Slides 8 Flashcards
What is the formula for calculating EBITDA?
Revenues - Operating Costs
EBITDA stands for Earnings Before Interest, Taxes, Depreciation, and Amortization.
What does ROTA stand for?
Return on Total Assets
What do profitability ratios measure?
The capacity to preserve the income equilibrium in the future
What do financial strength ratios measure?
The financial stability of a company
What do liquidity ratios measure?
The capacity for the company to pay bills as they arrive
What is the importance of time series comparisons in profitability ratios?
Indicates that a higher profitability ratio compared to previous periods shows the company is doing better than before
What is cross-sectional comparison in profitability ratios?
Comparing a company’s profitability ratio to its competitors to infer better performance
What is a key consideration when making profitability comparisons?
Comparisons need to be meaningful
What is the formula for calculating ROTA?
EBIT / Total Assets
What does a higher ROTA indicate?
Management is effectively using assets to generate an opening surplus
What are the components needed to calculate ROTA?
- EBIT
- Total Assets
What is the formula for Return on Sales (ROS)?
EBIT / Total Sales
What does Asset Turnover measure?
The ability of the firm to generate large sales with the lowest possible amount of assets
What are the standards for a good profit margin?
Higher than 10% is considered good
How can firms improve ROTA?
By focusing on variables that impact ROTA through targeted efforts
What is the formula for Return on Equity (ROE)?
Net Income / Owners’ Funds
What is the significance of a high ROE?
Compensates shareholders for risk and helps attract new funds
What does a declining asset turnover ratio imply?
Firms are incurring inefficiencies or not using resources at full capacity
True or False: ROTA can be improved directly.
False
What is the role of the operating profit model in improving ROTA?
Specifies fundamental variables that drive ROTA
What is the interpretation of a company’s ROS?
Identifies profit as a percentage of sales
What does a higher asset turnover indicate?
The firm is generating more revenue per euro of assets
What are two useful metrics for improving asset turnover?
- Average inventory days
- Collection period
What is the impact of comparing companies in different sectors?
Useless for performance evaluation
What is the relationship between ROTA and competitive advantage?
Higher ROTA than industry average indicates a competitive advantage
What does a decreasing ROS indicate?
Could signal troubles for the company
What does ROE stand for?
Return on Equity
What does ROE measure?
The absolute return delivered to shareholders
Why is a good ROE important for a company?
It makes it easy to attract new funds and enables the company to grow
How is ROE calculated?
Net income / Owners’ funds
What is an acceptable ROE value?
Greater than 10% is usually good
What should ROE be compared to for risk assessment?
It should exceed the cost of debt
What is the relationship between ROE and ROTA?
ROE is usually higher than ROTA
What does the interest coverage ratio indicate?
How many times a firm’s operating income exceeds interest expenses
What happens when the interest coverage ratio is less than 1?
<1 means bad financial situation, indicating economic loss
What does a debt-to-equity ratio greater than 2 indicate?
Excessive risk in the capital structure
What does a debt ratio indicate?
The part of assets financed by debt
What are the three components that determine the interest coverage ratio?
- Operating profit * Total amount borrowed * Effective rate of interest
What is financial leverage?
The use of debt to increase the potential return on equity
What is the formula for calculating ROE using financial leverage?
ROE = (Net income / Sales) * (Sales / Total assets) * (Total assets / Equity)
What are the risks associated with increasing debt/equity?
- Increases ROE * Increases corporate risk
What should companies consider when using financial leverage?
Use with caution, especially in times of high uncertainty
What is the financial strength ratio associated with?
The ability to meet interest and principal payments in the long run
What does the structure of capital refer to?
The composition of debt and equity
What is the result of a high corporate risk?
Higher likelihood of going out of business
What are the financial charges generated by debt?
- Interest * Payment of the principal
Fill in the blank: Debt + Equity = _______
Total Assets
True or False: Higher ROE makes it difficult to attract new funds.
False
What does a debt ratio of 0.5 indicate?
A debt-to-equity ratio of 1
What should firms combine with ROE for better analysis?
Other indexes, particularly ROTA and solvency indicators
What does a debt ratio of less than 1 indicate?
The company is over-capitalized
What is a negative interest coverage ratio indicative of?
The firm usually has an economic loss
What is the definition of profitability ratios?
Ratios that assess a company’s ability to generate profit relative to its revenue or assets
