Chapter 3

Question 1

Common Size Financial Statement

Answer 1

A Common Size Financial Statement shows the specific lines of the financial statement as a percentage of a broader statement line.

Question 2

Common Size Income Statement

Answer 2

PCT of sales

Question 3

Common Size Balance Sheet

Answer 3

PCT of Total Assets

Question 4

Liabilities

Answer 4

PCT of Total Liabilities

Question 5

Use of Common Size Financial Statement

Answer 5

Compare one or more Companies of different sizes

Question 6

Short Term Solvency

Answer 6

Do they have the cash to pay their bills? Current Ratio, Quick Ratio, Cash Ratio

Question 7

Long Term Solvency

Answer 7

Will the firm be able to service its debt? Debt to equity Ratio, Cash Coverage Ratio, Times Interest Earned

Question 8

Asset Management

Answer 8

How efficiently does the firm manage its assets Inventory Turnover, Days’ Sales in Inventory, Receivables Turnover Days’ Sales in Receivables, Payables Turnover, Days’ Cost in Payables

Question 9

Profitability Ratios

Answer 9

How efficiently does the firm use its assets and manage operation to generate profits
Profit Margin, Return on Assets, Return on Equity

Question 10

Market Value Ratios

Answer 10

Market Valuation of a company sensible Earnings Per Share, Price to Earnings

Question 11

Current Ratio

Answer 11

A current ratio somewhat greater than 1.0 suggests the firm can pay its suppliers, other bills, and debt service requirements over the next year

Question 12

Quick Ratio

Answer 12

Inventory is the hardest Current Asset to convert to cash. A sale has to be made, and the cash collected. Meanwhile, inventory that sits too long can become damaged or turn obsolete. The Quick Ratio backs Inventory out of Current Assets. A ratio of at least 1.0 gives confidence the firm can meet its obligations.

Question 13

Cash Ratio

Answer 13

Cash is King! Very short-term creditors, who won’t wait for non-cash assets to be converted, would be interested in the Cash Ratio before being willing to lend.

Question 14

Debt to Equity Ratio

Answer 14

A Debt-Equity ratio higher than 1.0 means the company is using debt funding more than equity funding.
If equity holders are last in line, then holding equity is more risky to the investor than holding debt.
More risk, more return. So equity holders demand more return than bond holders.
Therefore Debt is a cheaper source of financing for a company than equity. (So Debt is tempting.)
But more Debt equals more Risk.

Question 15

Financial Leverage

Answer 15

Financial Leverage ratios measure Capital Structure, or how much debt the company is using to fund its business, and the level of its risk.

Question 16

Cash Coverage Ratio

Answer 16

The Cash Coverage Ratio tells how many times a company can pay Interest due before exhausting cash.
Analysts are very interested in EBITDA and the Cash Coverage ratio for startups and fast-growing companies.
(This is because falling levels of cash and cash burn are the leading signs of startup failure.)

Question 17

Times Interest Earned

Answer 17

However, depreciation is an expense to be taken seriously – depreciated assets need to be replaced – but the issue here is whether or not enough cash is available to service debt – not whether the firm can service debt plus replace capital assets.
For mature firms, analysts are more interested in this ratio than Cash Coverage.

Question 18

Debt to Equity Ratio

Answer 18

Total Assets-Total Equity/Total Equity

Question 19

Inventory Turnover

Answer 19

As COGS is only booked as a sale is made, the higher COGS is a multiplier on inventory, the more efficiently inventory is turning into a sale. (Higher is better, unless the firm runs out of inventory, foregoing sales).

Question 20

Days Sales in Inventory

Answer 20

Recall how slowly the fictional Classen, Inc (Chapter 2 slides) sold off its inventory. It took than more than a year to go through it just once! As long as a firm is not running out of inventory (and foregoing sales), lower is better for this number.

Question 21

Receivables Turnover

Answer 21

If Inventory Turnover tells us how fast the firm is turning inventory into sales, Receivables Turnover tells us how fast the firm is collecting (turning into cash) those receivables.

Question 22

Days Sales in Receivables

Answer 22

Once we have Receivables Turnover, we can measure how many days it takes the firm to collect its receivables. (How long is the firm issuing free credit to the people who owe it money! Or how fast is it collecting on these loans so that they can make new loans to buyers!

Question 23

Payables Turnover

Answer 23

If we assume a firm buys all of its inventory on credit, then Payables Turnover measures many times the firm pays its bills.

Question 24

Days Costs in Payables

Answer 24

Likewise, we can measure in days how long the firm takes to pay its bills.

Question 25

Earnings Per Share

Answer 25

Earnings per Share (EPS) measures how much of the firm’s profit each share is entitled to.

Question 26

Price to Earnings

Answer 26

Measures how much an investor must pay for every dollar of profit the firm has earned.