Chapter 4
Analysis of Financial Statements
Learning Objectives
After reading this chapter, students should be able to:
◆ Explain what ratio analysis is.
◆ List the five groups of ratios and identify, calculate, and interpret the key ratios in each group. In addition, discuss each ratio’s relationship to the balance sheet and income statement.
◆ Discuss why ROE is the key ratio under management’s control, how the other ratios affect ROE, and explain how to use the DuPont equation to see how the ROE can be improved.
◆ Compare a firm’s ratios with those of other firms (benchmarking) and analyze a given firm’s ratios over time (trend analysis).
◆ Discuss the tendency of ratios to fluctuate over time, which
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4-4 Differences in the amounts of assets necessary to generate a dollar of sales cause asset turnover ratios to vary among industries. For example, a steel company needs a greater number of dollars in assets to produce a dollar in sales than does a grocery store chain. Also, profit margins and turnover ratios may vary due to differences in the amount of expenses incurred to produce sales. For example, one would expect a grocery store chain to spend more per dollar of sales than does a steel company. Often, a large turnover will be associated with a low profit margin, and vice versa.
4-5 Inflation will cause earnings to increase, even if there is no increase in sales volume. Yet, the book value of the assets that produced the sales and the annual depreciation expense remain at historic values and do not reflect the actual cost of replacing those assets. Thus, ratios that compare current flows with historic values become distorted over time. For example, ROA will increase even though those assets are generating the same sales volume. When comparing different companies, the age of the assets will greatly affect the ratios. Companies with assets that were purchased earlier will reflect lower asset values than those that purchased assets later at inflated prices. Two firms with similar physical assets and sales could have significantly different ROAs. Under inflation, ratios will also reflect differences in the way firms treat inventories. As
2. List the four basic types of financial ratios used to measure a company’s performance, give an example of each type of ratio and explain its significance.
Asset turnover depicts investment efficiency, because it shows how many sales dollars are generated for every dollar invested in the company’s assets. Lowe’s had relatively lower asset turnover ratios than Home Depot because their recent investment in PP&E.
This paper examines financial ratio analysis by defining, the three groups of stakeholders that use financial ratios, the five different kinds of ratios used and their applications, the analytical tools used in analysis, and finally financial ratio analysis limitations and benefits.
Ratio analysis: Perform trend and ratio analysis on current and fixed assets, current and long term liabilities, owner’s equity, sales revenues, EBIT, net income, and earnings per share. Project these trends
Next is Asset turnover with .55 times which is a measure of the efficiency of asset utilization. Finally the equity multiplier with 2.26 which is a measure of financial leverage of the firm. When compared to the traditional ratios we get similar results; Profit margin 25.44% (27% DuPont) versus 18.75% industry average. Asset turnover is .54 (.55 DuPont) versus .50 industry average. Equity multiplier 2.28 times (2.26 times DuPont) versus 2 times industry average. The results show that the DuPont analysis using ROE as the main determinant are very similar to the regular ratios. Furthermore the ROE of the traditional ratio is 31.32% with DuPont being 33.10% versus the industry average of 18.75% shows that the firms ROE is very robust. While the firm has some challenges with respect to liquidity and inventory management, as well as debt management it still is doing a good job with respect to its shareholders. However it could be doing a little better for the stockholders, and needs to address some of the above issues mentioned.
Before beginning an analysis of a company it is necessary to have a complete set of financial statements, preferably for the pas few years so that historical trends can be obtained. Ratios are a way for anyone to get an idea of the financial performance of a company by using the information contained in the financial statements. Ratios are grouped into four basic categories, liquidity, activity, profitability, and financial leverage. This document will use a variety of these ratios to analyze the firm, Sample Company, as of December 31,2000.
Financial statement and ratio analysis is also used to drill down within the larger financial performance of the company as a whole to evaluate various divisions and product or service lines. These analyses are critically important as they are often used to enhance the firm’s credibility in the larger marketplace; assist in determining its own creditworthiness; and comparing its performance to that of potential competitors.
HCS/571 Finance Resource Management Sept 24, 2013Rosetta Stringfellow, MBA, BSRatio Analysis Ratio analysis is a widely used managerial tool that compares one number with another to gain insights that would not arise from looking at either of the numbers separately. Ratio analysis is used to examine and interpret the relationship between two numbers on a financial statement. This is done so that the managers of a facility can determine whether or not the organization needs to change any of their financial variables in order to remain competitive in their market. The ratio analysis converts numbers into meaningful comparisons which managers can use
A successful business requires effective planning and financial management. Ratio analysis can improve understanding of the financial results and trends over time, providing key indicators of organizational performance (Demonstrating Value, n.d.). Financial ratios are used by stakeholders including creditors, corporate controllers, accountants, financial analysts, and investors. Analyzing ratios can help determine the liquidity, profitability, debt management, and stability of a corporation. Time series analysis allows users to see where a company has been and where they appear to be going and comparing the ratios to competitors offers insight into the ability to compete and thrive in their markets.
When deciding to invest there should be an extensive analysis of the company’s financial statement should be done. The analysis should involve a comparison of the company’s performance with other companies in the same industry. It should also involve and evaluation of trends in the company’s financial position over a period of time. The use of financial ratios is a way to gain important information that is neither simple nor obvious. Financial ratios are calculated by using data that can be found on the company’s balance sheets and income statements.
A firm’s performance and financial situation is measured by financial ratios. In order to reach these ratios a financial analysis must be done on the company’s financial information. Financial analysis is the evaluation, selection and interpretation of financial data to assist in investment and financial decision-making. Financial data is drawn from many sources however, the primary source is data that is provided by the company in its annual reports. These annual reports consist of the income statement, the balance sheet and the statement of cash flows. Financial ratios can be used to analyze trends and compare the firm’s financial standing to those of other firms. Financial ratios are
Ratio analysis is one of the methods used to construe financial information, they help to whittle down the vast amounts of information given in financial statements, to summarise the main points with a small number of ratios. There are a number of different ratios available which allows firms to select only the ratios which are most applicable to them. Ratios allow comparisons to be made within the company – for example from previous years or a ratio produced based on predictions or the budget that was set – to judge how well the company is performing at present, highlighting their strengths and weaknesses. However it is not only the present performance that a ratio can assess, they can also be used for identifying
In this we are going to analyze important key ratios such as profitability, liquidity, debt management, asset management.
Nerlove (1968, pp. 312-331) and Beaver et al. (1970, pp. 654-682) point out that financial researchers use financial ratios to examine the relation between financial data and common stock features. The analysis in this paper is focus on the usefulness of financial ratios, taking data from stock market to assist the judgment of whether ratios show the real variation of company business. Put it in detail, this paper adopts quantitative research method mainly; calculating the different ratios in different industry companies, and then comparing these data with the company’s stock price in stock market simultaneously by set up tables.