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
