Section A2: Financial Ratios
Degree of operating leverage (DOL)
% change in EBIT / % change in sales CM/EBIT CM = Sales - (cost of sales + all variable costs) EBIT = CM - fixed costs Increased debt also increases fixed cost because interest is a fixed cost. Fixed costs will increase the DOL compared to businesses not using debt.
Gross profit ratio
( Gross Profit / net sales ) x 100
Gross margin
(Sales - Cost of sales ) / Sales measures how much of each sales dollar is left over for operating expenses, administrative expenses, and profits.
Profitability-related ratios
1. Gross margin 2. Operating margin 3. Return on sales demonstrate the firm's ability to control expenses and generate more profit per dollar of sales.
Days sales outstanding (DSO)
= (AR x 365) / sales of the year
When a fixed asset is sold for less than book value, which one of the following will decrease?
Answer: Net profit *When a fixed asset is sold for less than book value, a loss occurs decreasing net profit.
COGS
Average inventory x inventory turnover rate
COGS
Beg inventory + COGM - End inventory
Cash flow ratio
Cash flow from operations / Current liabilities
Book value
Common equity par value + PIC+ Common shareholder's equity / # of common shares outstanding
Degree of total leverage
DOL x DFL The degree of total leverage measures the level of risk facing an organization.
What ratio measures the degree of cost structure that is fixed costs?
Degree of Operating Leverage (DOL).
Dividend paid on each share of common stock
Dividend per share / EPS or diluted eps
Stock price
EPS x industry P/E ratio
Breakeven point
Fixed costs / (sales - variable costs)
What ratio can organizations use to measure the cost-effectiveness of purchasing inventory for manufacture or sale?
Gross Margin ( (Sales − Cost of Sales) / Sales)
Which of the following must be considered in measuring income?
I. Estimates regarding future events II. Accounting methods used by the company III. The degree of informative disclosure about results of operations IV. Different needs of users
All else being equal, will Return on Assets increase or decrease if operating expenses decrease?
Increase, because net income will increase while Assets remain the same.
from notes: What impact net profit margin only
Interest expenses, taxes, and non-operating expenses, such as gains and losses on property sales
Return on common equity ratio
Net income - Preferred dividends / Average equity
Profit margin
Net income / Net sales
Dividend per share (DPS)
Net income / outstanding shares Dividend yield x price to earnings ratio
from notes: What impact operating margin and net profit margin
Operating expenses & Selling, general, and administrative expenses
Return on operating assets
Operating income / Average total assets
Gross profit
Sales - COGS
Asset turnover
Sales / Assets
Operating asset turnover
Sales / Average total assets
from notes: revenue, receivable, and inventory
are interrelated through sales process
Net profit margin (return on sales) & operating margin
are key profitability metrics in addition to gross margin.
Low DOL
has high variable costs (low breakeven point) reach profitability faster than firms with higher DOL
High DOL
has higher fixed costs (high breakeven point) (high contribution margin) sales are profits than firms with lower DOL.
Cash to current liabilities
is calculated by dividing the total of cash and cash equivalents and marketable securities by current liabilities. *such as stocks and money market fund
Fixed assets turnover
net sales / average net fixed assets for the year
DFL
reflects the firm's decision to use debt financing instead of equity financing to fund assets.
Net profit margin
shows how much of each sales dollar is available for equity holders after all expenses have been paid.
Operating margin
shows how much of each sales dollar is left for interest payments, taxes, and profit.
if gross profit margin is 30%
the rest is the percentage of COGS of the sale
Debt holders want organizations to carry less debt
to increase the probability of interest and principal payments.
Firms that do not have traditional cost of sales
use operating margin as a key metric of how well it controls expenses.
Financial leverage
Financial leverage refers to the use of debt (fixed costs) to acquire additional assets, or to increase returns to owners (stockholders). Financial leverage is raising capital through debt rather than equity.
