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Financial Management – Chapter 3

scaling companies relative to their own operations and size. Allows us to compare between companies or a company over time as it grows or shrinks.
Ratio analysis isn’t bound by rules. Can adapt per individual case. It is flexible.
Why do ratio analysis
– Standardize
– Flexible
– Lead us to look in right places
– Evaluating if firm achieving stated goal to maximize shareholder wealth
What are the four ratio types?
– Liquidity
– Asset use efficiency
– Financing
– Profitability
Liquidity Ratios
measure the company’s level of liquidity. liquidity of a firm refers to its ability to meet its short-term obligations.
– Current Ratio
– Quick Ratio (Acid Test Ratio)
– Average Collection Period
– AR Turnover
– Inventory Turnover
Current Ratio
Current Assets / Current Liabilities

Most common liquidity ratio. Compares current assets to current liabilities. Shows whether or not a company can meet its sort-term obligations using cash or near cash assets today. Higher current ratios mean better likelihood firm will be able to meet its short-term obligations. Increasing current ratio interpreted as increasing liquidity.

Quick Ratio (Acid Test Ratio)
(Current Assets – Inventory) / Current Liabilities

Similar to current ratio in that it compares current assets to current liabilities. Only difference is that it uses a more strict definition of liquidity, or what is considered a liquid asset. For this, just take out inventory and leave cash, marketable securities, and AR.

Average Collection Period
AR / Daily Credit Sales

Number of days it takes on average for a company to collect its receivables. Daily credit sales = annual credit sales divided by 365. If financial statements don’t differentiate between cash and credit sales, assume all on credit. If 32 it means on average it takes firm 32 days to collect cash.

AR Turnover
Credit Sales / AR

Describes the number of times a firm’s AR account turns per year. Inverse of avg. collection period. If 12, it means company collects its entire AR 12 times per year. In that case Average collection period would be 30 days. Since these are closely related, you don’t see them used together.

Inventory Turnover
COGS / Inventory

The number of times it turns (or sells) its inventory annually. Inventory on balance sheet is stated as its cost, not as its selling price. That’s why you can’t use sales, that would be cost + markup.

Efficiency Ratios
measure how well the company uses its assets to generate sales or profits. This is of interest to those providers of debt and equity capital.

– Total Asset Turnover
– Fixed Asset Turnover
– Operating Income Return on Investment (OIROI)

Total Asset Turnover
Sales / Total Assets

Calculates how many dollars in sales the form generates per dollar of assets it owns. If its 3 it means for every dollar of assets within the firm, it produces three dollars of sales.

Fixed Asset Turnover
Sales / Fixed Assets

Similar to total asset turnover. This calculates sales generated per dollar of fixed assets. Fixed assets include all non-current assets.

Operating Income Return on Investment – OIROI
Operating Income / Total Assets

Describes the relationship between operating profit (EBIT) and company’s total asset base. Tells us how much pretax, pre-financing profit the company generates per dollar of assets. Calculating the return, or profit, made per dollar of assets invested in the company’s operations. So if you have $1,000 worth of assets and operating profit is $100 then you made 10%.

Financing Ratios
They consider how the firm is financed. The firm has assets in place. The financing ratios describe in what proportions the firm uses equity and/or debt to finance those assets.

– Debt Ratio
– Times Interest Earned (TIE)

Debt Ratio
Total Debt / Total Assets

Compares total debt to total assets. Shows what proportion of debt financed with debt. 1 – debt ratio would then show proportion financed with equity. If .4 then for every dollar of assets firm owns, 40 cents is financed with debt (60 cents equity).

Optimal Debt Ratio
Differs depending on company or industry. Minimize cost of financing and maximize company value.
Times Interest Earned (TIE)
EBIT / Interest Expense

Tells us how many times a company covers (or could pay) its interest expanse given its earnings. Like if company EBIT = $1,000 and annual interest expanse = $100, its times interest earned ratio of 10 would mean it could pay its interest expanse 10 times over with its EBIT.

