CH 3

Inventory Turnover

COGS / avg inventory

cash ratio

Cash / Current Liabilities

Dividend payout ratio

Cash Dividends/Net Income

True or false: The price-earnings ratio is price per share times earnings per share.

False The price-earnings ratio is price per share divided by earnings per share.

______ are the prime source of information about a firm's financial health.

Financial statements

True or false: The retention ratio equals one minus the ROA.

False The retention ratio equals one minus the dividend payout ratio.

Return on Equity

Net Income/Total Equity measure on how stockholders fared during the year

Which of the following is the correct equation for return on equity? Total equity/Net income Net income/Sales Net income/Total equity Sales/Net income

Net income/Total equity

True or false: The total debt ratio equals the total assets minus total equity divided total assets.

True

True or false: There is a solid and prescriptive method to select which ratios to use in financial statement analysis.

false There is no theory or set method to select the ratios to use in financial statement analysis.

true or false. The internal growth rate is where the external funds needed (EFN) is equal to 1, also where the required increase in assets is exactly equal to the addition to retained earnings.

false. The internal growth rate is where the external funds needed (EFN) is equal to 0, also where the required increase in assets is exactly equal to the addition to retained earnings.

financial statements are a prime source of information about a firm's

financial health

Long-term solvency ratios are also known as:

financial leverage ratios

Based on the sustainable growth rate, which of the following factors affect a firm's ability to sustain growth? financial policy dividend policy current stock price profit margin

financial policy dividend policy profit margin

EBIT plus depreciation is often abbreviated EBIDT (earnings before interest taxes and depreciation) it is a basic measure of the firm's ability to

generate cash from operations and it is frequently used as a measure of cash flow available to meet financial obligations

Given an internal growth rate of 3 percent, a firm will

grow by 3 percent or less without any additional external financing

Apple's business strategy includes cost reduction initiatives such as lowering manufacturing costs, reducing structural or design costs, and cutting operating expenses. All else constant, a higher net income from any of these initiatives will lead to

higher Shareholders' Equity and decreased leverage, lowering the Assets to Equity ratio.

An increase in the profit margin will ______ a firm's sustainable growth rate.

increase

Holding sales constant, lower production costs will

increase net income, raising the return on equity.

If the firm chooses not to purchase new assets, pay down any debt, or increase dividends, an increase in net income due to lower costs of production will

increase the cash position of the firm, raising the cash ratio.

weakness in either operating or asset use efficiency or both will show up in a diminished return on assets which will translate

into a lower ROE

Inventory turnover is cost of goods sold divided by

inventory

low current ratio may not be a bad sign for a company with a

large reserve of untapped borrowing power

If a company has inventory, the quick ratio will always be ______ the current ratio.

less than

to the firm, a high current ratio indicates

liquidity but it also may indicate an inefficient use of cash and other short term assets

Whenever ______ information is available, it should be used instead of accounting data.

market

How is the price-earnings (PE) ratio computed?

market price per share/earnings per share

The price-earnings (PE) ratio is a ______ ratio.

market value

How is the market-to-book ratio measured?

market value per share/book value per share

______ group analysis is a way to establish a benchmark when using ratios.

peer

One of the most important uses of financial statement information within the firm is:

performance evaluation.

2 important internal use of financial statement information involves

performance evaluations & planning for the future

The DuPont identity shows that ____________ ___________ times total asset turnover times equity multiplier equals ROE.

profit margin

a firm's ability to sustain growth depends explicitly on the following four factors

profit margin, total asset turnover, Financial Policy, dividend policy

Return on assets (ROA) is a measure of

profitability

Return on equity (ROE) is a measure of

profitability

The profit margin is equal to net income divided by ______.

sales

Total Asset Turnover Ratio

sales / total assets measures the turnover of all of the firm's assets

In a common-size income statement, each item is expressed as a percentage of total ___________

sales or revenue

The times interest earned ratio is a measure of long-term

solvency

to a short term creditor such as a supplier, the higher the current ratio

the better

the market to book ratio compares

the market value of the firms investments to their costs -a value less than one could mean that the firm has not been successful overall in creating value for its stockholders

True or false: A way to establish a benchmark for ratio analysis is to identify a peer group.

true

True or false: In a common-size income statement, each item is expressed as a percentage of total sales.

true

True or false: It is important to investigate trends in financial ratios to identify the reason for the trend.

true

True or false: The cash ratio is found by dividing cash by current liabilities.

true

it is important to emphasize that whenever we have market information

we will use it instead of accounting data -also if there is a conflict between accounting and market data market data should be given precedence

True or false: The times interest earned ratio is EBIT minus interest.

False The times interest earned ratio is EBIT divided by interest.

Common-size statements

Financial statement in which data are expressed as percentages for comparing results from one accounting period to another.

