Chapter 3 Flashcards by Philip Hunt

What do common size statements accomplish when looking at comparisons over time?

Remove inflation as a factor.

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When is vertical analysis most useful?

Comparing businesses of different sizes.

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Which statement is usually looked at through trend analysis?

Income statement.

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What are the four categories of ratios ?

Efficiency
Liquidity
Leverage
Profitability

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Why must an analyst understand the company’s industry when performing vertical analysis?

Industry differences are reflected in statements.

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This type of analysis shows the composition of assets, liabilities, etc?

Vertical

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This shows growth in sales over time?

Trend analysis

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This analysis is typically focused on the income statement.

Trend analysis

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Inventory turnover ratio

Cost of goods sold / inventory

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Acid test formula

(Current assets - inventory) / current liabilities

Removed inventory from numerator. Better determines ability to convert assets to cash to satisfy liabilities.

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Current ratio

Assets / liability

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Return on equity

Net income / shareholders equity

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DuPont ROE

Net profit margin x asset turnover x equity multiplier

This will equal the base formula for roe. The difference is it will tell you what roe is based on.

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What does vertical analysis begin with?

Creating common size statements

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Looking at a common size statement to determine if the composition of assets and profitability are consistent with business strategy is an example of which type of analysis?

Vertical

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What two statements can single period vertical analysis be used on?

Balance sheet and income statement

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What is the downside to multiple period vertical analysis?

Doesn’t address how much the company can grow it has grown.

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What would a company which recently implemented growth strategies expect to see when using vertical analysis.

1) increased operating expenses as a percentage of total sales
2) decreased efficiency until production catches up with capacity
3) increased long term debt or common stock as a percentage of total sales

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Which statement does trend analysis mainly apply to?

Income statement. Looks for profitability over time.

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What are two types of trend analysis ?

Year-to-year

Base year-to-date

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This type of analysis provides standard measures of performance for analysts.

Ratio analysis

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4 types of financial ratios

Efficiency (how quickly collecting)
Liquidity (ability to turn assets to cash)
Leverage (extent using debt)
Profitability (earning capacity)

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What is AR turnover ratio used for?

Tell how quickly a business collects from customers.

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What does a high AR turnover ratio mean?

Efficiency

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What does a low AR turnover ratio mean?

Not giving customers enough time to pay.

AR Turnover Ratio Formula

Credit sales / accounts receivable

What does asset turnover ratio measure?

Use of assets

A high asset turnover ratio means ____.

Efficiency

When the asset turnover ratio is unusually high it could mean ______.

The company could be using old depreciated assets.

Formula for asset turnover ratio.

Sales/total assets

What does inventory turnover ratio measure?

How quickly inventory turns over.

What does a high inventory turnover ratio mean?

Efficiency

What is one thing thy cold lead to a low inventory turnover ratio?

Obsolete inventory.

Formula for inventory turnover ratio

Cost of goods sold / inventory

What is one easy measure of liquidity?

Working capital

What does the current ratio do?

Indicates ability to meet current liabilities with current assets.

What is multiple period vertical analysis good for?

Analyzing interim results Analyzing annual results Assessing loss exposure to make sure right premium charger Adjusters can compare before and after inventory to estimate loss.

This ratio shows how effective a business is at cost control.

Net profit margins. Higher the better.

This ratio shows how resources are being used?

Return on assets

Net income / total assets

Return on assets

This ratio shows the Rate of return shareholders are earning on their equity

Return on equity

This ratio can show if return on assets is due to generating lots of net income compared to sales (controlling expenses) or generating lots of sales compared to assets (efficient asset use)

DuPont identifier

How is DuPont identifier calculated?

1) break down roa: net profit margin x asset turnover ratio breaks down to (net income/sales)x(sales/total assets) 2) break down roe: roa x equity multiplier ---- (net income/sales)x(sales/total assets)x(total assets/equity)

This ratio shows operating efficiency

Net profit margin

This ratio shows effective use of assets.

Asset turnover ratio

Sales/total assets

Asset turnover ratio

This ratio shows how quickly goods are sold

Inventory turnover

Cost of goods sold / inventory

Inventory turnover ratio.

What does the current ratio determine?

If working capital is enough to meet obligations

Current assets / current liabilities

Current ratio

(Cash + marketable securities + accounts receivable)/current liabilities

Acid test / quick ratio

Why is the acid test more conservative than current ratio?

It only includes cash, marketable securities and ar

This measures amount of borrowing vs using own funds (sh equity)

Debt to equity

Long term debt/sh equity

Debt-to-equity

Measure extent assets are financed by debt.

Debt-to-assets

Total liabilities / total assets

Debt-to-assets

If this ratio is less than 1.5 most assets are financed through debt.

Debt-to-assets

Total assets / shareholder equity

Equity multiplier

Vertical Analysis

Uses common-size statements to highlight relationships among items in a single set of financial statements analysis

Trend Analysis

Compares financial statement data across two or more periods to identify patterns in past losses and project those patterns into the future

Ratio Analysis

Relates two or more data items to each other from a firm's accounting records and compares that relation to the same relation of data items from similar firms or from the same firm in

Single Period Vertical Analysis

Compares the common-size financial statement of two or more firms for one reporting period

Multiple Period Vertical Analysis

Compares the common-size financial statement of two or more firms for more than one reporting period

Common Size Statement

A financial statement that reports each amount as a percentage of a base figure; assets equals 100% on a balance sheet; total revenues equals 100% on an income statement

Gross Profit Margin

(gross sales - cost of goods) / (gross sales x 100)

Net Profit Margin

(gross sales - all expenses) / (gross sales x 100)

Year to Year Analysis

Compares statement items in consecutive years

Base Year to Date Analysis

Compares each statement item to the statement item from the earliest year under consideration

Return on Assets (ROA) Formula

net income / total assets

DuPont Identity

Analyzes ROE by breaking it into its component ratios; equals return on equity; identify driving factors of organization's returns;

Leverage

The practice of using borrowed money to invest

Leverage Ratio

Indicates the relationship between the amount of funds supplied by creditors and the funds supplied by the firm's owners

Asset Turnover Ratio Formula

sales / total assets

Equity Multiplier Formula

total assets / owners equity

Accounts Receivable Turnover Ratio Formula

credit sales / accounts receivable

Days' Sales Outstanding Formula

365 days / Account Receiveable Turnover Ratio

Inventory Turnover Ratio

cost of goods sold / inventory

Fixed Assets

Long-lived assets that are not expected to be sold or consumed within the firm's normal operating cycle

Current assets

Include cash, marketable securities, accounts receivable, and inventory

Acid-test ratio (aka Quick Ratio) Formula

(cash + marketable securities + accounts receivable) / current liabilities

Debt-to-Equity Ratio

= long-term debt / owners' equity

Debt-to-Assets Ratio

= total liabilities / total assets

Liquidity

Measures the ability to convert assets to cash to meet current financial obligations

Liqudity (of an asset)

Indicates its ability to be sold within a short time period and a small price range

4 Categories of Ratios

profitability

2 Methods of Trend Analysis

Year to year

Purpose of Efficiency Ratios

examine how well a company manages and uses its assets

Purpose of Profitability Ratios

Looks at how well a company generates the income needed to be profitable

Purpose of Return on Assets (ROA)

Shows how well a company has used its resources; the higher the better

Purpose of Return on Equity (ROE)

Shows the rate of return that shareholders are earning on their equity in the company's assets

Return on assets formula

Net income / total assets