Exercises: Economic and financial analysis of the business

Explain why a company's annual accounts are analysed and name three stakeholder groups interested in this analysis (management itself, banks lending money, and investors considering buying equity), stating what each group is interested in finding out.

A company has current assets of $45.000\ \text{€}$ (inventories, trade receivables, and cash) and current liabilities of $30.000\ \text{€}$ (debts due in less than a year). a) Calculate its working capital: $FM = \text{current assets} - \text{current liabilities}$. b) Interpret the result: explain what a positive working capital means and why it provides a buffer to pay short-term debts.

The figure shows a simplified balance sheet of a company: on the left are assets, divided into non-current and current assets, and on the right equity and liabilities, with current liabilities at the top. a) Calculate the working capital, marked with "?". b) Looking at the figure, explain what proportion of current assets is financed by permanent capital and why this provides stability to the business.

Explain what the assets, equity and liabilities of a company are, and what the difference is between current and non-current. Then classify these items into the appropriate balance sheet category: an industrial warehouse, debts to suppliers at 60 days, the capital contributed by the partners, a five-year loan, cash in the till and warehouse inventory.

Explain the difference between liquidity (being able to pay debts due soon) and solvency (being able to meet all debts with all its assets). Reason whether a company can be solvent and at the same time have liquidity problems, with the example of a company with many properties and little cash in the till.

A company has current assets of $70.000\ \text{€}$ and current liabilities of $50.000\ \text{€}$. a) Calculate its working capital: $FM = \text{current assets} - \text{current liabilities}$. b) Also calculate the working capital as $\text{equity} + \text{non-current liabilities} - \text{non-current assets}$, knowing that the permanent resources total $110.000\ \text{€}$ and the non-current assets $90.000\ \text{€}$, and check that both ways coincide. c) Explain in your own words why the two formulas give the same result.

Explain what a financial ratio is and what comparing it is useful for: with the values of previous years of the same company, with those of other companies in the sector and with benchmark values. Take the example of the liquidity ratio and reason why a value of 1.8 can be good in one sector and worrying in another.

Explain the difference between return on assets (what the business yields, comparing earnings before interest and taxes with assets) and return on equity (what the partners earn, comparing net profit with equity). Reason who is more interested in each one: the manager evaluating the business or the shareholder evaluating their investment.

A company presents the following data: inventories $20.000\ \text{€}$, trade receivables $15.000\ \text{€}$, cash $5.000\ \text{€}$, trade payables $12.000\ \text{€}$, and a loan of $18.000\ \text{€}$ maturing in six months. a) Group the line items into current assets and current liabilities and calculate the working capital. b) Interpret the result: is there short-term financial equilibrium? Justify your answer.

Another company has current assets of $25.000\ \text{€}$ and current liabilities of $40.000\ \text{€}$. a) Calculate its working capital. b) Explain what negative working capital means and what immediate problem it could cause (risk of insolvency: debts come due without short-term cash to meet them). c) Propose two measures to correct it (renegotiate debts from short to long term, raise equity capital, sell unused assets) and justify them.

A company has current assets of $60.000\ \text{€}$, current liabilities of $40.000\ \text{€}$, total liabilities of $60.000\ \text{€}$, and equity of $60.000\ \text{€}$. a) Calculate its liquidity ratio (current ratio), $L = \frac{\text{current assets}}{\text{current liabilities}}$, and evaluate it knowing that a recommended benchmark is between 1.5 and 2. b) Calculate its gearing ratio (debt ratio), $E = \frac{\text{liabilities}}{\text{equity} + \text{liabilities}}$, and evaluate it knowing that it typically should not exceed 0.6 (60% of total financing).

A catering company presents these items: inventory $8.000\ \text{€}$, customers pending payment $22.000\ \text{€}$, cash $6.000\ \text{€}$, debts to suppliers $14.000\ \text{€}$ and a bank credit of $10.000\ \text{€}$ due in eight months. a) Group the items into current assets and current liabilities and calculate the working capital. b) Calculate the liquidity ratio, $L = \frac{\text{current assets}}{\text{current liabilities}}$, and evaluate it knowing that a suitable guide value is between 1.5 and 2. c) Interpret the company's short-term financial situation.

