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PALMS
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Organize Your Financial Ratios Analysis with P A L M S
Abstract:
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Introduction:
Financial ratios are employed to assess a company’s financial position relative to its industry or
peer1. The gauge of a financial ratio is the company’s accounting information2, which can be
found in the company’s main financial statements such as Income Statement and Balance Sheet.
Accordingly, in order to use3 a financial ratio, one needs a relatively decent knowledge of basic
unquestionable. For example, in regulating companies to file for their 10-K, the U.S. Securities
Exchange and Commission requires them to show their ratio of earnings to fixed charges4. In
analyzing the probability of default of a credit issuer, Standard and Poor’s, Moody’s, and
FitchIBCA use several types of financial ratios of the rated companies5. Even the most
commonly-used financial databases such as Dun and Bradstreet6, Compustat7, Mergent Online8,
and Datastream9 provide financial ratios data to aid researchers conduct a company’s
textbooks, there will always be a section (sometimes even a chapter) dedicated on the discussion
of 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 Statement
of Equity holders. If needed, more explanations on the company’s financial position may be obtained in the
Management 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 the www.sec.gov/divisions/corpfin/forms/regsk.htm, 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 at www.standardandpoors.com/ratings; also see “Guide to
Moody’s Ratings, Rating Process, and Rating Practices” at www.moodys.com/moodys/cust/ratingdefinitions; and
“Corporate Rating Methodology” of FitchRatings at www.fitchibca.com.
6
See https://www.dnb.com/product/contract/ratiosP.htm.
7
See http://www.compustat.com/www/.
8
See http://www.mergentonline.com.
9
See http://www.datastream.net.
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company (see Table 1 for the list of commonly-used textbooks taught in introductory corporate
finance 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 to
calculate, simply define a set of accounting figures as the numerator and divide it with a set of
other accounting figures as the denominator10. Secondly, they are also relatively straightforward
to interpret because they refer directly to certain accounting figures11. Financial ratios, however,
have a few major drawbacks. Firstly, they depend on accounting figures, which can sometimes
be unreliable12. Secondly, there are so many types of them that make it uneasy to decide which
would be the most useful financial ratios to be employed. Thirdly there has been no method
designed so far, that will enable one to conduct a systematically and methodically comprehensive
analysis of the overall financial performance of a company. Nonetheless, each time a financial
analyst has to justify his/her analysis, he/she usually provides several figures of ratios, which
represent certain categories of a company’s financial position attempting to answer the five key
conditions 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 its
sources of funding, (d) its competency to do better than its peer in the market, and (d) its
10
The official definition of a Financial Ratio as defined by the U.S. Government Small Business Association can be
found at http://www.sba.gov/test/wbc/docs/finance/fs_ratio1.html.
11
The U.S. Securities and Exchange Commission defines ‘General Standard’ financial ratios as ratios or statistical
measures that are calculated using financial information that is reported in accordance with the GAAP (see the Final
Rule of the Conditions for Use of Non-GAAP Financial Measures by the U.S. SEC in 17 CFR Parts 228, 229, 244
and 249, at http://www.sec.gov/rules/final/33-8176.htm).
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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 that
the multiplicative character of the financial variables from which financial ratios are constructed is a necessary
condition of valid ratio usage, not just an assumption supported by evidence. Kaminski K.A., Wetzel T.S., and Guan
L. (2004) find that misclassification of financial ratios for fraud firms ranged from 58 – 98%, indicating limited
ability of financial ratios to predict fraudulent accounting information.
