Module 01 Assignments MF

Assignments:
Complete Chapters 2 and 3 Integrated Mini-Cases using the template provided. Save your file and upload it in Canvas by the deadline indicated. Put your last name and first name in the beginning of the Excel file name; e.g. Smith_Sam_Module1MiniCase.xlsx.
Ch2and3_IntegratedMiniCaseTemplate_Revised.xlsx
Complete the Module 1 (WalMart) Project using the data found in WalMart’s Annual Report. Follow the instructions found in the Excel template. Upload a completed Excel file, as well as a Word (or PDF) document with your analysis. Put your last name and first name in the beginning of the Excel and Word file names; e.g. Smith_Sam_Module 1Project.xlsx and Smith_Sam_Module1Project.docx.
WalMart’s 2019 Annual Report: Walmart-2019-AR-Final.pdf.
Project Template: Module1WalMartProjectTemplateRevised.xlsx
Don’t forget to upload a file (Word or PDF) with your written analysis. Note–these must be your original thoughts. Do not plagiarize!
Grading Criteria:
Financial data is accurately calculated using appropriate sources.
Analysis is complete and reflects a thorough understanding of the purpose and meaning of financial statements and financial ratios, as well as an understanding of the interrelationship of various ratios.
Assignments demonstrate a synthesis of the material covered in the readings.
Writing is professional in tone and free from errors in grammar or spelling that distract from the content of the document.
There is no plagiarism evident in submitted documents.
All files are submitted by the deadline in the required format(s).
ISBN-13: 978-1260013986
ISBN-10: 1260013987
Chapter 1 Viewpoints: Personal Application — Retirement strategies (Links to an external site.)
Chapter 1 Example 1-1: Finance Applications(Links to an external site.)
Chapter 1 Example 1-2: Executive Compensation(Links to an external site.)
Chapter 2 Viewpoints: Personal Application — Financing Entrepreneurship (Links to an external site.)
Chapter 2 Example 2-1: Calculating Book versus Market Value(Links to an external site.)
Chapter 2 Example 2-2: Impact of Capital Structure on a Firm’s EPS (Links to an external site.)
Chapter 2 Example 2-3: Calculation of Corporate Taxes(Links to an external site.)
Chapter 2 Example 2-4: Corporate Taxes with Interest and Dividend Income(Links to an external site.)
Chapter 2 Example 2-5: Effect of Debt-versus-Equity Financing on Funders’ Returns(Links to an external site.)
Chapter 2 Example 2-6: Calculating Free Cash Flow(Links to an external site.)
Chapter 2 Example 2-7: Statement of Retained Earnings(Links to an external site.)
Chapter 2 Appendix 2A: Colgate 10-K 2015(Links to an external site.)
Chapter 2 Appendix 2A: Colgate 10-K 2016 Excel(Links to an external site.)
Chapter 3 Viewpoints: Personal Application — Financial Ratios (Links to an external site.)
Chapter 3 Example 3-1: Calculating Liquidity Ratios(Links to an external site.)
Chapter 3 Example 3-2: Calculating Asset Management Ratios(Links to an external site.)
Chapter 3 Example 3-3: Calculating Debt Management Ratios(Links to an external site.)
Chapter 3 Example 3-4: Calculating Profitability Ratios(Links to an external site.)
Chapter 3 Example 3-5: Calculating Market Value Ratios(Links to an external site.)
Chapter 3 Example 3-6: Application of DuPont Analysis(Links to an external site.)
Chapter 3 Example 3-7: Calculating Internal and Sustainable Growth Rates
ATTACHED FILE(S)
Introduction to Financial Management
Finance 5th Edition
Cornett, Adair, and Nofsinger
1
Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
Finance in Business and in Life
Money flows from individuals who want to improve their financial future to businesses that want to expand the scale or scope of their operations
These financial exchanges lead to
A more productive economy
The growth of individuals’ wealth
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2
Economic Participants
Two dimensions
Participants with “extra” investment money
Participants with economically viable ideas
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Economic Participants – Type 1
Type 1 participants
Do not lend significant sums of money or spend much in business context
No direct role in financial markets
Play an indirect role by providing labor to economic enterprises or by consuming their products
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4
Economic Participants – Type 4
Type 4 participants
Use financial tools to evaluate their own business concepts and then choose the ideas with the most potential
Self-funded, so have no need for financial markets
Financial tools used and types of decisions made are narrowly focused to their own purposes
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5
Economic Participants – Types 2 and 3
Types 2 and 3 participants
Use financial institutions and financial markets for mutually beneficial exchange
Type 2 participants make temporary loans to type 3 participants, who put that money to use with their good business ideas
Usually individual investors
Type 3 participants are idea generators, typically companies with research and development (R&D) departments
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6
Where Does the Cash Go?
