The reason is that depreciation a noncash expense has

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Unformatted text preview: a measure of cash available to pay interest. The reason is that depreciation, a noncash expense, has been deducted out. Since interest is most definitely a cash outflow (to creditors), one way to define the cash coverage ratio is Cash coverage ratio E_____________________ Depreciation _ BIT Interest $____________ 276 _ 691 $141 $967 ______ $141 6.9 times [3.8] 1 Total equity here includes preferred stock, if there is any. An equivalent numerator in this ratio would be (Current liabilities + Long-term debt). CHAPTER 3 Financial Statements Analysis and Long-Term Planning 51 ros82361_ch03.indd ros82361_ch03.indd 51 5/27/08 10:14:58 AM Confirming Pages The numerator here, EBIT plus depreciation, is often abbreviated EBITD (earnings before interest, taxes, and depreciation). It is a basic measure of the firm’s ability to generate cash from operations, and it is frequently used as a measure of cash flow available to meet financial obligations. Asset Management or Turnover Measures We next turn our attention to the efficiency with which Prufrock uses its assets. The measures in this section are sometimes called asset utilization ratios. The specific ratios we discuss can all be interpreted as measures of turnover. What they are intended to describe is how efficiently, or intensively, a firm uses its assets to generate sales. We first look at two important current assets: inventory and receivables. INVENTORY TURNOVER AND DAYS’ SALES IN INVENTORY During the year, Prufrock had a cost of goods sold of $1,344. Inventory at the end of the year was $422. With these numbers, inventory turnover can be calculated as: Inventory turnover Cost of goods sold _____________________ Inventory $1,344 ________ $422 3.2 times [3.9] In a sense, we sold off, or turned over, the entire inventory 3.2 times. As long as we are not running out of stock and thereby forgoing sales, the higher this ratio is, the more efficiently we are managing inventory. If we know that we turned our inventory over 3.2 times during the year, then we can immediately figure out how long it took us to turn it over on average. The result is the average days’ sales in inventory: Days’ sales in inventory 365 days _____________________ Inventory turnover 365 _____ 3.2 114 days [3.10] This tells us that, roughly speaking, inventory sits 114 days on average before it is sold. Alternatively, assuming we used the most recent inventory and cost figures, it will take about 114 days to work off our current inventory. For example, in September 2007, sales of General Motors (GM) pickup trucks could have used a pick-me-up. At that time, the company had a 120-day supply of the GMC Sierra and a 114-day supply of the Chevrolet Silverado. These numbers mean that at the then-current rate of sales, it would have taken GM 120 days to deplete the available supply of the Sierra, whereas a 60-day supply is considered normal in the industry. Of course, the days in inventory is much lower for better selling models, and, fortunate...
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