4 - Analysis of Financial Statements Flashcards
Help us evaluate financial statements; used to make comparisons
Ratios
5 Categories of Ratios:
- Liquidity
- Asset Management
- Debt Management
- Profitability
- Market Value
Give an idea of firm’s ability to pay off debts that mature within a year
Liquidity ratios
How efficiently the firm is using its assets
Asset management ratios
How the firm has financed its assets as well as the firm’s ability to repay its long-term debt
Debt management ratios
How profitably the firm is operating and utilizing its assets
Profitability ratios
What investors think about the firm and its future prospects
Market value ratios
Shows how many times the particular asset is “turned over” during the year
Inventory Turnover Ratio
Term originated with old Yankee peddler; what he actually sold
Turnover
Represents the average length of time the firm must wait after making a sale before receiving cash
Days Sales Outstanding (DSO) Ratio
Days Sales Outstanding (DSO) Ratio is also called
Average Collection Period (ACP)
Measures how effectively the firm uses its plant and equipment
Fixed Assets Turnover Ratio
Measures how effectively the firm uses its total assets
Total Assets Turnover Ratio
Firms with relatively high debt ratios typically have higher expected returns when economy is normal, if in times with lower returns, it could possibly face
bankruptcy
2 Procedures Analysists Use to Examine Firm’s Debt:
- Check BS to determine portion of total funds represented by debt
- Review the IS to see the extent to which interest is covered by operating profits
Measures the percentage of the firm’s capital provided by debtholders
Total Debt to Total Capital
Generally refer to the total debt to total capital ratio
Company’s debt ratio
Measure of the firm’s ability to meet its annual interest payments
Times-Interest-Earned (TIE) Ratio
Group of ratios that show the combined effects of liquidity, asset management, and debt on operating results
Profitability Ratios
Measures operating income (EBIT) per dollar of sales
Operating Margin
Measures net income per dollar or sales
Profit Margin/Net Profit Margin
Interest changes pull down
net income
Measures the rate of return on the firm’s assets
Return on Total Assets (ROA)
Measures the rate of return on common stockholder’s investment
Return on Common Equity (ROE)
Measures the total return that the company has provided for its investors
Return on Invested Capital (ROIC)
Indicates the ability of the firm’s assets to generate operating income
Basic Earning Power (BEP) Ratio
Single best accounting measure of performance
Return on Common Equity (ROE)
Related the firm’s stock price to its earnings and book value per share
Market Value Ratios
Market Value Ratios are used in 3 primary ways:
- by investors
- by investment bankers
- by firms
Shows how much investors are willing to pay per dollar of reported profits
Price/Earnings (P/E) Ratio
Ratio of a stock’s market price to its book value
Market/Book (M/B) Ratio
Looks at the relative market value of all the company’s key financial claims; not heavily influenced by the company’s debt and tax situations
Enterprise Value/EBITDA (EV/EBITDA) Ratio
Shows the relationships among asset management, debt management, and profitability ratios
DuPont Equation
Develop by the chemical giant’s financial staff in 1920s
DuPont Equation
“Multiplier” that tells us how many times the profit margin is earned each year
Total assets turnover
Adjustment factor
Equity multiplier
Help identify ways to improve its performance
DuPont Equation
Study various expense items and work with engineers, purchasing agents, and other operating personnel, to seek ways to cut costs.
Cost accountants
Investigate ways to speed up collections, which would reduce accounts receivable and improve the quality of the total assets turnover ratio
Credit manager
Analyze the effects of alternative debt policies, showing how changes in leverage would affect both the expected ROE and the risk of bankruptcy
Financial staff
3 Problems that are likely to arise if firm relies too heavily on ROE to measure performance:
- ROE does not consider risk
- Does not consider the amount of invested capital
- Focus on ROE can cause managers to turn down profitable projects
Project’s ROE must be combined with its size and risk to determine its effect on shareholder value
- ROE
- Risk
- Capital invested
Process of comparing a particular company with a subset of top competitors in its industry; makes it easy to see exactly where a company stands relative to the competition.
Benchmarking
Companies used for the comparison
Benchmark companies
Analysis of firm’s financial ratios over time; used to estimate the likelihood of improvement or deterioration in its financial condition
Trend Analysis
Techniques employed by firms to make their financial statements look better than they really are
Window Dressing Techniques
Ratio analysis is used by 3 main groups:
- managers
- credit analysts
- stock analysts
