Information about Analysis of Financial Statements " Ratios"

Ratio analysis, Formulas, Uses and Limitations, Du Pont Equations

INTRODUCTION The primary goal of financial management is to maximize the stock price, not to maximize accounting measures such as net income or EPS. However, accounting data do influence stock prices, and to understand why a company is performing the way it is and to forecast where it is heading, one needs to evaluate the accounting information reported in the financial statements.

RATIO ANALYSIS Financial statements report both on a firm’s position at a point in time and on its operations over some past period. However, the real value of financial statements lies in the fact that they can be used to help predict future earnings and dividends.

1. Liquidity Ratios Liquid Asset : An asset that can be converted to cash quickly without having to reduce the asset’s price very much. Current ratio : It indicates the extent to which current liabilities are covered by those assets expected to be converted to cash in the near future. Quick (Acid Test) Ratio : The quick, or acid test, ratio is calculated by deducting inventories from current assets and then dividing the remainder by current liabilities:

2. Asset Management Ratios The second group of ratios, the asset management ratios, measures how effectively the firm is managing its assets. a) Inventory Turnover Ratio : The inventory turnover ratio is defined as sales divided by inventories. b) Days Sales Outstanding (DSO) : indicates the average length of time the firm must wait after making a sale before it receives cash. c) Fixed Assets Turnover Ratio : measures how effectively the firm uses its plant and equipment. d) Total Assets Turnover Ratio : measures the turnover of all the firm’s assets.

3. Debt Management Ratios a) Debt Ratio : measures the percentage of funds provided by creditors. b) Times-interest-earned (TIE) ratio : measures the extent to which operating income can decline before the firm is unable to meet its annual interest costs. c) EBITDA Coverage Ratio : A ratio whose numerator includes all cash flows available to meet fixed financial charges and whose denominator includes all fixed financial charges.

4. Profitability Ratios a) The profit margin on sales : calculated by dividing net income by sales, gives the profit per dollar of sales. b) Basic earning power (BEP) : This ratio shows the raw earning power of the firm’s assets, before the influence of taxes and leverage, and it is useful for comparing firms with different tax situations and different degrees of financial leverage. c) Return on Total Assets (ROA) : The ratio of net income to total assets measures the return on total assets (ROA) after interest and taxes. d) Return on Common Equity (ROE) : The ratio of net income to common equity; measures the rate of return on common stockholders’ investment.

5. Market Value Ratios a) Price/Earnings Ratio : The ratio of the price per share to earnings per share; shows the dollar amount investors will pay for $1 of current earnings. b) Price/Cash Flow Ratio : The ratio of price per share divided by cash flow per share; shows the dollar amount investors will pay for $1 of cash flow. c) Market/Book (M/B) Ratio : The ratio of a stock’s market price to its book value.

TREND ANALYSIS An analysis of a firm’s financial ratios over time; used to estimate the likelihood of improvement or deterioration in its financial condition.

THE DU PONT CHART AND EQUATION Du Pont Chart : A chart designed to show the relationships among return on investment, asset turnover, profit margin, and leverage. Du Pont Equation : A formula which shows that the rate of return on assets can be found as the product of the profit margin times the total assets turnover.

COMPARATIVE RATIOS and “BENCHMARKING” Ratio analysis involves comparisons — a company’s ratios are compared with those of other firms in the same industry, that is, to industry average figures.

USES AND LIMITATIONS of RATIO ANALYSIS Many large firms operate different divisions in different industries, and for such companies it is difficult to develop a meaningful set of industry averages. Most firms want to be better than average, so merely attaining average performance is not necessarily good. Inflation may have badly distorted firms’ balance sheets— recorded values are often substantially different from “true” values. judgment. Seasonal factors can also distort a ratio analysis.

Firms can employ “window dressing” techniques to make their financial statements look stronger. Different accounting practices can distort comparisons. It is difficult to generalize about whether a particular ratio is “good” or “bad.” A firm may have some ratios that look “good” and others that look “bad,” making it difficult to tell whether the company is, on balance, strong or weak.

LOOKING BEYOND THE NUMBERS Are the company’s revenues tied to one key customer? To what extent are the company’s revenues tied to one key product? To what extent does the company rely on a single supplier?. What percentage of the company’s business is generated overseas? Generally, increased competition lowers prices and profit margins. Future prospects. Does the company invest heavily in research and development? Legal and regulatory environment. Changes in laws and regulations have important implications for many industries.

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