ratio financial measurement

8/7/2019 ratio financial measurement

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CHAPTER 15

Financial Performance Measurement

0REVIEWING THE CHAPTER

Objective 1: Describe the objectives, standards of comparison, sources of information, and

compensation issues in measuring financial performance.

10. Financial performance measurement, orfinancial statement analysis, comprises all thetechniques users of financial statements employ to show important relationships in an

organizations financial statements and to relate them to important financial objectives.

Internal users of financial statements include top managers, who set and strive to achieve

financial performance objectives; middle-level managers of business processes; and lower-

level employee stockholders. External users are creditors and investors who want to assess

how well management has accomplished its financial objectives, as well as customers whohave cooperative agreements with the company.

20. Management is responsible for devising, executing, monitoring, and reporting on a

complete financial plan for the business. Such a plan should focus on the financial

objectives ofliquidity, or the ability to pay bills when due and to meet unexpected needs for

cash; profitability, the ability to earn a satisfactory net income; long-term solvency, theability to survive for many years; cash flow adequacy, the ability to generate sufficient cashthrough operating, investing, and financing activities; and market strength, the ability toincrease the wealth of owners.

30. Investors and creditors use financial performance to judge a companys past performance,

present position, and future potential. They also use it to assess the risk connected with

acting on that potential.

a0. In judging a companys past performance and current status, investors and creditors

look at trends in past sales, expenses, net income, cash flows, and return on

investment. They also look at a companys assets and liabilities, its debt in relation to

equity, and its levels of inventories and receivables.

b0. Information about a companys past and present enables creditors and investors to

make more accurate projections about its futureand the more accurate their

projections are, the lower their risk of realizing a loss will be. In return for assuming a

higher risk, creditors may charge higher interest rates or demand security on theirloans; stock investors look for a higher return in the form of dividends or an increase

in market price.

40. When analyzing financial statements, decision makers commonly use three standards of

comparison: rule-of-thumb measures, past performance of the company, and industry

norms.0

a0. Rule-of-thumb measures for key financial ratios are helpful but should not be the only

basis for making a decision. For example, a company may report high earnings per

share but lack the assets needed to pay current debts.


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b0. Analysis of a companys past performance is helpful in showing current trends and

may also indicate future trends. However, trends reverse at times, so projections based

on past performance should be made with care.

c0. Using industry norms to compare a companys performance with the performance of

other companies in the same industry has advantages, but it also has three limitations.

First, the operations of two companies in the same industry may be so different thatthe companies cannot be compared. Second, diversified companies, or

conglomerates, operate in many unrelated industries, which makes it difficult if not

impossible to use industry norms as standards. (The FASB requirement that financial

information be reported by segments has provided a partial solution to this problem.)

Third, companies may use different acceptable accounting procedures for recording

similar items.

50. The major sources of information about publicly held corporations are reports published by

the company, SEC reports, business periodicals, and credit and investment advisory

services.0

a0. A corporations annual report provides much useful financial information. Its main

sections are managements analysis of the past years operations; the financial

statements; the notes to the financial statements, which include a summary of

significant accounting policies; the auditors report; and financial highlights for a five-

or ten-year period. Most public companies also publish interim financial statements

each quarter. These reports present limited financial information in the form of

condensed financial statements and may indicate significant trends in a companys

earnings.

b0. Publicly held corporations must file an annual report with the SEC on Form 10-K, a

quarterly report on Form 10-Q, and a current report of significant events on Form 8-K.

These reports are available to the public and are a valuable source of financial

information.

c0. Financial analysts obtain information from such sources as The Wall Street Journal,

Forbes, Barrons, Fortune, the Financial Times, Moodys, Standard & Poors, andDun & Bradstreet.

60. Under the Sarbanes-Oxley Act of 2002, a public corporations board of directors mustestablish a compensation committee comprised of independent directors to determine how

the companys top executives will be compensated. Companies must disclose the

components of compensation (such as a base salary, incentive bonuses, and stock option

awards) and the criteria they use to remunerate top executives in documents they file withthe SEC.

