Financial Reporting II

Review of Ratio Analysis

Ratio analysis is a useful tool for analyzing financial statements. Calculating ratios will aid in understanding the company’s strategy and in understanding its strengths and weaknesses relative to other companies and over time. They can sometimes be useful in identifying earnings management and in understanding the effect of accounting choices on the firm’s reported profitability and growth. Finally, the ratios help in obtaining a better understanding of a firm’s current profitability, growth, and risk which can improve forecasts of future profitability and growth and estimates of the cost of capital.

In reviewing the basic financial ratios, we will examine the ratios of Best Buy*…show more content…*

Thus, the fall in ROA is not due to the reduction in income before financing costs per dollar of sales.

Asset Turnover

The asset turnover ratio (ATO) measures a firm's ability to generate revenues from a particular level of investment. ATO is calculated as follows:

Revenues

Average Total Assets

Best Buy

2002

2001

ATO

19597

6107.5

= 3.21

15327

3917.5

= 3.92

It appears that Best Buy’s fall in ROA was driven by a fall in ATO, not a fall in PM. The firm had difficulty generating sales from the assets in 2002 relative to 2001. For every dollar of average assets, Best Buy generated only $3.21 in sales in 2002 while Best Buy generated $3.92 in sales in 2001.

In order to gain even more insight into the source of the change in the ROA ratio, we can disaggregate the PM ratio and the ATO ratio to determine the source of the changes in those ratios.

Disaggregating the Profit Margin Ratio

To better understand why the profit margin ratio changed, the analyst can examine each income and expense item on the income statement as a percentage of revenue. This will provide insight into which components of the income statement changed over the period.

Best Buy

2002 2001

Cost of goods sold/sales 77.43% 80.04%

Selling, general and administrative expense/sales 17.82% 16.02%

Best Buy’s rise in profit margin in 2002 is due to

Review of Ratio Analysis

Ratio analysis is a useful tool for analyzing financial statements. Calculating ratios will aid in understanding the company’s strategy and in understanding its strengths and weaknesses relative to other companies and over time. They can sometimes be useful in identifying earnings management and in understanding the effect of accounting choices on the firm’s reported profitability and growth. Finally, the ratios help in obtaining a better understanding of a firm’s current profitability, growth, and risk which can improve forecasts of future profitability and growth and estimates of the cost of capital.

In reviewing the basic financial ratios, we will examine the ratios of Best Buy

Thus, the fall in ROA is not due to the reduction in income before financing costs per dollar of sales.

Asset Turnover

The asset turnover ratio (ATO) measures a firm's ability to generate revenues from a particular level of investment. ATO is calculated as follows:

Revenues

Average Total Assets

Best Buy

2002

2001

ATO

19597

6107.5

= 3.21

15327

3917.5

= 3.92

It appears that Best Buy’s fall in ROA was driven by a fall in ATO, not a fall in PM. The firm had difficulty generating sales from the assets in 2002 relative to 2001. For every dollar of average assets, Best Buy generated only $3.21 in sales in 2002 while Best Buy generated $3.92 in sales in 2001.

In order to gain even more insight into the source of the change in the ROA ratio, we can disaggregate the PM ratio and the ATO ratio to determine the source of the changes in those ratios.

Disaggregating the Profit Margin Ratio

To better understand why the profit margin ratio changed, the analyst can examine each income and expense item on the income statement as a percentage of revenue. This will provide insight into which components of the income statement changed over the period.

Best Buy

2002 2001

Cost of goods sold/sales 77.43% 80.04%

Selling, general and administrative expense/sales 17.82% 16.02%

Best Buy’s rise in profit margin in 2002 is due to

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