Standardized Financial Statements
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The values in common-size statements are standardized in order to facilitate comparison to common benchmarks.
Common-Size Balance Sheets are prepared by presenting all statement values as a percentage of total assets .
Common-Size Income Statements are prepared by presenting all statement values as a percentage of sales. Because common-size statements represent financial statement values with a common denominator, the effects of _____ differences across firms are removed. CONCEPT CHECK
Short-Term Solvency, or Liquidity, Ratios measure the firm's ability to meet short-term obligations.
Current Ratio = Current Assets/Current Liabilities
Quick Ratio = (Current Assets - Inventory)/Current Liabilities
Cash Ratio = Cash/Current Liabilities
Long-Term Solvency Measures gauge the extent to which a firm uses debt financing rather than equity financing. All else equal, more debt increases the probability of default, so these ratios can also be considered to be indicators of default risk.
Total Debt Ratio = (Total Assets – Total Equity)/Total Assets
Times Interest Earned = EBIT/Interest
Cash Coverage = (EBIT + Depreciation)/Interest
Asset Management, or Turnover, Measures indicate how effectively the firm’s managers use the assets under their control. Generally, higher turnover measures suggest greater efficiency.
Inventory Turnover = Cost of Goods Sold/Inventory
Days’ Sales in Inventory = 365/Inventory Turnover
Receivables Turnover = Sales/Accounts Receivable
Days’ Sales in Receivables = 365/Receivables Turnover
Total Asset Turnover = Sales/Total Assets
Profitability Ratios measure management's ability to control expenses and, as a result, generate income from sales, from the firm's asset base, or from the funds supplied by equityholders.
Profit Margin = Net Income/Sales
Return on Assets = Net Income/Total Assets
Return on Equity = Net Income/Total Equity
Why would one take the time to calculate all three of the profitability ratios? CONCEPT CHECK
Market Value Measures integrate market-based values with accounting values and, as a result, bring us closer to the measurement of the effects of managerial decisions on shareholder wealth.
Price-Earnings Ratio = Price per Share/Earnings per Share
Market-to-Book Ratio = Market Value per Share/Book Value per Share
Why is the Market-to-Book ratio generally different from 1.00 for a typical firm?CONCEPT CHECK
The Du Pont Identity
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is a means of decomposing ROE into its component parts. It suggests that ROE is a function of those decisions which impact profitability, asset utilization, and financial leverage. The Du Pont identity is computed as follows: (Net Income/Sales) ´ (Sales/Assets) ´ (Assets/Total Equity). How does the use of borrowed money impact ROE? CONCEPT CHECK
Internal and Sustainable Growth Sales growth is associated with both greater retained earnings needs and greater asset needs.
Dividend Payout and Earnings Retention The Dividend Payout Ratio measures the proprortion of net income is distributed to shareholders. The Earnings Retention Ratio, conversely, measures the proportion of earnings retained and reinvested in the firm.
ROA, ROE, and Growth Financial managers must be aware of the relationship between projected sales growth and the level of funds available from internal sources (i.e., retained earnings).
The Internal Growth Rate
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is the maximum growth rate the firm can achieve without obtaining external financing.
The Sustainable Growth Rate
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is the growth rate the firm can achieve without issuing new equity, while maintaining the current debt/equity ratio.
Determinants of Growth
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is positively related to profit margin, asset turnover, and the debt-to-equity ratio, and inversely related to dividend payout, all else equal.
Using Financial Statement Information
Why Evaluate Financial Statements?
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Financial statement analysis is crucial to an understanding of firm performance, both in terms of what the firm has done in the past, and what the firm is likely to do in the future.
Internal Uses of financial statement analysis include: evaluation of managerial performance via the evaluation of the effects of management decisions on firm variables (e.g., profitability, sales growth), and planning for the future.
External Uses of financial statement analysis include analyses performed by creditors and potential investors, evaluation of competitor firms, and performance assessment for the purpose of acquiring another firm.
Choosing a Benchmark
Time-Trend Analysis is the comparison of current data with historical data. That is, past performance is the relevant benchmark.
Peer Group Analysis involves comparison to firms that are similar to the firm being evaluated. In other words, the benchmark is the subject firm's peer group. The financial engine at StockScreener.com allows one to compare firms and industries on the basis of their financial characteristics.
Problems with Financial Statement Analysis arise because there are no clear or universally accepted guidelines regarding the determination of optimal values for the ratios discussed above. Other potential difficulties that may arise in financial statement analysis include: (1) identification of comparable peer groups; (2) differences in accounting procedures; (3) differences in fiscal years for financial statements; and, (4) unusual events which have an impact on reported financial results. These problems, as well as differences in interpretation of the date, frequently result in differing opinions about a firm's future performance. Recommendations of financial analysts can be viewed at StockSelector.com.
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