Managerial Finance, Chapter 3

Inventory Turnover

COGS / Inventory

Cash Ratio

Cash / Current Liabilities

What are some uses for financial statement analysis?

Financial statement analysis is useful for both internal uses and external uses: Internal: Performance evaluation (managers and divisions), planning for the future (projections) External: Granting credit to new customers (financial health), evaluating competitors, acquiring firms

What does a firm's internal growth rate tell us?

A firm's internal growth rate tells us the maximum possible growth rate for a firm that relies only on internal financing.

What does a firm's sustainable growth rate tell us?

A firm's sustainable growth rate tells us the maximum possible growth rate for a firm that maintains a constant debt ratio and doesn't sell new stock.

Market-to-Book Ratio

Market value per Share / Book value per Share

Short-term Solvency Ratio

Measures a company's ability to pay immediate debts

Profit Margin

Net Income / Sales

Return on Assets

Net Income / Total Assets

Return on Equity

Net Income / Total Equity

Financial Ratios

Relationships determined from a firm's financial information and used for comparison purposes.

Turnover ratios all have one of two figures as numerators. What are these two figures? What do these ratios measure? How do you interpret the results?

Turnover ratios either have cost of goods sold or sales as numerators. Turnover ratios measure how efficiently, or intensively, a firm uses its assets to generate sales.

Standard Industrial Classification (SIC) code

U.S. government code used to classify a firm by its type of business operations.

Quick (Acid-Test) Ratio

(Current Assets - Inventory) / Current Liabilities

Current Ratio

(Current Assets / Current Liabilities) Intended to measure short-term liquidity Used to provide credit High value indicates liquidity, but might be misleading because it might indicate an inefficient use of cash and other short-term assets Can be improved by borrowing over hte long term, which increases cash from the issue proceeds and an increase in long-term debt

Cash Coverage

(EBIT + Depreciation) / Interest

Internal Growth Rate

(ROA x b) / (1 - ROA x b)

Sustainable Growth Rate

(ROE x b) / (1 - ROE x b)

Total Debt Ratio

(Total Assets - Total Equity) / Total Assets

What are the five groups of ratios? Give two or three examples of each.

1) Short-term solvency, or liquidity, ratios A) Current Ratio B) Quick (or Acid-Test) Ratio C) Cash Ratio 2) Long-term solvency, or financial leverage, ratios A) Total Debt Ratio B) Times Interest Earned C) Cash Coverage 3) Asset management, or turnover, ratios A) Inventory Turnover & Days' Sales in Inventory B) Receivables Turnover and Day's Sales in Rec. C) Total Asset Turnover 4) Profitability Ratios A) Profit Margin B) Return on Assets C) Return on Equity 5) Market Value Ratios A) Price-Earnings Ratio B) Price-Sales Ratio C) Market-to-Book Ratio

Days' Sales in Inventory

365 Days / Inventory Turnover

Days' Sales in Receivables

365 Days / Receivables Turnovers

Common-Size Statement

A standardized financial statement presenting all items in percentage terms. Balance sheet items are shown as a percentage of assets and income statement items as a percentage of sales.

Why is the sustainable growth rate likely to be larger than the internal growth rate?

As the firm grows, it will have to borrow additional funds if it is to maintain a constant debt ratio. This new borrowing is an extra source of financing in addition to internally generated funds, so the company can expand more rapidly.

Describe how common-size balance sheets and income statements are formed.

Common-size balance sheets and income statements are formed by expressing each item as a percentage of total assets or total sales, respectively.

Times Interest Earned

Earnings before Interest & Tax / Interest

EBITDA Ratio

Enterprise Value / EBITDA

Given the total debt ratio, what other two ratios can be computed? Explain how.

Given the total debt ratio, the debt-equity ratio and equity multiplier can be computed. The debt-equity ratio is measured by Total Debt / Total Equity. The equity multiplier is measured by adding 1 + the Debt-equity ratio.

Questions to analyze Ratios

How is it computed? What is it intended to measure, and why might be interested? What is the unit of measurement? What might a high or low value be telling us? How might such values be misleading? How could this measure be improved?

Why is it often necessary to standardize financial statements?

