Financial Statement Analysis Midterm Stanton/Stevens

Current Ratio

• A liquidity ratio measures a company's ability to pay short-term obligations with current assets.

• Formula: Current Assets ÷ Current Liabilities

• Meaning: Can the company pay short-term bills?

Good Range:

• 1.5 – 2.0 = Good

• Low → Risky ⚠

• High → Safe but maybe inefficient

• Management: can they maintain it, Make sure the company keeps enough working capital to pay bills while still using assets efficiently.

Quick Ratio

• A liquidity ratio that measures a company's ability to meet its short-term obligations with its most liquid assets.

• Formula: (Current Assets − Inventory) ÷ Current Liabilities

• Meaning: Can the company pay short-term bills without selling inventory?

Good: 1.0 or higher 👍

• indicating a company can pay its short-term liabilities using only its most liquid assets (cash, marketable securities, receivables).
  Bad/Risky: Below 1.0, suggesting potential difficulty covering immediate debts.

• More restrictive than the current ratio, and it backs out inventory since we can’t sell all the inventory very quickly.

Cash Ratio

• A liquidity measure that indicates a company's ability to cover its short-term liabilities with cash and cash equivalents.

• Formula: Cash ÷ Current Liabilities

• Meaning: Can the company pay short-term bills using only cash?

Good: 0.5 – 1.0 👍, indicating a company can comfortably cover 50% to 100% of its short-term debt with cash on hand.
Low (<0.5): Risky ⚠
High (>1.0): Too much unused cash may show high liquidity but suggest inefficient cash management.

Total Debt Ratio

• A solvency ratio that indicates the proportion of a company's assets that are financed by debt.

• Creditors: How much debt do you have compared to assets? How risky is it to lend (is the company highly leveraged?)

• Management: Helps plan the capital structure (debt vs. equity)

• Government/Regulators: May set limits on leverage

• Formula: Total Liabilities ÷ Total Assets

• Meaning: How much of the company’s assets are paid for with debt

High ratio: More debt/leverage → more risk ⚠
Low ratio: Less debt → safer for creditors 👍

Debt-Equity Ratio

• A measure of a company's financial leverage calculated by dividing its total liabilities by shareholders' equity.

• Formula: Total Liabilities ÷ Shareholders’ Equity

• Meaning: Compares debt vs. owner investment

Why it matters:

• Management: Helps decide debt vs. equity financing leverage

• Creditors: High ratio = more debt, more risk

Quick meaning:

• > 1 → More debt than equity (creditors have more at stake) ⚠ higher risk

• < 1 → More owner investment, less risk 👍

• lower = better

Equity Multiplier

• A financial leverage ratio that measures the total assets owned by a company per dollar of shareholders' equity.

• Formula: Total Assets ÷ Total Equity
  (or 1 + Debt-to-Equity Ratio)

• Meaning: How many $ of assets a company has for every $1 of equity

Why it matters:

• Management: Helps plan capital structure

• Creditors: Rising ratio = more reliance on debt

Quick meaning:

• Higher ratio → More debt (higher risk) ⚠

• Lower ratio → Less debt (safer) 👍

Times Interest Earned (TIE)

• A measure of a company's ability to meet its debt obligations; calculated by dividing earnings before interest and taxes (EBIT) by interest expense.

• Formula: EBIT ÷ Interest Expense

• Meaning: How many times earnings can pay interest

Ranges:

• <1.5× → Risky ⚠

• 2–3× → Good 👍

• >3× → Strong 💪

Why it matters:

• Investors: Can they pay interest expense with what they earn?

• Creditors: Loan covenant check

• Management: Debt safety margin

Cash Coverage Ratio

• A measure that assesses a company’s ability to pay interest on outstanding debt using cash flow.

• Why it matters:

• Management - better than TIE for cash planning purposes b/c D&A are non-cash expenses

  • Creditors - prefer this vs TIE when D&A are particularly high (think capital intensive businesses)

• "better" version of TIE - adds back D&A to calculate actual cash available for interest; could be more relevant for capital-intensive industries

• Formula: (EBIT + Depreciation + Amortization) ÷ Interest Expense

• Meaning: How many times cash flow can pay interest

Quick meaning:

• Higher ratio → Easier to pay interest 👍

• Lower ratio → Higher risk ⚠

Debt/EBITDA

• How many years of EBITDA would it take us to pay back our debt?

• Formula: Total Debt ÷ EBITDA

• Meaning: How many years of earnings it would take to pay off debt

Why it matters:

• Creditors: Common loan covenant metric

• Management: Tracks leverage targets standard leverage target metric

Quick meaning:

• Higher ratio → More debt, more risk ⚠

• Lower ratio → Less debt, safer 👍

Inventory Turnover

• A ratio that measures how many times a company's inventory is sold and replaced over a period.

