This week its Accounting Theory Session 1 Session 2 Tuesday Financial Statements/Expenses/Revenues Accounting Cycle & Accounts Wednesday The Income Statement The Balance Sheet Thursday The Cash Flow Statement Tools & Techniques Friday Presentations Presentations

Tools and Techniques Key financial ratios standardize financial data in terms of mathematical relationships are expressed as percentages or times are extremely valuable have limitations

Tools and Techniques Key financial ratios serve as screening devices indicate areas of potential strength or weakness reveal matters that need further investigation are not predictive

Tools and Techniques Key financial ratios should be used with caution and common sense should be used in combination with other elements of analysis should be evaluated and interpreted within the context of the particular firm, industry, and economic environment

Tools and Techniques Key financial ratios Liquidity ratios Activity ratios Leverage ratios Profitability ratios Market ratios

Tools and Techniques Key financial ratios – Liquidity Ratios Measure ability to meet cash needs as they arise

Tools and Techniques Key Financial Ratios – Liquidity Ratios Current Ratio Quick Ratio (Acid-Test Ratio) Cash Flow Liquidity Ratio Average Collection Period Days Inventory Held Days Payable Outstanding

Tools and Techniques Current Ratio Commonly used measure of the ability of a firm to meet its debt requirements as they come due Limited by its components Some analysts eliminate prepaid assets. Necessary to evaluate the trend of liquidity over a period of time and compare with industry competitors

Tools and Techniques Quick Ratio (Acid-Test Ratio) More rigorous test of short-run solvency than the current ratio Numerator eliminates inventory (the least liquid current asset and the most likely source of losses) Some analysts eliminate prepaid expenses. Necessary to evaluate the trend of liquidity over a period of time and compare with industry competitors

Tools and Techniques Cash Flow Liquidity Ratio Considers cash flow from operating activities Uses cash and marketable securities as an approximation of cash resources in the numerator of the ratio

Tools and Techniques Average Collection Period Average number of days required to convert receivables into cash Credit sales can be substituted for net sales. Helps gauge the liquidity of account receivable May provide information about credit policies Should be compared with the firm’s stated credit policies and the strength of the firm within its industry

Tools and Techniques Days Inventory Held Average number of days required to sell inventory to customers Measures efficiency of the firm in managing its inventory Type of industry is important in evaluating this ratio Necessary to check the cost flow assumption used to value inventory and cost of goods sold when making comparisons among firms

Tools and Techniques Days Payable Outstanding Average number of days it takes to pay payables in cash Offers insight into a firm’s pattern of payments to suppliers

Tools and Techniques Key Financial Ratios – Cash Conversion Cycle Also called Net Trade Cycle Normal operating cycle of a firm that consists of: buying or manufacturing inventory, with some purchases on credit selling inventory, with some sales on credit collecting the cash Helps the analyst understand why cash flow generation has changed

Tools and Techniques Key Financial Ratios – Cash Conversion Cycle

Tools and Techniques Key financial ratios – Activity Ratios Measure liquidity of specific assets and efficiency of managing assets

Key Financial Ratios – Activity Ratios Tools and Techniques Key Financial Ratios – Activity Ratios Accounts Receivable Turnover Inventory Turnover Accounts Payable Turnover Fixed Asset Turnover Total Asset Turnover

Tools and Techniques Accounts Receivable Turnover Measures how many times on average accounts receivable are collected in cash during the year Measures efficiency of a firm’s collection and credit policies

Tools and Techniques Inventory Turnover Measures how many times on average inventory is sold during the year Measures efficiency of a firm in managing its inventory

Tools and Techniques Accounts Payable Turnover Measures how many times on average payables are paid during the year Helps to gain insight into a firm’s pattern of payment to suppliers

Tools and Techniques Fixed Asset Turnover Assesses management’s effectiveness in generating sales from investments in fixed assets Considers only the firm’s investment property, plant, and equipment Extremely important for a capital-intensive firm High ratio generally means only a small investment is required to generate sales (and thus the firm will be more profitable).

Tools and Techniques Total Asset Turnover Assesses management’s effectiveness in generating sales from investments in assets Considers all assets High ratio generally means only a small investment is required to generate sales (and thus the firm will be more profitable).

