VI. ANALYZING FINANCIAL STATEMENTS: RATIO ANALYSIS
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LEARNING OBJECTIVE 5
Explain the importance of ratio analysis in reporting financial information. (Text pages 406-413)
A. Accountants use financial information to
perform financial calculations, called ratios.
1. Financial ratios help in analyzing the
actual performance of the company
compared to its financial objectives.
2. RATIO ANALYSIS is the assessment
of a firm’s financial condition and performance through calculations and interpretations of financial ratios developed from the firm’s financial statements.
3. They also give insight into the firm’s
performance compared to other firms
in the industry.
4. There are four types of ratios businesses use to measure financial performance.
a. liquidity (speed of changing assets
into cash);
b. debt (leverage);
c. profitability;
d. business activity.
B. Liquidity Ratios
1. Liquidity ratios measure the company’s ability to turn assets into cash to
pay its short-term debts.
2. These short-term debts are expected
to be repaid within one year.
3. The current ratio is the ratio of a firm’s
current assets to its current liabilities.
a. current ratio =
12.1
POWERPOINT 12-13
Analyzing Financial Statements: Ratio Analysis
(Refers to text pages 406408)
current assets
current liabilities
b.
Usually, a company with a current
ratio of 2 or greater is considered
a safe credit risk.
c. The ratio should be compared to
that of competing firms within the
industry and to the company’s current ratio in the previous year.
4. The acid-test ratio (or quick ratio)
measures the cash, marketable securities (stocks and bonds), and receivables of the firm, compared to its current liabilities.
a. acid-test ratio =
(cash + accounts receivable + marketable securities) ÷ current liabilities
b. A number between 0.50 and 1.0 is
usually considered satisfactory.
C. Leverage (Debt) Ratio
1. Leverage (debt) ratios measure the
degree to which a firm relies on borrowed funds in its operations.
2. The debt to owners’ equity ratio
measures the degree to which the
company is financed by borrowed
funds that must be repaid.
a. debt to owners’ equity ratio =
total liabilities
owners’ equity
b. A ratio above 100% shows that a
firm has more debt than equity.
3. It is important to compare ratios to
those of other firms in the same industry and to the company’s ratios in previous years.
12.2
POWERPOINT 12-14
Leverage (Debt) Ratios
(Refers to text pages 408-413
INTRODUCTION TO BUSINESS: Instructor’s Resource Manual
D. Profitability (Performance) Ratios
1. Profitability (performance) ratios
measure how effectively a firm is using
its various resources to achieve profits.
2. Management’s performance is often
measured by using profitability ratios.
a. Basic earnings per share (basic
EPS) measures the amount of
profit earned by a company for
each share of common stock it
has outstanding.
3. Earnings per share
a. The diluted earnings per share (diluted EPS) ratio measures the
amount of profit earned by a company for each share of outstanding
common stock, but also takes into
consideration stock options, warrants, preferred stock, and convertible debt securities that can be
converted into common stock.
b. EPS is an important ratio because
earnings help stimulate growth.
c. earnings per share =
net income after taxes
num. com. stock outstanding
d. A larger number would mean the
company either has high net income or does not have any outstanding stock.
4. Return on sales (net profit margin)
a. This measures the return on sales
based on how much profit a company earns for every dollar it generates in revenue.
CHAPTER 12: Understanding Financial Information and Accounting
TEXT FIGURE 12.7
Industry Ratio Averages
(Box in text on page 409)
TEXT REFERENCE
Career Spotlight: So You
Want to Be … an Accounting Professional
(Box in text on page 412)
TEXT FIGURE 12.8
Putting Together Ratio
12.3
return on sales = net income
net sales
c. This ratio is an indicator of the
company’s ability to generate income from sales.
5. Return on equity
a. The higher the risk involved in an
industry, the higher the return investors expect.
b. It is calculated by comparing a
company’s net income with its total owner’s equity.
c. return on equity =
net income after taxes
total owners’ equity
d. It is best to compare this ratio with
other firms in the same industry.
E. Activity Ratios
1. Activity ratios measure how well a
company converts its resources to
profits.
2. Inventory turnover ratio measures the
speed of inventory moving through the
firm and its conversion into sales.
3. The more efficiently a firm manages its
inventory, the higher the return.
a. inventory turnover ratio =
cost of goods sold
average inventory
b. In most retail firms, a turnover of 4
would be acceptable.
c. A lower than average inventory
turnover ratio often indicates obsolete merchandise on hand or
poor buying practices.
F. Finance professionals use several other
b.
12.4
Analysis (Box in text on
page 412)
LECTURE LINK 12-6
Knowing the Numbers
Employees at Setpoint know
more about their company’s
finances than most investors
do. See complete lecture link
on page 12.Error!
Bookmark not defined. of
this manual.
TEXT REFERENCE
Real World Business Apps
(Box in text on page 413)
John Miller has met with an
accountant about his financial situation. Ashley, the
accountant, has explained the
role of the certified public
accountant and has given
John an overview of the financial reporting system.
CRITICAL THINKING
EXERCISE 12-4
Comparing Industry Ratios
An investor is considering
investing in a regional hotel
chain. This exercise lets students compare the financial
results for four possible investments. (See complete
exercise on page 12.Error!
Bookmark not defined. of
this manual.)
INTRODUCTION TO BUSINESS: Instructor’s Resource Manual
specific ratios to learn more about a firm’s
financial condition.
SELF CHECK QUESTIONS (Text page 413)
1.
What is the current ratio used for?
2.
What does debt to owners’ equity tell us?
3.
What is the major benefit of performing a ratio analysis
using the financial statements?
VII. SUMMARY
CHAPTER 12: Understanding Financial Information and Accounting
12.5