Discussion:
On the Financial Statements Analysis Worksheet, address each of the following as completely as possible, using examples and citations when necessary.
• Why are ratios useful? What three groups use ratios, and for what reasons?
• What qualitative factors should analysts look for when evaluating a company's likely future financial performance? Explain.
• You are training a new financial analyst who lacks experience. What are the most critical steps of financial analysis? Why are these steps critical and what will you hope to find?
MicroDrive writes and deposits checks every day. Because its managers don't know exactly when all of the checks will clear, they can't predict exactly what the balance in their checking accounts will be on any given day. Therefore, they must maintain a balance of cash and cash equivalents (such as very short-term marketable securities) to avoid overdrawing their accounts. We discuss the issue of cash management in Chapter 21, but MicroDrive's CFO assumed that the cash required to support MicroDrive's operations is proportional to its sales. For example, the forecasted cash in 2016 is 1%(2016 sales) 5 1%($5,500) 5 $55. The CFO applied the same process to project cash in subsequent years. Unless a company changes its credit policy or has a change in its customer base, accounts receivable should be proportional to sales.
The CFO assumed that the credit policy and customers' paying patterns would remain constant and so projected accounts receivable as 10%($5,500) 5 $550. As sales increase, firms generally must carry more inventories. The CFO as- sumed here that inventory would be proportional to sales. (Chapter 21 will discuss inventory management in detail). The projected inventory is 20%($5,500) 5 $1,100. It might be reasonable to assume that cash, accounts receivable, and inventories will be proportional to sales, but will the amount of net property, plant, and equipment go up and down as sales go up and down?
The correct answer could be either yes or no. When companies acquire PP&E, they often install more capacity than they currently need due to economies of scale in building capacity. Moreover, even if a plant is operating at its maximum-rated capacity, most companies can produce additional units by reducing downtime for scheduled maintenance, by running machinery at a higher than optimal speed, or by adding a second or third shift. Therefore, at least in the short run, sales and net PP&E may not have a close relationship.
However, some companies do have a close relationship between sales and net PP&E, even in the short term. For example, new stores in many retail chains achieve the same sales during their first year as the chain's existing stores. The only way such retailers can grow (beyond inflation) is by adding new stores. Such companies therefore have a strong proportional relationship between fixed assets and sales. Finally, in the long term there is a close relationship between sales and net PP&E for virtually all companies: Few companies can continue to increase sales unless they also add capacity.
Therefore, it is reasonable to assume that the long- term ratio of net PP&E to sales will be constant. For the first years in a forecast, managers generally build in the actual planned expenditures on plant and equipment. If those estimates are not available, it is gen- erally best to assume a constant ratio of net PP&E to sales. MicroDrive is a relatively large company and makes capital expenditures every year, so the CFO forecast net PP&E as a percent of sales. The projected net PP&E is 40%($5,500) 5 $2,200.
Being able to discuss and interpret financial statements and forecast future performance are critical skills for financial managers. Summarize what you can learn from the statement, and explain how you reached your conclusions.