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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
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