Intro to Ratio Analysis

FI:334

Explain the nature of audits
and assurance engagements

What Are Assurance Engagements?

▪ Assurance engagements analyze operations, reporting,

and/or procedures to help with decision-making.

🡪 Assurance = level of confidence that material

misstatements (mistakes) have been identified

▪ Assurance engagements must include:

🡪 Three-party relationship

🡪 Subject matter

🡪 Criteria

🡪 Evidence

🡪 Report

FI:334 Explain the nature of audits and assurance engagements

What Are Audits?

▪ Audits = assurance engagements that verify accounts and records

🡪 Attestation = audit conductor claims numbers are accurate

and reliable

▪ Internal audits (company employees to management)

▪ External audits (independent firm

to outside stakeholders)

▪ Effective audits are:

🡪 Scheduled

🡪 Objective

🡪 Discreet

FI:334 Explain the nature of audits and assurance engagements

▪ Positive assurance

▪ Negative assurance

▪ Reasonable assurance

▪ Limited assurance

FI:334 Explain the nature of audits and assurance engagements

Possible Limitations

▪ Audits check for fraud, misrepresentation,

misuse of funds, etc.

▪ Auditors must:

🡪 Be professional

🡪 Be objective

🡪 Be confidential

🡪 Comply with regulations

🡪 Show due care

FI:334 Explain the nature of audits and assurance engagements

The Role of Ethics

FI:100

Analyze cash-flow patterns

Information in Cash-Flow Patterns

FI:100 Analyze cash-flow patterns

▪ Analyze cash outflows and inflows

▪ Accrual or cash accounting

▪ Operational cash flow:

🡪 Direct or indirect method

▪ Understand financial health

▪ Assess payment collection, future

equipment purchases, etc.

▪ Enables business to stay in business

FI:100 Analyze cash-flow patterns

Importance of Cash-Flow Analysis

▪ Create cash-flow statement with inflows (+) and outflows (-)

🡪 Operating activities

🡪 Investment activities

🡪 Financing activities

▪ Calculate closing balance

▪ Determine positive or

negative cash flow

FI:100 Analyze cash-flow patterns

Procedures for Analyzing Cash-Flow Patterns

FI:100 Analyze cash-flow patterns

Actions Businesses Can Take

▪ Understand detailed cash status

🡪 Low on cash:

•Limit costs, short-term financing, increase funds

🡪 Extra cash:

•Invest in equipment, save for future

FI:358

Determine relationships among total revenue,

marginal revenue, output, and profit

Profit, Total Revenue, and Total Cost

▪ Profit

🡪 Total revenue minus total costs

▪ Total Revenue

🡪 Total amount of money company receives

▪ Total Costs

🡪 Sum of costs required to make a profit

▪ Companies want total revenue higher

than total cost

🡪 Improves profit

FI:358 Determine relationships among total revenue, marginal revenue, output, and profit

Calculating Marginal Revenue and Marginal Cost

▪ Marginal Revenue

🡪 Change in total revenue

•Marginal Revenue = Change in Total Revenue / Change in Quantity Sold

▪ Marginal Cost

🡪 Change in total cost

•Marginal Cost = Change in Total Cost / Change in Quantity Sold

▪ Helps to assess how much product should be made

FI:358 Determine relationships among total revenue, marginal revenue, output, and profit

FI:358 Determine relationships among total revenue, marginal revenue, output, and profit

Companies Want Profit

▪ Marginal cost and marginal revenue should be equal.

🡪 Means ideal point has been reached

🡪 Making one more product would be too costly.

🡪 Or price of product too high

▪ Marginal cost > marginal revenue is unsustainable

▪ Fixed costs

🡪 Labor

▪ Variable costs

🡪 Physical materials

▪ The Law of Diminishing Returns

FI:358 Determine relationships among total revenue, marginal revenue, output, and profit

Market Structure

▪ Type of market

▪ Perfectly competitive market

🡪 Similar or identical products

🡪 Marginal revenue is constant

🡪 Market price

▪ Monopoly, oligopoly, monopolistic

competitive markets

🡪 Marginal revenue falls as output increases

🡪 Prices reduced as output increases

🡪 Total revenue falls

FI:721

Describe common management

accounting measures

What Are Performance Measures?

▪ Performance measurement is the process of assessing how

well an organization is reaching its objectives.

🡪 Like a “progress check”

▪ Helps see where improvements are needed to reach goals

▪ Performance measures are ways to check progress.

🡪 Return on Investment

🡪 Balanced Scorecard

🡪 Customer Profitability Analysis

FI:721 Describe common management accounting measures

▪ Management strategy that tracks both

financial and nonfinancial activities

🡪 Financial

🡪 Customer

🡪 Internal process

🡪 Learning & growth

▪ Unique to organization

▪ Labor- and time-intensive

Balanced Scorecard

FI:721 Describe common management accounting measures

▪ ROI measures amount of return

against cost of investment.

🡪 Determines profitability of activity

🡪 The higher, the better

🡪 Doesn’t always provide context

around decision

Return on Investment

FI:721 Describe common management accounting measures

▪ Focuses on profit per customer

(not profit per product)

🡪 Identify & calculate costs when serving

specific customer/segment

🡪 Determine most profitable customers

🡪 Can be “backward looking”

Customer Profitability Analysis

FI:721 Describe common management accounting measures

Customer
Profitability

FI:097

Calculate financial ratios

The Importance of Financial Ratios

▪ Financial ratios are comparisons of

numbers from a business’s financial
statements.

