Statements. viewpoints PART TWO


 Estella Brooks
 2 years ago
 Views:
Transcription
1 PART TWO 3 Analyzing Financial Statements viewpoints Business Application The managers of DPH Tree Farm, Inc., have released public statements that the firm s performance surpasses that of other firms in the industry. They cite the firm s liquidity and asset management positions as particularly strong. DPH s superior performance in these areas has resulted in superior overall returns for their stockholders. What are the key financial ratios that DPH Tree Farm, Inc., needs to calculate and evaluate in order to justify these statements? (See solution on p. 99) Personal Application Chris Ryan is looking to invest in DPH Tree Farm, Inc. Chris has the most recent set of financial statements from DPH Tree Farm s annual report but is not sure how to evaluate them or measure the firm s performance relative to other firms in the industry. What are the financial ratios with which Chris should measure the performance of DPH Tree Farm, Inc.? How can Chris use these ratios to evaluate the firm s performance? (See solution on p. 99) So how can these financial ratios work in your life? 76
2 Final PDF to printer Learning Goals LG31 Calculate and interpret major liquidity ratios. LG32 Calculate and interpret major asset management ratios. LG33 Calculate and interpret major debt ratios. LG34 Calculate and interpret major profitability ratios. LG35 Calculate and interpret major market value ratios. LG36 Appreciate how various ratios relate to one another. LG37 Understand the differences between time series and crosssectional ratio analysis. LG38 Explain cautions that should be taken when examining financial ratios. W e reviewed the major financial statements in Chapter 2. These financial statements provide information on a firm s financial position at a point in time or its operations over some past period of time. But these financial statements real value lies in the fact that managers, investors, and analysts can use the information the statements contain to analyze the current financial performance or condition of the firm. More importantly, managers can use this information to plan changes that will improve the firm s future performance and, ultimately, its market value. Managers, investors, and analysts universally use ratios to evaluate financial statements. Ratio analysis involves calculating and analyzing financial ratios to assess a firm s performance and to identify actions that could improve firm performance. The most frequently used ratios fall into five groups: (1) liquidity ratios, (2) asset management ratios, (3) debt management ratios, (4) profitability ratios, and (5) market value ratios. Each of the five groups focuses on a specific area of the financial statements that managers, investors, and analysts assess. In this chapter, we review these ratios, describe what each ratio means, and identify the general trend (higher or lower) that managers and investment analysts look for in each ratio. Note as we review the ratios that the number calculated for a ratio is not always good or bad and that extreme values (either high or low) can be a bad sign for a firm. We will discuss how a ratio that seems too good can actually be bad for a company. We will also see how ratios interrelate how a change in one ratio may affect the value of several ratios. It is often hard to make sense of a set of performance ratios. Thus, when managers or investors review a firm s financial position through ratio analysis, they often start by evaluating trends in the firm s financial ratios over time and by comparing their firm s ratios with that of other firms in the same industry. Finally, we discuss cautions that you should take when using ratio analysis to evaluate firm performance. As we go through the chapter, we show sample ratio analysis using the financial statements for DPH Tree Farm, Inc., listed in Tables 2.1 and cor6168x_ch03_ indd 77 27/09/13 3:56 PM
3 ratio analysis LG31 The process of calculating and analyzing financial ratios to assess the firm s performance and to identify actions needed to improve firm performance. liquidity ratios Measure the relation between a firm s liquid (or current) assets and its current liabilities. EXAMPLE Liquidity Ratios As we stated in Chapter 2, firms need cash and other liquid assets (or current assets) to pay their bills (or current liabilities) as they come due. Liquidity ratios measure the relationship between a firm s liquid (or current) assets and its current liabilities. The three most commonly used liquidity ratios are the current ratio, the quick (or acidtest) ratio, and the cash ratio. Current assets Current ratio 5 (31) Current liabilities The broadest liquidity measure, the current ratio, measures the dollars of current assets available to pay each dollar of current liabilities. Current assets 2 Inventory Quick ratio (acidtest ratio) 5 (32) Current liabilities Inventories are generally the least liquid of a firm s current assets. Further, inventory is the current asset for which book values are the least reliable measures of market value. In practical terms, what this means is that if the firm must sell inventory to pay upcoming bills, the firm will most likely have to discount inventory items in order to liquidate them, and therefore, they are the current assets on which losses are most likely to occur. Therefore, the quick (or acidtest) ratio measures a firm s ability to pay off shortterm obligations without relying on inventory sales. The quick ratio measures the dollars of more liquid assets (cash and marketable securities and accounts receivable) available to pay each dollar of current liabilities. Cas h r ati o 5 Cash and marketable securities Current liabilities LG31 (33) If the firm sells accounts receivable to pay upcoming bills, the firm must often discount the accounts receivable to sell them the assets once again bring less than their book value. Therefore, the cash ratio measures a firm s ability to pay shortterm obligations with its available cash and marketable securities. Of course, liquidity on the balance sheet is important. The more liquid assets a firm holds, the less likely the firm is to experience financial distress. Thus, the higher the liquidity ratios, the less liquidity risk a firm has. But as with everything else in business, high liquidity represents a painful tradeoff for the firm. Liquid assets generate little, if any, profits for the firm. In contrast, fixed assets are illiquid, but generate revenue for the firm. Thus, extremely high levels of liquidity guard against liquidity crises, but at the cost of lower returns on assets. High liquidity levels may actually show bad or indecisive firm management. Thus, in deciding the appropriate level of current assets to hold on the balance sheet, managers must consider the tradeoff between the advantages of being liquid versus the disadvantages of reduced profits. Note that a company with very predictable cash flows can maintain low levels of liquidity without incurring much liquidity risk. Calculating Liquidity Ratios For interactive versions of this example visit Use the balance sheet (Table 2.1) and income statement (Table 2.2) for DPH Tree Farm, Inc., to calculate the firm s 2015 values for the liquidity ratios. 78 part two Financial Statements
4 SOLUTION: The liquidity ratios for DPH Tree Farm, Inc., are calculated as follows. The industry average is reported alongside each ratio. Current ratio 5 $205m times Industry average times $120m Quick ratio (acidtest ratio) 5 $205m 2 $111m $120m times Industry average times Cash ratio 5 $24m times Industry average times $120m All three liquidity ratios show that DPH Tree Farm, Inc., has more liquidity on its balance sheet than the industry average (we discuss the process used to develop an industry average in section 3.8). Thus, DPH Tree Farm has more cash and other liquid assets (or current assets) available to pay its bills (or current liabilities) as they come due than does the average firm in the tree farm industry. Similar to Problems 31, 32, selftest problem 1 TIME OUT 31 What are the three major liquidity ratios used in evaluating financial statements? 32 How do the three major liquidity ratios used in evaluating financial statements differ? 33 Does a firm generally want to have high or low liquidity ratios? Why? 3.2 Asset Management Ratios Asset management ratios measure how efficiently a firm uses its assets (inventory, accounts receivable, and fixed assets), as well as how efficiently the firm manages its accounts payable. The specific ratios allow managers and investors to evaluate whether a firm is holding a reasonable amount of each type of asset and whether management uses each type of asset to effectively generate sales. The most frequently used asset management ratios are listed in the following sections, grouped by type of asset. LG32 asset management ratios Measure how efficiently a firm uses its assets (inventory, accounts receivable, and fixed assets), as well as its accounts payable. Inventory Management As they decide the optimal inventory level to hold on the balance sheet, managers must consider the tradeoff between the advantages of holding sufficient levels of inventory to keep the production process going versus the costs of holding large amounts of inventory. Two frequently used ratios are the inventory turnover and days sales in inventory. or cost of goods sold Inventory turnover 5 (34) Inventory The inventory turnover measures the number of dollars of sales produced per dollar of inventory. Cost of goods sold is used in the numerator when managers chapter 3 Analyzing Financial Statements 79
5 want to emphasize that inventory is listed on the balance sheet at cost, that is, the cost of sales generated per dollar of inventory. Inventory days Days' sales in inventory 5 or cost of goods sold 365 days 5 Inventory turnover (35) The days sales in inventory ratio measures the number of days that inventory is held before the final product is sold. In general, a firm wants to produce a high level of sales per dollar of inventory; that is, it wants to turn inventory over (from raw materials to finished goods to sold goods) as quickly as possible. A high level of sales per dollar of inventory implies reduced warehousing, monitoring, insurance, and any other costs of servicing the inventory. So, a high inventory turnover ratio or a low days sales in inventory is generally a sign of good management. However, if the inventory turnover ratio is extremely high and the days sales in inventory is extremely low, the firm may not be holding sufficient inventory to prevent running out (or stocking out) of the raw materials needed to keep the production process going. Thus, production and sales stop, which wastes the firm s fixed resources. So, extremely high levels for the inventory turnover ratio and low levels for the days sales in inventory ratio may actually be a sign of bad firm or production management. Note that companies with very good supply chain relations can maintain lower levels of inventory without incurring as much risk of stockouts. 80 part two Financial Statements Accounts Receivable Management As they decide what level of accounts receivable to hold on the firm s balance sheet, managers must consider the tradeoff between the advantages of increased sales by offering customers better terms versus the disadvantages of financing large amounts of accounts receivable. Two ratios used here are the accounts receivable turnover and average collection period. Credit sales Accounts receivable turnover 5 (36) Accounts receivable The accounts receivable turnover measures the number of dollars of sales produced per dollar of accounts receivable. Accounts receivable days Average collection period (ACP) 5 Credit sales 365 days 5 Accounts receivable turnover (37) The average collection period (ACP) measures the number of days accounts receivable are held before the firm collects cash from the sale. This ratio is also sometimes termed the days sales outstanding (DSO). In general, a firm wants to produce a high level of sales per dollar of accounts receivable; that is, it wants to collect its accounts receivable as quickly as possible to reduce any cost of financing accounts receivable, including interest expense on liabilities used to finance accounts receivable and defaults associated with accounts receivable. In general, a high accounts receivable turnover or a low ACP is a sign of good management, which is well aware of financing costs and customer remittance habits. However, if the accounts receivable turnover is extremely high and the ACP is extremely low, the firm s accounts receivable policy may be so strict that
