Chapter 5: Highlights
1. When comparing investment alternatives, the investor bases the investment decision on the
return anticipated from each investment and the risk associated with that return. Most
financial statement analysis, therefore, examines some aspect of a firm's profitability, its risk,
or both.
2. Ratios are useful tools in financial statement analysis because they conveniently summarize
data in a form that the analyst can more easily understand, interpret, and compare. Ratios
should be used carefully. Once calculated, the analyst must compare the ratio with some
criterion or standard. Several possible criteria include: (a) the planned ratio for the period;
(b) the value of the ratio during the preceding period for the same firm; (c) the value of the
ratio for a similar firm in the same industry; or (d) the average ratio for other firms in the
same industry.
3. Three measures of profitability are (a) rate of return on assets; (b) rate of return on common
shareholders' equity; and (c) earnings per share of common stock.
4. The rate of return on assets (ROA) measures a firm's performance in using assets to generate
earnings independent of the financing of those assets. The rate of return on assets relates the
results of operating performance to the investments of a firm without regard to how the firm
financed the acquisition of those investments. The analyst computes the rate of return as
follows:
Net Income + Interest Expense Net of Income Tax Savings
Average Total Assets
5. The rate of return on assets has particular relevance to lenders and a firm’s other creditors
because, when providing debt capital to a firm or extending credit, creditors want to be sure
that the firm can generate a rate of return on that capital exceeding its cost.
6. The rate of return on assets is dependent upon a firm's profit margin for ROA ratio and the
total asset turnover ratio. We can express the relationship between the three ratios as follows:
Rate of Return on Assets
=
Profit Margin
x
For ROA Ratio
Total Assets
Turnover Ratio.
OR
Net Income +
Interest Expense
Net of Income
Tax Savings
Average Total Assets
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=
Net Income +
Interest Expense
Net of Income
Tax Savings
x
Sales
Sales________
Average Total Assets
Therefore, firm can increase their rate of return on assets by increasing the profit
margin for ROA ratio, the total assets turnover ratio, or both.
7. The profit margin for ROA ratio, the percentage of net income plus interest expense
net of tax savings to sales, is a measure of a firm's ability to control the level of
expenses relative to sales. By controlling costs, a firm can increase the profits from a
given amount of sales and improve its profit margin for ROA ratio.
8. To identify the reasons for a change in the profit margin for ROA ratio, the analyst
examines changes in a firm's expenses relative to sales.
9. The total assets turnover ratio, the ratio of sales to average total assets during the
period, provides a measure of the sales generated from a particular level of
investment in assets. The analyst can study changes in the total assets turnover ratio
by computing an accounts receivable turnover, an inventory turnover, and a fixed
asset turnover.
10. The accounts receivable turnover, which equals net sales on account divided by
average accounts receivable, indicates how quickly a firm collects cash. The average
number of days that accounts receivable are outstanding equals 365 days divided by
the accounts receivable turnover. The analyst can compare the average number of
days accounts receivable are outstanding with the firm's credit sales terms to assess if
the firm needs to take corrective action in its credit and collection policies.
11. The inventory turnover indicates how fast firms sell their inventory items. The
analyst computes the inventory turnover by dividing cost of goods sold by average
inventory. The average number of days that merchandise is held equals 365 days
divided by the inventory turnover.
12. The fixed asset turnover (or the fixed asset productivity ratio) equals sales divided by
average fixed assets (property, plant, equipment) during the year. It measures the
relation between the investment in fixed assets and sales. The reciprocal of the fixed
assets turnover ratio measures dollars of fixed assets required to generate one dollar
of sales.
13. The analyst should interpret changes in the fixed asset turnover ratio cautiously. A
decreasing rate of fixed asset turnover may indicate an expanding firm preparing for
future growth while an increasing rate of fixed asset turnover may indicate a firm is
anticipating a decline in sales and is cutting back its capital expenditures.
14. The rate of return on assets measures the profitability of a firm before any payments
to the suppliers of capital. Various portions of the return on assets are allocated to the
various providers of capital. The share allocated to creditors equals any contractual
interest net of tax savings. The share allocated to preferred shareholders equals the
stated dividend amounts on the preferred stock. The common shareholders have a
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residual claim on all earnings after creditors and preferred shareholders have received
amounts contractually owed them.
