Chapter 5 Analysis of Financial Statements
Mitra Company has a quick ratio value of 1.5. It has total current assets of $100,000 and total current liabilities of $25,000. If sales are $200,000, what is the value of the inventory turnover ratio?
($100,000 current assets - inventory) ÷ $25,000 = 1.5 quick ratio, therefore inventory = $62,500 $200,000 sales ÷ $62,500 inventory = 3.2 inventory turnover ratio
What is a financial ratio?
A financial ratio is a number that expresses the value of one financial variable relative to another. Put more simply, a financial ratio is the result you get when you divide one financial number by another. Calculating an individual ratio is simple, but each ratio must be analyzed carefully to effectively measure a firm's performance.
What is a mixed ratio?
A mixed ratio is a ratio that uses both income statement and balance sheet variables as inputs.
Why would an analyst use the Modified Du Pont system to calculate ROE when ROE may be calculated more simply? Explain.
Actually, an analyst would not use the Modified Du Pont equation to calculate ROE for precisely the reason stated above. What an analyst would use the Modified Du Pont equation for is to help analyze the factors that contribute to a firm's ROE. In other words, analysts use the Modified Du Pont system to ―take apart‖ ROE to see what factors are influencing it.
What do asset activity ratios measure?
Asset Activity Ratios measure how efficiently a firm uses its assets.
How do you calculate the average collection period? (This is an Asset Activity Ratio)
Average Collection Period = Accounts Receivable / Average Daily Credit Sales
The ___________________________measures how many days, on average, the company's credit customers take to pay their accounts.
Average collection period
Which ratios would a banker be most interested in when considering whether to approve an application for a short-term business loan? Explain.
Bankers and other lenders use liquidity ratios to see whether to extend short-term credit to a firm. Liquidity ratios measure the ability of a firm to meet its short-term obligations. These ratios are important because failure to pay such obligations can lead to bankruptcy. Generally, the higher the liquidity ratio, the more able a firm is to pay its short-term obligations.
Why are M/B and MVA highly correlated?
Both focus on the value of the stock: MVA focuses on total market value while M/B focuses on per share stock price and both focus on total invested capital.
Pendell Company has total sales of $4 million. One-fourth of these are credit sales. The amount of accounts receivable is $100,000. What is the average collection period for the company? Use a 365-day year.
Credit sales = $4,000,000 ÷ 4 = $1,000,000 Average collection period = accounts receivable ÷ average daily credit sales = $100,000 Accounts receivable ÷ ($1,000,000 annual credit sales ÷ 365 days per year) = 36.5 days
One way to judge whether a firm's ratio is too high or too low is to compare it to the ratios of other firms in the industry. This is sometimes called ____________.
Cross-sectional analysis
How do you calculate the current ratio? (This is a Liquidity Ratio)
Current Ratio = Current Assets / Current Liabilities
Which ratios would a potential long-term bond investor be most interested in? Explain.
Current and potential lenders of long-term funds, such as banks and bondholders, are interested in debt ratios. When a business's debt ratios increase significantly, bondholder and lender risk increases because more creditors compete for that firm's resources if the company runs into financial trouble.
If one-half the current assets in ST-2 consist of inventory, what is the value of the quick ratio?
Current assets - inventory = $50,000 - (.5 × $50,000) = $25,000 $25,000 ÷ $20,000 current liabilities = 1.25 quick ratio
Francisco Company has current assets of $50,000. Total assets are $200,000; and longterm liabilities and common stock collectively total $180,000. What is the value of the current ratio?
Current liabilities = $200,000 total assets - $180,000 LTD & CS = $20,000 $50,000 current assets ÷ $20,000 current liabilities = 2.5 current ratio
The ___________________compares all the current assets of the firm to all the company's current liabilities.
Current ratio
Yates Corporation has total assets of $500,000. Its equity is $200,000. What is the company's debt to total asset ratio?
Debt = $500,000 assets - $200,000 equity = $300,000 $300,000 debt ÷ $500,000 assets = .6 = 60% debt to total asset ratio
What are debt ratios?
