slides03 - 3 Working with financial statements • This...

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Unformatted text preview: 3. Working with financial statements • This chapter provides a quick review of financial ratios. • The significance of many of these ratios will be clearer later in the course. • But starting to think about these now will provide some help in beginning to understanding the relationships among items in the balance sheet and income statement. • It won’t really make sense to try a serious analysis until we have learned more about the workings of corporate finance. • We will run through a very brief ratio analysis. The mini-case will provide more practice. Caveat Remember that accounting statements are based on book values. We would prefer to make decisions based on market values, but such information may not be easy to obtain and is subject to dis- pute. 2 Ratio analysis • Financial ratios provide a convenient way of summarizing information • Useful for comparisons across companies or time. • Important note: it is possible to calculate many of these ratios in slightly different ways. In practice, it is not always clear what someone has done when they report financial ra- tios. • When using financial ratios, always carefully document how you have calculated things. If comparing your numbers to those from another source, be sure you understand what they have done. 3 Ratio analyis — continued There are many ratios that one might be interested in. We look at a few... 4 Liquidity measures (current ratio) Current ratio = current assets current liabilities • Liquidity is a measure of short-term solvency (ability to meet short-term obligations). • A high current ratio indicates liquidity, but may also imply an inefficient use of cash and other short-term resources. • Current ratio should normally be greater than 1. 5 Liquidity measures (quick ratio) quick ratio = current assets- inventory current liabilities • Also known as acid-test ratio . • Inventory is less liquid than other current assets. • Large inventory may also be a sign of trouble (some may turn out to be damaged, obsolete, or lost). Note: Some companies may try to keep unsaleable merchandise on the books to inflate their current ratio. 6 Ethics: “Stuffing the channel” One way to reduce inventory on the books and increase accounts payable is known as channel stuffing . 7 Example — Bristol-Myers • On August 4, 2004, the Commission (SEC) filed a civil action against Bristol-Myers alleging channel stuffing. • The Commission’s Complaint alleged that, from the first quarter of 2000 through the fourth quarter of 2001, Bristol-Myers en- gaged in a fraudulent scheme to overstate its sales and earnings in order to create the false appearance that the Company had met or exceeded financial projections set by the Company’s offi- cers (”targets”) and earnings estimates established by Wall Street securities analysts....
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slides03 - 3 Working with financial statements • This...

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