Module 2 Chapter 4: Financial Statements & Ratio Analysis

Liquidity, Asset Management, Debt Management, Profitability, Market Value

Ratios that assess the financial performance of the business

Liquidity Ratios

Can the firm meet the required payments as they fall due? These ratios give an idea of a firm’s ability to pay off debts that are maturing within a year.

Current Assets - Current Liabilities

Net Working Capital

Current Assets - Accounts Payables - Accruals

Net Operating Working Capital

Current Assets / Current Liabilities

Current Ratio

(Cash + Accounts Receivables) / Current Liabilities

Acid-Test or Quick Ratio

Accounts Receivable / (Credit Sales / 365)

Average Collection Period

Annual Credit Sales / Accounts Receivables

Accounts Receivable (A/R) Turnover

Cost of Goods Sold / Average Inventory

Inventory Turnover

Asset Management Ratios

Does the firm manage its assets efficiently to generate enough sales? These ratios give an idea of the firm’s operating efficiency or how well the firm is using its assets.

EBIT / Total Assets

Basic Earning Power (BEP) Ratio or Operating Return on Assets (OROA)

Operating Profit / Sales

Operating Profit Margin

Sales / Total Assets

Total Asset Turnover

Sales / Net Fixed Assets

Fixed Asset Turnover

Annual Credit Sales / Accounts Receivables

Accounts Receivable (A/R) Turnover

Sales / Average Inventory

Inventory Turnover

Receivables / (Annual Sales / 365)

Day Sales Outstanding

Debt Management Ratios

Does the firm finance its assets with the right mix of debt and equity? These ratios give an idea of how the firm has financed its assets as well as the firm’s ability to repay its long-term debt.

Total Debt / Total Equity

Debt / Equity Ratio

Debt Ratio / (1 - Debt Ratio)

Debt / Equity Ratio

Total Debt / Total Assets

Debt Ratio

Debt Equity Ratio / (1 + Debt Equity Ratio)

Debt Ratio

Operating Profits / Interest Expense

Times Interest Earned

Profitability Ratios

Are the firm’s managers providing good returns on shareholders’ capital? Do sales prices exceed unit costs, and are sales high enough as reflected in PM, ROE, and ROA? These ratios give an idea of how profitably the firm is operating and utilizing its assets.

Net Income / Common Equity

Return on Equity

Net Income / Total Assets

Return on Total Assets

Market Value Ratios

Are the firm’s managers creating shareholders’ value? Do investors like what they see as reflected in P/E and M/B ratios? These ratios give an idea of what investors think about the firm and its future prospects based on its stock price.

Common Shares + Preferred Shares

Number of Outstanding Shares

Net Income / Number of Outstanding Common Shares

Earnings per Share

Total Dividends Declared / Number of Outstanding Shares

Dividends per Share

Common Equity / Number of Outstanding Common Shares

Book Value per Share

Market Value of Equity - Equity Capital Supplied

Market Value Added Equation

Market Price per Share / Earnings per Share

Price / Earnings (P/E) Ratio

Market Price per Share / Equity Book Value per Share

Price / Book (P/BV) Ratio

[EBIT/Total Assets - ((Common Equity × Opportunity Rate) + (Total Debt × Interest Rate)) / Total Assets] × Total Assets

Economic Value Added Equation

EBIT (1 - T)

Net Operating Profit After Tax (NOPAT)

EBIT (1 - T) + Depreciation - (Capital Expenditures + Increase in Net Operating Working Capital)

Free Cash Flows (FCF)

(Net Income / Sales) × (Sales / Total Assets ) × (Total Assets / Total Common Equity)

Return on Equity (ROE)

[(EBIT / Sales) × (Sales / Invested Capital)] × [(Invested Capital / Owner’s Equity) + (EBT / EBIT)] × (EAT / EBT)

Return on Equity (ROE)

Annual Report

issued annually by a firm to its shareholders, which contains the management’s analysis of the firm’s past operations and future prospects as well as the following basic financial statements

Balance Sheet

provides a snapshot of a firm’s financial position at one point in time

Income Statement

summarizes a firm’s revenues and expenses over a given period of time; also known as Profit and Loss (P&L) Statement

Statement of Retained Earnings

shows how much of the firm’s earnings were retained, rather than paid out as dividends

Statement of Cash Flows

reports the impact of a firm’s activities on cash flows over a given period of time

Balance Sheet

• Shows a firm’s assets, liabilities, and shareholder’s equity, using the actual cost of acquiring them, at a given point in time

• Shows what assets the firm owns and who has claims on those assets as of a given date

Accounting Book Value

value of an asset as shown in the balance sheet; it represents the historical cost of the asset rather than current market value or replacement cost

Balance Sheet Equation

Total Assets = Total Liabilities + Total Shareholder’s Equity

Total Resources of the firm = How it was financed by Debt or Capital

Capital Supplied

Debt and Stock

Balance Sheet

Assets: current (short-term), fixed (long-term), other

Liabilities: current, long-term

Shareholders’ equity

Cash Flow

Sell equity/Issue debt

Buy assets/Buy inventory

Make sales, Pay costs/Pay taxes

Pay interest/Pay dividends

Retain vs. Return

Profits or debt-holders (with interest) and stockholders (with dividends)

