Financial Reporting and Analysis – Dr.

Michael Lee

CLASS 4

LIQUIDITY, LEVERAGE AND OPERATING EFFICIENCY

Learning Objectives

• Explain the objectives of analysing financial statements

• Describe the sources of information used to analyse financial statements
• Describe the tools and techniques used to analyse the financial statements
• Compute and evaluate key financial ratios for assessing liquidity, leverage and operating efficiency

Objective of Analysis
Before analysing any firm’s financial statements, it is necessary to specify the objectives of the analysis.

A creditor is ultimately concerned with the ability of an existing or prospective borrower to make interest
and principal payments on borrowed funds. The questions raised in a credit analysis should include:
• What is the purpose of the borrowing?
• What is the firm’s capital structure? How much debt is currently outstanding? How well has debt
been serviced in the past?
• What will be the source of debt repayment? How well does the company manage working
capital? Is the firm generating cash from operations?

The investor attempts to arrive at an estimation of a company’s future earnings stream in order to attach a
value to the securities being considered for purchase or liquidation. Questions raised include:
• What is the company’s performance record, and what are the future expectations?
• What is its record with regard to growth and stability of earnings? Of cash flow from operations?
• How much risk is inherent in the firm’s existing capital structure? What are the expected returns,
given the firm’s current condition and future outlook?
• How successfully does the firm compete in its industry? How well positioned is the company to
hold or improve its competitive position?

The investment analyst also uses historical financial statement data to forecast the future with the
ultimate objective of determining whether the investment is sound.

Management analyse the financial statement data to determine:

• How well has the firm performed and why?
• What operating areas have contributed to success and which have not?
• What are the strengths and weaknesses of the company’s financial position?
• What changes should be implemented to improve future performance?

Steps of a Financial Statement Analysis

1. Establish objectives of the analysis
2. Study the industry in which the firm operates and relate industry climate to current and projected
economic developments.
3. Develop knowledge of the firm and the quality of management.
4. Evaluate financial statements.
a. Tools: common-sized financial statements, key financial ratios, trend analysis, structural
analysis, and comparison with industry competitors.
b. Major areas: short-term liquidity, operating efficiency, capital structure and long-term
solvency, profitability, market ratios, segment analysis (when relevant), and quality of
financial reporting.
5. Summarise findings based on analysis and reach conclusions about the firm relevant to the
established objectives.

1
 Financial Reporting and Analysis – Dr. Michael Lee

Summary of Financial Ratios

2
 Financial Reporting and Analysis – Dr. Michael Lee

Short-run Solvency
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑎𝑠𝑠𝑒𝑡𝑠
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑅𝑎𝑡𝑖𝑜 =
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠

The current ratio is a commonly used measure of short-run solvency, the ability of a firm to meet its debt
requirements as they come due. Note that some analysts eliminate prepaid expenses from the
numerator because they are not a potential source of cash, rather they represent future obligations that
have already been satisfied.

𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑎𝑠𝑠𝑒𝑡𝑠 − 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦

𝑄𝑢𝑖𝑐𝑘 𝑜𝑟 𝐴𝑐𝑖𝑑 − 𝑇𝑒𝑠𝑡 𝑅𝑎𝑡𝑖𝑜 =
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠

The quick or acid-test ratio is a more rigorous test of short-run solvency than the current ratio because the
numerator eliminates inventory, considered the least liquid current asset and the most likely source of
losses. Some analysts eliminate prepaid expenses and supplies (if carried as a separate item) from the
numerator.

𝐶𝑎𝑠ℎ + 𝑀𝑎𝑟𝑘𝑒𝑡𝑎𝑏𝑙𝑒 𝑠𝑒𝑐𝑢𝑟𝑖𝑡𝑖𝑒𝑠 + 𝑐𝑎𝑠ℎ 𝑓𝑙𝑜𝑤 𝑓𝑟𝑜𝑚 𝑜𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑎𝑐𝑡𝑖𝑣𝑖𝑡𝑖𝑒𝑠

𝐶𝑎𝑠ℎ 𝐹𝑙𝑜𝑤 𝐿𝑖𝑞𝑢𝑖𝑑𝑖𝑡𝑦 𝑅𝑎𝑡𝑖𝑜 =
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠

This ratio is an approximation of cash resources, cash and marketable securities, which are truly liquid
current assets and cash flow from operating activities, which represents the amount of cash generated
from the firm’s operations, such as the ability to sell inventory and collect the cash.

