1. This week its Accounting Theory
Session 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

2. 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

3. 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

4. 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

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

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

7. 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

8. 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

9. 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

10. 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

11. 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

12. 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

13. 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

14. 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

15. Tools and Techniques
Key Financial Ratios – Cash Conversion Cycle

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

17. 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

18. 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

19. 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

20. 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

21. 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).

22. 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).

23. 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.

24. 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

25. 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

26. 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

27. 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)

28. 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

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

30. 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

31. 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.

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

33. 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

34. 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

35. 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

36. 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

37. 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.

38. 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

39. 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

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

41. 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.

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

43. 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

44. 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

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

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