ANALYSIS OF FINANCIAL STATEMENTS
Answers to Questions
The kind of decisions that require the analysis of financial statements include whether to
lend money to a firm, whether to invest in the preferred or the common stock of a firm,
and whether to acquire a firm. To properly make such decisions, it is necessary to
understand what financial statements are available, what information is included in the
different types of statements, and how to analyze this financial information to arrive at a
Analysts employ financial ratios simply because numbers in isolation are typically of
little value. For example, a net income of $100,000 has little meaning unless analysts
know the sales figure that generated the income and the assets or capital employed in
generating these sales or this income. Therefore, ratios are used to provide meaningful
relationships between individual values in the financial statements. Ratios also allow
analysts to compare firms of different sizes.
A major problem with comparing a firm to its industry is that you may not feel
comfortable with the measure of central tendency for the industry. Specifically, you may
feel that the average value is not a very useful measure because of the wide dispersion of
values for the individual firms within the industry. Alternatively, you might feel that the
firm being analyzed is not “typical,” that it has a strong “unique” component. In either
case, it might be preferable to compare the firm to one or several other individual firms
within the industry that are considered comparable to the firm being analyzed in terms of
size or clientele. For example, within the computer industry it might be optimal to
compare IBM to Burroughs and/or Control Data rather than to some total industry data
that might include numerous small firms.
In general, jewelry stores have very high profit margins but low asset turnover. It could
take them months to sell a 1-carat diamond ring, but once it is sold, the profit could be
tremendous. On the other hand, grocery stores usually have very low profit margins but
very high asset turnover. Assuming both business risk and financial risk of the firms are
ROE’s should likewise be equal.
Business risk is measured by the relative variability (i.e., the coefficient of variation) of
operating earnings for a firm over time. In turn, the variability of operating earnings is
function of sales volatility and the amount of operating leverage (i.e., fixed costs of
production) employed by the firm.
Sales variability is the prime determinant of earnings
volatility. In addition, the greater the firm’s operating leverage, the more variable the
operating earnings series will be relative to the sales variability.
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