Chapter 2 Finance

• How to know if actual process is being made?

  you have to compare to historical statements and or competitors (industry average)
• common-size statements are

  percentage income statement

  percentage balance sheet
• Percentage Income Statement

  all accounts as percent of Sales
• Percentage Balance Sheet

  all accounts as percentage of Total Assets
• Why would we want common-size statements

  removes size

  compare firm of different size

  see trends for same firm -> growing
• Liquidity Ratios are

  current ratio

  quick ratio
• liquidity means

  how easily can covert to cash
• Liquidity ratios are looking at

  how well a firm can cover short-term debt obligations with liquid assets
• Current Ratio

  current assets / current liabilities
• If current ratio is too high or too low

  too low - may have trouble covering short-term debt (lenders concern)

  too high - too much money in low or no return (stockholder concern)
• Quick Ratio

  current assets - inventory / current liabilities
• Why subtract inventory from Quick Ratio

  using most liquid assets and inventory is hard to convert to cash

  can compare firms that use different inventory practices
• Debt Management Ratios

  how much debt and how a firm handles it
• 2 types of Risk added by debt

  default risk = bankruptcy

  leverage = makes shareholder return more volatile
• Debt Management Ratios all of them means

  higher # = more debt (more leverage)

  higher # = more risk (more leverage)

  higher # = more risk
• Debt Management Ratios are

  total debt ratio

  debt-to-equity

  equity multiplier
• Total Debt Ratio


  total assets / total debt

  (debt to assets)

  proportion of assets financed with debt
• Debt-to-Equity Ratio

  total debt / total equity
• Equity Multiplier

  total assets / total equity ---> (1 + total debt / total equity)
• Total Debt Ratio, Debt-to-Equity, Equity Multiplier show

  how much debt
• Debt Management Ratio Part 2

  times interest expense ( TIE )

  cash coverage
• Times Interest Earned (TIE)

  EBIT / interest expense

  (interest coverage)
• TIE shows

  number of times operating income covers interest expense
• What's worse too high or too low for TIE

  too low - might have trouble interest expense
• Cash Coverage

  EBIT + Depreciation / Interest expense

  using CF instead of income
• Why add depreciation in Cash Coverage

  because its not cash
• Times Interest Earned and Cash Coverage show

  how well can they handle it ( default risk)
• Asset Management Ratios is

  how well a firm uses assets to generate sales

  ( assets are expensive)
• Asset Management ratios

  inventory turnover

  days sales in receivables

  total asset turnover
• Inventory Turnover

  cost of goods sold / inventory
• inventory turnover measures

  number of times sell out during the year
• Too high and too low in inventory turnover

  too high - the risk of missing sales

  too low - too much inventory for the sales level
• Days sales in receivables

  accounts receivable / (sales / 365)
• days sales in receivables measure

  number of days to collect on sales
• too high in days sales in receivables

  too long to get paid
• Total Assets Turnover

  sales / total assets
• total asset turnover measures

  amount of sales per $ of total assets
• too low in total asset turnover means

  too many assets for sales level = expensive
• Profitability Ratios

  operating margin

  ( net ) profit margin

  return on assets ( ROA )

  return on equity ( ROE )
• Operating Margin

  EBIT / sales