CASH (?) ACCOUNTS PAYABLE ACCRUED EXPENSES ACCRUED EXPENSES ACCOUNTS RECEIVABLE PROFIT / LOSS !?!
RAW MATERIALS WORK IN PROCESS FINISHED GOODS SALES SG & ADM. EXPENSES
_________________________________________________________
SPONTANEOUS FINANCING of the CYCLE
ASSETS Inventory Raw Materials LIABILITIES $100 Accounts Payable Net Worth Total Assets $100 $100 0
0 $125 0 $125
$100 25
0 0 $150 $150
$100 50
Accounts Receivable Inventory Raw Materials Work in Process Finished Goods Total Assets
$180 0 0 0 $180
$100 50
30
Cash Accounts Receivable Inventory Raw Materials Work in Process Finished Goods Total Assets
$30 0 0 0 0 $ 30
0 0
30
10 Days + 20 Days = 30 Days |_______________________|____________________________| Cash RM WIP Finished Goods Accts. Receivable Cash
= 30 Days
= 30 Days
IMPERFECTLY TIMED ASSET CONVERSION CYCLES REQUIRE NON-SPONTANEOUS FINANCING TO COMPLETE THE CYCLE:
THE CONCEPT OF WORKING INVESTMENT WI = (Accts Receivable + Inventory) (Accts Payable + Accrued Expenses) WI = the portion of trading assets that are not covered by spontaneous financing. Concepts: Permanent Level of Working Investment Increasing Working Investment due to Sales Growth Changing Working Investment due to Seasonality Financing Non-Current Assets
DEBT
External Claims
Senior
EQUITY
Residual
Undated
Junior
GREY AREA =
DEBT Spontaneous: Short Term: Long Term: Accounts Payable Notes Payable Bank Loans Accrued Expenses (Non-interest Bearing) Overdraft Bonds Current Portion Long Term Subordinated Debt
EQUITY Common Stock Preferred Stock Treasury Stock Capital Surplus Retained Earnings
SOURCES OF FUNDS
The Primary Source of Debt Repayment to a Bank is Cash Generation.
1. Net Profit (after Tax) Assets 1999 Cash Accs/Recble Inventory Fixed Assets Total Assets 150 400 300 500 1,350 2000 200 400 300 500 1,400 Liabilities Accs Payable Notes Payable Retained Earnings Capital Stock Total L & E 1999 200 300 700 150 1,350 2000 200 300 750 150 1,400
2. Conversion of an Asset to Cash Assets 1999 2000 Cash Accs/Recble Inventory Fixed Assets Total Assets 150 400 300 500 1,350 350 300 200 500 1,350
Liabilities Accs Payable Notes Payable Retained Earnings Capital Stock Total L & E
3. Increase in Liabilities Assets 1999 Cash Accs/Recble Inventory Fixed Assets Total Assets 150 400 300 500 1,350
Liabilities Accs Payable Notes Payable Retained Earnings Capital Stock Total L & E
4. Increase in Equity Assets 1999 Cash Accs/Recble Inventory Fixed Assets Total Assets 150 400 300 500 1,350
Liabilities Accs Payable Notes Payable Retained Earnings Capital Stock Total L & E
Sources and Uses of Cash: Assets Cash Accs/Recble Inventory Fixed Assets Total Assets Sources: Net Profit Increase in Acc. Pble Increase in Notes Pble Decrease in Cash TOTAL $ 50 $ 40 $ 10 $150 $250 1999 150 400 300 500 1,350 2000 Liabilities 0 Accs Payable 475 Notes Payable 375 Retained Earnings 600 Capital Stock 1,450 Total L & E 1999 200 300 700 150 1,350 Uses Increase in Acc. Receivable Increase in Inventory Increase in Fixed Assets $ 75 $ 75 $100 2000 240 310 750 150 1,450
$250
RISKS THAT MAY AFFECT THE ASSET CONVERSION CYCLE Supply Risks Production Risks Demand Risks Collection Risks Business Risk: Type of Asset Structure, Length of the Cycle and Value Added
