HBX- Accounting 6 Flashcards
What are the key things that you want to do when you use ratios?
- try to use amounts that can give an insight into the business
- be consistent in the way that the ratios are calculated when comparing them between periods for a company or when comparing them for different companies.
When calculating ratios that include both balance sheet and income statement amounts, we generally use an average of beginning and ending balances for the balance sheet amount.
What is ROE (Return on Equity) & The DuPont Framework?
- Define It
- List the Formulas
- State what it means for a company. Is a higher or lower # better?
- It shows the return that a business generated during a period on the equity invested in the business by the owners of the business.
Return on equity = (net income) / (total owners’ equity)
- While this is a useful measure of financial performance of a firm, it can be broken down further to reveal where the returns are being generated. The return on equity of a firm consists of three factors: profitability, operating efficiency and financial leverage. These are three general areas that management can adjust to increase overall ROE. This breakdown, known as the DuPont Framework, allows us to see more specifically where favorable or unfavorable returns are originating.
Return on equity = profitability x operating efficiency x financial leverage
- For a profitable company, increasing the ratio in any one of these areas will increase the overall return on equity and provide greater returns for investors.
- However, if this increase is accomplished by higher leverage, the riskiness of the business increases as well. If the business makes a loss, the negative ROE is amplified by the higher leverage, making leverage a two-edged sword.*
- For any one company, a higher ROE is generally better than a lower ROE.
- However, when comparing different companies in different industries, a higher return on equity by itself does not necessarily indicate that one business is doing better than another business.*
- We end up with the same number for ROE as we do when dividing net income by equity. The only difference is that we can see more detail about what is really going on in the business and driving the return on equity. Management can use this insight to improve the way business operates.
- It’s important to keep in mind many other aspects about the business and its operations. The individual components of ROE can vary greatly between companies, depending on the type of business. For example, an online retailer might have a very low profit margin, as it fights stiff competition and doesn’t add a lot of value to the product that its purchasing from the vendor. However, a manufacturer or a technology company that uses proprietary techniques can likely demand a much higher premium for their product, which results in a higher profit margin.
What is the DuPont Framework and what does it measure?
The DuPont Framework expands the ROE formula to consist of three measures:
- profitability using Profit Margin
- efficiency using Asset Turnover
- leverage using the Leverage Ratio (or Equity Multiplier)
For any one company, a higher ROE is generally better than a lower ROE.
PROFIT MARGIN FORMULA
The first section of the DuPont Framework, profitability, reveals how much profit is left from each dollar of sales after all expenses have been subtracted.
- *Profit Margin = NET INCOME / TOTAL SALES FOR THE PERIOD**
- *These values are taken from the income statement*
For H&M in the year 2012, the profit margin was 13.96%. In other words, for every hundred Swedish krona of sales that H&M had, 14 ended up in the net income for the period. Profit margin is an important measure.
A high net profit margin means a company keeps a large proportion of its revenue as profit, so it is better to have a high net profit margin than a low or negative net profit margin. (google)
How to do an average of 2 numbers in excel.
=AVERAGE(A1,A2) Or =SUM(A1,A2)/2 Or =(A1+A2)/2
The Profitability or Profit Margin is calculated by dividing the Net Income by the Revenue. In this case, the calculation is as follows:
Net Income / Revenue = 483,232 / 4,358,100 = 11.09%
The suggested correct answer formula is:
=C9/C4
The Profitability or Profit Margin is calculated by dividing the Net Income by the Revenue. In this case, the calculation is as follows:
Net Income / Revenue = 37,037 / 170,910 = 21.67%
The trick is to recognize that the Revenue is equal to the Cost of Sales plus the Gross Profit (170,910 = 106,606 + 64,304). As we have learned, Revenue minus Cost of Sales equals Gross Profit so it follows that Cost of Sales plus Gross Profit equals Revenue.
The suggested correct answer formula is:
=C12/(C6+C7)
Which of the following ratios measures the ability of a company to make a profit relative to the revenue generated during the period?
- ROA
- Profit Margin
- ROE
- ROI
- Profit Margin
- This is the correct answer! Profit margin shows the % of each dollar of sales that ends up as net profit.
How do you calculate the profit margin ratio within the DuPont Framework?
- Operating income/Sales
- COGS/Sales
- Net income/Sales
- EBIT/Sales
- Net income/Sales
- This ratio shows the % of each dollar of sales that ends up as net profit.
