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Chapter4overview

# Chapter4overview - Chapter 4 Chapter 3 vs Chapter 4 Chapter...

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Chapter 4

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Chapter 3 vs. Chapter 4 Chapter 3 described the four key financial statements and how they change as the firm’s operations undergo change Chapter 4 shows how ratios derived from financial statements are used by managers to improve performance, by lenders to evaluate the likelihood of collecting on loans, by stock holders to forecast earnings, dividends and stock price.
Why is ratio analysis important? Ratios are important for comparing one company’s performance with the industry average. Ratios help to plan, track and predict improvements in performance by comparing the past with the present. Five groups of ratios – Liquidity, Asset management, Debt management, Profitability and Market value. *ROE most important profitability ratio

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The two Liquidity ratios Why do they matter? Liquidity ratios answer the big question: Will the firm be able to pay of its debt as it comes due? 1)Current ratio = current assets / current liabilities. 2) Quick or Acid test ratio = current assets – inventories/current liabilities
Current ratio If current liabilities rise faster than current assets the ratio will fall - which could spell trouble Ratio used to judge how claims of short term creditors are covered by assets that can quickly be converted to cash Example from text: 1000 current assets/310 current liabilities = 3.2 x can be compared to industry average of 4.2 x (the higher the ratio the better)) With a 3.2 ratio the firm can liquidate its assets at only 1/3.2 = .31 pct of book value and still pay off its debt * Definition of a liquid asset – one that can be converted to cash quickly without having to reduce the price

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Quick ratio Quick ratio = Current Assets – Inventories/ current Liabilities Inventories deducted because they are the least liquid of the current assets Text example 385/310 = 1.2x Industry average 2.2 The company in the text is less liquid than the industry average
Asset Management Ratios Why are they important? Inventory turnover ratio Answers the question - is the total amount of each type of asset too high or too low in view of current or projected sales level? If too low then sales may be lost. If too high then cost of capital too high. Inventory turn over ratio = Sales/Inventories Text Example: 3000 sales/615 inventory = 4.9x Compare 4.9 to industry average of 9x (the higher the ratio the better) Indicates firm is holding too much inventory –an investment with zero return that has to be funded at some cost

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Asset management ratio Days sales outstanding Days sales outstanding = Receivables/Annual sales per day – also called average collection period. It is the average time a company must wait after making a sale before it receives cash Example: 375 in receivables divided by 3000 sales/365 = 45.625 compared to the industry average of 36. (the lower the ratio the better) If the customer is paying late then that could mean the
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Chapter4overview - Chapter 4 Chapter 3 vs Chapter 4 Chapter...

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