INVESTMENT DECISIONS SUMMARY
Generally accepted accounting principles (GAAP): The practice and procedure guidelines used to
prepare and maintain financial records and reports; authorised by the Financial Accounting
Standards Board (FASB).
Public company accounting oversight board (PCAOB): A not for profit corporation established by the
Sarbanes-Oxley Act of 2002 to protect the interests of investors and further public interest in the
preparation of informative, fair and independent audit reports.
Stockholders’ report: Annual report that publicly owned corporations must provide to stockholders;
it summarises and documents the firm’s financial activities during the past year.
Letter to stockholders: The first element of the annual stockholder’s report and the primary
communication from management.
The 4 key financial statements:
1. Income statement: provides a financial summary of the firm’s operating results during a
specified period.
- Dividend per share (DS): the dollar amount of cash distributed during the period on
behalf of each outstanding share of common stock.
2. Balance sheet: summary statement of the firm’s financial position at given point in time.
- Current assets: short-term assets, expected to be converted into cash within 1 year
- Current liabilities: short-term liabilities, “
- Long term debt: debt for which payment is not due in the current year
- Paid-in capital in excess of par: the amount of proceeds in excess of the par value
received from the original sale of common stock
- Retained earnings: The cumulative total of all earnings, net of dividends, that have been
retained and reinvested in the firm since it inception.
3. Statement of retained earnings: reconciles the net income earned during a given year, and
any cash dividends paid, with the change in retained earnings between the start and the end
of that year. an abbreviated form of statement of stockholders equity.
4. Statement of cash flows: provides a summary of the firm’s operating, investment and
financing cash flows and reconciles them with changes in its cash and marketable securities
during the period.
Notes to the financial statements: explanatory notes keyed to relevant accounts in the statements;
they provide detailed information on the accounting policies, procedures, calculations, and
transactions underlying entries in the financial statements.
Common issues addressed by these notes include: revenue recognition, income taxes, breakdowns of
fixed asset accounts, debt and lease terms, and contingencies.
1
,The issue of how to consolidate a company’s foreign and domestic financial statements has
tormented the accounting profession for many years.
Financial accounting standards board (FASB): mandates that US based companies translate their
foreign-currency-denominated assets and liabilities into US dollars, for consolidation with the parent
company’s financial statements. This process is done by using the current rate method.
Current (translation) method: technique used by US based companies to translate their foreign
currency denominated assets and liabilities into US dollars, for consolidation with the parent
company’s financial statements, using the year-end (current) exchange rate.
Income statement items are treated similarly. Equity accounts in contrast, are translated into dollars
by using the exchange rate that prevailed when the parent’s equity investment was made. Retained
earnings are adjusted to reflect each year’s operating profits or loses.
Ratio analysis: involves methods of calculating and interpreting financial ratios to analyse and
monitor the firm’s performance.
Ratio analysis of a firm’s financial statements is of interest to shareholders, creditors , and the firm’s
current and future level of risk and return, which directly affect share price. The firms creditors
concern themselves primarily with the short-term liquidity of the company and its ability to make
interest and principle payments. A secondary concern of creditors is the firm’s profitability; they
want assurance that the business is healthy. Management, like stockholders, focuses on all aspects of
the firm’s financial situation, and it uses ratios to monitor the firm’s performance from period to
period.
Ratio analysis is more than a calculation, more important is the interpretation of the ratio value.
Usually, the value of a particular ratio is less important than how it changes over time or how it
compares to the same ratios for competing firms.
Cross-sectional analysis: comparison of different firms’ financial ratios at the same point in time,
involves comparing the firm’s ratios with those of other firm’s ratios with those of other firms in its
industry or with industry averages.
Benchmarking: A type of cross-sectional analysis in which the firm’s ratio values are compared with
those of a key competitor or with a group of competitors that it wishes to emulate
Ratio analysis on its own is probably most useful in highlighting areas for further investigations.
Time-series analysis: evaluation of the firm’s financial performance over time using financial ratio
analysis.
The most informative approach to ratio analysis combines cross-sectional and time-series analysis. A
combined view makes it possible to asses the trend in the behaviour of the ratio in relationship to
the trend for the industry.
