Finance 3

  1. Commonsize Statements
    a standardized financial statemeent presenting all items in percentage terms.
  2. Current Ratio
    current assets/ current liabilities

    • ex: 708/540= 1.31
    • $1.31 in current assets for every $1 of current liabilities or current liabilities covered 1.31 times over

    the higher the ration the better, it indicates liquidity

    less than one is unhealthy and unable to cover liabilities
  3. Quick (acid test) Ratio
    (current assets- inventory)/ current liabilities
  4. Cash Ratio
    cash/current liabilities
  5. Short Term Ratios
    • Current Ratio
    • Quick Ratio
    • Cash Ratio
  6. Long Term Measures aka Financial Leverage Ratios
    • Total debt ratio
    • Debt Equity Ratio
    • Equity multiplier
    • Times interest earned
    • Cash Coverage ratio
  7. Total Debt Ratio
    (total assets-total equity)/total assets

    • (3588-2591)/3588= .28 times
    • 28% debt OR .28 for every $1 in assets, therefore .72 in equity and .28 in debt
  8. debt equity ratio
    total debt/total equity

    .28/.72= .39 times
  9. Equity Multiplier
    Total Assets/Total Equity

    1/.72= 1.39 times

    also 1 plus debt equity ratio

    • also can be equated by
    • (total debt + total equity)/ total equity
  10. Times Interest Earned (TIE) Ratio aka Interest coverage ratio

    691/141= 4.9 times

    covered 4.9 times over

    measures how well a company has its interest obligations covered

    *problem with measure is its not really a measure of cash available to pay interest because depreciation, a non cash expense, has been deducted out
  11. Cash Coverage Ratio

    (691+276)/141= 6.9 times

    • EBITD= earnings before interest taxes and depreciation
    • EBITDA= earnings before interest taxes, depreciation and amortization (amort is a intangible asset, like a machine)
  12. Asset Management or Turnover Measures
    aka Asset Utilization Ratios
    intended to describe how efficiently or intensively a firm uses its assets to generate sales

    • Inventory Turnover
    • Days Sales in inventory
    • Receivables turnover
    • Days sales in receivables
    • total asset turnover
    • capital intensity
  13. Inventory Turnover

    1344/422=3.2 times

    we sold off or turned over the entire inventory 3.2 times (per year usually)

    as long as we arent running out of stock and forgoing sales, the higher the ratio the more efficiently we are managing inventory
  14. Days Sales in inventory
    365/inventory turnover


    inventory sits 114 days on average before it is sold

    also it will take 114 days to work off current inventory
  15. Average inventory turnover
    COGS/[(Yr 1 inventory + yr 2 inventory)/2]

  16. Using Inventory turnovers
    if you are worried about the past- average inventory turnover

    future- the ending figure (inventory at the end of the year)

    ending figures also common for comparing industries
  17. Receivable Turnover
    Sales/Account Receivables

    2311/188=12.3 times

    we collected our outstanding credit accounts and reloaned the money 12.3 times during the year
  18. days sales in receivables aka Average Collection Period (ACP)
    365/receivable turnovers

    365/12.3= 30 days

    on average, we collected on our credit sales in 30 days

    also say that we have 30 days worth of sales currently unallocated
  19. Total Asset Turnover
    Sales/Total Assets

    2311/3588= .64 times

    for every dollar in assets we generated .64 in sales

    • reciprocal ratio= capital intensity ratio= 1/total asset turnover
    • known as the dollar amount needed to generate $1 in sales

    ex: 1/.64= 1.56 it takes 1.56 in assets to create $1 in sales
  20. Profitability Measures
    intended to measure how efficiently the firm uses its assets and how efficiently the firm manages operations

    focus is bottom line, net income

    • Profit margin
    • Return on assets
    • return on equity
  21. profit margin
    net income/sales

    363/2311= 15.7%

    firm generates a littles less than 16 cents in profit for every dollar in sales

    all things equal, a high profit  margin is desirable

    corresponds to low expense ratios relative to sales
  22. Return on assets
    Net income/total assets

    363/3588= 10.12%

    profit per dollar of assets

    accounting rates of return, return on book assets
  23. Return on Equity
    Net Income/ Total Equity

    363/2591= 14%

    for every dollar in equity firm generated 14 cents in profit

    • OR
    • (Net income/Sales)*(Sales/Assets)*(Assets/Equity)

    • OR
    • Profit Margin*Total Asset Turnover*Equity Multiplier

    • OR
    • ROA*Equity Multiplier= ROA* (1 + Debt Equity Ratio)

    also known as return on net worth

    accounting rates of return, return on book equity
  24. Market Value Measures
    Not necessarily on the financial statements

    • Earnings per share (EPS)
    • Price Earnings Ratio (PE)
    • Price Sales Ratio
    • Market to Book Ratio
  25. Earnings Per Share (EPS)
    Net Income/Shares outstanding

