Principles of Finance C708 V4 - UG: Unit 3 Module 5

Liquidity ratio may refer to:

*Reserve requirement - a bank regulation that sets the minimum reserves each bank must hold. *Acid Test - a ratio used to determine the liquidity of a business entity. Equation: Liquidity Ratio LR = Liquid assets/Short-term liabilities

5 Type of Ratios

1. Profitability ratios measure the firm's use of its assets and control of its expenses to generate an acceptable rate of return. 2. Liquidity ratios measure the availability of cash to pay debt. 3. Activity ratios, also called efficiency ratios, measure the effectiveness of a firm's use of resources, or assets. 4. Debt, or leverage, ratios measure the firm's ability to repay long-term debt. 5. Market ratios are concerned with shareholder audiences. They measure the cost of issuing stock and the relationship between return and the value of an investment in company's shares.

A company had $5,000,000 in total revenues for its fiscal year. Its expenses for the year were $3,500,000. Its total assets were $12,500,000. What is the company's return on assets for the fiscal year? A) 0.12 B) 0.28 C) 0.4 D) 0.7

A) 0.12 *ROA = NI/TA. NI = $5,000,000 - $3,500,000 = $1,500,000. Hence, ROA = $1,500,000/$12,500,000 = 0.12.

A company has $100,000 in cash, $300,000 in accounts receivable, $50,000 in inventory and a $300,000 office building. Its current liabilities are $250,000. What is the company's current ratio, and does that ratio show good short-term financial strength? A) The current ratio is 1.8, and the ratio indicates good short-term financial strength. B) The current ratio is 3, and the ratio indicates poor short-term financial strength. C) The current ratio is 3, and the ratio indicates good short-term financial strength. D) The current ratio is 1.8, and the ratio indicates poor short-term financial strength.

A) The current ratio is 1.8, and the ratio indicates good short-term financial strength. *Current ratio = CA/CL. CA = $100,000 + $300,000 + $50,000 = $450,000. (Note: office building is a Fixed Asset). Current ratio = $450,000/$250,000 = 1.8. The firm has $1.80 in current assets for every $1 it owes in current liability so this reflects good short-term financial strength.

A company has $450,000 in cash, $300,000 in marketable securities, and $500,000 worth of inventory. Its current assets are worth $1,750,000 and its current liabilities are $1,250,000. What is the company's acid test ratio? A) 1.04 B) 1 C) 0.8 D) 1.16

B) 1 *Acid test ratio = (CA - Inv)/CL = ($1,750,000-$500,000)/$1,250,000 = 1

A company has $750,000 in cash, $200,000 in marketable securities and $300,000 worth of accounts receivable. Its current assets are worth $1,500,000 and its current liabilities are $1,000,000. What is the company's quick ratio? A) 1.05 B) 1.3 C) 1.25 D) 1.5

C) 1.25 *Quick ratio = (CA - Inv)/CL. Since we are given all the current assets except for the Inventory, then (CA - Inv) = $750,000 + $200,000 + $300,000 = $1,250,000 and Quick Ratio = $1,250,000/$1,000,000 = 1.25.

During a fiscal year, a company had $25,000,000 in total sales. It had a cost of goods sold (COGS) of $18,000,000, and $4,000,000 in additional expenses. What is the company's gross profit margin? A) 16% B) 12% C) 28% D) 33.33%

C) 28% *Gross Profit Margin = Gross Profit / Sales. Gross Profit = Sales - COGS = $25,000,000 - $18,000,000 = $7,000,000. Hence, GP Margin = $7,000,000/$25,000,000 = 0.28 or 28%.

Benchmarking

Comparing the financial ratios of a company to those of the top performer in its class is a type of benchmarking. Key Points *Financial ratios allow for comparisons and are therefore intertwined with the process of benchmarking. This involves comparing one's business to that of relevant others, or of the same company at a different point in time processes, using a specific indicator or series of indicators. *Benchmarking can be done in many ways and ratio analysis is only one of these. One benefit of ratio analysis as a component of benchmarking is that many financial ratios are well-established calculations derived from verified data. *Benchmarking using ratio analysis can be useful to various audiences; for example, investors and managers interested in incorporate quantitative comparisons of a company to peers.