The information needed to compute the profit margin can be found on the ______.

income statement

If sales increase while there is no change in accounts receivable, the receivables turnover ratio will ______.

increase

considering the DuPont identity, it appears that a firm could leverage up it's a row by

increasing its amount of debt -this will happen only if the ratio of EBIT total assets is greater than the interest rate

PE Ratio

measures how much investors are willing to pay per dollar of current earnings

The retention ratio equals one __________ the dividend payout ratio.

minus

A firm may use a price-sales ratio when it has had ___________ (negative/positive) earnings over the past year.

negative

how rapidly a firm can grow if

one, it wishes to maintain a particular total debt ratio end two, it is unwilling to sell new stock

Price-Sales Ratio

price per share/sales per share

The price-earnings ratio is _______ per share divided by ________ per share.

price, earnings

A common-size balance sheet expresses accounts as a percentage of ______

total assets

True or false: If a company has inventory, the quick ratio will always be greater than the current ratio.

False If a company has inventory, the quick ratio will always be less than the current ratio.

financial ratios

Relationships between important financial data that is expressed as a fraction or a percentage. -are ways of comparing and investigating the relationships between different pieces of financial information

Receivables Turnover

Sales / Accounts Receivable

Which of the following represents the receivables turnover ratio? Cost of goods sold/Accounts receivable Sales/Accounts receivable Accounts receivable/Sales Accounts receivable/Cost of goods sold

Sales/Accounts receivable

______ financial statements enable one to compare firms that differ in size.

Standardized

True or false: Profit margin equals net income divided by sales.

True

profit margin

an increase profit margin will increase the firm's ability to generate funds internally and thereby increase its sustainable growth

The current ratio computes the relationship between ______.

current assets and current liabilities

The cash coverage ratio adds ______ to operating earnings (EBIT) for a better of measure of how much cash is available to meet interest obligations.

depreciation

one problem with ratios is that

different people and different sources frequently don't compute them in exactly the same way and this leads to much confusion

Return on assets equals net income ________ by total assets.

divided

The _________ payout ratio equals cash dividends divided by net income.

dividend

Price to Earnings Ratio (P/E)

price per share/Earnings per share. It is the comparison of a company's share price to its earnings(net income). ideal around 15-20. If less than 10=undervalued; if more than 20=overvalued.

The times interest earned ratio is a measure of long-term __________

solvency

Average Collection Period

(another name for Days' Sales in Receivables) The average amount of time that a receivable is outstanding, calculated by dividing 365 days by the accounts receivable turnover.

How is the inventory turnover ratio computed?

COGS/Inventory

absent some extraordinary circumstances, we would expect to see a current ratio of at least one because

because a current ratio of less than one would mean that net working capital (current assets less current liabilities) is negative -this would be unusual in a healthy firm at least for most types of businesses

The cash ratio is found by dividing cash by:

current liabilities

Which one of the following equations defines the total asset turnover ratio? sales/fixed assets sales/total assets current assets/sales total assets/sales

sales/total assets

Long term solvency ratios are intended to address

the firm's long run ability to meet its obligations or more generally its financial leverage -sometimes called financial leverage ratios or leverage ratios

the basic problem with financial statement analysis is that

there is no underlying theory to help us identify which items or ratios to look at and to guide us in establishing benchmarks

Which one of the following best explains why financial managers use a common-size balance sheet? to monitor labor costs to track changes in a firm's capital structure to identify changes in operating costs to keep an eye on the firm's profit margin

to track changes in a firm's capital structure

A common-size balance sheet expresses accounts as a percentage of ____________

total assets

book value per share is _______________ not just common stock divided by the number of shares outstanding because book value per share is an accounting number

total equity -it reflects historical costs

Market to Book Ratio

market value per share/book value per share

Based on the DuPont Identity, an increase in sales, all else held equal, ______ ROE.

may not change may increase or decrease

Return on Assets (ROA)

Measures how profitably a company uses its assets. Net income / Average total assets.

the quick (or acid test) ratio

(Current Assets - Inventory) / Current Liabilities the current ratio except inventory is omitted quick ratio equals current assets inventory current liabilities -using cash to buy inventory does not affect the current ratio but it reduces the quick ratio

Cash Coverage Ratio

(EBIT + Depreciation) / Interest

Internal Growth Rate

(ROA x b) / (1 - ROA x b) the maximum growth rate a firm can achieve without external financing of any kind

What is the formula for computing the internal growth rate (IGR)?

(ROA × b)/(1 − ROA × b)

Sustainable Growth Rate (SGR)

(ROE x b) / (1 - ROE x b) The growth rate that allows a firm to maintain its present financial ratios without issuing new equity.

total debt ratio

(Total Assets - Total Equity) / Total Assets takes into account all debts of all maturities to all creditors

Which of the following is the correct representation of the total debt ratio? Total equity/Total long-term debt Long-term debt/Total assets (Total assets − Total equity)/(Total assets)

(Total assets − Total equity)/(Total assets)

A firm with a profit margin of 10 percent generates ______ in net income for every dollar in sales.

10 cents

The DuPont identity breaks ROE into ______ parts.

3

Days' Sales in Receivables

365/receivables turnover

Days' sales in receivables is given by the following ratio:

365/receivables turnover

Times interest earned (TIE) ratio

EBIT/Interest Charges another common measure of long term solvency

DuPont Identity

Expression of the ROE in terms of the firm's profitability, asset efficiency, and leverage. ROE = profit marg x total asset turnover x equity multiplier

True or false: The current ratio will decrease if current assets increase, while everything else remains unchanged.

