Financial Management Chapter 2
coverage ratio, 44
A debt ratio that uses data from the income statement to assess the firm's ability to generate sufficient cash flow to make scheduled interest and principal payments. uses data from the income statement to assess the firm's ability to generate sufficient cash flow to make scheduled interest and principal payments. Investors and credit-rating agencies use both types of ratios to assess a firm's creditworthiness.
Balance Sheet
A firm's balance sheet presents a "snapshot" view of the company's financial position at a specific point in time. assets = liabilities + stockholders' equity
average tax rate, 51
A firm's tax liability divided by its pretax income. For example, the average tax rate for FVC in the preceding example would be exactly 34% ($952,000 ÷ $2,800,000). During 2012, FVC paid an average of 34 cents on each dollar of pretax income earned.
preferred stock, 31
A form of ownership that has preference over common stock when the firm distributes income and assets.
current ratio, 41
A measure of a firm's ability to meet its short-term obligations, defined as current assets divided by current liabilities.
net working capital, 41
A measure of a firm's liquidity calculated by subtracting current liabilities from current assets.
quick (acid-test) ratio, 41
A measure of a firm's liquidity that is similar to the current ratio except that it excludes inventory, which is usually the least-liquid current asset. similar to the current ratio except that it excludes inventory, which is usually the least-liquid current asset. The quick ratio provides a better measure of overall liquidity only when a firm's inventory cannot be easily converted into cash. If inventory is liquid, then the current ratio is a preferred measure.
price/earnings (P/E) ratio, 49
A measure of a firm's long-term growth prospects that represents the amount investors are willing to pay for each dollar of a firm's earnings. Investors often use the P/E ratio, the most widely quoted market ratio, as a barometer of a firm's long-term growth prospects and of investor confidence in the firm's future performance. A high P/E ratio indicates investors' belief that a firm will achieve rapid earnings growth in the future; hence, companies with high P/E ratios are referred to as growth stocks. Simply stated, investors who believe that future earnings are going to be higher than current earnings are willing to pay a lot for today's earnings, and vice versa. Using the per-share price of $76.25 for Global Petroleum Corporation on December 31, 2012, and its 2012 EPS of $5.29, the P/E ratio at year-end 2012 is:
inventory turnover, 42
A measure of how quickly a firm sells its goods. In the numerator we used cost of goods sold, rather than sales, because firms value inventory at cost on their balance sheets. Note also that, in the denominator, we use the ending inventory balance of $615. If inventories are growing over time or exhibit seasonal patterns then analysts sometimes use the average level of inventory throughout the year, rather than the ending balance, to calculate this ratio. The resulting turnover of 13.85 indicates that the firm basically sells outs its inventory 13.85 times each year, or slightly more than once per month. This value is most meaningful when compared with that of other firms in the same industry or with the firm's past inventory turnover. An inventory turnover of 20.0 is not unusual for a grocery store, whereas a common inventory turnover for an aircraft manufacturer is 4.0. GPC's inventory turnover is in line with those for other oil and gas companies, and it is slightly above the firm's own historic norms.
average age of inventory, 42
A measure of inventory turnover, calculated by dividing the turnover figure into 365, the number of days in a year. For GPC, the average age of inventory is 26.4 days (365 ÷ 13.85), meaning that GPC's inventory balance turns over about every 26 days.
gross profit margin, 45
A measure of profitability that represents the percentage of each sales dollar remaining after a firm has paid for its goods. The higher the gross profit margin, the better. GPC's gross profit margin in 2012 is 33.7%:
net profit margin, 45
A measure of profitability that represents the percentage of each sales dollar remaining after all costs and expenses, including interest, taxes, and preferred stock dividends, have been deducted.
operating profit margin, 45
A measure of profitability that represents the percentage of each sales dollar remaining after deducting all costs and expenses other than interest and taxes. As with the gross profit margin, the higher the operating profit margin, the better. This ratio tells analysts what a firm's bottom line looks like before deductions for payments to creditors and tax authorities. GPC's operating profit margin in 2012 is 11.9%:
total asset turnover, 43
A measure of the efficiency with which a firm uses all its assets to generate sales; calculated by dividing the dollars of sales a firm generates by the dollars of total asset investment. All other factors being equal, analysts favor a high turnover ratio: it indicates that a firm generates more sales (and, ideally, more cash flow for investors) from a given investment in assets. an analyst must be aware that these are calculated using the historical costs of fixed assets.A naive comparison of fixed asset turnover ratios for different firms may lead an analyst to conclude that one firm operates more efficiently than another when, in fact, the firm that appears to be more efficient simply has older (i.e., more fully depreciated) assets on its books.
