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Corporate Finance > Chapter 3: Working with Financial Statements > Flashcards

Chapter 3: Working with Financial Statements Flashcards

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1
Q

What do ratios allow us to compare?

A

They allow us to compare with ourselves, historically, as well as compare across companies.

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2
Q

How do you change a regular Income Statement into a Common-Size Income Statement?

A

You turn all of the raw numbers into percentages. (Usually percentage of Sales/Revenue)

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3
Q

What are the three common margins referenced?

A

Gross Profit Margin, Operating Profit Margin, Net Profit Margin

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4
Q

What can managers do with ratios within a company?

A

They can:
1) Identify problems in a firm and take proper actions.
2) Set goals for each division and evaluate its performance
3) Prepare for future financial projections (e.g., launch new products)
4) Compare with competitors or industry benchmarks.

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5
Q

What trend do you normally see with young companies?

A

These companies typically do not make a profit even though the stock market for them is very high. They even usually have a negative operating profit. Finally, it typically takes 5-6 years before you see any earning of returns.

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6
Q

What can ratios be used for outside of a company?

A

1) Investors can evaluate the company and determine whether to invest/lend.
2) Business Partners or suppliers can decide whether to extend credits/continue business.

Note that these individuals will look at your historical trends and also compare you with other companies that they are looking at investing in.

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7
Q

What are the key financial ratios?

A

1) Liquidity
2) Efficiency
3) Leverage and profitability
4) Market value measures

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8
Q

What two financial ratios tend to be used more internally?

A

Liquidity and Efficiency.

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9
Q

What two ratios tend to be used more from the investor perspective?

A

Leverage and Profitability and Market Value Measures

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10
Q

What is a liquid asset?

A

This is an asset that can be converted quickly and routinely into cash at the current market price.

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11
Q

What does liquidity measure?

A

This measures the firm’s ability to pay its bills on time. It is not saying how fast you can liquidate the firm, but if you can pay the bills in general.

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12
Q

Besides liquidity, what other calculation can measure the company’s ability to pay bills?

A

Net Working Capital.

NWC= Current Assets - Current Liabilities

You are looking at “absolute dollars” that the company has.

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13
Q

What ratios can be used to measure liquidity?

A

1) Current Ratio
2) Acid-Test (Quick) Ratio
3) Cash Ratio

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14
Q

How do you calculate the current ratio? What does it measure?

A

Current Assets/Current Liabilities

  • Measures how much the firm has in current assets for every $1 in current liabilities. You want this to be > $1
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15
Q

How do you calculate the Acid-Test (Quick) Ratio?

A

(Current Asset- Inventory)/ Current Liabilities

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16
Q

How do you calculate the cash ratio?

A

Cash/Current Liabilities

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17
Q

What is one aspect of using ratios that one has to be worried about?

A

For businesses that are highly seasonal, current ratio may not accurately reflect the true liquidity of the business (depending on the time period selected). Ratios only reflect a snapshot/period in time.

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18
Q

Why do companies need to be careful about comparing their ratios to the industry ratio?

A

If you are looking at the industry as a whole, you could have, for example, companies as wide as Walmart and Astha grouped together. Furthermore, depending on what the measure is, you could be the LEADER in the industry. Why would you aim lower?

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19
Q

Efficiency Measures

A

Tells you the operating return on assets. Note that you should only look at operating profits because it excludes financing costs, such as interest payments. (You’re not looking at Net Income)

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20
Q

How do you calculate the Operating Return on Assets (OROA)? What does it measure?

A

Operating Profits/Total Assets

  • Measures how much operating profits are generated per dollar invested in assets. Essentially, how efficiently you are using assets to generate profit.
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21
Q

What are two equivalent, but alternative, equations for calculating OROA?

A

OROA= Operating Profit Margin x Total Asset Turnover

or

(Operating Profits/Sales) x (Sales/Total Assets)

  • This helps demonstrate operating management and assets management. You should start with 1, and if needed, 2 can tell you where you might have “gone wrong”.
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22
Q

Operating Management

A

How well the company controls its costs and expenses.

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23
Q

Assets Management

A

How efficiently assets are being used to generate sales.

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24
Q

What are the three aspects of total asset turnover you can look at if you are concerned with that/Assets Management?

A
  • Accounts Receivable Turnover
  • Inventory Turnover
  • Fixed Asset Turnover
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25
Q

Accounts Receivable Turnover

A

This examines how quickly the firm can convert accounts receivable and inventory into cash. Can evaluate in two ways:

1) How many times are the accounts receivable “rolled over” each year?
2) How long does it take to collect the receivables?

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26
Q

How do you calculate the receivables turnover?

A

Annual Credit Sales/Accounts Receivables

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27
Q

Days in Receivables

A

365/Accounts Receivable Turnover

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28
Q

How do you calculate inventory turnover?

A

How fast Inventory is turned over into cash. Can evaluate it in two ways:

1)How many times are the firm’s inventories sold and replaced during the year?
2) How long is the inventory held before being sold?

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29
Q

Inventory Turnover

A

Cost of Goods Sold/Inventory

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30
Q

Days in Inventory

A

365/Inventory Turnover

31
Q

What does Fixed Asset Turnover Measure? How do you calculate it?

A

measures how much sales a company generates from every $1 invested in fixed assets.

Fixed Asset Turnover = Sales/Net Fixed Assets

32
Q

Why do we use net fixed assets when calculating fixed asset turnover instead of gross fixed assets?

A

Gross fixed assets reflect total expense, net fixed assets get rid of depreciation. (Takes out accumulated depreciation).

33
Q

What are the two ways to finance assets?

A

Debt or Equity

34
Q

What are Leverage Measures?

