Analysis of Financial Statements
After reading this chapter, students should be able to:
Explain why ratio analysis is usually the first step in the analysis of a company’s financial statements.
List the five groups of ratios, specify which ratios belong in each group, and explain what information each group gives us about the firm’s financial position.
State what trend analysis is, and why it is important.
Describe how the Du Pont chart is used, and how it may be modified to include the effect of financial leverage.
Explain “benchmarking” and its purpose.
List several limitations of ratio analysis.
Identify some of the problems with ROE that can arise when firms use it as a sole measure of performance.
Identify some of the qualitative factors that must be considered when evaluating a company’s financial performance.
Financial Statements and Reports
Annual Report: Yearly record of a publicly held company's financial condition. It includes a description of the firm's operations, as well as balance sheet, income statement, and cash flow statement information. SEC rules require that it be distributed to all shareholders. A more detailed version is called a 10-K. Income Statement (Statement of Operations, Profit and Loss Statement): A statement showing the revenues, expenses, and income (the difference between revenues and expenses) of a corporation over some period of time. Balance Sheet: Also called the statement of financial condition, it is a summary of a company's assets, liabilities, and owners' equity at a specific point in time. Statement of Retained Earnings: A statement of all transactions affecting the balance of a company's retained earnings account.
Accounting Income versus Cash Flow
Cash Flow From Operations: A firm's net cash inflow resulting directly from its regular operations calculated as the sum of net income plus noncash expenses (mainly depreciation) that are deducted in calculating net income. Statement of Cash Flows: A statement reporting the impact of a firm’s operating, investing, and financing activities on cash flows over an accounting period.
Ratio analysis of a firm’s financial statements is of interest to shareholders, creditors, and the firm’s management. Stockholders are interested in the firm’s current and future level of risk and return, which directly affect the stock price. The firm’s creditors are primarily interested in the short-term liquidity of the company and in its ability to make interest and principal payments. Internal management is concerned with all aspects of the firm’s financial performance. Therefore, they attempt to produce financial ratios that will be considered favorable to both owners and creditors. Additionally, management uses ratios to monitor the firm’s performance from period to period. Unexpected changes or variances are identified to isolate developing problem areas.
Liquidity Ratios: Ratios that measure a firm's ability to meet its short-term financial obligations on time.
1. Current Ratio: Indicator of short-term debt-paying ability. Determined by dividing current assets by current liabilities. The higher the ratio, the more liquid the company. 2. Quick Ratio: A stricter indication of a company's financial strength (or weakness). Calculated by taking current assets less inventories, divided by current liabilities. This ratio provides information regarding the firm's liquidity and ability to meet its obligations. Also called the Acid Test ratio.
Asset Management Ratios: Ratios that measure how effectively a firm is managing its assets.
1. Inventory Turnover: The ratio of cost of goods sold to inventory, which measures the speed at which inventory is produced and sold. Low turnover is an unhealthy sign, indicating excess stocks and/or poor sales. 2. Days Sales Outstanding (Average Collection Period): The ratio of accounts receivables to average sales per day, or...
Please join StudyMode to read the full document