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2022 | OriginalPaper | Buchkapitel

5. Financing Current Operations and Efficiency Ratio Analysis

verfasst von : John B. Guerard Jr., Anureet Saxena, Mustafa N. Gültekin

Erschienen in: Quantitative Corporate Finance

Verlag: Springer International Publishing

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Current financing encompasses managing and utilizing current assets and incurring and repaying current debt. The current assets of a firm differ from fixed assets; these differences are not abrupt but represent a continuum. The current assets (cash, receivables, inventory, etc.) support the short-run operations of the business. Current assets are what the classical economists called “circulating capital.” Within the current asset grouping, however, some items remain in the firm’s possession longer than others.

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Vorheriges Kapitel The Annual Operating Statements: The Income Statement and Cash Flow Statement

Nächstes Kapitel Financing Current Operations and the Cash Budget

Although only a fraction of net working capital is likely to be in cash, an adequate amount of net working capital assures a substantial short-term cash flow and serves as a good base for short-term credit.

As additional ratios are used, one soon discovers that the same information is being presented in a different form.

This means that these companies, in effect, carry no net working capital.

For completeness, we will relegate several widely used ratios to footnotes.

Acid test. The acid test, or quick ratio, is obtained by dividing current liabilities into the firm’s net receivables and cash. This ratio highlights the firm’s short-term liquidity position. The rule-of-thumb measure of a satisfactory acid test ratio is one to one. From an obverse point of view, the acid test ratio tends to indicate the amount of inventory in the working capital position of the firm. For example, if the current ratio is 3 to 1 and the acid test is only .85 to 1, the inventory account probably constitutes a heavy proportion of the current assets.

Sales to receivables or the receivable turnover ratio. This ratio is obtained by dividing credit sales by the outstanding trade accounts and trade notes receivable and indicates the collectibility and current condition of the receivables. The higher the sales to receivables ratio, the more current are the receivables. A variant of this ratio is to divide the turnover rate into 360 (representing the approximate number of days in the year). The resulting figure gives the number of days it takes to collect an average account. This figure can be compared to the usual terms (or allowable credit time) granted by the firm to ascertain whether the average account is collected in a period close to the credit terms

Sales to inventory: approximate inventory turnover. This ratio is obtained by dividing the inventory into the sales figure. The result is useful in analyzing how rapidly the firm’s inventory is sold. A slow turnover—relative to the type of business or its own previous performance—may indicate that the firm is overstocked or that the inventory contains too many old or out-of-style items or that the management is speculating in inventory. Again, as in the case of the receivable turnover, the inventory turnover figure can be divided into 360 days to get an average of how many days it takes for a given dollar amount of merchandise to be turned into an equivalent amount of sales.

Many analysts prefer to reserve the term “inventory turnover” for the ratio of inventory divided into the cost of goods sold. The ratio then indicates the true physical turnover of the inventory. Since the sales figure contains the gross markup (profit) over cost, the sales over inventory ratio overstates the actual physical turnover of the goods. The higher the customary gross margin, or markup over cost in the sales figure, the better the inventory into sales ratio appears in comparison to the true turnover ratio. Unfortunately, the figure for the cost of goods sold is not always as available as the amount of sales. Thus, the standard ratios are more often based on sales. Ratio analysis, in any case, is not an exact science but is based on historical or intra-industry comparisons. The ratio serves its purpose as long as it depicts a logical relationship and comparisons using it are made on a consistent basis.

Sales/net working capital: working capital turnover. The net working capital turnover is obtained by dividing net working capital into the annual sales. This ratio is double-edged; a high ratio can indicate either efficiency or risk. A low turnover may indicate managerial inefficiency in moving goods and collecting receivables, or it may indicate excessively conservative management—a tendency to hold redundant idle funds or a failure to use a reasonable amount of available current credit. The other edge of the ratio appears if the turnover is too high in contrast with the industry norm. It may not necessarily indicate efficiency but a tendency to take on undesirable levels of risk. An especially high net working capital turnover can indicate overtrading on current account—an attempt to carry a heavy volume of business on an inadequate current capital base. Such speculative striving on the part of the management can be dangerous to both owners and creditors.

It should be obvious that the ratios are not to be used singly but in a composite manner to fill out a financial portrait of the company. Thus, the position of the net working capital turnover can be checked against the other current operating ratios. For example, a firm with a high net working capital turnover and ordinary inventory and receivable turnovers whose current ratio is tight is likely to be overtrading. A firm with a low net working capital turnover, a normal cash cycle, and a very high acid test ratio may be holding excessive idle funds. These are only two possibilities. An experienced analyst may be able to rough out normal relationships in his head while scanning the financial figures. His instinct may lead him quickly to any items that are out of line and suggest the few ratios necessary to highlight the potential trouble spot.

Ratio analysis and related techniques are often called credit analysis.

The banks, which have a lower margin for risk, obviously have to restrict their credit more severely than suppliers. The following discussion applies mainly to trade credit.

If the loss experience in a given credit grade is to be fairly predictable, the classes have to be made quite large. Very fine grades might be useful for the purpose of finding the exact credit cutoff point. But they decrease the predictability of the results in each class.

In some cases where immediate financial risks are high but the possibilities of good profits exist in the buying firm’s activities, a supplier in a strong financial position has on occasion purchased some of its customer’s common stock as well as sold to it on credit. This gives the supplier an opportunity to obtain possible compensating gains to offset the credit risk. The use of convertible securities is an analogous situation.

No net profit might be made out of selling to this group, but we presume there would be profits on the sales to all the firms that were intra-marginal as far as credit loss probabilities are concerned.

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Titel: Financing Current Operations and Efficiency Ratio Analysis
verfasst von: John B. Guerard Jr.
Anureet Saxena
Mustafa N. Gültekin
Verlag: Springer International Publishing
Buch: Quantitative Corporate Finance
Print ISBN: 978-3-030-87268-7

Electronic ISBN: 978-3-030-87269-4

Copyright-Jahr: 2022
DOI: https://doi.org/10.1007/978-3-030-87269-4_5

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