▪ Managers use financial ratio analysis to:

🡪 Identify financial strengths and weaknesses

🡪 Evaluate operations and business

performance

🡪 Identify trends across time

🡪 Compare performance against competitors

FI:097 Calculate financial ratios

▪ Financial ratio analysis is also

used by:

🡪 Investors deciding whether to buy,

sell, or hold a company’s stock

🡪 Lenders measuring a company’s

debt

🡪 Suppliers looking at the company’s

ability to pay its bills

🡪 Governments reviewing the

company’s taxable profits

Liquidity Ratios

FI:097 Calculate financial ratios

▪ Liquidity is the ability to easily convert assets (e.g., investments)

back into cash.

▪ Managers calculate liquidity ratios to:

🡪 Measure the company’s ability to turn assets into cash

🡪 Determine whether the company can pay its bills as they come due

🡪 Compare current (liquid) assets with current debts

🡪 Identify any cash-flow problems

▪ Types of liquidity ratios:

🡪 Current Ratio

🡪 Quick Ratio a.k.a. Acid-Test Ratio

Profitability Ratios

FI:097 Calculate financial ratios

▪ Profitability is the level

of profit of a business
or product.

▪ Managers calculate

profitability ratios to:

🡪 Measure company’s

ability to make a profit

🡪 Determine how well

business is being operated

▪ Types of profitability ratios:

🡪 Gross Profit Margin a.k.a.

Gross Margin

🡪 Operating Profit Margin

🡪 Net Profit Margin

🡪 Earnings per Share (EPS)

🡪 Return on Assets (ROA) a.k.a.

Return on Total Assets or
Return on Investment (ROI)

🡪 Return on Equity (ROE) a.k.a.

Return on Common Equity

▪ Debt ratios are a class of financial ratios

that compares what a company owns to
what it owes.

▪ Managers calculate debt ratios to:

🡪 Determine the extent to which the company

uses money from creditors versus
shareholders to finance operations and growth

▪ Types of debt ratios:

🡪 Debt Ratio

🡪 Times Interest Earned Ratio

FI:097 Calculate financial ratios

Debt Ratios

▪ Activity ratios are a class of financial ratios that measures how

quickly a company can convert accounts into cash or sales.

▪ Managers calculate activity ratios to:

🡪 Measure how efficiently the business is managing its assets and its

current liability

▪ Types of activity ratios:

🡪 Inventory Turnover Ratio a.k.a. Stock Turnover Ratio

🡪 Average Collection Period a.k.a. Average Age of Accounts Receivable

🡪 Average Payment Period Ratio

🡪 Total Assets Turnover Ratio

FI:097 Calculate financial ratios

Activity Ratios

FI:647

Calculate return on investment (ROI)

Farhan’s Dilemma

▪ Last summer = two investments

🡪 $1,000 in Cheesy Slice

• Sold shares one year later for $1,200

🡪 $2,000 in Bloom with Us

• Sold shares one year later for $2,800

▪ This year, reinvest money in ONE business

▪ Which business to choose?

FI:647 Calculate return on investment

▪ ROI: financial ratio that measures

the amount of return against the cost
of investment

🡪 Helps determine if investment

is profitable

🡪 Helps compare investment opportunities

🡪 Can be applied to all kinds of scenarios

FI:647 Calculate return on investment

What Is Return on Investment?

▪ Calculated by dividing net profit by investment

▪ Net profit = (Current Value of Investment) – (Cost of Investment)

▪ ROI equation:

🡪 ROI = (Current Value of Investment – Cost of Investment) / Cost of Investment

FI:647 Calculate return on investment

How To Calculate ROI

▪ Cheesy Slice

🡪 Original investment: $1,000
🡪 Current value of investment: $1,200
🡪 Equation: ROI = ($1,200 – $1,000) / $1,000 🡪 ROI = ($200) / $1,000
🡪 ROI = .2 (or 20%)

▪ Bloom with Us

🡪 Original investment: $2,000
🡪 Current value of investment: $2,800
🡪 Equation: ROI = ($2,800 – $2,000) / $2,000 🡪 ROI = ($800) / $2,000
🡪 ROI = .4 (or 40%)

▪ 40% > 20% 🡪 Bloom with Us is the best choice!

FI:647 Calculate return on investment

Let’s Help Farhan

FI:556

Discuss the use of benchmarks

when analyzing ratios

What Are Benchmarks?

▪ Standard against which performance is measured

▪ Compare data to industry averages

▪ Identify areas for improvement

▪ Sources: internal, external, functional

🡪 Databases

🡪 Professional associations and publications

🡪 Expert opinions

🡪 Indicator analyses

FI:556 Discuss the use of benchmarks when analyzing ratios

▪ Financial statements: balance sheet,

income statement

▪ Calculate ratios, then compare to

competitors and industry
benchmarks

▪ Benchmarks as guidelines

FI:556 Discuss the use of benchmarks when analyzing ratios

Benchmarks and Ratios

▪ Measure progress, detect issues,

direct attention

▪ Compare performance across

industry

▪ Further analysis for full benefits

▪ Beneficial inside and outside

the business

FI:556 Discuss the use of benchmarks when analyzing ratios

Benefits of Using Benchmarks

▪ No solutions provided

▪ Can rely too heavily on external

comparisons

▪ Avoid crossing industries

▪ Industries can be incorrectly valued

FI:556 Discuss the use of benchmarks when analyzing ratios

Limitations of Using Benchmarks

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