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Financial Ratios

This Competency Assessment assesses the following outcome(s):

MT217M2: Analyze financial statements ratios used to measure the financial performance of a business entity.

GEL-1.03: Demonstrate college-level communication through the oral delivery of original materials in Standard English.

GEL-6.05: Adapt research skills to discover and sort relevant sources to complete tasks

Financial statement analysis is the process of analyzing a company’s financial statements to make better economic decisions. The process for financial statement analysis includes specific techniques for evaluating risks, performance, and future prospects of an organization.

Directions

This Assessment is separated into four parts. In Part 1 of this Assessment, you will begin by researching and summarizing four of the benefits of financial analysis and indicating which is the most significant to you. In Part 2  of this Assessment, you will define and properly classify the financial classifications and ratios listed below.  In Part 3 of this Assessment, you will calculate and explain the significance of the Liquidity, Profitability, and Market Value financial ratios, and provide a year to year comparison of assessed financial trends. In Part 4 of this Assessment, you will compose an analytical essay in a minimum of 350 words reporting the one financial measurement trend you find to be most significant.

Use the Word template provided to complete your Assessment.

Questions

Part 1.

Locate and read the following article:

Faello, J. (2015). Understanding the limitations of financial ratios. Academy of Accounting & Financial Studies Journal, 19(3), 75-85.

Refer to pages 75 and 76 of Faellos (2015) work. In four separate paragraphs (one for each question), summarize four of the benefits of financial analysis mentioned in the journal article. In one paragraph, describe which one of the four benefits you consider to be most significant.

Review the following financial data, then answer the questions below.

Income Statement and Balance Sheet
Company X Income Statement
FYE 2014 and 2015
Period Ending
31-Jan-15
31-Jan-14
Total Sales
$        485,651,000
$        476,294,000
Cost of Goods
            365,086,000
            358,069,000
Gross Profit
            120,565,000
            118,225,000
Selling General and Administrative
            93,418,000
            91,353,000
Operating Profit
            27,147,000
            26,872,000
Total Other Income/Expenses Net
            113,000
            119,000
Earnings Before Interest And Taxes
            27,034,000
            26,753,000
Interest Expense
            2,461,000
            2,335,000
Income Before Tax
            24,573,000
            24,418,000
Income Tax Expense
            7,985,000
            8,105,000
Net Income From Continuing Ops
            16,588,000
            16,313,000
Discontinued Operations
            285,000
            144,000
Net Income (Net Profit)
$  _    16,303,000
$  _    16,169,000
14,000,000 shares outstanding

Market Share price per share
$                    10.00
$                    9.00

Company X Balance Sheet
FYE 2014 and 2015
Period Ending
31-Jan-15
31-Jan-14
Assets

Current Assets

Cash and Cash Equivalents
$        9,135,000
$        7,281,000
Net Receivables
6,778,000
6,677,000
Inventory
45,141,000
44,858,000
Other Current Assets
2,224,000
2,369,000
Total Current Assets
63,278,000
61,185,000
Property Plant and Equipment
116,655,000
117,907,000
Goodwill
18,102,000
19,510,000
Other Assets
5,671,000
6,149,000
Total Assets
203,706,000
204,751,000
Liabilities

Current Liabilities

Accounts Payable
58,583,000
57,174,000
Short/Current Long Term Debt
6,689,000
12,082,000
Other Current Liabilities
– 
89,000
Total Current Liabilities
65,272,000
69,345,000
Long Term Debt
43,692,000
44,559,000
Deferred Long Term Liability Charges
8,805,000
8,017,000
Minority Interest
4,543,000
5,084,000
Total Liabilities
122,312,000
127,005,000
Miscellaneous Stocks Options Warrants
0
0
Common Stock
323,000
323,000
Retained Earnings
85,777,000
76,566,000
Capital Surplus
2,462,000
2,362,000
Other Stockholders Equity
-7,168,000
-1,505,000
Total Stockholders Equity
81,394,000
77,746,000

Total  Liabilities +  Stockholders Equity
$        203,706,000
$        204,751,000

Number of Shares Outstanding
14,000,000
14,000,000
Market Share price per share
$                    10.00
$                    9.00

Part 2.

Define the ten financial ratios below.

Financial Ratios:

Current Ratio
Quick Ratio
Accounts Receivable Turnover as a multiple
Accounts Payable Turnover as a multiple
Return on Equity as a percent
Return on Assets as a percent
Operating Profit Margin as a percent
Net Profit (after tax) Margin as a percent
Earnings per Share as a dollar value
Price to Earnings as a multiple
Part 3. Classify, calculate, and assess a) Liquidity and Turnover management of Current Assets and Liabilities, b) Profitability, and c) Market Value ratios. Please note outcomes as a multiple, percent, or dollar value.

