# Ratio Analysis Understanding the language (Part 1)

## Concept Title: Financial Terms

In this and the next few posts we look at the ratio analysis language, giving detailed descriptions of financial terms including Insolvency, Cost Functions, Dividends and Net Working Capital

#### Insolvency

‘Insolvency’ is the situation in which a firm’s assets are unable to pay or cover its liabilities. It could be short term or long term.

1. Short-term insolvency is when current assets are unable to cover current liabilities
2. Long-term insolvency occurs when the book value of total liabilities is more than the book value of total assets.

Insolvency and Bankruptcy are two different situations. Insolvency is the inability of a business to pay its bills or its obligations. Bankruptcy is a legal status or state that a business may claim to be in after going through a legal process.

#### Fixed & Variable Costs and Cost Functions

We can divide incurred costs incurred by a firm into their fixed and variable components. These are: Fixed costs are those that will occur irrespective of the level or volume of production (units produced). A firm will incur fixed costs even if it produces no units. For example if you have leased equipment for production. You will have to pay lease payments on this equipment irrespective of the level of production.A firm will not incur Variable costs if it does not produce anything . They only occur when production begins, so these costs vary with the level of production. For example, raw material costs are variable as they depend on the level of production.

The relationship between fixed costs, variable costs and the level of production is the Cost Function. Cost functions may be linear (directly proportional to the level of production) or non-linear (costs may increase more than the unit increase in production or vice versa).

Once you classify all costs as being either fixed or variable, a cost function can be developed. The most common and simplest cost functions are similar to the one shown below:

Total Costs = Fixed Costs + Unit Variable Costs * (Units of Production)

Obtain total Variable Costs by multiplying the Unit Variable Cost by the Number of Units Produced. Fixed and Variable Costs, when combined, give a figure for Total Costs.

The formula includes a range of values for Units of Production for which the fixed costs and variable costs will remain valid.

If, at a production level of 30,000 ice creams, the fixed cost is \$90,000 and variable cost per unit is 50 cents, the Total Cost of producing 30,000 ice creams will be

Total Costs = 90,000+ (0.5 * 30,000) =\$105,000

Total Costs = \$105,000

#### Relevant range of production

Relevant range of production is a given range within which the business can operate without needing to change its cost function. For example, Firm A can produce between 25,000 to 50,000 tennis balls per month given its existing plant size. The fixed costs for producing anything between 25,000 and 50,000 is \$ 90,000 per month. If a firm decides to produce more than 50,000 balls, it will have to install additional plant capacity, which means that it will incur additional fixed costs. Therefore, in the example above, the relevant range of production is 25,000 to 50,000 tennis balls.

#### Dividends

Dividends are payments that a corporation makes to its shareholders as a return on their investment. Firms pay dividends out of the income or earnings of a firm. However, depending on the geographic location and the business segment, payment may be made out of dividend reserves – reserves that are specifically created for maintaining a steady dividend payment.

#### Net Working Capital

Calculate Net Working Capital by subtracting current liabilities from current assets.

It is the total capital tied up during the operating cycle of the firm. The operating cycle starts from purchasing followed by production, distribution and collection, in that order.

What happens in the purchasing cycle? We buy material and input on credit from suppliers. What happens in production cycle? We combine effort, labor, resources and our purchases to manufacture products. Some of these are cash expenses, while others are on credit.

In the distribution cycle, we sell our products to distributors, customers and end users on credit. Before distribution takes place, our finished goods wait in warehouses before distributors or other parties pick them up. Finally, in collection we collect what other people owe to us.

Throughout the operating cycle, owners of a firm and the firm’s associates invest capital in the business.

A positive net working capital indicates that the firm has to make a net investment in its operating cycle. This means that the firm has to increase (read: buy, invest, purchase, spend money) its assets to support current and future volumes of sales. What are these assets? They are cash, accounts receivables, inventory and are collectively known as Current Assets. Investment in these assets is temporary (hence, the term Current Assets) and is paid back as the operational cycle of the firm ends.

Suppliers often fund this increase since they sell products and services to the firm on credit. This credit is better known by the term Current Liabilities. The incremental (additional) investment in current assets is greater than the funds provided by the increase in current liabilities hence we have positive a net working capital.

On the other hand a negative net working capital indicates that the credit provided by external parties (suppliers, customers, distributors, etc) is more than enough to support the additional investment in current assets required to generate sales.

Our next post continues with grasping the ratio analysis language including terms like marketable securities, debt, managerial efficiency and fundamental analysis.