Chapter 3: Working with Financial Statements Flashcards
common size financials
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
financial ratios
relationships determined from a firm’s financial information and used for comparison purposes
income statement
financial statement summarizing a firm’s performance over a period of time
balance sheet
financial statement showing a firm’s accounting value on a particular date
short term solvency/liquidity measures
firm’s ability to pay its bills over the short run without undue stress - consequently, these ratios focus on current assets and current liabilities
what is one advantage of looking at CURRENT assets and liabilities?
their book values and market values are likely similar
that said, they rarely live long enough for them to get seriously out of step
current ratio (short term solvency)
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
give an example of a situation that would effect the current ratio
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
quick ratio (acid-test ratio) (short term solvency)
current assets - inventory/current liabilities
cash ratio (short term solvency)
cash/current liabilities
a very short-term creditor might be interested in the cash ratio
total debt ratio (long term solvency)
total assets - total equity/total assets
debt equity ratio (long term solvency)
total debt/total equity
equity multiplier (long-term solvency)
total assets/total equity
times interest earned ratio (long term solvency)
EBIT/interest
EBIT is earnings before interest and taxes
cash coverage ratio (long-term solvency)
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
income statement structure
net sales depreciation expense earnings before interest/taxes interest paid taxable income taxes NI
inventory turnover ratio (asset utilization ratio)
COGS/inventory
in a sense, this will tell you how many times a firm sold off, or turned over the entire inventory
days’ sales in inventory ratio (asset utilization ratio)
365 days/inventory turnover
this will tell us that inventory sits for XXX number of days on average before it is sold.
receivables turnover ratio (asset utilization ratio)
sales/AR
we collected our outstanding credit accounts and reloaded the money XXX times during the year
days’ sales in receivables (asset utilization ratio)
365 days/receivables turnovers
on average, we collect on our credit sales in XXX days
total asset turnover ratio (asset utilization ratio)
sales/total assets
for every dollar in assets, we generated XXX in sales
profit margin ratio (profitability ratio)
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
return on assets (profitability ratio)
net income/total assets
is a measure of profit per dollar of assets
return on equity (profitability ratio)
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
earnings per share (market value measure)
net income/shares outstanding
price-earnings ratio (market value measure)
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
price-sales ratio (market value measure)
price per share/sales per share
market-to-book ratio (market value measure)
market value per share/book value per share
notice that book value per share is total equity divided by the number of shares outstanding
enterprise value equation
total market value of the stock + book value of all liabilities - cash
dupont identity
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
what two ratios can you multiply to produce the ROA ratio?
profit margin X total asset turnover
net income can be divided into two pieces
dividend payout and retention ratio
dividend payout ratio
cash dividends/net income
what this tells us is that XXX firm pays out XXX of its net income in dividends
retention ratio
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
what is important to notice about the dividend payout and plowback ratios?
they have to add up to one because net income must either be paid out or plowed back
a firm has two broad sources of financing, what are they?
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
internal growth rate
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
sustainable growth rate
maximum growth rate that can be achieved
ROE x B/1 - ROE x B
what four factors dictate a firm’s ability to sustain growth?
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
if there is a conflict between market data and accounting data, which should be given precedence?
market data
internal uses of financial analysis
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
external uses of financial analysis
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
choosing a benchmark: time-trend analysis
history, or seeing how financial numbers have changed over time
choosing a benchmark: peer group analysis
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
standard industrial classification (SIC) codes
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
problems with financial statement analysis
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
EBITDA ratio
enterprise value/EBITDA
earnings before interest and taxes + depreciation and amortization
