Dictionary of Financial and Business Terms (Part 2)

Act of state doctrine :This doctrine says that a nation is sovereign within its own borders and its domestic actions may not be questioned in the courts of another nation.

Active :A market in which there is much trading.

Active portfolio strategy :A strategy that uses available information and forecasting techniques to seek a better performance than a portfolio that is simply diversified broadly. Related: passive portfolio strategy

Actuals :The physical commodity underlying a futures contract. Cash commodity, physical.

Additional hedge :A protection against borrower fallout risk in the mortgage pipeline.

Adjustable rate preferred stock (ARPS) :Publicly traded issues that may be collateralized by mortgages and MBSs.

Adjusted present value (APV) The net present value analysis of an asset if financed solely by equity (present value of un-levered cash flows), plus the present value of any financing decisions (levered cash flows). In other words, the various tax shields provided by the deductibility of interest and the benefits of other investment tax credits are calculated separately. This analysis is often used for highly leveraged transactions such as a leverage buy-out.

Administrative pricing rules IRS rules used to allocate income on export sales to a foreign sales corporation.

Advance commitment A promise to sell an asset before the seller has lined up purchase of the asset. This seller can offset risk by purchasing a futures contract to fix the sales price.

Adverse selection A situation in which market participation is a negative signal.

Affirmative covenant A bond covenant that specifies certain actions the firm must take.

After-tax profit margin The ratio of net income to net sales.

After-tax real rate of return Money after-tax rate of return minus the inflation rate.

Agencies Federal agency securities.

Agency bank A form of organization commonly used by foreign banks to enter the U.S. market. An agency bank cannot accept deposits or extend loans in its own name; it acts as agent for the parent bank.

Agency basis A means of compensating the broker of a program trade solely on the basis of commission established through bids submitted by various brokerage firms. agency incentive arrangement. A means of compensating the broker of a program trade using benchmark prices for issues to be traded in determining commissions or fees.

Agency cost view The argument that specifies that the various agency costs create a complex environment in which total agency costs are at a minimum with some, but less than 100%, debt financing.

Agency costs The incremental costs of having an agent make decisions for a principal.

Agency pass-throughs Mortgage pass-through securities whose principal and interest payments are guaranteed by government agencies, such as the Government National Mortgage Association (" Ginnie Mae "), Federal Home Loan Mortgage Corporation (" Freddie Mac") and Federal National Mortgage Association (" Fannie Mae").

Agency problem Conflicts of interest among stockholders, bondholders, and managers.

A New Type of Corporate Executive

After the crash of October 2008, the perception of global business, and global business Leaders has changed from being the leaders of economic growth, to the villains of economic destruction. Is it the end of the traditional American Corporate Executive?

After the crash of October 2008, the perception of global business, and global business Leaders has changed from being the leaders of economic growth, to the villains of economic destruction. Is it the end of the traditional American Corporate Executive?

There is no doubt that Management structures and techniques have to change. The once mighty Corporate Executive now is seen as a leader that's flawed and has benefited from their own greed, whilst passing on the responsibility to someone else.

Bankers in particular are the new villains of capitalism, when in the past they were the Kings and Queens of Global empire building. In the future, the idea that business Leaders can pass on responsibility and gain the trust of people has been destroyed.

Surviving this new crisis means that a new type of Corporate structure, and Executive will take place of the old. Bringing opportunities for former outsiders to take over the positions of the pre October 2008 Executives. This is opportunity for Middle and Higher Managers in Corporations that are not touched with the blemish of in competency and greed to move up. Like many traditional politics, the corporate World looks like it is going to be restructured, and subjected to change.

This is not the end of the Corporate Executive, rather the start of a new type of Executive. Someone whose job is to win the public's trust back, whilst restructure their Organizations to meet the challenge of a very new marketplace.

And these new Corporate Leaders will have to come from unblemished backgrounds, many may be former corporate outcasts who were sidelined in the former Corporate structure. Others new economists, who realize that accountability cannot be sidestepped by hiding behind corporate banking laws, and Lawyers.

