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7400 Words Dec 23rd, 2012 30 Pages
Chapter 4

Analysis of Financial Statements

Learning Objectives

After reading this chapter, students should be able to:

◆ Explain what ratio analysis is.

◆ List the five groups of ratios and identify, calculate, and interpret the key ratios in each group. In addition, discuss each ratio’s relationship to the balance sheet and income statement.

◆ Discuss why ROE is the key ratio under management’s control, how the other ratios affect ROE, and explain how to use the DuPont equation to see how the ROE can be improved.

◆ Compare a firm’s ratios with those of other firms (benchmarking) and analyze a given firm’s ratios over time (trend analysis).

◆ Discuss the tendency of ratios to fluctuate over time, which
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4-4 Differences in the amounts of assets necessary to generate a dollar of sales cause asset turnover ratios to vary among industries. For example, a steel company needs a greater number of dollars in assets to produce a dollar in sales than does a grocery store chain. Also, profit margins and turnover ratios may vary due to differences in the amount of expenses incurred to produce sales. For example, one would expect a grocery store chain to spend more per dollar of sales than does a steel company. Often, a large turnover will be associated with a low profit margin, and vice versa.

4-5 Inflation will cause earnings to increase, even if there is no increase in sales volume. Yet, the book value of the assets that produced the sales and the annual depreciation expense remain at historic values and do not reflect the actual cost of replacing those assets. Thus, ratios that compare current flows with historic values become distorted over time. For example, ROA will increase even though those assets are generating the same sales volume. When comparing different companies, the age of the assets will greatly affect the ratios. Companies with assets that were purchased earlier will reflect lower asset values than those that purchased assets later at inflated prices. Two firms with similar physical assets and sales could have significantly different ROAs. Under inflation, ratios will also reflect differences in the way firms treat inventories. As

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