Term
| 3 reasons reported book value and true value are often different |
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Definition
o The financial statements do not reflect the company’s prospects within its business environment
o The financial statements do not reflect important unrecorded events
o Management prepares the reports in a biased manner |
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Term
| 3 adjustments to be made to equal true value |
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Definition
Business environment
Unrecorded Events
Management Bias |
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Term
| 5 elements of financial statement analysis |
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Definition
• Assessing the business environment
• Reading and studying the financial statements and footnotes
• Assessing earnings quality
• Analyzing the financial statements
• Predicting future earnings and/or cash flows |
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Term
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Definition
| the auditor’s statement that the financial statements fairly reflect the financial position and operations of the company and the internal control system is reasonably effective |
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Term
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Definition
| The extent to which an income statement item reported in the current period can be expected to reflect future income levels |
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Term
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Definition
| Different areas of the business with separate methods of generating revenue and incurring expenses |
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Term
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Definition
| The extent to which the reported financial statements deviate from the true financial condition and performance of the company |
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Term
| 4 strategies used by managers to "manage" reported accounting numbers |
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Definition
1. Overstating the Performance
2. Taking a Bath
3. Creating Hidden Reserves
4. Off-Balance Sheet Financing |
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Term
| Overstating the Performance |
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Definition
| Accelerating recognition of revenues or deferring the recognition of expenses to devise a more favorable picture |
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Term
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Definition
| Choosing conservative accounting methods estimates or judgments that, in turn, further reduce the company’s reported financial condition and operating performance in that year (recognizing loss in current year when already doing poor to make it less obvious) |
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Term
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Definition
| Using conservative accounting methods, estimates and judgments that can help management to “smooth” reported earnings over time (used in years of extremely good performance) |
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Term
| Off-Balance sheet financing |
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Definition
Structure financing transactions and choose certain accounting methods so that debt need not be reported on the balance sheet
o May make the reporting company appear less risky |
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Term
| 4 sources of industry information |
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Definition
(1) Dun & Bradstreet’s Key Business Ratios
(2) Robert Morris Associates’ Annual Statement Studies
(3) Moody’s Investors Service
(4) Standard and Poor’s Industry Surveys |
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Term
| Common Size Financial Statements |
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Definition
Financial statement numbers are expressed as percentages of other numbers on the same statements
o On the income statement, expense items and net income are often expressed as percentages of net sales
o On the balance sheet, assets and liabilities are expressed as percentages of total assets
o Can help indicate why changes occur in a company’s financial performance and financial condition |
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Term
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Definition
| Computing ratios using two or more financial statement numbers is also a common and useful practice |
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Term
| 5 Categories of ratios (Pratt) |
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Definition
Leverage
Solvency
Asset Turnover
Expense Control
Results |
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Term
| Capital Structure Leverage |
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Definition
Average total assets / average shareholders’ equity
• Measures the extent to which a company relies on its borrowing
• Ratio increases above 1 as liabilities in the capital structure increase
• High levels indicate a company is using leverage – large potential earning power and high levels of risk |
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Term
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Definition
Net income / (net income + interest expense [ 1 – tax rate])
• Compares the return available to the shareholders to the returns available to all capital providers
• High levels indicate shareholders are receiving a large portion of the total return generated by the company
• These are the result of a company not using leverage or using it very effectively |
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Term
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Definition
Current assets / current liabilities
• Measures solvency by comparing current assets to current liabilities |
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Term
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Definition
(Cash + short-term investments + A/R) / current liabilities
• Provides a more stringent test of a company’s solvency position
• Current assets like inventories and prepaid expenses (which aren’t immediate converted to cash) are excluded |
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Term
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Definition
(Net income + tax expense + interest expense) / interest expense
• Compares the annual funds available to meet interest to the annual interest expense
• Increasing levels of this ratio signal that a company is becoming more solvent |
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Term
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Definition
Cost of good sold / average accounts payable
• Measures how quickly, on average, suppliers are paid off or, in other words, the extent to which accounts payable is used as a form of financing
• Indicates the number of times during the year that accounts payable balance is paid off |
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Term
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Definition
Sales / average total assets
• Measures the speed with which all assets are used up in operations, aggregating the turnover measures of the component assets (AR, Inventory, Fixed assets) |
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Term
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Definition
Sales / average accounts receivable
• Reflects the number of times the trade receivables were recorded, collected, and recorded again during the period
• Measures the effectiveness of the credit-granting and collection activities of a company
• High Receivables turnover suggests effective credit-granting and collection activities
• Very high rate is not always desirable because it may indicate overly stringent credit terms, leading to missed sales and lost profits |
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Term
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Definition
Cost of goods sold / average inventory
• Measures the speed with which the inventories move through operations
• An increase in the inventory turnover is normally desirable, however high levels can indicate inventory levels are too low, giving rise to lost sales and profits due to items being out of stock |
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Term
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Definition
Sales / average fixed assets
• Compares the average level of Fixed assets to the sales for the year (the level of fixed asset investment necessary to generate the annual sales volume) |
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Term
| Working Capital Investment |
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Definition
| A/R turnover (days) + inventory turnover (days) – A/P turnover (days) |
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Term
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Definition
| Expenses expressed as a percentage of sales |
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Term
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Definition
| (Net income + interest expense [1 – tax rate]) / sales |
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Term
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Definition
(Net income + interest expense [1 – tax rate]) / average total assets
• It compares the returns to both shareholders and creditors to total assets, the total resources provided by shareholders and creditors |
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Term
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Definition
Net income / average shareholders’ equity
• This is considered as a measure of efficiency with which the shareholders’ investment is being managed |
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Term
| What is the formula for value creation? |
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Definition
| Return on equity - cost of equity |
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Term
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Definition
| = ROA x Common Equity Leverage x Capital Structure Leverage |
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Term
| What formula makes up ROA? |
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Definition
| = Profit Margin x Asset turnover |
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Term
| Which ratios make up profit margin? |
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Definition
COGS/Sales
SG&A/Sales
Interest/Sales
Other gains (losses)/Sales |
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Term
| What ratios go into Asset Turnover? |
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Definition
Fixed Asset Turnover
A/R turnover
Inventory turnover
Working capital investment |
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Term
| Which ratios are associated with financing? |
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Definition
Current Ratio
Quick Ratio
Interest coverage
A/P Turnover
Long-Term Debt/Total Assets |
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