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Flashcards in HBX- Accounting 6 Deck (66)
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1
Q

What are the key things that you want to do when you use ratios?

A
  • try to use amounts that can give an insight into the business
  • be consistent in the way that the ratios are calculated when comparing them between periods for a company or when comparing them for different companies.

When calculating ratios that include both balance sheet and income statement amounts, we generally use an average of beginning and ending balances for the balance sheet amount.

2
Q

What is ROE (Return on Equity) & The DuPont Framework?

  • Define It
  • List the Formulas
  • State what it means for a company. Is a higher or lower # better?
A
  • It shows the return that a business generated during a period on the equity invested in the business by the owners of the business.

Return on equity = (net income) / (total owners’ equity)

  • While this is a useful measure of financial performance of a firm, it can be broken down further to reveal where the returns are being generated. The return on equity of a firm consists of three factors: profitability, operating efficiency and financial leverage. These are three general areas that management can adjust to increase overall ROE. This breakdown, known as the DuPont Framework, allows us to see more specifically where favorable or unfavorable returns are originating.

Return on equity = profitability x operating efficiency x financial leverage

  • For a profitable company, increasing the ratio in any one of these areas will increase the overall return on equity and provide greater returns for investors.
  • However, if this increase is accomplished by higher leverage, the riskiness of the business increases as well. If the business makes a loss, the negative ROE is amplified by the higher leverage, making leverage a two-edged sword.*
  • For any one company, a higher ROE is generally better than a lower ROE.
  • However, when comparing different companies in different industries, a higher return on equity by itself does not necessarily indicate that one business is doing better than another business.*
  • We end up with the same number for ROE as we do when dividing net income by equity. The only difference is that we can see more detail about what is really going on in the business and driving the return on equity. Management can use this insight to improve the way business operates.
  • It’s important to keep in mind many other aspects about the business and its operations. The individual components of ROE can vary greatly between companies, depending on the type of business. For example, an online retailer might have a very low profit margin, as it fights stiff competition and doesn’t add a lot of value to the product that its purchasing from the vendor. However, a manufacturer or a technology company that uses proprietary techniques can likely demand a much higher premium for their product, which results in a higher profit margin.
3
Q

What is the DuPont Framework and what does it measure?

A

The DuPont Framework expands the ROE formula to consist of three measures:

  • profitability using Profit Margin
  • efficiency using Asset Turnover
  • leverage using the Leverage Ratio (or Equity Multiplier)​

For any one company, a higher ROE is generally better than a lower ROE.

4
Q

PROFIT MARGIN FORMULA

A

The first section of the DuPont Framework, profitability, reveals how much profit is left from each dollar of sales after all expenses have been subtracted.

  • *Profit Margin = NET INCOME / TOTAL SALES FOR THE PERIOD**
  • *These values are taken from the income statement*

For H&M in the year 2012, the profit margin was 13.96%. In other words, for every hundred Swedish krona of sales that H&M had, 14 ended up in the net income for the period. Profit margin is an important measure.

A high net profit margin means a company keeps a large proportion of its revenue as profit, so it is better to have a high net profit margin than a low or negative net profit margin. (google)

5
Q

How to do an average of 2 numbers in excel.

A

=AVERAGE(A1,A2) Or =SUM(A1,A2)/2 Or =(A1+A2)/2

6
Q
A

The Profitability or Profit Margin is calculated by dividing the Net Income by the Revenue. In this case, the calculation is as follows:

Net Income / Revenue = 483,232 / 4,358,100 = 11.09%

The suggested correct answer formula is:

=C9/C4

7
Q
A

The Profitability or Profit Margin is calculated by dividing the Net Income by the Revenue. In this case, the calculation is as follows:

Net Income / Revenue = 37,037 / 170,910 = 21.67%

The trick is to recognize that the Revenue is equal to the Cost of Sales plus the Gross Profit (170,910 = 106,606 + 64,304). As we have learned, Revenue minus Cost of Sales equals Gross Profit so it follows that Cost of Sales plus Gross Profit equals Revenue.

The suggested correct answer formula is:

=C12/(C6+C7)

8
Q

Which of the following ratios measures the ability of a company to make a profit relative to the revenue generated during the period?

  • ROA
  • Profit Margin
  • ROE
  • ROI
A
  • Profit Margin
  • This is the correct answer! Profit margin shows the % of each dollar of sales that ends up as net profit.
9
Q

How do you calculate the profit margin ratio within the DuPont Framework?

  • Operating income/Sales
  • COGS/Sales
  • Net income/Sales
  • EBIT/Sales
A
  • Net income/Sales
  • This ratio shows the % of each dollar of sales that ends up as net profit.
10
Q

Suppose the profit margin for Cardullo’s Gourmet Shoppe, Inc for Q1 was 4.99% and Q2 was 10.57%. Which of the following statements can you conclude regarding Cardullo’s?

  • Cardullo’s is more efficient in utilizing its assets in Q2 than in Q1.
  • Cardullo’s does a better job in cost control in Q2 than in Q1.
  • Cardullo’s is more effective in extending credit and collecting debts in Q2 than in Q1.]
A
  • Cardullo’s does a better job in cost control in Q2 than in Q1.
  • This is the correct answer! Profit margin is the percentage of selling price that turned into profit. Cardullo’s could increase its profit by reducing costs, thus increase its profit margin.
11
Q

The profit margin for East Corp. for each year from 2011 to 2013 is listed below.

