Assignment No.

Manapsal, Rob Miguel C. Mr. Richardson Navor BSA1G

BFM113

1. EXPLAIN WHY RATIO ANALYSIS IS USUALLY THE FIRST STEP IN THE ANALYSIS OF A COMPANY’S
FINANCIAL STATEMENT.

Because ffinancial ratios are a great way to quickly assess a company's health before digging deeper
into its financial statements.

2. LIST SEVERAL LIMITATIONS OF RATIO ANALYSIS.

(1) Historical. All of the information used in ratio analysis is derived from actual historical results. This
does not mean that the same results will carry forward into the future. However, you can use ratio
analysis on pro forma information and compare it to historical results for consistency.

(2) Historical versus current cost. The information on the income statement is stated in current costs
(or close to it), whereas some elements of the balance sheet may be stated at historical cost (which
could vary substantially from current costs). This disparity can result in unusual ratio results.

(3) Inflation. If the rate of inflation has changed in any of the periods under review, this can mean
that the numbers are not comparable across periods. For example, if the inflation rate was 100% in
one year, sales would appear to have doubled over the preceding year, when in fact sales did not
change at all.

(4) Aggregation. The information in a financial statement line item that you are using for a ratio
analysis may have been aggregated differently in the past, so that running the ratio analysis on a
trend line does not compare the same information through the entire trend period.

(5) Operational changes. A company may change its underlying operational structure to such an
extent that a ratio calculated several years ago and compared to the same ratio today would yield a
misleading conclusion. For example, if you implemented a constraint analysis system, this might lead
to a reduced investment in fixed assets, whereas a ratio analysis might conclude that the company is
letting its fixed asset base become too old.
(6) Accounting policies. Different companies may have different policies for recording the same
accounting transaction. This means that comparing the ratio results of different companies may be
like comparing apples and oranges. For example, one company might use accelerated depreciation
while another company uses straight-line depreciation, or one company records a sale at gross while
the other company does so at net.

(7) Business conditions. You need to place ratio analysis in the context of the general business
environment. For example, 60 days of sales outstanding for receivables might be considered poor in
a period of rapidly growing sales, but might be excellent during an economic contraction when
customers are in severe financial condition and unable to pay their bills.

(8) Interpretation. It can be quite difficult to ascertain the reason for the results of a ratio. For
example, a current ratio of 2:1 might appear to be excellent, until you realize that the company just
sold a large amount of its stock to bolster its cash position. A more detailed analysis might reveal that
the current ratio will only temporarily be at that level, and will probably decline in the near future.

(9) Company strategy. It can be dangerous to conduct a ratio analysis comparison between two firms
that are pursuing different strategies. For example, one company may be following a low-cost
strategy, and so is willing to accept a lower gross margin in exchange for more market share.
Conversely, a company in the same industry is focusing on a high customer service strategy where its
prices are higher and gross margins are higher, but it will never attain the revenue levels of the first
company.

(10) Point in time. Some ratios extract information from the balance sheet. Be aware that the
information on the balance sheet is only as of the last day of the reporting period. If there was an
unusual spike or decline in the account balance on the last day of the reporting period, this can
impact the outcome of the ratio analysis.

3. IDENTIFY SOME OF THE QUALITATIVE FACTORS THAT MUST BE CONSIDERED WHEN EVALUATING A
COMPANY’S FINANCIAL PERFORMANCE.

The extent to which the company’s revenues are tied to one key customer.

The extent to which the company’s revenues are tied to one key product.

The extent to which the company relies on a single supplier.

The percentage of the company’s business generated overseas.

Competition.
 Future prospects.

Legal and regulatory environment.

4. STATE WHAT TREND ANALYSIS IS, AND WHY IT IS IMPORTANT.

Trend analysis can provide clues as to whether the firm’s financial situation is likely to
improve or to deteriorate. It is important to analyze trends in ratios as well as their absolute levels.

5. WHAT IS COMMON-SIZED FINANCIAL STATEMENTS.

A common size financial statement displays all items as percentages of a common base figure rather
than as absolute numerical figures. This type of financial statement allows for easy analysis between
companies or between time periods for the same company. The values on the common size
statement are expressed as ratios or percentages of a statement component, such as revenue.

6. Identify different groups of ratios, specify which ratios belong in each group, and explain what
information each group gives us about the firm’s financial position.

(1) Liquidity ratios are used to measure a firm’s ability to meet its current obligations as they come
due.

One of the most commonly used liquidity ratios is the current ratio.

The current ratio measures the extent to which current liabilities are covered by current
assets.

It is determined by dividing current assets by current liabilities.

