Chapter 3 Financial Management
Quick Ratio
(Current Assets - Inventory) / Current Liabilities AKA Acid Test Measure of liquidity as it eliminates inventory
A firm has sales of $2.3 million, and 20 percent of the sales are for cash. The year-end accounts receivable balance is $175,000. What is the average collection period?
175000/ (2.3million x 80%) / 360 = 175,000/5111.11 =34.24
Liquidity Ratios
A group of ratios that allows one to measure the firm's ability to pay off short-term obligations as they come due. Primary attention is directed to the current ratio and the quick ratio. 9. Current ratio 10. Quick ratio For banker or trade creditor - primary consideration
debt utilization ratios
A group of ratios that indicates to what extent debt is being used and the prudence with which it is being managed. Calculations include debt to total assets, times interest earned, and fixed charge coverage. 11. Debt to total assets 12. Times interest earned 13. Fixed charge coverage Potential investors and security analysts - Secondary consideration For long-term creditors (bondholder) - Primary consideration
Disinflation
A leveling off or slowdown of price increases.
Fixed Charge Coverage
A solvency ratio measuring the number of times interest and lease payments are covered by operating income, calculated as (EBIT + lease payments) divided by (interest payments + lease payments).
FIFO (first in, first out)
A system of writing off inventory into cost of goods sold in which the items purchased first are written off first. Referred to as first-in, first-out inventory method.
LIFO (last in, first out)
A system of writing off inventory into cost of goods sold in which the items purchased last are written off first. Referred to as last-in, first-out inventory method.
Gates Appliances has a return-on-assets (investment) ratio of 16 percent. a. If the debt-to-total-assets ratio is 35 percent, what is the return on equity? b. If the firm had no debt, what would the return-on-equity ratio be?
A. Return on equity = return on assests (inventory) / (1- debt/assest) 16%/ (1-35%) = 0.246 =24.6% B. Since there would be no debt, the denominator would equal 1 being 16%/1 = 16%
Compute the ratio of net income to total assets for each year. a-2. What is the trend in the net income to total assets ratio? Compute the ratio of net income to stockholders' equity for each year. b-2. What is the trend in the net income to stockholders'
A. net income/ total assets 130,000/2,670,000 = 0.0486 136000/2550000 = 0.053 205000/2870000 = 0.071 209000/2380000 = 0.087 A-2. strongly upward B. net income/ stockholders equity 130,000/794,000 = 0.163 136,000/958,000 = 0.141 205,000/1460000 = 0.140 209000/2090000 = 0.1 b-2 strongly downward
Average Collection Period
Accounts Receivable/Daily Credit Sales how many days to collect accounts receivable
Deflation
Actual declining prices
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. Looks at decisions made over the years to determine a pattern.
Du Pont system of analysis
An analysis of profitability that breaks down return on assets between the profit margin and asset turnover. The second, or modified, version shows how return on assets is translated into return on equity through the amount of debt that the firm has. Actually, return on assets is divided by (1- Debt/Assets) to arrive at return on equity.
If the company's current ratio is 2.5 times and current liabilities are $600,000, what are the current assets
CR= CA/CL via CA=CR x CL CA= 2.5 x $600K = $1.5M
what does a time interest earned ratio of 10 times indicate?
Income before interest and taxes covers the interest obligation of the firm by 10 times
Return on Equity
Net Income / Average Stockholders' Equity Return on assets (investment)/(1 - Debt/Assets)
The company has a sales of 10 million, total assets a 240,000, stockholders Equity you two million, in the net income of 500000. The company's return on assets is
Net income. Total Assest 500K/.2.4M = 0.2083 = 20.83%
The three parts of the Dupont equation are:
Profit margin, Total asset turnover, & Equity Multiplier.
Four Main Groups of Ratios
Profitability ratios: ability to earn adequate return -Profit margin -Return on assets (investment) -Return on equity Asset utilization ratios: How quick company is performing turnover - Receivables turnover -Average collection period -Inventory turnover - Fixed asset turnover - Total asset turnover Liquidity ratios: ability to pay short obligations - Current ratio - Quick ratio Debt utilization ratios: overall debt of the company and - Debt to total assets - Times interest earned - Fixed charge coverage
Return on equity can be calculated as ROA × Equity multiplier. What is another way to express this equation?
ROE = ROA × (1 + Debt − Equity Ratio)
asset utilization ratios
Ratios that measure how efficiently a company performs day-to-day tasks, such as the collection of receivables and management of inventory. 4. Receivable turnover 5. Average collection period 6. Inventory turnover 7. Fixed asset turnover 8. Total asset turnover
In January 2007, the Status Quo Company was formed. Total assets were $563,000, of which $310,000 consisted of depreciable fixed assets. Status Quo uses straight-line depreciation of $31,000 per year, and in 2007 it estimated its fixed assets to have useful lives of 10 years. Aftertax income has been $45,000 per year for each of the last 10 years. Other assets have not changed since 2007. a. Compute return on assets at year-end for 2007, 2009, 2012, 2014, and 2016. (Use $45,000 in the numerator for each year.) b. To what do you attribute the phenomenon shown in part a? c. Now assume income increased by 10 percent each year. What effect would this have on your answers to part a?
