Chapter 2: Ratio Analysis

Lecture 2.1: Cash Flow Management

 Financial analysis techniques refer to the mechanisms that allow managers, analysts and decision
makers in general to read the financial statements (and other relevant sources of information) to get
knowledge about the company’s situation and thus make decisions about it.

 There are two types of financial analysis techniques:

Direct: analysis of captions/ accounts on an individual basis
Indirect: calculation and analysis of ratios and similar indicators, built from a combination of captions/
accounts
Analysis of Captions/ Accounts Individually
Common-size analysis is a technique that standardizes financial statements for size, thus improving comparability across a large
number of financial statements

Common-Size Analysis

Balance Sheet Standardization Income Statement Standardization

All items are expressed as a percentage of a All items are expressed as a percentage of a
similar base, which is usually total assets similar base, which is usually sales
Ratio Analysis
 As relevant as individual analysis may be, it will always be limited in its application.
 Ex: Accounts receivable might be growing fast which may point towards a higher collection risk but if sales are also increasing, this might just signal
a higher company’s volume

 Ratios are quotients between two or more accounting captions, which allow us to standardize and summarize the information and to relate different
variables with one another

 They allow us to evaluate the historical performance of the company and its position in the sector in areas like efficiency of activity, profitability,
credit risk, among others

 Ratios facilitate the diagnosis of company’s economical and financial performance and they are also the best tool to forecast the company’s future
performance

 However, this doesn’t mean they aren’t without its fair share of limitations. They are still a limited window into the company (only focus on a limited
number of captions) so conclusions may not be correct. Analyzing ratios is not about getting the right answer, but rather the most likely answer. The
more ratios are analyzed, the better the understanding of the company and the less probable it is to get the wrong picture. – more on this later
Financial analysis must always be comparative!

This means that whenever we are trying to infer information about a company from its financial
statements, we must have something to compare it against – having a benchmark/ standard for
comparison is required

Types of standards used:

Past performance of the company;
Performance from comparable companies (at least in the same sector)
Targets defined on a budget or planning previously made
Pre-defined standards (rare)
According to a study from the research firm CB Insights:

42%of start ups fail because of the lack of a need for their product in the
marketplace

29%of start ups fail because of a cash crisis

Activity: Nike manufactures athletic shoes and other sportswear and then sells them to retail outlets, typically on credit

1. Nike buys the raw materials to build the shoes on credit from its suppliers and it takes the company on average 44 days to pay for those materials

2. Upon buying the raw materials, it takes Nike on average 91 days before that inventory is turned into finished product and shipped to the retail stores that
sell them
3. It then takes Nike roughly 41 days from the moment the sale to the retail stores happen until it is able to collect the cash from that sale (because it is
selling on credit)

So, Nike has to pay its suppliers after 44 days but it does not collect the cash from selling its finished products until a total of 132 days have elapsed

There are 88 days during which Nike has to use cash from other sources to keep its operations going
Activity: McDonalds buys raw materials (food and packaging) and sells finished product (food wrapped in packaging) to clients directly

1. McDonalds buys the raw materials on credit from its suppliers and it takes the company on average 58 days to pay for those materials

2. Upon buying the raw materials, it takes McDonalds on average 7 days before that inventory is turned into finished product and sold to customers on their
stores
3. It then takes McDonalds roughly 2 seconds (0 days) from the moment the sale to the retail stores happen until it is able to collect the cash from that sale –
even if clients pay with cards, the transfer happens right away

So, McDonalds has to pay its suppliers after 58 days but it is able to collect cash from clients 7 days and 2 seconds after it began its operation

There are 51 days during which McDonalds has the cash before needing to use it to pay its own suppliers
 • Meant to evaluate the firm’s efficiency and get a sense of the executional risk involved, so as to better
understand the firm’s liquidity position
• Crucial for managers to negotiate with customers and suppliers as well as to deliberate on shipping
and distribution policies

# Days
• Determined in terms of number of days it takes, on average, for an activity to be executed
• No standard can be defined on how to evaluate these ratios – benchmarking with the sector is
paramount here
Average Holding Period

