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Financial Ratios

Financial Ratios - Financial Ratios This lecture deals with...

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Financial Ratios This lecture deals with the evaluation of financial performance using financial statement analysis. It is useful in assessing firm performance and in identifying the major strengths and weaknesses of the business. I. Financial ratio analysis is used to measure the relative performance and creditworthiness of a business entity. Some specific uses for ratio analysis include: A. Ratios are used internally by management for planning and for evaluating performance. B. Ratios are used by credit managers to estimate the riskiness of potential borrowers. C. Ratios are used by investors to evaluate the stocks and bonds of various corporations. D. Ratios are used by managers to identify and assess potential merger candidates. II. A financial ratio is a relationship that indicates something about a firm's activities, such as the ratio between the firm's current assets and current liabilities or between its accounts receivable and annual sales. We use the information from the firm’s financial statements to calculate the financial ratios. The firm's major financial statements are published quarterly and annually. 1. The Balance Sheet contains information on a firm's assets, liabilities, and stockholders' equity at the end of each period. 2. The Income Statement presents the firm's net sales, cost of sales, other operating expenses, interest expenses, taxes, and net income for the period. 3. The Statement of Cash Flows lists how a firm generated cash flows from its operations, how it used cash in investing activities, and how it obtained cash from financing activities. 1
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III. The effective use of financial ratio analysis requires some experience and effort. There are some basic approaches to financial ratio analysis, some basic interrelationships among ratios, and sources of information that can enhance the analyst's effectiveness. A. Two common types of ratio analysis are time-series and cross-sectional analysis. 1. Trend or time-series analysis --This requires the analyst to examine the ratios of a firm for several periods. This shows whether the firm's financial condition is improving or deteriorating over time. 2. Cross-sectional analysis --The analyst compares the ratios of the firm to the industry norms or other individual firms in the industry. 3. Frequently, time-series and cross-sectional analyses are pooled and performed simultaneously. B. Sources of comparative financial information The most popular sources of financial information for businesses and industries are: Industry Norms and Key Business Ratios published by Dun and Bradstreet (D&B) Statement Studies from Robert Morris Associates Reports of the Federal Trade Commission (FTC) and the Securities and Exchange Commission (SEC) Prentice-Hall's Almanac of Business and Industrial Financial Ratios Financial Studies of Small Business from Financial Research Associates Moody's or Standard and Poor's Industrial, Financial, Transportation, and Over-the-Counter manuals Annual reports and 10K's from corporations C. Computerized databases are available to assist in financial statement analysis.
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