Analysis of Financial Statements

University Degree Business and Administrative studies

Analysis of Financial Statements

Many companies rely on business intelligence to provide visibility into the range of their business and financial operations. Financial statement analysis is appropriate if the company is a major customer of the corporation and it is normal for that business to request financial information. Financial analysis is the transformation of financial data into a form that can be used to monitor and evaluate the firm’s financial position to plan future financing and to designate the site of the firms’ rate and growth. Ration analysis is a form of financial statement analysis that is used to obtain an indication of a company’s financial performance. Throughout the analysis of financial statement simulation, there were five ratios discussed:

Leverage,
Efficiency,
Dupont System,
Liquidity, and
Profitability Ratio.

Ratio Analysis is based upon accounting information, and should only be used as a first step in financial analysis, to obtain a quick indication of a firm’s performance and to identify areas that need to be investigated further.

Leverage ratio

A leverage ratio is a term commonly used in finance and accounting to describe the ability of fixed costs to magnify returns to firm owners. For a manager the importance of the ratio analysis tool is to make two basic comparisons according to . First the manager can compare a present ratio with past or expected ratios for the organization to determine if there has been improvement or deterioration or no change over time. Second the manager can take the ratios of one organization or with industry averages at the same point in time, for example in the assimilation Panorama was assessing candidates for a joint venture with two companies, Lambda TV and Coral. This type of “benchmarking” so that one may determine whether the organization is “average” in performance or doing better or worse than others as stated by . .

Efficiency Ratio

The managers of Panorama have several variables to consider when determining the financial stability of an organization when looking for new business partners. Common indicators that are carefully analyzed are: turnover, liquidity, capital structure, overall coverage, and profitability. All of this assist in the decision making process that will determine financial leverage and how has the company efficiently used its resources. Combined this information provide answers to critical questions that arise surrounding organizational performance.

The information that is brought forth from financial ratios highlights the strengths of a company and possibly signals red flags ...

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Efficiency Ratio

The information that is brought forth from financial ratios highlights the strengths of a company and possibly signals red flags in others. Tracy Casteuble states, “financial ratios are most useful at establishing benchmark measures proven useful in clarifying and answering critical financial questions of organizations.”

The efficiency ratios measure how productively the firm is using its assets. As for the business manager of Panorama Inc, the focus is with making the best use of the company’s assets and being a low-cost producer within the television industry. The efficiency ratios rely heavily on information supported by both current and long-terms assets of a company. This is often presented within the common-size balance sheet. The efficiency ratio or the asset turnover ratio does present the efficient use of assets. The formula applied to this concept is sales divided by average total assets. The answer represents the sales to assets. The ratio received can be compared to production and service of other “like” companies. It is here where managers of Panorama can get a picture of how capital is being used or the ratio of sales to net working capital.

In the samples presented by Stuart Mason, this information is captured in the liquidity area. Here the asset turnover (sales/total assets) for both Lambda TV and Coral for 2000,2001, and 2002 has been presented for review. In addition, industry averages were also listed for even comparison. Both consulting firms listed this information.

The efficiency ratio also takes into account the average collection period (average receivables/average daily sales) and inventory turnover (cost of goods sold/average inventory). This was an important measurement tool. Panorama desires to partner with a company that has sales growth, significant return on investment (ROI), good corporate structure, and adequate debt/equity management. It is equally important that Panorama partners with a company that has strengths that mirror their own. This will include control over inventory and cash collection.

The DuPont System

The Dupont system of financial analysis merges information found on the income and balance sheets in their efforts to measure profitability. These financial statements are primarily used to determine the profitability of a company. This involves the use of: operating profit margin ratios, asset turnover ratios (efficiency ratio), and equity multipliers. This aids in the effort to get a complete picture of operating efficiency and how well are assets utilized. This asset turnover ratio (efficiency ratio) looks at gross revenue divided by the average of a company’s assets.

The points of focus utilized in the DuPont System are a company’s return on assets and return on equity. This system uses three financial ratios: operating profit margin ratio, asset turnover ratio (efficiency ratio), and the equity multiplier. As these ratios are used the DuPont system users are better able to determine the efficiency of an organization and how well are their assets organized.

The ratios also serve as great resources to determine weaknesses in productivity or show significant gains within profit margins. They allow users to pinpoint areas of interest found in asset management, expense control, production, or marketing. The manager at Panorama needs to see key signs that the operating management system is going well. They should look at the net income divided by the sales (or total revenue) to understand the full picture. When attention is paid to asset management practices the manager would look at sales (total revenue) divided by total assets. In addition, the area that you would review in determining the level of success associated with equity distribution would be determined by measuring total assets divided by total equity.

The DuPont system does allow a skilled manager to look at critical areas when challenged to compare “like” partnerships. You are able to determine the return on equity and whether or not asset management is strong. Sound business decisions can be made as these ratios are used to mark a company’s financial condition. This is an excellent way to determine strengths and weaknesses.

Liquidity Ratio

It is essential for Panaroma, Inc.,the measuring of the cash flows over the time, to be aware of the liquid resources available to afford the obligations. The most used liquidity ratios are: current ratio and acid test ratio. These would examine the relationship between liquid resources held and creditors due for payment in the near future.

The current ration shows the size of the relationship between current assets (cash and assets which would become cash in a short time) and current liabilities (creditors falling due within one year), enhancing the comparability between the two firms, Coral and Lambda TV. The result of the division expresses the times that the current assets would cover the current liabilities. The Acid Test ratio is another reflection of the liquiditiy of Panaroma. It tells you if the business could meet its current obligations with quickly convertible assets. To calculate it, the manager should take the current assets, subtract the stock or inventory and divide the result by the current liabilities. The liquidity ratio, both, current and quick ratios only provide an estimate of Panaroma’s liquidity. They are not accurate enough to be used to predict whether or not the company is capable of paying the liabilities.

Profitability Ratio

Profitability ratios are measures of performance showing how much the firm is earning compared to its sales, assets or equity.

References

Casteuble, T. Using Financial Ratios to Assess Performance. Association Management. Washington: Jul 1997.Vo.49, Iss7; pg 29. As taken from Proquest.

http://www.aecottu.edu/courses/4316/lecture/notes.Dupont.htm.