Finance Chapter 4

Financial analysis involves:

1- Compare the firm's performance to that of other firms in the same industry 2- Evaluate trends in the firm's financial position over time

Ways to evaluate financial statements:

1- Comparison to industry average 2- Benchmarking 3- Trend analysis

Two of the most commonly liquidity ratios:

1- Current ratios 2- Quick (acid test) ratios -

Two reasons for "leveraging effect":

1- Interest is deductible, so the use of debt lowers the tax bill and leaves more of the firm's operating income available to its investors 2- If the rate of return on assets exceeds the interest rate on debt, as is generally expected, a company can use debt to acquire assets, pay the interest on the debt, and have something left over as a "bonus" for its stockholders. NOTE: Firms with relatively high debt ratios typically have higher expected returns when the economy is normal but lower returns and possibly bankruptcy if the economy goes into a recession

Four categories of asset management ratios:

1- Inventory turnover ratio - industry avg. 10.9x 2- Days sales outstanding( DSO) ratio - industry avg. 36 days 3- Fixed assets turnover ratio - industry avg. 2.8x 4- Total assets turnover ratio - industry avg. 1.8x

Five categories of ratios:

1- Liquidity ratios 2- Asset management ratios 3- Debt management ratios 4- Profitability ratios 5- Market value ratios

Ratio analysis is used by:

1- Managers 2- Credit analysts (e.g., bank loan officers, bond rating analysts) 3-Stock analysts

Five categories of profitability ratios:

1- Operating margin 2- Profit margin 3- Return on total assets 4- Basic earning power (BEP) ratio 5- Return on common equity

Two categories of market value:

1- Price/ Earnings ratio- industry avg. 11.3x 2- Market / Book ratio- industry avg. 1.7x

Two categories of debt management ratios:

1- Total debt to total assets- industry avg. 40% 2- Times-interest-earned ratio- industry avg. 6.0x

DuPont Equation:

A formula that shows that the rate of return on equity can be found as the product of profit margin, total assets turnover, and the equity multiplier. It shows the relationships among asset management, debt management, and profitability ratios. In other words, this is another alternative to find the ROE

Profitability ratios:

A group of ratios that show the combined effects of liquidity, asset management, and debt on operating results. Give us an idea of how profitably the firm is operating and utilizing its assets

Asset management ratios:

A set of ratios that measure how effectively a firm is managing its assets. Give us an idea of how efficiently the firm is using its assets

Trend analysis:

An analysis of a firm's financial ratios over time; used to estimate the likelihood of improvement or deterioration in its financial condition

Liquid asset:

An asset that can be converted to cash quickly without having to reduce the asset's price very much

Debt management ratios:

Give us an idea of how the firm has financed its assets as well as the firm's ability to repay its long-term debt

Liquidity ratios:

Give us an idea of the firm's ability to pay off debts that are maturing within a year. Ratios that show the relationship of a firm's cash and other current assets to its current liabilities

Equity multiplier:

Is a way of examining how a company uses debt to finance its assets. Also known as the financial leverage ratio or leverage ratio. It is calculated by dividing total assets by total common equity.

A company's market cap:

Is the total market value of the company's stock and it is calculated by multiplying the company's price by the number of outstanding shares

Window dressing techniques:

Techniques employed by firms to make their financial statements look better than they really are

Benchmarking:

The process of comparing a particular company with a set of benchmark

Market / Book (M/B) ratio:

The ratio of a stock's market price to its book value.