fixed asset turnover, 43
A measure of the efficiency with which a firm uses its fixed assets, calculated by dividing sales by the number of dollars of net fixed asset investment. The ratio tells analysts how many dollars of sales the firm generates per dollar of investment in fixed assets. The ratio equals sales divided by net fixed assets: GPC's fixed asset turnover in 2012 is 1.91. Stated another way, GPC generates almost $2 in sales for every dollar of fixed assets. As with other ratios, the level of fixed asset turnover considered normal varies widely from one industry to another.
times interest earned ratio, 45
A measure of the firm's ability to make contractual interest payments, calculated by dividing earnings before interest and taxes by interest expense. A higher ratio indicates a greater capacity to meet scheduled payments.
debt-to-equity ratio, 44
A measure of the firm's financial leverage, calculated by dividing long-term debt by stockholders' equity. GPC's long-term debts were therefore only 40.9% as large as its stockholders' equity. A word of caution: Both the debt ratio and the debt-to-equity ratio use book values of debt, equity, and assets. Analysts should be aware that the market values of these variables may differ substantially from their book values.
return on total assets (ROA), 46
A measure of the overall effectiveness of management in generating returns to common stockholders with its available assets.
debt ratio, 44
A measure of the proportion of total assets financed by a firm's creditors. The higher this ratio, the greater is the firm's reliance on borrowed money to finance its activities. The ratio equals total liabilities divided by total assets. GPC's debt ratio in 2012 was 0.551, or 55.1%:
equity multiplier, 44
A measure of the proportion of total assets financed by a firm's equity. Also called the assets-to-equity (A/E) ratio.
assets-to-equity (A/E) ratio, 44
A measure of the proportion of total assets financed by a firm's equity. Also called the equity multiplier. Note that the denominator of this ratio uses only common stock equity of $4,278 ($4,308 of total equity − $30 of preferred stock equity). The resulting value indicates that GPC's assets in 2012 were 2.24 times greater than its equity. This value seems reasonable given that the debt ratio indicates slightly more than half (55.1%) of GPC's assets in 2012 were financed with debt. The high equity multiplier indicates high debt and low equity, whereas a low equity multiplier indicates low debt and high equity.
return on common equity (ROE), 46
A measure that captures the return earned on the common stockholders' (owners') investment in a firm. For a firm that uses only common stock to finance its operations, the ROE and ROA figures will be identical. With debt or preferred stock on the balance sheet, these ratios will usually differ. When the firm earns a profit, even after making interest payments to creditors and paying dividends to preferred stockholders, the firm's ROE will exceed its ROA. Conversely, if the firm's earnings fall short of the amount it must pay to lenders and preferred stockholders, the ROE will be less than ROA.
market/book (M/B) ratio, 49
A measure used to assess a firm's future performance by relating its market value per share to its book value per share. The stocks of firms that investors expect to perform well in the future—improving profits, growing market share, launching successful products, and so forth—typically sell at higher M/B ratios than firms with less attractive prospects. Firms that investors expect to earn high returns relative to their risk typically sell at higher M/B multiples than those expected to earn low returns relative to risk.
accrual-based approach, 28
Accountants apply generally accepted accounting principles (GAAP) to construct financial statements using an accrual-based approach . This means that accountants record revenues at the point of sale and costs when they are incurred, not necessarily when a firm receives or pays out cash.
activity ratios, 42
Activity ratios measure the speed with which the firm converts various accounts into sales or cash. Analysts use activity ratios as guides to assess how efficiently the firm manages its assets and its accounts payable.
Cash Flow Analysis
Although financial managers are interested in the information contained in the firm's accrual-based financial statements, their primary focus is on cash flows. Without adequate cash to pay obligations on time, to fund operations and growth, and to compensate owners, the firm will fail.
deferred taxes, 31
An account that reflects the difference between the taxes that firms actually pay and the tax liabilities they report on their public financial statements.
Income Statement
Income is also called profit, earnings, or margin. Income = revenue - expenses Measures of Income Gross profit Operating profit Other income Earnings before interest and taxes Pretax income Net income / net profit after taxes
ordinary corporate income, 50
Income resulting from the sale of the firm's goods and services. Under current tax laws, the applicable tax rates are subject to the somewhat progressive tax rate schedule shown in Table 2.6. The purpose of the progressive rates
liquidity ratios, 41
Measure a firm's ability to satisfy its short-term obligations as they come due. Because a common precursor to financial distress or bankruptcy is low or declining liquidity, liquidity ratios are good leading indicators of cash flow problems. The two basic measures of liquidity are the current ratio and the quick (acid-test) ratio.
earnings available for common stockholders, 32
Net income net of preferred stock dividends.
operating cash flow (OCF), 37 continued
Next we convert this operating cash flow to free cash flow (FCF). To do so, we deduct the firm's net investments (denoted by Delta, the "change" symbol Δ) in fixed and current assets from operating cash flow, as shown in the following equation:
Financial Signs of an Improving Economy
One indicator of a recovering economy is a decrease in the time it takes customers to pay their bills.
