A304 Chapter 13

What are the factors of investment decisions?

• Industry factors • Economy-wide factors • Individual company factors

Financial statements are designed for external decision makers such as:

• Present and potential owners • Investment analysts • Creditors

What issues arise with insider information?

• Trading on insider information is a serious criminal offense often resulting in large fines and jail time • In some cases, determining whether something is insider information is difficult • Many public accounting firms prohibit their staff from investing in companies that they audit to discourage insider trading

Quick Ratio Formula

(Cash & Cash Equivalents + Net Accounts Receivable + Marketable Securities)/Current Liabilities

Times Interest Earned Formula

(Net Income + Interest Expense + Income Tax Expense) / Interest Expense

Beyond financial ratios, analysts commonly consider:

- Reasons for rapid growth - Uneconomical expansion - Non-financial information

The operating cycle for most companies involves three distinct phases:

1) The acquisition of inventory 2) The sale of inventory 3) The collection of cash from the customer

What is the meaning of a high receivable turnover ratio?

A high receivable turnover ratio suggests that a company collects its accounts receivable many times during a year

What is understood by the results of the current ratio?

A ratio greater than 1 implies that a company's current assets are sufficient to cover its current liabilities. If a company's current ratio is less than 1, analysts will want to understand how the company intends to meet its short-term obligations

What is the meaning of a quality of income ratio higher than 1?

A ratio higher than 1 indicates high-quality income because each dollar of income is supported by one or more dollars of cash flows

How do analysts decide what ratios to use?

Analysts will compute ratios that are most useful in a given situation. Financial statement analysis involves a lot of judgement. The more clearly you define the questions you want answered, the easier it is to select the most appropriate ratios to compute

Asset Turnover Ratios

Asset turnover ratios focus on capturing how efficiently a company uses its assets

Why is ROA broken down into two components?

Breaking down ROA into its two components allows you to more fully understand what underlies a company's performance. With this knowledge, you can better assess whether a company is effectively implementing its business strategy, especially when you examine how the ratios change across time

Cash Coverage Ratio Formula

Cash Flows from Operating Activities/Interest Paid

Quality of Income Ratio

Cash Flows from Operating Activities/Net Income

Cash Ratio Formula

Cash and Cash Equivalents/Current Liabilities

How are component percentage ratios computed? How does this compare to other ratios?

Component percentage ratios are computed using amounts from the same financial statement, either the income statement or balance sheet. Other ratios compare amounts from different financial statements, such as net income to total assets

Inventory Turnover Ratio

Cost of Goods Sold/Average Inventory

Current Ratio Formula

Current Assets/Current Liabilities

Data Visualization Tools

Data visualization tools can help analyze a company's financial data. This type of data analytics is especially useful when communicating findings during meetings or in printed form

Average Days to Collect Receivables Formula

Days in a Year/Receivables Turnover Ratio

Dividend Yield Ratio Formula

Dividends per Share/Market Price per Share

The _____________ is used by analysts to better assess how a company is implementing its business strategy

DuPont model

Where are earnings per share reported?

EPS and the average number of shares outstanding is reported on the bottom of the income statement

__________________ is probably the single most widely reported financial ratio, and it is the only ratio required by GAAP

Earnings per share

What is financial statement analysis based on?

Financial statement analysis is based on comparisons. These include time-series analysis and cross-sectional analysis

What is the purpose of financial statements?

Financial statements help people make better economic decisions. Published financial statements are designed primarily to meet the needs of external decision makers

Gross Profit Margin Ratio

Gross Profit/Net Sales Revenue

Time-Series Analysis

Information for a single company is compared over time

Cross-Sectional Analysis

Information for multiple companies is compared at a point in time

Insider Information

Knowing financial information before it is made available to the public

What is the purpose of liquidity ratios?

Liquidity ratios measure a company's ability to meet its short-term obligations

How can managers alter EPS?

Managers can significantly alter EPS by selling shares of common stock or repurchasing shares of common stock

Price/Earnings Ratio Formula

Market Price per Share/Earnings per Share

What is the purpose of market ratios?