Economically successful projects repay money (plus profit) to investors
Sources of friction arise, thereby reducing the amount of capital returned to investors
Retained earnings are funds the firm keeps for its ongoing operations
Taxes are imposed on corporations and individuals by the government to help fund public services
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7
Subareas of Finance
Investments
Subarea of finance that involves methods and techniques for making decisions about the following:
What kinds of securities to own (e.g., bonds or stocks)
Which firms’ securities to buy
How to pay the investor back in the form that the investor wishes (e.g., the timing and certainty of the promised cash flows)
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8
Subareas of Finance (continued)
Financial management
Subarea of finance that deals with a firm’s decisions in acquiring and using the cash that is received from investors or from retained earnings
How to organize the firm in a manner that will attract capital
How to raise capital (e.g., bonds versus stocks)
How to minimize taxation
Which projects to fund
How to pay back capital providers
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Subareas of Finance (concluded)
Financial institutions and markets
Facilitate flow of capital between investors and companies
International finance
The use of financial theory in a global business environment
Decisions are complicated by the uncertainty about future exchange rates, political risk, and changing business laws across the globe
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Application and Theory
Risk
Uncertainty of future cash flows due to timing and size
Financial asset
Something worth money, such as a stock or bond
Should depend on the cash flows you expect to receive from that asset in the future
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Application and Theory (continued)
Real assets
Physical property like gold, machinery, equipment, or real estate
Real markets
Places/processes that facilitate the trading of real assets
Time value of money (TVM)
Theory and application of valuing cash flows at various points in time
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12
Finance vs. Accounting
Accounting
Tracks what happened to firm’s money in the past
Financial management
Combines historical figures and current information
Determines what should happen with firm’s money now and in the future
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The Financial Manager
Chief Financial Officer
Highest level financial officer
Controller
Oversees accounting function
Treasurer
Responsible for managing cash, credit, financing, capital budgeting, and risk management
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Finance in Other Business Functions
CFO and treasurer positions tend to be the most visible finance-related positions
Finance permeates the entire business organization
Provides guidance for both strategic and day-to-day decisions of the firm and collecting information for control and feedback about the firm’s financial decisions
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Finance in Your Personal Life
Help you make good personal financial decisions
Borrowing money for a new car
Refinancing home mortgage at lower rate
Making credit card or student loan payments
Saving for retirement
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16
Business Organization
The number of owners is the key to how business structures are classified
Single owners, partners, and corporations operate businesses
Advantages and disadvantages related to
Controls and ownership of firm
Owners’ risks
Access to capital and tax ramifications
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17
Organizational Forms of Business
Sole Proprietorships
General Partnerships
Corporations
Hybrids
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Sole Proprietorships
Most common type of business in the U.S.
Advantages
Easy to start
Light regulatory and paperwork burden
Owner receives all the firm’s profits and is solely responsible for all losses
Disadvantages
Unlimited liability
Limited access to capital
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General Partnerships
Partners own the business together
Advantages
Relatively easy to start
Profits are added to each partner’s personal income and taxed at personal income tax rates
Disadvantages
Partners jointly share unlimited liability
Personally liable for legal actions and debts of firm
Partners may need to give up some ownership and control in the firm to raise more equity capital
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Public Corporations
Legally independent entity entirely separate from its owners
Advantages
Limited liability for owners
Can raise large amounts of capital
Easy to transfer ownership
Disadvantages
Double taxation (corporate level and personal level)
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Hybrid Organizations
Combine some attributes of corporations and some of proprietorships/partnerships
Advantages
Offer single taxation and limited liability to all owners
S Corporations
Limited Liability Partnerships (LLPs)
Limited Liability Companies (LLCs)
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Firm Goals
Owners’ perspective says the appropriate goal is to maximize shareholder wealth
Stakeholders’ perspective emphasizes social responsibility over profitability
Managers must maximize total satisfaction of all stakeholders in a business (e.g., owners, shareholders, customers, employees, etc.)
