Assignment 15

What are some ratios that are commonly used for capital structure purposes?

-Debt ratio -Debt to equity -Equity multiplier

What are the three coverage ratios?

-Times interest earned -Fixed charge coverage -Cash coverage ratios

Debt management ratios

Measure the extent to which the firm uses debt (or financial leverage) versus equity to finance its assets as well as how well the firm can pay off its debt. -This ratio allows managers and investors to evaluate whether a firm is financing its assets with a reasonable amount of debt versus equity financing as well as whether the firm is generating sufficient earnings or cash to make the promised payments on its debt..

Inventory turnover

measures the number of dollars of sales produced per dollar of inventory -COGS is used in the numerator when managers want to emphasize that inventory is listed on the balance sheet at cost of sales generated per dollar of inventory -Inventory turnover= sales or cost of goods sold / Inventory

Fixed asset turnover

measures the number of dollars of sales produced per dollar of net fixed assets -Fixed asset turnover=SalesNet fixed assets

Sales to working capital

measures the number of dollars of sales produced per dollar of net working capital (current assets minus current liabilities) -Sales to working capital=SalesWorking capital

Total asset turnover

measures the number of dollars of sales produced per dollar of total assets -Total asset turnover= SalesTotal assets

Earning before power (BEP)

measures the operating return on the firm's assets, regardless of financial leverage and taxes. This ratio measures the operating profit (EBIT) earned per dollar of assets on the firm's balance sheet. -Basic earnings power (BEP)=EBITTotal assets

Return on assets (ROA)

measures the overall return on the firm's assets, including financial leverage and taxes. This ratio is the net income earned per dollar of assets on the firm's balance sheet. -Return on assets (ROA)=Net income available to common stockholdersTotal assets

debt ratio

measures the percentage of total assets financed with debt -Debt ratio=Total debtTotal assets

Return on equity (ROE)

measures the return on the common stockholders' investment in the assets of the firm. ROE is the net income earned per dollar of common stockholders' equity. The value of a firm's ROE is affected not only by net income, but also by the amount of financial leverage or debt that firm uses. -Return on equity (ROE)=Net income available to common stockholdersCommon stockholders' equity

True or false. Generally, a high ROE is considered to be a positive sign of firm performance. However, if performance comes from a high degree of financial leverage, a high ROE can indicate a firm with an unacceptably high level of bankruptcy risk as well.

true

True or false. In general, a high accounts receivable turnover or a low ACP is a sign of good management, which is well aware of financing costs and customer remittance habits.

true

True or false. In general, the higher the level of sales per dollar of fixed assets and working capital, the more efficiently the firm is being run.

true

True or false. The higher the liquidity ratios, the less liquidity risk a firm has but has the cost of lower return on assets

true

True or false. The lower the debt vs equity ratios, the moore equity the firms uses to finance its assets.

true

What can managers, investors, and analysts determine from the times interest, cash coverage, and fixed charge ratios?

-determine whether a firm has taken on a debt burden that is too large. -These ratios measure the dollars available to meet debt and other fixed-charge obligations. A value of one for these ratios means that $1 of earnings or cash is available to meet each dollar of interest or fixed-charge obligations. A value of less (greater) than one means that the firm has less (more) than $1 of earnings or cash available to pay each dollar of interest or fixed-charge obligations.2 Further, the higher the times interest earned, fixed-charge coverage, and cash coverage ratios, the more equity and less debt the firm uses to finance its assets. Thus, low levels of debt will lead to a dilution of the return to stockholders due to increased use of equity as well as to not taking advantage of the tax deductibility of interest expense

Fixed-charge coverage

measures the number of dollars of operating earnings available to meet the firms interest obligations and other fixed charges -Fixed-charge coverage=Earnings available to meet fixed charges/Fixed charges

What should you look at before evaluating ratios?

