Chapter 3
EBIT =
NI / (1- TAX RATE)
growth has to be financed, so
a firm's ability to grow depends on his financing policies
Total asset turnover ratio
an important " big picture" ratio, shows how much we generated in sales for every dollar in assets
Book value per share ratio =
equity / shares
profit margin =
net income / sales
internal growth rate
shows how rapidly a firm can grow, at what maximum rate per year
Anything that increases ROE will increase
the sustainable growth rate by making the numerator larger and the denominator smaller
cash coverage ratio =
(EBIT + interest + depreciation) / interest
internal growth rate =
(ROA X b) / (1- ROA x b), ROA = return on assets, b = retention
sustainable growth rate =
(ROE x b) / (1- ROE x b), ROE = return on investment, b = retention
quick ratio =
(current assets- inventory) / current liabilities
total debt ratio =
(total assets- total equity) / total assets
Capital intensity ratio =
1 / total asset turnover
Profitability measures
Intended to measure how efficiently The Firm uses its assets and how efficiently The Firm manages its operations, the focus in this group is on the bottom line which is net income, the best known and most widely used of all financial ratios
What is ROE after being rearranged according to DuPont identity
ROE = profit margin X total asset turnover X Equity multiplier (leverage)
days sales in receivables ratio/ average collection period
Shows on average in how many days we collect on our credit sales
dividend policy ( in relation to sustaining growth)
a decrease in the percentage of net income paid out as dividends will increase the retention ratio, this increases internally-generated equity and thus increases internal and sustainable growth
return on equity
a measure of how the stockholders fared during the year, because benefiting shareholders is our goal this in an accounting sense is the true bottom line measure of performance
return on assets
a measure of profit per dollar of assets
What type of person may be interested in the cash ratio
a very short term creditor
retention ratio =
addition to retained earnings / net income
Enterprise Value
an estimate of the market value of the company's operating assets ( all assets of the firm accept cash, can you use the right hand side of the balance sheet to calculate it
profit margin ( in relation to sustaining growth)
an increase in profit margin will increase the firm's ability to generate funds internally and thereby increase its sustainable growth
Financial policy ( in relation to sustaining growth)
an increase in the debt equity ratio increases the firm's financial leverage, because this makes additional debt financing available it increases the sustainable growth rate
total asset turnover ( in relation to sustaining growth)
an increase in the firm's total asset turnover increases the sales generated for each Dollar in assets, this decreases the firm's need for new assets as sales grow and thereby increases the sustainable growth rate, notice that increasing total asset turnover is the same thing as decreasing Capital intensity
what might a high current ratio indicate to a firm
an inefficient use of cash and other short-term assets
times interest earned ratio
another common measure of long-term solvency, it measures how well a company has its interest obligations covered
EBITD
another way to say EBIT + depreciation
Total equity =
assets- liabilities
what value of a current ratio should you expect to see and why
at least one because anything less than one would mean that net working capital is negative which is unusual in a healthy firm
market value measures
based on the market price per share of the stock which is not necessarily information that is contained in financial statements, these measures can be calculated directly only for publicly traded companies
why might a sustainable growth rate be greater than an internal growth rate
because as the firm grows it will have to borrow additional funds if it is to maintain a constant debt ratio, this new borrowing is an extra source of financing in addition to internally generated funds
why is the DuPont identity so useful
because if ROE is unsatisfactory then the DuPont identity tells you where to start looking for the reasons
Why is it almost impossible to directly compare the financial statement s of two companies
because of differences in size
Cash ratio =
cash / current liabilities
dividend payout ratio =
cash dividends/ net income
Market to book ratio
compares the market value of the firm's Investments to their cost, a value less than one could mean that the firm has not been successful overall in creating value for its stockholders, it is important to note that book value is an accounting number so it reflects historical costs
Why are standardized statements useful for
comparing financial information year to year and comparing firms of different sizes
inventory turnover ratio =
cost of goods sold/ inventory
current ratio =
current assets/ current liabilities, this is a measure of short-term liquidity and the unit of measurement is either dollars or times
if a firm only relies on internal financing then through time is total debt ratio will
decline
Dividends per share ratio =
dividends / shares
How do you standardize the income statement
each item is a percentage of total sales
How do you standardize the balance sheet
everything under assets is that divided by total assets and the same with liabilities and stockholder's equity, it is self explanatory (ACTUAL DEF percent of total assets)
dividend payout ratio
expresses the dividends paid as a percentage of net income
external financing
funds raised by either borrowing money or selling stock
quick/ acid test ratio
further evaluates liquidity but omits inventory because Relatively large inventories are often a sign of short-term trouble so the firm may have overestimated sales and overbought or ever produced as a result
which is better for a creditor, a high current ratio or a low current ratio
high
What five questions come to mind when looking at a ratio
how is it computed? what is it intended to measure and why might we be interested? what is the unit of measurement? what might a high or low value be telling us and how might such values be misleading? how could this measure be improved?
