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FSM
Finance Skills for Managers Unit 3
| Question | Answer |
|---|---|
| Why can't we compare companies like Coca-Cola and PepsiCo using raw numbers? | Because differences in size, strategy, and risk can mislead; ratio analysis standardizes data for meaningful comparison. |
| What is the primary purpose of ratio analysis in finance? | To evaluate a company’s financial health and performance in a standardized way. |
| What are the four key benefits of financial ratios? | 1. Standardization 2. Flexibility 3. Focus 4. Evaluation |
| What does "standardization" in ratio analysis mean? | It allows comparison across companies of different sizes by expressing values as percentages or proportions. |
| Give an example of a standardized ratio and its use. | Profit Margin = Net Income ÷ Revenue; it shows efficiency regardless of company size. |
| Why is ratio analysis considered flexible? | Ratios are not limited by GAAP and can be customized to suit specific analysis needs. |
| How do ratios help with "focus"? | They highlight areas that need deeper investigation but don’t explain causes by themselves. |
| How are ratios used for "evaluation"? | They help assess how effectively management is increasing shareholder value. |
| What are the three ways ratios gain meaning? | 1. Trend Analysis (past) 2. Cross-Sectional Analysis (peers) 3. Progress Measurement (goals) |
| What is trend analysis in ratio comparison? | Comparing a company’s ratios over time to identify patterns or changes. |
| What is cross-sectional analysis in ratio comparison? | Comparing a company’s ratios to other firms or industry averages in the same period. |
| What is progress measurement in ratio analysis? | Comparing performance to internal goals to assess if targets are being met. |
| What’s a common timing issue in ratio analysis? | Seasonal distortions and mismatched financial periods between the balance sheet and income statement. |
| What’s a solution for timing issues in financial ratios? | Use average values (e.g., average equity for ROE) for more accuracy. |
| What accounting differences can affect ratio comparability? | Varying depreciation methods, inventory valuation, and revenue recognition policies. |
| Key takeaway: What do ratios help analysts and investors do? | Understand financial health, identify red flags, and make comparisons across time, peers, or goals. |
| Which statement below is an example of how ratios are used in the field of finance? | A firm’s ratios are compared with those of a benchmark peer group to determine the firm’s relative strength and performance. |
| Why are ratios considered flexible? | Because they are not regulated and can be changed or invented according to a firm’s needs |
| How might calculating financial ratios help shareholders? | Ratios can be used to determine whether a firm is maximizing shareholder wealth. |
| The firm Betsy’s Books conducts a financial analysis using ratios to know how it is performing in comparison to other similar firms. What is this process called? | Benchmarking |
| What are financial ratios used for? | Financial ratios help evaluate a company’s performance, making it easier to compare firms of different sizes, strategies, and risks. |
| What are the five major categories of financial ratios? | 1. Liquidity Ratios 2. Activity Ratios 3. Leverage Ratios 4. Profitability Ratios 5. Market Ratios |
| What do liquidity ratios measure? | They measure a firm’s ability to meet short-term obligations without needing external funds. |
| Why do liquidity ratios matter? | They indicate a company's financial cushion, with low liquidity posing a risk for payment difficulties, particularly to creditors. |
| What do activity (efficiency) ratios assess? | They evaluate how efficiently a company uses its assets to generate sales or cash. |
| Why are leverage ratios important? | They measure a firm’s use of debt to finance its operations, assessing financial risk and the potential for magnified returns. |
| What do profitability ratios measure? | They measure how effectively a company generates profit from its operations, reflecting management effectiveness and financial health. |
| What do market ratios help investors determine? | Market ratios help assess whether a company’s stock is overvalued or undervalued based on stock price and earnings. |
| What is the current ratio? | Current Ratio = Current Assets ÷ Current Liabilities; it measures a firm’s ability to pay short-term obligations. |
| What is the quick ratio? | Quick Ratio = (Current Assets – Inventory) ÷ Current Liabilities; it measures the ability to pay short-term obligations without relying on inventory. |
| What is the asset turnover ratio? | Asset Turnover = Revenue ÷ Total Assets; it measures how efficiently a company uses its assets to generate sales. |
| What is the debt-to-equity ratio? | Debt-to-Equity Ratio = Total Debt ÷ Total Equity; it measures a company’s financial leverage and reliance on debt for operations. |
