Redlining: Americas Racist Financial Policies
America is a developed country and an inclusive society. It should ideally no longer face the problems of racism and social inequality and yet it does. It is no accident that a large number of poor and destitute consist of people from African American and Latin American communities. In fact, it is a result of […]
How Pre-Revenue Companies are Valued?
Valuation of any company can be a very complex task. However, when it comes to pre-revenue companies, this complexity is magnified. This is because of the fact that valuation is generally the discounted value of the future cash flows which are likely to arise in the future. The current cash flows are used as a […]
Infrastructure Finance: An Introduction
Traditional economists are of the opinion that infrastructure is the heart of the economy. Empirical data clearly shows that given a choice, investors prefer to invest their money in countries whose infrastructure is more developed. Hence, it can be said that rapid infrastructure development is one of the most basic ways in which a country […]
Link between Present Value of Growth Opportunities (PVGO) and Dividend Valuation
Valuing a corporation is a complex exercise. This is partly because there are multiple ways of looking at the same information. One such example is mentioned in this article. Dividend discount valuation and present value of growth opportunities may seem to be two completely different topics. However, there exists a link between them. In fact […]
Spreadsheet Modeling: Dividend Discount Model
In the past few articles, we have studied about the various models that are available to help us predict the value of a firm based on the dividends that it provides. However, all these models had one flaw. They expected that the dividends of the firm will follow some set pattern. For instance, the assumptions […]
As we have seen earlier that there is a wide variety of financial ratios available. They fall into many categories and if variations are included there are hundreds of types of ratios that are common in practice. However, all the ratios are not used by everyone on a regular basis. There are some ratios which are more important to some user groups than they are to other user groups. This article explains why this is the case:
The management of the company may not be so concerned with the results. They are usually more interested in the cause. This is because while other classes of stakeholders do not have control over the working of the firm i.e. the cause, the management does. All the other stakeholders question the management at the annual general meeting. Hence, management tries to get as much insight into the ratios as possible. They create operating performance ratios and compare it to their previous performance and to the performance of others to learn from the past as well as to be able to give satisfactory answers to the investors.
Shareholders, for obvious reasons, are most concerned about profitability. Their investments are at risk and they expect to gain the maximum. Investors scrutinize profitability numbers and pounce upon the slightest signs of mismanagement. For the shareholders, the profitability ratios are the beginning point. They then follow the trail the ratios leave. However over the past two decades the focus has been steadily shifting towards cash flow ratios.
Debt holders and suppliers are concerned whether they will be paid the amount promised to them at the date that was promised to them. It is for this reason that they are very concerned about the liquidity of the firm. Slightest signs of liquidity issues are met with supply cutbacks from suppliers.
The fact that debt holders are concerned about the same ratios creates a self reinforcing negative loop for the company. This is because at the same time when suppliers cut credit and supplies, debt holders refuse to lend more money and the whole situation becomes a cash crunch.
While debt holders are suppliers are concerned about short term liquidity and cash flow, credit rating agencies go a step ahead. They use solvency ratios to rigorously analyze whether the company will be able to make good its obligations in the long run.
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