Topic 3: Ratio Analysis: Financial Statement Analysis and Free Cash Flows
quick ratio/acid test ratio
(current assets-inventory)/current liabilities acknowledges this difference in liquidity by subtracting inventory from current assets and then comparing the result to current liabilities`
Standardization
(or scaling companies relative to their own operations and size) also allows us to compare present company performance to its performance in the past, despite the fact that the company may have changed in size over the years
average collection period
AR/daily credit sales number of days it takes on average for the company to collect its receivables, and it is calculated as accounts receivable over daily credit sales
Red Way Inc. is a small company, much smaller than Fortune or S&P 500 firms. As an analyst, you have calculated a variety of ratios for Red Way and are looking to interpret the financial health of the firm. Which of the following benchmarks would be appropriate when interpreting Red Way's financial ratios? Close competitor ratios to Red Way Goal ratios that Red Way Management has set to achieve Historical quarterly ratios for Red Way Inc. All of the above
Answer: All of the above
Which one of the following is NOT a factor impacting the DuPont Decomposition? Sales as a percentage of total assets. Dividends as a percent of net income. Earnings as a percentage of sales. Portion of assets financed by debt.
Answer: Dividends as a percent of net income.
Which of the following is NOT an example of the three main comparison standards? Comparing a firm's ratios with competitor ratios to understand where you stand in the industry to create new strategies. Looking back over the ratios of the past several years to analyze what has been happening in the company and the industry. Setting some objectives and checking the ratios to see if you can make some improvement in certain areas to achieve goals. Follow the GAAP rules to make sure that the ratios are consistent with other firms.
Answer: Follow the GAAP rules to make sure that the ratios are consistent with other firms.
Which of the following is NOT a valid use of ratios? Use ratios to gain insight about performance goals. Analyzing a firm's ratios over several years. Report ratio deviations to the taxing authority. Compare a firm to its industry to determine potential problem areas.
Answer: Report ratio deviations to the taxing authority.
For eBuy's industry, the industry average total asset turnover is 0.66 and fixed asset turnover is 0.76. Which one of the following statements best describes the comparison of the total asset turnover and the fixed asset turnover for eBuy relative to the industry? eBuy is a very large firm for when compared to the industry. eBuy is more efficient than the industry average with fixed asset utilization. eBuy has a greater amount of current assets relative to sales than the industry. eBuy has more sales relative to total assets than the industry average.
Answer: eBuy has a greater amount of current assets relative to sales than the industry. For eBuy, total asset turnover is .45 (TAT = sales/total assets) and the fixed asset turnover is .68 (FAT = sales/gross fixed assets). Both ratios are lower than the industry average meaning that eBuy generates fewer dollars in sales per dollar of assets. Hence, B and D lean in the wrong direction. The TAT and FAT don't tell us anything about the size of eBuy relative to the industry, so A is not correct. For C, notice that the difference between TATs for eBuy and the industry (.45 vs. .66) is greater than the difference between FATs (.68 vs. .76). Given that the difference between FAT and TAT is the inclusion of current assets in the denominator of TAT, we can see that compared to sales eBuy has a relatively large amount of current assets. That is, since eBuy's TAT is much lower than its FAT the firm must have a large amount of current assets.
If the average debt ratio in the industry is 65%, then: eBuy is more conservatively financed than the industry average. eBuy cannot compete well in its industry. eBuy is more aggressively financed than the industry. eBuy has more debt financing than the industry norm.
Answer: eBuy is more conservatively financed than the industry average. eBuy has a lower debt ratio than the industry, therefore eBuys is more conservatively financed than the industry norm. Having more debt financing (and therefore a higher debt ratio) means the company is more aggressively financed. The debt ratio alone doesn't tell us about eBuy's competitive position. Debt ratio = Total Liabilities/Total Assets = 3661/6450 = 0.57
eBuy's competitor, Amazona has accounts receivable turnover of 9.50. Which one of the following statements best describes the comparison between eBuy and Amazona? (Assume all sales on account and 365 days in a year). eBuy probably has stricter credit standards than Amazona since eBuy's accounts receivable turnover is lower. eBuy is taking about 20 days longer to collect receivables than Amazona. eBuy is taking about 3.25 days less than Amazona to collect the accounts receivables. eBuy and Amazona are about the same with respect to the collection of accounts receivables.
Answer: eBuy is taking about 20 days longer to collect receivables than Amazona. Accounts receivable turnover for eBuy is about 6.24x (= sales/AR = 2877/461), which means eBuy's average collection period is 58.49 days (=365/AR turnover = 365/6.24). Amazona takes about 38.42 (= 365/9.5) days to collect its accounts receivable. Hence, eBuy takes about 20 days more to collect its receivables.
