Section III: GAAP Financial Statement Analysis

Acid-test ratio(Quick Ratio)

(current assets- Inventory ) ÷ current liabilities this ratio measures a company's ability to meet short-term financial obligations in the event that the company is unable to sell its inventory. This is more accurate than the current ratios because the current ratios assume inventory will be sold. *Current ratio without inventory. *Important for exam*

DuPont Identity

(net income ÷ sales) x (sales ÷ total assets) x (total assets ÷ shareholders' equity) ROE = Profit Margin x Asset Turnover Ratio x Equity Multiplier. The ratio is an expanded formula for ROE. It breaks ROE into component ratios to determine exactly which factor is driving the organizations ROE performance. Using this ratio a company can determine why ROE is higher or lower than expected. (because it is broken up; analyze the three different ratio(x together) )

Days sales outstanding ratio

365 ÷ accounts receivable turnover ratio is a measure of the average number of days it takes for a company to collect its accounts receivable. A low ratio indicates a more efficient company

Working capital

Current assets - current liabilities is a company's excess assets compared to its current liabilities. A positive number indicates a healthy business that is able to pay off current liabilities with its current assets.

Practice Question

Return on Equity = Net income / Shareholder's equity. 5 mil (net income) / .20 = 25 mil. Shareholder's equity = 25 mil accounting equition: 25 mil + 15 mil (total liabilities) = 40 mil (assets) ROA = net income / total assets 5 mil / 40 mil = 0.1250 = 12.5%

Ratio analysis

These ratios are used to compare a company's performance against the industry benchmark and against the performance of another company Ratios communicate summary information about financial aspects of the company. Benchmarks are needed for ratio analysis.

Equity Multiplier

Total Assets/ Shareholder's equity *part of Dupont ROE*

Calculating percentage change

Trend analysis compares the year to year percentage change for items on the financial statement. ((Year 2 - Year 1) ÷ Year 1) x 100 = Change

Analysis of Financial Statements (Vertical)

With a company that has recently implemented growth strategies, an analyst using vertical analysis would expect to see: Increased operating expenses as a % of total sales. Decreased efficiency until production catches up with capacity. Increased long-term debt or common stock as a % of total sales.

Trend Analysis (horizontal analysis)

analysis compares financial statements across two or more years. This provides a period to period view of a company's finances, allowing the analyst to identify patterns in past data. This is most commonly used with the income statement. (predominately focus on the income statement) EX: sales growing or are expenses growing or declining?

Vertical Analysis (%)

analysis that uses a common size statement to compare the financial statements of two different companies When underwriting business interruption loss exposures, it is important to have a clear picture of the organization's operating history. Underwriters can gain this understanding through the use of this analysis. (multi-period) looks for %'s that are unusual when compared to benchmarks. Eliminates effects of inflation when making comparisons over time.

Multi-period vertical analysis

applies single-period analysis to more than one period. Focuses on composition(!) of the company's assets, liabilities, income and expenses. Determines whether changes are consistent with the goals and objectives of the company. Can be used to analyse interim period results, as well as annual results. Does not address how much the company can grow or has grown. (We would perform trend analysis instead)

Singled-period vertical analysis

can be used to compare 2 companies over a single period. can be performed on both the balance sheet and income statement. %'s for assets, liabilities, income, and expenses are determined for one period.

Inventory turnover ratio

cost of goods sold ÷ inventory ratio measures how quickly inventory is sold. A high ratio indicates inventory is being sold quickly. A low ratio indicates inventory is not being sold quickly, meaning the company is incurring more costs than it would if the inventory was sold quickly. *Most important for exam*

Accounts receivable turnover ratio

credit sales ÷ accounts receivable measures how quickly a company collects the money it's owed by its customers. This is an important ratio because the longer money is outstanding, the greater the chance that the money will not be collected A higher ratio indicates a more efficient company

Current ratio

current assets ÷ current liabilities is an indication of how adequate a company's working capital is to meet its current financial obligations. Like working capital, this is also an indication of a company's ability to meet short term financial obligations

Trend analysis (year-to-year)

determines % change in values for statement items between consecutive year. Most common method of trend analysis.

Trend analysis ( base-year-to-date analysis)

determines percentage change in current year to base year. ex: 2005 compared to 2017

Leverage Ratios

indicate the degree to which a company has borrowed money (measure the extent to which a company uses deb financing) A company that relies on borrowing funds, such as loans, to fund their business is considered a highly leveraged company. A company that does not have any debt is considered a company with no financial leverage Ratios: Debt to equity ratio Debt to assets ratio

Common size financial statement

is a financial statement that reports each line of the financial statement as a percentage of a base figure. This allows the reader to evaluate the relative financial performance of two or more different companies; otherwise, it is difficult to compare two different size companies. Used in Vertical Analysis(%)

Uses of Trend Analysis

is an excellent tool for quantifying the changes in a company's profitability over the years. Multiple period vertical analysis does not quantify growth rates of a company's financial data. The quantification of growth rates can be used to help project the company's performance in the coming year.

Debt to equity ratio

long term debt ÷ shareholders' equity measures the amount to which a company finances their operations using borrowed money. A higher ratio indicates that a company has financed its growth with debt meaning there is a greater potential for financial distress if the company cannot repay its debt.

Profitability ratios

measure a company's ability to generate income. (earning capacity) ratios: Net profit margin Return on assets (ROA) Return on equity (ROE) DuPont Identity

Efficiency ratios

measure a company's ability to manage and use assets. Evaluate speed in which a business collects from customers or in which inventory is sold. ratios: Accounts receivable turnover ratio Days sales outstanding ratio Assets turnover ratio Inventory turnover ratio

Liquidity Ratios

measure a company's ability to pay off short term debt. Evaluate a business's ability to meet its cash obligations in the near term. ratios: Working capital Current ratio Acid-test ratio

Net Profit Margin

net income / Sales *part of Dupont ROE*

Return on equity (ROE)

net income ÷ shareholders' equity measures the rate of return that a shareholder is earning on their equity. This is a very important ratio because it measures the actual return to stockholders. A ratio lower than the industry average indicates the company is performing poorly compared to the industry. **Most important for EXAM**

Return on assets (ROA)

net income ÷ total assets measures how well a company uses its assets to generate income. A higher ratio indicates the company is effectively using its assets to generate income.

Asset turnover ratio

sales ÷ total assets measures a company's use of its assets. A high ratio indicates that a company is using its assets to generate higher sales *Part of Dupont ROE*

Debt to assets ratio(Debt Ratio)

total liabilities ÷ total assets measures the extent to which a company's assets are financed by debt such as borrowed funds and accounts payable. A high ratio indicates the company is highly leveraged meaning there is a greater potential for financial distress if the company cannot repay its debt. A ratio less than .5 indicates a company financed primarily through shareholder contributions. A ratio greater than .5 indicates a company primarily financed with debt.