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Chapter 7: Analysis of Financial Statements

Terms in this set (135)

____________________ are used to dig out that information which may not be extracted from analyzing the financial statement of the firm.
Financial Ratios
The following are 5 categories of _______________:

1. Liquidity
2. Asset Management
3. Debt Management
4. Profitability
5. Market Value
Financial Ratios
The following ratios fall under which financial ratio category:

1. Current Ratio
2. Quick (Acid Test) Ratio
Liquidity
The following ratios fall under which financial ratio category:

1. Inventory Turnover Ratio
2. Days Sales Outstanding
3. Fixed Asset Turnover
4. Total Asset Turnover
Asset Management
The following ratios fall under which financial ratio category:

1. Total Liabilities to Total Assets
2. Times Interest Earned Ratio
3. EBITDA Coverage Ratio
Debt Management
The following ratios fall under which financial ratio category:

1. Net Profit Margin
2. Basic Earning Power Ratio
3. Gross Profit Margin
4. Operating Profit Margin
5. Return On Common Equity
6. Return on Total Assets
Profitability
The following ratios fall under which financial ratio category:

1. Price/Earnings Ratio
2. Price/Cash Flow Ratio
3. Market/Book Value Ratio
Market Value
A(n)________________ will care more about a company's profitability and liquidity ratios.
Bank Loan Officer
A(n)__________________ will care more about a company's debt and asset management ratios.
Bond Analyst
A(n)_______________ will care more about a company's market value ratios.
Stock Analyst
___________________ is the ratio used to calculate the number of day's credit sales are converted into cash. It is calculated by dividing average receivables by Average Daily Sales.
Days Sales Outstanding (DSO)
Suppose a company has a Days Sales Outstanding DSO that is considerably higher than its industry average. If the company could reduce its accounts receivable to the point where its DSO was equal to the industry average without affecting its sales or its operating costs, then the company's __________________ will increase. This is because its cash sale will increase and now the company will have more cash available.
Free Cash Flows
Suppose a company has a Days Sales Outstanding DSO that is considerably higher than its industry average. If the company could reduce its accounts receivable to the point where its DSO was equal to the industry average without affecting its sales or its operating costs, then the company's __________________ will remain unaffected. This is because there will not be any effect on net income and common equity due to a decrease in accounts receivable.
Return on Common Equity
Suppose a company has a Days Sales Outstanding DSO that is considerably higher than its industry average. If the company could reduce its accounts receivable to the point where its DSO was equal to the industry average without affecting its sales or its operating costs, then the company's __________________ will be unaffected. This is because the accounts receivable will decrease and the cash sale will in crease. Thus current assets and total assets will remain the same.
Debt Ratio
Suppose a company has a Days Sales Outstanding DSO that is considerably higher than its industry average. If the company could reduce its accounts receivable to the point where its DSO was equal to the industry average without affecting its sales or its operating costs, then the company's __________________ will remain the same. This is because sales and operating costs will both be unaffected. Thus the earnings before interest and taxes will remain the same.
Times Interest Earned Ratio
Suppose a company has a Days Sales Outstanding DSO that is considerably higher than its industry average. If the company could reduce its accounts receivable to the point where its DSO was equal to the industry average without affecting its sales or its operating costs, then the company's __________________ will increase. This is because a decrease in accounts receivables and an increase in cash sales can increase the market price of the company. (The Answer Is not Market/Book Ratio)
Price/Earnings Ratio
Suppose a company has a Days Sales Outstanding DSO that is considerably higher than its industry average. If the company could reduce its accounts receivable to the point where its DSO was equal to the industry average without affecting its sales or its operating costs, then the company's __________________ will remain the same. This is because sales and operating costs are unaffected causing the earnings before interest and taxes to same the same. (answer is not Times Interest Earned Ratio)
Loan/EBITDA Ratio
Suppose a company has a Days Sales Outstanding DSO that is considerably higher than its industry average. If the company could reduce its accounts receivable to the point where its DSO was equal to the industry average without affecting its sales or its operating costs, then the company's __________________ will increase because a decrease in accounts receivables and an increase in cash sales can increase the market price of the company. (The Answer Is not Loan/EBITDA Ratio).
Market/Book Ratio
When financial ratios over a period of time are plotted on a graph, it shows the ___________.
Trend Analysis
Managers, bankers, and security analysts can use a(n)_________________ by observing the trend of relevant ratios.
Trend Analysis
When a company's financial ratios are compared to a smaller set of ideal companies' financial ratios, it is called _______________.
Benchmarking
Managers, bankers, and security analysts can use _________________ to compare the company with similar companies in the industry and observe whether the company is performing up to the the mark.
Benchmarking
In a(n)_________________, one base year is set up as the standard.
Percent Change Analysis
Managers and bankers can see the growth rate in a company as compared with the base year by doing a(n)________________ .
Percent Change Analysis
In a(n)______________, all items from the income statement are divided by the sales. All items from the balance sheet are divided by the total assets.
Common Size Analysis
A(n)_________________ income statement shows all the items as a percentage of sales and the balance sheets shows all items as a percentage of total assets.
Common Size Analysis
Ratio Analysis can be used by managers to maximize their stock prices. They can also utilize ______________________ to increase the value of their shares and to make their financial statements look stronger.
Window Dressing Techniques
The following example describes ____________________:

