An Integrated Form Of Financial Analysis Based On Earning Power

The analysis of a firms's earning power involves a two-stage procedure designed to answer two basic questions:
Stage 1
How effective has the firm's management been in generating sales using the total assets of the firm and converting those sales into operating profits?
Stages 2
How effective has the firm's management been in forming a financial structure that increase the returns to the common shareholders? Here we analyze the effect of the firm's financing decisions (that is, the mixture of bet and owner financing used by the firm) on the rate of return earned on the common shareholder's investment.

The operating income return on investment can be broken down into the product of two ratios,

Return on Investment = Operating Income x Operating Income
Sales Total Assets
Operating Income = Sales
Total Assets

Figure 5-4 simply lays the relationships that underlie the operating profit margin and total asset turnover ratios. Figure 5-5 provides a template for use in analyzing the effect of the firm's financing decisions on the return earned on the common shareholder's investment. The analysis presented in Figure 5-5 depends on the following basic relationship:

Return on Common Equity = Net Income Available to Common Shareholders
Common Equity

The 10-step procedure outline in Figure 5-4 and 5-5 connects the return earned on common equity to the firm's use of financial leverage and the operating profitability. The real value of this approach to financial analysis is its ability to demonstrate the interrelationships between the return earned on the owner's investment in the firm and a wide variety of financial attributes of the firm.


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Finance For Strategic Management
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