MANAGERIAL FINANCE Retained earnings - The cumulative total of all

earnings, net of dividends that have been

DEFINITION OF TERMS: retained and reinvested in the firm since its
inception.
CHAPTER 3 – FINANCIAL STATEMENTS AND
RATIO ANALYSIS Statement of cash flows - Provides a summary of the
firm’s operating, investment, and financing cash flows
Generally accepted accounting principles (GAAP) - The and reconciles them with changes in its cash and
practice and procedure guidelines used to prepare and marketable securities during the period.
maintain financial records and reports; authorized by
the Financial Accounting Standards Board (FASB). Notes to the financial statements - Explanatory notes
keyed to relevant accounts in the statements; they
Financial Accounting Standards Board (FASB) - The provide detailed information on the accounting policies,
accounting profession’s rule-setting body, which procedures, calculations, and transactions underlying
authorizes generally accepted accounting principles entries in the financial statements.
(GAAP)
CONSOLIDATING INTERNATIONAL FINANCIAL
Public Company Accounting Oversight Board (PCAOB) - STATEMENTS
A not-for-profit corporation established by the
Sarbanes-Oxley Act of 2002 to protect the interests of Financial Accounting Standards Board (FASB) Standard
investors and further the public interest in the No. 52 - Mandates that U.S.–based companies translate
preparation of informative, fair, and independent audit their foreign-currency-denominated assets and
reports. liabilities into dollars, for consolidation with the parent
company’s financial statements. This is done by using
THE STOCKHOLDERS’ REPORT the current rate (translation) method.
Stockholders’ report - Annual report that publicly Current rate (translation) method - Technique
owned corporations must provide to stockholders; it used by U.S.–based companies to translate their
summarizes and documents the firm’s financial foreign-currency-denominated assets and
activities during the past year. liabilities into dollars, for consolidation with the
parent company’s financial statements, using
Letter to stockholders - Typically, the first element of
the year-end (current) exchange rate.
the annual stockholders’ report and the primary
communication from management. USING FINANCIAL RATIOS
THE FOUR KEY FINANCIAL STATEMENTS Ratio analysis - Involves methods of calculating and
interpreting financial ratios to analyze and monitor the
Income statement - Provides a financial summary of the
firm’s performance.
firm’s operating results during a specified period.
TYPES OF RATIO COMPARISONS
Dividend per share (DPS) - The dollar amount of
cash distributed during the period on behalf of Cross-sectional analysis - Comparison of different firms’
each outstanding share of common stock. financial ratios at the same point in time; involves
comparing the firm’s ratios to those of other firms in its
Balance sheet - Summary statement of the firm’s
industry or to industry averages.
financial position at a given point in time.
Benchmarking - A type of cross-sectional
Statement of stockholders’ equity - Shows all equity
analysis in which the firm’s ratio values are
account transactions that occurred during a given year.
compared to those of a key competitor or group
Statement of retained earnings - Reconciles the net of competitors that it wishes to emulate.
income earned during a given year, and any cash
Time-series analysis - Evaluation of the firm’s financial
dividends paid, with the change in retained earnings
performance over time using financial ratio analysis.
between the start and the end of that year. An
abbreviated form of the statement of stockholders’ Combined Analysis - The most informative approach to
equity. ratio analysis combines cross-sectional and time-series
analyses. A combined view makes it possible to assess Times interest earned ratio - Measures the firm’s ability
the trend in the behavior of the ratio in relation to the to make contractual interest payments; sometimes
trend for the industry. called the interest coverage ratio.

CATEGORIES OF FINANCIAL RATIOS Fixed-payment coverage ratio - Measures the firm’s

ability to meet all fixed-payment obligations.
LIQUIDITY RATIOS
PROFITABILITY RATIOS
Liquidity - A firm’s ability to satisfy its short-term
obligations as they come due. Common-size income statement - An income
statement in which each item is expressed as a
Current ratio - A measure of liquidity calculated by percentage of sales.
dividing the firm’s current assets by its current
liabilities. Gross profit margin - Measures the percentage of each
sales dollar remaining after the firm has paid for its
Quick (acid-test) ratio - A measure of liquidity goods.
calculated by dividing the firm’s current assets minus
inventory by its current liabilities. Operating profit margin - Measures the percentage of
each sales dollar remaining after all costs and expenses
ACTIVITY RATIOS other than interest, taxes, and preferred stock
dividends are deducted; the “pure profits” earned on
Activity ratios - Measure the speed with which various
each sales dollar.
accounts are converted into sales or cash—inflows or
outflows. Net profit margin - Measures the percentage of each
sales dollar remaining after all costs and expenses,
Inventory turnover - Measures the activity, or liquidity,
including interest, taxes, and preferred stock dividends,
of a firm’s inventory.
have been deducted.
Average age of inventory - Average number of
Return on total assets (ROA) - Measures the overall
days’ sales in inventory.
effectiveness of management in generating profits with
Average collection period - The average amount of time its available assets; also called the return on investment
needed to collect accounts receivable. (ROI).