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The P A L M S:
This article proposes the mnemonic method of “PALMS for Financial Ratios” to assess a
important financial indicators. This method simply and conveniently uses the interface of a
normal palm with its five fingers stretched out representing the five key categories of all
financial ratios. Exhibit 1 shows the graphical illustration of this method in which P stands for
Profitability, A is the Assets Utilization, L denotes the Long-term solvency, M refers to the
company’s Market value, and S represents the Short-term solvency of the company. This method
is also intuitively systematic compared to its aliases (see Exhibit 2) that have been used variably
More specifically, the intuitive process of analysis in PALMS follows the flow of recording the
influential financial transactions that a company does throughout one financial period (see
Exhibit 3). Exhibit 3 illustrates a top-down approach that an investor would intuitively follow in
order to systematically analyze a company starting from the end result of the company’s
activities: profit. Profit results from smart management of assets and activities throughout a
financial period. In order to acquire the assets that the company needs to produce profits, some
support the company’s longevity in business. For example, if a company uses too much leverage
and takes up too much debts, it may end up having to pay the interest and principal of the debts
extensively, resulting in reduced profit from its business activities. This in turn will not satisfy its
owners, the share/equity/stock-holders, whose perceptions play a crucial role in the company’s
future expectation. On the other hand, debts are less costly than equities and easier to obtain.
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Therefore, it is essential that a company makes the most appropriate decision to use debts or
equities as their source of funding. Lastly, but not less important, is the analysis of a company’s
ability to manage its short-term ordeals, managing its current assets and liabilities during a one-
The first letter in PALMS, P, signifies the first question of a company’s profit-making capability
(profitability). In this category, the three main financial ratios are the Profit Margin, Return on
Assets (ROA), and Return on Equity (ROE) Ratios (see Exhibit 4). Different types of profits
may be used as the numerators in the calculation process of the Profit Margin Ratio (Gross
Margin, Operating Income and Net Income), allowing different users to satisfy their need of
information. For example, a debtor may be more interested in assessing a company’s ‘operating’
rather than ‘net’ income. This is because debtors are entitled to their interest payments, which are
deducted from the company’s operating rather than net income. On the other hand, stockholders
are probably more interested in the company’s net rather than operating income because they are
only entitled to the company’s income after a deduction of all payment obligations.
The second letter in PALMS, A, refers to the direct sources that companies use/produce in order
to make profits: assets. Assets may be broken down into two main classifications, current and
fixed or other; whose determination of efficiencies may be gauged based on their ratios to the
company’s sales or total assets. Although not limited, especially for industrial companies, the
types of current assets that typically should be placed under scrutiny are Inventories and Account
Receivables. This is because if a company has too much inventory relative to its ability to sell, it
means the company may have taken on unnecessary storage, production, and selling costs
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affecting its level of profit. Additionally, it may also reflect the company’s weakness in planning
its production level. The amount of account receivables turnover also reflects the company’s
policy in asset management. This is because if the company is unable to obtain cash from its
credit sales relatively quickly, it may end up having to run its business without obtaining any
The L letter in PALMS addresses the sources of funding that a company obtains to buy assets,
which produce its goods and services. Because these types of assets are used for more than one
year period, they should be funded by long-term obligations. The use of short-term financing can
result in a company having to file for a bankruptcy because the long-term assets would not have
produced sufficient income to pay off the short-term obligations. Therefore, the main inputs in
this category of ratio are long-term liabilities and equities. A ‘good’ balance of debts and equities
is required from a company because debts involve paying interest rate expenses every year and
paying back the whole principal at the end of the debt term. Moreover, if a company fails to meet
the debts indentures, debt-holders have the rights to force a company into bankruptcy. Another
form of long-term liabilities may also take form as a large sum of fixed expenses over a long-
term period such as the cost of leasing and other rent expenses that are in fixed operating
expenses. If a company fails to produce enough revenue to cover these long-term expenses, it
also indicates poor asset-liability management and is harmful for the company’s future.
Market Value Ratio (represented by M in the PALMS) describes most closely the performance
of a company's common stock in the stock market. There are two main financial ratios in this
category: The P/E (Price to Earnings) and B/M (Book to Market Value) Ratios. The P/E Ratio is
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normally used to determine whether a stock is 'expensive' or 'cheap'13. This indicates that a
company's common stock is priced based on the company’s ability to grow (generate) earnings.
