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This chapter starts a new unit in the textbook, dealing with Understanding Financial Statements and Cash Flow.  You will use your knowledge of accounting in a new way -- the way that a financial manager uses it -- to determine the current condition of the company and to make good financial decisions.

LEARNING OBJECTIVES

When you finish this chapter, you should be able to:

  1. Take a normal financial statement and standardize it so that you can COMPARE it with statements from other enterprises.
  2. ANALYZE a financial statement, using it to COMPUTE and INTERPRET some common financial ratios. (See table 3.5 on page 61)
  3. CALCULATE  and INTERPRET the DuPont Identity.
  4. EXPLAIN, ANALYZE and INTERPRET the Internal Growth rate and the Sustainable Growth rate, thereby EXPLAINING the things that determine a firm's profitability and growth.

STUDY TIP
The ratio analysis section of this chapter is the part that seems to give some students problems, since they have the very common, and irrational,  "fear of math complex".  However, do not let the ratio analysis blind you to the concepts that are also important in this chapter, such as using common size balance sheets and income statements to compare companies of different sizes, and how to use the DuPont identity to find out what is really going on with a corporation.  Finally, be sure that you understand the reasons for doing financial statement analysis, both as an internal manager and an outside investor or creditor.

The definitions in Table 3.5 on page 61 are key. Notice that there are five different groups of financial ratios:
  1. Measures of short-term solvency or liquidity
  2. Measures of long-term solvency or leverage
  3. Asset utilization or turnover measures
  4. Measures of Profitability
  5. Measures of Market Valuation

Don't think of these financial ratios as equations (although of course they are equations), but as definitions.  If you think about what they mean, rather than trying to memorize them, you have a much better chance of remembering them.  Clearly, if you are a lending officer at a bank who the firm is asking for a short-term line of credit, you will want to know if the firm is solvent in the short-term.  Think about what you need to know to determine if they are solvent. Do they have enough cash to pay their current bills?  Use your common sense to make the ratios make sense.

If you break these equations down into the five groups, you will often see that the first equation is the key measure, and the others are simply ways of restating that first concept in another way.  For example, there are two equations for ROE (return on equity).  The second one looks very complicated, but if you examine it more closely, you see that the first term is simply profit margin, the second term is asset turnover, and the third term is the equity multiplier. In addition, if you write the second equation out, and use the old arithmetic trick of canceling out terms in the numerator and denominator, you get back to the first equation.  Playing around with the equations like that will help you remember them.

KEY TERMINOLOGY

Acid-test ratio
Cash coverage
Common-size statement
Current ratio
Days' sales in Inventory
Days' sales in receivables
Determinants of growth
Dividend Payout
Du Pont Identity
Earnings retention
Financial ratios
Internal Growth rate
Inventory turnover
Market Value Measures
Market-to-Book ratio
Measures of Asset management
Measures of Liquidity
Measures of Long-term solvency
Measures of Profitability
Measures of short-term solvency
Measures of Turnover
Payables turnover
Peer group analysis
Price-Earnings Ratio
Profit margin
Quick ratio
Ratio analysis
Receivables turnover
Return on Assets
Return on Equity
Standardized Financial statements
Sustainable Growth rate
Times Interest Earned (TIE)
Time-trend analysis
Total Asset turnover
Total debt ratio

Ratios, charts, getting to the truth.  What is truth?

When working problems for the homework, do the ones that you have answers for first.  That way you can see if you are on track.  Don't forget to use the Statement Problem Analysis method -- it makes it so much easier.

Many students see all the ratios and equations in this chapter and let fear of math paralyze them. Think of them not as equations but as statements of fact.  They are sentences defining these things.  However, if you must perceive them as math, be aware that the math required is basically high school algebra, nothing more.  You can do it!

If for some reason you are having trouble with the math,  go to the library and pull out any algebra text and review solving linear equations like a+b = c, and substitution of one variable for another.  If you know that total equity = total assets--total liabilities, then you can substitute the other two for any of the three terms.

Numerical analysis like this is just a tool we learn to get to the good stuff -- digging out the dirt!  Later in the course, when we have our tool box of numerical techniques full of great analysis tools, we will look at companies and try to determine if they are financially sound and what their value is.

Valuation is one of the key purposes of finance, and is also the most fun.  This is what you do to see if a stock is a good buy, and, if you are an investment banker, what the IPO should go out at, or if a lending officer, what the collateral is.