These new decision makers, will have to accept much lower salaries, accountability for their decisions and be in the public eye more than previous Corporate Leaders. When they utter the words, sustainability, transparency, and profitability, they have to be convincing and more open than their predecessors who are the byword for greed and deception in many people’s eyes.

Their job is also to save Capitalism, because Capitalism cannot afford any more Bernie Madoff’s, if trust is going to be restored in the markets, and in Big business. Otherwise Capitalism may be reinvented, without the current role of corporations.

This means opportunity for more open and sustainable business Leaders, who will come from the ranks of middle, and higher management. 

Dictionary of Financial and Business Terms (Part 1)

Abandonment option: The option of terminating an investment earlier than originally planned.

Abnormal returns: Part of the return that is not due to systematic influences (market wide influences). In other words, abnormal returns are above those predicted by the market movement alone. Related: excess returns.

Absolute priority: Rule in bankruptcy proceedings whereby senior creditors are required to be paid in full before junior creditors receive any payment.

Accelerated cost recovery system (ACRS): Schedule of depreciation rates allowed for tax purposes.

Accelerated depreciation: Any depreciation method that produces larger deductions for depreciation in the early years of a project's life. Accelerated cost recovery system (ACRS), which is a depreciation schedule allowed for tax purposes, is one such example.

Accounting exposure: The change in the value of a firm's foreign currency denominated accounts due to a change in exchange rates.

Accounting earnings: Earnings of a firm as reported on its income statement.

Accounting insolvency: Total liabilities exceed total assets. A firm with a negative net worth is insolvent on the books.

Accounting liquidity: The ease and quickness with which assets can be converted to cash.

Accounts payable: Money owed to suppliers.

Accounts receivable: Money owed by customers.

Accounts receivable turnover: The ratio of net credit sales to average accounts receivable, a measure of howquickly customers pay their bills.

Accretion (of a discount): In portfolio accounting, a straight-line accumulation of capital gains on discount bond in anticipation of receipt of par at maturity.

Accrual bond: A bond on which interest accrues, but is not paid to the investor during the time of accrual. The amount of accrued interest is added to the remaining principal of the bond and is paid at maturity.

Accrued interest: The accumulated coupon interest earned but not yet paid to the seller of a bond by the buyer (unless the bond is in default).

Accumulated Benefit Obligation (ABO): An approximate measure of the liability of a plan in the event of a termination at the date the calculation is performed. Related: projected benefit obligation.

Acid-test ratio: Also called the quick ratio, the ratio of current assets minus inventories, accruals, and prepaid items to current liabilities.

Acquiree: A firm that is being acquired.

Acquirer: A firm or individual that is acquiring something.

Acquisition of assets: A merger or consolidation in which an acquirer purchases the selling firm's assets.

Acquisition of stock: A merger or consolidation in which an acquirer purchases the acquiree's stock.

Nine Thriving Businesses during the current Economic Transition

Whilst many businesses are either cutting back or closing down, other businesses are expanding during these initial economic changes. This provides opportunities for entrepreneurs with some capital, as property prices are lower, and profits are higher than ever before, for many of these businesses. So what are the new business opportunities of this current crisis?

1. Pawnshops

Traditionally a destination of the desperate, pawnshops are busier than ever before, with many people preferring to pawn their precious possessions than to sell them directly on ebay.

Pawnshops in Europe and the USA, are reporting up to 400% growth in business, since October 2008. And with the price of gold rising, many people are pawning in their gold for cash, as pawnbrokers make instant profits on the gold price.

2. Campsites

Even if there is an economic crisis, vacations are still a need for most people, and whilst the high end and long haul tourist business is suffering, lower end camping holidays are becoming the trend for this year.

Localized Tourism is winning in Countries like the UK, were a weak currency means that holidays are at home, and campsites are reporting huge increases in bookings. In the USA, weekend camping trips could replace the annual holiday, which is good news for anyone willing to invest in cheaper land, and creating a campsite.

