MANAGEMENT DECISIONS AND FINANCIAL ACCOUNTING REPORTS
Baginski & Hassell
FINANCIAL STATEMENTS AND EXTERNAL DECISION MAKING
Overview: Financial Statements and External Decision Making
– Financial statements reflect the aggregate outcomes of many managerial decisions. – External decision makers use financial statements to make assessments of profitability and risk.
. – External decision makers also assess the accounting quality reflected in a firm’s financial statements.– Ratio calculations are used to help understand profitability and risk.
which is a measure of how profitable a company is regardless of how the company’s assets are financed.
.Ratios Used to Assess Profitability
• Return on assets (ROA): General assessment of profitability (all capital providers point of view)
– ROA assesses net profitability of operating activities per dollar of average investment.
• Return on Common Equity (ROCE): Assessment of profitability from the viewpoint of common stockholders
– ROCE assesses net profitability. per dollar of common stockholders’ investment
• Earnings Per Share (EPS)
– Reflects net income. after preferred dividends. after preferred dividends.
. available to an average common share of stock
The topic of EPS is discussed later in the text.
net of income taxes Average total assets
Net income + Interest expense (1-t) Average total assets where “t” = effective (or statutory) tax rate
.Return on Assets (ROA)
Net income + Interest expense.
Return on Common Stockholders’ Equity (ROCE)
Net Income – Dividends on Preferred Stock Average Common Stockholders’ Equity
Decomposition of ROCE
ROCE subcomponents: ROA. and capital structure leverage ratio
ROCE = ROA Common earnings leverage ratio Capital structure leverage ratio
. common earnings leverage ratio.
The common earnings leverage ratio captures the negative effects of capital structure on ROCE:
Net income – Preferred dividends Net income + (1-t) Interest expense
The capital structure leverage ratio captures the positive effect of leverage on ROCE:
Average total assets Average common stockholders’ equity
How ROCE Components Combine
Common Earnings Leverage Ratio Net income – preferred stock dividends Net income + [interest expense (1–t)] Capital Structure Leverage Ratio Average total assets Average common stockholders’ equity
ROA Net income + [interest expense (1-t) ] Average total assets
.NOTE: On the previous slide. the denominator in ROA cancels the numerator in the capital structure leverage ratio (shown in blue) and the numerator in ROA cancels the denominator in the common leverage ratio (shown in green).
Reduced ROCE Formula
The final reduced form ROCE formula is: ROCE = Net income – preferred stock dividends Average common stockholders’ equity
Decomposition of ROA
ROA subcomponents: Net profit margin ratio and asset turnover ratio. Net profit margin ratio =
Net income + [interest expense x (1-t)]
The net profit margin ratio measures the prefinancing income per dollar of sales.
financial and otherwise.As with all targets. if we aim at nothing we are likely to hit it!
. analysts and decision makers should state in advance exactly what they are shooting for … because.
Asset turnover ratio =
Sales Average total assets
.The asset turnover ratio measures the ratio of sales per average dollar invested in net assets.
How ROA Components Combine
Net Profit Margin Ratio Net income + [interest expense (1-t)] Asset Turnover Ratio
Average total assets
GAAP-based financial statements do not do a good job in helping assess these risks.
.Analysis of Risk
• Three major future-oriented risks assessed by external decisions makers:
– Firm risks – Industry risks – General economic risks • Generally.
• GAAP-based financial statements are used to assess two types of risk: – Short-term liquidity risks – Long-term solvency risks
WC = CA .Short-Term Liquidity Risks
Working capital: The excess (deficit) of current assets minus current liabilities.
The current ratio shows the amount of current assets per dollar of current liabilities. Current Ratio = CA ÷ CL
Rule of thumb for minimum current ratio is 2:1
cash plus marketable securities plus accounts receivable.
Quick Ratio = Marketable + securities + Current liabilities Accounts receivable
. per dollar of current liabilities.The quick ratio shows the amount of quick assets.
Activity ratios measure the speed at which current assets turn into cash inflows and current liabilities turn into cash outflows. Accounts Receivable Turnover Ratio = Sales Average accounts receivable
Inventory Turnover Cost of goods sold Ratio = Average inventory
Accounts Payable Turnover Ratio
Purchases Average accounts payable
Cash Flow from Operations to Current Liabilities Ratio =
Cash flow from operations Average current liabilities
e. i.Long-Term Solvency Risk
Several ratios are used to assess a company’s ability to service current debt requirements.. to remain a going concern! Long-term Debt to Long-term debt Equity Ratio = Shareholders’ equity Long-term Debt to Total Assets Ratio = Long-term debt Total assets
bankers should not earn more than owners!
In general.Interest Coverage Ratio* = Income before income taxes + Interest expense Interest expense *Interest coverage ratio often is labeled times interest earned (sometimes “the thin ice” ratio).
Operating Cash Flow to Total Liabilities Ratio = Operating Cash Flow to Capital Expenditures = Ratio
Operating cash flow Average total liabilities Operating cash flow Capital expenditures
Usefulness of Ratios in Predicting the Future
• External users.
– Why are ratios at their current levels? – Will the ratios continue at this level? – If not. particularly financial analysts. use ratios to help explain the present and to predict the future. how & why will they change?
individuals trying to explain and predict should study:
– Industry conditions – Firm’s competitive strategy – Accounting quality
Compared to WHAT?
.• In addition to ratios.
• GAAP-based financial statements provide little information about industry conditions. such as: – Industry growth rate – Firm concentration – Product differentiation – Scale economies – Cyclicality and exit barriers – Legal barriers to entry – Relative bargaining power of buyers and suppliers and access to distribution channels
Firm Competitive Strategy
• GAAP-based financial statements provide little information about industry conditions. such as:
– Cost leadership versus product differentiation – Demonstration of acquisition of unique core competencies and value chain
• Accounting quality includes general characteristics of information that enable external decision-makers to assess and predict sustainability of current financial characteristics.
.• Accounting quality comes from .
. particularly adequate disclosure and degree of conservatism in assumptions.. – Truthful reporting (lack of earnings manipulation) – Persistence of earnings – Adequate disclosure – Using conservative assumptions in applying GAAP • GAAP-based financial statements are useful in assessing these characteristics.
End of Module A