Therefore, the logic is that the lower the stock price of a company compares to the ability of the
company generating earnings (as represented by the current earnings report14), the more
undervalued (cheaper) the stock is. The B/M Ratio assesses the difference of perception between
the market and the company’s management on the ‘real’ value of a company. This means, when
a company sells its stocks, the selling price of these stocks were recorded in the company’s
balance sheet, being established as the book value of the company. The market perception is
represented by the current price of the company’s common stock. If the B/M ratio is low, it
indicates that the value of the company may be higher than what the market currently thinks.
Therefore stocks with low B/M ratio are usually considered undervalued and worth buying.
Finally, the S in the PALMS, provides a picture of a company’s ability to manage its current
asset using its current liabilities. In other words, it is expected that a company holds enough
assets that can be quickly converted into cash, to pay its short-term (less than one-year) liabilities
such as credit purchases and interest expenses. If a company has current assets which are too low
compared to its current liabilities, it may mean that in an emergency event, the company may not
be able to make the necessary payments. The Quick and Cash Ratios refer more specifically to
the amount of cash that a company has to possess in order to pay off its current liabilities.
Furthermore, the level of balance between current assets and current liabilities may also be worth
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The term 'expensive' and 'cheap' are suggested in introductory business courses to provide an easier way of
understanding the concept.
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Earnings here should be calculated from the Net Income minus all preferred preferences. This is because P/E ratio
is used to assess a company's common stock and common stockholders are only entitled to the 'extra' income after
all other preferred outflows have been delivered.
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Caveats on Consistency and Comparability:
Consistency and comparability are two of the basic concepts of GAAP. Financial ratios are the
result of a relationship between two or more items in a company’s financial statement. Therefore,
neglected, the results of the financial ratios have no real significance and there can be no valid
comparability between periods of the same entity or as between two like entities.
Comparability falls apart when either the numerator or denominator in the financial ratios is
incorrectly calculated. For instance, if accounts receivable contains amounts for receivables
which are not due within 12 months, the numerator for current assets is overstated. Also, if a
bank loan due in 9 months is improperly classified as a long-term liability, current liabilities will
be understated. Similar misclassifications can occur within the components of any ratios,
Additionally, comparability also refers to the importance of choosing the appropriate benchmark,
because a benchmark supplies reference points that assess the performance of a company against
its competitors as well as being compared to the expectation of investors and analysts. Good
benchmarks and good ratios allow management to change direction and really manage a
company for optimum results. Unfortunately, possible manipulation by top management requires
good analysis to detect deception. Off balance sheet method, window dressing, related party
transactions, premature or false revenue recognition, are a few of the items that can alter
(modify) the ratios mentioned above. Thus, if these practices are present, assessing the financial
position of one company against its competitive benchmark will not truly reflect reality.
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The issue of good analysis to detect deception of top management has become more important,
especially after the Sarbanes-Oxley Act of 2002. The act encourages effective corporate
governance that puts a great deal of emphasis on the independent directors to act more
responsibly. This means, not following the CEO or CFO blindly, but to use their background,
experience, and business acumen to ask a lot of questions and really direct their company to
Conclusion:
The use of ratios has become a common technique to measure the performance of our day-to-day
lives. Financial ratios provide an assessment of a company’s financial position relative to its
industry or peer. This is because ratios are basically a comparison of two or more items.
Although the calculation process is simple, there are so many of them, that sometimes it can lead
to potential confusion in their practical usage. This article introduces the PALMS method to help
analysts better organize the process of their analysis of a company’s financial position. More
specifically, PALMS allows its users to conduct the analysis in a systematic and intuitive
manner. Additionally, by using PALMS, users will hopefully be better able to understand a
company’s financial stance without missing any important information about the company.