Suppose the profit margin for Cardullo’s Gourmet Shoppe, Inc for Q1 was 4.99% and Q2 was 10.57%. Which of the following statements can you conclude regarding Cardullo’s?
- Cardullo’s is more efficient in utilizing its assets in Q2 than in Q1.
- Cardullo’s does a better job in cost control in Q2 than in Q1.
- Cardullo’s is more effective in extending credit and collecting debts in Q2 than in Q1.]
- Cardullo’s does a better job in cost control in Q2 than in Q1.
- This is the correct answer! Profit margin is the percentage of selling price that turned into profit. Cardullo’s could increase its profit by reducing costs, thus increase its profit margin.
The profit margin for East Corp. for each year from 2011 to 2013 is listed below.
2011: 7.13%
2012: 7.68%
2013: 8.14%
Which of the following is NOT a reasonable explanation for the trend in the ratio?
- The variable costs decreased due to an improvement in technology.
- An increase in the sales price due to higher demand resulting from a successful marketing campaign.
- East Corp. declared a cash dividend to shareholders.
- The variable costs decreased due to an improvement in technology.
- Lower variable costs would result in a higher profit margin.
- An increase in the sales price due to higher demand resulting from a successful marketing campaign.
- Increase in sales price would result in a higher profit margin.
-
East Corp. declared a cash dividend to shareholders.
- This is the correct answer! This situation wouldn’t directly impact a company’s profit margin.
What is the purpose of Gross Profit Margin and what’s the formula?
Gross Profit Margin- Profitability Ratios
When the profit margin is used to determine profitability using the DuPont Framework, other ratios are also very useful. One of those is the gross profit margin. We’ve already talked about gross profit being revenues minus the cost of goods sold. This ratio is simply converting the numbers into a percentage– gross profit divided by sales. **This tells us what percentage of revenue is left to cover other expenses after the cost of goods sold is subtracted.
Gross Profit Margin = GROSS PROFIT / SALES**
*These values are taken from the income statement
What are the two Profitability Ratios?
- gross profit margin
- Earnings before interest after taxes, or EBIAT
Gross Profit Margin is calculated by dividing the Gross Profit (Revenue less Cost of Sales) by the Revenue. In this case, the calculation is as follows:
(Revenue - Cost of Sales) / Revenue = Gross Profit Margin
(170,910 - 106,606) / 170,910 = 37.62%
The suggested correct answer formula is:
=(B1-B4)/B1
Gross Profit Margin is calculated by dividing the Gross Profit by the Revenue. In this case, the calculation is as follows:
Gross Profit / Revenue = 1,619,386 / 4,358,100 = 37.16%
The suggested correct answer formula is:
=B6/B4
Higher demand has allowed Amazon to increase their prices, while higher overhead expenses have been hurting overall profits.
Higher selling prices would result in a higher gross profit margin, but increasing operating expenses could eat away the profits before they hit the bottom line.
The gross profit margin for Amazon for each year from 2010 to 2012 is listed below.
2010: 22.35%
2011: 22.44%
2012: 24.75%
Which explanation below is a reasonable explanation for the trend in the ratio?
- Increased competition is forcing Amazon to lower its prices.
- Amazon issued new stock during the year to raise additional capital.
- Inventory prices have fallen resulting in decreased COGS.
- Inventory prices have fallen resulting in decreased COGS.
- This is the correct answer! If the cost of inventory decreased, Amazon could make more money off of each item it sold.
Suppose the following were the gross profit margins for Green Mountain Coffee Roasters (GMCR) from 2011 through 2013.
2011: 34.13%
2012: 32.89%
2013: 37.16%
- What could be an explanation of the fluctuations in gross profit margins for GMCR from 2011 through 2013?
- Selling & Operating expenses went from 13.15% to 12.48% to 12.86% from 2011 to 2013.
- Labor and Overhead costs were lower as a percentage of Sales in 2012.
- An increase in manufacturing capacity at the beginning of 2012 caused overhead to increase but allowed for greater efficiency and significant sales growth later.
- An increase in manufacturing capacity at the beginning of 2012 caused overhead to increase but allowed for greater efficiency and significant sales growth later.
- This is the correct answer! The increase in overhead costs could hurt 2012 margins but pave the way for more profitable operations in 2013.