6 customers prefer to do business with competing firms. Firms offer accounts receivable terms as an incentive to get customers to buy products from their firm rather than a competing firm. By offering customers the accounts receivable privilege, management allows them to buy (more) now and pay later. Without this incentive, customers may choose to buy the goods from the firm s competitors who offer better credit terms. So extremely high accounts receivable turnover levels and low ACP levels may be a sign of bad firm management. Accounts Payable Management As they decide the accounts payable level to hold on the balance sheet, managers must consider the tradeoff between maximizing the use of free financing that raw material suppliers offer versus the risk of losing the opportunity to buy on account. Two ratios commonly used are the accounts payable turnover and average payment period. Cost of goods sold Accounts payable turnover 5 (38) Accounts payable The accounts payable turnover ratio measures the dollar cost of goods sold per dollar of accounts payable. Accounts payable days Average payment period (APP) 5 Cost of goods sold 365 days 5 Accounts payable turnover (39) The average payment period (APP) measures the number of days that the firm holds accounts payable before it has to extend cash to pay for its purchases. In general, a firm wants to pay for its purchases as slowly as possible. The slower the firm pays for its supply purchases, the longer it can avoid obtaining other costly sources of financing such as notes payable or longterm debt. Thus, a low accounts payable turnover or a high APP is generally a sign of good management. However, if the accounts payable turnover is extremely low and the APP is extremely high, the firm may be abusing the credit terms that its raw materials suppliers offer. At some point, the firm s suppliers may revoke its ability to buy raw materials on account and the firm will lose this source of free financing. If this situation is developing, extremely low levels for the accounts receivable turnover and high levels for the APP may point to bad firm management. Fixed Asset and Working Capital Management Two ratios that summarize the efficiency in a firm s overall asset management are the fixed asset turnover and sales to working capital ratios. Fixed asset turnover 5 Net fixed assets (310) The fixed asset turnover ratio measures the number of dollars of sales produced per dollar of net fixed assets. to working capital 5 Working capital (311) Similarly, the sales to working capital ratio measures the number of dollars of sales produced per dollar of net working capital (current assets minus current liabilities). chapter 3 Analyzing Financial Statements 81
7 In general, the higher the level of sales per dollar of fixed assets and working capital, the more efficiently the firm is being run. Thus, high fixed asset turnover and sales to working capital ratios are generally signs of good management. However, if either the fixed asset turnover or sales to working capital ratio is extremely high, the firm may be close to its maximum production capacity. If capacity is hit, the firm cannot increase production or sales. Accordingly, extremely high fixed asset turnover and sales to working capital ratio levels may actually indicate bad firm management if managers have allowed the company to approach maximum capacity without making any accommodations for growth. Note a word of caution here. The age of a firm s fixed assets will affect the fixed asset turnover ratio level. A firm with older fixed assets, listed on its balance sheet at historical cost, will tend to have a higher fixed asset turnover ratio than will a firm that has just replaced its fixed assets and lists them on its balance sheet at a (most likely) higher value. Accordingly, the firm with newer fixed assets would have a lower fixed asset turnover ratio. But this is because it has updated its fixed assets, while the other firm has not. It is not correct to conclude that the firm with new assets is underperforming relative to the firm with older fixed assets listed on its balance sheet. Similarly, for firms that are in an expansion phase, a lower fixed asset turnover is actually a good sign. It is not correct to conclude that a firm with expanding assets is underperforming relative to a firm with no growth. Total Asset Management The final two asset management ratios put it all together. They are the total asset turnover and capital intensity ratios. Total asset turnover 5 (312) The total asset turnover ratio measures the number of dollars of sales produced per dollar of total assets. Capital intensity 5 (313) Similarly, the capital intensity ratio measures the dollars of total assets needed to produce a dollar of sales. In general, a wellmanaged firm produces many dollars of sales per dollar of total assets, or uses few dollars of assets per dollar of sales. Thus, in general, the higher the total asset turnover and lower the capital intensity ratio, the more efficient the overall asset management of the firm will be. However, if the total asset turnover is extremely high and the capital intensity ratio is extremely low, the firm may actually have an asset management problem. As described above, inventory stockouts, capacity problems, or tight account receivables policies can all lead to a high total asset turnover and may actually be signs of poor firm management. EXAMPLE 32 For interactive versions of this example visit Calculating Asset Management Ratios LG32 Use the balance sheet (Table 2.1) and income statement (Table 2.2) for DPH Tree Farm, Inc., to calculate the firm s 2015 values for the asset management ratios. 82 part two Financial Statements
8 SOLUTION: We calculate the asset management ratios for DPH Tree Farm, Inc., as follows. The industry average is reported alongside each ratio. i. Inv e ntory turnov e r 5 $315m times Industry average times $111m ii. $111m days 365 days Days' sales in inventory days Industry average days $315m 2.84 times iii. Accounts receivable turnover 5 $315m $70m times Industry average times iv. $70m days 365 days Av e rage col l e cti on pe ri od days Industry average 5 95 days $315m 4.50 times v. Accounts payable turnover 5 $133m $55m times Industry average times vi. $55m days 365 days Average payment period days Industry average days $133m 2.42 times vii. Fixed asset turnover 5 $315m times Industry average times $315m viii. to working capital 5 $315m times Industry average times $205m 2 $120m ix. turnover 5 $315m times Industry average times $570m x. Capital intensity 5 $570m times Industry average times $315m In all cases, asset management ratios show that DPH Tree Farm, Inc., is outperforming the industry average. The firm is turning over its inventory faster than the average firm in the tree farm industry, thus producing more dollars of sales per dollar of inventory. It is also collecting its accounts receivable faster and paying its accounts payable slower than the average firm. Further, DPH Tree Farm is producing more sales per dollar of fixed assets, working capital, and total assets than the average firm in the industry. Similar to Problems 33, 34, selftest problem 1 TIME OUT 34 What are the major asset management ratios? 35 Does a firm generally want to have high or low values for each of these ratios? 36 Explain why many of these ratios are mirror images of one another. chapter 3 Analyzing Financial Statements 83
9 debt management ratios LG33 Measure the extent to which the firm uses debt (or financial leverage) versus equity to finance its assets as well as how well the firm can pay off its debt. capital structure The amount of debt versus equity held on the balance sheet. 3.3 Debt Management Ratios As we discussed in Chapter 2, financial leverage refers to the extent to which the firm uses debt securities in its capital structure. The more debt a firm uses as a percentage of its total assets, the greater is its financial leverage. Debt management ratios measure the extent to which the firm uses debt (or financial leverage) versus equity to finance its assets as well as how well the firm can pay off its debt. The specific ratios allow managers and investors to evaluate whether a firm is financing its assets with a reasonable amount of debt versus equity financing, as well as whether the firm is generating sufficient earnings or cash to make the promised payments on its debt. The most commonly used debt management ratios are listed in the following sections. Debt versus Equity Financing Managers choice of capital structure the amount of debt versus equity to issue affects the firm s viability as a longterm entity. In deciding the level of debt versus equity financing to hold on the balance sheet, managers must consider the tradeoff between maximizing cash flows to the firm s stockholders versus the risk of being unable to make promised debt payments. Ratios that are commonly used are the debt ratio, debttoequity, and equity multiplier. D e b t r ati o 5 Total debt The debt ratio measures the percentage of total assets financed with debt. D e b t to  e q u i ty 5 Total debt Total equity (314) (315) The debttoequity ratio measures the dollars of debt financing used for every dollar of equity financing. Equity multiplier 5 Total equity or Common stockholders equity (316) The equity multiplier ratio measures the dollars of assets on the balance sheet for every dollar of equity (or just common stockholders equity) financing. As you might suspect, all three measures are related. 1 Sp e c i f ic a l ly, Debt ratio Debttoequity 5 1 Equity multiplier 5 1 (1/Debttoequity) Equity multiplier 2 1 (1/Debt ratio) Equity multiplier Debt ratio 5 Debttoequity 1 1 So, the lower the debt, debttoequity, or equity multiplier, the less debt and more equity the firm uses to finance its assets (i.e., the bigger the firm s equity cushion). When a firm issues debt to finance its assets, it gives the debt holders first claim to a fixed amount of its cash flows. Stockholders are entitled to any residual 84 part two Financial Statements 1 To see this remember the balance sheet identity is Assets (A) 5 Debt (D) 1 Equity (E). Dividing each side of this equation by assets, we get A/A 5 D/A 1 E/A. Rearranging this equation, D/A 5 A/A 2 E/A E/A [1/(A/E)]. Also, D/A 5 (A 2 E)/A 5 1/[A/(A 2 E)] 5 1/ [(A 2 E 1 E)/(A 2 E)] 5 1/[(E/(A 2 E) 1 (A 2 E)/(A 2 E)] 5 1/[E/D 1 1] 5 1/[1/(D/E) 1 1]. Dividing each side of the balance sheet identity equation by equity, we get A/E 5 D/E 1 E/E, or A/E 5 D/E 1 1. Also, rearranging this equation, D/E 5 A/E 2 1.