1. Financial statement data are historical. Historical data may not reflect future performance. While we can make projections using historical data, we must also remember that projections may be inaccurate if historical performance does not persist. 2.Firms use different accounting procedures. For example, inventory methods can vary. One firm may use FIFO (first-in, first-out), transferring inventory at the first purchase price, while another uses LIFO (last-in, first-out), transferring inventory at the last purchase price. Likewise, the depreciation method used to value a firm's fixed assets over time may vary across firms. One firm may use straight-line depreciation, while another may use an accelerated depreciation method (e.g., MACRS). Particularly, when reviewing cross-sectional ratios, differences in accounting rules can affect balance sheet values and financial ratios. It is important to know which accounting rules the firms under consideration are using before making any conclusions about their performance from ratio analysis. 3.Similarly, a firm's cross-sectional competitors may often be located around the world. Financial statements for firms based outside the United States do not necessarily conform to GAAP. Even beyond inventory pricing and depreciation methods, different accounting standards and procedures make it hard to compare financial statements and ratios of firms based in different countries. 4.Sales and expenses vary throughout the year. Managers, analysts, and investors need to note the timing of these fund flows when performing cross-sectional analysis. Otherwise they may draw conclusions from comparisons that are actually the result of seasonal cash flow differences. Similarly, firms end their fiscal years at different dates. For cross-sectional analysis, this complicates any comparison of balance sheets during the year. Likewise, one-time events, such as a merger, may affect a firm's financial performance. Cross-sectional analysis involving these events can result in misleading conclusions. 5.Large firms often have multiple divisions or business units engaged in different lines of business. In this case, it is difficult to truly compare a set of firms with which managers and investors can perform cross-sectional analysis. 6.Firms often window dress their financial statements to make annual results look better. For example, to improve liquidity ratios calculated with year-end balance sheets, firms often delay payments for raw materials, equipment, loans, and so on to build up their liquid accounts and thus their liquidity ratios. If possible, it is often more accurate to use something other than year-end financial statements to conduct ratio analysis. 7.Individual analysts may calculate ratios in modified forms. For example, one analyst may calculate ratios using year-end balance sheet data, while another may use the average of the beginning- and end-of-year balance sheet data. If the firm's balance sheet has changed significantly during the year, this difference in the way the ratio is calculated can cause large variations in ratio values for a given period of analysis and large variations in any conclusions drawn from these ratios regarding the financial health of the firm.

Accounts receivable turnover

measures the number of dollars of sales produced per dollar of accounts receivable -Asset receivable turnover= credit sales /accounts receivable

What do extremely high levels for the inventory turnover ratio and low levels for the day sales inventory ratio show about the company?

A sign of bas firm or production management

DuPont system of analysis

An analytical method that uses the balance sheet and income statement to break the ROA and ROE ratios into component pieces. -looks at ROA as the product of the profit margin and the total asset turnover ratios: -ROA=Profit margin × Total asset turnoverNet income available to common stockholdersTotal assets=Net income available to common stockholdersSales×SalesTotal assets -looks at the firm's overall profitability as a function of the profit the firm earns per dollar of sales (operating efficiency) and the dollar of sales produced per dollar of assets on the balance sheet (efficiency in asset use). -Next, the DuPont system looks at ROE as the product of ROA and the equity multiplier. - ROA=ROA × Equity multiplierNet income available to common stockholdersCommon stockholders' equity=ROA ×Total assetsCommon stockholders' equity -ROE=Profit margin × Total asset turnover × Equity multiplierNet income available to common stockholdersCommon stockholders' equity=Net income available to common stockholdersSales ×SalesTotal assets×Total assetsCommon stockholders' equity

time series analysis

Analyzing firm performance by monitoring ratio trends.

cross-sectional analysis

Analyzing the performance of a firm against one or more companies in the same industry. -key to cross-sectional analysis is identifying similar firms that compete in the same markets, have similar asset sizes, and operate in a similar manner to the firm being analyzed. Since no two firms are identical, obtaining such a comparison group is no easy task. Thus, the choice of companies to use in cross-sectional analysis is at best subjective.