3. Social Network Websites

Now that many people have more time, and less to spend in their pockets, social networking websites are reporting large increases in traffic. An entrepreneur who comes up with an idea, to turn this trend into a way to earn an income, could in the future become extremely wealthy, as people look for alternative ways of cheap entertainment.

4. Gold Traders

Confidence in banks and currencies is at an all time low, as many investors are turning to gold as a safe haven. Trading in gold is a short-term winner, until confidence grows again in the economy, and people feel safe that their currencies are not going to be devalued.

5. Security Stores

In many Countries the hottest selling product is a “Safe,” as former bank depositors relocate their cash home, rather than leave it in unstable banks. Safes are one of the hottest selling products in Germany, the UK and in many parts of the USA.

All that cash and valuables locked away at home, simply means that owning a “safe” will also need other security devices like cameras, and burglar alarms, as homes could be targeted by thieves knowing more people are keeping cash at home.

6. Repossession Agents

What the Banks and Credit companies lent for, may have to come back as more and more highly exposed debtors cannot pay their monthly payments. Eventually the Reprocession Agent steps in, and with loan defaults increasing, so does the need for an “Agent.”

7. Solar Manufacturers

Ford and Citibank may be shedding workers, but thousands of small to medium scale Solar panel manufacturers are hiring. Cheap, self sustainable energy is the future, and any company manufacturing Solar panels is in for a boom period, as others are closing their doors forever.

8. Workshops

If you cannot buy new, then repair shops are the next big thing. Businesses that repair anything from the humble shoe to the Automobile, are reporting huge increases in business, since 2008.

9. Training Centers and Courses

Whether it is online or offline a new generation of unemployed need retraining for the jobs of the future. This spells opportunity, for anyone willing to invest in a training center or course.

Our economies are changing and moving towards a new direction, and training is going to be the key to moving our economies forward, creating futures for those who want to enter the new industries of tomorrow. 

Learning From the German New Deal of the 1990's

“The Chinese use two brush strokes to write the word 'crisis'. One brush stroke stands for danger; the other for opportunity. In a crisis, be aware of the danger-but recognize the opportunity.”

John F Kennedy

Few people realize that one Country tried a New deal only as recently as 18 years ago, Germany. The German modal could be the modal that some countries would choose today. But few people realize the German New Deal failed.

When the Berlin Wall fell, East Germany became part of West Germany to become a new Germany. The West German Government spent billions rebuilding Eastern Germany, investing in public works and the financial bailout of ordinary East German incomes.

The billions were paid by the taxpayer in the form of higher indirect and direct taxes, whilst key West German Industries were given incentives to invest and relocate in the East. The funds to pay for this rebuilding were funneled through private Companies, Banks and Government approved agencies.

The aim of this program was to create a new Germany for 12 Million citizens of the East that had a failed banking, industrial and at that time educational system. A mini-boom was created, and many large West German Corporations made fortunes out of the rebuilding.

This boom ended by the late 1990's, when the unemployment problem in the East was still increasing, even though East Germans had better roads, streets and nicer hospitals and schools. Eastern and parts of central Germany became a modal of unemployment.

East Germany depopulated, with many East Germans relocating to the old West, leaving behind Europe's biggest pool of empty properties, in Towns and villages that lost over 20-50% of their population.

Property values plummeted and never recovered, leading to German banks preferring to invest in sublime property in the USA than helping an estimated 46% of Germans who still rent today, because of the lack of domestic property loans.

The effects of this massive failure of the German New deal is seen today, high unemployment became "hidden unemployment". With the Government "creating" jobs around collecting fines for breaking new laws.

The "Chicken Police" were one example, hiring unemployed Germans to collect a tax from householders who kept chickens. A tax, paid for each Chicken, offenders who were caught not paying the fees, were fined heavily, covering the salaries of the "Chicken Police. who drove around catching and fining "offenders."

Aside from many of the ludicrous jobs created, the dark side of this failure was the need to create revenues by the Government to pay for the millions of unemployed. These indirect taxes, lowered the incomes working Germans earned, cut small and medium business profits and led to "work share" schemes and "means tested" unemployment benefits to cut costs.

