F2 - M8 - Ratio Analysis Flashcards
What is the relationship of a numerator and denominator of a ratio? Does numerator increase or decrease the ratio? Same for denominator?
If the numerator goes up, then the ratio goes up, denominator goes up, the ratio goes down.
What kind of risk does that balance sheet look at?
Short term risk - Liquidity
Long term risk - Solvency
Change in assets - Growing or downsizing.
What does the income statement tell us? What do people look at the income statement for?
They usually look at the income statement for performance.
How efficient they are in turning over their assets for sales
Profit margin, how much of a profit are they able to make
What do people normally look at the statement of cash flows for?
They normally look at operating activity to see if the company can make money on their operations. This helps value the company, see the risk, and overall performance.
What are some limitations on ratios?
One, if they client was not issued a clean opinion, then you probably want to stay away from using those numbers for your ratio analysis.
If the client is on accrual basis, they probably have estimates on their financials so that can be difficult to make ratios out of depending if they are more aggressive or conservative with their estimates.
What is the difference between horizontal analysis and vertical analysis?
Horizontal analysis - This is when you compare trends and note material changes. Like on account on the financials compared to another.
Vertical analysis - This is when you take an account on the balance sheet or income statement and divide it with another number. For example, maybe you want to see how profit margin changed year after year. This is good because you can compare financials with any entity using this method. You can a percentage and see how that compares with other competitors even if they are bigger than you. Numbers should hopefully stay similar.
What is the gross profit margin heavily dependent on?
What about profit margin?
It depends on the number of suppliers, if you have a lot of suppliers, you can pick and choose who you buy your inventory from. That gives you power to get the items at a lower cost. The more suppliers, the less the COGS will be, and gross profit will go up. (Sales - COGS)/ Sales).
Profit margins depend on competitors, the more competitors you have, the lower your profit margin, the less the competition, the more the profit margin. (Net Income/Sales).
For return on sales, what is the formula, and what is this dependent on?
This is dependent on your operating expenses:
COGS - Number of suppliers you have
SGA - Competition
Depreciation - Age of the asset, the estimate you use for depreciation.
This helps get you your operating income divided by your sales. The formula for this is:
Net Income + Taxes + Net interest expense = EBIT
EBIT/Sales = Operating Margin
Other way to get EBIT is by taking Sales-COGS-SGA-Depreciation = EBIT, which is your operating net income.
What is the return of assets? What is the formula for this?
Return on Assets (ROA) - Net Income/Average total assets
The point of this formula is to see how much of your assets are turning into sales. Owners want a bigger bottom line since that is more of a profit for owners.
You want your net income to be higher and your assets to be lower, which helps show that more assets are being turned over for profit.
What is the DuPont return on assets? What is the formula?
This breaks our the ROA into two areas found below
Turnover - This is asset turnover, this is managements efficiently to produce the optimal amount of assets. Think about the industry you are in, the dollar store probably has high turnover, but their profit margin is much lower. A yacht dealer, probably has very low turnover, but their profit margin is much higher, since it costs a lot to purchase a yacht. That is what turnover tells us.
Profit Margin - How much of their sales is being generated to net income? This is dependent on competitors.
Formula: Net Income/Sales (Profit Margin) * Sales/Average total assets (Asset turnover)
If you use the ROA formula or the DuPont formula, you get the same answer.
What is the formula for the Return on Equity ratio?
Net Income/Average total equity
What is the operating cash flow ratio? What is the formula?
The operating cash flows are the cash that you brought in from your operating business. This shows us if you are able to cover your current liabilities. You want the formula to be higher to see if you can cover those liabilities.
Cash flow from operations/Current liabilities
What is the purpose of the liquidity ratios? What is the current ratio?
Current ratios are measures of a firms short term ability to pay their obligations.
Current ratio is your current assets/current liabilities.
Current ratio assumes that all of your current assets are liquid which may not be the case.
What is the quick ratio, how is it different than the current ratio?
What is the cash ratio?
The quick ratio is different, because it takes prepaids and inventory out of the numerator of current assets compared to the current ratio. This only gives us more liquid assets to work with and should lower our ratio. Here is the formula.
Cash + Short term marketable securities + Receivable/ Current liabilities
Cash ratio is the most conservative because it is Cash + Marketable securities/ current liabilities
This is the most conservative but most liquid, and should decrease your ratio the most.
What is the accounts receivable turnover ratio? What does this tell us?
What about the Days sales in accounts receivable?
It’s Sales/Accounts Receivable.
This tells us if the firm is able to collect their accounts receivable that is outstanding. The higher the number the more likely you are to collect.
Day sales are, (AR)/(Sales/365), this gives you how often they are able to collect AR on days.
