chapter 4 business finance

The basic earning power (BEP) ratio shows the

shows the earning power of the firm's assets before taxes and debt and is useful for comparing firms with different debt ratios and tax rates.

The DuPont equation

shows the relationships among asset management, debt management, and profitability ratios.

High debt ratios

that exceed the industry average may make it costly for a firm to borrow additional funds without first raising more equity-.

For each ratio,

the higher the number, the better.

looking at the firm's income statement sheet.

the last two ratios (2) Times interest earned ratio (TIE), and (3) EBITDA coverage ratio analyze debt by

, but problems can arise when ROE is

the sole measure of performance.

The DSO can also be evaluated by comparison with

the terms on which the firm sells its goods. If its trend has been rising and credit policy has not changed, this would indicate a need to speed up the collection of receivables.

total assets

the total asset turnover ratio measures the companys ability to generate revenues with a given level of

annual depreciation

the value of net fixed assets decrease over time due to

Two of the most commonly used liquidity ratios are

the: (1) Current ratio and (2) Quick, or acid test, ratio.

lenient credit and collection policy

this can lead to a high DSO which could deprive the firm of critical funds and lead to cash flow problems

higher expected returns

under economic growth conditions, firms with more leverage will have

Excess inventory is

unproductive and represents an investment with a low rate of return.

More Issues Regarding Ratios

"Average" performance is not necessarily good, perhaps the firm should aim higher. Seasonal factors can distort ratios. "

Inventory turnover is

below industry average.

yes

can a companys stock have a negative P/E ratio

liquid asset

can be converted quickly to cash with little sacrifice in its value

high P/E ratios

companies with high research and development expenses tend to have

comparative analysis

compare the ratios with other firms in the industry

Financial analysis

compares a firm's performance to other firms in the same industry and evaluates trends in the firm's financial position over time.

inventory turnover ratio replaces sales in the numerator with

cost of goods sold of general administration cost of discounts given.

EBITDA

is more complete than the TIE ratio because it recognizes that depreciation and amortization are not cash expenses, so these amounts are available to service debt, and lease payments and principal repayments are fixed payments.

Holding assets constant,

if debt increases: Equity declines. .Interest expense increases - which leads to a reduction in net income

more interest or taxes

if operating margin increases but profit margin decreases it could mean that the company paid

increased

increase in a firms profitability ratios over a certain time span is that a companys income has

Financial analysis

indicates a company's relative strengths and weaknesses. and (5) market value.

The operating margin indicates

indicates what percentage of sales remain after operating costs are accounted for.

There can be problems interpreting the fixed asset turnover ratio due to

inflation particularly when an older firm is compared with a newer company.

EBIT is used as the numerator because

interest is paid with pretax dollars—the firm's ability to pay interest is not affected by taxes.

The rationale for this measurement of inventory turnover is that

inventory is carried at cost, so sales in the numerator overstates the true inventory turnover ratio.

Market value ratios give management an indication of what

investors think of the company's riskand future prospects.

The Market/Book (M/B) ratio is

is another indication of how investors regard a firm. :

factors that affect a company's roe directly

operational efficiency, efficiency in use of total assets, financial leverage

The debt-to-capital ratio measures the

percentage of funds provided by debtholders

0.10 for each dollar of sales

profit margin of 10% means that the company made

BEP

projected to improve, yet still below the industry average. There is definitely room for improvement.

asset management or activity ratios

provides insight to managements efficiency by using a firms working capital and long term assets

profit margin

ratio of net income and sales

The market value ratios include:

ratios include: (1) Price/Earnings ratio and (2) Market/Book ratio.

Profitability ratios

reflect the net result of all the firm's financing-policies and operating decisions.

BEP

removes the effects of taxes and financial leverage, and is useful for comparison.

The return on total assets (ROA) measures the

return on all the firm's assets after interest and taxes.

The return on common equity (ROE) measures the

return on common equity (ROE) measures the return on common stockholders' investment.

The Price/Earnings (P/E) ratio shows

shows how much investors are willing to pay per dollar of current earnings.

The return on invested capital (ROIC) shows

shows the after-tax operating return on total invested capital, which is equal to the sum of debt and equity (assuming no preferred stock is issued).

cash

An asset is liquid if it is easily converted to

ROA declines

(due to the reduction in net income).

ROE may increase or decrease

(since both net income and equity decline).