Cautions for using ratio analysis:
1. large deviations from the norm merely indicate the possibility of a problem
2. A single ratio does not generally provide sufficient information on which to judge the
overall performance of the firm.
3. Analysts should take care to use financial statements dated at the same point in the year
before calculating ratios for different companies
4. It is preferably to use audited financial statements for ratio analysis.
2
, 5. The financial data being compared should have been constructed using the same set of
accounting principles
6. Results can be distorted by high inflation, which can cause the book value of inventory
and depreciable assets to differ greatly from their replacement values.
No single financial ratio can reveal much about a firm’s financial health. Consequently, financial
experts typically analyse a firm using many different ratios.
Financial ratios fall into 5 general categories based upon the specific attributes of performance they
are designed to asses:
1. Liquidity
2. Activity
3. Debt
4. Profitability
5. Market ratios
Liquidity: a firm’s ability to satisfy its short-term obligations as they come due.
The liquidity needed depends on a variety of factors, including the firm’s size, its access to short term
financing sourcing, bank credit lines, and the volatility of its business.
A firm needs liquidity for safety, the amount depends on the industry.
Though determining exactly how much liquidity a firm needs represents a challenge, measuring a
firm’s liquidity is relativity straightforward. The 2 most common are current ratio and quick (acid test)
ratio.
Current ratio: a measure of liquidity calculated by dividing the firm’s current assets by its current
liabilities.
Current ratio = current assets : current liabilities
(liquidity ratio = total liquid assets : total current debts)
Quick (acid-test) ratio: a measure of liquidity calculated by dividing the firm’s current asserts less
inventory by its current liabilities.
Quick ratio = current assets – inventory : current liabilities
Activity ratios: measure the speed with which various accounts are converted into sales or cash, or
inflows or outflows.
This measures how efficiently a firm operates along a variety of dimensions, such as inventory
management, disbursements, and collections. A number of ratios measure the activity of the most
important current accounts, which include inventory, accounts receivable, and accounts payable.
Inventory turnover ratio: measures the activity, or liquidity o a firms inventory.
Inventory turnover = cost of goods sold : inventory
Average age of inventory: average number of day’s sales in inventory.
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Generally accepted accounting principles (GAAP): The practice and procedure guidelines used to
prepare and maintain financial records and reports; authorised by the Financial Accounting
Standards Board (FASB).
Public company accounting oversight board (PCAOB): A not for profit corporation established by the
Sarbanes-Oxley Act of 2002 to protect the interests of investors and further public interest in the
preparation of informative, fair and independent audit reports.
Stockholders’ report: Annual report that publicly owned corporations must provide to stockholders;
it summarises and documents the firm’s financial activities during the past year.
Letter to stockholders: The first element of the annual stockholder’s report and the primary
communication from management.
The 4 key financial statements:
1. Income statement: provides a financial summary of the firm’s operating results during a
specified period.
- Dividend per share (DS): the dollar amount of cash distributed during the period on
behalf of each outstanding share of common stock.
2. Balance sheet: summary statement of the firm’s financial position at given point in time.
- Current assets: short-term assets, expected to be converted into cash within 1 year
- Current liabilities: short-term liabilities, “
- Long term debt: debt for which payment is not due in the current year
- Paid-in capital in excess of par: the amount of proceeds in excess of the par value
received from the original sale of common stock
- Retained earnings: The cumulative total of all earnings, net of dividends, that have been
retained and reinvested in the firm since it inception.
3. Statement of retained earnings: reconciles the net income earned during a given year, and
any cash dividends paid, with the change in retained earnings between the start and the end
of that year. an abbreviated form of statement of stockholders equity.
4. Statement of cash flows: provides a summary of the firm’s operating, investment and
financing cash flows and reconciles them with changes in its cash and marketable securities
during the period.
Notes to the financial statements: explanatory notes keyed to relevant accounts in the statements;
they provide detailed information on the accounting policies, procedures, calculations, and
transactions underlying entries in the financial statements.
Common issues addressed by these notes include: revenue recognition, income taxes, breakdowns of
fixed asset accounts, debt and lease terms, and contingencies.
1
,The issue of how to consolidate a company’s foreign and domestic financial statements has
tormented the accounting profession for many years.
