Presentation on theme: "This week its Accounting Theory"— Presentation transcript:
1 This week its Accounting Theory Session Session 2Tuesday Financial Statements/Expenses/Revenues Accounting Cycle & AccountsWednesday The Income Statement The Balance SheetThursday The Cash Flow Statement Tools & TechniquesFriday Presentations Presentations
2 Tools and Techniques Key financial ratios standardize financial data in terms of mathematical relationshipsare expressed as percentages or timesare extremely valuablehave limitations
3 Tools and Techniques Key financial ratios serve as screening devices indicate areas of potential strength or weaknessreveal matters that need further investigationare not predictive
4 Tools and Techniques Key financial ratios should be used with caution and common senseshould be used in combination with other elements of analysisshould be evaluated and interpreted within the context of the particular firm, industry, and economic environment
6 Tools and Techniques Key financial ratios – Liquidity Ratios Measure ability to meet cash needs as they arise
7 Tools and Techniques Key Financial Ratios – Liquidity Ratios Current RatioQuick Ratio (Acid-Test Ratio)Cash Flow Liquidity RatioAverage Collection PeriodDays Inventory HeldDays Payable Outstanding
8 Tools and Techniques Current Ratio Commonly used measure of the ability of a firm to meet its debt requirements as they come dueLimited by its componentsSome analysts eliminate prepaid assets.Necessary to evaluate the trend of liquidity over a period of time and compare with industry competitors
9 Tools and Techniques Quick Ratio (Acid-Test Ratio) More rigorous test of short-run solvency than the current ratioNumerator eliminates inventory (the least liquid current asset and the most likely source of losses)Some analysts eliminate prepaid expenses.Necessary to evaluate the trend of liquidity over a period of time and compare with industry competitors
10 Tools and Techniques Cash Flow Liquidity Ratio Considers cash flow from operating activitiesUses cash and marketable securities as an approximation of cash resources in the numerator of the ratio
11 Tools and Techniques Average Collection Period Average number of days required to convert receivables into cashCredit sales can be substituted for net sales.Helps gauge the liquidity of account receivableMay provide information about credit policiesShould be compared with the firm’s stated credit policies and the strength of the firm within its industry
12 Tools and Techniques Days Inventory Held Average number of days required to sell inventory to customersMeasures efficiency of the firm in managing its inventoryType of industry is important in evaluating this ratioNecessary to check the cost flow assumption used to value inventory and cost of goods sold when making comparisons among firms
13 Tools and Techniques Days Payable Outstanding Average number of days it takes to pay payables in cashOffers insight into a firm’s pattern of payments to suppliers
14 Tools and Techniques Key Financial Ratios – Cash Conversion Cycle Also called Net Trade CycleNormal operating cycle of a firm that consists of:buying or manufacturing inventory, with some purchases on creditselling inventory, with some sales on creditcollecting the cashHelps the analyst understand why cash flow generation has changed
15 Tools and TechniquesKey Financial Ratios – Cash Conversion Cycle
16 Tools and Techniques Key financial ratios – Activity Ratios Measure liquidity of specific assets and efficiency of managing assets
18 Tools and Techniques Accounts Receivable Turnover Measures how many times on average accounts receivable are collected in cash during the yearMeasures efficiency of a firm’s collection and credit policies
19 Tools and Techniques Inventory Turnover Measures how many times on average inventory is sold during the yearMeasures efficiency of a firm in managing its inventory
20 Tools and Techniques Accounts Payable Turnover Measures how many times on average payables are paid during the yearHelps to gain insight into a firm’s pattern of payment to suppliers
21 Tools and Techniques Fixed Asset Turnover Assesses management’s effectiveness in generating sales from investments in fixed assetsConsiders only the firm’s investment property, plant, and equipmentExtremely important for a capital-intensive firmHigh ratio generally means only a small investment is required to generate sales (and thus the firm will be more profitable).
22 Tools and Techniques Total Asset Turnover Assesses management’s effectiveness in generating sales from investments in assetsConsiders all assetsHigh ratio generally means only a small investment is required to generate sales (and thus the firm will be more profitable).
23 Tools and Techniques Key financial ratios – Leverage Ratios Measure the extent of financing with debt relative to equity and ability to cover interest and other fixed chargesUse of debt provides a trade-off of risk and returnDebt ratios do not present the whole picture with regard to risk.Operating earnings must be sufficient to cover the associated fixed charges for debt to translate to leverage.
