Module 5--Financial Analysis Flashcards
What are the 14 Financial Measures/Ratios?
There are 14 ratios/measures covered in this course.
■ Liquidity measures (3)
* Working capital
* Current ratio
* Quick ratio
■ Debt ratios (2)
* Debt-to-equity ratio
* Long-term debt ratio
■ Profitability measures (7) – often used by shareholders or operating managers to assess profitability and productivity
* Gross margin
* Gross margin ratio
* Return on sales
* Earnings per share
* Return on assets
* Return on equity
* Return on total capital/return on capital employed
■ Funds management/turnover ratios (2) – measures related to cash flow issues
* Inventory turnover
* The collection period
What are the LIQUIDITY MEASURES?
Liquidity Measures Review
■ Working capital – indicator of a company’s ability to survive in the near future
■ Current ratio – measures the appropriate working capital
■ Quick ratio – measures assets that can be quickly turned to cash
What is WORKING CAPITAL?
Working capital – indicator of a company’s ability to survive in the near future
WORKING CAPITAL = Current Assets - Current Liabilities
What is CURRENT RATIO?
Current ratio – measures the appropriate working capital
CURRENT RATIO = Current Assets
—————————-
Current Liabilities
What is QUICK RATIO?
Quick ratio – measures assets that can be quickly turned to cash
QUICK RATIO = Cash + Market Securities + Receivables
——————————————————–
Current Liabilities
What are the DEBT RATIOs (two of them)?
Debt-to-Equity Ratio
Long term Debt Ratio
What is DEBT-to-EQUITY Ratio?
Debt-to-equity ratio – determines relative amount of debt to equity
DEBT-to-EQUITY = TOTAL LIABILITIES
———————————–
TOTAL SHAREHOLDERS’ EQUITY
What is Long TERM DEBT RATIO?
Long-term debt ratio – assesses a company’s risk and creditworthiness
LONG-TERM DEBT RATIO = LONG TERM DEBT
———————————————————
LONG TERM DEBT+ SHAREHOLDERS’
EQUITY
Where do we get the info for the Profitability Measures?
Comes from the PROFIT and LOSS OR the INCOME STATEMENT
What are Profitability Measures?
- Assess profitability and productivity
- Related to the income statement
- Seven measurements
What are the SEVEN Profitability Measures?
Seven measurements
* Gross margin
* Gross margin ratio
* Earnings per share
* Return on sales
* Return on assets
* Return on equity
* Return on total capital (return on capital employed)
What is GROSS MARGIN
Gross margin – gross profit after subtracting the cost of making product included in net sales
GROSS MARGIN = NET SALES - Cost of GOOD SOLD
WHAT is GROSS MARGIN Ratio
Gross margin ratio – used to compare companies’ efficiencies.
GROSS MARGIN RATIO = NET SALES - COST of GOOD SOLD
————————————————-
NET SALES
What is RETURN on SALES?
Return on sales – indicator of operating efficiency
RETURN ON SALES = NET INCOME
WHAT is Earnings per SHARE?
Earnings per share – reports net income per share of common stock
EARNINGS PER SHARE = NET INCOME
—————————————-
Average number of shares
Outstanding for the year
What is RETURN on ASSETS?
RETURN on ASSETS (ROA)
Total Assets
■ Sometimes referred to as return on investment (ROI)
■ ROA often is used by financial companies, such as banks, to indicate the profitability of all
resources. It also is used in capital intensive companies. It can be used at the business unit
level, as well as at corporate.
■ Used for project analysis and financial statements
■ Does not account for risk or time value of money
■ Assets on the books are valued based in part on the company’s depreciation policies (the ratio is
related to historic costs).
What is RETURN on EQUITY (ROE)
Return on Equity (ROE)
TOTAL SHAREHOLDERS’ EQUITY
This frequently used measure assesses how a company is capitalized (debt versus equity). It is sometimes referred to as ROI.
■ Calculates income as a percent of total equity
■ Measurement of operating efficiency
What is RETURN on TOTAL CAPITAL (ROTC)
Return on Total Capital (ROTC)
ROTC is also called return on capital employed and return on capital.
■ ROTC is useful in comparing one company with others, and in comparing company’s results in one period with another. It calculates profits after tax plus interest on long-term debt plus total equity.
■ Measures the total returns compared with the permanent capital
■ Net income is an after-tax number. This formula uses interest costs on an after-tax basis.
Interest costs are a tax deductible expense and reduce taxes otherwise payable. Thus the true cost of interest is less than the actual dollar interest cost.
What are the formulas for RETURN on TOTAL CAPITAL?
