Chapter 12: Introduction to Case Analysis and Analyzing Financial Statements Flashcards
Who are institutional investors?
Includes pension, mutual, endowment and other funds
that invest on the behalf of others
Who are private investors?
Individuals who purchase shares in companies
Who are lenders or creditors?
Suppliers, banks, commercial credit companies, and
other financial institutions that lend money to
companies
Walk me through the disclosure process?
-To provide timely information to external users and to
limit the possibility of selective leakage of information,
most public companies announce quarterly and annual
earnings through a press release: a written public news
announcement normally distributed to major news
services as soon as the verified figures (audited for annual
and reviewed for quarterly earnings) are available.
-The announcements are sent electronically to the major
print and electronic news services, which make them
immediately available to subscribers.
What do annual reports typically include?
1) Basic financial statements: statement of earnings, statement of financial position, statement of changes in equity, and statement of cashflows.
2) Related notes
3) Report of independent accountants (auditor’s opinion).
What two sections are the annual reports of public companies split into?
1) Non-financial
-Includes a letter to shareholders from the chairperson and
CEO, along with descriptions of the company’s
management philosophy, products, successes (and
occasionally failures), and exciting prospects and
challenges for the future.
2) Financial
-Includes the core of the report. Securities regulators set
minimum disclosure standards for the financial section of
the annual reports of public companies.
When analysing a company, what are three things you should look at that go beyond the financial statements?
-Economy-wide factors: The overall health of the economy
has a direct impact on the performance of an individual
business. Prudent investors must consider data such as the
unemployment rate, the general inflation rate, and changes
in interest rates.
-Industry factors: Certain events have a major impact on
each company within an industry but have only a minor
impact on other companies outside the industry.
-Individual company factors: To properly analyze a company,
you should learn as much as you can about it. Good analysts
do not rely solely on the information contained in the
financial statements. They visit the company, buy its
products, and read about it in the business press.
What are the two strategies business can follow to earn a high rate of return for the owners?
1) Product differentiation (or high-value): Companies offer products with unique benefits, such as high quality or unusual features or style.
2) Cost advantage: Reduce operating expenses to charge lower prices than competitors.
What are two popular tools that financial analysts use to analyze a company’s financial statements?
1) Component percentages
2) Ratio analysis
What is a component percentage?
A component percentage expresses each item on a
financial statement as a percentage of a single base
amount, the denominator of the ratio. The base amount
on the statement of earnings is net sales. On the statement of financial position, each amount is divided by total assets.
What is ratio analysis?
Ratio analysis is an analytical tool that measures the
proportional relationship between financial statement
amounts. It condenses a large volume of raw financial
data and helps decision makers identify significant
relationships and make meaningful comparisons.
What is the formula for return on equity? What does it measure?
Return on Equity=Net earnings/Average shareholder’s equity in the past two years.
Please note: Shareholder’s Equity includes retained earnings and common shares.
It measures how much income was earned for every dollar invested by the owners.
What is the formula for return on assets? What does it measure?
Retun on Assets=Net earnings/Average total assets in the past two years
Many analysts consider this ratio as the best overall measure of a company’s profitability.
What is the formula for gross profit margin ratio? What does it measure?
Gross profit margin ratio=Gross profit/Net sales
It reflects gross profit as a percentage of sales
What is the formula for net profit margin ratio? What does it measure?
Net profit margin ratio=Net earnings/Net sales
The net profit margin ratio measures the percentage of
each sales dollar, on average, that represents net
earnings.
What is the formula for earnings per share (EPS) ratio? What does it measure?
Earnings per share (EPS) ratio=Net earnings available to common shareholders/Average number of common shares outstanding
Earnings per share calculates the average number of shares
based on the number of shares at the beginning and end
of the year.
What is the formula for quality of earnings ratio? What does it measure?
Quality of earnings ratio=Cash flows from operating activities/Net earnings
Most financial analysts are concerned about the quality
of a company’s earnings because the use of some
accounting procedures can result in higher earnings
reports. A ratio higher than 1 indicates high-quality
earnings.
What are the six main profitability ratios?
1) Return on equity (ROE)
2) Return on assets (ROA)
3) Gross profit margin ratio
4) Net profit margin ratio
5) Earnings per share (EPS) ratio
6) Quality of earnings ratio
What are the four main asset turnover ratios?