2011: 7.13%
2012: 7.68%
2013: 8.14%

Which of the following is NOT a reasonable explanation for the trend in the ratio?

  • The variable costs decreased due to an improvement in technology.
  • An increase in the sales price due to higher demand resulting from a successful marketing campaign.
  • East Corp. declared a cash dividend to shareholders.
A
  • The variable costs decreased due to an improvement in technology.
    • Lower variable costs would result in a higher profit margin.
  • An increase in the sales price due to higher demand resulting from a successful marketing campaign.
    • Increase in sales price would result in a higher profit margin.
  • East Corp. declared a cash dividend to shareholders.
    • This is the correct answer! This situation wouldn’t directly impact a company’s profit margin.
12
Q

What is the purpose of Gross Profit Margin and what’s the formula?

A

Gross Profit Margin- Profitability Ratios
When the profit margin is used to determine profitability using the DuPont Framework, other ratios are also very useful. One of those is the gross profit margin. We’ve already talked about gross profit being revenues minus the cost of goods sold. This ratio is simply converting the numbers into a percentage– gross profit divided by sales. **This tells us what percentage of revenue is left to cover other expenses after the cost of goods sold is subtracted.

Gross Profit Margin = GROSS PROFIT / SALES**

*These values are taken from the income statement​

13
Q

What are the two Profitability Ratios?

A
  • gross profit margin
  • Earnings before interest after taxes, or EBIAT
14
Q
A

Gross Profit Margin is calculated by dividing the Gross Profit (Revenue less Cost of Sales) by the Revenue. In this case, the calculation is as follows:

(Revenue - Cost of Sales) / Revenue = Gross Profit Margin

(170,910 - 106,606) / 170,910 = 37.62%

The suggested correct answer formula is:

=(B1-B4)/B1

15
Q
A

Gross Profit Margin is calculated by dividing the Gross Profit by the Revenue. In this case, the calculation is as follows:

Gross Profit / Revenue = 1,619,386 / 4,358,100 = 37.16%

The suggested correct answer formula is:

=B6/B4

16
Q
A

Higher demand has allowed Amazon to increase their prices, while higher overhead expenses have been hurting overall profits.

Higher selling prices would result in a higher gross profit margin, but increasing operating expenses could eat away the profits before they hit the bottom line.

17
Q

The gross profit margin for Amazon for each year from 2010 to 2012 is listed below.

2010: 22.35%
2011: 22.44%
2012: 24.75%

Which explanation below is a reasonable explanation for the trend in the ratio?

  • Increased competition is forcing Amazon to lower its prices.
  • Amazon issued new stock during the year to raise additional capital.
  • Inventory prices have fallen resulting in decreased COGS.
A
  • Inventory prices have fallen resulting in decreased COGS.
  • This is the correct answer! If the cost of inventory decreased, Amazon could make more money off of each item it sold.
18
Q

Suppose the following were the gross profit margins for Green Mountain Coffee Roasters (GMCR) from 2011 through 2013.

2011: 34.13%
2012: 32.89%
2013: 37.16%

  • What could be an explanation of the fluctuations in gross profit margins for GMCR from 2011 through 2013?​
  • Selling & Operating expenses went from 13.15% to 12.48% to 12.86% from 2011 to 2013.
  • Labor and Overhead costs were lower as a percentage of Sales in 2012.
  • An increase in manufacturing capacity at the beginning of 2012 caused overhead to increase but allowed for greater efficiency and significant sales growth later.
A
  • An increase in manufacturing capacity at the beginning of 2012 caused overhead to increase but allowed for greater efficiency and significant sales growth later.
  • This is the correct answer! The increase in overhead costs could hurt 2012 margins but pave the way for more profitable operations in 2013.
19
Q

Suppose the gross profit margin for Cardullo’s Gourmet Shoppe, Inc for Q1 was 47.25% and Q2 was 47.70%. Which of the following is a reasonable explanation for the change in the ratio?

  • Cardullo’s offered a volume discount in Q2.
  • Cardullo’s negotiated with vendors and successfully reduced overall inventory prices.
  • Cardullo’s sold a truck and realized a gain on the sale in Q2.\
A
  • Cardullo’s negotiated with vendors and successfully reduced overall inventory prices.
  • This is the correct answer! If the cost of inventory decreased, Cardullo’s could make more money off of each item it sold.
20
Q

What is… Earnings before interest after taxes, or EBIAT?

A

Earnings before interest after taxes, or EBIAT, is a measure of how much income the business has generated while ignoring the effect of financing and capital structure, or the proportion of debt that the business has. As the name implies, interest expense, which is included on the income statement, is added back, and income tax expense is calculated and subtracted based on earnings before interest.

For H&M, EBIAT for 2012 is 16.8 billion Swedish krona.We will not go further into calculating EBIAT now, but it is an important measure to understand as we will see it again in Module 7.

21
Q

Define & List the Formula to Asset Turnover

A

This tells us how well a business is using its assets to produce sales. Initially, it may seem like it is good for a business to have many assets. However, from an efficiency perspective, this isn’t the case. A business that can create more revenue with fewer assets is more efficient.

