The primary focus of the security analyst should be the firm's real economic earnings
rather than its reported earnings. Accounting earnings as reported in financial statements
can be a biased estimate of real economic earnings, although empirical studies
reveal that reported earnings convey considerable information concerning a firm's
prospects.
A firm's ROE is a key determinant of the growth rate of its earnings. ROE is affected profoundly by the firm's degree of financial leverage. An increase in a firm's debt/equity ratio
will raise its ROE and hence its growth rate only if the interest rate on the debt is less than
the firm's return on assets.
It is often helpful to the analyst to decompose a firm's ROE ratio into the product of several
accounting ratios and to analyze their separate behavior over time and across companies
within an industry. A useful breakdown is
Other accounting ratios that have a bearing on a firm's profitability and/or risk are fixedasset turnover, inventory turnover, days receivable, and the current, quick, and interest
coverage ratios.
Two ratios that make use of the market price of the firm's common stock in addition to its
financial statements are the ratios of market to book value and price to earnings. Analysts
sometimes take low values for these ratios as a margin of safety or a sign that the stock is
a bargain.
A major problem in the use of data obtained from a firm's financial statements is comparability. Firms have a great deal of latitude in how they choose to compute various items of revenue and expense. It is, therefore, necessary for the security analyst to adjust accounting earnings and financial ratios to a uniform standard before attempting to compare
financial results across firms.
Comparability problems can be acute in a period of infl ation. Infl ation can create distortions in accounting for inventories, depreciation, and interest expense.
