Accounting: Chapter 5

How can debt financing negatively affect operating activities?

Use of this financing can --> covenants ( restrictions on operating activites imposed by creditors to help safeguard debt holders)

What can affect the asset turnover?

What metric is most directly affected by: - level of sales - level of assets

Profit Margin - equation, what does it measure

=(earnings without interest)/(sales revenue) description of company's profitability

True/False: financial ratios can indicate good or poor managment

False - alone, ratios cannot indicate quality of management - only indicate what analyst should investigate further

Solvency Analysis: 2 measurement approaches

Following are approaches of what type of analysis? - use balance sheet to assess proportion of capital raised from creditors --> debt-to-equity ratio - use income statement to assess profit generated relative to debt payment obligations --> times interest earned

What types of things will affect profit margin (PM)?

What metric will be most directly related to be affected by: - level of gross profit - level of operating expenses required to support sales - level of competition and company's ability to manage pricing/manage costs

Explain how a current ratio <1 in a service company is not necessarily problematic:

service company will typically report little to no inventories => current assets do not capture the service aspect => can have depressed ratio

When can the use of leverage be helpful in increasing ROE?

should use this tactic when the interest charged is less than the assets' rate of return

(1) What are return on investment metrics? (2) what are the three important metrics?

(1) = (some measure of performance)/(average amount of some investment per balance sheet) - numerator typically income statement measures (2) examples: - return on equity (ROE) - Return on Assets (ROA) - Return on financial Leverage (ROFL)

Liquidity vs Solvency Analysis: compare, breakdown

(1) = analysis of available cash (2) = ability to generate sufficient cash in future to meeting debt obligations (includes both periodic interest payments and repayments of principal borrowed)

Ratio Breakdown:

- ROA - Profit Margin - Gross Profit margin (GPM) - Expense to Sales (ETS) - Asset Turnover - Accounts Receivable Turnover (ART) - Inventory Turnover (INVT) - Property, Plant & Equipment Turnover (PPET) - ROFL - Liquidity and Solvency

What are porter's five forces?

1. Buyer Power 2. Supplier Power 3. Rivalry Among Firms 4. Threat of New Entrants 5. Threat of Substitutes

Inventory Turnover (INVT)

= (COGS)/(average inventory) = # times total inventory was sold (i.e. turned) within given time period => high value indicates inventory managed efficiently Falls under asset turnover

Operating Cash Flow to Current Liabilities

= (Cash flow from Operations)/(Average Current Liabilities)

Return on Assets

= (Earnings w/o interest expense)/ (average total assets) *EWI = net income + [interest expense*(1-statutory tax rate)] average total assets = (begining total assets + ending total assets)/2 measures the return earned on each dollar the firm invests in assets => captures returns generated from operating and investing activities, ignoring how they are financed

Operating Cash Flows to Current Liabilities (OCFCL)

= (cash flow from operations)/(avg current liabilities) - relates net amount of cash from operating activities to amount of current payment obligations key factor in ultimate ability to pay its debts - if operations can generate enough cash to coer debt payments

Current Ratio

= (current assets)/(current liabilities) describes working capital as ratio instead of difference => excess amount of capital beyond what is required to to cover current debts positive ratio => positive working capital => more expected cash inflows than outflows in short run note: generally, higher is better, but if too high, indicates inefficient asset use

times interest earned (TIE)

= (earnings before interest and taxes)/(interest expense) => sometimes called (EBIT/I) numerator is similar to EWI, but is PREtax instead of after tax = how much operating profit available to pay interest - higher ratio => smaller risk of default

Return on Equity (ROE)

= (net income) / (average stockholder's equity) - net income - measured by performance over specific period of time - determine average investment by shareholders via total stock holder's equity on balance sheet

Property, Plant & Equipment Turnover (PPET)

= (sales revenue)/(average PP&E) - avg PP&E - net of accumulated depreciation how much sales revenue was generated for each investment dollar spent on PP&E => measure of asset utilization and how efficiently company operates given its productive technology

Accounts Receivable Turnover

= (sales revenue)/(average accounts receivable) => how many times receivables have been collected during given period Falls under Asset Turnover

What is the structure of any ratio with the term "turnover"? Exception?

= (sales revenue)/(average of total assets or some specific asset) exception: inventory turnover => (cogs)/(average inventory)

Asset Turnover

= (sales revenue)/(average total assets) => level of sales generated by each dollar that a company invests in its assets - measure of company's productivity and efficiency

Debt-to-Equity Ratio

= (total liabilities)/(stockholder's equity) indicates how reliant company is on creditor financing vs equity financing; higher value => less solvency & more risk creditor financing = fixed claims vs equity = flexible/residual claims affected by mix of assets used, stability of business operations => be sure to compare to similar companies

Gross Profit Margin

= [(sales revenue) - (COGS)]/(sales revenue) = (gross profit)/(sales revenue)

(net) working capital

= current assets - current liabilities =>

Risk

= uncertainty that investment may not provide expected return

Explain Earnings without interest expense & how it's calculated

= what the net income would have been if there had been no interest removed = net income + [interest expense*(1-statutory tax rate)]

Expected Return

= what you expect to earn on an investment, given the risk of the investment

What is the relationship between ROA, profit margin (PM) and asset turnover (AT)

ROA = (EWI)/(average total assets) = (EWI)/(sales revenue)*(sales revenue)/(average total assets = (profit margin)*(asset turnover) basically separates the numerator and demonimator of ROA using sales revenue Note: can increase ROA by increasing either profit margin or asset turnover, but the mix between two generally based on company's industry

what must be true for the ROFL to be positive?

ROA > cost of debt (after-tax interest rate) interest cost on debt = tax deductable => use afer-tax i.r.

What is the relationship between ROE, ROA, and ROFL

ROE = ROA + ROFL - ROE: return on equity - ROA: return on assets - ROFL: return on financial leverage

Effect of Financing on ROE: good times vs bad times

ROE is based on net income and equity - by using financing, can boost net income and maintain/decrease equity => increase ROE!; trade off = interest expense and increased default risk - good times: boost to net income is greater than interest expense => net increase in net income with stable/decreased equity --> increased ROE - bad times: net income not significant enough to cover interest expense or negative --> net income depressed further than without financial leverage => makes bad year worse

Liquidity analysis ratios

What type of analysis looks at the following ratios: - current ratio - quick ratio - operating cash flow to current liabilities notes: compares either assets or cash flows to current liabilities - for first two, current or subset of assets divided by current liabilities, for last, cash flows divided by avg current liabilities

Solvency analysis ratios

What type of analysis looks at the following ratios: - debt to equity - times interest earned

Explain how a current ratio < 1 may not be a bad thing in a cash and carry company

cash and carry company: may have high amount of operating cash inflows, but little or no receivables => lots of liquidity, but not reflected in current assets --> low current ratio

Which is more costly: debt financing or equity? why?

debt financing is usually cheaper than equity reason: in case of default, creditors are paid first, then shareholders get paid with whatever is left over => shareholders have higher risk so require higher returns => more costly to company

Expense to Sales Ratio

examines how much of sales revenue went to cover a particular expense = (any given expense)/(net revenue)

Return on Financial Leverage (ROFL)

gauges effect of financial leverage (i.e. effect that debt financing) on shareholders return captures amount of ROE that can be attributed to financial leverage = ROE - ROA

quick ratio

variant of current ratio that focuses on assets that will be converted to cash in very short amount of time => reflects ability to meet liabilities without liquidating assets/inventory that could require marke downs = (cash & equivalents + short-term securities + accounts receivable)/(current liabilities)