Debt Ratios assess the relative size of a firm's debt load and the firm's ability to pay off the debt.
How do you calculate the debt to equity? (This is a Debt Ratio)
Debt to Equity = Total Debt / Equity
How do you calculate the debt to total assets? (This is a Debt Ratio)
Debt to Total Assets = Total Debt / Total Assets
The ___________________________is the percentage of debt relative to the amount of equity of the firm.
Debt to equity ratio
Sheth Corporation has a return on assets ratio of 6 percent. If the debt to total assets ratio is .5, what is the firm's return on equity?
Debt ÷ assets = .5, therefore equity ÷ assets = .5, therefore assets ÷ equity = 1 ÷ . 5 = 2 ROE = ROA × (A/E) = .06 × 2 = .12, or 12%
How do you calculate the du pont system of ratio analysis?
Du Pont Equation: Return on Assets = Net Profit Margin x Total Asset Turnover
How do you calculate EVA?
EVA = EBIT(1-TR) - (IC x Ka) Where: EBIT = earnings before interest and taxes TR = the effective or average income tax rate IC = invested capital Ka = investors' required rate of return on their investment.
What does economic value added (EVA) measure?
Economic Value Added (EVA) measures the amount of profit remaining after accounting for the return expected by the firm's investors and is said to be an ―estimate of the true economic profit.
In the modified Du Pont equation, ROE is the product of net profit margin, total asset turnover, and the ________________________.
Equity multiplier
Explain how financial ratio analysis helps financial managers assess the health of a company.
Financial ratios are numbers that express the value of one financial variable relative to another. They are comparative measures because they show relative value and allow the financial analysts to compare information that could not be compared in its raw form.
The difference between the firm's future earnings and liquidation value is the _____________________ of the firm.
Going concern value
How do you calculate gross profit margin? (This is a Profitability Ratio)
Gross Profit Margin = Gross Profit / Sales
_________ (Cross-Sectional analysis) judges whether a firm's ratio is too high or too low in comparison with other firms in the industry.
Industry analysis
If total assets are $20 million, noncurrent assets are $2 million, inventory is $3 million, and sales are $5 million for Toronto Brewing Company, what is the inventory turnover ratio?
Inventory Turnover = 5,000,000/3,000,000 = 1.67
How do you calculate inventory turnover? (This is an Asset Activity Ratio)
Inventory Turnover = Sales / Inventory
The ___________________________tells us how efficiently the firm converts inventory to sales.
Inventory turnover ratio
Why is the EVA an important new tool in financial analysis?
It enables the investors to see whether the income earned was sufficient to cover their expected return. It is an estimate of the amount that earnings exceed or fall short of the required minimum rate of return investors could get investing in other securities of comparable risk.
What do liquidity ratios measure?
Liquidity Ratios measure the ability of a firm to meet its short-term obligations.
How do you calculate M/B (market to book ratio)? (This is a Market Value Ratio)
M/B = Market Price per Share / Book Value per Share
What is market value added (MVA)?
Market Value Added (MVA) is the market value of the firm, debt plus equity, minus the total amount of capital invested in the firm and is similar to the market to book (M/B) ratio. MVA, however focuses on total market value and total invested capital, whereas M/B focuses on the per share stock price and invested equity capital.
What do market value ratios measure?
Market Value Ratios measure the market's perception of the future earning power of a company as reflected in the stock share price.
The ___________________________is the market price per share of a company's common stock divided by the accounting book-value-per-share ratio.
Market to book value ratio
How do you calculate the modified du pont equation?
Modified Du Pont Equation: ROE = Net Profit Margin x Total Asset Turnover x Equity Multiplier
How do you calculate net profit margin? (This is a Profitability Ratio)
Net Profit Margin = Earnings Available to Common Stockholders / Sales
The ____________________________measures how much profit out of each sales dollar is left after all expenses are subtracted.
Net profit margin
What are ratios used to compare?
One ratio to a related ratio The firm's performance to management's goals The firm's past and present performance The firm's performance to that of similar firms.