  26. Price Earnings Ratio (PE Ratio or Multiplier)
    Price per share/ Earning per share

    88/11=8 times

    firm's shares sell for 8 times earnings or shares "carry" a PE multiple of 8

    measures how much investors are willing to pay per dollar of current earnings

    HIgher PEs are meant that the firm has significant prospects for future growth, careful as if there are little to no earnings the number could be quite small and misleading
  27. Price Sales Ratio
    helpful in new companies with negative earnings

    Price per share/ sales per share

    88/(2311/33)= 88/70=1.26
  28. Market to Book Ratio
    market value per share/book value per share

    88/(2591/33)= 88/78.5= 1.12 times

    book value per share= total equity (not just common stock) divided by # shares outstanding

    a value less than 1 could indicate that the firm hasnt been successful in creating value for its stockholders
  29. Du Pont Indentity
    a famous way of decomposing ROE into its component parts

    • net income/total equity
    • OR
    • (Net income/Sales)*(Sales/Assets)*(Assets/Equity)

    Profit margin*total asset turnover*Equity multiplier

    • ROE is affected by 3 things:
    • Operating efficiency (measured by profit margin)
    • Asset Use Efficiency (measured by total asset turnover)
    • Financial Leverage (measured by the Equity Multiplier)

    Weakness in either operating or asset use efficiency (or both) will show up in a diminished ROA, which will translate to a lower ROE
  30. Using DU Pont Firm can leverage REO by
    Increasing amount of debt, this will only happen if the ratio of EBIT to total assets is greater than the interst rate

    increase sales and reducing one or more of COGS, selling, general or admin expenses

    also reducing inventory holdings reduces current assets, which reduces total assets which improves the total asset turnover
  31. Internal and Sustainable Growth
    • Dividend Payout Ratio
    • Earnings Retention Ratio
  32. Dividend Payout ratio
    Cash Dividends/ Net Income

    • 121/363= 33.3%
    • Firm pays out 1/3 of net income in dividends
  33. Rentention Ratio
    What the firm doesnt pay in dividends must be retained in the firm

    addition to retained earnings/Net income

    • 242/363= 66.6%
    • retains 2/3 of net income

    aka plowback ratio, because a portion of net income is plowed back into the business
  34. A firm has two broad sources of financing
    • internal- what a firm earns and plows back into the business 
    • external- funds raised by borrowing money or selling stock
  35. Internal Growth Rate
    can be used to determine growth if the firm intends to not borrow any funds or sell any new stock


    where b= retention or plowback ratio

    [.1012*(2/3)]/[1-.1012*(2/3)]= 7.23%
  36. Sustainable Growth Rate
    only relies on internal financing, through time debt ratio will decline

    • - wish to maintain a particular total debt ratio
    • - unwilling to sell new stock


    [.14*(2/3)]/[1-.14*(2/3)]= 10.29%

    as the firm grows it will need to borrow additional funds to maintain a constant debt ratio
  37. Determinants of Growth
    anything that increases ROE will increase the sustainable groth rate by making the top bigger and the bottom smaller. Increasing the plowback ration will have the same effect
  38. 4 factors to sustain growth
    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 total asset turnover increases the sales generated for each dollar in assets. This decreases the firm's need for new assets as sales grow and thereby increase the sustainable growth rate. (increasing the Total asset turnover is the same thing as decreasing the capitial 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 polidy. A decrease in the % of net income paid out as dividends will increase the rentention ratio. This increases internally generated equity and thus increases internal and sustainable growth

    If sales are to grow at a rate higher than the sustainable growth rate, the firm must increase profit margins, increase total asset turnover, increase financial leverage, increase earnings retention OR sell new shares
  39. Note on sustainable growth related to ROE
    can also see it calculated as ROE*b, which is used if total equity is used from the beginning of the period

    if the total equity is used at the end of the period, use (ROE*b)/(1-ROE*b)
  40. Evaluating Financial Statements
    If there is a conflict between market data and accounting data, market data should be given precendence

    Internal Uses: performance evaluation, planning for the future, checking realism of assumptions made in those projections

    External Uses: short term and long term potential investors, evaluate suppliers (credit), assessing creditworthiness/ financial health, competitors financial strength
  41. Choosing a benchmark
    Time trend analysis- example: current ratio for a firm is 2.4, but it has been steadily declining for the past ten years..

    peer group analysis- (no two companies are the same so there will be some problems with this). Standard Industrial Classification Codes (SIC)- 4 digit codes est'b by the US govt for statistical reporting purposes, firms with the same codes are assumed to be similiar.

    NAICS- North American Industry Classification System- 1997, intended to replace SIC codes
Card Set
Finance 3
Finance 3