06.01 Financial Statement Ratios and Performance Metrics

Question 1

What are FS ratios and performance metrics sued for?

Answer 1

FS ratios and performance metrics are used to evaluate companies on a host of factors including profitability, liquidity, and solvency. Management can use these results to determine the company’s strategy going forward. The ratios are also used by investors and lenders in assessing the company’s health.

Question 2

What is the purpose of profitability ratios?

Answer 2

To assess a company’s ability to generate profit from its sales, operations, assets, or equity.

Question 3

What is the purpose of liquidity ratios?

Answer 3

To asses a company’s ability to pay off short-term liabilities.

Question 4

What is the purpose of solvency ratios?

Answer 4

To assess a company’s ability to pay off long-term liabilities.

Question 5

What do companies use performance metrics to analyze?

Answer 5

Companies use performance metrics to analyze the company’s abilities, efficiency, operations, growth, and more. Performance metrics include items expressed as ratios (e.g. price-to-earnings ratio) and items that are not expressed as ratios (e.g. EBITDA).

Question 6

What are examples of profitability ratios?

Answer 6

Profit margin, Return on sales, Gross profit margin, Return on assets, Return on equity.

Question 7

What does profit margin measure?

Answer 7

Profit margin measures how much profit a company makes for every dollar of revenue generated.
The formula is “net income” divided by “net sales”

Question 8

What does return on sales measure?

Answer 8

Return on sales is similar to profit margin. However, in the numerator, rather than net income, the ratios uses earnings before interest and taxes (EBIT). As such, return on sales is generally higher than profit margin because the numerator doesn’t include the additional expenses of interest and taxes.
The formula is “EBIT” divided by “net sales”

Question 9

What does gross profit margin measure?

Answer 9

Gross profit margin uses gross profit in the numerator, and is generally higher than both profit margin and return on sales because COGS is the only expense in the numerator.
The formula is “gross profit” divided by “net sales”

Question 10

What does return on assets measure?

Answer 10

Return on assets measures how effectively the company is generating profit with its assets.
The formula is “net income” divided by “average total assets”

Question 11

What does return on equity measure?

Answer 11

Return on equity measures how effectively the company is generating profit with its equity.
The formula is “net income” divided by “average total equity”

Question 12

What are examples of liquidity ratios?

Answer 12

Current ratio, Quick ratio

Question 13

What does the current ratio measure?

Answer 13

The current ratio measures a firm’s ability to meet its short-term obligations. A current ratio greater than 1.0 generally indicates that a company is able to do so.
The formula is “current assets” divided by “current liabilities”

Question 14

What does the quick ratio measure?

Answer 14

The quick ratio is similar to the current ratio, but it excludes current assets that are difficult to convert into cash (such as inventory and prepaid expenses). Instead, only cash, cash equivalents, marketable securities, and net A/R are included in the numerator.
The formula is “(cash + cash equivalents + marketable securities + net A/R)” divided by “current liabilities”

Question 15

What does the accounts receivable turnover ratio measure?

Answer 15

The A/R turnover ratio is a measure of how well a company is managing the credit it extends to its customers. A higher A/R turnover generally indicates that it takes less time to collect cash from customers.
Dividing 365 by this turnover ratio results in days sales in receivables.

Question 16

What does the accounts payable turnover ratio measure?

Answer 16

The A/P turnover ratio indicates how quickly a company pays its vendors for inventory purchased on account. A lower A/P turnover ratio is generally preferred because companies can keep their cash invest for longer.
Dividing 365 by this turnover ratio results in days payables outstanding.

Question 17

What does the inventory turnover ratio measure?

Answer 17

The inventory ratio indicates how quickly finished inventory is sold to customers. A high inventory turnover ratio generally indicates that a company’s products are in high demand. However, if the inventory ratio is too high, it may indicate that a company is charging too little.
Dividing 365 by this turnover ratio results in days supply in inventory.

Question 18

What does days sales in receivables represent?

Answer 18

Days sales in receivables represents how long it takes to receive payment from customers after a sale on account is made.
The formula is “365 days” divided by “A/R turnover”

Question 19

What does days payables outstanding represent?

Answer 19

Days payables outstanding measures how long it takes to pay invoices for goods and services received from suppliers.
The formula is “365 days” divided by “A/P turnover”

Question 20

What does days supply in inventory represent?

Answer 20

Days supply in inventory measures how long a company holds inventory before it is sold.
The formula is “365 days” divided by “Inventory turnover”

Question 21

What is the cash conversion cycle?

Answer 21

The cash conversion cycle measures the number of days it takes for a company to convert the cash it spends on inventory back into cash through its sales. Companies aim to have a lower cash conversion cycle.
The formula is “Days sales in receivables” + “days supply in inventory” - “days payables outstanding”

Question 22

What is the operating cycle?

Answer 22

The operating cycle measures the number of days between producing/purchasing inventory and collecting cash for selling that inventory. Companies aim to have a lower operating cycle.
The formula is “Days sales in receivables” + “days supply in inventory”

Question 23

What are examples of solvency ratios?

Answer 23

Debt-to-equity, Total debt, and Times interest earned

Question 24

What does the debt-to-equity ratio measure?

Answer 24

The debt-to-equity ratio measures how much of the company is financed by creditors relative to that financed by stockholders.
The formula is “total debt” divided by “total equity”

Question 25

What does the total debt ratio measure?

Answer 25

The total debt ratio, is similar to the debt-to-equity ratio, indicates the proportion of assets that is financed by creditors rather than stockholders.
The formula is “total debt” divided by “total assets”

Question 26

What does the times earned interest ratio measure?

Answer 26

The times interest earned ratio is a measure of a company’s ability to cover its interest expense with the income the company generates.
The formula is “EBIT” divided by “Interest expense”

Question 27

What is EBITDA?

Answer 27

Earnings before interest, taxes, depreciation, and amortization.
An alternative measure of profitability that focuses on cash profit rather than accounting profit. As such, in addition to adding back taxes and interest to net income, it also adds back the noncash expenses of amortization and depreciation. This provides a figure that is more equivalent to cash profits. EBITDA is sometimes expressed as a ratio by dividing the dollar value of EBITDA by net sales.
Net income + tax expense + interest expense + depreciation + amortization

Question 28

What does the price-to-earnings ratio measure?

Answer 28

The price-to-earnings ratio measures the market price of a company’s shares relative to the per-share income the company generates.
The formula is “share price” divided by “EPS”

Question 29

What does the dividend payout ratio measure?

Answer 29

The dividend payout ratio measures the amount of income that is paid out to owners of a company.
The formula is “dividends” divided by “net income”

Question 30

What is the asset turnover ratio?

Answer 30

The asset turnover ratio is indicative of how effectively companies use their assets to generate sales.
The formula is “net sales” divided by “average total assets”