How do you calculate operating profit margin? (This is a Profitability Ratio)
Operating Profit Margin = Earnings before Interest and Taxes / Sales
How do you calculate P/E? (This is a Market Value Ratio)
P/E = Market Price per Share / Earnings per Share
What do profitability ratios measure?
Profitability ratios measure how much company revenue is eaten up by expenses, how much a company earns relative to sales generated, and the amount earned relative to the value of the firm's assets and equity.
How do you calculate the quick ratio? (This is a Liquidity Ratio)
Quick Ratio = Current Assets Less Inventory / Current Liabilities
Why do analysts calculate financial ratios?
Ratios are comparative measures. Because the ratios show relative value, they allow financial analysts to compare information that could not be compared in its raw form. For example, ratios may be used to compare one ratio to a related ratio, a firm's performance to management's goals, a firm's past and present performance, or a firm's performance to similar firms.
If the net profit margin of Dobie's Dog Hotel is maintained at 20 percent and total asset turnover ratio is .25, calculate return on assets.
Return on Assets = 0.20 X 0.25 = 0.05 = 5%
How do you calculate return on assets? (This is a Profitability Ratio)
Return on Assets = Earnings Available to Common Stockholders / Total Assets
How do you calculate return on equity? (This is a Profitability Ratio)
Return on Equity = Earnings Available to Common Stockholders / Common Equity
The ____________________________measures the average return on the firm's capital contributions from its owners.
Return on equity
De Marco Corporation has total assets of $5 million and an asset turnover ratio of 4. If net income is $2 million, what is the value of the net profit margin?
Sales ÷ $5,000,000 = 4, therefore sales = $20,000,000 $2,000,000 net income ÷ $20,000,000 sales = .1 = 10% net profit margin
What does the du pont system of ratio analysis examine?
The Du Pont System of ratio analysis examines the relationships between ratios.
Under what circumstances would market to book value ratios be misleading? Explain.
The Market to Book ratio is useful, but it is only a rough approximation of how liquidation and going concern values compare. This is because the Market to Book ratio uses accounting-based book values. The actual liquidation value of a firm is likely to be different than the book value. For instance, the assets of a firm may be worth more or less than the value at which they are currently carried on the company's balance sheet. In addition, the current market price of the company's bonds and preferred stock may also differ from the accounting value of these claims.
What is meant by the leverage effect?
The leverage effect is a result of debt on the balance sheet. By using borrowed funds, the firm can increase its ROE.
Explain the difference between the current and the quick ratio.
The quick ratio is similar to the current ratio but is a more rigorous measure of liquidity because it excludes inventory from current assets.
How do you calculate times interest earned? (This is a Debt Ratio)
Times Interest Earned = EBIT / Interest Expense
How do you calculate total asset turnover? (This is an Asset Activity Ratio)
Total Asset Turnover = Sales / Total Assets
Given $20 million in total assets, $14 million in total stockholders' equity, and a debt to total asset ratio of 30 percent for Folson Corporation, what will be the debt to equity ratio?
Total Debt = 0.30 X $20,000,000 = $6,000,000 Debt to Equity ratio = $6,000,000/$14,000,000 = 0.43
The ___________________________measures how efficiently a firm utilizes its assets.
Total asset turnover Ratio
________ uses computed ratio values for several time periods and compares them.
Trend analysis
Why are trend analysis and industry comparison important to financial ratio analysis?
Trend analysis helps financial managers and analysts see whether a company's current financial situation is improving or deteriorating. Cross-sectional analysis, or industry comparison, allows analysts to put the value of a firm's ratios in the context of its industry.
Explain trend analysis.
Trend analysis uses ratios to compare a firm's past and present performance.
Given $2,044,000 in total assets, $1,351,000 in total stockholders' equity, and debt-to-total-asset ratio of 33.90%, calculate the debt to equity ratio.
x/2044000 = .3390 x(debt) = 692,916 Debt/Equity = 692,916/1351000 = 51%.