Chapter 27 - Financial Analysis Techniques Flashcards
1
Q
Define “ratio” as it relates to financial analysis.
A
A ratio expresses a mathematical relationship between two quantities in terms of a percentage or a proportion. Ratios may be computed using data directly from companies’ financial statements or from other available databases. Computation of a ratio is a simple arithmetic operation but its interpretation may not be that simple. To be meaningful, a ratio must refer to an economically important relation.
2
Q
What do financial ratios provide insight into?
A
- Microeconomic relationships within the company that are used by analysts to project the company’s earnings and cash flows.
- A company’s financial flexibility.
- Management’s ability.
- Changes in the company and industry over time.
- How the company compares to peer companies and the industry overall.
3
Q
What do common-size statements allow analysts to do?
A
Common‐size statements allow analysts to compare a company’s performance with that of other firms and to evaluate its performance over time.
4
Q
What do common-size income statements express? Why are they useful?
A
A common‐size income statement expresses all income statement items as a percentage of revenues. Common‐size income statements are extremely useful in identifying trends in costs and profit margins. Further, certain financial ratios are explicitly stated on these statements (e.g., the gross profit margin and the net profit margin).
5
Q
What is the equation for vertical common-size income statement percentage?
A
Vertical common-size income statement percentage = (Income statement account/Revenue) x 100
6
Q
What do common-size balance sheets express? Why are they prepared?
A
Common‐size balance sheets express each item as a percentage of total assets. Common‐ size balance sheets are prepared to highlight changes in the mix of assets, liabilities, and equity.
7
Q
What is the equation for vertical common-size balance sheet percentage?
A
Vertical common-size balance sheet percentage = (Balance sheet account/Total assets) x 100
8
Q
What is cross-sectional analysis? Why is it useful?
A
Cross‐sectional analysis, also known as relative analysis, compares a specific metric for one company with the same metric for another company or group of companies over a period of time. This allows comparisons even though the companies might be of significantly different sizes and/or operate in different countries. Consider two companies from the same industry. If one of them has accounts receivable representing 20% of its total assets, while the other has 40% of its assets in the form of accounts receivable, we might conclude that the latter has a greater proportion of credit sales or that it uses aggressive accounting policies for revenue recognition.
9
Q
What does trend analysis provide? What do you prepare to look for trends over time?
A
Trend analysis provides important information about a company’s historical performance. It can also offer assistance in forecasting the financial performance of a company. When looking for trends over time, horizontal common‐size financial statements are often prepared. Dollar values of accounts are divided by their base‐year values to determine their common‐size values. Horizontal common‐size statements can also help identify structural changes in the business.
10
Q
We can use horizontal common‐size analysis to evaluate the financial performance of the company. The year‐on‐year percentage changes for various financial variables are calculated below: What do you see?
A
The percentage growth figures allow us to draw the following conclusions:
- Net income is growing faster than revenue. This indicates increasing profitability. However, the analyst should dig deeper and identify the source of this higher net income (i.e., whether it results from continuing operations, or from nonoperating, nonrecurring items).
- The company’s operating cash flow is decreasing. This is a cause for concern and requires further investigation. The fact that operating cash flow is declining in spite of the positive growth in revenues may indicate a problem with the company’s earnings quality (e.g., aggressive recognition of revenue).
- Total assets are growing faster than revenue. This suggests that the company’s efficiency levels are declining. The analyst should look to identify the reason for the high growth rate in assets and also examine the composition of the increase in assets.
11
Q
Using charts in financial analysis, how do graphs help?
A
Graphs facilitate comparisons of firm performance and financial structure over time, highlighting changes in significant aspects of business operations. They may also be used to communicate important conclusions of financial analysis.
12
Q
Using charts in financial analysis, how do pie charts help?
A
Pie charts are most useful in illustrating the composition of a total value. For example, a pie chart should be used when presenting the components of total expenses for the year (COGS, SG&A, depreciation).
13
Q
Using charts in financial analysis, how do line graphs help?
A
Line graphs help identify trends and detect changes in direction or magnitude. For example, a line graph that illustrates a marked increase in accounts receivable while cash balances are falling indicates that the firm might have problems managing its working capital going forward.
14
Q
Using charts in financial analysis, how do stacked common graph help?
A
A stacked common graph illustrates the changes in various items over the period in graphical form. Figure 1-1 illustrates the asset mix of Bilan Company. It is quite clear from this graph that while total assets are generally increasing over the 5‐year period, an increasing proportion of the company’s assets are composed of receivables.
15
Q
Using charts in financial analysis, how does regression analysis help?
A
Regression analysis can help identify relationships between variables (e.g., between sales and inventory) over time and assist analysts in making forecasts (e.g., the relationship between GDP and sales can be used to make revenue forecasts).
16
Q
For limitations of Ratio Analysis, how does industry comparison affect analysis?
A
Companies may have divisions that operate in different industries. This can make it difficult to find relevant industry ratios to use for comparisons.
17
Q
For limitations of Ratio Analysis, how do conflicting ratios affect analysis?
A
One set of ratios may suggest that there is a problem, but another set may indicate that the potential problem is only short term.
18
Q
For limitations of Ratio Analysis, how does ratios range affect analysis?
A
There are no set ranges within which particular ratios for a company must lie. An analyst must use her own judgment to evaluate the implications of a given value for a ratio. This usually involves examining the operations of a company, the external, industry and economic scenario before interpreting results and drawing conclusions.
19
Q
For limitations of Ratio Analysis, how do accounting methods affect analysis?
A
Firms enjoy significant latitude in the choice of accounting methods that are acceptable given the jurisdiction in which they operate. For example, under U.S. GAAP, companies can:
- Use the FIFO, AVCO, or LIFO inventory cost flow assumption.
