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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 may or may not be problematic. Explain how they can be influenced by accounting practices and other factors and why they must be used with care.

Lecture Suggestions

Chapter 4 shows how financial statements are analyzed to determine firms’ strengths and weaknesses. On the basis of this information, management can take actions to exploit strengths and correct weaknesses. At Florida, we find a significant difference in preparation between our accounting and non-accounting students. The accountants are relatively familiar with financial statements, and they have covered in depth in their financial accounting course many of the ratios discussed in Chapter 4. We pitch our lectures to the non-accountants, which means concentrating on the use of statements and ratios, and the “big picture,” rather than on details such as seasonal adjustments and the effects of different accounting procedures. Details are important, but so are general principles, and there are courses other than the introductory finance course where details can be addressed. What we cover, and the way we cover it, can be seen by scanning the slides and Integrated Case solution for Chapter 4, which appears at the end of this chapter solution. For other suggestions about the lecture, please see the “Lecture Suggestions” in Chapter 2, where we describe how we conduct our classes.

DAYS ON CHAPTER: 3 OF 58 DAYS (50-minute periods)

Answers to End-of-Chapter Questions

4-1The emphasis of the various types of analysts is by no means uniform nor should it be. Management is interested in all types of ratios for two reasons. First, the ratios point out weaknesses that should be strengthened; second, management recognizes that the other parties are interested in all the ratios and that financial appearances must be kept up if the firm is to be regarded highly by creditors and equity investors. Equity investors (stockholders) are interested primarily in profitability, but they examine the other ratios to get information on the riskiness of equity commitments. Credit analysts are more interested in the debt, TIE, and EBITDA coverage ratios, as well as the profitability ratios. Short-term creditors emphasize liquidity and look most carefully at the current ratio.

4-2The inventory turnover ratio is important to a grocery store because of the much larger inventory required and because some of that inventory is perishable. An insurance company would have no inventory to speak of since its line of business is selling insurance policies or other similar financial products—contracts written on paper and entered into between the company and the insured. This question demonstrates that the student should not take a routine approach to financial analysis but rather should examine the business that he or she is analyzing.

4-3Given that sales have not changed, a decrease in the total assets turnover means that the company’s assets have increased. Also, the fact that the fixed assets turnover ratio remained constant implies that the company increased its current assets. Since the company’s current ratio increased, and yet, its cash and equivalents and DSO are unchanged means that the...
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