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Part 1 Introduction to Financial Ratios, General Discussion of Balance Sheet,

Common-Size Balance Sheet


Part 2 Financial Ratios Based on the Balance Sheet
Part 3 General Discussion of Income Statement, Common-Size Income Statement,
Financial Ratios Based on the Income Statement
Part 4 Statement of Cash Flows
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
The balance sheet reports a company's assets, liabilities, and stockholders' equity
as of a specific date, such as December 31, 2011, March 31, 2012, etc.
The accountants' cost principle and the monetary unit assumption will limit the
assets reported on the balance sheet. Assets will be reported
(1) only if they were acquired in a transaction, and
(2) generally at an amount that is not greater than the asset's cost at the time of
the transaction.

This means that a company's creative and effective management team will not be
listed as an asset. Similarly, a company's outstanding reputation, its unique product
lines, and brand names developed within the company will not be reported on the
balance sheet. As you may surmise, these items are often the most valuable of all
the things owned by the company. (Brand names purchased from another company
will be recorded in the company's accounting records at their cost.)
The accountants' matching principle will result in assets such as buildings,
equipment, furnishings, fixtures, vehicles, etc. being reported at amounts less than
cost. The reason is these assets are depreciated. Depreciation reduces an asset's
book value each year and the amount of the reduction is reported as Depreciation
Expense on the income statement.
While depreciation is reducing the book value of certain assets over their useful
lives, the current value (or fair market value) of these assets may actually be
increasing. (It is also possible that the current value of some assetssuch as
computersmay be decreasing faster than the book value.)
Current assets such as Cash, Accounts Receivable, Inventory, Supplies, Prepaid
Insurance, etc. usually have current values that are close to the amounts reported
on the balance sheet.
Current liabilities such as Notes Payable (due within one year), Accounts Payable,
Wages Payable, Interest Payable, Unearned Revenues, etc. are also likely to have
current values that are close to the amounts reported on the balance sheet.
Long-term liabilities such as Notes Payable (not due within one year) or Bonds
Payable (not maturing within one year) will often have current values that differ
from the amounts reported on the balance sheet.
Stockholders' equity is the book value of the company. It is the difference between
the reported amount of assets and the reported amount of liabilities. For the
reasons mentioned above, the reported amount of stockholders' equity will
therefore be different from the current or market value of the company.
By definition the current assets and current liabilities are "turning over" at least
once per year. As a result, the reported amounts are likely to be similar to their
current value. The long-term assets and long-term liabilities are not "turning over"
often. Therefore, the amounts reported for long-term assets and long-term liabilities
will likely be different from the current value of those items.
The remainder of our explanation of financial ratios and financial statement analysis
will use information from the following balance sheet:

Example Company
Balance Sheet
December 31, 2011
ASSETS

LIABILITIES

Current Assets

Current Liabilities

Cash
Petty Cash

$ 2,100
100

Notes Payable

$ 5,000

Accounts Payable

35,900

Temporary Investments

10,000

Wages Payable

8,500

Accounts Receivable - net

40,500

Interest Payable

2,900

Inventory

31,000

Taxes Payable

6,100

Supplies

3,800

Warranty Liability

1,100

Prepaid Insurance

1,500

Unearned Revenues

1,500

Total Current Assets

89,000

Total Current Liabilities

61,000

Investments

36,000

Property, Plant & Equipment


Land

5,500

Land Improvements

6,500

Buildings

180,000

Equipment

201,000

Less: Accum Depreciation

(56,000)

Prop, Plant & Equip - net

337,000

Long-term Liabilities
Notes Payable

20,000

Bonds Payable

400,000

Total Long-term Liabilities

Total Liabilities

420,000

481,000

STOCKHOLDERS'
EQUITY

Intangible Assets
Goodwill

105,000

Common Stock

110,000

Trade Names

200,000

Retained Earnings

229,000

305,000

Less: Treasury Stock

(50,000)

Total Intangible Assets

Total Stockholders' Equity


Other Assets

3,000
-

289,000

Total Assets

$770,000

Total Liab. &


Stockholders' Equity

$770,000

PART 2
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
Working
Capital

How to Calculate It
=Current Assets Current
Liabilities
=$89,000 $61,000
$28,000
=

Current Ratio =Current Assets Current


Liabilities
=$89,000 $61,000

What It Tells You


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.
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.

