FINANCE 381 - chapter 3

choice of optimal debt ratio

financial leverage

asset use efficiency

total asset turnover

EBITDA ratio =

EBITDA ratio = enterprise value / EBITDA

EPS =

EPS = net income / shares outstanding

debt-equity ratio =

debt-equity ratio = total debt / total equity

market-to-book ratio =

market-to-book ratio = market value per share / book value per share

how quickly the entire inventory was sold off or turned over

inventory turnover

inventory turnover =

inventory turnover = cost of goods sold / inventory

net profit margin =

net profit margin = net income / sales

PE means

price-earnings

operating efficiency

profit margin

profit margin =

profit margin = net income / sales

return on assets =

return on assets = net income / total assets

return on equity =

return on equity = net income / total equity

the higher the net profit margin,

the better

the higher the total asset turnover,

the better

the higher the PE ratio,

the greater the investor confiendence.

the higher the inventory turnover ratio,

the more efficiently we are managing inventory

Determinants of growth:

1. PROFIT MARGIN. (operating efficiency) An increase in profit margin will increase the firms ability to generate funds internally and thereby increase its sustainable growth. 2. TOTAL ASSET TURNOVER. (asset use efficiency) 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. 3. FINANCIAL POLICY. (choice of optimal debt ratio) An increase in the debt-equity ratio increases the firm's financial leverage. Since this makes additional debt financing available, it increases the sustainable growth rate. 4. DIVIDEND POLICY. (choice of how much to pay to shareholders versus reinvesting in the firm) 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.

Choosing a benchmark:

1. TIME-TREND ANALYSIS - use history, ratios are analyzed in time series graphs to see what trends are developing. 2. PEER-GROUP ANALYSIS - use similar firms and/or industry averages, ratios are analyzed by reference to industry standards.

You are examining the common-size income statements for a company for the past five years and have noticed that the cost of goods as a percentage of sales has been increasing steadily. At the same time, EBIT as a percentage of sales has been decreasing. What might accounting for the trends in these ratios? What might managers take to improve these ratios?

A) As with any ratio analysis, the ratios themselves do not necessarily indicate a problem, but simply indicate that something is different and it is up to us to determine if a problem exists. If the cost of goods sold as a percentage of sales is increasing, we would expect that EBIT as a percentage of sales would decrease, all else constant. An increase in the cost of goods sold as a percentage of sales occurs because the cost of raw materials or other inventory is increasing at a faster rate than the sales price. This may be a bad sign since the contribution of each sales dollar to net income and cash flow is lower. However, when a new product, for example, the HDTV, enters the market, the price of one unit will often be high relative to the cost of goods sold per unit, and demand, therefore sales, initially small. As the product market becomes more developed, price of the product generally drops, and sales increase as more competition enters the market. In this case, the increase in cost of goods sold as a percentage of sales is to be expected. The maker or seller expects to boost sales at a faster rate than its cost of goods sold increases. In this case, a good practice would be to examine the common-size income statements to see if this is an industry-wide occurrence. B) If we assume that the cause is negative, the two reasons for the trend of increasing cost of goods sold as a percentage of sales are that costs are becoming too high or the sales price is not increasing fast enough. If the cause is an increase in the cost of goods sold, the manager should look at possible actions to control costs. If costs can be lowered by seeking lower cost suppliers of similar or higher quality, the cost of goods sold as a percentage of sales should decrease. Another alternative is to increase the sales price to cover the increase in the cost of goods sold. Depending on the industry, this may be difficult or impossible. For example, if the company sells most of its products under a long-term contract that has a fixed price, it may not be able to increase the sales price and will be forced to look for other cost-cutting possibilities. Additionally, if the market is competitive, the company might also be unable to increase the sales price.

a standardized financial statement presenting all items in percentage terms. Balance sheet items are shown as a percentage of assets and income statement items as a percentage of sales.

common-size statement

The internal growth rate tells us:

how much the firm can grow assets using retained earnings as the only source of financing.

quick ratio =

quick ratio = current assets - inventory / current liabilities

retention ratio =

retention ratio = additions to retained earnings / net income = 1 - payout ratio

times interest earned ratio =

times interest earned ratio = EBIT / interest

indicates the efficiency with which the firm uses its assets to generate sales

total asset turnover

total asset turnover =

total asset turnover = sales / total assets

total debt ratio =

total debt ratio = total assets - total equity / total assets

COPY PAGE 65

...

