Chapter 3: Working with Financial Statements

Question 1

common size financials

Answer 1

a standardized financial statement presenting all items in percentage terms. balance sheet times are shows as percentage of assets and income statement items as a percentage of sales

Question 2

financial ratios

Answer 2

relationships determined from a firm’s financial information and used for comparison purposes

Question 3

income statement

Answer 3

financial statement summarizing a firm’s performance over a period of time

Question 4

balance sheet

Answer 4

financial statement showing a firm’s accounting value on a particular date

Question 5

short term solvency/liquidity measures

Answer 5

firm’s ability to pay its bills over the short run without undue stress - consequently, these ratios focus on current assets and current liabilities

Question 6

what is one advantage of looking at CURRENT assets and liabilities?

Answer 6

their book values and market values are likely similar

that said, they rarely live long enough for them to get seriously out of step

Question 7

current ratio (short term solvency)

Answer 7

current assets/current liabilities

unit of measurement is either dollars or times

to a creditor, specifically a short-term creditor like a supplier, a higher current ratio is favorable

absent some extraordinary circumstances, we would expect to see a current ratio of at least 1, because a current ratio of less than 1 would mean that net working capital (current assets less current liabilities) is negative

Question 8

give an example of a situation that would effect the current ratio

Answer 8

suppose a firm borrows over the long term to raise money. the short-run effect would be an increase in cash from the issue proceeds and an increase in long-term debt. current liabilities would not be affected, so the current ratio would rise

note that an apparently low current ratio may not be a bad sign for a company with a large reserve of untapped borrowing power

Question 9

quick ratio (acid-test ratio) (short term solvency)

Answer 9

current assets - inventory/current liabilities

Question 10

cash ratio (short term solvency)

Answer 10

cash/current liabilities

a very short-term creditor might be interested in the cash ratio

Question 11

total debt ratio (long term solvency)

Answer 11

total assets - total equity/total assets

Question 12

debt equity ratio (long term solvency)

Answer 12

total debt/total equity

Question 13

equity multiplier (long-term solvency)

Answer 13

total assets/total equity

Question 14

times interest earned ratio (long term solvency)

Answer 14

EBIT/interest

EBIT is earnings before interest and taxes

Question 15

cash coverage ratio (long-term solvency)

Answer 15

EBIT + depreciation/interest

a problem with the TIE ratio is that it is based on EBIT, which is not really a measure of cash available to pay interest. the reason is that depreciation, a non cash expense, has been deducted out. because interest is most definitely a cash outflow to creditor

Question 16

income statement structure

Answer 16

net sales
depreciation
expense
earnings before interest/taxes
interest paid
taxable income
taxes
NI

Question 17

inventory turnover ratio (asset utilization ratio)

Answer 17

COGS/inventory

in a sense, this will tell you how many times a firm sold off, or turned over the entire inventory

Question 18

days’ sales in inventory ratio (asset utilization ratio)

Answer 18

365 days/inventory turnover

this will tell us that inventory sits for XXX number of days on average before it is sold.

Question 19

receivables turnover ratio (asset utilization ratio)

Answer 19

sales/AR

we collected our outstanding credit accounts and reloaded the money XXX times during the year

Question 20

days’ sales in receivables (asset utilization ratio)

Answer 20

365 days/receivables turnovers

on average, we collect on our credit sales in XXX days

Question 21

total asset turnover ratio (asset utilization ratio)

Answer 21

sales/total assets

for every dollar in assets, we generated XXX in sales

Question 22

profit margin ratio (profitability ratio)

Answer 22

net income/sales

this tells us that a firm, in an accounting sense, generates a little less than XXX cents in profit for every dollar in sales

Question 23

return on assets (profitability ratio)

Answer 23

net income/total assets

is a measure of profit per dollar of assets

Question 24

return on equity (profitability ratio)

Answer 24

net income/total equity

measure of how the stockholders fared during the year. because benefiting shareholders is our goal, ROE is, in an accounting sense, the turnover emotion-line measure of performance

therefore, for every dollar in equity, the firm generated XXX in profit

Question 25

earnings per share (market value measure)

Answer 25

net income/shares outstanding

Question 26

price-earnings ratio (market value measure)

