The Four Key Financial Statements:
1. Balance Sheet
2. Income Statement
(2) evaluating trends in the firm’s financial
position over time. These studies help
management identify deficiencies and then take
corrective actions.
3. Statement of Cash flows
4. Statement of Stockholders’ Equity
The most important ratio is the ROE
- net income to common stockholders divided by total
stockholders’ equity. Stockholders obviously want to earn a
high rate of return on their invested capital, and the ROE tells
them the rate they are earning. If the ROE is high, then the
stock price will also tend to be high, and actions that increase
ROE are likely to increase the stock price.
Some potential problems are listed here:(Ratio
Analysis)
--> primary goal of financial management is to
maximize shareholders’ wealth over the long run,
not to maximize accounting measures such as net
income or EPS.
1. It is difficult to develop a meaningful set of
industry averages (due to different industry
divisions). Thus, ratio analysis is more useful for
small, narrowly focused firms than for large,
multidivisional ones
USES AND LIMITATIONS OF RATIO ANALYSIS
2. Most firms want to be better than average, so
merely attaining average performance is not
necessarily good
ratio analysis is used by three main groups: (1)
managers, who employ ratios to help analyze,
control, and thus improve their firms’ operations;
(2) credit analysts, including bank loan officers
and bond rating analysts, who analyze ratios to
help judge a company’s ability to pay its debts;
and
(3) stock analysts, who are interested in a
company’s efficiency, risk, and growth prospects.
Financial analysis involves
(1) comparing the firm’s performance to other
firms, especially those in the same industry, and
3. recorded values are often substantially different
from “true” values.(Inflation distort balance
sheets)
4. Seasonal factors can also distort a ratio analysis
5. Firms can employ “window dressing”
techniques to make their financial statements look
stronger
6. . Different accounting practices can distort
comparisons
7. It is difficult to generalize about whether a
particular ratio is “good” or “bad.”For example, a
high fixed assets turnover ratio may indicate either
that the firm uses its assets efficiently or that it is
short of cash and cannot afford to make needed
investments.
8. A firm may have some ratios that look “good”
and others that look “bad,” making it difficult to
tell whether the company is, on balance, strong or
weak. However, statistical procedures can be used
to analyze the net effects of a set of ratios.
PROBLEMS WITH ROE
1) ROE does not consider risk. While shareholders
 Companies raise funds from a variety of
sources. The primary source is investors, including
stockholders, bondholders, and lenders such as
banks
 a company’s assets can be divided into
two groups, operating assets (or operating capital)
and nonoperating assets (or nonoperating capital).
 Companies typically use a combination of
investor-supplied capital and noninterest-bearing,
spontaneous current liabilities to finance their
required operating assets.
clearly care about returns, they also care about
risk.
2) ROE does not consider the amount of invested
capital.
Qualitative factors be considered when evaluating
a company
1) Are the company’s revenues tied to one key
customer?
2) . To what extent are the company’s revenues
tied to one key product?
3) To what extent does the company rely on a
single supplier?
4) What percentage of the company’s business is
generated overseas?
1) Accounting Profit - A firm’s net income as
reported on its income statement.
2) Amortization - A noncash charge similar to
depreciation except that it is used to write off the
costs of intangible assets.
3) Annual Report - report contains information
on the company’s financial state, such as
operation income and net profit. Sometimes it
also contains an accountant’s opinion on the
general health of the company. A report issued
annually by a corporation to its stockholders. It
contains basic financial statements as well as
management’s analysis of the firm’s past
operations and future prospects.
Contains 2 types of Information:
 Bankers and investors need accounting
information to make intelligent decisions,
managers need it to operate their businesses
efficiently, and taxing authorities need it to assess
taxes in a reasonable way
1) Verbal Section - often presented as a letter
from the chairman, that describes the firm’s
operating results during the past year and then
discusses new developments that will 66 Part 2
Fundamental Concepts in Financial
Management Annual Report A report issued
annually by a corporation to its stockholders. It
contains basic financial statements as well as
management’s analysis of the firm’s past
operations and future prospects. affect future
operations
 A business’s net cash flow differs from its
accounting profit because some of the revenues
and expenses listed on the income statement are
not paid in cash during the year
2) 4 basic financial statements—the balance
sheet, the income statement, the statement of
cash flows, and the statement of retained
earnings.