False

True or false: Financial ratios are computed using only balance sheet information.

False Financial ratios can use information from all financial statements.

True or false: If there is a conflict between market and accounting data, accounting data should be given precedence.

False If there is a conflict between market and accounting data, market data should be given precedence.

True or false: Inventory turnover is sales divided by inventory.

False Inventory turnover is cost of goods sold divided by inventory.

True or false: The DuPont identity is a popular expression breaking ROA into three parts.

False The DuPont identity is a popular expression breaking ROE into three parts.

True or false: The dividend payout ratio equals cash dividends divided by sales.

False The dividend payout ratio equals cash dividends divided by net income.

Which of the following is true about the sustainable growth rate? It is the minimum rate of growth a firm can maintain without increasing its financial leverage. It is the minimum rate of growth a firm can maintain while increasing its financial leverage. It is the maximum rate of growth a firm can maintain while increasing its financial leverage. It is the maximum rate of growth a firm can maintain without increasing its financial leverage.

It is the maximum rate of growth a firm can maintain without increasing its financial leverage.

What will happen to the current ratio if current assets increase, while everything else remains unchanged?

It will increase.

The three parts of the Dupont equation are:

Profit Margin * Total Asset Turnover * Equity Multiplier

Return on equity can be calculated as ROA × Equity multiplier. What is another way to express this equation?

ROE = ROA × (1 + Debt − Equity Ratio)

Which of the following best explains why financial managers use a common-size income statement? The common-size income statement can show sources of cash for the company. The common-size income statement can show which costs are rising or falling as a percentage of sales.

The common-size income statement can show which costs are rising or falling as a percentage of sales.

What does it mean when a company reports ROA of 12 percent?

The company generates $12 in net income for every $100 invested in assets.

Which of the following create problems with financial statement analysis? The firm and its competitors operate under different regulatory environments. The firm and its competitors are approximately the same size. The firm or its competitors are global companies. The firm or its competitors are conglomerates.

The firm and its competitors operate under different regulatory environments. The firm or its competitors are global companies. The firm or its competitors are conglomerates.

What does it mean when a firm has a days' sales in receivables of 45?

The firm collects its credit sales in 45 days on average.

What is the impact on the total asset turnover ratio if sales increase significantly while there is no change in any of the other variables?

The total asset turnover ratio will increase.

Which of the following are true of financial ratios? They are computed in the same manner by all firms. They use only balance sheet data. They always reflect market values. They are developed from a firm's financial information. They are used for comparison purposes.

They are developed from a firm's financial information. They are used for comparison purposes.

dividend policy

a decrease in the percentage of net income paid out as dividends will increase the retention ratio. This increases internally generated equity and thus increases internal and sustainable growth

Retention Ratio (Plowback Ratio)

addition to retained earnings / net income

financial statement analysis is

an application of "management by exception"

the current ratio, like any ratio, is affected by various types of transactions. for example, suppose the firm borrows over the long term to raise money. the short run effect would be

an increase in cash from the issue proceeds and an increase in long term debt. current liabilities would not be affected so the current ratio would rise

Financial Policy

an increase in the debt equity ratio increases the firm's financial leverage. because this makes additional debt financing available it increases the sustainable growth rate

Which one of these will decrease a firm's sustainable rate of growth? an increase in the dividend payout ratio an increase in the plowback ratio an increase in the asset turnover ratio an increase in the profit margin

an increase in the dividend payout ratio

total asset turnover

an increase in the firm's total asset turnover increases the sales generated for each dollar in assets. This decreases the firm's need for new assets as sales grow and thereby increases the sustainable growth rate. Notice that increasing total asset turnover is the same thing as decreasing capital intensity

A useful way of standardizing financial statements is to choose a _______ year and then express each item relative to that amount.

base

a very short term creditor might be interested in the

cash ratio

Which of the following would help a company take action to improve its ratios? comparing to DOW 30 companies comparing to aspirant companies comparing to peer companies comparing to major competitors comparing to its own historical ratios

comparing to aspirant companies comparing to peer companies comparing to major competitors comparing to its own historical ratios

Peer Group Analysis

comparison to a select group of firms in the same industry.

Common-size statements are best used for comparing:

competitors. firms of different sizes. year-to-year for your firm.

A firm with a market-to-book value that is greater than 1 is said to have ______ value for shareholders.

created

Current Ratio Formula

current assets - current liabilities

true or false. Common size income statements show balance sheet items as a percentage of current assets.

false Common size income statements show balance sheet items as a percentage of total assets.

DuPont identity tells us that our ROE is affected by three things

1. operating efficiency (as measured by profit margin) 2. asset use efficiency (as measured by total asset turnover) 3. financial leverage (as measured by the equity multiplier)

if you are ever using ratios as a tool for analysis you should

be careful to document how you calculate each one and if you are comparing your numbers to those of another source be sure you know how their numbers are computed