EFFICIENCY IN THE USE OF ASSETS How does a Company Generate Maximum Return from the Use of Assets? INVENTORY ACCOUNTS RECEIVABLE FIXED ASSETS
INVENTORY ANALYSIS Inventory Valuation: LIFO & FIFO Accounting Component Breakdown: Raw Materials, Work in Process, Finished Goods Inventory Turnover: Inventory x 365 Cost of Goods Sold = Inventory Days on Hand
Quality: Returns on Sales: % Returns & Allowances to Sales Ratio: Returns & Allowances x 100 Gross Sales
ACCOUNTS RECEIVABLE ANALYSIS Credit Terms Quality and Concentration of Customers Costs of Carrying the Receivables Historical Experience Aging Schedule Allowance for Bad Debts Accounts Receivable Turnover: Accounts Receivable x 365 Net Sales Charge-Offs: Beginning Allowance for Bad Debts (Balance Sheet) + Provision for Bad Debts (Income Statement) - Ending Allowance for Bad Debts = Charge-offs = Receivable Days on Hand
FIXED ASSETS ANALYSIS The Adequacy of Plant Investment is measured by Plant Turnover:
ASSET INVESTMENT:
1.
SUMMARY
Sales Total Assets
Production Cycle Capital Intensity Asset Components: E. g. Inventory Receivables Cash Securities
2.
3.
ANALYSIS OF PROFIT PERFORMANCE Format of the Income Statement Determinants of Profitability Quantitative Tools to Measure Operating Performance: o o o o o o o o o o Return on Sales (ROS) Sales Revenue Operating Leverage Cost of Goods Sold Gross Profit Margin Selling, General & Administrative Expenses (SG & A) EBIT Margin Interest Expense Investment Income Taxes
ROS is determined by the components of the Income Statement: Sales Revenue = Volume x Price
Operating Leverage =
CGS/Sales
(%?)
Gross Profit Sales = Selling, General & Administrative Expenses (%) Sales
SG&A/Sales
EBIT Margin
(%)
LTD+CPLTD+STD+LTD+CPLTD+STD 2
Interest Expense
(%)
SUMMARY:
FINANCIAL RISK Analysis of the Right Hand Side of the Balance Sheet
Evaluation of Short Term Liquidity: Working Capital Adequacy Reliance on Inventory Evaluation of Long Term Solvency: Leverage Ratios --Profitability --Current Ratio --Quick Ratio
Evaluation of the Adequate Capital Structure: The Mix of Short and Long Term Debt & Equity is dependent on Asset Investments, the Operating Performance and the Asset Conversion Cycle
Current Ratio
Adequacy Depends on
Quick Ratio
Bank Debt
10
Debt to Equity =
Adjusted Leverage
APPROPRIATE CAPITAL STRUCTURE When we have determined what the Left-Hand side of the balance sheet looks like, we can decide what the Right-Hand side SHOULD look like! Basically: TENORS SHOULD BE MATCHED BUSINESS RISK SHOULD BE COVERED BY EQUITY: Higher Business Risk should equal lower Financial Risk
Financing of Short Term Needs: o Adequacy of Working Capital: Liquidity of Receivables and Inventory after shrinkage should pay Short Term creditors. o Permanent Working Investment should be covered by permanent funds: either Long-Term Debt or Equity. o Whether long-term financing is debt or equity depends on the business risk. Longer Asset Conversion Cycles tend to have more permanent working investment and more business risk.
11
THE ROE EQUATION ROE = Net Profit After Tax Net Worth
= =
x x =
The Fact Sheet used for Analysis breaks down ROE, ROS, ATO and ALEV into their different components to highlight the elements of Profitability, Efficiency and Equity mix, both horizontally (over certain periods) and vertically (for the period in question).
12