How many types of ratios do managers, investors, and analysts use? What are the different types of ratios?

there are 5 types -Liquidity ratios -Asset management ratios -Debt management ratios -Profitability ratios -Market value ratios

How are the debt versus equity ratios related?

Debt ratio=1 − 1Equity multiplier=1(1/Debt-to-equity) +1Debt-to-equity=1(1/Debt ratio) − 1=Equity multiplier − 1Equity multiplier=1(1 − Debt ratio) − 1=Debt-to-equity+1

What signs are shown when accounts payable turnover is extremely low and the APP is extremely high?

Firm may be abusing credit terms that its raw materials suppliers offer

Why is a low accounts payable turnover or a high APP is generally a sign of good management?

In general, a firm wants to pay for its purchases as slowly as possible. The slower the firm pays for its supply purchases, the longer it can avoid obtaining other costly sources of financing such as notes payable or long-term debt

Asset management ratios

Measure how efficiently a firm uses its assets (inventory, accounts receivable, and fixed assets), as well as its accounts payable. -Ratios allow managers and investors to evaluate whether a firm is holding a reasonable amount of each type of asset and whether management uses each type of asset to effectively generate sales -Some of the most common types of these ratios include: -Inventory turnover -day sales in inventory -Accounts receivable turnover -Average collection period -Accounts payable turnover -Fixed asset turnover -Sales to working capital -Total asset turnover -Capital intensity

True or false. Generally, a high ROE is considered to be a positive sign of firm performance. However, if a high ROE results from a highly leveraged position, it can signal a firm with a high level of bankruptcy risk

true

Market value ratios

Ratios that relate a firm's stock price to its earnings and book value. -market value ratios measure what investors think of the company's future performance and risk.

Profitability ratios

Ratios that show the combined effect of liquidity, asset management, and debt management on the firm's overall operating results. -Are some of the most watched and well known financial ratios

capital structure

The amount of debt versus equity held on the balance sheet. -In deciding the level of debt versus equity financing to hold on the balance sheet, managers must consider the trade-off between maximizing cash flows to the firm's stockholders versus the risk of being unable to make promised debt payments.

Ratio Analysis

The process of calculating and analyzing financial ratios to assess the firm's performance and to identify actions needed to improve firm performance. -There are five groups to categorize the ratios: -Liquidity ratios -Asset management ratios -Debt management ratios -Profitability ratios -Market value ratios

Cash coverage

measures the number of dollars of operating cash available to meet each dollar of interest and other fixed charges that the firm owes. -Cash coverage=EBIT+ DepreciationFixed charges

why do current and potential debt holders look at equity financing as a safe cushion?

can absorb fluctuations in the firms earnings and asset values and guarantee debt service payments. Clearly, the larger the fluctuations or variability of a firms cash flows, the greater the need for an equity cushion.

Working capital

current assets minus current liabilities

Liquid assets

current assets that are sometimes uses to pay current liabilities/bills

Times interest earned

measures the number of dollars of operating earnings available to meet each dollar of interest obligations on the forms debt -Times interest= EBITInterest

What can lead to a high total asset turnover and may be signs of poor firm management?

inventory stockouts, capacity problems, or tight account receivables policies

Operating profit margin

is the percent of sales left after all operating expenses are deducted. -Profit margin=Net income available to common stockholders/Sales

Why is debt financing used?

it gives the debt holders first claim to a fixed amount of its cash flows. Stockholders are entitled to any residual cash flows—those left after debt holders are paid. When a firm does well, financial leverage increases the reward to shareholders since the amount of cash flows promised to debt holders is constant and capped. So when firms do well, financial leverage creates more cash flows to share with stockholders—it magnifies the return to the stockholders of the firm. This magnification is one reason that stockholders encourage the use of debt financing.

