Financial Statement Analysis Flashcards
What are ratios?
They are financial indicators that distill relevant information about a business entity by quantifying the relationship among selected items on the financial statements
key financial ratios and metrics that are used to analyze a company’s performance are classified into 4 high-level categories: profitability ratios, liquidity ratios, solvency ratios, and performance metrics
the numerator has a direct relationship with the ratio
the denominator has an indirect relationship with the ratio
sometimes, when both the numerator and denominator are affected by a given change, the final result (increase or decrease) is not easy to determine; the best way to answer questions such as these is to make up numbers and plug them into the ratio formula
What are profitability ratios?
they are measures of the success or failure of an enterprise for a given time period
What is gross profit margin?
it is the ratio that looks at profitability at the highest level; all profitability margins are interpreted the same way; all else being equal, higher is better
gross profit margin = net sales - cost of goods sold / net sales
What is profit margin?
as with all margins, the goal is to increase the ratio; the higher the net profit margin, the better; as this means a company is profitable after taking into account all costs associated with generating sales and operating its business
profit margin = net income / net sales
What is return on sales?
return on sales = income before interest income, interest expense, and taxes / net sales
What is return on assets (ROA)?
return on assets = net income / average total assets
a higher ROA implies that a company is generating more profits relative to its base of assets
What is DuPont return on assets?
DuPont return on assets = profit margin * asset turnover –> (net income / net sales) * (net sales / average total assets)
note that this ratio uses both profit margin and the asset turnover; this ratio allows for increased analysis of the changes in the percentages; the profit margin indicates the percentage return on each sale, and the asset turnover indicates the effective use of assets in generating that sale
What is return on equity (ROE)?
return on equity = net income / average total equity
a higher ROE is desirable, as higher net income for shareholders means greater profitability, higher EPS, and probably future stock growth
What is the operating cash flow ratio?
operating cash flow ratio = cash flow from operations / current liabilities
a higher ratio is desired, as it implies that a company is generating more cash from its core activities to pay its current liabilities
What are liquidity ratios?
they are measures of a firm’s short-term ability to pay maturing obligations
What is the current ratio?
current ratio = current assets / current liabilities
all else being equal, a higher current ratio is better because it implies that more current assets are available to pay short-term liabilities
What is the quick ratio?
quick ratio = cash and cash equivalents + short-term marketable securities + net receivables / current liabilities
like the current ratio, a higher quick ratio is better because it implies that more current liquid assets are available to pay short-term liabilities
Note about turnover ratios
they generally use average balances for balance sheet components; however, on some recent CPA exam questions, candidates have been instructed to use year-end balances instead; be sure to read the question carefully to determine the appropriate method to use
What is accounts receivable turnover?
accounts receivable turnover = net sales / average accounts receivable (net)
this measures the number of times receivables are collected over an accounting period (typically one year)
What is days sales in accounts receivable?
days sales in accounts receivable = ending accounts receivable (net) / (net sales / 365)
this measures the number of days after a typical credit sale is made until the firm receives payments; this ratio and the accounts receivable turnover are measures of the effectiveness of a company’s credit policy
What is inventory turnover?
inventory turnover = COGS / average inventory
the measure of how quickly inventory is sold is an indicator of enterprise performance; the higher the turnover, in general, the better the performance
What is days in inventory?
days in inventory = ending inventory / (COGS / 365)
this ratio indicates the average number of days required to sell inventory; this ratio and the inventory turnover ratio are measures of the effectiveness of an entity’s inventory management
What is accounts payable turnover?
accounts payable turnover = COGS / average accounts payable
this ratio indicates the number of times trade payables turn over during the year; a low turnover may indicate a delay in payment, such as from a shortage of cash
What is days of payables outstanding?
days of payables outstanding = ending accounts payable / (COGS / 365)
this ratio indicates the average length of time trade payables are outstanding before they are paid; this ratio and the accounts payable turnover ratio are measures of the effectiveness of a company’s attempt to delay payment to creditors
What is the cash conversion cycle?
cash conversion cycle = days sales in accounts receivable + days in inventory - days of payables outstanding
this ratio indicates the average length of time it takes from when the company pays cash for an inventory purchase to when the company receives cash from a sale
a company should minimize the amount of time it takes to convert inventory to cash while maximizing the amount of time it takes to pay vendors; therefore, the lower the cash conversion cycle, the better; each component of the cash conversion cycle should be analyzed individually
What are solvency ratios?
they are measures of security or protection for long-term creditors/investors
What is the debt-to-equity ratio?
debt-to-equity ratio = total liabilities / total equity
this ratio relates the two major categories of capital structure to each other and indicates the degree of leverage used; the lower the ratio, the lower the risk involved
What is the total debt ratio?
total debt ratio = total liabilities / total assets
the total debt ratio provides indications related to an organization’s long-term debt-paying ability; the lower the ratio, the greater the level of solvency and the greater the presumed ability to pay debts
What is the equity multiplier?
equity multiplier = total assets / total equity
a greater percentage of debt utilized by the firm results in more assets allocated to debt relative to equity and a higher equity multiplier
