Chapter 4: Financial Statement Analysis and Forecasting Flashcards
What is the DuPont System made up of?
It is made up of 3 different ratios 1. Net profit margin (NI/REV), 2. Asset Turnover Ratio (Rev/TA) 3. Leverage TA/SE
Why use the DuPont system
it breaks apart the ROE (NI/SE_ in order to get a better idea what affected the numbers. “decompose ROE”
why does the DuPont system provide a good starting point for any financial analysis?
shows that financial strength come from many sources. 1. profitability 2. asset utilization 3. leverage
What does financial leverage mean?
magnification of both profits and losses
What are the 3 major leverage ratios that relate to financial leverage?
- stock ratio 2. flow ratio 3. other ratio *******
What do stock ratios indicate
the amount of debt outstanding a particular time
What are the stock ratios
- leverage ratio 2. debt ratio 3. debt to equity ratio
What is the formula for the leverage ratio
total assets / shareholder’s equity
what is the formula for debt ratio
total liabilities / total assets
What is the formula for debt to equity ratio
total debt / se
what does the debt ratio indicate
the proportion of total assets financed by debt a the balance sheet date
what does the debt-equity ratio mean
the proportion that total debt represents in relationship to SE (both common stock and retained earnings) at the balance sheet date
What are the income statement flow ratios
- times interest earned (TIE) ratio 2. Cash flow to debt ratio
How do you calculate times interest earned ratio (TIE)
EBIT / Interest expense
How do you calculate cash flow to debt ratio
cash flow form operations / total debt
what does times interest earned ratio show
it shows the number of times the firm’s pre-tax income (EBIT) exceeds its fixed financial obligations to its lenders
What does cash flow to debt ratio show
it measures how long it would take to pay off a firm’s debt using cash flow from operations
What are the efficiency ratios
- degree of total leverage (DTL) 2. break-even point 3. gross profit margin 4. operating margin
what do efficiency ratios measure
measure how efficiently a dollar of sales is turned into profits - gives insight into the company’s cost structure - helps to determine if problems exist with either variable or fixed costs
how do you calculate the degree of total leverage (DTL)
CM / earnings before taxes
how do you calculate the break-even point
fixed costs / CM
How do you calculate gross profit margin
Revenue - COS / Revenue
How do you calculate operating margin
operating income / revenue
What does degree of total leverage measure
measures exposure of profits to changes in sales - the greater the DTL the greater the leverage effect
what does break-even point show
it estimates how much you need to sell in order to cover all costs (both fixed costs and variable costs) - usually increases as the use of fixed costs increases
what does gross profit margin show
shows the proportion of sales that are available to cover fixed period costs and financing expenses after variable costs have been paid
What does a declining gross profit margin mean
it raises concerns about the company’s ability to control variable costs, such as direct materials and labour
what does operating margin measure
it measures the cumulative effect of both variable and period costs on the ability of the company to turn sales into operating profits and cover interest, taxes, depreciation and amortization (EBITDA)
What are the productivity ratios
- receivable turnover ratio 2. average collection period (ACP) 3. inventory turnover ratio 4. average days sale sin inventory (ADSI) 5. fixed asset turnover
what do productivity ratios measure
the firm’s ability to generate sales from its assets
excessive investment in assets with little or no increase in sales reduces the rate of return on
both assets (ROA) and equity (ROE)
How do you calculate the receiver turnover
receiver turnover = Revenue / AR
what does the receivable turnover measure
measures the sales generated by every dollar of receivables
how do you calculate average collection period (ACP)
average collection period = A/R / Average daily credit sales = 365/ receivable turnover
what does average collection period estimate
estimates the number of days it takes a firm to collect on its A/R Example If ACP is 40 days, and the firm’s credit policy is net 30, clearly customers are not paying according to the firm’s policies - There may be concerns about the quality of customer’s credit and wheat might happen if economic conditions deteriorate
what does inventory turnover measure
the number of times ending inventory was “turned over” or sold during the year - involves both stocks and flow values - strongly a function of ending inventory
