Focus on value
Financial managers review and analyze the firm's financial statements periodically, both to uncover developing problems and to assess the firm's progress toward achieving its goals. These actions are aimed at preserving and creating value for the firm's owners. Financial ratios enable financial managers to monitor the pulse of the firm and its progress toward its strategic goals. Although financial statements and financial ratios rely on accrual concepts, they can provide useful insights into an important aspects of risk and return (cash flow) that affect share price, which management is attempting to maximize.
financial statements
The annual stockholders report, which publicly owned corporations must provide to stockholders, documents the firm's financial activities for the past year. It includes the letter to stockholders and various subjective and factual information, as well as for key financial statements: the income statement, the balance sheet, the statement of stockholders equity, and the statement of Cash flows. Notes describing the technical aspects of the financial statements follow. Financial statements of companies that have operations whose cash flows are denominated in one or more foreign currencies must be translated into dollars in accordance with FASB Standard No. 52.
Ratios
Ratio analysis enables stockholders and lenders and the firm's managers to evaluate the firm's financial performance. It can be performed on a cross sectional or a timeseries basis. Benchmarking is a popular type of cross sectional analysis.
Key cautions for applying financial ratios are as follows:
- ratios with a large deviations from the norm merely indicate symptoms of a problem
- a single ratio does not generally provide sufficient information
- the ratios being compared should be calculated using financial statements dated at the same point in time during the year
- audited financial statements should be used
- data should be checked for consistency of accounting treatment
- inflation and different asset ages can distort ratio comparisons
Liquidity and activity
liquidity, or the ability of the firm to pay its bills as they come due, can be measured by the current ratio and the quick (acid test) ratio. Activity ratios measure the speed with which accounts are converted into sales or cash -- inflows or outflows. The activity of inventory can be measured by its turnover; that of accounts receivable by the average collection.; and that of accounts payable by the average payment period. Total asset turnover measures the efficiency with which the firm uses its assets to generate sales.
Debt, financial leverage and ratios
The more debt a firm uses, the greater its financial leverage, which magnifies both risk and return. Financial debt ratios measure both the degree of indebtedness and the ability to service debts.a common measure of indebtedness is the debt ratio. The ability to pay fixed charges can be measured by Times interest earned and fixed payment coverage ratios.
Firm profitability, market value and ratios
The common size income statement, which shows all items as a percentage of sales, can be used to determine gross profit margin, operating profit margin, and net profit margin. Other measures of profitability include earnings per share, return on total assets, and return on common equity. Market ratios include the price/earnings ratio in the market/book ratio.
DuPont system/ratio
A summary of all ratios -- liquidity, activity, debt, profitability, and market -- can be used to perform a complete ratio analysis using cross sectional and timeseries analysis. The DuPont system of analysis is a diagnostic tool used to find the key areas responsible for the firm's financial performance. It enables the firm to break the return on common equity into three components: profit on sales, efficiency of asset use, and use of financial leverage.
