Balance sheet Company has invested in what kind of assets and how much What portion comes from

om creditors What portion comes from owners How efficiently company is utilizing its assets and managing its liabilities Accountants use historical data Assets Current assets Fixed assets Goodwill Liabilities Current liabilities Long term liabilities Owners equity Retained earnings profit after payment of dividends Contributed capital or paid-in capital capital received in exchange for shares Net Working capital Current assets current liabilities Too little bad position bcoz it may be unable to pay its bills or take advantage of profitable opportunities Too much reduces profitability since that capital must be financed in some way, usually through interest-bearing loans Inventory Plenty of inventory solves business problems as customers demand met without any delay Every piece need to be financed Its market value reduces while it sits on the shelf Financial leverage
Use of borrowed money to acquire an asset Highly leveraged means company having high percentage of debts in B/S For example, suppose that you paid $400,000 for an asset, using $100,000 of your own money and $300,000 in borrowed funds. For simplicity, well ignore loan payments, taxes, and any cash flow you might get from the investment. Four years go by, and your asset has appreciated to $500,000. Now you decide to sell. After paying of the $300,000 loan, you end up with $200,000 in your pocket

your original$100,000 plus a $100,000 profit. Th ats a gain of 100% on your personal capital, even though the asset increased in value by only 25%. Financial leverage made this possible. If you had financed the purchase entirely with your own funds ($400,000), you would have ended up with only a 25% gain.

Operating leverage Companys operating costs are fixed rather than variable, eg, high investment in machinery with few workers high operating leverage

CFS
Shows the relationship between net profit and the actual change in cash that appears in the companys bank accounts. Like depreciation is added to net profit if you are interested in change in cash.

Ratio analysis
Profitability ratios
1. ROA measures how well the company is using its assets to generate profit. It is a good measure to compare companies of different sizes. If ROA is shrinking, sayif costs are growing relative to salessenior executives will probably begin looking for cuts. Theyll ask managers to tighten their budgets, maybe even to delay hiring where possible. A growing ROA or ROS, by contrast, may put the senior team in a more expansive mood. Thats the best time to consider asking for a more generous budget, a new position in your department, or a new piece of capital equipment. ROA = Net profit / Average assets 2. ROE shows profit as a percentage of share equity. It is the owners return on their investment which they compare it with other alternatives if investments. ROE = Net Profit / Owners equity 3. Net Profit Margin measures how well a company is controlling its cost to turning its revenue into bottom-line profit. NP margin = Net profit / Sales Revenue 4. GP Margin measures how efficiently a company is producing its goods or deliver services by taking only direct cost into account. GP Margin = GP / Sales Revenue 5. EBIT Margin or Operating Margin shows how profitable a companys overall operations are, without regard to how they are financed or what taxes the company may be liable for. If its EBIT margin is higher than competitors, it may be more efficient than others in its operating processes.

EBIT Margin = EBIT / Sales Revenue

Operating Ratios
1. Asset turnover ratio shows how efficiently a company uses its assets to generate revenue. The higher the number, the better but it can be raised either by generating more revenue with the same assets or by decreasing the asset base of your business, by lowering the average receivables. ATR = Sales revenue / total assets 2. Receivable days (DSO) tells you how quickly a company collect funds owed by customer. DSO = accounts receivable on the last day of the month / revenue per day during the period The longer a companys DSO, the more WC is required to run the business. Managing DSO : o Quality problems and late deliveries often provoke late payments. o Manager should know about the financial health of customer. o Managers should know whether the credit terms offered are good for company. o Whether company is giving credit easily or it is too tough in its credit policies. o There is always a trade-off between increasing sales and issuing credit to poorer credit risks.

3. Days payable (DPO) tells you how quickly a company pay to its suppliers. The longer it takes the more cash a company has to work with. DPO = ending accounts payable / COGS per day 4. Days in inventory (DII) shows how a quickly a company sells its inventory during a given period of time. The longer it takes, the longer the companys cash is tied up and greater the likelihood that the inventory will not sell at full value. Inventory days = average inventory / COGS per day Managing inventory : o They use Lean manufacturing, JIT inventory and EOQ to reduce inventory, which reduces WC requirements by freeing up large amounts of cash. o They need to replenish their stock regularly to avoid the dread stock out. o Inventory can be regarded as frozen cash as cash cant be used for any other purpose. o Different managers can help in reduce inventory: Sales selling more of standard products with limited variations require fewer inventories. Engineers proliferation of products puts burden on inventory management. When product line is simple with a few interchangeable options, inventory declines.

Production frequent breakdowns require the company to carry more WIP and FG inventory. A well designed production flow in an efficient plant minimizes the need for inventory.

