Finance Chapter 3
Increase in accounts receivable is a ____________ in cash flows a.) Increase b.) Decrease
b.) Decrease (Because an increase in accounts receivable means customer owes you money. So you have not been paid yet. It's like you're spending money you haven't received)
Liquidity Ratios
financial ratios that measure the ability of a firm to obtain the cash it needs to pay its short-term debt obligations as they come due includes: 1.) Current ratio 2.) Quick (acid-test) ratio 3.) (personal liquidity ratio)
Ratio analysis
involves methods of calculating and interpreting financial ratios to analyze and monitor the firm's performance.
FASB 52
mandates that U.S.-based companies translate their foreign-currency-denominated assets and liabilities into dollars, for consolidation with the parent company's financial statements. This is done by using the current rate (translation) method
Times interest earned ratio (interest coverage ratio) (uses income statement)
measures the firm's ability to make contractual interest payments; sometimes called the interest coverage ratio. Formula: EBIT (i.e. operating profit) / Interest expense
Debt to equity ratio
measures the relative proportion of total liabilities and common stock equity used to finance the firm's total assets. Formula: Total liabilities / Total Common stock equity
Public corporations with more than _____ million in assets and more than _____ stockholders are required by the Securities and Exchange Commission (SEC) to provide their stockholders with an annual stockholders report.
$5 million, 500 stockholders
Inventory turnover
Measures the activity, or liquidity of a firm's inventory. I.e. how quickly (how many times) a firm can go through it's inventory, within a given period. Formula: cost of good sold (COGS) / Average Inventory or COGS/ (beg inventory + end inventory/2)
Current ratio
Measures the company's ability to pay current liabilities from current assets (i.e. meet it's short term obligations). Formula: Total current assets / Total current liabilities.
Fixed-payment coverage ratio (uses income statement)
Measures the firm's ability to meet all fixed-payment obligations. (See image for formula)
Personal liquidity ratio (a play on current ratio)
Measures the percent of annual debt obligations that an individual can meet using current liquid assets Liquidity Ratio = Total Liquid Assets / Total Current Debts
Net profit margin
Measures the percentage of each sales dollar remaining after all costs and expenses, including interest, taxes, and preferred stock dividends, have been deducted. Formula: Earnings available for common stockholders / Sales i.e. Net profit / Sales revenue
Gross profit margin (uses income statement)
Measures the percentage of each sales dollar remaining after the firm has paid for its goods. Formula: Net Sales - COGS / Net Sales (or) Gross Profits/ Net Sales
Operating profit margin
Measures the percentages of each sales dollar remaining after all costs and expenses other than interest, taxes, and preferred stock dividends are deducted (i.e. EBIT). Operating profits (EBIT) / sales
Debt ratio
Measures the proportion of total assets financed by the firm's creditors. Formula: Total liabilities / Total assets
Cash basis method
Not recognized under GAAP. Recognizes revenue and expenses when cash is received or removed (from the bank).
Sarbannes-Oxley Act of 2002
Passed to eliminate the many disclosure and conflict of interest problems of corporation. Established by the Public Company Accounting Oversight Board (PCAOB) PCAOB is a not for profit corporation that oversees auditors, and is charged with protecting the interest in the preparation of informative, fair, and independent audit reports.
Balance sheet
Presents a summary of a firm's financial position at a given time. Balances the firm's assets (what it owns) against its financing, which can be either debt (what it owes) or equity (what was provided by owners)
Income statement
Provides a financial summary of a company's operating results during a specified period (month, week, or year). Although they are prepared quarterly for reporting purposes, they are generally computed monthly by management and quarterly for tax purposes.
Stockholders' report
Summarizes and documents the firm's financial activities during the past year
Paid-in capital in excess of par on common stock (found on balance sheet; equity)
The amount of proceeds in excess of the par value received from the original sale of common stock
Average payment period
The average number of days a company takes to pay off credit purchases.
Total asset turnover
The efficiency with which the firm uses its assets to generate sales. Formula: Sales / Total assets
Financial leverage
The management of risk and return through the use of fixed cost (capital) financing, such as debt and preferred stock. The more fixed cost-debt the firm uses the greater it's expected risk and return.
Earnings management
The practice of manipulating earnings in order to mislead investors.
T/F: market ratios capture both risk and return
True
What are some methods firm's utilize to compare financial ratios?
