Chapter 3

EBIT =

NI / (1- TAX RATE)

growth has to be financed, so

a firm's ability to grow depends on his financing policies

Total asset turnover ratio

an important " big picture" ratio, shows how much we generated in sales for every dollar in assets

Book value per share ratio =

equity / shares

profit margin =

net income / sales

internal growth rate

shows how rapidly a firm can grow, at what maximum rate per year

Anything that increases ROE will increase

the sustainable growth rate by making the numerator larger and the denominator smaller

cash coverage ratio =

(EBIT + interest + depreciation) / interest

internal growth rate =

(ROA X b) / (1- ROA x b), ROA = return on assets, b = retention

sustainable growth rate =

(ROE x b) / (1- ROE x b), ROE = return on investment, b = retention

quick ratio =

(current assets- inventory) / current liabilities

total debt ratio =

(total assets- total equity) / total assets

Capital intensity ratio =

1 / total asset turnover

Profitability measures

Intended to measure how efficiently The Firm uses its assets and how efficiently The Firm manages its operations, the focus in this group is on the bottom line which is net income, the best known and most widely used of all financial ratios

What is ROE after being rearranged according to DuPont identity

ROE = profit margin X total asset turnover X Equity multiplier (leverage)

days sales in receivables ratio/ average collection period

Shows on average in how many days we collect on our credit sales

dividend policy ( in relation to sustaining growth)

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

return on equity

a measure of how the stockholders fared during the year, because benefiting shareholders is our goal this in an accounting sense is the true bottom line measure of performance

return on assets

a measure of profit per dollar of assets

What type of person may be interested in the cash ratio

a very short term creditor

retention ratio =

addition to retained earnings / net income

Enterprise Value

an estimate of the market value of the company's operating assets ( all assets of the firm accept cash, can you use the right hand side of the balance sheet to calculate it

profit margin ( in relation to sustaining growth)

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

Financial policy ( in relation to sustaining growth)

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

total asset turnover ( in relation to sustaining growth)

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

what might a high current ratio indicate to a firm

an inefficient use of cash and other short-term assets

times interest earned ratio

another common measure of long-term solvency, it measures how well a company has its interest obligations covered

EBITD

another way to say EBIT + depreciation

Total equity =

assets- liabilities

what value of a current ratio should you expect to see and why

at least one because anything less than one would mean that net working capital is negative which is unusual in a healthy firm

market value measures

based on the market price per share of the stock which is not necessarily information that is contained in financial statements, these measures can be calculated directly only for publicly traded companies

why might a sustainable growth rate be greater than an internal growth rate

because as the firm grows it will have to borrow additional funds if it is to maintain a constant debt ratio, this new borrowing is an extra source of financing in addition to internally generated funds

why is the DuPont identity so useful

because if ROE is unsatisfactory then the DuPont identity tells you where to start looking for the reasons

Why is it almost impossible to directly compare the financial statement s of two companies

because of differences in size

Cash ratio =

cash / current liabilities

dividend payout ratio =

cash dividends/ net income

Market to book ratio

compares the market value of the firm's Investments to their cost, a value less than one could mean that the firm has not been successful overall in creating value for its stockholders, it is important to note that book value is an accounting number so it reflects historical costs

Why are standardized statements useful for

comparing financial information year to year and comparing firms of different sizes

inventory turnover ratio =

cost of goods sold/ inventory

current ratio =

current assets/ current liabilities, this is a measure of short-term liquidity and the unit of measurement is either dollars or times

if a firm only relies on internal financing then through time is total debt ratio will

decline

Dividends per share ratio =

dividends / shares

How do you standardize the income statement

each item is a percentage of total sales

How do you standardize the balance sheet

everything under assets is that divided by total assets and the same with liabilities and stockholder's equity, it is self explanatory (ACTUAL DEF percent of total assets)

dividend payout ratio

expresses the dividends paid as a percentage of net income

external financing

funds raised by either borrowing money or selling stock

quick/ acid test ratio

further evaluates liquidity but omits inventory because Relatively large inventories are often a sign of short-term trouble so the firm may have overestimated sales and overbought or ever produced as a result

which is better for a creditor, a high current ratio or a low current ratio

high

What five questions come to mind when looking at a ratio

how is it computed? what is it intended to measure and why might we be interested? what is the unit of measurement? what might a high or low value be telling us and how might such values be misleading? how could this measure be improved?