Suppose the gross profit margin for Cardullo’s Gourmet Shoppe, Inc for Q1 was 47.25% and Q2 was 47.70%. Which of the following is a reasonable explanation for the change in the ratio?
- Cardullo’s offered a volume discount in Q2.
- Cardullo’s negotiated with vendors and successfully reduced overall inventory prices.
- Cardullo’s sold a truck and realized a gain on the sale in Q2.\
- Cardullo’s negotiated with vendors and successfully reduced overall inventory prices.
- This is the correct answer! If the cost of inventory decreased, Cardullo’s could make more money off of each item it sold.
What is… Earnings before interest after taxes, or EBIAT?
Earnings before interest after taxes, or EBIAT, is a measure of how much income the business has generated while ignoring the effect of financing and capital structure, or the proportion of debt that the business has. As the name implies, interest expense, which is included on the income statement, is added back, and income tax expense is calculated and subtracted based on earnings before interest.
For H&M, EBIAT for 2012 is 16.8 billion Swedish krona.We will not go further into calculating EBIAT now, but it is an important measure to understand as we will see it again in Module 7.
Define & List the Formula to Asset Turnover
This tells us how well a business is using its assets to produce sales. Initially, it may seem like it is good for a business to have many assets. However, from an efficiency perspective, this isn’t the case. A business that can create more revenue with fewer assets is more efficient.
ASSET TURNOVER = SALES / ASSETS
*These values are taken from the income statement & the balance sheet
H&M’s asset turnover for 2012 was 2.01. This shows that H&M generated sales of about 2 krona on each krona of assets during the period. An interesting thing to note here is that _this ratio uses both the income statement and the balance sheet._ Because the income statement covers the entire year, but the balance sheet is as of a specific point in time, we typically use the average of the beginning and ending balance sheet amounts to estimate the average level of assets during the period.
Asset Turnover is calculated by dividing the annual revenue by the average asset value for the year. In this case, we are using a two-point average of beginning and end of year asset values so the calculation is as follows:
Revenue / Average Assets = 170,910 / 191,532 = 0.89
To calculate average assets, you are given the beginning total of $176,064 but you must calculate the ending total by summing all asset accounts as of Sept 28, 2013 (a shortcut would be to add the Liabilities and Equity at September 28, 2013, since we know A = L + OE). The ending total is $207,000 making the average $191,532.
There are several formulas that could help you arrive at the correct answer, but one solution is presented below:
=B17/AVERAGE(B14,SUM(B2:B9))
Name the Different Efficiency Ratios
- Asset Turnover
- Inventory turnover
- Days Inventory
- The Accounts Receivable Turnover
- The average collection period
- Accounts Payable Turnover
- days purchases outstanding.
- Cash Conversion Cycle
- Define the purpose of the ratio for Inventory turnover,
- explain the formula, and
- state what a higher inventory represents
- This is a very useful ratio to understand how efficiently a business is managing its inventory levels. Just as more sales for a given level of assets increases efficiency, keeping less inventory on hand relative to the quantity of inventory sold does the same. Excess inventory costs money to store and uses up the firm’s cash that could be used for other investments. If a business can have lower inventory levels, while not running out of inventory for customers, it can operate more efficiently.
- INVENTORY TURNOVER = COGS/AVERAGE INVENTORY
- A higher inventory turnover represents more efficient inventory management.
Notice how again we used the average inventory balance instead of the ending balance that is typically displayed on the balance sheet. This is especially significant and provides better results than using the ending balance, especially for a firm that is growing quickly, as the level of inventory could have fluctuated during the year. We could further improve the accuracy by averaging more frequent inventory balances, such as quarterly or monthly, but for purposes of this course we’ll use the beginning and ending balances to determine average inventory.
Explain the purpose of the ratio Days Inventory and state the formulas.
- Days Inventory is closely tied to the inventory turnover. The only difference is that it is expressed as the average number of days the inventory is held before it is sold rather than how many times the inventory turned over during the period. Analyzing ratios expressed in days can often be more intuitive as we can more easily conceptualize the average number of days it takes to sell inventory.
- Two Ways to Calculate
- DAYS INVENTORY = AVERAGE INVENTORY / (COST OF GOODS SOLD/365)
- DAYS INVENTORY = 365 / INVENTORY TURNOVER
Inventory Turnover is calculated by dividing the annual Cost of Goods Sold (or Cost of Sales in this case) by the average inventory value for the year. In this case, we are using a two-point average of beginning and end of year asset values so the calculation is as follows:
Cost of Sales / Average Inventory = 106,606 / 1,278 = 83.45
Days Inventory is calculated by dividing Average Inventory by the average daily Cost of Sales which is Cost of Sales divided by 365.