RETURN on TOTAL CAPITAL (ROTC)
TOTAL PERMANENT CAPITAL
OR
LONG TERM DEBT + EQUITY
PROFITABILITY MEASURES SOLUTIONS:
Profitability Measures Solutions
■ Return on assets
$54,750,000
____________ = .082 or 8.2%
$667,000,000
■ Return on equity
$54,750,000
____________ = .156 or 15.6%
$351,000,000
■ Return on total capital
$54,750,000 + [$16,250,000 $54,750,000 + $9,750,000
× (1 – .40)]
——————————————- = ——————————————
$146,000,000 + 351,000,000 $497,000,000
$64,500,000
——————– = .130 OR 13%
$497,000,000
What are FUNDS MANAGEMENT RATIOS–TURNOVER RATIOs
Funds Management Ratios – Turnover Ratios
■ Measures related to cash flow issues
■ Measurements
* Inventory turnover
* Collection period
WHAT is INVENTORY TURNOVER?
INVENTORY TURNOVER
Average Inventory
Money is tied up in inventory. Companies generally like to hold inventories to the lowest reasonable level to allow efficient operations (and have products to provide to customers). A company with a high turnover rate needs to be sure it does not lead to shortages and dissatisfied customers.
■ Inventory turnover measures the average number of times the inventory was sold in the period.
■ Number of days inventory stays in company
■ Companies need to have adequate levels of inventory for customer satisfaction
■ Inventory turnover can be used to support the improvement of inventory levels.
What is the COLLECTION PERIOD?
Collection Period
■ Measures the average time a company takes to collect cash
■ Measures the credit/collection department’s effectiveness
What does the FORMULA FOR COLLECTION PERIOD LOOK LIKE?
ACCOUNTS RECEIVABLE
———————————- X NUMBER OF DAYS IN THE PERIOD
CREDIT SALES
AVERAGE INVENTORY + COLLECTION PERIOD
(NUMBER OF DAYS) (NUMBER OF DAYS)
Compensation & Benefits Implications
Acquiring inventory and collecting receivables are important cash flow considerations.
Highly leveraged companies needing consistent cash flow will be concerned about these calculations.
They can be factors in incentive plans.
INVENTORY TURNOVER
■ Inventory turnover
Ratio
$535,000,000
____________ = 2.9 times
$182,500,000
INVENTORY IN COMPANY
■ Inventory in company
365
____________ = 126 days
2.9
COLLECTION PERIOD
■ Collection period
$156,000,000
____________ × 365 = 74.2 days or 74 days
$767,000,000
INVENTORY TO CASH
■ Inventory to cash
126 + 74 = 200 days
In this example the company has an average of 126 days of inventory and takes 74 days to collect cash from customers, meaning that money is tied up for 200 days (nearly 7 months).
OTHER PEFORMANCE MEASURES
Other Performance Measures
These are not the only performance measures. Some companies have additional ones, or variations on those presented here.
■ Return on net assets (RONA) – Used at a division level and has some similarity to ROTC in that it is measuring the return on the net assets being used at the division. ROTC is usually only usable at the corporate level.
■ Total shareholder return (TSR) – The return to shareholders over a period of time taking into account both share price movement and dividends. Some include company money used to buy treasury stock in the TSR number; others do not.
■ Economic value added (EVA) – Used to estimate economic profit of a firm – profit minus cost of capital
■ Earnings before interest and taxes (EBIT) – Also called operating income. Noncash charges, such as depreciation and amortization, are included. EBIT can be used by equity-based companies for
incentive-based plans. Employees have no control over interest payments and taxes, but can have impact on certain noncash charges, such as depreciation and amortization.
■ Earnings before interest, taxes, depreciation and amortization (EBITDA) – Start-up or highly leveraged companies might use this as a performance measurement when cash flow is the focus and there is an incentive to generate cash.
- Which of the following is a profitability measure?
A. Gross margin ratio
B. Number of days sales in receivable
C. Current ratio
D. Long-term debt ratio
A. Gross margin ratio
- What type of measure or ratio is calculated using the following equation?
Credit Sales
A. Profitability measure
B. Liquidity measure
C. Debt ratio
D. Funds management ratio
D. Funds management ratio
- Which of the following financial ratios should be used to determine a company’s ability to pay its obligations in the near future?
A. CURRENT ASSETS
———————————-
CURRENT LIABILITIES
B. LONG TERM DEBT
————————————————–
LONG TERM DEBT+ SHAREHOLDER’S EQUITY
C. NET INCOME
———————————-
TOTAL ASSETS
D. TOTAL LIABILITIES
———————————–
TOTAL ASSETS
A. CURRENT ASSETS
———————————-
CURRENT LIABILITIES
- Which performance measure would most likely be used by a start-up company where cash is the focus and there is an incentive to generate cash?
A. Total shareholder return (TSR)
B. Earnings before interest and taxes (EBIT)
C. Earnings before interest, taxes, depreciation and amortization (EBITDA)
D. Economic value added (EVA)*
C. Earnings before interest, taxes, depreciation and amortization (EBITDA)
What type of measure or ratio is calculated using the following equation?
Accounts receivables
× Number of days in period
Credit sales
A. Profitability measure
B. Funds management ratio
C. Liquidity measure
D. Debt ratio
B. Funds management ratio
