Class 5: Financial Ratio Analysis

Question 1

Why do companies buy back shares?

Answer 1

More confidence, Pushes EPS higher

Question 2

What is a financial ratio?

Answer 2

A metric that measures financial performance by comparing two values from a company’s financial statements

Question 3

Why do managers, consultants and strategists use financial ratio analysis?

Answer 3

• Compare performance of companies across industries (apples to oranges)
• Benchmark companies against industry averages and competitors to identify strengths and weaknesses (apples to apples)
• Analyze trends in companies and industries- look at w/in context of industry, changes over time
• Quantitatively reflect strategic choices and changes

Question 4

Compare the ratios of crocs and steve madden

Answer 4

Gross margin: crocs are much cheaper to make
Operating margin: operating expenses are higher at crocs (overhead/advertising)
Net margin: crocs aren’t #winning

Question 5

What are the five primary ratio types:(u dumb hoe memorize that matrix)

Answer 5

measures of profitability, efficiency, liquidity, solvency and valuation

Question 6

How can you use financial ratios? (think like vital signs)

Answer 6

Historical (lagging):
-Diagnose: quickly diagnose a company’s situation (strengths, weaknesses), find issues
-Benchmark: Compare the company against its peers
-Investigate: develop hypotheses on what is wrong and look for further confirmation
Future (leading):
-Identify leading indicators: anticipate changes in the trend
-Analyze trends: gauge the company’s progress over time

Question 7

What is net profit margin?

Answer 7

net income/revenue

how much of a company’s revenues are kept as net income

Question 8

Why is grocery so unprofitable? (porters u hoe)

Answer 8

• bargaining power of suppliers is high
• threat of new entrants is high
• rivalry among existing competitors is high
• bargaining power of buyers is low
• threat of substitute products and services is low
• **basically, spoilage+lack of brand loyalty

Question 9

What is Return on Equity?

Answer 9

• net income/equity

- how much the company earns per dollar of common equity

Question 10

Why is ROE a popular measure?

Answer 10

Allows for: comparison of performance of dramatically different companies
Comparison vs. investment alternatives

Question 11

How do we interpret ROE? what do we have to be careful of?

Answer 11

The higher the ROE percentage, the more efficient management is in utilizing its equity base and the better investment returns.
However!! we can just increase ROE by just borrowing a ton of money and fudging the D/E ratio so hah take that- an increase in ROE does not necessarily indicate an increase in profitability

Question 12

What is the DuPont Formula?

Answer 12

ROE = Net Income/SalesXSales/Assets*XAssets/Equity

=Profit MarginXTotal Asset Turnover(Efficiency)XLeverage Factor(Leverage)

Question 13

Why is the DuPont Formula so awesome?

Answer 13

allows us to compare across a variety of industries, look at differences, etc

Question 14

Inventory Turnover

Answer 14

COGS/average inventory

how quickly goods enter and leave storage at the business

Question 15

Why is the Inventory Turnover ratio useful?

Answer 15

• Higher inventory turnover ratios indicate that a company is more efficient at managing its inventory
• Inventory turnover varies dramatically by industry- grocers typically have higher ratios than specialty furniture and jewelry

Question 16

What is the current ratio?

Answer 16

-current assets/current liabilities
shows a firm’s ability to pay off its current liabilities using its current assets
-basically, what you have in a short period versus what you owe in a short period

Question 17

What does the current ratio mean?

Answer 17

• The higher the current ratio, the better the firm’s liquidity position or short-term financial strength
• Current ratio must be looked at vs industry norms to determine high or low ratio

Question 18

What is the financial leverage ratio?

Answer 18

• total assets/total equity

- shows the long-term solvency of a company, taking into account long-term debt and equity investments

Question 19

What does the financial leverage ratio mean?

Answer 19

• critical ratio for analyzing companies which take on debt to make large, short-term investments
• if the ratio is too high, the company could become insolvent before paying back the debt

Question 20

What is Earnings per share? (EPS)?

Answer 20

(net income - preferred dividends)/average outstanding shares
shows the amount of a firm’s net income available for payment to its common stock holders or in other words how profitable the firm is on a shareholder basis

Question 21

How might a company manipulate its EPS?

Answer 21

• Can fudge by delaying expenses until next q, short term

- price higher in short term, might turn off ppl in long term

Question 22

Price to Earnings ratio?

Answer 22

• share price/earnings per share

- measure a company’s current share price relative to its per-share earnings

Question 23

what does the p/e ratio suggest

Answer 23

• a high p/e rato suggests investors are expecting higher earnings growth in the future
• tech companies tend to have higher pe ratios since they are viewed as high growth

Question 24

What are the biggest pitfalls of financial ratios?

Answer 24

• Ratios can be manipulated
• Ratios can be heavily influenced by short-term, 1 time events
• Different industries have different norms for ratios
• different industries emphasize different ratios