What should managers consider when they decide accounts payable level to hold on the balance sheet?

managers must consider the trade-off between maximizing the use of free financing that raw material suppliers offer versus the risk of losing the opportunity to buy on account.

Liquidity ratios

measure the relationship between a firm's liquid (or current) assets and its current liabilities -There are three common ratios: -Current ratio -The quick (or acid test) ratio -The cask ratio

Quick (acid test) ratio

measures a firm's ability to pay off short-term obligations without relying on inventory sales because inventory sales are generally the least liquid of a firm's current assets. It also measures the dollars of more liquid assets (cash and marketable securities and accounts receivable to pay each dollar of current liabilities) -Quick ratio= current assets- inventory /Current Liabilities

Cash ratio

measures a firms ability to pay short term obligatins with its available cash and marketable securities -Cash ratio= Cash and marketable securities (Current Liabilities)

Price earnings ratio

measures how much investors are willing to pay for each dollar the firm earns per share of its stock -Price-earnings (PE) ratio=Market price per shareEarnings per share -often quoted in multiples—the number of dollars per share—that fund managers, investors, and analysts compare within industry classes. Managers and investors often use PE ratios to evaluate the relative financial performance of the firm's stock. Generally, the higher the PE ratio, the better the firm's performance. Analysts and investors, as well as managers, expect companies with high PE ratios to experience future growth, to have rapid future dividend increases, or both, because retained earnings will support the company's goals. However, for value-seeking investors, high-PE firms indicate expensive companies. Further, higher PE ratios carry greater risk because investors are willing to pay higher prices today for a stock in anticipation of higher earnings in the future. These earnings may or may not materialize. Low-PE firms are generally companies with little expected growth or low earnings. However, note that earnings depend on many factors (such as financial leverage or taxes) that have nothing to do directly with firm operations.

Market to book ratio

measures the amount that investors will pay for the firms stock per dollar of equity used to finance the firms assets -compares the market (current) value of the firm's equity to its historical cost. In general, the higher the market-to-book ratio, the better the firm. If liquidity, asset management, debt management, and accounting profitability are good for a firm, then the market-to-book ratio will be high. A market-to-book ratio greater than one (or 100 percent) means that stockholders will pay a premium over book value for their equity investment in the firm. -Market-to-book ratio=Market price per shareBook value per share

Accounts payable turnover

measures the dollar cost of goods sold per dollar of accounts payable -Accounts payable turnover=Cost of goods soldAccounts payable

Equity multiplier ratio

measures the dollars of assets on the balance sheet for every dollar or equity (or just common stockholders equity) financing -Equity multiplier=Total assetsTotal equity or Total assetsCommon stockholders' equity

debt to equity ratio

measures the dollars of debt financing used for every dollar of equity financing -Debt-to-equity=Total debt/Total equity

Capital intensity

measures the dollars of total assets needed to produce a dollar of sales -Capital intensity= Total assets/Sales

Average collection period (ACP)

measures the number of days accounts receivable are held before the firm collects cash from the sale -Ratio is also sometimes termed the days sales outstanding (DSO) -ACP= accounts receivable/365 days/credit sales= 365 days/ accounts receivable turnover

Day sales in inventory

measures the number of days that inventory is held before the final product is sold -DSI= inventory /365 days / sales or COGS= 365 days Inventory Turnover