Profitability Ratios
Based either on sales or asset investment. Used to judge how well management is doing as they strive to maximize owner wealth.

– Return on Assets (ROA)
– Return on Equity (ROE)
– Gross Margin, Operating Margin, Net Margin

Return on Assets (ROA)
Net Income / Total Asset Base

Show how profitable the firm is given its asset investment.

Return on Equity (ROE)
Net Income / Total Equity

Comparing ROA with ROE will tell us how effective the firm is at financing new assets

Gross Margin, Operating Margin, Net Margin
All derived from the income statement. Sales is the denominator for all 3. Gross profit, EBIT, Net Income. Just take each of these three and divide it by sales. It will tell how much of that typr of profit is made per dollar of sales. Like if net margin is 5% then it means for every dollar of sales , 5 cents drops tot he bottom line as net income.
Dupont Equation
ROE = Net Profit Margin X Asset Turnover X Leverage Multiplier.

The grand-daddy ratio of them all. Allows us to see the various levers we can pull to get a certain ROE. If we drop leverage multiplier from DuPont we get ROA. If we want ROE of 20% , how can this be done? DuPont allows us to see various levers to pull.

Net Profit Margin
Net Income / Sales

This is a measure of a firms efficiency in controlling costs. Measure for amount of bang for buck a firm sells.

Asset Turnover
Sales / Assets

Measures how efficiently the firm is using its assets to generate sales.

Leverage Multiplier
Assets / Equity
ROA DuPont Style
ROA = NI/S x S/A

Allows us to remove the impact of debt from the leverage factor.

Return on Invested Capital (ROIC)
ROIC = NOPAT / Costly Capital

NOPAT is equal to net operating profit after taxes and is defined as EBIT (l-t) and costly capital equals all interest bearing debt plus total equity.

This is to completely remove the effects of leverage in profitability ratios.

This measures the return regardless if the company’s financing comes from debt or equity.

Free Cash Flows to the Firm (FCFF)
FCFF = EBIT – Cash Tax Payments + Depreciation – CAPEX – Increases in NWC

This is interested in measuring the cash flows before either creditors and owners are compensated.

FCFF = Free cash flow to the firm
Cash Tax Payments = Total tax payments from the income statement
Depreciation = depreciation from the income statement (or two balance sheets)
EBIT = from income statement
CAPEX = Capital expenditure (gross property, plant, and equipment) changes from two balance sheets.
NWC = Networking capital (current assets – current liabilities) changes from two balance sheets.

Free Cash Flows to Equity Holders (FCFE)
FCFE = NI + Depreciation – CAPEX – Increases in NWC + Increases in Net Long-Term Debt

NI = Net Income
Net Long-Term Debt = new long-term debt minus principal (debt due) payments.

Economic Profit or Economic Value Added (EVA)
EVA = NOPAT – WACC x (Costly Capital)

Term coined to define a specific approach to economic profit. The two names are used interchangeably (two on front of this flash card).

NOPAT = Net operating profit after taxes. Also equals EBIT minus taxes
WACC = Weighted average cost of capital. Includes cost of debt and cost of equity
Costly Capital = all of our interest bearing debt and all of our equity.
Equity = assets – liabilities.

What are the 3 main comparison methods used in ratio analysis.
Trend Analysis
Cross-sectional analysis
Measure progress and achieve goals
Trend Analysis
Looks at the firm’s financial ratios over time. Compares this year with previous years. Generally looks back 5 years and looks forward 3 years.
Cross-sectional analysis
Compares a firm’s financial ratios with those of some peer group. Common in equity valuation. Tells about the firms relative strength or weakness.
Measure progress and achieve goals
management may set a goal, like ROE for this form will be 15%. It it is 10% they have meore work to do if it is above 15% then they met goal.
Two types of firms where data timing is a problem
1)Seasonal firms
2)High growth firms
Seasonal Firms
high sales in one part of the year and low in another. Like inventory or sales.
High growth firms
Create a data-timing dilemma. Balance sheet will be a snap shot in like December when company just had a huge growth, when income statement will be an average for the year when it was small in January and huge in December.

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