Chapter 7 Flashcards
1. Explain how the balance sheet is dependent on the income statement for analysis 2. Understand balance sheet analysis basics pertaining to assets, liabilities, and equity 3. Calculate balance sheet profitability ratios 4. Interpret balance sheet analysis to inform financial planning
what are loan covenants
the terms and conditions of a loan that require the borrower to meet certain requirements established by the lender.
If a borrower violates a loan covenant, the lender can legally enforce specific actions, depending on the loan contract, which can also vary widely–e.g., require the lender to improve a ratio by the end of the quarter, or demand the loan be repaid immediately.
What is the Return on Assets Ratio
ROA indicates how effective a company’s assets—invested by both shareholders and creditors—are in generating net income, and is expressed by the following formula:
ROA = net income + interest expense / average total assets
*higher the better
why is interest expense added back into ROA
When we think about the return on assets, we must consider the fact that the stakeholders that lent the company money (i.e., lenders such as the bank) earn a return through interest which, for the borrowing company, is the company’s cost of borrowing. That cost of borrowing is shown as interest expense on the income statement of the borrower and represents a return to the lender. Therefore, if we think about all of the returns the company generates, they include the returns owing to the lenders (i.e., interest expense).
Including interest expense in the calculation would distort the ROA ratio because it would make companies with higher debt levels appear less profitable due to the higher interest expenses they incur. By adding back interest expense, we can focus on the operational profitability of the company and evaluate how effectively it is generating profit from its assets without the influence of financing decisions.
What is Return on Equity (ROE)
tells us how good a company is at turning cash from investors into profit.
ROE = net income / average shareholder’s equity
*higher the better
What is Asset turnover
also indicates how well a company is managing its assets but it is in the context of generating sales rather than net income.
this ratio can be interpreted as the amount of sales generated for each dollar invested in assets.
AT = revenue / average total assets
*depends on the industry = higher the better
