FINANCE 381 - chapter 3

a standardized financial statement presenting all items in percentage terms. Balance sheet items are shown as a percentage of assets and income statement items as a percentage of sales.

common-size statement

relationships determined from a firm's financial information and used for comparison purposes.

financial ratios

current ratio =

current ratio = current assets / current liabilities

financial ratios are traditionally grouped into the following categories:

1. short-term solvency, or liquidity, ratios
2. long-term solvency, or financial leverage, ratios
3. asset management, or turnover, ratios
4. profitability ratios
5. market value ratios

quick ratio =

quick ratio = current assets - inventory / current liabilities

cash ratio =

cash ratio = cash / current liabilities

total debt ratio =

total debt ratio = total assets - total equity / total assets

debt-equity ratio =

debt-equity ratio = total debt / total equity

equity multiplier =

equity multiplier = total assets / total equity

times interest earned ratio =

times interest earned ratio = EBIT / interest

cash coverage ratio =

cash coverage ratio = EBIT + depreciation / interest

inventory turnover =

inventory turnover = cost of goods sold / inventory

receivables turnover =

receivables turnover = sales / accounts receivable

days' sales in inventory =

days' sales in inventory = 365 days / inventory turnover

days' sales in receivables =

days' sales in receivables = 365 days / receivables turnovers

total asset turnover =

total asset turnover = sales / total assets

profit margin =

profit margin = net income / sales

return on assets =

return on assets = net income / total assets

return on equity =

return on equity = net income / total equity

EPS =

EPS = net income / shares outstanding

PE ratio =

Price-Earnings (PE) ratio = market price per share of common stock / earnings per share

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price-sales ratio =

price-sales ratio = price per share / sales per share

market-to-book ratio =

market-to-book ratio = market value per share / book value per share

enterprise value =

enterprise value = total market value of the stock + book value of all liabilities - cash

EBITDA ratio =

EBITDA ratio = enterprise value / EBITDA

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High PE ratios tells us that:

firms have significant growth opportunity

the higher the PE ratio,

the greater the investor confiendence.

dividend payout ratio =

dividend payout ratio = cash dividends / net income

retention ratio =

retention ratio = additions to retained earnings / net income = 1 - payout ratio

The internal growth rate tells us:

how much the firm can grow assets using retained earnings as the only source of financing.

operating efficiency

profit margin

asset use efficiency

total asset turnover

choice of optimal debt ratio

financial leverage

choice of how much to pay shareholders versus reinvesting in the firm

dividend policy

why evaluate financial statements?

1. internal users: evaluating performance, spotting trouble, generating projections
2. external users: making credit decisions, evaluating competitors, assessing acquisitions

the higher the inventory turnover ratio,

the more efficiently we are managing inventory

how quickly the entire inventory was sold off or turned over

inventory turnover

net profit margin =

net profit margin = net income / sales

the higher the net profit margin,

the better

the higher the total asset turnover,

the better

indicates the efficiency with which the firm uses its assets to generate sales

total asset turnover

PE means

price-earnings

Determinants of growth:

1. PROFIT MARGIN. (operating efficiency) An increase in profit margin will increase the firms ability to generate funds internally and thereby increase its sustainable growth.
2. TOTAL ASSET TURNOVER. (asset use efficiency) An increase in the firm's total

Choosing a benchmark:

1. TIME-TREND ANALYSIS - use history, ratios are analyzed in time series graphs to see what trends are developing.
2. PEER-GROUP ANALYSIS - use similar firms and/or industry averages, ratios are analyzed by reference to industry standards.

What effect would the following action have on a firm's ratio? Assume that net working capital is positive.
Inventory is purchased.

If inventory is purchased with cash, then there is no change in the current ratio. If inventory is purchased on credit, then there is a decrease in the current ratio if it was initially greater than 1.0.

What effect would the following action have on a firm's ratio? Assume that net working capital is positive.
A supplier is paid.

Reducing accounts payable with cash increases the current ratio if it was initially greater than 1.0.

What effect would the following action have on a firm's ratio? Assume that net working capital is positive.
A short-term bank load is repaid.

Reducing short-term debt with cash increases the current ratio if it was initially greater than 1.0

What effect would the following action have on a firm's ratio? Assume that net working capital is positive.
Inventory is sold at cost.

Inventory sold at cost reduces inventory and raises cash, so the current ratio is unchanged.