Liquidity and Turnover management of Current Assets and Liabilities
In this section, properly classify which of the above (from Part 2) are the liquidity and turnover ratios. Then, using the data from the Income Statement and Balance Sheet, provide the correct calculation of these four liquidity and turnover ratios and an assessment of the companys ability to maintain liquidity and the management of current assets and current liabilities.

Include the proper assessment of outcomes as positive or negative trends when all four ratio outcomes are factored as a group.

b. Profitability

In this section, properly classify which of the above (from Part 2) are the profitability ratios. Then, using the data from the Income Statement and Balance Sheet, provide the correct calculation of these four profitability ratios and an assessment of the companys ability to maintain if not improve profitability based on the amounts of Equity, Assets, and  levels of profits from Sales. Include the proper assessment of outcomes as positive or negative trends when all four ratio outcomes are factored as a group.

c. Market Value

In this section, use the price per share data, the Income Statement and Balance Sheet to provide the correct calculation these two Market Value ratios; Earnings per Share (EPS) and Price to Earnings (P/E) ratio. 

Given the changes of EPS from one year to the next, what is your assessment of the company’s net income theoretically available for payment for investors holding common stock? As an investor to what extent are you more or less confident of the companys ability to add value to your ownership position?

Based on the companys P/E ratio changes from one year to the next what might this tell us about either investor sentiments of future profits, or stock price/value given the ability to generate income at a set price? 

Part 4. Overall Analysis

In this section, you will compose an analytical essay in a minimum of 350 words. Based on the above, provide a proper assessment of the companys most significant negative trend and what corrective actions can be taken to improve results. You should search the Library, your textbook, and the internet using a variety of criteria to find academic sources that will support your assessment of the trends and actions that could be taken.

Please address items 1 and 2 as the preliminary portion of your assignment.  And build on that commentary as the body of your overall assessment.

1. The most significant concern is

2. The quantitative aspect of this assessment of negative trends is based upon  ratios and comparative data

Followed by:

The corrective actions, research findings on interpreting financial ratio outcomes from Library, textbook, etc;, conclusion and references

Minimum Submission Requirements

This Assessment should be in a separate Microsoft Word document. Use this template for your Assessment.

Respond to the questions in a thorough manner, providing specific examples of concepts, topics, definitions, and other elements asked for in the questions. Your paper should be highly organized, logical, and focused.

Your paper must be written in Standard English and demonstrate exceptional content, organization, style, grammar, and mechanics.

Your paper should provide a clearly established and sustained viewpoint and purpose.

Your writing should be well ordered, logical and unified, as well as original and insightful.

A separate page at the end of your paper should contain a list of references, in APA format. Use your textbook, the Library, and/or the internet for research.

Be sure to cite both in-text and reference list citations were appropriate and reference all sources. Your sources and content should follow proper APA citation style. Review the APA formatting and citation style resources found in the Writing Center. The Writing Center can be found in the Academic Success Center in the Academic Tools area of your course. (It should be in Times New Roman 12-point font, include correct citations, Standard English with no spelling or punctuation errors, and correct references at the bottom of the last page.)

If work submitted for this competency assessment does not meet the minimum submission requirements, it will be returned without being scored.

Plagiarism

Plagiarism is an act of academic dishonesty. It violates the University Honor Code, and the offense is subject to disciplinary action. You are expected to be the sole author of your work. Use of another person’s work or ideas must be accompanied by specific citations and references. Whether the action is intentional or not, it still constitutes plagiarism.

For more information on the Plagiarism policy, refer to the current Catalog.

Directions for Submitting Your Course Assessment

Before you submit your Course Assessment, you should save your work on your computer in a location and with a name that you will remember. Make sure your Assessment is in the appropriate format (Word), then, when you are ready, you may submit to the Course Assessment Dropbox.

