Vol. 3 LM4 Common-Size Balance Sheets Flashcards
Define
common-size analysis
Common-size Analysis
describe tools and techniques used in financial analysis, including their uses and limitations, either by vertical or horizontal methods using ratios
Common-size Analysis
Define
describe tools and techniques used in financial analysis, including their uses and limitations
common-size analysis
A vertical common-size balance sheet is prepared by
Common-size Analysis
dividing each item on the blanace sheet by the same period’s total assets and expressing the results as percentages
Common-size Analysis
The term ____ is used to denote a common-size analysis using only one reporting period or one base financial statement, whereas ____ refers to an anlysis comparing a specific financial statement with prior or future time periods
vertical analysis; horizontal analysis
Common-size Analysis
Concept
compares a specific metric for one company with the same metric for another company or group of companies, allowing comparisons even though the companies might be significantly different sizes and/or operate in different currencies
cross-sectional analysis
Describe
cross-sectional analysis
compares a specific metric for one company with the same metric for another company or group of companies, allowing comparisons even though the companies might be significantly different sizes and/or operate in different currencies
Concept
provides important information regarding historical performance and growth and, given a sufficiently long history of accurate seasoned information
trend analysis
Fill in the blank
In financial statement analysis, the “trend analysis” usually refers to comparisons across time periods of ____ not involving statistical tools
3-10 years
Use of Comparative Growth Information
In July 1996, Sunbeam, a US company, brought in new management to turn the company around. In the following year, 1997, using 1996 as the base, the following was observed based on reported numbers:
* Revenue +19%
* Inventory +58%
* Receivables +38%
- It is generally more desirable to observe inventory and receivables growing at a slower (or similar) rate compared to revenge growth
- Receivables growing faster than revenue can indicate operational issues, such as lower credit standards or aggressive accounting policies for revenue recognition
- inventory growing faster than revenue can indicate an operational problem with obsolescence or aggressive accounting policies, such as an improper overstatement of inventory to increase profits
explanation is in the aggressive accounting policies
Sunbeam was later charged by the U.S. SEC with improperly accelerating the recognition of revenue
comparative growth information
Receivables growing faster than revenue can indicate
operational issues such as lower credit standards or aggressive accounting policies for revenue recognition
comparative growth information
inventory growing faster than revenue can indicate
an operational problem with obsolescence or aggressive accounting policies, such as an improper overstatement of inventory to increase profits
common-size financial statement ratios
a common indicator of profitability
the net profit margin
* calculated as net income divided by sales
* this ratio appears on a vertical common-size income statement
because of the large number of ratios, it is helpful to think about ratios in terms of
broad categories based on what aspects of performance a ratio is intended to detect
financial ratio category
measures how efficiently a company performs day-to-day tasks, such as the collection of receivables and management of inventory
activity ratios
Describe
activity ratios
measures how efficiently a company performs day-to-day tasks, such as the collection of receivables and management of inventory
financial ratio category
measures the company’s ability to meet its short-term obligations
liquidity ratios
describe
liquidity ratios
measures the company’s ability to meet its short-term obligations
financial ratio category
- measures a company’s ability to meet long-term obligations
- subsets of these ratios are also known as “leverage” and “long-term debt” ratios
solvency ratios
Describe
solvency ratios
- measures a company’s ability to meet long-term obligations
- subsets of these ratios are also known as “leverage” and “long-term debt” ratios
financial ratio category
measures the company’s ability to generate profits from its resources (assets)
profitability ratios
Describe
profitability ratios
measures the company’s ability to generate profits from its resources (assets)
financial ratio category
measure the quantity of an asset or flow associated with ownership of a specified claim
valuation ratios
Describe
valuation ratios
measure the quantity of an asset or flow associated with ownership of a specified claim
goal
financial ratios
to understand the underlying causes of divergence between a company’s ratios and those of the industry
list three principles
an analyst should evaluate financial ratios
- Company goals and strategy
- Industry norms (cross-sectional analysis)
- Economic conditions
financial ratio analysis
Company goals and strategy
- actual ratios can be compared with company objectives to determine whether objectives are being attained and whether the results are consistent with the company’s strategy
financial ratio analysis
Industry norms (cross-sectional analysis)
A company can be compared with others in its industry by relating its financial ratios to industry norms or to a subset of the companies in an industry. Care must be taken because:
* many ratios are industry specific, and not all ratios are important to all industries
* companies may have several different lines of business -> this will cause aggregate financial ratios to be disorted
* differences in accounting methods used by companies can distort financial ratios
* differences in corporate strategies can affect certain financial ratios
financial ratio analysis
Economic conditions
- For cyclical companies, financial ratios tend to improve when the economy is strong and weaken during recessions
- therefore, financial ratios should be examined in light of the current phase of the business cycle
ratio
are also known as asset utilization ratios or operating efficiency ratios
activity ratios
Concept
these ratios reflect the efficient management of both working capital and longer term assets
activity ratios
Fill in the blank
____ has a direct impact on liquidity (the ability of a company to meet its short-term obligations)
efficiency
ratio
Since efficiency has a direct impact on liquidity, certain ____ are also useful in assessing liquidity
activity ratio
Components
inventory turnover
-
activity ratio
numerator: cost of sales or cost of goods sold
denominator: average inventory
Components
days of inventory on hand (DOH)
-
activity ratio
numerator: number of days in period
denominator: inventory turnover = cost of goods sold/average inventory
Components
receivables turnover
-
activity ratio
numerator: revenue
denominator: average receivables
Components
days of sales outstanding (DSO)
-
activity ratio
numerator: number of days in period
denominator: receivables turnover = revenue/average receivables
Components
payables turnover
-
activity ratio
numerator: purchases
denominator: average trade payables
Components
number of days of payables
-
activity ratio
numerator: number of days in period
denominator: payables turnover = purchases / average trade payables
Components
working capital turnover
-
activity ratio
numerator: revenue
denominator: average working capital
Components
fixed asset turnover
-
activity ratio
numerator: revenue
denominator: average net fixed assets
Components
total asset turnover
-
activity ratio
numerator: revenue
denominator: average total assets
process
How do you compensate for the fact that activity ratios combine information from the income statement and the balance sheet?
