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Questions and Answers
What is the primary purpose of computing financial ratios in financial analysis?
Which of the following is NOT a use of financial ratios within a firm?
What type of analysis involves comparing a firm's financial ratios with those of its industry leaders?
Which of the following users of financial ratios is most concerned with a firm's creditworthiness?
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What is the primary advantage of using financial ratios in financial analysis?
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What is the term for the relationship between two numbers, often used in financial analysis?
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What is the primary concern of a supplier when deciding whether to extend credit to a company?
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What does a liquid asset enable a company to do?
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What do liquidity measures indicate about a company?
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What is one of the key questions that financial ratios can help answer?
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What is the primary purpose of measuring key financial relationships?
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What do market-value ratios indicate about a company's management?
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What does a Price/Earnings Ratio of $26.22 for Walmart indicate?
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What does a Price/Book Ratio of 3.27X for Walmart indicate?
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Why is it challenging to conduct financial ratio analysis across different firms?
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What is a limitation of using published peer group or industry averages in financial ratio analysis?
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What does a comparison of Walmart's and Target's Price/Earnings Ratios indicate?
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Study Notes
Measuring Key Financial Relationships
- Five questions can be answered by using ratios:
- How liquid is the firm?
- Are the firm’s managers generating adequate operating profits on the company’s assets?
- How is the firm financing its assets?
- Are the firm’s managers providing a good return on the capital provided by the shareholders?
- Are the firm’s managers creating shareholder value?
Liquidity Measures
- A liquid asset can be converted quickly into cash at the current market price.
- Liquidity measures the firm’s ability to pay its bills on time.
- It indicates the ease with which non-cash assets can be converted to cash to meet financial obligations.
Financial Analysis
- Financial analysis using ratios is a popular way to analyze financial statements.
- A ratio is a relationship between two numbers (e.g., A:B = 30:10 means A is 3 times B).
- Financial ratios provide two ways of making meaningful comparisons of a firm's financial data:
- Ratios examined over time (comparing previous years to the current year).
- Ratios compared to that of other firms or leaders in the same industry.
Uses of Financial Ratios
- Within the firm:
- Identify deficiencies in a firm’s performance and take corrective action.
- Evaluate employee performance and determine incentive compensation.
- Compare the financial performance of the firm’s different divisions.
- Prepare financial projections at both firm and division levels.
- Understand the financial performance of the firm’s competitors.
- Evaluate the financial condition of a major supplier.
- Some users of financial ratios:
- Lenders in deciding whether to lend to a company.
- Credit-rating agencies in determining a firm’s creditworthiness.
- Investors (shareholders and bondholders) in deciding whether to invest in a company.
Market-Value Ratios
- Market-value ratios indicate what investors think of management’s past performance and prospects.
- Price/Earnings (P/E) Ratio:
- Measures how much investors are willing to pay for $1 of reported earnings.
- Example: investors are willing to pay more for Walmart for every dollar of earnings per share compared to Target ($26.22 for Walmart versus $14.07 for Target).
- Price/Book Ratio:
- Compares the market value of a share of stock to the book value per share of the reported equity on the balance sheet.
- A ratio greater than 1 indicates that the shares are more valuable than what the shareholders originally paid.
- Example: Walmart ratio of 3.27X is lower than Target ratio of 3.53X, suggesting that Target is perceived as having better growth prospects relative to its risk.
Limitations of Financial Ratio Analysis
- It is sometimes difficult to identify the industry to which a firm belongs or determine comparable peers.
- The published peer group or industry averages are only approximations.
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Description
This quiz covers the concepts of financial analysis, including the use of ratios to evaluate a firm's financial performance, as discussed in the 10th edition of Foundations of Finance, Global Edition.
