A.2. Financial Ratio Analysis Flashcards

Question

How does an increase in sales volume typically affect liquidity ratios?

Answer 1

It will typically cause increases in accounts receivable and inventory as well as in current liabilities. However, the liquidity ratios may decrease rather than increasing because cash will decrease. ## Footnote Cash decreases because sales growth requires cash to support the increases in receivables and inventory, and unless the company is extremely profitable, the cash needed will outstrip the cash available from profits. Cash will decrease precipitously, and the cash flow ratio and possibly other liquidity ratios will decrease.

Answer 2

Long-term sources of cash such as additional equity or possibly long-term debt.

Answer 3

Cash will increase temporarily as older receivables are collected and not replaced with the same level of new receivables.

Answer 4

The quality of current liabilities, including urgency of payment; whether the company has unrecorded liabilities such as purchase commitments or short-term leases that are expensed; and whether the company is in compliance with its loan payment obligations and loan covenants.

Answer 5

A condition or requirement in a loan agreement or bond indenture that restricts the actions of the borrower or requires maintaining certain ratio requirements. ## Footnote If the borrower fails to meet the requirements of the covenants, the loan becomes in default, just as if the borrower had failed to make scheduled loan payments.

Answer 6

The potential to earn a high level of return relative to the amount of cost expended.

Answer 7

The ability of a company to pay its long-term obligations from earnings as they come due. A company is solvent if its assets are greater than the sum of its debt obligations.

Answer 8

Increasing debt relative to the level of a company's equity decreases a company's solvency by increasing interest expense and financial leverage.

Answer 9

It magnifies the effect of both managerial success (profits) and managerial failure (losses).

Answer 10

It refers to the use of debt to finance a company's assets and operations, magnifying both profits and losses. ## Footnote Financial leverage involves using borrowed funds to increase the potential return on equity, but it also increases the risk of loss if the returns on the borrowed funds are less than the cost of the debt.

Answer 11

It is an indication of the extent to which a company uses debt financing supplied by its creditors relative to equity financing supplied by its owners to finance its assets. Financial Leverage Ratio = Total Assets / Total Equity ## Footnote A higher ratio suggests more debt relative to equity.

Answer 12

* If financial leverage is used successfully, interest expense paid on debt will be less than the return earned from investing it, benefiting equity investors. * Financial leverage offers the potential to earn a high level of return relative to the amount of cost expended in interest expense on debt. * Interest paid on debt is tax-deductible, effectively reducing interest as an expense.

Answer 13

* If financial leverage is used unsuccessfully, the return from investing debt capital will be less than the interest expense, and equity investors will be harmed. * Excessive financial leverage increases the cost of capital due to perceived higher risk by investors. * The company assumes risk by borrowing because interest must be paid regardless of whether the investment generates the expected return or not. * If the company’s financial position weakens, it may face difficulty refinancing maturing debt, potentially requiring principal repayment at an inopportune time.

Answer 14

It refers to using financial leverage (debt) in an effort to achieve increased returns. ## Footnote This strategy aims to earn a greater return on investments than the interest paid on borrowed funds, thereby increasing profits.

Answer 15

DFL can be calculated in two ways: * DFL = % Change in Projected Net Income / % Change in Projected EBIT * DFL = EBIT / EBT

Answer 16

It is the multiplication factor by which EBT and net income can be expected to change in the future in relation to a future change in earnings before interest and taxes, since interest on debt is a fixed expense. ## Footnote It measures both the opportunity and the risk inherent in debt from the standpoint of the shareholder.

Answer 17

False ## Footnote While financial leverage can increase returns, it also increases risk. If the return on borrowed funds is less than the cost of debt, it can harm the company's financial position. The company must be able to generate sufficient cash flow to service interest payments and maintain lender confidence. The principal is an obligation that must either be repaid or successfully refinanced at each maturity date.

Answer 18

profits; losses

Answer 19

It decreases because the proportional increase in total equity is greater than the proportional increase in total assets.

