Chapter 3

Question 1

Net addition to cash

Answer 1

Difference between sources and uses of cash

Question 2

Examples of sources of cash

Answer 2

Increase in accounts payable; increase in common stock; increase in retained earnings

Question 3

Examples of uses of cash

Answer 3

Increase in accounts receivable; increase in inventory; Decrease in notes payable; decrease in long-term debt; net fixed asset acquisitions

Question 4

Common-size statements

Answer 4

Way of standardizing financial statements: express each item on the balance sheet as a % of assets and to express each item on the income statement as a % of sales.
Each item is expressed as a % of assets.

Question 5

Common-base year financial statements

Answer 5

Helps examine the trends of the company’s operating pattern over time. Way of standardizing financial statements in this case is to choose a base year and then express each item relative to the base amount.

Question 6

Ratio analysis

Answer 6

Ratios are ways of comparing and investigating the relationships between different pieces of financial information.

Question 7

Internal uses

Answer 7

Performance evaluations, profit margin and return of equity.
Planning for the future - historical financial statement information is useful for generating projections about future and for checking the realism of assumptions made in those projections.

Question 8

External uses

Answer 8

Financial statements are useful to parties outside the firm, including short-term and long-term creditors and potential investors.

Question 9

Time trend analysis, Peer group analysis

Answer 9

Time trend analysis: One standard we could use is history.
Peer group analysis: establishing benchmark is to identify firms similar in the sense that they compete in the same markets, have similar assets and operate in similar ways.

Question 10

Groups of financial ratios

Answer 10

*Short-term solvency, or liquidity ratios;
*Long-term solvency, or financial leverage ratios;
* Asset management, or turnover ratios;
*Profitability ratios;
*Market value ratios

Question 11

Short-term solvency (or liquidity) ratios

Answer 11

Provide information about firm’s liquidity. Primary concern is the firm’s ability to pay its bills over the short run without undue stress.
Current ratio
The quick (or acid-test)
Cash ratio
Net working capital to total assets
Interval measure

Question 12

Current ratio

Answer 12

Current ratio = Current assets/Current liabilities
Measure of short-term liquidity. To a creditor, particularly a short-term creditor, the higher the current ratio, the better.
To the firm, a high current ratio indicates liquidity, may also indicate an inefficient use of cash and other short-term assets.

Question 13

The quick (or acid-test)

Answer 13

The quick (or acid-test) = (current assets-inventory)/current liabilities

Relatively large inventories are often a sign of a short-term trouble.

Question 14

Cash ratio

Answer 14

Cash ratio = cash/current liabilities

Question 15

Net working capital to assets

Answer 15

Net working capital to assets = Net working capital/total assets

Question 16

Interval measure

Answer 16

Interval measure = current assets/average daily operation costs

Question 17

Long-term solvency ratios

Answer 17

Intended to address the firm’s long-term ability to meet its obligations, more generally, its financial leverage.
Total debt ratio

Question 18

Total debt ratio

Answer 18

Total debt ratio = (total assets-total equity)/total assets

Question 19

Debt-equity ratio

Answer 19

Debt-equity ratio = total debt/total equity

Question 20

Equity multiplier

Answer 20

Equity multiplier = total assets/total equity

Question 21

Times interest earned (TIE)

Answer 21

Times interest earned = EBIT/Interest
Measures how well a company has its interest obligations covered. Problem with TIE ratio is that it is based on EBIT, which isn’t a measure of cash available to pay interest.

Question 22

Cash coverage ratio

Answer 22

Cash coverage ratio = (EBIT + Depreciation) / Interest

Question 23

Asset management, turnover measures

Answer 23

Also called asset utilization ratios; can be interpreted as measures of turnover and are intended to describe how efficiently or intensively a firm uses its assets to generate sales.

Question 24

Inventory turnover

Answer 24

Inventory turnover = Cost of goods sold / Inventory

Question 25

Days’ sales in inventory

Answer 25

Days’ sales in inventory = 365 days / Inventory turnover

Question 26

Receivables turnover (average collection)

Answer 26

How quickly is revenue from sales realized, how quickly are receivables collected.

Receivables turnover = Sale revenues / Accounts receivable

Days’ sales in receivables = 365days / receivables turnover –> also called average collection period (ACP)

Question 27

Asset turnover ratios

Answer 27

NWC turnover = Sales / NWC

Fixed asset turnover = Sales / Net fixed assets

Total asset turnover = Sales / Total assets

Question 28

Profitability measures

Answer 28

Most widely used of all financial ratios, intended to measure how efficiently a firm uses its assets and manages its operations:
Profit margin

Question 29

Profit margin

Answer 29

Profit margin = Net income / Sales

Question 30

Return on Assets (ROA)

Answer 30

Measure of profit per dollar of assets:

ROA = Net income / Total assets

one $ worth of assets generated at x cents in profit

Question 31

Return on equity (ROE)

Answer 31

Measure of how the stockholders fared during the year:

ROE = Net income / Total equity

the firm generated a profit of x cents per $ of equity

Question 32

Problems with financial statement analysis

Answer 32

No underlying theory to help identify which quantities to look at; Diversified firms; Geographic differences; Monopolies and regulatory differences

Question 33

What does Market value measure

Answer 33

Earnings per share;

Question 34

Earnings per share (EPS)

Answer 34

EPS = Net income / Share outstanding

Question 35

Price-earnings ratio (PE)

Answer 35

PE ratio = Price per share / Earnings per share (EPS)

Measures how much investors are willing to pay per dollar of current earnings.

Question 36

Price-sales ratio (PS)

Answer 36

Price-sales ratio = Price per share / Sales per share

Question 37

Market to book ratio (MB)

Answer 37

MtB ratio = market value per share / book value per share

Question 38

Tobin’s Q ratio

Answer 38

Tobin’s Q = Market value of firm’s assets / Replacement cost of firm’s assets = Market value of firm’s debt and equity / replacement cost of firm’s assets

Question 39

Enterprise value-EBITDA ratio

Answer 39

Company’s enterprise value is an estimate of the market value of the company’s operating assets.

Enterprise value = total market value of the stock + book value of all liabilities - cash

Question 40

Enterprise value-EBITDA ratio (or multiplier)

Answer 40

EBITDA-ratio = Enterprise value / EBITDA