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SG_CH04 - CHAPTER 4 Evaluating a Firm's Financial...

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CHAPTER 4 Evaluating a Firm’s Financial Performance 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. I Financial ratios help us identify some of the financial strengths and weak-nesses of a company. II. The ratios give us a way of making meaningful comparisons of a firm’s financial data at different points in time and with other firms. III. We could use ratios to answer the following important questions about a firm’s 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 firm’s 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 firm’s liquid assets are being converted into cash. 46
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B. Question 2: Is management generating adequate operating profits on the firm’s 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 distribution expenses. Net income includes the unwanted effects of the firm’s financing policies. This leaves operating profits as our best choice in measuring the firm’s 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 profits to interest expense for a crude measure of the firm’s capacity to service its debt. D.Question 4: Are the owners (stockholders) receiving an adequate return on their investment? 1. We want to know if the earnings available to the firm’s 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) = equity common 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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