F2 M8 Ratio and Variance Analysis

ratio

are financial indicators that distill relevant information about a business entity by quantifying the relationship among selected items on the financial statements; may be compared to a different period for same entity, competitor, or industry

key financial ratios and metrics

profitability ratios, liquidity ratios, solvency ratios, and performance metrics; produces a measure that an investor can use to evaluate the strength of an entity and whether its performance is improving over time or trending unfavorably

numerator increases

means the resulting ratio increases

denominator increases

means the resulting ratio decreases (more “partners”)

profitability ratios

are measures of the success or failure of an enterprise for a given time period

gross (profit) margin

want to be greater than or equal to the standard; the company keeps more of each sales dollar after paying for the goods sold (lower COGS relative to sales)

*(sales (net) - COGS)/sales (net)

profit margin

want to be greater than or equal to the standard; the company earns more profit from each dollar of net sales after paying the applicable costs (lower COGS relative to sales)

*net income/sales (net)

return on sales

want to be greater than or equal to the standard; measures how much income the company generates from each dollar of sales before considering interest and income taxes (better profitability)

*(income before interest income, interest expense, & taxes)/sales (net)

return on assets (ROA)

want to be greater than or equal to the standard; measures how efficiently the company uses its assets to generate profit (company using assets more efficiently)

*net income/avg. total assets

dupont return on assets

want to be greater than or equal to the standard; the company is earning more profit from each dollar of sales and using its assets more efficiently to generate sales

*profit margin x asset turnover

return on equity

want to be greater than or equal to the standard; measures how effectively the company uses shareholders’ invested equity to generate profit

*net income/avg. total equity

operating cash flow ratio

want to eb greater than or equal to the standard; the company’s ability to use cash generated from its core operations to pay its current liabilities (stronger short-term liquidity)

*cash flow from operations (operating activities)/current liabilities

liquidity ratios

are measures of a firm’s short-term ability to pay maturing obligations

current ratio

want to be greater than or equal to the standard; the company’s ability to pay its short-term obligations with its current assets (better short-term liquidity)

*current assets/current liabilities

quick ratio

want to be greater than or equal to the standard; measures whether the company can pay its current liabilities using its most liquid current assets (exclude inventory and prepaids)

*(cash & cash equivalents + short-term marketable securities + accounts receivable (net))/current liabilities

turnover ratios

measures how effectively a company uses an asset to generate sales or activity; generally use average balance for balance sheet components (may be instructed to use year-end balances instead)

accounts receivable turnover

want to be greater than or equal to the standard; measures how effectively the company collects money owed by customers (customers are paying more quickly)

*sales (net)/avg. accounts receivable (net)

days sales in accounts receivable

want to be less than the standard; it is the average number of days it takes to collect accounts receivable (faster collection of receivables)

*ending accounts receivable (net)/(sales (net)/365)

inventory turnover

want to be greater than or equal to the standard; measures how many times the company sales and replaces its average inventory during the period (inventory is selling more quickly)

*COGS/avg. inventory

days in inventory

want to be less than the standard; measures the average number of days inventory is held before sold (inventory is selling faster)

*ending inventory/(COGS/365)

accounts payable turnover

want to be less than the standard; measures how quickly the company pays its suppliers; need to take advantage of available payment terms (paying early earns a valuable purchase discount)

*COGS/avg. accounts payable

days in payables outstanding

want to be greater than or equal to the standard, but only up to the allowed payment deadline; measures the average number of days the company takes to pay its suppliers

*ending accounts payable/(COGS/365)

cash conversion cycle

want to be less than the standard; measures the number of days between paying suppliers for inventory and collecting cash from customers (cash is tied up for fewer days and inventory sells faster)

*days sales in accounts receivable + days in inventory - days of payables outstanding

solvency ratios

measures of security or protection for long-term creditors/investors

debt-to-equity

want to be less than the standard; measures how much debt financing the company uses compared with shareholders’ equity; degree of protection to creditors in case of insolvency

*total liabilities/total equity

total debt ratio

want to be less than the standard; measures the percentage of the company’s assets financed by creditors (less reliance on debt)

*total liabilities/total assets

equity multiplier

want to be less than the standard; measures the company’s use of financial leverage or how many dollars of assets are supported by each dollar of equity (less debt = lower financial risk)

*total assets/total equity

financial leverage

is the use of debt financing to acquire assets or operate a business

times interest earned

want to be greater than or equal to the standard; measures how many times the company’s earnings before interest and taxes can cover its interest expense (greater ability to pay interest)

*EBIT/interst expense

performance metrics

measures used to evaluate operating performance and elements of a company’s stock performance from the perspective of current and potential investors

earnings before, interest, taxes, depreciation, and amortization (EBITDA)

want to be greater than or equal to the standard; measures how much income the company generates before the effects of financing, taxes, depreciation, and amortization; higher ratio indicates stronger profitability and better performance

EBITDA top-down

*sales - COGS - operating expenses (excluding depreciation and amortization)

EBITDA bottom-up

*net income + income tax expense + interest expenses + depreciation and amortization

earnings per share (EPS)

want to be greater than or equal to the standard; measures how much income is available for each common share; higher means less partners and more earnings are available to common shareholders

*income available to common shareholders/WACSO

price-to-earnings ratio

neither greater than or less than are applicable, it depends on the comparison; measures how much investors are willing to pay for $1 of the company’s earnings; higher may mean expected growth and lower may mean stock is attractively priced, resulting in lower growth

*price per share/basic EPS

dividend payout

neither greater than or less than are applicable, it depends on the company’s goals and the investor’s preference; measures the percentage of earnings paid to shareholders as dividends; higher means more earnings distributed to shareholders and lower means more earnings reinvested in the company (or retained for growth)

*cash dividends/net income

asset turnover

want to be greater than or equal to the standard; measures how efficiently the company uses its assets to operates sales (stronger operating performance)

*sales (net)/avg. total assets

limitations of ratios

they depend entirely on the reliability of the data on which they are based (estimates, fair value, historical costs, etc.)

horizontal analysis

measures the dollar and percentage change over a period of time; useful in evaluating trends and noting material changes from period to period

vertical analysis

expresses each financial statement item as a percentage of a common base amount; helps compare items within the same period and compare companies of different sizes

variance analysis

compares actual results with a budget, plan, or standard to evaluate performance and identify differences in revenues and costs; a favorable variance increases operating income and an unfavorable variance decreases operating income

variable costs

total cost changes with activity volume, but per unit amount should generally remain constant within the relevant range (ex: direct materials, shipping costs, etc.)

fixed costs

total cost generally remains constant within the relevant range (while activity changes) (ex: rent, insurance, depreciation, etc.)

budget

is a formal financial plan for a future period, where expected estimates are created for revenues, costs, cash flows, and other financial activities; created on a set sales price per unit, a set variable cost per unit, and a set fixed costs (in total)

contribution margin (CM)

amount of sales revenue remaining after subtracting variable costs; it is used to cover fixed costs and then generate operating income

*sales - variable costs

budget variance analysis

compares actual result with budgeted results to evaluate performance and identify favorable and unfavorable differences

flexible budget

adjusts the original budget to the actual level of activity; it gives a more fair comparison by removing the effects of selling and producing a different number of units

master budget

is the company’s complete financial plan for a specific future period, based on the planned level of activity (not adjusted for actual volume)

operating income variance

difference between planned sells and actual sales either results in a favorable or an unfavorable outcome

*planned sells (units x $ per unit)
- variable costs
- fixed costs

COGS

*beginning inventory + purchases - ending inventory