1.46
=
Quick Ratio
(Acid Test
Ratio)

=[(Cash + Temp. Investments + This ratio is similar to the


Accounts Receivable) Current current ratio except that
Liabilities] : 1
Inventory, Supplies, and Prepaid
Expenses are excluded. This
[($2,100 + $100 + $10,000 + indicates the relationship
=$40,500) $61,000] : 1
between the amount of assets
that can quickly be turned into
[$52,700 $61,000] : 1
cash versus the amount of
current liabilities.
=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, 2011
Sales (all on credit)
Cost of Goods Sold
Gross Profit

Financial
Ratio

$500,00
0
380,00
0
120,00
0

Operating Expenses
Selling Expenses
Administrative Expenses
Total Operating Expenses

35,000
45,000
80,000

Operating Income
Interest Expense

40,000
12,000

Income before Taxes


Income Tax Expense

28,000
5,000

Net Income after Taxes

$ 23,000

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

=
Days' Sales in =365 days in Year Accounts
Accounts
Receivable Turnover in Year
Receivable
365 days 11.90
=
30.67 days

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.
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.

=
=Cost of Goods Sold for the Year The number of times per year
Average Inventory for the that Inventory turns over. Keep
Year
in mind that the result is an
average, since sales and
=$380,000 $30,000 (a
inventory levels are likely to
computed average)
fluctuate during the year. Since
inventory is at cost (not sales
12.67
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 =365 days in Year Inventory
The average number of days
Inventory
Turnover in Year
that it took to sell the average
inventory during the year. This
365 days 12.67
statistic is only as good as the
=
Inventory Turnover figure.
28.81
Inventory
Turnover

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

How to Calculate It
=(Total liabilities Total

What It Tells You


The proportion of a company's

Equity

Stockholders' Equity) : 1
( $481,000 $289,000) : 1
=
1.66 : 1
=

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, 2011
Sales (all on credit)
Cost of Goods Sold
Gross Profit

$500,000
380,000
120,000

Operating Expenses
Selling Expenses
Administrative Expenses
Total Operating Expenses

35,000
45,000
80,000

Operating Income
Interest Expense

40,000
12,000

Income before Taxes


Income Tax Expense
Net Income after Taxes

28,000
5,000
$ 23,000

Earnings per Share


(based on 100,000 shares
outstanding)

0.23

Financial Ratios Based on the Income Statement


How to Calculate It

Financial Ratio
Gross Margin

= Gross Profit Net Sales


= $120,000 $500,000
= 24.0%

Profit Margin
(after tax)

= Net Income after Tax Net Sales


= $23,000 $500,000
= 4.6%

Earnings Per
Share (EPS)

Times Interest
Earned

What It Tells You


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.
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.

= Net Income after Tax Weighted


Expresses the corporation's net
Average Number of Common Shares income after taxes on a per share of
Outstanding
common stock basis. The
computation requires the deduction
= $23,000 100,000
of preferred dividends from the net
income if a corporation has preferred
= $0.23
stock. Also requires the weighted
average number of shares of
common stock during the period of
the net income.
= Earnings for the Year before Interest Indicates a company's ability to meet
and Income Tax Expense Interest the interest payments on its debt. In
Expense for the Year
the example the company is earning
3.3 times the amount it is required to
= $40,000 $12,000
pay its lenders for interest.

= 3.3
Return on
Stockholders'
Equity (after
tax)

= Net Income for the Year after Taxes Reveals the percentage of profit after
Average Stockholders' Equity
income taxes that the corporation
during the Year
earned on its average common
stockholders' balances during the
= $23,000 $278,000 (a computed
year. If a corporation has preferred
average)
stock, the preferred dividends must
be deducted from the net income.
= 8.3%

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, 2011
Cash Flow from Operating Activities:
Net Income
Add: Depreciation Expense
Increase in Accounts Receivable
Decrease in Inventory
Decrease in Accounts Payable
Cash Provided (Used) in Operating Activities

$23,000
4,000
(6,000)
9,000
(5,000)
25,000

Cash Flow from Investing Activities


Capital Expenditures
Proceeds from Sale of Property
Cash Provided (Used) by Investing Activities

(28,000)
7,000
(21,000)

Cash Flow from Financing Activities:


Borrowings of Long-term Debt
Cash Dividends
Purchase of Treasury Stock
Cash Provided (Used) by Financing Activities

10,000
(5,000)
(8,000)
(3,000)

Net Increase in Cash


Cash at the beginning of the year
Cash at the end of the year

Financial Ratio

1,000
1,200
$ 2,200

How to Calculate It

Free Cash Flow = Cash Flow Provided by Operating


Activities Capital Expenditures
= $25,000 $28,000
= ( $3,000)

What It Tells You


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.

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