10 cash flows those left after debt holders are paid. When a firm does well, financial leverage increases the reward to shareholders since the amount of cash flows promised to debt holders is constant and capped. So when firms do well, financial leverage creates more cash flows to share with stockholders it magnifies the return to the stockholders of the firm (recall Example 25). This magnification is one reason that stockholders encourage the use of debt financing. However, financial leverage also increases the firm s potential for financial distress and even failure. If the firm has a bad year and cannot make promised debt payments, debt holders can force the firm into bankruptcy. Thus, a firm s current and potential debt holders (and even stockholders) look at equity financing as a safety cushion that can absorb fluctuations in the firm s earnings and asset values and guarantee debt service payments. Clearly, the larger the fluctuations or variability of a firm s cash flows, the greater the need for an equity cushion. Coverage Ratios Three additional debt management ratios are the times interest earned, fixedcharge coverage, and cash coverage ratios. These ratios are different measures of a firm s ability to meet its debt obligations. Times interest earned 5 EBIT Interest (317) The times interest earned ratio measures the number of dollars of operating earnings available to meet each dollar of interest obligations on the firm s debt. Earnings available to meet fixed charges Fixedcharge coverage 5 Fixed charges (318) The fixedcharge coverage ratio measures the number of dollars of operating earnings available to meet the firm s interest obligations and other fixed charges. EBIT 1 Depreciation Cas h c o v e r age 5 Fixed charges (319) The cash coverage ratio measures the number of dollars of operating cash available to meet each dollar of interest and other fixed charges that the firm owes. With the help of the times interest earned, fixedcharge coverage, and cash coverage ratios, managers, investors, and analysts can determine whether a firm has taken on a debt burden that is too large. These ratios measure the dollars available to meet debt and other fixedcharge obligations. A value of one for these ratios means that $1 of earnings or cash is available to meet each dollar of interest or fixedcharge obligations. A value of less (greater) than one means that the firm has less (more) than $1 of earnings or cash available to pay each dollar of interest or fixedcharge obligations. 2 Further, the higher the times interest earned, fixedcharge coverage, and cash coverage ratios, the more equity and less debt the firm uses to finance its assets. Thus, low levels of debt will lead to a dilution of the return to stockholders due to increased use of equity as well as to not taking advantage of the tax deductibility of interest expense. 2 The fixedcharge and cash coverage ratios can be tailored to a particular firm s situation, depending on what really constitutes fixed charges that must be paid. One version of it follows: (EBIT 1 Lease payments)/[interest 1 Lease payments 1 Sinking fund/(1 2 t )], where t is the firm s marginal tax rate. Here, it is assumed that sinking fund payments must be made. They are adjusted by the division of (1 2 t ) into a beforetax cash outflow so they can be added to other beforetax cash outflows. chapter 3 Analyzing Financial Statements 85
11 EXAMPLE 33 For interactive versions of this example visit Calculating Debt Management Ratios Use the balance sheet (Table 2.1) and income statement (Table 2.2) for DPH Tree Farm, Inc., to calculate the firm s 2015 values for the debt management ratios. SOLUTION: LG33 The debt management ratios for DPH Tree Farm, Inc., are calculated as follows. The industry average is reported alongside each ratio. i. De bt rati o 5 ii. De bttoequity 5 $120m 1 $195m $570m $120m 1 $195m $255m % Industry average % times Industry average times iii. Equity multiplier 5 $570m times Industry average times $255m or iv. Times interest earned 5 $152m $16m v. Fi x e dcharge coverage 5 $152m $16m vi. C as h cov e rage 5 $570m times Industry average times $255m 2 $5m $152m 1 $13m $16m times Industry average times times Industry average times times Industry average times In all cases, debt management ratios show that DPH Tree Farm, Inc., holds less debt on its balance sheet than the average firm in the tree farm industry. Further, the firm has more dollars of operating earnings and cash available to meet each dollar of interest obligations (there are no other fixed charges listed on DPH Tree Farm s income statement) on the firm s debt. This lack of financial leverage decreases the firm s potential for financial distress and even failure, but may also decrease equity shareholders chance for magnified earnings. If the firm has a bad year, it has promised relatively few payments to debt holders. Thus, the risk of bankruptcy is small. However, when DPH Tree Farm, Inc., does well, the low level of financial leverage dilutes the return to the stockholders of the firm. This dilution of profit is likely to upset common stockholders of the firm. Similar to Problems 35, 36, selftest problem 1 profitability ratios Ratios that show the combined effect of liquidity, asset management, and debt management on the firm s overall operating results. TIME OUT 37 What are the major debt management ratios? 38 Does a firm generally want to have high or low values for each of these ratios? 39 What is the tradeoff between using too much financial leverage and not using enough leverage? Who is likely to complain the most in each case? LG part two Financial Statements 3.4 Profitability Ratios The liquidity, asset management, and debt management ratios examined so far allow for an isolated or narrow look at a firm s performance. Profitability ratios show the combined effects of liquidity, asset management, and debt management on the overall operating results of the firm. Profitability ratios are among
12 the most watched and best known of the financial ratios. Indeed, firm values (or stock prices) react quickly to unexpected changes in these ratios. The most commonly used profitability ratios are listed below. 2 Cost of goods sold Gross profit margin 5 (320) The gross profit margin is the percent of sales left after costs of goods sold are deducted. Operating profit margin 5 EBIT (321) The operating profit margin is the percent of sales left after all operating expenses are deducted. Profit margin 5 Net income available to common stockholders (322) The profit margin is the percentage of sales left after all firm expenses are deducted. Thus, this ratio provides the net profit margin of the firm, as opposed to the gross profit or operating profit margin. Bas i c e ar ni ngs p o w e r ( BEP) 5 EBIT (323) The basic earnings power ratio measures the operating return on the firm s assets, regardless of financial leverage and taxes. This ratio measures the operating profit (EBIT) earned per dollar of assets on the firm s balance sheet. Return on assets (ROA) 5 Net income available to common stockholders (324) Return on assets (ROA) measures the overall return on the firm s assets, including financial leverage and taxes. This ratio is the net income earned per dollar of assets on the firm s balance sheet. Return on equity (ROE) 5 Net income available to common stockholders Common stockholders equity (325) Return on equity (ROE) measures the return on the common stockholders investment in the assets of the firm. ROE is the net income earned per dollar of common stockholders equity. The value of a firm s ROE is affected not only by net income, but also by the amount of financial leverage or debt that firm uses. As stated previously, financial leverage magnifies the return to the stockholders of the firm. However, financial leverage also increases the firm s potential for financial distress and even failure. Generally, a high ROE is considered to be a positive sign of firm performance. However, if performance comes from a high degree of financial leverage, a high ROE can indicate a firm with an unacceptably high level of bankruptcy risk as well. D i v i de nd p ayo u t 5 Common stock dividends Net income available to common stockholders (326) Finally, the dividend payout ratio is the percentage of net income available to common stockholders that the firm actually pays as cash to these investors. For all but the dividend payout, the higher the value of the ratio, the higher the profitability of the firm. But just as has been the case previously in this chapter, high profitability ratio levels may result from poor management in other areas chapter 3 Analyzing Financial Statements 87