managers often try to improve its inventory turnover ratio as they approach year end through
inventory reduction strategies (cash and carry sales, inventory clearance etc)
how do you calculate inventory turnover
inventory turnover = COGA/ inventory or Rev/ inventory
when COGS is not publicly available, the inventory turnover ration can be estimated using what
sales(Revenue) instead rev/inventory - not ideal - because while COGS is based on inventoried cost, sales includes a profit margin that may not be comparable to other firms
what is ADSI
average days sales in inventory
what does ADSI estimate
the number of days of sales tied up in inventory - based on inventory values
how do you calculate ADSI
avg. days sales in inventory = inventory / avg. daily sales = 365/ inventory turnover
what is fixed asset turnover
estimates the number of dollars of sales produced by each dollar of next fixed assets
how do you calculate fixed asset turnover
fixed asset turnover = sales/net fixed assets
what are the liquidity ratios
- working capital 2. current 3. quick (Acid test)
what do liquidity ratios measure
the ability of the firm to meet its financial obligations as they mature using liquid (ie cash and near cash resources)
what does working capital measure
the proportion of total assets invested in current assets
how do you calculate working capital
current assets / total assets ca/ ta
what does the current measure
the number of dollars of current assets for each dollar of current liabilities - estimates the capacity of the firm to meet its financial obligations as they mature
how do you calculate current ratio
current assets / current liabilities ca/ cl
what does the quick (Acid test) recognize
that inventories and other current assets may be less liquid and in some cases, when liquidated quickly, can result in cash flows that are less than book value - therefore, the quick ratio gives a clearer indication fo the firm’s ability to meet its maturing financial obligations out of very liquid current assets
what is the calculation for quick ratio
cash + Marketable securities + AR / current liabilities c + MS + AR /CL
What is important to note regarding liquidity ratios
- When firms are financially strained and no longer a going concern, accounting values become less valid - Instead, net liquidation values can be estimated by discounting asset values based on their degree of liquidity - Liquid assets are valued at close to or the same as book value - Liquid assets are discounted from book value based on their degree of liquidity - Liabilities are stated in nominal terms, because it takes those dollars to satisfy debt obligations - Preferred stock value is based on residual values, if any residual remains after liquidation
What are the valuation ratios
- Equity book value per share (EVPS) 2. Dividend yield 3. Dividend payout 4. Trailing Price –earnings (P/E) 5. Forward P/E 6. Market-to-book 7. Earnings before interest, taxes, depreciation and amortization (EBITDA) multiple
what are valuation ratios used for?
- are used to assess how the market is valuing the firm (ie its share price) in relation to its o assets o earnings o profits o dividends
what does equity book value per share (EVPS) show
expresses shareholder’s equity on a per share basis
how do you calculate equity book value per share
book value per share = shareholder’s equity / number of shares
what does the dividend yield express
the dividend payout as a proportion of the current share price
dividend yield can be compared to what
the yield on other investment instruments such as Bonds or The stocks of other dividend paying companies
how do you calculate dividend yield
dividend per share / price per share DPS / P
what is the price-earnings (P/E) ratio
o An earnings multiple based on the most recent earnings o Often used to estimate the value of a stock
how do you calculate the price earnings ratio (P/E ratio)
share price / earnings per share P / EPS Example: a stock trading at a P/E multiple of 10 will take 10 years at current earnings to recover its price
what is the forward P/E ratio
o Is an earnings multiple based on forecast earnings per share o Often used to estimate the value of a stock for companies with rapid growth in EPS
Forward P/E: what do Low P/E shares indicate
regarded as value stocks
Forward P/E : what do high p/e shares indicate
regarded as growth stocks
how do you calculate the forward P/E
share price/ estimated earnings per share P / EEPS
what is market to book ratio
- Estimates the dollars of share price per dollar of book value per share - Given historical cost accounting as the basis for BVPS, the degree to which market value per share exceeds BVPS indicates the value that has been added to the company by management