ASSET TURNOVER = SALES / ASSETS
*These values are taken from the income statement & the balance sheet

H&M’s asset turnover for 2012 was 2.01. This shows that H&M generated sales of about 2 krona on each krona of assets during the period. An interesting thing to note here is that _this ratio uses both the income statement and the balance sheet._ Because the income statement covers the entire year, but the balance sheet is as of a specific point in time, we typically use the average of the beginning and ending balance sheet amounts to estimate the average level of assets during the period.

22
Q
A

Asset Turnover is calculated by dividing the annual revenue by the average asset value for the year. In this case, we are using a two-point average of beginning and end of year asset values so the calculation is as follows:

Revenue / Average Assets = 170,910 / 191,532 = 0.89

To calculate average assets, you are given the beginning total of $176,064 but you must calculate the ending total by summing all asset accounts as of Sept 28, 2013 (a shortcut would be to add the Liabilities and Equity at September 28, 2013, since we know A = L + OE). The ending total is $207,000 making the average $191,532.

There are several formulas that could help you arrive at the correct answer, but one solution is presented below:

=B17/AVERAGE(B14,SUM(B2:B9))

23
Q

Name the Different Efficiency Ratios

A
  • Asset Turnover
  • Inventory turnover
  • Days Inventory
  • The Accounts Receivable Turnover
  • The average collection period
  • Accounts Payable Turnover
  • days purchases outstanding.
  • Cash Conversion Cycle
24
Q
  • Define the purpose of the ratio for Inventory turnover,
  • explain the formula, and
  • state what a higher inventory represents
A
  • This is a very useful ratio to understand how efficiently a business is managing its inventory levels. Just as more sales for a given level of assets increases efficiency, keeping less inventory on hand relative to the quantity of inventory sold does the same. Excess inventory costs money to store and uses up the firm’s cash that could be used for other investments. If a business can have lower inventory levels, while not running out of inventory for customers, it can operate more efficiently.
  • INVENTORY TURNOVER = COGS/AVERAGE INVENTORY
  • A higher inventory turnover represents more efficient inventory management.

Notice how again we used the average inventory balance instead of the ending balance that is typically displayed on the balance sheet. This is especially significant and provides better results than using the ending balance, especially for a firm that is growing quickly, as the level of inventory could have fluctuated during the year. We could further improve the accuracy by averaging more frequent inventory balances, such as quarterly or monthly, but for purposes of this course we’ll use the beginning and ending balances to determine average inventory.

25
Q

Explain the purpose of the ratio Days Inventory and state the formulas.

A
  • Days Inventory is closely tied to the inventory turnover. The only difference is that it is expressed as the average number of days the inventory is held before it is sold rather than how many times the inventory turned over during the period. Analyzing ratios expressed in days can often be more intuitive as we can more easily conceptualize the average number of days it takes to sell inventory.
  • Two Ways to Calculate
    • DAYS INVENTORY = AVERAGE INVENTORY / (COST OF GOODS SOLD/365)
    • DAYS INVENTORY = 365 / INVENTORY TURNOVER
26
Q
A

Inventory Turnover is calculated by dividing the annual Cost of Goods Sold (or Cost of Sales in this case) by the average inventory value for the year. In this case, we are using a two-point average of beginning and end of year asset values so the calculation is as follows:

Cost of Sales / Average Inventory = 106,606 / 1,278 = 83.45

Days Inventory is calculated by dividing Average Inventory by the average daily Cost of Sales which is Cost of Sales divided by 365.

Average Inventory / Average Daily Cost of Sales = 1,278 / 292 = 4.37

There are several formulas that could help you arrive at the correct answer, but one solution is presented below:

Inventory Turnover:

=C15/AVERAGE(B4:C4)

Days Inventory:

=AVERAGE(B4:C4)/(C15/365)

27
Q
  1. Define the purpose of ACCOUNTS RECEIVABLE turnover,
  2. state the formula, &
  3. state what a higher AR turnover represents
A
  • The Accounts Receivable Turnover, often called AR turnover, is similar to the inventory turnover, but provides an indication of a business’ efficiency in collecting receivables from customers. AR turnover represents the number of times per year a company is collecting its outstanding accounts receivable. Uncollected receivables represent cash that is tied up and can’t be used for other purposes. An AR turnover that is too low could indicate that the business’ customers are having trouble paying. Inefficient cash collections could lead to eventual cash flow problems.
  • AR TURNOVER = CREDIT SALES / AVERAGE ACCOUNT RECEIVABLES

*Notice how again we used the average AR balance, as we did with inventory. This is for the same reasons mentioned previously.
* A higher AR turnover represents more efficient cash collections.
Note that in the absence of information about credit sales, we will often simply use sales as a substitute. There are some limitations to simply using sales, especially if a company does have a large discrepancy between total sales and credit sales.