- Choose from a variety of depreciation methods.
20
Q
For limitations of Ratio Analysis, how do regulatory bodies affect analysis?
A
Comparing ratios of firms across international borders is even more difficult in that most countries use IFRS. Despite the growing convergence between IFRS and U.S. GAAP, significant differences remain, which make it very difficult for analysts to compare ratios of firms that use different accounting standards.
21
Q
Across the analyst community, what is important to understand about the differences in exact ratio definitions?
A
It is also important to understand that the exact definitions of certain ratios vary across the analyst community. For example, in measuring leverage, some analysts use total liabilities, while others using only interest‐bearing debt.
22
Q
What has research shown about the usefulness of ratio analysis?
A
Research has shown that in addition to being useful in evaluating the past performance of a company, ratios can be useful in predicting future earnings and equity returns.
23
Q
Ratios are typically classified into the following categories:
A
Activity
Liquidity
Solvency
Profitability
Valuation
24
Q
Based on the categories that ratios are typically classified into, define the activity classification.
A
Activity ratios measure how productive a company is in using its assets and how efficiently it performs its everyday operations.
25
**Based on the categories that ratios are typically classified into, define the liquidity classification.**
Liquidity ratios measure the company’s ability to meet its short-term cash requirements.
26
**Based on the categories that ratios are typically classified into, define the solvency classification.**
Solvency ratios measure a company’s ability to meet long‐term debt obligations.
27
**Based on the categories that ratios are typically classified into, define the profitability classification.**
Profitability ratios measure a company’s ability to generate an adequate return on invested capital.
28
**Based on the categories that ratios are typically classified into, define the valuation classification.**
Valuation ratios measure the quantity of an asset or flow (e.g., earnings) associated with ownership of a specific claim (e.g., common stock).
29
**Based on the categories that ratios are typically classified into, what is an important note about the categories not being mutually exclusive.**
These categories are not mutually exclusive. Some ratios are useful in evaluating multiple aspects of the business. Certain profitability ratios, for example, also reflect the operating efficiency of the business.
30
**How are financial ratios compared and analysed?**
The financial ratios of a company are compared to those of its major competitors in cross-sectional analysis. A company’s ratios for a given year can also be compared to its own prior period ratios to identify trends. The goal of ratio analysis is to understand the causes of material differences in ratios of a company compared to its peers.
31
**Why should an analyst evaluate ratios based on company’s objectives?**
Actual ratios should be compared to the company’s stated objectives. This helps in determining whether the company’s operations are moving in line with its strategy.
32
**If a company’s financial ratios are compared with those of the same industry, the analyst should be careful because:**
- Not all ratios are important to every industry.
- Companies may have several lines of business, which can cause aggregate
financial ratios to be distorted. In such a situation, analysts should evaluate ratios for each segment of the business in relation to relevant industry averages.
- Companies might be using different accounting standards.
- Companies could be at different stages of growth or may have different
strategies. This can result in different values for various ratios for firms in the same industry.
33
**Why should an analyst evaluate ratios based on company’s current phase?**
Ratios should be studied in light of the current phase of the business cycle.
34
**What are activity ratios and what do they measure?**
Activity ratios are also known as **asset utilization ratios** or **operating efficiency** ratios. They measure how well a company manages its operations and particularly how efficiently it manages its assets—working capital and long‐lived assets.
35
**What is the inventory turnover ratio equation and what is it used to evaluate?**
Inventory turnover = (Cost of goods sold/Average inventory)
This ratio is used to evaluate the effectiveness of a company’s inventory management. Generally, this ratio is benchmarked against the industry average.
36
**What does a high inventory turnover ratio indicate?**
A high inventory turnover ratio relative to industry norms might indicate highly effective management. Alternatively, it could also indicate that the company does not hold adequate inventory levels, which can hurt sales incase shortages arise. A simple comparison of the company’s sales growth to the industry’s growth in sales can indicate whether sales are suffering because too little stock is available for sale at any given point in time.
37
**What does a low inventory turnover ratio indicate?**
A low inventory turnover relative to the rest of the industry can be an indicator of slow moving or obsolete inventory. It suggests that the company has too many resources tied up in inventory.
38
**What is the days of inventory on hand (DOH) ratio equation and what is it used to evaluate?**
Days of inventory on hand (DOH) = (365/Inventory Turnover)
The ratio evaluates the length of the period the inventory is held on average.
This ratio is inversely related to inventory turnover.
39
**What does a higher days of inventory on hand (DOH) ratio indicate?**
The *higher* the inventory turnover ratio, the *shorter* the length of the period that inventory is held on average.
40
**What is the receivable turnover ratio and what is it used to evaluate?**
Receivable turnover = Revenue/Average receivables
It evaluates the efficiency of a company’s credit or collection policies.
41
**What does a high receivable turnover ratio indicate?**
A high receivables turnover ratio might indicate that the company’s credit collection procedures are highly efficient. However, a high ratio can also result from overly stringent credit or collection policies, which can hurt sales if competitors offer more lenient credit terms to customers.
42
**What does a low receivable turnover ratio indicate?**
A low ratio relative to industry averages will raise questions regarding the efficiency of a company’s credit or collection procedures.
43
**How can we come to a conclusion about a high or low receivable turnover ratio value?**
As with the inventory turnover ratio, a simple comparison of the company’s sales growth with industry sales growth can help determine whether the reason behind a high receivables turnover ratio is strict credit terms or efficient receivables management.
Analysts can also compare current estimates of the company’s bad debts and credit losses with its own past estimates and peer companies’ estimates to assess whether low receivables turnover is the result of credit management issues.
44
**What is the days of sales outstanding (DSO) ratio equation and what does it indicate?**
Days of sales outstanding (DSO) = 365/Receivables turnover
This ratio indicates the length of period receivables are cashed on average.
