Dr. BALAMURUGAN MUTHURAMAN

INTER-COMPANY EVALUATION OF FINANCIAL STATEMENTS

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Chapter 5

CLASSIFIED FINANCIAL STATEMENTS

• Information in financial statements may be used to evaluate two important goals of management– Maintaining adequate liquidity– Achieving satisfactory profitability

• A series of ratios are used to evaluate these two goals

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EVALUATING LIQUIDITY

Liquidity means having enough cash on hand to pay bills when they become due and to cover unexpected needs for cash

• Two measures of liquidity– Working capital– Current ratio

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WORKING CAPITAL

… is the amount by which total current assets exceed total current liabilities

sLiabilitieCurrent Total - AssetsCurrent Total

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Capital Working

WORKING CAPITAL

• Current assets– Assets that will be converted to cash or used up

within one year or one operating cycle, whichever is longer

• Current liabilities– Debts that must be paid or obligations that must be

performed within one year or one operating cycle, whichever is longer

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WORKING CAPITAL

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• By definition, current liabilities are paid out of current assets

• The excess of current assets over current liabilities is the net current assets on hand to continue operations

Total Current Assets – Total Current Liabilities = Net Current Assets Available to Continue Business Operations

Total Current Assets – Total Current Liabilities = Working Capital

If

thenWorking Capital = Net Current Assets Available to Continue

Business Operations

WORKING CAPITAL• Working capital is used to buy inventory, obtain

credit, and finance expanded sales• Lack of working capital can lead to a company's

failure

Compute working capital for Shafer Auto Parts Corporation

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Current assets $124,356 Current liabilities – 42,683 Working capital $ 81,673

CURRENT RATIO

• Is closely related to working capital• Believed by many to be a good indicator of a

company’s ability to– Pay its bills– Repay outstanding debt

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sLiabilitieCurrent

AssetsCurrent RatioCurrent

… is the ratio of current assets to current liabilities

CURRENT RATIO

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sLiabilitieCurrent AssetsCurrent RatioCurrent

Compute the current ratio for Shafer Auto Parts Corporation

2.9 $42,683

$124,356

This means that Shafer has $2.90 of current assets for each $1.00 of current liabilities

For proper analysis, this ratio must be compared with ratios from previous years and with ratios from successful companies in the same industry

Current Ratio

• Very low current ratio– Unfavorable

• Means the company may not have the ability to pay its bills and outstanding debt when due

• High current ratio– Can be unfavorable

• May indicate the company is not using its assets effectively

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Evaluating Profitability

Profitability means the ability to earn a satisfactory income

• Common profitability measures– Profit margin– Asset turnover– Return on assets– Debt to equity– Return on equity

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PROFIT MARGIN… shows the percentage of each sales dollar

that results in net income

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SalesNet

IncomeNet Margin Profit

Compute the profit margin for Shafer Auto Parts

$289,656$14,500 Margin Profit (5.0%) .050

This means that on each dollar of net sales, Shafer Auto Parts made 5.0 cents

Asset Turnover

… measures how efficiently assets are used to produce sales

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Assets Total Average

SalesNet Turnover Asset

• It shows how many dollars of sales were generated by each dollar of assets

• A high asset turnover means a company uses its assets productively

This ratio shows a meaningful relationship between an income statement figure and a balance sheet figure

Asset TurnoverCompute asset turnover for Shafer Auto Parts Corporation

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2 $148,620) ($158,916

$289,656 Turnover Asset

Assets Total AverageSalesNet Turnover Asset

Average total assets is computed by adding total assets at the beginning of the year to total assets at the end of the year and dividing by 2

times1.9 $153,768$289,656

This means that Shafer produces $1.90 in sales for each $1.00 invested in average total assets

Return on Assets

… measures how efficiently a companyuses its assets to produce income

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Assets Total Average

IncomeNet Assetson Return

Return on Assets• Combines profit margin and asset turnover

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Indicates how efficiently the company is using all

its assets

Indicates income-generating strength of the company’s

resources

• Return on assets overcomes the limitations of profit margin and asset turnover ratios

– Profit margin does not consider the assets necessary to produce income– Asset turnover ratio does not take into account the amount of net income produced

Net Income Net Sales Net Income Net Sales x Average Total Assets = Average Total Assets

Profit Margin x Asset Turnover = Return on Assets

Return on Assets

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Compute return on assets for Shafer Auto Parts Corporation

2 $148,620) ($158,916$14,500 Assetson Return

(9.4%) .094

$153,768$14,500

Average total assets is computed by adding total assets at the beginning of the year to total assets at the end of the year and dividing by 2

This means that for each dollar invested by the owner, Shafer’s assets generate 9.4 cents of net income

Assets Total AverageIncomeNet Assetson Return

Assetson Return Turnover Asset Margin Profit Or,9.5% times1.9 5.0% Difference between

9.4 and 9.5 due to rounding

Debt to Equity… shows the portion of the company

financed by creditors in comparison to that financed by stockholders

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Equity rs'Stockholde

sLiabilitie Total Equity Debt to

• A company with a high debt to equity ratio is riskier in poor economic times because it must continue to repay creditors

• A company with a low debt to equity ratio is safer because the stockholders do not have to be repaid and dividends can be deferred

Debt to Equity• The assets of a company are financed by

– Creditors (creating liabilities) – Investors

• A debt to equity ratio of 1.0 means that half the company’s assets are financed by creditors and half are financed by investors

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Represents assets financed by investors

Represents assets financed by creditors

0.1$45,253$45,253

Equity rs'StockholdesLiabilitie Total Equity Debt to

Debt to Equity

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Equity rs'StockholdesLiabilitie Total Equity Debt to

Compute debt to equity for Shafer Auto Parts Corporation

(61.4%) .614 $98,433$60,483 Equity Debt to

A ratio less than 1.0 (or 100%) means that less than half of the company’s assets are financed by creditors and more than half are financed by investors

For every 61.4 cents of financing from creditors, $1.00 of financing came from investors