28
Q
  • State the purpose of the AVERAGE COLLECTION PERIOD ratio
  • List the formulas
A
  • The average collection period, sometimes referred to as Days Sales Outstanding or Days Sales in Receivables, is the average number of days it took for a business to collect payment from a customer. It is closely tied to the AR turnover. The AR turnover and average collection period ratios are parallel to Inventory turnover and days inventory ratios. Both reveal information about the efficiency of managing a specific account in terms of number of times per year the account is turned over or the number of days values remain in the account.​The average collection period is very useful because it can be compared to the cash collection policy of the firm. If payment is expected from customers within 30 days, but the average collection period is 40 days, it may be a sign of concern. Businesses can influence their collection period by altering the payment terms they offer, but will have to balance the desire for greater cash collection efficiency with the impact that it will have on sales, as customers generally find value in receiving credit terms from a supplier.
  • AVERAGE COLLECTION PERIOD =
  • *AVERAGE ACCOUNTS RECEIVABLE / AVERAGE CREDIT SALES PER DAY**
  • *Assuming all sales were made on credit, Credit Sales per Day can be calculated as Sales / 365. Again, in the absence of information about credit sales, we will often simply use sales as a substitute anyway.*
  • AVERAGE COLLECTION PERIOD = 365 / ACCOUNTS RECEIVABLE TURNOVER

The average collection period for H&M was 6.86 days. This is a relatively small collection period likely due to H&M receiving most payments from customers by cash or credit card. Credit card companies typically transfer the actual cash to the vendor within a few days. A business that sells to other businesses and provides credit terms, will have a much larger collection period.

29
Q
A

Accounts Receivable Turnover is calculated by dividing the annual credit sales by the average accounts receivable balance. In this case, we assume that all of Apple’s revenue is from sales made on credit terms. Again we will use a 2-point average of beginning and end of year accounts receivable balances.

Credit Sales / Average Accounts Receivable = 170,910 / 12,016 = 14.22

Average Collection Period is calculated by dividing Average A/R by the average daily Credit Sales, which is Credit Sales divided by 365.

Average Accounts Receivable / Average Daily Credit Sales = 12,016 / 468 = 25.66

There are several formulas that could help you arrive at the correct answer, but one solution is presented below:

Accounts Receivable Turnover:

=C14/AVERAGE(B3:C3)

Average Collection Period:

=AVERAGE(B3:C3)/(C14/365)

30
Q

Accounts Payable Turnover Ratio

  • Define
  • List Formula
  • State what it means- higher # better or worse?
A
  • Accounts Payable Turnover, or AP turnover, is very similar to both inventory turnover and AR turnover. The same process is followed but for the accounts payable account. We are looking at how long it takes us to pay our vendors (suppliers of inventory/services or other non-inventory items)
  • ACCOUNTS PAYABLE TURNOVER = CREDIT PURCHASES / ACCOUNTS PAYABLE
  • ACCOUNTS PAYABLE TURNOVER = COGS / AVERAGE ACCOUNTS PAYABLE
  • One input for this ratio is credit purchases. If this ratio is being calculated by someone outside of the business, credit purchases can be a difficult number to determine. He or she likely won’t know exactly what credit purchases are. A common way to estimate credit purchases is to use cost of goods sold. This will usually be slightly different than actual credit purchases because fluctuations in inventory and other current asset accounts would mean that more or less was sold or used than was actually purchased. That said, COGS is probably a reasonable proxy for purchases for merchandising companies such as retailers, wholesalers, and distributors. However for manufacturing companies, labor and overhead are included in cost of goods sold, but they aren’t part of actual purchases. We can adjust for inventory fluctuations by adding or subtracting the change in inventory to the COGS amount, similar to what we did when creating the statement of cash flows. Added labor can be a bit more difficult to figure out. For simplicity in this course, we’ll use Cost of Goods Sold as a surrogate for credit purchases. This is still a very useful number, especially when used to identify trends over time rather than to draw specific conclusions from the ratio for an isolated year.
  • Another assumption being made by this approach is that all goods are bought on credit and not paid for with cash. If a business pays cash for some purchases, other adjustments may have to be made.
  • A smaller AP turnover, meaning it is taking longer to pay suppliers, isn’t necessarily a bad thing as long as payment is being made within the terms or expectations of the supplier. Generous payment terms from a supplier can be a huge benefit to a business because it acts as free short term financing. However, companies are often offered a discount for paying quickly, so there is a trade off between discounts for paying early and taking advantage of free short term financing.
31
Q

Days Purchases Outstanding Ratio

  • Define
  • List Formula
  • State what it means- higher # better or worse?
A
  • Another way to gauge our accounts payable is to look at days purchases outstanding. Again this simply shows the AP turnover measured in average days outstanding. A days purchases outstanding that is longer than the allowed terms from the vendor could indicate that the business is struggling to pay its obligations.
  • DAYS PURCHASES OUTSTANDING = AVERAGE ACCOUNTS PAYABLE / (ANNUAL CREDIT PURCAHSES/365)
    *where credit purchases data is available
  • DAYS PURCHASES OUTSTANDING = AVERAGE ACCOUNTS PAYABLE / (COGS/365)
    *where credit purchases data is NOT available
  • DAYS PURCHASES OUTSTANDING = 365 / ACCOUNTS PAYABLE TURNOVER
    *Another formula to look at
  • For H&M, using COGS as a proxy for credit purchases, the days purchases outstanding in 2012 was 31.86 days. This means that, on average, H&M pays its suppliers back within about 31.86 days.
32
Q
A

Accounts Payable Turnover is calculated by dividing the annual credit purchases by the average accounts payable balance. In this case, we do not have access to Apple’s credit purchases so we are using Cost of Sales as a proxy. Again we will use a 2-point average of beginning and end of year accounts payable balances.

