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Unformatted text preview: Chapter 4 Analysis of Financial Statements Learning Objectives After reading this chapter, students should be able to: Explain what ratio analysis is. List the five groups of ratios and identify, calculate, and interpret the key ratios in each group. In addition, discuss each ratios relationship to the balance sheet and income statement. Discuss why ROE is the key ratio under managements control, how the other ratios affect ROE, and explain how to use the DuPont equation to see how the ROE can be improved. Compare a firms ratios with those of other firms (benchmarking) and analyze a given firms ratios over time (trend analysis). Discuss the tendency of ratios to fluctuate over time, which may or may not be problematic. Explain how they can be influenced by accounting practices and other factors and why they must be used with care. Chapter 4: Analysis of Financial Statements Learning Objectives 41 Answers to End-of-Chapter Questions 4-1 The emphasis of the various types of analysts is by no means uniform nor should it be. Management is interested in all types of ratios for two reasons. First, the ratios point out weaknesses that should be strengthened; second, management recognizes that the other parties are interested in all the ratios and that financial appearances must be kept up if the firm is to be regarded highly by creditors and equity investors. Equity investors (stockholders) are interested primarily in profitability, but they examine the other ratios to get information on the riskiness of equity commitments. Credit analysts are more interested in the debt, TIE, and EBITDA coverage ratios, as well as the profitability ratios. Short-term creditors emphasize liquidity and look most carefully at the current ratio. 4-2 The inventory turnover ratio is important to a grocery store because of the much larger inventory required and because some of that inventory is perishable. An insurance company would have no inventory to speak of since its line of business is selling insurance policies or other similar financial productscontracts written on paper and entered into between the company and the insured. This question demonstrates that the student should not take a routine approach to financial analysis but rather should examine the business that he or she is analyzing....
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This note was uploaded on 11/08/2011 for the course MAT/FIN 272 taught by Professor Burns during the Spring '11 term at Central Connecticut State University.
- Spring '11