What effect would the following action have on a firm's ratio? Assume that net working capital is positive.
Inventory is sold for a profit.

Inventory sold for a profit raises cash in excess of the inventory recorded at cost, so the current ratio increases.

In recent years, Dixie Co, has greatly increased its current ratio. At the same time, the quick ratio has fallen. What has happened? Has the liquidity of the company improved?

The firm has increased inventory relative to other current assets; therefore, assuming current liability levels remain mostly unchanged, liquidity has potentially decreased.

Explain what it means for a firm to have a current ratio equal to .50. Would the firm be better off if the current ratio were 1.50? What if it were 15.0? Explain your answers.

A current ratio of .50 means that the firm has twice as much in current liabilities as it does in current assets; the firm potentially has poor liquidity. If pressed by its short-term creditors and suppliers for immediate payment, the firm might have a di

Fully explain the kind of information the following financial ratio provide about a firm:
quick ratio

Quick ratio provides a measure of the short-term liquidity of the firm, after removing the effects of inventory, generally the least liquid of the firm's current assets.

Fully explain the kind of information the following financial ratio provide about a firm:
cash ratio

Cash ratio represents the ability of the firm to completely pay off its current liabilities balance with its most liquid asset (cash).

Fully explain the kind of information the following financial ratio provide about a firm:
total asset turnover

Total asset turnover measures how much in sales is generated by each dollar of firm assets.

Fully explain the kind of information the following financial ratio provide about a firm:
equity multiplier

Equity multiplier represents the degree of leverage for an equity investor of the firm; it measures the dollar worth of firm assets each equity dollar has a claim to.

What types of information do common-size financial statements reveal about the firm? what is the best use for these common-size statements?

Common size financial statements express all balance sheet accounts as a percentage of total assets and all income statement accounts as a percentage of total sales. Using these percentage values rather than nominal dollar values facilitates comparisons b

Explain what peer group analysis means. As a financial manager, how could you use the results of peer group analysis to evaluate the performance of your firm? How is a per group different from an aspirant group?

Peer group analysis involves comparing the financial ratios and operating performance of a particular firm to a set of peer group firms in the same industry or line of business. Comparing a firm to its peers allows the financial manager to evaluate whethe

Why is the DuPoint identity a valuable tool for analyzing the performance of a firm? Discuss the types of information it reveals as compared to ROE considered by itself.

Return on equity is probably the most important accounting ratio that measures the bottom-line performance of the firm with respect to the equity shareholders. The Du Pont identity emphasizes the role of a firm's profitability, asset utilization efficienc

So-called same-store sales are very important measure for companies as diverse as McDonald's and Sears. As the name suggests, examining same-store sales means comparing revenues from the same stores or restaurants at two different points in time. Why migh

If a company is growing by opening new stores, then presumably total revenues would be rising. Comparing total sales at two different points in time might be misleading. Same-store sales control for this by only looking at revenues of stores open within a

You are examining the common-size income statements for a company for the past five years and have noticed that the cost of goods as a percentage of sales has been increasing steadily. At the same time, EBIT as a percentage of sales has been decreasing. W

A) As with any ratio analysis, the ratios themselves do not necessarily indicate a problem, but simply indicate that something is different and it is up to us to determine if a problem exists. If the cost of goods sold as a percentage of sales is increasi

SDJ Inc., has net working capital of $1,730, current liabilities of $5,140, and inventory of $2,170. What is the current ratio? What is the quick ratio?

To find the current assets, we must use the net working capital equation. Doing so, we find:
NWC = Current assets - Current liabilities
$1,730 = Current assets - $5,140
Current assets = $6,870
Now, use this number to calculate the current ratio and the qu

Remi, Inc., has sales of $15 million, total assets of $9 million, and total debt of $3.7 million. If the profit margin is 7 percent, what is net income? What is ROA? What is ROE?

To find the return on assets and return on equity, we need net income. We can calculate the net income using the profit margin. Doing so, we find the net income is:
Profit margin = Net income / Sales
.07 = Net income / $15,000,000
Net income = $1,050,000

Allen, Inc., has a total debt ratio of .34. What is its debt-equity ratio? What is its equity multiplier?

To find the debt-equity ratio using the total debt ratio, we need to rearrange the total debt ratio equation. We must realize that the total assets are equal to total debt plus total equity. Doing so, we find:
Total debt ratio = Total debt / Total assets