45
**How are days of sales outstanding (DSO and receivables turnover ratio related?**
The receivables turnover ratio and days of sales outstanding are *inversely* related.
The *higher* the receivables turnover ratio, the *lower* the DSO.
46
**What is the payables turnover ratio equation? What does it measure? If the amount for purchases over the year is usually not explicitly stated on the income statement; it is typically only disclosed in the footnotes to the financial statement. If we have to calculate purchases, what is the formula?**
Payables turnover = (Purchases/Average trade payables)
Payables turnover measures how many times a year the company theoretically pays off all
its creditors.
Purchases = Ending inventory + COGS − Opening inventory
47
**What does a high payables turnover ratio indicate?**
A high ratio can indicate that the company is not making full use of available credit facilities and repaying creditors too soon. However, a high ratio could also result from a company making payments early to avail early payment discounts.
48
**What does a low payables turnover ratio indicate?**
A low ratio could indicate that a company might be having trouble making payments on time. However, a low ratio can also result from a company successfully exploiting lenient supplier terms. If the company has sufficient cash and short-term investments, the low payables turnover ratio is probably not an indication of a liquidity crisis. It is probably a result of lenient supplier credit and collection policies.
49
**What is the number of days of payables ratio equation? What does it evaluate?**
Number of days payables = 365/Payables turnover
Number of days payables indicates the average length of time it takes for a company to pay off its creditors.
50
**What does a higher payables turnover ratio indicate? How is it related to the payables turnover ratio?**
The number of days of payables is *inversely* related to the payables turnover ratio.
The *higher* the payables turnover, the *lower* the number of days of payables.
51
**What is the working capital turnover ratio equation? What does it indicate?**
Working capital turnover = Revenue/Average working capital
Working capital turnover indicates how efficiently the company generates revenue from its working capital. Working capital equals current assets minus current liabilities
52
**What does a higher working capital turnover ratio indicate?**
A higher working capital turnover ratio indicates higher operating efficiency.
53
**What is the fixed asset turnover ratio equation? What does it indicate?**
Fixed asset turnover = Revenue/Average fixed assets
This ratio measures how efficiently a company generates revenues from its investments in long‐lived assets.
54
**What does a high fixed asset turnover ratio indicate?**
A higher ratio indicates more efficient use of fixed assets in generating revenue.
55
**What does a low fixed asset turnover ratio indicate?**
A low ratio could be an indicator of operating inefficiency. However, a low fixed
asset turnover can also be the result of a capital intensive business environment. Companies that have recently entered a new business that is not fully operational also report low fixed asset turnover ratios.
56
**How does the age of assets affect the fixed asset turnover ratio?**
The fixed asset turnover ratio will be lower for a firm whose assets are newer than for a firm whose assets are relatively older. The older‐asset firm will have depreciated its assets for a longer period so the book value of its fixed assets will be lower.
57
**What is the total asset turnover ratio equation? What does it evaluate?**
Total asset turnover = Revenue/Average total assets
Total asset turnover measures the company’s overall ability to generate revenues with a given level of assets.
58
**What does high/low total asset turnover ratio indicate?**
A high ratio indicates efficiency, while a low ratio can be an indicator of inefficiency or the level of capital intensity of the business.
59
**How does the total asset turnover ratio relate to strategic decisions by management?**
This ratio also identifies strategic decisions by management. For example, a business that uses highly capital-intensive techniques of production will have a lower total asset turnover compared to a business that uses labor-intensive production methods.
60
**List the commonly used activity ratios and their equations.**
Inventory turnover = Cost of goods sold/Average Inventory
Days of inventory on hand (DOH) = Number of days in period/Inventory Turnover
Receivables turnover = Revenue/Average Receivables
Days of sales outstanding (DSO) = Number of days in period/Receivables Turnover
Payables turnover = Purchases/Average Trade Payables
Number of days of payables = Number of days in period/Payables Turnover
Working capital turnover = Revenue/Average working capital
Fixed asset turnover = Revenue/Average fixed net assets
Total asset turnover = Revenue/Average total assets
61
**What is the purpose of liquidity ratios?**
Analysis of a company’s liquidity ratios aims to evaluate a
short-term obligations. Liquidity measures how quickly a company can convert its assets into cash at prices that are close to their fair values.
62
**What is the current ratio equation? What does it evaluate?**
Current ratio = Current assets/Current liabilities
Measures level of liquidity
63
**What does a higher current ratio indicate?**
A higher ratio is desirable because it indicates a higher level of liquidity.
64
**What does a current ratio of 1.0 indicate?**
A current ratio of 1.0 indicates that the book value of the company’s current assets
equals the book value of its current liabilities.
65
**What does a low current ratio indicate?**
A low ratio indicates less liquidity and implies a greater reliance on operating cash
flow and outside financing to meet short-term obligations.
66
**What is the basic assumption of the current ratio?**
The current ratio assumes that inventory and accounts receivable can readily be
converted into cash at close to their fair values.
67
**What is the quick ratio equation? What does it indicate?**
Quick ratio = (Cash + Short-term marketable investments + Receivables) / Current liabilities
The quick ratio recognizes that certain current assets (such as prepaid expenses) represent costs that have been paid in advance in the current year and cannot usually be converted into cash. This ratio also considers the fact that inventory cannot be immediately liquidated at its fair value. Therefore, these current assets are excluded from the numerator in the calculation of the quick ratio. When inventory is illiquid, this ratio is a better indicator of liquidity than current ratio.
68
**What does a high quick ratio indicate?**
A high quick ratio indicates greater liquidity.
