Topic 4 - Ratio Analysis

In order to make ratio analysis a more effective tool, you should carefully consider: Demographic trends. Bubbles and recessions. Technological changes. All the statements are correct.

All the statements are correct.

The flexibility aspect of ratios and ratio analysis refers to which of the following? Analysts can create new ratios if needed. Firms of different size can be compared on the same scale. Ratios determine the financial flexibility of a company. Ratios can be used to compare a firm to the industry's top performers.

Analysts can create new ratios if needed.

If a company has current assets of $90 and fixed assets of $140, if it has debt of $125, what is its debt ratio? 1.36 1.84 1.12 0.54

Answer: 0.54(debt) 125 / 140 + 90 (total assets) = .5435

A company has cash of $100, accounts receivable of $250, inventory of $300, and accounts payable of $300. What is the quick ratio? 1.00 2.17 0.33 1.17

Answer: 1.17100 + 250 / 300 = 1.17

If a company has current assets of $80 and fixed assets of $120, if sales are $150 and EBIT is $35, what is the fixed asset turnover? 1.25 0.80 2.29 5.71

Answer: 1.25150 / 120 = 1.25

Intel provides the following data for 2014: · A/R 600 · Inventory 800 · Fixed assets 1,000 · A/P 500 · Long term debt 900 · Common stock 400 What is the current ratio? 1.5 1.2 2.0 2.8

Answer: 2.8600 + 800 / 500 = 2.8

A company has sales of $300, expenses of $200 and interest expense of $25, what is its times interest earned ratio? 3.00 4.00 1.75 2.00

Answer: 4.00EBIT / Int Exp (300 - 200) / 25 = 4

For Eastern Family, what percentage of sales is consumed by Cost of Goods Sold? Since Gross Margin = Gross Profit / Sales = 4110 / 10000 = 41.10% 58.90% 47.92% 52.08% 41.10%

1 - Gross Margin = 58.90%.

Suppose a firm has a financial leverage ratio of 2.50. What percentage of the firm's assets is financed by equity? 40% 70% 60% 50%

40

Which of the following statements is NOT correct with respect to using ratios to analyze a firm or firms? Ratio analysis can be used to assess the need for cost cutting initiatives. Ratio analysis can be used to compare three companies with different size, strategy and risks: Toyota, Ford and Tesla. A change in a ratios reveals the economic character of the firm. Analysts can create a new ratio to show more detail about the cost structure of a company.

A change in a ratios reveals the economic character of the firm.

Average Collection Period (ACP) converts AR turnover into

A day count measure. A ratio of 6 means The firm collects cash 60 days after a sale. (365/6) = 60 days.

Interest-bearing debt to total capital (IBDTC) is a more precise measure of

A firm's financial structure

The timing of a firm's fiscal year end would be most relevant to which of the following firms: A snowboard shop. A supermarket. A hospital. A restaurant.

A snowboard shop.

Why would a company be interested in the TAT (total asset turnover) ratio? It indicates how efficient assets are to liabilities and equity. It indicates what the turnover of sales is to liabilities. It indicates how efficient assets are at producing income. It indicates how efficient assets are at producing sales.

Answer: It indicates how efficient assets are at producing sales.

A company has cash sales of $200 and credit sales of $750. It's average accounts receivable is $90. What is the A/R turnover? What is the average collection period? Turnover: 8.33 ACP: .694 Turnover 10.56 ACP: 24.9 Turnover: 10.56 ACP: 43.8 Turnover 8.33 ACP: 43.8

Answer: Turnover 8.33 ACP: 43.8750 / 90 = 8.33 ACP = 365 / 8.33 = 43.8

If a firm's financial leverage ratio is 2.50, what percentage of assets are financed by debt?

Assets/Equity; thus Y = 40%, so X = 60% percent financed by debt.