• Formula: COGS ÷ Avg. Inventory

• Meaning: How many times the inventory is sold in a period

Quick meaning:

• Higher → More efficient 👍

• Lower/declining → Possible problem ⚠

Why it matters:

• Investors: Shows business efficiency

• Management: Helps with purchasing & sales decisions

Days in Inventory

• Formula: 365 ÷ Inventory Turnover

• Meaning: Average days inventory sits before being sold

Quick meaning:

• Lower → Better 👍

• Higher/rising → Slower sales ⚠

Why it matters:

• Investors: Rising DII may signal falling sales

• Management: Helps guide purchasing & sales

Receivables Turnover

• A measure of how efficiently a company uses its assets; it calculates how many times a company collects its average accounts receivable in a period

• how efficiently is the company collecting on credit sales; higher = better (faster collection)

• Formula: Sales ÷ Avg. Receivables

• Meaning: How fast a company collects money from customers

Quick meaning:

• Higher → Faster collection 👍

• Lower → Slow collection or credit risk ⚠

Why it matters:

• investors: Shows sales quality & credit risk if this decreases or is low, indicates to investors either customer credit risk or decreasing sales quality

• Management: Helps set credit policies

Days Sales Outstanding (DSO)

• The average number of days that it takes a company to collect payment after a sale has been made.

• Formula: 365 ÷ Receivables Turnover

• Meaning: Average days to collect cash from customers

Quick meaning:

• Lower → Faster collection 👍

• Higher/rising → Collection issues ⚠

Why it matters:

• Investors & Management: Rising DSO may signal collection problems

Total Asset Turnover

• A ratio that measures the efficiency of a company's use of its assets in generating sales revenue.

• Formula: Sales ÷ Avg. Total Assets

• Meaning: How much revenue is generated per $1 of assets

Quick meaning:

• Higher → More efficient 👍 good measure of asset efficiency

• Lower → Less efficient ⚠

Why it matters:

• Investors & Management: Measures asset productivity of asset base

Fixed Asset Turnover

• Formula: Sales ÷ Avg. Fixed Assets

• Meaning: Revenue per $ of PP&E

• Key Idea: Higher = more efficient (important for capital-intensive firms)

Gross Profit Margin

• A profitability ratio that shows the percentage of revenue that exceeds the cost of goods sold.

• Investors - good indicators of efficiency

  Mgmt - measuring our product costs, how can we control this?

• Formula: Gross Profit ÷ Sales

• Meaning: % of revenue left after COGS

• Key Idea: Higher = better product cost control

Operating Profit Margin

• Mgmt - core ratio bc it includes most other costs (SG&A)

  Investors - covers the cost structure

• Formula: Operating Profit or EBIT ÷ Sales

• Meaning: Profit after operating costs (like SG&A)

• Key Idea: Shows core business profitability

Profit Margin

• Investors/mgmt - bottom line return of revenue; overall profitability

• Formula: Net Income ÷ Sales

• Meaning: Bottom-line profit per $ of sales

• Key Idea: Higher = more profitable company

ROA (Return On Assets)

• Investors/Mgmt - measure of efficiency of asset base; how does the company use its assets to make money?

• net income per $ of assets - measure of profitability and efficiency; higher = better

• Formula: Net Income ÷ Total Assets

• Meaning: Profit per $ of assets

• Key Idea: Measures asset efficiency

Basic Earning Power

• Formula: EBIT ÷ Total Assets

• Meaning: Asset profitability before financing effects

• Key Idea: Good for comparing competiton

• Investors/mgmt - great for competitor analysis; mgmt uses to measure performance exclusive of financing

• higher = better due to higher productivity

ROE (Return on Equity)

• Investors/mgmt - primary equity return metrics; can get skewed if company is highly leveraged

• how much net income is generated from equity

• Formula: Net Income ÷ Total Equity

• Meaning: Profit per $ of shareholder equity

• Key Idea: Main investor return metric

how much profit a company generates with the money shareholders have invested. Generally, a higher is better, as it indicates more efficient management.

Dupont ROE

• ROE = Profit Margin x Asset Turnover x Equity Multiplier

Investors- helps to distiguish high quality

Mgmt - good ratio to target operational and standard improvements

• Meaning: Shows if ROE comes from:

  • Profitability

  • Efficiency

  • Leverage

In summary, a high, consistent ROE driven by operations (high margin/turnover) is ideal, while a high ROE based heavily on debt is a red flag for high risk.

Return on Investment Capital (ROIC)

ROIC = [EBIT*(1-T)]/(BV of Equity + Debt) or = (EBIT*(1-T))/(Total Assets)

• Meaning: Return earned on all invested capital

• Key Idea: Measures true business performance

• Investors - best measure of value creation; ROIC vs WACC is a good metric to see if earnings outpace cost of capital

• Mgmt - guides capital allocation and acquisition hurdle rates

• if ROIC > WACC, the company is CREATING VALUE

  if ROIC < WACC, it destroys value (means cost of capital is higher than earnings on invested capital)