Firm A has taken a 2 year, $2 million loan at the end of the year. Since the term of the loan is greater than 1 year (it's considered long term), it will not be included in current liabilities. However, the cash received from the loan will be treated as current assets. This will improve the company's current ratio, and it can help the company to improve its share price.
Window Dressing Techniques
The __________________ considers profitability, assets efficiency and debt ratios together.
DuPont Model/System
ROA and ROE are both profitability ratios within the DuPont Model. Stocks increase based on Profitability Ratios. Thus a manager of a company can increase its share price by increasing the ROA and ROE (together the Dupont Model).
T
If a firm uses more debt to repurchase stock, then the debt will increase on the balance sheet. This will increase the ______________.
Debt Ratio
Cash received from issuing debt that is then used to repurchase stock will not increase the cash on the balance sheet.
T
Using debt to finance the repurchase of stock will increase the firm's debt ratio.
T
Using debt to finance the repurchase of stock will decrease the firm's debt ratio.
F
Using debt to finance the repurchase of stock will increase the firm's liquidity ratio.
F
If a company leases assets more than the industry average, then its earnings before interest, taxes, depreciation, and amortization (EBITDA) Ratio will decrease.
T
If a company leases assets more than the industry average, then its earnings before interest, taxes, depreciation, and amortization (EBITDA) Ratio will increase.
F
If a company's EBITDA ratio is less than the industry average, then the company may have a relatively high level of debt.
T
If a company eases its credit policy and increases credit terms to 60 days, then its ___________________ ratio will increase.
Days Sales Outstanding (DSO)
Financial ratio analysis is conducted by ____________ to analyze, control, and to improve the firm's performance.
Managers
Financial Ratio Analysis is conducted by ___________________ in order to know about the company's efficiency, risk, and growth prospects.
Equity Investors
Financial Ratio Analysis is conducted by _________________________in order to ascertain a company's ability pay its debt.
Long/Short Term Creditors
All else equal, an increase in a company's current ratio and a decrease in its total asset turnover ratio could be the result of an increase in ___________________.
Inventory
A(n)______________________ indicates the amount of assets required to generate $1 of sales.
Total Asset Turnover Ratio
The difference between the _______________ of one industry and another is mainly due to the incurrence of expenditures in generating a dollar of sales. Expenses are higher in one industry than they are in another.
Profit Margin
7-1
400,000
7-2
15%
7-3
10
7-4
...
7-5
12%
7-6
2.4, 1.67
7-7
2, 1
7-8
3.3%
7-9
...
7-11
...
7-12
...
Which type of ratios show the relationship of a firm's current assets to its current liabilities and thus its ability to meet maturing debt?
Liquidity
Which ratios reveal: 1. the extent to which the firm is financed with debt, and 2. its likelihood of defaulting on its debt obligations.
Debt management
Which ratios show the combined effects of liquidity, asset management, and debt management policies on operating results?
Profitability
Which ratios relate a firm's stock price to its earnings, cash flow, and book value per share, thus giving management and indication of what investors think of the company's past performance and future prospects?
Market Value
Downward trends or negative ___________________ from operations almost always indicate problems.
Net Cash Flow
If the _____________________ is greater than the company's weighted average cost of capital (WACC), then the company is usually adding value.
Return on Invested Capital (ROIC)
If the _____________________ is less than the company's weighted average cost of capital (WACC), then the company is usually has serious problems
Return on Invested Capital (ROIC)
________________s normally include cash, marketable securities, accounts receivable, and inventories.
Current Asset
__________________s consist of accounts payable, short term notes payable, current maturities of long term debt, accrued taxes, and other accrued expenses.
Current Liability
Creditors like to see a high current ratio.
T
Because the ____________________ provides the best single indicator of the extent to which the claims of short term creditors are covered by assets that are expected to be converted to cash fairly quickly, it is the most commonly used measure of short term solvency.
Current Ratio
Current Assets/Current Liabilities = ?
Current Ratio
(Current Assets - Inventories) / Current Liabilities = ?
Quick Ratio
Which current asset is typically the least liquid?
Inventory
A company has current liabilities of $800 million, and its current ratio is 2.5. Its level of current assets = $_________________.
2,000,000,000
A company has current liabilities of $800 million, and its current ratio is 2.5. If the firm's quick ratio is 2, then it has $_______________ in inventory.
400,000,000
If a company has excessive investments in assets, then its operating capital is unduly high, which reduces its ___________ and ultimately its stock price.
Free Cash Flow
A low _________________ means a company isn't using its assets efficiently.
Total Asset Turnover Ratio
Sales / Total Assets = ?
Total Asset Turnover Ratio
If your __________________ is low, then you can use the following ratio to figure out why:

