Question

You work for a brokerage firm. Your boss asked you to analyze Eagle Manufacturing's performance for the past five years and to write a report that includes the benchmarking of the company’s performance.

(a.) What components would be best for you to include in tour financial statement analysis? Explain your answer.

(b.) Identify and explain several weaknesses or limitations of ratio analysis.

(c.) Define and explain how the following four ratios are used to examine the different aspects of a company's performance: liquidity, asset management or activity, profitability, and market-value.

Please show work

Answer 1

a. The three financial statements that are released to the public every quarter or at the end of the accounting period are the essential components of financial statement analysis. They are:

1. Balance Sheet - It is the statement of all the assets, liabilities, and capital invested in a firm. It provides an idea regarding the current/short-term assets, long-term/fixed assets, short-term liability, long-term liability, and the capital invested i.e shareholder's fund retained earnings of an organization on a particular date.
2. Income Statement - It consists of the revenue generated, cost of goods sold, additional expenses incurred like selling and administrative cost, marketing expenses, salary is given, depreciation charged, interest amount paid, tax rate.
3. Cash Flow Statement - It gives us an idea about the sources and uses of cash. It also tells us how much cash is generated in different types of activities like - operation, investing, and financing. The cash amount in the balance sheet has to match the amount in the cash flow statement.

These statements carry all the valuable information that is essential to carry out financial analysis.

b. Limitation of Ratio Analysis:

• It reflects the historic/past information, not the current information
• It does not take into account the macroeconomic factors and the external parameters like monetary and fiscal policy which affect the economic environment substantially.
• It can be only used to compare firms of the same size, the same type
• Some firm may do year-end alteration in the financial statement to improve ratios
• Accounting frauds are a major challenge to it

c. LIQUIDITY RATIOS: It says about the debtor's ability to pay off the current obligation or short term debts without raising any external finance. This includes Current Ratio, Quick Ratio

Current Ratio = Current Assets/Current Liability ;    more the ratio means the ability is high to pay off the short term obligations and hence the firm can be referred to as liquid enough.

Quick Ratio = {Current Assets - Inventories}/Current Liability; it shows the companies ability to meet short term obligations from the company's most liquid assets so inventory is excluded.

Higher these ratios provide more comfort to the creditors.

ASSET MANAGEMENT: It is also known as asset turnover ratios which gives an idea about the judicious asset utilization to increase the efficiency of it by generating more sales.

Total Asset Turnover Ratio = Total Sales/Average total assets maintained throughout the year

Fixed Asset Turnover Ratio = Total Sales/Average fixed assets maintained throughout the year

Current Asset Turnover Ratio = Total Sales/Average current assets maintained throughout the year

Higher these ratios mean better utilization of assets to generate sales. A higher the Fixed asset turnover ratio means the company has used its investment properly in fixed assets to generate revenue.

PROFITABILITY RATIO: This financial metric is used to check the ability of firm to generate profit or not by using shareholder's investment given by ROE and by employing assets given by ROA.

ROA = PAT/Average total assets maintained throughout the year; This provides us an idea on usage of economies of scale. With the increase in production, the fixed cost reduces per unit results in the improvement of profit or bottom line. So an increase in this ratio means better usage of assets and improvement in the bottom line.

ROE = PAT/Shareholders equity; This provides an idea of whether the wealth maximization of investors is done or not.

MARKET VALUE RATIO: These ratios are used to find the fair price of company's stock and hence identify whether the stock is overpriced or underpriced. And accordingly, a position is taken.

EPS = PAT/Number of outstanding share ; used in Gordon's dividend discount model to find the stock price. It also gives an idea regarding the income growth.

Dividen Yield = Dividend Paid/Current Market Price; this is a return for an investor if they want o purchase it at current market price

Price-to-earning ratio = Current Market Price/PAT ; it is a very helpful multiple used in relative valuation to find out the price of a stock of similar firms of same industry.