Finance 1 Exam 2
Which analytical techniques should be used in a complete financial statement analysis?
A thorough financial statement analysis usually consists of a Du Pont analysis to provide an overview and then includes several different techniques such as ratio, common size, and percentage change analysis
Why might a focus on operating revenue and operating income be preferable to a focus on total revenue and net income?
All applicable ratios, as well as the Du Pont analysis, could be recast to focus on operations by using operating revenue and operating income in lieu of total revenues and net income. This might be preferable because operating is where businesses should be getting the majority of their profits.
What is the primary difference between financial statement analysis and operating indicator analysis?
Although financial statement analysis provides a great deal of important information regarding financial condition, it fails to provide much insight into the operational causes of that condition.
Does the fact that a business's cash position has improved provide much insight into the year's financial results?
Although the statement of cash flows is filled with valuable information, the bottom line tells little about the business's financial condition because operating losses can be covered by financing transactions such as borrowing or selling new common stock (if investor owned), at least in the short run.
What are two ratios that measure debt management?
Capitalization ratios: use balance sheet data to determine the extent to which borrowed funds have been used to finance assets Debt ratio: total debt divided by total assets (prefer low ratios)—how much financing have creditors supplied Debt-to-capitalization ratio: long term debt divided by long-term capital (long-term debt plus equity)—focuses on proportion of debt used in a business's permanent capital structure Coverage ratios: income statement data are used to determine the extent to which fixed financial charges are covered by reported profits Times interest earned (TIE) ratio: dividing earnings before interest and taxes (EBIT) by interest charges—measures the number of dollars of accounting income available to pay each dollar of interest expense Cash flow coverage (CFC) ratio: the amount by which cash flow covers the fixed financial requirements (EBIT + Lease payments+depreciation expense)/ (interest expense+lease payments+debt principle/(1-T))
What advantage do common size statements have over regular statements when conducting a financial statement analysis?
Common size statements facilitate comparisons of income statements and balance sheets over time and across companies because they remove the influence of scale (size) of the business
How can comparative and trend analyses be used to help interpret a ratio?
Comparative advantage allows us to see how the organization's ratios were compared with average ratios for the industry Trend analysis gives clues about whether a business's financial situation is improving, holding constant, or deteriorating
What are two ratios that measure liquidity?
Current ratio: current assets divided by current liabilities Days-cash-on-hand ratio: (cash and equivalents +short-term investments)/ (expenses-depreciation)/365 The denominator of the equation estimates average daily cash expenses by stripping out noncash expenses from reported total expenses and then dividing by the number of days in a year. The numerator is the cash and securities that are available to make those cash payments.
Assume that a large managed care company has a low return on equity (ROE). How could DuPont analysis be used to identify possible actions to help boost Roe?
DuPont measures expense control, asset utilization, and debt utilization so you can figure out where the problems lie
What is the difference between net income and cash flow, and which is more meaningful to a business's financial condition?
Financial condition is driven by cash flows and the statement gives a good picture of the annual cash flows generated by the organization. Net income takes into account depreciation and accruals and cash flow does not because they are not cash expenses.
What are two ratios that measure asset management?
Fixed asset turnover (utilization) ratio: measures the utilization of property and equipment, and it is the ratio of total (all) revenues to net fixed assets (property and equipment) Total asset turnover ratio: measures the turnover, or utilization, of all of a business's assets; calculated by dividing total (all) revenues by total assets Days in patient accounts receivable: used to measure effectiveness in managing receivables; divide net patient accounts receivable by average daily patient revenue to find the number of days that it takes an organization to collect it receivables Average age of plant: gives a rough measure of the average age in years of a business's fixed assets (net property and equipment); accumulated depreciation divided by depreciation expense
What are the four required financial statements?
Income statement, statement of changes in equity, balance sheet, and statement of cash flows
Explain how inflation effects created problems in the Riverside illustration.
Inflation effects tend to make ratio comparisons over time for a given business, and across businesses at any point in time, less reliable than would be the case in the absence of inflation.
One asset management ratio, the inventory turnover ratio, is defined as sales (i.e., revenues) divided by inventories. Why would this ratio be important for a medial device manufacturer or a hospital management company?
