118 financial position- Ratios, Liquidity and Solvency

Inventory Turnover formula

COGS / Avg Inventory COGS = beg inventory + purchases - ending inventory

Current assets and liabilities book vs fair value

Current assets and liabilities generally do not have significant difference between book value and fair value. Longer term assets (which factor into solvency ratios) may have fair values substantially different from what is recorded under GAAP!

Financial Flexability

Even a strong financial position will erode without cash flows from operations/ FCF... When we look past the static moment of financial position, we start looking into longer term solvency, which considers longer term assets, liabilities and expected future cash flows

Analyzing Long-Term Solvency Risk

Examines a firm's ability to make interest and principal payments on long-term debt and similar obligations.

How do you suppose tangible book/ share generally compares to the trading price per share?

Generally company value is based on future cash flows.If its trading at its book value, then the company should probably go out of business

Operating cash flow to current liabilities:

It indicates the amount of cash from operations after funding working capital needs.

When a company is a going concern, or is worth more by being sold off for parts... then traditional analysis goes out the window. Value is generally based on:

Liquidation values LV may be more than the company value (the opposite of goodwill).

Long-term Debt to Long-term Capital Ratio *on exam

Long-term Debt/Long-term Debt + Total Shareholders Equity (Total capital = Long-term Debt + Total Shareholders Equity)

Long-term Debt to Shareholders Equity Ratio *on exam

Long-term Debt/Shareholders Equity

Accounts Payable Turnover

Purchases / Avg AP Purchases = COGS + ending inventory - beg inventory

Working capital activity ratios:

Rate of activity measures used to study cash-generating ability of operations and short-term liquidity risk of a firm are: - Accounts Receivable Turnover - Inventory Turnover - Accounts Payable Turnover

Accounts Receivable Turnover formula

Sales / Avg. Accounts Receivable how long it takes to collect sales

Marketable securities examples

Stocks, bonds, preferred shares, and ETFs are among the most common examples of marketable securities. Money market instruments, futures, options, and hedge fund investments can also be marketable securities. The overriding characteristic of marketable securities is their liquidity.

Lenders Perspective

The stronger the financial position and the greater the security (i.e. net assets collateralizing the loan), the lower the perceived risk by the lender and consequently the lower the interest rate.

Liabilities to Assets Ratios

Total Liabilities/ Total Assets Proportion of company's assets financed through the liabilities of company (or debt). - Ratio less than 0.5 - most assets are financed through equity - Greater than 0.5 - most assets financed through liabilities

Liabilities to Shareholders Equity Ratio

Total Liabilities/Total Shareholders Equity - How much liabilities company is using to finance its assets relative to the value of shareholders equity - Ratio can range, 0.5 to 3, depending on how capital intensive a Company is. More capital asset needs, often higher liabilities. - Would need to consider industry/ competitors - Lower tends to be better, but not always holds true.

Things to consider relative to liquidity and factor into computing ratios

Unusual items impacting this year, such as: −Impairments & restructurings −Unusual gains and losses Current maturities of long term debt and interest expense: is there ability to meet these near term obligations?

Is borrowing or having debt a bad thing?

When I can earn a greater return on borrowed funds than the cost of the borrowing, that is a good thing. Borrowing to buy your home is an example that generally over a long term provides a significant benefit.

Short-Term Liquidity Risk Ratios

- Current Ratio - Quick Ratio - Operating cash flow to current liabilities - Working Capital Activity Ratios -

Common ratios: Liquidity

- Current ratio & Quick ratio - Turnover ratios: A/R and Inventory - Operating cash flow ratios

Three measures used to examine long-term solvency risk are:

- Debt ratios - Interest coverage ratio - Operating cash flow to total liabilities ratio

Comparing financial statement ratios with other firms consider the following:

- Definition of the industry - Calculation of industry average - Distribution of ratios around the mean - Definition of financial statement ratios

Comparing financial statement ratios with earlier periods raise the following questions:

- Has the firm made a significant change in its product, geographic, or customer mix? - Has the firm made a major acquisition or divestiture? - Has the firm changed its methods of accounting over time? - Are there any unusual or nonrecurring amounts that impair a comparable analysis of financial results across?

