Formulas Flashcards
What are the four main classifications of financial ratios?
- Activity ratios
- Liquidity ratios
- Solvency ratios
- Profitability ratios
These classifications provide insights into different aspects of a company’s financial health.
What do activity ratios measure?
Efficiency in managing assets
Activity ratios are also known as asset utilization or turnover ratios.
Define liquidity ratios.
Ability to pay short-term obligations
Liquidity ratios help assess a company’s capability to cover its short-term liabilities.
What information do solvency ratios provide?
Financial leverage and ability to meet long-term obligations
Solvency ratios are crucial for understanding a company’s long-term financial stability.
What do profitability ratios indicate?
How well a company generates operating and net profits
Profitability ratios assess the effectiveness of a company’s operations.
What is the formula for receivables turnover?
receivables turnover = annual sales / average receivables
This ratio indicates how efficiently a company collects its receivables.
What does a high receivables turnover ratio suggest?
- Excellent credit management
- Stringent credit terms
- Large discounts for early payment
- High penalties for late payment
High turnover can reflect both effective collections and potentially lost sales due to strict credit policies.
How is the average collection period calculated?
days of sales outstanding = 365 / receivables turnover
This metric indicates the average number of days taken for customers to pay their bills.
What is the formula for inventory turnover?
inventory turnover = cost of goods sold / average inventory
This ratio measures how efficiently inventory is managed.
What might a high inventory turnover indicate?
- Effective inventory management
- Potentially low inventory levels leading to lost sales
Analysis of revenue growth relative to peers can provide more context.
Define payables turnover.
payables turnover = cost of goods sold / average trade payables
This ratio measures how quickly a company pays its suppliers.
What is the formula for the number of days of payables?
number of days of payables = 365 / payables turnover ratio
This indicates the average time taken to pay suppliers.
What does a high payables turnover ratio suggest?
- Not fully utilizing supplier credit terms
- Paying suppliers early for discounts
It may also indicate cash flow issues or lenient supplier terms.
What is total asset turnover?
total asset turnover = revenue / average total assets
This measures how effectively a company uses its assets to generate revenue.
What is the formula for fixed asset turnover?
fixed asset turnover = revenue / average net fixed assets
This ratio assesses the efficiency of fixed asset usage.
What does working capital turnover measure?
Working capital turnover = revenue / average working capital
This ratio indicates how effectively a company uses its working capital.
What is the current ratio?
current ratio = current assets / current liabilities
This is a primary measure of a company’s liquidity.
What does a current ratio of less than one indicate?
Negative working capital and potential liquidity crisis
Working capital is calculated as current assets minus current liabilities.
Define the quick ratio.
quick ratio = (cash + marketable securities + receivables) / current liabilities
This ratio provides a stricter measure of liquidity, excluding inventories.
What is the cash ratio?
cash ratio = (cash + marketable securities) / current liabilities
This is the most conservative liquidity measure.
What does the defensive interval ratio indicate?
Number of days of average cash expenditures covered by liquid assets
It evaluates how long a company can sustain its operations with current liquid assets.
What is the cash conversion cycle?
cash conversion cycle = days’ sales outstanding + days of inventory on hand - number of days of payables
This measures the time between outlaying cash for inventory and receiving cash from sales.
Days Sales Outstanding (DSO) measures how long, on average, it takes a company to collect payment after making a sale
True or False: A high cash conversion cycle is desirable.
False
A high cycle indicates excessive capital tied up in the sales process and potential cash flow issues.
What do solvency ratios measure?
A firm’s financial leverage and ability to meet its long-term obligations.
What is the formula for the debt-to-equity ratio?
debt-to-equity = total debt / total shareholders’ equity
What does an increase in the debt-to-equity ratio suggest?
A greater reliance on debt as a source of financing.
How is total debt defined in this context?
Interest-bearing long-term and short-term debt.
True or False: Non-interest-bearing current liabilities are always included in total debt calculations.
False
Non-interest-bearing current liabilities (e.g., accounts payable, wages payable) are not typically included in total debt calculations because they do not represent interest-bearing obligations.
Key Points:
Total Debt usually includes only interest-bearing liabilities, such as:
Short-term debt
Long-term debt
Bonds payable
Bank loans
Non-interest-bearing liabilities (e.g., accounts payable, deferred revenue) are excluded since they arise from operating activities rather than financing activities.
What should be included in the total debt figure for the exam according to the professor’s note?
All interest-bearing liabilities.
