Chapter 8

Question 1

why do internal stakeholders monitor cash flow

Answer 1

to understand if and when the company needs to obtain additional cash from investors (issuing new shares) or banks (loans0

management teams monitor cash flows from operating activities and assesses if these cash flows are sufficient to make investments required for continued growth or cover financing activities (loan repayments and/or dividend payments) and budget future cash flows

Question 2

why do external stakeholders analyze cash flows

Answer 2

determine a company’s continued ability to pay dividends and to assess whether a company’s continued ability to pay dividends and to assess whether a company is investing enough cash to fund future growth

banks analyze cash flows to assess whether a company will be able to make interest payments and repay its debt

Question 3

define liquidity

Answer 3

having cash available to run the day-to-day operations of the business

Question 4

what are the 4 questions used to analyze a statement of cash flows

Answer 4

1. what was the net change in cash during the period?
2. what were the major sources of cash?
3. what were the major uses of cash?
4. what overall strengths and/or weaknesses do you see?

Question 4

why is cash important to shareholders

Answer 4

they expect management to manage cash effectively to operate the business, make interest payments, re-invest cash into the business and pay them dividends

Question 5

what does liquidity refer to?

Answer 5

company’s ability to convert assets to cash

short-term focused and the company’s liquidity is assessed by looking at its working capital

Question 6

what’s the net working capital

Answer 6

the difference between a company’s current assets and current liabilities

an indicator of the company’s operating efficiency and short-term financial health

Question 7

what are the 2 main basic liquidity ratios companies use?

Answer 7

current and quick ration

Question 8

what’s current ratio

Answer 8

current assets/current liabilities

company’s ability to pay current obligations in 1 year
ratio of 1.0 or greater is considered satisfactory

a ratio of less than 1.0 indicates that the company would run into problems if it had to repay all its current liabilities immediately

Question 9

what’s quick (acid-test) ratio

Answer 9

(current assets - inventory)/current liabilities

measure the company’s ability to pay current obligations without selling or liquidating its inventory - the company should be able to pay all its short-term liabilities without relying on the sale of inventory - as inventory typically takes longer to turn into cash than other current assets

if a company’s quick ration is considerably lower than its current ratio, it implies that the company’s current assets are heavily comprised of inventory - might not be a red flag but more analysis if necessary

a ratio more than 1.0 implies that the company can pay off all its current liabilities without having to sell any inventory

Question 10

what questions does the liquidity ratios answer?

Answer 10

1. does the company turn over its inventory quickly, without hanging onto it for long periods of time?
2. does the company collect its credit sales in a timely manner?
3. does the company pay its suppliers within the credit terms?

Question 11

what’s a cash conversion cycle

Answer 11

the number of days it takes for a company to convert inventory + sales into cash

cash conversion cycle in days = days in inventory + days in A/R - days in A/P

Question 12

what’s the inventory turnover ratio

Answer 12

inventory turnover = COGS/average inventory

measure a company’s effectiveness in selling its inventory throughout the period

the ratio tells how many times a company has soldits average level of inventory in a specified period

a low turnover it generally considered worse however too high a turnover can signal that the company isn’t stocking enough inventory and is potentially losing out on sales

Question 13

what’s days’ inventory outstanding

Answer 13

tells us how long in days it takes to sell the average level of inventory

DIO = 365/ inventory turnover

Question 14

what’s the A/R turnover - receivables turnover

Answer 14

A/R turnover = net credit sales/ average A/R

measures a company’s effectiveness in collecting its A/R or how efficiently a company collects its revenue - this ratio tells you how many ties a company collects it A/R in a specified periods

the higher the ration the better as it implies that the company is collecting its A/R more times or more frequently throughout the analysis period - however a ratio too high can signal that the company’s credit terms were too aggressive and it could be losing out on potential customers

Question 15

A/R turnover can be converted into

Answer 15

days’ sales outstanding (DSO)

Question 16

what’s days’ sales outstanding

Answer 16

DSO = 365/A/R turnover

it indicates how long, in days, it takes for the company to collect its receivables

Question 17

what’s the accounts payable turnover - payables turnover

Answer 17

A/P turnover = COGS/average A/P

measure the number of times a company pay its creditors in a specified period

companies prefer this ratio to be lower as a lower ratio may signal that the company has the ability to pay quickly it’s in the company’s best interest to collect receivables SAP but make payments as slowly as possible to maximize liquidity and cash on hand

Question 18

we can convert payables turnover into

Answer 18

days’ payables outstanding (DPO)

indicates how long, in days, it takes for the company to pay off its accounts payable

DSO = 365/ A/P turnover

Question 19

what are solvency ratios

Answer 19

assess a company’s ability to take on additional debt in the future

a company’s debt level can have significant implications on a company bc of the legal obligations of payment associated with that debt

Question 20

define debt ratio

Answer 20

the most basic leverage ratio which measure the extent to which a company’s assets are financed by debt

debt ratio = total liability/total assets

there’s no rule of thumb for this ratio - however companies with a high debt ratio are associated with higher credit risk bc it implies that the company has financed its growth primarily with debt, with a legal requirement to pay consistently and the principal eventually

a ratio 1 = all company’s assets are financed by debt

it’s important to consider that some companies may not have easy access to equity

if a company chooses to maintain a high level of debt - it needs to ensure that it can cover its associated interest costs and eventually pay back the debt

Question 21

what’s the time interest earned ratio

Answer 21

measures the number of times a company can pay its interest expense with the operating income it generates

when companies take on debt to finance their operations, they need to ensure they can cover the interest cost associated with debt

times-interest-earned = operating income/interest expense

the higher the TIE ratio the better, as it implies that the company is capable of paying off its interest obligation through its normal operations

a low ratio implies that the company isn’t generating sufficient operating income to cover its interest obligations or that it is carrying a large amount of debt