Chapter 3 Working With Financial Statements Flashcards
What is the equation for a firm’s cash flow from assets?
Cash flow to creditors + Cash flow to owners
What is the statement of cash flows?
A statement depicting the cash sources and cash spending of a firm during a period of time.
What three categories represent possible changes on the statement of cash flows?
Operating activities, financing activities, investment activities
How is interest paid handled differently in accounting?
Interest paid usually goes under financing activities. However in accounting practices it is represented as an expense. And is deducted when net income is computed.
If our net purchase of fixed assets was $149 and we wrote off $276 worth in depreciation, how much cash did we spend on fixed assets?
$149 + $276 = $425
Does standard accounting practice express a change in cash on a per-share basis?
No
What is a common-size statement?
A standardized financial statement presenting all items in percentage terms. The statement of financial position is shown as a percentage of assets, and the income statement is shown as a percentage of sales.
In a common sized statement what is the total change usually set to due to the way the statement is set up
0%
What is a common-base year statement?
A standardized financial statement presenting all items relative to a certain base year amount
If we were using a common base year statement model, answer the following question:
Prufrock’s inventory rose from 393 to 422. If we pick 2019 as our base year how would we find the common size for inventory growth for 2020
2019 = 393
2020 = 422
422/393 = 1.07
All were looking for is the ratio that exhibits the change in a certain metric between whatever periods of time
1.07 implies that inventory grew by 7% from 2019 to 2020
What is combined common size and base year analysis?
By forming common size statements we eliminate the effect of overall growth and then we can apply the trend analysis.
Prufrock’s accounts receivable were 165, 4.9% of total assets in 2019
Prufrock’s accounts receivable were 188, 5.2% of total assets in 2020
Give me a combined common size and base year analysis using this information
Prufrock’s accounts receivable grew by 188/165 = 1.14, 14%.
Whilst
Prufrock’s accounts receivable as a percentage of total assets grew by 5.2/4.9 = 6%
This tells us that 14-6 = 8% is attributable simply to growth in total assets.
Why is it often necessary to standardize financial statements?
To have a basis from which to use certain metrics and to have easy comparability between different firms
Name two types of standardized statements and describe how each is formed?
We got the common-size standardized statement which views all items as a % of total assets
We also have a common-base year standardized statement that views all items as % change based on a certain year that is picked as the base
What are some of the questions to ask ourselves when looking at financial ratios?
- How is it computed? (How are we actually getting the ratio)
- What is it intended to measure, and why might we be interested (what is the actual purpose of this ratio, and how is it useful for us)
- What might a high or low value be telling us and how might these values be misleading
(What are the base measurements we use to determine whether a certain ratio is good or bad and if it is appropriate to use in such a case - How could this measure be improved? (What other measures could I look at or how could I follow this measure further to discern more information)
What are the five categories of financial ratios?
- Short term solvency, Liquidity ratios
- Long term solvency, financial leveraging ratios
- Asset Management and turnover ratios
- Profitability ratios
- Market value ratios
Are the book and market values of assets usually similar?
Yes, and this makes using short term solvency / liquidity ratios very useful in the short term
What is the current ratio?
Current ratio = Current Assets / Current Liabilities
An organization’s measure of liquidity and its ability to cover its current liabilities. A higher ratios implies a better ability to cover liabilities.
However too high of a ratio can also mean inefficient use of cash and other short term assets
If company A has current assets of $1500 and current liabilities of $1000. What is the current ratio of that company and what does it imply?
1.5 and it implies that the company could cover its liabilities 1.5 times over
What is the Quick (Acid-test) ratio?
Quick ratio = Current Assets - Inventory / Current Liabilities
Since inventory is the least liquid asset as well as the one with the most chance of having inaccurate values. We remove it from the current assets pool to get a quick ratio.
When buying inventory using cash how are the current and quick ratios affected?
The current ratio is unaffected whilst the quick ratio gets smaller.
Since current ratio represents all assets while
quick ratio represents current assets - inventory
What is the cash ratio?
Cash ratio = (Cash + Cash equivalents) / Current liabilities
Shows us how much cash we actually have compared to all of our current liabilities
What is the net working capital to total assets ratio?
Net working capital / Total assets
Shows us how much capital we have engaged in comparison to total assets
What is the interval measure?
The number of days an organization could survive without any new assets
Interval measure = Currents assets / Average daily operating costs
What is the total debt ratio?
Total Debt ratio = Total Assets - Total Equity / Total assets
Essentially Total Liabilities / Total assets
Indicates how much debt/leverage a firm has comparatively to its assets
What is the debt-equity ratio?