69
**What is the cash ratio equation? What does it indicate?**
Cash ratio = (Cash + Short-term marketable investments) / Current liabilities
The cash ratio is a very reliable measure of an entity’s liquidity position in the event of an unforeseen crisis. This is because it only includes cash and highly liquid short-term investments in the numerator.
70
**What is the defensive interval ratio equation? What does it indicate?**
The defensive interval ratio = (Cash + Short-term marketable investments + Receivables) / Daily cash expenditures
This ratio measures how long the company can continue to meet its daily expense requirements from its existing liquid assets without obtaining any additional financing. A defensive interval of 40 indicates that the company can pay its operating expenses for 40 days by liquidating its quick assets.
71
**What does a high defensive ratio indicate?**
A high defensive interval ratio is desirable as it indicates greater liquidity.
72
**What does a low defensive ratio indicate?**
If a company’s defensive interval ratio is very low compared to the industry
average, the analyst might want to determine whether significant cash inflows are expected in the near future to meet expense requirements.
73
**What is the cash conversion cycle ratio equation? What does it indicate?**
The cash conversion cycle = DSO + DOH – Number of days of payables
The cash conversion cycle (also known as net operating cycle) measures the length of the period between the point that a company invests in working capital and the point that the company collects cash proceeds from sales. Specifically, it is the time between the outlay of cash (to pay off accounts payable for credit purchases) and the collection of cash (from accounts receivable for goods sold on credit).
74
**What does a shorter cash conversion cycle indicate?**
A shorter cycle is desirable, as it indicates greater liquidity.
75
**What does a longer cash conversion cycle indicate?**
A longer cash conversion cycle indicates lower liquidity. It implies that the company
has to finance its inventory and accounts receivable for a longer period of time.
76
**List the commonly used liquidity ratios and their equations.**
Current ratio = Current assets/Current liabilities
Quick ratio = (Cash + Short-term marketable investments + Receivables) / Current liabilities
Cash ratio = (Cash + Short-term marketable investments) / Current liabilities
The defensive interval ratio = (Cash + Short-term marketable investments + Receivables) / Daily cash expenditures
77
**What is the purpose of solvency ratios?**
Solvency refers to a company’s ability to meet its long‐term debt obligations. Solvency ratios measure the relative amount of debt in a company’s capital structure and the ability of earnings and cash flows to meet debt-servicing requirements. The amount of debt in
the capital structure is important to assess a company’s degree of financial leverage (its financial risk). If the company can earn a return on borrowed funds that is greater than interest costs, the inclusion of debt in the capital structure will increase shareholder wealth.
78
**What is the debt-to-assets ratio equation? What does it evaluate?**
Debt-to-assets ratio = Total debt / Total assets
In this reading, we take total debt in this context to be the sum of interest-bearing shot-term and long‐term debt. The debt-to-asset ratio measures the proportion of the firm’s total assets that have been financed by debt.
79
**What does a higher debt to assets ratio indicate?**
A higher D/A ratio is undesirable because it implies higher financial risk and a weaker solvency position.
80
**What is the debt-to-capital ratio equation? What does it indicate?**
Debt-to-capital ratio = Total debt / (Total debt + Shareholders’ equity)
This ratio measures the proportion of a company’s total capital (debt plus equity) that is composed of debt.
81
**What does a higher debt-to-capital ratio indicate?**
A higher ratio indicates higher financial risk and is undesirable.
82
**What is the debt-to-equity ratio? What does it indicate?**
Debt-to-equity ratio = Total debt / Shareholders’ equity
This ratio measures the amount of debt capital relative to a firm’s equity capital.
83
**What does a higher debt-to-equity ratio indicate?**
A higher ratio is undesirable and indicates higher financial risk.
84
**What does a debt-to-equity ratio of 1.0 indicate?**
A ratio of 1.0 indicates equal amounts of debt and equity in the company’s capital
structure.
85
**What is the financial leverage ratio equation? What does it indicate?**
Financial leverage ratio = Average total assets / Average total equity
This ratio measures the amount of total assets supported by each money unit of equity. For example, a leverage ratio of 2 means that each dollar of equity supports $2 worth of assets. This ratio uses *average* values for total assets and total equity and plays an important role in Dupont decomposition, which we study later in this reading.
86
**What does a higher financial leverage ratio indicate?**
The higher the leverage ratio, the more leveraged (dependent on debt for finance) the company.
87
**What is the interest coverage ratio equation? What does it indicate?**
Interest coverage ratio = EBIT / Interest payments
This ratio measures the number of times a company’s operating earnings (earnings before interest and tax, or EBIT) cover its annual interest payment obligations. This very important ratio is widely used to gauge how comfortably a company can meet its debt‐ servicing requirements from operating profits.
88
**What does a higher interest coverage ratio indicate?**
A higher ratio provides assurance that the company can service its debt from operating earnings.
89
**What is the fixed charged coverage ratio equation? What does it indicate?**
Fixed charge coverage ratio = (EBIT + Lease payments) / (Interest payments + Lease payments)
This ratio relates the fixed charges or obligations of the company to its earnings. It measures the number of times a company’s operating earnings can cover its interest and lease payments.
90
**What does a higher fixed charge coverage ratio indicate?**
A higher ratio suggests that the company is comfortably placed to service its debt and make lease payments from the earnings it generates from operations.
91
**List the commonly used solvency ratios, grouped into debt ratios and coverage ratios.**
_Debt Ratios_
Debt-to-assets ratio = Total debt / Total assets
Debt-to-capital ratio = Total debt / (Total debt + Shareholders’ equity)
Debt-to-equity ratio = Total debt / Shareholders’ equity
Financial leverage ratio = Average total assets / Average total equity
_Coverage Ratios_
Interest coverage ratio = EBIT / Interest payments
Fixed charge coverage ratio = (EBIT + Lease payments) / (Interest payments + Lease payments)
92
**What is the purpose of profitability ratios?**
The ability of a company to generate profits is a key driver of the company’s overall value and the value of the securities it issues. Therefore, many analysts consider profitability to be the focus of their analysis.