The aim was to discourage people from taking benefits, reduce the actual unemployment figures by rejecting applicants who owned a property or had more than 5000 Euros in assets. Technically leaving millions of Germans neither employed or unemployed, making the disastrous unemployment figures look good on paper.

Along with questions about where many of the billions disappeared, with many Corporate CEO's caught on corruption charges. All the New Deal did was to whitewash dilapidated Towns and villages, impoverish more Germans, and enrich a few large German Corporations.

There were some success stories, but looking at the former Eastern and Central Germany today, you see "rust belts", emptying Villages, states were populations have decreased by over 30%, and real long term unemployment levels of over 8 million.

By 2030, experts believe the population of Germany could decrease by 20 million, as Germans have lost the confidence to have a family. Germany now has the Worlds lowest birthrates, and in some areas Europe's highest unemployment rates, along with the biggest wealth gaps in Western Europe.

Before the crash, middle class Germans were embarrassed lining up at Soup Kitchens in Financial Centers like Frankfurt and Munich. Well dressed, somber and hungry, a testimony to the failed New Deal of the 1990's that Germans are still paying for today. 

When to Recognize Our Economies Are Recovering

Even after a series of bailout plans, and new stimulus plans by our Governments, most economists and business gurus agree that we have not hit the road to the bottom yet. How do we know when we have started a sustainable economic recovery?

Our economy is being restructured, after the crash of 2008. This means ruminants of the old economy are going to naturally die out, and then be replaced by the new. This takes time, and until we hit the road to the bottom, we will not see the positive changes of our new Economy.

1. Bankruptcies

Business bankruptcies will reach their peak, and then we will see recovery when these bankruptcies start to decline in numbers, whilst new business start-ups increase in volume.

2. The Banking Industry

Our Banks will settle down to doing business 'as normal.' whether they are State or private Banks. Once banks are being sold again to private buyers, our economies are recovering.

3. Stock Markets

Our Stock Markets will naturally reach the bottom. Some shares will still decline, but once new companies start seeing increases in their share values, our economies are recovering.

4. Unemployment

Official and Hidden unemployment figures reach their peak, and then slowly decline without any State re-adjustment of the way unemployment is measured. Once a real decline in unemployment is proved, then our economy is on the road to recovery.

5. Housing Prices

Housing prices should reach their real market value, according to the real condition of the economy. This could be uneven, as areas harder hit by the economic depression, will have lower house prices, whilst areas recovering should have more stable housing prices.

6. Consumer Confidence

Our Economies are primarily consumer economies, and one of the reasons it collapsed was because consumers borrowed and spent more than they could afford. Once consumers start to shop again, confidence will grow, but if we see wholesale stores and ecommerce websites closing, then we have not reached the end of the old economy.

7. Politics

Our political parties will begin to have more conservative leaders like they did in the boom years. Socially conservative leaders that are there to keep the economy running rather than spend time fixing its problems. If we see the growth of radical politics, then we have not yet reached the bottom.

Recognizing when the economy reaches the bottom could be the difference between thriving again and surviving. Those who seize the opportunities as it hits the bottom could see their wealth grow again, quickly.

6 Financial Ratios You Should Watch Closely In The Crisis

There are certain financial ratios you need to watch closely during a—global or company—crisis. What ratios? You asked. Among many items in a company’s assets, cash is the most sensitive one to even a small crisis. Cash is the blood of company’s operation—basically no business will run smoothly if there is no enough cash available for its operation. Therefore, watching the cash availability is super important for any of us in the financial and accounting department.

Keeping some cash reserves are always a good strategy. But, in such crisis you won’t have enough cash excesses for any reserves—otherwise we don’t call it crisis.  So, forget about cash reserve. Another good way to make sure that you have enough cash for company’s operation is by watching some specific ratios. Ratios that enable you to determine how quickly various accounts are converted into sales or cash. Liquidity ratios?

