Chapter 3: Working with Financial Statements

Flashcards generated from lecture notes on financial statement analysis.

Sources of cash

Activities that result in an inflow of cash into the company, such as collecting payments from customers or selling assets.

Uses of cash

Activities where a company spends cash, such as paying for inventory, salaries, or capital expenditures.

Statement of cash flows

A financial statement that summarizes the total movement of cash both into and out of a company over a defined period of time.

Three categories of cash flow activities

The statement of cash flows is divided into three main activities: Cash from day-to-day operations (Operating), buying and selling long-term assets (Investment), and raising capital (Financing).

Common-size statements

Financial statements where each line item is expressed as a percentage of a common base, which helps in comparing companies of different sizes.

Common-size balance sheets

A balance sheet where each asset, liability, and equity item is shown as a percentage of total assets, facilitating comparison across different periods or companies.

Common-size income statements

An income statement where each item is listed as a percentage of total sales, providing insight into the relative importance of each cost and profit item.

Common-base year statements

Financial statements that show each item relative to its value in a chosen base year, making it easier to spot trends over time.

Financial ratios

Calculations using values from a company's financial statements that provide indicators into a company's performance, efficiency and finanacial health, used for analysis and comparison.

Five categories of financial ratios

Financial ratios can be grouped into five main areas: the company's ability to meet short term obligations (Short-term solvency), the company's ability to meet long term obligations (Long-term solvency), how efficiently the company uses its assets (Asset management), how well the company generates profits (Profitability), and how investors view the company's value (Market value ratios).

Current ratio

Calculated by dividing current assets by current liabilities; it indicates whether a firm has enough short-term assets to cover its short-term debt.

Quick (or acid-test) ratio

Similar to the current ratio, but excludes inventory from current assets, providing a more conservative measure of liquidity by focusing on the most liquid assets.

Total debt ratio

Calculated as total debt divided by total assets; it measures the proportion of a firm’s assets that are financed by debt.

Times interest earned (TIE) ratio

Calculated by dividing earnings before interest and taxes (EBIT) by interest expense; it indicates how easily a firm can pay its interest expenses from its operating income.

Cash coverage ratio

Calculated as (EBIT + Depreciation) / Interest Expense; it is a more comprehensive measure of a firm’s ability to handle its interest obligations using its cash flow.

Inventory turnover

Calculated by dividing the cost of goods sold by the average inventory; it measures how many times a company has sold and replaced its inventory during a period.

Receivables turnover

Calculated by dividing annual sales by accounts receivable; it measures how efficiently a firm uses its credit policy by measuring how many times a firm collects outstanding credit accounts and reloans the money.

Profit margin

Calculated as net income divided by sales; it shows the percentage of revenue that turns into profit after all expenses, including taxes, are paid.

Return on assets (ROA)

Calculated by dividing net income by total assets; it measures how much profit a company generates for each dollar of assets.

Return on equity (ROE)

Calculated by dividing net income by total equity; it measures the stockholders' return for their investment in the company.

Price-earnings (PE) ratio

Calculated by dividing the price per share by the earnings per share (EPS); it shows how much investors are willing to pay for each dollar of a company’s earnings.

Market-to-book ratio

Calculated by dividing the market value per share by the book value per share; it compares the market’s valuation of a company to its historical cost.

Tobin’s Q ratio

Calculated as the market value of a company’s assets divided by the replacement cost of its assets; it assesses whether a company’s stock is over- or under-valued.

DuPont identity

A formula that breaks down ROE into three components: profit margin, total asset turnover, and equity multiplier, providing a detailed view of the factors driving a company’s return on equity.

Time trend analysis

Evaluating a company’s performance metrics over a historical period to identify patterns and changes, using the company’s own history as the benchmark.

Peer group analysis

Comparing a company’s financial ratios and performance against similar companies in the same industry or sector.

Standard industrial classification (SIC) codes

A system developed by the U.S. government to classify companies based on their primary business activities, used in peer group analysis.