If the industry gross margin, operating margin and net margin are 64.3%, 23.1% and 9.1%. Which of the following statements is the most plausible reason for eBuy to have a smaller net margin than the industry? (Assume that the tax rate is the same across the industry)
Answer: eBuy may have greater interest expense relative to sales than the industry. The difference between Operating Margin and Net Margin will tell us the potion of sales consumed by interest expense and tax expenses. For eBuy this difference is bigger than for the industry generally. Hence, eBuy must have higher interest expense or tax expenses. Since the problem states that the tax rate is the same across the industry, the difference most likely stems from larger (relative to sales) interest expense at eBuy. Gross margin is higher at eBuy (64.82%) indicating lower COGS (cost of goods sold). The difference between gross and net margin for eBuy and the industry is almost identical indicating the eBuy has operating expenses very similar to the industry. The ratios do not give us any insight into eBuy's sales volume.
eBuy's competitor, Amazona, has a gross margin of 67.21% and operating margin of 24.75%. Which of the following is most likely correct? eBuy's has lower cost of goods relative to sales than Amazona. eBuy's has lower operating expenses (including depreciation) relative to sales than Amazona. eBuy has higher operating expenses (including depreciation) relative to sales than Amazona. eBuy's is more profitability than Amazona.
Answer: eBuy's has lower operating expenses (including depreciation) relative to sales than Amazona. If you take Gross Margin - Operating Margin, you get Operating Expense/Sales. For example, for Amazona 67.21-24.75 = 42.46%. This means that operating expenses at Amazona consume 42.46% of sales. For eBuy, this is only 41.18%. Hence, relative to sales, eBuy has lower operating expenses. eBuy's gross margin is lower than Amazona indicating that ebuy has higher cost of goods. Since, eBuy has lower gross and operating margin the data do not support the conclusion that eBuy is more profitable than Amazona.
For eBuy's industry, the 20x1 industry average current ratio and quick ratio were 1.55 and 1.38, respectively. Which one of the following is the most plausible statement when comparing eBuy's current and quick ratios in 20x1 to the industry average? A)eBuy has a higher liquidity than the industry norm. B)eBuy has a lower liquidity than the industry average. C)eBuy's accounts receivable may be more liquid that the industry average. d)eBuy's inventory may be less liquid than the industry average.
Answer: eBuy's inventory may be less liquid than the industry average. A and B are not correct for at least two reasons: 1) you cannot assess the firm's liquidity with only two ratios, and 2) eBuy has a higher current ratio but a lower quick ratio when compared to the industry. C is not correct since the relationship between the current and quick ratio doesn't address the liquidity of accounts receivable. D is the most reasonable statement since a higher current ratio and lower quick ratio (as compared to the industry) indicates that eBuy has lots of inventory. The inventory build-up may be due to illiquid/non-salable inventory holdings.
compare and contrast FCFE and FCFF
As such, it does not equal FCFF unless a company has no debt in its capital structure
leverage multiplier
Assets/Equity
compare and contrast ROA and ROE
Because the numerators of the two ratios are equal when we look at the differences between ROA and ROE for a firm, we essentially look at the effectiveness of the firm's financing policy. when we look at the differences between ROA and ROE for a firm, we essentially look at the effectiveness of the firm's financing policy Unlike ROA, ROE is hard to compare from firm to firm because each firm has a slightly different financing policy (they use different amounts and types of debt and equity to finance their company Nonetheless, ROE is used as a primary measure of the effectiveness of management. allows us to remove the impact of debt from the leverage factor (although some of the effects of debt are still felt through interest expense which is deducted to get Net IncomeReturn on Invested Capital (ROIC).
Free Cash Flow to the Firm
Cash left over after operations and taxes available to creditors and shareholders. FCFF = Free cash flow to the firm Cash Tax Payments = Total tax payments from the income statement Depreciation = Depreciation from the income statement (or two balance sheets) EBIT = Earnings before interest and taxes (from the income statement) CAPEX = Capital expenditure (gross property, plant, and equipment) changes from two balance sheets NWC = Net working capital (current assets - current liabilities) changes from two balance sheets
AR turnover
Credit Sales / AR an AR turnover ratio of 12 means that the company collects its entire accounts receivable 12 times per year, or about once per month. Alternatively, this indicates an average collection period of 30 days—it takes the company 30 days (or one month) to collect its receivable
The goal of calculating Free Cash Flow to the Firm (FCFF) is to measure . A. Only the cash flows that show up in the Cash Flows from Operations section of the Cash Flow Statement. B. What the cash balance was at the beginning of the year. C. What the cash balance will be at the end of the year. D. Cash available to creditors and shareholders after paying for taxes and continuing operations.