Suppose a firm has a financial leverage ratio of 2.50. What percentage of the firm's assets are financed by equity? 60% 40% 50% 70%

B. 40%The correct answer is 40%. We know that Assets (100%) = Liabilities (X%) + Equity (Y%). So Financial leverage ratio = 2.5 = 100% / Y% = Assets/Equity; thus Y = 100 / 2.5 = 40%.

Bookmark question for later When performing ratio analysis, scrubbing the data includes all of the following except: Identifying accounting differences among competitors. Choosing a relevant comparison set. Alignment of ratios for companies with different fiscal year-ends. All are included in scrubbing the data.

Choosing a relevant comparison set.

If a firm's financial leverage ratio is 2.50, what percentage of assets are financed by debt? 60% 70% 40% 50%

D. 60%Solution: We know that Assets (100%) = Liabilities (X%) + Equity (Y%). So, Financial leverage ratio = 2.5 = 100%/Y% = Assets/Equity; thus Y = 40%, so X = 60% = percent financed by debt.

Days on Hand (DOH) converts inventory turnover into a

Day count metric. Ratio of 2 = (365 / 2) so about every 180 days.

The OIROI (operating income return on investment) uses what elements on the income statement? Net margin, total current assets EBIT, total assets Sales, total assets, equity Operating income, EBIT, total liabilities

EBIT, total assets

Assume that the industry average ROE is 12%. For Eastern Family, which of the following best describes their ROE: (ROE for Eastern is 8.94%) Eastern Family is more profitable than the industry. Eastern Family is generating lower return to owners than the industry. Eastern Family is in a good position in the industry regarding to the return to its owner. Eastern Family's ROE is 2.93%.

Eastern Family is more profitable than the industry.

If a competitor of Eastern Family has a Total Asset Turnover (TAT) of 1.10, then: Eastern Family's asset utilization success cannot be assessed by the TAT alone. Eastern Family is generating more sales per dollar of assets than the competitor. Eastern Family is in good shape since its TAT is higher than the competitor. Eastern Family is in bad shape since its TAT is lower than the competitor.

Eastern Family's asset utilization success cannot be assessed by the TAT alone. Looking only at TAT for Eastern and a competitor will not allow us to judge whether Eastern is doing good or bad. We have to consider issues such as technology investment and cost structure.

The ratios used in financial analysis are defined by GAAP. T or F

False

Which one of the following is NOT included in the DuPont calculation? Return on asset Net profit margin Fixed asset turnover Financial leverage ratio

Fixed asset turnover

A Debt ratio of .40 means

For every dollar of assets held by the firm .40 cents is financed with debt. 1 - .40 = how much was financed with equity

Which of the following best describes the problem associated with GAAP accounting standards when performing ratio analysis? GAAP accounting standards are too simplistic for most firms. Most firms use cash accounting rather than GAAP accounting. Most firms use cash accounting rather than accrual accounting. GAAP accounting standards allow for significant managerial discretion in reported financial statements.

GAAP accounting standards allow for significant managerial discretion in reported financial statements.

If a company wishes to obtain a bank loan, will it want to have a higher current ratio or a lower current ratio? The same Higher It does not matter Lower

Higher

The three tools for ROE are below. Explain Higher Margins: Greater Efficiency: Lever Up:

Higher Margins: decrease costs relative to sales (higher net margin) Greater Efficiency: Increase sales relative to assets (higher TAT) Lever Up: Increase debt relative to equity (higher FLR)

Is a higher current ratio better or worse?

Higher is better - meaning the firm will be more likelihood to meet it's short term obligations.

Consider two companies, Hoogle and Mapple. They are economically identical. However, for reporting purposes Hoogle uses the managerial discretion that is required with accrual accounting to increase net income relative to Mapple (assume any balance sheet effects are inconsequential). Which of the following is correct: Hoogle's OIROI is higher than Mapple's but Hoogle is NOT more efficient. Hoogle's OIROI is higher than Mapple's and Hoogle is more efficient. Mapple's OIROI is higher than Hoogle's and Mapple is more efficient. Mapple's OIROI is higher than Hoogle's but Mapple is NOT more efficient.

