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5-2 Learning Objectives 1. Understand the relation between the expected return and risk of investment alternatives, and the role of analysis in providing risk and return information. 2. Understand the usefulness of the rate of return on assets (ROA) as a measure of a firm’s operating profitability. 3. Understand the usefulness of the rate of return on common shareholders’ equity (ROCE) as a measure of profitability. 4. Understand the strengths and weaknesses of earnings per common share as a measure of profitability. 5. Understand the distinction between short-term liquidity risk and long-term liquidity (solvency) risk. 6. Develop skills to interpret an analysis of profitability and risk. 7. (Appendix) Develop skills to prepare pro forma financials. 8. (Appendix) Understand the usefulness of pro forma financials. 5-3 Chapter Outline 1. Objectives of financial statement analysis 2. Usefulness of ratios 3. Analysis of profitability 4. Analysis of risk 5. Limitations of ratio analysis 6. International perspective Chapter Summary 7. Appendix 5.1: Pro Forma Financial Statements 5-4 1. Objectives of Financial Statement Analysis To understand the economics of a firm and To help forecast its future profitability and risk Profitability is an increase in wealth Risk is the probability that a specific level of profitability will be achieved. 5-5 2. Usefulness of Ratios Help compare different firms, and Help compare the firm against its past performance Standards against which to compare ratios 1. The planned ratio for the period 2. The corresponding ratio from a prior period 3. The corresponding ratio for another firm in the same industry 4. The average ratio for other firms in the same industry 5-6 3. Analysis of Profitability Profitability is subtle and complex concept. Doing well may be measured by different standards. Three concepts of profitability are given by: a. Return on assets b. Return on common equity c. Earnings per common share Each of these are discussed in turn.
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