D. Cash available to creditors and shareholders after paying for taxes and continuing operations.
examples of financing ratios
Debt Ratio = Total Debt / Total Assets Times Interest Earned = EBIT / Interest Expense
times interest earned ratio (TIE)
EBIT/Interest Charges Specifically, it tells us how many times a company covers (or could pay) its interest expense given its earnings. For instance, if a company has an operating profit of $1,000 and an annual interest expense of $100, its times interest earned ratio of 10 would mean that it could pay its interest expense 10 times over with its EBIT
FCFE (Free Cash Flow to Equity)
FCFE = Net Income + Depreciation - CAPEX - Increase in NWC + Increase in Net Long-Term Debt measure the cash flows that are left over for equity holders after all company operations and after paying the creditors
what happens to the firm when debts are paid off? when new debts are taken out?
If the firm issues more debt than it pays off, it will have that much additional cash. On the other hand, if the firm pays down more debt than it issues new debt, it is using cash and decreasing free cash flows.
DuPont Equation (ROE)
NI/Equity =Net Profit Margin * Total Asset Turnover * Leverage Multiplier
return on equity ratio
Net Income/Stockholders Equity
Which one of the following is NOT true with respect to the usefulness of ratios?
Ratios are useful in the comparison of firms with different size and/or strategy. Ratio analysis help identify key areas for further investigation. ****Ratios provide definitive answers to company performance questions. Ratio creation/analysis is NOT governed by GAAP.
fixed asset turnover
Sales/Fixed Assets (remember that fixed assets= total assets-current assets) good because it takes management out of the picture because they have a greater voice in decided current assets but fixed assets are set by the industry
total asset turnover ratio
Sales/Total Assets A total asset turnover ratio of three means that for every dollar of assets within the firm, it produces three dollars of sales
Return on Invested Capital (ROIC).
The ratio of after-tax operating income to total invested capital; it measures the total return that the company has provided for its investors. completely remove the effects of leverage in profitability ratios ROIC = NOPAT / (Costly Capital) NOPAT is equal to net operating profit after taxes and is defined as EBIT (1 - t) Costly Capital equals all interest bearing debt plus total equity.
Gross Margin, Operating Margin, Net Margin
To calculate gross, operating, and net margin, we simply take each of these three primary profitability measures and divide it by sales all found on the income statement Note that they should decrease in value; that is, gross margin should be greater than operating margin, which should in turn be greater than net margin Each of these ratios describes how much of that type of profit is made per dollar of sales. For example, a net margin of 5% means that for every dollar of sales, 5 cents drops to the bottom line as net income.
examples of efficiency ratios
Total Asset turnover = sales / total assets Fixed Asset turnover = sales / fixed assets OIROI = operating income / total assets (also used as a profitability ratio)
debt ratio
Total Debt / Total Assets For example, a debt ratio of .4 literally means that for every dollar of assets the firm owns, 40 cents is financed with debt (and thus 60 cents is financed with equity) how much debt the company is using to run and stay alive tells % of assets paid for by debt lower=better
If our goal is to obtain an ROE of 20%, how can we do so?
We can decrease costs, while holding sales constant (thus increasing NI). We can increase sales, while holding assets constant (thus increasing asset turnover). We can increase debt, while holding equity constant (we lever up).
principle-agent problem
When management chooses to enrich itself at the expense of the shareholders
PoliBoard has recently been added as a Fortune 500 company. As an analyst, you have calculated a variety of ratios for Poliboard and are looking to interpret the financial health of the firm. Which of the following benchmarks are most appropriate when interpreting PoliBoard's financial ratios? Historical ratios for PoliBoard over the last 5 years Current quarterly ratios for PoliBoard's competitors Both historical and current ratios for PoliBoard's competitors All of the above None of the above
all of the above
daily credit sales
annual credit sales/365
accounts receivable and credit sales
are rarely seen together because they essentially give the same information Both ratios compare accounts receivable to credit sales
who cares the most about liquidity ratios?
banks and lendors because they want to make sure that we have enough cash to pay them every month
Higher current ratios are usually interpreted to mean
better likelihood that the firm will be able to meet its short-term obligations
cross sectional anaylsis
compares a firm's financial ratios with those of some peer group ex walmart in 2016 to kmart in 2016
ratios are only useful if
contrasted against other ratios
current ratio
current assets/current liabilities It directly compares current assets to current liabilities and shows whether the company can meet its short-term obligations using its cash or near-cash assets today how well the company can change its stuff into cash the higher the current ratio the less risk
examples of liquidity ratios
current, quick, average collection period, AR turnover, inventory turnover
Financing ratios
describe in what proportions the firm uses equity and/or debt to finance those assets.