Return on assest (investment) = income after tax/ total assests (current + fixed) 2007 = 45000/ 532000 = 0.084 2009 = 45,000/ 470000 = 0.095 2012 = 45,000/377000 = 0.119 2014 = 45,000/315000 =0.142 2016= 45,000/ 253,000 = 0.177 b Annual depreciation charges c higher
Receivables Turnover
Sales / Accounts Receivable
The company has the sale of 10 million, total assets of 2400000, fix access 7 million, inventory 600,000, and accounts receivable of 500,000. What is the company's fixed asset turnover
Sales/Fixed Assests 10M/1M= 10 times
Fixed Asset Turnover
Sales/Fixed Assets
Inventory Turnover
Sales/Inventory How often you have to replace inventory over the course of a year
Total Asset Turnover
Sales/Total Assets How efficiently assets are used to create one dollar of sales.
The company has sales of 10 million, total assets of 2400000, fixed as tense of a million, inventory of 600000, and accounts receivable 500,000. The company's total inventory rate is
Sales/inventory 10M/$600K= 16.67 times
debt to total assets ratio
Total Debt/Total Assets How much is financed by debt and how much by owners equity
The company has current liabilities of 530000, long-term liabilities of a million, total assets of 240000, and stockholders Equity of 870000. The company's debt to total assets ratio is
Total debt/ Total assets ($530K+$1,000K)/$2.4M = 0.6375 = 63.75%
Financial ratios
Used to weigh and evaluate operating performance of firm •Measured in relation to other values •Compares performance record against similar firms in industry •Additional evaluation of company management, physical facilities and other factors is needed
debt utilization ratios indicates to what extent the firm is
Using debt and the Prudence with which it is being managed
Perez Corporation has the following financial data for the years 20X1 and 20X2: 20X1 and 20X2 Sales; $3,935,500$4,624,000 Cost of goods sold; 2,778,000 3,808,000 Inventory; 463,000 544,000 a. Compute the inventory turnover for each year using the formula b. Compute inventory turnover based on an alternative calculation that is used by many financial analysts, Cost of goods sold/Inventory, for each year. /Inventory.
a. sales/inventory = $3,935,500/463,000 = 8.5 $4,624,000/ 544,000 = 8.5 b. cost of goods sold/ inventory 2,778,000 /463000=6 3,808,000/544000= 7
The company has the credit sales of $10,000,000, total assets of 2100000, fixed assets of a million, inventory of 600,000, and accounts receivable of $500,000. The company's average collection is
accounts receivable/ average daily credit sales = $500,000/ ($10M/360) = 18 days
Martin Electronics has an accounts receivable turnover equal to 12 times. If accounts receivable are equal to $80,000, what is the value for average daily credit sales?
credit sales/ 360 (80,000x12) = 960000 960000/360 = 2666.66
Current Ratio
current assets / current liabilities how the company can pay off current assets
If the company's fixed charge coverage ratio is 4.5 times and income before fixture charges and tax is 450,000, the company has a fixed charges balance of
income before fixed charges and taxes / fixed charges. 450,000/4.5 = 100,000
A firm has net income before interest and taxes of $179,000 and interest expense of $29,500. a. What is the times-interest-earned ratio? b. If the firm's lease payments are $44,000, what is the fixed charge coverage?
income before interest and tax / interest 179000/29500= 6.06 IBIT+ before tax fixed charges / intrest + fixed charges 179000+44000/29500+44000 = 3.03
Polly Esther Dress Shops Inc. can open a new store that will do an annual sales volume of $620,200. It will turn over its assets 1.4 times per year. The profit margin on sales will be 7 percent. What would net income and return on assets (investment) be for the year?
net income = sales x profits 620,200 x 7% (0.07) = 43414 Return on assests = net income/ total assest 43414/ (620,200/1.4) = .098 =9.80%
profit margin
net income/net sales
times interest earned ratio
operating income/interest expense
Inflation
price increasing over time
profitability ratios
ratios that measure the amount of operating income or net income an organization is able to generate relative to its assets, owners' equity, and sales 1. Profit margin 2. Return on assets (investment) 3. Return on equity Potential investors and security analysts and For long-term creditors (bondholder) - Primary considerations
Replacement Cost
the cost to replace an inventory item in its identical form. Replacing item at current or opposed to original cost.
