Why to look at financial statements?
It helps to analyze trends in data and operating results. •
Trends are important because they may point to basic changes in the nature of the business. •
With the use of ratios they help to evaluate a company’s past performance and are useful in projecting its financial future and also reflects a company’s performance compared to industry averages.
Why ratios advantageous?
Measurement of economic events and transactions and the communication of the information is one of the responsibilities of a management accountant. •
Financial ratios are a part of this communication process that includes analysis, interpretation and evaluation of the financial statements. •
Ratios display a relationship between various elements of financial data and are used to assist management in interpreting and explaining financial statements and can be effective tools in evaluating company’s liquidity, debt position and profitability. •
Financial ratios are an important part of evaluating a company’s past performance and are useful in projecting its financial future. •
Gives some indication of the company’s short term solvency and helps to assess the level of risk involved. •
Useful in analyzing a company’s performance compared to industry averages, and thus serves as a benchmark for comparison to other companies. •
Ratios reduce absolute dollar amounts to more meaningful data in order to compare ratios to prior periods, other companies and industry. •
They can be used to show how well the company is being managed and to highlight areas for further investigation.
Limitations to ratios?
Although ratios are useful as starting point in financial analysis, they are not at end in themselves. •
Ratios can be used as indicators of what to pursue in a more detailed analysis. •
Difficulties can arise in making average comparisons;
Different companies could use different accounting methods (FIFO vs LIFO) •
Even though 2 companies are in the same industry, they may not be comparable because they are focused on a different aspect of business.(For e.g ; oil industry; one is refinery other is primarily marketer) •
Companies may be conglomerates that operate in many different industries. •
If accounting policies are questionable the resulting ratios would also be questionable. •
Ratios represent past conditions that may not indicate future trends.
Measures the ability to meet short-term obligations using short-term assets. •
Decline in the ratio indicates the company should be watched in the future.
Measures the ability to meet short-term obligations debt using the most liquid assets. That is, it excludes the amount in inventory. •
Ratio below 1.0 indicated that the company may have difficulty meeting its short-term obligations if inventory does not turn over fast enough.
Total asset turnover?
Measures efficiency of resource use; the ability to generate sales through the use of assets. Inventory turnover?
Measures how quickly inventory is sold as well as how effectively investment in inventory is used and managed. •
This ratio can be significantly affected by inventory costing method used. (FIFO,LIFO, WA) •
Slower than industry average ratio may indicate a decline in operating efficiency, hidden obsolete inventory or overpriced stock items.
Interest coverage ratio?
Measures the ability to meet interest commitments from current earnings. •
The higher the ratio, the more safety there is for long-term creditors a sign of long-term stability.
Debt to equity ratio?
Measures the level of protection that creditors have in case of possible insolvency. •
Measures the degree of financial leverage and whether or not the firm will be able to obtain additional financing through borrowing.
Operating activities; which involves the cash effects of transactions that enter into the determination of net income, such as...
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