Cost of Sales / Average Accounts Payable = 106,606 / 21,771 = 4.90

Days Purchases Outstanding is calculated by dividing Average Accounts Payable by the average daily Cost of Sales, which is Cost of Sales divided by 365.

Average Accounts Payable / Average Daily Cost of Sales = 21,771 / 292 = 74.54

There are several formulas that could help you arrive at the correct answer, but one solution is presented below:

Accounts Payable Turnover:

=C17/AVERAGE(B7:C7)

Days Payable Outstanding:

=AVERAGE(B7:C7)/(C17/365)

33
Q

CASH CONVERSATION CYCLE

A
  • This metric is a measure of how long it takes a business from the time it has to pay for inventory from its suppliers until it collects cash from its customers. This number has a large impact on the cash needs of a business.
  • CASH CONVERSION CYCLE =
  • *DAYS INVENTORY + AVERAGE COLLECTION PERIOD - DAYS PURCHASES OUTSTANDING**
  • A business that is growing and has a positive cash conversion cycle will need more and more cash to fund operations as it gets bigger.
34
Q

Show/Explain the Difference

  • Days Inventory is closely tied to the inventory turnover. The only difference is that it is expressed as the average number of days the inventory is held before it is sold rather than how many times the inventory turned over during the period.
  • The average collection period, sometimes referred to as Days Sales Outstanding or Days Sales in Receivables, is the average number of days it took for a business to collect payment from a customer.
  • Days purchases outstanding. Again this simply shows the AP turnover measured in average days outstanding. A days purchases outstanding that is longer than the allowed terms from the vendor could indicate that the business is struggling to pay its obligations.

Some businesses can actually have a negative cash conversion cycle. This happens when a business purchases goods from a supplier on credit terms, and is able to sell the inventory and collect cash from the customer before payment is required to be made to the supplier. Having a negative cash conversion cycle can be very beneficial for the cash flows of a business, especially if that business is growing. Rather than requiring more and more cash to increase inventory, the business can rely on the credit from its suppliers.

A
35
Q
A

The correct answer is -44.50.

The correct answer formula is:

=F6+F7-F8

The Cash Conversion Cycle is the number of days between when your company pays for inventory purchases and when your company collects from customers. It is calculated by subtracting the Days Purchases Outstanding from the total of the Days Inventory and the Average Collection Period. For the year ending June 30, 2013 it was:

Days Inventory + Average Collection Period - Days Purchases Outstanding = 4.37 + 25.66 - 74.54 = -44.50

36
Q

Which of the following changes will cause a company’s Asset Turnover to decrease?

  • Increase in Sales Revenue
  • Fixed Asset Write off
  • Increase in inventory ending balance
A
  • Increase in inventory ending balance
  • Asset Turnover = Sales / Average Assets An increase in the inventory ending balance will cause Average Assets, the denominator, to increase, and thus will decrease Asset Turnover.
37
Q

A company’s Inventory Turnover decreased during the year. Which of the following is a reasonable explanation to this trend?

  • Inventories were less marketable compared with last year.
  • 3% of inventories were written off by the end of the year.
  • Cost of Goods Sold of current year increased by 5%.
A
  • Inventories were less marketable compared with last year.
  • Inventory Turnover = Cost of goods sold / Average inventory As the inventories became less marketable, the company would be less efficient in operating its inventories, and thus the Inventory Turnover would decrease.
38
Q

Company A has a higher Days Inventory than Company B. Which of the following statements is true regarding these two companies?

  • Company A has a lower Inventory Turnover than Company B.
  • Company A has a higher average inventory than Company B.
  • Company A is more efficient in using its inventory to generate revenue.
A
  • Company A has a lower Inventory Turnover than Company B.
  • Days Inventory = Average Inventory / (COGS / 365) Days Inventory is inversely related to Inventory Turnover. A company with a lower Inventory Turnover would have a higher Days Inventory.
39
Q

Company A has a shorter Average Collection Period than Company B. Which of the following statements is true regarding these two companies?

  • Company A has a lower Accounts Receivable Turnover than Company B.
  • Company A is more efficient in collecting receivables from customers than Company B.
  • Company A is more efficient in generating revenue than Company B.
A
  • Company A is more efficient in collecting receivables from customers than Company B.
  • Average Collection Period = 365 / (Credit Sales / Average AR Balance) A lower Average Collection Period means the company is more efficient in collecting from their customers.
40
Q

Company A has a higher Days Purchases Outstanding than Company B. Which of the following statements is true regarding these two companies?

  • Company A is paying suppliers at a faster rate than Company B.
  • Company A has a lower Accounts Payable Turnover than Company B.
  • Company A has a better ability to pay off its short-term liabilities than Company B.
A

Company A has a lower Accounts Payable Turnover than Company B.

Days Purchases Outstanding = 365 / (Credit Purchases / Average Accounts Payable Balance) Days Purchases Outstanding is inversely related to Accounts Payable Turnover. A company with a higher Days Purchases Outstanding would have a lower Accounts Payable Turnover.

