Ratio Analysis and Statement Evaluation

Financial Statements Across Periods

Companies prepare three financial statements according to GAAP rules: the income statement, the balance sheet, and the cash flow statement.

Learning Objectives

Identify the three main financial statements that companies generally submit

Key Takeaways

Key Points

  • The income statement gives an account of what the company sold and spent in the year ( revenues and expenses ).
  • The balance sheet is a financial snapshot of the company’s assets and liabilities, and informs shareholders about its financial health.
  • The cash flow statement shows what came into and went out of the company in cash. It gives a better idea than the other two financial statements about how well the company can meet its cash obligations.
  • The Securities and Exchange Commission (SEC) regulates these financial statements. Companies must file extensive reports annually (known as a 10K ), as well as quarterly reports ( 10Q ).
  • A company may report its financials in a fiscal year that is different from the calendar year.

Key Terms

  • 10Q: A quarterly report mandated by the United States federal Securities and Exchange Commission to be filed by publicly traded corporations.
  • generally accepted accounting principles: The standard framework of guidelines for financial accounting used in any given jurisdiction; generally known as accounting standards. GAAP includes the standards, conventions, and rules accountants follow in recording and summarizing, and in the preparation of financial statements.
  • 10K: An annual report, required by the U.S. Securities and Exchange Commission (SEC), that gives a comprehensive summary of a public company’s performance.

Financial statements are records that outline the financial activities of a business, individual, or any other entity. Corporations report financial statements following Generally Accepted Accounting Principles ( GAAP ). The rules about how financial statements should be put together are set by the Financial Accounting Standards Board (FASB). Standardized rules ensure, to some extent, that a firm’s financial statements accurately represent the company’s financial status.

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Financial Statements Analysis: Corporations report financial statements following Generally Accepted Accounting Principles (GAAP).

Companies generally submit three forms of financial statements. The information contained in these statements, and how this information fluctuates across periods, is very telling for investors and government regulatory agencies. These three financial statements are:

The income statement (also called the “profit and loss statement”): This gives an account of what the company sold and spent in the year. Sales (also called “revenues”), or what the company sold in products and services, less any expenses (expenses are divided into a number of categories) and less taxes, gives the company’s income. The income statement summarizes all this type of activity for the year.

The balance sheet: This is a financial snapshot of what the company owns (assets), what it owes (liabilities), and its worth free and clear of debt (or the value of its equity). Analyzing a balance sheet informs shareholders about the company’s financial health.

The cash flow statement: It tells what transactions went into and came out of the company in the form of cash. This is necessary because accounting sometimes deals with revenues and expenses which are not real cash, such as accounts receivable and accounts payable. Looking at the actual cash flow gives a better idea of how well the company can meet its cash obligations.

The period represented in a given financial statement can vary. A company may report its financials in a fiscal year that is different from the calendar year. While some firms do follow the calendar year, others–such as retail companies–prefer not to follow the calendar year due to seasonality of sales or expenses, et cetera.

The reporting of these financial statements is regulated by the federal agency, the Securities and Exchange Commission (SEC). According to SEC regulations, companies have to file an extensive report (called the 10K) on what happened during the year. In addition to the 10K, companies have to file 10Qs every three months, which give their quarterly financial performance. These reports can be accessed through the SEC’s website, www.sec.gov, the company’s website, or various financial websites, such as finance.yahoo.com.

Profitability Ratios

Profitability ratios are used to assess a business’s ability to generate earnings.

Learning Objectives

Compare the information given by calculating the various profitability ratios

Key Takeaways

Key Points

  • Profitability ratios are used to compare companies in the same industry, since profit margins will vary widely from industry to industry.
  • Taxes should not be included in these ratios, since tax rates will vary from company to company.
  • The profit margin shows the relationship between profit and sales and is mostly used for internal comparison.
  • Profit Margin = Net Profit / Net Sales. It shows the relationship between profit and sales and is mostly used for internal comparison.
  • ROE = Net Income / Shareholder Equity. It measures a firm’s efficiency at generating profits from every unit of shareholders’ equity.
  • The BEP ratio compares earnings before income and taxes to total assets. BEP = EBIT / Total Assets.

