BUS105 Study Guide
Unit 11: Using Managerial Accounting: Trends and Ratios
11a. Use a trend analysis and a common-size analysis to evaluate financial statement information
- What is the difference between trend analysis and common-size analysis?
- When using trend analysis, why would it be prudent to convert the changes to percentages and not only focus on dollar amounts?
- In common-size analysis of a balance sheet, why is it smart to convert all line items as a percentage of total assets?
- How can trend and analysis and common-size analysis be used in tandem?
Trend analysis analyzes a company's data over a period of time. This is done by examining the changes in specific line items on either the income statement or the balance sheet. These changes can be measured in dollars and percentages or both. Trends over several periods can be identified and examined by calculating the trend percentage as the current year divided by the base year.
A second way to analyze financial data is by using common-size analysis. This method converts each line of a financial statement to a percent. When analyzing an income statement, items are usually stated as a percentage of net sales. When analyzing a balance sheet, items are usually stated as a percentage of total assets. Common-size analysis allows for the evaluation of information from one period to the next both within a company (for example net income as a percentage of sales from year to year) and between competing companies (net income as a percentage of sales of each company).
11b. Use ratio analysis to measure profitability, short-term liquidity, long-term solvency, and market valuation
- What are the four categories of ratios used to measure financial performance?
- What are some of the limitations inherent in using ratio analysis?
- What is the difference between liquidity ratios and solvency ratios?
Managers, investors, and other stakeholders usually use various ratios to assess the financial performance and financial condition of organizations. Ratio analysis could be used to measure a firm's performance against a benchmark, against a previous period's performance, against a competitor, or against an industry standard.
There are four categories of ratios used to measure financial performance. Each category includes many different individual ratios.
- Profitability ratios (focus is on the income statement). These ratios focus on trends in the company's profitability and ability to continue generating a profit. The five ratios used to evaluate profitability are: gross margin ratio, profit margin ratio, return on assets, return on common shareholders' equity, and earnings per share.
- Liquidity ratios (focus is on short-term liabilities). These ratios are focused on a company's ability to meet its short-term cash needs such as to pay suppliers and interest expenses. The four ratios used to evaluate liquidity are the current ratio, quick ratio, receivables turnover ratio (often converted to average collection period), and inventory turnover ratio (often converted to average sale period). These ratios are of special interest to suppliers and banks who may have extended short-term loans to the company.
- Solvency ratios (focus is on long-term liabilities). These ratios focus on a company's ability to meet its long-term obligations such as to pay back long-term debt and bond principal. The three measures used to evaluate solvency are debt to assets, debt to equity, and times interest earned. These measures are of special interest to debt and bondholders.
- Valuation ratios (focus is on the market value of the company). These ratios are used to evaluate a company's market value. The two ratios used for this are the market capitalization and the price-earnings ratio. These ratios are of special interest to current and potential investors.
11c. Create a balanced scorecard to analyze non-financial performance
- Why is it important to include non-financial information when evaluating a company or a manager within a company?
- What are the four perspectives that are included in the balanced scorecard?
- What are some examples of non-financial items that can be incorporated into the balanced scorecard?
While financial measures are very important for evaluation purposes, many organizations prefer to use a mix of financial and non-financial measures in order to evaluate performance. Many organizations do this by using a balanced scorecard approach which incorporates both financial and non-financial measures.
The balanced scorecard approach uses a balanced set of measures separating performance into four perspectives—financial, internal business process, learning and growth, and customer. All, except the first perspective, can include non-financial measures, such as customer satisfaction, employee retention, and other such measures in order to evaluate performance. The primary idea is to link financial and non-financial measures to the company's strategies and goals.
Unit 11 Vocabulary
This vocabulary list includes terms you will need to know to successfully complete the final exam.
- average collection period
- average sale period
- balanced scorecard
- common-size analysis
- current ratio
- debt to assets
- debt to equity
- earnings per share
- gross margin ratio
- inventory turnover ratio
- liquidity ratios
- market capitalization
- price-earnings ratio
- profit margin ratio
- profitability ratios
- quick ratio
- receivables turnover ratio
- return on assets
- return on common shareholders' equity
- solvency ratios
- times interest earned
- trend analysis
- valuation ratios