13 EXAMPLE 34 For interactive versions of this example visit of the firm as much as superior financial management. A high profit (and gross profit or operating profit) margin means that the firm has low expenses relative to sales. The BEP reflects how much the firm s assets earn from operations, regardless of financial leverage and taxes. It follows logically that managers, investors, and analysts find BEP a useful ratio when they compare firms that differ in financial leverage and taxes. In contrast, ROA measures the firm s overall performance. It shows how the firm s assets generate a return that includes financial leverage and tax decisions made by management. ROE measures the return on common stockholders investment. Since managers seek to maximize common stock price, managers, investors, and analysts monitor ROE above all other ratios. The dividend payout ratio measures how much of the profit the firm retains versus how much it pays out to common stockholders as dividends. The lower the dividend payout ratio, the more profits the firm retains for future growth or other projects. A profitable firm that retains its earnings increases its level of equity capital as well as its own value. Calculating Profitability Ratios Use the balance sheet (Table 2.1) and income statement (Table 2.2) for DPH Tree Farm, Inc., to calculate the firm s 2015 values for the profitability ratios. SOLUTION: LG34 The profitability ratios for DPH Tree Farm, Inc., are calculated as follows. The industry average is reported alongside each ratio. i. Gros s profi t margi n 5 $182m % Industry average % $315m ii. O pe rati ng profi t margi n5 $152m % Industry average % $315m iii. Profit margin 5 $80m % Industry average % $315m iv. Bas i c e arni ngs powe r (BEP) 5 $152m % Industry average % $570m v. Return on assets (ROA) 5 $80m % Industry average % $570m vi. Return on equity (ROE) 5 $80m % Industry average % $40m 1 $210m vii. Dividend payout 5 $25m % Industry average % $80m These ratios show that DPH Tree Farm, Inc., is more profitable than the average firm in the tree farm industry. The profit margin, gross profit margin, operating profit margin, BEP, and ROA are all higher than industry figures. Despite this, the ROE for DPH Tree Farm is much lower than the industry average. DPH s low debt level and high equity level relative to the industry is the main reason for DPH s strong figures relative to the industry. As we mentioned above, DPH s managerial decisions about capital structure dilute its returns, which will likely upset its common stockholders. To counteract common stockholders discontent, DPH Tree Farm pays out a slightly larger percentage of its income to its common stockholders as cash dividends. Of course, this slightly high dividend payout ratio means that DPH Tree Farm retains less of its profits to reinvest into the business. A profitable firm that retains its earnings increases its equity capital level as well as its own value. Similar to Problems 37, 38, selftest problem 1 88 part two Financial Statements
14 TIME OUT 310 What are the major profitability ratios? 311 Does a firm generally want to have high or low values for each of these ratios? 312 What are the tradeoffs to having especially high or low values for ROE? 3.5 Market Value Ratios As noted, ROE is a most important financial statement ratio for managers and investors to monitor. Generally, a high ROE is considered to be a positive sign of firm performance. However, if a high ROE results from a highly leveraged position, it can signal a firm with a high level of bankruptcy risk. While ROE does not directly incorporate this risk, for publicly traded firms, market prices of the firm s stock do. (We look at stock valuation in Chapter 8.) Since the firm s stockholders earn their returns primarily from the firm s stock market value, ratios that incorporate stock market values are equally, and arguably more, important than other financial statement ratios. The final group of ratios is market value ratios. Market value ratios relate a firm s stock price to its earnings and its book value. For publicly traded firms, market value ratios measure what investors think of the company s future performance and risk. LG35 market value ratios Ratios that relate a firm s stock price to its earnings and book value. Market price per share Markettobook ratio 5 Book value per share (327) The markettobook ratio measures the amount that investors will pay for the firm s stock per dollar of equity used to finance the firm s assets. Book value per share is an accountingbased number reflecting the firm s assets historical costs, and hence historical value. The markettobook ratio compares the market (current) value of the firm s equity to its historical cost. In general, the higher the markettobook ratio, the better the firm. If liquidity, asset management, debt management, and accounting profitability are good for a firm, then the markettobook ratio will be high. A markettobook ratio greater than one (or 100 percent) means that stockholders will pay a premium over book value for their equity investment in the firm. Market price per share Priceearnings (PE) ratio 5 Earnings per share (328) One of the best known and most often quoted figures, the priceearnings (or PE) ratio measures how much investors are willing to pay for each dollar the firm earns per share of its stock. PE ratios are often quoted in multiples the number of dollars per share that fund managers, investors, and analysts compare within industry classes. Managers and investors often use PE ratios to evaluate the relative financial performance of the firm s stock. Generally, the higher the PE ratio, the better the firm s performance. Analysts and investors, as well as managers, expect companies with high PE ratios to experience future growth, to have rapid future dividend increases, or both, because retained earnings will support the company s goals. However, for valueseeking investors, highpe firms indicate expensive companies. Further, higher PE ratios carry greater risk because investors are willing to pay higher prices today for a stock in anticipation of higher earnings in the future. These earnings may or may not materialize. LowPE firms chapter 3 Analyzing Financial Statements 89
15 are generally companies with little expected growth or low earnings. However, note that earnings depend on many factors (such as financial leverage or taxes) that have nothing to do directly with firm operations. EXAMPLE 35 For interactive versions of this example visit Calculating Market Value Ratios Use the balance sheet (Table 2.1) and income statement (Table 2.2) for DPH Tree Farm, Inc., to calculate the firm s 2015 values for the market value ratios. SOLUTION: The market value ratios for DPH Tree Farm, Inc., are calculated as follows. The industry average is reported alongside each ratio. LG35 i. Mark e ttobook ratio 5 $ times Industry average times $12.50 ii. Pri ceearnings (PE) ratio 5 $17.25 $ times Industry average times These ratios show that DPH Tree Farm s investors will not pay as much for a share of DPH s stock per dollar of book value and earnings as the average for the industry. DPH s low leverage level and high reliance on equity relative to the industry are likely the main reason for investors disinterest. As mentioned previously, DPH s seemingly intentional return dilution will likely upset the firm s common stockholders. Accordingly, stockholders lower the amount they are willing to invest per dollar of book value and EPS. Similar to Problems 39, 310, selftest problem 1 TIME OUT 313 What are the major market value ratios? 314 Does a firm generally want to have high or low values for each of these ratios? 315 Discuss the priceearnings ratio and explain why it assumes particular importance among all of the other ratios we have presented. DuPont system of analysis LG36 An analytical method that uses the balance sheet and income statement to break the ROA and ROE ratios into component pieces. 90 part two Financial Statements 3.6 DuPont Analysis Table 3.1 (on page 92) lists the ratios we discuss, their values for DPH Tree Farm, Inc., as of 2015, and the corresponding values for the tree farm industry. The value of each ratio for DPH Tree Farm is highlighted in green if it is generally stronger than the industry and is highlighted in red if it is generally a negative sign for the firm. As we noted in this chapter s introduction, many of the ratios we have discussed thus far are interrelated. So a change in one ratio may well affect the value of several ratios. Often these interrelations can help evaluate firm performance. Managers and investors often perform a detailed analysis of ROA (return on assets) and ROE (return on equity) using the DuPont system of analysis. Popularized by the DuPont Corporation, the DuPont system of analysis uses the balance sheet and income statement to break the ROA and ROE ratios into component pieces.
