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3. RATIO ANALYSIS
Objectives: After reading this chapter, the students will be able to
1. Construct simple financial statements of a firm.
2. Use ratio analysis in the working capital management.
3 .1

Balance Sheet Model of a Firm

Business firms require money to run their operations. This money, or capital, is provided by the investors. This is mutually beneficial to the firms and to the investors. The investors get a reasonable return on their investment, and the firms get the badly needed capital. Generally speaking, the firms employ two forms of capital: the debt capital and the equity capital. The firms acquire the capital from two types of investors, the bondholders provide the debt capital and the stockholders the equity capital. From the perspective of the investors, the risk of these investments is different, the bonds being the safer investment relative to the stocks. Similarly, the firms bear more risk when they issue bonds, because the firms must pay interest on the bonds.
Consider a corporation that has no debt. Stockholders provide the entire financing of the company. We call it an all-equity firm. Figure 3.1 shows this as Firm A. This firm can borrow some money, by selling long-term bonds. From the proceeds of the sale of the bonds, it buys back some of its outstanding stock. Thus it can replace some equity with debt. Suppose it is able to do so in a judicious way so that its debt ratio, or debt-to-assets ratio, becomes 25%. Now it looks like Firm B in the diagram.
Equity

Debt

100%
90%

25%

80%
70%

80%

60%
50%

100%

40%

75%

30%
20%

20%

10%
0%

Firm A

Firm B

Firm C

Fig. 3.1: The capital structure of three corporations with differing amounts of debt..

36

W orking Capital Management
3. Ratio Analysis
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Occasionally, corporations get too far in debt. For example, Firm C in the diagram has
80% debt, which is too much. Such a company is always worried about its ability to pay interest to the bondholders. If it is unable to pay interest on time, the bondholders can force it into bankruptcy. It is the possibility of bankruptcy that makes it a risky company.
Figure 3.1 shows the relative amounts of money invested by the two types of investors, the stockholders, and the bondholders. Their stakes in the company are represented by the two areas, white and gray. We know that the company should employ the debt and the equity in proper proportions. Too much debt can lead to financial failure of a company.
The capital is invested in the assets of the firms. If the debt capital is B, and the equity capital S, then the total capital of the company is B + S. This must also be equal to the total value of the company, V,
V=B+S
(3.1)
Now we may look at the financial condition of a company from a different angle. This time we look at its balance sheet. The balance sheet of a company lists its assets and liabilities at a particular time. For example, we may be looking at the balance sheet of a company as of December 31, 1998. The stockholders equity, or just equity, by definition, is Stockholders Equity = Assets − Liabilities
(3.2)
When a corporation is set up, it clearly spells out the rights and expectations of both types of investors. The bondholders are lending their money to the corporation at a certain rate of interest. They expect to receive their interest on time, along with the final payment of the bonds when they mature. The stockholders cannot demand dividends from the firm.
The stockholders, even though they are owners of the firm, have limited liability in case the company gets into serious financial or legal difficulties. They are also the holders of a call option on the assets of the firm, with an exercise price equal to the face value of the bonds of a company. In case of liquidation, they receive whatever the company is left
with…