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Financial Check Up

Financial Check Up. John B. Penson, Jr. Regents Professor and Stiles Professor of Agriculture Texas A&M University. Seen the Doc Lately?. Benefits from an annual financial checkup. Treadmill stress test your financial strength. Get your vision examined. What is the status of your….

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Financial Check Up

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  1. Financial Check Up John B. Penson, Jr. Regents Professor and Stiles Professor of Agriculture Texas A&M University

  2. Seen the Doc Lately? • Benefits from an annual financial checkup. • Treadmill stress test your financial strength. • Get your vision examined.

  3. What is the status of your…. • Liquidity? • Solvency? • Profitability? • Efficiency? • Debt repayment capacity? • Survivability?

  4. Key Financial Indicators • Measures of liquidity • See equations 1 and 2; page 13 of booklet • Measures of solvency • See equations 3 – 6; page 14 • Measures of profitability • See equations 7 – 8; page 15 • Measures of economic efficiency • See equations 10 – 14; pages 16-17 • Measures of debt repayment capacity • See equations 15 – 17; page 17

  5. Measures of Liquidity • 1. Current ratio: • Current assets divided by current liabilities. • Demonstrates ability to cover scheduled current liabilities for the • coming year out current assets and still have “cash” left over. • Should exceed 1.0 to be technically liquid. • Some firms fail despite exceeding this hurdle.

  6. Measures of Liquidity • 1. Current ratio: • Current assets divided by current liabilities. • Demonstrates ability to cover scheduled current liabilities for the • coming year out current assets and still have “cash” left over. • Should exceed 1.0 to be technically liquid. • Some firms fail despite exceeding this hurdle. • 2. Working capital: • Current assets minus current liabilities. • Expresses liquidity in dollars rather than ratio. • Should be positive. • Cash is King!

  7. Liquidity Trends Survived Failed Page 13 Source: W. H. Beaver, “Financial Ratios and Predictors of Failure”, Journal of Accounting Research

  8. Liquidity Trends Survived Failed Minimum Page 13 Source: W. H. Beaver, “Financial Ratios and Predictors of Failure”, Journal of Accounting Research

  9. Liquidity Trends Desired level varies by type of firm Survived Failed Page 14 Source: W. H. Beaver, “Financial Ratios and Predictors of Failure”, Journal of Accounting Research

  10. Measures of Solvency • 1. Debt ratio: • Total debt divided by total liabilities. • Demonstrates ability to liquidate the firm, cover all liabilities out • of all assets, and still have “cash” left over. • Should not exceed 0.50 to minimize financial risk exposure. • Some firms fail however at lower levels.

  11. Measures of Solvency • 1. Debt ratio: • Total debt divided by total liabilities. • Demonstrates ability to liquidate the firm, cover all liabilities out • of all assets, and still have “cash” left over. • Should not exceed 0.50 to minimize financial risk exposure. • Some firms fail however at lower levels. • 2. Leverage ratio: • Total debt divided by equity or net worth. • Often a credit standard in loan approval decisions. • Should not exceed 1.0 to minimize financial risk exposure. • Effects of rising interest rates.

  12. Solvency Trends Failed Survived Page 15 Source: W. H. Beaver, “Financial Ratios and Predictors of Failure”, Journal of Accounting Research

  13. Solvency Trends Failed Maximum Survived Page 15 Source: W. H. Beaver, “Financial Ratios and Predictors of Failure”, Journal of Accounting Research

  14. Measures of Profitability • 1. Rate of return on assets: • Net farm income before interest divided by total assets. • Demonstrates the return to management and total capital invested • in the firm. • Should be positive; the higher the better.

  15. Measures of Profitability • 1. Rate of return on assets: • Net farm income before interest divided by total assets. • Demonstrates the return to management and total capital invested • in the firm. • Should be positive; the higher the better. • 2. Rate of return on equity: • Net farm income divided by total equity. • Demonstrates return to owner’s investment in the firm. • Should be positive; the higher the better.

  16. Profitability Trends Survived Failed Page 16 Source: W. H. Beaver, “Financial Ratios and Predictors of Failure”, Journal of Accounting Research

  17. Profitability Trends Survived Minimum Failed Page 16 Source: W. H. Beaver, “Financial Ratios and Predictors of Failure”, Journal of Accounting Research

  18. Measure of Debt Repayment Capacity • 1. Term Debt and Capital Lease Coverage Ratio: • Net cash incomedivided by scheduled principal payments • on term loans and capital leases • After provision for taxes and withdrawals. • Should be greater than 1.0.

  19. Measure of Debt Repayment Capacity • 1. Term Debt and Capital Lease Coverage Ratio: • Net cash incomedivided by scheduled principal payments • on term loans and capital leases • After provision for taxes and withdrawals. • Should be greater than 1.0. • 2. Debt burden ratio: • Total liabilities divided by net income • After provision for taxes and depreciation • Should be as low as possible to avoid financial risk exposure

  20. Debt Repayment Capacity Desired level varies by type of firm Survived Failed Page 18 Source: W. H. Beaver, “Financial Ratios and Predictors of Failure”, Journal of Accounting Research

  21. Indicators of growth/survival: Increasing liquidity Increasing solvency Increasing debt repayment capacity Increasing profitability Indicators of potential failure: Declining liquidity Declining solvency Decreasing debt repayment capacity Decreasing profitability Some Conclusions….

