MANAGEMENT DECISIONS AND FINANCIAL ACCOUNTING REPORTS Baginski & Hassell Electronic presentation adaptation by Dr. Barbara...
MODULE A FINANCIAL STATEMENTS AND EXTERNAL DECISION MAKING
Overview:  Financial Statements and External Decision Making <ul><li>Topics </li></ul><ul><ul><li>Financial statements ref...
<ul><ul><li>Ratio calculations are used to help understand profitability and risk. </li></ul></ul><ul><ul><li>External dec...
Ratios Used to Assess Profitability <ul><li>Return on assets (ROA):   General assessment of profitability (all capital pro...
<ul><li>Return on Common Equity (ROCE):   Assessment of profitability from the viewpoint of  common stockholders </li></ul...
Return on Assets (ROA) where, “t” = the effective (or statutory) tax rate Average total assets Net income + Interest expen...
Return on Common Stockholders’ Equity (ROCE) Average Common Stockholders’ Equity Net Income – Dividends on Preferred Stock...
Decomposition of ROCE ROA     Common earnings leverage ratio    Capital structure leverage ratio ROCE =   ROCE subcompon...
Average common stockholders’ equity Average total assets The capital structure leverage ratio captures the positive effect...
How ROCE Components Combine Average common stockholders’ equity Net income + [interest expense     (1–t)] Average total a...
<ul><li>NOTE:   On the previous slide, the denominator in ROA cancels the numerator in the capital structure leverage rati...
Reduced ROCE Formula Average common stockholders’ equity Net income – preferred stock dividends The final reduced form ROC...
Decomposition of ROA sales Net income + [interest expense  x  (1-t)] Net profit margin ratio  = The  net profit margin rat...
As with all targets, financial and otherwise, analysts and decision makers should  state in advance exactly what they are ...
Sales Average total assets Asset turnover ratio  = The  asset turnover ratio  measures the ratio of sales per average doll...
How ROA Components Combine Sales Net income + [interest expense     (1-t)]   Average total assets Sales Asset Turnover R...
Analysis of Risk <ul><li>Three major future-oriented risks  assessed by external decisions makers: </li></ul><ul><ul><li>F...
<ul><li>GAAP-based financial statements are used to assess two types of risk: </li></ul><ul><ul><li>Short-term liquidity r...
Short-Term Liquidity Risks WC = CA - CL Working capital:  The excess (deficit) of current assets minus current liabilities.
Rule of thumb for minimum current ratio is 2:1 CA / CL Current Ratio  = The  current ratio  shows the amount of current as...
Current liabilities Marketable securities  + Accounts receivable Quick Ratio = Cash  + The  quick ratio  shows the amount ...
Cost of goods sold Average inventory Inventory Turnover   Ratio   = Sales Average accounts receivable Accounts Receivable ...
Cash flow from operations Average current liabilities Cash Flow from Operations to Current Liabilities Ratio   = Purchases...
Long-Term Solvency Risk Long-term debt Total assets Long-term Debt to Total Assets Ratio   = Long-term debt Shareholders’ ...
In general, bankers should not earn more than owners! *Interest coverage ratio often is labeled  times interest earned (so...
Operating cash flow Capital expenditures Operating Cash Flow to Capital Expenditures  =  Ratio   Operating cash flow Avera...
Usefulness of Ratios in  Predicting the Future <ul><li>External users, particularly financial analysts, use ratios  to hel...
<ul><li>In addition to ratios, individuals trying to explain and predict should study: </li></ul><ul><ul><li>Industry cond...
Industry Conditions <ul><li>GAAP-based financial statements provide little information about industry conditions, such as:...
Firm Competitive Strategy <ul><li>GAAP-based financial statements provide little information about industry conditions, su...
Accounting Quality <ul><li>Accounting quality   includes  general characteristics of information  that enable external dec...
<ul><li>Accounting quality comes from ...  </li></ul><ul><ul><li>Truthful reporting (lack of earnings manipulation) </li><...
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Module A

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

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