Question Details

(solution) ackground for Financial Statement Analysis A. Stockholders'


Read over attachment and answer following two questions.


1. What is financial leverage? What are the benefits and risks associated with financial leverage?


2. Analyze ROA and ROE and how each one fits into Profitability Ratios.


ackground for Financial Statement Analysis

 

A. Stockholders' Perspective

 

Shareholders' focus centers on the value of the

 

stock they hold. Their interest in the financial statement is to

 

gauge the cash flows that the firm

 

will generate from operations, This allows them to determine the firm's

 

profitability, their return for that

 

period, and the dividend they are

 

likely to receive. B. Managers' Perspective On one hand, management's interest in the firm's

 

financial statement is similar to

 

that of shareholders. A good performance by the firm will keep the

 

management in the firm, while a

 

poor performance can cost them

 

their jobs. In addition, management gets feedback on their

 

investing, financing, and working

 

capital decisions by identifying

 

trends in the various accounts that are reported in the financial

 

statements. C. Creditors' Perspective Creditors or lenders are primarily concerned

 

about getting their loans repaid

 

and receiving interest payments on

 

time. Their focus is on: Amount of debt the firm has. Firm's ability to meet short-term obligations. Firm's ability to generate sufficient cash flows to

 

meet all legal obligations first

 

and still have sufficient cash

 

flows to meet debt repayment

 

and interest payments. D. Guidelines for Financial Statement

 

Analysis Identify whose perspective you are using to

 

analyze a firm?management,

 

shareholder, or creditor. Use only audited financial statements if possible. Perform analysis over a three- to five-year

 

period?trend analysis. Compare the firm's performance to its direct

 

competitors?that is, firms that are

 

similar in size and offer similar

 

products. Perform a benchmark analysis. This involves

 

comparing it to one or more of the

 

most relevant competitors?

 

American Air with Delta or United

 

Airlines. Common-Size Financial Statements

 

A common-sized balance is created by

 

dividing each asset or liability by a base

 

number like total assets or sales. Such

 

common-size or standardized financial

 

statements allow one to compare firms that

 

are different in size. A. Common-Size Balance Sheets Each asset and liability item on the balance sheet

 

is standardized by dividing it

 

by total assets, This results in these accounts being represented

 

as percentages of total assets. B. Common-Size Income Statements Each income statement item is standardized by

 

dividing it by the dollar amount

 

of sales. Each income statement item is now indicated as

 

a percentage of sales. Financial Statement Analysis

 

A. Overview A ratio is computed by dividing one balance

 

sheet or income statement item by

 

another. A variety of ratios can be computed to focus on

 

specialized aspects of the firm's

 

performance. The choice of the scale determines the story that

 

can be garnered from the ratio. Different ratios can be calculated based on the

 

type of firm being analyzed or the

 

kind of analysis being performed. Ratios may be computed to measure liquidity,

 

efficiency, leverage, profitability,

 

or market-value performance. B. Liquidity Ratios Liquidity ratios measure the ability of the firm to

 

meet short-term obligations with

 

short-term assets without putting

 

the firm in financial trouble. There are two commonly used ratios to measure

 

liquidity?current ratio and quick

 

ratio. Current ratio is calculated by dividing the

 

current assets by current liabilities. It tells how many dollars of current assets the

 

firm has per dollar of current

 

liabilities. The higher the number, the more liquid the firm

 

and the better its ability to pay

 

its short-term bills. Quick ratio or acid-test ratio is calculated by

 

dividing the most liquid of current

 

assets by current liabilities.

 

Inventory that is not very liquid is

 

subtracted from total current assets to determine the most liquid

 

assets. It tells us how many dollars of liquid assets the

 

firm has per dollar of current

 

liabilities. The higher the number, the more liquid the firm

 

and the better its ability to pay

 

its short-term bills. Quick ratios will tend to be much smaller than

 

current ratios for manufacturing

 

firms or other industries that have

 

a lot of inventory, while service

 

firms that tend not to carry too

 

much inventory will see no

 

significant difference between the

 

two. C. Efficiency Ratios This set of ratios, sometimes called asset

 

turnover ratios, measures the

 

efficiency with which a firm's

 

management uses the assets to

 

generate sales. While management can use these ratios to

 

identify areas of inefficiency that require improvement, creditors can

 

use some of these ratios to

 

determine the speed with which

 

inventory can be converted to

 

receivables, which can then be

 

converted to cash and help the

 

