Milwaukee Surgical Supplies
To calculate the firm’s average collection period, we take a weighted average of the payment schedules. The terms of sale are 3/10, net 30. This means that customers of Milwaukee Surgical Supply are to pay their bills within 30 days. They receive a 3% discount if they pay within ten days. Gross sales for the year are $1,200,000.
30% of customers pay on the tenth day to receive the discount. 40% pay on the 30th day, and 30% pay on average of 40 days. Thus, the average collection period is:
(.3)(10) + (.4)(30) + (.3)(40) = 27 days.
To calculate the current receivables balance, the receivables turnover ratio can be used. This ratio is:
Receivables turnover in days = 360 / (Total Sales / Avg. Receivables)
(total sales / receivables) = 360
$1,200,000 / receivables = 360/27
$1,200,000 = (13.33) receivables = $1,200,000 / 13.33 = $90,000
If the company toughened its receivables policy so that all non-discount customers paid on the 30th day, the new average collections period would be:
(.3)(10) + (.7)(30) = 24 days.
This would give a receivables balance of:
( $1,200,000 / 360 ) * 24 = $80,000
Note that this calculation is a re-working of the calculation that was used above. If that calculation was used, the result would be the same:
24 ($1,200,000 / R) = 360
$1,200,000 / R = 360/24
$1,200,000 = R (15)
R = $1,200,000 / 15 = $80,000
4. To calculate the annual savings from this new, tougher, policy, the carrying cost of the difference must be calculated. The difference is:
$90,000 – $80,000 = $10,000
The carrying cost of $10,000 over the course of the year at 8% is (.08)(10,000) = $800.
Thus, the new policy saves the company $800 over the course of the year.
This can also be calculated as follows:
(.08)(90,000) – (.08)(80,000) = Savings
$7,200 – $6,400 = Savings
S = $800
5. Financial statement analysis is the use of financial statements to explain the financial condition of the firm (McClure, 2011). There are a number of metrics that are derived from the financial statement. These include liquidity and solvency ratios, profitability ratios and efficiency ratios. Each of the different ratios provides insight into an element of the firm’s operations. What financial statement analysis does is it uses these ratios to attempt to explain what is going on at the firm. For example, if the receivables turnover increases in the year, this could be taken as an indication that the firm has loosened its credit policy. If an event such as this corresponds with an economic downturn, it could be taken as a sign that the company’s customers have seen a downturn in their business, which is making it more difficult for them to pay on time.
Operating indicator analysis is the process of using key metrics that are not on the financial statements to explain what is on the financial statements. Most firms have operating indicators as part of their managerial accounting. Airlines, for example, have load factors and passenger revenue per mile flown as operating indicators. A hospital could have net price per discharge, which reflects how much money it makes per customer (FACHE, 2007).
The two types of analysis differ in a few key ways. Financial statement analysis relies on publicly available financial data. The metrics therefore are consistent across firms and industries, which allows for comparability between companies and over time. This consistency is especially useful for external entities such as regulators, creditors and prospective investors. Operating indicator analysis relies on internal measures, and these can differ from firm to firm and industry to industry. With some, the measures are common throughout a given industry (the aforementioned airline metrics, for example), but this is not necessarily the case.
The direction in which knowledge flows also differs between these two types of analysis. Financial statement analysis examines the firm’s financial condition in order to gain insight into its operations. Operating indicator analysis examines the firm’s operations in order to gain insight into its financial condition. In both cases, the conclusions will likely be the same for a given firm, but the two approaches differ in their starting and ending points.
Operating indicator analysis is therefore more useful for internal stakeholders, whereas financial statement analysis is geared towards external stakeholders. The former is used to help managers understand the underlying conditions of the firm’s financial performance. The latter uses the financial performance to better understand what the firm is doing. Thus, while both approaches have value, they appear to be valuable in different ways to different people, with the perspective of the beholder being a key variable in the usefulness of the chosen approach.
6. The market multiple approach to business valuation is based on the idea that a private firm can be valued on the basis of its current financial performance and the expected multiple that the market would give that firm. This process involves several steps. The first of these is to gather information about the firm’s performance. This would typically involved gathering GAAP financial statements, which can be used to directly compare the performance of the firm with others. In particular, profit and capital structure are two key metrics that will be considered.
The second step is to identify comparable firms that can be used to determine an appropriate market multiple (Maps of the World, no date). There are a number of criteria that are used to select the body of comparable firms. They should be firms in the same industry; they should have roughly the same size and financial characteristics as well. In general, the more close the two firms are in terms of their finances and their operations, the better the comparable will be. For example, two fast food companies, one with $10 billion in revenue and $2 billion in profit; the other with $12 billion in revenue and $1.7 billion in profit, might make good comparables. If the second firm, however, has $68 billion in revenue and lost money last year, the comparable might be considerably poorer. Thus, it is important that appropriate comparable firms are identified.
The next step is to find the market multiple for the comparable firm. This is usually the P/E ratio. The P/E ratio will lead to the market capitalization of the comparable firm. These numbers are then applied to the firm being evaluated. It is assumed that a similar multiple will exist for the firm being evaluated and this will lead to an assumption about the market capitalization of that firm. Ultimately, the process relies on finding good comparable companies. The greater the deviation between the evaluated firm and the comparable firm, the more adjustments will need to be made to the assumed multiple. For example, if the comparable firm is much stronger and is growing faster, its P/E cannot be directly used, but must be adjusted downward to reflect the fact that the firm being evaluated is not as enticing to investors. Such an adjustment will be approximate and roughly arbitrary.
FACHE. (2007). Chapter 17: Financial condition analysis. Foundation of the American College of Healthcare Executives. Retrieved March 7, 2011 from http://brkhealthcare.com/uploads/HSA525Chapter17.pdf
Maps of the World. (no date). Market approach of business valuation. Maps of the World.com. Retrieved March 7, 2011 from http://finance.mapsofworld.com/corporate-finance/business-valuation/market-approach.html
McClure, B. (2011). Fundamental analysis: Introduction. Investopedia. Retrieved March 7, 2011 from http://www.investopedia.com/university/fundamentalanalysis/
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