Hoogle's OIROI is higher than Mapple's but Hoogle is NOT more efficient.

Financial Leverage Ratio (FLR) = Total Assets / Equity Similar to the debt ratio

In a very simplistic firm, 40% debt implies the other 60% must be financed with equity. Thus, 60% equity financing (or equity/assets) implies an FLR of 1.67 (assets/equity).

Why does quick ratio not use inventory?

Inventory is less liquid. More stringent test of what is considered a liquid asset. Higher is better

Big-Tokyo Inc. has a financial leverage ratio of 2.00, total asset turnover of 1.50 and ROE of 18.00%. For Big-Tokyo's industry, the average ROE is 16.00% and the industry average total asset turnover (TAT) and financial leverage ratio (FLR) are the same as Big-Tokyo. The industry average net margin must be: Lower than Big-Tokyo's. Equal to Big-Tokyo's. Cannot be determined with available data. Higher than Big-Tokyo's.

Lower than Big-Tokyo's.

If the industry average ROE is 4.12% and ROA is 2.09%, the most plausible conclusion about Macrosoft's profitability is: (Macrosoft has higher ROE & ROA) Macrosoft should use more equity financing. Macrosoft is underperforming the industry. The industry is outperforming Macrosoft. Macrosoft is more profitable than the industry.

Macrosoft is more profitable than the industry.

Suppose that Macrosoft decides to increase the estimated life over which fixed assets are depreciated. Which of the following is most likely? Macrosoft's OIROI will increase. Macrosoft's total asset turnover will increase. Macrosoft's inventory turnover will decrease. None of the above are likely.

Macrosoft's OIROI will increase. Opt profit = Gross profit - Depreciation expense

Suppose that Macrosoft's times interest earned ratio has varied between 0.80 times and 5.23 over the past five years. Which of the following statements is most plausible? Macrosoft's borrowing cost may increase due to the fluctuations in interest coverage. Banks will be eager to loan to Macrosoft because of the fluctuations in the times interest earned ratio. Macrosoft should use more debt to finance assets. Macrosoft's borrowing cost may decrease due to the uncertainty of being able to cover interest payments.

Macrosoft's borrowing cost may increase due to the fluctuations in interest coverage.

Liquidity ratios speak to a firm's ability

Meet short - term obligations.

ROE= Using Du pont X*X*X = ROE

NetMargin×TAT×FLR

Which one of the following is NOT part of the common ratio categories? Liquidity Profitability Operating Financing

Operating

Which one of the following ratios is NOT part of the common ratio categories? Operating Liquidity Profitability Financing

Operating

Gross Margin = Gross Profit / Sales GM measures the

Percent of revenue remaining after the COGS. High gross margins are associated with an efficient production process.

Which one of the following is not an element of the DuPont decomposition? Earnings as a percentage of sales. Portion of assets financed by equity. Sales as a percentage of total assets. Percentage of net income paid out as dividends.

Percentage of net income paid out as dividends.

Operating Income Return on Investment (OIROI) = EBIT / Total Assets Tells us how much

Pre-Tax , pre - financing profit the company generates per dollar of assets. $100 in operating profit on an asset investment of $1000, we have earned a 10% return.

Kyoto Restaurant has total asset turnover of 1.50, ROE of 18.00%, and net profit margin of 6.00%. What is Kyoto's financial leverage ratio? 2.00 2.50 1.00 1.50

ROE = Net Margin x TAT x FLR, so FLR = ROE / (Net Margin x TAT) = 0.18 / (0.06 x 1.50) = 2.00.

Internal Goal Monitoring

Ratios can measure progress relative to specific goals set within the company. For instance, if management sets a specific goal for ROE, assessment of progress will involve ratio analysis.