firm to meet its debt obligations. These efficiency ratios focus on inventory,

 

receivables, and the use of fixed

 

and total assets. Inventory turnover ratio is calculated by

 

dividing the cost of goods sold by

 

inventory. Year-end inventory can be used or, if a firm

 

experiences significant

 

changes in the inventory level

 

during the year, the average

 

inventory level can be used. It measures how many times the inventory is

 

turned over into saleable

 

products. The more times a firm can turn over the

 

inventory, the better. Too high a turnover or too low a turnover could

 

be a warning sign. Another ratio that builds on the inventory

 

turnover ratio is the days' sales in

 

inventory. It measures the number of days the firm takes to

 

turn over the inventory. The smaller the number, the faster the firm is

 

turning over its inventory and

 

the more efficient it is. Accounts receivables turnover ratio measures

 

how quickly the firm collects on

 

its credit sales. The higher the frequency of turnover, the quicker

 

it is converting its credit sales

 

into cash flows. Another measure of the firm's efficiency in this

 

regard is Days Sales

 

Outstanding. It measures in days the time the firm takes to

 

convert its receivables into

 

cash. The fewer the days it takes the firm to collect on

 

its receivables, the more

 

efficient the firm is. Recognize, however, that an overzealous credit

 

department may turn off the

 

firm's customers. Total asset turnover ratio measures the level of

 

sales a firm is able to generate per

 

dollar of total assets. The higher the total asset turnover, the more

 

efficiently management is

 

using total assets. Fixed asset turnover ratio measures the level of

 

sales a firm is able to generate per

 

dollar of fixed assets. The higher the fixed asset turnover, the more

 

efficiently management is

 

using its plant and equipment. This ratio is more significant for equipmentintensive manufacturing

 

industry firms, while the total

 

assets turnover ratio is more

 

relevant for service industry

 

firms. D. Leverage Ratios The ability of a firm and its owners to use their

 

equity to generate borrowed funds

 

is reflected in the leverage ratios. Financial leverage refers to the use of long-term

 

debt in a firm's capital structure. The use of debt increases shareholders' returns

 

thanks to the tax benefits provided

 

by the interest payments on debt. Two sets of ratios can be used to analyze

 

leverage?debt ratios that quantify

 

the use of debt in the capital

 

structure and coverage ratios that

 

measure the ability of the firm to

 

meet its debt obligations. The first ratio, total debt ratio, is calculated by

 

dividing total debt by total assets. Total debt includes short-term and long-term

 

debt. The higher the amount of debt, the higher the

 

firm's leverage, and the more

 

risky it is. The second leverage ratio is debt-to-equity

 

ratio. It measures the amount of debt per dollar of

 

equity. The third leverage ratio is called the equity

 

multiplier or leverage multiplier. It tells us the amount of assets that the firm has

 

for every dollar of equity. It serves as the best measure of the firm's ability

 

to leverage shareholders'

 

equity with borrowed funds. Of the coverage ratios, the first one is times

 

interest earned. It measures the number of dollars in operating

 

earnings the firm generates per

 

dollar of interest expense. The higher the number, the greater the ability of

 

the firm to meet its interest

 

obligations. The second ratio is the cash coverage ratio. It measures the amount of cash a firm has to

 

meet its interest payments. E. Profitability Ratios These ratios measure the financial performance

 

of the firm. Gross profit margin measures the amount of

 

gross profit generated per dollar of

 

net sales, while operating profit

 

margin measures the amount of

 

operating profit generated by the

 

firm for each dollar of net

 

sales. Net profit margin measures

 

the amount of net income after

 

taxes generated by the firm for

 

each dollar of net sales. In each case, the higher the ratio, the more

 

profitable the firm. While management and creditors are likely to

 

focus on these profitability

 

measures, shareholders are likely

 

to concentrate on two others. The return on assets (ROA) ratio measures the

 

amount of net income per dollar of

 

total assets. A variation of this ratio, called the EBIT return

 

on assets, is a powerful measure

 

of return because it tells us how

 

efficiently management utilized

 

the assets under their command,

 

independent of financing decisions

 

and taxes. This measures the

 

amount of EBIT per dollar of total

 

assets. The return on equity (ROE) ratio measures the

 

dollar amount of net income per

 

dollar of shareholder s' equity. For a firm with no debt ROA = ROE; for firms

 

with leverage ROE > ROA

 

(assuming that ROA is positive). F. Market-Value Indicators The ratios that follow tell us how the market

