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What is Quality of Earnings and why is it important?
- Degree of Conservatism in the firm's reported earnings. Important Because -
- High earnings quality is considered less risky
- High earnings quality should result in higer P/E ratio
- Such firms are freqeuntly risk adverse
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Examples of Balance Sheet Quality Issues
- Charging off assets (operating leases)
- Hidden Liabilities (operating leases)
- Hidden Assets (Book value < market value, intangibles)
- Off balance sheet financing (operating leases, joint ventures)
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Examples of Earnings Management Tricks
- Timing store openings and asset sales in a way that keeps earnings growing smoothly.
- Capitalising normal OPEX in order to avoid reporting losses.
- Increasing reserves in good times and reducing them in bad times.
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Advantages of Financial Ratios
- Key points of information
- Serve as Size deflators
- Can compare different firms
- Establish a trend over time
- Comparable with Industry Averages
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Problems and Limitations of Ratio Analysis
- Defining an Industry
- Seasonality of operations may distort ratios
- Differences in accounting policies between firms
- Price level distort ratios
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Importance of Working Capital Management (WCM)
- WCM involes the administration of current assets and current liabilities
- Important for small firms who have limited access to long term capital markings
- Important to ensure an entity can meet its current obligations
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Definition: Current Assets
Current assets are turned over and at least partially replaced within the operating cycle of the firm.
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Equation: Operating Cycle
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Definition & Equation: Inventory Conversion Period
Definition: The time required to convert raw materials into finished goods and sell these goods.
Equation: 
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Definition & Equation: Inventory Conversion Period
- Definition: Time required to convert receivables into cash
- Equation:
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Equation and Definition:Payables Deferral Period
Definition: Time between the acquisition of raw materials and labour and the payment for them.
Equation:
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Equation and Definition: Cash Conversion Cycle
Definition: Period during which funds are tied up in current assets.
Equation:
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The Investment Decision
Determining the appropriate level of current assets
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The Financing Decision
- Determining how to finance the required level of current assets
- a)the proportion of short term/long term funds
- b)the mix of short term funds
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Three Sources of Financing
- Spontaneous: eg trade credits, wages payable
- Temporary: eg bank loans commercial bill
- Permanent: eg debentures, shares, term loan
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Principles of Working Capital Management
- As risk of associated working capital policy increases, associated profitability increases
- Increased Profitability results from - investing less in working capital but risk increases because of illiquidity, forgoing credit sales
- The firm should increase its investment until the cost of holding one more unit exceeds the benefit of one more unit
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Appropriate Levels of Working Capital
- Conservative: High C/A, lower profitability, lower risk
- Aggresive: Less C/A, higher profitability, higher risk
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The Hedging Principle
- Finance Short Term needs (temporary investment in C/A) with short term sources
- Finance Long Term needs (fixed asset, permanent investment) with long term sources
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Equation: Additional Financing Cost
(the cost of short term credit)
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Equation: AFC - Trade Credit
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6 Major Sources of unsecured Short-term Credit
- 1. Spontaneous financing - Trade Credit
- 2. Spontaneous Financing - Accrued wages, accrued taxes
- 3. Commercial Banks
- 4.Commercial Paper
- 5. bills of Exchange
- 6.Leasing
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Definition: Financial Analysis
The assessment of a firms past, present and anticipated future financial conditon
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Obejctives of Financial Analyst
- Assess the Liquidity of a firm
- Assess the utilisation of assets
- Assess the profitability of a firm
- Assess the firm's financing mix
- Examine the shareholders returns
- Assess the performance of management (via above)
- Predict other useful variables.
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Equation: Average Collection Period
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Equation: Inventory Turnover
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Equation: Fixed Asset Turnover
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Equation: Total Asset Turnover
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Equation: Debt to Equity Ratio
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Equation: Times interest Earned
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Equation: Fixed Charge Coverage
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Equation: Gross Profit margin
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Equation: Net Profit Margin
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Equation: P/E Ratio
(How much investors will pay for $1 of earnings. Higher is better. High if ROE is high, risk is low
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Equation: Market to book ratio
(How much paid for $1 of book value. higher is better)
High if ROE is high, risk is low
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Equation: Market Value Added
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Equation: Economic Value Added
- r = return on total capital eat/total capital
- k = weighted after tax cost of capital
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Common Size balance Sheet
Common Size balance sheet shows assets, liabilities and equity as a percentage of total assets
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Common Size Income Statement
Common Size Income Statement shows income and expense items as a percentage of total sales
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