A company has inventory of $30.000\ \text{€}$, receivables of $25.000\ \text{€}$, cash of $5.000\ \text{€}$ and current liabilities of $40.000\ \text{€}$. a) Calculate its liquidity ratio, $\frac{\text{current assets}}{\text{current liabilities}}$. b) Calculate its quick ratio or acid test, $\frac{\text{receivables} + \text{cash}}{\text{current liabilities}}$, which leaves out inventory because it is the hardest to turn into cash, and evaluate it knowing that the guide value is that it should be close to 1. c) Explain what problem the second ratio detects that the first one hides.

A company has equity of $80.000\ \text{€}$, long-term debts of $70.000\ \text{€}$ and short-term debts of $30.000\ \text{€}$. a) Calculate its gearing ratio, $E = \frac{\text{liabilities}}{\text{equity} + \text{liabilities}}$, and evaluate it knowing that it should usually not exceed 0.6. b) Calculate the weight of equity over total financing and explain what it means for the company's independence from the banks. c) Reason what would happen to the ratio if the company increased its capital by $20.000\ \text{€}$ and used that money to cancel debt.

A canning factory stores raw materials for an average of 25 days, takes 5 days to manufacture, 20 days to sell and collects from its customers at 45 days, but pays its suppliers at 30 days. a) Calculate its operating cycle (economic maturation period) by adding the four stages up to collection. b) Calculate the financial maturation period by subtracting the days it takes to pay suppliers, and interpret the result: for how many days it must finance its activity itself. c) Explain why paying suppliers later shortens the financial period and what risk stretching that period too far has.

A company has total assets of $300.000\ \text{€}$, equity of $120.000\ \text{€}$ and total liabilities of $180.000\ \text{€}$. a) Calculate its solvency ratio, $G = \frac{\text{assets}}{\text{liabilities}}$, and evaluate it knowing that the guide value is that it should be close to 2 (assets doubling debts). b) Explain what this ratio tells a bank considering lending it money. c) Reason whether it is in the company's interest to take out another long-term loan of $100.000\ \text{€}$ to grow and how the ratio would look after the operation.

An investment group is analysing two companies in the agri-food sector to acquire one of them. The data for the last closed financial year are as follows:

• Company North: Total assets = $200.000\ \text{€}$; Total liabilities = $50.000\ \text{€}$; EBIT = $30.000\ \text{€}$; Financial interest = $2.000\ \text{€}$; Tax rate = $25\ \%$.

• Company South: Total assets = $120.000\ \text{€}$; Total liabilities = $60.000\ \text{€}$; EBIT = $19.200\ \text{€}$; Financial interest = $3.200\ \text{€}$; Tax rate = $25\ \%$.

1. a) Determine the return on assets (ROA) and the return on equity (ROE) for each company and argue which one exploits its productive investments more efficiently and which one provides a better return on the capital contributed by the shareholders.
2. b) Formally explain why Company South achieves a substantially higher ROE than Company North, even though the difference between their ROAs is minimal. Relate this fact to its level of indebtedness and the financial leverage effect.
3. c) If in the next financial year a demand crisis reduces the EBIT of both companies by $60\ \%$ and financial expenses remain constant, predict how the ROE of each company will change. Based on the results, justify which company has assumed a riskier financial structure and why.

The board of directors of a company is debating how to finance a new business line that requires total assets of $100.000\ \text{€}$. Operational projections estimate an annual EBIT of $12.000\ \text{€}$. Two alternative capital structures are proposed (assume zero corporate income tax):

• Structure A: $100\ \%$ with equity (net equity of $100.000\ \text{€}$).

• Structure B: $50\ \%$ with equity and $50\ \%$ via a bank loan at an annual interest rate of $6\ \%$.

The Chief Financial Officer states: "Option B is always superior because taking on debt increases the return for the shareholders". However, a board member warns that the market is volatile.