16 The basic DuPont equation looks at ROA as the product of the profit margin and the total asset turnover ratios: ROA 5 Profit margin 3 Total asset turnover Net income available Net income available to common stockholders to common stockholders 5 3 (329) The basic DuPont equation looks at the firm s overall profitability as a function of the profit the firm earns per dollar of sales (operating efficiency) and the dollar of sales produced per dollar of assets on the balance sheet (efficiency in asset use). With this tool, managers can see the reason for any changes in ROA in more detail. For example, if ROA increases, the DuPont equation may show that the net profit margin was constant, but the total asset turnover (efficiency in using assets) increased, or that total asset turnover remained constant, but profit margins (operating efficiency) increased. Managers can identify the reasons for an ROA change more specifically by using the ratios described above to further break down operating efficiency and efficiency in asset use. Next, the DuPont system looks at ROE as the product of ROA and the equity multiplier. ROE 5 ROA 3 Equity multiplier Net income available to common stockholders Common stockholders equity 5 ROA 3 Common stockholders equity (330) Notice that this version of the equity multiplier uses the return to common stockholders (the firm s owners) only. So the DuPont equity multiplier uses common stockholders equity only, rather than total equity (which includes preferred stock). Taking this breakdown one step further, the DuPont system breaks ROE into the product of the profit margin, the total asset turnover, and the equity multiplier. ROE 5 Profit margin 3 Total asset turnover 3 Equity multiplier Net income available to common stockholders 5 Common stockholders equity Net income available to common stockholders 3 3 Common stockholders equity This presentation of ROE allows managers, analysts, and investors to look at the return on equity as a function of the net profit margin (profit per dollar of sales from the income statement), the total asset turnover (efficiency in the use of assets from the balance sheet), and the equity multiplier (financial leverage from the balance sheet). Again, we can break these components down to identify possible causes for a ROE change more specifically. Figure 3.1 illustrates the DuPont system of analysis breakdown of ROA and ROE. The figure highlights how many of the ratios discussed in this chapter are linked. (331) chapter 3 Analyzing Financial Statements 91
17 table 3.1 Summary of Ratios and Their Values for DPH Tree Farm, Inc., and the Tree Farm Industry Ratio Liquidity ratios: Value for DPH Tree Farm, Inc. Value for the Tree Farm Industry Current ratio 5 Current assets Current liabilities Current assets 2 Inventory Quick ratio (acidtest ratio) 5 Current liabilities Cash ratio 5 Cash and marketable securities Current liabilities Asset management ratios: or cost of goods sold Inventory turnover 5 Inventory Inventory days Days sales in inventory 5 or cost of goods sold Accounts receivable turnover 5 Credit sales Accounts receivable Accounts receivable days Average collection period 5 Credit sales Cost of goods sold Accounts payable turnover 5 Accounts payable Accounts payable days Average payment period (APP) 5 Cost of goods sold Fixed asset turnover 5 to working capital 5 Net fixed assets Working capital 1.71 times 1.50 times 0.78 times 0.50 times 0.20 times 0.15 times 2.84 times 2.15 times 129 days 170 days 4.50 times 3.84 times 81 days 95 days 2.42 times 3.55 times 151 days 102 days 1.00 times 0.85 times 3.71 times 3.20 times (Continued) figure 3.1 DuPont System Analysis Breakdown of ROA and ROE ROE ROA Equity multiplier Profit margin Total asset turnover Gross profit margin Liquidity ratios Operating profit margin Asset management ratios Basic earnings power Cost of goods sold to sales Interest expense to sales Taxes to sales 92 part two Financial Statements
18 Ratio Value for DPH Tree Farm, Inc. Value for the Tree Farm Industry turnover 5 Capital intensity times 0.40 times 1.81 times 2.50 times Debt management ratios: Debt ratio 5 Debttoequity 5 Equity multiplier 5 Total debt Total debt Total equity or Times interest earned 5 Total equity Common stockholders equity EBIT Interest Earnings available to meet fixed charges Fixedcharge coverage 5 Fixed charges EBIT 1 Depreciation Cash coverage 5 Fixed charges 55.26% 68.50% 1.24 times 2.17 times 2.24 times 4.10 times 2.28 times 4.14 times 9.50 times 5.15 times 9.50 times 5.70 times times 7.78 times Profitability ratios: 2 Cost of goods sold Gross profit margin 5 Operating profit margin 5 EBIT Profit margin 5 Basic earnings power 5 Return on assets 5 Return on equity 5 Dividend payout 5 Net income available to common stockholders EBIT Net income available to common stockholders Net income available to common stockholders Common stockholders equity Common stock dividends Net income available to common stockholders 57.78% 56.65% 48.25% 46.88% 25.40% 23.25% 26.67% 22.85% 14.04% 9.30% 32.00% 38.00% 31.25% 30.90% Market value ratios: Market price per share Markettobook ratio 5 Book value per share Market price per share Priceearnings ratio 5 Earnings per share LG times 2.15 times 4.31 times 6.25 times EXAMPLE 36 Application of DuPont Analysis Use the balance sheet (Table 2.1) and income statement (Table 2.2) for DPH Tree Farm, Inc., to calculate the firm s 2015 values for the ROA and ROE DuPont equations. SOLUTION: For interactive versions of this example visit The ROA and ROE DuPont equations for DPH Tree Farm, Inc., are calculated as follows. The industry average is reported below each ratio. chapter 3 Analyzing Financial Statements 93
19 i. ROA 5 Profit margin 3 Total asset turnover 14.04% % times Industry average: 9.30% % times Net income available to common stockholders $80m $570m 5 5 Net income available to common stockholders 3 $80m $315m 3 $315m $570m ii. ROE 5 Profit margin 3 Total asset turnover 3 Equity multiplier 32.00% % times times Industry average: 38.50% % times times Net income available to common stockholders Common stockholders equity $80m 5 $40m 1 $210m Net income available 5 to common stockholders $80m $315m 3 3 Common stockholders equity 3 $315m $570m 3 $570m $40m 1 $210m As we saw with profitability ratios, DPH Tree Farm, Inc., is more profitable than the average firm in the tree farm industry when it comes to overall efficiency expressed as return on assets, or ROA. The DuPont equation highlights that this superior performance comes from both profit margin (operating efficiency) and total asset turnover (efficiency in asset use). Despite this, the ROE for DPH Tree Farm lags the average industry ROE. The DuPont equation highlights that this inferior performance is due solely to the low level of debt and high level of equity used by DPH Tree Farm relative to the industry. Similar to Problems 311, 312 TIME OUT 316 What are the DuPont ROA and ROE equations? 317 How do each of these equations help to explain firm performance and pinpoint areas for improvement? LG36 commonsize financial statements Dividing all balance sheet amounts by total assets and all income statement amounts by net sales. 94 part two Financial Statements 3.7 Other Ratios Spreading the Financial Statements In addition to the many ratios listed, managers, analysts, and investors can also compute additional ratios by dividing all balance sheet amounts by total assets and all income statement amounts by net sales. These calculations, sometimes called spreading the financial statements, yield what we call commonsize financial statements that correct for sizes. Yeartoyear growth rates in commonsize balance sheets and income statement balances provide useful ratios for identifying trends. They also allow for an easy comparison of balance sheets and income statements across firms in the industry. Commonsize financial statements may provide quantitative clues about the direction that the firm (and perhaps the industry) is moving. They may thus provide roadmaps for managers next moves.
20 Internal and Sustainable Growth Rates Remember again that any firm manager s job is to maximize the firm s market value. The firm s ROA and ROE can be used to evaluate the firm s ability to grow and its market value to be maximized. Specifically, managers, analysts, and investors use these ratios to calculate two growth measures: the internal growth rate and the sustainable growth rate. The internal growth rate is the growth rate a firm can sustain if it uses only internal financing that is, retained earnings to finance future growth. Mathematically, the internal growth rate is: Internal growth rate 5 ROA 3 RR 1 2 (ROA 3 RR) (332) internal growth rate The growth rate a firm can sustain if it finances growth using only internal financing, that is, retained earnings growth. where RR is the firm s earnings retention ratio. The retention ratio represents the portion of net income that the firm reinvests as retained earnings: Addition to retained earnings Retention ratio (RR) 5 Net income available to common stockholders (333) Since a firm either pays its net income as dividends to its stockholders or reinvests those funds as retained earnings, the dividend payout and the retention ratios must always add to one: Retention ratio Dividend payout ratio (334) A problem arises when a firm relies only on internal financing to support asset growth: Through time, its debt ratio will fall because as asset values grow, total debt stays constant only retained earnings finance asset growth. If total debt remains constant as assets grow, the debt ratio decreases. As we noted above, shareholders often become disgruntled if, as the firm grows, a decreasing debt ratio (increasing equity financing) dilutes their return. So as firms grow, managers must often try to maintain a debt ratio that they view as optimal. In this case, managers finance asset growth with new debt and retained earnings. The maximum growth rate that can be achieved this way is the sustainable growth rate. Mathematically, the sustainable growth rate is: Sustainable growth rate 5 ROE 3 RR 1 2 (ROE 3 RR) (335) Maximizing the sustainable growth rate helps firm managers maximize firm value. When applying the DuPont ROE equation (331) here (i.e., ROE 5 Profit margin 3 Total asset turnover 3 Equity multiplier), notice that a firm s sustainable growth depends on four factors: 1. The profit margin (operating efficiency). 2. The total asset turnover (efficiency in asset use). 3. Financial leverage (the use of debt versus equity to finance assets). 4. Profit retention (reinvestment of net income into the firm rather than paying it out as dividends). sustainable growth rate The growth rate a firm can sustain if it finances growth using both debt and internal financing such that the debt ratio remains constant. Increasing any of these factors increases the firm s sustainable growth rate and hence helps to maximize firm value. Managers, analysts, and investors will want to focus on these areas as they evaluate firm performance and market value. chapter 3 Analyzing Financial Statements 95
Chapter 3 Analyzing Financial Statement
Chapter 3 Analyzing Financial Statement Five major areas to analyze. (1) Liquidity Position (2) Management of Assets (3) Management of Debt (4) Company's Profitability (5) Market's View of Company (1)
More informationWhat Do ShortTerm Liquidity Ratios Measure? What Is Working Capital? How Is the Current Ratio Calculated? How Is the Quick Ratio Calculated?
