ROA ROA Total Asset Turnover Return on Assets Operating Income A firm s overall profitability is the product of an activity ratio and a profitability ratio Relationship between ROE and ROA ROE ROA Debt ROA  Cost of Debt Equity Benefits from financial leverage Disaggregation of ROE ROE Income Net Income EBT Profitability EBT EBIT Activity Assets EBIT Solvency Assets Equity Net Income Standard dupont analysis Extended dupont analysis Handout Problem Set 1: Financial Ratios 19
14 Appendix: The income statement some definitions revenue is income from sales (gross revenue) minus cost associated with things like returned or undeliverable merchandise (synonyms: sales, net sales, revenue, net revenue). cost are expenses directly related to creating the goods or services being sold (like the cost of raw materials, salaries of persons turning raw materials into sellable goods, depreciation of equipment); not included are expenses like R&D, marketing, and interest payments on debt. Synonyms: cost of sales, cost of goods sold (CoGS). Gross profit (synonym: sales profit) = sales revenue sales cost Operating expenses are expenses associated with running a business but not (necessarily) considered directly applicable to the current line of goods and services being sold. These include and Marketing, R & D, and General and Administrative costs (including the salaries of people working in these areas). Operating income = gross profit operating expenses. Operating income is the pretax, preinterest profit from the company's operations. Synonymous to EBIT, if the firm has no nonoperating income. Recurring income refers to a company s income by recurring activities and excludes the impact of transitory or random components which should not be regarded as components of permanent or sustainable income (unusual or infrequent items). Earnings (synonym: net income or profit) = total income minus total expenses. "Net income" is used for aftertax profit before paying dividends; this is the number that's carried to the top of the cash flow statement. Handout Problem Set 1: Financial Ratios 20
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