Financial Statement Analysis & Accounting Ratios Flashcards
Why is financial statement analysis absolutely necessary?
A company’s reported financial statements may not accurately represent the actual performance of the business.
What is a nonrecurring item?
A nonrecurring item refers to an entry that is infrequent or unusual that appears on a company’s financial statements.
How are non-recurring items dealt with in financial statement analysis?
Adjustments are made to remove non-recurring items so as to not distort the ability to analyze the business’ operating performance.
What are some examples of non-recurring items?
- product recalls
- litigation settlements
- restructuring
- company sells a business
What is the purpose of the income statement?
Summarizes the revenue and expenses for a period of time - reports the profit performance of the business.
Which of the “Big 3” financial statements are used to analyze profitibility?
the Income Statement
What is the purpose of the Cash Flow statement?
Reports the sources of a business’ cash inflows and outflows between two balance sheet dates.
What is the purpose of the balance sheet?
Reports the balance of assets, liabilities and equity at a PRECISE moment in time.
Since we have the income statement, why do we need the statement of cash flows?
Revenue does not record cash flow, because revenue is recognized as it is received (as opposed to being recorded when cash changes hand).
Is depreciation a cash inflow or cash outflow?
Neither! It is not a cash flow and must be removed from the cash flow statement.
How do we complete a financial statement analysis?
- Identify risks within the business and industry (SWOT analysis)
- Identify financial risks
(can company generate enough cash flow to meet financial obligations)
What is a SWOT analysis?
An analysis of the company’s:
- Strengths
- Weaknesses
- Opportunities
- Threats
What is the key reason income statments and cash flow statements do not reflect the same change in cash?
Revenue is recognized when it is earned.
What is the accounting matching principle?
Revenues are matched with expenses.
What is the normalization process?
The process of removing non-recurring items
What are the major line items on the income statement?
Income Statement
Total Revenues
- Cost of Goods Sold (COGS)
Gross Profit
-SG&A
-Depreciation/Amortization
Operating Profit
- Interest expense
- Interest (income)
Pre-tax Income
- Income taxes
Net Income
What is included in Cost of Goods Sold?
- Cost of good sold
- direct costs
- shipping costs
What is included in SG&A?
SG&A = Overhead
- Sales
- General
- Admin
What is interest income?
Income from interest on a company’s cash
What is interest expense?
expense due to use of debt
Which investors have access to a company’s revenue?
- Debt holders
- Common stock holders
- Preferred stock holders
All of the above.
Which investors have access to a company’s operating income?
- Debt holders
- Common stock holders
- Preferred stock holders
All of the above
Which investors have access to a company’s net income?
- Debt holders
- Common stock holders
- Preferred stock holders
- Common stock holders
- Preferred stock holders
What are some sources of revenue growth?
- Organic Growth
- Acquisitions
- Market Share gains
- Sector Growth
What is the growth formula?
Final - Initial
Initial
What does profitibility measure?
Measures management’s ability to maximize revenues and control expenses
What are margins?
A means of measuring profitability in which a financial statistic is divided by sales(revenue).
- How do you calculate gross margin?
- What does it mean?
- Gross Profit / Sales
- The amount of gross profit a company earns per $1.00 of sales.
What are returns?
A means of calculating profitability as a function of a business input.
- How do you calculate Return on Assets?
- What is the value in this metric?
- Net Income / Total Assets
- The ROA figure gives investors an idea of how effective the company is in converting the money it invests into assets into net income.
- How do you calculate Return on Equity?
- What is the value in this metric?
- Net Income / Shareholders equity
- The ROE figure gives investors an idea of how effective the company is in converting the shareholders invest into the company into net income.
- How do you calculate Return on Invested Capital (ROIC)?
- What is the value in this metric?
- Net Income / [Debt + Equity]
- The ROIC figure gives investors an idea of how effective the company is at converting money invested into the company into net income.
What are some methods of measuring a company’s profitability?
- Margins (Gross Profit Margin)
- Returns (ROA, ROE, ROIC)
What is EBIT proportional to?
EBIT = Operating Income
What does EBIT stand for?
Earnings Before Interest and Taxes
What is the purpose of EBIT?
Understand the profitability BEFORE the effects of financing and taxes
Why is EBIT preferred over Net Income when comparing two companies?
The two companies may have (1) different capital structures and (2) different levels of taxation.
If you wanted to compare two company’s operating income, which metric would you use?
EBIT
When people say “the line” what metric serves as “the line”?
EBIT
What distinction is made for items that are “above the line”?
If the income or expense is operating in nature.
List some items that would be “above the line”?
- Sales
- COGS
- SG&A
- R&D
What distinction is made for items that are “below the line”?
Income/Expenses that are not operating in nature
List some activities that would be considered “below the line”
- Interest Income
- Interest Expense
- Dividend Income
- Taxes
When looking at an income statment, how do we determine which items should be included in EBIT or EBITDA?
- Must comb through the income statment and identify line items that are operating in nature.
True/False:
Net Income = Cash from Operations
False!
What is the most crucial item for a company?
Cash
What are the three types of line items on a cash flow statement?