Liquidity of Current Assets

𝑁𝑒𝑡 𝑎𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑟𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐶𝑜𝑙𝑙𝑒𝑐𝑡𝑖𝑜𝑛 𝑃𝑒𝑟𝑖𝑜𝑑 =
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑑𝑎𝑖𝑙𝑦 𝑠𝑎𝑙𝑒𝑠

The average collection period of accounts receivable is the average number of days required to convert
receivables into cash. The ratio is calculated as the relationship between net accounts receivable (net of
the allowance for doubtful accounts) and average daily sales (sales/365 days). Where available, the
figure for credit sales can be substituted for net sales because credit sales produce the receivables.

𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦
𝐷𝑎𝑦𝑠 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝐻𝑒𝑙𝑑 =
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑑𝑎𝑖𝑙𝑦 𝑐𝑜𝑠𝑡 𝑜𝑓 𝑠𝑎𝑙𝑒𝑠

The days inventory held is the average number of days it takes to sell inventory to customers. The ratio
measures the efficiency of the firm in managing its inventory. Generally, a low number of days inventory
held is a sign of efficient management, the faster inventory sells, the fewer funds tied up in inventory. On
the other hand, too low a number could indicate understocking and lost orders, a decrease in prices, a
shortage of materials, or more sales than planned. A high number of days inventory held could be the
result of carrying too much inventory or stocking inventory that is obsolete, slow-moving, or inferior;
however, there may be legitimate reasons to stockpile inventory, such as increased demand, expansion
and opening of new retail stores, or an expected strike. The type of industry is important in assessing
days inventory held (florists vs. homes).

3
 Financial Reporting and Analysis – Dr. Michael Lee

𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑝𝑎𝑦𝑎𝑏𝑙𝑒
𝐷𝑎𝑦𝑠 𝑃𝑎𝑦𝑎𝑏𝑙𝑒 𝑂𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔 =
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑑𝑎𝑖𝑙𝑦 𝑐𝑜𝑠𝑡 𝑜𝑓 𝑠𝑎𝑙𝑒𝑠

The days payable outstanding is the average number of days it takes to pay payables in cash. This ratio
offers insight into a firm’s pattern of payments to suppliers. Delaying payment for payables may be
desirable if the firm is meeting terms required by the supplier and can earn a return on cash held.

𝐶𝑎𝑠ℎ 𝑐𝑜𝑛𝑣𝑒𝑟𝑠𝑖𝑜𝑛 𝑐𝑦𝑐𝑙𝑒 = 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑐𝑜𝑙𝑙𝑒𝑐𝑡𝑖𝑜𝑛 𝑝𝑒𝑟𝑖𝑜𝑑 + 𝐷𝑎𝑦𝑠 𝑖𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 ℎ𝑒𝑙𝑑 − 𝐷𝑎𝑦𝑠 𝑝𝑎𝑦𝑎𝑏𝑙𝑒 𝑜𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔

The cash conversion cycle or net trade cycle is the normal operating cycle of a firm that consists of buying
or manufacturing inventory, with some purchases on credit and the creation of accounts payable; selling
inventory, with some sales on credit and the creation of accounts receivable; and collecting cash. The
cash conversion cycle helps the analyst understand why cash flow generation has improved or
deteriorated by analysing the key balance sheet accounts that affect cash flow from operating activities.

Amount of Debt
𝑇𝑜𝑡𝑎𝑙 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠
𝐷𝑒𝑏𝑡 𝑅𝑎𝑡𝑖𝑜 =
𝑇𝑜𝑡𝑎𝑙 𝑎𝑠𝑠𝑒𝑡𝑠

𝑇𝑜𝑡𝑎𝑙 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠
𝐷𝑒𝑏𝑡 𝑡𝑜 𝐸𝑞𝑢𝑖𝑡𝑦 =
𝑆𝑡𝑜𝑐𝑘ℎ𝑜𝑙𝑑𝑒𝑟𝑠 ′ 𝑒𝑞𝑢𝑖𝑡𝑦

