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Explanation of the Topic...

Financial RatiosPrint  Email 

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 

Introduction to Financial Ratios, General Discussion of Balance

Sheet, Common-Size Balance Sheet

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 

o General discussion

o Common-size balance sheet

o Financial ratios based on the balance sheet

• Income Statement 

o General discussion

o Common-size income statement

o Financial ratios based on the income statement

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• Statement of Cash Flows 

General Discussion of Balance SheetThe balance sheet reports a company's assets, liabilities, and stockholders' equity as of 

a specific date, such as December 31, 2007, September 28, 2008, 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 assets–such as computers–may 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.

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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 reasonsmentioned 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, 2007

ASSETS LIABILITIES

Current Assets Current Liabilities

Cash $ 2,100 Notes Payable $ 5,000

Petty Cash 100 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 Long-term Liabilities

Notes Payable 20,000

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Property, Plant & Equipment Bonds Payable 400,000

Land 5,500 Total Long-term Liabilities 420,000

Land Improvements 6,500

Buildings 180,000

Equipment 201,000 Total Liabilities 481,000

Less: Accum Depreciation (56,000)

Prop, Plant & Equip - net 337,000

-

Intangible Assets STOCKHOLDERS' EQUITY

Goodwill 105,000 Common Stock 110,000

Trade Names 200,000 Retained Earnings 229,000Total Intangible Assets 305,000 Less: Treasury Stock (50,000)

Total Stockholders' Equity 289,000

Other Assets 3,000

-

Total Assets $770,000Total Liabilities & Stockholders'

Equity$770,000

To learn more about the balance sheet, go to:

• Explanation of Balance Sheet 

• Drills for Balance Sheet 

• Crossword Puzzles for Balance Sheet 

Common–Size Balance Sheet

One technique in financial statement analysis is known as vertical analysis. Verticalanalysis results in common-size financial statements. A common-size balance sheet is a

balance sheet where every dollar amount has been restated to be a percentage of total

assets. We will illustrate this by taking Example Company's balance sheet (shown

above) and divide each item by the total asset amount $770,000. The result is the

following common-size balance sheet for Example Company:

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Example Company

Balance Sheet

December 31, 2007

ASSETS LIABILITIES

Current Assets Current Liabilities

Cash 0.3% Notes Payable 0.6%

Petty Cash 0.0% Accounts Payable 4.7%

Temporary Investments 1.3% Wages Payable 1.1%

Accounts Receivable - net 5.3% Interest Payable 0.4%

Inventory 4.0% Taxes Payable 0.8%

Supplies 0.5% Warranty Liability 0.1%

Prepaid Insurance 0.2% Unearned Revenues 0.2%

Total Current Assets 11.6% Total Current Liabilities 7.9%

-

Investments 4.7% Long-term Liabilities

Notes Payable 2.6%

Property, Plant & Equipment Bonds Payable 52.0%

Land 0.7% Total Long-term Liabilities 54.6%

Land Improvements 0.8%

Buildings 23.4%

Equipment 26.1% Total Liabilities 62.5%

Less: Accum Depreciation (7.3%)

Prop, Plant & Equip - net 43.7%

-

Intangible Assets STOCKHOLDERS' EQUITY

Goodwill 13.6% Common Stock 14.3%

Trade Names 26.0% Retained Earnings 29.7%

Total Intangible Assets 39.6% Less: Treasury Stock (6.5%)

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Total Stockholders' Equity 37.5%

Other Assets 0.4%

-

Total Assets 100.0% Total Liabilities & Stockholders'Equity

100.0%

The benefit of a common-size balance sheet is that an item can be compared to a

similar item of another company regardless of the size of the companies. A company

can also compare its percentages to the industry's average percentages. For example, a

company with Inventory at 4.0% of total assets can look to its industry statistics to see if 

its percentage is reasonable. (Industry percentages might be available from an industry

association, library reference desks, and from bankers. Generally banks have

memberships in Robert Morris Associates, an organization that collects and distributesstatistics by industry.) A common-size balance sheet also allows two businesspersons to

compare the magnitude of a balance sheet item without either one revealing the actual

dollar amounts.

Read more: http://www.accountingcoach.com/online-accounting-

course/03Xpg01.html#ixzz0RGwp9LDz

Financial Ratios Based on the Balance Sheet

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 currentobligations (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

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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, 2007

Sales (all on credit) $500,000

Cost of Goods Sold 380,000

Gross Profit 120,000

Operating Expenses

Selling Expenses 35,000Administrative Expenses 45,000

Total Operating Expenses 80,000

Operating Income 40,000

Interest Expense 12,000

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Income before Taxes 28,000

Income Tax Expense 5,000

Net Income after Taxes $ 23,000

To learn more about the income statement, go to:

• Explanation of Income Statement 

• Drills for Income Statement 

• Crossword Puzzle for Income Statement 

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 accountsreceivable 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.

InventoryTurnover  =

=

=

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 thatInventory 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 

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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.

General Discussion of Income Statement, Common-Size Income

Statement,

Financial Ratios Based on the Income Statement 

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 hasacquired 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.

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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, 2007

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

(To learn more about the income statement, go to:

• Explanation of Income Statement 

• Drills for Income Statement 

• Crossword Puzzle for Income Statement 

Common–Size Income StatementFinancial statement analysis includes a technique known as vertical analysis. Vertical

analysis results in common-size financial statements. A common-size income statement

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presents all of the income statement amounts as a percentage of net sales. Below is

Example Corporation's common-size income statement after each item from the income

statement above was divided by the net sales of $500,000:

Example Corporation

Income Statement

For the year ended December 31, 2007

Sales (all on credit) 100.0%

Cost of Goods Sold 76.0%

Gross Profit 24.0%

Operating Expenses

Selling Expenses 7.0%

Administrative Expenses 9.0%

Total Operating Expenses 16.0%

Operating Income 8.0%

Interest Expense 2.4%

Income before Taxes 5.6%

Income Tax Expense 1.0%

Net Income after Taxes 4.6%

The percentages shown for Example Corporation can be compared to other companies

and to the industry averages. Industry averages can be obtained from trade

associations, bankers, and library reference desks. If a company competes with a

company whose stock is publicly traded, another source of information is that company's

"Management's Discussion and Analysis of Financial Condition and Results of 

Operations" contained in its annual report to stockholders. Generally the annual report

as well as reports to the Securities and Exchange Commission are available on the

company's website.

Financial Ratios Based on the Income Statement

Financial Ratio How to Calculate It What It Tells You

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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 itsdebt. 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.

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Statement of Cash Flows

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 manywell-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, 2007

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

 Activities25,000

Cash Flow from Investing Activities

Capital Expenditures (28,000)

Proceeds from Sale of Property 7,000

Cash Provided (Used) by Investing

 Activities(21,000)

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• Explanation of Cash Flow Statement 

• Drills for Cash Flow Statement 

• Crossword Puzzle for Cash Flow Statement