Chapter 6: 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:
NetIncome+InterestExpenseNetofIncome TaxSavings
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 Total Assets
For ROA Ratio Turnover Ratio.
OR
Net Income + Net Income +
Interest Expense Interest Expense
Net of Income Net of Income
Tax Savings = Tax Savings x Sales______
Average Total Assets 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 sales and the investment in fixed assets. 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 that 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 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:
NetIncome-DividendsonPreferredStock.
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.
18. The analyst can disaggregate the rate of return on common shareholders' equity as follows:
Rate of Return Profit Margin
on Common Ratio for ROCE Total Assets Capital
Shareholders' = (after Interest x Turnover x Structure
Equity Expense and Ratio Leverage
Dividends) Preferred Dividend) Ratio
OR
Net Income - Net Income -
Dividends on Dividends on Average
Preferred Stock = Preferred Stock x Sales x Total Assets
Average Common Sales Average Average Common Total Assets Shareholders’
Shareholders’ Equity
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:
NetIncome-PreferredStockDividends
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:
MarketPriceperShare
Earnings per Share
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.
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 total assets) and the debt-equity ratio (which equals total liabilities divided by total shareholders’ equity) 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:
CashFlowfromOperations.
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 net 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.