Fundamentals of Financial Management (Concise 6th Edition)

86 Part 2 Fundamental Concepts in Financial Management

weaknesses, and concluded that managerial actions could

boost the firm’s cash flows and value. Icahn’s views were

shared by Larry Ellison, chairperson of Oracle Corporation,

a $17 billion software company. As we write this, Oracle

and Icahn have combined forces and are trying to force a

change in BEA’s operations. Thousands of analysts are

doing similar analyses of thousands of other companies,

trying to find the next BEA and becoming the next Buffett

or Icahn. It’s fun; and unless the efficient markets folks are

correct, it can be profitable.

P U T T I N G T H I N G S I N P E R S P E C T I V E

The primary goal of! nancial management is to maximize shareholders’ wealth, not

accounting measures such as net income or EPS. However, accounting data in" uence

stock prices, and this data can be used to see why a company is performing the way

it is and where it is heading. Chapter 3 described the key! nancial statements and

showed how they change as a! rm’s operations change. Now, in Chapter 4, we show

how the statements are used by managers to improve the! rm’s stock price; by lend-

ers to evaluate the likelihood that borrowers will be able to pay o# loans; and by

security analysts to forecast earnings, dividends, and stock prices.

If management is to maximize a! rm’s value, it must take advantage of the! rm’s

strengths and correct its weaknesses. Financial analysis involves (1) comparing the

! rm’s performance to that of other! rms in the same industry and (2) evaluating

trends in the! rm’s! nancial position over time. These studies help managers identify

de! ciencies and then take corrective actions. In this chapter, we focus on how man-

agers and investors evaluate a! rm’s! nancial position. Then, in later chapters, we

examine the types of actions managers can take to improve future performance and

thus increase the! rm’s stock price.

The most important ratio is the ROE, or return on equity, which tells us how much

stockholders are earning on the funds they provide to the! rm. When ROE is high,

the stock price also tends to be high; so actions that increase ROE generally

in crease the stock price. Other ratios provide information about how well assets such

as inventory, accounts receivable, and! xed assets are managed and about the! rm’s

capital structure. Managers use ratios related to these factors to help develop plans

to improve ROE.

When you! nish this chapter, you should be able to:

• Explain what ratio analysis is.


• List the 5 groups of ratios and identify, calculate, and interpret the key ratios in
  each group. In addition, discuss each ratio’s relationship to the balance sheet and
  income statement.


• Discuss why ROE is the key ratio under management’s control, how the other
  ratios a# ect ROE, and explain how to use the DuPont equation to see how the ROE
  can be improved.


• Compare a! rm’s ratios with those of other! rms (benchmarking) and analyze a
  given! rm’s ratios over time (trend analysis).


• Discuss the tendency of ratios to " uctuate over time, which may or may not be
  problematic. Explain how they can be in" uenced by accounting practices and
  other factors and why they must be used with care.