● ● ●

732

bre44380_ch28_732-758.indd 732 10/06/15 09:49 AM

Part 9 Financial Planning and Working Capital Management

G

ood financial managers plan for the future. They check

that they will have enough cash to pay the upcoming

tax bill or dividend payment. They think about how much

investment the firm will need to make and about how they

might finance that investment. They reflect on whether

they are well placed to ride out an unexpected downturn in

demand or an increase in the cost of materials.

In Chapter 29 we will describe how financial managers

develop both short- and long-term financial plans. But know-

ing where you stand today is a necessary prelude to contem-

plating where you might be in the future. Therefore, in this

chapter we show how the firm’s financial statements help you

to understand the firm’s overall performance and how some

key financial ratios may alert senior management to potential

problem areas.

You have probably heard stories of whizzes who can

take a company’s accounts apart in minutes, calculate some

financial ratios, and divine the company’s future. Such people

are like abominable snowmen: often spoken of but never truly

seen. Financial ratios are no substitute for a crystal ball. They

are just a convenient way to summarize large quantities of

financial data and to compare firms’ performance. The ratios

help you to ask the right questions; they seldom answer

them.

Financial Analysis

28

CHAPTER

Financial ratios are usually easy to calculate. That’s the good news. The bad news is that there

are so many of them. To make it worse, the ratios are often presented in long lists that seem to

require memorization rather than understanding.

We can mitigate the bad news by taking a moment to preview what the ratios are measur-

ing and how they connect to the ultimate objective of value added for shareholders.

Shareholder value depends on good investment decisions. The financial manager evalu-

ates investment decisions by asking several questions, including these: How profitable are

the investments relative to the cost of capital? How should profitability be measured? What

does profitability depend on? (We will see that it depends on efficient use of assets and on the

bottom-line profits on each dollar of sales.)

Shareholder value also depends on good financing decisions. Again, there are obvious

questions: Is the available financing sufficient? The firm cannot grow unless financing is

available. Is the financing strategy prudent? The financial manager should not put the firm’s

assets and operations at risk by operating at a dangerously high debt ratio. Does the firm have

sufficient liquidity (a cushion of cash or assets that can be readily sold for cash)? The firm has

to be able to pay its bills and respond to unexpected setbacks.

28-1 Financial Ratios

● ● ●