(2)Working capital ratios • The concept of working capital relies on the classification of assets and liabilities into “current” and “noncurrent” categories. The traditional distinction between current assets and liabilities is based on maturity of less than one year or the operating cycle of the company. ①Current ration=current assets/current liabilities （drawbacks and demerits？？） ？？） ②Quick ratio=(cash + marketable securities + accounts receivable)/current liabilities ③Cash ratio=(cash + marketable securities)/current liabilities ④cash flow from operations ratio=cash flow from operations/current liabilities
2. Ratio analysis: cautionary notes
(1)Economic assumptions • Ratio analysis is designed to facilitate comparisons by eliminating size differences across firms and over time. Implicit in this process is the proportionality assumption that the economic relationship between numerator and denominator does not depend on size. This assumption ignores the existence of fixed costs. When there are fixed costs, changes in total costs are not proportional to changes in sales.
(2) Long-term activity ratios ①Fixed asset turnover ratio • Fixed assets turnover=sales/average fixed assets ②Total asset turnover • Total asset turnover=sales/average total assets
The Analysis and use of Financial statements
Chapter 4 Foundations of Ratio and Financial Analysis
CHAPTER OBJECTIVE • 1. Examine the purpose and use of ratios and provide some cautionary notes. • 2. Explain the use of common-size statements. • 3. Discuss the construction and use of: • Short-term and long-term activity ratios that measure the efficiency with which the firm uses its resources. • Liquidity ratios, including working capital ratios, and the defensive interval, that assess the firm’s ability to meet its near-term obligatir broad ratio categories measure the different aspects of risk and return relationships: (1)Activity analysis: evaluates revenue and output generated by the firm’s assets. (2)Liquidity analysis: measures the adequacy of a firm’s cash resources to meet its near-term cash obligations. (3)Long-term debt and solvency analysis: Examines the firm’s capital structure, including the mix of its financing sources and the ability of the firm to satisfy its longerterm debt and investment obligations. (4)Profitability analysis: measures the income of the firm relative to its revenues and invested capital.
(5)Accounting methods • The choice of accounting methods and estimates can greatly affect reported financial statement amounts. In addition, even “pure” numbers such as cash flows from operations may be affected by accounting choices. Thus, ratios are not comparable between firms or for the same firm over time. To interpret such ratios, it may be necessary to convert from one accounting method to another. A strong understanding of accounting rules and a judicious eye for information contained in the notes to financial statements are required for this type of analysis.
Much financial and ratio analysis today is computer generated, the existence of negative numbers will be overlooked unless the program is well written. As income approaches zero, the payout ratio approaches infinity.
INTRODUCTION
1. Purpose and use of ratio analysis • Ratios can also provide a profile of a firm, its economic characteristics and competitive strategies, and its unique operating, financial, and investment characteristics.
• Transaction at year-end can lead to manipulation of the ratios to show the firm in a more favorable light, often called window dressing.
(4)Negative numbers •
(2)Benchmarks • Ratio analysis often lacks appropriate benchmarks to indicate optimal levels. The evaluation of a ratio often depends on the point of view of the analyst. Industry norms as benchmarks. One relevant benchmark is the industry norm as empirical evidence indicates that①industry classification is the primary factor in explaining ratio dispersion and ②ratios of individual firms tend to converge toward the industry wide average.
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(3)Timing and window dressing •
Date used to compute ratios are available only at specific points in time when financial statements are issued. Especially in the case of seasonal business, ratios may not reflect normal operating relationships.
2. Liquidity analysis (1)Length of cash cycle • The operating cycle of a merchandising firm is the sum of the number of days it takes to sell inventory and the number of days until the resulting receivables are converted to cash. • Cash cycle is the number of days a company’s cash is tied up by its current operating cycle. • Operating cycle=Inventory + Receivables • Cash cycle= Inventory + Receivables - Payables