Accounting profit accurately measures economic profit.
false
ration analysis evaluates if the firm is making money
false; evaluates if the firm is making as much money as it could
ratios tell you what is happening in the company
false; ratios tell you what questions to ask to find out what is happening in the company A changing ratio indicates that something is changing in the company, but it does not necessarily tell you why, what, or how things are changing
high growth firms
firms growing at a fast rate a discrepancy is created between income statements and balance sheets because a balance sheet for dec would make the company look large but if the income for the whole year is taken into account, the company would look average so we can use the average equity in equation below to balance it out ROE=NI20X8/(E20X7+E20X8)÷2
accounting data
for example a firm using the FIFO method and another using the LIFO method would have different they would have different inventory ratios on the balance sheet
seasonal firms
have high sales during one part of the year and low sales in another part of the year if a swimsuit company closes its books in December, it would have lots of inventory and liabilities and would look like a large company but if it closes its books en July it would have little inventory and liabilities
Holding all else equal, an increase in net margin will: Decrease the leverage multiplier Increase the debt ratio Increase ROE Decrease ROE None of the above
increase ROE
profitability ratios
judge how well management is doing as they strive to maximize owner wealth.
rations answer questions about
liquidity asset use efficiency financing profitability
trend analysis
looks at firms financial ratios over time ex. walmart i 2016 and 2018
Efficiency Ratios
measure how well the company uses its assets to generate sales or profit.
what is the advantage of ROIC?
measures the return regardless of whether the company's financing comes from debt or equity.
return on assets (ROA)
net income/average total assets OR NI/S × S/A ROA is comparable across industries and thus is a good profitability ratio to use when benchmarking a firm against a multi-industry group.
net profit margin
net income/sales how good the firm is at making money
operating income return on investment ((OIROI) or profitability ratio
operating income(EBIT) / total assets tells us how much pre-tax, pre-financing profit the company generates per dollar of assets. It is similar to the return on an investment portfolio. If you made $100 on your investment portfolio of $1,000, you would have made a 10% return
OIROI is a good measurement of not only efficiency, but also the ___________ of a firm.
profitability
As the current ratio approaches (or, in an extreme case, falls below) a value of 1
questions about liquidity are likely to dominate analysis of the firm
measure progress anaalysis
ratios used to measure progress and goals
The liquidity of a firm
refers to its ability to meet its short-term obligations how easily a company can pay off its debts
examples of profitability ratios
return on assets: annual net income/ assets return on equity: annual net income/ equity gross margin: gross profit/ sales operating profit: operating profit/sales net margin; net profit/ sales
two types of firms where data timing could be problematic
seasonal firms and high-growth firms.
why are rations important for comparing company data?
standardization and evaluation of goals First, they standardize financial data, thus making it comparable across firms (ex. debt relative to assets) flexibility. It is not determined by any set of rules leads us to look in the right places so we can correctly understand the current performance and position of the company evaluating whether the firm is achieving its stated goal to maximize shareholder wealth
how does a quick ratio differ from a normal current ratio
subtracts inventory from current assets because it is the least liquid
inventory turnover
the number of times it turns (or sells) its inventory annually calculated as cost of goods sold divided by inventory
leverage
the use of borrowed money to supplement existing funds for purposes of investment
what are the three comparison methods used in ratio analysis
trend analysis, cross sectional analysis, measure progress analysis
Economic Value Added (EVA)/ economic profits
unlike accountings profits (which use earnings) EVA economic profits include both direct costs and opportunity costs. EVA = NOPAT - [WACC × (Costly Capital)] NOPAT = net operating profit after taxes, and equals EBIT minus taxes WACC (the average cost of financing a firm in percentage terms)= is the weighted average cost of capital—a measure that includes the cost of debt and the cost of equity NOPAT captures the income to the firm (not including the interest expense). The product of WACC and Costly Capital gives us the dollar cost of earning that income, including interest and equity costs. The difference between the two dollar amounts is the economic profit.
common mistake in calculating inventory turnover
use sales instead of cost of goods sold in the numerator. Inventory is stated on the balance sheet at its cost, not at its sale price. Since inventory is in the denominator of this ratio, the numerator should also be in terms of cost in order to correctly calculate how many times inventory turns. Sales equals cost plus markup, and thus is not stated in the same terms as the inventory denominator
when might having a high asset turnover ratio be bad
when a firm refuses to invest in new technology which results in high operating costs yet they are still making money
