chapter 4 - key concepts (analysis of financial statement)

Question 1

What are ratios used for and why are they useful?

Answer 1

• Ratios are used to highlight weaknesses and strengths of different firms
• Ratio comparisons should be made through time and with competitors.

Question 2

Liquidity Ratios

Answer 2

need a strong liquidity ratio to avoid bankruptcy

• Learn about the firm’s ability to pay off debts that are maturing within a year
• “Cash is king”

Current Ratio: current assets / current liabilities

Quick Ratio/acid test = (Current Assets – Inventories) / Current Liabilities

Very similar to the current ratio, except subtract inventories from the current assets
More cautious measure of liquidity than current ratio

Question 3

Asset Management Ratios

Answer 3

Does the company have too many or two few assets? (didn’t spend enough or spent too much)

Four total ratios:
- Inventory Turnover Ratio
- Days Sales Outstanding (DSO Ratio)
- Fixed Asset Turnover Ratio
- Total Asset Turnover Ratio

Inventory turnover ratios (each item is sold and restocked or turned over) = sales/inventories

Days sales outstanding (DSO ratio) (epresents the average length of time the firm waits to receive cash) = Accounts receivable/average daily sales

Fixed asset turnover ratio (How effectively is the firm using its plant/equipment?) =
sales/net fixed assets

Total assets turnover ratio (Measures the turnover of all the firm’s assets) = sales/total assets

Question 4

Debt Management Ratios

Answer 4

Debt allows a firm to increase its ROE and profits

debt to capital ratio = Total debt / (total debt + total equity)

tie (time interest ratio) = EBIT / interest charges

Question 5

Profitability Ratios

Answer 5

Operating Margin = EBIT / Sales

Net Profit Margin = Net income/sales

Basic Earnings Power = EBIT/total assets

Return on Total Assets (Measures the rate of return on the firm’s assets) = Net Income / Total Assets

Return on Common Equity (Measure the rate of return on equity) = Net income / total equity

Return on invested capital = [EBIT(1 - T)] / Total invested capital

Question 6

Market Value Ratio

Answer 6

Price to Earnings Ratio aka P/E Ratio (How much will investors pay for $1 of current earnings?) =
Stock price / Earnings

Market to book ratio aka M/B rato (How much investors are willing to pay for $1 of book value equity) =
Market price/book value per share

Question 7

What are some of the limitations of financial ratios?
* What are prominent examples that show these limitations?

Answer 7

• Financial ratios can be distorted by inaccurate or misleading information
• Seasonal factors can distort ratios – sales are often stronger during certain quarters (such as gift-buying before Christmas, 4th quarter)
• “Window dressing” techniques can be used to manipulate financial numbers
• Offer an end-of-quarter sale to boost revenue before earnings report is released
• Asset valuations such as land votes may be listed at purchase price, not fair market value.
• Inflation can distort valuations

Question 8

Know how a change in market conditions/corporate policy will impact ratios
* If a company’s business weakens (revenues decline, what will happen to ROA or
ROE?)

Answer 8

Effects of debt on ROA and ROE if equity/revenue declines and expense increase…

• ROA declines (due to the reduction in net income)
• ROE may increase or decrease (since both net income and equity decline)

Question 9

Know how a change in market conditions/corporate policy will impact ratios
* If the company decides to increase its dividend, what will happen to debt-to-capital
ratio?

Answer 9

shrinks

Total debt / (total debt + total equity)

if equity increases then the bottom of the equation gets bigger making the ratio smaller