D775 - Section 2

Financial models are used to

1. assess finanical health of the firm (diagnosis)

2. forecast the financial health of hte firm (prognosis)

3. identify changes to improve the financial health of the firm (treatment)

liquidity ratios

measure a company's ability to meet its short-term financial obligations using its most liquid assets

High liquidity ratios indicate

strong capacity to cover short-term debts, enhancing the firm's creditworthiness and financial stability

Low liquidity ratios indicate

a company may have a problem with paying its bills.

activity ratios - aka efficiency ratios

evaluate how efficiently a firm utilizes its assets to generate sales or revenue.

provide insights into the operational performance of the company, indicating how well it manages its overall asset base.

activity ratios - aka efficiency ratios

provide insights into the operational performance of the company, indicating how well it manages its overall asset base.

leverage ratios

measure the extent to which a firm uses debt to finance its operations and growth

leverage ratios

highlight the company's structure or mixture of debt and equity—which is called "capital structure"—and its reliance on external funding

higher leverage ratios may indicate

greater financial risk, as the company might struggle to meet its debt obligations during economic downturns

moderate leverage ratio can

enhance returns on equity when managed properly

profitability ratios

assess a company's ability to generate earnings relative to its revenue, assets, or equity.

profitability ratios

provide an indication of the firm's capacity to produce profits.

higher profitability ratios typically suggest

a well-managed company with effective cost control and strong revenue-generating capabilities

market ratios

analyze a company's financial performance in relation to its stock price

market ratios

provide insights into investor perceptions and market valuation of the firm. They help in understanding how the market values the company's earnings, growth prospects, and risk profile

Favorable market ratios generally reflect

positive investor sentiment and confidence in the company's future performance

Unfavorable market ratios sometimes indicate

a company might be overvalued by market participants.

cross-sectional analysis.

Comparing the financial ratios of one company to the same financial ratios of another company.

time-series analysis

Comparing a financial ratio across time.

How do you conduct cross-sectional analysis using financial ratios?

By comparing the financial ratios of one company to the same financial ratios of another company

How do you conduct time-series analysis using financial ratios?

By comparing a particular financial ratio for a company across time

financial statements

documents that provide a comprehensive snapshot of a company's performance and operational efficiency

balance sheet

presents a company's financial position at a specific point in time.

Assets = Liabilities + Shareholders' Equity.

assets

Resources owned by a company with economic value.

current assets

cash, inventories, receivables

fixed assets

property, plant and equipment

liabilities

Obligations or debts owed by a business.

current liabilities

due within one year

long-term liabilities

due after one year

shareholders equity

Owner's claim on assets after liabilities are settled.

includes paid-in capital, retained earnings, treasury stock

total assets

sum of current and fixed assets

total liabilities

sum of current liabilities and long-term debt

total equity

the difference between total assets and total liabilities

What is the difference between assets and shareholders' equity?

Assets are resources that have economic value, while shareholders' equity is the owners' claim on the company's assets after all liabilities have been settled.

What is the difference between a current liability and long-term debt?

Current liabilities are those that are due within one year of the current date. They are also known as short-term liabilities. Long-term debt includes liabilities that are due after one year of the current date. They are also known as long-term liabilities.

income statement

outlines the company's financial performance over a specific period, usually a month, quarter, or year.

income statement

details how the company's revenues are transformed into net income, or profit, through the deduction of expenses

revenue

Income generated from normal business operations.

Cost of Goods Sold (COGS)

represent the direct costs attributable to the production of gooods sold by the company

depreciation

non-cash expense represents gradual reduction in value of fixed assets over time

taken out of revenue before company pays taxes - lowers tax liability

earnings before interest and taxes (EBIT)

equal to revenue minus COGS, SG&A, and R&D, expenses minus depreciation.

net income

Revenues - Expenses

What is the difference between cost of goods sold and depreciation?

Cost of goods sold (COGS) describes direct costs attributable to the production of goods sold by the company, while depreciation is a non-cash expense that represents the gradual reduction in the value of a company's fixed assets over time.

What is the difference between the balance sheet and the income statement?

The balance sheet presents a company's financial position at a specific point in time, while the income statement outlines the company's financial performance over a specific period.

Why do companies use financial ratios in their analysis?

To diagnose financial health, forecast future performance, and identify areas for improvement

What do liquidity ratios primarily measure?

A company’s ability to meet short-term financial obligations

What is cross-sectional analysis of financial ratios used for?

It allows firms to compare their financial performance to other firms.

How do companies benefit from using the income statement in conjunction with financial ratios?

They assess profitability and efficiency over a specific period.

Which key advantage does debt financing have over equity financing?

Interest payments are tax-deductible, reducing overall tax liability.

Types of liquidity ratios

current ratio

quick ratio

cash ratio

average collection period

accounts receivable turnover

inventory turnover

current ratio

current assets divided by current liabilities

current ratio

measures a company's ability to satisfy its short-term liabilities with its short-term assets.

current ratio

of one or higher generally indicates that a company has sufficient assets to meet its short-term obligations, with higher values suggesting greater liquidity.

A value less than one indicates that the company may struggle to meet its short-term liabilities.

agency cost

costs that are incurred by the firm when management and employees of a company do not act in the best interests of shareholders.

quick ratio aka acid-test ratio

(Current Assets - Inventory) / Current Liabilities

quick ratio aka acid-test ratio

assesses a company's ability to fulfill its short-term obligations without relying on the sale of inventory, which might not be as readily convertible to cash

quick ratio aka acid-test ratio

bove one is desirable, indicating strong liquidity without depending on inventory liquidation

cash ratio

Cash / Current Liabilities

Cash Ratio

most conservative liquidity ratio

focuses strictly on a company's most liquid assets, providing insight into its ability to pay off short-term liabilities with its cash on hand.