Answer 20

It refers to the fact that, for a given level of fixed expenses, a given percentage change in sales will result in a higher percentage of change in earnings before interest and taxes (EBIT). Operating leverage measures the use of fixed operating costs to generate greater operating profit. ## Footnote Because fixed costs do not vary as volume changes, a change in sales volume causes a more than proportional change in EBIT.

Answer 21

For a company with high operating leverage, small changes in sales will lead to larger changes in EBIT, both positive and negative. The existence of the fixed costs magnifies the effect of increased sales on EBIT. * If the company’s sales increase, EBIT will increase relatively more than the sales increase. * If the company's sales decrease, EBIT will decrease relatively more than the sales decrease.

Answer 22

False ## Footnote When a company with operating leverage is performing near its breakeven point, the company will have **greater** changes in EBIT relative to changes in sales revenue than it will when it is operating above or below its breakeven point. At sales levels above and below the breakeven point, the magnification effect of operating leverage will still be present, but it will not be quite as pronounced as it will be near the breakeven point.

Answer 23

Degree of operating leverage can be calculated in two ways: * DOL = % Change in Projected EBIT / % Change in Projected Sales * DOL = Contribution Margin / EBIT

Answer 24

* Variable costs represent the same percentage of revenue in both periods. * Total fixed costs are the same for both periods. * Non-operating gains or losses, discontinued operations, and interest income are the same in both periods.

Answer 25

Degree of total leverage can be calculated in two ways: * DTL = % Change in Projected Net Income / % Change in Projected Sales Revenue * DTL = Contribution Margin / EBT

Answer 26

DTL = DFL × DOL

Answer 27

A higher proportion of fixed expenses in total operating expenses results in higher operating leverage.

Answer 28

It refers to the risk of variability in earnings, caused by variability of demand for the company’s products or services, variability in the company’s selling prices, variability of the price of inputs to the product, and changes to the company’s degree of operating leverage.

Answer 29

Operating leverage has the effect of **magnifying** both profits and losses.

Answer 30

Total leverage incorporates both operating and financial leverage. It expresses the degree to which a company uses fixed costs in its operations as well as fixed rate financing in its capital structure. For a company with high fixed operating costs and high fixed financing costs, a small change in sales revenue will bring about a large change in net income.

Answer 31

As long as fixed costs and fixed financing costs remain the same, the degree of total leverage decreases as sales revenue and EBT increase.

Answer 32

The debt-to-equity ratio is a comparison of total liabilities to total equity. Debt-to-Equity Ratio = Total Liabilities / Total Equity

Answer 33

It indicates that the company's total liabilities are twice its total equity, meaning it has $2.00 of debt for every $1.00 of equity.

Answer 34

False ## Footnote A company with a very low debt-to-equity ratio has very little risk of insolvency and default. It is a company with a very high debt-to-equity ratio that has a high risk of defaulting on its loans. However, a company with a very low debt-to-equity ratio is probably not making as much use as it could of financial leverage.

Answer 35

The long-term debt-to-equity ratio measures how much long-term debt a company has compared to its total equity. Long-term Debt-to-Equity Ratio = (Total Debt − Current Liabilities) / Total Equity

Answer 36

It indicates more reliance on long-term debt financing than on equity financing. A high long-term debt-to-equity ratio higher can indicate the need to do some extended analysis that focuses on other ratios such as profitability, as well as the company’s future prospects.

Answer 37

The debt-to-total assets ratio measures the proportion of the company’s total assets that are financed by creditors. Debt-to-Total Assets Ratio = Total Liabilities / Total Assets

Answer 38

A lower ratio indicates a lower risk of the company defaulting on its debt. ## Footnote Note: Lenders also prefer low debt-to-equity and long-term debt-to-equity ratios, for the same reason.

Answer 39

The interest coverage ratio compares earnings before interest and taxes (EBIT) with interest expense. Interest Coverage Ratio = EBIT / Interest Expense

Answer 40

It indicates an excellent ability to cover interest payments.

