14. Financial Ratio Analysis Flashcards
Why do we study financial ratios?
- Examine relative strengths and weaknesses of a company compared to competitors
- Learn whether company’s position is improving or deteriorating
What are the key areas of ratios?
- Debt management
- Liquidity
- Market trend
- Profitability
- Asset Management
What are the ratios involved in asset management analysis?
- Inventory turnover ratio
- Day’s sales outstanding ratio
- Total assets turnover ratio
What does days sales outstanding (accounts receivable turnover) tell us?
(average of accounts payable)/ (total revenue/365)
Determines whether receivables are being collected aggressively enough.
Take average of accounts receivable balance between two years then divide it by the total revenue for the year.
Convert into days by multiplying by 365 days/yr
What does inventory turnover ratio tell us?
= (sales)/(average inventory)
Highlights the rate at which inventory is being sold.
Inventory turnover = sales/ (average inventory)
Average between $ amount of assets from start to end of year.
How do you find asset turnover?
(net sales)/(average total assets)
- Indicates whether a company is generating enough revenue for the size of its asset investment
What ratios are involved in profitability analysis?
Shows effects of liquidity, asset management and debt on operating results
- Profit margin on sales
- Financial leverage
- Return on Equity
- Return on assets
What does profit margin on sales show us?
Profit margin on sales = Net income / net sales
How do you calculate Financial leverage ratio?
Financial Leverage = Average total assets / Average equity
What’s Dupont Identity?
(Profit margin) x (Asset turnover) x (Financial leverage)
(Net income/sales)·(Sales/Assets)·(Assets/Average shareholder equity)
= (Net income/Average shareholder’s equity)
(ROE = return on equity)
What is Return on Equity?
- It measures a company’s profitability
- Reveals how much profit a company generates with the money invested by shareholders
ROE = Net income / Average shareholder’s equity
What is Return on Assets
ROA = Net income / Average total assets
Measures a company’s success in using its assets to earn a profit
What are the Debt Management ratios?
- Debt to Equity ratio
2. Times-interest-earned ratio
How do you find Debt to Equity Ratio?
Debt ratio = (total debt)/(equity)
- Shows how much liability exists for every dollar of owner’s equity
How do you find times-interest-earned ratio?
Times-interest-earned = (EBIT) / (interest charges)
*EBIT = operating income, which is income before interest and taxes
The margin of protection for the creditors.
How do you find the current ratio?
Current ratio = current assets / current liabilities
How do you find the price to earnings (P/E) ratio?
P/E = Price per share / EPS
EPS is the earnings per share.
EPS = (Net income - preferred stock dividends) / Common shares outstanding
