FA 6 - Analyzing Financial Statements

Question 1

Return on Equity

Answer 1

ROE = Net Income/ Owners’ Equity

Question 2

The DuPont Framework

Answer 2

ROE = Profitability (Profit Margin) X Efficiency (Asset Turnover) X Leverage (Leverage)

Question 3

Profit Margin and Gross Profit Margin

Answer 3

Profit Margin = Net Income/ Sales

Gross Profit Margin = Gross Profit/ Sales
Gross Profit = Revenue - COGS

Question 4

EBIAT

Answer 4

Earnings Before Interest After Taxes
Measure of how much income the business has generated while ignoring the effect of financing and capital - i.e. the proportion of debt that a business has.

Question 5

Inventory Turnover and Days Inventory

Answer 5

Inventory Turnover = COGS/ Average Inventory
how efficiently business is managing its inventory levels; higher => more efficient.

Days Inventory = 365/ Inventory Turnover
Average number of days the inventory is held before it is sold.

Question 6

Accounts Receivable Turnover and Average Collection Period

Answer 6

Accounts Receivable Turnover = Credit Sales/ Average Accounts Receivable
business’ efficiency in collecting receivables from customers; higher => more efficient.

Average Collection Period = 365/ AR Turnover
a.k.a. Days Sales Outstanding or Days Sales in Receivables.
Average number of days it took for a business to collect payment from a customer

Question 7

Accounts Payable Turnover and Days Purchases Outstanding

Answer 7

Accounts Payable Turnover = Credit Purchases (or COGS)/ Average Accounts Payable
how long it takes a business to pay its vendors

Days Purchases Outstanding = 365/ AP Turnover

Question 8

Cash Conversion Cycle

Answer 8

Measure of how long it takes a business from the time it has to pay for inventory from its suppliers until it collects cash from its customers.

Cash Conversion Cycle =
Days Inventory + Average Collection Period - Days Purchases Outstanding

Question 9

Leverage ratio and Debt to Equity

Answer 9

Equity Multiplier = Average Total Assets/ Average Total Equity
If all debts are financed by equity, multiplier is 1. As liabilities increase, multiplier increases.

Debt to Equity = Average Total Liabilities/ Average Total Equity

Higher leverage implies higher potential returns; higher risk; higher impact of potential losses.

Question 10

Current and Quick Ratios

Answer 10

Current Ratio = Current Assets/ Current Liabilities
business’ ability to pay its short term obligations

Quick Ratio = (Current Assets - Inventory)/ Current Liabilities
highly liquid assets; a.k.a. acid test ratio

Question 11

Interest Coverage Ratio

Answer 11

Interest Coverage Ratio = EBIT/ Interest Expense
a.k.a. Times Interest Earned
Earnings Before Interest and Taxes = Net Income + Interest Expense + Tax Expense

this is a good measure of how capable a business is of making the interest payments of its debt - i.e. it tells us the number of times over that a company can cover its interest expense using its EBIT.

Question 12

Seasonality

Answer 12

can cause repeating fluctuations

this can be seen when comparing statements from several smaller periods rather than for the whole year

Question 13

Ratios are useful for comparison because

Answer 13

eliminate the impact of size difference

but influenced by managerial judgment

Question 14

Typical policy differences

Answer 14

• how revenue is recognized;
• capitalizing expenditures; and
• depreciation.

Question 15

Common Size Balance Sheet

Answer 15

For comparison and to see trends:

i. divide each number in balance sheet by total assets; and
ii. divide each number in income statement by sales.