Domain IV − Financial Management − Section A.2 Financial Analysis

Question 1

Financial statement analysis

Answer 1

is the process of analyzing reported financial data to evaluate the risk and financial performance of a company as well as identifying its financial strengths and weaknesses.

Question 2

Accounting Ratios Analysis

Answer 2

an accounting ratio measures the relationship between two or more items or accounts of the company’s financial statements based on the logical relationship among those accounts or items.
=> The main categories that are going to be discussed in this topic are liquidity ratios, asset management ratios, debt management ratios, profitability ratios, market value ratios, and growth potential ratios.

Question 3

Trend Analysis

Answer 3

Elements of the financial statements or ratios are prepared for successive periods and then analyzed to identify the pattern (or trend) of the changes in those elements or ratios over time.
=> Trend analysis shows the amount and direction of the changes and allows for investigating the reasons of those changes.

Question 4

Vertical Common‐Size Analysis

Answer 4

in vertical common‐size statements, the elements of the statement for one year are presented as a percentage of a base amount. (i.e. total assets for the balance sheet and sales for the income statement.) Vertical common‐size statements are used in comparing the data of a company over two or more periods.

Question 5

Horizontal Common‐Size Analysis

Answer 5

in horizontal common‐size statements, the elements of the financial statement for one year are presented as a percentage of base‐year elements. This presentation allows for comparing data of a single company over several periods and show the trends of the changes and evaluating the overall performance.

Question 6

Liquidity Ratios

Answer 6

are ratios that measure the relationship of a firm’s cash and other current assets to its current liabilities. (i.e., current ratio, quick ratio, cash ratio, working capital)

Question 7

Current Ratio

Answer 7

= Current Assets / Current Liabilities
 If the company’s current ratio is low, it may face a potential solvency problem.
 On the other hand, a significantly high current ratio may be due to excess current assets implying improper current asset management (excess cash, accounts receivable, and/or inventory).

Question 8

Quick Ratio

Answer 8

= (Current Assets – Inventories – Prepayments) / Current Liabilities OR (Cash + Receivables) / Current Liabilities
 An increase in the quick ratio generally implies that a company is better able to meet its short‐term financing needs and vice versa.

Question 9

Cash Ratio

Answer 9

= (Cash + Marketable Securities) / Current Liabilities

Question 10

Working Capital

Answer 10

= Current Assets – Current Liabilities

Question 11

Asset Management Ratios

Answer 11

are a set of ratios that measure how effectively a firm is managing its assets. (i.e. inventory turnover, account receivable, account payable, operating cycle, fixed assets turnover)

Question 12

Inventory Turnover Ratio

Answer 12

= Cost of Goods Sold / Average Inventories
A higher turnover rate for inventory indicates that the firm is better utilizing its capital that is invested in inventory.

Question 13

Inventory Turnover (Days)

Answer 13

= 360 / Inventory Turnover Ratio
 A shorter period indicates that management is better managing its inventory purchase functions, however, care should be taken to also measure any associated stock‐out costs.

Question 14

Accounts Receivable Turnover Ratio

Answer 14

= Net Credit Sales / Average Trade Receivables
NB:
Days Sales Outstanding = Average Receivables / Average Daily Sales
Days Sales Outstanding = 360 / Accounts Receivables Turnover Ratio

Question 15

Operating Cycle

Answer 15

= Inventory Turnover (days) + Days Sales Outstanding – Accounts Payable Turnover (days)

Question 16

Fixed Assets Turnover

Answer 16

= Sales / Average Fixed Assets
NB:
Total Assets Turnover = Sales / Average Total Assets

Question 17

Debt Management Ratios

Answer 17

are ratios that measure the debt of the company in relation to numerous factors. (i.e. total debt to total assets, debt to equity, time interest earned.)

Question 18

Total Debt to Total Assets

Answer 18

= Total Debt / Total Assets
 Creditors prefer lower debt ratios because the lower the debt ratio, the greater the cushion against creditors’ losses in the event of liquidation.

Question 19

Debt/equity Ratio

Answer 19

= Total Debt / Common Stockholders’ Equity

 The optimal debt/equity ratio is that which minimizes the firm’s weighted average cost of capital.

Question 20

Times Interest Earned (TIE)

Answer 20

= Earnings Before Interest and Taxes (EBIT) / Interest Expense

Question 21

Profitability Ratios

Answer 21

are a group of ratios that measure the combined effects of liquidity, asset management, and debt management on operating results. (i.e., Profit Margin, Basic Earning, ROA, ROE, Earning per share)

Question 22

Profit Margin on Sales

Answer 22

= Net Income / Sales

Question 23

Basic Earning Power (BEP)

Answer 23

= EBIT / Average Total Assets

Question 24

Return on Total Assets (ROA)

Answer 24

= (Net income – Preferred Dividends) / Average Total Assets

Question 25

Return on Operating Assets

Answer 25

= Operating Income / Net Operating Assets

Question 26

Return on Common Equity (ROE)

Answer 26

= (Net income – Preferred Dividends) / Average Common Equity

Question 27

Earnings Per Share (EPS)

Answer 27

= (Net income – Preferred Dividends) / Weighted Average Number of Shares Outstanding

Question 28

Market Value Ratios

Answer 28

are a set of ratios that relate the firm’s stock price to its earnings and book value per share. These ratios give management an indication of what investors think of the company’s past performance and future prospects.

• Price/Earnings Ratio (P/E) = Market Price per Share / Earnings per Share
• Market/Book Ratio = Market Price per Share / Book Value per Share
• Book Value per Share = Net Common Equity / Common Shares Outstanding