- Adjustments for non-cash expenses
- Cash Inflow (Source of Cash)
- Cash Outflow (Usage of Cash)
What are the four major sections in a typical cash flow statement?
- Cash flow from operating activities
- Cash flow from investing activities
- Cash flow from financing activities
- Net change in cash
What is the purpose of the cash flow statement?
- To reconcile the changes in cash for the period.
What is the starting point for the statement of cash flows?
Net Income
What line items are seen under “Operating Activities” in the cash flow statement?
Operating Activities
Net Income
+ [Adjustments for non-cash expenses]
+ [Adjustment: Depreciation]
+ [Adjustment: Amortizaiton]
+ [Adjustment: Stock-based compensation]
+ [Subtract change in working capital]
Cash flow from operating activities
What line items are seen under “Investing Activities” in the cash flow statement?
Investing Activities
- Capital Expenditures (CAPEX)
- Additions to definitite-life intangibles
Cash flow from investing activities
What line items are seen under “Financing Activities” in the cash flow statement?
Financing Activities
Issuance (repayment) of revolver
Issuance (repayment) of long-term debt
Repurchase of equity
Dividends
Option Proceeds
Cash flow from financing activities
How does an increase in accounts receivable impact cash flow?
reduces cash flow as your net income goes up, but you haven’t received any cash.
How does an increase in accounts payable impact cash flow?
Increases cash flow as cash is received but COGS not paid out to supplier yet.
How should we think of “investing activities”?
think of it as CAPEX
How is CAPEX related to Depreciation?
Should be of comparable magnitude.
Depreciation Exercise
Click on the image to access the question
Click on the image below to see the answer
What is amortization?
Amortization is an accounting technique used to periodically lower the book value of a loan or intangible asset over a set period of time.
What metric is used as a proxy for operating cash flow?
EBITDA
Why shouldn’t EBIT be used as a proxy from operating cash flow?
Because EBIT reflects depreciation and amortizaiton which are non-cash expenses.
What are some of the weaknesses for using EBITDA as “actual” cash flow?
EBITDA doesn’t include:
- Changes in WC
- CAPEX
- Additions to intangibles (such as purchase of software licenses)
- Interest Expense
- Tax Expense
- Debt Paydown
- Dividends
What is the purpose of the balance sheet?
provides a snapshot (ending balance) of the company’s financial position
What is the typical time frame for when a current asset or current liability will be due?
1 year
What is the typical time frame for when a long-term (LT) asset or LT liability will be due?
Due after 1 year
What is an activity ratio?
Activity ratios measure the efficiency of a business in turning over its assets
What are three important activity ratios?
- Accounts Receivable Turnover
- Inventory Turnover
- Accounts Payable Turnover
How do you calculate Accounts Receivable Turnover?
ART = Sales / AR
What does Accounts Receivable Turnover indicate?
Indicates how efficient the business is at turning a sale into cash
How do you calculate Accounts Receivable Days?
ART / Days
What does Accounts Receivable Days indicate?
The average amount of time it takes before a cash payment is collected.
What does the inventory turnover ratio convey?
Inventory turnover is a ratio showing how many times a company has sold and replaced inventory during a given period.
How do you calculate inventory turnover ratio?
COGS / Inventory
What does Accounts Payable Turnover convey?
Accounts payable turnover shows how many times a company pays off its accounts payable during a period.
How is Accounts Payable Turnover calculated?
COGS / AP
What are the two common liquidity ratios?
(and how are they calculated)
- Working Capital (CA - CL)
- Current Ratio (CA / CL)
Why is it better for a company to turn over its working capital faster?
A quicker turnover ratio means the company is able to quickly convert assets to cash.
What is the equation for the Cash Conversion Cycle?
CCC = INV Days + AR Days - AP Days
What do liquidity ratios indicate?
The company’s ability to convert an asset into cash quickly
What do Balance Sheet leverage ratios indicate?
A leverage ratio is any one of several financial measurements that assesses the ability of a company to meet its financial obligations (debt).
What are two common Balance Sheet leverage ratios and how are they calculated?
- Debt-to-Capital ratio (D/EV)
- Net Debt-to-Capital ratio (Debt - Cash / EV)
What are two common Cash Flow leverage ratios and how are they calculated?
- Debt-to-EBIT (Total Debt / EBIT)
- Debt-to-EBITDA (Total Debt/EBITDA)
What does Debt-to-EBIT (Total Debt / EBIT) convey?
How many years of the current level of operating income is required to pay of the entire debt balance.
What does Debt-to-EBITDA (Total Debt / EBITDA) convey?
How many years of the current level of operating cash flow is required to pay off the entire debt balance.
What are coverage ratios?
A coverage ratio, broadly, is a metric intended to measure a company’s ability to service its debt and meet its financial obligations, such as interest payments or dividends
What are two common coverage ratios and how are they calculated?
- EBITDA Coverage (EBITDA / Interest Expense)
- EBIT Coverage (EBIT/Interest Expense)
If a company had a low coverage ratio such as EBITDA Coverage, what would that indicate to stakeholders?
A poor ability to pay off debt or dividends.