93
**In the income statement, detail the link between Net Sales to Income available to common shareholders.**
94
**What is the gross profit margin equation? What does it indicate?**
Gross profit margin = gross profits / Revenues
The gross profit margin tells us the percentage of a company’s revenues that are available to meet operating and nonoperating expenses. A high gross profit margin can be a combination of high product prices (reflected in high revenues) and low product costs (reflected in low COGS).
95
**What is operating profit margin? What does it indicate?**
Operating profit margin = Operating profit / Revenue
Operating profits are calculated as gross profit minus operating costs.
The operating profit margin tells us the percentage of a company’s revenues that are operating profit.
96
**How can we relate the operating profit margin to the gross profit margin?**
An operating profit margin that is increasing at a higher rate than the gross profit margin indicates that the company has successfully controlled operating costs.
97
**What does a decreasing operating profit margin indicate?**
A decreasing operating profit margin when gross profit margins are rising indicates that the company is not efficiently controlling operating expenses.
98
**What is the pretax margin equation? What does it indicate?**
Pretax margin = EBT (Earnings before tax, but after interest) / Revenue
Pretax income is also called earnings before tax (EBT). It is calculated as operating income minus nonoperating expenses plus nonoperating income.
**Pretax** profit **margin** is a company's earnings before tax as a percentage of total sales or revenues.
99
**What does a higher pretax profit margin indicate?**
The higher the **pretax** profit **margin**, the more profitable the company.
If a company’s pretax margin is rising primarily due to higher nonoperating income, the analyst should evaluate whether this source of income will continue to bring in significant earnings going forward.
100
**What is the equation for net profit margin? What does it indicate?**
Net profit margin = Net profit / Revenue
Net profit margin shows how much profit a company makes for every dollar it generates in revenue.
101
**What does a low net profit margin indicate?**
A low net profit margin indicates a low margin of safety. It alerts analysts to the risk that a decline in the company’s sales revenue will lower profits or even result in a net loss (reduction in shareholder wealth).
102
**What is the return on assets (ROA) equation? What does it indicate?**
ROA = Net income / Average total assets
Return on assets measures the return earned by the company on its assets.
103
**What does a higher return on assets (ROA) ratio indicate?**
The higher the ROA, the greater the income generated by the company given its total assets.
104
**What is the problem with the calculation of return on assets (ROA)? How is the equation adjusted?**
The problem with this calculation of ROA (net income/average total assets) is that it uses only the return to equity holders (net income) in the numerator. Assets are financed by both equity holders and bond holders. Therefore, some analysts prefer to add interest expense back to net income in the numerator. However, interest expense must be adjusted for the tax shield that it provides.
Adjusted ROA = [Net income + Interest expense (1 – Tax rate)] / Average total assets
105
**What is the Operating Return on Assets (Operating ROA) equation? What does it indicate?**
Some analysts choose to calculate ROA on a pre‐interest and pre‐tax basis as:
Operating ROA = Operating income or EBIT / Average total assets
This ratio reflects the return on all assets used by the company, whether financed with debt or equity.
106
**What is an extremely important note when calculating return on assets (ROA)?**
Whichever formula is used to calculate ROA, the analyst must use it consistently in cross-sectional analysis and trend analysis.
107
**What is the return on total capital equation? What does it indicate?**
Return on total capital = EBIT / (Short-term debt + Long-term debt + Equity)
This ratio measures the profits that a company earns on all sources of capital that it employs—short‐term debt, long‐term debt, and equity. Once again, returns are measured prior to deducting interest expense.
108
**What is the return on equity equation? What does it indicate?**
Return on equity = Net income / Average total equity
This ratio measures the rate of return earned by a company on its equity capital. Equity capital includes minority equity, preferred equity, and common equity. It measures a firm’s efficiency in generating profits from every dollar of net assets (assets minus liabilities),
and shows how well a company uses its investment dollars to generate earnings. ROE is commonly used to compare the profitability of a company to that of other firms in its industry.
109
**What is the return on common equity ratio equation? What does it indicate?**
Return on common equity = (Net income – Preferred dividends) / Average common equity
This ratio measures the return earned by a company only on its common equity.
110
**List the commonly used profitability ratios. Group in return on sales and return on investment.**
_Return on sales_
Gross profit margin = Gross profit / Revenue
Operating profit margin = Operating income / Revenue
Pre-tax margin = EBT (earnings before tax but after interest) / Revenue
Net profit margin = Net income / Revenue
_Return on Investment_
Operating ROA = Operating income / Average total assets
ROA = Net income / Average total assets
Return on total capital = EBIT / Short- and long-term debt and equity
ROE = Net income / Average total equity
Return on common equity = (Net income – Preferred dividends) / Average common equity
111
**ROE measures the return a company generates on its equity capital. Decomposing ROE into its components through DuPont analysis has the following uses:**
- It facilitates a meaningful evaluation of the different aspects of the company’s performance that affect reported ROE.
- It helps in determining the reasons for changes in ROE over time for a given company. It also helps us understand the reasons for differences in ROE for different companies over a given time period.
- It can direct management to areas that it should focus on to improve ROE.
- It shows the relationship between the various categories of ratios and how they all
influence the return that owners realize on their investment.