Practitioners and academics believe primary responsibility is to maximize shareholder wealth
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Corporate Goals
Maximize value of owners’ equity
Increase current value per share (stock price) of existing shares
Common alternatives to maximizing the value of owners’ equity
Maximize net income or profit
Minimize costs
Maximize market share
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24
Agency Problem
Stockholders hire managers to run the company, but managers may be tempted to act in their own best interests
The agency problem states that problems arise when a principal (shareholder) hires an agent (manager) and cannot carefully monitor the agent’s actions
Manager’s interest may not be aligned with shareholder goals
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Agency Problem (continued)
Three approaches to minimizing this conflict of interest
Ignore it
Research suggests allowing the manager a certain amount of perks might enhance owner value because it may boost managers’ productivity
Monitor managers’ actions
Make the managers owners
E.g., award options on the firm’s stock, allow purchase through an ESPO, etc.
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Corporate Governance Defined
The process of monitoring managers and aligning their incentives with shareholder goals is known as corporate governance
Corporate governance involves the set of laws, policies, incentives, and monitors designed to handle the issues arising from the separation of ownership and control
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Corporate Governance – Inside
Inside monitors
Board of Directors
Hires the CEO
Evaluates management
Design compensation contracts to tie management’s salaries to firm performance
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Corporate Governance – Outside
Outside monitors
Auditors examine the firm’s accounting systems and comment on whether financial statements fairly represent the firm’s financial position
Investment analysts follow a firm, conduct their own evaluations, and report to the investment community
Investment banks help firms access capital markets
Credit rating agencies examine a firm’s financial strength for its debt holders
The government monitors activities via the SEC and the IRS
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Corporate Governance Monitors
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Corporate governance balances the needs of stockholders and managers. Inside the public firm, the members of the board of directors monitor how the firm is run. Outside the firm, auditors, analysts, investment banks, and credit rating agencies act as monitors.
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Ethics
Financial professionals manage other people’s money
Corporate managers
Bankers
Investment advisors
Ethical dilemmas of corporate agency relationship
Stealing from firms = stealing from shareholders
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Financial Markets and Intermediaries
Financial markets and financial intermediaries
Facilitate flow of capital from investors to firms and back to investors
Earn very high profits because of specialized expertise and assets
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Financial Institutions’ Cash Flows
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The unique services and products that financial institutions provide allow them to make money.
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Big Picture Environment
One of the biggest recent factors affecting the business environment in the U.S. is the Tax Cuts and Jobs Act (TCJA) of 2017
Reduces the amount of debt interest that can be deducted from tax bill
Companies are, therefore, likely to use more equity financing and less debt financing in the future
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Tax Cuts and Jobs Act (TCJA) of 2017
Reductions in individual income tax rates
Corporate tax rates reduced
New deduction for “pass-through” business income
Liberalized asset expensing and depreciation provisions
New limits on business interest deductions
Stricter rules for deducting losses
Reduced or eliminated deductions for business entertainment and some employee fringe benefits
Change to R&D expense deduction
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35
Reviewing
Financial
Statements
Finance 5th Edition
Cornett, Adair, and Nofsinger
2
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Introduction
A financial statement provides an accounting-based picture of a firm’s financial position
An annual report is made up of four basic financial statements
Balance sheet
Income statement
Statement of cash flows
Statement of retained earnings
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Introduction (continued)
Reports are used by accountants as a picture of past financial performance
Finance professionals use financial statements to draw inferences about the future
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Balance Sheet
The balance sheet reports firm’s assets, liabilities and equity at a point in time
Assets = Liabilities + Equity
Assets of firm appear on left side
Liabilities and equity appear on right side
Both assets and liabilities are listed in decreasing order of liquidity, that is, the time and effort needed to convert the accounts to cash
Equity never matures, and therefore appears last
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The most liquid assets (called current assets) appear first on the asset side of the balance sheet. The least liquid, called fixed assets, appear last. Similarly, current liabilities – those obligations that the firm must pay within a year – appear first on the right hand side of the balance sheet. Stockholders’ equity, which never matures, appears last on the balance sheet.
