Organize Your Financial Ratios Analysis With PALMS

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Organize Your Financial Ratios Analysis with PALMS Elisa Rinastiti Muresan, PhD (The author is an Assistant Professor of Finance at the School of Business, Long Island University at 1 University Plaza, Brooklyn, New York, NY11201. Tel. +1 – 718 – 488 1150, Fax. +1 – 718 – 488 1125, Email: Professor Philip Wolitzer, CPA (The author is a Professor Emeritus of Accounting at the School of Business, Long Island University at 1 University Plaza, Brooklyn, New York, NY11201. Te
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   1   Organize Your Financial Ratios Analysis withP A L M S Elisa Rinastiti Muresan, PhD (The author is an Assistant Professor of Finance at the School of Business,Long Island University at 1 University Plaza, Brooklyn, New York, NY11201.Tel. +1 – 718 – 488 1150, Fax. +1 – 718 – 488 1125,Email:   )   Professor Philip Wolitzer, CPA (The author is a Professor Emeritus of Accounting at the School of Business,Long Island University at 1 University Plaza, Brooklyn, New York, NY11201.Tel. +1 – 718 – 488 1152, Fax. +1 – 718 – 488 1125,Email:   )     2  Organize Your Financial Ratios Analysis with P A L M S Abstract: Financial ratios are useful measures to provide a snapshot of a company’sfinancial position. There are so many of them, making it difficult to decide andmemorize which one(s) would be the most appropriate to be used for getting theoverall financial picture about a company. Additionally, the interpretation of thecalculated ratios plays an important role in determining the quality of the financialanalysis of the company. This article presents a mnemonic formula, which isintuitively appealing, srcinal, and innovative; serving as an aid for identifyingthe five most useful categories of financial ratios to obtain the overall picture of acompany’s financial position, the PALMS (Profitability, Asset utilization, Long-term solvency, Market value, and Short-term solvency ratios). Not only isPALMS easy to remember, it is also flexible to use and systematically intuitive tointerpret. PALMS help analysts to better organize their process of analyzing acompany’s financial position to arrive at a comprehensive and accurateconclusion about the company.   3 Introduction: Financial ratios are employed to assess a company’s financial position relative to its industry or  peer  1 . The gauge of a financial ratio is the company’s accounting information 2 , which can befound in the company’s main financial statements such as Income Statement and Balance Sheet.Accordingly, in order to use 3 a financial ratio, one needs a relatively decent knowledge of basicmathematical and accounting concepts. The importance of financial ratios analysis isunquestionable. For example, in regulating companies to file for their 10-K, the U.S. SecuritiesExchange and Commission requires them to show their ratio of earnings to fixed charges 4 . Inanalyzing the probability of default of a credit issuer, Standard and Poor’s, Moody’s, andFitchIBCA use several types of financial ratios of the rated companies 5 . Even the mostcommonly-used financial databases such as Dun and Bradstreet 6 , Compustat 7 , Mergent Online 8 ,and Datastream 9 provide financial ratios data to aid researchers conduct a company’sfundamental analysis. Therefore it is not surprising that in (introductory) corporate financetextbooks, there will always be a section (sometimes even a chapter) dedicated on the discussionof using (calculating and interpreting) financial ratios to analyze the financial position of a 1 Comparison to the industry is usually considered sufficient using up to four digits SIC level; and comparison to the peer usually depends on the amount of a firm's total assets, market capitalization, and stockholders’ equity. 2 The ‘main’ accounting report consists of Income Statement, Balance Sheet, Cash Flows Statement, and Statementof Equity holders. If needed, more explanations on the company’s financial position may be obtained in theManagement Discussions and Analysis, and the Notes to Financial Statement. 3 The word ‘use’ here refers to the process of calculating and interpreting the financial ratios. 4 See, Subpart 229.500, Item 503: Summary Information, Risk Factors and Ratio of Earnings to Fixed Charges. 5 See “Corporate Ratings Criteria” of Standard and Poor’s; also see “Guide toMoody’s Ratings, Rating Process, and Rating Practices”; and“Corporate Rating Methodology” of FitchRatings 6 See 7 See 8 See 9 See   4company (see Table 1 for the list of commonly-used textbooks taught in introductory corporatefinance classes in the US, which discuss financial ratios analysis in their chapters).Why are financial ratios so popular? Firstly, perhaps because they are intuitively easy tocalculate, simply define a set of accounting figures as the numerator and divide it with a set of other accounting figures as the denominator  10 . Secondly, they are also relatively straightforwardto interpret because they refer directly to certain accounting figures 11 . Financial ratios, however,have a few major drawbacks. Firstly, they depend on accounting figures, which can sometimes be unreliable 12 . Secondly, there are so many types of them that make it uneasy to decide whichwould be the most useful financial ratios to be employed. Thirdly there has been no methoddesigned so far, that will enable one to conduct a systematically and methodically comprehensiveanalysis of the overall financial performance of a company. Nonetheless, each time a financialanalyst has to justify his/her analysis, he/she usually provides several figures of ratios, whichrepresent certain categories of a company’s financial position attempting to answer the five keyconditions of the company: (a) its profitability, (b) its ability to manage its assets effectively, (c)its potential to stay alive and healthy as long as possible through efficacy management of itssources of funding, (d) its competency to do better than its peer in the market, and (d) itsefficiency in managing its day-to-day activities. 10 The official definition of a Financial Ratio as defined by the U.S. Government Small Business Association can befound at 11 The U.S. Securities and Exchange Commission defines ‘General Standard’ financial ratios as ratios or statisticalmeasures that are calculated using financial information that is reported in accordance with the GAAP (see the FinalRule of the Conditions for Use of Non-GAAP Financial Measures by the U.S. SEC in 17 CFR Parts 228, 229, 244and 249, at   ). 12 Lanez J.A. and Callao S. (2000) find important differences in the situation of companies (liquidity, solvency,indebtedness and profitability) under different accounting principles. McLeay S. and Trigueiros D. (2002) show thatthe multiplicative character of the financial variables from which financial ratios are constructed is a necessarycondition of valid ratio usage, not just an assumption supported by evidence. Kaminski K.A., Wetzel T.S., and GuanL. (2004) find that misclassification of financial ratios for fraud firms ranged from 58 – 98%, indicating limitedability of financial ratios to predict fraudulent accounting information.
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