Book 3 - FRA - Ratios Flashcards
Which is the average number of days it takes for the company’s customers to pay their bills. It is considered desirable to have a collection period (and receivables turnover) close to the industry norm. The firm’s credit terms are another important benchmark used to interpret this ratio. A collection period that is too high might mean that customers are too slow in paying their bills, which means too much capital is tied up in assets. A collection period that is too low might indicate that the firm’s credit policy is too rigorous, which might be hampering sales.
A measure of a firm’s efficiency with respect to its processing and inventory management.
As is the case with accounts receivable, it is considered desirable to have days of inventory on hand (and inventory turnover) close to the industry norm. A processing period that is too high might mean that too much capital is tied up in inventory and could mean that the inventory is obsolete. A processing period that is too low might indicate that the firm has inadequate stock on hand, which could hurt sales.
A measure of the use of trade credit by the firm.
Which is the average amount of time it takes the
company to pay its bills.
The effectiveness of the firm’s use of its total assets to create revenue. Different types of industries might have considerably different turnover ratios. Manufacturing businesses that are capital-intensive might have asset turnover ratios near one, while retail businesses might have turnover ratios near 1 0 . As was the case with the current asset turnover ratios discussed previously, it is desirable for the total asset turnover ratio to be close to the industry norm. Low asset turnover ratios might mean that the company has too much capital tied up in its asset base. A turnover ratio that is too high might imply that the firm has too few assets for potential sales, or that the asset base is outdated.
The utilization of fixed assets. As was the case with the total asset turnover ratio, it is desirable to have a fixed asset turnover ratio close to the industry norm. Low fixed asset turnover might mean that the company has too much capital tied up in its asset base or is using the assets it has inefficiently. A turnover ratio that is too high might imply that the firm has obsolete equipment, or at a minimum, that the firm will probably have to incur capital expenditures in the near future to increase capacity to support growing revenues. Since “net” here refers to net of accumulated depreciation, firms with more recently acquired assets will typically have lower fixed asset turnover ratios.
How effectively a company is using its working capital. Working capital (sometimes called net working capital) is current assets minus current liabilities. The working capital turnover ratio gives us information about the utilization of working capital in terms of dollars of sales per dollar of working capital. Some firms may have very low working capital if outstanding payables equal or exceed inventory and receivables. In this case the working capital turnover ratio will be very large, may vary significantly from period to period, and is less informative about changes in the firm’s operating efficiency.
The higher the current ratio, the more likely it is that the company will be able to pay its short-term bills. A current ratio ofless than one means that the company has negative working capital and is probably facing a liquidity crisis. Working capital equals current assets minus current liabilities.
The quick ratio is a more stringent measure of liquidity because it does not include inventories and other assets that might not be very liquid. The higher the quick ratio, the more likely it is that the company will be able to pay its short-term bills. Marketable securities are short-term debt instruments, typically liquid and of good credit quality.
The most conservative liquidity measure is the cash ratio. The higher the cash ratio, the more likely it is that the company will be able to pay its short-term bills.
The defensive interval ratio is another measure ofliquidity that indicates the number of days of average cash expenditures the firm could pay with its current liquid assets. Expenditures here include cash expenses for costs of goods, SG&A, and research and development. If these items are taken from the income statement, noncash charges such as depreciation should be added back just as in the preparation of a statement of cash flows by the indirect method.
The cash conversion cycle is the length of time it takes to turn the firm’s cash investment in inventory back into cash, in the form of collections from the sales of that inventory. High cash conversion cycles are considered undesirable. A conversion cycle that is too high implies that the company has an excessive amount of capital investment in the sales process.
A measure of the firm’s use of fixed-cost financing sources is the debt-to-equity ratio.
Increases and decreases in this ratio suggest a greater or lesser reliance on debt as a source of financing.
Total debt is calculated differently by different analysts and different providers of financial information. Here, we will define it as long-term debt plus interest-bearing short-term debt.
Some analysts include the presentvalue oflease obligations and/or non-interest bearing current liabilities, such as trade payables.
Another way of looking at the usage of debt is the debt-to-capital ratio. Capital equals all short-term and long-term debt plus preferred stock and equity. Increases and decreases in this ratio suggest a greater or lesser reliance on debt as a source of financing.
Increases and decreases in this ratio suggest a greater or lesser reliance on debt as a source of financing.
Another measure that is used as an indicator of a company’s use of debt financing is thefinancial leverage ratio (or leverage ratio). Average here means the average of the values at the beginning and at the end of the period. Greater use of debt financing increases financial leverage and, typically, risk to equity holders and bondholders alike.
The lower this ratio, the more likely it is that the firm will have difficulty meeting its debt payments.
A second ratio that is an indicator of a company’s ability to meet its obligations is thefixed charge coverage ratio. Here, lease payments are added back to operating earnings in the numerator and also added to interest payments in the denominator. Significant lease obligations will reduce this ratio significantly compared to the interest coverage ratio. Fixed charge coverage is the more meaningful measure for companies that lease a large portion of their assets, such as some airlines.
Analysts should be concerned if this ratio is too low. The net profit margin should be based on net income from continuing operations, because analysts should be primarily concerned about future expectations, and below-the-line items such as discontinued operations will not affect the company in the future.
An analyst should be concerned if this ratio is too low. Gross profit can be increased by raising prices or reducing costs. However, the abiliry to raise prices may be limited by competition.
