Principles Of Finance Chapter 3

Front 1

Common Size Statement

Back 1

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.

Front 2

Financial Ratios

Back 2

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

Front 3

Short Term solvency ratios

Back 3

intended to provide info about a firm's liquidity. Primary concern is the firm's ability to pay its bills over the short run without undue stress.
Current Ratio= current assets/current liabilities
Quick (acid test) ratio= current assets - inventory / current liabilities
cash ratio= cash / current liabilities

Front 4

Current ratio

Back 4

Current assets / current liabilities
To a creditor, the higher the current ratio, the better. To a firm, a high current ratio indicates liquidity, but it also may indicate an inefficient use of cash and other short term assets. We expect a ratio higher than 1.

Front 5

Quick Ratio

Back 5

Current Assets - inventory / current liabilities

Inventory is often the least liquid asset. Relatively large inventories are often a sign of short term trouble. The firm may have overestimated sales and over bought or over produced as a result.

Front 6

Cash ratio

Back 6

Very short term creditors are often concerned with this ratio.

cash / current liabilities

Front 7

Long term solvency measures

Back 7

Address a firm's long run ability to meet obligations, more generally its financial leverage. Ratios include:
total debt ratio= total assets - total equity / total assets.
Debt equity ratio= total debt / total equity
Equity multiplier= total assets / total equity
Times interest earned= EBIT / Interest
Cash coverage ratio = EBIT + depr. / interest

Front 8

Total debt ratio

Back 8

Total assets - total equity / total assets
Takes into account all debts of all maturities to all creditors. the number is expressed as the co uses ____ percent debt.

Front 9

Debt equity ratio

Back 9

Total debt / total equity

Front 10

Equity multiplier

Back 10

Total assets / total equity

Front 11

Times interest Earned

Back 11

EBIT / interest
Measures how well a co. has it's interest obligations covered.

Front 12

Cash Coverage

Back 12

EBIT + depr / Interest

Better indicator of how much cash you have to pay your interest since depreciation is a non cash expense.

Front 13

Inventory turnover

Back 13

COGS / Inventory
As long as we are not running out of stock and thereby forgoing sales, the higher this ratio is, the more effectively we are managing inventory.

Front 14

Days sales in inventory

Back 14

365 days / Inventory Turnover
Inventory turnover= COGS / inventory
Tell us that inventory sits _____ days on average before it is sold.

Front 15

REceivaables turnover

Back 15

Sales / Accounts receivable
We collected on our outstanding credit accounts and reloaned the money _____ times per year.

Front 16

Days sales in receivables

Back 16

365 days / receivables turnovers
This tells us we collect on our credit sales in roughly ____ days.

Front 17

Total asset turnover

Back 17

Sales / total assets
In other words, for every dollar in assets we generated ____ in sales.
It might seem that a high total asset turnover ratio is always a good sign for a co. but it isn't necessarily. Consider a co. with old assets. The assets would be almost fully depreciated and may be out dated. In this case the book value of assets is low, contributing to a higher asset turnover. This may mean the co. will need to do overhaul in the new future and have huge capital spending.

Front 18

Profit margin

Back 18

Net income / sales
This tells us that the co. generates a little less than ____ in profit for every dollar in sales. All other things being equal, a relatively high profit margin is desirable. This situation corresponds to low expense ratios relative to sales. Other things are often not equal however.

Front 19

Return on Assets (ROA)

Back 19

Net Income / Total assets
A measure of profit per dollar of assets.

Front 20

Return on Equity (ROE)

Back 20

Net income / total equity
Measure of how stockholders fared during the year. Since benefitting shareholders is our goal, ROE is, in an accounting sense, the true bottom line of performance. Therefore for every dollar in equity the co. generated _____ in net profit. This is only correct in accounting terms. You cannot compare the results to an interest rate observed in the financial market.

Front 21

EPS

Back 21

Net income / shares outstanding

Front 22

P/E ratio

Back 22

Price per share / Earnings per share
EPS= Net income / shares outstanding
Higher PEs are often taken to mean that the firm has significant propospects of future growth. Of courst, if a firm has no or almost no earnings, its PE would be quite large so we have to use care in interpreting this ratio.

Front 23

Price/ sales ratio

Back 23

Price per share / sales per share
In some cases companies will have negative earnings for extended time periods so their P/E ratios aren't very meaningful. Good example is a recent start up. So we look at this instead.

Front 24

Market to book ratio

Back 24

Market value per share / book value per share
Market to book ratio compares the market value of the firm's investments tot their cost. A value less than 1 could mean that the firm has not been successful overall in creating value for its stockholders.

