Unit 7: Ratio Analysis

Question 1

Ratio Limitations

Answer 1

• Ratios are constructed from accounting data, much of which is subject to estimation.
• Accounting profit is not equal to economic profit (latter includes explicit AND implicit costs).
• A firm’s mgmt. has an incentive to window dress financial statements to improve results.
• Earnings quality (affected by consistency and used of certain accounting principles)
• Earnings power is the capacity of a firm’s operation to produce cash inflows, and definitely helps to fund payment of fixed changes, long term debt and future dividends.
• Variances in ratio analysis can be attributed to inflation
• May be affected by seasonal factors
  
  • Working capital might vary widely , and year-end balances may not reflect the averages for the period.

Question 2

Liquidity Definition and Liquidity Order

(Order for Assets and Liabilities)

Answer 2

• Liquidity is a firm’s ability to pay its current obligations as they come due and thus remain in business in the short run. Liquidity reflects the ease with which assets can be converted to cash.
  
  • Current assets liquidity, descending order:
    
    • Cash and equivalents
    • Marketable securities
    • Receivable (net of allowance for uncollectible)
    • Inventories
    • Prepaid items
  • Current liabilities must be settled sooner
    
    • Accounts payable
    • Notes payable
    • Current maturities of long term debt
    • Unearned revenues
    • Taxes payable
    • Wages payable
    • Other accruals

Question 3

Liquidity Ratios

(Current Ratio

Quick/Acid Test Ratio

Cash Ratio

Cash Flow Ratio

Networking capital ratio)

Answer 3

• Current Ratio: CURRENT ASSETS / CURRENT LIABILITIES
  
  • Low might indicate solvency problem
  • Quality of accounts receivable and merchandise should be considered before evaluating the current ratio.
  • A general principle is the current ratio should be proportional to the operating cycle. Thus a shorter cycle may justify a lower ratio. This means that company recoups cash fast enough to avoid WC buildup (lower ratio).
• Quick (ACID TEST) ratio – excludes inventories and prepaid from numerator since these assets are harder to liquidate. MORE CONSERVATIVE and measures ability to pay it’s short term debt and avoids inventory valuation.
  
  • (Cash + Marketable securities + net receivables)/current liabilities
• Cash ratio (even more conservative)
  
  • (Cash+ marketable securities)/current liabilities
• Cash flow ratio (significance of cash flow)
  
  • CASH FLOW FROM OPS / CL
• NET WORKING CAPITAL ratio
  
  • (current assets – current liabilities)/ current assets

Question 4

Relevant Question Tips for Ratios

Answer 4

• TRICK: IF A QUESTION GIVES YOU MONETARY AMOUNT OF ASSETS , THEN YOU CAN CALCULATE MORE SPECIFIC LIABILITY ACCOUNTS STARTING FROM THE BASIC PRINCIPLE THAT ASSETS = LIAB + EQUITY.
• PURCHASE OF INVENTORY ON ACCOUNT IS NOT BY USING CASH, BUT RAHTER INCREASING PAYABLES
• IF THE COMPANY WRITES OFF UNCOLLECTIBLE DEBT THERE IS NO IMPACT ON ASSETS SINCE NET RECEIVABLES ARE UNCHANGED = (RECEIVABLES – ALLOWANCE)
• >> RULE OF THUMB FOR RATIO. If N>D, then decrease in numerator and denominator on the same amount increases ratio.

Question 5

Liquidity of current liabilities

Answer 5

• How easy a company can issue new debt or raise new structured (convertible, puttable, callable, etc) funds.

Question 6

Income Statement Ratios

(Gross Profit Margin)

(Operating Profit Margin)

(Net Profit Margin)

Answer 6

• Gross Profit Margin Ratio = PC1 / NR.
• Operating profit margin = EBIT / NR
• Net profit margin = NI / NR
  
  • There can be adjustments to net profit margin to account for discontinued operations, extraordinary items, accounting changes.
  • Numerator can also be based on NI available to shareholders.

Question 7

Profitability Ratios

(ROA, ROE, ROA vs ROE, Sustainable growth rate)

Answer 7

• ROA = Net income / average total assets (beg + end balance divided by 2)
• ROE = Net income / average total equity
• ROE is always greater than ROA by definition since equity < assets.
• _ROA = ROE * (1- D/E)_
• Sustainable growth rate = ROE * (1 – DIVIDEND PAYOUT = RETENTION(g))

Question 8

Dupont Model

ROA (2 TERMS)

&

ROE (3 TERMS)

Answer 8

ROA = NI/NR (NET PROFIT MARGIN) * NR/TA (=TOTAL ASSET TURNOVER)

• This breakdown emphasizes that shareholder return may be explained in terms of profit margin and the efficiency of asset management to generate revenue.

ROE = NI/NR *NR/TA * NA/TE

• Equity multiplier measures a company’s leverage. So taking more debt can help on growth as more debt is being used to finance assets (equity shrinks compared to debt).

Question 9

Revenue Recognition relies in two definitions…

Answer 9

• Revenues are realized when:
  
  • Goods or services have been exchanged for cash or claims of cash (includes inventories), or also for other assets that are readily convertible to cash.
• Revenues are earned when:
  
  • When the earning process has been substantially completed and entity is entitled to them and benefits..

