Question

Discuss the reasons why a firm may have a positive "cash flow" and have financial problems, while another firm with a negative "cash flow" is in a good financial position.

Mention and describe the four methods or categories to use the financial ratios (financial ratios).

Briefly explain the two perspectives that can be considered in the execution of financial ratios.

Answer 1

1. Reasons why a firm may have a positive "cash flow" and have financial problems, while another firm with a negative "cash flow" is in a good financial position.

The reason companies should prepare both an income statement and a cash flow statement is that cash and profitability may not mirror each other. If there is a divergence and the firm registers a profit while its cash position declines, these two statements will explain why that happened.

Credit Sales

A firm's cash position may decline while its profits go up if it engages in profitable activities that do not result in positive cash flow. The most typical example is credit sales. When a furniture retailer pays $100 cash to buy a kitchen table and sells it for $50 down and $100 due in 2 months, it will register a profit of $50. The sales proceeds are $150, which are made up of $50 cash and $100 accounts receivable. The cost of goods sold is $100, resulting in a net income of $50. However, the firm took in only $50 in cash, for an item it had bought by paying $100 cash. In every such sale, the firm will register a profit, yet its cash reserves will decline by $50.

Other Transactions

Numerous other transactions, in addition to credit sales, can increase or decrease cash while having either no effect on profits or having the opposite impact on cash and profitability. Assume a firm buys an office building for $1 million in cash. Suddenly the cash position will taken an enormous hit, a $1 million decline to be exact, yet profits will remain unchanged. Purchasing something for cash has no effect on profit, because the firm trades one form of asset for another. If later on the the company sells the building for $900,000 in cash, it will register a loss of $100,000, yet cash in the balance sheet will go up by a hefty $900,000.

2. Methods or categories to use the financial ratios

Financial ratios can be broadly classified into liquidity ratios, solvency ratios, profitability ratios and efficiency ratios (also called activity ratios or asset utilization ratios). Other categories include cash flow ratios, market valuation ratios, coverage ratios

• Liquidity Ratios

  Liquidity ratios asses a business’s liquidity, i.e. its ability to convert its assets to cash and pay off its obligations without any significant difficulty (i.e. delay or loss of value). Liquidity ratios are particularly useful for suppliers, employees, banks, etc.

• Solvency Ratios

  Solvency ratios assess the long-term financial viability of a business i.e. its ability to pay off its long-term obligations such as bank loans, bonds payable, etc. Information about solvency is critical for banks, employees, owners, bond holders, institutional investors, government, etc.

• Profitability Ratios

  Profitability ratios measure the ability of a business to earn profit for its owners. While liquidity ratios and solvency ratios explain the financial position of a business, profitability ratios and efficiency ratios communicate the financial performance of a business.

• Activity Ratios

  Activity ratios assess the efficiency of operations of a business. For example, these ratios attempt to find out how effectively the business is converting inventories into sales and sales into cash, or how it is utilizing its fixed assets and working capital, etc.

3. Two perspective that can be considered in the execution of financial ratios

There are basically two uses of financial ratio analysis: to track individual firm performance over time, and to make comparative judgments regarding firm performance. Firm performance is evaluated using trend analysis—calculating individual ratios on a per-period basis, and tracking their values over time. This analysis can be used to spot trends that may be cause for concern, such as an increasing average collection period for outstanding receivables or a decline in the firm's liquidity status. In this role, ratios serve as red flags for troublesome issues, or as benchmarks for performance measurement.

Another common usage of ratios is to make relative performance comparisons. For example, comparing a firm's profitability to that of a major competitor or observing how the firm stacks up versus industry averages enables the user to form judgments concerning key areas such as profitability or management effectiveness. Users of financial ratios include parties both internal and external to the firm. External users include security analysts, current and potential investors, creditors, competitors, and other industry observers. Internally, managers use ratio analysis to monitor performance and pinpoint strengths and weaknesses from which specific goals, objectives, and policy initiatives may be formed.