Table 2.1 – Balance Sheet for DPH
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Assets
Current assets normally convert to cash within one year
E.g., cash and marketable securities, accounts receivable, and inventory
Fixed assets have a useful life exceeding one year
Physical (tangible) assets
E.g., net plant and equipment
Less tangible, long-term assets
E.g., patents and trademarks
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The value of net plant and equipment is found by taking the difference between gross plant and equipment and the depreciation accumulated against the fixed assets since their purchase.
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Liabilities
Liabilities are funds provided to the firm by lenders
Current liabilities constitute the firm’s obligations due within one year
E.g., accrued wages and taxes, accounts payable, and notes payable
Long-term debt include those obligations with maturities of more than one year
E.g., long-term loans and bonds with maturities greater than one year
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Stockholders’ Equity
Stockholders’ equity is the difference between a firm’s total assets and total liabilities
Preferred stock is a hybrid security with characteristics of both long-term debt and common stock
Common stock and paid-in-surplus is the fundamental ownership claim in public or private company
Retained earnings are company profits that are kept by the firm rather than distributed to the stockholders as cash dividends
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Managing the Balance Sheet
Managers must monitor a number of issues underlying items reported on their firms’ balance sheets:
Accounting method for fixed asset depreciation
Level of net working capital
Liquidity position of the firm
Method for financing the firm’s assets
Equity or debt
Difference between firm’s book value and true market value
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Accounting Method for Fixed Asset Depreciation
Managers can choose the accounting method they use to record depreciation against their fixed assets
Straight-line method
Commonly chosen when reporting income to the firm’s stockholders
MACRS method
Typically used when computing taxes, as it accelerates depreciation, resulting in lower taxable income, which leads to lower taxes in the early years of a project’s life.
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Net Working Capital
Net Working Capital =
Current assets – Current liabilities
Net working capital is measure of the firm’s ability to pay obligations as they come due
Healthy firms have positive net working capital values
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Liquidity
Liquidity refers to two dimensions
Ease with which the firm can convert an asset to cash
Degree to which such a conversation takes place at a fair market value
Current assets remain relatively liquid
E.g., cash
Fixed assets remain relatively illiquid
E.g., buildings and equipment
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Highly liquid assets can be sold quickly at their fair market values, while illiquid assets cannot be sold quickly unless the price is reduced far below fair value.
Liquidity (continued)
Liquidity is double-edged sword
The good?
The more liquid assets a firm holds, the less likely the firm will be to experience financial distress
The bad?
Liquid assets generate little or no profits for a firm
Managers must carefully consider this trade-off
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Debt vs. Equity Financing
Financial leverage refers to the extent to which a firm chooses to finance its ventures or assets by issuing debt securities
Magnifies gains and losses
Debt holders have a fixed claim on firm’s cash flows (interest paid on securities and principal repayments)
Stockholders claim any cash flows left after debt holders are paid
Choice of firm’s capital structure represents management’s risk and return preference
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Book Value vs. Market Value
In many cases, book values differ widely from market values
The book (or historical cost) value is the amount the firm paid for the assets
Under GAAP, assets appear on the balance sheet at what the firm paid for them, regardless of what those assets might be worth today if the firm were to sell them
The market value is the amount the firm would get if it sold the assets
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Income Statement
The income statement shows the total revenues that a firm earns and the total expenses the firm incurs to generate those revenues over a specific period of time
The top part of the income statement reports the firm’s operating income
The bottom part of the income statement summarizes the firm’s financial and tax structure
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Remember, the balance sheet reports a firm’s position at a specific point in time, while the income statement reports performance over a period of time (e.g., the last year).
Income Statement Structure
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DPH Tree Farm Income Statement
XXX – Add Table 2.2
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Income/Firm Value Summary Below the Bottom Line
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Corporate Income Taxes
Firms taxed on earnings
U.S. tax code determines corporate tax obligations – overseen by Congress
Tax rate changes driven by changes in administration or other changes in the business or public environment
Tax Cut and Jobs Act (TCJA) of 2017
Permanently lowers corporate taxes from a progressive schedule (where the highest tax rate was 35%) to a flat 21% beginning in 2018
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The TCJA of 2017 represents one of the most significant changes to corporate tax laws in more than 30 years.