Front 25

The Du Pont identity tells us that ROE is affected by 3 things

Back 25

1. Operating efficiency (as measured by profit margin)
2. Asset use efficiency (as measured by total asset turnover)
3. Financial leverage (as measured by the equity multiplier) The decomposition is a convenient way of systematically approaching financial statement analysis. If ROE is unsatisfactory by some measure, the Du Pont identity tells you where to start looking for the reason.

Front 26

Dividend payout ratio

Back 26

Cash dividends / net income
Tells us how much income is put into dividends.

Front 27

Retention ratio

Back 27

Addition to retained earnings / Net income
Tells us how much of the net income is retained.

Front 28

What is necessary in order for growth to occur?

Back 28

If sales are to grow, assets have to grow as well, at least over the long run.
If assets are to grow, then the firm must somehow obtain the money to finance the needed acquisition.

Front 29

Internal growth rate

Back 29

RAO x b / 1 - ROA x b

Were ROA is, as usual, and b is the retention ratio.

This tells us how fast a co. can grow if they are not willing to issue any new stock.

Front 30

The sustainable growth rate

Back 30

ROE x b / 1 - ROE x b

This tells us how rapidly a firm can trow if they wish to maintain a particular total debt ratio and is unwilling to sell new stock. It is larger than the internal growth rate because as a firm grows they 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. So now they can expand more rapidly.

Front 31

If we examine the sustainable growth rate, we see that anything that increases ROE will increase sustainable growth rate by making the top bigger and the bottom smaller. Increasing the retention ratio will have the same effect.

Back 31

Okay...

Front 32

A firm's ability to sustain growth depends on 4 factors:

Back 32

1. Profit margin: an increase in profit margin will increase the firm's ability to generate funds internally and thereby increase its sustainable growth.
2. Total asset turnover. An increase in the firm's total asset turnover increases that sales generated for each dollar in assets. This decreases the firm's need for new assets as sales grow and thereby increases sustainable growth. Notice that increasing total asset turnover is the same thing as decreasing capital intensity.
3. Financial policy. An increase in the debt equity ratio increases the firm's financial leverage. Since this makes additional debt financing available, it increases the sustainable growth rate.
4. Dividend policy. A decrease in the percentage of net income paid out in the form of dividends will increase the retention ratio. This increases internally generated equity and thus increases internal and sustainable growth.

Front 33

Sustainable growth rate: what does it illustrate?

Back 33

The explicit relationship between the firms 4 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.

Front 34

Why evaluate financial statements?

Back 34

The primary reason for looking at accounting info is that we don't have and can't reasonably expect to get market value info. If we do have it we will always use that instead.

Front 35

Internal use of financial statements

Back 35

Most imp. is performance evaluation. Managers are often compensated on the basis of accounting measures of performance such as profit margin and return on equity. Involves planning for the future. Historical financial statement info is very useful for generating projections about the future and checking the realism of assumptions made in those projections.

Front 36

External uses of financial statements

Back 36

Useful to short term and long term creditors and investors. Use this info to evaluate suppliers and they would use our statements before deciding to extend credit to us. Large customers would use this to decide if we are likely to be around. Credit rating ppl use it to asses a firm's overall credit worthiness. Common theme is that financial statements are a prime source of info about a firm's financial health.

Front 37

Choosing a benchmark

Back 37

Time trend analysis, peer group analysis

Front 38

Time trend analysis

Back 38

Benchmark that involves using history. Example of what we mean by management by exception. A deteriorating time trend may not be bad but, it does merit investigation.

Front 39

Peer group analysis

Back 39

Identify firms similar in the sense that they compete in the same markets, have similar assets, and operate in similar ways. Firms with the same SIC code are assumed to be similar. Not always true, instead analysts often identify a set of primary competitors and then compute a set of averages based off of these instead.

Front 40

Standard Industrial Classification Code

Back 40

U.S. gov. code used to classify a firm by its type of business operations.

Front 41

Problems with financial statement analysis

Back 41

There is no underlying theory to help us identify which items or ratios to look at and to guide us in establishing benchmarks. One prob is many firms are conglomerates owning more or less unrelated lines of business. Consolidated statements for such firms don't really fit any neat industry category. Major competitors and natural peer group members in an industry may be scattered around the globe. The existence of different standards and procedures makes it very difficult to compare financial statements across borders. Even US companies that are clearly in the same line of business may not be comparable. Profitability is strongly affected by regulatory environment, so utilities in diff locations may be very similar but show very diff profits. Diff firms use diff acct. proceedures, diff firms end their fiscal years at diff times, for any particular firm, unusual or transient events can affect financial performance.

Front 42

Du Pont ROE

Back 42

Profit margin x Total Asset Turnover x debt/equity multiplier

Front 43

Du Pont ROA

Back 43

Profit margin x total asset turnover