PAGE 66

...

Explain what it means for a firm to have a current ratio equal to .50. Would the firm be better off if the current ratio were 1.50? What if it were 15.0? Explain your answers.

A current ratio of .50 means that the firm has twice as much in current liabilities as it does in current assets; the firm potentially has poor liquidity. If pressed by its short-term creditors and suppliers for immediate payment, the firm might have a difficult time meeting its obligations. A current ratio of 1.50 means the firm has 50% more current assets than it does current liabilities. This probably represents an improvement in liquidity; short-term obligations can generally be met completely with a safety factor built in. A current ratio of 15.0, however, might be excessive. Any excess funds sitting in current assets generally earn little or no return. These excess funds might be put to better use by investing in productive long-term assets or distributing the funds to shareholders.

Fully explain the kind of information the following financial ratio provide about a firm: cash ratio

Cash ratio represents the ability of the firm to completely pay off its current liabilities balance with its most liquid asset (cash).

What types of information do common-size financial statements reveal about the firm? what is the best use for these common-size statements?

Common size financial statements express all balance sheet accounts as a percentage of total assets and all income statement accounts as a percentage of total sales. Using these percentage values rather than nominal dollar values facilitates comparisons between firms of different size or business type.

Fully explain the kind of information the following financial ratio provide about a firm: equity multiplier

Equity multiplier represents the degree of leverage for an equity investor of the firm; it measures the dollar worth of firm assets each equity dollar has a claim to.

What effect would the following action have on a firm's ratio? Assume that net working capital is positive. Inventory is purchased.

If inventory is purchased with cash, then there is no change in the current ratio. If inventory is purchased on credit, then there is a decrease in the current ratio if it was initially greater than 1.0.

Explain what peer group analysis means. As a financial manager, how could you use the results of peer group analysis to evaluate the performance of your firm? How is a per group different from an aspirant group?

Peer group analysis involves comparing the financial ratios and operating performance of a particular firm to a set of peer group firms in the same industry or line of business. Comparing a firm to its peers allows the financial manager to evaluate whether some aspects of the firm's operations, finances, or investment activities are out of line with the norm, thereby providing some guidance on appropriate actions to take to adjust these ratios, if appropriate. An aspirant group would be a set of firms whose performance the company in question would like to emulate. The financial manager often uses the financial ratios of aspirant groups as the target ratios for his or her firm; some managers are evaluated by how well they match the performance of an identified aspirant group.

In recent years, Dixie Co, has greatly increased its current ratio. At the same time, the quick ratio has fallen. What has happened? Has the liquidity of the company improved?

The firm has increased inventory relative to other current assets; therefore, assuming current liability levels remain mostly unchanged, liquidity has potentially decreased.

SDJ Inc., has net working capital of $1,730, current liabilities of $5,140, and inventory of $2,170. What is the current ratio? What is the quick ratio?

To find the current assets, we must use the net working capital equation. Doing so, we find: NWC = Current assets - Current liabilities $1,730 = Current assets - $5,140 Current assets = $6,870 Now, use this number to calculate the current ratio and the quick ratio. The current ratio is: Current ratio = Current assets / Current liabilities Current ratio = $6,870 / $5,140 Current ratio = 1.34 times And the quick ratio is: Quick ratio = (Current assets - Inventory) / Current liabilities Quick ratio = ($6,870 - 2,170) / $5,140 Quick ratio = .91 times

Fully explain the kind of information the following financial ratio provide about a firm: total asset turnover

Total asset turnover measures how much in sales is generated by each dollar of firm assets.

cash coverage ratio =

cash coverage ratio = EBIT + depreciation / interest

cash ratio =

cash ratio = cash / current liabilities

current ratio =

current ratio = current assets / current liabilities

days' sales in inventory =

days' sales in inventory = 365 days / inventory turnover

days' sales in receivables =

days' sales in receivables = 365 days / receivables turnovers

dividend payout ratio =

dividend payout ratio = cash dividends / net income

choice of how much to pay shareholders versus reinvesting in the firm

dividend policy

enterprise value =

enterprise value = total market value of the stock + book value of all liabilities - cash

equity multiplier =

equity multiplier = total assets / total equity

why evaluate financial statements?

