Uchicago Financial Ratios
Financial Reporting and Analysis
Mark Hendricks
Financial Mathematics
University of Chicago
September 2011
Outline
Financial Reporting
Financial Analysis
Hendricks,
Financial Reporting and Analysis
UChicago Financial Mathematics
2/55
Financial reporting
Financial reporting is important for well-functioning markets.
Investors need information to properly allocate capital and hedge risk.
Regulators need good information to monitor fraudulently activity and systemic risk.
Financial reports are prepared according to accounting practices.
Hendricks,
Financial Reporting and Analysis
UChicago Financial Mathematics
3/55
Financial statements
There are three key financial statements.
The balance …show more content…
Namely, assets and liabilities are valued in the statements according to accounting principles.
The values are based more on historical transaction prices than current valuations.
Hendricks,
Financial Reporting and Analysis
UChicago Financial Mathematics
5/55
Balance equation
The central idea behind the balance sheet is an accounting identity: assets = liabilities + shareholders’ equity
Note that this equation is an identity. The “shareholders’ equity” component is not a real market value of equity.
Rather, it is just a plug for the equation. This “book” value is rarely used.
The first section of the balance sheet lists the assets of the firm. The short-term, or current assets are listed first. This is where cash and other liquid securities are listed. After this, longer-term assets are listed.
Liabilities are listed similarly, with current liabilities being listed first.
Hendricks,
Financial Reporting and Analysis
UChicago Financial Mathematics
6/55
Balance sheet for commercial banking
Figure: Income statement for the banking sector, 2008.
Source: Mishkin (2010)
Hendricks,
Financial Reporting and Analysis
UChicago Financial …show more content…
Source: Higgins (2009)
Hendricks,
Financial Reporting and Analysis
UChicago Financial Mathematics
46/55
Problems with ROE
ROE is not necessarily a good measure of financial performance.
For as much attention as it gets, one must be careful.
Market valuations are forward-looking and consider the long-term prospects of the firm.
By contrast, ROE is largely backward-looking and considers only one year’s data.
We have already noted that accounting values can easily be manipulated to push earnings to different time periods.
Hendricks,
Financial Reporting and Analysis
UChicago Financial Mathematics
47/55
ROE and risk
We mentioned already, that ROE can be increased by taking on more leverage.
Clearly then, a higher ROE is not always better.
Improving ROE while keeping risk exposure level is an acheivement. Increasing ROE by increasing risk, (leverage or other types,) is not.
Thus, investors must consider whether high ROE is a good deal. If your money market fund returned 10%, would you be happy? Hendricks,
Financial Reporting and
Mark Hendricks
Financial Mathematics
University of Chicago
September 2011
Outline
Financial Reporting
Financial Analysis
Hendricks,
Financial Reporting and Analysis
UChicago Financial Mathematics
2/55
Financial reporting
Financial reporting is important for well-functioning markets.
Investors need information to properly allocate capital and hedge risk.
Regulators need good information to monitor fraudulently activity and systemic risk.
Financial reports are prepared according to accounting practices.
Hendricks,
Financial Reporting and Analysis
UChicago Financial Mathematics
3/55
Financial statements
There are three key financial statements.
The balance …show more content…
Namely, assets and liabilities are valued in the statements according to accounting principles.
The values are based more on historical transaction prices than current valuations.
Hendricks,
Financial Reporting and Analysis
UChicago Financial Mathematics
5/55
Balance equation
The central idea behind the balance sheet is an accounting identity: assets = liabilities + shareholders’ equity
Note that this equation is an identity. The “shareholders’ equity” component is not a real market value of equity.
Rather, it is just a plug for the equation. This “book” value is rarely used.
The first section of the balance sheet lists the assets of the firm. The short-term, or current assets are listed first. This is where cash and other liquid securities are listed. After this, longer-term assets are listed.
Liabilities are listed similarly, with current liabilities being listed first.
Hendricks,
Financial Reporting and Analysis
UChicago Financial Mathematics
6/55
Balance sheet for commercial banking
Figure: Income statement for the banking sector, 2008.
Source: Mishkin (2010)
Hendricks,
Financial Reporting and Analysis
UChicago Financial …show more content…
Source: Higgins (2009)
Hendricks,
Financial Reporting and Analysis
UChicago Financial Mathematics
46/55
Problems with ROE
ROE is not necessarily a good measure of financial performance.
For as much attention as it gets, one must be careful.
Market valuations are forward-looking and consider the long-term prospects of the firm.
By contrast, ROE is largely backward-looking and considers only one year’s data.
We have already noted that accounting values can easily be manipulated to push earnings to different time periods.
Hendricks,
Financial Reporting and Analysis
UChicago Financial Mathematics
47/55
ROE and risk
We mentioned already, that ROE can be increased by taking on more leverage.
Clearly then, a higher ROE is not always better.
Improving ROE while keeping risk exposure level is an acheivement. Increasing ROE by increasing risk, (leverage or other types,) is not.
Thus, investors must consider whether high ROE is a good deal. If your money market fund returned 10%, would you be happy? Hendricks,
Financial Reporting and