Answer 41

It measures how much in earnings a company has available to cover its fixed financing charges, including interest, principal repayments on loans, and lease payments. Fixed Charge Coverage Ratio = Earnings Before Fixed Financing Charges and Taxes / Fixed Financing Charges. ## Footnote “Fixed financing charges” are all contractually committed payments on both debt and leases, as follows: * Interest and principal payments on debt * Total lease payments on operating and finance leases, including interest and lease liability payments * Total short-term lease payments

Answer 42

It indicates the company has four times as much in earnings as needed to fulfill its contractual obligations to make interest and principal payments on its loans, lease liability payments on its leases, and operating and short-term lease payments.

Answer 43

It indicates the amount of cash flow from operations available to pay contractual financing obligations. Cash Flow to Fixed Charges = Adjusted Cash Flow from Operations / Fixed Financing Charges ## Footnote Adjusted cash flow from operations = Cash Flow from Operations [after tax] + Cash Fixed Financing Charges + Cash Tax Payments

Answer 44

The company has 3.54 times as much in cash flow from operations as it needs to fulfill its contractual obligations to make interest and principal payments on its loans and finance leases and to make its operating and short-term lease payments.

Answer 45

Financial leverage magnifies both profits and losses.

Answer 46

It measures the number of times receivables are collected and are replaced with new receivables. It tracks the efficiency of a company’s accounts receivable collections efforts and indicates the amount of investment in receivables that is needed to maintain the company’s level of sales. A/R Turnover Ratio = Net Annual Credit Sales / Average Gross Accounts Receivable

Answer 47

Receivables are being collected more rapidly.

Answer 48

The average collection period is the average number of days receivables remain outstanding before being collected. Day's Sales in A/R (Average Collection Period) = 365 / Accounts Receivable Turnover Ratio Or Days' Sales in A/R( Average Collection Period) = Average Gross Accounts Receivable / Average Daily Net Credit Sales ## Footnote Average Daily Net Credit Sales = Net Annual Credit Sales / 365.

Answer 49

It indicates how many times during the year the company sells its average level of inventory and replaces it with new inventory. A high inventory turnover may mean the company is using good inventory management and is not holding excessive amounts of inventories that may be obsolete, unmarketable goods. However, it can also mean that the company is not holding enough inventory and may be losing sales because prospective customers may be unable to make purchases due to out-of-stock items.

Answer 50

Inventory Turnover Ratio = Annual Cost of Goods Sold (COGS) / Average Inventory

Answer 51

It represents the average number of days that inventory items remain in stock before being sold, or the average number of days required to sell an item of inventory. Days' Sales in Inventory = 365 / Inventory Turnover Ratio Or Days' Sales in Inventory = Average Inventory / Average Daily COGS (Annual COGS ÷ 365)

Answer 52

The number of times payables turn over, or the number of times they are paid and new ones are generated by new purchases, during a period of a year. It indicates the speed with which the company pays its suppliers. A/P Turnover Ratio = Annual Credit Purchases / Average Accounts Payable ## Footnote Analysts outside the company must use estimates of annual credit purchases, because purchases is not an item usually reported in a company's financial statements. Cost of Goods Sold is usually used as a proxy for Purchases.

Answer 53

It represents the average number of days the company takes to pay its payables. Days' Purchases in Payables = 365 / Accounts Payable Turnover Ratio Or Days' Purchases in Payables = Average Accounts Payable / Average Daily Credit Purchases (Annual Credit Purchases ÷ 365) ## Footnote Analysts outside the company must use estimates of annual credit purchases, because purchases is not an item usually reported in a company's financial statements. Cost of Goods Sold is usually used as a proxy for Purchases.

Answer 54

The company is paying its payables more slowly, indicating possible liquidity problems.

Answer 55

The annual credit purchases figure, a component needed for the calculations, is rarely reported in a company’s financial statements.

