RATIO ANALYSIS (IMP POINTS)

● Exercising share options improves (decreases) the debt-equity

ratio because the entity is increased with no effect on debt.
When share options are exercised, common stock and
additional paid-in capital are credited and cash is debited.

● Exercising share options also decreases the asset turnover

ratio.

● a high ratio could indicate that a firm is undercapitalized and

does not have the resources to invest in
● working capital
● A high sales-to-working capital ratio could indicate that a
firm is undercapitalized and does not have the resources to
invest in working capital

● Accounts payable (trade credit) are a spontaneous source

of financing. Trade credit is the largest source of short-term
financing because it arises automatically as part of the
purchase transaction.

● Allocating cost over shorter periods enhances earning quality.

● Fair Value disclosures can supplement historical cost ratio

analysis. If market prices decline, then ratios using fair value
prices will show worse results than those using historical cost.
If market prices increase, ratios using fair value prices will
show higher ratios than those using historical cost.

● ROE is equal to ROA multiplied by leverage ratios. The

leverage ratio is the ratio of total assets to common stock
equity. The leverage ratio is greater than one if leverage is
effective. ROA is also called ROI. Total shareholder’s equity
 includes preferred stock, which is a part of the financial
leverage.

● DuPONT model enhances the analysis of ROA by - It

measures operational efficiency, asset use efficiency and
financial leverage.

● DuPONT ROA MODEL = Return on sales ( net profit margin) *

Asset turnover.

● DuPont ROE MODEL = Net profit margin*Asset

turnover*average total asset
Average total
eqty
● FINANCIAL LEVERAGE INDEX = ROE
ROA

● The purchase of assets using debt financing will increase total

assets and total liabilities without affecting shareholder’s
equity. Therefore, the financial leverage ratio of total assets to
common shareholder’s equity will increase.

● Earnings power is defined as the best possible estimate of the

average business earnings that can be expected to be
sustained in the future for a number of years, preferable over
an entire business cycle. Earnings power is used as a
forecasting tool but does not try to anticipate probable future
conditions other than a continued trend.

● Net profit margin ratio is the ratio that is most affected by

miscellaneous or non- recurring income.

● The current ratio measures only the ratio of current

assets to current liabilities. It does not measure the
efficiency of handling the individual current asset
 accounts. A high ratio may indicate, for example,slow
collection of accounts receivable, holding of excess inventory,
or retention of more cash than needed for the cash flow
requirements of the firm. The weaker and less efficient
company may have a higher current ratio.

● If the company uses a direct write-off method to account for

uncollectible accounts receivable. If the company
subsequently collects an account receivable that was written
off in a prior accounting period, the effect of the collection of
the account receivable on the current ratio and total working
capital would increase.

● If the company uses an allowance method to account for

uncollectible accounts receivable. If the company
subsequently collects an account receivable that was written
off in a prior accounting period, the effect of the collection of
the account receivable on the current ratio and total working
capital would be no effect.

● The relationship of the total debt to the total equity of a

corporation is a measure of Creditors risk.

● A bondholder would be most concerned with Times interest

earned.

● Debt to total asset ratio is the best indicator for long term
debt paying ability.

● Two primary factors that contribute to business risk are sales

volatility and degree of operating leverage.

● The concept of economic profit is best defined as total

revenue minus all explicit and implicit costs.
● Average collection period, day’s sales in inventory and
asset turnover ratio measure a firm’s ability to use its assets
efficiently.

● Current ratios measure liquidity and do not measure a

firm's ability to use its assets efficiently.

● If a company is profitable and is effectively using leverage,

then return on common equity ratio will likely be highest.

● Dividend paid to company shareholders would be shown on

the statement as Cash flow from financing activities.

● Return on assets is defined as asset turnover * profit

margin.

● Repeat customers who continually purchase the product or

services are an example of the principle of stability.

● Elasticity refers to how the customers respond to a change in

selling price.

● The tradeoff between fixed and variable costs are the key
determinant of operating leverage.

● In an inflammatory economy, if a company changes from

FIFO to LIFO,The current ratio would decrease and the
inventory turnover ratio would increase.

● A company with a higher dividend payout ratio will have a

higher debt-to-asset ratio and a lower current ratio.

● Deferred tax is not a current liability.

● The debt ratio means the debt-to-total assets ratio.

● A degree of operating leverage of 3 means that a 1%

change in sales causes a 3% change in earnings before
interest and taxes.

● Miscellaneous or non-recurring income would not be

included in the operating profit margin or gross profit
margin, It is included in the net profit margin.

● Miscellaneous or non-recurring income would affect the

debt-to-equity ratio only minimally because it is an income
statement item. Net-profit margin is the most affected.

● Return on assets = Return of equity * (1– debt ratio)

● Extraordinary gain is an item with low earnings

persistence.

● Sustainable growth rate = ROE * retention ratio.

● Liberalization of credit policy will increase receivables.

● The two financial statements that are most important for

assessing a firm’s liquidity are the balance sheet and
statement of cash flows.

● When the average collection period is increasing, credit

and collection policies will be tightened.

● Similarity in liquidity and solvency: Both are concerned

with company’s debt-to-asset ratio.
● A lower dividend payout ratio will be favoured by
investors if dividends are taxed at a high rate than a
capital gain.

● The cost of equity for the company will be lower under

the lower dividend payout policy because more retained
earnings will be available for reinvestment.

● Income taxes are an expense of the business and affect

the rate of return and earnings per share. Any ratio that
uses net income as a part of the calculation is
affected.

● Allocating costs over shorter periods enhance earnings

quality.

● Immediately expensing product R&D costs, Estimating a

low rate of return on the company's pension plan assets
will increase pension expense, which leads to a more
conservative income statement and a higher quality of
earnings.

● Book value represents the amount of net assets owned by

the common shareholders.

● The PE ratio is a measure of investor confidence in the

management of a firm. A high ratio implies greater
confidence.