Finance ch 4
Trend analysis
- analysis of the performance of the company over time
Percentage change analysis
2nd year- 1st year/first year/period (for change on financial statements period by period)
Common size analysis
All Income Statement items are divided by sales All Balance Sheet Items are divided by total assets Facilitates comparison over time and across companies
Qualitative factors to be considered
Are the firm's revenues tied to 1 key customer, product, or supplier? What percentage of the firm's business is generated overseas? Competition Future prospects Legal and regulatory environment
Profitability
Are we able to generate adequate profit given our expenditures?
market/book ratio
BV per share :common equity/shares outstanding Market book ratio: market price per share/ book value per share
On the total debt ratio explain why it goes both ways (lower or higher)
Because having too much debt can be risky...but having too little debt causes you to pay interest (also important to use the industry average for comparison)
Why will ROE always be high?
Because the denominator will always be lower
Liquidity
Can we meet our obligations?
Limitations of ratio analysis (name 4)
Comparison with industry averages is difficult for a conglomerate firm that operates in many different divisions "Average" performance is not necessarily good, perhaps the firm should aim higher Seasonal factors can distort ratios "Window dressing" techniques can make statements and ratios look better Different operating and accounting practices can distort comparisons Sometimes it is hard to tell if a ratio is "good" or "bad" Difficult to tell whether a company is, on balance, in strong or weak position
Market value
Do investors perceive our company as a strong investment?
time interest earned
EBIT/Interest charges
Operating margin
EBIT/Sales (measures EBIT per dollar)
Basic Earning Power (BEP)
EBIT/Total assets (indicates ability of the firm's assets to generate assets to general operating income)
Equity multiplier
Equity multiplier = Total assets/ Common equity (reverse of equity ratio)
What does the DuPont equation help us to do
Helps to identify sources of strength and weakness in current performance Helps to focus attention on value drivers (What is driving the equation)
Who are the 3 groups who use ratios and why do each use them?
Lenders - to determine creditworthiness Stockholders - to estimate future cash flows and risk Managers - to identify areas of weakness and strength
Du Pont equation
Method to breakdown ROE into(if ROE isn't looking to good): ROA and Equity Multiplier ROA is further broken down as: Profit Margin and Asset Turnover
Return on common equity
Net income/common equity (measures the rate of return on common stockholders' investment)
Profit margin
Net income/sales (net income/dollar)
Does a firm taking steps to improve its ROE necessarily improve stockholder wealth?
No. 3 problems are likely to arise if firm relies too heavily on ROE to measure performance
DuPont Equation
Profit Margin * TATO * Equity Multiplier =ROE
Although certain ratios are more important for some firms than other firms, What tends to be the main focal point
ROE
DuPont Equation
ROE = ROA X Equity multiplier
What are these 3 problems?
ROE does not consider risk ROE does not consider the amount of invested capital ROE can cause managers to turn down profitable projects
Why use ratios? (2)
Ratios standardize numbers and facilitate comparisons Ratios better highlight weaknesses and strengths than raw accounting data
Asset management
Right amount of assets vs. sales?
Debt management
Right mix of debt and equity?
What are the 4 comparison bases?
Trend analysis Benchmarking Common size analysis Percentage change analysis
what is a liquid asset?
an asset that can be quickly converted to cash without having to reduce the asset price very much
Days sales outstanding (DSO)
average collection period" - the average length of time from the time the sale is made until the cash on that sale is collected/Lower ratio indicates that the company collects on its sales very quickly. DSO=0 for cash businesses; this depends on credit policy of the company/unit=days
market value ratios
bring stock price and give us an idea of what investors think about the firm and future prospects
Current ratio
commonly used as a measure of short-run solvency, i.e., the immediate ability of a business to pay its current debts as they come due/ the higher the number the better/units=times
What does financial analysis involve? (2)
comparing the firms performance to other firms in the same industry and evaluating trends in the firm's financial position over time (through ratios)
Benchmarking
comparing the performance of the company to Industry average & Main competitor
quick ratio
current assets-inventories/current liabilities (measures firm's ability to pay off short term obligations)
current ratio
current assets/current liabilities (indicates the extent to which current liabilities are covered by those assets expected to be converted to cash in the near future)
What are the 2 liquidity ratios?