 Indicates the number of days, on average, that inventories remain in the company before being sold

Inventories
Average Holding Period = X 365
Cost of Sales
Average Collection Period

 Indicates the number of days, on average, that it takes for the company to collect sales from its clients

Receivables
Average Collection Period = X 365
Sales
Average Payable Period

 Indicates the number of days, on average, that it takes for the company to settle up with its suppliers

Payables
Average Payable Period = X 365
Cost of Sales
Average Collection Period Average Holding Period Average Payable Period

Receivables Inventories Payables

X 365 X 365 X 365
Sales Cost of Sales Cost of Sales

The higher it is, the higher the The higher it is, the higher the The higher it is, the lower the
pressure on the firm’s liquidity (more pressure on the firm’s liquidity (more pressure on the firm’s liquidity (less
likely to need external, more likely to need external , more likely to need external, more
expensive – funding) expensive – funding) expensive – funding)
Cash Conversion Cycle (or Net Trade Cycle)

Credit from Credit to clients

suppliers

storage production storage

purchase sale
Cash Conversion Cycle (or Net Trade Cycle)
 Indicates the number of days that it takes, on average, for a company to perform its regular trade cycle!

+ Average Holding Period

+ Average Collection Period
- Average Payable Period
= Cash Conversion Cycle
Cash Conversion Cycle (or Net Trade Cycle)
 It should be as low as possible, as it will minimize the risk for the company and ensure less
pressure on liquidity, allowing cash flow to be generate faster to support the needs of the
company

 A low value represents a combination of a low holding period, a low collection period and/or
a high payable period.

 If negative, it means suppliers are essentially financing the operational activity of the company.
Managing the Cash Conversion Cycle

 A high cash conversion cycle poses challenges to the company in terms of financing new investments and
typically leads to companies requiring additional debt as a result. Additionally, the executional risk associated
with the activity is higher, which puts further pressure on liquidity.

 Managing the cash conversion cycle is one of the main functions of the financial area of a company, which
should articulate the cash flow needs of the company with any loss of profitability that may arise from having
too much liquidity (either because it meant worse commercial conditions or because there was no application
for the additional liquidity)
 Hence the importance of the budgeting process

 The average periods are often used to determine part of the compensation of the operational managers responsible for each
activity.
Managing the Cash Conversion Cycle

 The cash cycle should be managed in an integrated manner and it is a fundamental tool to negotiate with
new suppliers and new clients, as well as to decide on the inventory policy of the company.

 There can obviously be reasons that justify a worse position of the average periods, mostly from a
profitability point of view – for instance, a significant discount granted by suppliers associated with an
upfront payment.

 To assess whether or not the company should accept these situations, one should analysis whether or not it
has the capacity to be “absorbed” that increase in its cash conversion cycle without compromising the
liquidity position of the company. Ideally, that effect would be offset by another metric (e.g. a decrease in
the collection period).
Cash Conversion Cycle (or Net Trade Cycle)

 Sectors with conversion cycles typically low are those that are able to take a while to pay up to its
suppliers while receiving upfront from clients:
 Supermarkets
 Insurance companies

 Sectors with conversion cycles typically high are those in which suppliers will require immediate
payments or in which the clients take a long time to settle up (these tend to be situations where there
are installment payment schedules involved):
 Pharmaceuticals
 Retail electronics
Two young managers are looking into Sainsbury’s activity efficiency. Based on the comparison with
Johnson & Johnson, one of them argues the company is vastly overperforming. The other one, basing
himself on a comparison with Tesco, claims the company is in line with the sector.

Johnson &
Sainsbury Tesco
Johnson
Average Collection Period 2 0 54
Average Inventory Holding Period 16 19 129
Average Payable Period 32 34 80
Cash Conversion Cycle -14 -15 103

The second analyst is obviously correct because Tesco and Sainsbury have similar operations so the comparison
makes sense, whereas it is meaningless to compare the activity of a retail company like Sainsbury with that of a
pharmaceutical company like Johnson & Johnson.