1. Fixed Asset Turnover Ratio
2. The Days Sales Outstanding (DSO)
3. Inventory Turnover Ratio
4.
Total Assets Turnover Ratio
Which asset management ratio measures how effectively the firm uses its plant and equipment?
Fixed Assets Turnover Ratio
Sales / Fixed Assets = ?
Fixed Assets Turnover Ratio
If a company's _____________ is low, then that indicates that the firm is not using its fixed assets a intensively as other firms in its industry.
Fixed Assets Turnover
A low ______________ indicates that a company isn't generating as much business, relative to its peers, given its total asset investment.
Total Asset Investment
The _______________ represents the average length of time that the firm must wait after making a sale before receiving cash, which is the average collection period.
Days Sales Outstanding (DSO)
Receivables / (Annual Sales/365) = ?
Days Sales Outstanding (DSO)
As with inventory, high levels of accounts receivables cause high levels of NOWC, which hurts Free Cash Flows and STOCK PRICE.
T
As with inventory, low levels of accounts receivables cause high levels of NOWC, which hurts Free Cash Flows and STOCK PRICE.
F
It is better to compare inventory with costs rather than sales.
T
It is better to compare inventory with sales rather than costs.
F
Cost of goods sold except depretiation + Depreciation = ?
Cost of Goods Sold (COGS)
A company's cost of good sold except depreciation is 4,000. Its depreciation is 400. Its average inventories is 1,000. Its inventory turnover ratio is ______________.
4.4
Using Figure 7-1 on page 255, calculate
...
A firm has $200 million annual sales, $180 million cost of goods sold, $40 million of inventory, and $60 million of accounts receivable. Its inventory turnover ratio is _____________.
4.5
A firm has $200 million annual sales, $180 million cost of goods sold, $40 million of inventory, and $60 million of accounts receivable. Its DSO based on a 365 day year is ______________ days
109.5
The inventory turnover ratio calculates the amount of time an item is sold to when that item is then restocked or turned over.
T
The extent to which a firm uses debt financing is called _____________.
Financial Leverage
The following are 3 implications of ____________:

1. Stockholders can control a firm with smaller investments of their own equity if they finance part of the firm with debt.

2. If the firm's assets generate a higher pretax return than the interest rate on debt, then the shareholders' returns are magnified. Conversely, shareholders' losses are also magnified.
3. IF a company has high leverage, even a small decline in performance might cause the firm's value to fall below the amount it owes to creditors.
Financial Leverage
_____________ is the sum of all short term debt and long term debt, it does not include other liabilities.
Total Debt
Total Debt / Total Assets = ?
Debt to Asset Ratio (Debt Ratio)
Total Debt / Total Common Equity = ?
Debt to Equity Ratio
Total Debt / (Total Debt + Market Value of Equity) = ?
Market Debt Ratio
The _______________ reflects a source of risk that is not captured by the conventional debt ratio.
Market Debt Ratio
The __________________ shows the extent to which a firm's assets are not financed by equity.
Liabilities to Assets Ratio
________________ are a type of Debt management Ratios that show how a firm is financed.
Leverage Ratios
The following are which type of Debt Management ratios:

1. Debt to Asset Ratio
2. Debt to Equity Ratio
3. Market Debt Ratio
4. Liabilities to Assets Ratio
Leverage Ratios
The ___________________ is a Debt Management Ratio that measures the extent to which operating income can decline before the firm is unable to meet its annual interest costs.
Times Interest Earned Ratio (TIE)
Because Interest is paid with pre-tax dollars, the firm's ability to pay current interest is not affected by taxes.
T
Because Interest is paid with after-tax dollars, the firm's ability to pay current interest is affected by taxes.
F
The following are 2 shortcomings of which Debt Management Ratio?

1. Interest is not the only fixed financial charge-- companies must also reduce debt on schedule, and many firms lease assets and thus must make lease payments.

