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CFA Level I > Vol. 3 LM4 Common-Size Balance Sheets > Flashcards

Vol. 3 LM4 Common-Size Balance Sheets Flashcards

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CFA flashcards
1
Q

Define

common-size analysis

Common-size Analysis

A

describe tools and techniques used in financial analysis, including their uses and limitations, either by vertical or horizontal methods using ratios

Common-size Analysis

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2
Q

Define

describe tools and techniques used in financial analysis, including their uses and limitations

A

common-size analysis

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3
Q

A vertical common-size balance sheet is prepared by

Common-size Analysis

A

dividing each item on the blanace sheet by the same period’s total assets and expressing the results as percentages

Common-size Analysis

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4
Q

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

A

vertical analysis; horizontal analysis

Common-size Analysis

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5
Q

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

A

cross-sectional analysis

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6
Q

Describe

cross-sectional analysis

A

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

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7
Q

Concept

provides important information regarding historical performance and growth and, given a sufficiently long history of accurate seasoned information

A

trend analysis

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8
Q

Fill in the blank

In financial statement analysis, the “trend analysis” usually refers to comparisons across time periods of ____ not involving statistical tools

A

3-10 years

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9
Q

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%

A
  • 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

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10
Q

comparative growth information

Receivables growing faster than revenue can indicate

A

operational issues such as lower credit standards or aggressive accounting policies for revenue recognition

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11
Q

comparative growth information

inventory growing faster than revenue can indicate

A

an operational problem with obsolescence or aggressive accounting policies, such as an improper overstatement of inventory to increase profits

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12
Q

common-size financial statement ratios

a common indicator of profitability

A

the net profit margin
* calculated as net income divided by sales
* this ratio appears on a vertical common-size income statement

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13
Q

because of the large number of ratios, it is helpful to think about ratios in terms of

A

broad categories based on what aspects of performance a ratio is intended to detect

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14
Q

financial ratio category

measures how efficiently a company performs day-to-day tasks, such as the collection of receivables and management of inventory

A

activity ratios

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15
Q

Describe

activity ratios

A

measures how efficiently a company performs day-to-day tasks, such as the collection of receivables and management of inventory

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16
Q

financial ratio category

measures the company’s ability to meet its short-term obligations

A

liquidity ratios

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17
Q

describe

liquidity ratios

A

measures the company’s ability to meet its short-term obligations

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18
Q

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
A

solvency ratios

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19
Q

Describe

solvency ratios

A
  • measures a company’s ability to meet long-term obligations
  • subsets of these ratios are also known as “leverage” and “long-term debt” ratios
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20
Q

financial ratio category

measures the company’s ability to generate profits from its resources (assets)

A

profitability ratios

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21
Q

Describe

profitability ratios

A

measures the company’s ability to generate profits from its resources (assets)

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22
Q

financial ratio category

measure the quantity of an asset or flow associated with ownership of a specified claim

A

valuation ratios

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23
Q

Describe

valuation ratios

A

measure the quantity of an asset or flow associated with ownership of a specified claim

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24
Q

goal

financial ratios

A

to understand the underlying causes of divergence between a company’s ratios and those of the industry

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25
Q

list three principles

an analyst should evaluate financial ratios

A
  1. Company goals and strategy
  2. Industry norms (cross-sectional analysis)
  3. Economic conditions
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26
Q

financial ratio analysis

Company goals and strategy

A
  • 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
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27
Q

financial ratio analysis

Industry norms (cross-sectional analysis)

A

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

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28
Q

financial ratio analysis

Economic conditions

A
  • 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
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29
Q

ratio

are also known as asset utilization ratios or operating efficiency ratios

A

activity ratios

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30
Q

Concept

these ratios reflect the efficient management of both working capital and longer term assets

A

activity ratios

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31
Q

Fill in the blank

____ has a direct impact on liquidity (the ability of a company to meet its short-term obligations)

A

efficiency

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32
Q

ratio

Since efficiency has a direct impact on liquidity, certain ____ are also useful in assessing liquidity

