-> OBJ: evaluate the status of liquidity and its “coherence” to existing present obligations
- Short-Term Analysis: looking next years & sources are Balance Sheet and Cash Flow Statement.
- Assess the amount of money needed to sustain the operating cycle of a company (Working Capital Assessment).
- IDEA: evaluate the ability of the company to meet its financial obligations.
Connetc these number to the strategy.
RATIOS are used two different perspectives:
- ASSETS-LIABILITIES PERSPECTIVE, analysing “liquidity” items in the Balance Sheet;
- CASH FLOW PERSPECTIVE: analysing “liquidity” items in Cash Flow Statement.
-> Don’t use the financial statement, is the most important component of the profitability analysis (try to explain revenue and costs and the focus is on the cash flows of the cash affluss).
-> Talking about liquidity there’re no golden rules;
-> Remember that:
- Not all the ratios have the same relevance;
- Ratios pose questions more than providing answers;
Balance Sheet Perspective:
NWC, Working Capital
-> DEF NWC, Net Working Capital: amount of money needed (generated) during the working capital cycle.
- 📌There is not a global recognise definition.
Net Working Capital = Current Assets – Current Liabilities;
- CURRENT ASSETS: Al the current assets became cash in the next 12 months;
- CURRENT LIABILITIES: obbligations that will be due in the next 12 months;
-> IDEA: the current assets will be enought to pay for liabilities that will cash out in the next 12 months.
-> The ratio is 0 (there’re NOT enought cash to cover obbligations)
-> EXTREME: C.A. became cash in december and C.L. due in jennuary => the difference is positive, but consider that wouldn’t in jennuary.
NOWC, Net Operative Working Capital:
-> HP: company don’t have much cash, becasue is expensive & we should invest it (not keeping it unused).
Net Operative Working Capital = Receivables + Inventory – Payables.
- PAYABLES (Current Assets): include the payments of purchases in the next 12 monts;
- INVENTORIES & RECEIVABLES (Non Current Assets): are cash to pay this year.
-> Current Inventories & Receivables are cash that will be paid in the next 12 months.
-> Should be more than 0.
-> IMPORTANT: used to compute net cash flow.
-> Start-Up: 🔺 Receivables & Inventories, 🔻Payables: during first year have to pay suppliers, but no one pay you. This indicator looks at the next year.
Ratios
-> DEF: They measure what extent company’s current asset are readily available to pay off its current liabilities.
Current Ratio:
-> We use CR when we don’t know if the inventories will become value.
-> We want that is more than 1: current assets cover the current liabilities;
Quick Ratio (Test Acido):
-> IDEA: consider only those assets that have high probability to became cash (is prudent);
-> Used when we are sure that inventories will become value.
- Lower than the first;
- N = Current Assets – Inventories.
-> Industries in which QR is preferred:
- Elettronic goods: the obsolescence of the products is very high;
- Fashion goods: value of some products decreases very fast, every season is a new collection.
- Highly perishable goods.
Inventory Turnover Ratio:
-> Turnover => inventory are rotating in order to generate revenue
- Efficiency ratio: capability of maximizing the output (Revenues) and minimizing the input (Inventories).
-> CHAR:
- Zero inventories or toyota approach (JIT);
- Should be high, with a small # of inventories => is difficult to produce revenue;
- Avoid the stock out.
- Used when inventories are big part of current assets.
-> Dynamics:
- Improving => company became more efficient;
- Decreasing => company could enter in a new market.
DSO, Days Sales Outstanding:
-> DEF: average period that customers take to pay the receivables (in days).
- PURCHASES: products & services from supplier.
-> Connects supplyer to the company;
-> Difficult to compute: company not always report purchases.
⚠ COGS are NOT Purchases!!! COGS have the salaries, deprezation and other items that are different from purchases.
-> Important
- Monitor all the time;
- Students are not able to calculate these numbers. Purchases are missing in the most of the sheet.(fell free to search these numbers on internet).
❓Should be DSO lower or higher than the DPO?
- 👀 Porter’s Value Chain: the main idea is that the company should have a low DSO and a high DPO because this allows to increase the bargaining power along the value chain to gain the most. This is true is we look at players in the same value chain.
- 👀 Competition between Value Chains: it’s my value chain against competitors’ value chains. The more we fight within our value chain, the more competitors gain.
-> E.g. For example, a big company could decide to have a high DSO to allow small distributors to survive during the financial crisis (by allow them to have more liquidity to pay employees, etc.). If the suppliers are in a moment of crisis, we should reduce the DPO.
-> We act like a bank in a certain way (bankeffect: the leader provides money and liquidity along the value chain).
-> We need to protect our value chain! So, the strategy related to DSO and DPO should consider also the value chain.
=> DPO and DSO are relevant to manage the bargaining power but also the capability of the supply chain to survive over time.
Cash Flow Perspective:
Cash Flow-to-Debt Ratio:
- Not always the higher is the better!
- Operating Cash Flow: is a measure of the amount of cash generated by a company’s normal business operations.
⚠Considers cash in and out of financial & fiscal activities (taxes and interests), it’s different from EBIT.
- Debt Liabilities: bank debts + bonds (current or non current) = financial liabilities;
-> INVERSE=> Numbers of years needed to (self) generate sufficient cash to pay back financial liabilities.