Answer 56

Cost of Goods Sold

Answer 57

It measures the amount of sales revenue the company is generating from the investment it has in its average total assets. It is a means of measuring the overall efficiency of the company’s use of all its investments, including both current assets and non-current assets. Total Asset Turnover Ratio = Sales / Average Total Assets

Answer 58

it measures the amount of sales revenue the company is generating from its investment in its net fixed assets. It measures the company’s efficiency in the use of its fixed assets. Fixed Asset Turnover Ratio = Sales / Average Net Property, Plant, and Equipment ## Footnote "Net property, plant, and equipment” means property, plant, and equipment, that is, all fixed assets, net of accumulated depreciation.

Answer 59

It represents the per share amount for the common stockholders if the company were to be liquidated at the amounts reported on the balance sheet. Book Value Per Share of Common Stock = (Total Stockholders' Equity − Preferred Equity) / Number of Common Shares Outstanding

Answer 60

* GAAP definitions of assets and liabilities may not coincide with economic reality. * Long-lived assets are recorded at historical cost less depreciation, not current market value. * Book values of fixed assets are affected by depreciation, which is an estimate. * Intangible assets such as Goodwill may be of uncertain value or not reflected. * Off-balance sheet assets and liabilities are not included.

Answer 61

It is the ratio between the company’s current market price per common share of stock and its book value per share as of the same date. Market-to-Book Ratio = Current Stock Price Per Share / Book Value Per Share

Answer 62

A share's market value should be greater than its book value. A market-to-book ratio lower than 1.0 indicates an expectation in the market of abnormally low future earnings for the company.

Answer 63

A company's P/E ratio indicates what shareholders are paying for continuing earnings per share. Investors view it as an indication of what the market considers to be the company’s future earning power. P/E Ratio = Market Price Per Common Share / Basic Earnings Per Share (annual)

Answer 64

It measures the income-producing power of one share of common stock at its current market price. It is the inverse of the P/E ratio. Earnings Yield = Basic Earnings Per Share (annual) / Current Market Price Per Common Share

Answer 65

It measures the relationship between the current annual dividend and the current market price of the company’s common stock. It is the annual percentage return in dividends received by a shareholder based on the stock's current price and current dividend. Dividend Yield = Annual Dividends Per Common Share / Current Market Price Per Share

Answer 66

It is the proportion of earnings available to common stockholders that are paid out as dividends. The dividend payout ratio can be calculated either on a per-share basis or on a whole-company basis. Dividend Payout Ratio = Annual Dividends Per Common Share / Basic Earnings Per Share Or Dividend Payout Ratio = Total Common Dividends (annual) / Income Available to Common Shareholders (IAC) ## Footnote Income available to common shareholders is net income minus preferred dividends if the company has preferred stock.

Answer 67

It is total return to individual shareholders on their investments in the company’s common stock. Shareholder Return = (Ending Stock Price − Beginning Stock Price + Annual Dividends Per Share) / Beginning Stock Price

Answer 68

* Basic Earnings Per Share (BEPS) * Diluted Earnings Per Share (DEPS)

Answer 69

The earnings per share for all common shares that were outstanding during the period.

Answer 70

The earnings per share that would have resulted if all potentially issuable and dilutive common shares had been issued as actual common shares on the first day of the period or on their date of issue as potential common shares.

Answer 71

If a company has common stock and nonconvertible preferred stock but no potential common stock.

Answer 72

* Income Available to Common Stockholders (IAC) * Weighted Average Number of Common Shares Outstanding (WANCSO)

Answer 73

Net income minus preferred dividends.

Answer 74

In calculating IAC, cumulative preferred dividends are deducted from net income in the year they are **earned**, whether declared or not.

Answer 75

In calculating IAC, noncumulative preferred dividends are deducted from net income in the year they are **declared**. If a noncumulative preferred dividend is not declared, it is not deducted from net income in that year.

Answer 76

Assume that a preferred dividend was declared and paid unless specified otherwise.

Answer 77

The average number of common shares that were outstanding each day during the period.