𝐿𝑜𝑛𝑔 𝑡𝑒𝑟𝑚 𝑑𝑒𝑏𝑡

𝐿𝑜𝑛𝑔 𝑡𝑒𝑟𝑚 𝐷𝑒𝑏𝑡 𝑡𝑜 𝑇𝑜𝑡𝑎𝑙 𝐶𝑎𝑝𝑖𝑡𝑎𝑙𝑖𝑠𝑎𝑡𝑖𝑜𝑛 =
𝐿𝑜𝑛𝑔 𝑡𝑒𝑟𝑚 𝑑𝑒𝑏𝑡 + 𝑆𝑡𝑜𝑐𝑘ℎ𝑜𝑙𝑑𝑒𝑟𝑠 ′ 𝑒𝑞𝑢𝑖𝑡𝑦

Each of these three debt ratios measures the extent of the firm’s financing with debt. The amount and
proportion of debt in a firm’s capital structure is extremely important to the financial analyst because of
the trade-off between risk and return. Use of debt involves risk because debt carries a fixed commitment
in the form of interest charges and principal repayment. Failure to satisfy the fixed charges associated
with debt will ultimately result in bankruptcy. A lesser risk is that a firm with too much debt has difficulty
obtaining additional debt financing when needed or finds that credit is available only at extremely high
rates of interest. Although debt implies risk, it also introduces the potential for increased benefits to the
firm’s owners. When debt is used successfully, if operating earnings are more than sufficient to cover the
fixed charges associated with debt, the returns to shareholders are magnified through financial leverage.

The debt ratio considers the proportion of all assets that are financed with debt.

The debt to equity ratio measures the riskiness of the firm’s capital structure in terms of the relationship
between the funds supplied by creditors (debt) and investors (equity).

The ratio of long-term debt to total capitalisation reveals the extent to which long-term debt is used for the
firm’s permanent financing (both long-term debt and equity).

The higher the proportion of debt, the greater is the degree of risk because creditor must be satisfied
before owners in the event of bankruptcy. The equity base provides a cushion of protection for the
suppliers of debt.

4
 Financial Reporting and Analysis – Dr. Michael Lee

Coverage of Debt
𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑝𝑟𝑜𝑓𝑖𝑡
𝑇𝑖𝑚𝑒𝑠 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝐸𝑎𝑟𝑛𝑒𝑑 =
𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑒𝑥𝑝𝑒𝑛𝑠𝑒

𝐶𝐹𝑂 + 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑝𝑎𝑖𝑑 + 𝑇𝑎𝑥𝑒𝑠 𝑝𝑎𝑖𝑑

𝐶𝑎𝑠ℎ 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝐶𝑜𝑣𝑒𝑟𝑎𝑔𝑒 =
𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑝𝑎𝑖𝑑

For a firm to benefit from debt financing, the fixed interest payments that accompany debt must be more
than satisfied from operating earnings. The higher the times interest earned ratio, the better; however, if
a firm is generating high profits, but no cash flow from operations, the ratio can be misleading. It takes
cash to make interest payments. The cash interest coverage ratio measures how many times interest
payments can be covered by cash flow from operations before interest and taxes.

𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑝𝑟𝑜𝑓𝑖𝑡 + 𝑅𝑒𝑛𝑡 𝑒𝑥𝑝𝑒𝑛𝑠𝑒

𝐹𝑖𝑥𝑒𝑑 𝐶ℎ𝑎𝑟𝑔𝑒 𝐶𝑜𝑣𝑒𝑟𝑎𝑔𝑒 =
𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑒𝑥𝑝𝑒𝑛𝑠𝑒 + 𝑅𝑒𝑛𝑡 𝑒𝑥𝑝𝑒𝑛𝑠𝑒

The fixed charge coverage ratio is a broader measure of coverage capacity than the times interest earned
ratio because it includes the fixed payments associated with leasing. Operating lease payments,
generally referred to as rent expense in annual reports, are added back in the numerator because they
were deducted as an operating expense to calculate operating profit. Operating lease payments are
similar in nature to interest expense in that they both represent obligations that must be met on an annual
basis. This ratio is important for firms that operate extensively with operating leases.