A

activity ratio

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33
Q

Components

inventory turnover

A
  • activity ratio
    numerator: cost of sales or cost of goods sold
    denominator: average inventory
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34
Q

Components

days of inventory on hand (DOH)

A
  • activity ratio
    numerator: number of days in period
    denominator: inventory turnover = cost of goods sold/average inventory
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35
Q

Components

receivables turnover

A
  • activity ratio
    numerator: revenue
    denominator: average receivables
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36
Q

Components

days of sales outstanding (DSO)

A
  • activity ratio
    numerator: number of days in period
    denominator: receivables turnover = revenue/average receivables
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37
Q

Components

payables turnover

A
  • activity ratio
    numerator: purchases
    denominator: average trade payables
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38
Q

Components

number of days of payables

A
  • activity ratio
    numerator: number of days in period
    denominator: payables turnover = purchases / average trade payables
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39
Q

Components

working capital turnover

A
  • activity ratio
    numerator: revenue
    denominator: average working capital
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40
Q

Components

fixed asset turnover

A
  • activity ratio
    numerator: revenue
    denominator: average net fixed assets
41
Q

Components

total asset turnover

A
  • activity ratio
    numerator: revenue
    denominator: average total assets
42
Q

process

How do you compensate for the fact that activity ratios combine information from the income statement and the balance sheet?

A
  • 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
43
Q

time horizon

If a semiannual report is prepared, it can be taken over

A

three periods
* beginning
* middle
* end of year

44
Q

number

  • if a quarter is 3 month, we can annualize by ____
  • if a quarter is 90 days, we can annualize by ____
A
  • 4 (12 months / 3 months)
  • 4.06 (365 days / 90 days)
45
Q

Computation of activity ratios

  1. 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

A

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

46
Q

interpretation of activity ratios

a higher inventory turnover ratio implies

A
  • 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

47
Q

interpretation of activity ratios

a lower inventory turnover and commensurately high DOH implies

A

slow-moving inventory, perhaps due to technological obsolescence

48
Q

interpretation of activity ratios

the number of DSO represents

A

the elapsed time between a sale and cash collection
* reflecting how fast the company collects cash from customers to whom it offers credit

49
Q

Interpretation of activity ratios

a relatively high receivables turnover ratio (and commensurately low DSO) might indicate

A

highly efficient credit and collection

50
Q

interpretation of activity ratios

a relatively low receivables turnover ratio

A

would typically raise questions about the efficiency of the company’s credit and collections

51
Q

indications of activity ratios

what might indicate highly efficient credit and collection

A

a relatively high receivables turnover ratio (and commensurately low DSO) might indicate

52
Q

interpretation of activity ratios

the number of days of payables and the payables turnover ratio reflects

A
  • 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
53
Q

interpretation of activity ratios

A payables turnover ratio that is high relative to the industry could indicate

A

the company is not making full use of available credit facilities

54
Q

interpretation of activity ratios

an excessively low turnover ratios could indicate (high days payable)

A

could indicate trouble making payments on time, or alternatively, exploitation of lenient supplier terms

55
Q

Concept

is defined as current assets minus current liabilities
* current assets - current liabilities

A

working capital

56
Q

describe

working capital turnover

A
  • indicates how efficiently the company generates revenue with its working capital
57
Q

Indication

working capital turnover ratio = 4.0

A
  • indicates that the company generates $4 of revenue for every $1 of working capital
58
Q

indication

high working capital turnover ratio

A

greater efficiency (i.e., the company is generating a high level of revenues relative to working capital

59
Q

Concept

measures how efficiently the company generates revenues from its investments in fixed assets

A

fixed asset turnover

60
Q

Define

fixed asset turnover

A

measures how efficiently the company generates revenues from its investment in fixed assets

61
Q

indication

higher fixed asset turnover ratio

A

more efficient use of fixed assets in generating revenue

62
Q

indication

low ratio can indicate inefficiency

A
  • 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
63
Q

considerations in

asset turnover

A

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

64
Q

Reason

year-to-year changes in the fixed asset turnover may not be as important

A
  • increases in fixed assets may not follow a smoooth pattern
65
Q

Concept

measures the company’s overall ability to generate revenues with a given level of assets

