Chapter 7

return on equity (ROE)

A ratio calculated by dividing income available to stockholders by common equity; measures the rate of return on common stockholders' investments.

debt ratio

A ratio calculated by dividing total debt by total assets; indicates the percentage of total funds provided by creditors.

annual report

A report in the forms of 10-K issued by a corporation to its stockholders that contains basic financial statements as well as the opinions of management about the past year's operations and the firm's future prospects.

statement of retained earnings

A statement reporting the change in the firm's retained earnings as a result of the income generated and retained during the year. The balance sheet figure for retained earnings is the sum of the earnings retained for each year that the firm has been in business.

income statement

A statement summarizing the firm's revenues and expenses over an accounting period, generally a quarter or a year.

statement of cash flows

A statement that reports the effects of a firm's operating, investing, and financing activities on cash flows over an accounting period.

True or False: The balance sheet is a financial statement measuring the flow of funds into and out of various accounts over time while the income statement measures the progress of the firm at a point in time.

False

days sales outstanding (DSO),

also called the average collection period (ACP), A ratio calculated by dividing accounts receivable by average sales per day, which indicates the average length of time it takes the firm to collect for credit sales.

DuPont equation

A formula that gives the rate of return on assets by multiplying the profit margin by the total assets turnover.

free cash flow

A measure of the cash flow that the firm is free to pay to investors after considering cash investments that are needed to continue operations.

economic value added (EVA)

After-tax operating earnings adjusted for the costs associated with the firm's financing—shows how much a firm's economic value increased during a particular period.

common stockholders' equity (net worth)

The funds provided by common stockholders— common stock, paid-in capital, and retained earnings. It equals total assets minus total liabilities.

retained earnings

The portion of the firm's earnings that has been reinvested in the firm rather than paid out as dividends.

market/book (M/B) ratio

The ratio of a stock's market price to its book value.

T or F: A stock dividend and a stock split should, at least conceptually, have the same effect on shareholders' wealth.

True

balance sheet

A statement that shows the firm's financial position—assets, and liabilities and equity—at a specific point in time.

return on assets (ROA)

A ratio calculated by dividing net income by total assets; provides an idea of the overall return on investment earned by the firm.

accounting profits

A firm's net income as reported on its income statement.

quick (acid test) ratio

A ratio calculated by deducting inventories from current assets and dividing the remainder by current liabilities.

inventory turnover ratio

A ratio calculated by dividing cost of goods sold by inventories.

current ratio

A ratio calculated by dividing current assets by current liabilities. It indicates the extent to which current liabilities are covered by assets expected to be converted to cash in the near future.

times interest earned (TIE) ratio

A ratio calculated by dividing earnings before interest and taxes (EBIT) by interest charges; measures the ability of the firm to meet its annual interest payments.

price/earnings (P/E) ratio

A ratio calculated by dividing market price per share by earning per share; measures how much investors are willing to pay per dollar of current profits.

net profit margin

A ratio calculated by dividing net income by sales; measures net income per dollar of sales.

True or False: On the balance sheet, total assets must always equal total liabilities. The amount remaining is what is used to finance the firm and includes equity and long-term debt.

False

T or F: A firm whose days sales outstanding is much higher than the industry's average is likely to either be too "tight" in its credit policy or too "loose" in its collection policy.

False

T or F: Depreciation, as shown on the income statement, is regarded as a use of cash because it is an expense.

False

T or F: If a firm has high current and quick ratios, this always is a good indication that a firm is managing its liquidity position well.

False

T or F: In accounting, emphasis is placed on determining net income. In finance, the primary emphasis also is on net income because that is what investors use to value the firm. However, a secondary consideration is cash flow because that's what is used to run the business.

False

T or F: Since ROA measures the firm's effective utilization of assets (without considering how these assets are financed), two firms with the same EBIT must have the same ROA.

False

T or F: The balance sheet lists ant their fair market value as of midnight on the annual fiscal end date for the firm.

False

T or F: The book value of an asset is the market value less any accumulated depreciation.

False

T or F: The four basic financial statements included in the annual report are the balance sheet, the income statement, the statement of cash flows, and the statement of reported earnings.

False

T or F: The inventory turnover ratio and days sales outstanding (DSO) are two ratios that can be used to assess how effectively the firm is managing its assets in consideration of current and projected operating levels.

False

T or F: The time dimension is important in financial statement analysis. While the balance sheet and income statements represent the firm's financial position at a point in time, the statement of cash flows reports changes that were made to the firm's accounts over a period of time.

False

T or False: During a period of lowering prices, the FIFO accounting method will produce a higher balance sheet inventory but a lower cost of goods sold than the LIFO accounting method.

False

True or False: An increase in an asset account is a source of cash, whereas an increase in a liability account is a use of cash.

False

net working capital

The amount of current assets that is financed with long-term sources of funds —equals current assets minus current liabilities.

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Slide 82 Chapter 7

"window dressing" techniques

Techniques employed by firms to make their financial statements look better than they actually are.

operating cash flows

Those cash flows that arise from normal operations; the difference between cash collections and cash expenses associated with the manufacture and sale of inventory.

T or F: Market value ratios provide management with a current assessment of how investors in the market view the firm's past performance and future prospects.

True

T or F: Net fixed assets reflect the historical costs for property, plant, and equipment less accumulated depreciation.

True

T or F: The inventory turnover and current ratios are related. The combination of a high current ratio and a low inventory turnover ratio relative to the industry norm might indicate that the firm is maintaining too high an inventory level or that part of the inventory is obsolete or damaged.

True

T or F: The times-interest-earned ratio is one indication of a firm's ability to meet both long-term and short-term obligations.

True

T or F: When a firm pays off a loan using cash, the source of funds is the decrease in the asset account, cash, while the use of funds involves a decrease in a liability account, debt.

True