Analysis 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 firms 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 firms true liquidity
Liquidity - most of interest to a firms suppliers
The ratios that are used to determine a companys 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 shortterm 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 companys immediate shortterm 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.
strategy from the viewpoint of stockholders of companies
having steady or rising profits
The ratio that indicates a companys 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 and 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 companys 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
increasing the current and quick ratios.

debt,

thereby

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.