lAnalysis on Financial Statements

Management is interested in the view of investors. Management is interested in the asset structure of the entity. Management is interested in the financial structure of the

entity A limitation in calculating ratios in financial statement

analysis is that they seldom identify problem areas in a company.

The availability of information. – not a limitation Financial analysis can be used to detect apparent liquidity

problems. The use of alternative accounting methods may be a problem in

ratio analysis even if disclosed. Relative numbers would be most meaningful for both the large

and small firm, especially for interfirm comparisons – type of numbers would be most meaningful for statement analysis.

Many companies will not clearly fit into any one industry. A financial service uses its best judgment as to which

industry the firm best fits. The analysis of an entity's financial statements can be more

meaningful if the results are compared with industry averages and with results of competitors.

Common-sized financial statements - is the most useful in analyzing companies of different sizes. These are statements in which all items are expressed only in relative terms (percentages of a base).

The percentage analysis of increases and decreases in individual items in comparative financial statements is called horizontal analysis.

Horizontal analysis is a technique for evaluating a series of financial statement data over a period of time to determine the amount and/or percentage increase or decrease that has taken place.

Risk and return The present and prospective stockholders are primarily

concerned with a firm’s risk and return. Common stockholders - suppliers of funds bear the greatest

risk and should therefore earn the greatest return. The following groups of ratios primarily measure risk:

liquidity, activity, and debt.

Financial Ratios Ratios are used as tools in financial analysis because they

can provide information that may not be apparent from inspection of the individual components of a particular ratio.

In the near term, the important ratios that provide the information critical to the short-run operation of the firm are: liquidity, activity, and profitability.

The ability of a business to pay its debts as they come due and to earn a reasonable amount of income is referred to as: solvency and profitability

Liquidity Ratios Short term liquidity - The primary concern of short-term

creditors when assessing the strength of a firm Liquidity - Short-term creditors are usually most interested

in assessing this Liquidity and activity ratios - The two categories of ratios

that should be utilized to asses a firm’s true liquidity Liquidity - most of interest to a firm’s suppliers The ratios that are used to determine a company’s short-term

debt paying ability are current ratio, acid-test ratio, receivables turnover, and inventory turnover.

Current ratio - is a measure of the liquidity position of a corporation

Current ratio - ratios would not likely be used by a short-term creditor in evaluating whether to sell on credit to a company

Current ratio - ratios would be least helpful in appraising the liquidity of current assets

Accounts receivable turnover - ratio is most helpful in appraising the liquidity of current assets

Current ratio - considered to be the most indicative of a firm's short-term debt paying ability

Current ratio - is rated to be a primary measure of liquidity and considered of highest significance rating of the liquidity ratios a bank analyst

A weakness of the current ratio is that it does not take into account the composition of the current assets.

Acid-test ratio - A measure of a company’s immediate short-term liquidity

The acid-test or quick ratio relates cash, short-term investments, and net receivables to current liabilities.

Activity Ratios A general rule to use in assessing the average collection

period is that it should not greatly exceed the credit term period.

Asset turnover measures how efficiently a company uses its assets to generate sales. Total asset turnover measures the ability of a firm to generate sales through the use of assets

A measure of how efficiently a company uses its assets to generate sales is the asset turnover ratio.

Long-term creditors are usually most interested in evaluating solvency.

Trading on the equity (leverage) refers to the use of borrowed money to increase the return to owners.

The tendency of the rate earned on stockholders' equity to vary disproportionately from the rate earned on total assets is sometimes referred to as leverage.

Using financial leverage is a good financial strategy from the viewpoint of stockholders of companies having steady or rising profits

The ratio that indicates a company’s degree of financial leverage is the debt to total assets.

Interest expense creates magnification of earnings through financial leverage because while earnings available to pay interest rise, earnings to residual owners rise faster

The set of ratios that is most useful in evaluating solvency is debt ratio, times interest earned, and cash flow to debt

Ratio of fixed assets to long-term liabilities are ratios that provides a solvency measure that shows the margin of safety of noteholders or bondholders sdsjkndfdaksdfandfasjnfaksljnfalsdadand also gives an indication of the potential ability of the business to borrow additional funds on a long-term basis.

The debt ratio indicates a comparison of liabilities with total assets

The debt to total assets ratio measures the percentage of the total assets provided by creditor

The debt to tangible net worth ratio is more conservative than the debt/equity ratio.

A times interest earned ratio of 0.90 to 1 means that net income is less than the interest expense

A fixed charge coverage is an income statement indication of debt carrying ability

If a firm has substantial capital or financing leases disclosed in the notes but not capitalized in the financial statements, then the debt ratio will be understated

The return on assets ratio is affected by the asset turnover and profit margin ratios

Profitability - Stockholders are most interested The set of ratios that are most useful in evaluating

profitability are ROA, ROE, and dividend yield Earnings per share - ratios appears most frequently in annual

reports Return on assets can be affected by the company’s choice of a

depreciation method Return on investments return to all long-term suppliers of

funds

Price/earnings ratio is a gauge of future earning power as seen by investors

price/earnings ratio are ratios usually reflects investors opinions of the future prospects for the firm

Dividend yield - ratios represents dividends per common share in relation to market price per common share

An acceleration in the collection of receivables will tend to cause the accounts receivable turnover to increase.

stable current ratio with declining quick ratios best indicate that the firm is carrying excess inventory

A labor-intensive industry will cause sales to fixed assets to be abnormally high.

A firm with a total asset turnover lower than the industry standard and a current ratio which meets industry standard might have excessive fixed assets.

A firm has a current ratio of 1:1. In order to improve its liquidity ratios, this firm should decrease current liabilities by utilizing more long-term debt, thereby increasing the current and quick ratios.

Tyner Company had P250,000 of current assets and P90,000 of current liabilities before borrowing P60,000 from the bank with a 3-month note payable. What effect did the borrowing transaction have on Tyner Company's current ratio? The ratio decreased.

Jones Company has long-term debt of P1,000,000, while Smith Company, Jones' competitor, has long-term debt of P200,000. Which of the following statements best represents an analysis of the long-term debt position of these two firms? Not enough information to determine if any of the answers are correct.

A rise in preferred stock dividends will not cause times interest earned to drop? Assume no other changes than those listed.