Ch. 20 Flashcards
Major Users of financial analysis
- Creditors
- Equity Investors
Creditors
- Banks and Bond investors
- Creditors want to make sure they get their investment back and receive a return
- Credit rating agencies - Watched closely by creditors
Equity Investors
- Individuals with a stock ownership in a company
- Equity investors want the stock to generate an acceptable return
- Investors will sell the stock if they feel they will not get a reasonable rate of return
Horizontal Analysis
- generally compares one period against another period
Vertical Analysis
- Compares a given period by a total for the period
- Compares Balance sheet and Income statement
Activity ratios
- Help a financial statement reader assess whether the company is experiencing any changes in the normal flow of business
Accounts Receivable turnover ratio
= Net Credit Sales / Avg. Net accounts receivable
- This ratio explains how fast the company is converting accounts receivable into cash
- Higher ratio means cash is coming into business faster (the higher the better)
Inventory Turnover ratio
= COGS / Avg. Inventory for the Period
- The ratio explains how fast the company is converting inventory into sales
- Higher ratio means inventory is not building (higher the better)
Current Ratio
= Current Assets / Current Liabilities
- The ratio shows the amount of current assets to cover current liabilities
- A banker would be more likely to give a short-term loan to a company with a high current ratio vs. a low current ratio
- High current ratio means a banker has a higher likelihood of receiving the bank’s money back
Working Capital
= Current Assets - Current Liabilities
- This calculation tries to measure the short-term liquidity of a business. Could the current assets cover the current liabilities?
Gross Margin Ratio
= Gross Margin / Net Sales
- The ratio shows the % of profit generated by each sale (Gross Margin = Net Sales - COGS)
- A company wants to increase the gross margin on each sale. The additional gross margin can be used to cover expenses below the gross margin
Earnings per Share (EPS)
= Net Income - Preferred Dividends / Weighted Avg. - Avg. # of Common Stock Outstanding
- The EPS ratio is the most talked about financial ratio
- A company wants to increase its earnings per share
Price-earnings Ratio
= Current stock market price / Earnings per share (EPS)
- As the P/E ratio increases, the stock becomes a more expensive stock
- An investor wants to buy a stock before P/E ratio increases
Debt to Equity Ratio
= Total Debt/Total Equity
- Ratio of 1 - Debt financing = equity financing
- Ratio of 1.5 - More debt financing than equity financing
- As the debt to equity ratio increases the risk associated with the business increases
Time Interest Earned Ratio
= Earnings before interest and taxes / Interest expense
- As the times interest ratio goes up, the firm is in a better position to payoff creditors
