Midterm 1 Part 2 Flashcards
What does the inventory turnover ratio tell us?
It tells us how many times the company sells its inventory each year.
What is one common mistake of calculating inventory turnover?
To use sales instead of COST OF GOODS SOLD in the equation
What do efficiency ratios measure?
How well the company uses its assets to generate sales or profit
Who is most interested in efficiency ratios?
Investors (providers of debt and equity capital). They want to make sure they’re making a good investment
Which efficiency ratio is also used as a profitability ratio?
OIROI
What does the total asset turnover ratio calculate?
How many dollars in sales the firm makes per dollar of assets it owns.
What are the three efficiency ratios?
- Total asset turnover
- Fixed asset turnover
- OIROI
What does a total asset turnover ratio of 3 mean?
That for every dollar of assets the company owns, it makes 3 dollars in profit
Are ratios always accurate?
No, their interpretation really depends on a number of factors, but they give us a starting point
What does the fixed asset turnover ratio calculate?
The dollar amount of profits compared to each dollar of fixed assets the company owns
Which type of assets does management have more control over?
Current assets
Which type of assets are mostly determined by the industry?
Fixed assets
What does OIROI stand for?
Operating income return on investment
What does the OIROI calculate?
How much pre-tax, pre-financing profit we are making per dollar of assets
For our purposes, what is operating profit equal to?
EBIT
What is JIT inventory?
Just in time inventory, pioneered by Japan. The idea is to take something immediately off the truck and put it onto the production line and then ship it right after it’s been built.
This leads to inventory moving more quickly off the shelves, which costs the company less in the long run.
True or False: A high inventory turnover ratio is good because it costs less to finance long-term inventory
TRUE
What do financing ratios tell us?
They determine the proportions of debt, equity, and assets. In what proportions debt and equity finances assets.
True or False: You get a tax break for having debt.
True
What are the two financing ratios you need to know?
- Debt ratio
- Times Interest earned
What does the debt ratio calculate?
What proportion of the firm’s assets are financed with debt
What does a debt ratio of 0.4 mean?
That for every dollar of assets owned, 40 cents is financed with debt. (and 60 cents with equity).
What is an optimal debt ratio?
The amount of debt that maximizes the firm’s cost of capital
What is the optimal debt ratio for all companies!
It varies from company to company, but it CAN be calculated
Why is the optimal debt ratio important to find?
Because it minimizes the cost of financing and maximizes company value
What does the times interest earned (TIE) ratio tell us?
How many times a company could cover/pay its interest expense given its earnings.
What does a TIE ratio of 10 mean?
That it could pay its interest expenses with EBIT 10 times over.
Why is the TIE ratio important?
Because if you default on interest payments, you get in big trouble with the law and have to explain it to a judge.
What do profitability ratios measure?
How well the owner or manager is doing to maximize wealth
What are the profitability ratios you need to know?
- Return on assets
- Return on equity
- Gross Margin
- Operating margin
- Net margin
What does the return on assets ratio tell us?
How profitable a company is based on its current asset investment
True or False: ROA is comparable across industries
True
True or False: ROA is a good benchmarking ratio
True
True or False: A firm that is effectively using debt will have a better ROE than ROA
TRUE
True or False: The ROE is comparable across industries
FALSE
Why is the ROE hard to compare across industries?
Because each company uses different financing strategies/ratios
Where do you find the three margin ratios? Where do you derive them?
The income statement
True or False: Gross margin should be greater than operating margin, and operating margin should be greater than net margin
TRUE
What do the margin ratios tell us?
How much of that particular type of profit is being made per dollar of sales
What do all three margin ratios have in common?
They are all some type of profit being divided by sales
What does a net margin of 5% mean?
That for every dollar of sales, 5 cents drops to the bottom as net income
What is the greatest, grand-daddy ratio called?
The DuPont
What is the equity multiplier telling us?
The leverage relationship to profitability. How much our asset leverage affects our profits
How many levers can you pull in the DuPont equation?
3
What are the levers in the DuPont equation?
- The Net profit margin ratio
- Asset turnover ratio
- Leverage / equity multiplier
Simplified, what do each of the three levers in the DuPont equation mean?
One is a profitability lever, one is an efficiency lever, and one is for leverage.
It’s basically ROA x leverage. The more leverage you have, the more you can magnify the results from the other two levers.
True or False: If your first two levers (ROA) are bad, then your leverage will make it worse
True
What is the key factor of leverage?
DEBT. The more debt you have, the more leverage you have.
(D/E + 1) = A/E
Why is ROE so important?
Because those are the returns going to your equity holders, your financeers, the SHAREHOLDERS
What does the DuPont measure?
The efficiency in controlling costs and generating sales
What is the ROIC used for?
To completely remove the leverage multiplier from our profitability ratios. It does not take debt into account to meet our goals of decreasing costs and increasing sales.
Where do you find EBIT?
Income statement
Where do you find cash taxes?
Income statement
Why do you take cash taxes out of FCFF equation?
Because you’re trying to figure out how much cash flow is left over after all your money is taken by the government and expenses.
True or False: Depreciation is non-cash expense
True
Where do you find depreciation?
Income statement or two balance sheets
Where do you find CAPEX?
The balance sheet
How do you solve for CAPEX?
You take Gross Fixed Assets from the most recent year, and subtract the Gross fixed assets from the previous year
Where do you find increases in NWC?
Balance sheet
What is important to remember about finding INCREASES in NWC?
You have to take (CA-CL) from one year and subtract off the (CA-CL) from another year. It’s not just one year. The only way to look at an INCREASE is to compare over time.
What is our primary concern in finance?
Cash flows
Summarize who gets paid in what order when looking at FCFF.
The FCFF equation takes out payments made to the 1. government and 2. expenses, and leaves us with the amount that can be paid to 3. creditors, 4. owners, and 5. investors
True or False: When finding FCFE, you are also taking out money you owe to creditors to see what’s left for shareholders
True
Where do you find net income?
Income statement
Where do you find increases in long term debt?
The balance sheet
What is the most popular method to calculate free cash flows, FCFE or FCFF?
FCFE
True or False: The only time FCFF and FCFE would equal each other is if the firm didn’t use any debt in the company
True
True or False: Interest and debt due payments count as “creditors”
True