A

total asset turnover

66
Q

When interpreting activity ratios

the analysts should …

A
  • examine not only the individual ratios, but also
  • the collection of relevant ratios to determine the overall efficiency of a company
67
Q

interpret activity ratios

  • focuses on cash flows
  • measures a company’s ability to meet its short-term obligations
A

liquidity ratios
OR
liquidity analysis

68
Q

day-to-day operations

liquidity management

A

is typically achieved through efficient use of assets

69
Q

disclosure+ description

contingent liabilities in the non-banking sector

A
  • 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
70
Q

disclosure + description

in the banking sector, contingent liabilities

A
  • 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
71
Q

Reason

macroeconomic or market crisis can trigger a substantial increase in cash outflows related to contingent liabilties

A
  • 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
72
Q

sector

contingent liabilities warrant particular attention

A

banking sector

73
Q

ratios

three measures of a company’s ability to pay current liabilities

A
  • current
  • quick
  • cash
74
Q

Concept

measures how long a company can pay its daily cash expenditures using only its existing liquid assets, without additional cash flow coming in

A

defensive interval ratio

75
Q

Concept

colloquial term for the defensive interval ratio

A

burn rate

76
Q

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)

A

cash conversion cycle

77
Q

Concept

is sometimes expressed as the length of time funds are tied up in working capital

A

cash conversion cycle

78
Q

Calculation

current ratio

A

Numerator
* ……….current assets

Denominator
* ………current liabilities

79
Q

Calculation

quick ratio

A

Numerator
* Cash + Short-term marketable investments + Receivables

Denominator
* current liabilities

80
Q

Calculation

cash ratio

A

Numerator
* Cash + Short-term marketable investments

Denominator
* current liabilities

81
Q

Calculation

defensive interval ratio

A

Numerator
* Cash + Short-term marketable investments + Receivables

Denominator
* daily cash expenditures

82
Q

Calculation

cash conversion cycle
(net operating cycle)

A

DOH + DSO - number of days of payables

83
Q

indication

a higher current ratio

A
  • indicates a higher level of liquidity (i.e., a greater ability to meet short-term obligations)
84
Q

indication

current ratio of 1.0

A

would indicate that the book value of its current assets exactly equals the book value of its current liabilities

85
Q

Concept

is more conservative than the current ratio because it includes only the more liquid current assets

A

quick ratio

86
Q

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

A

quick ratio

87
Q

Concept

ratio also reflects the fact that inventory might not be easily and quickly converted into cash

A

quick ratio

88
Q

Concept

in situations where inventories are illiquid, this ratio may be a better indicator of liquidity

A

quick ratio

89
Q

Describe

quick ratio

A
  • 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
90
Q

Concept

normally represents a reliable measure of an entity’s liquidity in a crisis situation

A

cash ratio

91
Q

Describe

cash ratio

A

normally represents a reliable measure of an entity’s liquidity in a crisis situation

92
Q

reason

cash ratio is susceptible to market crises

A
  • fair value of highly marketable short-term investments could decrease significantly as a result of market factors
93
Q

indication

a defensive interval ratio of 50

A

indicates that the company can continue to pay its operating expenses for 50 days before running out of quick assets

94
Q

analysis

very low defensive interval ratio relative to peer companies

A

the analyst would want to ascertain whether there is sufficient cash inflow expected to mitigate the low defensive interval ratio

95
Q

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

A

cash conversion cycle (net operating cycle)

96
Q

describe

cash conversion cycle in merchandising company

A

The time between the outlay of cash and the collection of cash

97
Q

indication

a shorter cash conversion cycle

A

indicates greater liquidity

better credit collection

98
Q

indication

a longer cash conversion cycle

A
  • indicates lower liquidity
  • implies that the company must finance its inventory and accounts receivable for a longer period of time
99
Q

liquidity analysis

A
  • 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

CFA Level I (64 decks)

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