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32 Cards in this Set
- Front
- Back
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What are the 5 categories of financial ratios? |
Profitability - 3 Leverage - 4 Solvency - 4 Asset Turnover - 4 Market - 4 |
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What are the three profitability ratios? |
Return on Equity Return on Assets Return on Sales (These ratios are designed to measure a firm’s earnings power. Net income, the primary measure of the overall success of a company, is compared to other measures of financial activity or condition to assess performance as a percent of some level of activity or investment.) |
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Return on Equity |
Net Income Divided By Average Shareholder's Equity (BTA+ETA/2) (This ratio measures the effectiveness at managing capital provided by the shareholders.) (Average Shareholder’s Equity = beginning of year stockholder’s equity + end of year stockholder’s equity / 2) |
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Return on Assets |
Net Income + Interest Expense (1-tax rate)
Divided By Average Total Assets This ratio measures the effectiveness at managing capital provided by all investors (stockholders and creditors). |
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Return on sales/profit margin (Profit Ratio) |
Net Income + Interest Expense (1-tax rate) Divided By Net Sales This ratio provides an indication of a company’s ability to generate and market profitable products and control its costs; also called the Profit Margin. |
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What are the four leverage (debt versus equity) ratios? |
Common Equity Leverage Capital Structure Leverage *Debt to Equity Long Term Debt Financial leverage refers to using borrowed funds to generate returns for stockholders. Financial leverage is desirable because it creates returns for shareholders without using any of their money. Financial leverage increases risk by committing the company to future cash obligations. |
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Common Equity (Leverage Ratio)
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Net Income
Divided By Net Income + Interest Expense (1-tax rate) (This ratio compares the return available to the shareholders to returns available to all capital providers) |
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Capital Structure (Leverage Ratio) |
Average Total Assets Divided By Average Shareholder's Equity (This ratio measures the extent to which a company relies on borrowings (liabilities).) |
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*Debt/Equity Ratio (Leverage Ratio) |
Average Total Liabilities Divided By Average Shareholder's Equity (This ratiocompares liabilities to shareholders’ equity and is another measure of capitalstructure leverage.) |
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Long-Term Debt (Leverage)
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Long-Term Debt
Divided By Total Assets (This ratio measures the importance of long-term debt as a source of asset financing.) |
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What are the four solvency ratios? |
*Current Ratio Quick Ratio Interest Coverage Accounts Payable Turnover (in the short-term do we have enough cash to pay the bills as they come due) Solvency refers to a company’s ability to meet its current debts as they come due. There is pressure on companies with high levels of leverage to manage their solvency.) |
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*Current Ratio
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Current Assets
Divided By Current Liabilities (This ratio measures solvency in the sense that current assets can be used to meet current liabilities. Rules of thumb – ratio should be 2 to 1) |
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Quick Ratio (Solvency Ratio) |
Cash + Marketable Securities, + AP Divided By Current Liabilities The higher the quick ratio the better ability to meet obligations as they come due. Similar to the current ratio, this ratio provides a more stringent test of a company’s solvency. |
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Interest Coverage Ratio (Solvency Ratio) |
Net Income + Interest Expense + Tax Expense Divided By Interest Expense This ratio compares the annual funds available to meet interest to the annual interest expense. |
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Accounts Payable Turnover (Solvency Ratio) |
Cost of Goods Sold Divided By Average Accounts Payable (This ratio measures the extent to which accounts payable is used as a form of financing.) How quickly suppliers are paid off on average |
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What are the four asset turnover ratios? |
Receivables Turnover Inventory Turnover Fixed Assets Turnover Total Asset Turnover (Asset turnover ratios are typically computed for total assets, accounts receivable, inventory, and fixed assets. These ratios measure the speed with which assets move through operations or reflect the number of times during a given period that these specific assets are acquired, used, and replaced.) |
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Receivables Turnover (Asset Turnover Ratio) |
Net Credit Sales Divided By Average Accounts Receivable # of times trade receivables were recorded, collected, and recorded again during the period. (Can be converted into the average number of days sales in accounts receivable by dividing 365 days by the receivable turnover ratio) |
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Inventory Turnover (Asset Turnover Ratio) |
Cost of Goods Sold Divided By Average Inventory This ratio measures the speed with which inventories move through operations. Can be converted into average number of days sales in inventory by dividing 365 days by the inventory turnover ratio) |
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Fixed Assets (Turnover Ratio) |
Sales Divided By Average Fixed Assets (This ratio measures the speed with which fixed assets are used up.) |
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Total Asset Turnover |
Sales Divided By Average Total Assets (This ratio measures the speed with which all assets are used up in operations.) |
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What are the four market ratios? |
Earnings Per Share Price/Earnings Dividend Yield Stock Price Return (These additional ratios are used by the financial community to assess company performance.) |
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*Earnings Per Share (Market Ratio) |
Net Income
Divided By Average # of Common Shares Outstanding (This ratio,according to the financial press, is the primary measure of a company’s performance. It calculates the amount of income that is earned for each shareholder.) |
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*Price/Earnings Ratio (Market Ratio)
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Market Price Per Share
Divided By Earnings Per Share (This ratio is used by many analysts to assess the investment potential of common stocks.) |
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Dividend Yield Ratio (Market Ratio) |
Dividends Per Share
Divided By Market Price Per Share (This ratio indicates to cash return on the shareholders’ investment.) |
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Stock Price Return (Market Ratio) |
Market Price1 – Market Price0 + Dividends
Divided By Market Price0 (This ratio measures the pretax performance of an investment in a share of common stock.) |
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Earnings quality may be affected by a number of strategies managers use to influence accounting numbers?
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Four major strategies are discussed:
Overstating operating performance “Taking a bath” Creating hidden reserves Employing off-balance-sheet financing |
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Overstating operating performance |
Overstating operating performance through the acceleration of recognition of revenue - shift the timing of revenue from a future period to the current period, through legitimate or questionable activities.Overstating operating performance through the allocation and estimation of expenses - shift the recognition of expenses through the use of “taking a bath” and “creating hidden reserves.”
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Taking a bath |
Taking a bath (also called “big bath”) - large losses and expenses this year may increase income in future years.Rationale: if the current year is going to be disappointing to investors anyway, increase the loss to make next year look better. For example: Excessive write-downs of equipment will lead to lower depreciation expense in future years.Excessive write-downs of inventory will lead to lower cost of goods sold next year.
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Creating hidden reserves
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Creating hidden reserves - expenses may be shifted from one year to another year by overestimating expense accrual.Excessive bad debt expense or warranty expense in the current year will lead to reduced estimates in future years, as the “reserve” is used up.Note that these “reserves” have nothing to do with cash reserves; they simply reserve some of the “income” to future periods.
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Employing off-balance-sheet financing
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Employing off-balance-sheet financing - this relates to certain economic transactions that are not reflected in the balance sheet. Managers prefer to keep certain liabilities off the balance sheet when GAAP permits it, primarily because of potential debt covenant violations, and because of the effect on certain ratios. Examples include: treatment of leases as operating leases (Radio Shack)
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Return on Equity
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Return on Assets X Capital Structure Leverage X Common Equity Leverage
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Return on Assets |
Profit margin X Asset Turnover
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