Total debt to total capital ratio
It is a measurement of financial leverage of a corp. Measures the proportion of debt compared to total capital of a corporation This ratio demonstrates how much of a company's contributed capital is debt. Current liabilities + long term liabilities / Total debt + Total equity Companies can finance their operations through either debt or equity Higher ratio = financial weakness
Market-to-book ratio
It measures how much a company worth at present Current share price / Book value per share
Degree of financial leverage (DFL)
% change in Net Income / % change in EBIT DFL = (% change in net income after tax) / (% change in operating income, or EBIT) EBIT/EBT the lower the DFL, the lower the risk
Preferred stock dividends
% of cumulative times par value
Diluted EPS
((Profit or loss attributable to common equity holders of parent company + After-tax interest on convertible debt + Convertible preferred dividends - preferred stock dividends)) ÷ (Weighted average number of common shares outstanding during the period + All dilutive potential common stock)
Total debt to total capital
(Current liabilities + long term liabilities) / (Total debt + Total equity)
If ROA ratio goes down
1. Cut expenses 2. Reduce assets 3. Boost sales
3 ratios used to measure leverage
1. debt to total assets ratio 2. debt to equity ratio 3. times interest earned (interest coverage) ratio
The after-tax effect of the interest expense
= (1 - tax rate)(interest rate)
After-tax interest on convertible debt
= (1-tax rate%)(interest expense) * interest expense calculated by taking outstanding shares times percentage of convertible debt
Convertible securities
A convertible security is an investment that can be changed into another form.
Off-balance sheet financing
A form of financing to keep the debt to equity ratio low 1. Factoring of AR 2. Special-purpose entities 3. Leases (capital lease or operating lease) 4. Joint ventures (hold less than
Days' sales in inventory
Calculate the days it takes to sell the inventory on hand. 360 or 365 / Inventory turnover ratio or (Average inventory[last yr & current yr] / COGS) x 360 or 365 low = weak sales (excess inventory) High = strong sales (offer discounts)
Current liabilities consists of
AP, accrued expenses, short term payable, current portion of long-term debt
Debt / liabilities
Assets - Equity
Shareholders' equity
Assets - Liabilities
Financial leverage ratio
Assets / Equity
The two financial statements that are most important for assessing a firm's liquidity are the:
Balance sheet & statements of cash flow
Purchases
COGS + ending inventory - beginning inventory
Cash ratio
Cash + cash equivalent / Current liabilities
Current assets consists of
Cash, AR, inventory, prepaid, short-term marketable securities, short-term note receivable Current assets = (cash + receivables + pre-paid expenses + inventory + available-for-sale securities at fair value)
Dupont model for ROE
Company's tax burden x company's interest burden x company's operating profit margin x company's asset turnover x company's leverage ratio (Net profit / Pretax profit) x (Pretax profit / EBIT) x (EBIT / Sales) x (Sales / Assets) x (Assets / Equity)
Notes
Current ratio > quick ratio > cash ratio
Diluted EPS
Diluted EPS is a performance metric used to gauge the quality of a company's earnings per share (EPS) if all convertible securities were exercised. Net income - dividends on preferred shares / Diluted weighted # of shares outstanding
Dividend payout ratio (comes out as %)
Dividend per common share / Earnings per share (shareholder's equity) If percentage is over 75%, dividend is too high If percentage is lower, dividend is acceptable
Operating cycle (cash conversion cycle or cash cycle)
Days Sales Outstanding + Days Sales in Inventory − Days Purchases in Accounts Payable. Shorter operating cycle translates into improved liquidity This means the organization must finance xx days' worth of purchases through external means, such as retained earnings or a line of credit. Some businesses using just-in-time (JIT) inventory can get paid before purchasing inventory and have a negative operating cycle. Dell Computer is an example of an organization with a negative operating cycle.
Days' sales in receivables
Determine how efficiently the company manages its receivables (how long the sales sit in a AR before it turns into cash) 360 or 365/ AR turnover ratio or (Average AR / Credit sales) x 365 or 360 *a firm with exceptionally low day's sales in receivables may have excessively tight credit policies that can result in lost sales
Days' purchases in AP
Determines how much purchases sit in AP, and decide how much cash need to pay the purchases that have been made in the past 365 / Payable turnover ratio or average AP / 365 or cost of sales High = Strong relationship with suppliers in making payments
In which of the following circumstances would financial leverage be likely to increase?
Firm issues bonds to repurchase some of its own common stock. Financial leverage relates to the fixed financing costs of a firm. Of the choices given, issuing new bonds is the only one that affects fixed financing costs.
In which one of the following circumstances would operating leverage be likely to increase?
Firm signs a contract to rent a new manufacturing site. *Operating leverage relates to the fixed operating costs of a firm. Of the choices given, the rental of a new manufacturing site is the only one that will increase fixed operating costs.