It is necessary to standardize financial statements because it is difficult to compare companies that are different in size or currency.

Why do we say that financial statement analysis is management by exception?

Management by exception is a style of business management that focuses on identifying and handling cases that deviate from the norm. If a ratio declines steadily over a certain period, we might wonder if the liquidity position of the firm has deteriorated. A deteriorating time trend may not be bad, but it does merit investigation.

Explain what peer group analysis means. As a financial manager, how could you use the results of peer group analysis to evaluate the performance of your firm? How is a per group different from an aspirant group?

Peer group analysis involves comparing the financial ratios and operating performance of a particular firm to a set of peer group firms in the same industry or line of business. Comparing a firm to its peers allows the financial manager to evaluate whether some aspects of the firm's operations, finances, or investment activities are out of line with the norm, thereby providing some guidance on appropriate actions to take to adjust these ratios, if appropriate. An aspirant group would be a set of firms whose performance the company in question would like to emulate. The financial manager often uses the financial ratios of aspirant groups as the target ratios for his or her firm; some managers are evaluated by how well they match the performance of an identified aspirant group.

DuPont Identity

Popular expression breaking ROE into 3 parts: 1.) Operating Efficiency (as measured by profit margin) 2.) Asset use efficiency (as measured by total asset turnover) 3.) Financial leverage (as measured by the equity multiplier)

Price-Earnings Ratio

Price per Share / Earnings per Share

Price-Sales Ratio

Price per Share / Sales per Share

Return on assets, or ROA, can be expressed as the product of two ratios. Which two?

ROA is the product of profit margin and asset turnover ratios.

Return on equity, or ROE, can be expressed as the product of three ratios. Which three?

ROE is the product of profit margin, asset turnover, and the equity multiplier.

Why is the DuPoint identity a valuable tool for analyzing the performance of a firm? Discuss the types of information it reveals as compared to ROE considered by itself.

Return on equity is probably the most important accounting ratio that measures the bottom-line performance of the firm with respect to the equity shareholders. The DuPoint identity emphasizes the role of a firm's profitability, asset utilization efficiency, and financial leverage in achieving a ROE figure. For example, a firm with ROE of 20% would seem to be doing well, but this figure may be misleading if it were a marginally profitable (low profit margin) and highly levered (high equity multiplier). If the firm's margins were to erode slightly, the ROE would be heavily impacted.

Receivables Turnover

Sales / Accounts Receivable

Total Asset Turnover

Sales / Total Assets

What are some of the problems that can come up with financial statement analysis?

Some problems that can come up with financial statement analysis are: There is no underlying theory to help us identify which items or ratios to look at and to guide us in establishing benchmarks. Many firms are conglomerates owning more or less unrelated lines of business. The consolidated financial statements for such firms don't really fit any neat industry category. The kind of peer group analysis we have been describing is going to work best when the firms are strictly in the same line of business, the industry is competitive, and there is only one way of operating. Major competitors and natural peer group members in an industry may be scattered around the globe. Financial statements from outside the US do not necessarily conform at all to GAAP. The existence of different standards and procedures makes it very difficult to compare financial statements across national borders. Companies may be in the same line of business, but operating activities may differ and thus they are not comparable. Firms use different accounting methods. Firms end fiscal years at different times. Unusual or transient events may affect financial performance.

What are SIC codes and how might they be useful?

Standard Industrial Classification (SIC) codes are four-digit codes established by the US Government for statistical reporting purposes. They are used to classify a firm by its type of business operations. SIC codes are useful for evaluating another firm based on its financial statements. It provides a standard of comparison.

Sustainable Growth Rate

The maximum possible growth rate for a firm that maintains a constant debt ratio and doesn't sell new stock.

Internal Growth Rate

The maximum possible growth rate for a firm that relies only on internal financing.

Profitability ratios all have the same figure in the numerator. What is it? What do these ratios measure? How do you interpret the results?

The numerator in profitability ratios is always Net Income. Profitability ratios measure how efficiently the firm uses its assets and how efficiently the firm manages its operations. Results are interpreted as the rate of return to investors.

Enterprise Value-EBITDA Ratio

Total market value of the stock + Book value of all liabilities - cash