Not really. Overall liquidity ratios generally do not give an adequate picture of a company’s real liquidity, due to differences in the kinds of current assets and liabilities the company holds. What you have to do is to evaluate the activity or liquidity of specific current accounts: receivables and inventory, and cash—perform ratio analyses related to those accounts.

1. Accounts Receivable Ratios

Accounts receivable ratios consist of the accounts receivable turnover ratio and the average collection period. The accounts receivable turnover ratio gives the number of times accounts receivable is collected during the year.

It is found by dividing net credit sales (if not available, then total sales) by the average accounts receivable. Average accounts receivable is typically found by adding the beginning and ending accounts receivable and dividing by 2.

Although average accounts receivable may be computed annually, quarterly, or monthly, the ratio is most accurate when the shortest period available is used.

In general, the higher the accounts receivable turnover, the better since the company is collecting quickly from customers and these funds can then be invested. However, an excessively high ratio may indicate that the company’s credit policy is too stringent, with the company not tapping the potential for profit through sales to customers in higher risk classes (Note: Before changing its credit policy, a company has to weigh the profit potential against the risk inherent in selling to more marginal customers.

Here is the formula:

Accounts receivable turnover = net credit sales / average accounts receivable

Say, Lie Dharma Company’s average accounts receivable for 2010 is: ($15,000 + $20,000) / 2 = $17,500. And the accounts receivable turnover ratio for 2011 is: $80,000 / $17,500 = 4.57 times. If in 2010, the accounts receivable turnover ratio was 8.16. The drop in this ratio in 2011 is significant and indicates a serious problem in collecting from customers. The company needs to reevaluate its credit policy, which may be too lax, or its billing and collection practices, or both.

The collection period (days sales in receivables) is the number of days it takes to collect on receivables, with the following formula:

Average collection period = 365 / accounts receivable turnover

Therefore, the Lie Dharma Company’s average collection period for 2011 is: 365 / 4.57 = 79.9 days. This means that it takes almost 80 days for a sale to be converted into cash. In 2010, the average collection period was 44.7 days. With the substantial increase in collection days in 2011, there exists a danger that customer balances may become uncollectible!

One possible cause for the increase may be that the company is now selling to highly marginal customers. The analyst should compare the company’s credit terms with the extent to which customer balances are delinquent. An aging schedule, which lists the accounts receivable according to the length of time they are outstanding, would be helpful for this comparison.

Case Example:

The Lie Dharmas Company reports the following data relative to accounts receivable:

                                                                2010             2009

Average accounts receivable        $   400,000     $   416,000

Net credit sales                              $2,600,000     $3,100,000

If the terms of sale are net 30 days, what is the accounts receivable turnover and the collection period?

Solution:

Accounts receivable turnover:

= net credit sales / average accounts receivable

For 2010: $2,600,000 / $400,000 = 6.5 times

For 2009: $3,100,000 / $416,000 = 7.45 times

Collection period = 365 / accounts receivable turnover

For 2010: 365 / 6.5 = 56.2 days

For 2009:  365 / 7.45 = 49 days

What does this mean?

Okay. The company’s management of accounts receivable is poor. In both years, the collection period exceeded the terms of net 30 days. The situation getting worse, as is indicated by the significant increase in the collection period in 2010 relative to 2009. The company has significant funds tied up in accounts receivable that otherwise could be invested for a return. A careful evaluation of the credit policy is needed; perhaps too many sales are being made to marginal customers.

2. Inventory Ratios

If a company is holding excess inventory, it means that funds which could be invested elsewhere are being tied up in inventory. In addition, there will be high carrying cost for storing the goods, as well as the risk of obsolescence. On the other hand, if inventory is too low, the company may lose customers because it has run out of merchandise. Two major ratios for evaluating inventory are inventory turnover and average age of inventory.

Inventory turnover is computed as:

Inventory turnover = cost of goods sold / average inventory

Note: Average inventory is determined by adding the beginning and ending inventories and dividing by 2.