Lastly, even though financial ratios may be easily abused due to its simplicity and sources of
accounting data, they are able to provide a platform of benchmarking, which can be a good
method of control and a springboard for inquiring into variances for firms to evaluate themselves
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Table 1
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Keown, Martin, 4th, Foundations of Prentice Hall Part I: The Scope and Environment of
Petty, and Scott Jr. 2003 Finance: The Logic and Financial Management;
Practice of Financial Chapter 4: Evaluating a Firm's
Management Financial Performance
Ross, Westerfield, 7th, Corporate Finance McGraw-Hill Chapter 2: Financial Planning and
and Jaffe 2005 Irwin Growth
Ross, Westerfield, 4th, Essentials of Corporate McGraw-Hill Part II: Understanding Financial
and Jordan 2004 Finance Irwin Statements and Cash Flow;
Chapter 3: Working with Financial
Statements
Ross, Westerfield, 6th, Fundamentals of McGraw-Hill Part II: Financial Statements and
and Jordan 2003 Corporate Finance Irwin Long-Term Financial Planning;
Chapter 3: Working with Financial
Statements
Van Horne 12th, Financial Management Prentice Hall Part IV: Tools of Financial Analysis
2002 and Policy and Control;
Chapter 12: Financial Ratio Analysis
Van Horne and 11th, Fundamentals of Prentice Hall Part III: Tools of Financial Analysis
Wachowicz Jr. 2001 Financial Management and Planning;
Chapter 6: Financial Statement
Analysis
Werner and Stoner 2002 Fundamentals of Authors Part I: About Finance and Money;
Financial Managing Academic Chapter 2: Data for Financial Decision
Press Making
Werner and Stoner 2001 Modern Financial Authors Part I: Introduction;
Managing: Continuity Academic Chapter 4: Data for Financial Decision
& Change Press Making
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Exhibit 1
LONG-TERM SOLVENCY
MARKET VALUE
ASSET UTILIZATION
S
H
PROFITABILITY O
R
T
T
E
R
M
S
O
L
V
E
N
C
Y
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Exhibit 2
Profitability Ratios
Operational / Efficiency / Managerial Decision /
Asset Utilization Ratios Activity / Turnover Ratios
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Exhibit 3
1
Profit
4
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Investors 2
watching for Assets
the company’s
market value
3
Sources of
Funding
Day-to-day 5
Activities
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Exhibit 4
The List of Financial Ratios that Are Commonly-Used in Financial Analysis (not exhaustive)
P rofitability Ratios
Net Income
Profit Margin (1) =
Sales
Gross Margin
Profit Margin (3) =
Sales
Net Income
ROA =
Total Assets
Net Income
ROE P1 =
Total Equity
365 Days
Day's of Sales of Inventory A3 =
Inventory Turnover
Credit Sales
Receivable Turnover A4 =
Average Accounts Receivable
P1
It is very common to include the very long-term debts (over 30-year maturity) as part of the denominator.
A1
Financial ratios in this category are also commonly used to assess a firm's liquidity.
A2
An average of quarterly or monthly end-of-the-month inventory data should provide a more accurate picture than
the one-off end-of-the-year inventory data.
A3
A more realistic consideration should take into account that the actual operating days of a firm during a one-year
period is approximately 250 days.
A4
An average of quarterly or monthly end-of-the-month accounts receivables data should provide a more accurate
condition than the one-off end-of-the-year accounts receivables data.
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365 Days
Average Collection Period A5 =
Receivable Turnover
Sales
Net Working Capital Turnover =
Net Working Capital
Sales
Fixed Asset Turnover =
Net Fixed Assets
Sales
Total Asset Turnover =
Total Assets
Total Liabilities
Total Debt Ratio =
Total Assets
TotalAssets
Equity / Financial Leverage Multiplier =
TotalEquity
A5
It should be considered that 250 days may be a more accurate numerator.
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M arket Value Ratios
Current Assets
Current Ratio =
Current Liabilities
Current Assets
Interval Measure =
Average Daily Operating Costs
M1
P/E Ratio is commonly used for assessing common stocks. Therefore, the price per share should be the price of
the common stock.
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