ACC_411_Chapter_5

ACC_411_Chapter_5 - FinancialRatioAnalysis...

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ACC 411 Chapter 5 1 Financial Ratio Analysis Tools for Forecasting
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ACC 411 Chapter 5 2 Overview of Ratio Analysis n Use ratio analysis to assess the firm’s current condition and performance q Profitability q Efficiency q Leverage q Risk (liquidity, operating risk, all financial risk) n Ratios don’t explain firm performance…they suggest the questions we need to ask to better explain firm performance.
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ACC 411 Chapter 5 3 Overview of Ratio Analysis n Comparison to benchmarks is an essential part of interpreting ratios n Alternative Benchmarks for Ratios: q Absolute benchmarks, e.g., ROE= or >Cost of Capital q Close competitors q Industry averages q Time-series: the same firm over time n Last year’s ratio n Average of prior years’ ratios
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ACC 411 Chapter 5 4 Important Cautions n There are no standard formulas for most ratios so be sure you know what formulas have been used n Ratios for companies that use different GAAP methods should not be compared directly without adjustments to standardize the accounting n Managers and their accountants manage financial amounts in order to manipulate ratios making them appear stronger than the underlying economic reality q Examples: operating leases, joint ventures, off-balance sheet transactions, LIFO liquidation, channel stuffing (more on this in Chapter 4)
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ACC 411 Chapter 5 5 n Some GAAP measurements are frequently meaningless amounts, e.g., LIFO inventory, book values of intangible assets (patents, copyrights, trademarks, goodwill), stock compensation expense, book values of long-lived tangible assets (land, buildings) n Negative numbers make many ratios meaningless, e.g., [price/earnings = $5.00/-$1.00 = -5.0] is actually better than [$5.00/-$5.00 = -1.0] n Small denominators (including zero) make ratios meaningless, e.g., [price/earnings = $5.00/$.01 = 500] sounds impressive but is it? n Ratios tend to mean-revert (toward the industry and/or company mean) so don’t assume that ratios are a random walk (expected to stay the same)….Why? Important Cautions
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ACC 411 Chapter 5 6 Figure 5.1 Mean Reversion in Return on Equity -0.3 -0.2 -0.1 0 0.1 0.2 0.3 year 0 year 1 year 2 year 3 year 4 year 5 year 6 year 7 year 8 year 9 year 10
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ACC 411 Chapter 5 7 Do you know which B.S. amounts  to use? n Use end of period amounts when only B.S. amounts are included in the ratio, e.g., Current Ratio = Current Assets t / Current Liabilities t n Use average of beginning and ending B.S. amounts when ratio includes income statement or cash flow amounts for the period, e.g., ROE = Net Income t /Avg. Common Equity
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ACC 411 Chapter 5 8 Primary Categories of Ratios  1. Profitability – Profit per $ of something, e.g., profit per sales dollar (profit margin), ROE, 2. Asset Efficiency (turnover) – Getting the most out of the firm’s investments in assets [maximizing sales per $ of assets] 3. Leverage – Using borrowed money to maximize the owners’ return (cheap debt financing)
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ACC_411_Chapter_5 - FinancialRatioAnalysis...

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