Financial accounting standards board (FASB): mandates that US based companies translate their
foreign-currency-denominated assets and liabilities into US dollars, for consolidation with the parent
company’s financial statements. This process is done by using the current rate method.
Current (translation) method: technique used by US based companies to translate their foreign
currency denominated assets and liabilities into US dollars, for consolidation with the parent
company’s financial statements, using the year-end (current) exchange rate.
Income statement items are treated similarly. Equity accounts in contrast, are translated into dollars
by using the exchange rate that prevailed when the parent’s equity investment was made. Retained
earnings are adjusted to reflect each year’s operating profits or loses.
Ratio analysis: involves methods of calculating and interpreting financial ratios to analyse and
monitor the firm’s performance.
Ratio analysis of a firm’s financial statements is of interest to shareholders, creditors , and the firm’s
current and future level of risk and return, which directly affect share price. The firms creditors
concern themselves primarily with the short-term liquidity of the company and its ability to make
interest and principle payments. A secondary concern of creditors is the firm’s profitability; they
want assurance that the business is healthy. Management, like stockholders, focuses on all aspects of
the firm’s financial situation, and it uses ratios to monitor the firm’s performance from period to
period.
Ratio analysis is more than a calculation, more important is the interpretation of the ratio value.
Usually, the value of a particular ratio is less important than how it changes over time or how it
compares to the same ratios for competing firms.
Cross-sectional analysis: comparison of different firms’ financial ratios at the same point in time,
involves comparing the firm’s ratios with those of other firm’s ratios with those of other firms in its
industry or with industry averages.
Benchmarking: A type of cross-sectional analysis in which the firm’s ratio values are compared with
those of a key competitor or with a group of competitors that it wishes to emulate
Ratio analysis on its own is probably most useful in highlighting areas for further investigations.
Time-series analysis: evaluation of the firm’s financial performance over time using financial ratio
analysis.
The most informative approach to ratio analysis combines cross-sectional and time-series analysis. A
combined view makes it possible to asses the trend in the behaviour of the ratio in relationship to
the trend for the industry.
Cautions for using ratio analysis:
1. large deviations from the norm merely indicate the possibility of a problem
2. A single ratio does not generally provide sufficient information on which to judge the
overall performance of the firm.
3. Analysts should take care to use financial statements dated at the same point in the year
before calculating ratios for different companies
4. It is preferably to use audited financial statements for ratio analysis.
2
, 5. The financial data being compared should have been constructed using the same set of
accounting principles
6. Results can be distorted by high inflation, which can cause the book value of inventory
and depreciable assets to differ greatly from their replacement values.
No single financial ratio can reveal much about a firm’s financial health. Consequently, financial
experts typically analyse a firm using many different ratios.
Financial ratios fall into 5 general categories based upon the specific attributes of performance they
are designed to asses:
1. Liquidity
2. Activity
3. Debt
4. Profitability
5. Market ratios
Liquidity: a firm’s ability to satisfy its short-term obligations as they come due.
The liquidity needed depends on a variety of factors, including the firm’s size, its access to short term
financing sourcing, bank credit lines, and the volatility of its business.
A firm needs liquidity for safety, the amount depends on the industry.
Though determining exactly how much liquidity a firm needs represents a challenge, measuring a
firm’s liquidity is relativity straightforward. The 2 most common are current ratio and quick (acid test)
ratio.
Current ratio: a measure of liquidity calculated by dividing the firm’s current assets by its current
liabilities.
Current ratio = current assets : current liabilities
(liquidity ratio = total liquid assets : total current debts)
Quick (acid-test) ratio: a measure of liquidity calculated by dividing the firm’s current asserts less
inventory by its current liabilities.
Quick ratio = current assets – inventory : current liabilities
Activity ratios: measure the speed with which various accounts are converted into sales or cash, or
inflows or outflows.
This measures how efficiently a firm operates along a variety of dimensions, such as inventory
management, disbursements, and collections. A number of ratios measure the activity of the most
important current accounts, which include inventory, accounts receivable, and accounts payable.
Inventory turnover ratio: measures the activity, or liquidity o a firms inventory.
Inventory turnover = cost of goods sold : inventory
Average age of inventory: average number of day’s sales in inventory.
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