- because the income statement measures what happened during a period whereas the balance sheet shows what happened at the end of the period, averaged balance sheet data are normally used used for consistency
time horizon
If a semiannual report is prepared, it can be taken over
three periods
* beginning
* middle
* end of year
number
- if a quarter is 3 month, we can annualize by ____
- if a quarter is 90 days, we can annualize by ____
- 4 (12 months / 3 months)
- 4.06 (365 days / 90 days)
Computation of activity ratios
- an analyst would like to evaluate Lenovo Group’s efficiency in collecting its trade accounts receivable during the fiscal year ended 31 March 2018 (FY2017). The analyst gathers the following information from Lenovo’s annual and interim reports
Trade receivable as of 31 March 2017
* $4,468,392
Trade receivable as of 31 March 2018
* $4,972,722
Revenue for year ended 31 March 2018
* $45,349,943
Calculate Lenovo’s receivables turnover and number of days of sales outstanding (DSO) for the fiscal year ended 31 March 2018
Receivables turnover = Revenue / average receivables
* = 45,349,943 / [ (4,468,392 + 4,972,72) / 2 ]
* = 45,349,943 / 4,720,557
* = 9.6069 times, or 9.6 rounded
DSO = Number of days in period / receivables turnover
* = 365 / 9.6
* = 38.0 days
interpretation of activity ratios
a higher inventory turnover ratio implies
- a shorter period that inventory is held, and thus, a lower DOH
- relative to industry norms might indicate highly effective inventory management
alternatively,
* could indicate the company does not carry adequate inventory, so shortages could potentially hurt revenue
interpretation of activity ratios
a lower inventory turnover and commensurately high DOH implies
slow-moving inventory, perhaps due to technological obsolescence
interpretation of activity ratios
the number of DSO represents
the elapsed time between a sale and cash collection
* reflecting how fast the company collects cash from customers to whom it offers credit
Interpretation of activity ratios
a relatively high receivables turnover ratio (and commensurately low DSO) might indicate
highly efficient credit and collection
interpretation of activity ratios
a relatively low receivables turnover ratio
would typically raise questions about the efficiency of the company’s credit and collections
indications of activity ratios
what might indicate highly efficient credit and collection
a relatively high receivables turnover ratio (and commensurately low DSO) might indicate
interpretation of activity ratios
the number of days of payables and the payables turnover ratio reflects
- the average number of days the company takes to pay its suppliers
- the payables turnover ratio measures how many times per year the company theoretically pays off all its creditors
interpretation of activity ratios
A payables turnover ratio that is high relative to the industry could indicate
the company is not making full use of available credit facilities
interpretation of activity ratios
an excessively low turnover ratios could indicate (high days payable)
could indicate trouble making payments on time, or alternatively, exploitation of lenient supplier terms
Concept
is defined as current assets minus current liabilities
* current assets - current liabilities
working capital
describe
working capital turnover
- indicates how efficiently the company generates revenue with its working capital
Indication
working capital turnover ratio = 4.0
- indicates that the company generates $4 of revenue for every $1 of working capital
indication
high working capital turnover ratio
greater efficiency (i.e., the company is generating a high level of revenues relative to working capital
Concept
measures how efficiently the company generates revenues from its investments in fixed assets
fixed asset turnover
Define
fixed asset turnover
measures how efficiently the company generates revenues from its investment in fixed assets
indication
higher fixed asset turnover ratio
more efficient use of fixed assets in generating revenue
indication
low ratio can indicate inefficiency
- a capital-intensive business environment
- a new business not yet operating at full capacity—in which case the analyst will not be able to link the ratio directly to efficiency
considerations in
asset turnover
would be lower for a company whose assets are newer—therefore, less depreciated where a higher carrying value is reflected in the financial statement—than those of company will older assets
Reason
year-to-year changes in the fixed asset turnover may not be as important
- increases in fixed assets may not follow a smoooth pattern
Concept
measures the company’s overall ability to generate revenues with a given level of assets
total asset turnover
When interpreting activity ratios
the analysts should …
- examine not only the individual ratios, but also
- the collection of relevant ratios to determine the overall efficiency of a company
interpret activity ratios
- focuses on cash flows
- measures a company’s ability to meet its short-term obligations
liquidity ratios
OR
liquidity analysis
day-to-day operations
liquidity management
is typically achieved through efficient use of assets
disclosure+ description