2. EBIT (Earnings Before Interest and Taxes) does not represent all the cash flow available to service debt, especially if a firm has high noncash expenses, like depreciation and/or amortization charges.
Times Interest Earned Ratio (TIE)
EBIT / Interest Expense = ?
Times Interest Earned Ratio
(EBITDA + Lease Payments) / (Interest + Principal Payments + Lease Payments) = ?
EBITDA Coverage Ratio
Which Debt Management Ratio is most useful for relatively short term lenders such as banks, which rarely makes loans (except real estate backed loans) for longer than about 5 years?
EBITDA Coverage Ratio
Over a relatively short period, depreciation generated funds can be used to service debt. Over a longer time, those funds must be reinvested to maintain the plant and equipment or else the company cannot remain in business. Therefore, Banks and other relatively short term lenders focus on the TIE Ratio, whereas long term bondholders focus on the EBITDA Coverage Ratio.
F
Over a relatively short period, depreciation generated funds can be used to service debt. Over a longer time, those funds must be reinvested to maintain the plant and equipment or else the company cannot remain in business. Therefore, Banks and other relatively short term lenders focus on the EBITDA Coverage Ratio, whereas long term bondholders focus on the TIE Ratio.
T
A company has EBITDA of $600 million, interest payments of $60 million, lease payments of $40 million, and required principal payments (due this year) of $30 million. The EBITDA Coverage Ratio of this company is ______________.
4.9
Net Income / Sales = ?
Net Profit Margin
EBIT / Sales = ?
Operating Profit Margin
(Sales - COGS) / Sales = ?
Gross Profit Margin
EBIT / Total Assets = ?
Basic Earning Power (BEP) Ratio
This ratio shows the earning power of the firm's assets Before the influence of taxes and leverage, and it is useful for comparing firms with different tax situations and different degrees of financial leverage.
Basic Earning Power (BEP) Ratio
Basic Earning Power (BEP) Ratio is like a return rate on invested assets.
T
Net Income / Total Assets = ?
Return on (Total) Assets (ROA)
Low basic earning power and high interest costs can result in a low Return on Assets.
T
A low return on assets is a result of a low net income. Therefore to find out why the ROA is low, one must first find out why the Net Income is Low.
T
Net Income / Common Equity = ?
Return on Common Equity (ROE)
________________ is like the Rate of Return all shareholders of a company received for that period.
Return on Common Equity (ROE)
The use of debt lowers ROA because of the increase in interest costs.
T
The use of debt increases ROA because of the increase in interest costs.
F
A company has $200 billion of sales and $10 billion of net income. Its total assets are $100 billion, financed half by debt and half by common equity. The profit margin is ______________%
5
A company has $200 billion of sales and $10 billion of net income. Its total assets are $100 billion, financed half by debt and half by common equity. The ROA is ____________%
10
A company has $200 billion of sales and $10 billion of net income. Its total assets are $100 billion, financed half by debt and half by common equity. The ROE is ____________%.
20
A company has $200 billion of sales and $10 billion of net income. Its total assets are $100 billion, financed half by debt and half by common equity. Would ROA increase if the firm used less leverage?

T. Yes
F. No
T
A company has $200 billion of sales and $10 billion of net income. Its total assets are $100 billion, financed half by debt and half by common equity. Would ROE increase if the firm used less leverage?

T. Yes
F. No
F
(Net Income / Sales) x (Sales / Total Assets) x (Total Assets / Common Equity) = ?
Return on Common Equity (ROE)
(Net Income / Total Assets) x (Total Assets / Common Equity) = ?
Return on Common Equity (ROE)
A company has a profit margin of 6%, a total aset turnover ratio of 2, and an equity multiplier of 1.5. Its ROE is _______________%
18
The following are some examples of the limitations of _____________________:

1. Industry averages are more meaningful for small, narrowly focused firms than for large, multidivisional firms.
2. To set goals for high level performance, it is best to benchmark on the industry LEADERS' ratios rather than the industry AVERAGE ratios.
3. Inflation can distort a ratio analysis for one firm over time or a comparative analysis of firms of different ages.
4. Seasonal factors can distort a ratio analysis.
5. Firms can employ window dressing techniques to make their financials statements look stronger
6. Companies' choices of different accounting practices can distort comparisons.
7.
Financial Ratios
The following are good questions to ask oneself when analyzing a firm's ratios:

1. To what extent are the company's revenues tied to one key customer or to one key product?
2. To what extend does the company rely on a single supplier? (Reliance on single customers, products, or suppliers increases risk.)
3. What percentage of the company's business is generated overseas? (Companies with a large percentage of overseas business are exposed to risk of currency exchange volatility and political instability.)
4. What are the probable actions of current competitors and the likelihood of additional new competitors?
5. Do the company's future prospects depend critically on the success of products currently in the pipeline or on existing products?
6. How do the legal and regulatory environments affect the company?
T
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