Corporate Income Taxes (continued)
Average tax rate
Percentage of each dollar of taxable income that the firm pays in taxes
Marginal tax rate
Amount of additional taxes a firm must pay out for every additional dollar of taxable income it earns
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Interest and Dividends Received
Interest is taxable with two exceptions
Interest on state and local government bonds are federally tax-exempt
One corporation owns stock in another corporation
50% of dividends received from the other corporation are considered tax exempt
Taxed on remaining 50% of dividends received at the receiving corporation’s tax rate
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Interest and Dividends Paid
Interest payments appear on the income statement as an expense item
They are deducted from income before calculating taxable income
Dividends paid to shareholders by corporations are not tax deductible
Encourages managers to finance with debt, which is less expensive than using equity
Due to the deductible nature of interest paid by firm
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Statement of Cash Flows
The statement of cash flows is a financial statement that shows firm’s cash flows over given period of time
Reports the amounts of cash the firm has generated and distributed during a particular time period
Bottom line on the statement of cash flows reflects difference between cash sources and uses
Equal to the change in cash and marketable securities on the firm’s balance sheet over a period of time
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GAAP Accounting Principles
Company accountants use GAAP principles to prepare firm income statements
Revenue recognition and actual cash outflows incurred with production may occur at a different time than GAAP principles allow
GAAP principles
Revenue recognized at the time of sale
Production and other expenses shown on the income statement as the sales of those goods take place
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Sources and Uses of Cash
An activity that increases cash is a cash source
Increasing liabilities (or equity)
Decreasing noncash assets
An activity that decreases cash is a cash use
Decreasing liabilities (or equity)
Increasing noncash assets
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Sources and Uses of Cash (continued)
Four categories are used to separate cash flows on the statement of cash flows:
Cash flows from operating activities
Cash flows from investing activities
Cash flows from financing activities
Net change in cash and marketable securities
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DPH Tree Farm Statement of Cash Flows
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Cash Flows from Operations
Cash flows that are the direct result of the production and sale of the firm’s products are cash flows from operations, and include:
Net income (adding back depreciation)
Change in working capital accounts other than cash and operations-related short-term debt
Positive cash flows from operations is what gives the firm value
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Considered to be the most important section of the statement of cash flows by most finance professionals
Cash Flows from Investing Activities
Cash flows associated with the purchase or sale of fixed or other long-term assets are cash flows from investing activities
Shows inflows and outflows from changes in long-term investing activities
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Cash Flows from Financing Activities
Cash flows from financing activities result from debt and equity financing transactions and include:
Issuing short-term debt
Issuing long-term debt
Issuing stock
Using cash to pay dividends
Using cash to pay off debt
Using cash to buy back stock
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Net Change in Cash and Marketable Securities
The sum of the cash flows from operations, investing activities, and financing activities is the net change in cash and marketable securities (i.e., the bottom line of the statement of cash flows)
Reconciles to the net change in cash and marketable securities account on the balance sheet over period of analysis
Positive bottom line indicates cash inflows exceeded cash outflows for the period
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Free Cash Flow
Free cash flows is the cash actually available for distribution to the investors in the firm after the investments that are necessary to sustain the firm’s ongoing operations are made
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Free Cash Flow (continued)
Firms generate operating cash flow (OCF) after they have paid necessary operating expenses and taxes
Net operating profit after taxes (NOPAT) is the net profit a firm earns after taxes, but before any financing costs
Investment in operating capital (IOC) includes gross investments in fixed assets, current assets, and spontaneous current liabilities
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Free Cash Flow (concluded)
Firms with positive free cash flow (FCF) have funds available for distribution to investors
Potential implications for firms with negative FCF
May be experiencing operating or managerial problems
May be investing heavily in operating capital to support growth
Note: FCF might be negative while OCF is positive
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35
Free Cash Flow Equation
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Statement of Retained Earnings
The statement of retained earnings reconciles net income earned during a given period and any cash dividends paid with the change in retained earnings over the period
Advantages of reinvesting
Less expensive than raising capital from outside sources (equity markets)
Allows the firm to grow by providing additional funds that can be spent on plant and equipment
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Cautions in Interpreting Financial Statements
GAAP standards required for financial statements
Firms can use earnings management with GAAP accounting rules
Firms may wish to smooth earnings
Firms utilize different depreciation methods, making comparison across firms difficult
Sarbanes-Oxley Act passed in 2002
Aims to prevent deceptive accounting and management practices
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Analyzing Financial Statements
Finance 5th Edition
Cornett, Adair, and Nofsinger
3
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Introduction
Various uses of financial statements
Provide information on firm’s financial position at a point in time or its operations over some past period
Information contained in financial statements may be used to analyze the current financial performance of the firm
Information provided assists in decision-making that improves the firm’s future performance, and ultimately, its market value
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2
Ratio Analysis
Ratio analysis is the process of calculating and analyzing financial ratios to assess a firm’s performance and to identify actions needed to improve firm performance
Five groups of ratios
Liquidity
Asset management
Debt management
Profitability
Market value
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Managers, investors, and analysts universally use ratios to assess a firm’s performance and to identify actions that could improve firm performance.
