In Chaper 2,”Review of Accounting”,we examined the basic as-sumptions of accounting and the various components that make up the financial statements of the firm . We now use this fundamental material as a springboard into the area of financial analysis -in which we evaluate the financial performance of the firm
The format for the chapter is twofold .in the fist part,we wil use financial ratios to evaluate success of the firmVar-ious measures such as net income to sales and current assets to current liabilities will be computed for a hypothetical company and examined in light of industry norms and past trends.
In the second part of the chapter,we further explore the inpact of inflation on financial operations in the 1970 and early 1980s. Heretofore given scant coverage in financial text-books,the material is significant for financial managers of the fu-ture.The student begins to appreciate the impact of rising prices (or at times declining prices) on the various financial ratios.The chaper concludes with a discussion of how other factors-in ad-dition to price changes-may distort the financial statements of the firm.Terms such sa income to sales,return on investment,and inventory turnover take on much greater meaning when they are evaluated through the eyes of a financial manager who does more than merely pick out the top or bottom line of an income statement.The examples in the chapter are designed from the viewpoint of a financial manager(with only minor attention to accounting theory)
Ratios are used in much of our daily life.We buy cars based on miles per gallon;we evaluate baseball players by earned run aver-ages and batting averages,basketball players by field goal and foul-shooting,and so on.Financial ratios serve a similar purpose,but you must know what is being measured in order to construct a ratio and tounderstand the significance of the resultant number.
Financial ratios are used to weigh and evaluate the operating performance of the firm..While an absolute value such as earnings of $500,000 or accounts receivable of$100,000 may appear satisfac-tory,its acceptability car only be measured in relation to other val-ues.For this reason,financial managers place heavy emphasis on ratio analysia.
For example,are earnings of $500,000 of sales(10 percent”profit margin”ratio),that might be quite satisfactory-whereas earnings of $50,000 on $5,000,000 could be disappointing (a meager 1 percent return).After we have computed the appropriate ratio,we must compare our re-sults to those achieved by similar firms in our industry as well as our own past record of performance.Even then,this”number crunching”process is not fully adequate,as we are forced to sup-plenment our financial findings with an evaluation of company man-agement, physical facilities,and numerous other factors.