Chapter 5 Flashcards
financial statement analysis
identifies relationships between numbers within financial statements and trends in these relationships from one period to the next; goal is to help investors, creditors, managers interpret the info in statements
vertical analysis
method that attempts to overcome variations in company size by restating financial statement information in ratio (or percentage) form
common-size financial statements
restatement of components of the income statement as percent of net sales, balance items as percent of total assets; facilitates comparisons across companies of different sizes as well as comparisons of accounts within a set of financial statements
horizontal analysis
examines changes in financial data across time; helpful in analyzing company performance and in predicting future performance
return on equity (ROE) definition
primary summary measure of company performance, measures return on the investment made by the stockholders; relates net income to the average investment by shareholders as measured by total stockholders equity from the balance sheet
return on equity (ROE) equation
net income/average stockholders equity
- net income is from a point in time
- average SE= adding beginning and ending stockholders equity balances divided by 2
return on asset (ROA) definition
measures the return earned on each dollar that the firm invests in asset; captures returns generated by firm’s operating and investing activities (without regard for finance details)
return on asset (ROA) equation
earnings without interest expense (EWI)/average total assets
- EWI: net income + (interest expense X (1-statutory tax rate) )
- average total assets: add beginning and ending balances in total assets/2
earnings without interest expense (EWI) definition
measures the income generated by the firm before taking into account any of its financing costs; interest costs should be excluded
EWI equation
net income + (interest expense X (1-statutory tax rate) )
return on asset (ROA) equation detailed
net income+ (interest expense X (1-statutory tax rate) )/ (beginning total assets + ending total assets)/2
financial leverage
effect that liabilities (including debt financing) have on ROE
return on financial leverage (ROFL) equation
ROFL= ROE-ROA
profit margin (PM) definition
measures the profit, without interest expense, that is generated from each dollar of sales revenue; higher profit margin is preferable; affected by level of gross profit that the company earns on its sales which depends on product prices and cost of manufacturing; also affected by operating expenses required to support sales (wages, salaries, marketing, research and development)
capacity cost
wages and salaries, marketing, research and development, depreciation
profit margin (PM) equation
earnings without interest expense (EWI)/sales revenue
asset turnover (AT) definition
insights into company’s productivity and efficiency; level of sales generated by each dollar that company invests in assets; high asset ratio suggests that assets used efficiently- high ratio preferable; affected by inventory management practices, credit policies, and technology; improve by increasing level of sales for a given level of assets
asset turnover (AT) equation
sales revenue/average total assets
gross profit margin (GPM) definition
percentage of each sales dollar that is left over after product costs subtracted
gross profit margin (GPM) equation
sales revenue-cost of goods sold/sales revenue
expense to sales (ETS) defnition
measures percentage of each sales dollar that goes to cover a specific expense item
expense to sales (ETS) equation
expense/sales revenue
account receivable turnover (ART) definition
measures how many times receivables have been turned (collected) during a period
account receivable turnover (ART) equation
sales revenue/average accounts receivable
inventory turnover (INVT) definition
measures number of times during a period that total inventory is turned (sold); high INVT indicates that inventory managed efficiently
inventory turnover (INVT) equation
cost of goods sold/average inventory
property, plant, and equipment turnover (PPET) definition
measures sales revenue produced for each dollar of investment in PP&E; provides insight into asset utilization and how efficiently a company operates given its production technology
property, plant, and equipment turnover (PPET) equation
sales revenue/average PP&E
covenant
company has to execute on loan agreement that places various restrictions on operating activities; help safeguard debtholders in the face of increased risk
default risk
debt increases it; the risk that company will be unable to repay debt when it comes due
liquidity analysis
analysis of available cash
solvency analysis
company’s ability to generate sufficient cash in the future
liquidity
cash availability- how much cash a company has, how much it can raise on short notice
current asset
assets company expects to convert to cash within the next operating cycle
current liabilities
liabilities that come due within the next year
working capital (net working capital)
excess of current assets over current liabilities; current assets-current liabilities
current ratio- what does it measure, what is the equation
measure of liquidity
current assets/current liabilities
current ratio greater than one implies positive working capital; ignores cash inflows from future sales, looks at existing balance sheet only
when might a current ratio less than 1 not be problematic?
1) cash and carry company like grocery story that has little receivables- minimize receivables/inventory and maximize payables
2) service company because not significant account receivables
quick ratio- what does it measure, what is the equation
measure of liquidity
cash+short term securities+account receivable/current liabilities
focuses on quick assets, which are those converted to cash in 90 days or less; examples include cash, short term securities, prepaid assets; reflects company’s ability to meet current liabilities without liquidating inventories
operating cash flow to current liabilities - what does it measure, what is the equation
measure of liquidity
OCFCL= cash from operations/average current liabilities
net amount of cash derived from operating activities; ability of company to pay debts determined by whether operations can generate enough cash to cover debt payments; higher OCFCL preferred
cash burn rate- what does it measure, what is the equation
measure of liquidity
free cash flow/number of days in the period
used when a company’s free cash flow is negative; could be negative because young company or for established company that has run into financial distress
solvency
ability to meet debt obligations, including periodic interest payments and repayment of principal and amount borrowed
debt to equity- what does it measure, what is the equation
measure of solvency
debt to equity= total liabilities/total stockholders equity
how reliant a company is on creditor financing (fixed claim) compared with equity financing (flexible or residual claims)
times interest earned- what does it measure, what is the equation
measure of solvency
times interest earned= earnings before interest expense and taxes/interest expense
operating income available to pay interest expense; management wants ratio to be high so there is little risk of default
what are the limitations of ratio analysis
- measurability
- non-capitalized costs
- historical cost
- company changes
- conglomerate effects
- means to an end
