Essential Accounting Principles and Financial Ratios Study
Financial Statement Classification
Cash CA – Accounts Receivable CA – Inventory CA – Prepaid Expenses CA – Property, Plant, and Equipment NCA – Accounts Payable CL – Long-Term Debt NCL – Common Stock SE
a. Assets, liabilities, and shareholders’ equity → Balance Sheet
b. Revenues and expenses → Income Statement
Core Accounting Principles
Revenue Recognition – Revenues should be recognized when they are earned.
Matching Principle – Expenses should be associated with the revenues they help generate.
Going Concern – The firm is expected to continue its operations in the foreseeable future.
Consistency – Accounting methods should be applied consistently across periods.
Full Disclosure – Relevant financial information should be properly reported.
Financial Ratio Analysis Basics
Why is financial ratio interpretation more important than simply calculating a ratio?
Financial ratio interpretation is important because it explains what the number means about the firm’s financial condition and performance. It helps compare the company’s liquidity, profitability, and financing and supports better financial decisions.
What does this ratio measure? (Current Assets)
It measures the firm’s ability to pay its short-term obligations using its current assets.
Why are Inventory and Prepaid Expenses excluded?
Because inventory may take time to be sold and converted into cash, while prepaid expenses generally cannot be converted into cash to pay current liabilities.
Key Financial Formulas
- Current ratio = Current assets / Current liabilities
- Quick ratio = Cash + Marketable securities + Accounts receivable / Current liabilities
- Long-term debt ratio = Long-term debt / (Long-term debt + Shareholders’ equity)
- Debt-equity ratio = Long-term debt / Shareholders’ equity
- Times interest earned = EBIT / Interest expense
- Profit margin = Net income / Sales revenue
- ROA = After-tax operating income / Average total assets
- After-tax operating income = EBIT × (1 − Tax rate)
- Average total assets = (Beginning assets + Ending assets) / 2
- ROE = Net income / Average shareholders’ equity
- Average shareholders’ equity = (Beginning equity + Ending equity) / 2
Ratio Performance Measures
What does ROA measure?
ROA measures how efficiently the company uses its assets to generate net income.
What does ROE measure?
ROE measures the return generated for the firm’s shareholders’ investment.
Alternative Terminology
diferentes nombres – mismo dato
- Long-term debt (Total debt)
- After-tax operating income (Net income)
Ratio Summary Guide
- Current Ratio: Measures short-term liquidity.
- Quick Ratio: Measures ability to pay short-term debts without selling inventory.
- Long-term Debt Ratio: Measures the proportion of financing from long-term debt.
- Debt-Equity Ratio: Measures debt relative to shareholders’ equity.
- Times Interest Earned: Measures ability to pay interest expenses.
- Profit Margin: Measures how much profit is generated from sales.
- ROA: Measures how efficiently assets generate operating income.
- After-Tax Operating Income: Measures operating income after taxes.
- Average Total Assets: Represents the average assets during the period.
- ROE: Measures the return generated on shareholders’ equity.
- Average Shareholders’ Equity: Represents the average equity during the period.
Debt and Ratio Interpretation Case Study
What does this ratio tell us?
It shows the amount of debt used to finance the firm relative to shareholders’ equity. A ratio of 0.67 means the company has about $0.67 of debt for every $1 of equity.
Q8 – Current Ratio: 1.50 → 2.10
Quick Ratio: 1.10 → 0.80
Answer: Inventory could have increased or decreased significantly.
Explanation: The Current Ratio includes inventory, while the Quick Ratio excludes inventory. Therefore, a significant fluctuation in inventory could impact the Current Ratio while causing the Quick Ratio to move inversely relative to current liabilities.
Q11 – Interpretation
The company has $2 of debt for every $1 of shareholders’ equity.
Q9 – Company A and Company B have approximately the same ROA, but Company A has a substantially lower ROE.
Answer
A possible factor is lower financial leverage or less debt.
Explanation
Company A may have more shareholders’ equity and less debt in its financing. Therefore, with similar ROA, its ROE can be lower because there is less financial leverage.