Analysis of Financial Statements

The primary goal of financial management is to maximize shareholders’ wealth, not
accounting measures such as net income or EPS. However, accounting data influence
stock prices, and this data can be used to see why a company is performing
the way it is and where it is heading. Chapter 3 described the key financial statements
and showed how they change as a firm’s operations change. Now, in
Chapter 4, we show how the statements are used by managers to improve the
firm’s stock price; by lenders to evaluate the likelihood that borrowers will be able
to pay off loans; and by security analysts to forecast earnings, dividends, and stock
prices.
If management is to maximize a firm’s value, it must take advantage of the
firm’s strengths and correct its weaknesses. Financial analysis involves (1) comparing
the firm’s performance to that of other firms in the same industry and (2)
evaluating trends in the firm’s financial position over time. These studies help
managers identify deficiencies and then take corrective actions. In this chapter, we
focus on how managers and investors evaluate a firm’s financial position. Then, in
later chapters, we examine the types of actions managers can take to improve
future performance and thus increase the firm’s stock price.
The most important ratio is the ROE, or return on equity, which tells us how
much stockholders are earning on the funds they provide to the firm. When ROE is
high, the stock price also tends to be high; so actions that increase ROE generally increase
the stock price. Other ratios provide information about how well assets such
as inventory, accounts receivable, and fixed assets are managed and about the
firm’s capital structure. Managers use ratios related to these factors to help develop
plans to improve ROE.
When you finish this chapter, you should be able to:
l Explain what ratio analysis is.
l List the 5 groups of ratios and identify, calculate, and interpret the key ratios in
each group. In addition, discuss each ratio’s relationship to the balance sheet
and income statement.
l Discuss why ROE is the key ratio under management’s control, how the other
ratios affect ROE, and explain how to use the DuPont equation to see how the
ROE can be improved.
l Compare a firm’s ratios with those of other firms (benchmarking) and analyze a
given firm’s ratios over time (trend analysis).
l 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.