Week 2 (Financial Statement Review)

What does the financial statement analysis involve the examination of?

• Relationships among financial statement numbers (financial ratios)

• Trends in those numbers over time

What does working capital measure?

Ability to repay debt in the short run in absolute terms

• Working capital = current assets - current liabilities

What does current ratio measure?

Ability to repay debt in short run in relative terms

• Current ratio = current assets/current liabilities

• Historically, less than 2:1 indicative of liquidity concerns

• Now, frequently less than 1:1

What is a quick (acid-test) ratio?

A more rigorous test of liquidity that focuses on the most liquid of company’s current assets

• Quick ratio = ($ + S/T investments + receivables)/current liabilities

What is debt ratio?

Percentage of funds that a company acquires through borrowing

• Debt ratio = total liabilities/total assets

What is debt-equity ratio?

Number of dollars of borrowing for each dollar of equity investment

• Debt-to-equity ratio = total liabilities/total equity

What is debt ratio & debt-equity ratio interpretation?

• Larger these ratios, more reliant the company is on borrowing in its capital structure

• All other factors being equal, the larger these ratios the more risky (risk of insolvency) the company is perceived to be

• Smaller these ratios, more reliant the company is on equity financing in its capital structure

• All other factors being equal, the smaller these ratios the safer (lower risk of insolvency) the company is perceived to be

What is return on investment (or return on assets)?

Shows the company’s performance relative to its resource base

• Return on assets (ROI) = net income/average assets

What can ROI be broken down into?

2 components

• Profitability (return on sales)

• Productivity (asset turnover)

What is the ROI equation?

• ROI = net income/average assets

• ROI = net income/net sales * net sales/average assets

• ROI = profit margin * asset turnover

What is return on equity?

Amount of net income stated as a percentage of stockholders’ equity

• Return on equity = net income/avg stockholders’ equity

• Provides an indication of a company’s ability to generate a return for the stockholders (owners of the business)

What is financial statement analysis both?

Diagnostic & prognostic

What do the ratios describe?

Relationships b/w 2 financial numbers

What does GAAP allow?

Companies choices in preparing financial statements (inventories, property, & equipment)

What must companies choose among?

Alternatives that are acceptable under GAAP

What do financial statements depend on?

Countless estimates