Which one of the following is NOT an example of the use of meaningful comparison standards for ratio analysis? Using ratios to assess whether the firm is meeting established goals. Reporting ratios in annual financial statements. Comparing ratios over several years to understand changes in the company. Comparing a firm's ratios to the industry average to assess strengths and weaknesses.

Reporting ratios in annual financial statements.

Net Margin = Net Income / Sales measures the percent of

Revenue that drops to the bottom line 5% net margin indicated that for every dollar of revenue 5 cents remains for the equity holders after all other costs are covered.

Fixed Asset Turnover (FAT) = Sales/Fixed Assets This ratio calculates

Sales generated per Dollar of Fixed Assets Fixed Assets = non current assets or TTL Assets - current assets.

Operating Margin = EBIT / Sales is the percent of

Sales remaining after covering the COGS and Operating expenses. We use this to compare firms with different capital structures (different amounts of debt)

Total Asset Turnover (TAT) = Sales / Total Assets. This ratio measure how many...

Sales the firm generates per dollar of assets. A Tat of 3 means per Every $1 of assets , the firm generates $3 dollar of sales.

Consider Kyoto Restaurant. Kyoto's ROE is lower than the industry average. However, Kyoto's total asset turnover and financial leverage ratio are identical to the industry. The industry average net margin must be: Equal to Kyoto's net margin. Higher than Kyoto's net margin. Cannot be determined Lower than Kyoto's net margin.

Since TAT x FLR x net margin = ROE, the industry average net margin must be higher than Kyoto's since the industry has a higher ROE. Correct Answer: Higher than Kyoto's net margin.

Suppose an analyst is reviewing the profitability ratios for a firm. Which of the following statements represents the most valid insight for the analyst? Since the profitability ratios of the firm declined, the analyst devotes additional effort to understanding revenues and costs. Since the profitability ratios of the firm declined, the firm is facing serious competitive pressures. Since the profitability ratios of the firm improved, the firm is not subject to competitive pressures. Since the profitability ratios of the firm improved, the firm is obviously headed in the right direction.

Since the profitability ratios of the firm declined, the analyst devotes additional effort to understanding revenues and costs.

Ratio analysis is such a popular tool for three reasons

Standardization Flexibility Focus

Big-Tokyo Inc. has a financial leverage ratio of 2.00, total asset turnover of 1.50 and ROE of 18.00%. For Big-Tokyo's industry, the average ROE is 16.00% and the industry average total asset turnover (TAT) and financial leverage ratio (FLR) are the same as Big-Tokyo. The industry average net margin must be: Equal to Big-Tokyo's. Lower than Big-Tokyo's. Higher than Big-Tokyo's. Cannot be determined with available data.

TAT and FLR are the same for the industry and Big-Tokyo. Hence, since Big-Tokyo has a higher ROE, Big-Tokyo must have a higher net margin than the industry. Correct Answer: Lower than Big-Tokyo's.

AR Turnover ratio of 12 means

The company collects its entire AR 12 times per year. Credit Sales / AR

Suppose the inventory turnover of a company is higher than the industry. Based on this observation, which of the following is most likely? The firm has low sales volume. The firm has too little inventory resulting in lost sales or stock-outs. The firm has too much inventory thus impairing overall liquidity. The firm has lower liquidity than the industry average.

The firm has too little inventory resulting in lost sales or stock-outs

Suppose the inventory turnover of a company is higher than the industry. Based on this observation, which of the following is most likely? The firm has too little inventory resulting in lost sales or stock-outs. The firm has lower liquidity than the industry average. The firm has low sales volume. The firm has too much inventory thus impairing overall liquidity.

The firm has too little inventory resulting in lost sales or stock-outs.