What Do ShortTerm Liquidity Ratios Measure? What Is Working Capital? HOCK international  2004 1 HOCK international  2004 2 How Is the Current Ratio Calculated? How Is the Quick Ratio Calculated? HOCK
More informationChapter 17: Financial Statement Analysis
FIN 301 Class Notes Chapter 17: Financial Statement Analysis INTRODUCTION Financial ratio: is a relationship between different accounting items that tells something about the firm s activities. Purpose
More informationUnderstanding Financial Management: A Practical Guide Guideline Answers to the Concept Check Questions
Understanding Financial Management: A Practical Guide Guideline Answers to the Concept Check Questions Chapter 3 Interpreting Financial Ratios Concept Check 3.1 1. What are the different motivations that
More informationTYPES OF FINANCIAL RATIOS
TYPES OF FINANCIAL RATIOS In the previous articles we discussed how to invest in the stock market and unit trusts. When investing in the stock market an investor should have a clear understanding about
More informationChapter 4. Financial Analysis: Sizing up Firm Performance. Chapter Contents. Learning Objectives
Chapter 4 Financial Analysis: Sizing up Firm Performance Learning Objectives Chapter Contents Principles Used in this Chapter 1.Why Financial Statements are Analyzed 2.Common Size Statements Standardizing
More informationFUNDAMENTALS OF HEALTHCARE FINANCE. Online Appendix B Financial Analysis Ratios
3/27/09 FUNDAMENTALS OF HEALTHCARE FINANCE Online Appendix B Financial Analysis Ratios Introduction In Chapter 13 of Fundamentals of Healthcare Finance, we indicated that financial ratio analysis is a
More informationChapter 2 Financial Statements and Analysis
Chapter 2 Financial Statements and Analysis Solutions to Problems P21. LG 1: Reviewing Financial Statements Income statement: In this oneyear summary of the firm s operations, Technica, Inc. showed a
More informationCHAPTER 5. RATIO ANALYSIS, FINANCIAL PLANNING AND FINANCIAL ANALYSIS
CHAPTER 5. RATIO ANALYSIS, FINANCIAL PLANNING AND FINANCIAL ANALYSIS The financial statements discussed in Chapter 4 provide valuable information about a firm s financial and business health. Ratio analysis
More informationFinancial Ratio Cheatsheet MyAccountingCourse.com PDF
Financial Ratio Cheatsheet MyAccountingCourse.com PDF Table of contents Liquidity Ratios Solvency Ratios Efficiency Ratios Profitability Ratios Market Prospect Ratios Coverage Ratios CPA Exam Ratios to
More informationFSA Note: Summary of Financial Ratio Calculations
FSA Note: Summary of Financial Ratio Calculations This note contains a summary of the more common financial statement ratios. A few points should be noted: Calculations vary in practice; consistency and
More informationFinancial Statement and Cash Flow Analysis
Chapter 2 Financial Statement and Cash Flow Analysis Answers to Concept Review Questions 1. What role do the FASB and SEC play with regard to GAAP? The FASB is a nongovernmental, professional standards
More informationIntegrated Case. 425 D Leon Inc., Part II Financial Statement Analysis
Integrated Case 425 D Leon Inc., Part II Financial Statement Analysis Part I of this case, presented in Chapter 3, discussed the situation of D Leon Inc., a regional snack foods producer, after an expansion
More informationUsing Financial Ratios: Interested Parties
Using Financial Ratios: Interested Parties Ratio analysis involves methods of calculating and interpreting financial ratios to assess a firm s financial condition and performance. It is of interest to
More informationHEALTHCARE FINANCE: AN INTRODUCTION TO ACCOUNTING AND FINANCIAL MANAGEMENT. Online Appendix A Financial Ratios
HEALTHCARE FINANCE: AN INTRODUCTION TO ACCOUNTING AND FINANCIAL MANAGEMENT Online Appendix A Financial Ratios INTRODUCTION In Chapter 17, we indicated that ratio analysis is a technique commonly used to
More informationRatio Analysis CBDC, NB. Presented by ACSBE. February, 2008. Copyright 2007 ACSBE. All Rights Reserved.
Ratio Analysis CBDC, NB February, 2008 Presented by ACSBE Financial Analysis What is Financial Analysis? What Can Financial Ratios Tell? 7 Categories of Financial Ratios Significance of Using Ratios Industry
More informationIncome Measurement and Profitability Analysis
PROFITABILITY ANALYSIS The following financial statements for Spencer Company will be used to demonstrate the calculation of the various ratios in profitability analysis. Spencer Company Comparative Balance
More informationFINANCIAL RATIO ANALYSIS: PUTTING THE NUMBERS TO WORK
FINANCIAL RATIO ANALYSIS: PUTTING THE NUMBERS TO WORK By John Bajkowski Financial ratio analysis uses historical financial statements to quantify data that will help give investors a feel for a firm s
More informationChapter3 Solutions to Problems
Chapter3 Solutions to Problems P31. P32. Reviewing basic financial statements LG 1; Basic Income statement: In this oneyear summary of the firm s operations, Technica, Inc. showed a net profit for
More informationChapter. How Well Am I Doing? Financial Statement Analysis
Chapter 17 How Well Am I Doing? Financial Statement Analysis 172 LEARNING OBJECTIVES After studying this chapter, you should be able to: 1. Explain the need for and limitations of financial statement
More informationReturn on Equity has three ratio components. The three ratios that make up Return on Equity are:
Evaluating Financial Performance Chapter 1 Return on Equity Why Use Ratios? It has been said that you must measure what you expect to manage and accomplish. Without measurement, you have no reference to
More informationKey Concepts and Skills. Standardized Financial. Chapter Outline. Ratio Analysis. Categories of Financial Ratios 11. Chapter 3
Key Concepts and Skills Chapter 3 Working With Financial Statements Know how to standardize financial statements for comparison purposes Know how to compute and interpret important financial ratios Know
More informationFinance Master. Winter 2015/16. Jprof. Narly Dwarkasing University of Bonn, IFS
Finance Master Winter 2015/16 Jprof. Narly Dwarkasing University of Bonn, IFS Chapter 2 Outline 2.1 Firms Disclosure of Financial Information 2.2 The Balance Sheet 2.3 The Income Statement 2.4 The Statement
More information140 SU 3: Profitability Analysis and Analytical Issues
140 SU 3: Profitability Analysis and Analytical Issues QUESTIONS 3.1 Profitability Ratios Questions 1 and 2 are based on the following information. The financial statements for Dividendosaurus, Inc., for
More informationBrief Exercise 142 (20 minutes)
Brief Exercise 142 (20 minutes) 1. This Year Last Year Sales... 100.0% 100.0% Cost of goods sold... 62.3 58.6 Gross margin... 37.7 41.4 Operating expenses: Selling expenses... 18.5 18.2 Administrative
More informationFNCE 3010 (Durham). HW2 (Financial ratios)
FNCE 3010 (Durham). HW2 (Financial ratios) 1. What effect would the following actions have on a firms net working capital and current ratio (assume NWC is positive and current ratio is initially greater
More informationFINANCIAL ACCOUNTING TOPIC: FINANCIAL ANALYSIS
SYLLABUS Compulsory part Basic ratio analysis 1. State the general functions of accounting ratios. 2. Calculate and interpret the following ratios: a. working capital/current ratio, quick/liquid/acid test
More informationICAP GROUP S.A. FINANCIAL RATIOS EXPLANATION
ICAP GROUP S.A. FINANCIAL RATIOS EXPLANATION OCTOBER 2006 Table of Contents 1. INTRODUCTION... 3 2. FINANCIAL RATIOS FOR COMPANIES (INDUSTRY  COMMERCE  SERVICES) 4 2.1 Profitability Ratios...4 2.2 Viability
More informationPrinciples of Managerial Finance Solution Lawrence J. Gitman CHAPTER 2. Financial Statements And Analysis
Principles of Managerial Finance Solution Lawrence J. Gitman CHAPTER 2 Financial Statements And Analysis INSTRUCTOR S RESOURCES Overview This chapter examines the key components to the stockholders' report:
More informationMAN 4720 STRATEGIC MANAGEMENT AND POLICY FORMULATION FINANCIAL ANALYSIS GUIDE
MAN 4720 STRATEGIC MANAGEMENT AND POLICY FORMULATION FINANCIAL ANALYSIS GUIDE Revised December 13, 2011 1 FINANCIAL ANALYSIS USING STRATEGIC PROFIT MODEL RATIOS Introduction Your policy course integrates
More informationChapters 3 and 13 Financial Statement and Cash Flow Analysis
Chapters 3 and 13 Financial Statement and Cash Flow Analysis Balance Sheet Assets Cash Inventory Accounts Receivable Property Plant Equipment Total Assets Liabilities and Shareholder s Equity Accounts
More informationRatios Formula Purpose/Use
Ratio Review: Formulas, Purpose & Use Word of Caution: Please remember that the significance of any particular ratio in the ratio analysis set is highly dependent upon the industry. For example, Gross
More informationFinancial Planning for East Coast Yachts
Financial Planning for East Coast Yachts Prepared for East Coast Yachts Prepared by Dan Ervin, MaryAnn Lawrence, Kevin Klepacki, Katie Wilson, Andrew Wright January 1, 2010 Table of Contents iii Table
More informationSolutions to Chapter 4. Measuring Corporate Performance
Solutions to Chapter 4 Measuring Corporate Performance 1. a. 7,018 Longterm debt ratio 0. 42 7,018 9,724 b. 4,794 7,018 6,178 Total debt ratio 0. 65 27,714 c. 2,566 Times interest earned 3. 75 685 d.