3
Ratio Analysis Options
Trend analysis
Comparison to the same firm over time
Industry analysis
Comparison to other firms in the same industry
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Liquidity Ratios
Liquidity ratios measure the relationship between a firm’s liquid (or current) assets and its current liabilities
Commonly-used liquidity ratios
Current ratio
Quick (or acid-test) ratio
Cash ratio
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Current Ratio
Broadest liquidity measure
Measures the dollars of current assets available to pay each dollar of current liabilities
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Quick Ratio
Measures the firm’s ability to pay off short-term obligations without relying on inventory sales
Inventories are generally the least liquid of a firm’s current assets
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Cash Ratio
Measures a firm’s ability to pay short-term obligations with its available cash and marketable securities
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Asset Management Ratios
Asset management ratios measure how efficiently a firm uses its assets, as well as how efficiently the firm manages its accounts payable
Inventory management
Accounts receivable management
Accounts payable management
Fixed asset and working capital management
Total asset management
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Inventory Management
The inventory turnover ratio measures the number of dollars of sales produced per dollar of inventory
Cost of goods sold is used as the numerator when managers want to emphasize that inventory is listed on the balance sheet at cost, that is, the cost of sales generated per dollar of inventory
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Managers are faced with considering the trade-off between the advantages of holding sufficient levels of inventory to keep the production process going versus the costs of holding large amounts of inventory.
10
Inventory Management (continued)
The days’ sales in inventory ratio measures the number of days that inventory is held before the final product is sold
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Accounts Receivable Management
The accounts receivable turnover measures the number of dollars of sales produced per dollar of accounts receivable
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Accounts Receivable Management (continued)
The average collection period (ACP) measures the number of days accounts receivable are held before the firm collects cash from the sale
Also referred to as days’ sales outstanding (DSO)
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Accounts Payable Management
The accounts payable turnover ratio measures the dollar cost of goods sold (COGS) per dollar of accounts payable
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Accounts Payable Management (continued)
The average payment period (APP) ratio measures the number of days that the firm holds accounts payable before it has to extend cash to pay for its purchases
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Fixed Asset and Working Capital Management
The fixed asset turnover ratio measures the number of dollars of sales produced per dollar of net fixed assets
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Fixed Asset and Working Capital Management (continued)
The sales to working capital ratio measures the number of dollar of sales produced per dollar of net working capital (current assets minus current liabilities)
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Total Asset Management
The total asset turnover ratio measures the number of dollars of sales produced per dollar of total assets
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Total Asset Management (continued)
The capital intensity ratio measures the dollars of total assets needed to produce a dollar of sales
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Debt Management Ratios
Debt management ratios measure the extent to which the firm uses debt (or financial leverage) versus equity to finance its assets as well as how well the firm can pay off its debt
Two major types of debt management ratios
Evaluate whether a firm is financing its assets with a reasonable amount of debt versus equity financing
Measure whether the firm is generating sufficient earnings or cash to make promised debt payments
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Debt versus Equity Financing
Capital structure refers to the amount of debt versus equity financing held on the balance sheet
Three primary ratios
Debt ratio
Debt-to-equity
Equity multiplier
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Debt Ratio
The debt ratio measures the percentage of total assets financed with debt
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Debt-to-Equity Ratio
The debt-to-equity ratio measures the dollars of debt financing used for every dollar of equity financing
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Equity Multiplier Ratio
The equity multiplier ratio measures the dollars of debt financing used for every dollar of equity financing
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Times Interest Earned Ratio
The times interest earned ratio measures the number of dollars of operating earnings dollars available to meet each dollar of interest obligations on the firm’s debt
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The times interest earned, fixed charge coverage, and cash coverage ratios are different measures of a firm’s ability to meet its debt obligations.
