FIN 345 1st Edition Lecture 9Outline of Current Lecture1. How do investors use financial statements?a. Working/operating capitali. Short term financingii. Short term investingiii. Net working capitalb. Operating cash flows, Free cash flow, economic value added (EVA)2. Ratio Analysisa. Objective is to anticipate future financial conditionsb. Starting point for planning future actionsc. Liquid asseti. An asset that can be easily converted into cash without significant loss of its original valued. Liquidity ratiosi. Ratios that relate the firms cash and other assets to its current liabilitiesii. Indicate how well a firm can meet its current obligationse. Current ratioi. Indicates the extent to which current liabilities are covered by assets expected to be converted into cash in the near future. Current ratio=current assets/current liabilitiesf. Quick ratioi. Deducts inventories from current assets and divides the remainder by current liabilitiesg. Asset management ratiosi. Ratios that measure how effectively a firm is managing its assetsii. Inventory turnover=cost of goods sold/inventory=variable operating costs/inventoryiii. Days sales outstanding = receivables/average sales per day=receivables/(annual sales/360)iv. Fixed assets turnover ratio = sales/net fixed assets (how efficiently is thefirm using fixed assets)v. Total assets turnover ratio=sales/total assetsh. Debt management ratiosi. Analyze the company’s use of debtii. Financial leverage: the use of debt financingiii. Debt ratio: total liabilities/total assetsThese notes represent a detailed interpretation of the professor’s lecture. GradeBuddy is best used as a supplement to your own notes, not as a substitute.iv. Times-interest-earned ratio: EBIT/interest chargesv. Fixed charge coverage ratiovi. Profitability ratios:1. Ratios showing the effect of liquidity, asset management, and debt management on operating resultsvii. Net profit margin on sales=net profit/salesviii. Return on total assets: net income/total assetsix. Return on common equity: net income available to common stockholders/total assetsi. Market value ratiosi. Ratios that relate the firms stock price to its earnings and book value per sharej. Ratio analysisi. Trend analysis: an analysis of the firms financial ratios over time, used to determine whether a firms financial position is improving or notii. The Du Pont Analysis:1. An analysis designed to show the relationships among return on investment, asset turnover, the profit margin, and leverage2. ROA=Net profit margin x Total assets turnoveriii. Comparative ratio analysis (benchmarking)1. An analysis based on a comparison of a firms ratios with those ofother firms in the same industry at a particular point in timeiv. Uses and limitations:1. Large firms operate divisions in different industries so its difficultto develop meaningful industry averages2. If the goal is to be better than average, industry averages are not the target3. Inflation distorts balance sheets4. Seasonal factors distort ratios5. Window dressing techniquesa. Make financial statements appear better than they are; borrowing “long-term” to be repaid quickly distorts ratios6. Different accounting practices7. Difficult to generalize about good or bad ratios8. Firm may have some good ratios and others that look bad9. **The most important and most difficult part of effective ratio analysis is the judgment that must be used to reach conclusions about a firms financial