Chapter 3 Flashcards
Working with financial statements
Net addition to cash
Difference between sources and uses of cash
Examples of sources of cash
Increase in accounts payable; increase in common stock; increase in retained earnings
Examples of uses of cash
Increase in accounts receivable; increase in inventory; Decrease in notes payable; decrease in long-term debt; net fixed asset acquisitions
Common-size statements
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.
Common-base year financial statements
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.
Ratio analysis
Ratios are ways of comparing and investigating the relationships between different pieces of financial information.
Internal uses
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.
External uses
Financial statements are useful to parties outside the firm, including short-term and long-term creditors and potential investors.
Time trend analysis, Peer group analysis
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.
Groups of financial ratios
*Short-term solvency, or liquidity ratios;
*Long-term solvency, or financial leverage ratios;
* Asset management, or turnover ratios;
*Profitability ratios;
*Market value ratios
Short-term solvency (or liquidity) ratios
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
Current ratio
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.
The quick (or acid-test)
The quick (or acid-test) = (current assets-inventory)/current liabilities
Relatively large inventories are often a sign of a short-term trouble.
Cash ratio
Cash ratio = cash/current liabilities
Net working capital to assets
Net working capital to assets = Net working capital/total assets
Interval measure
Interval measure = current assets/average daily operation costs
Long-term solvency ratios
Intended to address the firm’s long-term ability to meet its obligations, more generally, its financial leverage.
Total debt ratio
Total debt ratio
Total debt ratio = (total assets-total equity)/total assets
Debt-equity ratio
Debt-equity ratio = total debt/total equity
Equity multiplier
Equity multiplier = total assets/total equity
Times interest earned (TIE)
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.
Cash coverage ratio
Cash coverage ratio = (EBIT + Depreciation) / Interest
Asset management, turnover measures
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.
Inventory turnover
Inventory turnover = Cost of goods sold / Inventory
Days’ sales in inventory
Days’ sales in inventory = 365 days / Inventory turnover
Receivables turnover (average collection)
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)
Asset turnover ratios
NWC turnover = Sales / NWC
Fixed asset turnover = Sales / Net fixed assets
Total asset turnover = Sales / Total assets
Profitability measures
Most widely used of all financial ratios, intended to measure how efficiently a firm uses its assets and manages its operations:
Profit margin
Profit margin
Profit margin = Net income / Sales
Return on Assets (ROA)
Measure of profit per dollar of assets:
ROA = Net income / Total assets
one $ worth of assets generated at x cents in profit
Return on equity (ROE)
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
Problems with financial statement analysis
No underlying theory to help identify which quantities to look at; Diversified firms; Geographic differences; Monopolies and regulatory differences
What does Market value measure
Earnings per share;
Earnings per share (EPS)
EPS = Net income / Share outstanding
Price-earnings ratio (PE)
PE ratio = Price per share / Earnings per share (EPS)
Measures how much investors are willing to pay per dollar of current earnings.
Price-sales ratio (PS)
Price-sales ratio = Price per share / Sales per share
Market to book ratio (MB)
MtB ratio = market value per share / book value per share
Tobin’s Q ratio
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
Enterprise value-EBITDA ratio
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
Enterprise value-EBITDA ratio (or multiplier)
EBITDA-ratio = Enterprise value / EBITDA