Answer 26

price per share/earnings per share

in the vernacular, we would say that Prufrock shares sell for XXX times earnings, or we might say that Prufrock’s shares have a PE multiple of XXX

because the PE ratio measures how much investors are willing to pay per dollar of current earnings, higher PE’s are often taken to mean that the firm has significant prospects for future growth

Question 27

price-sales ratio (market value measure)

Answer 27

price per share/sales per share

Question 28

market-to-book ratio (market value measure)

Answer 28

market value per share/book value per share

notice that book value per share is total equity divided by the number of shares outstanding

Question 29

enterprise value equation

Answer 29

total market value of the stock + book value of all liabilities - cash

Question 30

dupont identity

Answer 30

its a popular expression breaking down ROE into three parts: operating efficiency, asset use efficiency, and financial leverage

the dupont identity tells us that ROE is affected by three things:

1) operating efficiencies (as measured by profit margin)
2) asset use efficiency (as measured by total asset turnover)
3) financial leverage (as measured by the equity multiplier)

ROE = profit margin X total asset turnover X equity multiplier

proof: NI/total equity = NI/sales X sales/total assets x total assets/total equity
NI/total equity = NI/total equity

Question 31

what two ratios can you multiply to produce the ROA ratio?

Answer 31

profit margin X total asset turnover

Question 32

net income can be divided into two pieces

Answer 32

dividend payout and retention ratio

Question 33

dividend payout ratio

Answer 33

cash dividends/net income

what this tells us is that XXX firm pays out XXX of its net income in dividends

Question 34

retention ratio

Answer 34

addition to retained earnings/net income

shows that a firm retains XXX of its net income. the retention ratio is also known as the plowback ratio because it is, in effect, the portion of net income that is plowed back into the business

Question 35

what is important to notice about the dividend payout and plowback ratios?

Answer 35

they have to add up to one because net income must either be paid out or plowed back

Question 36

a firm has two broad sources of financing, what are they?

Answer 36

internal and esternal

internal refers to the funds that the company plows back into its operations

external refers to outside financing the company receives to increase sales

Question 37

internal growth rate

Answer 37

ROA x B/1 - ROA x B

B is the retention or plowback

suppose a firm has policy of financing forth using only internal financing. how rapidly can the firm grow? this ratio will tell you that

it will give you a percentage. thus, if a company relies solely on internally generated financing, it can grow at a maximum rate of XXX percent per year

Question 38

sustainable growth rate

Answer 38

maximum growth rate that can be achieved

ROE x B/1 - ROE x B

Question 39

what four factors dictate a firm’s ability to sustain growth?

Answer 39

1) profit margin
2) total asset turnover
3) financial policy (debt-equity ratio)
4) dividend policy (retention ratio)

because ROE appears so prominently in the determination of the sustainable growth rate, the factors important in determining ROE are also important determinants of growth

Question 40

if there is a conflict between market data and accounting data, which should be given precedence?

Answer 40

market data

Question 41

internal uses of financial analysis

Answer 41

1) performance evaluation: manages are frequently evaluated and compensated on the basis of accounting measures of performance such as profit margin and return on equity
2) planning for the future

Question 42

external uses of financial analysis

Answer 42

1) useful for parties outside the firm, like short and long term creditors and potential investors
2) we would also use financial info to vet suppliers, and vice versa
3) evaluating our main competitors
4) good to think about when acquiring another firm

Question 43

choosing a benchmark: time-trend analysis

Answer 43

history, or seeing how financial numbers have changed over time

Question 44

choosing a benchmark: peer group analysis

Answer 44

identify firms similar in the sense that sense that they compete in the same markets, have similar assets, and operate in similar ways. in other words, we need to identity a peer group

Question 45

standard industrial classification (SIC) codes

Answer 45

US government code used to classify a firm by its type of business operations

the first digit establishes the general type of business, and each additional digit narrows down the industry

Question 46

problems with financial statement analysis

Answer 46

there is no underlying theory to help us identify which items or ratios to look at and to guide us in establishing benchmarks

another problem is that major competitors and natural peer group members in an industry may be scattered around the globe. the problem here is financial statements from different countries have different standards of reporting. the existence of different GAAP make it very difficult to compare financial statements across national borders

Question 47

EBITDA ratio

Answer 47

enterprise value/EBITDA

earnings before interest and taxes + depreciation and amortization