| What is the interest coverage ratio? | Interest Coverage Ratio = EBIT ÷ Interest Expense; it measures a company’s ability to cover its interest payments with earnings. |
| What is the net profit margin? | Net Profit Margin = Net Income ÷ Sales; it shows how much profit a company generates from each dollar of sales. |
| What is the price-to-earnings (P/E) ratio? | P/E Ratio = Market Price per Share ÷ Earnings per Share (EPS); it helps assess whether a company’s stock is fairly valued relative to earnings. |
| What does a P/E ratio of 25 imply? | A P/E ratio of 25 means investors are willing to pay 25 times the earnings per share for the company's stock. A higher P/E can signal overvaluation. |
| How do market ratios benefit investors? | They help investors assess stock value, guiding buy or sell decisions based on market conditions and earnings comparisons. |
| What type of ratio is used to assess a firm’s ability to meet short-term obligations without raising external capital? | Liquidity ratios |
| Why are several different types of ratios used to analyze a firm? | Because different types of ratios are needed to get information about different parts of a firm |
| What do leverage ratios describe? | What proportions of equity and debt a firm uses to finance its assets |
| A firm has paid off its short-term loans more quickly in the past couple of years. What might this trend indicate about the firm’s financial ratios? | Its liquidity ratio is increasing. |
| What do liquidity ratios measure? | Liquidity ratios measure a company’s ability to meet short-term obligations using its liquid assets. |
| What is the current ratio? | Current Ratio = Current Assets ÷ Current Liabilities; it indicates the ability to cover current liabilities with current assets. |
| What does a current ratio below 1 imply? | It may indicate liquidity issues, meaning the company might struggle to cover its short-term liabilities. |
| What is the quick ratio? | Quick Ratio = (Current Assets − Inventory) ÷ Current Liabilities; it excludes inventory to provide a stricter test of liquidity. |
| What do activity ratios assess? | Activity ratios assess how efficiently a company uses its assets to generate revenue or cash. |
| What is the accounts receivable turnover ratio? | Accounts Receivable Turnover = Credit Sales ÷ Accounts Receivable; it measures how often receivables are collected annually. |
| What does a high accounts receivable turnover indicate? | It suggests efficient collection of receivables and effective credit policies. |
| What is the inventory turnover ratio? | Inventory Turnover = Cost of Goods Sold ÷ Inventory; it measures how often inventory is sold and replaced. |
| What does a high inventory turnover ratio suggest? | It suggests efficient inventory management, but excessively high turnover could risk stockouts. |
| What is the debt ratio? | Debt Ratio = Total Liabilities ÷ Total Assets; it measures the portion of assets financed by debt. |
| What does a higher debt ratio indicate? | It implies greater financial leverage and increased risk. |
| What is the debt-to-equity ratio? | Debt-to-Equity Ratio = Total Liabilities ÷ Total Equity; it compares the amount of debt used to finance operations relative to equity. |
| What does a high debt-to-equity ratio imply? | It suggests higher financial risk but potential for higher returns. |
| What is the times interest earned (TIE) ratio? | TIE Ratio = EBIT ÷ Interest Expense; it measures the company’s ability to cover its interest payments. |
| What does a higher TIE ratio indicate? | It indicates a stronger ability to cover interest payments and less risk of financial distress. |
| What is the operating income return on investment (OIROI) ratio? | OIROI = Operating Income ÷ Total Assets; it evaluates pre-tax, pre-financing return on assets, focusing on core operations’ profitability. |
| What does a higher ROA indicate? | It shows efficient use of assets to generate profit. |
| What is net profit margin? | Net Profit Margin = Net Income ÷ Sales; it measures how much profit is retained from each dollar of sales. |
| What is the operating margin? | Operating Margin = Operating Profit (EBIT) ÷ Sales; it reflects operational efficiency by showing the proportion of sales that is profit. |
| What is the gross margin? | Gross Margin = Gross Profit ÷ Sales; it indicates how well a company controls its production or acquisition costs. |
| What does a high operating margin indicate? | It signals good operational efficiency with relatively low costs compared to sales. |
| What is Return on Assets (ROA)? | ROA = Net Income ÷ Total Assets; it measures the efficiency of asset utilization in generating profit. |
| What is Return on Equity (ROE)? | ROE = Net Income ÷ Shareholders' Equity; it shows how effectively shareholder capital is used to generate profit. |
| What is the times interest earned ratio used for? | It assesses a company’s ability to meet interest payments from operating earnings. |
| Which type of ratio is a current ratio? | Liquidity |
