Finance Chapter 4: Evaluating a Firm's Financial Performance

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Questions and Answers

What is the primary purpose of computing financial ratios in financial analysis?

To evaluate the financial performance of a firm over time

To determine the creditworthiness of a potential lender

To compare a firm's financial data with that of its industry leaders

To identify deficiencies in a firm's performance and take corrective action (correct)

Which of the following is NOT a use of financial ratios within a firm?

Preparing financial projections at the firm and division levels

Determining the optimal capital structure of a firm (correct)

Evaluating employee performance and determining incentive compensation

Comparing the financial performance of different divisions

What type of analysis involves comparing a firm's financial ratios with those of its industry leaders?

Horizontal analysis

Inter-firm comparison (correct)

Vertical analysis

Trend analysis

Which of the following users of financial ratios is most concerned with a firm's creditworthiness?

Credit-rating agencies Signup and view all the answers

What is the primary advantage of using financial ratios in financial analysis?

They enable the comparison of a firm's financial performance with that of its industry leaders Signup and view all the answers

What is the term for the relationship between two numbers, often used in financial analysis?

Ratio Signup and view all the answers

What is the primary concern of a supplier when deciding whether to extend credit to a company?

The firm's ability to pay its bills on time Signup and view all the answers

What does a liquid asset enable a company to do?

Convert quickly into cash at the current market price Signup and view all the answers

What do liquidity measures indicate about a company?

The ease with which noncash assets can be converted to cash to meet financial obligations Signup and view all the answers

What is one of the key questions that financial ratios can help answer?

How is the firm financing its assets? Signup and view all the answers

What is the primary purpose of measuring key financial relationships?

To answer key questions about the firm's financial performance Signup and view all the answers

What do market-value ratios indicate about a company's management?

Their performance in creating or destroying shareholder value Signup and view all the answers

What does a Price/Earnings Ratio of $26.22 for Walmart indicate?

Investors are willing to pay more for Walmart's shares because of its growth prospects Signup and view all the answers

What does a Price/Book Ratio of 3.27X for Walmart indicate?

Walmart's shares are more valuable than what shareholders originally paid Signup and view all the answers

Why is it challenging to conduct financial ratio analysis across different firms?

It is difficult to identify a firm's industry or determine comparable peers Signup and view all the answers

What is a limitation of using published peer group or industry averages in financial ratio analysis?

They are only approximations and may not reflect the company's actual performance Signup and view all the answers

What does a comparison of Walmart's and Target's Price/Earnings Ratios indicate?

Investors are willing to pay more for every dollar of earnings from Walmart compared to Target Signup and view all the answers

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.