Chapter 13 Important Concepts and Key Terms
The Three categories of ratios The 3 categories of ratios
1) Profitability ratios, which relate to the company's performance in the current period—in particular, the company's ability to generate income. 2) Liquidity ratios, which relate to the company's short-term survival—in particular, the company's ability to use current assets to repay liabilities as they become due. 3) Solvency ratios, which relate to the company's long-run survival—in particular, the company's ability to repay lenders when debt matures and to make required interest payments prior to the date of maturity.
Going-Concern (Continuity) Assumption
A business is assumed to be of continuing its operations long enough to meet its obligations.
Comprehensive Income
Comprehensive Income = Net income + Other Comprehensive Income (OCI). OCI includes gains and losses arising from the changes in the values of certain assets and liabilities.
Current Ratio interpretation
Current Assets/Current Liabilities The current ratio compares current assets to current liabilities. The current ratio measures the company's ability to pay its current liabilities.
liquidity ratios formulas and examples (part 2)
Days to Sell Current Ratio
solvency ratios formulas and examples
Debt-to-assets Times Interest Earned
Earnings per Share (EPS) interpretation
Earnings per share (EPS) indicates the amount of earnings generated for each share of outstanding common stock.
Lowe's Helps Suppliers Collect on Account (not super important, but makes sense)
Lowe's has a low current ratio because it carries a large balance in Accounts Payable. The large Accounts Payable balance arises because suppliers give Lowe's favorable payment terms, including a longer period to pay its Accounts Payable. Why would suppliers be willing to allow this? The reason is that Lowe's participates in supply chain financing, or what some call "reverse factoring." The way this works is Lowe's tells a finance company what it owes to particular suppliers. The finance company then contacts the suppliers and offers to take over the collection of Lowe's account balance. Just like a normal factoring arrangement (discussed in Chapter 8), the finance company pays the supplier right away. The finance company charges the supplier a smaller-than-normal factoring fee because it knows Lowe's balance will be easily collected because Lowe's has openly told the finance company how much it owes. The supplier appreciates collecting right away and being charged a smaller factoring fee, so it gives Lowe's more favorable payment terms. Lowe's fiscal 2016 annual report indicates it has made this supply chain financing possible for 15 percent of its suppliers.
Receivables Turnover Ratio interpretation
Most home improvement retailers have low levels of accounts receivable relative to sales revenue because they either collect the majority of their sales immediately in cash or sell credit card receivables to finance companies (as Lowe's does, as explained in the "Credit Programs" section of its financial statement Note 1). Consequently, the receivables turnover ratio is not terribly meaningful for Lowe's or The Home Depot.
profitability ratios formulas and examples (part 1)
Net Profit Margin Gross Profit Percentage Fixed Asset Turnover
Net Profit Margin ratio interpretation
Net profit margin represents the percentage of revenue that ultimately makes it into net income, after deducting expenses. Using the equation in Exhibit 13.5, the calculation of Lowe's net profit margin for each of the last two years yields
Price/Earnings (P/E) Ratio interpretation Price/Earnings Ratio interpretation P/E Ratio interpretation
Price/Earnings Ratio = Stock Price (per share)/Earnings per Share (annual) Using the stock price immediately after Lowe's announced its fiscal 2016 and 2015 earnings (on March 1, 2017, and February 24, 2016), the P/E ratio was 23.4 and 25.1, respectively. This means investors were willing to pay 23.4 times earnings to buy a share of Lowe's stock in early 2017 (versus 25.1 times earnings a year earlier). The decrease from the prior year suggests investors were less optimistic about the company's future than they were the year before.
liquidity ratios formulas and examples (part 1)
Receivables Turnover Days to Collect Inventory Turnover
Guide for taking notes so I don't spend 4 hours doing something that should take 2 hours
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profitability ratios formulas and examples (part 2)
Return on Equity (ROE) Earnings per Share (EPS) Price/Earnings Ratio
Factors Contributing to Going-Concern Uncertainties
Revealed by Financial Analyses: Declining sales Declining gross profit Significant one-time expenses Fluctuating net income Insufficient current assets Excessive reliance on debt financing Negative operating cash flows Revealed by Other Analyses: Loss of a key supplier or customer Insufficient product innovation/quality Significant barriers to expansion Loss of key personnel without replacement Unfavorable long-term commitments Inadequate maintenance of long-lived assets Loss of a key franchise, license, or patent
Solvency definition
The ability to survive long enough to repay lenders when debt matures
Debt to assets ratio interpretation
The debt-to-assets ratio indicates the proportion of total assets that creditors finance. Remember that creditors must be paid regardless of how difficult a year the company may have had. The higher this ratio, the riskier is the company's financing strategy. Lowe's ratios at the end of fiscal 2016 and 2015 follow. Lowe's ratio of 0.81 in 2016 indicates that creditors contributed 81 percent of the company's financing, implying that it was the company's main source of financing. The debt-to-assets ratio increased from 2015 to 2016 as a result of issuing new bonds (and reducing equity financing by repurchasing its common stock). Although this increase suggests greater financing risk, it is not out of line with others in the home improvement industry.
