Chapter 5--Analysis of Financial Statements Flashcards
What three groups of people use financial statements?
Investors, creditors, and managers
What is the key to financial statement analysis?
Comparability with past results or other companies
In financial statement analysis, what is horizontal analysis?
A comparison of how balance statement or income statement items change year to year
In financial statement analysis, what is vertical analysis?
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
In what three areas do analysts normally evaluate companies?
- Operating performance
- Liquidity
- Financial strength
When analysts evaluate operating performance, what are they interested in?
- Profitability
- Efficiency in investment of assets
- Efficiency in use of assets
How is profit margin ratio calculated, and what does it measure?
Net income / Net sales
Shows how much of sales ends up as income–measure of efficiency
The primary measure of operating performance
How is gross margin ratio calculated, and what does it measure?
Gross profit / Net sales
Compares the markup (gross profit = net sales - cost of goods sold) to the cost of goods sold
How is asset turnover ratio calculated, and what does it measure?
Net sales / Average total assets
Depicts investment efficiency, by showing sales dollars per dollar of asset
How is return on assets (ROA, or return on investment, ROI) calculated, and what does it do?
Net income / Average total assets
Best overall indicator of the efficiency of use and investment of assets
What two ratios can be multiplied to yield ROA (aka ROI)?
ROA = Profit Margin X Asset Turnover ROA = (Net income / net sales) X (Net sales / average total assets)
How is return on equity (ROE) calculated, and what does it do?
Net income / Average shareholder’s equity
Shows how much income was used for every dollar invested by owners–relevant for investors
What is financial leverage?
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.
How is Earnings per Share calculated, and what does it do?
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
How is the Price-Earnings Ratio calculated, and what does it do?
Market price per share / Earnings per share
Shows how much in excess of current earnings are investors willing to pay for common stock
How is the payout ratio calculated, and what does it do?
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
How is the times interest earned ratio calculated, and what does it do?
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
How is working capital calculated, and what does it do?
Current assets - current liability
Shows company’s ability to meet its short-term obligations
How is the current ratio calculated, and what does it do?
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)
How is the quick ratio calculated, and what does it do?
Cash, Marketable Securities, and Account Recoverable / Current Liabilities
Better measure of immediate liquidity than current ratio.
How is the accounts receivables turnover ratio calculated, and what does it do?
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.
How is the inventory turnover ratio calculated, and what does it do?
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
How is the Operating Cycle calculated, and what does it do?
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)
How are the Operating Cycle and Current Ratio linked?
The longer the operating cycle, the less useful the Current Ratio as a measure of liquidity (since accounts receivable are part of current assets)
How is the Accounts Payable Turnover Ratio calculated, and what does it do?
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.
How does the Accounts Payable Turnover Ratio value tell us about the financial health of the company?
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.
How is the Debt to Total Assets ratio calculated, and what does it do?
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
How is the Stockholders’ Equity to Assets ratio calculated, and what does it do?
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
How is the Debt to Equity Ratio calculated, and what does it do?
Total Liabilities / Total Equity
Compares liabilities to equity. The smaller the value, the healthier the company.
What do the liquidity ratios measure, and who uses them?
Short-term financial position; Bankers and Creditors
What do the financial strength ratios measure, and who uses them?
Long-term capitalization (that is, the extent the company is funded with investments, rather than debt); Capital Markets
What do the operating performance ratios measure, and who uses them?
Firm’s performance over a period of time; Investors and Suppliers
What is the Future Value of Money?
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
What is Discounting?
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)]}