Current Assets

Cash, A/R, Inventories, Prepaid Expenses

Current Assets

called Gross Working Capital because these assets “turnover” (used & replaced within a year)

Cash

refers to Cash on hand, demand deposits, short-term marketable securities that can be quickly converted into cash

A/R

money owed by customers who purchased goods & services on credit

Inventories

raw materials, work in progress, and finished goods held for eventual sale

Other Current Assets

items such as prepaid expenses

Long-Term Fixed Assets

PPE, Land, Long-Term Investments, Intangible Assets (Patents, Copyrights, Trademarks, Goodwill)

Fixed Assets

will be used over a number of years; Purchase cost are booked as assets and are not considered expenses in Income Statement

Depreciation Expense

a non-cash expense (found in Income Statement) to allocate the cost of depreciable assets, such as machinery and equipment, over the asset’s expected useful life

Accumulated Depreciation

sum of all depreciation taken over the entire life of a depreciable asset (found in Balance Sheet)

Gross Fixed Assets

reflect the original cost of fixed assets

Net Fixed Assets

Gross Fixed Assets minus Accumulated Depreciation taken over life of the assets

Current Liabilities

A/P, Accrued Expenses, Short-Term Debt (Notes Payable)

Liabilities (Debt)

money that was borrowed and must be repaid at a predetermined date

Current Liabilities

borrowed money that must be repaid within 12 months

A/P or Trade Credit

the credit suppliers have extended when materials or inventories were purchased and will be paid within 30, 60, and 90 days

Accrued Expenses

unpaid short-term liabilities incurred during the firm’s operations

Short-Term Notes

borrowings from banks or other FIs that are due and payable within 12 months

Long-Term Liabilities

Long-Term Loans, Corporate Bonds, Mortgages

Long-Term Liabilities

borrowed money from banks or other financial institutions that must be repaid longer than 12 months

Corporate Bonds

borrowings of the firm through issuance of its own securities with medium to long-term maturities

Mortgages

loan to finance real estate where the lender has first claim on the property in the event the borrower is unable to repay the loan

Shareholders’ Equity

Par Value of Common Stocks, Paid-In Capital, Retained Earnings

includes both preferred and common shareholders’ investment in the firm

Preferred Stockholders

stockholders that have claims on the firm’s income and assets after creditors, but before common stockholders; Receives dividends that are fixed in amount

Common Stockholders

investors who own the firm’s common stocks; also known as residual owners of the firm

Common Stocks

the amount the firm receives after selling the stocks, which represent ownership in a corporation

Par Value

the arbitrary value a firm puts on each share of stock prior to its being offered for sale

Additional Paid-In Capital

the amount the firm receives from selling stock to investors above par value

Treasury Stock

firm’s stock that has been issued and repurchased by the firm

Retained Earnings

cumulative profits retained in business up to the date of the balance sheet

Income Statement

• Shows the firm’s sales and costs over a given time period

• Known also as Profit & Loss (P&L) Statement; indicates the amount of profits generated by a firm, which is calculated on an accrual basis

Income Statement Equation

Sales - Expenses = Profits

Sales or Revenues (Paid in Cash, Paid thru Credit, Sold on Installment, Deferred Sales) - Cost of Goods Sold = Gross Profits

Gross Profit Equation

Revenues

Total Sales Pesos equals Selling Price X Units Sold, whether sold in cash, thru credit, on installment or deferred

Cost of Goods Sold

the cost of producing or acquiring a product or service to be sold in the ordinary course of business

Gross Profits

Sales or Revenues minus Cost of Goods Sold

Gross Profits - Operating Expenses (Marketing & Selling Expenses, General & Administrative Expenses) = Earnings Before Interest, Taxes, Depreciation & Amortization) - Depreciation Expenses - Amortization Expenses = Operating Income or Operating Profits or Earnings Before Interest

Operating Income/Operating Profit/Earnings Before Interest and Taxes Formula

Marketing & Selling Expenses

the (variable) cost of promoting and distributing the firm’s products or services to customers

General & Administrative Expenses

the firm’s overhead (fixed) expenses, such as salaries and rent

Depreciation Expense

a noncash expense to allocate the cost of depreciable assets, such as plant & equipment, over the life of the asset

Amortization Expense

a noncash expense to allocate the cost of the intangible assets, such as copyrights, over the life of the asset

Operating Income - Financing Cost (Interest Expenses, Preferred Dividends) = Taxable Income or Earnings Before Taxes

Taxable Income / EBT Formula

Operating Income

also called earnings before interest & taxes (EBIT); the result of management’s decisions relating only to the operations of the business

Financing Cost

interest expenses resulting from the use of debt to finance operations and, if the firm issued preferred stocks, includes also preferred dividends

Taxable Income

Operating Income minus Financing Cost; also called earnings before taxes (EBT)

Taxable Income - Income Tax = Net Income

Net Income Formula

Taxable Income

Operating Income minus Financing Cost; also called earnings before taxes (EBT)

Income Tax

computed based on earnings before taxes (EBT) and the applicable tax rate for the amount of income reported

Net Income

earnings available to common stockholders, which represents income that may be reinvested in the firm or distributed to its owners, provided that there is available cash to do so