F2 - M8 - Ratio Analysis

Question 1

Ratio Analysis

Answer 1

Goal is to quickly identify “RED FLAGS”, historical trends, industry standard

Question 2

Ratios

Answer 2

financial indicators, “relevant”, selected items on F/S, compared with rations of a different period, compared to competitor ratios and industry ratios, “primary users”

• Important for investors, lenders, and other interested parties
• Classifications
  o Liquidity ratios, activity ratios, profitability ratios and coverage ratios
• Calculation on interpretation, analysis of the effect of a change
• Generally
  o Numerator goes up, resulting ration does up
  o Denominator goes up, resulting ratio goes down

Question 3

Liquidity Ratio

Answer 3

SHORT TERM, risk of distress
- What’s in the numerator to cover denominator
- BS – Current Year / BS – Current Year
- HIGHER the ratio, LOWER the risk
- Current Ratio = ability to meet its short-term obligations
Current Ratio = Current Assets / Current Liabilities
Compare to industry average

Question 4

Quick Ratio

Answer 4

More liquid / conservative than current

Quick Ratio = (Cash and cash equivalents + Short term marketable securities + receivables) / current liabilities

Question 5

Activity Ratios

Answer 5

“Turnover”, how effectively an enterprise is using its asset

Question 6

Activity Ratios - AR Turnover

Answer 6

Ratio indicates average number of says required to collect AR.

AR Turnover = Net Sales / Average AR Net

Question 7

Activity Ratios - Days Sales in AR

Answer 7

Days in sales Accounts Receivable = indicates the average number of days required to collect accounts receivable.

Days Sales in AR = Ending accounts receivable (net) / (Sales (net) / 365)

Question 8

Activity Ratios - Inventory Turnover

Answer 8

How quickly inventory is sold is an indicator of enterprise performance.

Inventory Turnover = COGS / Average Inventory

Question 9

Activity Ratios - Days in Inventory

Answer 9

Average number of days required to sell inventory. Days TOO HIGH = SLOW MOVING; Days TOO LOW = TOO FATST / GIVING IT AWAY

Days in Inventory = Ending Inventory / (COGS / 365)

Question 10

Activity Ratios - Accounts Payable Turnover

Answer 10

Number of times trade payables turn over during the year, low could indicate delay in payment. No problem paying on time, don’t pay too fast unless 2/10.

Accounts Payable Turnover = COGS / Average AP

Question 11

Activity Ratios - Days of Payable Outstanding

Answer 11

Average length of time trade payables are outstanding before they are paid. TOO HIGH, PROBLEMS PAYING; TOO LOW, POOR CASH MGT

Days of payables outstanding = Ending AP / (COGS / 365)

Question 12

Activity Ratios - Cash Conversion Cycle

Answer 12

Average length of time it takes from when the company pays cash for an inventory purchase to when the company receives cash from the sale

Cash conversion cycle = Days in AR + Days in Inventory - Days of payables outstanding

Question 13

Activity Ratios - Asset Turnover

Answer 13

Ability of asset to generate revenue - Higher better

Asset Turnover = Sales (net) / Average total assets

Question 14

Profitability Ratios

Answer 14

Success or failure of an enterprise for a given time period.

Question 15

Profitability Ratios - Profit Margin

Answer 15

Turn revenue into profit but first cover costs

Profit Margin = Net Income / Sales (Net)

Question 16

Profitability Ratios - Return on Assets (ROA)

Answer 16

Turn asset into profit for owners

Return on assets = Net Income / Average Total Assets

Question 17

Profitability Ratios - DuPont Return on Assets

Answer 17

Explains ROA is what it is

DuPont = Net Income x Average Total Assets

Question 18

Profitability Ratios - Return on Total Equity

Answer 18

Required rate, Higher the better

Return on Equity = Net Income / Average Total Equity

Question 19

Profitability Ratios - Gross (Profit) Margin

Answer 19

Gross Margin = (Sales (net) - COGS) / Sales (Net)

Question 20

Profitability Ratios - Operating Cash Flow Ratio

Answer 20

Higher the coverage, less risk of distress; cash generated from core business

Operating Cash Flow = Cash flow from operations / Current liabilities

Question 21

Coverage Ratios

Answer 21

Long Term Risk / Solvency – Capital Structure, measures of security or protection for long term creditors / investors.

Question 22

Coverage Ratios - Debt to Equity

Answer 22

Dependent on risk that mgt is willing to assume; degree of protection from creditors; LOWER is BETTER

Debt to Equity Ratio = Total liabilities / Total equity

Question 23

Coverage Ratios - Total Debt Ratio

Answer 23

Assets financed by creditors

Total Debt Ratio = Total Liabilities / Total Assets

Question 24

Coverage Ratios - Equity Multiplier

Answer 24

Amplifies both risk assumed and potential return

Question 25

Coverage Ratios - Times Interest Earned

Answer 25

Ability of a company to cover interest charges

Times Interest Earned = Income before interest expense and taxes / interest expense

Question 26

Investor Ratios

Answer 26

Two ways to make money on CE; Current income – dividend and change in price – growth

Question 27

Investor Ratios - Earning per Share

Answer 27

Stock Price

Earnings per Share = Income available to common shareholders / weighted average common shares outstanding

Question 28

Investor Ratios - Price Earnings Ratio

Answer 28

Investment potential; rise indicates investors are pleased

Price earnings ration = price per share / basic earnings per share

Question 29

Investor Ratios - Dividend Payout

Answer 29

Portion of current earnings being paid out in dividends

Dividend Payout = Cash dividends / Net Income

Question 30

Limitations of Ratios

Answer 30

easy to compute, “reliable” data, based on estimates, historical costs, fair value, etc, horizonal analysis = dollar and % change over time (trend analysis), vertical analysis – comparability among over entities,