Objective 2: Apply horizontal analysis, trend analysis, vertical analysis, and ratio analysis to

financial statements.

70. The most widely used tools of financial analysis are horizontal analysis, trend analysis,vertical analysis, and ratio analysis.0

a0. Horizontal analysis is commonly used to study comparative financial statements,which present data for the current year and previous year side by side. Horizontal

analysis computes both dollar and percentage changes in specific items from one year

to the next. The first year is called the base year, and the percentage change is

computed by dividing the amount of the change by the base year amount.


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b0. Trend analysis is like horizontal analysis, except that it calculates percentage changes

for several consecutive years. To show changes in related items over time, trend

analysis uses an index number, which is calculated by setting the base year equal to

100 percent.

c0. Vertical analysis uses percentages to show the relationship of individual items on a

statement to a total within the statement (e.g., cost of goods sold as a percentage of netsales). The result is a common-size statement. On a common-size balance sheet, total

assets are set at 100 percent, as are total liabilities and stockholders equity; on a

common-size income statement, net sales or net revenues are set at 100 percent.

Comparative common-size statements enable analysts to identify changes both within

a period and between periods. They also make it easier to compare companies.

d0. Ratio analysis identifies meaningful relationships between the components of the

financial statements. The primary purpose of ratios is to identify areas needing further

investigation.

Objective 3: Apply ratio analysis to financial statements in a comprehensive evaluation of a

companys financial performance.

80. The ratios used in ratio analysis provide information about a companys liquidity,profitability, long-term solvency, cash flow adequacy, and market strength. The most

common ratios are shown in the table that follows.

Ratio Components Use

Liquidity Ratios

Current ratio Current Assets Measure of short-term debt-

Current Liabilities paying ability

Quick ratio Cash + Marketable Securities + Receivables Measure of short-term debt-

Current Liabilities paying ability

Receivable

turnover

Net Sales Measure of relative size of

Average Accounts Receivable accounts receivable and

effectiveness of credit policies

Days sales Days in Year Measure of average days taken

uncollected Receivable Turnover to collect receivables

Inventoryturnover Cost of Goods Sold Measure of relative size of Average Inventory inventory

Days inventory Days in Year Measure of average days taken

on hand Inventory Turnover to sell inventory

Payables turnover Cost of Goods Sold +/ Change in Inventory Measure of relative size of

Average Accounts Payable accounts payable


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Days payable Days in Year Measure of average days taken

Payables Turnover to pay accounts payable

(Note: The operating cycle is the time taken to sell and collect for products sold. It equals days inventory on

hand plus days sales uncollected.)

Profitability Ratios

Profit margin Net Income Measure of net income produced

Net Sales by each dollar of sales

Asset turnover Net Sales Measure of how efficiently assets

Average Total Assets are used to produce sales

Return on assets Net Income Measure of overall earning

Average Total Assets power or profitability

Return on equity Net Income Measure of the profitability of Average Stockholders Equity stockholders investments

Long Term Solvency Ratios

Debt to equity ratio Total Liabilities Measure of capital structure and

Stockholders Equity leverage

Interest coverage Income Before Inc. Taxes + Int. Expense Measure of creditors protection

ratio Interest Expense from default on interest payme

Cash Flow Adequacy Ratios

Cash flow yield Net Cash Flows from Operating Activities Measure of the ability to generate

Net Income operating cash flows in relation

to net income

Cash flows to sales Net Cash Flows from Operating Activities Measure of the ability of sales to

Net Sales generate operating cash flows

Cash flows to assets Net Cash Flows from Operating Activities Measure of the ability of assets to

Average Total Assets generate operating cash flows

Free cash flow Net Cash Flows from Operating Activities Measure of cash generated or

Dividends Net Capital Expenditures cash deficiency after providing

for commitments

Market Strength Ratios

Price/earnings (P/E) Market Price per Share Measure of investor confidence

ratio Earnings per Share in a company


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Dividends yield Dividends per Share Measure of a stocks current

Market Price per Share return to an investor

ratio financial measurement

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