Analysis of Financial Statements
After reading this chapter, students should be able to:
◆ Explain what ratio analysis is.
◆ List the five groups of ratios and identify, calculate, and interpret the key ratios in each group. In addition, discuss each ratio’s relationship to the balance sheet and income statement.
◆ Discuss why ROE is the key ratio under management’s control, how the other ratios affect ROE, and explain how to use the DuPont equation to see how the ROE can be improved.
◆ Compare a firm’s ratios with those of other firms (benchmarking) and analyze a given firm’s ratios over time (trend analysis).
◆ Discuss the tendency of ratios to fluctuate over time, which …show more content…
The equity multiplier, defined as total assets divided by common equity, is a measure of debt utilization; the more debt a firm uses, the lower its equity, and the higher the equity multiplier. Thus, using more debt will increase the equity multiplier, resulting in a higher ROE.
4-7 a. Cash, receivables, and inventories, as well as current liabilities, vary over the year for firms with seasonal sales patterns. Therefore, those ratios that examine balance sheet figures will vary unless averages (monthly ones are best) are used.
b. Common equity is determined at a point in time, say December 31, 2008. Profits are earned over time, say during 2008. If a firm is growing rapidly, year-end equity will be much larger than beginning-of-year equity, so the calculated rate of return on equity will be different depending on whether end-of-year, beginning-of-year, or average common equity is used as the denominator. Average common equity is conceptually the best figure to use. In public utility rate cases, people are reported to have deliberately used end-of-year or beginning-of-year equity to make returns on equity appear excessive or inadequate. Similar problems can arise when a firm is being evaluated.
4-8 Firms within the same industry may employ different accounting techniques that make it difficult to compare financial ratios. More fundamentally, comparisons may be misleading if firms in the