FA Week 8 Ratios

Question 1

2 types of business strategy

Answer 1

1. Product differentiation
   - make products stand out
   - cost more, produce less, higher margin per product (ie. more profit for every $1 sale)
   eg. Tesla, Nordstrom
2. Cost differentiation
   - produce tons of products
   - lower margin but sell so much that still get high net income
   eg. Kia, Walmart

Question 2

6 Profitability ratios - focus on Net Income

*take AVERAGE for SOFP accounts
Quality of income less important

Answer 2

1. Return on Equity (ROE) = net income / avg total shareholders’ equity
2. Return on assets (ROA) = net income / avg total assets
3. Gross profit margin/percentage = gross profit / net sales revenue
4. Net profit margin = net profit / net sales
   ^mgmt is more effective at getting profits AND/OR controlling expenses, if higher than competitor
5. Earnings per share (EPS) = net income / avg total ordinary outstanding shares
6. Quality of income = cash flow from operating activities / net income
   ^general rule of thumb is: good if > 1, ie. each $1 income is supported by > $1 cash flow

Question 3

4 Asset turnover ratios + 1 Accounts payable turnover ratio

Answer 3

1. Total asset turnover ratio = net sales / avg total assets
   ^if high means mgmt is more efficient at utilising assets to generate revenue
2. Fixed asset turnover ratio = net sales / avg total fixed assets
   ^again, high ratio means effective mgmt
3. Payable turnover ratio = COGS / avg accounts payable
   ^measures how quickly company is paying A/P
   » more useful to convert to Average DAYS to pay payables = 365 days / turnover ratio
   - if low, might imply that suppliers are putting pressure to pay faster
4. Receivables turnover ratio = Net CREDIT sales / avg accounts receivable
   *or use total sales as an approximation
   » Average days to collect receivables
   - if very low, ineffective collection efforts
   - if very high, troublesome also b/c suggests overly stringent credit policy that could cause lost sales & profits
5. Inventory turnover ratio = COGS / avg inventory
   ^measures how quickly company sells inventory
   - high is usually favourable but if too high, sales were LOST b/c desired items were not in stock
   » Average days to sell inventory

Question 4

Using ratios to analyse a company’s operating (cash) cycle

1. Payable turnover ratio
2. Inventory turnover ratio
3. Receivables turnover ratio

Answer 4

OCC calculates the period taken by a company to convert its inventory and receivables net of its payables into cash

Short cycle = sign that co. has EFFECTIVE MGMT of its inventory, customers & suppliers
∴ good indicator of operating efficiency

Companies need to have finance AVAILABLE as it awaits the conversion of its inventory and receivables into cash in the bank and also consider paying its suppliers.

Collection days
Inventory holding days
» Days for cash to come in Less: Payable days
» FINANCING PERIOD

eg. It takes on average 77 days (69.39 + 7.20) for it to sell its inventory and collect cash from its customer.
Therefore, Home Depot must tie up its cash in its operations for at least 38 days (77 - 39).

Question 5

3 Liquidity ratios - ability to meet short-term obligations

Answer 5

1. Current ratio = current assets / current liabilities
   ^concerning if high compared to other co.s in same industry
   - operating inefficiently when ties up to much $$ in inventory or A/R
   - b/c CA other than cash need to be converted to cash before paying CL
2. Quick ratio = (cash & cash equivalents + marketable securities + net A/R) / current liabilities
   *marketable securities = short-term investments
   ^more stringent version of current ratio. aka Acid test
   OR (CA - inventory)/CL
3. Cash ratio = cash & cash equivalents / current liabilities
   ^not good to have too much excess cash, better to use for more productive purposes, eg. investing
   ^not exactly worrisome if low (eg. 22c for $1 CL) b/c rmb that not all the CL need to be paid immediately

Question 6

3 Solvency ratios - ability to meet long-term obligations

*EBIT same as (net income + interest expense + income tax expense)?
» Earnings before interest & Taxes

Answer 6

1. Times interest earned ratio
   = (net income + interest expense + income tax expense) / interest expense; units are __ TIMES
   ^how much income available to pay interest expense
   ^indicates a MARGIN OF PROTECTION to CREDITORS; high margin = high protection
   *accrual version
2. Cash coverage ratio = cash flows from operating activities / interest paid; units are __ TIMES
   ^compares CFO to cash needed to make interest payments
   *cash version

^^both higher the better; creditors & investors less worried that co. will go bankrupt

3. Debt-to-equity ratio {Gearing ratio}
   = total liabilities / total stockholders’ equity
   » don’t take average since both are SoFP accounts

Question 7

2 Market ratios - related to market price per share

Answer 7

1. Price/Earnings (P/E) ratio
   = market price per share / EPS
   ^high ratio indicates that earnings are expected to grow rapidly. Does market think the co. is able to perform well in future?
2. Dividend yield ratio
   = dividends per share / market price per share
   ^investors can accept shares w/ low dividends if they expect price of stock will INCREASE more than dividends per share

Question 8

5 limitations of ratio analysis

Answer 8

1. Analysts must decide which ratios to use based on their decision objective
2. Ratios can only be interpreted by comparing to other ratios or BENCHMARK value
3. Comparing ratios for 2 years is appropriate only if they are COMPARABLE in terms of industry, operations & accounting policies
4. Because ratios are based on the aggregation of information, they may obscure underlying factors that are of interest to the analyst.
5. A company’s accounting policy choices will influence your ratios