Exam 2 p1 Flashcards

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ROA

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Return on Assets measures a firm’s profitability from using assets to generate earnings independent of financing. It is calculated as $\mathrm{ROA}=\frac{NI + Interest(1 - t)}{Average\ Total\ Assets}$, which adds back after-tax interest to exclude financing effects. A lower ROA than industry average suggests less efficient asset use.

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Profit Margin

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Profit Margin for ROA measures the ability to convert sales into profits and is a component of ROA. It is computed as $\text{Profit Margin for ROA}=\frac{NI + Interest(1 - t)}{Sales}$. Higher margins indicate better profitability per dollar of sales.

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Asset Turnover

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Asset Turnover measures how efficiently a firm uses assets to generate sales and is a component of ROA. It is calculated as $\text{Asset Turnover}=\frac{Sales}{Average\ Total\ Assets}$. A higher turnover means each dollar of assets produces more sales.

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Receivables Turnover

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Accounts Receivable Turnover measures how many times receivables are collected in a year. It is computed as $\text{Receivables Turnover}=\frac{Sales}{Average\ Accounts\ Receivable}$, and days outstanding are $\frac{365}{\text{Receivables Turnover}}$. Higher turnover and fewer days indicate faster collection.

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Inventory Turnover

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Inventory Turnover indicates how many times inventory is sold and replaced during a period. It is given by $\text{Inventory Turnover}=\frac{Cost\ of\ Goods\ Sold}{Average\ Inventories}$ and can be converted to average days on hand by $\frac{365}{\text{Inventory Turnover}}$. High turnover suggests strong sales or low inventory levels, but too-low inventory risks lost sales.

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Expense Capitalization

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Expensing large marketing or R\&D costs rather than capitalizing them can understate assets and overstate ROA. This accounting treatment makes comparisons across firms misleading when one firm capitalizes similar costs. Analysts should adjust or interpret ROA carefully when such expenses are material.

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EPS

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Earnings Per Share (EPS) is the GAAP-required per-share measure of a firm's earnings attributable to common shareholders. Basic EPS is calculated as $\mathrm{EPS}=\frac{NI - Preferred\ Dividends}{Weighted\ Average\ Common\ Shares\ Outstanding}$. EPS is popular because it is comparable to share price but can be affected by capital actions.

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Basic EPS

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Basic EPS applies when the capital structure is simple with no convertible securities or options outstanding. It uses net income less preferred dividends divided by the weighted average common shares outstanding. The weighted average denominator reflects issuances and repurchases during the period.

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Diluted EPS

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Diluted EPS is presented when a firm has convertible securities or stock options outstanding that could increase common shares. It shows the reduced EPS that would result if those instruments were converted into common stock. Diluted EPS quantifies potential dilution and must be shown alongside basic EPS for complex capital structures.

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P/E Ratio

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The Price/Earnings ratio shows what the market is willing to pay per dollar of current earnings and reflects investor expectations. It is calculated as $\mathrm{P/E}=\frac{Market\ Price\ per\ Share}{EPS}$. Higher P/E often indicates higher expected growth or lower perceived risk.

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Pro Forma

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Pro forma (adjusted) earnings exclude one-time or nonrecurring items to present an alternate view of earning power. Managers often report pro forma figures by removing charges they deem nonrecurring, which can increase reported earnings. Investors should scrutinize such adjustments for consistency and relevance.

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ROCE

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Return on Common Shareholders' Equity (ROCE) measures the return earned by common shareholders and incorporates financing effects. It is computed as $\mathrm{ROCE}=\frac{NI - Preferred\ Dividends}{Average\ Common\ Shareholders'\ Equity}$. ROCE reflects leverage and will exceed ROA only when leverage is used effectively and ROA exceeds the cost of debt.

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Capital Leverage

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Capital Structure Leverage is the ratio relating total assets to common shareholders' equity used in ROCE disaggregation. It is measured as $\text{Capital Leverage}=\frac{Average\ Total\ Assets}{Average\ Common\ Shareholders'\ Equity}$. Higher leverage magnifies returns to equity when asset returns exceed borrowing costs, and magnifies losses otherwise.

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Profit Margin ROCE

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Profit Margin for ROCE measures profitability relative to sales for equity holders and is a component of ROCE. It is calculated as $\text{Profit Margin for ROCE}=\frac{NI - Preferred\ Dividends}{Sales}$. This margin captures earnings available to common shareholders per dollar of sales.

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ROCE vs ROA

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ROA measures return on all assets irrespective of capital structure, while ROCE measures return to common equity and incorporates financing. ROCE should exceed ROA if leverage is used effectively and ROA is greater than the after-tax cost of debt. Thus differences between them indicate the impact of capital structure on shareholder returns.

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ROE

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Return on Equity (ROE) measures a firm's profitability for all equity holders. It is calculated as $\mathrm{ROE}=\frac{NI}{Average\ Shareholders'\ Equity}$. ROE is influenced by profit margins, asset turnover, and leverage and is commonly used to assess shareholder returns.

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Leverage Example

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A leverage example shows how two firms with equal ROA can produce very different ROCE depending on capital structure and after-tax cost of debt. If debt is cheap relative to ROA, equity returns (ROCE) can be amplified; if debt cost equals or exceeds ROA, ROCE may not benefit. This illustrates the trade-off between risk and return from leverage.

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ROA Rearranged

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You can rearrange the ROA relation to express net income in terms of ROA, assets, and interest: $$NI = ROA \times Average\ Total\ Assets - Interest(1 - t).$$ This identity helps in analyzing how changes in ROA or interest affect reported net income. It is useful when connecting ROA, ROCE, and financing costs.

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Liquidity Risk

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Short-term liquidity risk measures a firm's ability to meet near-term obligations and bridge timing gaps between cash inflows and outflows. Firms use short-term debt to manage these gaps, and healthy liquidity reduces default and bankruptcy risk. Common ratios used include the current and quick ratios.

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Current Ratio

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The Current Ratio measures the amount of current assets available to cover current liabilities and is computed as $\text{Current Ratio}=\frac{Current\ Assets}{Current\ Liabilities}$. A ratio of at least 1 is generally considered healthy, though very high ratios may indicate excess inventory or receivables. The ratio helps predict short-term default risk.

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Quick Ratio

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The Quick Ratio includes only the most liquid current assets and is calculated as $\text{Quick Ratio}=\frac{Cash + Marketable\ Securities + Accounts\ Receivable}{Current\ Liabilities}$. It provides a conservative view of short-term liquidity by excluding inventory. For firms with illiquid inventory, the quick ratio is especially informative.

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Payables Turnover

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Accounts Payable Turnover measures how many times a firm pays its suppliers during the year and is computed as $\text{Payables Turnover}=\frac{Purchases}{Average\ Accounts\ Payable}$. Days payable outstanding equals $\frac{365}{\text{Payables Turnover}}$, and a higher turnover implies more frequent payments and potentially stronger short-term liquidity.