BOTH USUALLY HAPPEN AT THE TIME OF DELIVERY.

Question 10

When to use retrospective or prospective changes in accounting?

Answer 10

Retrospective: change in accounting principle (a bit linked to accounting error, kind of linked to new accounting principle), change in reporting entity structure (for comparability), and accounting errors.

Prospective: change in new information and reassessment of the future benefits of obligations.

Question 11

Solvency (non-current)

and Key Elements

Answer 11

Elements of solvency

• Key ingredients are capital structure and leverage
• As long as the return on debt (NI/long term debt) exceeds the amount of interest paid the use of debt financing is advantageous to the firm.
• Capital adequacy is usually used in connection with financial institutions.
  
  • Can be discussed in terms of solvency, liquidity, reserves or sufficient capital.

Question 12

Capital structure ratios

(Affect Risk Perception)

Answer 12

• Total debt to capital ratio (debt plus equity)
• Debt to equity ratio
• Long term debt / equity ratio
• Debt to total assets = liabilities=debt / assets , NUMERICALLY THE SAME AS DEBT TO CAPITAL SINCE CAPITAL = ASSETS.
• Earnings Coverage
  
  • Times interest earned ratio = EBIT / interest expenses
    
    • EBIT should be adjusted for non-recurrent events.
    • Denominator should include capitalized interest.
  • Earnings to fixed charge, extends the concept to include on the denominator interest portion associated with long-term leases obligations.
    
    • (Earnings before fixed charges and taxes) / fixed charges
      
      • If EBIT is 200 and Lease Payments is 300, then numerator is 500.
    • Fixed charges include 1) interest 2) required principal repayments AND LEASES.
  • Cashflow to fixed charges ratio
    
    • (Cash flow from operations + fixed charges + tax payments)/fixed charges

Note: cash from operations is after-tax .

Question 13

Definition

(Operational vs Financial Leverage)

Answer 13

• Types of leverage
  
  • Leverage is the relative amount of fixed cost in a firm’s overall cost structure. Leverage creates risk because fixed costs must be covered, regardless of the level of sales.
    
    • Operating leverage: high level of plant and machinery in the production process, revealed through charges for depreciation, property taxes, etc..
    • Financial leverage: arises from the use of a high level of debt in the firm’s financing structure, revealed through amounts paid out for interest.
  • Degree of leverage = pre-fixed-cost income amount / post-fixed-cost income amount

Question 14

DOL – Degree of Operating Leverage

(TWO VERSIONS)

Answer 14

• Contribution margin / EBIT (=operating income). Reading better: EBIT = CM - FC
• Multiperiod version of DOL:
  
  • % Delta of EBIT / % Delta in Sales
    
    • Every 1% change in sales generates x% change in EBIT.
    • A firm with high operating leverage necessarily carries a greater degree of risk because fixed costs must be covered regardless of the level of sales. However, such a firm is also able to expand production rapidly in times of higher product demand.

Question 15

DFL - Degree of financial leverage

(ALSO TWO VERSIONS)

Answer 15

• EBIT/ EBT – more interest the higher the ratio.
• Multiperiod version of DFL:
  
  • % Delta Net Income / % in EBIT –
    
    • 1% change in EBIT generates x% in NI.
    • A firm with higher financial leverage has a higher risk because debt hast o serviced regardless of the level of earnings.

Question 16

Comparing Financial Statements

(Vertical vs Horizontal)

Answer 16

• Vertical = based on % of a number in the upper row. Like IS and BS based on total revenue or total assets/liabilities (plus equity).
• Horizontal = change on % based on a given year reference.

Question 17

Off Balance Sheet Financing

(Investment in unconsolidated entities - less than 50% accounts as equity method)

(SPE - Special Purpose Entities)

(Factoring with Recourse)

(Short term lease and OFF BALANCE SHEET FINANCING)

Answer 17

• Firms that carry extensive debt financing but attempt to disguise the fact are engaging in off-balance-sheet financing.
• Investments in unconsolidated entities:
  
  • Can reduce debt on the balance sheet.
  • Less than 50% ownership results in parenting reporting equity investment, but not debt. JOINT VENTURE assumes a similar purpose.
• Special purpose entity (SPE)
  
  • Create another firm with the sole purpose of keeping the liabilities associated with a specific project off the parent firm’s book.
  • Enron hid a huge amount of debt on the balance sheet of SPEs.
• Factoring receivables with recourse (if non recourse is just a sale and genuinely a transfer – no hiding)
  
  • Contingent liability does not have to be shown in the firm balance’s sheet.
• THE MOST COMMON EXAMPLE OF OFF-BALANCE SHEET FINANCING IS THE AMOUNT DUE IN FUTURE YEARS ON SHORT-TERM LEASES. UNDER US GAAP, SHORT TERM LEASES ARE NOT CAPITALIZED, ONLY THE PERIODIC PAYMENTS OF RENT IS REPORTED WHEN ACTUALLY PAID. FINANCE LEASES MUST BE CAPITALIZED.