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




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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