Cash Ratio

higher cash ratio indicates a stronger position to cover short-term debts immediately, reflecting higher financial stability.

lower ratio highlights less liquidity and, perhaps, more difficulty in meeting short-term liabilitie

average collection period

number of days it takes on average for the company to collect its receivables

averagae collection period

calculated as accounts receivable over daily credit sales

Accounts receivable (A/R) turnover

A type of liquidity ratio that describes the number of times a firm's accounts receivable account is paid off. Accounts Receivable Turnover = Credit Sales ÷ Accounts Receivable.

Accounts receivable (A/R) turnover

credit sales divided by A/R

Accounts receivable (A/R) turnover

higher A/R turnover indicates that the company is able to collect its receivables more often

Accounts receivable (A/R) turnover

lower A/R turnover, on the other hand, indicates that the company may be struggling collecting its receivables

inventory turnover formula

cost of goods sold / inventory

inventory turnover

A liquidity ratio that calculates the number of times the company sells its receivables per year. Inventory Turnover = Cost of Goods Sold ÷ Inventory.

What do liquidity ratios measure?

Liquidity ratios measure a company's ability to meet its short-term obligations using its most liquid assets.

activity ratios

ometimes called "efficiency ratios" because they will inform us about how efficient a company is at having assets that can generate new revenue

total asset turnover ratio

A type of activity ratio that ratio evaluates how efficiently a company uses all its assets to generate revenue or sales. Total Asset Turnover Ratio = Total Revenue ÷ Total Assets.

total asset turnover ratio

can be thought of as how much revenue is generated for every dollar of total assets.

total asset turnover ratio

higher total asset turnover ratio implies that the company is effectively using its assets to produce revenue, reflecting operational efficiency.

lower ratio might indicate underutilization of assets.

fixed asset turnover ratio

A type of activity ratio that evaluates how effectively fixed assets contribute to generating sales. Fixed Asset Turnover Ratio = Total Revenue ÷ Fixed Assets.

fixed asset turnover ratio

focuses on a company's fixed assets, such as property, plant, and equipment (PP&E), and how effectively these assets contribute to generating sales

fixed asset turnover ratio

higher ratio suggests that the company is efficiently using its fixed assets to generate sales, which is particularly relevant in capital-intensive industries

Interpreting activity ratios involves

comparing them to industry standards and historical performance

leverage

A company's ability to finance debt.

financial solvency

A company's tendency toward bankruptcy.

capital structure

The mixture of debt and equity that a firm uses to finance the company.

leverage ratio

A type of financial ratio that measures the extent to which a firm uses debt to finance its operations and growth.

debt-to-assets (D/A) ratio

A type of leverage ratio that measures the percentage of a company's assets that are financed by debt. Debt-to-Assets Ratio = Total Liabilities ÷ Total Assets.

debt-to-assets (D/A) ratio

higher ratio suggests that a company is more heavily reliant on debt to finance its assets, which could signal higher financial risk, especially in times of economic downturns.

Conversely, a lower ratio indicates a more conservative approach to leverage and potentially greater financial stability

debt-to-equity (D/E) ratio

A type of leverage ratio that compares the company's total debt to its equity. Debt-to-Equity Ratio = Total Liabilities ÷ Total Equity.

debt-to-equity (D/E) ratio

offers insight into how a company finances its operations and growth. The D/E ratio speaks directly to the company's capital structure.

debt-to-equity (D/E) ratio

high D/E ratio may indicate that a company is aggressively using debt to fuel growth, which could result in higher earnings volatility. However, it also increases the risk of financial distress if the company cannot generate sufficient returns on its debt.

In contrast, a low ratio suggests a reliance on equity financing, which might signify lower risk but also reflects on the company's conservative growth strategies.

times interest earned (TIE) ratio

A type of leverage ratio that compares company operating profit to paid interest. TIE Ratio = EBIT ÷ Paid Interest.

times interest earned (TIE) ratio

tells us how many times a company covers (or could pay) the interest on its debt given its earnings.

Interpreting leverage ratios

higher leverage can amplify higher valuations and greater growth

might also increase the company's risk profile, particularly in adverse economic conditions.

What do leverage ratios measure?

Leverage ratios are financial ratios that measure the extent to which a firm uses debt to finance its operations and growth.

Return on assets (ROA)

A type of profitability ratio that measures how efficiently a company utilizes its assets to generate net income. Return on Assets (ROA) = Net Income ÷ Total Assets.

Return on equity (ROE)

A type of profitability ratio that gauges the profitability generated from shareholders' equity. Return on Equity (ROE) = Net Income ÷ Total Equity.

Profit margin

A type of profitability ratio that provides insight into the portion of revenue that remains as net income after all expenses are deducted. Profit Margin = Net Income ÷ Total Revenue.

profit Margin

reflects the overall profitability of a company and its ability to manage costs relative to its revenue.

A higher profit margin suggests a more profitable company that retains a larger percentage of revenue as profit.

A lower profit margin might indicate that a company has a higher cost structure and retains less of its revenue as profit

Profitability Ratios

A type of financial ratio that assesses a company's ability to generate earnings relative to its revenue, assets, or equity.

Return on assets (ROA)

indicates how effectively management uses the company's assets to produce profits.

Return on equity (ROE)

reveals how well a company uses equity financing to grow its profits.

A high ROE indicates that the company is effectively generating income from investors' funds, making it an attractive investment.

A lower ROE suggests that a company is struggling to generate profit from investors' funds

Interpreting profitability ratios

consider both industry standards and historical trends.

High profitability ratios generally indicate strong financial performance and operational efficiency, making a company more attractive to investors.

market ratios

A type of financial ratio that analyzes a company's financial performance in relation to its stock price or market value of a company.

book value

Literal value or face value.