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MANAGEMENT DECISIONS AND FINANCIAL ACCOUNTING REPORTS

MANAGEMENT DECISIONS AND FINANCIAL ACCOUNTING REPORTS. Baginski & Hassell. Electronic presentation adaptation by Dr. Barbara L. Hassell & Dr. Harold O. Wilson. MODULE A FINANCIAL STATEMENTS AND EXTERNAL DECISION MAKING. Overview: Financial Statements and External Decision Making. Topics

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MANAGEMENT DECISIONS AND FINANCIAL ACCOUNTING REPORTS

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  1. MANAGEMENT DECISIONS AND FINANCIAL ACCOUNTING REPORTS Baginski & Hassell Electronic presentation adaptation by Dr. Barbara L. Hassell & Dr. Harold O. Wilson

  2. MODULE AFINANCIAL STATEMENTS AND EXTERNAL DECISION MAKING

  3. Overview: Financial Statements and External Decision Making • Topics • Financial statements reflect the aggregate outcomes of many managerial decisions. • External decision makers use financial statements to make assessments of profitability and risk.

  4. Ratio calculations are used to help understand profitability and risk. • External decision makers also assess the accounting quality reflected in a firm’s financial statements.

  5. Ratios Used to Assess Profitability • Return on assets (ROA): General assessment of profitability (all capital providers point of view) • ROA assesses net profitability of operating activities per dollar of average investment, which is a measure of how profitable a company is regardless of how the company’s assets are financed.

  6. Return on Common Equity (ROCE): Assessment of profitability from the viewpoint of common stockholders • ROCE assesses net profitability, after preferred dividends, per dollar of common stockholders’ investment • Earnings Per Share (EPS) • Reflects net income, after preferred dividends, available to an average common share of stock • The topic of EPS is discussed later in the text.

  7. Return on Assets (ROA)

  8. Return on Common Stockholders’ Equity (ROCE)

  9. Decomposition of ROCE

  10. How ROCE Components Combine

  11. NOTE: On the previous slide, the denominator in ROA cancels the numerator in the capital structure leverage ratio (shown in blue) and the numerator in ROA cancels with the denominator in the common leverage ratio (shown in green). Got it?

  12. Reduced ROCE Formula

  13. Decomposition of ROA

  14. As with all targets, financial and otherwise, analysts and decision makers should state in advance exactly what they are shooting for … because, if we aim at nothing we are likely to hit it!

  15. How ROA Components Combine

  16. Analysis of Risk • Three major future-oriented risks assessed by external decisions makers: • Firm risks • Industry risks • General economic risks • Generally, GAAP-based financial statements do not do a good job in helping assess these risks.

  17. GAAP-based financial statements are used to assess two types of risk: • Short-term liquidity risks • Long-term solvency risks

  18. Short-Term Liquidity Risks

  19. Rule of thumb for minimum current ratio is 2:1

  20. Long-Term Solvency Risk

  21. In general, bankers should not earn more than owners!

  22. Usefulness of Ratios in Predicting the Future • External users, particularly financial analysts, use ratios to help explain the present and to predict the future. • Why are ratios at their current levels? • Will the ratios continue at this level? • If not, how & why will they change?

  23. In addition to ratios, individuals trying to explain and predict should study: • Industry conditions • Firm’s competitive strategy • Accounting quality Compared to WHAT?

  24. Industry Conditions • GAAP-based financial statements provide little information about industry conditions, such as: • Industry growth rate • Firm concentration • Product differentiation • Scale economies • Cyclicality and exit barriers • Legal barriers to entry • Relative bargaining power of buyers and suppliers and access to distribution channels

  25. Firm Competitive Strategy • GAAP-based financial statements provide little information about industry conditions, such as: • Cost leadership versus product differentiation • Demonstration of acquisition of unique core competencies and value chain

  26. Accounting Quality • Accounting qualityincludes general characteristics of information that enable external decision-makers to assess and predict sustainability of current financial characteristics.

  27. Accounting quality comes from ... • Truthful reporting (lack of earnings manipulation) • Persistence of earnings • Adequate disclosure • Using conservative assumptions in applying GAAP • GAAP-based financial statements are useful in assessing these characteristics, particularly adequate disclosure and degree of conservatism in assumptions.

  28. End of Module A

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