Page 75&76
UNDERSTANDING THE LIMITATIONS OF FINANCIAL RATIOS
Joseph Faello, Mississippi State University ABSTRACT
The purpose of this paper is to provide financial statement users and accounting academics with some useful insights when working with financial ratios. Initially, the uses and benefits of financial ratios and the limitations of using financial ratios are discussed from the financial statement users and accounting academics perspectives. Then, practical advice is provided to both financial statement users and accounting academics alike to mitigate the limitations of using financial ratios. Financial statement users and accounting academics will find the issues discussed in this paper useful in their work with financial ratios.
Keywords: Financial ratios, Comparability, Homoscedasticity, Outliers
INTRODUCTION
Financial ratios play an important role in the analysis of financial statements and accounting research. However, the use of financial ratios comes with its hazards. Both accounting academics and financial statements users need to understand the problems and limitations in working with financial ratios. The purpose of this paper is to address these issues and to provide guidance on how to mitigate the problems surrounding financial ratios. Both accounting academics and financial statement users will find this study useful in their dealings with financial ratios.
The study is organized as follows:
1.Uses and benefits of financial ratios;
2.Limitations of Financial Ratios
3.Dealing with limitations of financial ratios
4. Conclusion.
Uses and benefits of financial ratios;
Limitations of financial ratios;
Dealing with the limitations of financial ratios; and
USES AND BENEFITS OF FINANCIAL RATIOS
Financial ratios play an important role in financial reporting. A ratio expresses the mathematical relationship between one quantity and another, (Kieso et al. 2013, p. 245). A financial ratio consists of a numerator and a denominator, relating two financial amounts. The two financial amounts can be from the balance sheet (e.g. current ratio), or from the income statement (e.g. times interest earned), or from both the balance sheet and the income statement (e.g. return on total assets).
Financial ratios help explain financial statements. For example, financial ratios assist in benchmarking a firms performance with other firms in the same industry. Further, financial ratios help financial statement users in identifying problem areas with a companys operations, liquidity, debt position, or profitability. From this benchmarking and assessment of a firms performance, financial ratios help in assessing the firms overall risk (CICA, 1993). Priorresearch supports the use of financial ratios as a means to predict firms performance,
specifically stock returns and return on assets (e.g., Soliman, 2008; Nissim & Penman, 2001; Fairfield & Yohn, 2001).
Financial ratios are frequently used in loan contracts between a firm (borrower) and a financial institution (lender) as a means to limit the firms activities. A borrower has an incentive to engage in activities that benefit his or her self-interests at the expense of the firms overall value, resulting in the lender inserting accounting numbers in the debt contract (i.e., debt covenant) to restrict the borrowers value-reducing activities (Watts & Zimmerman, 1986). For example, the loan contract may stipulate that the firm must maintain a current ratio of at least 2:1. In this manner, the firm is encouraged to effectively manage its current assets and current liabilities, for example, by collecting its accounts receivables on a timely basis.
For financial statement users, financial ratios not only provide information about where a firm has been, but also provides guidance about where it is headed in the future. For example, negative trends in financial ratios over time could indicate a firm is in decline and provide insights into predicting corporate failure. The Canadian Institute of Chartered Accountants (CICA, 1993) in their Research Report titled Using Ratios and Graphics in Financial Reporting, summarizes these and additional benefits of financial ratio analysis (see Appendix 1).
From an academic perspective, financial ratios play an important role in modeling. A variable of interest (dependent variable) is estimated in a linear regression model by key independent variables that are frequently financial ratios. Many bankruptcy prediction models utilize financial ratios (Altman & Hotchkiss, 2006).
In summary, financial ratios provide important information about a firms past performance, predicting a firms future performance prospects, assessing managements decision-making, risk assessment, and are a critical tool employed in lending agreements to control a firms activities. In addition, accounting academics use financial ratios in modeling the key variable of interest in their research studies.
LIMITATIONS OF FINANCIAL RATIOS
Inherent in the use of financial ratios are limitations that if not understood could result in drawing incorrect conclusions from the results. Significant limitations in the use of financial ratios are discussed below.
A financial ratio consists of a numerator and a denominator. If either the numerator or denominator is misstated, then the financial ratio will be in error. Misstatement of either the numerator or denominator could be the result of human error. For example, an error could be made in collecting the firms financial statement data. Alternatively, the firms could be employing earnings management techniques (e.g., manipulating accruals) that results in the data itself being misstated. Prior accounting research provides evidence that firms managers manipulate accruals to portray firms financial results in a more positive manner (e.g., Healy & Wahlen, 1999; McNichols, 2000). In either case, financial statement users and academics would obtain results from their analyses that could lead to erroneous conclusions.
Financial ratios derived from a particular firms financial statements are based on
accounting principles, accounting methods, and accounting classifications chosen by the firm. These choices may not be consistent over time or between firms, thus compromising comparability. Financial statement users and researchers alike need to understand that the availability of accounting choices under generally accepted accounting principles (GAAP) may

 

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