Statement of Cash Flows
Reconciles the firm's operating, investment, and financing cash flows with changes in its cash and marketable securities during the year.
operating cash flow (OCF), 37
The amount of cash flow generated by a firm from its operations. Mathematically, earnings before interest and taxes (EBIT) minus taxes plus depreciation.
net operating profits after taxes (NOPAT), 36
The amount of earnings before interest and after taxes, which equals EBIT 3 (1-T), where EBIT is earnings before interest and taxes and T equals the corporate tax rate.
average collection period, 42
The average amount of time that elapses from a sale on credit until the payment becomes usable funds for a firm. Calculated by dividing accounts receivable by average daily sales. Also called the average age of accounts receivable. or average age of accounts receivable, is useful in evaluating credit and collection policies.6 It measures the average amount of time that elapses from a sale on credit until the payment becomes useable funds for a firm. To compute the measure, we divide the firm's average daily sales into the accounts receivable balance. As shown in the following equations, in 2012 it takes GPC on average 46.0 days to receive payment from a credit sale:
average payment period, 43
The average length of time it takes a firm to pay its suppliers. Calculated by dividing the firm's accounts payable balance by its average daily purchases. Firms use the average payment period to evaluate their payment performance. This metric measures the average length of time it takes a firm to pay its suppliers. The average payment period equals the average daily purchases divided into the accounts payable balance. Before calculating average daily purchases an analyst may need to estimate the firm's annual purchases, because they are not reported on a firm's published financial statements. Instead, annual purchases are included in its cost of goods sold.
retained earnings, 31
The cumulative total of the earnings that a firm has reinvested since its inception. Be sure you know that retained earnings are not a reservoir of unspent cash. When the retained earnings vault is empty, it is because the firm has already reinvested the earnings in new assets.
capital gains, 51
The difference between the sale price and the initial purchase price of a capital asset, such as equipment or stock held as an investment; the increase in the price of an asset that occurs over a period of time. The amount of the capital gain is equal to the difference between the sale price and initial purchase price. Under current tax law, corporate capital gains are merely added to operating income and taxed at the ordinary corporate tax rates
capital loss, 51
The loss resulting from the sale of a capital asset, such as equipment or stock held as an investment, at a price below its book, or accounting, value; the decrease in the price of an asset that occurs over a period of time. If the sale price is less than the asset's book, or accounting, value, the difference is called a capital loss The tax treatment of capital losses on depreciable business assets involves a deduction from pretax ordinary income, whereas any other capital losses must be used to offset capital gains.
financial leverage, 44
The magnification of both risk and expected return that results from the fixed cost associated with the use of debt, which leads to a higher stock beta; the use of fixed-cost sources of financing, such as debt and preferred stock, to magnify both the risk and the expected return on a firm's securities. In general, the more debt a firm uses in relation to its total assets, the greater its financial leverage. That is, the more a firm borrows, the riskier its outstanding stock and bonds and the higher the return that investors require on those securities. In Chapter 12, we discuss in detail the effect of debt on the firm's risk, return, and value. This explains our focus on the use of debt ratios when assessing a firm's indebtedness and its ability to meet the fixed payments associated with debt—a way of quantifying financial leverage.
common stock, 31
The most basic form of corporate ownership. The common stock entry equals the number of outstanding common shares multiplied by the par value per share
free cash flow (FCF), 35
The net amount of cash flow remaining after the firm has met all operating needs, including capital expenditure and working capital needs. Represents the cash amount that a firm could distribute to investors after meeting all its other obligations.
paid-in capital in excess of par, 31
The number of shares of common stock outstanding multiplied by the original selling price of the shares, net of the par value. The combined value of common stock and paid-in capital in excess of par equals the proceeds the firm received when it originally sold shares to investors
dividend per share (DPS), 32
The portion of the earnings per share paid to stockholders. cash
Retained Earnings Statement
The statement of retained earnings reconciles the net income earned during a given year, and any cash dividends paid, with the change in retained earnings between the start and end of that year.
marginal tax rate, 51
The tax rate applicable to a firm's next dollar of earnings. This rate is important because new decisions consider incremental benefits and costs, and therefore, the tax rate used in the analysis should likewise be an incremental, rather than an average rate.
Corporate Taxes
represent a significant cash outflow. -Ordinary corporate income Progressive tax rate schedule Average tax rate: tax divided by the pretax income More relevant for financial decision making: marginal tax rate Corporate capital gains Under existing tax laws, ordinary income tax rates apply
cash flow approach, 28
Used by financial professionals to focus attention on current and prospective inflows and outflows of cash. The financial manager must convert relevant accounting and tax information into cash inflows and cash outflows so that companies and investors can use this information for analysis and decision making.