 

views the company's liquidity,

 

efficiency, leverage, and

 

profitability. The earnings per share (EPS) ratio measures

 

the income after taxes generated

 

by the firm for each share

 

outstanding. The price-earnings (P/E) ratio ties the firm's

 

earnings per share to price per

 

share. The P/E ratio reflects investors' expectations that

 

the firm's earnings will grow in

 

the future. The DuPont System: A Diagnostic Tool

 

A. An Overview The DuPont system is a set of related ratios that

 

links the balance sheet and the

 

income statement. It is used as a diagnostic tool to evaluate a firm's

 

financial health. Both management and shareholders can use this

 

tool to understand the factors that

 

drive a firm's ROE. It is based on two equations that relate a firm's

 

ROA and ROE. B. The ROA Equation Return on assets, which is Net income / Total

 

assets, can be broken down into

 

two components?profit margin

 

and total assets turnover ratio. The net profit margin measures management's

 

ability to generate sales and

 

efficiently manage the firm's

 

operating expenses; overall, this is

 

a measure of operating efficiency. Total asset turnover looks at how efficiently

 

management uses the assets under

 

its command?that is, how much

 

output can be generated with a

 

given asset base. Thus, asset

 

turnover is a measure of asset use

 

efficiency. The ROA equation says that if management

 

wants to increase the firm's ROA, it can increase the profit margin,

 

asset turnover, or both. By the same token, management can examine a

 

poor ROA and determine whether

 

operating efficiency is the problem

 

or asset use efficiency problem. C. The ROE Equation This equation is simply a restatement of

 

Equation 41.8. Reorganization of

 

the terms allows ROE to be

 

restated as a product of the ROA

 

and the equity multiplier. ROE is determined by the firm's ROA and its use

 

of leverage. A firm with a small ROA can magnify it by

 

using a higher leverage to get a

 

higher ROE. D. The DuPont Equation Substituting the ROA into the ROE equations ROE is determined by three factors: (1) net profit

 

margin, which measures the firm's

 

operating efficiency, (2) total asset turnover, which measures the

 

firm's asset use efficiency, and (3)

 

the equity multiplier, which

 

measures the firm's financial

 

leverage.

 

Analyzing a firm's financial performance will

 

allow one to identify where the

 

inefficiencies are and where the

 

strengths are. If operational efficiency is the area of weakness,

 

then it calls for a closer look at the

 

firm's income statement items. If asset turnover or leverage is the problem area,

 

then the focus shifts to the balance

 

sheet. E. ROE as a Goal The issue of whether maximizing ROE is

 

equivalent to maximizing

 

shareholders' wealth is something

 

to be discussed. Those who do not agree that they are the same

 

identify three key weaknesses. The first weakness with ROE is that it is based

 

on after-tax earnings, not cash

 

flows. Next, ROE does not consider risk. Third, ROE ignores the size of the initial

 

investment as well as future

 

cash flows. Those who believe that they are consistent

 

propose that: ROE allows management to break down the

 

performance and identify areas

 

of strengths and weaknesses. ROE is highly correlated with shareholder

 

wealth maximization. Selecting a Benchmark A ratio analysis becomes relevant only if it can

 

be compared against a benchmark. Financial managers can create a benchmark for

 

comparison in three ways: through

 

trend analysis, industry average

 

analysis, and peer group analysis.

 

A. Trend Analysis This benchmark is based on a firm's historical

 

performance. It allows management to examine each ratio over

 

time and determine whether the

 

trend is good or bad for the firm. B. Industry Analysis Industry analysis is another way of developing a

 

benchmark. Firms in the same industry are grouped by size,

 

sales, and product lines to

 

establish benchmark ratios. One way of identifying industry groups is

 

the Standard Industrial

 

Classification (SIC) System. C. Peer Group Analysis Instead of selecting an entire industry,

 

management may choose to

 

identify a set of firms that are

 

similar in size or sales, or who

 

compete in the same market. The average ratios of this peer group would then

 

be used as the benchmark. Depending on the industry, peer groups can be as

 

small as three or four firms. Using Financial Ratios

 

Limitations of ratio analysis include the

 

following: It depends on accounting data based on historical

 

costs. There is no theoretical backing in making

 

judgments based on financial

 

statement and ratio analysis. When doing industry or peer group analysis, you

 

are often confronted with large,

 

diversified firms that do not fit

 

into any one SIC code. Trend analysis could be distorted by financial

 

statements affected by inflation.

 


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