When computing financial ratios and when doing other financial statement analysis always keep in mind that the financial statements reflect the accounting principles. This means assets are generally not reported at their current value. It is also likely that many brand names and unique product lines will not be included among the assets reported on the balance sheet, even though they may be the most valuable of all the items owned by a company.

These examples are signals that financial ratios and financial statement analysis have limitations. It is also important to realize that an impressive financial ratio in one industry might be viewed as less than impressive in a different industry.

Our explanation of financial ratios and financial statement analysis is organized as follows:

• Balance Sheet
  • General discussion
  • Common-size balance sheet
  • Financial ratios based on the balance sheet
• Income Statement
  • General discussion
  • Common-size income statement
  • Financial ratios based on the income statement
• Statement of Cash Flows

Financial statement analysis includes financial ratios. Here are three financial ratios that are based solely on current asset and current liability amounts appearing on a company's balance sheet:

Financial Ratio		How to Calculate It	What It Tells You
Working Capital	= = =	Current Assets – Current Liabilities $89,000 – $61,000 $28,000	An indicator of whether the company will be able to meet its current obligations (pay its bills, meet its payroll, make a loan payment, etc.) If a company has current assets exactly equal to current liabilities, it has no working capital. The greater the amount of working capital the more likely it will be able to make its payments on time.
Current Ratio	= = =	Current Assets ÷ Current Liabilities $89,000 ÷ $61,000 1.46	This tells you the relationship of current assets to current liabilities. A ratio of 3:1 is better than 2:1. A 1:1 ratio means there is no working capital.
Quick Ratio (Acid Test Ratio)	= = = =	[(Cash + Temp. Investments + Accounts Receivable) ÷ Current Liabilities] : 1 [($2,100 + $100 + $10,000 + $40,500) ÷ $61,000] : 1 [$52,700 ÷ $61,000] : 1 0.86 : 1	This ratio is similar to the current ratio except that Inventory, Supplies, and Prepaid Expenses are excluded. This indicates the relationship between the amount of assets that can quickly be turned into cash versus the amount of current liabilities.

Four financial ratios relate balance sheet amounts for Accounts Receivable and Inventory to income statement amounts. To illustrate these financial ratios we will use the following income statement information:

Example Corporation Income Statement For the year ended December 31, 2010 Sales (all on credit) $500,000 Cost of Goods Sold   380,000 Gross Profit   120,000 Operating Expenses Selling Expenses 35,000 Administrative Expenses    45,000 Total Operating Expenses    80,000 Operating Income 40,000 Interest Expense    12,000 Income before Taxes 28,000 Income Tax Expense     5,000 Net Income after Taxes $ 23,000

Financial Ratio		How to Calculate It	What It Tells You
Accounts Receivable Turnover	= = =	Net Credit Sales for the Year ÷ Average Accounts Receivable for the Year $500,000 ÷ $42,000 (a computed average) 11.90	The number of times per year that the accounts receivables turn over. Keep in mind that the result is an average, since credit sales and accounts receivable are likely to fluctuate during the year. It is important to use the average balance of accounts receivable during the year.
Days' Sales in Accounts Receivable	= = =	365 days in Year ÷ Accounts Receivable Turnover in Year 365 days ÷ 11.90 30.67 days	The average number of days that it took to collect the average amount of accounts receivable during the year. This statistic is only as good as the Accounts Receivable Turnover figure.
Inventory Turnover	= = =	Cost of Goods Sold for the Year ÷ Average Inventory for the Year $380,000 ÷ $30,000 (a computed average) 12.67	The number of times per year that Inventory turns over. Keep in mind that the result is an average, since sales and inventory levels are likely to fluctuate during the year. Since inventory is at cost (not sales value), it is important to use the Cost of Goods Sold. Also be sure to use the average balance of inventory during the year.
Days' Sales in Inventory	= = =	365 days in Year ÷ Inventory Turnover in Year 365 days ÷ 12.67 28.81	The average number of days that it took to sell the average inventory during the year. This statistic is only as good as the Inventory Turnover figure.

The next financial ratio involves the relationship between two amounts from the balance sheet: total liabilities and total stockholders' equity:

Financial Ratio		How to Calculate It	What It Tells You
Debt to Equity	= = =	(Total liabilities ÷ Total Stockholders' Equity) : 1 ( $481,000 ÷ $289,000) : 1 1.66 : 1	The proportion of a company's assets supplied by the company's creditors versus the amount supplied the owner or stockholders. In this example the creditors have supplied $1.66 for each $1.00 supplied by the stockholders.

The income statement has some limitations since it reflects accounting principles. For example, a company's depreciation expense is based on the cost of the assets it has acquired and is using in its business. The resulting depreciation expense may not be a good indicator of the economic value of the asset being used up. To illustrate this point let's assume that a company's buildings and equipment have been fully depreciated and therefore there will be no depreciation expense for those buildings and equipment on its income statement. Is zero expense a good indicator of the cost of using those buildings and equipment? Compare that situation to a company with new buildings and equipment where there will be large amounts of depreciation expense.