High debt
High tax rate
DOL ratio
If ratio is high because it has higher fixed costs
Current ratio
Indicates a company's ability to pay current liabilities with current assets Higher ratio = capable CA / CL Although the current ratio should be above 1.0 for organizations, often the quick ratio is not above 1.0. The current ratio is considered a liquidity ratio and not a solvency ratio
Earnings per share (EPS)
Is a measurement of a company's profit Investors use EPS to determine whether to purchase a security. Net income - dividends on preferred shares / # of shares outstanding
Profitability ratio
Measures a company's ability to generate income for investors
Times interest earned (interest coverage) ratio
Measures a company's ability to pay interest through the operations EBIT / Interest expense (Net income + tax + Interest / Interest expense) Higher ratio = able to meet its interest obligations High debt ratio and low times interest earned ratio = poor solvency High debt ratio and high times interest earned ratio = less worry
Solvency ratio
Measures a company's ability to pay short term and long term obligations
Liquidity ratio
Measures a company's ability to pay short term obligations
Fixed-charge coverage ratio
Measures a company's ability to satisfy fixed charges EBIT+ Fixed charge (before tax)/ Fixed charge Higher ratio = able to meet fixed charge obligations
Cash flow to fixed charges ratio
Measures a company's ability to satisfy fixed charges from cash flow generated from operations cash from operations + fixed charges + tax payments/ fixed charges
Fixed asset turnover ratio
Measures how able a company is to generate net sales from fixed-asset investments Sales / Average PPE
Price to EBITDA ratio
Measures how much a shareholder is paying for a given amounts of earnings Market price per share / EBITDA per share
Debt to total assets ratio
Measures the proportion of assets financed through debt Creditors use this ratio to determine how well their interests are protected if the firm becomes insolvent. Total debt / total assets (Total current & long term liabilities / Total assets) Lower ratio = company has enough money to cover long-term debt obligations (better for creditors)
Total asset turnover ratio
Measures the revenue generated from the total assets Sales / Average total assets Higher ratio = company is using the assets efficiently to make money Lower ratio = need to change method to maximize its revenue
EBIT
Net earning + interest + tax
Earnings per "common" share
Net income - dividends on preferred shares / # of common shares outstanding
Return on equity (ROE)
Net income - preferred stock dividends / Shareholder's equity
Dupont model for ROA
Net profit margin x total asset turnover ratio (Net income / sales) x (Sales / Average total assets)
Gross profit margin
Net sales - COGS
Operating leverage
Operating leverage is a measurement of the degree to which a firm or project incurs a combination of fixed and variable costs. A business that makes sales providing a very high gross margin and fewer fixed costs and variable costs has much leverage
Paid-in capital
Paid-in capital represents the funds raised by the business from equity, and not from ongoing operations. Paid-in capital also refers to a company balance sheet entry listed under stockholder's equity,
Dupont mode
Profit Margin x Asset Turnover Ratio x Equity Multiplier.
Accounts payable turnover ratio
Purchases for the year / average AP balance
Equity
Retained earnings + paid-in capital
Book value per common share
Shareholders' equity / # shares of common share outstanding
Inventory turnover ratio
Showing how many times a company's inventory is sold and replaced over a period of time. COGS / Average inventory
Debt to equity ratio
Shows the extent to which shareholders' equity can fulfill a company's obligations to creditors in the event of a liquidation. high debt-to-equity ratio indicates that a company may not be able to generate enough cash to satisfy its debt obligations. low debt-to-equity ratios may also indicate that a company is not taking advantage of the increased profits that financial leverage may bring. Total debts / Total shareholder's equity The lower the D/E ratio, the lower the risk
Dividend yield
Stock's dividend as a percentage of the stock price. = Annual dividend per share/ current price per share
Acid-test ratio
The acid test ratio is calculated as current assets less inventories and prepayments divided by total current liabilities. The acid test ratio shows the ability of a company to pay its current liabilities without having to liquidate its inventory.
Capital structure
The capital structure is how a firm finances its overall operations and growth by using different sources of funds (mix of long-term debt & equity in the form of common and preferred stock)
Dividend payout ratio
The dividend payout ratio provides an indication of 1. how much money a company is returning to shareholders as dividends 2. how much money it is keeping on hand to reinvest in growth, pay off debt or add to cash reserves.
An example that will affect current ratio
The effect of the change in inventory valuation would cause the current ratio to decrease
Leverage involves the use of non-common stock equity to enhance the return on common stock equity.
The most highly leveraged firm would be the one with the lowest percent of common equity in its capital structure.
Sustainable growth rate
The sustainable growth rate (SGR) is the maximum rate of growth that a firm can sustain without having to borrow money to fund its growth. (just from using internally generated revenue to fund its growth) This ratio used by businesses to plan: long term growth, capital acquisitions, cash flow projections, and borrowing strategies = ROE x (1-Dividend payout ratio) is a measure of how large and how quickly a firm can grow without borrowing more money. After a firm has passed this rate, its growth will decline in the long term, and it must borrow funds to facilitate additional growth.