What is the formula for the debt-to-capital ratio?
debt-to-capital = total debt / (total debt + total shareholders’ equity)
What does the debt-to-assets ratio indicate?
The proportion of debt in relation to total assets.
What is the formula for the financial leverage ratio?
financial leverage = average total assets / average total equity
What does a financial leverage ratio close to 1 indicate?
Equity is being used to finance assets.
What is the interest coverage ratio used for?
To determine the firm’s ability to meet its debt payments.
What is the formula for the interest coverage ratio?
interest coverage = earnings before interest and taxes / interest payments
What does a lower interest coverage ratio indicate?
The more likely it is that the firm will have difficulty meeting its debt payments.
What is the debt-to-EBITDA ratio used for?
To indicate how long it would take to repay current total debt from operating cash flow.
What is the formula for the debt-to-EBITDA ratio?
debt-to-EBITDA = total debt / EBITDA
What does the fixed charge coverage ratio account for?
Lease payments in addition to interest payments.
What is the formula for the fixed charge coverage ratio?
fixed charge coverage = (earnings before interest and taxes + lease payments) / (interest payments + lease payments)
What do profitability ratios measure?
The overall performance of the firm relative to revenues, assets, equity, and capital.
What is the formula for the net profit margin?
net profit margin = net income / revenue
What is the gross profit margin formula?
gross profit margin = gross profit / revenue
What does a low gross profit margin indicate?
Potential issues with pricing or cost management.
What is the operating profit margin formula?
operating profit margin = operating income / revenue
What is the pretax margin formula?
pretax margin = EBT / revenue
What does the return on assets (ROA) measure?
Profitability relative to average total assets.
What is the formula for ROA?
ROA = net income / average total assets
What is the operating ROA formula?
operating ROA = operating income / average total assets
What is the return on invested capital (ROIC) formula?
return on invested capital = after-tax operating profit / average long-term capital
What does the return on equity (ROE) measure?
Net income relative to average total equity.
What is the formula for ROE?
ROE = net income / average total equity
How is return on common equity calculated?
return on common equity = (net income - preferred dividends) / average common equity
What is the DuPont decomposition used for?
To analyze return on common equity more thoroughly.
What does the DuPont analysis break down?
Return on equity (ROE) into different ratios
It helps in analyzing the impact of leverage, profit margins, and turnover on shareholder returns.
What are the two variants of the DuPont system?
Original three-part approach and extended five-part system
Each variant provides a different level of detail in analyzing ROE.
How is ROE defined in the original DuPont approach?
ROE = net income / average equity
Average or year-end values for equity can be used.
What is the formula for ROE after multiplying by (average total assets / average total assets)?
ROE = (net income / average total assets) × (average total assets / average stockholders’ equity)
The first term is ROA, and the second term is a financial leverage ratio.
What does the financial leverage ratio indicate?
It increases as the use of debt financing increases
This reflects the company’s reliance on debt for financing.
What is the expanded formula for ROE including revenue?
ROE = (net income / revenue) × (revenue / average total assets) × (average total assets / average stockholders’ equity)
The first term becomes net profit margin, the second term is total asset turnover, and the third term is financial leverage.
What is the original DuPont equation?
ROE = net profit margin × total asset turnover × financial leverage
This equation breaks down ROE into three key components.
What happens if ROE is relatively low?
At least one of the following is true: poor profit margin, poor asset turnover, or too little leverage
This indicates potential areas for improvement in financial performance.
What does the extended (5-way) DuPont equation include?
ROE = (net income / EBT) × (EBT / EBIT) × (EBIT / revenue) × (revenue / average assets) × (average assets / average equity)
This version decomposes net profit margin into three additional components.
What is the tax burden in the extended DuPont equation?
net income / EBT, equal to (1 - tax rate)
It reflects the effect of taxes on net income.
What is the interest burden in the extended DuPont equation?
EBT / EBIT
It indicates the proportion of earnings before interest and taxes that is consumed by interest payments.
What is the EBIT margin?
EBIT / revenue
It measures the operational profitability of the company.
How does an increase in interest expense affect ROE?
It increases the interest burden and tends to decrease ROE
Higher interest payments can offset the positive effects of leverage.
What effects do high profit margins, leverage, and asset turnover have on ROE?
They generally lead to high levels of ROE
However, more leverage can lead to higher interest payments, which may negate some benefits.
What is the relationship between taxes and ROE?
Higher taxes will always lead to lower levels of ROE
This indicates the negative impact of taxation on shareholder returns.
