Ch 3 analyzing Financial Statements

Question 0

What are the 6 ratios to analyze debt?

Answer 0

Preferred Dividend Coverage

(Working)Asset Coverage

Interest Coverage

Debt/Equity Ratio

Percentage of Total Capital Ratios

Cash flow/Debt

Question 1

What are the 2 ratios to analyze liquidity?

Answer 1

Working Capital Ratio

Quick Ratio (Acid Test)

Question 2

What are the 7 ratios to analyze profitability?

Answer 2

Gross Profit MargIn

Operating profit margin

Net profit margin

Net return on equity

Net return on investment capital

Pre-tax return on investment capital

Inventory turnover

Question 3

What are the 6 ratios to analyze value?

Answer 3

Dividend yield (current dividend per share / market price per share). For those investors interested in cash profits.

Equity per preferred share

Equity per common share.

Earnings per common share (net income/# of outstanding common shares). How much did we make and how many shares do we have to split it between.

Percentage of available earnings paid out as preferred and common dividends

Percentage of available earnings paid out as common dividends

Price-earnings ratio (market price per common share/ earnings per common share). How much the public is willing to pay for the companies prospects to earn. High numbers mean the company’s income is expected to grow at a fast rate. For investors interested market price appreciation.

Question 4

Why do we analyze liquidity?

Answer 4

For a company to remain solvent it must meet it’s current liabilities. Liquidity helps the investor evaluate the ability of a company to turn as seats into cash to meet its short term obligations.

Lack of sufficient working capital and inability to liquidate current assets readily are frequent causes of business failure.

Question 5

How do you calculate working capital ratio? What type of test is it and what does it mean?

Answer 5

(Test of Liquidity)

Current assets / current liabilities

(Assets that would be liquidated in a year / debts that are due in a year)

2:1 is a good ratio. There are $2 of assets for every dollar owed.

If the ratio consistently exceeds 5:1 the company may have an unnecessary accusation of funds which could indicate sales problems (too much inventory) or financial mismanagement.

Question 6

How do you calculate the Quick Ratio (Acid Test)? What type of test is it and what does it mean?

Answer 6

Test of liquidity

Current assets - inventory / current liabilities

A more stringent test than the current ratio (working capital ratio test).

Inventory may be difficult to quickly convert to cash so if is removed from current assets.

1:1 is a good ratio but companies with large inventories and a quick inventory turnover can be less than 1.

Question 7

How do you calculate working asset coverage? What type of test is it and what does it mean?

Answer 7

(Debt analysis)

Total assets - deferred charges - intangible assets - [total current liabilities - (bank advances + current portion of long term debt)] / (short term + long)/$1000

This ratios shows the net TANGIBLE assets per $1000 of total outstanding. It enables the debts holder to measure the protection provided by the companies tangible assets.

Rules of thumb:

Utilities : at least $1500/1000

Industrials : at least $2000/1000

Considered by some to be an academic number but it is a required prospectus number in Ontario

Question 8

How do you calculate invested capital?

Answer 8

Invested capital = Short term debt + long term debt + par value of preferred shares + stated value if common shares + contributed surplus + retained earnings + foreign exchange adjustment

Question 9

How do you calculate percentage of total capital ratios? What type of test is it?

Answer 9

(Debt / invested capital) X 100

ie preferred shareholders percentage would be:

750000 / 16559000 X 100 = 4.56%

Invested capital = Short term debt + long term debt + par value of preferred shares + stated value if common shares + contributed surplus + retained earnings + foreign exchange adjustment

Question 10

What are the rules for Total capital percentages (Capital Structure)

Answer 10

There are no general rules as it varies widely among various industries.

Utilities - total debt outstanding shouldn’t exceed 60% of the total capital

Industrials - total debt outstanding shouldn’t exceed 1/3rd of the total capital.

Question 11

How do you calculate debt/equity ratio and what kind of test is it?

Answer 11

Test of debt.

Total debt (long and short term) / book value of shareholder equity.

Question 12

What is the significance and the rules of thumb for debt/ equity ratio.

Answer 12

It pinpoints the relationship of debt to equity and can be a warning sign that a companies borrowing is excessive. The higher the ratio the higher the financial risk.

Utilities - total debt outstanding should not be more than one and a half times the book value of shareholders equity. Should not exceed 1.5.

Industrials - total debt outstanding should not be more than half times the book value of shareholders equity. Should not exceed 0.5.

Question 13

Why is the cash flow/total debt ratio important?

Answer 13

It gauges the company’s ability to repay the funds that it has borrowed

Question 14

How do you calculate cash flow / total debt ratio and what are the rules of thumb?

Answer 14

Net earnings (before extraordinary items) - equity income+ minority interest in earnings of subsidiary companies + deferred income taxes + depreciation + any any other deductions not paid in cash e.g. Depletion, amortization etc / total debt outstanding (short and long term)

Utilities - cash flow should be at least 20% of total outstanding debt in each respective year over the past 5 years.

Industries - cash flow should be at least 30% of total outstanding debt in each respective year over the past 5 years.

Question 15

How do you calculate cash flow?

Answer 15

Net earnings (before extraordinary items) - equity income+ minority interest in earnings of subsidiary companies + deferred income taxes + depreciation + any any other deductions not paid in cash e.g. Depletion, amortization etc

Question 16

What does the interested coverage ratio tell us about a company?

Answer 16

It tests the company’s ability today the interests charges on its debt and indicates how many times these charges are covered based upon the earnings available to pay them.

It is generally considered to be the most important quantitative test.

A company may fail to meet its coverage standards and never experience difficulties, however the company is considered to be a much higher at risk

Question 17

How do you calculate interest coverage ratio and what are the rules of thumb?

Answer 17

Net earnings (before extraordinary items) - equity income+ minority interest in earnings of subsidiary companies + ALL income taxes + total interest charges / total interest charges

Utilities - total annual interest payments
in each of the past 5 fiscal years should be covered at least 2 times by earnings available in each respective year.

Industrials - total annual interest payments
in each of the past 5 fiscal years should be covered at least 3 times by earnings available in each respective year.

Question 18

How do you calculate preferred dividend coverage and what are the rules of thumb?

Answer 18

Net earnings (before extraordinary items) - equity income+ minority interest in earnings of subsidiary companies + ALL income taxes + total interest charges / total interest charges + preferred dividend payment before tax.

Utilities - the combined debt and preferred charges in each of the last 5 fiscal years should be covered at least 2 times by earnings available in each if the respective years.

Industrials - the combined debt and preferred charges in each of the last 5 fiscal years should be covered at least 3 times by earnings available in each if the respective years.

Question 19

What Is the significance of.preferred dividend coverage?

Answer 19

This ratio indicates the margin of safety behind preferred dividends. It is essentially an extension of the interest coverage calculation to include preferred dividends.

Question 20

What is the gross profit margin an indication of?

Answer 20

It is an indication of efficiency of the management in turning the companies goods into profit.

Question 21

How do you calculate gross profit margin?

Answer 21

Net sales - cost of goods sold / net sales.

Question 22

What is the operating profit margin an indication of?

Answer 22

It is a more stringent test (than gross profit margin) of a companies ability to manage its resources because it also takes into account selling, General and administrative costs.

Question 23

How do you calculate operating profit margin?

Answer 23

Net sales - (cost of goods + selling administrative + administrative and general expenses) / net sales

for companies subject to excise tax like tobacco companies you must use net sales AFTER tax*