AR turnover ratio
This ratio determines how effective a company in collecting its debts Net sales or credit sales / Average AR high = collection of AR is efficient (recommend cash basis) low = poor collecting process
Gross profit margin percentage
To find out how much of the percentage of the revenue is the profit Gross profit / sales
Window dressing
Window dressing is a strategy used by mutual fund and other portfolio managers near the year or quarter end to improve the appearance of a fund's performance before presenting it to clients or shareholders.
ROE: Average common shareholders' equity
[(beginning balance common shareholders' equity − preferred stock equity) + (ending balance common shareholders' equity − preferred stock equity)] / 2
Firms must manage debt levels to maximize value and balance the needs of different stakeholders.
a. Debt holders want organizations to carry less debt to increase the probability of interest and principal payments. b. Stockholders want the firm to utilize an optimal level of debt to lower the firm's cost of capital and maximize shareholder value.
Debt or liabilities
accounts payable + accrued liabilities + 7% bonds payable
Donovan Corporation recently declared and issued a 50% stock dividend. This transaction will reduce the company's:
book value per common share. * A stock dividend would increase the number of shares outstanding without affecting the equity.
Quick ratio
current assets - inventories / current liabilities
Equity
common stock + retained earnings + the reserve for bond retirement
Return on investment (ROI)
evaluate the efficiency of an investment Income of business unit / Assets of business unit Gain from investment - cost of investment / cost of investment
Earnings yield ratio
evaluates whether stocks are overvalued or undervalued helps investors evaluate whether those returns commensurate (成比例) with an investment's risk. Last 12 months EPS / Current market price per share
Return on assets (ROA)
how efficient management is at using its assets to generate earnings. Net income / Total assets
Long-term debt to equity ratio
i. A higher ratio generally means more fixed expenses from interest payments and higher risk. ii. A lower ratio means a company could raise long-term debt to finance future expansion. Total debts - current liabilities / Total shareholder's equity
DFL ratio
if ratio is high because interest expense is high *interest means debt, it means you use more debt to finance your operation compared to equity
e.g A DOL of 2
implies that every 1% increase/decrease in sales will result in a 2% increase/decrease in EBIT *Companies with high DOL often have a high degree of business risk
Dividend yield (comes out as %)
indicates how much a company pays out in dividends each year relative to its share price. it is also a measure of the cash return realized by the investor Annual dividend per share / Market price per share
Net working capital
is a measure of a company's ability in the short run to pay its obligation CA-CL
Cash Flow Ratio
is a measure of how well current liabilities are covered by the cash flow generated from a company's operations. Cash flow from operations / CL
Operating profit margin percentage
is a measurement of what proportion of a company's revenue is left over after paying for variable costs of production such as wages, raw materials, etc. Operating income / sales
Return on equity (ROE)
is the amount of net income returned as a percentage of shareholders equity. Net income / Shareholder's equity or ROE = ROA x Financial leverage
Price to earnings ratio (P/E ratio)
is used to determine how much investors to pay for a stock relative to the company's earnings Market price per share / EPS High ratio = investors pay higher price per share to get same return as low ratio e.g $18 / $2 = $9 (investor pays $9 for every $1 of earning) $18 / $6 = $3 (investor pays $3 for every $1 of earning) <recommended!> When the P/E ratio is increasing from year 1 to year 2, it is showing a positive trend in growth opportunities in year 2 compared to year 1.
Financial leverage ratio of < than 2
liabilities < equity
Financial leverage ratio of 2
liabilities = equity
Financial leverage ratio of > than 2
liabilities > equity
Financial leverage ratio
look at how much capital comes in the form of debt (loans), or assesses the ability of a company to meet financial obligations.
Quick (Acid-test) ratio
measures a company's ability to meet its short-term obligations with its most liquid assets. Quick ratio = (current assets - inventories) / current liabilities, or = (cash and equivalents + marketable securities + accounts receivable) / current liabilities *Current liabilities such as accounts payable, accrued liabilities)
Net profit margin percentage
net profit margins show how much of each dollar collected by a company as revenue translates into profit. Net income / sales
Debt ratio
short & long term debts / total assets
High DFL ratio
some companies have high DFL ratio because they use significant amount of debt for the operations. It is because interest expenses is tax deductible and they can increase their cash flows
Operating lease
the lessor keeps the asset on its balance sheet and the company leasing the asset only reports the rental expense
* The purchase of a fixed (long-term) asset partly by cash and partly by signing a long-term note
will decrease current assets without affecting current liabilities.
Capital lease
would show up as a liability on the lessee's balance sheet, and the leased asset as an asset on the lessee's balance sheet.