It is the most commonly used measure of short-term solvency.

(2) Asset management ratios measure how effectively a firm is managing its assets and whether the
level of those assets is properly related to the level of opera¬tions as measured by sales.

The inventory turnover ratio is defined as sales divided by inventories.

It is often necessary to use average inventories rather than year-end inventories, especially if
a firm’s business is highly seasonal, or if there has been a strong upward or downward sales trend
during the year.
 Days sales outstanding (DSO), also called the “average collection period” (ACP), is used to
appraise accounts receivable, and it is calculated by dividing accounts receivable by average daily
sales to find the number of days’ sales tied up in receivables.

The DSO represents the average length of time that the firm must wait after making a sale
before receiving cash.

The DSO can also be evaluated by comparison with the terms on which the firm sells its
goods.

If the trend in DSO over the past few years has been rising, but the credit policy has not been
changed, this would be strong evidence that steps should be taken to expedite the collection of
accounts receivable.

The fixed assets turnover ratio is the ratio of sales to net fixed assets.

It measures how effectively the firm uses its plant and equipment.

A potential problem can exist when interpreting the fixed assets turnover ratio of a firm with
older, lower-cost fixed assets compared to one with recently acquired, higher-cost fixed assets.
Financial analysts recognize that a problem exists and deal with it judgmentally.

The total assets turnover ratio is calculated by dividing sales by total assets.

It measures the utilization, or turnover, of all the firm’s assets.

(3) Debt management ratios measure the extent to which a firm is using debt financing, or financial
leverage, and the degree of safety afforded to creditors.

The debt ratio, or ratio of total debt to total assets, measures the percentage of funds
provided by creditors. Total debt includes both current liabilities and long-term debt.

The lower the ratio, the greater the protection afforded creditors in the event of liquidation.

Stockholders, on the other hand, may want more leverage because it magnifies expected
earnings.
 A debt ratio that exceeds the industry average raises a red flag and may make it costly for a
firm to borrow additional funds without first raising more equity capital.

The times-interest-earned (TIE) ratio is determined by dividing earnings before interest and
taxes (EBIT) by the interest charges.

The TIE measures the extent to which operating income can decline before the firm is unable
to meet its annual interest costs.

Note that EBIT, rather than net income, is used in the numerator. Because interest is paid
with pre-tax dollars, the firm’s ability to pay current interest is not affected by taxes.

This ratio has two shortcomings: (1) Interest is not the only fixed financial charge.

(2) EBIT does not represent all the cash flow available to service debt, especially if a firm has high
depreciation and/or amortization charges.

(4) Profitability ratios show the combined effects of liquidity, asset management, and debt on
operating results.

The profit margin on sales is calculated by dividing net income by sales.

It gives the profit per dollar of sales.

The basic earning power (BEP) ratio is calculated by dividing earnings before interest and
taxes (EBIT) by total assets.

It shows the raw earning power of the firm’s assets, before the influence of taxes and
leverage.

It is useful for comparing firms with different tax situations and different degrees of financial
leverage.
 The return on total assets (ROA) is the ratio of net income to total assets.

It measures the return on all the firm’s assets after interest and taxes.

The return on common equity (ROE) measures the rate of return on the stockholders’
investment.

It is equal to net income divided by common equity. Stockholders invest to get a return on
their money, and this ratio tells how well they are doing in an accounting sense.

(5) Market value ratios relate the firm’s stock price to its earnings, cash flow, and book value per
share, and thus give management an indication of what investors think of the company’s past
performance and future prospects. If the liquidity, asset management, debt management, and
profitability ratios all look good, then the market value ratios will be high, and the stock price will
probably be as high as can be expected.

The price/earnings (P/E) ratio, or price per share divided by earnings per share, shows how
much investors are willing to pay per dollar of reported profits.

P/E ratios are higher for firms with strong growth prospects, other things held constant, but
they are lower for riskier firms.

The price/cash flow ratio is the ratio of price per share divided by cash flow per share.

It shows the dollar amount investors will pay for $1 of cash flow.

The market/book (M/B) ratio, defined as market price per share divided by book value per
share, gives another indication of how investors regard the company.

Higher M/B ratios are generally associated with firms with relatively high rates of return on
common equity.

An M/B ratio greater than 1.0 means that investors are willing to pay more for stocks than
their accounting book values.

NOTES
SOURCES:

https://www.accountingtools.com/articles/what-are-the-limitations-of-ratio-analysis.html

https://www.investopedia.com/terms/r/ratioanalysis.asp#ixzz5JjR6EHex

https://www.slideshare.net/jiwonp/m04-titman-254431811finmgtc04