Investment Decisions summary
Chapter 3
Ratio analysis = methods of calculating and interpreting financial ratios to
analyse and monitor the firm’s performance.
Using financial ratios
Interested parties are shareholders, creditors and the firm’s own management.
They are interested in…
- The short-term liquidity of the company and its ability to make interest
and principal payments
- The firm’s profitability, to assure the business is healthy.
Types of ratio comparisons
Cross-sectional analysis
Cross-sectional analysis = comparison of different firm’s financial ratios at the
same point in time; involves comparing the firm’s ratios with those of other
firms in its industry or with industry averages.
Benchmarking = a type of cross-sectional analysis in which the firm’s ratio
values are compared with those of a key competitor or with a group of
competitors that wishes to emulate.
Time-series analysis
= evaluation of the firm’s financial performance over time using financial ratio
analysis.
Combined analysis
This combines cross-sectional and time-series analyses. This makes it possible to
compare the company with the industry it is in.
Cautions about using ratio analyses
1. Additional work must be done to research a large deviation, because there
may be a problem behind it.
2. A single ratio is not enough; most of the times you need more than one
analyses.
3. All used financial statements should be from the same date.
4. Use audited financial statements.
5. The used financial statements should be made under the same accounting
principles (like GAAP).
6. Book value of e.g. assets may be influenced by inflation: the real values
may differ from the written values, therefore distorting profits.
Liquidity ratios
Liquidity = a firm’s ability to satisfy its short-term obligations as they come due.
Generally, a company with greater liquidity will have an easier time paying its
bills and is less likely to become insolvent.
2 most common measures of liquidity:
1. Current ratio
2. Quick ratio (acid-test)
,Current ratio
= a measure of liquidity calculated by dividing the firm’s current assets by its
current liabilities.
Current assets
Current ratio=
Current liabilities
Quick ratio (acid test)
= a measure if liquidity calculated by dividing the firm’s current assets less
inventory by its current liabilities.
Current assets−inventory
Quick ratio=
Current liabilities
The general low liquidity of inventory results from 2 primary factors:
1. Many types of inventory cannot be sold easily
2. Inventory is typically sold on credit (resulting in accounts receivable
before being converted into cash)
The quick ratio is a better measure of overall liquidity only when a firm’s
inventory cannot be easily converted into cash.
If inventory is liquid, the current ratio is a preferred measure of overall liquidity.
Activity ratios
= measure the speed with which various asset and liability accounts are
converted into sales or cash, or inflows or outflows.
It shows how efficient a firm operates along a variety of dimensions, like:
- Inventory management
- Disbursements
- Collections
Inventory turnover ratio
= measures the activity/liquidity of a firm’s inventory.
Average age of inventory = average number of day’s sales in inventory.
You calculate this by dividing the turnover ratio into 365.
Average collection period
= the average amount of time needed to collect accounts receivable.
It is useful in evaluating credit and collection policies.
, It equals the accounts receivable balance divided by average daily sales.
=
Average payment period
= the average amount of time needed to pay accounts payable.
=
Total asset turnover
= the efficiency with which the firm uses its assets to generate sales.
Formula: total asset turnover = sales / total assets
Debt ratios
The more debt a firm uses in relation to its total assets, the greater is its
financial leverage.
Financial leverage = the magnification of risk and return through the use of
fixed-cost financing, such as debt and preferred stock.
The term refers to the degree to which a firm uses debt financing and to
the effects of debt financing.
When a firm finances more of its investment by borrowing money, the
expected return on investment increases, but so does the risk: with
increases det comes greater risk as well as higher potential return.
The greater the financial leverage, the greater the potential risk and
return.
Degree of indebtedness = ratios that measure the amount of debt relative to
other significant balance sheet amounts.
Ability to repay debt coverage ratios = ratios that measure a firm’s ability to
make required debt payments and to pay other fixed charges such as lease
payments.
Also called overage ratios, help analysts figuring out if a company can
service their debts: make payments on time.
Debt ratio
Debt ratio = measures the proportion of total assets financed by the firm’s
creditors.
