Ratio Analysis Flashcards
Ratios are useful in assessing profitability, liquidity, and risk. But given that ratios are contextual, how they must be used?
Ratios are used to compare same firm across time (time-series analysis) or to compare firm to other firms or to industry (cross-sectional analysis). The analyst must try to determine the underlying activity that the ratio represents to determine whether it is good or bad news.
Ratio analysis does not provide answers, but instead helps you ask better questions. What does it mean?
Rations highlight sources of competitive advantage and “red flag” potential trouble. But ratios must be compared to a benchmark, and they are contextual.
Standard ratios have multiple definitions (There is no GAAP for ratio definitions). How could mistakes be avoided?
Make sure the same definition is being used to make valid comparisons.
Choosing the appropriate benchmark for comparison is important. What can distort a time-series analyses? And a cross-sectional analyses? Is there any other source of misusing?
Major changes in the firm distort time-series analysis. Differences in business strategy, capital structure, or business segments distort cross-sectional analysis. Differences in accounting methods also make all comparisons difficult and ratios may be manipulated by managerial action.
Is a Net Income of $10,000,000 good or bad? How can it be measured?
It depends on level of investment required. Return on Equity (ROE) measures Return on Investment (ROI).
Return on Investment (ROI) should increase with the risk of the company. Is it true or false?
It’s true.
What are the two drivers of Return on Equity?
- Operating Performance, measured by Return on Assets (ROA), and - Financial Leverage, measured by Avg. Assets/Avg. Shareholders’ Equity. Some leverage rations are defined differently!! (e.g., debt-to-equity)
Which question does Operating Performance try to answer?
How effectively do managers use company resources (assets) to generate profits?
Which question does Financial Leverage try to answer?
How much do the managers use debt to increase available assets for a given level of shareholder investment?
How does Return on Assets (ROA) is defined?
ROA = (De-Levered or not) Net Income/Average Assets
How does Leverage is defined?
Financial Leverage = Avg. Assets/Avg. Shareholders’ Equity
A company raises $100 from shareholders and borrows $100 from bank to buy $200 of assets, which are used to generate $10 of net income. What are the return on equity?
ROE = 10% (10/100), ROA = 5% (10/200), Leverage = 2 (200/100) => 10% = 5% x 2
What are the two drivers of Return on Asset?
- Profitability, measured by Return on Sales (ROS), and - Efficiency, measured by Asset Turnover.
Which question does Profitability try to answer?
How much profit does the company earn on each dollar of sales?
Which question does Efficiency try to answer?
How much sales does the company generate based on its available resources?