Say, for the Lie Dharma Company, the inventory turnover in 2011 is: $50,000 / $47,500 = 1.05 times. In 2010, the inventory turnover was 1.26 times.

The decline in the inventory turnover indicates the stocking of goods. An attempt should be made to determine whether specific inventory categories are not selling well and if this is so, the reasons therefore. Perhaps there are obsolete goods on hand not actually worth their stated value.

However, a decline in the turnover rate would not cause concern if it were primarily due to the introduction of a new product line for which the advertising effects have not been felt yet.

Average age of inventory is computed as follows:

Average age of inventory = 365 / inventory turnover

The average age of inventory in 2011 is: 365 / 1.05 = 347.6 days. In 2010, the average age was 289.7 days. The lengthening of the holding period shows a potentially greater risk of obsolescence.

Inventory Ratio Case Example:

On January 1, 2011, the Lie Dharma Company’s beginning inventory $400,000. During 2011, Lie Dharma purchased $1,900,000 of additional inventory. On December 31, 2011, Lie Dharma’s ending inventory was $500,000.

What is the inventory turnover and the age of inventory for 2011?

Solution:

Step-1. Determine the cost of goods sold:

Beginning inventory         $   400,000

Purchases                           1,900,000

Cost of goods available   $2,300,000

Ending inventory                  500,000

Cost of goods sold          $1,800,000

Step-2. Average inventory:

= [beginning inventory / ending inventory] / 2

= [$400,000 + $500,000] / 2

= $450,000

Step-3. Inventory turnover:

= cost of goods sold / average inventory

= $1,800,000 / $450,000

= 4

Step-4. Average age of inventory:

= 365 / inventory turnover = 365 / 4  = 91.3 days

What does this mean?

Okay. Say, the inventory turnover in 2010 was 3.3 and the average age of the inventory was 100.6 days, means Lie Dharma Company’s inventory management improved in 2011, as evidenced by the higher turnover rate and the decrease in the number of days that inventory was held.

As a result, there is less liquidity risk and the company’s profitability will benefit from the increased turnover of merchandise. Note that this is only a conjecture, based on an evaluation of two ratios in isolation; keep in mind that if the rapid turnover was accomplished by offering excessive discounts, for example, profitability ratios may not show an improvement.

3. Operating Cycle

The operating cycle of a business is the number of days it takes to convert inventory and receivables to cash. Hence, a short operating cycle is desirable. 

The formula is:

Operating cycle = average collection period + average age of inventory

Say, the operating cycle for the Ratio Company in 2011 is: 79.9 days + 347.6 days = 427.5 days. If in 2010 the operating cycle was 334.4 days, this is an unfavorable trend since an increased amount of money is being tied up in noncash assets.

Operating Cycle Case Example

Based on the last case example of the inventory, what is the Lie Dharma Company’s operating cycle in 2011 if it is assumed that the average collection period is 42 days?

Solution:

Average age of inventory =   91.3

Average collection period =  42.0

Operating cycle                = 133.3 days

4. Cash Conversion Cycle

Noncash working capital consists of current assets and liabilities other than cash. One way to view noncash working capital efficiency is to view operations as a cycle—from initial purchase of inventory to the final collection upon sale. The cycle begins with a purchase of inventory on account followed by the account payment, after which the item is sold and the account collected. These three balances can be translated into days of sales and used to measure how well a company efficiently manages noncash working capital.

This measure is termed the cash conversion cycle or cash cycle. This is the number of days that pass before we collect the cash from a sale, measured from when we actually pay for the inventory.

The cash conversion cycle formula is:

Cash conversion cycle = operating cycle - accounts payable period

Where:

Accounts payable period = 365 / accounts payable turnover

Note, that:

Accounts payables turnover = cost of goods sold / average accounts payable

Example:

In 2011, Accounts payables turnover = $50,000 / ($50,400 + $50,000)/2 = 0.95 times, and accounts payable period = 365 / 0.95 = 384.2 days (Note that current liabilities for the Ratio Company are all accounts payable.). If in 2011 for the Ratio Company, the cash conversion cycle = 427.5 days - 384.2 days = 43.3 days. Thus, on average, there is a 43-day delay between the time the company pays for merchandise and the time it collects on the sale. In 2010, the ratio was 25.1 days.