Reasons of debt ratios

- How much debt company is using to finance its assets relative to the value of 1. total capital or 2. shareholders equity - Ratio can range, 0.5 to 3, depending on how capital intensive a Company is. More capital asset needs, often higher debt. - Would need to consider industry/ competitors - If no debt, clearly value is 0, which is usually very good. - Lower tends to be better, but not always holds true.

Current Ratio

- It indicates the amount of cash available and other current assets of the firm, relative to obligations coming due (1 year) - how well a company can pay off current debt

Debt Ratios

- It is used to measure the amount of liabilities, particularly long-term debt in a firm's capital structure. - The higher this proportion, the greater the long-term solvency risk.

Common Ratios: Solvency and Financial Flexibility

- Liabilities to assets - Liabilities to shareholders equity - Debt to equity - Interest coverage ratio (goes by many names, such as "times interest earned") - Operating cash flow to XXX (same as liquidity, except long term items) - Free cash flows - Effective borrowing rate - Tangible book value

Financial flexibility is composed of

- financial position (liquidity, solvency) - Profitability/ Cash flows

Investors perspective

- investors don't see debt as bad necessarily, as long as its not too much and the good kind: - Don't want to see it be too large on the balance sheet, too costly (high interest rate) or too much of a drain on otherwise available cash flow.

Financial Position, Common Approach: typically broken into two components

1) Liquidity (Near term) −"Static"- Balance sheet is "As of" so as of this moment in time −Near-term/ current assets 2) Solvency (Longer term) −Substantially "Static" −Longer-term/ LT assets −Begins to incorporate some future elements

Commonly used measures of Debt Ratios:

1) Total Capital: Long-term Debt to Long-term Capital Ratio 2) Leverage: Long-term Debt to Shareholders Equity Ratio Total amount of LT debt divided by all 1. capital (debt and equity) or 2. shareholders equity

What can you do with the balance sheet: investors approach

1.Evaluate the tangible book value of a company - Tangible BV = Total Assets - Intangibles - Goodwill - Total liabilities 2.Divide the tangible book value by the basic or diluted shares to estimate the tangible book value PER SHARE = TBV / # shares outstanding

Quick Ratio formula

= (cash and cash equivalents + all marketable securities) / current liabilities

Marketable securities

are assets that can be liquidated to cash quickly. These short-term liquid securities can be bought or sold on a public stock exchange or a public bond exchange. These securities tend to mature in a year or less and can be either debt or equity.

Current ratio formula

current assets / current liabilities

Operating cash flow to current liabilities formula

operating cash flows (SOCF) / avg current liabilities (B/S)

Quick Ratio

−Also called as Acid Test Ratio. −Includes only those current assets the firm could convert quickly into the cash (e.g., Cash, Marketable securities and Receivables). - quick usually means 90 days

Long-Term Liquidity Risk: Interest coverage ratio

−It indicates the number of times a firm's income or cash flows could cover interest charges. EBIT/Interest expense EBIT- earnings before interest and tax or net income + Intrest expense + Income Tax

Analyzing Short Term Liquidity Risk

Measures a firm's ability to generate sufficient cash to supply operating working capital needs and to service debts. Short-term liquidity problems can arise from the following: −Untimed cash inflows and outflows. −High Degree of long-term leverage.

Long-Term Liquidity Risk: Operating cash flow to total liabilities ratio

OCF / Avg total liabilities - Considers the firm's ability to generate cash flow from operations to service "liabilities" - How long Company would be able to repay "liabilities" if devoted all of its cash flows to it. - The " _____" are used to fill in the blank for what you are comparing - Higher usually better - can easily pay off - Less than 1 is usually not good and may raise concerns

In what circumstance might you see company trading at something around book value/ share?

Often in valuations, when there is doubt about the company's ability to continue, you find the stock trading close to the NBV/ share