112
**What is the two-way DuPont Decomposition equation? What two components does it break into?**
ROE = (Net income/Average total assets) x (Average total assets/Average shareholder’s equity)
Net income/average total assets is ROA
Average total assets/average shareholder’s equity is Leverage
113
**What does the two-way DuPont breakdown of ROE illustrate?**
The two‐way breakdown of ROE illustrates that ROE is a function of company’s return on assets (ROA) and financial leverage ratio. A company can improve its ROE by improving ROA or by using leverage (debt) more extensively to finance its operations. As long as a company is able to borrow at a rate lower than the marginal rate it can earn by investing the borrowed money in its business, taking on more debt will result in an increase in ROE. However, if a company’s borrowing costs exceed its marginal return, taking on more debt would depress ROA and ROE as well.
114
**What does the three-way DuPoint decomposition ROE equation? What are it’s components?**
ROE = (Net income/Revenue) x (Revenue/Average total assets) x (Average total assets/Average shareholders’ equity)
(Net income/Revenue) = Net profit margin
(Revenue/Average total assets) = Asset turnover
(Average total assets/Average shareholders’ equity) = Leverage
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**In the three-way DuPont decomposition ROE Equation, what is net profit margin an indicator of?**
Net profit margin is an indicator of profitability. It shows how much profit a company generates from each money unit of sales.
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**In the three-way DuPont decomposition ROE Equation, what is asset turnover an indicator of?**
Asset turnover is an indicator of efficiency. It tells us how much revenue a company generates from each money unit of assets.
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**In the three-way DuPont decomposition ROE Equation, what is ROA a function of?**
ROA is a function of its profitability (net profit [NP] margin) and efficiency (asset turnover [TO]).
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**In the three-way DuPont decomposition ROE Equation, what is financial leverage an indicator of?**
Financial leverage is an indicator of solvency. It reflects the total amount of a company’s assets relative to its equity capital.
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**What is the five-way DuPont decomposition equation? What are its components?**
ROE = (Net income/EBT) x (EBT/EBIT) x (EBIT/Revenue) x (Revenue/Average total assets) x (Average total assets/Avg. Shareholder equity)
(Net income/EBT) = Tax burden
(EBT/EBIT) = Interest burden
(EBIT/Revenue) = EBIT margin
(Revenue/Average total assets) = Asset turnover
(Average total assets/Avg. Shareholder equity) = Leverage
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**What is the five-way DuPont decomposition of ROE a function of?**
This decomposition shows that ROE is a function of the company’s tax burden, interest burden, operating profitability, efficiency, and leverage.
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**In the five-way DuPont decomposition, what does the tax burden component indicate?**
The tax burden ratio equals one minus the average tax rate. It basically measures the proportion of its pretax profits that a company gets to keep. A *higher* tax burden ratio implies that the company can keep a *higher* percentage of its pretax profits. A decrease in the tax burden ratio implies the opposite.
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**In the five-way DuPont decomposition, what does the interest burden ratio component indicate?**
The interest burden ratio captures the effect of interest expense on ROE. High borrowing costs reduce ROE. As interest expense rises, EBT will fall as a percentage of EBIT, the interest burden ratio will fall, and ROE will also fall.
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**In the five-way DuPont decomposition, what does the EBIT margin component indicate?**
The EBIT margin captures the effect of operating profitability on ROE.
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**In the five-way DuPont decomposition, what does the asset turnover and leverage ratios indicate?**
We already know that the asset turnover ratio is an indicator of the overall efficiency of the company, while the leverage ratio measures the total value of a company’s assets relative to its equity capital.
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**What is equity analysis?**
Analysts use a variety of methods to value a company’s equity. One of the most common method involves the use of valuation ratios.
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**What is the price to earnings ratio equation? What does it express?**
P/E = (Price per share/Earnings per share)
The P/E ratio expresses the relationship between the price per share of common stock and the amount of earnings attributable to a single share. It basically tells us how much a share of common stock is currently worth per dollar of earnings of the company.
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**What is the price to cash flow ratio equation?**
P/CF = (Price per share / Cash flow per share)
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**What is the price to sales ratio equation?**
P/S = (Price per share / Sales per share)
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**What is the price to book value ratio equation?**
P/BV = (Price per share / Book value per share)
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**What is the Basic EPS ratio equation? What does it indicate?**
Basic EPS = (Net income – Preferred dividends) / Weighted average number of ordinary shares outstanding
**Basic EPS** are the earnings of a company attributable to each share of common stock. The weighted average number of shares consists of the number of ordinary shares outstanding at the beginning of the period, adjusted for those bought back or issued during the period, weighted by the length of time that they were outstanding during the relevant period.
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**What is the diluted EPS equation? What does it indicate?**
Diluted EPS = (Adjusted income available for ordinary shares reflecting conversion of dilutive securities / Weighted average number of ordinary and potential ordinary shares outstanding)
**Diluted EPS** includes the effects of all outstanding securities whose conversion or exercise will result in a reduction in EPS. Dilutive securities include convertible debt, convertible preference shares, warrants, and options.
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**What is the cash flow per share ratio equation?**
Cash flow per share = (Cash flow from operations / Average number of shares outstanding)
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**What is the EBITDA per share ratio equation?**
EBITDA per share = (EBITDA / Average number of shares outstanding)
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**What is the dividends per share ratio equation? What does it measure?**
Dividends per share = (Common dividends declared / Weighted average number of ordinary shares)
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**What is the dividend payout ratio equation? What does it measure?**
Dividend payout ratio = (Common share dividends / Net income attributable to common shares)
The dividend payout ratio measures the percentage of earnings that a company pays out as dividends to shareholders. The per-share dividend paid by companies is typically fixed, so this ratio fluctuates as a percentage of earnings. Therefore, conclusions about a company’s dividend payout policy should be based on examination of the payout ratio over a number of periods.
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**What is the retention rate ratio equation? What does it measure?**
Retention rate = (Net income attributed to common shares – Common share dividends) / Net income attributed to common shares
This ratio measures the percentage of earnings that a company retains and reinvests in the business.
