Using the Financial Statements Flashcards
3.2: Identify and calculate ratios for analyzing a company’s liquidity, solvency, and profitability.
What is data analytics?
The process of analyzing data to find patterns and correlations, trends, and other valuable insights to enhance decision-making.
This includes decisions that will impact financial reporting.
Why must companies now find ways to manage and analyze data as efficiently as possible?
The amount of this data is expanding each year
Does data analytics start with data?
No, it starts with developing the questions that the data will help to answer.
What must companies consider when using data analytics?
The sources of data that can be captured and analyzed to answer specific questions
What are the two main types of data sources?
Internal data (within the organization) and external data (from outside sources like industry and government agencies).
Give examples of sources of data.
- Customer data
- Supplier data
- Product data
- Shipping data
- Accounting data
- Marketing data
- Employee data
- Traffic count
- Attendees at events
- Call data
- RFID
- Emails
- Customer surveys
- Industry data
- Government data
- Google search
- GPS records
What type of data do companies commonly collect on their customers?
Companies collect personal information, demographics, purchase history, website search history, and credit history.
What is an example of a company collecting Big Data?
Walmart’s Transactional data: Walmart records more than 1 million customer transactions every hour, gathering over 2.5 petabytes of data.
What is Big Data?
Big Data refers to data with high volume, velocity, and variety that requires innovative methods of processing to provide insights for decision-making.
What are some sources of Big Data?
Sources include transactional data, online activity records, machine-to-machine interactions, metering, call records, sensors, environmental sensing, and RFID systems.
What 2 financial statements does ratio analysis analyze?
- the statement of financial position 2. the statement of income
How can we use specific tools such as ratio analysis for the 2 financial statements?
In order to make a more meaningful evaluation of a company
What does ratio analysis express?
The relationships between selected items of financial statement data
What are the 3 general types of ratios?
- Liquidity ratios
- Solvency ratios
- Profitability ratios
How is net income calculated?
Revenues - Expenses = Net Income
What do profitability ratios measure?
The income or operating success of a company for a given period of time
What do liquidity ratios measure?
The short-term ability of the company to pay its maturing obligations and to meet unexpected needs for cash
What do solvency ratios measure?
The ability of the company to survive over a long period of time
Why is it important to consider ratios in relation to other items on financial statements?
Ratios can reveal underlying conditions that may not be apparent when examining individual financial items. They provide context by comparing relationships between items on financial statements.
What are the 3 types of comparisons used in financial ratio analysis?
- Intracompany comparisons (comparing two or more periods for the same company)
- Intercompany comparisons (comparing a company with a competitor in the same industry)
- Industry average comparisons (comparing with average ratios for the industry).
What are liquidity ratios?
Measures of a company’s short-term ability to pay its maturing obligations (usually current liabilities) and to meet unexpected needs for cash. These include working capital and the current, receivables turnover, average collection period, inventory turnover, and days in inventory ratios.
What is working capital?
A measure of liquidity used to evaluate a company’s short-term debt-paying ability. It is calculated by subtracting current liabilities from current assets.
Why would a supplier selling merchandise on credit to Aritzia be concerned with its liquidity?
The supplier would be concerned with Aritzia’s liquidity to ensure the company can meet its short-term obligations and pay its debts that are due within the next year.
What type of ratios would you use to look closely at the relationship of a comany’s current assets to its current liabilities?
Liquidity ratios
What are the two liquidity measures introduced in chapter 3?
- Working capital
- Current ratio.
What does positive working capital indicate about a company?
Positive working capital indicates that a company is likely able to pay its liabilities and has liquid assets available to expand its operations.
What does negative working capital imply for a company?
Negative working capital means that unless the company generates enough cash from operations to offset it, it may need to borrow money, or short-term creditors might not be paid.
What is the calculation for working capital?
Current assets - current liabilities
What is current ratio?
A measure of liquidity used to evaluate a company’s short-term debt-paying ability. It is calculated by dividing current assets by current liabilities.
What is the calculation for current ratio?
Current assets/current liabilitites
What does positive working capital typically result from?
Positive working capital is usually the result of positive operating cash flows.
When industry averages are not available for ratios, how are they indicated?
When industry averages are not available, they are indicated by “n/a” (not available).
Why is the current ratio considered a more relevant liquidity indicator than working capital?
The current ratio is more relevant because it measures the relative relationship between current assets and current liabilities, allowing comparisons between companies of different sizes.
What can two companies with the same working capital have despite that?
Two companies with the same working capital can have significantly different current ratios.
What do the working capital and current ratio help users assess?
They help users assess a company’s liquidity.
What does a current ratio of 2.6:1 mean for Aritzia in 2019?
A current ratio of 2.6:1 means that for every dollar of current liabilities, Aritzia has $2.60 of current assets.
What is the general belief regarding the current ratio?