24 Tools and Techniques Key Financial Ratios – Leverage Ratios Debt Ratio Long-Term Debt to Total CapitalizationDebt to EquityTimes Interest EarnedCash Interest CoverageFixed Charge CoverageCash Flow Adequacy
25 Tools and Techniques Debt Ratio Measures the extent of the firm’s financing with debtConsiders the proportion of all assets that are financed with debt
26 Tools and Techniques Long-Term Debt to Total Capitalization Measures the extent of the firm’s financing with debtReveals the extent to which long-term debt is used for the firm’s permanent financing
27 Tools and Techniques Debt to Equity Measures the extent of the firm’s financing with debtMeasures the riskiness of the firm’s capital structure in terms of the relationship between the funds supplied by creditors (debt) and investors (equity)
28 Tools and Techniques Times Interest Earned Indicates how well operating earnings cover fixed interest expensesThe higher the ratio, the betterCan be misleading depending on cash flow
29 Tools and Techniques Cash Interest Coverage Measures how many times interest payments can be covered by cash flow from operations before interest and taxes
30 Tools and Techniques Fixed Charge Coverage Broader measure of coverage capability than the times interest earned ratioIncludes the fixed payments associated with leasingImportant for firms that operate extensively with operating leases
31 Tools and Techniques Cash Flow Adequacy Measures firm’s ability to cover capital expenditures, long-term debt payments, and dividends each yearDefined differently by analystsOperating cash flow should cover investing and financing activities.
32 Tools and Techniques Key financial ratios – Profitability Ratios Measure the overall performance of a firm and its efficiency in managing assets, liabilities, and equity
33 Tools and Techniques Key Financial Ratios – Profitability Ratios Gross Profit MarginOperating Profit MarginNet Profit MarginCash Flow MarginReturn on Total Assets (ROA)Return on Equity (ROE)Cash Return on Assets
34 Tools and Techniques Gross Profit Margin Represents firm’s ability to translate sales dollars into profitsShows the relationship between sales and the cost of products soldMeasures the ability to control costs of inventories or manufacturing and to pass along price increases through sales
35 Tools and Techniques Operating Profit Margin Represents firm’s ability to translate sales dollars into profitsMeasures overall operating efficiencyIncorporates all expenses associated with ordinary business activities
36 Tools and Techniques Net Profit Margin Represents firm’s ability to translate sales dollars into profitsMeasures profitability after consideration of all revenue and expense, including interest, taxes, and nonoperating items
37 Tools and Techniques Cash Flow Margin Measures ability to translate sales into cashCash is needed to service debt, pay dividends, and invest in new capital assets.
38 Tools and Techniques Return on Total Assets (ROA) Also called Return on Investment (ROI)Measures the overall efficiency of the firm in managing its total investment in assetsIndicates the amount of profit earned relative to the level of investment in total assets
39 Tools and Techniques Return on Equity (ROE) Measures the overall efficiency of the firm in generating return to shareholdersCalculated as return on common equity if a firm has preferred stock outstanding
40 Tools and Techniques Cash Return on Assets Offers a useful comparison to return on investmentMeasures the firm’s cash-generating ability of assets
41 Tools and Techniques Key financial ratios – Market Ratios Measure returns to stockholders and the value the marketplace puts on a company’s stockReporting of these numbers has a significant impact on stock price changes in the marketplace.Thorough analysis of a company, its environment, and its financial information offers a much better gauge of future prospects of the company than looking exclusively at these ratios.
42 Tools and Techniques Key Financial Ratios – Market Ratios Earnings Per Common SharePrice-to-Earnings (P/E) RatioDividend Payout RatioDividend Yield
43 Tools and Techniques Earnings per Common Share Provides the investor with a common denominator to gauge investment returnsMust be disclosed on the income statement for publicly held companies
44 Tools and Techniques Price to Earnings (P/E) Ratio Relates earnings per common share to the market price at which the stock trades, expressing the “multiple” that the stock market places on a firm’s earningsFunction of a myriad of factors including quality of earnings, future earnings potential, and performance history
45 Tools and Techniques Dividend Payout Ratio Relates cash dividends per share to earnings per share
46 Tools and Techniques Dividend Yield Shows the relationship between cash dividends and market price