Tools and Techniques Key financial ratios – Leverage Ratios Measure the extent of financing with debt relative to equity and ability to cover interest and other fixed charges Use of debt provides a trade-off of risk and return Debt ratios do not present the whole picture with regard to risk. Operating earnings must be sufficient to cover the associated fixed charges for debt to translate to leverage.

Tools and Techniques Key Financial Ratios – Leverage Ratios Debt Ratio Long-Term Debt to Total Capitalization Debt to Equity Times Interest Earned Cash Interest Coverage Fixed Charge Coverage Cash Flow Adequacy

Tools and Techniques Debt Ratio Measures the extent of the firm’s financing with debt Considers the proportion of all assets that are financed with debt

Tools and Techniques Long-Term Debt to Total Capitalization Measures the extent of the firm’s financing with debt Reveals the extent to which long-term debt is used for the firm’s permanent financing

Tools and Techniques Debt to Equity Measures the extent of the firm’s financing with debt Measures the riskiness of the firm’s capital structure in terms of the relationship between the funds supplied by creditors (debt) and investors (equity)

Tools and Techniques Times Interest Earned Indicates how well operating earnings cover fixed interest expenses The higher the ratio, the better Can be misleading depending on cash flow

Tools and Techniques Cash Interest Coverage Measures how many times interest payments can be covered by cash flow from operations before interest and taxes

Tools and Techniques Fixed Charge Coverage Broader measure of coverage capability than the times interest earned ratio Includes the fixed payments associated with leasing Important for firms that operate extensively with operating leases

Tools and Techniques Cash Flow Adequacy Measures firm’s ability to cover capital expenditures, long-term debt payments, and dividends each year Defined differently by analysts Operating cash flow should cover investing and financing activities.

Tools and Techniques Key financial ratios – Profitability Ratios Measure the overall performance of a firm and its efficiency in managing assets, liabilities, and equity

Tools and Techniques Key Financial Ratios – Profitability Ratios Gross Profit Margin Operating Profit Margin Net Profit Margin Cash Flow Margin Return on Total Assets (ROA) Return on Equity (ROE) Cash Return on Assets

Tools and Techniques Gross Profit Margin Represents firm’s ability to translate sales dollars into profits Shows the relationship between sales and the cost of products sold Measures the ability to control costs of inventories or manufacturing and to pass along price increases through sales

Tools and Techniques Operating Profit Margin Represents firm’s ability to translate sales dollars into profits Measures overall operating efficiency Incorporates all expenses associated with ordinary business activities

Tools and Techniques Net Profit Margin Represents firm’s ability to translate sales dollars into profits Measures profitability after consideration of all revenue and expense, including interest, taxes, and nonoperating items

Tools and Techniques Cash Flow Margin Measures ability to translate sales into cash Cash is needed to service debt, pay dividends, and invest in new capital assets.

Tools and Techniques Return on Total Assets (ROA) Also called Return on Investment (ROI) Measures the overall efficiency of the firm in managing its total investment in assets Indicates the amount of profit earned relative to the level of investment in total assets

Tools and Techniques Return on Equity (ROE) Measures the overall efficiency of the firm in generating return to shareholders Calculated as return on common equity if a firm has preferred stock outstanding

Tools and Techniques Cash Return on Assets Offers a useful comparison to return on investment Measures the firm’s cash-generating ability of assets

Tools and Techniques Key financial ratios – Market Ratios Measure returns to stockholders and the value the marketplace puts on a company’s stock Reporting of these numbers has a significant impact on stock price changes in the marketplace. Thorough analysis of a company, its environment, and its financial information offers a much better gauge of future prospects of the company than looking exclusively at these ratios.

Tools and Techniques Key Financial Ratios – Market Ratios Earnings Per Common Share Price-to-Earnings (P/E) Ratio Dividend Payout Ratio Dividend Yield

Tools and Techniques Earnings per Common Share Provides the investor with a common denominator to gauge investment returns Must be disclosed on the income statement for publicly held companies

Tools and Techniques Price to Earnings (P/E) Ratio Relates earnings per common share to the market price at which the stock trades, expressing the “multiple” that the stock market places on a firm’s earnings Function of a myriad of factors including quality of earnings, future earnings potential, and performance history

Tools and Techniques Dividend Payout Ratio Relates cash dividends per share to earnings per share

Tools and Techniques Dividend Yield Shows the relationship between cash dividends and market price