Download Liquidity ratios

Module 10
Long-term planning
You start this module by learning the use of financial statement
ratios for long- and short-term trend identification. As long-term
objectives involve assessing strategic advantage, this module looks
at how to assess strategic advantages. Treasury risk management and
mergers and acquisitions are touched on briefly. Finally, you apply
ethical reasoning to typical business scenarios.
Ratio analysis
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Liquidity ratios
current assets
 current ratio =
current liabilities

acid test or quick ratio =
current assets – inventory
current liabilities

inventory turnover = cost of goods sold
average inventory
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Liquidity ratios
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average collection period =
receivables turnover ratio =
receivables
average daily credit sales
annual credit sales
receivables
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Leverage ratios
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long-term debt
debt-to-equity =
shareholders’ equity
total debt-to-assets =
total debt
total tangible assets
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Coverage ratios
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times-interest-earned =
earnings before interest and taxes
interest charges

fixed-charges-coverage =
earnings before interest and taxes
interest charges
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Profitability and activity ratios

gross operating margin =
sales – cost of goods sold
sales

net operating margin =
earnings before interest and taxes
sales

sales
asset turnover =
total assets
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Profitability and activity ratios

earnings power =
earnings before interest and taxes
total assets

return on common equity =
earnings after taxes  preferred dividends
net worth  preferred shares

Market-value ratios
 price-earnings ratio =
price per common share
earnings per common share

Tobin’s q ratio =
market value of debt and equity securities
replacement cost of assets

market-to-book ratio =
market value of debt and equity securities
book value of assets
Elements in the financial planning process
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A major tool in the financial planning process is the
preparation of pro forma financial statements.
Preparation of pro forma financial statements:
 develop estimates of future operating and
financial data, such as sales and interest rates
 aggregate current short-term planning tools, such
as cash budgets, into annual data
 weigh the effect of future strategic choices on the
firm’s financial position, including capital
budgeting opportunities, capital structure
changes, and dividend policy
Preparation of a long-term financial plan
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Formulate a statement of strategic, operating, and
financial objectives.
Prepare a list of underlying assumptions describing
the expected business and economic environment.
Assess the current and new projects.
Prepare pro forma financial statements.
Analyze the pro forma statements for feasibility and
consistency.
Assess the sensitivity of the plan to the future
business environment.
Developing a strategic plan
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The first step is to develop an understanding of the
current situation as a baseline for planning.
Planning next requires a forecast of macroeconomic
conditions and an analysis of the strengths and
weaknesses of the company in terms of the
conditions.
Timing is an essential element of planning.
Financial policies can be built into the plan.
Marketing strategy must be part of the plan.
A strategic plan will involve tradeoffs.
Fundamentals of treasury risk management

Three fundamental risks are assessed and
controlled:
 interest rate risk
 foreign-exchange rate risk
 commodity price risk
…continued
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Approaches to measuring risk include
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Gap analysis — assets and liabilities are
classified as either rate sensitive or not. Then, the
difference between the rate-sensitive assets and
liabilities is minimized.
Volatility analysis — this is the change in the
present value of an asset or liability as a result of
changes in the financial variable.
…continued

There are four approaches to treasury risk
management:
Opportunistic  takes advantage of changes
through transaction timing
 Passive — does nothing and rides out the
changes
 Defensive — limits exposure using hedging
techniques
 Benchmarking — combines defensive and
opportunistic approaches

Mergers and acquisitions
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Motives include
 synergy
 changes in management
 market control
 raw material control
 economies of scale
 tax considerations
 fast growth
In assessing potential mergers and acquisitions, both
quantitative (business valuation, capital budgeting
approach) and qualitative analyses are needed.
Presentation complete!