Investments, tenth edition

     3.   It is often helpful to the analyst to decompose a firm’s ROE ratio into the product of several 

accounting ratios and to analyze their separate behavior over time and across companies within 

an industry. A useful breakdown is   

ROE

5

Net profits

Pretax profits

3

Pretax profits

EBIT

3

EBIT

Sales

3

Sales

Assets

3

Assets

Equity

   

     4.   Other accounting ratios that have a bearing on a firm’s profitability and/or risk are fixed-asset 

turnover, inventory turnover, days sales in receivables, and the current, quick, and interest 

 coverage  ratios.  

     5.   Two ratios that make use of the market price of the firm’s common stock in addition to its finan-

cial statements are the ratios of market to book value and price to earnings. Analysts sometimes 

take low values for these ratios as a margin of safety or a sign that the stock is a bargain.  

     6.   Good firms are not necessarily good investments. Stock market prices of successful firms may 

be bid up to levels that reflect that success. If so, the price of these firms relative to their earn-

ings prospects may not constitute a bargain.  

     7.   A major problem in the use of data obtained from a firm’s financial statements is comparabil-

ity. Firms have a great deal of latitude in how they choose to compute various items of revenue 

and expense. It is, therefore, necessary for the security analyst to adjust accounting earnings 

and financial ratios to a uniform standard before attempting to compare financial results across 

firms.  

     8.   Comparability problems can be acute in a period of inflation. Inflation can create distortions in 

accounting for inventories, depreciation, and interest expense.  

     9.   Fair value or mark-to-market accounting requires that most assets be valued at current market 

value rather than historical cost. This policy has proved to be controversial because ascertaining 

true market value in many instances is difficult, and critics contend that financial statements 

are therefore unduly volatile. Advocates argue that financial statements should reflect the best 

estimate of current asset values.  

    10.   International financial reporting standards have become progressively accepted throughout the 

world, including the United States. They differ from traditional U.S. GAAP procedures in that 

they are principles-based rather than rules-based.   

 Related Web sites 

for this chapter are 

available at   www.

mhhe.com/bkm   

   income  statement  

  economic  earnings  

  accounting  earnings  

  balance  sheet  

  statement of cash flows  

  return on assets (ROA)  

  return on equity (ROE)  

  economic  value  added  

  residual  income  

  DuPont  system  

  profit  margin  

  return  on  sales  

  total  asset  turnover  

  interest  coverage  ratio  

  times  interest  earned  

  leverage  ratio  

  inventory  turnover  ratio  

  average  collection  period  

  liquidity  

  current  ratio  

  quick  ratio  

  acid  test  ratio  

  cash  ratio  

  market–book-value  ratio  

  price–earnings  (P/E)  ratio  

  LIFO  

  FIFO  

  fair  value  accounting  

  mark-to-market  accounting  

  quality  of  earnings  

  international  financial 

reporting standards