Chapter 4 Essentials

Question 1

Chapter 4 focuses on

Answer 1

Measuring Performance

Question 2

Financial Ratios

Answer 2

Allow for both an internal and external assessment of a firm

Question 3

Return on Equity or ROE

Answer 3

Net income available for common shareholders / common shareholders’ equity

Question 4

ROE Decomposition or DuPont Method

Answer 4

ROE = Profit Margin x Asset Turnover x Financial Leverage

Question 5

Profit Margin

Answer 5

Measures how effective management is at creating earnings for every dollar of sale generated

Net income / revenue

Question 6

Asset Turnover

Answer 6

Measure management’s ability to harvest or “sweat” the assets in order to generate sales

Revenues / assets

Question 7

Financial Leverage

Answer 7

Indicates the degree to which effective use of borrowing contributed to the firm’s ROE

Assets / Equity

Question 8

Return on Assets or ROA

Answer 8

Profit Margin x Asset Turnover

Question 9

Profitability Measures

Answer 9

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

Question 10

Gross Margin Percentage

Answer 10

Gross Profit / Revenues

Question 11

EBIT Margin Percentage

Answer 11

EBIT / Revenues

Question 12

EBITDA Margin Percentage

Answer 12

EBITDA / Revenues

Question 13

Expense Ratio

Answer 13

Expenses / Revenues

Question 14

Break Even Net Sales

Answer 14

Fixed Costs / Gross Margin Percentage

Question 15

ROIC

Answer 15

EBIT x (1 - tax rate) / net working capital + fixed assets

Or

EBIT x (1 - tax rate) / interest bearing debt + equity

Question 16

Resource Management Measures

Answer 16

Focus on management’s ability to effectively utilize the resources at their disposal, such as fixed assets and working capital

Question 17

Fixed Asset Turnover

Answer 17

Revenues / Net Property Plant and Equipment

Question 18

Age of Inventory (In days)

Answer 18

Inventories / Average Daily Cost of Sales

Question 19

Inventory Turnover

Answer 19

Annual Cost of Sales / Inventories

Question 20

Age of AR (in days)

Answer 20

AR / Average Daily Credit Sales or Rev

Question 21

Age of AP (in days)

Answer 21

AP / Average Daily Purchases

Question 22

Liquidity

Answer 22

A measure that focuses on a firm’s ability to meet its short term obligations

Question 23

Current Ratio

Answer 23

Current Assets / Current Liabilities

Question 24

Quick Ratio or Acid Test

Answer 24

(Cash + AR) / Current Liabilities

Question 25

Leverage Measures

Answer 25

Look at a firm’s ability to meet its long term obligations, as well as its overall optimal use of debt

Question 26

Debt to Assets Ratio

Answer 26

Total Liabilities / Total Assets

Question 27

Debt to Equity Ratio

Answer 27

Total Liabilities / Equity

Question 28

Long Term Debt to Capital

Answer 28

Interest Bearing Debt / (Interest Bearing Debt + Equity)

Question 29

Interest Coverage

Answer 29

Earnings before Interest and Tax / Interest Expenses

Question 30

Debt Service Coverage

Answer 30

Earnings before Interest, Taxes, Depreciation, and Amortization / Interest + (Principal Repayments / (1 - Tax Rate) )

Question 31

Annual Reports Important Inclusions

Answer 31

Regulatory Documents, Senior Management Comments, Letter to Shareholders, Footnotes, Legal Discussions, Analysis, etc.

Question 32

Relevance for Managers

Answer 32

The ability to understand how your company is doing and what investors are thinking about it