The general belief is that the current ratio should exceed a value of at least 1:1 to ensure a company can meet its current liabilities.
Why is the current ratio different for companies in different industries?
The current ratio can vary by industry because companies in different sectors have different types of assets. For example, service companies may have lower current assets because they don’t sell inventory.
It is therefore more meaningful to compare the ratios of competitors within an industry than the ratios of companies operating in different industrie
How did Aritzia’s current ratio change from 2018 to 2019?
Aritzia’s current ratio improved significantly in 2019 due to an increase in current assets and a decrease in current liabilities.
Why is the current ratio only one measure of liquidity?
The current ratio is only one measure because it doesn’t account for the composition of current assets, which is important in assessing liquidity.
What’s the issue with a satisfactory current ratio if current assets include uncollectible accounts or slow-moving inventory?
A satisfactory current ratio might be misleading if a significant portion of current assets is tied up in assets that cannot be quickly converted to cash, such as uncollectible accounts receivable or slow-moving inventory.
What happens if a company’s current assets rise without a change in current liabilities?
What happens if a company’s current assets rise without a change in current liabilities?
What are solvency ratios?
Measures of a company’s ability to survive over a long period of time by having enough assets to settle its liabilities as they fall due. These include the debt to total assets and times interest earned ratios and free cash flow.
What is the debt to total assets ratio?
A measure of solvency showing the percentage of total financing that is provided by lenders and other creditors. It is calculated by dividing total liabilities by total assets.
Why would a long-term creditor or investor be interested in a company’s solvency?
Interested in a company’s long-run solvency—its ability to pay interest as it comes due and to repay the face value of debt at maturity
Why is debt financing riskier than equity financing?
Debt financing is riskier because the company must repay the debt and interest on specified dates, regardless of the company’s performance, whereas equity financing does not require repayment or dividends.
How is the debt to total assets ratio calculated?
Total debt (current and non current)/total assets
What does a higher debt to total assets ratio indicate?
A higher debt to total assets ratio indicates a greater risk that the company may struggle to pay its debts and related interest when they come due.
What alternative ratio can be used to evaluate solvency?
An alternative ratio is the debt to equity ratio, which divides debt by shareholders’ equity. A lower debt to equity ratio indicates better solvency and less risk.
What does Aritzia’s 2019 debt to total assets ratio of 40.5% indicate?
Aritzia’s 2019 debt to total assets ratio means that approximately 40.5 cents of every dollar invested in assets came from creditors.
What does it mean for a company’s debt to total asset ratio to improve?
Decrease meaning a smaller proportion of its assets are financed by debt compared to previous years
What impact does a higher debt to total assets ratio have on a company?
A higher ratio increases the amount of interest expense a company will incur and reduces the equity cushion available to creditors in case of insolvency.
What is an equity cushion?
The equity cushion is the excess of assets over liabilities, providing a margin of safety for creditors in case the company becomes insolvent and needs to sell its assets to repay debts.
Why is a high debt to total assets ratio undesirable from a creditor’s perspective?
A high ratio is undesirable because it means there’s less equity available to cover debt in the event of insolvency. Also, creditors may recover less than the amount of debt owed when the company sells assets.
What type of company is Aritzia, and how does it generate revenue?
Aritzia is a retailer or merchandising company, generating revenue by selling products directly to consumers.
What is a retailer or merchandising company?
A company that sells products, rather than services, directly to consumers
What does the statement of income report?
The statement of income reports a company’s revenues and expenses, helping to measure its net income.
What additional information does Aritzia provide beyond the condensed statement of income?
Aritzia provides additional details about its revenue and expenses in the notes to its financial statements.
Why do Aritzia’s fiscal years end on different dates (March 3, 2019, and February 25, 2018)?
Some retailers, like Aritzia, choose a year-end that falls on a weekend, explaining the different year-end dates.
What alternative name does Aritzia use for its statement of income?
Aritzia calls its statement of income the “statement of operations.”
What is the cost of goods sold, and where does it appear on the statement of income?
The cost of goods sold represents the cost of inventory sold and is an expense that appears after sales revenue on the statement of income.
What is gross profit, and how is it calculated?
Gross profit is the difference between sales revenue and the cost of goods sold:
sales revenue - COGS = gross profit
What are profitability ratios?
Measures of a company’s operating success for a specific period of time. These include the gross profit margin, profit margin, return on assets, return on common shareholders’ equity, earnings per share, price-earnings, payout, and dividend yield ratios.
What is basic earnings per share (EPS)?
A measure of profitability showing the income earned by each common share. It is calculated by dividing income available to common shareholders by the weighted average number of common shares.
Why are investors and creditors interested in a company’s profitability?
Investors and creditors are interested in a company’s profitability to assess its ability to generate profit and its financial health over time.