In what case would a high total asset turnover ratio be a bad sign for a company

if a company had old assets that were almost fully depreciated turn the book value of assets as low which contributes to a higher asset turnover

in what case would a low total asset turnover ratio be a good sign for a company

if a company just purchased a lot of new equipment which implies that the book value of assets is relatively High, these new assets could be more productive and efficient than those used by the company's competitors

if sales are to grow at a rate higher than the sustainable growth rate The Firm must

increase profit margins, increase total asset turnover, increase financial leverage, increase earnings retention, or sell their shares

Long-term solvency measures

intended to address the firm's long-run ability to meet its obligations, or, more generally, it's financial leverage, consists of the total debt ratio, the times interest earned ratio, and the cash coverage ratio

Asset Management/ turnover measures

intended to describe how effectively or intensively a firm uses its assets to generate sales

Using cash to buy inventory reduces the quick ratio because

inventory is relatively illiquid compared to cash

what two ratios do asset management/ turn over consist of

inventory turnover and days sales in inventory AND receivables turnover and days sales in receivables

what is one of the problems with the times-interest-earned ratio

it is based on EBIT which is not really a measure of cash available to pay interest because depreciation has been deducted out

Receivables turnover ratio

looks at how fast we collect profit on the sales that we made from turning over our inventory, answers shows how many times during the year we collected our outstanding credit accounts and reloaned the money

Market to book ratio =

market value per share / book value per share

price-earnings ratio

measures how much investors are willing to pay per dollar of current earnings, care is needed in interpreting this ratio.

Earnings-per-share ratio =

net income / shares outstanding

return on assets =

net income / total assets, only correct in accounting terms

return on equity =

net income / total equity, only correct in accounting terms

days sales in inventory

once we know how many times during the year we turned over inventory week and then figure out how long it took us to turn it over on average

what three things does the DuPont identity tell us that ROE is affected by

operating efficiency ( as measured by profit margin), asset use efficiency ( as measured by total asset turnover), financial leverage ( as measured by the equity multiplier)

What is one problem with ratios

people and different sources frequently do not compute them in exactly the same way which leads to much confusion

price-earnings ratio =

price per share / earnings per share

price-sales ratio =

price per share / sales per share

what three ratios consist of profitability measures

profit margin, return on assets, and return on equity

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

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

Short-term solvency/ liquidity measures

provide information about a firm's liquidity, the primary concern is the firm's ability to pay its bills over the short run without undue stress, consists of the current ratio, quick ratio, and cash ratio

Financial ratios

ratios that compare and investigate the relationships between different pieces of financial information, used as another way to compare companies

receivables turnover ratio =

sales / accounts receivable

total asset turnover ratio =

sales / total assets

what are groups are financial ratios traditionally broken up into

short-term solvency or liquidity ratios, long-term solvency or financial leverage ratios, asset management or turnover ratios, profitability ratios, market value ratios

retention ratio

shows anyting that a company does not pay out in the form of dividends as a percentage of net income

Inventory turnover ratio

shows how many times during the year we turned over our entire inventory

profit margin

shows how much profit the company makes for every dollar in sales

Common-size statements

standardized financial statements that work with percentages instead of dollars, used to be able to compare different companies

total debt ratio

takes into account all debts of all maturities to all creditors

what are the two variations on the total debt ratio

the debt-equity ratio and the equity multiplier ratio

Capital intensity ratio

the dollar investment and assets needed to generate $1 in sales, it is the reciprocal of the total asset turnover ratio

days sales in inventory

365 days / inventory turnover

days sales in receivables

365 days / receivables turnover

times interest earned ratio =

EBIT / interest

EBITDA

Earnings before interest, taxes, depreciation, and amortization, ( here amortization refers to a non-cash deduction similar conceptually to depreciation except it applies to an intangible asset rather than a tangible asset)

EBITDA ratio =

Enterprise Value / EBITDA

what does the sustainable growth rate illustrate

the explicit relationship between the firm's four major areas of concern: its operating efficiency as measured by profit margin, its asset use efficiency as measured by total asset turnover, its Financial policy as measured by the debt-equity ratio, and its dividend policy as measured by the retention ratio, this makes it a VERY useful number

sustainable growth rate

the maximum growth rate that can be achieved while keeping two things in mind: 1) if it wishes to maintain a particular total debt ratio, 2) if it is unwilling to sell new stock

The difference between the two profitability measures ROA and ROE is a reflection of

the use of debt financing or financial leverage

What is one advantage of looking at current assets and liabilities

their book values and Market values are likely to be similar

Equity multiplier ratio =

total assets/ total equity OR 1 + debt equity ratio, you will get the same thing

debt equity ratio =

total debt/ total equity

Enterprise Value =

total market value of the stock + Book value of all liabilities- cash

internal financing

what the firm earns and subsequently plowed back into the business

what is important to note with PE ratio and PS ratio

whether the ratio is high or low depends on the industry involved