5) Competition
6) Future products
7) Legal and regulatory environment
4) Asset Management Ratios - A set of ratios that
measure how effectively a firm is managing its
assets.
in time; involves comparing the firm’s ratios to
those of other firms in its industry or to industry
averages
5) Balance Sheet – known as the “Statement of
Financial Position”. Reports the assets, liabilities,
and owner’s equity of the business entity as of a
specific date. These three accounting elements
are always presented in an equality which is a
formal presentation of the accounting equation:
(Assets = Liabilities + Owner’s Equity) --> shows
liquidity, and stability
13) Current assets include cash, marketable
securities, accounts receivable, and inventories.
- balance sheet represents a “snapshot” of the
firm’s position at a specific point in time
6) Basic Du Pont Equation A formula that shows
that the rate of return on assets can be found as
the product of the profit margin times the total
assets turnover
7) Basic Earning Power (BEP) Ratio This ratio
indicates the ability of the firm’s assets to
generate operating income; calculated by dividing
EBIT by total assets.This ratio shows the raw
earning power of the firm’s assets, before the
influence of taxes and leverage, and it is useful
when comparing firms with different degrees of
financial leverage and tax situations.
8) Benchmarking is a type of cross-sectional
analysis in which the firm’s ratio values are
compared to those of a key competitor or group
of competitors that it wishes to emulate. o
Comparison to industry averages (also known as
Industry Analysis). Process of comparing a
particular company with a group of “benchmark”
companies
9) Benchmark companies - the companies used
for the comparison are called
10) Convertible bonds are debt securities that
give the bondholder an option to exchange bonds
for shares of common stock
11) Common Equity (Net Worth) - The capital
supplied by common stockholders: common stock,
paid-in capital, retained earnings, and,
occasionally, certain reserves.
12) Cross-sectional analysis is the comparison of
different firms’ financial ratios at the same point
14) Current Ratio - This ratio is calculated by
dividing current assets by current liabilities. It
indicates the extent to which current liabilities are
covered by those assets expected to be converted
to cash in the near future.
15) Days Sales Outstanding (DSO) This ratio is
calculated by dividing accounts receivable by
average sales per day; it indicates the average
length of time the firm must wait after making a
sale before it receives cash.
16) Debt Ratio (+,-) - The ratio of total debt to
total assets. Measures the percentage of funds
provided by creditors
17) Depreciation - The charge to reflect the cost
of assets used up in the production process.
Depreciation is not a cash outlay.
18) Earnings before interest and taxes (EBIT) and it is often referred to as operating income.
Used to compare companies’ operating
performances
19) EBITDA Coverage Ratio - A ratio whose
numerator includes all cash flows available to
meet fixed financial charges and whose
denominator includes all fixed financial charges.
20) Economic Value Added (EVA) Excess of
NOPAT over capital costs.
21) Financial Leverage - the use of debt financing
has three important implications:
(1) By raising funds through debt, stockholders
can control a firm with a limited amount of
equity investment.
(2) Creditors look to the equity, or
owner-supplied funds, to provide a margin of
safety, so the higher the proportion of the
total capital provided by stockholders, the less
the risk faced by creditors.
(3) If the firm earns more on its assets than the
interest rate it pays on debt, then using debt
“leverages,” or magnifies, the return on equity,
ROE.
22) Fixed assets turnover ratio measures how
effectively the firm uses its plant and equipment.
It is the ratio of sales to net fixed assets
23) Free Cash Flow - The cash flow actually
available for distribution to all investors
(stockholders and debtholders) after the
company has made all the investments in fixed
assets, new products, and working capital
necessary to sustain ongoing operations.
Represents the cash that is actually available for
payments to investors. Therefore, managers
make their companies more valuable by
increasing their free cash flow.
24) Future free cash flows - defined as after-tax
operating profit minus the investments in working
capital and fixed assets necessary to sustain the
business.
25) Income Statement – provides a financial
summary of a company’s operating results during
a specified period. Although they are prepared
quarterly for reporting purposes, they are
generally computed monthly by management and
quarterly for tax purposes
26) Intangible Assets - Assets such as patents,
copyrights, trademarks, and goodwill.
27) Inventory Turnover Ratio - Turnover ratios
are ratios where sales are divided by some asset,
and as the name implies, they show how many
times the item is “turned over” during the year
on its assets, then its M/B ratio will be relatively
low versus an average company.
31) Market Value Added (MVA) The excess of the
market value of equity over its book value.
32) Market Value Ratios A set of ratios that relate
the firm’s stock price to its earnings, cash flow,
and book value per share.
33) Net Cash Flow - The actual net cash, as
opposed to accounting profit (net income), that a
firm generates during a specified period.
