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Lecture 5: Financial Ratios


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Lecture 5: Financial Ratios

  1. 1. Mgt 455 – Summer, 09 Craig S. Galbraith Presentation derived in part from original material developed by Craig Galbraith and various presentations from Alan Barefield, University of Tennessee
  2. 2. <ul><li>Number one reason for business failure (particularly small business) is not understanding financial statements </li></ul><ul><li>Need to know financial statements in order to track and predict success </li></ul><ul><li>Need to develop pro-formas for business plans </li></ul><ul><li>Need to analyze financial performance for valuation </li></ul>
  3. 3. <ul><li>Projection of future financial condition </li></ul><ul><li>3 to 5 year projection </li></ul><ul><ul><li>Why only 3 to 5 year? </li></ul></ul><ul><li>Key issues in pro-forma are </li></ul><ul><ul><li>Consistency with underlying business plan </li></ul></ul><ul><ul><li>Consistency with accounting formats </li></ul></ul><ul><ul><li>Sources for line items </li></ul></ul><ul><ul><li>Assumptions for line items </li></ul></ul><ul><li>Underlying analysis is critical </li></ul><ul><li>Be reasonable </li></ul>
  4. 4. <ul><li>Income or Profit & Loss Statement </li></ul><ul><li>Balance Sheet </li></ul><ul><li>Cash Flow Statement </li></ul><ul><li>Budget Forecast </li></ul>
  5. 5. <ul><li>Provides a summary of the revenues and expenses associated with the period’s operating activities </li></ul><ul><li>Provide information to complete the business and personal income tax returns </li></ul><ul><li>Shows the profitability of the business for lenders and other interested parties </li></ul>
  6. 6. <ul><li>The income or profit and loss statement summarizes the level of revenue and expenses for the business </li></ul><ul><li>Major components include: </li></ul><ul><ul><li>Revenues </li></ul></ul><ul><ul><li>Expenses </li></ul></ul><ul><ul><li>Taxes </li></ul></ul><ul><ul><li>Extraordinary Items </li></ul></ul>
  7. 7. <ul><li>Summarizes the levels of cash that the business has available to meet current obligations </li></ul><ul><li>Generally divided into monthly or quarterly periods to show when excess cash is available or when borrowing needs to occur </li></ul>
  8. 8. <ul><li>Highlights the financing arrangements necessary to cover cash requirements </li></ul><ul><li>Serves as a benchmark for budgeting activities </li></ul><ul><li>Analyzes the timing of financial borrowing activities </li></ul>
  9. 9. <ul><li>Details the financial position of a business at a particular point in time </li></ul><ul><li>Assets = Liabilities + Equity </li></ul><ul><li>Tells the reader what the business owns of monetary value and what the business owes to others . </li></ul><ul><li>Personal and business assets and liabilities are frequently reflected on the same statement </li></ul>
  10. 10. <ul><li>The balance sheet indicates the degree to which the business is liquid and solvent </li></ul><ul><li>Liquidity – Can the business’ current liabilities be retired if the current assets are converted to cash? </li></ul><ul><li>Solvency – Can the total liabilities of the business be retired if all assets are converted to cash? </li></ul>
  11. 11. <ul><li>Assets </li></ul><ul><ul><li>Current Assets </li></ul></ul><ul><ul><li>Intermediate Assets </li></ul></ul><ul><ul><li>Long-term Assets </li></ul></ul><ul><li>Liabilities </li></ul><ul><ul><li>Current Liabilities </li></ul></ul><ul><ul><li>Intermediate Liabilities </li></ul></ul><ul><ul><li>Long-term Liabilities </li></ul></ul><ul><li>Net Worth </li></ul>
  12. 12. <ul><li>Many persons assert that the budget is simply a projection of the cash flow statement </li></ul><ul><li>However this is not correct </li></ul><ul><li>The budget must incorporate all key financial statements </li></ul><ul><li>Forecasting statements are also called pro forma statements </li></ul>
  13. 13. <ul><li>Expected selling prices </li></ul><ul><li>Expected input prices </li></ul><ul><li>Expected input productivity </li></ul><ul><li>Pro forma operating budget </li></ul><ul><ul><li>Production costs and sales objectives </li></ul></ul><ul><li>Pro forma financial budget </li></ul><ul><ul><li>Cash receipts and disbursements </li></ul></ul><ul><li>Family living budgets </li></ul>
  14. 14. <ul><li>Ratio analysis </li></ul><ul><ul><li>Alleviates the unit of measure problems incurred when comparing raw numbers </li></ul></ul><ul><ul><li>Four different types of ratios can be examined </li></ul></ul><ul><ul><ul><li>Liquidity ratios – can current debts be met </li></ul></ul></ul><ul><ul><ul><li>Solvency ratios – can all debts be met </li></ul></ul></ul><ul><ul><ul><li>Efficiency ratios – how efficient is the operation </li></ul></ul></ul><ul><ul><ul><li>Profitability ratios – how profitable is the operation </li></ul></ul></ul>
  15. 15. <ul><li>Ratios don’t mean anything by themselves </li></ul><ul><li>They must be compared over time and with similar companies </li></ul><ul><li>Look at industry standards through trade magazines, Standard & Poore’s, RMA analysis, etc. </li></ul>