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Fixed Charge Coverage Ratio
The fixed charge coverage ratio measures the number of dollars of operating earnings available to meet the firm’s interest obligations and other fixed charges
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Cash Coverage Ratio
The cash coverage ratio measures the number of dollars of operating cash available to meet each dollar of interest and other fixed charges that the firm owes
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Profitability Ratios
Ratios that show the combined effect of liquidity, asset management, and debt management on the firm’s overall operating results are profitability ratios
Closely monitored by investors
Stock prices react very quickly to unexpected changes in these ratios
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Profit Margin
The gross profit margin is the percent of sales left after cost of goods sold are deducted
The operating profit margin is the percent of sales left after all operating expenses are deducted
The profit margin is the percent of sales left after all firm expenses are deducted
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Basic Earnings Power Ratio
The basic earnings power ratio measures the operating return on the firm’s assets, regardless of financial leverage and taxes
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Return on Assets (ROA)
Return on assets (ROA) measures the overall return on the firm’s assets, including financial leverage and taxes
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Return on Equity (ROE)
Return on equity (ROE) measures the return on common stockholders’ investment in the assets of the firm
Affected by net income and amount of financial leverage used by the firm
High ROE is usually a positive sign, unless driven by excessively high leverage
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Dividend Payout Ratio
The dividend payout ratio is the percentage of net income available to common stockholders that the firm actually pays as cash to these investors
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Market Value Ratios
Market value ratios relate a firm’s stock price to its earnings and book value
Market values measure what investors think of the company’s future performance and risk
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Market-to-Book Ratio
The market-to-book ratio measures the amount that investors will pay for the firm’s stock per dollar of equity used to finance the firm’s assets
Compares the market (current) value of the firm’s equity to its historical cost
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Price-Earnings Ratio
The price-earnings ratio measures how much investors are willing to pay for each dollar the firm earns per share of its stock
Best known and most often quoted figure
Often quoted in multiples – the number of dollars per share – that fund managers, investors, and analysts compare within industry classes
High PE ratio usually indicates projected growth
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DuPont Analysis
The DuPont system of analysis is an analytical method that uses the balance sheet and income statement to break the ROA and ROE ratios into component pieces
ROA is evaluated as the product of the profit margin and the total asset turnover ratios
ROE is evaluated as the product of ROA and the equity multiplier
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37
DuPont System Analysis
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Other Ratios
Spreading the financial statement occurs when balance sheet amounts are divided by total assets and income statement amounts are divided by net sales
Result in common-size financial statements
Year-to-year growth rates provide useful ratios for identifying trends and allow for an easy comparison across firms in the industry
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Internal and Sustainable Growth Rates
The internal growth rate is the growth rate a firm can sustain if it uses only internal financing – that is, retained earnings – to finance future growth
The sustainable growth rate is the growth rate a firm can sustain if it finances growth using both debt and internal financing such that the debt ratio remains constant
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Time Series and Cross-Sectional Analyses
Time series analysis occurs when one is analyzing firm performance by monitoring ratio trends
I.e., performance of the firm over time
Cross-sectional analysis occurs when one is analyzing the performance of a firm against one of more companies in the same industry
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Cautions in Using Ratios
Caution should be exercised in using ratios to evaluate firm performance
Historical data may not reflect future performance
Firms utilize different account procedures
Competitors may be based outside of the U.S.
Sales and expenses vary throughout the year
Large firms have multiple divisions/business units
Firms often employ window dressing techniques
Individual analysts may calculate ratios in modified forms
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