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**What is the sustainable growth rate equation? Include retention rate equation in your answer. What does sustainable growth rate measure?**
Retention rate = (1 − Dividend payout ratio)
Sustainable growth rate = Retention rate × ROE
A company’s sustainable growth rate is a function of its profitability (ROE) and its ability to finance its operations from internally generated funds (measured by the retention rate). Higher ROE and higher retention rates result in a higher sustainable growth rates.
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**List the valuation ratios and their equations.**
Price to earnings (P/E) = Price per share / Earnings per share
Price to cash flow (P/CF) = (Price per share / Cash flow per share)
Price to sales (P/S) = (Price per share / Sales per share)
Price to book value (P/BV) = (Price per share / Book value per share)
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**List the pre-share quantities and their equations.**
Basic EPS = (Net income – Preferred dividends) / Weighted average number of ordinary shares outstanding
Diluted EPS = (Adjusted income available for ordinary shares reflecting conversion of dilutive securities / Weighted average number of ordinary and potential ordinary shares outstanding)
Cash flow per share = (Cash flow from operations / Average number of shares outstanding)
EBITDA per share = (EBITDA / Average number of shares outstanding)
Dividends per share = (Common dividends declared / Weighted average number of ordinary shares)
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**List the dividend-related quantities and their equations.**
Dividend payout ratio = (Common share dividends / Net income attributable to common shares)
Retention rate = (Net income attributed to common shares – Common share dividends) / Net income attributed to common shares
Sustainable growth rate = Retention rate × ROE
[Retention rate = (1 − Dividend payout ratio)]
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**Aspects of performance that are deemed relevant in one industry may be irrelevant in another. Industry****‐****specific ratios reflect these differences. Describe how this relates for companies in the retail industry.**
For companies in the retail industry, changes in same store sales should be tracked. This is because it is important to distinguish between sales growth generated from opening new stores and sales growth resulting from higher sales at existing stores.
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**Aspects of performance that are deemed relevant in one industry may be irrelevant in another. Industry****‐****specific ratios reflect these differences. Describe how this relates for companies in the banking industry.**
Regulated industries are required to adhere to specific regulatory ratios. The banking sector has liquidity and cash reserve ratio requirements. Banking capital adequacy requirements relate banks’ solvency to their specific levels of risk exposure.
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**What are the common ratios used to analyze business risk?**
Coefficient of variation of operating income = Standard deviation of operating income / Average operating income
Coefficient of variation of net income = Standard deviation of net income / Average net income
Coefficient of variation of revenues = Standard deviation of revenues / Average revenue
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**What are the common ratios used to analyze the financial sector?**
Capital adequacy—Banks = Various components of capital / Risk weighted assets, market risk exposure, and level of operational risk assumed
Monetary reserve requirement = Reserves held at central bank / Specified deposit liabilities
Liquid asset requirement = Approved “readily marketable securities” / Specified deposit liabilities
Net interest margin = Net interest income / Total interest‐earning assets
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**What are the common ratios used to analyze the retail sector?**
Same store sales = Average revenue growth year on year for stores open in both periods
Sales per square foot (meter) = Revenue / Total retail space in feet or meters
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**What are the common ratios used to analyze service companies?**
Revenue per employee = Revenue / Total number of employees
Net income per employee = Net income / Total number of employees
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**What are the common ratios used to analyze hotels?**
Average daily rate
= Room revenue / Number of rooms sold
Occupancy rate
= Number of rooms sold / Number of rooms available
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**What is credit risk?**
Credit risk is the risk of loss that is caused by a debtor’s failure to make a promised payment. Credit analysis is the evaluation of credit risk.
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**Describe the credit-rating process.**
The credit-rating process involves the analysis of a company’s financial reports and a broad assessment of a company’s operations.
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**The credit rating process includes the following procedures:**
- Meetings with management.
- Tours of major facilities, if time permits.
- Meetings of ratings committees where the analyst’s recommendations are voted on,
after considering various factors.
- Monitoring of publicly distributed ratings, including reconsideration of ratings due
to changing conditions.
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**In the credit rating process, under the procedure of the** **meetings of ratings committees where the analyst’s recommendations are voted on,**
**what are the factors that are considered after?**
Business Risk, including the evaluation of:
- Operating environment.
- Industry characteristics.
- Success areas and areas of vulnerability.
- Company’s competitive position, including size and diversification.
Financial risk, including:
- The evaluation of capital structure, interest coverage, and
profitability using ratio analysis.
- The examination of debt covenants.
Evaluation of management
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**For the credit ratios used by Standard & Poor’s, what is the equation for EBIT interest coverage ratio?**
EBIT interest coverage = EBIT / Gross Interest (prior to deductions for capitalized interest or
interest income)
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**For the credit ratios used by Standard & Poor’s, what is the equation for EBITDA interest coverage ratio?**
EBITDA interest coverage = EBITDA / Gross Interest (prior to deductions for capitalized interest or interest income)
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**For the credit ratios used by Standard & Poor’s, what is the equation for funds from operations to total debt ratio?**
Funds from operations to total debt = FFO
(net income adjusted for noncash items) / Total debt
cFFO: Funds from operations.
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**For the credit ratios used by Standard & Poor’s, what is the equation for free operating cash flow to total debt ratio?**
Free operating cash flow to total debt = CFO (adjusted) less capital expenditures / Total debt
CFO: Cash flow from operations.
