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Unformatted text preview: CHAPTER 4 Evaluating A Firms Financial Performance CHAPTER ORIENTATION Financial analysis can be defined as the process of assessing the financial condition of a firm. The principal analytical tool of the financial analyst is the financial ratio. In this chapter, we provide a set of key financial ratios and a discussion of their effective use. CHAPTER OUTLINE I Financial ratios help us identify some of the financial strengths and weaknesses of a company. II. The ratios give us a way of making meaningful comparisons of a firms financial data at different points in time and with other firms. III. We could use ratios to answer the following important questions about a firms operations. A. Question 1: How liquid is the firm? 1. The liquidity of a business is defined as its ability to meet maturing debt obligations. That is does or will the firm have the resources to pay the creditors when the debt comes due? 2. There are two ways to approach the liquidity question. a. We can look at the firms assets that are relatively liquid in nature and compare them to the amount of the debt coming due in the near term. b. We can look at how quickly the firms liquid assets are being converted into cash. B. Question 2: Is management generating adequate operating profits on the firms assets? 1. We want to know if the profits are sufficient relative to the assets being invested. 2. We have several choices as to how we measure profits: gross profits, operating profits, or net income. Gross profits are not acceptable because it overlooks important information such as marketing and 73 distribution expenses. Net income includes the unwanted effects of the firms financing policies. This leaves operating profits as our best choice in measuring the firms operating profitability. Thus, the appropriate measure is the operating return on assets (OROA): OROA = assets total profits operating C. Question 3: How is the firm financing its assets? Here we are concerned with the mix of debt and equity capital the firm is using. Two primary ratios used to answer this question are the debt ratio and times interest earned. The debt ratio is the proportion of total debt to total assets. Times interest earned compares operating income to interest expense for a crude measure of the firms capacity to service its debt. D. Question 4: Are the owners (stockholders) receiving an adequate return on the equity invested in the firm? 1. We want to know if the earnings available to the firms owners or common equity investors are attractive when compared to the returns of owners of similar companies in the same industry. 2. Return on equity (ROE) = earnings retained stock comon income net + 3. The effect of using debt on net income: This example shows how, through the use of debt, firms can affect their return on equity....
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This note was uploaded on 01/29/2009 for the course FIN 301 taught by Professor Selassie during the Spring '09 term at Oakwood University.
- Spring '09