1. a) Calculate the net profit and return on equity (ROE) of both structures with the projected EBIT ($12.000\ \text{€}$). Explain the mechanism by which ROE increases in option B despite total net profit decreasing.
2. b) Simulate the impact on the ROE of both options if a market contraction reduces the EBIT to $5.000\ \text{€}$. What happens to the leverage effect in this new scenario?
3. c) Formally refute the CFO's statement: calculate the indifference EBIT value at which both options offer an identical ROE and define the general rule that the return on assets must satisfy with respect to the cost of debt for indebtedness to be advisable.

A footwear manufacturing company presents the following average periods of its operating cycle during the financial year:

• Storage of raw materials: $20\ \text{días}$.

• Manufacturing of the products: $10\ \text{días}$.

• Sale of finished products held in the warehouse: $15\ \text{días}$.

• Collection from customers: $30\ \text{días}$.

• Payment to raw material suppliers: $25\ \text{días}$.

1. a) Calculate the economic Average Maturity Period and the financial Average Maturity Period. Justify precisely the conceptual difference between the two concepts and their impact on cash management.

1. b) Interpret the consequences for the company of the value of the financial Average Maturity Period that you obtained in part a) and identify which balance sheet items must finance the operating activity during that period.

1. c) The finance department sets itself the goal of reducing the financial AMP to $30\ \text{días}$ without altering the duration of the production process. Design two concrete strategies in different operating areas to achieve it and explain how this reduction will affect the company's operating funds requirements (required working capital).

An industrial company presents the following at the end of its financial year: total assets of $250.000\ \text{€}$, net equity of $100.000\ \text{€}$, total liabilities of $150.000\ \text{€}$, EBIT of $20.000\ \text{€}$, and net profit of $11.000\ \text{€}$.

1. a) Determine the return on assets (ROA) and the return on equity (ROE). Interpret both indicators and explain what financial condition is taking place in the company so that the return obtained by the owners exceeds the return on total assets.
2. b) The shareholders' meeting is divided: one group proposes distributing $100\ \%$ of the net profit as dividends, while another proposes retaining the entirety in reserves to self-finance the renewal of machinery without resorting to external debt. Reasonably evaluate how each of the two decisions will impact the debt ratio ($\text{Liabilities} / \text{Equity}$) in the following financial year, assuming that liabilities remain constant.
3. c) If for the next financial year total assets must increase by $50.000\ \text{€}$ to undertake an investment, predict what will happen to the ROE if that investment is financed entirely with debt at $8\ \%$ per annum, knowing that the new investment will generate an increase in EBIT of $3.500\ \text{€}$ (assume a tax rate of $20\ \%$ on the additional EBT generated). Justify whether the investment benefits or harms the shareholders.

An entrepreneurial team plans to launch a company that requires an initial asset investment of $200.000\ \text{€}$. An average annual EBIT of $24.000\ \text{€}$ is estimated. To finance the project, two alternatives are being considered (for the purposes of this analysis, ignore taxes):

• Structure A: Finance $100\ \%$ through contributions from the partners ($200.000\ \text{€}$ in net equity).

• Structure B: Contribute $120.000\ \text{€}$ in equity and obtain a long-term loan of $80.000\ \text{€}$ with a nominal interest rate of $7\ \%$ per annum.

1. a) Determine the return on assets of the investment and the return on equity (ROE) for each of the two alternatives with the projected EBIT. Justify technically and conceptually why the debt option amplifies the shareholders' return.
2. b) Analytically find the financial indifference EBIT (the level of EBIT at which both options would provide exactly the same ROE). Demonstrate the relationship between this EBIT level, the cost of debt capital, and the return on assets.
3. c) If there is a considerable probability that a drop in sales reduces EBIT to $10.000\ \text{€}$, provide reasoned advice to the entrepreneurial team on which of the two capital structures they should choose, warning them about the risks associated with the financial burden.