how do you calculate Market-to-book value
share price / book value per share P / BVPS
what is EBITDA multiple
- Expresses total enterprise value (TEV) for each dollar of operating income or earnings before interest, taxes, depreciation, and amortization (EBITDA)
how do you calculate EBITDA multiple
TEV / EBITDA
what is total enterprise value
o An estimate of the market value of the firm o Ie. the market value of both its equity and its debt
- Financial managers must produce forecasts of the results of the business plans in order to
- Determine if the plans will require additional external financing 2. Determine if the plans will produce surplus cash resources that could be distributed to shareholders as dividends 3. Assess financial forecasts to determine if plans are feasible; o If poor results are forecast, management has the opportunity to amend plans in an attempt to produce better results before resources are committed
the basis for all financial forecasting is
o The sales forecast and o The most recent balance sheet values are the starting point
- Pro Forma (forecast) balance sheets are projected assuming
some relationship with projected sales as a constant percentage of sales
- Current liabilities are usually assumed to rise and fall in a
constant percentage with sales, and are called spontaneous liabilities because they change without negotiation with creditors
Percentage of sales method involves what
5 steps
what are the 5 steps in the percentage sales method
- Determine the financial policy variables in which you are interested 2. Set all the non-financial policy variables as a percentage of sales 3. Extrapolate the balance sheet based on a percentage of sales 4. Estimate future retained earnings 5. Modify and re-iterate until the forecast makes sense
the percentage sales method process most often results in
a balance sheet that does not balance o So a “plug” (or balancing) amount is the external funds required or o The surplus funds forecast
Further Improvements to the pro forma balance sheet include
Re-examining asset growth assumptions
- Refinement of the cash forecast
- Realization that EFR can be offset by marketable securities that can be easily liquidated to finance growth needs
- Re-examination of assumptions of a/r growth and whether we want to change credit polcies in the context of the forecast macroeconomic and competitive environment
- Re-examination of inventory management policies taking into account the macroeconomic and competitive environment
- Realization that increases in net fixed assets is “lumpy” and continuously incremental;
If the firm has excess capacity, it may not need to invest any further in fixed assets until it is forecast to exceed that capacity
page 12, 13 and part of 14
additional improvements to foreceast also include
re-examining assumptions about growth in spontaneous liabilites
page 16
ppage 16
what is the formula for forecasting
We can express the foregoingpercentage of sales method of forecasting using equations rather than spreadsheets
External financing requirements
EFR: EFR = a x S x g –b x PM x (1+g) x S
Where
a = the treasurer’s financial policy variable, the total invested capital or net assets of the firm as a percentage of its sales
g = sales growth rate
S = current period sales
S x g = next period sales
a X S x g = incremental capital requirement
PM = profit margin on sales
B = payout ratio
1 – b = retention or plowback ratio
what is the plowback ratio
??
External financing requirements can also be expressed as
a linear function of the sales growth rate (g)
By dividing both sides of equation 4-32 by the current sales level to obtain the next equation
EFR / S = -b x PM + (a-b x PM) g
the equation is plotted
The sustainable growth rate (g*) occurs where the blue line intersects the horizontal axis
The sustainable growth rate (g*) is the sales growth rate at which
The firm neither generates nor needs external financing
It can sustain its own rate of growth through the reinvestment of its own profits
what is the formula for sustaninable growth rate
** g* = b x PM / a –b x PM**
When g = g*
EFR = 0
The firm can finance its own growth with retained earnings
When g is less than g*
- EFR is less than 0
- the firm will have surplus funds available after financing its planned growth
in sustainable growth rate, when g = g
EFT = 0
the firm can finance its own growth with redidual earnings
with sustainable growth rate, when g is greater than g*
EFT is greater than 0
external financing will be required
with sustaninable growth rate
when g is less than g*
EFT is less than 0
- the firm wil lhave surplus funds available after financing its planned growth
