Revise Lecture 15 Revise Lecture 15 Other Sources

Revise Lecture 15

Revise Lecture 15 Other Sources of funds • Three other sources of funds are important to most firms; 1. Sale of stock 2. Long-term borrowing 3. Sale of fixed assets

Revise Lecture 15 Uses of Funds • A firm may apply its funds in a number of areas. The main uses are the following; 1. Purchases Fixed Assets 2. Pay off Liabilities or Retire stock 3. Declare Cash Dividends 4. Make up Losses

Financial Analysis • What is financial analysis? • Why financial analysis important?

Financial Analysis • Financial analysis is the process of determining the significant operating and financial characteristics of a firm from accounting data and financial statements. • The goal of such analysis is to determine the efficiency and performance of the firm’s management, as reflected in the financial records and reports.

Financial Analysis • The analyst is attempting to measure the firm’s liquidity, profitability and other indications that business is conducted in a rational and orderly way. • Two view points in receiving and evaluating financial data:

Financial Analysis 1. External analysis 2. Internal analysis

Financial Analysis External analysis • This is performed by outsiders to the firm, such as creditors, stockholders or investment analysts. • It makes use of existing financial statements and involves limited access to confidential information on a firm.

Financial Analysis Internal analysis • This is performed by the corporate finance and accounting departments and is more detailed than external analysis. • These departments have available more detailed and current information than is available to outsiders. • They are able to prepare future statements and are able to produce a more accurate and timely analysis of the firm’s strengths and weaknesses.

Financial Analysis Financial Ratios • A ratio may be defined as a fixed relationship in degree or number between two numbers. • In finance ratios are used to point out relationships that are not obvious from the raw data.

Financial Analysis Some uses of ratios are the following: 1. To compare different companies in the same industry 2. To compare different industries 3. To compare performance in different time periods

Financial Analysis To Compare different companies in the same industry: Ratios can highlight the factors associated with successful and unsuccessful firms. They can reveal strong firms and weak firms, overvalued and undervalued firms

Financial Analysis To compare different industries • Every industry has its own unique set of operating and financial characteristics. These can be identified with the aid of ratios

Financial Analysis To compare performance in different time periods • Over a period of years, a firm or an industry develops certain norms that may indicate future success or failure. • If relationships change in a firm’s data over different time periods, the ratios may provide clues on trends and future problems

Financial Analysis • From all the financial accounts on the balance sheet, income statement and flow-of-funds statements, it is possible to formulate countless ratios. • To be successful in financial analysis, the analyst must select only those ratios that provide significant information about a firm’s situation

Financial Analysis Users of Ratios • Different analyst desire different kinds of ratios, depending largely on who the analyst is and why the firm is being evaluated. • Some users of ratios are the following; 1. Short-term creditors 2. Long-term creditors 3. Stockholders

Financial Analysis Short-term creditors • These persons hold obligations that will soon mature and they are concerned with firm’s ability to pay its bills promptly. • In the short run the amount of liquid assets determines the ability to pay off current liabilities. These persons are interested in liquidity.

Financial Analysis Long-term creditors • These persons hold bonds or mortgages against the firm and are interested in current payments of interest and eventual repayment of principal. • The firm must be sufficiently liquid in the short term and have adequate profits for the long term. These persons examine liquidity and profitability

Financial Analysis Stockholders • In addition to liquidity and profitability, the owner of the firm are concerned about the policies of the firm that affect the market price of the firm’s stock. • Without liquidity, the firm could not pay cash dividends. Without profits, the firm would not be able to declare dividends. With poor policies, the common stock would trade at low prices in the markets.

Financial Analysis Comparative ratios • Ratios are most effectively used when compared to industry average or norms for similar firms. • A comparative ratio is defined as a fixed relationship between numbers that is derived from industry average or other data that can provide a benchmark for evaluating an individual firm.

Financial Analysis Kinds of Ratios • Financial ratios may be classified a number of ways. One classification scheme uses three major categories; 1. Liquidity ratios 2. Profitability ratios 3. Ownership ratios

Financial Analysis Liquidity Ratios 1. 2. 3. 4. Current ratio Quick ratio / Acid test ratio Receivables ratios Inventory turnover ratio

Financial Analysis Liquidity ratios • These examine the adequacy of funds, the solvency of the firm and the firm’s ability to pay its obligations when due. • Short-term liquidity involves the relationship between current assets and current liabilities. If a firm has sufficient net working capital (the excess of current assets over current liabilities) , it is deemed to have sufficient liquidity.

Financial Analysis Liquidity ratios • Two ratios are commonly used to measure liquidity directly; 1. Current ratio 2. Quick ratio / Acid test ratio

Financial Analysis Current ratio • The current ratio is a ratio of the firm’s total current assets to its total current liabilities. A low ratio is an indicator that a firm may not be able to pay its future bills on time. • A high ratio may indicate an excessive amount of current assets and management’s failure to utilize the firm’s resources properly.

Financial Analysis Current ratio • As a general rule 2: 1 ratio is considered acceptable for most firms. • Formula is = Current assets / Current liabilities

Financial Analysis Quick ratio • The quick ratio or acid test is a more stringent measure of liquidity than the current ratio because inventories, which are the least liquid of current assets, are excluded from the ratio • As a guideline, a 1: 1 quick ratio has traditionally been deemed adequate for most firms.

Financial Analysis Quick ratio • A higher ratio may have several meanings. It could indicate that the firm has excessive cash or receivables, both sign of lax management. It could indicate that the firm is too cautiously ensuring sufficient liquidity. • A low ratio is usually an indication of possible difficulties in the prompt payment of future bills.

Financial Analysis Quick Ratio • The quick ratio may be calculated two ways: 1. Cash + marketable securities + accounts receivables / current liabilities 2. Current assets – inventories / current liabilities

Financial Analysis Receivables ratios • Two ratios are used to measure the liquidity of a firm’s account receivables: 1. Accounts receivable turnover = sales / accounts receivable 2. Average collection period = accounts receivable / daily sales

Financial Analysis Receivables ratios • The account receivable turnover is a comparison of the size of the firm’s sales and the size of its uncollected bills from customers. • If the firm is having difficulty collecting its money, it has a large receivables balance and a low ratio

Financial Analysis Receivables ratios If it has a strict credit policy and aggressive collection procedures, it has a low receivables balance and a high ratio.