Average payment period (APP)

measures the number of days that the firm holds accounts payable before it has to extend cash to pay for its purchases -Average payment period (APP)=Accounts payable /365 daysCost of goods sold=365 daysAccounts payable turnover

profit margin

percentage of sales left after all firm expenses are deducted. Thus, this ratio provides the net profit margin of the firm, as opposed to the gross profit or operating profit margin. -Profit margin=Net income available to common stockholders/Sales

what are some notes to be CAUTIOUS of

the age of a firm's fixed assets will affect the fixed asset turnover ratio level. A firm with older fixed assets, listed on its balance sheet at historical cost, will tend to have a higher fixed asset turnover ratio than will a firm that has just replaced its fixed assets and lists them on its balance sheet at a (most likely) higher value. Accordingly, the firm with newer fixed assets would have a lower fixed asset turnover ratio. But this is because it has updated its fixed assets, while the other firm has not. It is not correct to conclude that the firm with new assets is underperforming relative to the firm with older fixed assets listed on its balance sheet. Similarly, for firms that are in an expansion phase, a lower fixed asset turnover is actually a good sign. It is not correct to conclude that a firm with expanding assets is underperforming relative to a firm with no growth.

Current ratio

the broadest of the liquid ratios that measure the dollar of current assets available to pay each dollar of current liabilities -Current ratio= current assets/current liabilities

Gross profit margin

the percent of sales left after COGS are deducted -Gross profit margin=Sales − Cost of goods sold/Sales

Dividend payout

the percentage of net income available to common stockholders that the firm actually pays as cash to these investors -Dividend payout=Common stock dividendsNet income available to common stockholders -the higher the value of the ratio, the higher the profitability of the firm. But just as has been the case previously in this chapter, high profitability ratio levels may result from poor management in other areas of the firm as much as superior financial management. A high profit (and gross profit or operating profit) margin means that the firm has low expenses relative to sales. The BEP reflects how much the firm's assets earn from operations, regardless of financial leverage and taxes. It follows logically that managers, investors, and analysts find BEP a useful ratio when they compare firms that differ in financial leverage and taxes. In contrast, ROA measures the firm's overall performance. It shows how the firm's assets generate a return that includes financial leverage and tax decisions made by management. -The lower the dividend payout ratio, the more profits the firm retains for future growth or other projects. A profitable firm that retains its earnings increases its level of equity capital as well as its own value.

What must manager consider when deciding what level of accounts receivable to hold on the firms balance sheet?

the trade-off between the advantages of increased sales by offering customers better terms versus the disadvantages of financing large amounts of accounts receivable. -There are 2 ratios for this -Accounts receivable turnover -Average collection period

True or false. high fixed asset turnover and sales to working capital ratios are generally signs of good management. However, if either the fixed asset turnover or sales to working capital ratio is extremely high, the firm may be close to its maximum Page 32production capacity. If capacity is hit, the firm cannot increase production or sales. Accordingly, extremely high fixed asset turnover and sales to working capital ratio levels may actually indicate bad firm management if managers have allowed the company to approach maximum capacity without making any accommodations for growth.

true

True or false. if the accounts receivable turnover is extremely high and the ACP is extremely low, the firm's accounts receivable policy may be so strict that customers prefer to do business with competing firms

true

True or false. in general, a well-managed firm produces many dollars of sales per dollar of total assets, or uses few dollars of assets per dollar of sales. Thus, in general, the higher the total asset turnover and lower the capital intensity ratio, the more efficient the overall asset management of the firm will be. However, if the total asset turnover is extremely high and the capital intensity ratio is extremely low, the firm may actually have an asset management problem.

true

true or false? -A high level of sales per dollar of inventory implies reduced warehousing, monitoring, insurance, and any other costs of servicing the inventory. So, a high inventory turnover ratio or a low days' sales in inventory is generally a sign of good management. -However, if the inventory turnover ratio is extremely high and the days' sales in inventory is extremely low, the firm may not be holding sufficient inventory to prevent running out (or stocking out) of the raw materials needed to keep the production process going. Thus, production and sales stop, which wastes the firm's fixed resources

true

How do managers use information from the financial statements?

use this information to plan changes that will improve the firm's future performance and, ultimately, its market value.

How do managers, analysts, and investors interpret financial ratios?

use two major types of benchmarks: (1) performance of the firm over time (time series analysis) and (2) performance of the firm against one or more companies in the same industry (cross-sectional analysis).