Financial analysts generally use two criteria in evaluating the reasonableness of a financial ratio. One criterion is the trend in the ratio over a period of years. By reviewing this trend, analysts are able to determine whether a company’s performance or financial position is improving or deteriorating.
Second;analysts often compare a company’s financial ratios with those of similar companies and with industry-wide averages. These comparisons assist analysts in evaluating a particular ratio in light of the company’s current business environment.
Annual Reports Publicly owned corporations issue annual reports that provide a great deal of information about the company. For example, annual reports include comparative financial statements that have been audited by a tirm of independent public accountants.
They also include five- or ten-year summaries of key financial data, and management’e discussion and analysis of the company’s operating results. liquidity. and financial position. This is where management identifies and discusses favorable and unfavorable trends and events that may affect the company in the future. (For example. see Appendix A where you will find the management discussion in the Toys “R” Us annual Annual reports are mailed directly to all stockholders of the corporation.
They are also available to the public either through the Internet. in libraries. or by writing or calling the Stockholder Relations Department of the corporation. Industry Information Financial information about entire industries is available through financial publications (such as Dun & Bradstreet, Inc.), and through on-line databases (such as Media General Financial Services). Such information allows investors and creditors to compare the financial health of an individual company with the industry in which that company operates.
Usehilness and limitations of Financial Ratios A financial ratio expresses the relationship of one amount to another. Most users of financial statements find that certain .ratios assist them in quickly evaluating the financial position, profitability, and future prospects of a business. A comparison of key ratios for several successive yea~s usually indicates whether the business is becoming stronger or weaker. Ratios also provide a way to compare quickly the financial strength and profitability of different cbmpanies.
Users of financial statements should recognize, however, that ratios have several limitations. For example, management may enter into year-end transactions that temporarily improve key ratios~a process called window dressing. To illustrate, the balance sheet of Computer Barn (page 618) includes current .assets of $180,000 and current liabilities of $100,000, indicating a current ratio of 1.8 to 1.
What would happen if shortly before year-end, management used $20,000 of the com-pany’s cash to pay accounts payable? This transaction would reduce current assets to . $160,000 and current liabilities to $80,000. However, it would also increase the company’s
year-end current ratio to a more impressive 2 to. /($160,000 ~ $80,000).
Financial statement ratios contain the same limitations as do the dollar amounts used in financial statements. For example, ‘most assets are reported at historical cost rather than current market value. Also, financial statement ratios express only financial relationships. They give no indication of a company’s progress. in achieving non financial goals, such as improving customer satisfaction or worker productivity.
A thorough analysis of investment opportunities involves more than merely computing and comparing financial ratios..No Ratio Ever Tells the Whole Story Each financial ratio. focuses on only one aspect of a company’s total financial picture. A high current ratio, for example. does not guarantee solvency, nor does a low current ratio signal that bankruptcy is near.
There are numerous factors of greater importance to a company’s future performance than one or more financial ratios.In summary, ratios are useful tools, but they can be interpreted properly only by individuals who understand the chracteristics’ of the company and its environment.Concluding Comment~Solvency, Credit Risk, and the taw .
Accountants view a business entity as separate from the other economic activities of its owners, regardless of how the business is organized. The law, however, ‘draws an important distinction between corporations and unincorporated business organizations. Users of financial statements should understand this legal distinction, as it may affect both creditors and owners.Under the law, the owners of unincorporated businesses (sole proprietorship and partnerships) are personally liable for any and all debts of the business organization.
Therefore, creditors of unincorporated businesses often base their lending decisions on the sol- ~ency of the owners, rather than the financial strength of the business entity If a business is organized as a corporation.ihoweventhe owners (stockholders) are not personally responsible for the debts of the business. Creditors may look.only to tile , business entity in seeking payment of their claims.
Therefore, the solvency of the business entity becomes much more important if the business is organized as a corporation.
Small Corporations and Loan Guarantees Small corporations often do not have- sufficient financial resources to qualify for the credit they need. In such cases, creditors may require that one or more of the company’s stockholders personally guarantee (or cosign) . spebific debts of the business entity.
By cosigning ‘debts of the corporation, the individual stockholders do become personally liable for the debt if the corporation fails to make payment. 31na limited partnership, only the genera/partners a personally responsible for the debts of the business. Every limited partnership must have one or more general partners