The remainder of our explanation of financial ratios and financial statement analysis will use information from the following income statement:

Example Corporation Income Statement For the year ended December 31, 2010 Sales (all on credit) $500,000 Cost of Goods Sold   380,000 Gross Profit   120,000 Operating Expenses Selling Expenses 35,000 Administrative Expenses    45,000 Total Operating Expenses    80,000 Operating Income 40,000 Interest Expense    12,000 Income before Taxes 28,000 Income Tax Expense     5,000 Net Income after Taxes $ 23,000 Earnings per Share (based on 100,000 shares outstanding) $     0.23

Financial Ratio		How to Calculate It	What It Tells You
Gross Margin	= = =	Gross Profit ÷ Net Sales $120,000 ÷ $500,000 24.0%	Indicates the percentage of sales dollars available for expenses and profit after the cost of merchandise is deducted from sales. The gross margin varies between industries and often varies between companies within the same industry.
Profit Margin (after tax)	= = =	Net Income after Tax ÷ Net Sales $23,000 ÷ $500,000 4.6%	Tells you the profit per sales dollar after all expenses are deducted from sales. This margin will vary between industries as well as between companies in the same industry.
Earnings Per Share (EPS)	= = =	Net Income after Tax ÷ Weighted Average Number of Common Shares Outstanding $23,000 ÷ 100,000 $0.23	Expresses the corporation's net income after taxes on a per share of common stock basis. The computation requires the deduction of preferred dividends from the net income if a corporation has preferred stock. Also requires the weighted average number of shares of common stock during the period of the net income.
Times Interest Earned	= = =	Earnings for the Year before Interest and Income Tax Expense ÷ Interest Expense for the Year $40,000 ÷ $12,000 3.3	Indicates a company's ability to meet the interest payments on its debt. In the example the company is earning 3.3 times the amount it is required to pay its lenders for interest.
Return on Stockholders' Equity (after tax)	= = =	Net Income for the Year after Taxes ÷ Average Stockholders' Equity during the Year $23,000 ÷ $278,000 (a computed average) 8.3%	Reveals the percentage of profit after income taxes that the corporation earned on its average common stockholders' balances during the year. If a corporation has preferred stock, the preferred dividends must be deducted from the net income.

The income statement has some limitations since it reflects accounting principles. For example, a company's depreciation expense is based on the cost of the assets it has acquired and is using in its business. The resulting depreciation expense may not be a good indicator of the economic value of the asset being used up. To illustrate this point let's assume that a company's buildings and equipment have been fully depreciated and therefore there will be no depreciation expense for those buildings and equipment on its income statement. Is zero expense a good indicator of the cost of using those buildings and equipment? Compare that situation to a company with new buildings and equipment where there will be large amounts of depreciation expense.

The statement of cash flows is a relatively new financial statement in comparison to the income statement or the balance sheet. This may explain why there are not as many well-established financial ratios associated with the statement of cash flows.

We will use the following cash flow statement for Example Corporation to illustrate a limited financial statement analysis:

Example Corporation Statement of Cash Flows For the Year Ended December 31, 2010 Cash Flow from Operating Activities: Net Income $23,000  Add: Depreciation Expense 4,000  Increase in Accounts Receivable (6,000) Decrease in Inventory 9,000  Decrease in Accounts Payable    (5,000) Cash Provided (Used) in Operating Activities   25,000  Cash Flow from Investing Activities Capital Expenditures (28,000) Proceeds from Sale of Property     7,000  Cash Provided (Used) by Investing Activities  (21,000) Cash Flow from Financing Activities: Borrowings of Long-term Debt 10,000  Cash Dividends (5,000) Purchase of Treasury Stock    (8,000) Cash Provided (Used) by Financing Activities    (3,000) Net Increase in Cash 1,000  Cash at the beginning of the year     1,200  Cash at the end of the year $  2,200

Financial Ratio		How to Calculate It	What It Tells You
Free Cash Flow	= = =	Cash Flow Provided by Operating Activities – Capital Expenditures $25,000 – $28,000 ( $3,000)	This statistic tells you how much cash is left over from operations after a company pays for its capital expenditures (additions to property, plant and equipment). There can be variations of this calculation. For example, some would only deduct capital expenditures to keep the present level of capacity. Others would also deduct dividends that are paid to stockholders, since they are assumed to be a requirement.

The cash flow from operating activities section of the statement of cash flows is also used by some analysts to assess the quality of a company's earnings. For a company's earnings to be of "quality" the amount of cash flow from operating activities must be consistently greater than the company's net income. The reason is that under accrual accounting, various estimates and assumptions are made regarding both revenues and expenses. When it comes to cash, however, the money is either in the bank or it isn't.

About the Author

By Muhammad Atif Saeed on 09:52. Filed under Accounting , feature . Follow any responses to the RSS 2.0. Leave a response