Average payment period - The average amount of time Return on common equity (ROE) - Measures the return
needed to pay accounts payable. earned on the common stockholders’ investment in the
firm.
Total asset turnover - Indicates the efficiency with
which the firm uses its assets to generate sales. MARKET RATIOS

DEBT RATIOS Market ratios - Relate a firm’s market value, as

measured by its current share price, to certain
Financial leverage - The magnification of risk and return accounting values.
through the use of fixed cost financing, such as debt and
preferred stock. Price/earnings (P/E) ratio - Measures the amount that
investors are willing to pay for each dollar of a firm’s
Degree of indebtedness - Measures the amount of debt earnings; the higher the P/E ratio, the greater the
relative to other significant balance sheet amounts. investor confidence.

Ability to service debts - The ability of a firm to make Market/book (M/B) ratio - Provides an assessment of
the payments required on a scheduled basis over the how investors view the firm’s performance. Firms
life of a debt. expected to earn high returns relative to their risk
typically sell at higher M/B multiples.
Coverage ratios - Ratios that measure the firm’s ability
to pay certain fixed charges.

Debt ratio - Measures the proportion of total assets

financed by the firm’s creditors.
DUPONT SYSTEM OF ANALYSIS

DuPont system of analysis - System used to dissect the

firm’s financial statements and to assess its financial
condition.

DuPont formula - Multiplies the firm’s net profit margin

by its total asset turnover to calculate the firm’s return
on total assets (ROA).

Modified DuPont formula - Relates the firm’s return on

total assets (ROA) to its return on common equity (ROE)
using the financial leverage multiplier (FLM).

Financial leverage multiplier (FLM) - The ratio of the

firm’s total assets to its common stock equity.
SUMMARY: receivable by the average collection period and that of
accounts payable by the average payment period. Total
FOCUS ON VALUE asset turnover measures the efficiency with which the
firm uses its assets to generate sales.
Financial managers review and analyze the firm’s
financial statements periodically, both to uncover LG4. Discuss the relationship between debt and
developing problems and to assess the firm’s progress financial leverage and the ratios used to analyze a
toward achieving its goals. These actions are aimed at firm’s debt.
preserving and creating value for the firm’s owners.
Financial ratios enable financial managers to monitor The more debt a firm uses, the greater its financial
the pulse of the firm and its progress toward its leverage, which magnifies both risk and return.
strategic goals. Although financial statements and Financial debt ratios measure both the degree of
financial ratios rely on accrual concepts, they can indebtedness and the ability to service debts. A
provide useful insights into important aspects of risk common measure of indebtedness is the debt ratio. The
and return (cash flow) that affect share price. ability to pay fixed charges can be measured by times
interest earned and fixed-payment coverage ratios.
REVIEW OF LEARNING GOALS
LG5. Use ratios to analyze a firm’s profitability and its
LG1. Review the contents of the stockholders’ report market value.
and the procedures for consolidating international
financial statements. The common-size income statement, which shows each
item as a percentage of sales, can be used to determine
The annual stockholders’ report, which publicly owned gross profit margin, operating profit margin, and net
corporations must provide to stockholders, documents profit margin. Other measures of profitability include
the firm’s financial activities of the past year. It includes earnings per share, return on total assets, and return on
the letter to stockholders and various subjective and common equity. Market ratios include the
factual information. It also contains four key financial price/earnings ratio and the market/book ratio.
statements: the income statement, the balance sheet,
and the statement of stockholders’ equity (or its LG6. Use a summary of financial ratios and the DuPont
abbreviated form, the statement of retained earnings), system of analysis to perform a complete ratio
and the statement of cash flows. Notes describing the analysis.
technical aspects of the financial statements follow.
A summary of all ratios can be used to perform a
Financial statements of companies that have operations
complete ratio analysis using cross-sectional and time-
whose cash flows are denominated in one or more
series analysis. The DuPont system of analysis is a
foreign currencies must be translated into dollars in
diagnostic tool used to find the key areas responsible
accordance with FASB Standard No. 52.
for the firm’s financial performance. It enables the firm
LG2. Understand who uses financial ratios and how. to break the return on common equity into three
components: profit on sales, efficiency of asset use, and
Ratio analysis enables stockholders, lenders, and the use of financial leverage.
firm’s managers to evaluate the firm’s financial
performance. It can be performed on a cross-sectional
or a time-series basis. Benchmarking is a popular type of
cross-sectional analysis. Users of ratios should
understand the cautions that apply to their use.

LG3. Use ratios to analyze a firm’s liquidity and

activity.

Liquidity, or the ability of the firm to pay its bills as they

come due, can be measured by the current ratio and
the quick (acid-test) ratio. Activity ratios measure the
speed with which accounts are converted into sales or
cash—inflows or outflows. The activity of inventory can
be measured by its turnover: that of accounts