𝐶𝑎𝑠ℎ 𝑓𝑙𝑜𝑤 𝑓𝑟𝑜𝑚 𝑜𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑎𝑐𝑡𝑖𝑣𝑖𝑡𝑖𝑒𝑠

𝐶𝑎𝑠ℎ 𝐹𝑙𝑜𝑤 𝐴𝑑𝑒𝑞𝑢𝑎𝑐𝑦 =
𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝑒𝑥𝑝𝑒𝑛𝑑𝑖𝑡𝑢𝑟𝑒𝑠 + 𝐷𝑒𝑏𝑡 𝑟𝑒𝑝𝑎𝑦𝑚𝑒𝑛𝑡𝑠 + 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑠 𝑝𝑎𝑖𝑑

Credit rating agencies often use cash flow adequacy ratios to evaluate how well a firm can cover annual
payments of items such as debt, capital expenditures and dividends from operating cash flows. Cash
flow adequacy is generally defined differently by analysts and it is important to understand what is
actually being measured. It is being used here to measure a firm’s ability to cover capital expenditures,
debt maturities, and dividend payments each year. Firms over the long run should generate enough cash
flow from operations to cover investing and financing activities of the firm. If purchases of fixed assets
are financed with debt, the company should be able to cover the principal payments with cash generated
by the company. A larger ratio would be expected if the company pays dividends annually because
cashed used for dividends should be generated internally by the company rather than by borrowing.

𝑅𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝐸𝑞𝑢𝑖𝑡𝑦
𝐹𝑖𝑛𝑎𝑛𝑐𝑖𝑎𝑙 𝐿𝑒𝑣𝑒𝑟𝑎𝑔𝑒 𝐼𝑛𝑑𝑒𝑥 =
𝐴𝑑𝑗𝑢𝑠𝑡𝑒𝑑 𝑅𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝐴𝑠𝑠𝑒𝑡𝑠

This ratio indicates whether a firm is employing debt successfully.

5
 Financial Reporting and Analysis – Dr. Michael Lee

Asset Management
𝑁𝑒𝑡 𝑠𝑎𝑙𝑒𝑠
𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟 =
𝑁𝑒𝑡 𝑎𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑟𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒
𝐶𝑜𝑠𝑡 𝑜𝑓 𝑔𝑜𝑜𝑑𝑠 𝑠𝑜𝑙𝑑
𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟 =
𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦

𝐶𝑜𝑠𝑡 𝑜𝑓 𝑔𝑜𝑜𝑑𝑠 𝑠𝑜𝑙𝑑

𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑃𝑎𝑦𝑎𝑏𝑙𝑒 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟 =
𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑝𝑎𝑦𝑎𝑏𝑙𝑒

These three asset management turnover ratios measure how many times, on average, accounts
receivable is collected in cash, inventory is sold, and payables are paid during the year. These three
measures are mathematical complements to the ratios that make up the cash conversion cycle, and
therefore measure exactly what the average collection period, days inventory held, and days payable
outstanding measure for a firm; they are merely an alternative way to look at the same information.

𝑁𝑒𝑡 𝑠𝑎𝑙𝑒𝑠
𝐹𝑖𝑥𝑒𝑑 𝐴𝑠𝑠𝑒𝑡 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟 =
𝑁𝑒𝑡 𝑝𝑟𝑜𝑝𝑒𝑟𝑡𝑦, 𝑝𝑙𝑎𝑛𝑡, 𝑒𝑞𝑢𝑖𝑝𝑚𝑒𝑛𝑡

𝑁𝑒𝑡 𝑠𝑎𝑙𝑒𝑠
𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟 =
𝑇𝑜𝑡𝑎𝑙 𝑎𝑠𝑠𝑒𝑡𝑠

These two asset turnover ratios are two approaches to assessing management’s effectiveness in
generating sales from investments in assets. The fixed asset turnover considers only the firm’s
investment in property, plant and equipment and is extremely important for a capital-intensive firm, such
as a manufacturer with heavy investments in long-lived assets. The total asset turnover measures the
efficiency of managing all of a firm’s assets. Generally, the higher these ratios, the smaller is the
investment required to generate sales and therefore the more profitable the firm. When the asset
turnover ratios are low relative to the industry or the firm’s historical record, either the investment in
assets is too heavy and/or sales are sluggish. There may be other plausible explanations such as the
firm may have undertaken extensive plant modernisation or placed assets in service at year-end, which
will generate positive results in the long-term. Large amounts of cash, marketable securities, and long-
term investments unrelated to the core operations of the firm will cause the total asset turnover to be
lower as the return on these items is recorded in nonoperating revenue accounts, not sales.