Chapter 3 Flashcards
What do common size statements accomplish when looking at comparisons over time?
Remove inflation as a factor.
When is vertical analysis most useful?
Comparing businesses of different sizes.
Which statement is usually looked at through trend analysis?
Income statement.
What are the four categories of ratios ?
Efficiency
Liquidity
Leverage
Profitability
Why must an analyst understand the company’s industry when performing vertical analysis?
Industry differences are reflected in statements.
This type of analysis shows the composition of assets, liabilities, etc?
Vertical
This shows growth in sales over time?
Trend analysis
This analysis is typically focused on the income statement.
Trend analysis
Inventory turnover ratio
Cost of goods sold / inventory
Acid test formula
(Current assets - inventory) / current liabilities
Removed inventory from numerator. Better determines ability to convert assets to cash to satisfy liabilities.
Current ratio
Assets / liability
Return on equity
Net income / shareholders equity
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.
What does vertical analysis begin with?
Creating common size statements
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
What two statements can single period vertical analysis be used on?
Balance sheet and income statement
What is the downside to multiple period vertical analysis?
Doesn’t address how much the company can grow it has grown.
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
Which statement does trend analysis mainly apply to?
Income statement. Looks for profitability over time.
What are two types of trend analysis ?
Year-to-year
Base year-to-date
This type of analysis provides standard measures of performance for analysts.
Ratio analysis
4 types of financial ratios
Efficiency (how quickly collecting)
Liquidity (ability to turn assets to cash)
Leverage (extent using debt)
Profitability (earning capacity)
What is AR turnover ratio used for?
Tell how quickly a business collects from customers.
What does a high AR turnover ratio mean?
Efficiency
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
