D076 Module 7

Which statement below is an example of how ratios are used in the field of finance?

A firm's ratios are compared with those of a benchmark peer group to determine the firm's relative strength and performance.

DuPont Framework

An expanded formula of the return of equity, net margin times total asset turnover times leverage multiplier, which represent the components of profitability, activity (efficiency), and financing.

What is the ratio that tells you on average how long it takes for a firm to collect accounts receivable?

Average collection period

Why are several different types of ratios used to analyze a firm?

Because different types of ratios are needed to get information about different parts of a firm

Why are ratios considered flexible?

Because they are not regulated and can be changed or invented according to a firm's needs

The firm Betsy's Books conducts a financial analysis using ratios to know how it is performing in comparison to other similar firms. What is this process called?

Benchmarking

What is operating margin useful for?

Comparing the profitability of firms with different capital structures

You are a financial analyst of an investment bank, and you are doing research on equity. You are looking at a book publisher's financial ratios in comparison to its competitors and the industry average. What is this an example of?

Cross-sectional analysis

Which actions, taken together, will certainly increase a firm's ROE?

Decreasing equity financing and increasing net margin

What allows an investor to determine which financial activities are contributing to changes in the return on equity?

DuPont framework

Knowing that you are taking this finance class, a friend asks you about two investment opportunities he is considering. He wants to know which of the firms is using its assets more efficiently to generate sales. Which set of information could help you determine this?

Firm A has an asset turnover of 4, and Firm B has an asset turnover of 2.5.

You are considering starting a new business to sell Widgets in your hometown. You can import the Widgets at a low cost, and you hope to be able to sell them for significantly more. Which ratio can help you calculate how much profit you will earn from the sale of each Widget? (Assume you are only considering the cost of the Widget, not any other operating costs.)

Gross margin

Which action increases the return on equity of a firm if all else remains constant?

Increasing debt financing

How can the DuPont framework help a company assess its return on equity?

It allows the company to determine how its abilities to generate profits, manage assets, and use financing contribute to the return on equity.

What does a debt ratio of 40% indicate?

It indicates that 40% of assets are financed by debt.

A firm has paid off its short-term loans more quickly in the past couple of years. What might this trend indicate about the firm's financial ratios?

Its liquidity ratio is increasing.

Which type of ratio is a current ratio?

Liquidity

What type of ratio is used to assess a firm's ability to meet short-term obligations without raising external capital?

Liquidity ratios

Which type of ratio are suppliers interested in?

Liquidity ratios

Which of these measures is a component of return on equity?

Net margin

What does an average collection period of 70 tell you?

On average, a firm takes 70 days to collect accounts receivable.

A company currently has a ratio of 1.5 but hopes to improve the ratio to 2 to align more with the industry benchmark. To achieve this goal, costs were cut in production through an investment in efficient equipment, and the company achieved a higher profit margin. If this continues, you are certain that the firm will achieve its goal in two years. What is this an example of?

Progress measurement

What is the difference between return on assets (ROA) and return on equity (ROE)?

ROE considers the capital structure of a company, while ROA does not.

How might calculating financial ratios help shareholders?

Ratios can be used to determine whether a firm is maximizing shareholder wealth.

MiniCo recently spun off of BigCo. Both companies have the same leverage and asset turnover ratios, but MiniCo is underperforming on its return on equity to shareholders. If MiniCo would like to improve its return on equity, which action would help?

Reduce costs to improve its overall profitability.

What is a component of the DuPont framework?

Return on assets

BigDog and SmallDog are two companies that have an identical return on equity. One difference between the two companies is that BigDog has 40% of assets financed by debt while SmallDog has 100% of assets financed by equity. What can you conclude about BigDog and SmallDog?

SmallDog has a higher ROA than BigDog.

What is one way that a firm can improve its return on equity?

Successfully cutting production costs to boost net margin

What is the main difference between the current ratio and the quick ratio?

The current ratio includes inventory in current assets, and the quick ratio does not.

What does high inventory turnover relative to the industry and competitors indicate?

The firm does not hold enough inventory and is making its customers wait longer to receive their purchased goods.

What does the net margin measure?

The percent of revenue that is retained as profit for the firm

The firm Betsy's Books has a market-to-book ratio of 1.2. What does this tell you about the firm?

This firm is expected to grow in the future.

For what purpose are market ratios used?

To evaluate the current share price of a public firm's stock

Which method of ratio analysis looks at a firm's performance over time?

Trend analysis

What do leverage ratios describe?

What proportions of equity and debt a firm uses to finance its assets

profitability ratios

a category of ratios that are commonly used to directly judge how well management is doing as they strive to maximize owner wealth

market ratios

a category of ratios that are used to evaluate the current share price of a public firm's stock.

leverage ratios

a category of ratios that consider how a firm is financed

liquidity ratio

a category of ratios that measure a firm's ability to meet short-term obligations

activity ratio

a category of ratios that measure how well a company uses its assets to generate sales or cash, showing the firm's operational efficiency and profitability

times interest earned (TIE)

a financing ratio found by EBIT/interest expenses

debt ratio

a financing ratio found by total liabilities/total assets

debt-to-equity ratio

a financing ratio found by total liabilities/total equity

quick ratio

a liquidity ratio found by current assets-inventory/current liabilities. also called the acid-test ratio. a company with a higher ratio is usually viewed as having a greater ability to meet short-term obligations.

current ratio

a liquidity ratio found by current assets/current liabilites. a direct comparison of the two variables. a higher ratio if usually interpreted as a better likelihood that the firm will be able to meet its short-term obligations.

market-to-book ratio (M/B ratio)

a market ratio found by market value of equity/book value of equity. if ratio is greater that 1, considered a growth stock. if less than 1 it is considered a value stock.

price-to-earnings ratio (P/E ratio)

a market ratio found by price per share/earnings per share.

net margin

a profitability found by net income/sales

operating margin

a profitability ratio found by EBIT profit/sales

gross margin

a profitability ratio found by gross profit/sales

return on equity

a profitability ratio found by net income/owners' equity

return on assets (ROA)

a profitability ratio found by net income/total assets

inventory turnover

an activity ratio found by COGS/inventory

accounts receivable turnover (AR turnover)

an activity ratio found by credit sales/account receivable

operative income return on investment (OIROI)

an activity ratio found by operating income/total assets. describes the relationship between operating profit (EBIT) and the company's asset base.

fixed asset turnover (FAT)

an activity ratio found by sales/fixed assets. tells you how many dollars in sales the firm generates per dollar of fixed assets.

total asset turnover (TAT)

an activity ratio found by sales/total assets, measures how many dollars in sales the firm generates per dollar of assets.

average collection period (ACP)

an activity ratio found by the number of days in a year 365/AR Turnover. converts AR Turnover into a day count measure.

liquid asset

an asset that can be converted into cash quickly without the loss of significant value

leverage

another name for debt or liability

total asset turnover

calculates how well a firm is using its assets to generate sales, which you will define as sales/total assets.

cross-sectional analysis

comparing a firm's financial ratios to other firms' ratios or industry averages.

trend analysis

comparing a firm's ratios across time.

market value of equity

computed by multiplying the price per share by the number of shares outstanding.

seasonal firms

firms whose performance varies according to the season

fixed assets

include all non-current assets, or total assets minus current assets

financial risk

increased volatility in earnings as a result of using debt

current assets

items that will generate cash within the next year

progress measurement

measure progress and achieve goals.

current liabilities

obligations that will require cash within the next year

benchmarking

the process of completing a financial analysis to compare a firm's financial performance to that of other similar firms.