34) Net income - income after interest
35) Net Operating Profit After Taxes (NOPAT)
The profit a company would generate if it had no
debt and held only operating assets
36) Net Operating Working Capital (NOWC)
Operating working capital less accounts payable
and accruals. It is the working capital acquired
with investor supplied funds.
37) Net Working Capital - defined as current
assets minus current liabilities. It is a frequently
used measure of liquidity.
38) Non operating assets include items like land
held for future use, stock in other companies, and
marketable securities in excess of those held for
liquidity purposes
39) Operating capital includes those current and
net fixed assets that are necessary to operate the
business
40) Preferred stock is a hybrid between common
stock and debt
28) Liquid Asset An asset that can be converted
to cash quickly without having to reduce the
asset’s price very much.
41) Price/Cash Flow Ratio - The ratio of price
per share divided by cash flow per share; shows
the dollar amount investors will pay for $1 of cash
flow.
29) Liquidity Ratios - Ratios that show the
relationship of a firm’s cash and other current
assets to its current liabilities.
42) price/earnings (P/E) ratio shows how much
investors are willing to pay per dollar of reported
profits.
30) Market/Book (M/B) Ratio The ratio of a
stock’s market price to its book value.Gives
another indication of how investors regard the
company.If a company earns a low rate of return
43) Profitability refers to the ability of the
business to increase owner’s capital. It deals with
the effectiveness of the business to achieve net
income rather than net loss.
44) Profit Margin on Sales - This ratio measures
net income per dollar of sales; it is calculated by
dividing net income by sales.
45) Profitability Ratios A group of ratios that
show the combined effects of liquidity, asset
management, and debt on operating results.
Reflect the net result of all of the financing
policies and operating decisions.
46) Quick (Acid Test) Ratio This ratio is calculated
by deducting inventories from current assets and
then dividing the remainder by current liabilities.
47) Ratio analysis involves methods of calculating
and interpreting financial ratios to analyze and
monitor the firm’s performance.
48) Retained Earnings - portion of the firm’s
earnings that has been saved rather than paid out
as dividends
49) Return on Common Equity (ROE) The ratio of
net income to common equity; measures the rate
of return on common stockholders’ investment.
This ratio tells how well they are doing in an
accounting sense
50) Return on Total Assets (ROA) The ratio of the
net income to total assets
51) spontaneously generated,
non-interest-bearing current liabilities generated spontaneously through normal
business operations, not by a specific act such as
going to a bank and borrowing money
52) Statement of Cash flows – also known as
Statement of Changes in Financial Position,
answers two basic questions: what sources of
funds that flowed into the business (operations,
borrowings, sale of property, or owner’s
investment) and how these funds will be used in
the business (pay maturing liabilities, acquire
property, or withdrawn by the owner for personal
use)
53) Statement of Retained Earnings - A
statement reporting how much of the firm’s
earnings were retained in the business rather
than paid as dividends. The balance sheet number
reported for retained earnings is the sum of the
annual retained earnings for each year of the
firm’s history
54) Statement of Stockholders’ Equity - also
known as statement of retained earnings
reconciles the net income earned during a given
year, and any cash dividends paid, with the
change in retained earnings between the start
and the end of that year.
55) Tangible Assets -Physical assets such as plant
and equipment.
56) Times-Interest-Earned (TIE) Ratio The ratio of
earnings before interest and taxes (EBIT) to
interest charges; a measure of the firm’s ability to
meet its annual interest payments. Measures the
extent to which operating income can decline
before the firm is unable to meet its annual
interest costs
two shortcomings:
(1) Interest is not the only fixed financial
charge— companies must also retire debt on
a fixed schedule, and many firms also lease
assets and thus must make lease payments.
(2) EBIT does not represent all the cash flow
available to service debt, especially if a firm
has high depreciation and/or amortization
charges.
57) Time-series analysis is the evaluation of the
firm’s financial performance over time using
financial ratio analysis (also known as Trend
Analysis) ---> The most informative approach to
ratio analysis combines cross-sectional and
time-series analyses
58) total assets turnover ratio, measures the
turnover of all the firm’s assets, and it is
calculated by dividing sales by total assets
59) Total debt includes all current liabilities and
long-term debt.
60) Trend Analysis An analysis of a firm’s financial
ratios over time; used to estimate the likelihood
of improvement or deterioration in its financial
condition.
61) Window Dressing - Techniques employed by
firms to make their financial statements look
better than they really are.