Short-Term Financing and Financial Ratio Analysis

Posted on Mar 25, 2025 in Finance

Short-Term Financing Options

  • Line of Credit: Offers a maximum loan balance the firm can access for a specific period. Involves interest payments and a commitment fee.
  • Commercial Paper: Short-term, unsecured debt issued by large corporations, often a cheaper funding source than short-term bank loans.
  • Sale of Short-Term Financial Investments: Financial assets acquired to temporarily invest excess cash flows. Generally very liquid, flexible in amount and maturity, and risk-free.
  • Invoice Discounting: The firm uses accounts receivable as collateral for a secured loan. If the firm defaults, the lender can collect the receivables. The lender typically lends a percentage of the accepted invoices’ value.
  • Factoring: The firm sells accounts receivable to a factor at a discount. The factor obtains all rights associated with the receivables and is responsible for collecting from customers.
  • Reverse Factoring: A funder finances early payment terms for a buyer. The supplier receives a discounted rate for quick payment, benefiting from accelerated cash flow.

Reverse Factoring vs. Factoring

Reverse factoring is initiated by the buyer to facilitate easier and cheaper financing of the supplier’s receivables. In reverse factoring, the supplier is protected once the finance company pays the receivables. With recourse factoring, the supplier is responsible for payment issues. Reverse factoring uses accounts payable to advance funds, while factoring relies on accounts receivable for repayment.

Key Financial Cycle Definitions

  • Cash Cycle: The time required to convert resources into cash.
  • Operating Cycle: The time to acquire inventory, sell it, and receive cash from the sale.

Profitability Ratios

  • ROA (Return on Assets): EBIT / Average Total Assets = Operating Profit Margin x Asset Turnover Ratio.
  • Debt-to-Equity Ratio: Measures the proportion of equity and debt used to finance assets = Total Debt / Total Equity.
  • ROE (Return on Equity): Net Income / Average Total Equity – Profit generated per euro of shareholder equity.

ROA and Debt Relationship

  • If ROA > rD (interest rate on debt), the firm earns more than it pays to creditors, and ROE increases with the Debt-to-Equity ratio.
  • If ROA < rD, ROE decreases with debt.
  • Without debt or when ROA = rD, ROE = ROA(1 – Tax Rate).

Market Value Ratios

  • P/E Ratio (Price-to-Earnings Ratio): Price per Share / Earnings per Share.
  • Net losses instead of Net Income: P/E ratio is undefined.
  • 0 < P/E < 10: Potentially undervalued stock.
  • 10 < P/E < 17: Adequate P/E for a majority of stocks.
  • 17 < P/E < 25: Potentially overvalued stock.
  • P/E > 25: May indicate high profit growth.
  • Tobin’s Q: Market value of a company divided by the replacement value of its assets.
    • > 1: Stock potentially overvalued.
    • < 1: Stock potentially undervalued.

Business Risk Ratios

  • Degree of Operating Leverage (DOL): Elasticity of EBIT with respect to the change in units sold. (P = Price per unit, V = Variable cost per unit, F = Fixed operating cost)
  • Degree of Financial Leverage (DFL): Elasticity of Net Income with respect to the change in EBIT. (C = Fixed financial cost)
  • Degree of Total Leverage (DTL): Elasticity with respect to the change in units sold = DOL x DFL.