15. The rate of return on common shareholders' equity (ROCE) measures a firm's
performance in using and financing assets to generate earnings and is of primary
interest to common shareholders. The ratio is computed as follows:
Net Income - Dividends on Preferred Stock.
Average Common Shareholders' Equity
This measure of profitability assesses a firm's performance in using assets to generate
earnings and explicitly considers the financing of those assets. The rate of return on
common shareholders' equity will exceed the rate of return on assets if the rate of
return on assets exceeds the after-tax cost of debt and any dividends required for
preferred shareholders.
16. Financing with debt and preferred stock to increase the return to the residual common
shareholders' equity is referred to as financial leverage. The common shareholders
benefit from financial leverage when capital contributed by creditors and preferred
shareholders earns a greater rate of return than the payments made to creditors and
preferred shareholders.
17. In financial leverage, the common shareholders take extra risk (because the firm
incurs debt obligations with fixed payments dates) for a potentially higher return. As
a firm adds more debt to the capital structure, the risk of default or insolvency
increases and lenders will require a higher return to compensate for this additional
risk. Firms will reach a point where leverage can no longer increase the potential rate
of return to common shareholders' equity because the after tax cost of debt will
exceed the rate of return earned on assets.
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18. The analyst can disaggregate the rate of return on common shareholders' equity as
follows:
Rate of Return
on Common
Shareholders' =
Equity
Dividends)
Profit Margin
Ratio for ROCE
(after Interest
x
Expense and
Preferred Dividend)
Total Assets
Turnover
Ratio
x
Capital
Structure
Leverage
Ratio
OR
Net Income Dividends on
Preferred Stock =
Average Common
Common
Shareholders’
Equity
Net Income Dividends on
Preferred Stock
Sales
x
Sales
Average
Total Assets
x
Average
Total Assets
Average
Shareholders’
Equity
19. The profit margin for ROCE percentage indicates the portion of the sales dollar left
over for the common shareholders after covering all operating costs and subtracting
all claims of creditors and preferred shareholders. The total assets turnover indicates
the sales generated from each dollar of assets. The capital structure leverage ratio
indicates the relative proportion of capital provided by common shareholders versus
that provided by creditors and preferred shareholders.
20. The larger the capital structure leverage ratio, the smaller the portion of capital
provided by common shareholders and the larger the proportion provided by creditors
and preferred shareholders. Therefore, the larger the capital structure leverage ratio,
the greater the extent of financial leverage.
21. Earnings per share of common stock equals:
Net Income - Preferred Stock Dividends
Weighted Average Number of Common
Shares Outstanding
Analysts frequently compare earnings per share amounts with the market price of the
stock, a ratio called a price-earnings ratio (or P/E ratio), and compute this ratio as
follows:
Market Price per Share
Earnings per Share
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22. GAAP requires firms to present a dual presentation of basic earnings per share and
diluted earnings per share when a firm has outstanding securities that, if exchanged
for shares of common stock, would decrease basic earnings per share by 3 percent or
more. Basic earnings per share equals net income attributable to common stock
divided by the average number of common shares outstanding. Diluted earnings per
share is the amount of earnings per share reflecting the maximum dilution that would
occur if all options, warrants, and convertible securities outstanding at the end of the
accounting period were exchanged for common stock.
23. When assessing risk, the focus is generally on the firm's relative liquidity. Cash and
near-cash assets provide a firm with the resources needed to adapt to the various types
of risk. Four measures for assessing short-term liquidity risk are (a) current ratio; (b)
quick ratio; (c) operating cash flow to current liabilities ratio; and (d) working capital
turnover ratio.
24. The current ratio, which equals current assets divided by current liabilities, is of
particular significance to short-term creditors because it indicates the ability of the
firm to meet its short-term obligations.
25. Firms can manipulate the current ratio. When the current ratio exceeds 1 to 1, an
increase of equal amount in both current assets and current liabilities will decrease the
current ratio. An equal decrease in both current assets and current liabilities will
increase the current ratio.
26. A company's management can take deliberate steps to produce a financial statement
that presents a better current ratio at the balance sheet date than the normal current
ratio. Common terminology refers to these actions taken by management to increase
the current ratio as "window dressing."