Current Ratio

Current ratio is a financial ratio that measures whether or not a firm has enough resources to pay its debts over the next 12 months. Key Points *The liquidity ratio expresses a company's ability to repay short-term creditors out of its total cash. The liquidity ratio is the result of dividing the total cash by short-term borrowings. *The current ratio is a financial ratio that measures whether or not a firm has enough resources to pay its debts over the next 12 months. *Current ratio = current assets / current liabilities. *Acceptable current ratios vary from industry to industry and are generally between 1.5 and 3 for healthy businesses. Example: Current ratio = Current assets/Current liabilities

Financial Ratios

Financial ratios quantify many aspects of a business and are an integral part of the financial statement analysis. Financial ratios are categorized according to the financial aspect of the business which the ratio measures. Financial ratios allow for comparisons: *between companies *between industries *between different time periods for one company *between a single company and its industry average

Goodwill

Goodwill is an accounting concept meaning the value of an asset owned that is intangible but has a quantifiable "prudent value" in a business for example a reputation the firm enjoyed with its clients.

Price/Earnings Ratio

Price to earnings ratio (market price per share / annual earnings per share) is used as a guide to the relative values of companies. Key Points *PE/ ratio = Market price per share Annual earnings per share *The PE/PE ratio is a widely used valuation multiple used as a guide to the relative values of companies; for example, a higher PE/PE ratio means that investors are paying more for each unit of current net income, so the stock is more expensive than one with a lower PE/PE ratio. *Different types of PE/PE include: trailing PE/PE or PE ttm/PE ttm, trailing PE/PE from continued operations, and forward PE/PE or PEf/PEf. PE/ ratio = Market price per share/Annual earnings per share

Profit Margin

Profit margin measures the amount of profit a company earns from its sales and is calculated by dividing profit (gross or net) by sales. Key Points *Profit margin is the profit divided by revenue. *There are two types of profit margin: gross profit margin and net profit margin. *A higher profit margin is better for the company, but there may be strategic decisions made to lower the profit margin or to even have it be negative. Equation: Net Profit Margin: The percentage of net profit (gross profit minus all other expenses) earned on a company's sales Net Profit/Sales×100 Gross Profit Margin: The percentage of gross profit earned on the company's sales. Gross Profit/Sales×100

Ratio Analysis

Ratio analysis consists of calculating financial performance using five basic types of ratios: profitability, liquidity, activity, debt, and market. Key Points *Ratio analysis consists of the calculation of ratios from financial statements and is a foundation of financial analysis. *A financial ratio, or accounting ratio, shows the relative magnitude of selected numerical values taken from those financial statements. *The numbers contained in financial statements need to be put into context so that investors can better understand different aspects of the company's operations. Ratio analysis is one method an investor can use to gain that understanding.

Return on Equity (ROE)

Return on equity (ROE) measures how effective a company is at using its equity to generate income and is calculated by dividing net profit by total equity. Key Points *ROE is net income divided by total shareholders' equity. *ROE is also the product of return on assets (ROA) and financial leverage. *ROE shows how well a company uses investment funds to generate earnings growth. There is no standard for a good or bad ROE, but a higher ROE is better. Equation: Return on Equity: The return on equity is a ratio of net income to equity. It is a measure of how effective the equity is at generating income. ROE = Net profit/Sales × Sales/Assets × Assets/Equity

Acid Test (Quick Ratio)

The Acid Test or Quick Ratio measures the ability of a company to use its assets to retire its current liabilities immediately. Key Points *Quick Ratio = (Cash and cash equivalent + Marketable securities + Accounts receivable) / Current liabilities. *Acid Test Ratio = (Current assets - Inventory) / Current liabilities. *Ideally, the acid test ratio should be 1:1 or higher, however this varies widely by industry. In general, the higher the ratio, the greater the company's liquidity. Equation: Quick Ratio = Cash and cash equivalent + Marketable securities + Accounts Receivable/Current liabilities Acid Test Ratio=(Current assets-Inventory)/Current liabilities

Total Debt to Total Assets

The debt ratio is expressed as Total debt Total assets Total debt Total assets. Key Points *The debt ratio measures the firm's ability to repay long-term debt by indicating the percentage of a company's assets that are provided via debt. *Total debt/Total assets *The higher the ratio, the greater risk will be associated with the firm's operation Debt Ratio = Total Debt/Total Assets Or alternatively: Debt Ratio = Total Liability/Total Assets

Operating Margin

The operating margin is a ratio that determines how much money a company is actually making in profit and equals operating income divided by revenue. Key Points *The operating margin equals operating income divided by revenue. *The operating margin shows how much profit a company makes for each dollar in revenue. Since revenues and expenses are considered 'operating' in most companies, this is a good way to measure a company's profitability. *Although it is a good starting point for analyzing many companies, there are items like interest and taxes that are not included in operating income. Therefore, the operating margin is an imperfect measurement a company's profitability. Example: Operating Margin = (Operating income/Revenue)

Book Ratio

The price-to-book ratio is a financial ratio used to compare a company's current market price to its book value. Key Points *The calculation can be performed in two ways: 1) the company's market capitalization can be divided by the company's total book value from its balance sheet, 2) using per-share values, which is to divide the company's current share price by the book value per share. *A higher PB/PBratio implies that investors expect management to create more value from a given set of assets, all else equal. *Technically, P/B can be calculated either including or excluding intangible assets and goodwill.

