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FAR > F2 - M8 - Ratio Analysis > Flashcards

F2 - M8 - Ratio Analysis Flashcards

1
Q

What are ratios, in terms of finance?

A

Financial indicators that distill relevant information about a business entity

Helps to quickly identify red flags

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2
Q

Ratio Comparisons

A

Ratio must be compared to a benchmark to be useful

“Time Series” - Compare with ratios of a different period for the same company

“Cross-Sectional” Compare with ratios of a competitor industry

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3
Q

List the key financial ratios.

A

Liquidity
Activity (Turnover)
Profitability
Coverage

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4
Q

What is the Liquidity Ratio?

A

Measures a firm’s short-term ability to pay maturing obligations (i.e., Can you pay your bills as they come due?)

Industry > Company = Higher Risk

Higher Ratio = Less Risk

Bigger Numerator = Smaller Denominator = Less Risk

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5
Q

List of Liquidity Ratios

A

Working Capital
Current Ratio
Acid-Test (Quick) Ratio
Cash Ratio

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6
Q

Working Capital

A

Current Assets - Current Liabilities

The bigger the spread between current assets and current liabilities, the less risk.

Helps to generate sales. Need inventory and supplies to create sales. Need collections to fund supplies to create inventory.

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7
Q

Current Ratio

A

Current Assets / Current Liabilities

Misleading - Making assumptions such as assuming AR will be collected within the next year and inventory will be sold within the next year.

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8
Q

Acid-Test (Quick) Ratio

A

(Cash + Cash Equivalents + Marketable Securities + Net Receivables) / Current Liabilities

More liquid (Conservative) —-> EXCLUDES Inventory

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9
Q

Cash Ratio

A

(Cash + Cash Equivalents + Marketable Securities) / Current Liabilities

Most liquid (Conservative) —-> EXCLUDES AR & Inventory

Has the smallest numerator - common since most companies do not have a ton of cash on hand

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10
Q

What is the Activity (Turnover) Ratio?

A

Measures how effectively a company is using its assets

i.e., the more a company can turnover assets, the better they are doing

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11
Q

List of Activity Ratios

A 
Accounts Receivable Turnover
Accounts Receivable Turnover (in Days)
Inventory Turnover
Inventory Turnover (in Days)
Operating Cycle
Working Capital Turnover
Total Asset Turnover
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12
Q

Activity (Turnover) Ratio Analysis

A

Measures how effectively a company is using its assets

IS of Current Year / BS Average of CY and PY

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13
Q

Accounts Receivable Turnover

A

Net Credit Sales / Average Net Receivables

Indicates the success of the firm in collecting outstanding receivables.

Bigger the spread = NO issues collecting

Higher is better

Industry < Company

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14
Q

Accounts Receivable Turnover (Days)

A

365 Days / Accounts Receivable Turnover

Indicates the average number of days to collect AR

Lower is better

Industry > Company

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15
Q

Inventory Turnover

A

COGS / Average Inventory

Measures how quickly inventory is sold which indicates performance

Bigger the spread = NO issues selling

Higher is better

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16
Q

Inventory Turnover (Days)

A

365 / Inventory Turnover

Indicates average number of days to sell inventory

Industry = Company

Should be close to the industry standard; otherwise,
If too low - selling too fast (giving it away)
If too high - may be losing market share

17
Q

Operating Cycle

A

AR Turnover (Days) + Inventory Turnover (Days)

Indicates the number of days between acquisition of inventory and realization of cash from sale of inventory. We want to collect quickly and sell quickly.

Lower is better

Industry > Company

18
Q

Working Capital Turnover

A

Sales / Average Working Capital

Indicates how effectively working capital is used. WC (CA & CL) helps to generate sales.

Higher is better

Industry < Company

19
Q

Total Asset Turnover

A

Net Sales / Average Total Assets

Indicates how effectively the company uses its assets. We want to maximize sales with least amount of assets

Higher is better

Industry < Company

20
Q

What is the Profitability (Performance) Ratio?

A

Measures of success or failure (performance).
Return on Investment

Industry < Company

21
Q

List of Profitability Ratios

A

Net Profit Margin
Return on Total Assets
DuPont Return on Assets
Return on Common Equity

22
Q

Net Profit Margin

A

Net Income / Net Sales

Indicates profit rate. We want to maximize our net income.

Higher is better

Industry < Company

23
Q

Return on Total Assets

A

Net Income / Average Total Assets

Indicates rate of return on assets. We want to maximize our net income with the least use of assets.

Higher is better

Industry < Company

24
Q

DuPont Return on Assets

A

Net Profit Margin x Total Asset Turnover
= Net Income / Average Total Assets

Explains what drives the return on assets.
How much profit when you sell the asset?
How often can you generate revenue from the asset?

Higher is better

Industry < Company

25
Q

Return on Common Equity

A

Income Available to Common Stockholders = Net Income - Preferred Dividends

Income Available to Common Stockholders / Average Common Equity

Measures the rate of return that will compensate for the associated risk

Higher is better

Ratio > Required Rate of Return

26
Q

What is the Coverage (Performance) Ratio?

A

Measures of security or protection for long-term creditors/investors.

Long Term Risk Assessment –> Capital Structure

When you raised capital, how was it done?

  • Add partners? - Reduces risk of distress, no interest, but return on equity decreases
  • Borrow money? - Greater risk of distress but return on equity increases
  • Issue Stock?
27
Q

List of Coverage Ratios

A

Debt-to-Equity
Debt-to-Assets
Times Interest Earned
Operating Cash Flow/Total Debt

28
Q

Debt-to-Equity

A

Total Liabilities / Common Stockholders Equity

Indicates degree of protection to creditors in case of solvency

Lower is better

High Risk, Low Equity = Higher ROE
Low Risk, High Equity = Lower ROE

29
Q

Debt-to-Assets

A

Total Liabilities / Total Assets

Indicates that approximately half of assets are financed

Lower is better

30
Q

Times Interest Earned

Interest Coverage Ratio

A

EBIT = Recurring Income Before Taxes and Interest

EBIT / Interest

What do you have available before interest and taxes to cover the interest.

Higher is better

31
Q

Operating Cash Flow / Total Debt

A

Indicates company’s ability to cover total debt with yearly cash flow

Higher is better

32
Q

Limitations of Ratios

A
  • Reliability

- May need additional information

33
Q

How to determine if the information to compute ratios are reliable?

A
  • Reference the auditors opinion of the financials

- Look at the methods/estimates used

34
Q

What is Horizontal Analysis?

A

Measures the dollar and percentage over a period time

Useful to evaluate trends and noting material changes

35
Q

What is Vertical Analysis?

A

Helpful in reducing statement items to a common size (i.e., percentages)

Period-to-period comparison

Comparability among other entities of varying sizes (i.e,. mom and pop vs corporations)

FAR (22 decks)

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