More informationCredit Analysis 101
Credit Analysis 101 102 Liquidity and Working Capital Basics Liquidity  Ability to convert assets into cash or to obtain cash to meet shortterm obligations. Shortterm  Conventionally viewed as a
More informationProblems for CFA Level I
Problems for CFA Level I Analysis of Inventories 1. Assume that purchases and unit costs throughout the year were as in Table 1. Inventory at beginning of Quarter I: 400 units at $20 per unit = $8,000.
More informationUnderstanding Financial Information for Bankruptcy Lawyers Understanding Financial Statements
Understanding Financial Information for Bankruptcy Lawyers Understanding Financial Statements In the United States, businesses generally present financial information in the form of financial statements
More informationCHAPTER 13. Financial Analysis: The Big Picture
CHAPTER 13 Financial Analysis: The Big Picture Discuss the Need for comparative analysis and identify the tools of financial statement analysis Throughout the book we will rely on three types of comparisons
More information1) In words, an equity multiplier of 2 means that for every $1:
Questions in [New Questions] 1) In words, an equity multiplier of 2 means that for every $1: [A] of debt, a firm has $2 in equity. [B] in equity, a firm has $2 in debt. [C] in assets, a firm has $2 in
More informationFinancial ratio analysis
Financial ratio analysis A reading prepared by Pamela Peterson Drake O U T L I N E 1. Introduction 2. Liquidity ratios 3. Profitability ratios and activity ratios 4. Financial leverage ratios 5. Shareholder
More informationFIN 3000. Chapter 4. Financial Analysis. Liuren Wu
FIN 3000 Chapter 4 Financial Analysis Liuren Wu Overview 1. Why Do We Analyze Financial Statements 2. Common Size Statements Standardizing Financial Information 3. Using Financial Ratios 4. Selecting a
More informationBACKGROUND KNOWLEDGE for Teachers and Students
Pathway: Business, Marketing, and Computer Education Lesson: BMM C6 4: Financial Statements and Reports Common Core State Standards for Mathematics: N.Q.2 Domain: Quantities Cluster: Reason quantitatively
More informationPortfolio Management FMI Skema Paris campus Contrôle continu 2 2 April 2014 O. Williams
Portfolio Management FMI Skema Paris campus Contrôle continu 2 2 April 2014 O. Williams 1. The comparisons with which ratios should be made include the following, except: a. The firm's own past performance
More informationFinancial ratios can be classified according to the information they provide. The following types of ratios frequently are used:
Financial Ratios Financial ratios are useful indicators of a firm's performance and financial situation. Most ratios can be calculated from information provided by the financial statements. Financial ratios
More informationCHAPTER 3 LONGTERM FINANCIAL PLANNING AND GROWTH
CHAPTER 3 LONGTERM FINANCIAL PLANNING AND GROWTH Answers to Concepts Review and Critical Thinking Questions 1. Time trend analysis gives a picture of changes in the company s financial situation over
More informationOften stock is split to lower the price per share so it is more accessible to investors. The stock split is not taxable.
Reading: Chapter 8 Chapter 8. Stock: Introduction 1. Rights of stockholders 2. Cash dividends 3. Stock dividends 4. The stock split 5. Stock repurchases and liquidations 6. Preferred stock 7. Analysis
More informationHEALTHCARE FINANCE An Introduction to Accounting and Financial Management. Online Appendix A Financial Analysis Ratios
11/16/11 HEALTHCARE FINANCE An Introduction to Accounting and Financial Management Online Appendix A Financial Analysis Ratios INTRODUCTION In Chapter 17, we indicated that financial ratio analysis is
More informationCourse 1: Evaluating Financial Performance
Excellence in Financial Management Course 1: Evaluating Financial Performance Prepared by: Matt H. Evans, CPA, CMA, CFM This course provides a basic understanding of how to use ratio analysis for evaluating
More informationCHAPTER 2 FINANCIAL STATEMENTS AND CASH FLOW
CHAPTER 2 FINANCIAL STATEMENTS AND CASH FLOW Solutions to Questions and Problems NOTE: All endofchapter problems were solved using a spreadsheet. Many problems require multiple steps. Due to space and
More informationFundamental analysis
Fundamental analysis 2 June 2016 CERN Finance Club c.laner@cern.ch Introduction Let s cover the two main types of investment analysis used in traditional investing Today: Fundamental analysis Next time:
More informationSolutions to Problems
Solutions to Problems P21. P22. LG 1: Reviewing basic financial statements Income statement: In this oneyear summary of the firm s operations, Technica, Inc. showed a net profit for 2009 and the ability
More informationChapters 34 Financial Statements, Cash Flow, and Analysis of Financial Statements. Balance Sheet. Total Liabilities and Shareholder s Equity
Chapters 34 Financial Statements, Cash Flow, and Analysis of Financial Statements Balance Sheet Assets Cash Inventory Accounts Receivable Property Plant Equipment Liabilities and Shareholder s Equity
More informationGuide to Financial Statements Study Guide
Guide to Financial Statements Study Guide Overview (Topic 1) Three major financial statements: The Income Statement The Balance Sheet The Cash Flow Statement Objectives: Explain the underlying equation
More informationPerformance Review for Electricity Now
Performance Review for Electricity Now For the period ending 03/31/2008 Provided By Mark Dashkewytch 7809635783 Report prepared for: Electricity Now Industry: 23821  Electrical Contractors Revenue:
More informationFinancial Statement Ratio Analysis
Management Accounting 319 Financial Statement Ratio Analysis Financial statements as prepared by the accountant are documents containing much valuable information. Some of the information requires little
More informationComputing Liquidity Ratios Current Ratio = CA / CL 708 / 540 = 1.31 times Quick Ratio = (CA Inventory) / CL (708 422) / 540 =.53 times Cash Ratio =
1 Computing Liquidity Ratios Current Ratio = CA / CL 708 / 540 = 1.31 times Quick Ratio = (CA Inventory) / CL (708 422) / 540 =.53 times Cash Ratio = Cash / CL 98 / 540 =.18 times 2 Computing Leverage
More information6. Financial Planning. Breakeven. Operating and Financial Leverage.
6. Financial Planning. Breakeven. Operating and Financial Leverage. Financial planning primarily involves anticipating the impact of operating, investment and financial decisions on the firm s future
More informationRatio Analysis. A) Liquidity Ratio :  1) Current ratio = Current asset Current Liability
A) Liquidity Ratio :  Ratio Analysis 1) Current ratio = Current asset Current Liability 2) Quick ratio or Acid Test ratio = Quick Asset Quick liability Quick Asset = Current Asset Stock Quick Liability
More informationDiscussion Board Articles Ratio Analysis
Excellence in Financial Management Discussion Board Articles Ratio Analysis Written by: Matt H. Evans, CPA, CMA, CFM All articles can be viewed on the internet at www.exinfm.com/board Ratio Analysis Cash
More informationFI3300 Corporation Finance
Learning Objectives FI3300 Corporation Finance Spring Semester 2010 Dr. Isabel Tkatch Assistant Professor of Finance Explain the objectives of financial statement analysis and its benefits for creditors,
More informationLiquidity analysis: Length of cash cycle
2. Liquidity analysis: Length of cash cycle Operating cycle of a merchandising firm: number of days it takes to sell inventory + number of days until the resulting receivables are converted to cash Acquisition
More informationFundamental Analysis Ratios
Fundamental Analysis Ratios Fundamental analysis ratios are used to both measure the performance of a company relative to other companies in the same market sector and to value a company. There are three
More informationAccounting  Analysis and Uses of Financial Statements  Final Exam 105 Questions 1. are least interested in financial statement analysis.