41
Q

What are the LEVERAGE RATIOS?

A
  • Leverage (Leverage = Assets / Equity)
  • Debt to Equity Ratio (Debt to Equity Ratio = Average Total Liabilities / Average Total Equity)
42
Q

Leverage Ratio

  • Define
  • List Formula
  • State what it means- higher # better or worse?
A
  • The last section of the DuPont Framework is financial leverage, which is also known as the equity multiplier. This measures the impact of all non-equity financing, or debt of all sorts, on the firm’s ROE. If all of the assets are financed by equity, the multiplier is one. As liabilities, which are forms of debt, increase, the multiplier increases from one, demonstrating the leverage impact of the debt.
  • LEVERAGE = ASSETS / EQUITY
  • While increased leverage has the potential to increase returns, it also increases the riskiness of the investment. When a business makes a loss, the debt amplifies the impact of the loss on equity holders. Moreover, if the business were to fail, debt holders would receive their money back before any money went to the equity holders. Leverage is calculated by dividing average total assets by average equity.
    ​H&M’s leverage for 2012 was 1.37, meaning that for every krona of equity outstanding, it had .37 krona funding from various liabilities.
  • You can think of it this way. If a firm receives a $100 equity investment and has no debt, it can use that $100 to buy assets that generate income. If the firm takes out an additional $100 of debt, however, it can use the extra capital to purchase even more revenue-generating assets, resulting in even more profits for the shareholders, provided the business generates a higher return on its assets than the cost of the debt.
43
Q
A

In the DuPont Framework, the leverage ratio is calculated by dividing the average total assets by the average equity.

Average Total Assets / Average Equity = 191,532 / 120,879.50 = 1.58

The suggested correct answer formula is:

=AVERAGE(B6:C6)/AVERAGE(SUM(B12:B14),SUM(C12:C14))

44
Q

DEBT TO EQUITY

  • Define
  • List Formula
  • State what it means- higher # better or worse?
A
  • Another very common indicator of leverage is the debt to equity ratio. This number is very similar to the equity multiplier, but we use total liabilities in the numerator rather than assets.
  • DEBT TO EQUITY = AVERAGE TOTAL LIABILITIES / AVERAGE TOTAL EQUITY
  • Debt to equity for H&M was 0.37 for 2012.
45
Q
A

The Debt to Equity Ratio is calculated by dividing the total liabilities by the total equity. In this case, total liabilities includes Accounts Payable, Accrued Expenses, Other Current Liabilities, Long Term Debt, and Other Long Term Liabilities. Total equity includes Common Stock, Retained Earnings, and AOCI & Other Equity.

For 2012, total liabilities are $57,854 and total equity is $118,210.

Total liabilities / total equity = $57,854 / $118,210 = 0.49

The suggested correct answer formula is:

=SUM(B7:B11)/SUM(B12:B14)

For 2013, total liabilities are $83,451 and total equity is $123,549.

Total liabilities / total equity = $83,451 / $123,549 = 0.68

The suggested correct answer formula is:

=SUM(C7:C11)/SUM(C12:C14)

For the average, average total liabilities are $70,653 and average total equity is $120,880.

Total liabilities / total equity = $70,653 / $120,880 = 0.58

The suggested correct answer formula is:

=AVERAGE(SUM(B7:B11),SUM(C7:C11))/AVERAGE(SUM(B12:B14),SUM(C12:C14))

Note that there is no requirement to calculate ratios using beginning and ending balances before calculating a ratio using average balances, but some managers may find it useful to see how the ratio differs under these different calculation methods.

46
Q

The Current Ratio

  • Define
  • List Formula
  • State what it means- higher # better or worse?
A
  • The current ratio helps us understand the business’ ability to pay its short term obligations, and is measured as current assets divided by current liabilities. The ratio focuses on the business’ more liquid assets and liabilities, or those that are convertible to cash or coming due, within a year. Remember that short term assets (Essentially these are the assets that a business has in cash or will turn into cash to help pay approaching obligations.) are like (Cash, Inventory, accounts receivable. Current liabilities (are items that must be paid, in cash, in the short term.) include accounts payable & wages payable.
  • CURRENT RATIO = CURRENT ASSETS / CURRENT LIABILITIES
  • If current assets aren’t larger than current liabilities, which would lead to a ratio less than 1, it could indicate that a business may have trouble meeting its obligations in the near term. Generally, the higher the current ratio the better position the business is in to meet its approaching liabilities. But if the current ratio is too high, it might indicate that the business is not managing its working capital efficiently.
  • Let’s look at how the current ratio would be calculated for H&M. H&M had current assets of 37.23 billion krona and current liabilities of 14.01 billion krona. This results in a current ratio of 2.66, meaning thatfor every krona in current liabilities, H&M has 2.66kronain at least somewhat liquid assets to be able to pay those liabilities.**
47
Q
A

The Current Ratio is calculated by dividing Current Assets by Current Liabilities at a point in time. For this ratio, we do not use the average amounts. Current Assets include Cash, Equivalents, Marketable Securities, Accounts Receivable, Inventory, and Other Current Assets. Current Liabilities include Accounts Payable, Accrued Expenses, and Other Current Liabilities.