27. The analyst computes the quick ratio, or acid test ratio, by including in the numerator
of the fraction only those current assets that the firm could convert into cash quickly
(cash, marketable securities, and receivables). The denominator includes all current
liabilities.
28. The current ratio and quick ratio are criticized because they use amounts at a specific
point in time. The cash flow from operations to current liabilities ratio, which is
calculated by dividing cash flow from operations by average current liabilities,
overcomes this deficiency because it measures short-term liquidity for a period of
time. A ratio of 40 percent or more is common for a healthy firm.
29. The operating cycle of a firm is a sequence of activities in which a firm (a) purchases
inventory on account from suppliers; (b) sells the inventory on account to customers;
(c) receives cash from customers for amounts due; and (d) pays suppliers amounts
due. The longer the cycle, the longer the time a firm ties up funds in receivables and
inventories and the less liquid is the firm.
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30. The analyst studies the operating cycle of a firm by computing several ratios. The
inventory turnover ratio indicates the length of the period between the purchase and
sale of inventory during each operating cycle. The accounts receivable turnover ratio
indicates the length of the period between the sale of inventory and the collection of
cash from customers during each operating cycle. The accounts payable turnover
ratio indicates the length of the period between the purchase of inventory on account
and the payment of cash to suppliers during each operating cycle. The accounts
payable turnover ratio equals purchases of inventory on account divided by average
accounts payable.
31. Analyst use measures of long-term liquidity risk in assessing a firm's ability to meet
interest and principal payments on long-term debt and similar obligations as they
come due. A good indicator of long-term liquidity risk is a firm's ability to generate
profits over a period of years. If a firm is profitable, it will either generate sufficient
cash from operations or be able to obtain needed capital from creditors and owners.
In addition to measures of profitability, three other measures of long-term liquidity
risk are debt ratios, the cash flow from operations to total liabilities ratio, and the
interest coverage ratio.
32. The long-term debt ratio (which equals total long-term debt divided by the sum of
total long-term debt and total shareholders' equity) and the debt-equity ratio (which
equals total liabilities divided by total equities) measure a firm's long-term liquidity
risk. The analyst interprets these ratios by considering the stability of the firm's
earnings and cash flows from operations. In general, the more stable the earnings and
cash flows, the higher the debt ratio that analyst consider acceptable or safe.
33. The debt ratios do not consider the availability of liquid assets to cover various levels
of debt. A ratio that overcomes this deficiency is the cash flow from operations to
total liabilities ratio. The ratio is calculated as follows:
Cash Flow from Operations.
Average Total Liabilities
A financially healthy company normally has a cash flow from operations to total
liabilities ratio of 20 percent or more.
34. Another measure of long-term liquidity risk, the number of times that earnings cover
interest charges, equals income before interest and income taxes divided by interest
expense. The analyst uses the interest coverage ratio to indicate the relative
protection that operating profitability provides bondholders and permits them to
assess the probability of a firm's failing to meet required interest payments. Analysts
typically view an interest coverage ratio below 3.0 as risky. If bond indentures require
periodic repayments of principal on long-term liabilities, the denominator of the ratio
might include such repayments. Common terminology then calls the ratio the fixed
charges coverage ratio.
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35. Accountants use the term "pro forma financial statements" to refer to financial
statements prepared under a particular set of assumptions. The usefulness of the pro
forma financial statements depends on the reasonableness of those assumptions.
36. The preparation of pro forma financial statements typically begins with the income
statement, followed by the balance sheet and then the statement of cash flows. The
level of operating activity usually dictates the amount of assets required, which in
turn affects the level of financing needed. Amounts for the statement of cash flows
come directly from the income statement and comparative balance sheets.
37. Managers, security analysts, and others analyze financial statements (both historical
and pro forma) to form judgments about the market value of a firm. One approach to
approximating market value projects the amount of cash flows a firm will generate
from operating, investing, and financing activities over some number of years in the
future and discounts this net amount at an appropriate discount rate to find the present
value of these future cash flows.
38. Other approaches to approximating a firm's market value rely on market multiples of
certain financial statement items for similar firms in the market. One common
valuation approach relates market prices to multiples of earnings. Another valuation
approach relates market values to the book values of common shareholders' equity of
similar firms.
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