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MANAGEMENT DECISIONS AND FINANCIAL
ACCOUNTING REPORTSBaginski & Hassell
Electronic presentation adaptation byDr. Barbara L. Hassell & Dr. Harold O. Wilson
MODULE A
FINANCIAL STATEMENTS AND EXTERNAL
DECISION MAKING
Overview: Financial Statements and External Decision Making
• Topics– Financial statements reflect the
aggregate outcomes of many managerial decisions.
– External decision makers use financial statements to make assessments of profitability and risk.
– Ratio calculations are used to help understand profitability and risk.
– External decision makers also assess the accounting quality reflected in a firm’s financial statements.
Ratios Used to Assess Profitability
• Return on assets (ROA): General assessment of profitability (all capital providers point of view)– 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.
• Return on Common Equity (ROCE): Assessment of profitability from the viewpoint of common stockholders– ROCE assesses net profitability, after
preferred dividends, per dollar of common stockholders’ investment
• Earnings Per Share (EPS)– Reflects net income, after preferred dividends,
available to an average common share of stock
The topic of EPS is discussed later in the text.
Return on Assets (ROA)
ROA =Net income + Interest expense, net of income taxes
Average total assets
ROA =Net income + Interest expense (1-t)
Average total assets
where, “t” = the effective (or statutory) tax rate
Return on Common Stockholders’ Equity (ROCE)
ROCE =
Net Income – Dividends on Preferred Stock
Average Common Stockholders’ Equity
Decomposition of ROCE
ROCE subcomponents: ROA, common earnings leverage ratio, and capital structure leverage ratio
ROCE =
ROA Common earnings leverage ratio Capital structure leverage ratio
The common earnings leverage ratio captures the negative effects of capital structure on ROCE:
Net income – Preferred dividends
Net income + (1-t) Interest expense
The capital structure leverage ratio captures the positive effect of leverage on ROCE:
Average total assets
Average common stockholders’ equity
How ROCE Components Combine
ROCE =
ROACommon Earnings Leverage Ratio
Capital Structure Leverage Ratio
Net income + [interest expense
(1-t) ]
Net income – preferred stock dividends
Average total assets
Average total assets Net income +
[interest expense (1–t)]
Average common stockholders’ equity
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).
Got it?
Reduced ROCE Formula
The final reduced form ROCE formula is:
ROCE =
Net income – preferred stock dividends
Average common stockholders’ equity
Decomposition of ROA
ROA subcomponents: Net profit margin ratio and asset turnover ratio.
The net profit margin ratio measures the prefinancing income per dollar of sales.
Net profit margin ratio =
Net income + [interest expense x (1-t)]
sales
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!
The asset turnover ratio measures the ratio of sales per average dollar invested in net assets.
Asset turnover ratio =
Sales
Average total assets
How ROA Components Combine
ROA =
Net Profit Margin Ratio Asset Turnover Ratio
Net income + [interest expense (1-t)]
Sales
Sales Average total assets
Analysis of Risk• Three major future-oriented risks assessed
by external decisions makers:– Firm risks– Industry risks– General economic risks
• Generally, GAAP-based financial statements do not do a good job in helping assess these risks.
• GAAP-based financial statements are used to assess two types of risk:
– Short-term liquidity risks
– Long-term solvency risks
Short-Term Liquidity Risks
Working capital: The excess (deficit) of current assets minus current liabilities.
WC = CA - CL
The current ratio shows the amount of current assets per dollar of current liabilities.
Current Ratio = CA / CL
Rule of thumb for minimum current ratio is 2:1
The quick ratio shows the amount of quick assets, cash plus marketable securities plus accounts receivable, per dollar of current liabilities
Quick Ratio =
Cash +Marketable securities +
Accounts receivable
Current liabilities
Activity ratios measure the speed at which current assets turn into cash inflows and current liabilities turn into cash outflows.
Accounts Receivable Turnover Ratio =
Sales
Average accounts receivable
Inventory Turnover Ratio =
Cost of goods sold
Average inventory
Accounts Payable Turnover Ratio =
Purchases
Average accounts payable
Cash Flow from Operations to Current Liabilities Ratio =
Cash flow from operations
Average current liabilities
Long-Term Solvency Risk
Several ratios are used to assess a company’s ability to service current debt requirements, i.e., to remain a going concern!
Long-term Debt to Equity Ratio =
Long-term debt
Shareholders’ equity
Long-term Debt to Total Assets Ratio =
Long-term debt
Total assets
Interest Coverage Ratio* =
Income before income taxes + Interest expense
Interest expense
*Interest coverage ratio often is labeled times interest earned (sometimes, “the thin ice” ratio).
In general, bankers should not earn more than owners!
Operating Cash Flow to Total Liabilities Ratio =
Operating cash flow
Average total liabilities
Operating Cash Flow to Capital Expenditures = Ratio
Operating cash flow
Capital expenditures
Usefulness of Ratios in Predicting the Future
• External users, particularly financial analysts, use ratios to help explain the present and to predict the future.– Why are ratios at their current levels?– Will the ratios continue at this level? – If not, how & why will they change?
• In addition to ratios, individuals trying to explain and predict should study:– Industry conditions– Firm’s competitive strategy– Accounting quality
Compared to WHAT?
Industry Conditions• GAAP-based financial statements provide little
information about industry conditions, such as:– Industry growth rate– Firm concentration– Product differentiation– Scale economies– Cyclicality and exit barriers– Legal barriers to entry– Relative bargaining power of buyers and
suppliers and access to distribution channels
Firm Competitive Strategy
• GAAP-based financial statements provide little information about industry conditions, such as:– Cost leadership versus product differentiation– Demonstration of acquisition of unique core
competencies and value chain
Accounting Quality
• Accounting quality includes general characteristics of information that enable external decision-makers to assess and predict sustainability of current financial characteristics.
• Accounting quality comes from ... – Truthful reporting (lack of earnings
manipulation)– Persistence of earnings– Adequate disclosure– Using conservative assumptions in applying
GAAP• GAAP-based financial statements are useful
in assessing these characteristics, particularly adequate disclosure and degree of conservatism in assumptions.
End of Module A