  22. Tale of Two Cities… Failed Source: W. H. Beaver, “Financial Ratios and Predictors of Failure”, Journal of Accounting Research

  23. Tale of Two Cities… Failed Failed Source: W. H. Beaver, “Financial Ratios and Predictors of Failure”, Journal of Accounting Research

  24. Tale of Two Cities… Failed Failed Failed Source: W. H. Beaver, “Financial Ratios and Predictors of Failure”, Journal of Accounting Research

  25. Tale of Two Cities… Failed Failed Failed Failed Source: W. H. Beaver, “Financial Ratios and Predictors of Failure”, Journal of Accounting Research

  26. Sample Question Same firm level data used in Slide Show #1 Is this firm liquid, solvent, profitable and can it cover its term debt and capital lease payments?

  27. Sample Question Step #1 Calculate the following: 1. Current assets and total assets 2. Current liabilities and total liabilities 3. Net income 4. Equity (or net worth) Total current assets = 10,000 + 11,000 + 22,000 = 43,000 Total current liabilities = 1,200 + 7,500 + 7,213 = 15,913 Total assets = total current assets + 76,500 +14,000 + 99,500 = 233,000 Total liabilities = total current liabilities + 29,500 + 1,200 = 46,613 Equity = 233,000 – 46,613 = 186,387 Cash receipts from product sales = 73,000 Total operating expenses = 51,200 + 2,500 + 7,400 = 61,100 Net income from operations = 73,000 – 61,100 = 11,900 Net income before taxes = 11,900 Net income = 11,900 – 7,213 = 4,687

  28. Sample Question Step #2 Calculate the following: 1. Current ratio 2. Debt and leverage ratio Asset liquidity analysis: Total current assets = 10,000 + 11,000 + 22,000 = 43,000 Total current liabilities = 1,200 + 7,500 + 7,213 = 15,913 Current ratio = 43,000/15,913 = 2.702 Working capital = 43,000 – 15,913 = 27,087 Solvency analysis: Total assets = total current assets + 76,500 +14,000 + 99,500 = 233,000 Total liabilities = total current liabilities + 29,500 + 1,200 = 46,613 Equity = 233,000 – 46,613 = 186,387 Debt ratio = 46,613/233,000 = 0.20 Leverage ratio = 46,613/186,387 = 0.25

  29. Sample Question Step #3 Calculate the following: 3. ROA and ROE Total assets = 233,000 Equity = 186,387 Cash receipts from product sales = 73,000 Total operating expenses = 51,200 + 2,500 + 7,400 = 61,100 Net income from operations = 73,000 – 61,100 = 11,900 Net income before taxes = 11,900 Net income = 11,900 – 7,213 = 4,687 Profitability analysis: ROA = (4,687 + 2,500)/233,000 = 0.0308 or 3.1% ROE = 4,687/186,387 = 0.025 or 2.5%

  30. Sample Question Step #4 Calculate the following: 4. Term debt and capital lease coverage ratio 5. Debt burden ratio Debt repayment capacity analysis: Net cash income = 4,687 + 7,400 = 12,087 Principal payments = 5,000 Coverage ratio = 12,087/5,000 = 2.42 Debt burden analysis: Net income = 4,687 Total liabilities = 46,613 Debt burden ratio = 46,613/4,687 = 9.95

  31. Historical Analysis • A look backwards like the Beaver study. • Comparison of current performance with past performance. • Recommend doing this at the enterprise level as well as for the farm as a whole. Page 19

  32. Historical Analysis • A look backwards like the Beaver study. • Comparison of current performance with past performance. • Recommend doing this at the enterprise level as well as for the farm as a whole. • Reasons underlying unwanted trends such as the declines in last two years? Page 19

  33. Comparative Analysis • Compare the firm’s current performance with the performance of similar operations like the Beaver study did. • Benchmark analysis at enterprise level should be done whenever possible. Benchmark Your firm Page 20

  34. Comparative Analysis • Compare the firm’s current performance with the performance of similar operations like the Beaver study did. • Benchmark analysis at enterprise level should be done whenever possible. • Address reasons why your firm is performing more poorly than other comparable operations before it is too late. Benchmark Your firm Page 20

  35. Pro Forma Analysis • Stress testing current expected cash flows by varying prices, unit costs and yields (Slide Show #3). • Look at implications of longer run price and unit cost trends on future financial health when making major decisions.

  36. Forces of change…. • Impacts of rising unit costs of production inputs. • Prices, costs and yields can all affect the financial health of the firm. • Failure to account for the risk associated with adverse trends can lead to failure of the firm.

  37. Sources of Uncertainty • Global trends in production and consumption • Energy prices and core inflation trends • Interest rates and exchange rates • WTO and the 2007 farm bill

  38. Any Questions?

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