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Financial Analysis and Reporting Working Capital Simulation

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Financial Analysis and Reporting

Working Capital Simulation

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  1. Option selection, Influence and Impact on Firm Value
  • How we select options

Our goal is to increase firm value as much as we can. For each stage, we try to maximize the firm value of the current stage given previous decisions. Although the ultimate firm value may not be maximum through this strategy, we justify our decision by assuming that in a certain stage, we have no information about future choices of later stages. Following the methodology above, we find: for the first and second stages, choice 1 should be excluded; for the last stage, all choices should be selected. However, after running simulations for many times, we observe that the best strategy is to accept all decisions in stage 1 and 3, and decline choice 2 in stage 2.

  • How Financial Statements are affected

For the optimal strategy, influences on financial statements are as follows: in the first stage, all four options impose a one-time influence on the financial statements. Revenues, COGS, EBIT, net income, and working capital are all increased in 2013 and remain the same until 2015. In the second stage, revenue and EBIT are increased in inconstant rates; DSO, DSI are affected directly, rather than account receivable and inventory; both net income and working capital increases. In the last stage, sales, EBIT and net income are increased drastically; DSO, DSI increased and DSP is restricted to 10 days. In excel attached there are tables explaining the influences of each choice in detail.

  • Why Firm Value Increases/Decreases

In this simulation, we identify two key factors influencing firm value: EBIT and working capital. Given a fixed cost of capital, firm value is determined by free cash flow to firm, which is the difference between EBITA and change in working capital. EBITA affects current FCFF, so holding other things constant, we prefer higher EBIT. But when it comes to decision on working capital, there is a tradeoff between FCFF and long term value added. An increase in working capital harms FCFF in current stage, but is beneficial for future values. As result, there is an optimal level of working capital for maximizing firm value.

2. Profitability and Liquidity Ratios

  • Profitability and Liquidity Ratios

For measuring profitability, we pick operating margin, pre-tax margin, net profit margin, ROE and ROA. For liquidity, we use cash ratio, current ratio, quick ratio and CFO/Average current liability ratio. Calculation results are presented in excel.

  • How is Profitability Influenced

To be more profitable, there are mainly two ways: increasing EBIT and decreasing interest payment.

  • EBIT

If the increase in EBIT is a bigger proportion of increase in Sales than the firm’s current operating margin, this choice would provide more profitability, as it would lift the EBIT percentage in revenue.

  • Interest

As for interest, it’s a fixed proportion of firm’s credit borrowed. If we have less debt, we would pay less interest and have more profit. However, credit borrowing depends on whether we have enough cash to meet the minimum requirement ($300). If cash holding falls below that, we need to borrow new debt and that’s a burden for profit. That means we need to generate cash at a proper level.

  • How is Liquidity Influenced

For liquidity issues, we consider cash flows. In this case, there is no investment cash flow, and financing cash flow is determined by operating cash flow, so we focus on CFO.

  • Where CFO comes from

CFO is net income after subtracting working capital. It indicates liquidity is positively related to profitability, and the level of working capital is significant for liquidity too.

  • Where CFO goes

CFO is the source for cash holding and debt repaying, and for our firm, meeting minimum cash requirement is prior to repaying debt. However, we can only borrow debt until reaching credit line ($3200), and after that, if our cash flow is still negative, we have to reduce cash below $300, which is a warning signal that firm is operating problematically. Overall, liquidity is affected by profit, working capital and debt.



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