Chapter 8 Flashcards
Cash flow analysis + planning
why do internal stakeholders monitor cash flow
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
why do external stakeholders analyze cash flows
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
define liquidity
having cash available to run the day-to-day operations of the business
what are the 4 questions used to analyze a statement of cash flows
- what was the net change in cash during the period?
- what were the major sources of cash?
- what were the major uses of cash?
- what overall strengths and/or weaknesses do you see?
why is cash important to shareholders
they expect management to manage cash effectively to operate the business, make interest payments, re-invest cash into the business and pay them dividends
what does liquidity refer to?
company’s ability to convert assets to cash
short-term focused and the company’s liquidity is assessed by looking at its working capital
what’s the net working capital
the difference between a company’s current assets and current liabilities
an indicator of the company’s operating efficiency and short-term financial health
what are the 2 main basic liquidity ratios companies use?
current and quick ration
what’s current ratio
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
what’s quick (acid-test) ratio
(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
what questions does the liquidity ratios answer?
- does the company turn over its inventory quickly, without hanging onto it for long periods of time?
- does the company collect its credit sales in a timely manner?
- does the company pay its suppliers within the credit terms?
what’s a cash conversion cycle
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
what’s the inventory turnover ratio
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
what’s days’ inventory outstanding
tells us how long in days it takes to sell the average level of inventory
DIO = 365/ inventory turnover
what’s the A/R turnover - receivables turnover
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
A/R turnover can be converted into
days’ sales outstanding (DSO)
what’s days’ sales outstanding
DSO = 365/A/R turnover
it indicates how long, in days, it takes for the company to collect its receivables
what’s the accounts payable turnover - payables turnover
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
we can convert payables turnover into
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
what are solvency ratios
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
define debt ratio
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
what’s the time interest earned ratio
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