Interest expense increases

- which leads to a reduction in net income

Asset management ratios include

: (1) Inventory turnover ratio, (2) Days sales outstanding, (3) Fixed assets turnover, and (4) Total assets turnover.

The profitability ratios include the

: (1) Operating margin, (2) Profit margin, (3) Return on total assets (ROA), (4) Basic earning power (BEP), (5) Return on invested capital (ROIC), and (6) Return on common equity (ROE).

M/B =

= Market price/Book value per share

ROA

= Net income/Total assets

ROE

= Net income/Total common equity

P/E =

= Price/Earnings per share

DSO

= Receivables/Avg. sales per day = Receivables/(Annual sales/365)

inventory turnover

= Sales/Inventories

FA turnover =

= Sales/Net fixed assets

TA turnover =

= Sales/Total assets

Debt-to-capital ratio =

= Total debt/Total invested capital

ROIC

= [EBIT(1 T)]/Total invested capital

roe=The DuPont Equation

= profit margin times total asset turnovers times equity multiplyer (NI/sales)*(sales/TA)/(TA/equity)

true

An analysis based on ratios should be supplemented with judgmental considerations such as the possible effects of new competitors like the Internet on newspapers, labor problems such as those experienced by the U.S. auto industry, environmental problems such as those facing the U.S. electric utilities, and the like.

Consider Qualitative Factors When Evaluating a Company's Future Financial Performance

Are the firm's revenues tied to one key customer, product, or supplier? What percentage of the firm's business is generated overseas? Firm's competitive environment Future prospects Legal and regulatory environment

is expensive

Asset management ratios are important - firms need to manage assets efficiently because capital obtained to acquire those assets is -----.

1.0 in "good" industries and be lower in "bad" industries.

Average M/Bs will exceed

Liquidity:asks

Can we make required payments?

M/B ratios.

Companies with low risk and high-growth have high

Potential Problems and Limitations of Financial Ratio Analysis

Comparison with industry averages is difficult for a conglomerate firm that operates in many different divisions.

financial leverage

Firms that use a lot of debt are said to have a great deal of

M/B:

How much investors are willing to pay for $1 of book value equity.

P/E:

How much investors are willing to pay for $1 of earnings.

Potential Problems and Limitations of Financial Ratio Analysis

Different operating and accounting practices can distort comparisons.

Market value: asks

Do investors like what they see as reflected in P/E and M/B ratios?

Profitability:asks

Do sales prices exceed unit costs, and are sales high enough as reflected in PM, ROE, and ROA?

TIE =

EBIT/Interest

operating margin

EBIT/sales

basic earning power

EBIT/total assets

liquidity ratios

Expected to improve but still below the industry average. Liquidity position is weak.

The DuPont Equation focuses on

Focuses on expense control (PM), asset utilization (TA TO), and debt utilization (equity multiplier).

increase its current liabilities causing a decline in the current ratio.

If a firm is having financial difficulty, it typically begins to pay its accounts payable more slowly and to borrow from the bank—both of which will

may or may not increase

If a firm takes steps that increase its expected future ROE, this means that its shareholders' wealth

raise the firm's expected return on common equity (ROE).

If a firm's expected basic earning power (BEP) is constant for all of its assets and exceeds the interest rate on its debt, then adding assets and financing them with debt will

won't help its future performance.

If the fundamentals of an industry change, then strong historical ratios

ratio comparisons

Industry analysis Benchmark (peer) analysis Trend analysis

More Issues Regarding Ratios

Inflation has distorted many firms' balance sheets, so analyses must be interpreted with judgment.

The operating margin is a measure of

It is a measure of the firm's operating efficiency.

The profit margin

It measures the firm's combined impact of operating efficiency and leverage on the firm's profitability.

the firm's performance.

Management can use the DuPont equation to analyze ways of improving

profit margin

Net income/sales

inventory forcast

No improvement is currently forecasted.

are correlated

ROE and shareholder wealth are

risk

ROE does not consider

. Qualitative Foreign factors

Ratio analysis is important to understand and interpret financial statements; however, sound financial analysis involves more than just calculating and interpreting numbers. ------------ also need to be considered.

Potential Uses of Freed Up Cash

Repurchase stock Expand business Reduce debt All these actions would likely improve the stock price.

Asset management: asks

Right amount of assets vs. sales?

Debt management:asks

Right mix of debt and equity?