| What is the main difference between the current ratio and the quick ratio? | The current ratio includes inventory in current assets, and the quick ratio does not. |
| The firm Betsy’s Books has a market-to-book ratio of 1.2. What does this tell you about the firm? | This firm is expected to grow in the future. |
| What does the net margin measure? | The percent of revenue that is retained as profit for the firm |
| What does the DuPont Framework analyze? | It analyzes Return on Equity (ROE) by breaking it into three components: profitability, efficiency, and leverage. |
| What is the formula for ROE in the DuPont Framework? | ROE = (Net Income / Sales) × (Sales / Total Assets) × (Total Assets / Equity) |
| What are the three components of the DuPont ROE formula? | Net Profit Margin, Asset Turnover, and Equity Multiplier. |
| What does Net Profit Margin represent in DuPont analysis? | Profitability — how much net income is generated from each dollar of sales. |
| What is the formula for Net Profit Margin? | Net Profit Margin = Net Income ÷ Sales |
| What does Asset Turnover represent in DuPont analysis? | Efficiency — how well a company uses its assets to generate sales. |
| What is the formula for Asset Turnover? | Asset Turnover = Sales ÷ Total Assets |
| What does the Equity Multiplier represent? | Leverage — how much of a company’s assets are financed by equity versus debt. |
| What is the formula for the Equity Multiplier? | Equity Multiplier = Total Assets ÷ Equity |
| What is the alternative form of the DuPont formula? | ROE = ROA × Equity Multiplier |
| How does using more debt affect the equity multiplier? | It increases the equity multiplier, which can amplify ROE (or losses). |
| Why is leverage described as a double-edged sword? | It increases ROE if ROA is positive but magnifies losses if ROA is negative. |
| In the DuPont framework, what improves ROE? | Higher profitability, more efficient asset use, and strategic leverage. |
| What does a high equity multiplier indicate? | Greater use of debt financing (higher leverage and potentially more risk). |
| How did Allstate (2018) achieve strong ROE? | Through solid profitability (5.66%), good efficiency (1.30× asset turnover), and moderate leverage (1.44× multiplier). |
| What’s the key insight from the dairy farm example? | With a positive ROA above loan interest rates, adding leverage can increase ROE. |
| Which of these measures is a component of return on equity? | Net margin |
| How can the DuPont framework help a company assess its return on equity? | It allows the company to determine how its abilities to generate profits, manage assets, and use financing contribute to the return on equity. |
| Which action increases the return on equity of a firm if all else remains constant? | Increasing debt financing |
| What is a component of the DuPont framework? | Return on assets |
| What are the three components of the DuPont Framework? | Profitability (Net Profit Margin), Efficiency (Asset Turnover), and Financing (Leverage Multiplier). |
| What is the DuPont formula for Return on Equity (ROE)? | ROE = Net Profit Margin × Asset Turnover × Leverage Multiplier. |
| Why is the DuPont Framework useful? | It shows how ROE is generated—through profit margins, efficiency, or financial leverage. |
| What does a higher leverage multiplier indicate? | Greater use of debt financing and higher financial risk. |
| Can two companies have the same ROE but different risk profiles? | Yes, because ROE can be driven by different combinations of margin, efficiency, and leverage. |
| In the example of Firm 1 vs. Firm 2, how do they differ despite having the same ROE (24%)? | Firm 1 has higher margins and efficiency with low leverage; Firm 2 relies on high leverage and has lower profitability and efficiency. |
| What’s the key risk in Firm 2’s strategy to achieve a 24% ROE? | Heavy reliance on leverage, which increases financial risk. |
| In the candy company comparison, which company had the highest ROE and why? | Hershey’s, due to high profit margins, good efficiency, and high leverage. |
| How does Mondelēz’s business model affect its asset turnover? | Its diverse brand portfolio leads to lower asset efficiency. |
| What does Tootsie Roll’s low leverage multiplier suggest? | It uses little debt and has low financial risk. |
| How can a company improve its ROE using the DuPont levers? | Increase profit margin, improve asset efficiency, or use more debt (leverage). |
| What is the main trade-off of increasing leverage to improve ROE? | Higher financial risk and potential for amplified losses during downturns. |
| What does the DuPont Framework help investors and analysts do? | Identify strengths, weaknesses, and the sources of a firm’s financial performance. |
| Why might a company with a lower ROE still be more attractive than one with a higher ROE? | It may have a safer and more sustainable business model with less financial risk. |
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heavenlypure
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