Accounting  Analysis and Uses of Financial Statements  Final Exam 105 Questions 1. are least interested in financial statement analysis. A. Auditors Tax lawyers Investors Creditors 2. According SFAC
More informationChapter 15. Learning Objectives Principles Used in This Chapter 1.A Glance at Capital Structure Choices in Practice 2.Capital Structure Theory
Chapter 15 Capital Structure Policy Agenda Learning Objectives Principles Used in This Chapter 1.A Glance at Capital Structure Choices in Practice 2.Capital Structure Theory 3.Why Do Capital Structures
More informationChapter 8 Financial Statement Analysis
Chapter 8 Financial Statement Analysis rue/false Questions F 1. Balance sheet items are carried at original cost or market value at the discretion of the individual firm. F 2. A primary use of the sources
More informationACCOUNTING FOR NONACCOUNTANTS
Deutsch and Chikarovski's ACCOUNTING FOR NONACCOUNTANTS A Question and Answer Handbook Robert Deutsch and Kris Chikarovski THE FEDERATION PRESS 2012 Preface  x Who is this book for? x What is in this
More informationMeasuring Financial Performance: A Critical Key to Managing Risk
Measuring Financial Performance: A Critical Key to Managing Risk Dr. Laurence M. Crane Director of Education and Training National Crop Insurance Services, Inc. The essence of managing risk is making good
More informationCHAPTER 2 INTRODUCTION TO CORPORATE FINANCE
CHAPTER 2 INTRODUCTION TO CORPORATE FINANCE Solutions to Questions and Problems NOTE: All end of chapter problems were solved using a spreadsheet. Many problems require multiple steps. Due to space and
More informationCurrent Ratio: Current Assets / Current Liabilities. Measure of whether company has enough cash to cover immediate expenses
1 Beta: a measure of a stock s volatility relative to the overall market (typically the S&P500 index is used as a proxy for the overall market ). The higher the beta, the more volatile the stock price.
More informationChapter 1 Financial Statement and Cash Flow Analysis
Chapter 1 Financial Statement and Cash Flow Analysis MULTIPLE CHOICE 1. Which of the following items can be found on an income statement? a. Accounts receivable b. Longterm debt c. Sales d. Inventory
More informationCreating a Successful Financial Plan
Creating a Successful Financial Plan Basic Financial Reports Balance Sheet  Estimates the firm s worth on a given date; built on the accounting equation: Assets = Liabilities + Owner s Equity Income Statement
More informationAppendix 10A. Credit Analysis
Appendix 10A Credit Analysis 1 Appendix 10A Credit Analysis This appendix discusses credit analysis for real estate lending, consumer and smallbusiness lending, and midmarket commercial and industrial
More informationHHIF Lecture Series: Financial Statement Analysis
HHIF Lecture Series: Financial Statement Analysis Alexander Remorov Based on the Materials by Daanish Afzal University of Toronto November 5, 2010 Alexander Remorov, Daanish Afzal (University of Toronto)
More informationSOLUTIONS. Learning Goal 30
S1 Learning Goal 30 Multiple Choice 1. d 2. d 3. b 4. a Earnings per share is also used directly for comparing profitability on a pershare basis. 5. d 6. c An airline would have a much greater investment
More informationTIP If you do not understand something,
Valuing common stocks Application of the DCF approach TIP If you do not understand something, ask me! The plan of the lecture Review what we have accomplished in the last lecture Some terms about stocks
More informationChapter 2 Financial Statement and Cash Flow Analysis
Chapter 2 Financial Statement and Cash Flow Analysis MULTIPLE CHOICE 1. Which of the following items can be found on an income statement? a. Accounts receivable b. Longterm debt c. Sales d. Inventory
More informationRAPID REVIEW Chapter Content
RAPID REVIEW BASIC ACCOUNTING EQUATION (Chapter 2) INVENTORY (Chapters 5 and 6) Basic Equation Assets Owner s Equity Expanded Owner s Owner s Assets Equation = Liabilities Capital Drawing Revenues Debit
More informationFINANCIAL STATEMENTS AND RATIO ANALYSIS
In following we will be demonstrating the use of ratios to help examine the health of a firm. Ratios allow managers evaluate to a firm's financial statements in order to point out the strengths and weaknesses
More information9901_1. A. 74.19 days B. 151.21 days C. 138.46 days D. 121.07 days E. 84.76 days
1. A stakeholder is: 9901_1 Student: A. a creditor to whom a firm currently owes money. B. any person who has voting rights based on stock ownership of a corporation. C. any person or entity other than
More informationFinancial Statements and Analysis
Chapter 2 Financial Statements and Analysis LG1 LG2 LG3 LG4 LG5 LG6 LEARNING GOALS Review the contents of the stockholders report and the procedures for consolidating international financial statements.
More informationGlobal Review of Business and Economic Research GRBER Vol. 8 No. 2 Autumn 2012 : 237245. Jian Zhang *
Global Review of Business and Economic Research GRBER Vol. 8 No. 2 Autumn 2012 : 237245 Jian Zhang * Abstract: This study analyzes the contribution of return on asset (ROA) and financial leverage gain
More informationChapter 4 Analysis of Financial Statements ANSWERS TO SELECTED ENDOFCHAPTER QUESTIONS
Chapter 4 nalysis of Financial Statements NSWERS TO SELECTED ENDOFCHPTER QUESTIONS 41 a. liquidity ratio is a ratio that shows the relationship of a firm s cash and other current assets to its current
More informationManagerial Accounting Prof. Dr. Varadraj Bapat Department of School of Management Indian Institute of Technology, Bombay
Managerial Accounting Prof. Dr. Varadraj Bapat Department of School of Management Indian Institute of Technology, Bombay Lecture  18 Financial Statements Analysis Dabur India Case Dear students, in last
More information3 Financial Analysis and Planning
3 Financial Analysis and Planning BASIC CONCEPTS AND FORMULAE 1. Financial Analysis and Planning Financial Analysis and Planning is carried out for the purpose of obtaining material and relevant information
More informationFinancial Statement Analysis
Financial Statement Analysis 15.511 Corporate Accounting Summer 2004 Professor SP Kothari Sloan School of Management Massachusetts Institute of Technology June 18, 2004 1 Financial Statement Analysis:
More informationLong Term Incentive Plan
Long Term Incentive Plan Overview This, the fourth in a series will address the elements of a longterm incentive plan. Over the past few years the predominant reward vehicle for longterm performance
More informationFinancial Ratios and Quality Indicators
Financial Ratios and Quality Indicators From U.S. Small Business Administration Online Women's Business Center If you monitor the ratios on a regular basis you'll gain insight into how effectively you
More informationPlease NOTE This example report is for a manufacturing company; however, we can address a similar report for any industry sector.
Please NOTE This example report is for a manufacturing company; however, we can address a similar report for any industry sector. Performance Review For the period ended 12/31/2013 Provided By Holbrook
More informationCompany Financial Plan
Financial Modeling Templates http://spreadsheetml.com/finance/companyfinancialplan.shtml Copyright (c) 20092014, ConnectCode All Rights Reserved. ConnectCode accepts no responsibility for any adverse
More informationNIKE Case Study. Professor Corwin. An overview of the individual questions and their relation to the lecture topics is provided below.
NIKE Case Study Professor Corwin This case study includes several problems related to the valuation of Nike. We will work through these problems throughout the course to demonstrate some of the most important
More informationFINANCIAL ANALYSIS GUIDE
MAN 4720 POLICY ANALYSIS AND FORMULATION FINANCIAL ANALYSIS GUIDE Revised August 22, 2010 FINANCIAL ANALYSIS USING STRATEGIC PROFIT MODEL RATIOS Introduction Your policy course integrates information
More informationInterpretation of Financial Statements
Interpretation of Financial Statements Author Noel O Brien, Formation 2 Accounting Framework Examiner. An important component of most introductory financial accounting programmes is the analysis and interpretation
More informationReview for Exam 3. Instructions: Please read carefully
Review for Exam 3 Instructions: Please read carefully The exam will have 25 multiple choice questions and 5 work problems. You are not responsible for any topics that are not covered in the lecture note
More informationESSENTIALS OF ENTREPRENEURSHIP AND SMALL BUSINESS MANAGEMENT 6E
CHAPTER 11 Creating a Successful Financial Plan The Importance of a Financial Plan Financial planning is essential to running a successful business and is not that difficult! Common mistake among business
More informationChapter 002 Financial Statements, Taxes and Cash Flow
Multiple Choice Questions 1. The financial statement summarizing the value of a firm's equity on a particular date is the: a. income statement. B. balance sheet. c. statement of cash flows. d. cash flow
More informationReview for Exam 3. Instructions: Please read carefully
Review for Exam 3 Instructions: Please read carefully The exam will have 25 multiple choice questions and 5 work problems. Questions in the multiple choice section will be either concept or calculation
More informationThe following information is available on Toy Inc. There are 100 shares outstanding, each selling for $25
The following information is available on Toy Inc. There are 100 shares outstanding, each selling for $25 Corporate tax 34.00% Interest rate 4.25% Retention ratio 65.00% Case A. Toy Inc. Zero growth in
More informationMBA Finance PartTime Financial Statement Analysis and Cash Flows
MBA Finance PartTime Financial Statement Analysis and Cash Flows Professor Hugues Pirotte Spéder 1 1 Levers of Performance Return on Equity Return on Invested Capital Leverage Profit Margin Asset Turnover
More information