Analize the numerator and the denominator by its self, because, for example…
-> If DL are low could means:
- Company is not renewing/ investing enought;
- Company pay back a lot of her debts
Short-Term Debt Coverage:
-> MEASURES if the company generate enought value to pay the short term obbligations
-> FOCUS: on the short term;
-> It’s more than 1: we want the cash flow from operating activities to be enough to pay back the money to the short term (due within the next year).
Capital Expenditure Coverage
-> CAPEX (Cash Flow): installments that company pay for install assets.
- Not the value of the assets!!!
- CAPEX in Cash Flow is with minus => We have to take it positive.
-> INVERSE: are NOT the number of years to pay the assets, is true only if the company is paing one asset.
CF from INVESTING ACTIVITIES:
- Cash out flow = CAPEX;
- Cash in flow = disposal of assets (when the comany is selling the asset) not frequently.
=> Usually this voices is negative
=> We have to generate as much as possible Cash Flow from CF from OPERATED ACTIVITIES, otherway we have to ask money to shareholders and banks.
🔗BCG Matrix (ASSUMPTION: company can NOT ask money to bank or shareholders);
-> Negative value -> when N is negative (CAPEX couldn’t be) => the return on equity is negative,
❓Why it is negative? That is the important question when when we have negative CAPEX Coverage, because it is suppose to be always positive!
Liquidity Matrix:
-> Not to much useful.
ORIZONTAL axes: short-term liquidity perspective,
- Capability of company to meet the financial obbligation in the next 12 months;
- CURRENT
VERTICAL axes: long-term liquidity perspective,
- Meet the financial obbligation over the next 12 months (10 years).
- NON CURRENT
- 0.1 company generate enought cash to pay banks and bound holders;
Happy face: very good liquidity both in the long and in the short term.
Ban area: not able to meet obligations neither in the long nor in the short term.
Lightning: no problem in the short term, but could have problem in the future.
Cloudy: able to meet obligations in the long term, not sure in the short term.
Absolute Indicators:
-> DEF: indicators between profitability and liquidity also connected to value-based indicators;
- Residual Income;
- Cash flow ROI;
RI, Resdual Income:
-> DEF: net operating income minus the return expected by stakeholders and debtholders (WACC: Weighted Average Cost of Capital)
- Can be used to benchmark companies ONLY if they’ve similar size (size = revenues, being an absolute indicator);
- Does not consider taxes;
- Should be more than 0 because we need to pay taxes.
RESIDUAL INCOME (RI) = EBIT – K* INVESTED CAPITAL
Where:
- K = WACC = cost of capital of the company considering the cost of equity (shareholders) and the cost of banks debts;
- Invested Capital = E + Financial Liabilities;
- Residual Income = what remains of the EBIT once we pay shareholders and banks.
-> Tells us the amount of money that remains to the company after banks and shareholders have been paied;
📌SIZE:
- Revenue;
- Employee;
-> Company has the right to exist until ROI > WACC (because invest to see a return that should be able to pay banks and shareholders, creating money):
ROI = EBIT / invested Capital > WACC
| RI = EBIT – WACC * I > 0 | ROI = (EBIT/I) > WACC |
| Confident about future (not exclude future investments); | Foggy situation (we’ll grow with small investments); Not liquidity, no stability; |
-> ROI is a ration and RI it’sn’t => Different indicators show different alternatives.
❓Why should we use: RI or ROI? Consider this situation:
| AS IS | Opportunity | MIGHT BE |
| TARGET ROI = 18% WACC = 10% | TARGET ROI = 18% WACC = 10% | |
| I = 1000 EBIT = 200 | I = 1000 EBIT = 150 | I = 2000 EBIT = 350 |
| ROI = 20% RI = 100 | ROI = 17.5% RI = 100 |
-> If we use as a decision criterion the ROI, we wouldn’t make the investment. Instead, if we look at the RI we would do it -> Conflict.
-> RI prefers very large investments being an absolute indicator, so it prefers large investments able to generate EBIT.
-> ROI prefers smaller investments with a faster remuneration, being a ratio.
❓What should we do? Theory tells us to prefer RI, but large investments are risky. So, we should use it when a company is in a situation of “perfect information”, so the future is very predictable, we should use the RI because we can understand what will happen, so we are sure that the investment will be profitable.
CFROI, Cash Flow ROI:
-> DEF: Proxy of capability of the company to repay its resources and meet the expectations of both shareholders and debtholders.
- Cash Flow from Operating Activities = cash-in-flows – cash-out-flows;
- Market Value of Invested Capital or fair value (it’s the market value of the assets, not the real one).
-> Is the fair value, but we don’t know it!
-> CHAR:
- Intresting but not easily calculated;
- Used by CFOs (have all data);
- Should be higher than 1 (should be able to repay the average cost of capital).
-> Rappresent the # of years needed to self-generate the cash to purchase once again all the assets of the company.
- Proxy of capability of the company to repay its resources.
Altman’s Z Score:
Altman’s Z score: Try to predict the capability of a company to avoid bankruptcy;
| Z > 3 | => Solve situation, probability = 0; |
| Z<1.8 | => High probability of bankruptcy; |
| 1.8< Z < 3 | => Great zone |
-> B: Retained earnings < Liabilities < Balance Sheet
-> C: is ROA, 🔺ROA <=> 🔻bankruptcy
🔎ROA is the most important parameter -> Connection between liquidity and profitability.
