FINANCE CH4

What are the limitations of industry average ratios? Discuss briefly.

1. It is sometimes difficult to identify the industry category to which a firm belongs when the firm engages in multiple lines of business. 2. Published peer group or industry averages are only approximations and provide the user with general guidelines rather than scientifically determined averages of the ratios of all, or even a representative sample, of the firms within an industry. 3. Accounting practices differ widely among firms and can lead to differences in computed ratios. 4. Financial ratios can be too high or too low. For example, a current ratio that exceeds the industry norm may signal the presence of excess liquidity, which results in a lowering of overall profits in relation to the firm's investment in assets. On the other hand, a current ratio that falls below the norm may indicate (1) the possibility that the firm has inadequate liquidity and may at some future date be unable to pay its bills on time, or (2) the firm is managing accounts receivables and inventories more efficiently than other similar firms. 5. An industry average is not necessarily a desirable target ratio or norm. There is nothing magical about an industry norm. 6. Many firms experience seasonality in their operations. Thus, balance sheet entries and their corresponding ratios will vary with the time of year when the statements are prepared.

What is Economic Value Added? Why is it used?

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Describe the "five-question approach" to using financial ratios.

In learning about ratios, we could simply study the different types or categories of ratios. These categories have conventionally been classified as follows: Liquidity ratios are used to measure the ability of a firm to pay its bills on time. Example ratios include the current and acid-test ratio. Efficiency ratios reflect how effectively the firm has utilized its assets to generate sales. Examples of this type of ratio include accounts receivable turnover, inventory turnover, fixed asset turnover, and total asset turnover. Leverage ratios are used to measure the extent to which a firm has financed its assets with outside (non-owner) sources of funds. Example ratios include the debt ratio, long-term debt-to-total-capitalization ratio, and times interest earned ratio. Profitability ratios serve as overall measures of the effectiveness of the firm's management relative to sales and/or to investment. Examples of profitability ratios include the net profit margin, return on total assets, operating profit margin, operating return on assets, and return on common equity. Instead, we have chosen to cluster the ratios around important questions that may be addressed to some extent by certain ratios. These questions, along with the related ratios may be stated as follows: 1. How liquid is the firm? Current ratio Quick ratio Accounts receivable turnover (average collection period) Inventory turnover 2. Is management generating adequate operating profits on the firm's assets? Operating return on assets Operating profit margin Gross profit margin Asset turnover ratios, such as for total assets, accounts receivable, inventory, and fixed assets 3. How is the firm financing its assets? Debt to total assets or debt to equity Times interest earned 4. Are the owners (stockholders) receiving an adequate return on their investment? Return on common equity 5. Is the management team creating shareholder value? Price/Earnings Price/Book Economic Value Added

What is liquidity, and what is the rationale for its measurement?

Liquidity is the ability to repay short-term debt. We measure liquidity by comparing the firm's liquid assets—cash or assets that will be turned into cash in the operating cycle—to the amount of short-term debt outstanding, which is the measurement provided by the current ratio and the quick or acid-test ratio. We can also measure liquidity by computing how quickly accounts receivables turn over (how long it takes to collect them on average) and how quickly inventories turn over. The more quickly these assets can be turned over, the more liquid the firm is.

Distinguish between a firm's operating return on assets and operating profit margin.

Operating return on assets is the amount of operating income produced relative to $1 of assets invested (total assets), while operating profit margin is the amount of operating income per $1 of sales. The first ratio measures the profitability on the firm's assets, while the latter measures the profitability on the sales.

Explain what determines a company's return on equity.

Return on equity is equal to net income divided by the total equity. But knowing how to compute return on equity is not the same as understanding what decisions drive return on equity. It helps to know that return on equity is driven by the spread between operating return on assets and the interest rate paid on the firm's debt. The greater the OROA compared to the interest rate, the higher the return on equity will be. And if OROA is higher (lower) than the interest rate, the more debt the firm uses, the higher (lower) the return on equity will be.

What information do the price/earnings ratio and the price/book ratio give us about the firm and its investors?

The price/earnings (P/E) ratio indicates how much investors are willing to pay for $1 of reported earnings, and is computed as follows: Price/earnings ratio = earnings per share price per share The price/earnings ratio will be higher for companies that investors think have strong growth prospects with low risk. The price/book ratio compares the market value of a share of stock to the book value per share of the firm's reported equity in the balance sheet, calculated as follows: Price/book ratio = equity book value per share price per share Given that the book value per share is an accounting number that reflects historical costs, we can roughly think of it as the investors' original price they paid for their shares. So, a ratio greater than one indicates that investors believe the firm is more valuable than what they originally paid for the stock. In like manner, a ratio less than one suggests that investors do not believe the stock i