Current Assets / Current Liabilities = 73,286 / 43,658 = 1.68

The suggested correct answer formula is:

=SUM(B2:B5)/SUM(B12:B14)

48
Q
A

Current assets continued to grow without a proportionate increase to its liabilities.

There has been some increase in working capital coming from increases in cash, accounts receivable, and other current assets, and the biggest increase in short term marketable securities.

49
Q
A

Looks the same on the surface but underlying changes are resulting in higher cash.

Although the change in the current ratio is very small, there are significant underlying movements. Increases in accounts receivable have been offset by increases in accounts payable & accrued expenses. The biggest change could be the reduced investment in inventory which could be a reason cash has increased.

50
Q

The current ratios for Cardullo’s and H&M are listed below.

Cardullo’s: 1.69

H&M: 2.25

Which of the following statements is true regarding the two companies?

  • H&M has more current assets than Cardullo’s.
  • H&M likely has better ability to pay off its short-term liabilities than Cardullo’s.
  • H&M manages its working capital better than Cardullo’s.
A
  • H&M likely has better ability to pay off its short-term liabilities than Cardullo’s.
  • Current ratio indicates a company’s liquidity. A higher current ratio means a higher proportion of current assets available to cover current liabilities.
51
Q

The current ratios of 2012 and 2013 for Cardullo’s Gourmet Shoppe are listed below.

2012: 1.39
2013: 1.69

What does the upward trend in the ratio mean for Cardullo’s?

  • Cardullo’s has better ability to pay off its short-term liabilities in 2013 than in 2012.
  • In 2013, a larger portion of asset financing is being done through equity.
  • Cardullo’s Accounts Payable Turnover is higher in 2013 than in 2012.
A
  • Cardullo’s has better ability to pay off its short-term liabilities in 2013 than in 2012.
  • Current ratio indicates a company’s liquidity. A higher current ratio means a higher proportion of current assets available to cover current liabilities.
52
Q

The QUICK Ratio

  • Define
  • List Formula
  • State what it means- higher # better or worse?
A
  • The quick ratio is similar to the current ratio except only highly liquid current assets are used in the numerator. One way to calculate this is to use current assets less inventory (because inventory tends to be less liquid than other current assets). The quick ratio is an even more stringent test than the current ratio to see if a business can meet its current obligations because it depends only on the most readily available current assets. Some businesses may have trouble turning their inventory into cash, so this gives us an idea of their ability to meet current obligations even if their inventory can’t be sold immediately. This ratio is also sometimes called an acid test ratio.
  • QUICK RATIO = CURRENT ASSETS - INVENTORY / CURRENT LIABILITIES
  • H&M’s quick ratio for 2012 was 1.57. Notice that this is significantly lower than the current ratio of 2.66. This is due to H&M’s large stock of inventory.
53
Q
A

The Quick Ratio is calculated by dividing the most liquid Current Assets by Current Liabilities at a point in time. One way to calculate Quick assets removes inventories from current assets. At September 28, 2013:

(Current Assets - Inventory) / Current Liabilities = 71,522 / 43,658 = 1.64

The suggested correct answer formula is:

=(SUM(B2:B5)-B4)/SUM(B12:B14)

54
Q

INTEREST COVERAGE RATIO

  • Define
  • List Formula
  • State what it means- higher # better or worse?
A
  • For this, we use a common income number called:is a good way to gauge how capable a business is of making the interest payments on its debt. The interest coverage ratio, also known as times interest earned, EBIT (Earnings Before Interest and Taxes). This number has to be calculated from the income statement by:
    • adding back interest expense and tax expense for the period to net income.
    • We then divide by interest expense for the period.
  • This ratio tells us the number of times a company can cover its interest expense using its earnings before interest and taxes.
  • INTEREST COVERAGE RATIO = EBIT / INTEREST EXPENSE
  • *OR**
  • *TIMES INTEREST EARNED = EBIT / INTEREST EXPENSE**
  • Because H&M had relatively low interest expense for the period, it has a very large times interest earned of 4,458. This means that H&M has a high enough EBIT to cover its interest expense 4,458 times.
55
Q
A

To calculate Earnings Before Interest and Taxes (EBIT), we start with Net Income and then add back Interest Expense and Income Tax Expense.

Net Income + Interest Expense + Income Tax Expense = 37,037 + 136 + 13,118 = 50,291

The suggested correct answer formula is:

=B16+B11+B15

To calculate the Interest Coverage Ratio, we divide EBIT by Interest Expense.

EBIT / Interest Expense = 50,291 / 136 = 370

The suggested correct answer formula is:

=E6/B11

56
Q

Why is it important to consider seasonality of industries when analyzing financial statements of companies?

  • Management applies different policies in accordance with the different seasons.
  • Outcomes of the analysis would depend on when you are looking at the statements.
  • Analysts need to apply US GAAP in all quarters.
  • Valuation and forecasts rely on the worst season for most companies.
A
  • Outcomes of the analysis would depend on when you are looking at the statements.
  • Ratio analysis could differ significantly by looking at peak times as opposed to the entire fiscal year.
57
Q

Which of the following companies would potentially be most affected by seasonality while reporting its interim financial statements?

  • Toy retailer
  • Gold extraction
  • Consulting firm
  • Car leasing company
A

Toy retailer

58
Q

Do businesses have different policies that are necessary to think about while analyzing ratios?

