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market valuation

What are the standard measures of a firm`s leverage, liquidity, profitability, asset management, and market valuation? What is the significance of these measures?

If you are analyzing a company`s financial statements, there is a danger of being overwhelmed by the sheer volume of data contained in the income statement, balance sheet, and statement of cash flow. Managers use a few salient ratios to summarize the firm`s leverage, liquidity, efficiency, and profitability. They may also combine accounting data with other data to measure the esteem in which investors hold the company or the efficiency with which the firm uses its resources.

Table A.17 summarizes the four categories of financial ratios that we have discussed in this material. Remember though that financial analysts define the same ratio in different ways or use different terms to describe the same ratio.

Leverage ratios measure the indebtedness of the firm. Liquidity ratios measure how easily the firm can obtain cash. Efficiency ratios measure how intensively the firm is using its assets. Profitability ratios measure the firm`s return on its investments. Be selective in your choice of these ratios. Different ratios often tell you similar things. Financial ratios crop up repeatedly in financial discussions and arrangements. For example, banks and bondholders commonly place limits on the borrower`s leverage ratios. Ratings agencies also look at leverage ratios when they decide how highly to rate the firm`s bonds.

How does the Du Pont formula help identify the determinants of the firm`s return on its assets and equity?

The Du Pont system provides a useful way to link ratios to explain the firm`s return on assets and equity. The formula states that the return on equity is the product of the firm`s leverage ratio, asset turnover, profit margin, and debt burden. Return on assets is the product of the firm`s asset turnover and profit margin.

What are some potential pitfalls of ratio analysis based on accounting data?

Financial ratio analysis will rarely be useful if practiced mechanically. lt requires a large dose of good judgment. Financial ratios seldom provide answers but they do help you ask the right questions. Moreover, accounting data do not necessarily reflect market values properly, and so must be used with caution. You need a benchmark for assessing a company`s financial position. Therefore, we typically compare financial ratios with the company`s ratios in earlier years and with the ratios of other firms in the same business.

How do measures such as market value added and economic value added help to assess the firm`s performance?

The ratio of the market value of the firm`s equity to its book value indicates how far the value of the shareholders` investment exceeds the money that they have contributed. The difference between the market and book values is known as market value added and measures the number of dollars of value that the company has added.

Managers often compare the company`s return on assets with the cost of capital, to see whether the firm is earning the return that investors require. It is also useful to deduct the cost of the capital employed from the company`s profits to see how much profit the company has earned after all costs. This measure is known as residual income, economic value added, or EVA. Managers of divisions or plants are often judged and rewarded by their business`s economic value added.