It is not beneficial to have a lot of devices and tools in storage because they are not making you any money in storage. They are simply depreciating with no use to you.
Why is it important to be familiar with the comparative data set?
It is very important to know the specific definitions used in the comparative data because definitional differences between the ratios being calculated and the comparative ratios can lead to erroneous interpretations and conclusions.
Assume Kindred Healthcare and Sun Healthcare Group, two operators of nursing homes, have fiscal years that end at different times-- say, one in June and one in December. Would this fact cause any problems when comparing ratios between the two companies?
It should not cause any problems when comparing ratios because you can compare a year at one company to a year at the other
How are KPIs and dashboards used in financial condition analysis?
KPIs assess the current state of the business, measure progress toward organizational goals, and facilitate prompt managerial action to correct. The basic idea of a dashboard is to allow managers to monitor the business's most important financial and operating metrics on a regular basis in a form that is easy to read and interpret.
What are key performance indicators (KPIs)? What is a dashboard?
KPIs: a financial statement ratio or operating indicator that is considered by management to be critical to mission success Dashboard: a format for presenting a business's key performance indicators that resembles the dashboard of an automobile
Why are both types of analyses useful to health services managers and investors?
Managers use financial statement analysis both to assess current condition and to plan for the future Through operating indicator analysis, managers are better able to identify and implement strategies that ensure a sound financial condition in the future.
Briefly describe some of the problems encountered when performing financial statement and operating indicator analyses.
Many large healthcare businesses operate a number of different services in quite different lines of business, and in such cases it is difficult to develop meaningful comparative data. Generalizing about whether a particular ratio or indicator is good or bad is often difficult. Different accounting practices can distort financial statement ratio comparisons. Inflation effects can distort balance sheets and income statements.
In your view, what is the most important piece of information reported on the statement?
Net cash from operations because it is a better indicator of financial well-being than is the net increase in cash line.
Should financial statement and operating indicator analyses be conducted only on historical data? Explain your answer.
No because it is equally important to see how they are doing at the moment in order to compare their current status to their past status
Regardless of the specific line of business, should all healthcare businesses use the same set of ratios when conducting a financial statement analysis? Explain your answer.
No, because it depends on where that industry's problem areas are within the industry
What type of health services organization is most likely to use fund accounting?
Not-for-profit
What is the difference between financial and operating indicator analyses?
Operating indicator analysis goes one step beyond financial statement analysis by examining operating variables with the goal of explaining a business's financial condition.
Describe several metrics commonly used in operating indicator analysis.
Profit per discharge: provides a measure of the amount of profit on inpatient services earned per discharge; inpatient profit/total discharges Net price per discharge: measures the average inpatient revenue collected on each discharge; net inpatient revenues/total discharges Occupancy Rate (percentage): measures the utilization of a hospital's licensed beds and hence fixed assets; inpatient days/ (number of licensed beds x 365) Average length of stay: the number of days an average inpatient is hospitalized with each admission; inpatient days/total discharges All patient case-mix index: based on diagnosis, diagnoses requiring more complex treatments are assigned a higher value—intensity-of-service indicator Inpatient full-time equivalents (FTEs) per occupied bed: measure of workforce productivity and an efficiency indicator; inpatient FTEs/average daily census Salary per FTE: a simple measure of the relative cost of the largest resource item used in the hospital industry—labor; total salaries/total FTEs
What is percentage change analysis and why is it useful?
See definition; it is easy to see what accounts and items are growing faster or slower than others and thus to identify which are under control and which are out of control
Explain how the Du Pont equation combines several ratios to obtain an overview of a business's financial condition.
The Du Pont equation decomposes a business's return on equity (ROE) into the product of three other ratios: ROE= total margin x total asset turnover x equity multiplier The value of this equation stem from the fact that the total margin measures expense control, the total asset turnover measures asset utilization, and the equity multiplier measures debt utilization. Du Pont analysis is particularly useful when the equation can be compared with both benchmark equations and previous years' results.
What is the purpose of ratio analysis?
The true burden of debts and each practice's ability to pay the interest and principal due on them cannot be easily assessed without additional data analyses, like ratio analysis. Used to compare firms of different sizes and their financial states
How does the statement of cash flows differ from the income statement?
There may be cash raised by means other than operations that does not even appear on the income statement. It does not provide details on why the cash account is greater or smaller than the previous year's value Movement of cash instead of accounting profitability
Is trend or comparative analysis more important?
They are both important for different reasons and for different purposes
Why is operating indicator analysis important?
They examine the operating variables in order to EXPLAIN a business's financial condition
What are two ratios that measure profitability?
Total margin (total profit margin/profit margin): net income divided by all revenues (operating and nonoperating) Operating margin: operating income divided by patient-related revenues Return on assets: net income divided by total assets Return on equity: net income divided by total equity
What type of financial performance information is provided in the statement of cash flows?
Whether the firms core operations are profitable, how much capital the firm raised and how this capital was used, and what impact operating and financing decisions had on the firm's cash position
Is there a significant difference in the economic content of balance sheets created using fund accounting and those prepared under conventional accounting guidelines?
With the exception of further breakdown of some accounts into unrestricted and restricted components, such balance sheets have the same economic content as those prepared using standard accounting guidelines
Assume that two companies that operating walk-in clinics both had the same December year-end, but one was based in Aspen, Colorado, a winter resort, while the other operated in Cape Cod, Massachusetts, a summer resort. Would their locations lead to problems in a comparative analysis?
Yes because location has an impact on the types of injuries they see and how much money they make.
Du Pont analysis
a financial statement analysis tool that decomposes return on equity into three components: profit margin, total asset turnover, and equity multiplier
Key performance indicator (KPI)
a financial statement ratio or operating indicator that is considered by management to be critical to mission success
Statement of cash flows
a financial statement that focuses on the cash flows that come into and go out of a business
Dashboard
a format for presenting a business's key performance indicators that resembles the dashboard of an automobile
Profitability ratios
a group of ratios that measure different dimensions of a business's profitability
Debt management ratios
a group of ratios that measure the extent of a business's financial leverage (capital structure)
Trend analysis
a ratio analysis technique that examines the value of a ratio over time to see if it is improving or deteriorating
Operating indicator
a ratio that focuses on operating data rather than financial data
Fund accounting
a system for recording financial statement data that categorizes accounts as restricted or unrestricted
Common size analysis
a technique to analyze a business's financial statements that expresses income statement items and balance sheet accounts as percentage rather than in dollars
Percentage change analysis
a technique to analyze a business's financial statements that expresses the year-to-year changes in income statement items and balance accounts as percentages
Are only balance sheet accounts or both balance sheet accounts and income statement items affected by inflation?
balance sheet and income statement
Asset management (activity) ratios
financial statement analysis ratios that measure how effectively a firm is managing its assets
How does inflation distort ratio analysis comparisons, both for one company over time and when different companies are compared?
inflation effects tend to make ratio comparisons over time for a give business, and across businesses at any point in time, less reliable than would be the case in the absence of inflation.
Briefly explain the three major categories shown on the statement.
operating activities: focuses on the sources and uses of cash tied directly to operations (depreciation added back here) investing activities: both property and equipment (fixed assets) investments and securities investments financing activities: use of securities to finance its operations and other business activities
Liquidity ratios
ratios that measure the ability of a business to meet its cash obligations as they come due
Comparative analysis
the comparison of key financial and operational measures of one business with those of comparable businesses or industry averages. Also called benchmarking.
Benchmarking
the comparison of performance metrics, such as financial ratios, of one business against those of similar businesses and industry averages. Also called comparative analysis
Ratio analysis
the process of creating and analyzing ratios from financial statement and other data to help assess a business's financial condition
Financial statement analysis
the process of using data contained in financial statements to make judgments about a business's financial condition
Operating indicator analysis
the process of using operating indicators to help explain a business's financial condition
What is the difference between trend analysis and comparative analysis?
trend analysis looks at the value of a ratio over time and comparative analysis looks at the value of a ratio compared to other businesses or industry averages
Explain the differences between unrestricted, temporarily restricted, and permanently restricted funds.
unrestricted: not contractually required to be used for a specific purpose temporarily: donors have stipulated either time or predetermined goal restrictions permanently: all or part of the associated earnings can be spent but not the actual donation