3.9. Ratio analysis (1) – current position and performance

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From the course by Moscow Institute of Physics and Technology

Core Concepts of Accounting – Numbers and People

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Moscow Institute of Physics and Technology

Core Concepts of Accounting – Numbers and People

ratings

Course 3 of 5 in the Specialization Understanding Modern Finance

Whenever the word “accounting” is pronounced, it is immediately associated with the need to memorize endless boring numbers. However, it is the common financial statements that contain important information that provides inputs for valuation of investment projects. The only challenge is how to properly extract them. Accounting and finance are indeed intertwined. Sometimes people that are not experienced in the area even mix them up. But most often emphasis in accounting is on numbers. Still, the deep understanding of key accounting concepts helps reveal the interests and actions of people behind these numbers. And the human dimension of accounting adds invaluable insight in the potential of successful project implementation. This Course discusses core ideas and concepts of both financial and managerial accounting. It by no means pretends to be comprehensive to any extent. But, being rather an accounting overview, it focuses on the issues that are most relevant and important for effective valuation of investment projects. The learners will gain insight into the essence of accounting. They will be able to use the obtained knowledge and skills to successfully advance in their career at a financial institution, as well as in the area of financial management at non-financial businesses. To pursue a career in accounting, a more detailed study is strongly recommended.

From the lesson

The Statement of Cash Flows. Analysis and Use of Financial Statements. Financial Accounting and Project Valuation

In Week 3 of the Course we discuss the idea and format of the Statement of Cash Flows and use examples to delve deeper in its role and importance. Special attention is paid to the use of financial accounting inputs – cash flows, net income, and investments – in valuation. Then we briefly discuss the analysis and use of financial statements as a powerful tool in the overall assessment of performance, financial stability, and future development of a company or investment project. Finally, wrapping up the first part of the Course, we draw conclusions about the role of financial accounting in financial valuation in the world of uncertainty.

3.1. The statement of cash flows (SCF) – idea and format10:51

3.2. SCF – Example 114:05

3.3. SCF – a more advanced Example 2 (1)12:25

3.4. SCF – a more advanced Example 2 (2)8:24

3.5. Valuation revisited – cash flows, net income, and FCF7:04

3.6. Comparison of interest treatment in SCF and FCF9:49

3.7. The big question – why use earnings?10:25

3.8. Analysis and use of financial statements – an overview12:39

3.9. Ratio analysis (1) – current position and performance6:05

3.10. Ratio analysis (2) – capital structure5:56

3.11. Ratio analysis (3) – operating performance11:11

3.12. Financial accounting and valuation – conclusions8:55

Meet the Instructors

Konstantin Kontor
Director and Professor of Finance and Strategy
American Institute of Business and Economics (AIBEc)

Now, in the next three short episodes,

we will talk about the ratio analysis.

The ratio analysis, that is just a technical tool that allows us to hopefully,

see some trends and also observe

some signals that provide us important information about,

not only the performance but also about

the potential future of the development of certain projects.

We will start. So, that will be ratio analysis one.

And this is one.

So, that will be the current position.

So here, we analyze ratios that deal with immediate

or short-term solvency because we remember that

companies may show negative income for quite a while,

but if for any reason they lack resources to pay their bills,

that results in a significant problem.

So first, this is the current ratio.

I will just give some example.

And this is by definition,

current assets over current liabilities.

And normally, if it's about two to one,

that's taken to be good.

So, you have your current assets,

this is cash accounts,

receivable, and others, these are all your short-term assets.

And then you can use them to retire your short-term liabilities.

Well, strictly speaking, with your accounts receivable you cannot pay off your bills,

but you can expect them to be

collected over a short period of time and then you will have received this cash,

and this cash you will be able to use to redeem some of your liabilities.

Then, the next is the so-called quick ratio,

or sometimes it's called asset test or asset ratio.

This is quick assets over current liabilities.

And again, quick assets,

they are easier to convert into cash.

For example, here in the current assets you also have inventories.

And some of these inventories,

it may take a lot of time for you to be able to sell them and here,

you use only assets that can be quickly converted into cash.

And that is if it's about one,

that's a good story.

Now, the next idea is again,

working capital to total assets.

That shows to you what basically,

if your working capital is- it may be larger or smaller,

it all depends upon the industry standard.

Remember, we said that in our analysis of financial statements,

we always have to refer to the industry standard.

It's sometimes not a good idea to

compare the financials statements of

two companies from completely different industry sectors,

because you can see that their numbers are very far from each other.

But that does not immediately attest to the fact that

something is going wrong with one of the companies.

Then some others, let's say the accounts receivable turnover.

So, this is basically the same as

net credit sales to average accounts receivable.

So, this is the idea how your sales,

they generate accounts receivable and how you collect them too.

Then also, you can have the same for inventory turnover.

And then you can have a working capital turnover.

So, in the third turnover will be cost of goods sold divided by average inventory,

and then that will be net sales over average working capital.

Again, I will not delve deeper in this,

I'm just giving you the idea that,

all that is in your handouts that has provided all the definitions, with all references.

But the story here is again,

this is the short-term part of your company's operations.

And I would say that these two are very important

in order to see what's going on with your short-term liquidity.

For example, if you see a trend that your quick ratio,

the current ratio they steadily deteriorate,

that's a bad sign because that means that the point

of even a temporary insolvency may occur at any moment in time,

and that creates serious stress over the company.

And all that is sort of the efficiency of performance of the company because let's

say if you sell a lot but if you collect your cash very slowly, that's too bad.

Or if you have large inventories but you sell them slowly,

that's even worse, because you have to spend time,

effort and money on the storage of these inventories.

They can wear off,

they can become obsolete, and so on, and so forth.

So the idea is that sometimes seeing this ratio is the one thing,

and then analyzing these ratios over time or compared to your competitors for example,

that shows you what's going on with your company.

So, that's about the current position.

Then in the next episode,

we'll proceed with capital structure.

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