Chapter 3
Ratio analysis = methods of calculating and interpreting financial ratios to
analyse and monitor the firm’s performance.
Using financial ratios
Interested parties are shareholders, creditors and the firm’s own management.
They are interested in…
- The short-term liquidity of the company and its ability to make interest
and principal payments
- The firm’s profitability, to assure the business is healthy.
Types of ratio comparisons
Cross-sectional analysis
Cross-sectional analysis = comparison of different firm’s financial ratios at the
same point in time; involves comparing the firm’s ratios with those of other
firms in its industry or with industry averages.
Benchmarking = a type of cross-sectional analysis in which the firm’s ratio
values are compared with those of a key competitor or with a group of
competitors that wishes to emulate.
Time-series analysis
= evaluation of the firm’s financial performance over time using financial ratio
analysis.
Combined analysis
This combines cross-sectional and time-series analyses. This makes it possible to
compare the company with the industry it is in.
Cautions about using ratio analyses
1. Additional work must be done to research a large deviation, because there
may be a problem behind it.
2. A single ratio is not enough; most of the times you need more than one
analyses.
3. All used financial statements should be from the same date.
4. Use audited financial statements.
5. The used financial statements should be made under the same accounting
principles (like GAAP).
6. Book value of e.g. assets may be influenced by inflation: the real values
may differ from the written values, therefore distorting profits.
Liquidity ratios
Liquidity = a firm’s ability to satisfy its short-term obligations as they come due.
Generally, a company with greater liquidity will have an easier time paying its
bills and is less likely to become insolvent.
2 most common measures of liquidity:
1. Current ratio
2. Quick ratio (acid-test)
,Current ratio
= a measure of liquidity calculated by dividing the firm’s current assets by its
current liabilities.
Current assets
Current ratio=
Current liabilities
Quick ratio (acid test)
= a measure if liquidity calculated by dividing the firm’s current assets less
inventory by its current liabilities.
Current assets−inventory
Quick ratio=
Current liabilities
The general low liquidity of inventory results from 2 primary factors:
1. Many types of inventory cannot be sold easily
2. Inventory is typically sold on credit (resulting in accounts receivable
before being converted into cash)
The quick ratio is a better measure of overall liquidity only when a firm’s
inventory cannot be easily converted into cash.
If inventory is liquid, the current ratio is a preferred measure of overall liquidity.
Activity ratios
= measure the speed with which various asset and liability accounts are
converted into sales or cash, or inflows or outflows.
It shows how efficient a firm operates along a variety of dimensions, like:
- Inventory management
- Disbursements
- Collections
Inventory turnover ratio
= measures the activity/liquidity of a firm’s inventory.
Average age of inventory = average number of day’s sales in inventory.
You calculate this by dividing the turnover ratio into 365.
Average collection period
= the average amount of time needed to collect accounts receivable.
It is useful in evaluating credit and collection policies.
, It equals the accounts receivable balance divided by average daily sales.
=
Average payment period
= the average amount of time needed to pay accounts payable.
=
Total asset turnover
= the efficiency with which the firm uses its assets to generate sales.
Formula: total asset turnover = sales / total assets
Debt ratios
The more debt a firm uses in relation to its total assets, the greater is its
financial leverage.
Financial leverage = the magnification of risk and return through the use of
fixed-cost financing, such as debt and preferred stock.
The term refers to the degree to which a firm uses debt financing and to
the effects of debt financing.
When a firm finances more of its investment by borrowing money, the
expected return on investment increases, but so does the risk: with
increases det comes greater risk as well as higher potential return.
The greater the financial leverage, the greater the potential risk and
return.
Degree of indebtedness = ratios that measure the amount of debt relative to
other significant balance sheet amounts.
Ability to repay debt coverage ratios = ratios that measure a firm’s ability to
make required debt payments and to pay other fixed charges such as lease
payments.
Also called overage ratios, help analysts figuring out if a company can
service their debts: make payments on time.
Debt ratio
Debt ratio = measures the proportion of total assets financed by the firm’s
creditors.