Return on Total Assets (ROA)

The return on assets ratio (ROA) measures how effectively assets are being used for generating profit. Key Points *ROA is net income divided by total assets. *The ROA is the product of two common ratios: profit margin and asset turnover. *A higher ROA is better, but there is no metric for a good or bad ROA. An ROA depends on the company, the industry and the economic environment. *ROA is based on the book value of assets, which can be starkly different from the market value of assets. Equation: Return on Assets: The return on assets ratio is net income divided by total assets. That can then be broken down into the product of profit margins and asset turnover. ROA = Net profit/Sales × Sales/Total assets = Net income/Total assets

Trend Analysis

Trend analysis consists of using ratios to compare company performance on an indicator over time, often to forecast or inform future events. Key Points *Trend analysis is the practice of collecting information and attempting to spot a pattern or trend in the same metric historically by examining it in tables or charts. Often this trend analysis is used to predict or inform decisions around future events. *Trend analysis can be performed in different ways in finance. Fundamental analysis relies on historical financial statement analysis, often in the form of ratio analysis. *Trend analysis using financial ratios can be complicated by changes to companies and accounting over time. For example, a company may change its business model and begin to operate in a new industry, or it may change the end of its financial year or the way it accounts for inventories.

Industry Comparisons

While ratio analysis can be quite helpful in comparing companies within an industry, cross-industry comparisons should be done with caution. Key Points *One of the advantages of ratio analysis is that it allows comparison across companies. However, while ratios can be quite helpful in comparing companies within an industry and even across some similar industries, cross-industry comparisons may not be helpful and should be done with caution. *An industry represents a classification of companies by economic activity, but "industry" can be too broad or too narrow a definition for ratio analysis comparison. When comparing ratios, companies should be comparable in terms of having similar characteristics in the statistics being analyzed. *Valuation using multiples only reveals patterns in relative values. For multiples to be useful, the statistic involved must bear a logical, meaningful relationship to the market value observed, which is something that can vary across industries.

Financial Ratio

With a few exceptions, the majority of the data used in ratio analysis comes from evaluation of the financial statements. Key Points *Ratio analysis is a tool for evaluating financial statements but also relies on the numbers in the reported financial statements being put into order to be used for comparison. With a few exceptions, the majority of the data used in ratio analysis comes from the financial statements. *Prior to the calculation of financial ratios, reported financial statements are often reformulated and adjusted by analysts to make the financial ratios more meaningful as comparisons across time or across companies. *In terms of reformulation, earnings might be separated into recurring and non-recurring items. In terms of adjustment of financial statements, analysts may adjust earnings numbers up or down when they suspect the reported data is inaccurate due to issues like earnings management.

Earnings management

a euphemism, such as creative accounting, to refer to fraudulent accounting practices that manipulate reporting of income, assets, or liabilities with the intent to influence interpretations of the income statements.

Sentiment

a general thought, feeling, or sense.

Metric

a measure for something; a means of deriving a quantitative measurement or approximation for otherwise qualitative phenomena.

Ratio

a number representing a comparison between two things.

Debt to total assets ratio

after-tax income divided by liabilities.

Forecast

an estimation of a future condition.

Inflation

an increase in the general level of prices or in the cost of living.

Liquidity

availability of cash over short term: ability to service short-term debt.

Working capital management

decisions related to working capital and short-term financing are referred to as working capital management. These involve managing the relationship between a firm's short-term assets and its short-term liabilities.

Shareholder

one who owns shares of stock.

Operating income

revenue—operating expenses. (Does not include other expenses such as taxes and depreciation).

Outstanding shares

shares outstanding are all the shares of a corporation that have been authorized, issued and purchased by investors and are held by them.

Gross profit

the difference between net sales and the cost of goods sold.

Valuation

the process of estimating the market value of a financial asset or liability.

Ratio analysis

the use of quantitative techniques on values taken from an enterprise's financial statements.

Time value of money

the value of money, figuring in a given amount of interest, earned over a given amount of time.

Treasury bills

treasury bills (or T-Bills) mature in one year or less. Like zero-coupon bonds, they do not pay interest prior to maturity; instead they are sold at a discount of the par value to create a positive yield to maturity.