1) Total asset turnover ratio
2) Fixed asset turnover ratio
3) Receivables turnover ratio
4) Inventory turnover ratio
What is the formula for total asset turnover ratio? What does it measure?
Total Asset Turnover Ratio=Net Sales/Average Total Assets
The total asset turnover ratio captures how well a
company uses its assets to generate revenue.
What is the formula for fixed asset turnover ratio? What does it measure?
Fixed Asset turnover ratio=Net sales/average net fixed assets
Net fixed assets include: cash, accounts receivable, merchandise inventory, prepayments, and PPE.
This ratio measures a company’s ability to generate sales
given an investment in fixed assets.
What is the formula for receivables turnover ratio? What does it measure?
Receivables turnover ratio=Net credit sales/Average net accounts receivable
This ratio measures how quickly a company collects
its trade receivables.
What is the formula for inventory turnover ratio? What does it measure?
Inventory turnover ratio=Cost of sales/Average inventory
This ratio measures how quickly the company sells its
inventory.
What are the three main liquidity ratios?
1) Current ratio
2) Quick ratio
3) Cash ratio
What is the formula for current ratio? What does it measure?
Current ratio=Current assets/Current liabilities
-The current ratio measures the relationship between
current assets and current liabilities at a specific date.
-It measures the ability of the company to pay current
debts as they become due.
What is the formula for quick ratio? What does it measure?
Quick ratio=Quick assets/Current liabilities
-The quick ratio, sometimes referred to as the acid test, is
a more stringent test of short-term liquidity than the
current ratio.
-The quick ratio compares quick assets, defined as cash
and near-cash assets, to current liabilities.
What is the formula for cash ratio?
Cash ratio=Cash+Cash equivalents/Current liabilities
What are the three main solvency ratios?
1) Times interest earned ratio
2) Cash coverage ratio
3) Debt-to-equity ratio
What is the formula for times interest earned ratio? What does it measure?
Times interest earned ratio=Net earnings+Interest expense+Income tax expense/Interest expense
It measures a company’s ability to meet it’s long-term obligations. For times interest earned ratio, a high ratio is viewed as better than a low ratio. A high ratio indicates an extra margin of protection in case profitability deteriorates.
What is the formula for cash coverage ratio? What does it measure?
Cash coverage ratio=Cash flows from operating activities(before interest and taxes)/Interest paid
This ratio compares the cash generated with the cash
obligations of the period.
What is the formula for debt-to-equity ratio? What does this formula measure?
Debt-to-equity ratio=Total liabilities/Shareholder’s Equity
Please note: Shareholders Equity is only for the current year. It is not average shareholder’s equity.
This ratio measures the amount of liabilities that exists for
each $1 invested by the owners. A high debt to equity ratio means that a company relies heavily on funds provided by creditors.
What are the two main market ratios?
1) Price/earnings ratio
2) Dividend yield ratio
What is the formula for price/earnings ratio? What does this ratio measure?
Price/Earnings ratio=Current market price per share/Earnings per share
This ratio measures the relationship between the current
market price of the share and its earnings per share.
What is the formula for dividend yield ratio? What does it measure?
Dividend yield ratio=Dividends per share/Market price per share
Take dividends per share=net earnings-(
This ratio is often used to compare the dividend-paying performance of different investment alternatives.
What do profitability ratios measure?
Several profitability ratios focus on measuring the
adequacy of net earnings by comparing it to other items
reported on the financial statements.
What do asset turnover ratios measure?
Asset turnover ratios focus on capturing how efficiently a
company uses its assets.
What do liquidity ratios measure?
-Liquidity refers to a company’s ability to meet its short-
term obligations.
-Because most short-term obligations are paid with
current assets, liquidity ratios focus on the relationship
between current assets and current liabilities.
What do solvency ratios measure?
Solvency refers to a company’s ability to meet its long-
term obligations.
What do market ratios measure?
Market ratios, relate the current
market price per share to the return that accrues to
investors.
To calculate the effects of transactions on ratios, which three-step process should you follow?
1) Journalize the transaction to determine its effects on various accounts
2) Determine which accounts belong to the financial statement subtotals or totals in the numerator (top) and denominator (bottom) of the ratio and the direction of their effects.
3) Evaluate the combined effects from step 2 on the ratio
What are the current assets?
Cash, accounts receivable, merchandise inventory, prepayments.
What are the current liabilities?
Accounts payable, and income tax payable.
What are the quick assets?
Cash and accounts receivables
