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Finance Chapter 3
Terms in this set (49)
Common Size Statement
A standardized financial statement presenting all items in percentage terms. Balance sheet items are shown as a percentage of total assets (bottom #) and income statements as a percentage of sales (top #). Able to directly compare the financial statements for two companies with different sizes
Common-Base Year Statement
A standardized financial statement present all items relative to a certain base year amount.
Combining Common Size and Base Year Analysis
The reason for doing this is that as total assets grow, most of the other accounts must grow as well. By first forming a common-size statements, we eliminate the effect of this overall growth.
Relationship determined from a firm's financial information and used for comparison purposes. In doing so, it avoids the problem involved in comparing companies of different sizes because the size effectively is divided out. In one form or another, they are intended to measure how efficiently a firm uses its assets and manage its operations. Definitions vary form place to place.
Short Term Solvency Ratios
Intended to provide information about a firm's liquidity, and these ratio are sometimes called liquidity measures. These ratios focus on current assets and current liabilities. Measures the ability to make payments on short term debt.
Division by 1
For every dollar, I have x number of assets.
Current Assets / Current Liabilities
A measure of short term liquidity. the Higher the current ratio, the better. A high current ratio indicates liquidity, but it also may indicate an inefficient use of cash and other short-term assets. Low current ratio may not be a bad sign for a company with a large reserve of untapped borrowing power
Quick (Acid-Test) Ratio
(Current Assets - Inventory) / Current Liabilities
Evaluates Liquidity, with the exception of inventory because inventory is often the least liquid current asset. Relatively large inventory are often a sign of short-term trouble. The idea is that inventory is relatively illiquid compared to cash.
Cash / Current Liabilities
A measure of liquidity. Short-term creditors might be interested in this ratio.
NWC to Total Assets
New Working Capital / Total Assets
= Current Asset - Current Liabilities / Total Assets
A measure of liquidity where a relatively low value might indicate a relatively low levels of liquidity
Current Assets / Average Daily Operating Cost
Useful for newly founded or start-up companies that often have little in the way of revenues. This indicates how long the company can operate until it needs another round of financing.
Another name for the average daily operating cost, meaning the rate at which cash is burned in the race to become profitable
Long Term Solvency Ratios
Intended to address the firm's long-term ability to meet its obligations, or more generally, its financial leverage. Sometimes called financial leverage ratio or just leverage ratio. Measures the ability to make payment on long-term debt.
Disadvantage of Debt
Debt is a problem because a company might not make enough to payback causing bankruptcy
Advantages of Debt
The benefit of debt is that it is not using company/owner's money so shareholder benefit. It is also a tax deduction
Debt Equity Ratio
Total Debt / Total Equity
= Total Liabilities / Total Equity
Total Debt Ratio
(Total Assets - Total Equity) / Total Assets
Takes into account all debt of all maturities to all creditors. Whether this is high or low or whether it even makes any difference depends on whether capital structure matters.
Total Assets / Total Equity
= (Total Equity + Total Debt) / Total Equity
= 1 + Debt Equity Ratio
Long-Term Debt Ratio
Long-Term Debt / (Long-Term Debt + Total Equity)
= Long-Term Liabilities / (Long-Term Liabilities + Total Equity)
Financial analysts are more concerned with a firm's long-term debt than its short term debt because short-term debt will constantly be changing
Long-Term Debt + Total Equity
Times Interest Earned (TIE) Ratio
EBIT / Interest
Measure of long-term solvency. This ratio measures how well a company has its interest obligations covered, and it is often called the interest coverage ratio
Cash Coverage Ratio
(EBIT + Depreciation) / Interest
A measure of cash available to pay interest
Earnings before interest, tax, and depreciation. It is a basic measure of the firm's ability to generate cash from operation, and it is frequently used as a measure of cash flow available to meet financial obligations
Asset Management (Turnover) Ratios
Measures of turnover. Measures how efficiently we are using our assets
Cost of Goods Sold / Inventory
Measures how fast a firm can sell product. As long as we are not running out of stock and thereby forgoing sales, the higher this ratio is, the more efficiently we are managing inventory.
Days' Sales in Inventory
365 days / Inventory Turnover
Measures the average of how long it took for inventory to turnover. The general rule is the higher the ratio, the lower the turnover
Sales / Accounts Receivable
Measures how fast a firm collects on the sales of those products.
Days' Sale in Receivables
365 days / Receivable Turnover
Average Collection Period (ACP)
Sales / Net Working Capital
This ratio measure how much "work" we get out of our working capital.
Fixed Asset Turnover
Sales / Net Fixed Assets
Total Asset Turnover
Sales / Total Assets
Measures the ability to make a profit
Net Income / Sales
A relatively high margin is obviously desirable.
Return on Assets (ROA)
Net Income / Total Assets
A measure of profit per dollar of assets.
Return on Equity (ROE)
Net Income / Total 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.
Market Value Measures
The market price per share of stock, not necessarily contained in financial statements. This is outside the financial statement because of market value
Earnings per Share (EPS)
Net Income / Share Outstanding
Price-Earning (PE) Ratio
Price per Share / Earnings per Share
Measures how much investors are willing to pay per dollar of current earnings, higher ratios often taken to mean the firm has significant prospects for future growth. Of course, if a firm had no or almost no earnings, its ratio would probably be quite large.
Price per Share / Sales per Share
Useful when companies have negative earnings for extended periods, such as a recent startup. A ratio is high or low depends on industry involvement.
Market Value per Share / Book Value per Share
Compares the market value of the firm's investments to their costs. A value less than 1 could mean that the firm has not been successful overall in creating value for its stockholders. Focuses on historical costs, which are less relevant.
Market Value of Assets / Replacement Cost of Asset
= Market Value of Debt and Equity / Replacement Cost of Asset
Focuses on what the firm is worth today relative to what it would cost to replace it today. Firm with high ratios tend to be those with attractive investment opportunities or significant competitive advantage (or both).
Total Market Value of the Stock + Book Value of all Liabilities - Cash
An estimate of the market value of the company's operating assets. Use the right-hand side of the balance sheet to calculate this value
Enterprise Value / EBITDA
Relates the value of all the operating assets (the enterprise value) to a measure of the operating cash flow generated by those assets (EBITDA).
ROE = Profit Margin X Total Asset Turnover X Equity Multiplier
Popular expression breaking ROE into three parts: operating efficiency, asset use efficiency, and financial leverage. Weakness in either operating or asset use efficiency (or both) will show up in a diminished return on assets, which will translate into a lower ROE. With leverage, ROE is greater than ROA
Decomposition of Equation:
ROE = Net Income / Total Assets
= (Net Income / Assets) * (Assets / Total Equity)
= ROA * Equity Multiplier
= ROA * (1 + Debt-Equity Ratio)
= (Net Income / Sales)
(Sales / Assets)
(Assets / Total Equity)
Ues of Financial Statement
Common Size Analysis
Financial statement information has a variety of uses within a firm:
1. performance evaluation
2. planning for the future.
Financial statements are useful to parties outside the firm, including short-term and long-term creditors and potential investors.
1. Evaluate suppliers, and suppliers would review statements before deciding to extend credit to firm
2. Evaluating main competition
3. Essential in identifying potential targets and deciding what to offer
Limitations of Financial Statement
Effect of Inflation
Different Operating and Accounting Practices
The Big Picture
A standard or point of reference against which things are compared.
1. Time Trend Analysis - looking at the history
2. Peer Group Analysis - identifying firms similar in the sense that they compete in the same markets, have similar assets, and operate in similar ways
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