Liquidity ratios tells you about a companys ability to meet short term obligations such as debt payments, accounts payable and payroll.
1. Current ratio measures a companys current asset against current liabilities. A ratio of less than 1 is a sign of trouble. A ratio higher than industry averages may indicate that it is holding a lot of cash that it is not putting to work or returning to shareholders in the form of dividends. CR = Total CA / Total CL 2. Quick ratio or Acid test measures a companys ability to meet its current obligations quickly. It thus ignore inventory, which can be hard to liquidate. If it is less than 1, then company may be unable to pay its bills. QR = CR-inventory/ CL

Leverage Ratios - tell you to what extent a company is using debt to pay for its operations and how easily it can cover the cost of that debt.
1. Interest coverage - assesses the margin of safety on a companys debt in other words, how its profit compares to its interest payments during a given period. Nobody likes to lend money to a company if its profits arent substantially higher than its interest obligations. Interest coverage = EBIT / Interest expense 2. Debt to equity - shows the extent to which a company is using borrowed m o n e y t o e n h a n c e t h e r e t u r n o n o w n e r s equity. Investors and lenders scrutinize the ratio to determine whether a company is too highly leveraged (usually compared to industry averages)or whether, in contrast, management has been too conservative and isnt using enough debt to generate profits. If your firms debt-to-equity ratio is higher than average, for example, the company may be particularly vulnerable to adown turn in the industry. Debt to equity = total liabilities / owners equity

Other financial assessments

Valuation process of determining the total value of a company for the purpose of selling it. It can be on the basis of physical assets, future cash flows, in the form of unique technology or engineering talent, stock prices, etc. o EPS = Net income / number of outstanding shares If it falls, it will most likely take the stocks price down with it. o Price-to-earnings ratio (P/E) = current price of a share of stock / EPS

It is a measure of how cheap or expensive a share is relative to the companys earnings. o Growth indicators growth allows a company to provide increasing returns to its shareholders. The number of years over which you should measure growth depends on the industrys business cycle. For e.g., for an oil company, a one-year growth figure probably wouldnt tell you much because of the industrys long cycles. Measures sales growth, profitability growth and growth in EPS. Economic Value Added (EVA) focuses on the net value a company creates. EVA is the profit remaining after the company has accounted for the cost of its capital. If profit is less than its cost of capital i.e. EVA is negative the company is essentially destroying its value. Productivity measures - Sales per employee and net income per employee link revenue and p r o f i t - g e n e r a t i o n i n f o r m a t i o n t o w o r k f o r c e data. Trend lines in these numbers help you see whether a company is becoming more or less productive over time

Return on Invested Capital (ROIC)

= earnings interest expense / (total assets cash non- interest-bearing current liabilities) Effective customer centric supply chain management techniques can improve ROIC. Companies can either increase their earnings or reduce the assets to improve ROIC. Supply chain management in customer-focused decisions: o Cut some low-volume or unprofitable products that will bring efficiency and reduced our inventory. o Removing the channels that are relatively unprofitable. o Extended warranty and maintenance agreement for our customers.

Return on Investment (ROI)

It includes terms like Breakeven, IRR and Discounted Cash flows. It enables the comparison between two business alternatives.

Profit is not equal to cash

Profit is not equal to cash shown in CFS because cash may be coming from loans or from investors, and even operating cash flow is also not equal to net profit because: 1. Sales revenue is recorded at the time of delivery but no cash has changed hands. 2. Expenses may not be paid at the time when it is due. 3. Capital expenditure like machinery is not recorded in income statement but its depreciation is recorded. Cash transaction is recorded in CFS. All these are the reasons because of which Net profit in income statement and net cash in CFS differs. If a company is profitable but short of cash, then it needs the financial assistance for lining up additional financing.

If a company has cash but is unprofitable, it needs operation assistance for bringing down the costs or generating additional revenue without adding costs.

So financial statements tell you not only what is going on in the company but also what kind of expertise you need to hire. Taking decisions at right time is also very important. For example if it is known to us that we will be having cash in next quarter then we can take decision of buying equipment in next quarter become easier and profitable also. Therefore, cash and profit are different but for a healthy business both are required.

Why cash matters?

Reasons to understand CFS: 1. It will help you see what is going on now, where the business is headed, and what senior managements priorities are likely to be. a. Where the cash is coming from i. Either from regular business or from investors. b. Are we paying off the loans c. Are we buying equipment 2. Managers should focus on both profit and cash. a. Factors like customers satisfaction will tell us how fast they are likely to pay their bills. b. Managing inventory avoid having lots in stock. c. Take into account the expenses you made. d. Credit balance need to be carefully recorded. Case study on WC Model: Case Facts o Customers pay you before production. o Company have negative WC. Cash received from customers is a liability as delivery of goods is still left. So modest CA and large CL gives you negative WC. o Due to the advent of digital media, company is losing subscribers. o CA Inventory = 4 days and DSO = 33 days o CL Accounts payable = 70 days and unearned subscription = 39 days o Net = 37-109 = -72 days o This 72 days worth of customer cash can be used for other purposes like paying bills. o Company is financed by the customers cash, so no need of investors.