What are the 2 examples of profitability ratios covered in this chapter?
- Basic earnings per share (EPS)
- Price-earnings ratio.
How is basic EPS calculated?
Income available to common shareholders/weighted average number of common shares.
How does basic EPS help users?
Basic EPS helps users compare a company’s performance with that of previous years.
What does the net income on a company’s statement of income represent if they only issue common shares?
The income available to common shareholders will be the same as the net income reported on a company’s statement of income
What happens if a company has preferred shares when calculating basic earnings per share (EPS)?
If a company has preferred shares, the preferred share dividends declared must be deducted from net income to calculate the income available to common shareholders for EPS.
How does basic EPS benefit shareholders?
Shareholders usually think in terms of the number of shares they own—or plan to buy or sell—so determining net income on a per-share basis gives a useful number for determining the investment return
Why is basic earnings per share an important measure for publicly traded companies?
Basic EPS is important because it is the only ratio that publicly traded companies must present in their financial statements. It gives a useful measure of a company’s profitability on a per-share basis.
What is the only ratio that has to be presented in financial statements by publicly traded companies?
Basic earnings per share
What is an additional type of earnings per share companies will report?
Diluted earnings per share. (We will assume that EPS means basic EPS unless the term diluted is specifically used)
Are private corporations required to report earnings per share?
No, private corporations reporting under Accounting Standards for Private Enterprises (ASPE) are not required to report earnings per share.
What is the price-earnings (P-E) ratio?
A profitability measure of the ratio of the market price of each common share to the earnings per share. It reflects investors’ beliefs about a company’s future income potential.
Why is it not meaningful to compare basic earnings per share (EPS) between different companies (intercompany basis)?
Comparing basic EPS between companies is not meaningful due to variations in the number of shares issued and differences in how companies finance their assets.
No industry average for the basic earnings per share
What ratio can be used to make meaningful comparisons based on basic earnings per share?
The price-earnings (P-E) ratio can be used to make meaningful comparisons, as it relates a company’s share price to its basic earnings per share.
How is the price-earnings (P-E) ratio calculated?
Market price per share/basic earnings per share.
What does the price-earnings (P-E) ratio help investors assess?
How a company’s share price relates to its net income or earnings per share, reflecting expectations about future earnings.
What does a higher price-earnings ratio indicate?
A higher P-E ratio suggests that investors expect the company’s earnings potential to be higher in the future.
How can investors use the P-E ratio to evaluate share prices?
Investors can compare the P-E ratios of different companies to assess how expensive or inexpensive each company’s shares are relative to their earnings per share.
What does the price-earnings (P-E) ratio indicate about a company?
The P-E ratio indicates what investors expect from a company’s future profitability. A higher ratio suggests optimism about future earnings, while a lower ratio suggests lower expectations.
Why do the price-earnings ratios of Facebook and Google differ from those of Ford and General Motors?
Facebook and Google have higher P-E ratios because investors expect higher future net income from them, whereas Ford and General Motors have lower P-E ratios due to lower expectations for future earnings.
How does the price-earnings ratio help users?
The P-E ratio helps users assess a company’s profitability and investors’ expectations about future profitability.
How does the change in earnings per share (EPS) and share price affect the price-earnings ratio?
If EPS and share price both rise by the same %, the P-E ratio remains unchanged. However, if the share price rises more than the EPS, the P-E ratio increases, which may indicate that investors are overly optimistic.
What happened to Aritzia’s price-earnings ratio after it went public in 2016?
Aritzia’s P-E ratio was very high when it went public in 2016, reflecting optimism. However, the company reported losses, and the share price dropped in 2017, indicating that the initial high ratio was based on overly optimistic expectations.
Who was Benjamin Graham, and what did he advocate in his book The Intelligent Investor?
Benjamin Graham was an economist and finance professor who advocated for buying stable, profitable companies with low share prices. He emphasized purchasing shares with low price-earnings ratios and recommended companies with a current ratio greater than 2:1 for good liquidity and a margin of safety.
Why did Benjamin Graham prefer companies with low price-earnings ratios?
Not because they had low growth prospects but because the shares were cheap
What current ratio did Benjamin Graham believe indicated good liquidity?
Graham believed a current ratio greater than 2:1 indicated good liquidity, which provided a margin of safety for investors.
How did Warren Buffett apply Benjamin Graham’s investment philosophy?
Warren Buffett, a student of Benjamin Graham, bought shares in Berkshire Hathaway in 1962 for just over $11 per share and used the company to invest in others, following Graham’s principles of value investing. By early 2019, one Berkshire Hathaway share was worth over $312,000.
What is one reason Warren Buffett is one of the richest U.S. citizens?
Warren Buffett is one of the richest U.S. citizens because of his successful investment in Berkshire Hathaway, which grew significantly in value following Benjamin Graham’s value investing strategy.
