Ratio Analysis of Forecasts and Projections Flashcards
A quick way to gain efficiency on ratio questions
the numerator has a direct relationship with the ratio; an increase in the numerator results in an increase in the ratio
the denominator has an inverse relationship with the ratio; an increase in the denominator results in a decrease in the ratio
if both are affected by a given change, the final result is not easy to determine; the best way to answer these questions is to make up numbers and plug them into the ratio formula
What are liquidity ratios?
they focus on the current liabilities side of a company’s balance sheet and on whether or not a company will have enough in current assets and other funds to pay the liabilities when they are due
working capital = current assets - current liabilities
current ratio = current assets / current liabilities [a higher current ratio is better because it implies that more current assets are available to pay short-term liabilities]
quick ratio = (cash and cash equivalents + short-term marketable securities + net receivables) / current liabilities [a higher quick ratio is better because it implies that more current liquid assets are available to pay short-term liabilities]
when current assets are used to pay down current liabilities, the numerator and denominator of the current and quick ratios decrease by the same amount; if the current or quick ratio is already less than one, this will result in a lower ratio amount
operating cash show ratio = cash flow from operations / ending current liabilities [a higher ratio is desired as it implies that a company is generating more cash from its core activities to pay its current liabilities]
working capital turnover = sales / average working capital [all else being equal, a higher working capital turnover ratio is better; higher projected net sales in future years or projected declines in current assets or increases in current liabilities will cause this ratio to increase; a ratio that is too high could indicate a working capital amount that is too low]
What are activity ratios?
they are used to assess how efficient a company is at utilizing its resources to generate sales and profits
turnover ratios generally use average balances for balance sheet components, but it’s possible you might be instructed to use year-end balances instead
days in inventory = ending inventory / (COGS / 365) [this ratio reflects how long it takes on average to turn inventory into sales; the output will be in days, with a lower number indicating a company is more efficient in converting inventory into sales]
days sales in accounts receivable = net ending accounts receivable / (net sales / 365) [this measure provides an average number of days to convert sales into cash; a shorter number of days indicates that a company is doing a good job collecting on its outstanding receivables]
days of payables outstanding = ending accounts payable / (COGS / 365) [this is a measure of how long it takes for a company to pay its vendors for goods purchased on credit; if a company wishes to conserve cash, it will project longer average time periods to pay its vendors]
cash conversion cycle = days in inventory + days sales in accounts receivable - days of payables outstanding [all else being equal, a lower cash conversion cycle is better because a company would want to minimize the number of days it takes to convert inventory into sales and sales into cash, while taking as long as possible to pay its vendors]
What are debt ratios?
they measure the extent to which a company employs financial leverage in its capital structure; although debt is cheaper than equity from a cost standpoint because of the tax benefits and lower interest rates, too much debt is risky for the borrowing company
debt-to-equity = total liabilities / total equity [a higher ratio indicates that the company employs more risk]
total debt ratio = total liabilities / total assets [very similar to debt-to-equity, a company’s risk level increases as this ratio increases]
times interest earned = earnings before interest expense and taxes (EBIT) / interest expense [a higher number implies that a company has more funding to cover its required interest expense associated with debt; by paying down old debt or replacing old debt with new debt carrying lower interest rates, interest expense can be lowered in the future, which will increase this ratio]
What are profitability ratios?
they focus on how profitable a company is at various levels of its business; although the bottom line is very important, cost controls earlier in the process can be extremely beneficial for a company
gross margin = (net sales - COGS) / net sales [all profitability margins are interpreted the same way: all else being equal, higher is better]
profit margin = net income / net sales [the higher the net profit margin the better, as this means a company is profitable after taking into account all costs associated with generating sales and operating its business]
return on equity (ROE) = net income / average total equity [a higher ROE is desirable, as higher net income for shareholders means greater profitability, higher EPS, and probably future stock growth]
return on assets (ROA) = net income / average total assets [a higher ROA implies that a company is generating more profits relative to its base assets]