Average Inventory / Average Daily Cost of Sales = 1,278 / 292 = 4.37
There are several formulas that could help you arrive at the correct answer, but one solution is presented below:
Inventory Turnover:
=C15/AVERAGE(B4:C4)
Days Inventory:
=AVERAGE(B4:C4)/(C15/365)
Accounts Receivable Turnover is calculated by dividing the annual credit sales by the average accounts receivable balance. In this case, we assume that all of Apple’s revenue is from sales made on credit terms. Again we will use a 2-point average of beginning and end of year accounts receivable balances.
Credit Sales / Average Accounts Receivable = 170,910 / 12,016 = 14.22
Average Collection Period is calculated by dividing Average A/R by the average daily Credit Sales, which is Credit Sales divided by 365.
Average Accounts Receivable / Average Daily Credit Sales = 12,016 / 468 = 25.66
There are several formulas that could help you arrive at the correct answer, but one solution is presented below:
Accounts Receivable Turnover:
=C14/AVERAGE(B3:C3)
Average Collection Period:
=AVERAGE(B3:C3)/(C14/365)
Accounts Payable Turnover is calculated by dividing the annual credit purchases by the average accounts payable balance. In this case, we do not have access to Apple’s credit purchases so we are using Cost of Sales as a proxy. Again we will use a 2-point average of beginning and end of year accounts payable balances.
Cost of Sales / Average Accounts Payable = 106,606 / 21,771 = 4.90
Days Purchases Outstanding is calculated by dividing Average Accounts Payable by the average daily Cost of Sales, which is Cost of Sales divided by 365.
Average Accounts Payable / Average Daily Cost of Sales = 21,771 / 292 = 74.54
There are several formulas that could help you arrive at the correct answer, but one solution is presented below:
Accounts Payable Turnover:
=C17/AVERAGE(B7:C7)
Days Payable Outstanding:
=AVERAGE(B7:C7)/(C17/365)
Show/Explain the Difference
- Days Inventory is closely tied to the inventory turnover. The only difference is that it is expressed as the average number of days the inventory is held before it is sold rather than how many times the inventory turned over during the period.
- The average collection period, sometimes referred to as Days Sales Outstanding or Days Sales in Receivables, is the average number of days it took for a business to collect payment from a customer.
- Days purchases outstanding. Again this simply shows the AP turnover measured in average days outstanding. A days purchases outstanding that is longer than the allowed terms from the vendor could indicate that the business is struggling to pay its obligations.
Some businesses can actually have a negative cash conversion cycle. This happens when a business purchases goods from a supplier on credit terms, and is able to sell the inventory and collect cash from the customer before payment is required to be made to the supplier. Having a negative cash conversion cycle can be very beneficial for the cash flows of a business, especially if that business is growing. Rather than requiring more and more cash to increase inventory, the business can rely on the credit from its suppliers.
The correct answer is -44.50.
The correct answer formula is:
=F6+F7-F8
The Cash Conversion Cycle is the number of days between when your company pays for inventory purchases and when your company collects from customers. It is calculated by subtracting the Days Purchases Outstanding from the total of the Days Inventory and the Average Collection Period. For the year ending June 30, 2013 it was:
Days Inventory + Average Collection Period - Days Purchases Outstanding = 4.37 + 25.66 - 74.54 = -44.50
In the DuPont Framework, the leverage ratio is calculated by dividing the average total assets by the average equity.
Average Total Assets / Average Equity = 191,532 / 120,879.50 = 1.58
The suggested correct answer formula is:
=AVERAGE(B6:C6)/AVERAGE(SUM(B12:B14),SUM(C12:C14))
The Debt to Equity Ratio is calculated by dividing the total liabilities by the total equity. In this case, total liabilities includes Accounts Payable, Accrued Expenses, Other Current Liabilities, Long Term Debt, and Other Long Term Liabilities. Total equity includes Common Stock, Retained Earnings, and AOCI & Other Equity.
For 2012, total liabilities are $57,854 and total equity is $118,210.
