Ch. 3 Financial Analysis

return on assets

net income divided by assets; shows how much income the firm produces for every dollar invested in assets

return on equity

net income divided by owner's equity; also called return on investment (ROI). ROE shows how much income is generated by each dollar the owners have invested in the firm

profit margin ratio

net income divided by sales; shows the overall percentage profit by the company on $1 of sales

times interest earned

operating income dividend by interest expense; a measure of the safety margin a company has with respect to the interest payments it must make to creditors. a high number indicates that there is less risk of default

current ratio

current assets divided by current liabilities, a measure of the firm's ability to pay off its current assets

quick ratio

current assets minus inventory divided by current liabilities. the ratio is sometimes called the acid test ratio and is a more stringent measure of liquidity because it eliminates inventory (the least liquid asset) from current assets

fixed charge coverage

income before fixed charges and taxes divided by fixed charges. a common fixed charge in addition to interest expense is a lease expense. this ratio is considered more rigorous than the times interest earned ratio

receivable turnover

sales divided by accounts receivable, indicates how many times a firm collects its accounts receivable in one year. it also indicates how quickly a firm is able to collect payments on its credit sales

fixed asset turnover

sales divided by fixed assets; indicates how efficiently the company is using its fixed assets to generate one dollar of sales

total asset turnover

sales divided by total assets; measures how efficiently an organization utilizes all of its assets to create one dollar of sales. it indicates whether a company is using its assets productively

inventory turnover

sales divided by total inventory; indicates how many times a firm sells and replaces its inventory over the course of a year

replacement costs

the cost of replacing the existing asset base at current prices as opposed to original cost

inflation

the phenomenon of prices increasing with the passage of time

debt to total assets

total debt divided by total assets; indicates how much of the firm is financed by debt and how much by owner's equity

liquidity ratios

a group of ratios that allows one to measure the firm's ability to pay off short term obligations as they come due. primary attention is directed to the current ratio and the quick ratio

profitability ratios

a group of ratios that indicates the return on sales, total assets, and invested capital. Specifically, we compute the profit margin (net income to sales), return on assets, and return on equity

debt utilization ratios

a group of ratios that indicates to what extent debt is being used and the prudence with which it is being managed. calculations include debt to total assets, times interest earned, and fixed charge coverage

asset utilization ratios

a group of ratios that measures the speed at which the firm is turning over or utilizing it's assets. they measure inventory turnover, and the average time it takes to collect accounts receivable

disinflation

a leveling off or slowdown of price increases

LIFO

a system of writing off inventory into cost of goods sold in which the items purchased last are written off first. referred to as last in, first out inventory method

FIFO

a system of writing off inventory into cost of goods sold, in which the items purchased first are written off first. referred to as first in, first out inventory method

average collection period

accounts receivable divided by average daily credit sales; calculates how many days it takes to collect the company's accounts receivables

deflation

actual declining prices

trend analysis

an analysis of performance that is made over a number of years in order to ascertain significant patterns

Du Pont system of analysis

an analysis of profitability that breaks down return on assets between the profit margin and asset turnover. the second, or modified version shows how return on assets is translated into return on equity through the amount of debt that the firm has. actually, return on assets is divided by (1-Debt/Assets) to arrive at return on equity