Class 5: Financial Ratio Analysis Flashcards
Why do companies buy back shares?
More confidence, Pushes EPS higher
What is a financial ratio?
A metric that measures financial performance by comparing two values from a company’s financial statements
Why do managers, consultants and strategists use financial ratio analysis?
- 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
Compare the ratios of crocs and steve madden
Gross margin: crocs are much cheaper to make
Operating margin: operating expenses are higher at crocs (overhead/advertising)
Net margin: crocs aren’t #winning
What are the five primary ratio types:(u dumb hoe memorize that matrix)
measures of profitability, efficiency, liquidity, solvency and valuation
How can you use financial ratios? (think like vital signs)
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
What is net profit margin?
net income/revenue
how much of a company’s revenues are kept as net income
Why is grocery so unprofitable? (porters u hoe)
- 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
What is Return on Equity?
- net income/equity
- how much the company earns per dollar of common equity
Why is ROE a popular measure?
Allows for: comparison of performance of dramatically different companies
Comparison vs. investment alternatives
How do we interpret ROE? what do we have to be careful of?
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
What is the DuPont Formula?
ROE = Net Income/SalesXSales/Assets*XAssets/Equity
=Profit MarginXTotal Asset Turnover(Efficiency)XLeverage Factor(Leverage)
Why is the DuPont Formula so awesome?
allows us to compare across a variety of industries, look at differences, etc
Inventory Turnover
COGS/average inventory
how quickly goods enter and leave storage at the business
Why is the Inventory Turnover ratio useful?
- 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
What is the current ratio?
-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
What does the current ratio mean?
- 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
What is the financial leverage ratio?
- total assets/total equity
- shows the long-term solvency of a company, taking into account long-term debt and equity investments
What does the financial leverage ratio mean?
- 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
What is Earnings per share? (EPS)?
(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
How might a company manipulate its EPS?
- Can fudge by delaying expenses until next q, short term
- price higher in short term, might turn off ppl in long term
Price to Earnings ratio?
- share price/earnings per share
- measure a company’s current share price relative to its per-share earnings
what does the p/e ratio suggest
- 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
What are the biggest pitfalls of financial ratios?
- 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