Total liabilities / total equity = $57,854 / $118,210 = 0.49
The suggested correct answer formula is:
=SUM(B7:B11)/SUM(B12:B14)
For 2013, total liabilities are $83,451 and total equity is $123,549.
Total liabilities / total equity = $83,451 / $123,549 = 0.68
The suggested correct answer formula is:
=SUM(C7:C11)/SUM(C12:C14)
For the average, average total liabilities are $70,653 and average total equity is $120,880.
Total liabilities / total equity = $70,653 / $120,880 = 0.58
The suggested correct answer formula is:
=AVERAGE(SUM(B7:B11),SUM(C7:C11))/AVERAGE(SUM(B12:B14),SUM(C12:C14))
Note that there is no requirement to calculate ratios using beginning and ending balances before calculating a ratio using average balances, but some managers may find it useful to see how the ratio differs under these different calculation methods.
The Current Ratio is calculated by dividing Current Assets by Current Liabilities at a point in time. For this ratio, we do not use the average amounts. Current Assets include Cash, Equivalents, Marketable Securities, Accounts Receivable, Inventory, and Other Current Assets. Current Liabilities include Accounts Payable, Accrued Expenses, and Other Current Liabilities.
Current Assets / Current Liabilities = 73,286 / 43,658 = 1.68
The suggested correct answer formula is:
=SUM(B2:B5)/SUM(B12:B14)
Current assets continued to grow without a proportionate increase to its liabilities.
There has been some increase in working capital coming from increases in cash, accounts receivable, and other current assets, and the biggest increase in short term marketable securities.
Looks the same on the surface but underlying changes are resulting in higher cash.
Although the change in the current ratio is very small, there are significant underlying movements. Increases in accounts receivable have been offset by increases in accounts payable & accrued expenses. The biggest change could be the reduced investment in inventory which could be a reason cash has increased.
The Quick Ratio is calculated by dividing the most liquid Current Assets by Current Liabilities at a point in time. One way to calculate Quick assets removes inventories from current assets. At September 28, 2013:
(Current Assets - Inventory) / Current Liabilities = 71,522 / 43,658 = 1.64
The suggested correct answer formula is:
=(SUM(B2:B5)-B4)/SUM(B12:B14)
To calculate Earnings Before Interest and Taxes (EBIT), we start with Net Income and then add back Interest Expense and Income Tax Expense.
Net Income + Interest Expense + Income Tax Expense = 37,037 + 136 + 13,118 = 50,291
The suggested correct answer formula is:
=B16+B11+B15
To calculate the Interest Coverage Ratio, we divide EBIT by Interest Expense.
EBIT / Interest Expense = 50,291 / 136 = 370
The suggested correct answer formula is:
=E6/B11
How to Compare Different Companies?
One common problem when comparing financial statements from different companies is that different sizes and scales of businesses can make it difficult to compare them. One helpful tool is to prepare common size financial statements.
- divide each number on the balance sheet by total assets
- each number in the income statement by sales
This converts the financial statement items into ratios that help us see trends and can easily be compared from one company to another.
The correct answer is Company B. Company B is likely a high volume retailer because its low profit margin indicates that it isn’t adding a lot of value to products, and the high asset turnover means that it is selling through a lot of inventory.
Company A is more efficient in utilizing its assets than Company B.
Company A has a higher ROE than Company B because it has a higher Asset Turnover Ratio, which means Company A is more efficient in utilizing its assets.
Which Company is which on this outline…?
Choices are: Airline, Grocery Store, Consumer Electronic Store
To complete these cases, it is best to start by looking for something that stands out as being very different. In this case, one of the most notable differences is that Company C has zero inventory, so we start there.
Company C has zero inventory, which indicates it is likely a service industry. It also has very high plant & equipment. So this must be in the airline industry.
Company A has high inventory which indicates it is retail. It also has high plant & equipment which means it has many and large stores. The low receivables collection period indicates that the company makes most of its sales in cash or credit card. It also has a high inventory turnover, which means it sells its inventory quickly. All of these signs point to a grocery retail chain.
Company B has a very high inventory turnover, indicating that whatever inventory they have moves quickly. The relatively low plant and equipment combined with the high inventory turnover suggests that a lot of sales are made online and there are relatively few brick and mortar stores. The high receivables collection period is usually due to an extension of credit, so the company likely makes a lot of sales business-to-business, rather than directly to the consumer. So this is in the electronic consumer products industry.