The operatingprofit margin is the ratio of operating profit (gross profit less selling, general, and administrative expenses) to sales. Operating profit is also referred to as earnings before interest and taxes (EBIT). Strictly speaking, EBIT includes some nonoperating items, such as gains on investment. The analyst, as with other ratios with various formulations, must be consistent in his calculation method and know how published ratios are calculated. Analysts should be concerned if this ratio is too low. Some analysts prefer to calculate the operating profit margin by adding back depreciation and any amortization expense to arrive at earnings before interest, taxes, depreciation, and amortization (EBITDA).
Sometimes profitability is measured using earnings before tax (EBT), which can be calculated by subtracting interest from EBIT or from operating earnings. The pretax margin is calculated as:
Another set of profitability ratios measure profitability relative to funds invested in the company by common stockholders, preferred stockholders, and suppliers of debt financing. The first of these measures is the return on assets (ROA) . This measure is a bit misleading, however, because interest is excluded from net income but total assets include debt as well as equity. Adding interest adjusted for tax back to net income puts the returns to both equity and debt holders in the numerator. The interest expense that should be added back is gross interest expense, not net interest expense (which is gross interest expense less interest income) .
Another set of profitability ratios measure profitability relative to funds invested in the company by common stockholders, preferred stockholders, and suppliers of debt financing. The first of these measures is the return on assets (ROA) . This measure is a bit misleading, however, because interest is excluded from net income but total assets include debt as well as equity. Adding interest adjusted for tax back to net income puts the returns to both equity and debt holders in the numerator. The interest expense that should be added back is gross interest expense, not net interest expense (which is gross interest expense less interest income) .
A measure of return on assets that includes both taxes and interest in the numerator is the operating return on assets.
Total capital includes short- and long-term debt, preferred equity, and common equity. Analysts should be concerned ifthis ratio is too low.
An alternative method for computing ROTC is to include the present value of operating leases on the balance sheet as a fixed asset and as a long-term liability. This adjustmentisespeciallyimportantforfirmsthataredependentonoperatingleasesas a major form of financing.
Analysts should be concerned if this ratio is too low. It is sometimes called return on total equity.
This ratio differs from the return on total equity in that it only measures the accounting profits available to, and the capital invested by, common stockholders, instead of common and preferred stockholders. That is why preferred dividends are deducted from net income in the numerator. Analysts should be concerned ifthis ratio is too low.
The return on common equity is often more thoroughly analyzed using the DuPont decomposition, which is described later in this topic review.
Free Cash Flow to the Firm
FCFF
Free cash flow to the firm (FCFF) is the cash available to all investors, both equity owners and debt holders.
Note that interest expense, net of tax, is added back to net income. This is because FCFF is the cash flow available to stockholders and debt holders. Since interest is paid to (and therefore “available to”) the debt holders, it must be included in FCFF.
Free Cash Flow to the Firm
(Calculated from CFO)
FCFF
Cash Flow to Equity
FCFE
Free cash flow to equity (FCFE) is the cash flow that would be available for distribution to common shareholders.
ROE
Original DuPont Equation
It uses basic algebra to break down ROE into a function of different ratios, so an analyst can see the impact ofleverage, profit margins, and turnover on shareholder returns. It is arguably the most important equation in ratio analysis, since it breaks down a very important ratio (ROE) into three key components. If ROE is relatively low, it must be that at least one of the following is true: The company has a poor profit margin, the company has poor asset turnover, or the firm has too little leverage.
ROE
Extended (5 way) DuPont equation.
The extended (5-way) DuPont equation takes the net profit margin and breaks it down further.
An increase in interest expense as proportion of EBIT will increase the interest burden (i.e., decrease the interest burden ratio). Increases in either the tax burden or the interest
burden (i.e., decreases in the ratios) will tend to decrease ROE.
EBIT in the second two expressions can be replaced by operating earnings. In this case, we have the operating margin rather than the EBIT margin. The interest burden term would then show the effects of nonoperating income as well as the effect of interest expense.
Note that in general, high profit margins, leverage, and asset turnover will lead to high levels of ROE. However, this version of the formula shows that more leverage does not always lead to higher ROE. As leverage rises, so does the interest burden. Hence, the positive effects of leverage can be offset by the higher interest payments that accompany more debt. Note that higher taxes will always lead to lower levels of ROE.
The cash flow-to-revenue ratio measures the amount of operating cash flow generated for each dollar ofrevenue.
The cash return-on-assets ratio measures the return of operating cash flow attributed to all providers of capital.
The cash return-on-equity ratio measures the return of operating cash flow attributed to shareholders.
The cash-to-income ratio measures the ability to generate cash from firm operations.
Cash flow per share is a variation of basic earnings per share measured by using CPO instead of net income. Note: If common dividends were classified as operating activities under IPRS, they should be added back to CPO for purposes of calculating cash flow per share.
The debt coverage ratio measures financial risk and leverage.
The interest coverage ratio measures the firm’s ability to meet its interest obligations.
The reinvestment ratio measures the firm’s ability to acquire long-term assets with operating cash flow.
The debt payment ratio measures the firm’s ability to satisfy long-term debt with operating cash flow.
The dividend payment ratio measures the firm’s ability to make dividend payments from operating cash flow.
The investing and financing ratio measures the firm’s ability to purchase assets, satisfy debts, and pay dividends.
