L9- -Financial Analysis

Question 1

What are the 4 types of Ratios

Answer 1

–Liquidity Ratios
–Solvency Ratios
–Activity ratios
–Profitability ratios

Question 2

Define Liquidity Ratios

Answer 2

They measure the firm’s ability to meet current obligations

Question 3

Define Solvency Ratios

Answer 3

These ratios show the proportion of debt and equity in financing the firm’s assets

Question 4

Define Activity Ratios

Answer 4

They reflect the firm’s efficiency in utilising the assets

Question 5

Define Profitability Ratios

Answer 5

These ratios measure overall performance & effectiveness of the firm

Question 6

What’s on the balance sheet

Answer 6

Assets and Liabilities

Question 7

What’s on the income statement

Answer 7

Income and Costs

Question 8

Net working capital Equation

Answer 8

CAs – CLs (a rough measure of the firm’s cash holdings)

Question 9

EBIT (Earnings Before Interest and Taxes) Equation

Answer 9

Total revenues –Costs – Depreciation (a rough measure of profitability)

Question 10

What does Market-to-Book measure

Answer 10

–Measure of how much value has been added per unit of capital that has been invested
–Measure of the value of growth opportunities

Question 11

Market-to-book equation

Answer 11

Market value of equity/Book value of equity

Question 12

Define Economic Value Added (EVA)

Answer 12

–Measures how much value a company creates beyond its cost of capital.
–A positive EVA means the firm generates returns above the cost of capital, creating shareholder value.

Question 13

EVA equation

Answer 13

= (After tax interest + Net income) – (Cost of capital * Total Capital)

Question 14

EVA Alternative Equation

Answer 14

= (Return on capital – Cost of capital) * Total Capital

Question 15

Return on capital equation

Answer 15

(After-tax interest + Net income)/Total capital

Question 16

Return on Equity equation

Answer 16

Net income/Equity

Question 17

Return on assets equation

Answer 17

(After-tax interest + Net income)/Total assets

Question 18

Total assets equation

Answer 18

Total capital + Current liabilities

Question 19

Measures for performance

Answer 19

–Market-to-Book
–Economic Value Added
–Return on capital
–Return on equity
–Return on assets

They reveal how effectively a company utilizes its resources (equity, assets) to generate profits

Question 20

Asset turnover equation

Answer 20

Sales/Total assets at the start of the year (a
measure of sales generated per unit of total assets)

Question 21

Inventory turnover equation

Answer 21

= Cost of goods sold/Inventory at the start
of the year

Question 22

Receivables turnover equation

Answer 22

Sales/Receivables at the start of the
year

Question 23

Measures for efficiency

Answer 23

–Asset turnover
–Inventory turnover
–Receivables turnover

Higher turnover ratios generally indicate better utilization of assets in generating sales.

Question 24

What is the Du Pont System and why is it useful?

Answer 24

The Du Pont System breaks down Return on Assets (ROA) into two components:
–Asset Turnover – Efficiency in using assets.
–Operating Profit Margin – Profitability from operations.

Helps identify whether profitability comes from asset efficiency or high margins.

Question 25

What is the formula for Asset Turnover and what does it measure?

Answer 25

Sales/Total assets at the start of the year --Measures how efficiently a company uses its assets to generate sales. --Higher Asset Turnover → More efficient use of assets.

Question 26

What is the formula for Operating Profit Margin and what does it measure?

Answer 26

(After-tax interest+Net income)/Sales --Measures profitability from operations (correcting for leverage). --Higher margin → More profitable sales

Question 27

What are the 2 Return on Assets formula

Answer 27

--Asset Turnover × Operating Profit Margin --(After-tax interest+Net income) / Total assets

Question 28

How can a company improve Return on Assets

Answer 28

--Increasing Asset Turnover (better efficiency). --Increasing Operating Profit Margin (better profitability).

Question 29

What is Leverage and why is it important?

Answer 29

--Leverage refers to a company's use of debt to finance its assets. --Helps assess financial risk and ability to meet interest obligations. --Higher leverage can lead to higher returns, but also higher financial risk.

Question 30

What is the Long-term Debt Ratio, and what does it measure?

Answer 30

=LT Debt/ (LT Debt + Equity) --Measures the proportion of long-term financing that comes from debt. --Higher ratio = More reliance on long-term debt.

Question 31

What is the Total Debt Ratio, and what does it indicate?

Answer 31

=Total liabilities/Total assets --Measures the percentage of assets financed by debt. --Higher ratio = More financial risk.

Question 32

What is Times-Interest-Earned (TIE), and why is it important?

Answer 32

=EBIT/Interest payments --Measures how many times a company can cover its interest expenses with EBIT --Higher TIE = More financial stability. --Lower TIE (<1) = Possible risk of default.

Question 33

What is the Cash-Coverage Ratio, and what does it measure?

Answer 33

=(EBIT + Depreciation)/Interest Payments --Measures how well a company can cover its interest payments using EBIT plus depreciation. --Higher ratio = Better ability to handle interest obligations.

Question 34

How does Leverage affect Return on Equity (ROE)?

Answer 34

ROE= (Assets/Equity) × (Sales/Assets) × (OP Margin) × (Debt Burden Measure) --Higher leverage (Assets/Equity) increases ROE but also risk. --A company can increase ROE by: -------Using more debt (higher leverage). -------Improving asset efficiency (higher asset turnover). -------Increasing profit margins.

Question 35

What is Liquidity, and why is it important?

Answer 35

Liquidity offers insights into a company's short-term solvency --They show the company's ability to meet short-term obligations using its most liquid assets. --Higher liquidity = Lower financial risk in the short term.8

Question 36

What is the Current Ratio, and what does it measure?

Answer 36

=Current Assets/Current Liabilities --Measures a company’s ability to pay short-term liabilities using all current assets. --Higher ratio (>1) = Better liquidity. --Very high ratio may indicate inefficient use of assets.

Question 37

What is the Quick Ratio (Acid-Test Ratio), and why is it useful?

Answer 37

=Cash + Marketable Securities + Receivables/Current liabilities --Measures liquidity without relying on inventory, which may take longer to convert into cash. --Higher ratio = Better ability to quickly pay off short-term liabilities.

Question 38

What is the Cash Ratio, and when is it used?

Answer 38

=Cash + Marketable Securities/Current Liabilities --Most conservative liquidity measure—only considers cash and near-cash assets. --Used in stress testing to see if a company can immediately cover its short-term debts.

Question 39

What is Tracking Trends

Answer 39

Compare a company's ratios over time to identify improvements or deteriorations in performance

Question 40

What is Benchmarking

Answer 40

Compare a company's ratios to industry averages or competitors to assess relative performance.

Question 41

Why are financial ratios useful for asking the right questions about a company?

Answer 41

Ratios often highlight areas that require further investigation, guiding deeper analysis.

Question 42

Are financial ratios are more effective when used in comparison

Answer 42

Yes

Question 43

What are Industry-Specific Variations

Answer 43

Ratios can vary significantly across industries, so comparisons should be made within the same industry

Question 44

Is there international standard for financial ratios

Answer 44

NO