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**For the credit ratios used by Standard & Poor’s, what is the equation for EBIT interest coverage ratio?**
Return on capital = EBIT / Capital = Average equity (common and preferred equity) and short-term portions of debt, noncurrent deferred taxes, minority interest
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**For the credit ratios used by Standard & Poor’s, what is the equation for EBIT interest coverage ratio?**
Total debt to total debt plus equity = Total debt / Total debt plus equity
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**What are the credit ratios used by Standard & Poor’s?**
EBIT interest coverage
EBITDA interest coverage
Funds from operations to total debt
Free operating cash flow to total debt
Return on capital
Total debt to total debt plus equity
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**Describe segment analysis.**
Analysts often need to analyze the performance of underlying business segments to understand the company as a whole. These segments may include subsidiary companies, operating units, or simply operations in different geographical areas.
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**What are the two segments analyzed in segment analysis?**
Business segment
Geographical segment
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**In segment analysis, what is the business segment?**
A business segment is a separately identifiable component of a company that is engaged in providing an individual product or service or a group of related products or services. It is subject to risks and returns that are different from those of other business segments of the company.
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**In segment analysis, what is the geographical segment?**
A geographical segment is a distinguishable component of a company that is engaged in providing an individual product or service within a particular region.
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**In segment ratio analysis, what is the segment turnover equation? What does it analyze?**
Segment margin = Segment profit (loss) / Segment revenue
Operating profitability relative to sales.
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**In segment ratio analysis, what is the segment ROA equation? What does it analyze?**
Segment turnover = Segment revenue / Segment assets
Overall efficiency—how much revenue is generated per dollar
of assets.
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**In segment ratio analysis, what is the segment debt ratio equation? What does it analyze?**
Segment ROA = Segment profit (loss) / Segment assets
Operating profitability relative to assets.
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**In segment ratio analysis, what is the segment margin equation? What does it analyze?**
Segment debt ratio = Segment liabilities / Segment assets
Solvency of the segment.
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**List the segment ratios.**
Segment margin
Segment turnover
Segment ROA
Segment debt ratio
168
**Describe how ratio analysis and other techniques can be used to model and forecast earnings.**
In forecasting future earnings of companies, analysts use data about the economy, industry, and company itself. The results of financial analysis, which includes common‐size and ratio analysis, are integral to this process.
Analysts also develop models and pro forma financial statements to forecast future performance. They are constructed using past trends and relationships and also account for expected future events and changes. Pro forma income statements are usually prepared by using the historical relationship between a company’s income statement items and sales to project the nature of the relationship going forward. Items that are not sales‐driven can be assumed fixed, or assumed to vary with a balance sheet item (e.g., interest expense varies with the amount of long-term liabilities). Some balance sheet items also vary with sales, especially working capital accounts. As the company’s scale of operations increases, the firm has to increase its investment in working capital to ensure the smooth running of day‐ to‐day operations. Further, investments in long‐lived assets will also be required to expand the scale of the business.
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**What are some other techniques that are used to modeling and forecasts earnings?**
Sensitivity analysis
Scenario analysis
Simulations
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**For techniques that are used to modeling and forecasts earnings, describe sensitivity analysis.**
Sensitivity Analysis, which shows the range of possible outcomes as underlying assumptions are altered.
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**For techniques that are used to modeling and forecasts earnings, describe scenario analysis.**
Scenario Analysis, which shows the changes in key financial quantities that result from given events such as a loss of supply of raw materials or a reduction in demand for the firm’s products.
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**For techniques that are used to modeling and forecasts earnings, describe simulation analysis.**
Simulations are computer-generated sensitivity or scenario analyses based on probability models for the factors that drive outcomes.
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**What effect do common-size financial statements and financial ratios remove in analysis?**
Common-size financial statements and financial ratios remove the effect of size, allowing comparisons of a company with peer companies (cross-sectional analysis) and comparison of a company’s results over time (trend or time-series analysis).
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**What do activity ratios measure? What are the major activity ratios?**
Activity ratios measure the efficiency of a company’s operations, such as collection of receivables or management of inventory. Major activity ratios include inventory turnover, days of inventory on hand, receivables turnover, days of sales outstanding, payables turnover, number of days of payables, working capital turnover, fixed asset turnover, and total asset turnover.
175
**What do liquidity ratios measure? What are the major liquidity ratios?**
Liquidity ratios measure the ability of a company to meet short-term obligations. Major liquidity ratios include the current ratio, quick ratio, cash ratio, and defensive interval ratio.
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**What do solvency ratios measure? What are the major solvency ratios?**
Solvency ratios measure the ability of a company to meet long-term obligations. Major solvency ratios include debt ratios (including the debt-to-assets ratio, debt-to-capital ratio, debt-to-equity ratio, and financial leverage ratio) and coverage ratios (including interest coverage and fixed charge coverage).
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**What do profitability ratios measure? What are the major profitability ratios?**
Profitability ratios measure the ability of a company to generate profits from revenue and assets. Major profitability ratios include return on sales ratios (including gross profit margin, operating profit margin, pretax margin, and net profit margin) and return on investment ratios (including operating ROA, ROA, return on total capital, ROE, and return on common equity).
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**How does combining and evaluating ratios as a group help better understand a company?**
Ratios can also be combined and evaluated as a group to better understand how they fit together and how efficiency and leverage are tied to profitability.
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**How can Return on Equity be analyzed?**
ROE can be analyzed as the product of the net profit margin, asset turnover, and financial leverage. This decomposition is sometimes referred to as DuPont analysis.
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## Footnote
**What do valuation ratios express?**
Valuation ratios express the relation between the market value of a company or its equity (for example, price per share) and some fundamental financial metric (for example, earnings per share).
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**How do ratios relate to credit rating?**
Ratio analysis is useful in the selection and valuation of debt and equity securities and is a part of the credit rating process.
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**How do ratios relate to business segments?**
Ratios can also be computed for business segments to evaluate how units within a business are performing.
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**What do the results of financial analysis provide?**
The results of financial analysis provide valuable inputs into forecasts of future earnings and cash flow.
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