current ratios and quick ratios
What is used to finance assets (2) and how do they work?
debt + equity. Together they always = 100%
EPS
earnings per share (NI/shares outstanding)
Return on equity (ROE)
estimates the rate of return on shareholder's investment/higher number the better/unit=percentage (equity alone)
Total assets turnover ratio
evaluates how effectively company uses all assets (both current and fixed)/Higher number the better/unit=time
Fixed assets turnover ratio
evaluates how effectively company uses its fixed assets (plant and equipment)/Higher number the better/unit=time
Quick ratio
excludes inventories from current assets, because usually inventory is not very liquid/less than 1.0 implies "dependency" on inventory to liquidate short-term debt (higher number the better). (Also called "acid test" or "liquid" ratio)/unit=times
Trend analysis
firm's financial ratios over time (estimates improvement or deterioration of firm's financial condition over time)
liquidity
firms ability to pay off debts that are maturing within a year
The higher the PE, the higher
growth opportunities
debt management ratios
how firm has financed its assets as well as ability to pay off long term debt
Inventory turnover
how many times per year did company sell out and restocked/Low ratio indicates that either the company is generating low volume of sales or it keeps too much inventory/unit=times
asset management
idea of how efficiently the firm is using the assets
profitability
idea of profitably operating firm and utilizing its assets
The quick ratio excludes inventories because
inventories are not as liquid as other assets
What are the 4 asset management ratios?
inventory turnover ratios, days sales outstanding, fixed assets turnover, total assets turnover
What are the 5 categories of ratios
liquidity, asset management, debt management, profitability, market value
Who are the 3 groups ratio analysis is used by?
managers who want to improve operation, credit analysts who want to judge company's ability to pay off debt stock analysts interested in companies efficiency risks, growth prospects
Return on total assets (ROA)
measures NI generated per dollar of total assets/higher number the better/unit=percentage (equity and debt)
Time interest earned (TIE) ratio
measures ability to pay interest/higher number the better/units=time
Profit Margin
measures net income per dollar of sales ; shows how much money company on its sales after accounting for all expenses/higher number the better/unit=percentage
Total debt ratio
measures percentage of funds provided by creditors, more general debt ratio, percentage of funds to provide creditors/lower and higher is better/units=%
return on total assets (ROA)
net income/total assets
Liquid asset
one that can be converted to cash quickly and without the loss of value
What are the 5 profitability ratios?
operating margin, profit margin, return on total assets, basic earning power ratio, return on common equity
price earnings ratio
price per share /earnings per share ( shows the dollar amount investors will pay for $1 of current earnings)
What are the 2 market value ratios?
price/earnings ratio and market/book ratio
Day sales outstanding
receivables/average sales per day (indicates average length of time the firm must wait after making a sale before it receives cash)
What are some factors that good analysis requires?
revenues being tied to key customers company relying on single supplier competition changes in laws and regulation need for R and D
Total assets turnover ratio
sales/ total assets
Inventory turnover ratio
sales/inventories
Fixed asset turnover ratio
sales/net fixed assets
Market/Book (M/B) ratio
shows how much investors are willing to pay per book value of shares. / usually 1-2 unit less/ higher is better
Price/Earnings ratio (P/E)
shows how much investors are willing to pay per dollar of reported profits/unitless-usually 15-18/higher means investors willing to pay more because they forecast future cash flows
DuPont Equation
shows rate of return on equity that can be found as the product of profit margin , total assets turnover, and equity multiplier. Shows the relationship among ratios
What are a few potential problems for ratios?
some firms are not narrow, but multidivisional, and multidivisional firms have trouble developing a meaningful set of industry averages It is best to focus on leading industries not the average ones Seasonal factors can distort ratio analysis
Liquidity must be the first order of business for a firm if.....
the firm is unable to pay off its debt
inventory is...
the least liquid current asset
Ratios are designed to help analyze
the past performance of the company and make reasonable predictions regarding company's future
What are the 2 debt management ratios?
total debt to total assets and time interest earned
total debt to total assets
total debt/total assets