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Chapter 4

Chapter 4 Notes


Department
Finance
Course Code
MGFB10H3
Professor
Derek Chau
Chapter
4

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Chapter 4 Financial Statement Analysis and Forecasting Notes
4.1 Consistent Financial Analysis
despite efforts to harmonize accounting standards, important differences in GAAP still persist
these GAAP differences have forced users of financial statements to attempt an external reconciliation of GAAP
this is important because users need to be able to compare statements of companies in the same industry from different countries
the transition to International Financial Reporting Standards (IFRS) by 2011 will complicate issues in the short term
on the other hand, as more countries adopt these standards, comparability should be enhanced in the long term
aside from the use of different principles (i.e., different forms of GAAP) in preparing financial standards, an additional
complication arises because there are “generally accepted financial ratios”
4.2 A Framework for Financial Analysis
Return on Equity (ROE) and the DuPont System
return on equity (ROE) return earned by equity holders on investment in firm; net income divided by shareholders’ equity
ROE is not a “pure” financial ratio because it involves dividing an income statement (flow) item by a balance sheet (stock) item
as a result, some people calculate the ROE as NI over the “average” SE—the average of the starting and ending SE
this adjustment acknowledges that NI is earned throughout the year, so it makes sense to divide by an average of SE to recognize
that not all of those funds were invested throughout the year
return on asset (ROA) net income divided by total assets
if the ROE is multiplied by TA and divided by SE, the TA’s cancel out and produce the ROE
leverage ratio total assets divided by shareholders’ equity; it measures how many dollars of total assets are supported by each
dollar of shareholders’ equity, or how many times the firm has leveraged capital provided by shareholders into total financing
financial leverage the use of capital provided by shareholders to increase total financing
net profit margin part of return on assets; net income divided by revenues
turnover ratio art of return on assets; revenues divided by total assets
ROA = NI / TA = NI / Revenues × Revenues / TA
DuPont: ROE = NI /SE = NI / Revenues × Revenues / TA × TA / SE = Net profit margin × Turnover ratio × Leverage ratio
4.3 Leverage Ratios
it is good when a firm is low risk and earns a healthy ROE, since it magnifies these high ROAs into even higher ROEs; but when
the firm loses money, the use of leverage magnifies ROEs on the downside as well
there are basically three types: stock ratios, flow ratios, and other ratios
stock ratios the amounts of debt outstanding at a particular time
debt ratio total liabilities divided by total assets; just a rearrangement of leverage ratio
invested capital the sum of interest-bearing debt and shareholders’ equity
debt-equity (D/E) ratio debt divided by shareholders’ equity; it measures the use of interest-bearing debt
times interest earned (TIE) earnings before interest and taxes divided by interest expense; also called the “coverage ratio”
cash flow to debt ratio how long it would take to pay off debt from cash flow from operations (CFO); CFO divided by debt
4.4 Efficiency Ratios
efficiency ratios ratios that measure how efficiently a dollar of revenues is turned into profits
degree of total leverage (DTL) contribution margin divided by earnings before taxes
break-even point (BEP) the level of revenues at which the firm covers all its operating and fixed costs; total operating and
fixed costs divided by the contribution margin ratio; CM ratio is just complement of VC as percentage of revenues
gross profit margin revenues minus the cost of sales divided by revenues
operating margin operating income (OI) divided by revenues
operating income (OI) the earnings before interest and taxes (EBIT) figure
4.5 Productivity Ratios
productivity ratios measurements of how productive the firm is in generating revenues from its assets
receivables turnover ratio revenues dived by accounts receivables (AR)
average collection period (ACP) accounts receivable dived by the average daily revenue; 365 divided by receivables turnover
inventory turnover ratio the cost of sales (or revenue) divided by inventory
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