Answer 78

The number of shares issued for cash during the period is adjusted (weighted) for the time period they were outstanding during the period after issuance. ## Footnote For example, 10,000 shares issued on July 1 are weighted as 5,000 shares because they were outstanding for only half the year.

Answer 79

The reacquired shares are outstanding only for the time they were owned by someone other than the company, before they were repurchased by the company. ## Footnote For example, if the company purchased 12,000 of its own shares on the open market on September 1, the weighted average number of those repurchased shares that were outstanding during the year is 8,000 (12,000 ÷ 12 months × 8 months outstanding).

Answer 80

Stock splits and stock dividends are reported as if they had occurred on January 1 of the first period presented in the comparative financial statements. All shares outstanding and all calculations that pre-date the split or stock dividend are adjusted, and the adjustment goes back to the beginning of the first period reported.

Answer 81

They are not adjusted for the stock dividend or stock split.

Answer 82

Basic EPS = Income Available to Common Stockholders (IAC) / Weighted Average Number of Common Shares Outstanding (WANCSO)

Answer 83

If the company has net income/expense from discontinued operations on the income statement that are reported below the income from continuing operations line, Basic EPS must be calculated three times: 1. Using income from continuing operations minus preferred dividends in the numerator. 2. Using the income from discontinued operations in the numerator. 3. Using net income minus preferred dividends in the numerator.

Answer 84

Adjustments are made only to shares/transactions that were in place before the stock split or stock dividend occurred.

Answer 85

They are calculated individually by year for each year presented by pretending that all potentially issuable common shares that were outstanding at the year-end had been converted or exercised on January 1 (or on the date they were issued, if they were issued later than January 1).

Answer 86

Potentially issuable shares are not currently outstanding as shares, but someone other than the company can convert them into common shares. They include: * Options and warrants * Convertible bonds * Convertible preferred shares

Answer 87

It is used to evaluate outstanding stock options and warrants issued by the company for their dilutive potential. The treasury stock method assumes that: 1. The options and warrants were converted into common stock at the beginning of the period or at the time of issuance, if issued during the period, and 2. The proceeds were used to purchase the company’s common stock (treasury stock) at the average market price during the period. ## Footnote Options and warrants must be evaluated separately each period for diluted EPS calculations for each period for which comparative financial statements are presented because the treasury stock method depends on period-specific data. The average market price of the stock varies each period, and so the dilutive effect of each warrant or option and the net number of shares of common stock it could have been converted into differs each period.

Answer 88

Their exercise or conversion into common stock during the period would have caused a **decrease** in basic earnings per share, so they decrease diluted earnings per share.

Answer 89

If a company has potential common shares, it has a complex capital structure. If a company has a complex capital structure, both basic and diluted earnings per share must be reported with equal prominence.

Answer 90

From the most dilutive to the least dilutive.

Answer 91

The weighted averages of shares outstanding at the beginning of the period and all shares issued or acquired before the stock dividend took place are adjusted for the stock dividend.

Answer 92

Treasury stock method ## Footnote The treasury stock method assumes that options and warrants are converted into common stock at the beginning of the period or at the time of issuance, and the proceeds are used to purchase the company's common stock at the average market price during the period.

Answer 93

The potential exercise of options and warrants does not affect the numerator of the EPS calculation. Only the denominator is affected. ## Footnote The potential exercise of options and warrants does not change the income available to common stockholders.

Answer 94

The WANCSO increases. The weighted average number of common shares outstanding is changed by the **difference** between the number of shares potentially to be issued and the number of shares that would have been purchased for the treasury to replace the shares issued, calculated using the proceeds that would have been received from the sale of the new shares and the average market price of the stock during the period. ## Footnote When calculating DEPS, the potential exercise of options and warrants increases the denominator of the EPS calculation due to the increase in the number of common shares outstanding.

Answer 95

When the exercise price is above the average market price. ## Footnote If the exercise price is higher than the average market price, the number of treasury shares that could be purchased with the proceeds of the exercise of the options or warrants would be greater than the number of shares issued, **decreasing** the net number of outstanding shares.

