MANAGEMENT DECISIONS
AND FINANCIAL
ACCOUNTING REPORTS
Baginski & Hassell
MODULE A
FINANCIAL STATEMENTS
AND EXTERNAL
DECISION MAKING
Overview: Financial Statements
and External Decision Making
• Topics
– Financial statements reflect the
aggregate outcomes of many managerial
decisions.
– External decision makers use financial
statements to make assessments of
profitability and risk.
– Ratio calculations are used to help
understand profitability and risk.
– External decision makers also assess the
accounting quality reflected in a firm’s
financial statements.
Ratios Used to Assess Profitability
• Return on assets (ROA): General
assessment of profitability (all capital
providers point of view)
– ROA assesses net profitability of operating
activities per dollar of average investment,
which is a measure of how profitable a
company is regardless of how the company’s
assets are financed.
• Return on Common Equity (ROCE):
Assessment of profitability from the
viewpoint of common stockholders
– ROCE assesses net profitability,
preferred dividends, per dollar
common stockholders’ investment
after
of
• Earnings Per Share (EPS)
– Reflects net income, after preferred dividends,
available to an average common share of stock
The topic of EPS is discussed later
in the text.
Return on Assets (ROA)
ROA =
Net income + Interest expense, net of income taxes
Average total assets
ROA =
Net income + Interest expense (1-t)
Average total assets
where “t” = effective (or statutory) tax rate
Return on Common
Stockholders’ Equity (ROCE)
ROCE =
Net Income – Dividends on Preferred Stock
Average Common Stockholders’ Equity
Decomposition of ROCE
ROCE subcomponents: ROA, common
earnings leverage ratio, and capital structure
leverage ratio
ROCE =
ROA  Common earnings leverage ratio
 Capital structure leverage ratio
The common earnings leverage ratio captures the
negative effects of capital structure on ROCE:
Net income – Preferred dividends
Net income + (1-t) Interest expense
The capital structure leverage ratio captures the
positive effect of leverage on ROCE:
Average total assets
Average common stockholders’ equity
How ROCE Components Combine
ROCE =
ROA
Common Earnings
Leverage Ratio
Capital Structure
Leverage Ratio
Net income +
[interest expense
 (1-t) ]

Average total assets
Net income –
preferred stock
dividends
Net income +
Average total
assets
[interest expense 
(1–t)]

Average common
stockholders’
equity
NOTE: On the previous slide, the
denominator in ROA cancels the numerator
in the capital structure leverage ratio (shown
in blue) and the numerator in ROA cancels
the denominator in the common leverage
ratio (shown in green).
Got it?
Reduced ROCE Formula
The final reduced form ROCE formula is:
ROCE =
Net income – preferred stock dividends
Average common stockholders’ equity
Decomposition of ROA
ROA subcomponents: Net profit margin
ratio and asset turnover ratio.
The net profit margin ratio measures the
prefinancing income per dollar of sales.
Net profit margin ratio =
Net income + [interest expense x (1-t)]
sales
As with all targets, financial and
otherwise, analysts and decision
makers should state in advance exactly
what they are shooting for …
because, if we aim at nothing
we are likely to hit it!
The asset turnover ratio measures the ratio of sales
per average dollar invested in net assets.
Asset turnover ratio =
Sales
Average total assets
How ROA Components Combine
ROA =
Net Profit Margin Ratio
Net income + [interest
expense  (1-t)]
Sales
Asset Turnover Ratio

Sales
Average total assets
Analysis of Risk
• Three major future-oriented risks assessed
by external decisions makers:
– Firm risks
– Industry risks
– General economic risks
• Generally, GAAP-based financial
statements do not do a good job in
helping assess these risks.
• GAAP-based financial statements are used
to assess two types of risk:
– Short-term liquidity risks
– Long-term solvency risks
Short-Term Liquidity Risks
Working capital: The excess (deficit) of
current assets minus current liabilities.
WC = CA - CL
The current ratio shows the amount of
current assets per dollar of current liabilities.
Current Ratio =
CA ÷ CL
Rule of thumb for minimum current ratio is 2:1
The quick ratio shows the amount of quick
assets, cash plus marketable securities plus
accounts receivable, per dollar of current
liabilities.
Quick Ratio =
Cash
Marketable
+ securities
+
Current liabilities
Accounts
receivable
Activity ratios measure the speed at which current
assets turn into cash inflows and current liabilities
turn into cash outflows.
Accounts Receivable
Turnover Ratio
=
Sales
Average accounts receivable
Inventory Turnover Cost of goods sold
Ratio
= Average inventory
Accounts Payable
Turnover Ratio
=
Purchases
Average accounts payable
Cash Flow from
Operations to Current
Liabilities Ratio
=
Cash flow from operations
Average current liabilities
Long-Term Solvency Risk
Several ratios are used to assess a company’s ability
to service current debt requirements, i.e., to remain
a going concern!
Long-term Debt to
Long-term debt
Equity Ratio
=
Shareholders’ equity
Long-term Debt to
Total Assets Ratio =
Long-term debt
Total assets
Interest Coverage Ratio* =
Income before income taxes + Interest expense
Interest expense
*Interest coverage ratio often is labeled times
interest earned (sometimes “the thin ice” ratio).
In general, bankers should not earn more than owners!
Operating Cash Flow to
Total Liabilities Ratio =
Operating cash flow
Average total liabilities
Operating Cash Flow to
Capital Expenditures =
Ratio
Operating cash flow
Capital expenditures
Usefulness of Ratios in
Predicting the Future
• External users, particularly financial
analysts, use ratios to help explain the
present and to predict the future.
– Why are ratios at their current levels?
– Will the ratios continue at this level?
– If not, how & why will they change?
• In addition to ratios, individuals trying to
explain and predict should study:
– Industry conditions
– Firm’s competitive strategy
– Accounting quality
Compared to WHAT?
Industry Conditions
• GAAP-based financial statements provide little
information about industry conditions, such as:
– Industry growth rate
– Firm concentration
– Product differentiation
– Scale economies
– Cyclicality and exit barriers
– Legal barriers to entry
– Relative bargaining power of buyers and
suppliers and access to distribution channels
Firm Competitive Strategy
• GAAP-based financial statements provide
little information about industry conditions,
such as:
– Cost leadership versus product differentiation
– Demonstration of acquisition of unique core
competencies and value chain
Accounting Quality
• Accounting quality includes general
characteristics of information that enable
external decision-makers to assess and
predict sustainability of current financial
characteristics.
• Accounting quality comes from ...
– Truthful reporting (lack of earnings
manipulation)
– Persistence of earnings
– Adequate disclosure
– Using conservative assumptions in applying
GAAP
• GAAP-based financial statements are
useful in assessing these characteristics,
particularly adequate disclosure and
degree of conservatism in assumptions.
End of Module A