Potential Problems and Limitations of Financial Ratio Analysis

Sometimes it is hard to tell if a ratio is "good" or "bad." Difficult to tell whether a company is, on balance, in a strong or weak position.

getting better

Suppose a firm's P/E ratio showed a rising trend over the last 5 years. This would suggest that the firm's image was

false

Suppose two firms have identical sales, operating costs, employee competence, assets, and financing policies. These firms would have to report the same amount of profits, and their ratios would all be the same, provided they both followed generally accepted accounting principles in their financial reporting. True or false?

assets relative to sales

The asset management ratios measure how effectively a firm is managing its

the average collection period (ACP).

The days sales outstanding (DSO) ratio is also called

liquid the asset

The easier it is to convert an asset to cash at close to a given value, the more

the firm's balance sheet,

The first ratio (debt to capital) analyzes debt by looking at

how many times during the year inventory is sold-and restocked.

The inventory turnover ratio indicates

Debt management ratios include

They include the: (1) Debt-to-capital ratio, (2) Times interest earned ratio (TIE), and (3) EBITDA coverage ratio. ​

More Issues Regarding Ratios

Window dressing" techniques can make statements and ratios look better than they actually are.

more risky

a company with a one key product is considered------ than a company with a wide range of products

short term obligations

a company with high liquid ratios should have enough ratios to pay off its

unleveraged company

a company with no debt on its books

A low ROA can result from

a firm's decision to use more debt because high interest expenses will cause net income to decline-.

The quick ratio is

a measure of a firm's ability to pay off short-term-obligations without relying on the sale of inventories-, which are typically the least liquid of a firm's current assets.

checking account not car

an example of a liquid asset?

ratios

are the tools used in financial analysis and they are grouped into five categories: (1) Liquidity, (2) asset management, (3) debt

Liquidity ratios

are used to measure a firm's ability to meet its current obligations as they come due.

low debt ratios

creditors would prefer to give companys loans that have

quick ratio

current assets-inventories/ current liabilities

currents ratio

current assets/current liabilities

ROE does not consider

does not consider the amount of capital invested.

low DSO

efficient credit and collection policy but stringent and could lead to loss of sales if competitors are offering more lenient terms

P/E and M/B are high if

expected growth is high and risk is low.

The times interest earned ratio measures the

extent to which operating income can decline before the firm is unable to meet its annual interest payments.

may or may not increase

future ROE increases its stock price

market value or market based ratios

help analysis and investors figure out what the markets think about the growth prospects or current and future operational performance

dent or financial leverage ratios

help analysis determine whether a company has sufficient cash to repay its short term debt obligations

ratios

help us make better comparisons between the operations of firms that differ in size and other aspects.

P/E ratios are

high for firms with strong growth prospects and relatively little risk but low- for slowly growing and risky firms.

more revenues per dollar of investment in assets

higher total asset turnover ratio means that its generating

Ratios are used to

highlight weaknesses and strengths.

fixed assets

historical acquisition cost, are not updated to reflect market values

high, which will help its ROE.

if a firm can command a premium price and hold down its costs, its profit margin will be

DSO

is the average length of time that it takes for a company to receive cash after making a sale

Ratio comparisons should be

made through time and with competitors.

Given these problems, reliance on ROE may encourage managers to

make investments that do not benefit shareholders. As a result, analysts have looked to develop other performance measures, such as EVA.

Debt management ratios

measure the extent to which a firm uses financial leverage and the degree of safety afforded to creditors.

The fixed assets turnover ratio

measures how effectively the firm uses its plant and equipment.

The total assets turnover ratio

measures how effectively the firm uses its total assets and whether the firm generates enough sales given its total assets.

The current ratio is the

most commonly used measure of short solvency.

Ratios standardize

numbers and facilitate comparisons.

D'Leon might have

old inventory, or its control might be poor.

lenders

use this information to evaluate whether borrowers have the ability to pay off loans;

security analysts

use this information to forecast earnings, dividends, and stock prices.

Managers

use this information to improve the firm's operations and stock price; management, (4) profitability,

weakness of ratio analysis includes

weakness dressing might be in effect, market data not sufficiently considered, seasonal factors can distort data

inventory

what is the a least liquid asset

The profit margin indicates

what percentage of sales net income- represents.

M/B ratios typically exceed one which means

which means that investors are willing to pay more for stocks than their accounting book values

Reducing A/R

will have no effect on sales