A
  • Debt Ratio
  • Debt-to-Equity Ratio
  • Asset-to-Equity Ratio (Equity Multiplier)
  • Times Interest Earned
  • Cash Coverage
35
Q

What does debt ratio measure?

A

This measures the financial risk of a company.

36
Q

How do you calculate the debt ratio?

A

Total Liabilities/Total Assets

37
Q

Financial Risk

A

The risk that a company cannot pay back its debts. Investors will loses their money.

38
Q

How do you calculate the Debt-to-Equity Ratio?

A

Total Liabilities/Total Equity

39
Q

How do you calculate the Asset-to-Equity Ratio? (Equity Multiplier)

A

Total Assets/Total Equity

40
Q

How do you calculate Times Interest Earned? (Interest Coverage Ratio)

A

Operating Income (EBIT)/Interest Expense

41
Q

How do you calculate Cash Coverage?

A

EBIT + Depreciation(EBITD)/Interest Expense

42
Q

What do you pay interest with?

A

It is important to note that you pay interest with cash, not income.

43
Q

What are examples of Profitability Measures?

A

Return on Asset and Return on Equity

44
Q

How do you calculate the Return on Asset ratio? What does it mean?

A

Net Income/Total Asset. It measures profit per dollar invested in assets.

45
Q

How do you calculate the Return on Equity? What does it mean?

A

Net Income/Total Equity. This measures profit generated per dollar invested by shareholders.

46
Q

What does DuPont Analysis determine?

A

This determines the reason for ROE changes.

47
Q

What is ROE comprised of?

A

This is comprised of the Net Profit Margin, Total Asset Turnover, and Equity Multiplier.

48
Q

What type of income are we using when we are talking about profit?

A

Remember that we have gross, operating, and net income. When we talk about this, we are usually talking about Net Income.

49
Q

Why is leverage important?

A

This can greatly impact the ratios that are calculated. Net income in unleveraged companies increases because they don’t have any interest expense.

Also, when the business is doing well, having some sort of debt will increase ROE. But when things are going bad, you EBIT will decrease drastically, and ROE will be bad.

50
Q

What is the effect of leverage on ROE referred to?

A

This is referred to as the magnified effect.

51
Q

What do the Market Value Ratios (P/E) measure?

A

This measures how much investors are willing to pay for $1 of reported earnings.

52
Q

What is the equation for the P/E Ratio?

A

Market Price per Share/Earnings per Share

53
Q

How do you calculate Earnings per Share

A

You calculate this by Net Income/# of Shares.

54
Q

What type of value is net income?

A

This is a book value.

55
Q

What is market price per share?

A

This tells us how much you’re actually paying. It also allows you to compare stock.

56
Q

What is the equation for the PEG Ratio

A

PE Ratio/Expected Future Growth Rate

57
Q

Why is the Industry Average P/E Controversial?

A

This is controversial because some companies can be very high. Generally companies land between 20-30. However, if this number is really high it tells you that the investors are expecting the company to grow a lot. If the company does not meet these expectations, their stock will be very volatile.

58
Q

What does the price-to-earnings ratio (PEG) tell us?

A

Tells us that, for stock, for every earning ($) they report, the amount they are willing to pay. “Price per $ earning.”

59
Q

How can a company grow?

A

External Growth and Internal Growth

60
Q

External Growth

A

Through infusion of capital by:
- Borrowing
- Issuing new common stock
- Merge & Acquisition

61
Q

Internal Growth

A

This is done by management retaining some or all of the profits to reinvest in the firm.
- This reinvestment determines future earnings growth and increase in the value of stock.

62
Q

What are the two ways to calculate Internal Growth?

A

1) Using ROA
- Assuming you are just reinvesting, your debt ratio will go down as your assets grow.
- There is no additional debt borrowing. No capital from outside of the company.
2) Using ROE.
- In this method we are holding the debt ratio constant.
- Sustainable Growth

63
Q

How do you calculate Sustainable Growth?

A

g= Profit Retention Rate(b) x ROE

64
Q

How do we calculate the profit retention rate?

A

RE/NI.
- This tells us out of the R.E., we can retain ___ to grow the company.

65
Q

What does the price-to-book ratio do?

A

This compares the market value of a share of stock to the book value per share of equity on the balance sheet.

66
Q

What is the equation for the Price/Book (Market-to-Book) Ratio?

A

Market Price per Share/Equity Book Value per Share

67
Q

What does it mean if the price/book ratio is greater than 1?

A

This tells us that shares are more valuable than the price shareholders have invested in (good investment or over-valued).

68
Q

What does it mean if the price/book ratio is less than 1?

A

This tells us that shares are less valuable than the price investors have paid (bad investment or undervalued).

69
Q

What is the equation for the price/sales ratio?

A

Market Price per Share/Sales per Share

70
Q

What is the equation for the Market Value of Stock

A

Price Stock is Trading At * # of Stock

71
Q

What is the formula for the EBITDA Ratio?

A

Enterprise Value/EBITDA
- This solves the problem when the company does not have positive earnings.

72
Q

How do you calculate the enterprise value?

A

Total Market Value of the Stock + Book Value of all Liabilities - Cash

73
Q

What is the equation for EBITDA?

A

EBIT + Depreciation + Amorization

74
Q

What are the limitations of financial ratio analysis?

A

1) It is based on historical information
2) Accounting practices differ widely among firms.
3) The numbers in the financial statements are biased by seasonal sales.
4) It is sometimes difficult to identify industry categories or comparable peers.
5) Industry averages may not provide a desirable target ratio.
6) A high or low ratio does not automatically lead to a specific conclusions.

Corporate Finance (13 decks)

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