Times-interest-earned (TIE) ratio:

The ratio of earnings before interest and taxes (EBIT) to interest charges; a measure of the firm's ability to meet its annual interest payment. The industry average is 6.0x. The TIE ratio measures the extent to which operating income can decline before the firm is unable to meet its annual interest costs. Because interest is paid with pretax dollars, the firm's ability to pay current interest is not affected by taxes Below the industry average means that a firm is covering its interest charges by much lower margin of safety than an average firm which in other words this means this firm will face difficulties if it attempts to borrow additional money

3- Return on total assets(ROA):

The ratio of net income to total assets. It is always better to have a higher than lower return on assets. A low ROA may be the result of a great deal of debt and the net income becomes low

3- Fixed assets turnover ratio:

The ratio of sales to net fixed assets. It measures how effectively the firm uses its plant and equipment. Above the industry average means that the firm is using its fixed assets at least as intensively as other firms in the industry

5- Return on common equity (ROE):

The ratio of the net income to common equity; measures the rate of return on common stockholders' investment. This is the most important or " bottom-line accounting ratio." ROE reflects the effects of all of the ratios, and it is the single best accounting measure of performance. Investors like a high ROE, and high REOs are correlated with high stock prices. Financial leverage generally increases the ROE but also increases the firm's risk

Price/ Earnings(P/E) ratio:

The ratio of the price per share to earnings per shares; shows the dollar amount investor will pay for $1 of current earnings. This shows how much investors are willing to pay per dollar. If the ratio is above average, it means that the firm has a strong growth prospect and little risk. But when the ratio is below the industry average means the firm is risky and has poor growth prospects

Total debt to total assets(Debt ratio):

The ratio of total debt to total assets. The industry average is 40%. If a firm exceed the industry average, this may make it costly to borrow additional funds without first raising more equity. Also, creditors will be reluctant to lend the firm more money, and management would probably be subjecting the firm to too high a risk of bankruptcy if it sought to borrow a substantial amount of additional funds

4- Basic earning power (BEP) ratio:

This ratio indicates the ability of the firm's assets to generate operating income; it is calculated by dividing EBIT by total assets. The industry average is 18% Having a percentage below industry average indicates a poor performance of the turnover ratios and profit margin on sales

Quick (acid test) ratio:

This ratio is calculated by deducting inventories from current assets and then dividing the remainder by current liabilities.

2- Days sales outstanding (DSO) ratio [Average collection period (ACP)]:

This ratio is calculated by dividing account receivable by average sales per day; it indicates the average length of time the firm must wait after making a sale before it receives cash. More days than the average ratio represents that customers are not paying their bills on time. This deprives the company of funds that could be used to reduce bank loans or some other type of costly capital. Late-paying customers often default, so their receivables may end up as bad debt that never be collected

Current ratio:

This ratio is calculated by dividing current assets by current liabilities. It indicates the extent to which current liabilities are covered by those assets expected to be converted to cash in the near future. Having less than the average ratio, it represents that the firm's liquidity position is somewhat weak but by no mean desperate. On the other hand, a higher ratio indicates a very strong, safe liquidity position. Sometimes it may mean that a firm has too much old inventory that will have to be written off and too many old accounts receivable that may turn into bad debt. Other cases it means that the firm has too much cash, receivable, and inventory relative to its sales, in which case these assets are not being managed efficiently

1- Inventory turnover ratio:

This ratio is calculated by dividing sales by inventories. Having less than the average ratio means that the firm is holding too much inventory. Excess inventory is unproductive and represents an investment with a low or zero rate of return

4- Total assets turnover ratio:

This ratio is calculated by dividing sales by total assets. If the ratio of a firm is below the average ratio, it means that the firm is not generating enough sales given its total assets. To some extent, there is a problem with current assets, inventories, and account receivable compared to fixed assets. it is essential for the firm to consider to reduce inventory and collect receivable faster to improve operations

2- Profit margin or net profit margin:

This ratio measures net income per dollar of sales and is calculated by dividing net income by sales. Profit margin may be negatively impacted by a heavy use of debt. Interests pull down net income that result in low profit margin

1- Operating margin:

This ratio measures operating income, or EBIT, per dollar of sales; it is calculated by dividing operating income by sales. Percentage lowers than the industry average indicates that the firm's operating costs are too high