Key Financial Terms, Ratios, and Analysis Methods

Posted on Jan 4, 2025 in Economy

Key Financial Terms and Concepts

GAAP: The practice and procedure guidelines to prepare and maintain financial records and reports.
Financial Accounting Standards Board: The accounting profession’s rule-setting body.
Securities and Exchange Commission (SEC): The federal regulatory body that governs the sale and listing of securities.
Stockholders: Receive an annual report from publicly owned corporations.
Income Statement: Provides a summary of the firm’s performance during a specific time.
Dividend per Share (DPS): The dollar amount of cash distributed during the period on behalf of each outstanding share of common stock.
Balance Sheet: A summary statement of the firm’s financial position at a given point in time.
Current Assets: Assets that are expected to be converted into cash within a year.
Current Liabilities: Debts that are due within a year.
Long-Term Debt: Debts for which payment is not due in the current year.
Retained Earnings: The cumulative total of all earnings.
Statement of Cash Flows: Provides a summary of the firm’s operating, investment, and financing cash flows.
Current Rate Method: Used to translate foreign currency-denominated assets and liabilities into dollars.

Ratio Analysis: Involves methods of calculating and interpreting financial ratios to analyze and monitor a firm’s performance.
Cross-Sectional Analysis: Comparison of different firms’ financial ratios at the same point in time.
Benchmarking: A type of cross-sectional analysis in which a firm’s ratio values are compared to those of a key competitor or group.

Liquidity: A firm’s ability to satisfy its short-term obligations.
Current Ratio: A measure of liquidity.
Formula: Current Assets / Current Liabilities
Quick (Acid Test) Ratio: A more stringent measure of liquidity.
Formula: Current Assets – Inventory / Current Liabilities

Activity Ratios: Measure the speed at which various accounts are converted into sales or cash flows.
Inventory Turnover: Measures the activity or liquidity of a firm’s inventory.
Formula: Cost of Goods Sold / Inventory
Average Collection Period: Measures the time it takes to collect receivables.
Formula: Accounts Receivable / Average Sales per Day
or
Formula: Accounts Receivable / (Annual Sales / 365)
Average Payment Period: Measures the time it takes to pay suppliers.
Formula: Accounts Payable / Average Purchases per Day
or
Formula: Accounts Payable / (Annual Purchases / 365)
Total Assets Turnover: Measures how efficiently a firm uses its assets to generate sales.
Formula: Sales / Total Assets

Financial Leverage: The magnification of risk and return introduced through the use of fixed-cost financing.
Coverage Ratios: Ratios that measure a firm’s ability to pay certain fixed charges.
Debt Ratio: Measures the proportion of assets financed with debt.
Formula: Total Liabilities / Total Assets
Times Interest Earned Ratio: Measures a firm’s ability to meet its interest obligations.
Formula: Earnings Before Interest and Taxes / Interest
Fixed Payment Coverage Ratio: Measures a firm’s ability to meet all fixed payment obligations.
Formula: (Earnings Before Interest and Taxes + Lease Payments) / (Interest + Lease Payments + (Principal Payment + Preferred Stock Dividends) * (1 / (1-T)))

Gross Profit Margin: Measures the percentage of each sales dollar remaining after deducting the cost of goods sold.
Formula: Sales – Cost of Goods Sold / Sales or Gross Profits / Sales
Operating Profit Margin: Measures the percentage of each sales dollar remaining after deducting operating expenses.
Formula: Operating Profits / Sales
Net Profit Margin: Measures the percentage of each sales dollar remaining after all expenses, including taxes, have been deducted.
Formula: Earnings Available for Common Stockholders / Sales
Return on Total Assets (ROA): Measures the overall effectiveness of management in generating profits with its available assets.
Formula: Earnings Available for Common Stockholders / Total Assets
Return on Equity (ROE): Measures the return earned on the common stockholders’ investment in the firm.
Formula: Earnings Available for Common Stockholders / Common Stock Equity

Market Ratios: Relate a firm’s market value, as measured by its current share price, to certain accounting values.
Price Earnings (P/E) Ratio: Measures the amount that investors are willing to pay for each dollar of a firm’s earnings.
Formula: Market Price per Share of Common Stock / Earnings per Share
Book Value per Share of Common Stock: Measures the accounting value of each share of common stock.
Formula: Common Stock Equity / Number of Shares of Common Stock Outstanding
Market/Book (M/B) Ratio: Compares the market value of a share to its book value.
Formula: Market Price per Share of Common Stock / Book Value per Share of Common Stock

DuPont System of Analysis: A system used to dissect a firm’s financial statements and assess its financial condition.
ROA = Net Profit Margin x Total Assets Turnover
DuPont Formula: Multiplies the firm’s net profit margin by its total assets turnover to calculate the firm’s return on total assets (ROA).
Formula: Earnings Available for CS / Sales x Sales / Total Assets = Earnings Available for CS / Total Assets
Modified DuPont Formula: Relates the firm’s return on total assets (ROA) to its return on common equity (ROE) using the financial leverage multiplier (FLM).
Financial Leverage Multiplier (FLM): The ratio of the firm’s total assets to its common stock equity.
ROE = ROA x FLM
ROE = Earnings available for CS / Total Assets x Total Assets / Common Stock Equity = Earnings available for CS / Common Stock Equity