Chapter 4 Essentials Flashcards
Chapter 4 focuses on
Measuring Performance
Financial Ratios
Allow for both an internal and external assessment of a firm
Return on Equity or ROE
Net income available for common shareholders / common shareholders’ equity
ROE Decomposition or DuPont Method
ROE = Profit Margin x Asset Turnover x Financial Leverage
Profit Margin
Measures how effective management is at creating earnings for every dollar of sale generated
Net income / revenue
Asset Turnover
Measure management’s ability to harvest or “sweat” the assets in order to generate sales
Revenues / assets
Financial Leverage
Indicates the degree to which effective use of borrowing contributed to the firm’s ROE
Assets / Equity
Return on Assets or ROA
Profit Margin x Asset Turnover
Profitability Measures
Focus on elements of a firm’s income statement and examine how the firm is able to generate profits from a particular level of revenue generation
Gross Margin Percentage
Gross Profit / Revenues
EBIT Margin Percentage
EBIT / Revenues
EBITDA Margin Percentage
EBITDA / Revenues
Expense Ratio
Expenses / Revenues
Break Even Net Sales
Fixed Costs / Gross Margin Percentage
ROIC
EBIT x (1 - tax rate) / net working capital + fixed assets
Or
EBIT x (1 - tax rate) / interest bearing debt + equity
Resource Management Measures
Focus on management’s ability to effectively utilize the resources at their disposal, such as fixed assets and working capital
Fixed Asset Turnover
Revenues / Net Property Plant and Equipment
Age of Inventory (In days)
Inventories / Average Daily Cost of Sales
Inventory Turnover
Annual Cost of Sales / Inventories
Age of AR (in days)
AR / Average Daily Credit Sales or Rev
Age of AP (in days)
AP / Average Daily Purchases
Liquidity
A measure that focuses on a firm’s ability to meet its short term obligations
Current Ratio
Current Assets / Current Liabilities
Quick Ratio or Acid Test
(Cash + AR) / Current Liabilities
Leverage Measures
Look at a firm’s ability to meet its long term obligations, as well as its overall optimal use of debt
Debt to Assets Ratio
Total Liabilities / Total Assets
Debt to Equity Ratio
Total Liabilities / Equity
Long Term Debt to Capital
Interest Bearing Debt / (Interest Bearing Debt + Equity)
Interest Coverage
Earnings before Interest and Tax / Interest Expenses
Debt Service Coverage
Earnings before Interest, Taxes, Depreciation, and Amortization / Interest + (Principal Repayments / (1 - Tax Rate) )
Annual Reports Important Inclusions
Regulatory Documents, Senior Management Comments, Letter to Shareholders, Footnotes, Legal Discussions, Analysis, etc.
Relevance for Managers
The ability to understand how your company is doing and what investors are thinking about it