Debt-equity = Total Debt / Total Equity
Comparatively how much a firm derives its financing from debt versus equity
What is the equity multiplier?
Equity multiplier = Total Assets / Total Equity
Calculates how many assets the firm has compared to equity
Equity multiplier also = Debt-equity ratio + 1
What is the long-term debt ratio?
Long-term debt ratio = Long-term debt / Long-term debt + Total equity
What is a firm’s total capitalization?
Total capitalization = Long term debt + Total equity
What does times interest earned (TIE) ratio mean?
TIE ratio = EBIT / Interest
Earnings before income, taxes
Measures how well a company has its interest obligations covered
What is the cash coverage ratio?
Cash coverage ratio = (EBIT + Depreciation) / Interest
Measures how well a company has its interest obligations covered before deduction is taken out
What is a problem with the TIE ratio?
It uses EBIT which means that depreciation which is a non-cash expense has been deducted. So we do not get a fully accurate picture of how much cash is available.
What is EBIT and what is EBITDA?
Earnings before interest and taxes
Earnings before Interest, taxes, depreciation, amortization
Which ratios are responsible for determining the efficacy with which an organization uses its assets?
Asset utilization ratios
What is Inventory turnover?
Cost of goods sold (COGS)
Inventory turnover = COGS / Inventory
Essentially how many times has the company sold their entire inventory over. A higher number indicates that inventory moves faster
What is Receivables turnover?
Receivables turnover ratio = Sales / Accounts receivable
How many times over has the firm collected on due payments.
A higher ratio indicates a faster rate of receiving due payments
What is NWC turnover? =
NWC turnover = Sales / NWC
Measures how much work we get out of our working capital
What is fixed asset turnover?
Fixed asset turnover = Sales / Net fixed assets
Profit Margin equation
Net income / Sales
Return on Assets
Net income / Total Assets
Return on Equity
Net income / Total Assets
What is EPS?
Earnings per share
EPS = Net income / Shares outstanding
What is the P/E ratio?
Price-to-earnings ratio
P/E ratio = Price per share / Earnings per share
What is the PEG ratio?
PEG ratio = P/E ratio / Expected Future earnings growth rate * 100
High PEG ratios suggest that the P/E may be too high relative to growth and vice versa
Market to Book Ratio
Market to book ratio = Market Value per share / Book value per share
What is Enterprise Value / Earnings before income, tax, depreciation and amortization?
EV / EBITDA multiple = (Market value of equity + makret value of interest bearing debt - cash (and cash equivalents) / EBITDA
Essentially take the combined market values for equity and debt - cash and divide by the earnings of the company before any deductions are made
What are the appeals of the EV/EBITDA ratio?
- High up on the financial statement, so there’s been less modifications made to the numbers that could lessen the accuracy of the ratio
- It can be used to value companies with negative earnings.
What is the DuPont Identity?
ROE = ROA * Equity multiplier
also
ROEO = Profit margin * Total asset turnover * Equity multiplier
Equity multiplier = Total assets / Total equity
Because ROA = profit margin (some percentage) * how much value in assets did the turn over at x profit margin rate, ex. 0.06, 6%
What does the DuPont Identity tell us?
- Tells us the profit margin rate of the firm which tells us how efficient the firm is in managing costs and generating income. A.K.A Operating Efficiency
- The total asset turnover tells us how efficient they are at using assets, Asset Use Efficiency
- The Equity multiplier tells us how much financial leverage the firm is using / currently has, Financial Leverage.
By using the accounting equation if the Equity multiplier goes up that means assets increased more than equity which means liabilities must have increased as well, aka financial leverage
When we have market information, should we use that over accounting data?
Yes, and if market and accounting data conflict. Market data should be given precedence.
What are some internal uses of financial information?
To properly pay out performance bonuses
To compare different divisions of the company in terms of performance.
What are some external uses of a company’s financial statement?
Used by creditors and other businesses to gauge the trustworthiness and performance of the company.
Invest analysts use automated software that essentially pings certain ratios once they cross thresholds as a point of interest
What are NAICS codes?
North American Industry Classification System codes
Help to categorize companies in the NA to the closest category/ cluster of similar companies
What are some problems with financial statement analysis?
Most companies are conglomerates which makes it difficult to trace sub businesses to make comparisons
Companies compete a lot more globally now and different nations have different accounting standards which makes it difficult to compare companies
Ex. U.S still remains on GAAP while some other nations are adopting IFRS principles
Some companies are monopolies or are in lines of business where you cant really compare them to other companies. Example, energy utility companies