Suppose the inventory turnover of a company is higher than the industry. Based on this one ratio, which of the following is most likely to be correct? The firm has too much inventory thus impairing overall liquidity. The firm has low sales volume relative to inventory. The firm has too little inventory resulting in lost sales or stock-outs. The firm has lower liquidity than the industry average

The firm has too little inventory resulting in lost sales or stock-outs.

two common pitfalls analysts must avoid

Timing issues: Mixing data from the income statement and balance sheet causes problems. This is particularly problematic for seasonal firms. Consider the ROA calculation for two identical swimsuit manufacturers, one with a balance sheet date of December 31 and the other with a balance sheet date of June 30. Since they are identical, they report the same net income. Accounting issues: Accounting data is the biggest potential menace in ratio analysis. The goal of ratio analysis is to understand the true economic character of the firm. However, the rules of accrual accounting allow for significant variation in reported results. Analysts must therefore be careful to understand each firm's accounting choices before assuming their ratios are comparable.

Interest bearing debt is calculated by

Total liabilities - Accounts payable and accruals. allows us to focus more directly on management's formal financing decisions.

There are three main comparison standards for ratio analysis

Trend Analysis Cross-sectional analysis Internal Goal Monitoring

Ratios help identify the areas of a firm that need investigation. T or F

True

Does FAT remove the management - influenced current assets from the denominator and compares sales solely to the long - term assets used to produce the company's products? T or F

True - current assets volume is a reflection of management's risk preferences. Managers with low risk tolerance will maintain higher current asset levels.

Ratios help identify the areas of a firm that need investigation. TrueFalse

True. Ratios tell you what questions to ask about the company.

True/False. The process of making a target firm's data comparable to a peer group is known as scrubbing the data. TrueFalse

True. Scrubbing the data is a preliminary step in ratio analysis. The process entails recasting the target/peer financial statements to align significant accounting choices, fiscal year-ends, etc.

Inventory Turnover Ratio is the number of times the company

Turns its inventory annually

Which one of the following is NOT an example of meaningful ratio analysis? Using GAAP rules to calculate standard ratios. Using ratios to assess goal achievement. Using ratios to compare a firm with high performing competitors. Analyzing the trend in ratios over time for a single firm.

Using GAAP rules to calculate standard ratios.

If the current ratio of a company is higher than the industry, then: The company has higher liquidity than the industry. The company has lower liquidity than the industry. The company has about the same liquidity as the industry. You cannot tell without looking at other liquidity ratios.

You cannot tell without looking at other liquidity ratios.

If the current ratio of a company is higher than the industry, then: You cannot tell without looking at other liquidity ratios. The company has lower liquidity than the industry. The company has higher liquidity than the industry. The company has about the same liquidity as the industry.

You cannot tell without looking at other liquidity ratios.

Return on Assets (ROA) = Net Income / Total Assets Think of ROA as net earnings as a percent of

all assets entrusted to management.

Efficiency ratio - measure how effectively a company/management team uses

assets to generate sales or profits

Cross-sectional analysis

comparing a firm's ratios to a peer group. Peer groups can include competitors, the industry, or even the market.

Financing ratios describe in what proportions the firm uses

equity and/or debt to finance assets.

Return on Equity (ROE) = Net Income / Owners' Equity Turn for a fact

firm that is effectively using debt will have an ROE that exceeds ROA

Profitability ratios can be divided into two categories

hose based on sales and those based on investment(i.e., assets or equity)

The Times Interest Earned Ratio (TIE) = EBIT / Interest Expense This ratio tells us how many times a company can pay

interest expense given profit. A TIE of 10 means the company can pay interest expense 10 times over out of operating expense. Important because if they miss a payment they have to explain it to a bankruptcy judge

Suppose a firm has a financial leverage ratio of 2.50. What percentage of the firm's assets are financed by equity? 40% 70% 50% 60%

o Financial leverage ratio = 2.5 = 100% / Y% = Assets/Equity; thus Y = 100 / 2.5 = 40%.

The Asset Turnover measures

the dollars of revenue generated for each dollar of assets

Trend Analysis

we examine a firm's ratios over time, essentially comparing the current year to previous years. Back 5 years and sometimes forecast forward 3 yeas