A retail store chain presents the following balance sheet and income statement data at the end of the financial year:

• Non-current assets: $120.000\ \text{€}$

• Inventories: $60.000\ \text{€}$

• Trade and other receivables (customers and debtors): $20.000\ \text{€}$

• Cash and cash equivalents: $10.000\ \text{€}$

• Equity: $60.000\ \text{€}$

• Non-current liabilities: $75.000\ \text{€}$

• Current liabilities: $75.000\ \text{€}$

• EBIT: $18.000\ \text{€}$

• Net profit: $9.000\ \text{€}$

1. a) Calculate working capital and interpret the short-term solvency situation by contrasting the current ratio with the acid-test ratio (quick ratio). Justify the source of the liquidity strain revealed by the composition of current assets.
2. b) Analyse the long-term financial structure using the debt-to-equity ratio (or total debt ratio) and the debt coverage/solvency ratio. Determine whether the company is in a state of financial equilibrium, at risk of default/suspension of payments, or technically bankrupt, justifying your assessment.
3. c) Design a financial restructuring plan with two specific measures (one targeting current asset management and another targeting the liability/equity structure) that correct the diagnosed imbalances without harming economic profitability (ROA).

A technology company in a rapid expansion phase has doubled its turnover over the past year and recorded a record net profit of $85.000\ \text{€}$. However, its managing director cannot understand why the company is on the brink of suspension of payments, unable to pay salaries at the end of the month and with its bank credit line exhausted. The balance sheet shows working capital of $-40.000\ \text{€}$, inventories worth $110.000\ \text{€}$, an average collection period from customers of $90\ \text{days}$, and an average payment period to suppliers of $30\ \text{days}$.

1. a) Resolve the apparent paradox that baffles the managing director: distinguish with analytical rigor between "economic flow" (revenues and expenses) and "financial flow" (collections and payments), justifying how accelerated sales growth can destroy the cash flow of a profitable company ("growing broke" or "overtrading").
2. b) Evaluate the balance sheet situation based on the negative working capital and identify the fundamental error in the financing of its operating investments.
3. c) Design a comprehensive financial viability proposal with two actions targeting the commercial operating cycle and two measures targeting the capital structure and long-term financing sources, explaining the mechanism by which each one will restore financial equilibrium.

A plumbing supplies distribution company has an annual cost of goods sold of $900.000\ \text{€}$. Its current cash conversion cycle (financial operating cycle or CCC) is $60\ \text{days}$ (assume a commercial year of $360\ \text{days}$). The company finances its operating cycle through working capital of $150.000\ \text{€}$.

1. a) Determine the volume of financial resources that the company ties up on average in its operating cycle (Required Working Capital or Working Capital Needs) and compare this amount with its actual working capital. Interpret the resulting cash equilibrium situation.
2. b) Management is considering reducing the CCC to $40\ \text{days}$. Calculate the amount of cash resources that would be freed up by this optimisation and formulate two specific measures in the supply chain and credit collection policy to achieve that goal.
3. c) Suppose the company decides not to modify its operating timeframes ($CCC = 60\ \text{days}$), but achieves a $30\ \%$ growth in its activity and operating costs. Predict the quantitative impact that this growth will have on its operating financing needs and infer what will happen to cash if actual working capital remains unchanged.

Unit challenge. Act as a junior financial analyst and advise an SME on purchasing eco-efficient machinery for $40.000$ €.

1. Data and financing: Check the website of the Banco de España for the current average interest rate on corporate loans (this will be your discount rate, $k$, approx. $4,8\,\%$). Propose how to finance the investment: $60\,\%$ bank loan and $40\,\%$ equity financing.

2. Accounting impact: Design the initial and final balance sheets after the acquisition, reflecting the change in working capital, and prepare a provisional income statement for a 3-year horizon.

3. Investment appraisal: Estimate the annual net cash flows ($FNC$) generated by the cost savings. Calculate the payback period, the $VAN$, and deduce whether the $TIR$ will exceed $k$.

4. Executive report: Write a one-page report that integrates solvency, return on investment ($ROI$), and project viability, recommending its reasoned approval or rejection.

Assessment criteria:

• Rigorous data extraction from the Banco de España and consistency in the financial structure.

• Mathematical correctness in calculating the $VAN$, payback period, and financial balance.

• Coherent integration across the balance sheet, income statement, and cash flows.

• Critical thinking and clear presentation in the final recommendation.