Chapter 5--Analysis of Financial Statements

Question 1

What three groups of people use financial statements?

Answer 1

Investors, creditors, and managers

Question 2

What is the key to financial statement analysis?

Answer 2

Comparability with past results or other companies

Question 3

In financial statement analysis, what is horizontal analysis?

Answer 3

A comparison of how balance statement or income statement items change year to year

Question 4

In financial statement analysis, what is vertical analysis?

Answer 4

A comparison of how balance statement or income statement components compare, as a percentage, to a base value, normally the total assets for a balance statement, or the net income for the income statement

Question 5

In what three areas do analysts normally evaluate companies?

Answer 5

1. Operating performance
2. Liquidity
3. Financial strength

Question 6

When analysts evaluate operating performance, what are they interested in?

Answer 6

1. Profitability
2. Efficiency in investment of assets
3. Efficiency in use of assets

Question 7

How is profit margin ratio calculated, and what does it measure?

Answer 7

Net income / Net sales
Shows how much of sales ends up as income–measure of efficiency
The primary measure of operating performance

Question 8

How is gross margin ratio calculated, and what does it measure?

Answer 8

Gross profit / Net sales

Compares the markup (gross profit = net sales - cost of goods sold) to the cost of goods sold

Question 9

How is asset turnover ratio calculated, and what does it measure?

Answer 9

Net sales / Average total assets

Depicts investment efficiency, by showing sales dollars per dollar of asset

Question 10

How is return on assets (ROA, or return on investment, ROI) calculated, and what does it do?

Answer 10

Net income / Average total assets

Best overall indicator of the efficiency of use and investment of assets

Question 11

What two ratios can be multiplied to yield ROA (aka ROI)?

Answer 11

ROA = Profit Margin X Asset Turnover
ROA = (Net income / net sales) X (Net sales / average total assets)

Question 12

How is return on equity (ROE) calculated, and what does it do?

Answer 12

Net income / Average shareholder’s equity

Shows how much income was used for every dollar invested by owners–relevant for investors

Question 13

What is financial leverage?

Answer 13

The increase in ROE that comes from purchasing debt at a lower interest rate than what the company can provide to its investors by using those debt assets for revenue acquisition.
As financial leverage goes up, there is more debt, and the chance the company will be unable to satisfy its debts goes up.

So, an increase in ROE often comes with more risk.

Question 14

How is Earnings per Share calculated, and what does it do?

Answer 14

Net income available for common shares / Average number of common shares outstanding
Shows how much of a companies money are available for dividends per share of common stock.
Not terribly comparable between companies

Question 15

How is the Price-Earnings Ratio calculated, and what does it do?

Answer 15

Market price per share / Earnings per share

Shows how much in excess of current earnings are investors willing to pay for common stock

Question 16

How is the payout ratio calculated, and what does it do?

Answer 16

Dividends / Net Income
What proportion of a company’s net income is paid out to shareholders.
Tends to be lower in growth companies that need to reinvest for growth

Question 17

How is the times interest earned ratio calculated, and what does it do?

Answer 17

Profit before interest and taxes / Interest
Shows how many times a company’s earnings cover the interest payment obligations.
Helps creditors assess the risk of the company not repaying its loans

Question 18

How is working capital calculated, and what does it do?

Answer 18

Current assets - current liability

Shows company’s ability to meet its short-term obligations

Question 19

How is the current ratio calculated, and what does it do?

Answer 19

Current assets / Current liabilities
Useful to compare liquidity between firms
Shows the value of current assets per dollar of current liabilities.
Acceptable values depend on the volatility of the industry (e.g.: more volatility requires a higher current ratio for creditors to decide to invest)

Question 20

How is the quick ratio calculated, and what does it do?

Answer 20

Cash, Marketable Securities, and Account Recoverable / Current Liabilities
Better measure of immediate liquidity than current ratio.

Question 21

How is the accounts receivables turnover ratio calculated, and what does it do?

Answer 21

Net sales / Average Accounts Receivable

The ratio value tells us the average number of times a year accounts receivables are converted to cash (liquidity). So, it is possible to convert this value to days.

Fewer days (higher ratio) is better.

Question 22

How is the inventory turnover ratio calculated, and what does it do?

Answer 22

Cost of Goods Sold / Average Inventory

This value tells us how fast inventory is sold and replaced (liquidity). The ratio value is the number of times a year this occurs, so it can be easily converted to days

Question 23

How is the Operating Cycle calculated, and what does it do?

Answer 23

Days Inventory (i.e.: converted Inventory Turnover) + Days Receivable (i.e.: converted Receivables Turnover)

Rough estimate of the time it takes to go from cash to inventory to accounts receivables to cash (liquidity)

Question 24

How are the Operating Cycle and Current Ratio linked?

Answer 24

The longer the operating cycle, the less useful the Current Ratio as a measure of liquidity (since accounts receivable are part of current assets)

Question 25

How is the Accounts Payable Turnover Ratio calculated, and what does it do?

Answer 25

Purchases (est. Cost of Goods Sold + Change in Inventory) / Average Accounts Payable

Ratio value is the number of times in a year accounts receivables are converted to cash that is used to make purchases (liquidity). This value can be easily converted to days.

Question 26

How does the Accounts Payable Turnover Ratio value tell us about the financial health of the company?

Answer 26

The smaller the value, the longer it takes for companies to convert their accounts payable into new purchases, implying they are delaying paying their suppliers, and thus may lack sufficient cash flow to operate effectively.

Question 27

How is the Debt to Total Assets ratio calculated, and what does it do?

Answer 27

Total liabilities / total assets

Measures the long-term solvency (financial strength) of a company by describing the proportion of total assets supplied by creditors.

The higher the value, the more risk of possible bankruptcy to investors and creditors

Mature, stable companies can tolerate a higher level of debt that fledgling companies

Question 28

How is the Stockholders’ Equity to Assets ratio calculated, and what does it do?

Answer 28

Stockholders’ Equity / Total Assets

Tends to be the inverse of the Debt to Assets Ratio, as assets not acquired by debt are usually acquired by money from investors

Question 29

How is the Debt to Equity Ratio calculated, and what does it do?

Answer 29

Total Liabilities / Total Equity

Compares liabilities to equity. The smaller the value, the healthier the company.

Question 30

What do the liquidity ratios measure, and who uses them?

Answer 30

Short-term financial position; Bankers and Creditors

Question 31

What do the financial strength ratios measure, and who uses them?

Answer 31

Long-term capitalization (that is, the extent the company is funded with investments, rather than debt); Capital Markets

Question 32

What do the operating performance ratios measure, and who uses them?

Answer 32

Firm’s performance over a period of time; Investors and Suppliers

Question 33

What is the Future Value of Money?

Answer 33

The projected value of an amount of money after a specific time period, taking into account the Time Value of Money (compounding interest)

FV = (Amount of Investment) x (1 + Interest Rate) ^ number of periods

Question 34

What is Discounting?

Answer 34

The reciprocal of compounding, this is the process of taking a known future quantity and discounts it to a present value

PV = (Amount of Investment or Return) x {1 / [(1 = Interest Rate) ^ number of periods)]}