Answer 96

They are included in the calculation of Diluted EPS if they are dilutive. ## Footnote Per ASC 260-10-45-22, unvested stock options that depend only on the future passage of time are included in Diluted EPS calculations if they are dilutive even if they were not available for exercise during the period because they were not yet vested.

Answer 97

The "if-converted" method ## Footnote The if-converted method assumes that convertible securities were converted at the beginning of the period or when issued if issued during the period, affecting both the numerator and the denominator of the EPS calculation.

Answer 98

Calculate BEPS | (Basic Earnings Per Share) ## Footnote BEPS is calculated by dividing Income Available to Common shareholders (IAC) by the Weighted Average Number of Common Shares Outstanding (WANCSO).

Answer 99

EPS Effect of Convertible Bonds = Interest on the Bonds × (1 – Tax Rate) / # of Shares the Bonds are Convertible Into ## Footnote The EPS Effect for each issue is the additional income that would have been available to common shareholders if the bonds had been converted divided by the additional shares that would have been outstanding if all the convertible bonds had been converted to common stock on January 1 (or on their issue date, if issued during the period). The EPS Effect will be used only to rank the various potentially issuable common stock instruments according to their dilutive potential.

Answer 100

EPS Effect of Convertible Preferred Shares = Dividends Earned (cumulative) or Declared (noncumulative) / # of Common Shares the Preferred Shares are Convertible Into ## Footnote The EPS Effect of convertible preferred shares is calculated without tax adjustments since dividends do not affect taxable income. The EPS Effect will be used only to rank the various potentially issuable common stock instruments according to their dilutive potential.

Answer 101

They are used only to rank the issues of convertible securities according to their dilutive potential, from the most dilutive to the least dilutive. The lower the ratio of the numerator to the denominator—and the lower the EPS Effect—the **more** dilutive the securities are because the more their conversion would decrease the company’s EPS. Therefore, the various issues are ranked from the **lowest EPS Effect** to the **highest EPS Effect**. ## Footnote The EPS Effect is a ratio between the amount of change in the numerator (income) and the amount of change in the denominator (number of shares) of the EPS calculation that would result from the conversion of each potentially dilutive security.

Answer 102

They are included first in the calculation of Intermediate DEPS without needing to calculate their EPS Effect. ## Footnote The EPS Effect is a ratio between the amount of change in the numerator (income) and the amount of change in the denominator (number of shares) of the EPS calculation that would result from the conversion of each potentially dilutive security. The EPS Effect for options and warrants is always zero since they have no impact on net income, and thus they are ranked first if they are dilutive.

Answer 103

When its inclusion would cause Intermediate DEPS to increase instead of decrease. ## Footnote A security that would cause IDEPS to increase will have an EPS Effect that is higher than the current IDEPS.

Answer 104

They must be disclosed in the notes to the financial statements because they may become dilutive in the future.

Answer 105

To ensure comparability of EPS figures across periods as if the split or dividend had occurred at the beginning of the first period presented.

Answer 106

If they are dilutive, it makes them the most dilutive of all the potential common stock. ## Footnote If the exercise price of the options or warrants is **greater than** the average market price of a share during the period, the exercise of the options or warrants would be **antidilutive**. If the exercise price is **less than** the average market price of a share, the options or warrants would be **dilutive**.

Answer 107

Yes ## Footnote If Diluted Earnings Per Share is reported for at least one period presented, Diluted Earnings Per Share must be reported for all periods presented, even if DEPS is the same as Basic EPS for every other period presented.

Answer 108

The security is considered antidilutive and is excluded from the calculation of DEPS.

Answer 109

It is a capital structure with only common stock and, if it has preferred stock, only nonconvertible preferred stock outstanding and no potential common stock. Entities with simple capital structures should present basic earnings per share amounts for income from continuing operations and for net income on the face of the income statement.