contingent liabilities in the non-banking sector
- usually disclosed in the footnotes to the company’s financial statements
- represent potential cash outflows, when appropriate, should be included in an assessment of a company’s liquidity
disclosure + description
in the banking sector, contingent liabilities
- represent potentially significant cash outflows that are not dependent on the bank’s financial condition
- macroeconomic or market crisis can trigger a substantial increase in cash outflows because of the increase in defaults and business bankruptcies
Reason
macroeconomic or market crisis can trigger a substantial increase in cash outflows related to contingent liabilties
- because of the increase in defaults and business bankruptcies that often accompany such events
- such crises are usually characterized by diminished levels of overall liquidity, which can further exacerbate funding shortfalls
sector
contingent liabilities warrant particular attention
banking sector
ratios
three measures of a company’s ability to pay current liabilities
- current
- quick
- cash
Concept
measures how long a company can pay its daily cash expenditures using only its existing liquid assets, without additional cash flow coming in
defensive interval ratio
Concept
colloquial term for the defensive interval ratio
burn rate
Concept
a financial metric not in ratio form, measures the length of time required for a company to go from cash paid (used in its operations) to cash received (as a result of its operations)
cash conversion cycle
Concept
is sometimes expressed as the length of time funds are tied up in working capital
cash conversion cycle
Calculation
current ratio
Numerator
* ……….current assets
Denominator
* ………current liabilities
Calculation
quick ratio
Numerator
* Cash + Short-term marketable investments + Receivables
Denominator
* current liabilities
Calculation
cash ratio
Numerator
* Cash + Short-term marketable investments
Denominator
* current liabilities
Calculation
defensive interval ratio
Numerator
* Cash + Short-term marketable investments + Receivables
Denominator
* daily cash expenditures
Calculation
cash conversion cycle
(net operating cycle)
DOH + DSO - number of days of payables
indication
a higher current ratio
- indicates a higher level of liquidity (i.e., a greater ability to meet short-term obligations)
indication
current ratio of 1.0
would indicate that the book value of its current assets exactly equals the book value of its current liabilities
Concept
is more conservative than the current ratio because it includes only the more liquid current assets
quick ratio
Ratio
ratio reflects the fact that certain current assets—such as prepaid expenses, some taxes and employee-related prepayments—represent costs of the current period that have been paid in advance and cannot usually be converted back
quick ratio
Concept
ratio also reflects the fact that inventory might not be easily and quickly converted into cash
quick ratio
Concept
in situations where inventories are illiquid, this ratio may be a better indicator of liquidity
quick ratio
Describe
quick ratio
- This ratio reflects the fact that inventory might not be easily and quickly converted into cash
- certain current assets—such as prepaid expenses, some taxes, and employee-related prepayments—represent costs of the current period that have been paid in advance
Concept
normally represents a reliable measure of an entity’s liquidity in a crisis situation
cash ratio
Describe
cash ratio
normally represents a reliable measure of an entity’s liquidity in a crisis situation
reason
cash ratio is susceptible to market crises
- fair value of highly marketable short-term investments could decrease significantly as a result of market factors
indication
a defensive interval ratio of 50
indicates that the company can continue to pay its operating expenses for 50 days before running out of quick assets
analysis
very low defensive interval ratio relative to peer companies
the analyst would want to ascertain whether there is sufficient cash inflow expected to mitigate the low defensive interval ratio
Concept
This metric indicates the amount of time that elapses from the point when a company invests in working capital until the point at which the company collects cash
cash conversion cycle (net operating cycle)
describe
cash conversion cycle in merchandising company
The time between the outlay of cash and the collection of cash
indication
a shorter cash conversion cycle
indicates greater liquidity
better credit collection
indication
a longer cash conversion cycle
- indicates lower liquidity
- implies that the company must finance its inventory and accounts receivable for a longer period of time
liquidity analysis
- the minimal DOH indicates that Apple maintains lean inventories attributable to key aspects of the company’s business model where manufacturing is outsourced
- in isolation, the increase in number of days payable (86 to 112) might suggest an inability to pay suppliers; however, Apple’s $70 billion in cash and short-term investments would suggest otherwise.
- negative cash cycle—Apple takes advantage of favorable credit terms
- Apple has excess cash to invest for over 50 days
