Ratio analysis can be a very important ingredient in financial analysis. And the textbook explains how various
Question:
Ratio analysis can be a very important ingredient in financial analysis. And the textbook explains how various ratios can provide fresh, new insights.
But it must be remembered that sets of figures can be tampered with to present varying pictures of a firms financial health. Even if there is no intention to mislead stockholders or some other constituency, sometimes, among financial statements, one situation getting worse can make another situation look better.
Here are some examples of how ratios can fool you. A rule of thumb on the current ratio (current assets divided by current liabilities) is that 2 to 1 (or two times) is good. Suppose a firm has current assets of $400,000 and current liabilities of $300,000. By dividing $300,000 into $400,000, you arrive at a current ratio of 1.33not very good. Just before this ratio is to be shown to stockholders, the finance officer is able to borrow $200,000 of longterm funds and use these funds to pay off $200,000 of the current liabilities. If you calculate the current ratio with $100,000 divided by $400,000, it is 4 to 1 (or four times). Thats quite an improvement in the current ratios, but a deterioration of the long-term debt situation.
Speaking of long-term debt, lets see how a deterioration of debt and retained earnings pictures can improve return on equity. First, here is a greatly simplified version of the liabilities and equities side of a balance sheet for a company experiencing some financial difficulties.
| Total debt | $ | 2,700,000 |
| Common stock | 2,000,000 | |
| Retained earnings | 2,000,000 | |
| $ | 6,700,000 |
For this first year, the firm made a net profit of $80,000. Since total equity is $4,000,000, that income is a return on equity of .02 or 2 percent. The firm wants to pay a 15 percent return to its common stockholders. To do this, the board feels it is best to borrow $300,000 in order to make payment of a cash dividend. This means at the end of next year, the right side of the simple balance sheet will look like this:
| Total debt | $ | 3,000,000 |
| Common stock | 2,000,000 | |
| Retained earnings | 1,700,000 | |
| $ | 6,700,000 |
Although the loan of $300,000 provided the cash with which to make the dividend payments, the payment of dividends comes out of retained earnings. If the next year the firm has a net income of $80,000, the return on equity goes up to .0216 or 2.16 percenteven though the debt is higher and retained earnings are lower.
QUESTION:
- As these examples have indicated, games can be played with figures and ratios. What are some other quirks in the system? What are the incentives in changing the ratios?
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Expert Answer:
