Analyzing Financial Statements Flashcards
Analyzing financial statements is critical in order to understand
the performance of a business. To do so, we can use different types of ratios that uncover important relationships between financial statement items.
Ratios are typically most useful when
making comparisons to other companies or to the past performance of the company itself. Therefore, it’s important to first get an overall understanding of the company and the industry in which it operates.
One of the most commonly evaluated ratios is a firm’s ___ which shows ___
return on equity or ROE, which shows the return that a business generated during a period on the equity invested in the business by the owners of the business.
Return on Equity = Net Income / Owners Equity
The DuPont Framework measures profitability using
Profit Margin, efficiency using Asset Turnover, and leverage using the Leverage Ratio (or Equity Multiplier
Profitability reveals
how much profit is left from each dollar of sales after all expenses have been subtracted.
Profit margin is calculated
by dividing net income by the total sales for the period.
The gross profit margin ratio tells us
what percentage of our revenue is left to cover other expenses after the cost of goods sold is subtracted. Recall that gross profit is equal to sales minus cost of goods sold.
(Revenue - Cost of Sales) / Revenue = Gross Profit Margin
Earnings before interest after taxes or EBIAT, is a measure of
how much income the business has generated while ignoring the effect of financing and capital structure, or the proportion of debt that the business has. As the name implies, interest expense, which is included on the income statement, is added back, and income tax expense is calculated and subtracted based on earnings before interest.
asset turnover tells us how well a business is
using its assets to produce sales. A business that can create more revenue with fewer assets is more efficient. This ratio uses both the income statement and the balance sheet; we typically use the average of the beginning and ending balance sheet amounts to estimate the average level of assets during the period.
Asset Turnover is calculated by dividing the annual revenue by the average asset value for the year.
Inventory turnover helps understand how efficiently a business is
managing its inventory levels. Excess inventory costs money to store and uses up the firm’s cash that could be used for other investments. A higher inventory turnover represents more efficient inventory management.
INVENTORY TURNOVER = COGS / AVG INVENTORY
Days Inventory is expressed
as the average number of days the inventory is held before it is sold rather than how many times the inventory turned over during the period. At times it may be more intuitive to consider and discuss ratios and changes to these ratios when the terms are expressed in days.
DAYS INVENTORY = AVG INVENTORY / (COGS/365)
or
365 / INVENTORY TURNOVER
The accounts receivable turnover or AR turnover indicates a business’ efficiency in
collecting receivables from customers.Uncollected receivables represent cash that is tied up and can’t be used for other purposes. A higher AR turnover represents more efficient cash collections. An AR turnover that is too low could indicate that the business’ customers are having trouble paying.
= CREDIT SALES / AVG ACCOUNTS RECEIVABLE
The average collection period, sometimes referred to as Days Sales Outstanding (DSO) or Days Sales in Receivables,is the average number of days
it took for a business to collect payment from a customer. This helpful measure can be compared to the cash collection policy of the firm. If payment is expected from customers within 30 days, but the average collection period is 40 days, it may be a sign of concern.
We can calculate the average collection period by first finding the average credit sales per day. Dividing the average accounts receivable balance by credit sales per day will leave us with the number of days sales our accounts receivable balance represents, or the average collection period
= 365 / Accounts receivable turnover
To measure Accounts payable turnover, or AP turnover, we look at how long it takes us
at how long it takes us to pay our vendors. Vendors include suppliers of inventory and also suppliers of services or other non-inventory items. One input for this ratio is credit purchases, which can be estimated by looking at COGS. We are also assuming that all goods are bought on credit and not paid for with cash. In both cases other adjustments may have to be made.
= CREDIT PURCHASES / AVG Accounts Payable
or
COGS / avg accounts payable
days purchases outstanding =
AVG accounts payable / (Annual credit purchases/ 365)
cash conversion cycle is a measure of
how long it takes a business from the time it has to pay for inventory from its suppliers until it collects cash from its customers.
= Days Inventory + Average Collection Period - Days Purchases Outstanding
Financial Leverage, also known as the Equity Multiplier, measures the impact
the impact of all non-equity financing, or debt of all sorts, on the firm’s ROE. If all of the assets are financed by equity, the multiplier is 1. As liabilities, which are forms of debt, increase, the multiplier increases from 1 demonstrating the leverage impact of the debt.
debt to equity ratio =
The Debt to Equity Ratio is calculated by dividing the total liabilities by the total equity.
Total liabilities / total equity =
The current ratio helps us understand the business’ ability
to pay its short term obligations. It focuses on the business’ more liquid assets and liabilities, or those that are convertible to cash or coming due, within a year.
Current Assets / Current Liabilities =
The quick ratio =
The quick ratio is an even more stringent test than the current ratio to see if a business can meet its current obligations because it depends only on the most readily available current assets. Some businesses may have trouble turning their inventory into cash, so this gives us an idea of their ability to meet current obligations even if their inventory can’t be sold immediately.
(Current Assets - Inventory) / Current Liabilities =
The interest coverage ratio, also known as the times interest earned, is a good way to gauge how
capable a business is of making the interest payments on its debt. For this, we use a common income number called EBIT (Earnings Before Interest and Taxes). This number has to be calculated from the income statement by adding back interest expense and tax expense for the period to net income.
To calculate Earnings Before Interest and Taxes (EBIT), we start with Net Income and then add back Interest Expense and Income Tax Expense.
To calculate the Interest Coverage Ratio, we divide EBIT by Interest Expense.
Credit Sales per Day can be calculated as
Sales / 365
A company’s Inventory Turnover decreased during the year. Which of the following is a reasonable explanation to this trend?
Inventories were less marketable compared with last year.
Inventory Turnover = Cost of goods sold / Average inventory As the inventories became less marketable, the company would be less efficient in operating its inventories, and thus the Inventory Turnover would decrease.
Company A has a shorter Average Collection Period than Company B. Which of the following statements is true regarding these two companies?
Company A is more efficient in collecting receivables from customers than Company B.
Average Collection Period = 365 / (Credit Sales / Average AR Balance) A lower Average Collection Period means the company is more efficient in collecting from their customers.
What is the formula used to calculate Cash Conversion Cycle?
Cash Conversion Cycle = Days Inventory + Average Collection Period - Days Payable Outstanding
Company C has zero inventory, which indicates it is likely a ___ industry.
service
Company A has high inventory which indicates it is ____
retail.
Days Purchases Outstanding is calculated by
dividing Average Accounts Payable by the average daily Cost of Sales, which is Cost of Sales divided by 365.
Average Accounts Payable / Average Daily Cost of Sales
Gross Profit Margin is calculated by
the Gross Profit (Revenue less Cost of Sales) by the Revenue
(Revenue - Cost of Sales) / Revenue = Gross Profit Margin
Interest Coverage Ratio =
EBIT / Interest Expense = (Net Income + Income Tax + Interest Expense)
Days Inventory =
365 / Inventory Turnover
Average Collection Period =
365 / Accounts Receivable Turnover
Days Purchases Outstanding =
365 / Accounts Payable Turnover
