Chapter 24 – Financial Statement Ratio Analysis & Case (Part 1)

We are looking at how financial statements are used to analyze the financial profile of companies. Financial statement analysis is done by equity analysts (stock), and credit rating agencies (debt). We have already touched on two key financial ratios in the course: Long-term debt to equity (in the “Rethinking the Optimal Capital Structure” article and related Stanley Works assignment) and in our last unit, return on equity (ROE) was introduced.

Finkler (chapter 24) describes financial statement ratios and how they can be used to evaluate individual companies, and to make comparisons between companies. Read chapter 24. For return on investment ratios (starts bottom of page 286) just read through the third paragraph on page 287. The remaining discussion chapter 24 deals with using ROI to evaluate division managers, a topic we will not address. You are free to read it if interested but it is optional.

The ratios do not require complex calculations, and in most cases it is easy to see whether a higher or lower ratio is considered “better.” For example, the current ratio reflects a company’s ability to meet short-term obligations, so a higher ratio is generally better. However, as Finkler points out, a very high current ratio could mean a company is holding too much cash — and earning no interest or yield. Message: interpret ratios with caution.

After reading the chapter, you may find it useful to do Review Question #5 to give you some practice calculating several ratios from the financial statements in the chapter. Check the solutions I provided

For our final assignments in the course, we need to look at the Case F-0805, “The Financial Detective.” In Exhibit 1 of the case you will see data for a series of companies. The data includes Common-Sized Data (page 4), and Operating and Condition Ratios (page 5) all of which are covered in Finkler Chapter 24.

Common size data in the case is based on the same concept as in Finkler: balance sheet items and components are expressed as a percentage of total assets; income statement items and components are expressed as a percentage of sales. Common size data for the balance sheet uses a single item, “Other assets,” for the combined total of non-current assets such as long-term investments and intangible assets. Common size data for the income statement includes a line item “SG&A” (Selling, General, and Administrative Expenses) which is simply another name for operating expenses. For companies H and O this line item differs because it includes operating expenses and cost of goods sold. These two companies report their cost of goods sold along with other operating expenses. “Nav.” is shown for cost of goods for these two companies, meaning the data item is “not available.” Nav. may also used when a company doesn’t have a certain item at all, so in this case it is interpreted as “not applicable.” For example, notice there is a line for research and development expense (R&D expense). Not all companies engage in research and development activities; this can be due to the nature of the industry and/or company strategy. You would expect to see a pharmaceutical company with R&D if they are developing new drugs. However you could find a pharmaceutical company with no R&D if their strategy is to manufacture generic drugs at low cost (patent has expired).

For the Operating & Condition Ratios, as mentioned, Finkler discusses all of these. However in some instances there is a difference as to whether the ratio is presented as a percentage. The following document explains these issues: Percentage versus pure numberPreview the document.

For your first assignment, list the top four companies, in descending order, based on Return on equity (ROE). You will find that when you get to the third best company, there is a tie. List these two companies, in either order, as the third and fourth companies on your list. Identify each company by its letter, and show the return on equity in parentheses. For example:

1. Company R (41%)

2. Company U (39%)

3. Company S (35%)

4. Company V (35%)

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Chapter 24-Financial Statement Analysis & Case( Part 2)

1. For each of the companies you identified in Part 1, identify its profit margin percentage.

2. Which measure would you use to evaluate which company to buy stock in, the return on equity, or the profit margin? Explain your reasoning.