Answer 110

Assume all conversions and exercises occurred over again each year at the beginning of the year unless the securities were issued during a given year. If any potential common stock was issued during a given year, in calculating DEPS **for that year only**, assume the newly issued securities were converted on the date they were issued, and adjust both IAC (if applicable) and WANCSO for that security for that year accordingly.

Answer 111

A reconciliation of the numerators and the denominators of the basic and diluted earnings per share calculations for income from continuing operations.

Answer 112

Any transaction that would have materially changed the number of common shares or potential common shares outstanding if it had occurred before the end of the period.

Answer 113

No ## Footnote Cash flow per share information is not to be reported.

Answer 114

The percentage of the net sales revenue available to cover expenses other than cost of sales, usually called selling, general, and administrative expenses, or SG&A. Gross Profit Margin Percentage = Gross Profit / Net Sales Revenue ## Footnote Gross Profit = Net Sales Revenue − Cost of Goods Sold Net Sales Revenue = Sales Revenue − Sales Discounts and Sales Returns and Allowances

Answer 115

* Sales volume changes * Unit selling price changes * Cost per unit changes ## Footnote Gross Profit Margin Percentage = Gross Profit / Net Sales Revenue

Answer 116

It measures how much of its net sales revenue the company keeps as operating income. Operating Profit Margin Percentage = Operating Income / Net Sales Revenue ## Footnote Net Sales Revenue = Sales Revenue − Sales Discounts and Sales Returns and Allowances

Answer 117

The percentage of net sales revenue represented by operating expenses, usually SG&A expenses. ## Footnote Operating expenses include period costs such as selling, general, and administrative expenses that relate to the company’s principal operations and are expensed as incurred.

Answer 118

The net profit margin percentage measures the percentage of net sales revenue that becomes profit. Net Profit Margin Percentage = Net Income / Net Sales Revenue ## Footnote Net Sales Revenue = Sales Revenue − Sales Discounts and Sales Returns and Allowances

Answer 119

The difference is the percentage of net sales revenue represented by financial income and expense, non-operating gains and losses, and the provision for income taxes.

Answer 120

EBITDA stands for earnings before interest, taxes, depreciation, and amortization. EBITDA is EBIT plus depreciation and amortization expense, to “add back” the depreciation and amortization since they are non-cash expenses.

Answer 121

EBITDA Margin Percentage = EBITDA / Net Sales Revenue ## Footnote Net Sales Revenue = Sales Revenue − Sales Discounts and Sales Returns and Allowances

Answer 122

1. Simply adding depreciation and amortization to EBIT does not result in a statement of cash flows. 2. EBITDA can be used to manipulate perceptions because interest, taxes, depreciation, and amortization are omitted. 3. EBITDA is a non-GAAP measure and does not include non-cash charges like depreciation, which understates the profits needed for a company to remain operational.

Answer 123

It measures how much return the company earns on the capital it has invested in its assets. It measures the company’s success in using financing to generate profits. The higher the ROA, the better, or more effectively, the company is using its assets. ROA = Income / Average Total Assets

Answer 124

ROA helps senior management assess how well managers of individual profit centers or business units have met their goals and can be used to set goals for the coming period.

Answer 125

The income statement figure should be annualized because the "return" is a rate of return and is intended to be an **annual** rate of return. ## Footnote Annualizing an income statement figure that covers less than one year's time expresses it as if that same level of revenue or expense had persisted for a full year. For example, if the income is for one quarter, it should be multiplied by 4 before dividing it by the average assets during the same quarter.

Answer 126

Return on equity measures the return the business receives on the stockholders’ equity invested in the business. Return on Equity = Income / Average Equity ## Footnote Average equity in the denominator of return on equity includes preferred stock. However, if a company has preferred stock outstanding, return on **common** equity is more meaningful because it focuses on the return to common shareholders only. If common equity (total shareholders' equity − preferred equity) is used in the denominator, the numerator should be Net Income − Preferred Dividends.

A.2. Financial Ratio Analysis Flashcards

Analyze liquidity, leverage, activity, and profitability using key financial ratios, including EPS and ROE. (150 cards)