This is an unfavorable sign since an increased cycle implies that more money is being tied up in inventories and receivables.

Operating and Cash Conversion Cycles Case Example

Consider the following selected financial data for the Putra Retailer:

Item                            Beginning                Ending

Inventory                    $5,000                     $7,000

Accounts receivable     1,600                       2,400

Accounts payable         2,700                       4,800

Net credit sales                             $50,000

Cost of goods sold                         30,000

What is Putra Retailer’s ‘operating and cash conversion cycles’?

Step-1. Calculate three turnover ratios, as follows:

Average inventory turnover = $30,000 / [(5,000 + 7,000) / 2] = 5 times

Average receivable turnover = $50,000 / [(1,600 + 2,400) / 2] = 25 times

Average payable turnover = $30,000 / [(2,700 + 4,800 / 2] = 8 times

Step-2. Calculate three average periods, as follows:

Average age of inventory = 365/5 = 73 days

Average collection period = 365/25 = 14.6 days

Average payable period = 365/8 = 45.6 days

The time it takes to acquire inventory and sell it is about 73 days. Collection takes another 14.6 days, and the operating cycle is thus 73 + 14.6 =87.6 days. Therefore, the cash conversion cycle is 87.6 days less 45.6 days = 42 days.

Another two important ratios you need to watch closely are:

5. Total Asset Turnover

The total asset turnover ratio is helpful in evaluating a company’s ability to use its asset base efficiently to generate revenue. A low ratio may be due to many factors, and it is important to identify the underlying reasons. For example, is investment in assets excessive when compared to the value of the output being produced? If so, the company might want to consolidate its present operation, perhaps by selling some of its assets and investing the proceeds for a higher return or using them to expand into a more profitable area.

The total asset turnover formula is = net sales / average total assets

Say, in 2011 the total asset turnover ratio for the Lie Dharma Company is: $80,000 / $210,000 = 0.381. If in 2010, the ratio was 0.530 ($102,000/$192,500), means the company’s use of assets declined significantly, and the reasons need to be pinpointed. For example, are adequate repairs being made? Or are the assets getting old and do they need replacing?

6. Interrelationship of Liquidity and Activity to Earnings

A trade-off exists between liquidity risk and return. Liquidity risk is minimized by holding greater current assets than noncurrent assets. However, the rate of return will decline because the return on current assets (i.e., marketable securities) is typically less than the rate earned on productive fixed assets. Also, excessively high liquidity may mean that management has not aggressively searched for desirable capital investment opportunities.

Maintaining a proper balance between liquidity and return is important to the overall financial health of a business. It must be pointed out that high profitability does not necessarily infer a strong cash flow position. Income may be high but cash problems may exist because of maturing debt and the need to replace assets, among other reasons. For example, it is possible that a growth company may experience a decline in liquidity since the net working capital needed to support the expanding sales is tied up in assets that cannot be realized in time to meet the current obligations.

The impact of earning activities on liquidity is highlighted by comparing cash flow from operations to net income. If accounts receivable and inventory turn over quickly, the cash flow received from customers can be invested for a return, thus increasing net income.

One Final Note

Some people may think financial ratio is just a number, number is number—there is nothing to do with the business. That is quiet true if you think that computing and getting the financial ratios is the end of the road. Getting number is just the end of your road to get the tools. The real works is right after getting the tools: Once a ratio is computed, it should be compared with related ratios of the company, the same ratios from previous years, and the ratios of competitors.

The comparisons show trends over a period of time and hence the ability of an enterprise to compete with others in the industry. Ratio comparisons do not mark the end of the analysis of the company, but rather indicate areas needing further attention. If you are a controller, your road is even longer if the ratios show some serious issues—you would need to fix and solve the problems. And to do that, you would need more than numbers—some sound financial strategies.