L9- -Financial Analysis Flashcards
What are the 4 types of Ratios
–Liquidity Ratios
–Solvency Ratios
–Activity ratios
–Profitability ratios
Define Liquidity Ratios
They measure the firm’s ability to meet current obligations
Define Solvency Ratios
These ratios show the proportion of debt and equity in financing the firm’s assets
Define Activity Ratios
They reflect the firm’s efficiency in utilising the assets
Define Profitability Ratios
These ratios measure overall performance & effectiveness of the firm
What’s on the balance sheet
Assets and Liabilities
What’s on the income statement
Income and Costs
Net working capital Equation
CAs – CLs (a rough measure of the firm’s cash holdings)
EBIT (Earnings Before Interest and Taxes) Equation
Total revenues –Costs – Depreciation (a rough measure of profitability)
What does Market-to-Book measure
–Measure of how much value has been added per unit of capital that has been invested
–Measure of the value of growth opportunities
Market-to-book equation
Market value of equity/Book value of equity
Define Economic Value Added (EVA)
–Measures how much value a company creates beyond its cost of capital.
–A positive EVA means the firm generates returns above the cost of capital, creating shareholder value.
EVA equation
= (After tax interest + Net income) – (Cost of capital * Total Capital)
EVA Alternative Equation
= (Return on capital – Cost of capital) * Total Capital
Return on capital equation
(After-tax interest + Net income)/Total capital
Return on Equity equation
Net income/Equity
Return on assets equation
(After-tax interest + Net income)/Total assets
Total assets equation
Total capital + Current liabilities
Measures for performance
–Market-to-Book
–Economic Value Added
–Return on capital
–Return on equity
–Return on assets
They reveal how effectively a company utilizes its resources (equity, assets) to generate profits
Asset turnover equation
Sales/Total assets at the start of the year (a
measure of sales generated per unit of total assets)
Inventory turnover equation
= Cost of goods sold/Inventory at the start
of the year
Receivables turnover equation
Sales/Receivables at the start of the
year
Measures for efficiency
–Asset turnover
–Inventory turnover
–Receivables turnover
Higher turnover ratios generally indicate better utilization of assets in generating sales.
What is the Du Pont System and why is it useful?
The Du Pont System breaks down Return on Assets (ROA) into two components:
–Asset Turnover – Efficiency in using assets.
–Operating Profit Margin – Profitability from operations.
Helps identify whether profitability comes from asset efficiency or high margins.
What is the formula for Asset Turnover and what does it measure?
Sales/Total assets at the start of the year
–Measures how efficiently a company uses its assets to generate sales.
–Higher Asset Turnover → More efficient use of assets.
What is the formula for Operating Profit Margin and what does it measure?
(After-taxinterest+Netincome)/Sales
–Measures profitability from operations (correcting for leverage).
–Higher margin → More profitable sales
What are the 2 Return on Assets formula
–AssetTurnover × OperatingProfitMargin
–(After-taxinterest+Netincome) / Total assets
How can a company improve Return on Assets
–Increasing Asset Turnover (better efficiency).
–Increasing Operating Profit Margin (better profitability).
What is Leverage and why is it important?
–Leverage refers to a company’s use of debt to finance its assets.
–Helps assess financial risk and ability to meet interest obligations.
–Higher leverage can lead to higher returns, but also higher financial risk.
What is the Long-term Debt Ratio, and what does it measure?
=LT Debt/ (LT Debt + Equity)
–Measures the proportion of long-term financing that comes from debt.
–Higher ratio = More reliance on long-term debt.
What is the Total Debt Ratio, and what does it indicate?
=Total liabilities/Total assets
–Measures the percentage of assets financed by debt.
–Higher ratio = More financial risk.
What is Times-Interest-Earned (TIE), and why is it important?
=EBIT/Interest payments
–Measures how many times a company can cover its interest expenses with EBIT
–Higher TIE = More financial stability.
–Lower TIE (<1) = Possible risk of default.
What is the Cash-Coverage Ratio, and what does it measure?
=(EBIT + Depreciation)/Interest Payments
–Measures how well a company can cover its interest payments using EBIT plus depreciation.
–Higher ratio = Better ability to handle interest obligations.
How does Leverage affect Return on Equity (ROE)?
ROE= (Assets/Equity) × (Sales/Assets) × (OPMargin) × (DebtBurdenMeasure)
–Higher leverage (Assets/Equity) increases ROE but also risk.
–A company can increase ROE by:
——-Using more debt (higher leverage).
——-Improving asset efficiency (higher asset turnover).
——-Increasing profit margins.
What is Liquidity, and why is it important?
Liquidity offers insights into a company’s short-term solvency
–They show the company’s ability to meet short-term obligations using its most liquid
assets.
–Higher liquidity = Lower financial risk in the short term.8
What is the Current Ratio, and what does it measure?
=Current Assets/Current Liabilities
–Measures a company’s ability to pay short-term liabilities using all current assets.
–Higher ratio (>1) = Better liquidity.
–Very high ratio may indicate inefficient use of assets.
What is the Quick Ratio (Acid-Test Ratio), and why is it useful?
=Cash + MarketableSecurities + Receivables/Current liabilities
–Measures liquidity without relying on inventory, which may take longer to convert into cash.
–Higher ratio = Better ability to quickly pay off short-term liabilities.
What is the Cash Ratio, and when is it used?
=Cash + MarketableSecurities/Current Liabilities
–Most conservative liquidity measure—only considers cash and near-cash assets.
–Used in stress testing to see if a company can immediately cover its short-term debts.
What is Tracking Trends
Compare a company’s ratios over time to identify improvements or
deteriorations in performance
What is Benchmarking
Compare a company’s ratios to industry averages or competitors to assess
relative performance.
Why are financial ratios useful for asking the right questions about a company?
Ratios often highlight areas that require further investigation, guiding deeper analysis.
Are financial ratios are more effective when used in comparison
Yes
What are Industry-Specific Variations
Ratios can vary significantly across industries, so comparisons should be made within the same industry
Is there international standard for financial ratios
NO