DuPont system, 46 ROA
An analysis that uses both income statement and balance sheet information to break the ROA and ROE ratios into component pieces. It highlights the influence of both the net profit margin and the total asset turnover on a firm's profitability. In the DuPont system, the return on total assets equals the product of the net profit margin and total asset turnover: ROA = net profit margin × total asset turnover By definition, the net profit margin equals earnings available for common stockholders divided by sales, and total asset turnover equals sales divided by total assets. When we multiply these two ratios together, the sales figure cancels, resulting in the familiar ROA measure: Naturally, the ROA value for GPC in 2012 obtained using the DuPont system is the same value we calculated before. Yet now, seeing its two component parts, we can think of the ROA as a product of how much profit the firm earns on each dollar of sales and the efficiency with which the firm uses its assets to generate sales. Holding the net profit margin constant, an increase in total asset turnover increases the firm's ROA. Similarly, holding total asset turnover constant, an increase in the net profit margin increases ROA.
par value (common stock), 31
An arbitrary value assigned to common stock on a firm's balance sheet.
common-size income statement, 31
An income statement in which all entries are expressed as a percentage of sales.
Using Financial Ratios
Benchmark 1 Analysts compare the current year's financial ratios with previous years' ratios to identify trends that help them evaluate the firm's prospects. Benchmark 2 Analysts compare the ratios of one company with those of other firms in the same industry
ratio analysis, 40
Calculating and interpreting financial ratios to assess a firm's performance and status. To analyze financial statements, we need relative measures that, in effect, normalize size differences. Effective analysis of financial statements is thus based on the use of ratios or relative values.
financing flows, 35
Cash flow that result from debt and equity financing transactions. Taking on new debt (short term or long term) results in a cash inflow; repaying existing debt requires a cash outflow. Similarly, the sale of stock generates a cash inflow, whereas the repurchase of stock or payment of cash dividends results in a cash outflow. In combination, the operating, investment, and financing cash flows during a given period affect the firm's cash and marketable securities balances.
investment flows, 35
Cash flows associated with the purchase or sale of fixed assets. Clearly, purchases result in cash outflows, whereas sales generate cash inflows
operating flows, 35
Cash inflows and outflows directly related to the production and sale of a firm's products or services.
treasury stock, 31
Common shares that were issued and later reacquired by the firm through share repurchase programs and are therefore being held in reserve by the firm. Usually, treasury stock appears on the balance sheet because the firm has reacquired previously issued stock through a share repurchase program.
long-term debt, 31
Debt that matures more than one year in the future.
earnings per share (EPS), 32
Earnings available for common stockholders divided by the number of shares of common stock outstanding. Earnings per share represents the amount earned during the period on each outstanding share of common stock. Because there are 178,719,400 shares of GPC stock outstanding on December 31, 2012, its EPS for 2012 is $5.29, which represents a significant increase from the 2011 EPS of $2.52.
noncash charges, 37
Expenses, such as depreciation, amortization, and depletion allowances, that appear on the income statement but do not involve an actual outlay of cash. Almost all firms list depreciation on their income statements, so we focus on depreciation in our presentation. But when amortization or depletion occur in a firm's financial statements, they are treated in a similar manner.
Notes to Financial Statements
Explanatory notes that provide detailed information on the accounting policies, calculations, and transactions underlying entries in the financial statements.
DuPont system, 46 ROE
We can push the DuPont system one step further by multiplying the ROA by the assets-to-equity (A/E) ratio, or the equity multiplier. The product of these two ratios equals the return on common equity. ROE = ROA × A/E For a firm that uses no debt and has no preferred stock, the assets-to-equity ratio equals 1.0, and so the ROA equals the ROE. For all other firms, the assets-to-equity ratio exceeds 1. We can apply this version of the DuPont system to GPC and thereby recalculate its return on common equity in 2012: Observe that GPC's assets-to-equity ratio is 2.24. This means that GPC's return on common equity was more than twice as large as its return on total assets. Note also that if GPC's return on total assets were a negative number then the firm's return on common equity would be even more negative than its ROA. The advantage of the DuPont system is that it allows the firm to break its return on common equity into three components tied to the financial statements: (1) a profiton-sales component (net profit margin) that ties directly to the income statement; (2) an efficiency-of-asset-use component (total asset turnover) that ties directly to the balance sheet; and (3) a financial leverage use component (assets-to-equity ratio) that also ties directly to the balance sheet. Analysts can then study the effect of each of these factors on the overall return to common stockholders, as demonstrated in the following example.10