Financial Analysis Overview

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Questions and Answers

What is the goal of Financial Analysis?

To identify the major strengths and weaknesses of a business.

What are the three main financial statements?

Balance Sheet, Income Statement, Statement of Cash Flows

What does the Balance Sheet show?

A snapshot of a firm's assets and liabilities.

What does the Income Statement show?

How the firm turns revenues into income. Signup and view all the answers

What does the Statement of Cash Flows show?

Where does cash come from/go? Signup and view all the answers

What is a benchmark used for?

It is used to make numbers comparable Signup and view all the answers

What are the three components of the Dupont Equation?

Net Profit Margin, Total Asset Turnover, Equity Multiplier (A) Signup and view all the answers

What is the formula for the Current Ratio?

Current Assets/Current Liabilities Signup and view all the answers

What is the formula for the Quick Ratio?

(Current Assets - Inventories)/Current Liabilities Signup and view all the answers

What does the Average Collection Period measure?

How long it takes to collect accounts receivables. Signup and view all the answers

What is the formula for Inventory Turnover?

Cost of Goods Sold/Average Inventory Signup and view all the answers

What is the formula for Fixed Asset Turnover?

Sales/Net Fixed Assets Signup and view all the answers

What is the formula for the Debt to Equity Ratio?

Total Debt/Total Equity Signup and view all the answers

What is the formula for Times Interest Earned (TIE)?

Earnings Before Interest and Taxes (EBIT)/Interest Expense Signup and view all the answers

What is the formula for Fixed Charge Coverage?

(EBIT + Lease Payments)/(Interest Expense + Lease Payments + Preferred Dividends + Sinking Fund Payments) Signup and view all the answers

What is the formula for Gross Profit Margin?

(Sales - Cost of Goods Sold)/Sales Signup and view all the answers

What is the formula for Return on Assets (ROA)?

Net Income/Total Assetsor EBITDA/Total Assets Signup and view all the answers

What is the formula for Return on Equity (ROE)?

Net Income/Shareholders' Equity Signup and view all the answers

What is the formula for Price-to-Sales Ratio?

Market Price Per Share/Sales Per Share Signup and view all the answers

What is the formula for Market-to-Book Ratio?

Market Price Per Share/Book Value Per Share Signup and view all the answers

What is the formula for EV/EBITDA Ratio?

Enterprise Value/EBITDA Signup and view all the answers

What is the formula for Dividend Payout Ratio?

Dividends Per Share/Earnings Per Share Signup and view all the answers

What is the formula for Dividend Yield?

Dividends Per Share/Market Price Per Share Signup and view all the answers

Study Notes

Chapter 3 - Evaluation of Financial Performance

Financial analysis is the process of evaluating businesses, projects, budgets, and other finance-related transactions to determine their performance and suitability.
The goal of financial analysis is to identify the major strengths and weaknesses of a business, assess its viability and health, and analyze problem areas.
Credit managers use financial analysis to decide whether to extend credit.
Security analysts use financial analysis to assess whether to invest.
Bankers use financial analysis for deciding to grant loans.

Overview of Financial Analysis

Financial analysis involves examining three main financial statements: balance sheet, income statement, and statement of cash flows.
The balance sheet shows what a firm owns—its assets—and how it's financed—its liabilities and equity.
The income statement explains how a firm turns its revenues into income and operating expenses.
The statement of cash flows shows where cash comes from and goes to.
Financial statements, such as the income statement and balance sheet, can be converted to "common size" statements (income statement or balance sheet) by dividing by sales (income statement) or assets (balance sheet).

Financial Statements

A balance sheet presents a snapshot of a firm's assets and liabilities at a specific point in time.
Assets are what a firm owns.
Liabilities represent the firm's obligations through debt.
Equity shows the owners' stake in the company's assets.
Equity represents the sourced funds through financing through stock or reinvesting earnings.
Higher up assets/liabilities are typically more liquid.

Income Statement

An income statement summarizes a firm's financial performance over a period of time.
The income statement begins with sales, which subtract the cost of goods sold to arrive at gross profit.
Operating expenses are subtracted from gross profit to arrive at earnings before interest and taxes (EBIT).
Interest expense is deducted next to arrive at earnings before taxes (EBT).
Taxes are then subtracted, resulting in earnings after taxes, which are also known as net income.

Ratio Analysis

Ratio analysis involves comparing lines from financial statements to other parts of financial statements or industry averages. This makes it possible to see if a company is performing well within its industry.
For example, ratios can be used to compare two firms or the same firm over time.
Ratios need to be considered in context of the firm and its competitors.

Liquidity Ratios

Liquidity ratios indicate a company's ability to meet short-term obligations.
Current Ratio = Current Assets / Current Liabilities
Quick Ratio = (Current Assets – Inventory) / Current Liabilities
Cash Ratio = Cash / Current Liabilities

Asset Management Ratios

Asset management ratios assess how efficiently a firm uses its assets.
Average Collection Period = Accounts Receivable / (Annual Credit Sales / 365)
Inventory Turnover = Cost of Goods Sold / Average Inventory
Fixed Asset Turnover = Sales / Net Fixed Assets
Total Asset Turnover = Sales / Total Assets

Leverage Ratios

Leverage ratios measure the extent to which a firm relies on debt financing.
Debt Ratio = Total Debt / Total Assets
Debt to Equity = Total Debt / Total Equity
Times Interest Earned (TIE) = EBIT / Interest Expense

Profitability Ratios

Profitability ratios measure a firm's ability to generate income.
Gross Profit Margin = Gross Profit / Sales
Net Profit Margin = Net Income / Sales
Return on Assets (ROA) = Net Income / Total Assets
Return on Equity (ROE) = Net Income / Total Equity

Market Ratios

Market ratios evaluate a firm's market performance.
Price-earnings ratio (PE) = Market Price per Share / Earnings Per Share.
Price-to-sales ratio = Market Price per Share / Sales per Share.
Market-to-book ratio = Market Price/Book Value per Share.
Enterprise Value to EBITDA (EV/EBITDA) = Enterprise Value/ EBITDA

Dividend Policy Ratios

Dividend payout ratio = Dividends Per Share / Earnings Per Share
Dividend yield = Dividend per Share / Price per Share

The DuPont Equation

This equation breaks down a company's return on equity (ROE) into components such as net profit margin, total asset turnover rate, and equity multiplier. This equation helps to see how different parts influence the company's return.

Note on Benchmarking

Ratios are most effective when compared to a benchmark, such as industry averages or prior performance.
Comparing ratios to a benchmark is effective, as it allows for the measurement of performance against other firms within the same industry.
Benchmark performance can be compared for a better outlook of a company's current situation.

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Description

This quiz focuses on Chapter 3, which covers the evaluation of financial performance through financial analysis. It emphasizes the importance of examining financial statements such as the balance sheet, income statement, and statement of cash flows. The chapter highlights how various stakeholders use financial analysis for decision-making.

Financial Analysis Overview - Chapter 3

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