Module 6&7 Flashcards
Why is analyzing financial statements critical?
It is essential to understand the performance of a business.
What do financial ratios help uncover?
They reveal important relationships between financial statement items.
When are ratios most useful?
When making comparisons to other companies or the past performance of the company itself.
What is important to understand before analyzing ratios?
An overall understanding of the company and the industry in which it operates.
What does Return on Equity (ROE) measure?
It shows the return generated during a period on the equity invested by the owners.
What is the formula for Return on Equity (ROE)?
Return on Equity (ROE) = Net Income / Owners’ Equity
What does the DuPont Framework expand?
It expands the ROE formula to consist of three factors: Profitability, Efficiency, and Leverage.
What are the components of the DuPont Framework?
- Profitability: Net Income / Sales
- Efficiency: Sales / Assets
- Leverage: Assets / Equity
What does the DuPont Framework measure?
The DuPont Framework measures profitability using Profit Margin, efficiency using Asset Turnover, and leverage using the Leverage Ratio (or Equity Multiplier).
What do profitability ratios reveal?
Profitability ratios reveal how much profit is left from each dollar of sales after all expenses have been subtracted.
How is Profit Margin calculated?
Profit Margin is calculated by dividing net income by the total sales for the period.
Profit Margin = Net Income / Sales
What does the gross profit margin ratio indicate?
The gross profit margin ratio indicates what percentage of revenue is left to cover other expenses after the cost of goods sold is subtracted.
Gross Profit Margin = Gross Profit / Sales
What is EBIAT?
EBIAT, or Earnings Before Interest After Taxes, is a measure of how much income the business has generated while ignoring the effect of financing and capital structure.
What does Asset Turnover measure?
Asset Turnover measures Operating Efficiency by indicating how well a business is using its assets to produce sales.
What does a higher Asset Turnover ratio indicate?
A higher Asset Turnover ratio indicates that a business can create more revenue with fewer assets, demonstrating greater efficiency.
What does inventory turnover indicate?
Inventory turnover helps understand how efficiently a business is managing its inventory levels. A higher inventory turnover represents more efficient inventory management.
Why is average inventory balance used in inventory turnover calculation?
Average inventory balance is used instead of the ending balance to provide better results, especially for a firm that is growing quickly.
What is Days Inventory?
Days Inventory relates to inventory turnover and is expressed as the average number of days the inventory is held before it is sold.
How is Days Inventory calculated?
Days Inventory = (Average Inventory / Cogs) * 365
What does accounts receivable turnover indicate?
The accounts receivable turnover (AR turnover) indicates a business’s efficiency in collecting receivables from customers. A higher AR turnover represents more efficient cash collections.
How is accounts receivable turnover calculated?
Accounts Receivable Turnover = Credit Sales / Average Accounts Receivable
What is the average collection period?
The average collection period, also known as Days Sales Outstanding, is the average number of days it takes a business to collect payment from a customer.
If payment is expected within 30 days but the average collection period is 40 days, it may indicate a concern.
How is the average collection period calculated?
Average Collection Period = Accounts Payable Turnover / Average Accounts Receivable / Credit Sales Per Day
What does accounts payable turnover measure?
Accounts payable turnover measures how long it takes a business to pay its vendors, which include suppliers of inventory and services.
What is one input for calculating accounts payable turnover?
One input is credit purchases, which can be estimated by looking at Cost of Goods Sold (COGS).
How can accounts payable turnover be calculated?
Accounts Payable Turnover = Credit Purchases / Average Accounts Payable
If credit purchases data is not available, it can also be calculated by: Accounts Payable Turnover = COGS / 365.
What is days purchases outstanding?
Days purchases outstanding shows the average days accounts payable is outstanding, indicating how long it takes to pay vendors.
What is the cash conversion cycle?
The cash conversion cycle combines days purchases outstanding, days inventory, and average collection period to measure how long it takes a business to pay for inventory until it collects cash from customers.
What is Financial Leverage?
Financial Leverage, also known as the Equity Multiplier, is calculated as average total assets divided by average total equity and measures the impact of all non-equity financing on the firm’s ROE.
What does a Financial Leverage multiplier of 1 indicate?
A multiplier of 1 indicates that all assets are financed by equity.
What happens to the Financial Leverage multiplier as liabilities increase?
As liabilities increase, the multiplier increases from 1, demonstrating the leverage impact of the debt.
What is the Debt to Equity ratio?
The Debt to Equity ratio is another common indicator of leverage.
What does the Current Ratio measure?
The Current Ratio helps us understand the business’s ability to pay its short-term obligations.
What does the Current Ratio focus on?
It focuses on the business’s more liquid assets and liabilities, or those that are convertible to cash or coming due within a year.
What are the components of the Current Ratio?
The components are Current Assets and Current Liabilities.
What is the quick ratio?
The quick ratio is similar to the current ratio except only highly liquid current assets can be used in the numerator. It’s also sometimes called an acid test ratio.
What is the formula for the quick ratio?
Quick Ratio = (Current Assets - Inventory) / Current Liabilities
What is the interest coverage ratio?
The interest coverage ratio, also known as times interest earned, gauges how capable a business is of making the interest payments on its debt.
What is EBIT?
EBIT stands for Earnings Before Interest and Taxes and is used to calculate the interest coverage ratio.
How is EBIT calculated?
EBIT is calculated by adding back interest expense and tax expense for the period to net income.
What is the formula for the interest coverage ratio?
Interest Coverage Ratio = EBIT / Interest Expense
What should be considered regarding seasonality in business performance?
Seasonality can cause repeating fluctuations, and comparing financial statements for a full period to those for smaller periods can help reveal these performance cycles.
Why are ratios useful for comparing companies?
Ratios allow you to eliminate the impact of size differences among companies.
What influences financial ratios?
Most ratios are influenced by managerial judgment in recording transactions that impact the financial statement.
What policy differences impact financial statements?
Policy differences affect how companies recognize revenue, whether purchased assets are expensed or capitalized, and how long-lived assets are depreciated.