In what case would a high total asset turnover ratio be a bad sign for a company
if a company had old assets that were almost fully depreciated turn the book value of assets as low which contributes to a higher asset turnover
in what case would a low total asset turnover ratio be a good sign for a company
if a company just purchased a lot of new equipment which implies that the book value of assets is relatively High, these new assets could be more productive and efficient than those used by the company's competitors
if sales are to grow at a rate higher than the sustainable growth rate The Firm must
increase profit margins, increase total asset turnover, increase financial leverage, increase earnings retention, or sell their shares
Long-term solvency measures
intended to address the firm's long-run ability to meet its obligations, or, more generally, it's financial leverage, consists of the total debt ratio, the times interest earned ratio, and the cash coverage ratio
Asset Management/ turnover measures
intended to describe how effectively or intensively a firm uses its assets to generate sales
Using cash to buy inventory reduces the quick ratio because
inventory is relatively illiquid compared to cash
what two ratios do asset management/ turn over consist of
inventory turnover and days sales in inventory AND receivables turnover and days sales in receivables
what is one of the problems with the times-interest-earned ratio
it is based on EBIT which is not really a measure of cash available to pay interest because depreciation has been deducted out
Receivables turnover ratio
looks at how fast we collect profit on the sales that we made from turning over our inventory, answers shows how many times during the year we collected our outstanding credit accounts and reloaned the money
Market to book ratio =
market value per share / book value per share
price-earnings ratio
measures how much investors are willing to pay per dollar of current earnings, care is needed in interpreting this ratio.
Earnings-per-share ratio =
net income / shares outstanding
return on assets =
net income / total assets, only correct in accounting terms
return on equity =
net income / total equity, only correct in accounting terms
days sales in inventory
once we know how many times during the year we turned over inventory week and then figure out how long it took us to turn it over on average
what three things does the DuPont identity tell us that ROE is affected by
operating efficiency ( as measured by profit margin), asset use efficiency ( as measured by total asset turnover), financial leverage ( as measured by the equity multiplier)
What is one problem with ratios
people and different sources frequently do not compute them in exactly the same way which leads to much confusion
price-earnings ratio =
price per share / earnings per share
price-sales ratio =
price per share / sales per share
what three ratios consist of profitability measures
profit margin, return on assets, and return on equity
a firm's ability to sustain growth depends explicitly on the following four factors
profit margin, total asset turnover, Financial policy, dividend policy
Short-term solvency/ liquidity measures
provide information about a firm's liquidity, the primary concern is the firm's ability to pay its bills over the short run without undue stress, consists of the current ratio, quick ratio, and cash ratio
Financial ratios
ratios that compare and investigate the relationships between different pieces of financial information, used as another way to compare companies
receivables turnover ratio =
sales / accounts receivable
total asset turnover ratio =
sales / total assets
what are groups are financial ratios traditionally broken up into
short-term solvency or liquidity ratios, long-term solvency or financial leverage ratios, asset management or turnover ratios, profitability ratios, market value ratios
retention ratio
shows anyting that a company does not pay out in the form of dividends as a percentage of net income
Inventory turnover ratio
shows how many times during the year we turned over our entire inventory
profit margin
shows how much profit the company makes for every dollar in sales
Common-size statements
standardized financial statements that work with percentages instead of dollars, used to be able to compare different companies
total debt ratio
takes into account all debts of all maturities to all creditors
what are the two variations on the total debt ratio
the debt-equity ratio and the equity multiplier ratio
Capital intensity ratio
the dollar investment and assets needed to generate $1 in sales, it is the reciprocal of the total asset turnover ratio
days sales in inventory
365 days / inventory turnover
days sales in receivables
365 days / receivables turnover
times interest earned ratio =
EBIT / interest
EBITDA
Earnings before interest, taxes, depreciation, and amortization, ( here amortization refers to a non-cash deduction similar conceptually to depreciation except it applies to an intangible asset rather than a tangible asset)
EBITDA ratio =
Enterprise Value / EBITDA
what does the sustainable growth rate illustrate
the explicit relationship between the firm's four major areas of concern: its operating efficiency as measured by profit margin, its asset use efficiency as measured by total asset turnover, its Financial policy as measured by the debt-equity ratio, and its dividend policy as measured by the retention ratio, this makes it a VERY useful number
sustainable growth rate
the maximum growth rate that can be achieved while keeping two things in mind: 1) if it wishes to maintain a particular total debt ratio, 2) if it is unwilling to sell new stock
The difference between the two profitability measures ROA and ROE is a reflection of
the use of debt financing or financial leverage
What is one advantage of looking at current assets and liabilities
their book values and Market values are likely to be similar
Equity multiplier ratio =
total assets/ total equity OR 1 + debt equity ratio, you will get the same thing
debt equity ratio =
total debt/ total equity
Enterprise Value =
total market value of the stock + Book value of all liabilities- cash
internal financing
what the firm earns and subsequently plowed back into the business
what is important to note with PE ratio and PS ratio
whether the ratio is high or low depends on the industry involved