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CHAPTER
5
FINANCIAL ANALYSIS
CONTENT
• Net working capital and finance policy
• Leverage ratios analysis
• Debt ratios
• Exercise and Case study
Working capital and the policy
• Financial balance
Current Short term Long term
+ Non current = +
assets assets capital capital
• Financing policy for assets
• Short-term capital funding for short-term assets
• Long-term capital funding for long-term assets
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CONSERVATIVE FINANCING POLICY
NWC >0
Current assets Current liabilities
NWC
Non current assets Non current
liabilities
NWC >0
ACTIVE FINANCING POLICY
Net working capital < 0
Current assets
Current liabilities
NWC
Non current
Non current assets liabilities
NWC <0
CENTRAL FINACING POLICY
NWC = 0
Current assets Current liabilities
Non current assets
Non current
liabilities
NWC =0
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WORKING CAPITAL NEEDS
• The amount that must be available in treasury to settle the company’s debts
in time.
Working = Amount of inventories - Debts
capital need in progress + Amount
of receivables in
progress
WORKING CAPITAL NEEDS
• Working capital need > 0
• Short term capital need > Short term capital
• Solution: Mobilize long-term resources: Long-term
borrowings, issue shares
• Working capital need < 0
• Short term capital need < Short term capital
• Solution: Use short term capital for long term investment
WORKING CAPITAL NEEDS
• Working capital need > 0
• Short term capital need > Short term capital
• Solution: Mobilize long-term resources: Long-term
borrowings, issue shares
• Working capital need < 0
• Short term capital need < Short term capital
• Solution: Use short term capital for long term investment
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WORKING CAPITAL
Working Current
= Current assets -
capital liabilities
Working Non current Non current
= -
capital assets liabilities
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Working capital
• Exercise 4
• Case study 3: X – ML Corporation
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LEVERAGE ANANLYSIS
Risk Leverage Degree of
leverage
Business risk Operating leverage Degree of operating
leverage
Finance risk Financial leverage
Degree of financial
Total risk Total leverage leverage
Degree of total
leverage
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Business Risk
• Business risk : The riskiness is inherent in the firm’s operations if it uses no debt.
• Business risk depends on a number of factors, which are listed here:
Demand variability Ability to adjust output prices for changes
in input costs
Sales price variability Ability to develop new products in a
timely, cost-effective manner
Input cost variability. Scientific and technological progress
Natural disasters, World War. The extent to which costs are fixed
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OPERATING LEVERAGE
• Operating leverage: The extent to which fixed costs
are used in a firm’s operations.
• Other things held constant, the higher a firm’s
operating leverage, the higher its business risk.
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OPERATING LEVERAGE
A1 B1 A2 B2
Q = 500
Net Sales = 2 * Q 1,000 1,000
Variable costs = 50% Net sale
Fixed costs 300 400
EBIT
Q = 100
Net Sales = 2 * Q 200 200
Variable costs = 50% Net sale
Fixed costs 300 400
EBIT
% Changes in EBIT?
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OPERATING LEVERAGE ANANLYSIS
• Degree of operating leverage
DOL = EBIT Q
×
EBIT Q
• Degree of operating leverage by Q (Quantity)
Q( P − V ) Q
DOLQ = =
Q( P − V ) − F Q − QBE
• Degree of operating leverage by S (Sales)
S −V EBIT + F
DOLS = =
S −V − F EBIT
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OPERATING LEVERAGE ANANLYSIS
• Eg:
• A bicycle manufacturing company sells a bicycle with
a unit price is $ 50, the annual fixed costs are $
100,000 and variable costs are $ 25 / unit.
Consumption volume is 500,000 units.
• Requirements:
➢ Compute DOL? Meaning?
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