A

Most ratios, however, are in some ways influenced by managerial judgment in recording transactions. While accounting standards attempt to minimize the differences between companies, situations exist where two companies will reasonably elect different ways of accounting for items that appear very similar. Understanding these differences is essential to analyzing companies using ratio analysis. In some cases, you’ll need to make adjustments to financial statements to account for the differences before they can be used for comparisons.
Three of these differences include:

  • Revenue Recognition (How do you account for a liberal return policy where the customer can return an item for any reason for a full refund? Or what about a membership fee where a business is providing a service to a customer over time, but the customer can cancel the membership and receive a full refund at any time? What if the fee is non-refundable? The way a business answers these questions and the resulting revenue recognition will have a large impact on the amount of revenue that they recognize for a given period.)
  • Capitalizing Expenditures. How does a business deal with improvements and upgrades that extend the useful life of previously existing assets? Does a business purchase and capitalize assets or lease their assets? How does the level of what is considered material differ between businesses? The financials could look very different for operationally similar firms depending on these choices.
  • Depreciation. We looked previously at how many assumptions are included when a business determines how a long-lived asset will be depreciated. What if these assumptions were to change during the lifetime of the asset? We mentioned how improvements can change some of these assumptions, but other factors such as market conditions can also change management’s estimates. How will this impact the financial statements?
59
Q

List the OTHER RATIOS that are helpful, but fall out of the dupoint framework.

A
  • The current ratio- helps us understand the business’ ability to pay its short-term obligations
    CURRENT RATIO = CURRENT ASSETS / CURRENT LIABILITIES
  • The quick ratio- is an even more stringent test than the current ratio to see if a business can meet its current obligations because it depends only on the most readily available current assets

QUICK RATIO CURRENT ASSETS - INVENTORY / CURRENT LIABILITIES

  • The interest coverage ratio, also known as times interest earned- is a good way to gauge how capable a business is of making the interest payments on its debt
    INTEREST COVERAGE RATIO = EBIT / INTEREST EXPENSE
    OR
    TIMES INTEREST EARNED = EBIT / INTEREST EXPENSE
60
Q

How to Compare Different Companies?

A

One common problem when comparing financial statements from different companies is that different sizes and scales of businesses can make it difficult to compare them. One helpful tool is to prepare common size financial statements.

  • divide each number on the balance sheet by total assets
  • each number in the income statement by sales

This converts the financial statement items into ratios that help us see trends and can easily be compared from one company to another.

61
Q
A

The correct answer is Company B. Company B is likely a high volume retailer because its low profit margin indicates that it isn’t adding a lot of value to products, and the high asset turnover means that it is selling through a lot of inventory.

62
Q

What does the asset turnover represent in the DuPont formula?

  • The efficiency with which assets are used to generate revenue
  • Management use assesment of the working capital
  • How important intangible assets are overall
  • The margins generated by total assets
A
  • The efficiency with which assets are used to generate revenue
  • DuPont framework measures a business’ operating efficiency using Asset Turnover, which indicates how well a business is using its assets to produce sales. A business that can create more revenue with fewer assets is considered to be more efficient.
63
Q

How does the equity multiplier measure the impact of debt for a company if the formula does not include debt at all under the DuPont Framework?

  • ROE calculation does not consider the amount of leverage
  • DuPont Framework allows us to use Debt/Equity instead
  • The debt is implied in the numerator (total assets)
  • It includes the impact of convertible bonds that are usually relevant
A
  • The debt is implied in the numerator (total assets)
  • As liabilities (including debt) increase, the equity multiplier will be higher than one. Increasing leverage has the potential of higher returns but the investment become riskier too.
64
Q
A

Company A is more efficient in utilizing its assets than Company B.

Company A has a higher ROE than Company B because it has a higher Asset Turnover Ratio, which means Company A is more efficient in utilizing its assets.

65
Q

Which Company is which on this outline…?
Choices are: Airline, Grocery Store, Consumer Electronic Store

A

To complete these cases, it is best to start by looking for something that stands out as being very different. In this case, one of the most notable differences is that Company C has zero inventory, so we start there.

Company C has zero inventory, which indicates it is likely a service industry. It also has very high plant & equipment. So this must be in the airline industry.

Company A has high inventory which indicates it is retail. It also has high plant & equipment which means it has many and large stores. The low receivables collection period indicates that the company makes most of its sales in cash or credit card. It also has a high inventory turnover, which means it sells its inventory quickly. All of these signs point to a grocery retail chain.

Company B has a very high inventory turnover, indicating that whatever inventory they have moves quickly. The relatively low plant and equipment combined with the high inventory turnover suggests that a lot of sales are made online and there are relatively few brick and mortar stores. The high receivables collection period is usually due to an extension of credit, so the company likely makes a lot of sales business-to-business, rather than directly to the consumer. So this is in the electronic consumer products industry.

66
Q
  • When a top number on a fraction increases (or just is bigger), the final # …..
  • When the bottom number on a fraction increases (or is bigger), the final # ….
A
  • When a top number on a fraction increases (or just is bigger), the final # gets bigger
  • When the bottom number on a fraction increases (or is bigger), the final # gets smaller