1. Cross sectional analysis 2. Benchmarking 3. Comparing industry averages 4. Time-series analysis
Cautions about Using Ratio Analysis
1. ratios that reveal large deviations from the norm merely indicate the possibility of a problem (often you have to look further into the problem) 2. a single ratio does not generally provide sufficient information from which to judge the overall performance of the firm. must have value to compare it to. (don't look at one ratio and take it as gospel, there could be many reasons for whats going on) 3. the ratios being compared should be calculated using financial statements dated at the same point in time during the year. 4. it is preferable to use audited financial statements 5. financial data being compared should have been developed in the same way (use the same formula) 6. results can be distorted by inflation (be consistent)
Interested parties in ratio analysis
1.) Current and prospective shareholders: are interested in the firm's current and future level of risk and return, which directly affects share price 2.) Creditors: are interested in the short-term liquidity of the company and its ability to make interest and principal payments. 3.) Management is concerned with all aspects of the firm's financial situation, and it attempts to produce financial ratios that will be considered favorable by both owners and creditors.
Current rate (translation method)
A technique used by U.S. based companies to translate their foreign-currency-denominated assets and liabilites into dollars, for consolidation with the parent company's financial statement, using the year-end (current) exchange rate. Equity accounts are translated into dollars by using the exchange rate that prevailed when the parent's equity investment was made (the historical rate). Retained earnings are adjusted to reflect each year's operating profits (or losses).
International Financial Reporting Standards (IFRS)
Accounting standards, issued by the International Accounting Standards Board, IASB, that have been adopted by many countries outside of the United States.
Average collection period (ACP)
Average amount of time needed to collect accounts receivable. I.e. average time it takes to convert accounts receivable to cash. (See image for formula)
Average age of inventory (AAI)
Average number of days that pass before a firm sells all of its inventory. I.e. how long the inventory sits. Formula: 365 / Inventory turnover
What is the most informative approach to ratio analysis?
Combination of cross-sectional and time-series analyses. This is called combined cross-sectional analysis.
Time series analysis
Evaluation of the firm's financial performance over time using financial ratio analysis, which enables analysts to assess the firm's progress.
Common Size Income Statement
Income statement where all items on the income statement are expressed as a percentage of revenues
Quick (acid-test) ratio
Is like the current ratio, but removes inventory from current assets.
Debt ratios
Ratios that measure the degree and effect of a firm's use of borrowed funds (debt) to finance its operations. Includes: 1.) Debt ratio 2.) Debt to equity ratio 3.) Times interest earned ratio 4.) Fixed payment coverage ratio
Profitability ratios
Ratios that measure the rate of return a firm is earning on various measures of investment. Includes: 1.) Gross profit margin 2.) Operating profit margin 3.) Net profit margin 4.) Earnings per share 5.) Return on total assets 6.) Return on equity
Accrual basis method
Recognizes revenue and expenses when sale is made or expense is incurred (not when funds are actually obtained or removed from the bank). Based on when transaction took place.
Statement of retained earnings
Reconciles the net income earned during a given year, and any cash dividends paid, with the change in retained earnings between the start and the end of that year
Activity ratios
Show how well financial managers are creating value from organizational assets. Includes: 1.) Inventory turnover 2.) Average collection period 3.) Average payment period 4.) Total assets turnover
Benchmarking
a type of cross-sectional analysis in which the firm's ratio values are compared to those of a key competitor or group of competitors that it wishes to emulate
Increase in liabilities is a _________________ in cash flows
a.) Increase
Increase in accounts payable is a ______________ in cash flows a.) Increase b.) Decrease
a.) Increase (if you have an increase in accounts payable or any liabilities, means you have just received cash from a creditor so you have increased the amount of cash/assets your firm has "temporarily")
Statement of cash flows
provides a summary of the firm's operating, investment, and financing cash flows and reconciles them with changes in its cash and marketable securities during the period Note: this statement not only provides insight into a company's investment, financing, and operating activities, but also ties together the income statement and previous and current balance sheets.
Earnings per share
represents the number of dollars earned during the period on the behalf of each outstanding share of common stock. Formula: Earnings available for common stockholders / Number of shares of common stock outstanding
Liquidity, activity, and debt ratios primarily measure __________, while profitability ratios measure _____________.
risk, return
Cross sectional analysis
the comparison of different firms' financial ratios at the same point in time; involves comparing the firm's ratios to those of other firms in its industry or to industry averages.
Generally accepted accounting principles (GAAP)
the practice and procedure guidelines used to prepare and maintain financial records and reports; authorized by the Financial Accounting Standards Board (FASB)