1. internal users: evaluating performance, spotting trouble, generating projections 2. external users: making credit decisions, evaluating competitors, assessing acquisitions

financial ratios are traditionally grouped into the following categories:

1. short-term solvency, or liquidity, ratios 2. long-term solvency, or financial leverage, ratios 3. asset management, or turnover, ratios 4. profitability ratios 5. market value ratios

price-sales ratio =

price-sales ratio = price per share / sales per share

receivables turnover =

receivables turnover = sales / accounts receivable

So-called same-store sales are very important measure for companies as diverse as McDonald's and Sears. As the name suggests, examining same-store sales means comparing revenues from the same stores or restaurants at two different points in time. Why might companies focus on same-store sales rather than total sales?

If a company is growing by opening new stores, then presumably total revenues would be rising. Comparing total sales at two different points in time might be misleading. Same-store sales control for this by only looking at revenues of stores open within a specific period.

What effect would the following action have on a firm's ratio? Assume that net working capital is positive. Inventory is sold at cost.

Inventory sold at cost reduces inventory and raises cash, so the current ratio is unchanged.

What effect would the following action have on a firm's ratio? Assume that net working capital is positive. Inventory is sold for a profit.

Inventory sold for a profit raises cash in excess of the inventory recorded at cost, so the current ratio increases.

PE ratio =

Price-Earnings (PE) ratio = market price per share of common stock / earnings per share

Fully explain the kind of information the following financial ratio provide about a firm: quick ratio

Quick ratio provides a measure of the short-term liquidity of the firm, after removing the effects of inventory, generally the least liquid of the firm's current assets.

What effect would the following action have on a firm's ratio? Assume that net working capital is positive. A supplier is paid.

Reducing accounts payable with cash increases the current ratio if it was initially greater than 1.0.

What effect would the following action have on a firm's ratio? Assume that net working capital is positive. A short-term bank load is repaid.

Reducing short-term debt with cash increases the current ratio if it was initially greater than 1.0

Why is the DuPoint identity a valuable tool for analyzing the performance of a firm? Discuss the types of information it reveals as compared to ROE considered by itself.

Return on equity is probably the most important accounting ratio that measures the bottom-line performance of the firm with respect to the equity shareholders. The Du Pont identity emphasizes the role of a firm's profitability, asset utilization efficiency, and financial leverage in achieving a ROE figure. For example, a firm with ROE of 20% would seem to be doing well, but this figure may be misleading if it were a marginally profitable (low profit margin) and highly levered (high equity multiplier). If the firm's margins were to erode slightly, the ROE would be heavily impacted.

Allen, Inc., has a total debt ratio of .34. What is its debt-equity ratio? What is its equity multiplier?

To find the debt-equity ratio using the total debt ratio, we need to rearrange the total debt ratio equation. We must realize that the total assets are equal to total debt plus total equity. Doing so, we find: Total debt ratio = Total debt / Total assets .34 = Total debt / (Total debt + Total equity) .66(Total debt) = .34(Total equity) Total debt / Total equity = .34 / .66 Debt-equity ratio = .52 And the equity multiplier is one plus the debt-equity ratio, so: Equity multiplier = 1 + D/E Equity multiplier = 1 + .52 Equity multiplier = 1.52

Remi, Inc., has sales of $15 million, total assets of $9 million, and total debt of $3.7 million. If the profit margin is 7 percent, what is net income? What is ROA? What is ROE?

To find the return on assets and return on equity, we need net income. We can calculate the net income using the profit margin. Doing so, we find the net income is: Profit margin = Net income / Sales .07 = Net income / $15,000,000 Net income = $1,050,000 Now we can calculate the return on assets as: ROA = Net income / Total assets ROA = $1,050,000 / $9,000,000 ROA = .1167, or 11.67% We do not have the equity for the company, but we know that equity must be equal to total assets minus total debt, so the ROE is: ROE = Net income / (Total assets - Total debt) ROE = $1,050,000 / ($9,000,000 - 3,700,000) ROE = .1981, or 19.81%

relationships determined from a firm's financial information and used for comparison purposes.

financial ratios

High PE ratios tells us that:

firms have significant growth opportunity