Profitability definition
The extent to which a company generates income
Liquidity definition
The extent to which a company is able to pay its current maturing obligations
Fixed Assets Turnover ratio interpretation
The fixed asset turnover ratio indicates how much revenue the company generates for each dollar invested in fixed assets, such as store buildings and the property they sit on.
Gross Profit Percentage interpretation
The horizontal analysis indicated that Lowe's gross profit increased from 2015 to 2016 in terms of total dollars, as a result of a greater number of sales transactions. However, it did not indicate whether that increase was caused solely by greater Page 620total sales volume or also by more profit per sale. The gross profit percentage addresses these possibilities by indicating how much profit was made, on average, on each dollar of sales after deducting the cost of goods sold.
Inventory Turnover ratio interpretation
The inventory turnover ratio indicates how frequently inventory is bought and sold during the year. The measure "days to sell" converts the inventory turnover ratio into the average number of days needed to sell inventory.
Return on Equity (ROE) interpretation
The return on equity ratio compares the amount of net income earned for common stockholders to the average amount of common stockholders' equity. (The amount of net income earned for common stockholders is net income minus any dividends on preferred or "participating" stock.)
Times Interest Earned ratio interpretation
The times interest earned ratio indicates how many times the company's interest expense was covered by its operating results. A times interest earned ratio above 1.0 indicates that net income (before the costs of financing and taxes) is sufficient to cover the company's interest expense. Lowe's ratio of 9.1 indicates the company is generating more than enough profit to cover its interest expense.
Fact
Turnover ratios vary significantly from one industry to the next. Companies in the food industry (restaurants and grocery stores) have high inventory turnover ratios because their inventory is subject to spoilage. Companies that sell expensive merchandise (automobiles and high-fashion clothes) have much slower turnover because sales of those items are infrequent, but these companies tend to carry lots of inventory so that customers have a wide selection to choose from when they do buy.
Year-to-Year Change (%) formula
Year-to-Year Change (%) = (Change This Year/Prior Year's Total) = (Current Year's Total − Prior Year's Total)/Prior Year's Total
Horizontal (Trend) Analysis
comparing results across time, often expressing changes in account balances as a percentage of prior year balances
Solvency ratios:
debt-to-assets times interest earned
Vertical (Common Size) Analysis
expressing each financial statement amount as a percentage of another amount on the same financial statement
Conceptual Framework for Financial Accounting and Reporting Objective of External Financial Reporting To provide useful financial information to external users for decision making: - It must be relevant and a faithful representation of the business - It is more useful if it is comparable, verifiable, timely, and understandable Elements to Be Measured and Reported - Assets, Liabilities, Stockholders' Equity, Revenues, Expenses, Dividends Concepts for Measuring and Reporting Information - Assumptions: Unit of Measure, Separate Entity, Going Concern, Time Period - Principles: Cost, Revenue and Expense Recognition, Full Disclosure
fact
Ratio analyses help financial statement users understand relationships among various items reported in the financial statements.
fact
Profitability ratios:
net profit margin gross profit percentage fixed asset turnover return on equity (ROE) Earnings per share (EPS) Price/ Earnings ratio
Liquidity ratios:
receivables turnover days to collect inventory turnover days to sell current ratio
The common size income statement reports each income statement item as a percentage of sales. For example, in the picture on this flash card, Cost of Sales was equal to 65.4 percent of Net Sales Revenue in fiscal 2016 ($42,553 ÷ $65,017 = 0.654).
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Vertical (Common Size) Analysis of Lowe's Summarized Balance Sheets (assets)
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Vertical (Common Size) Analysis of Lowe's Summarized Balance Sheets (liabilities)
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Discontinued Operations
result from the disposal of a major component of the business and are reported net of income tax effects (net of tax is simply the amount left after taxes have been subtracted)
Full Disclosure Principle
the financial statements should present information needed to understand the financial results of the company's business activities