Market ratios relate the current price per share of a company's stock to the return that accrues to stockholders. Analysts find these ratios helpful because they are based on the current value of an owner's investment in a company

Receivables Turnover Ratio

Net Credit Sales/Average Net Receivables

Return on Assets Ratio (ROA)

Net Income/Average Total Assets

Return on Equity Ratio (ROE)

Net Income/Average Total Stockholders' Equity

Net Profit Margin Ratio

Net Income/Net Sales Revenue

Earnings per Share Ratio (EPS)

Net Income/Weighted Average Number of Common Shares Outstanding

Fixed Asset Turnover Ratio

Net Sales Revenue/Average Net Fixed Assets

Total Asset Turnover Ratio

Net Sales Revenue/Average Total Assets

What are the market ratios?

Price/Earnings (P/E) Ratio and Dividend Yield Ratio

What are two fundamental strategies for understanding a company's strategy?

Product differentiation and cost differentiation

What is the function of ratio analysis?

Ratio analysis helps decision makers identify significant relationships and make meaningful comparisons

One of the most general frameworks for evaluating a company's profit drivers is to examine its _______________

Return on Assets (ROA)

What ratio compares income to the total assets used to generate the income?

Return on assets (ROA)

What are the types of profitability ratios?

Return on equity ratio (ROE), return on assets ratio (ROA), gross profit margin ratio, net profit margin ratio, earnings per share ratio (EPS), and quality of income ratio

What is the purpose of return on equity?

Return on equity relates income earned to the investment made by the owners. Investors expect to earn a return on the money they invest

What is the purpose of solvency ratios?

Solvency ratios measure a company's ability to meet its long-term obligations

What is the purpose of the earnings per share ratio?

The earnings per share ratio is a measure of return on investment that is based on the number of common shares outstanding

Operating Cycle

The operating cycle is the time it takes for a company to pay cash to its suppliers, sell goods to its customers, and collect cash from it customers. Analysts are interested in the operating cycle because it helps them evaluate a company's cash needs and is a good indicator of operating efficiency

What is the purpose of the quality of income ratio?

The quality of income ratio compares net income to cash flows from operating activities

Component Percentages

These express each item on a particular financial statement as a percentage of a single base amount

Profitability Ratios

These focus on net income and how it compares to other amounts reported on the financial statements

What is the purpose of the total asset turnover ratio?

This ratio captures how well a company uses its assets to generate revenue

What is the purpose of the cash coverage ratio?

This ratio compares the cash from operations to the cash needed to make required interest payments

What is the purpose of the times interest earned ratio?

This ratio compares the income available to pay interest in a period to a company's interest obligation for the same period. This ratio indicates a margin of protection for creditors. Interest expense and income tax expense are included in the numerator because these amounts are available to pay interest

What is the purpose of the debt-to-equity ratio?

This ratio expresses a company's debt as a proportion of its stockholders' equity

What is the purpose of the quick ratio?

This ratio is a more stringent test of short-term liquidity than the current ratio

What is the purpose of the fixed asset turnover ratio?

This ratio measures a company's ability to generate sales given an investment in fixed assets

What is the purpose of the receivable turnover ratio?

This ratio measures how quickly a company collects its accounts receivable

What is the purpose of the inventory turnover ratio?

This ratio measures how quickly the company sells its inventory

What is the purpose of the current ratio?

This ratio measures the ability of the company to pay current debts as they become due

What is the purpose of the cash ratio?

This ratio measures the adequacy of available cash

What is the purpose of the Price/Earnings Ratio?

This ratio measures the relationship between the current market price of a company's stock and its earnings per share. The P/E ratio reflects the stock market's assessment of a company's future performance. A high ratio indicates that earnings are expected to grow rapidly

What is the purpose of the gross profit margin ratio?

This ratio reflects gross profit as a percentage of sales. If not shown separately on a company's income statement, gross profit is computed by subtracting cost of sales from net sales

What is the purpose of the net profit margin ratio?

This ratio reflects net income as a percentage of sales and is used as a measure of operating efficiency • Note: It is difficult to compare profit margins for companies in different industries. There is a trade-off between profit margin and sales volume

What is the purpose of the dividend yield ratio?

This ratio reflects the return on investment solely due to the dividends a company pays

Debt-to-Equity Ratio Formula

Total Liabilities/Total Stockholders' Equity

What are the types of asset turnover ratios?

Total asset turnover ratio, fixed asset turnover ratio, receivables turnover ratio, and inventory turnover ratio

What do financial statements portray?

While financial statements reflect transactions, each of those transactions is the result of a company's operating decisions as it implements its business strategy