Chapter 4 Lecture Notes

Question 1

Current Ratio

Answer 1

Current Assets/Current Liabilities

Question 2

Quick (Acid Test) Ratio

Answer 2

Current Assets-Inventories/Current Liabilities

Question 3

What is the benefit of using the quick ratio?

Answer 3

Inventory makes it hard to cover costs

Question 4

What are current assets?

Answer 4

Cash, marketable securities, inventory, accounts receivable

Question 5

Inventory Turnover

Answer 5

Sales/Inventory

Question 6

Fixed Assets Turnover

Answer 6

Sales/Net Fixed Assets

Question 7

Total Assets Turnover

Answer 7

Sales/Total Assets

Question 8

DSO (Days Sales Outstanding)

Answer 8

Accounts Receivable/Average Sales Per Day

Question 9

How do you tighten up a bad DSO?

Answer 9

Discount for early payment, and penalty for late payment

Question 10

Debt Ratio

Answer 10

Debt/Assets-(Accounts Payable+Accruals)

Question 11

What equation represents “invested capital”?

Answer 11

Assets-(Accounts Payable+Accruals)

Question 12

What equation shows a company’s capital structure?

Answer 12

Debt Ratio

Question 13

Times-Interest-Earned (TIE)

Answer 13

EBIT/Interest

Question 14

Profit Margin

Answer 14

Net Income/Sales

Question 15

What does profit margin show?

Answer 15

Return on Sales

expense management ratio

Question 16

Basic Earning Power (BEP) Ratio

Answer 16

EBIT/Total Assets

Question 17

What does the BEP Ratio show?

Answer 17

How well you are getting a product out there

Question 18

Return on Assets (ROA)

Answer 18

Net Income/Total Assets

Question 19

Return on Common Equity

Answer 19

Net Income/Common Equity

Question 20

Return on “Invested Capital”

Answer 20

EBIT(1-T)/Invested Capital

Question 21

How does debt in the capital structure affect ROA and ROE?

Answer 21

Equity decreases, Debt increases, and ROE increases

YOU DO NOT WANT TO MAXIMIZE ROE (this requires a lot of debt)

Question 22

Price per Earnings

Answer 22

Price per Share/Earnings per Share

Question 23

Earnings per Share

Answer 23

Net Income/# of Shares Outstanding

Question 24

PEG

Answer 24

Price per Earnings/5-yr EPS Growth Rate

Question 25

Price/Cash Flow

Answer 25

Price per Share/Cash Flow per Share

Question 26

Cash Flow per Share

Answer 26

(Net Income+Depreciation+Amortization)/# of Shares Outstanding

Question 27

Market/Book Ratio

Answer 27

Price per Share/Book Value per Share

Question 28

Book Value per Share

Answer 28

Common Equity/# of Shares Outstanding

Question 29

What is the general rule for PEG?

Answer 29

Price/Earnings should approximately equal growth rate (should be about one)

Question 30

What is the specific rule for PEG?

Answer 30

PEG for the company should approximately equal the PEG of the industry

Question 31

Du Pont Equation

Answer 31

ROA=Net Income/Total Assets

Question 32

Extended Du Pont Equation

Answer 32

(profit margin)(total assets turnover)(equity multiplier)

Question 33

What are limitations of Ratio Analysis?

Answer 33

1. Difficult to use for diversified companies 2. Average performance is not the goal 3. Inflation may distort 4. Distortion may occur due to seasonality 5. Accuracy can be affected by "window dressing" techniques 6. Different accounting practices 7. Difficult to make definite conclusions 8. Overall company health is difficult to generalize

Question 34

What are weaknesses of ROE?

Answer 34

1. Does not consider risk 2. Size of mutually exclusive projects are not considered (higher ROE may add less value) 3. Bonus determined by ROE can lead to corruption