Ch 3 Financial Management Terms
Which of the following is a potential problem of utilizing ratio analysis
-Trends and industry averages are historical in nature. -Financial data may be distorted due to price-level changes. -Firms within an industry may not use similar accounting methods
Income can be distorted by factors other than inflation. The most important causes of distortion for inter-industry comparisons are
-timing of revenue receipts and nonrecurring gains or losses -tax write-off policy and use of different inventory methods
ABC Co. has an average collection period of 90 days. Total credit sales for the year were $6,000,000. What is the balance in accounts receivable at year-end?
ACP = AR/ Avg Daily Credit Sales 90 = AR / ($6,000/360 days) AR = $1.5M
An increasing average collection period indicates
An increasing average collection period indicates
A company experiencing rapid price increases for its products would take the most conservative approach by using
LIFO accounting
Which two ratios are used in the DuPont system to create return on assets
Profit margin and asset turnover
Disinflation may cause
a reduced required return demanded by investors on financial assets
deflation
actual declining prices
Disinflation as compared to inflation would normally be good for investments in
bonds
How do we use financial ratios
compare data and results from the firm to compare in the form of ratios
A banker or trade creditor is most concerned about a firm's profitability ratios
f
Absolute values taken from financial statements are more useful than relative values
f
Asset utilization ratios measure the returns on various assets such as return on total assets
f
If two companies have the same ROE, they will also have the same ROA
f
LIFO inventory valuation is responsible for much of the inventory profits caused by inflation
f
Ratios are not distorted by inflation
f
The current ratio is a more severe test of a firm's liquidity than the quick ratio
f
Times interest earned is an example of a profitability ratio
f
Unlike financial assets such as stocks and bonds, tangible (real) assets have the potential to do well during disinflation
f
Who uses financial ratios
for profitability: investor or security analyst for liquidity: banker or trade creditor for debt utilization: bondholder
replacement costs
increase with inflation
A decreasing average collection period could be associated with
increasing sales and decreasing accounts receivable
If the company's accounts receivable turnover is increasing, the average collection period
is going down
A short-term creditor would be most interested in
liquidity ratios
trend analysis
performance that is made over a number of years in order to ascertain significant patterns
The most rigorous test of a firm's ability to pay its short-term obligations is its
quick ratio
A higher times interest earned ratio will always increase a firm's return on equity given a positive return on assets
t
As long as prices continue to rise faster than costs in an inflationary environment, reported profits will generally continue to rise
t
Asset utilization ratios can be used to measure the effectiveness of a firm's managers
t
Debt utilization ratios are used to evaluate the firm's debt position with regard to its asset base and earning power.
t
During disinflation, stock prices tend to go up because the investor's required rate of return goes down
t
Fiercely competitive industries such as the computer industry have had lower profit margins and return on equity in recent years even though they are under extreme pressure to maintain high profitability
t
Heavy use of long-term debt can be of benefit to a firm
t
Profitability ratios allow one to measure the ability of the firm to earn an adequate return on sales, total assets, and invested capital
t
Profitability ratios are distorted by inflation because profits are stated in current dollars and assets and equity are stated in historical dollars
t
Return on equity will be higher than return on assets if there is debt in the capital structure
t
The DuPont system of analysis emphasizes that profit generated by assets can be derived by various combinations of profit margins and asset turnover
t
Inventory Turnover
tells us firm's ability to flip its products for cash
Total Asset Turnover
tells us firm's ability to generate sales from its assets
Current Ratio
tells us firm's ability to pay back its liabilities with assets
Fixed Charge Coverage
tells us firm's ability to pay fixed charges, such as interest and lease expense
Times Interest Earned
tells us firm's ability to pay its interest payments
ROE
tells us how much profit a company generates with the money shareholders have invested
Fixed Asset Turnover
tells us how well the firm is using its fixed assets to generate sales
ROA
tells us percent of profit earned in relation to its overall resources
Profit margin
tells us percent of revenue left after all expenses have been deducted
Quick Ratio
tells us the dollar amount of liquid assets available for each dollar of current liabilities
Receivables Turnover
tells us the effectiveness of the firm in on extending credit and collecting debt on that credit
Average Collection Period
tells us the how long it takes for the firm to receive money from the customer
Debt to total assets
tells us the percent of total assets that were financed by equity and debt
Why do we use financial ratios
to weigh and evaluate the operating performance of the firm
disinflation
when price increases stop rising