Key Terms

  • profitability: The capacity to make a profit.
  • Cost of Goods Sold: Cost of goods sold (COGS) refer to the inventory costs of those goods a business has sold during a particular period.
  • financial leverage: The degree to which an investor or business is utilizing borrowed money.

Profitability Ratios

Profitability ratios show how much profit the company takes in for every dollar of sales or revenues. They are used to assess a business’s ability to generate earnings as compared to expenses over a specified time period.

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Increasing Profits: Profitability ratios are used to assess a business’s ability to generate earnings.

Profitability ratios are going to vary from industry to industry, so comparisons should be between other companies in the same field. When comparing companies in the same industry, the company with the higher profit margin is able to sell at a higher price or lower expenses. They tend to be more attractive to investors.

Net Profit Margins and Returns on Sales

Many analysts focus on net profit margins or returns on sales, which are calculated by taking the net income after taxes and dividing by the revenues or sales. This ratio uses the bottom line on the income statement to calculate profit for every dollar of sales or revenues. The operating margin takes the profit before taxes further up the income statement and divides by revenues. Operating margins are also important, since they focus on the operating income and operating expenses. Other profitability ratios include:

  • Return on Assets: The return on assets ratio (ROA) is found by dividing the net income by total assets. The higher the ratio, the better the company is at using their assets to generate income (i.e., how many dollars of earnings they derive from each dollar of assets they control). It is also a measure of how much the company relies on assets to generate profit. The return on assets gives an indication of the company’s capital intensity, which will depend on the industry. Companies that require large initial investments will generally have reduced return on assets.
  • Profit Margin: The profit margin is one of the most used profitability ratios. The profit margin refers to the amount of profit that a company earns through sales. The profit margin ratio is broadly the ratio of profit to total sales times one hundred percent. The higher the profit margin, the more profit a company earns on each sale. The profit margin is mostly used for internal comparison. It is difficult to accurately compare the net profit ratio for different entities. A low profit margin indicates a low margin of safety and a higher risk that a decline in sales will erase profits and result in a net loss or a negative margin.
  • Return on Equity: The return on equity (ROE) measures profitability related to ownership. It measures a firm’s efficiency at generating profits from every unit of the shareholders’ equity. ROEs between 15 percent and 20 percent are generally considered good. The ROE is equal to the net income divided by the shareholder equity.
  • Basic Earning Power Ratio: The basic earning power ratio (or BEP ratio) compares earnings separately from the influence of taxes or financial leverage to the assets of the company. The BEP is equal to the earnings before interest and taxes divided by the total assets. The BEP differs from the ROA in that it includes the non-operating income.
  • Gross Profit Ratio: This indicates what portion of each sales dollar is available to meet expenses and generate profit after taking into account the cost of goods sold. Generally, it is calculated as the selling price of an item minus the cost of goods sold (production or acquisition costs).

Liquidity Ratios

Liquidity ratios measure how quickly assets can be turned into cash in order to pay the company’s short-term obligations.

Learning Objectives

Compare the current ratio to the quick ratio

Key Takeaways

Key Points

  • Liquidity ratios should fall within a certain range—too low and the company cannot pay off its obligations, or too high and the company is not utilizing its cash efficiently.
  • Current Ratio = Current Assets / Current Liabilities. This ratio examines whether a firm can cover its short-term debts. If below 1, the company may have difficulty meeting short-term obligations.
  • Acid Test Ratio (or Quick Ratio) = [Current Assets – Inventories ] / Current Liabilities. More stringent and meaningful than the Current Ratio, since it does not include inventory. A ratio of 1:1 is recommended, but not necessarily a minimum.
  • A company can improve its liquidity ratios by raising the value of its current assets, reducing current liabilities by paying off debt, or negotiating delayed payments to creditors.

Key Terms

  • liquidity ratio: total cash and equivalents divided by short-term borrowings
  • liquidity: An asset’s ability to become solvent without affecting its value; the degree to which it can be easily converted into cash.
  • creditor: A person to whom a debt is owed.

Liquidity ratios measure a company’s ability to pay short-term obligations of one year or less (i.e., how quickly assets can be turned into cash). A high liquidity ratio indicates that a business is holding too much cash that could be utilized in other areas. A low liquidity ratio means a firm may struggle to pay short-term obligations.

One such ratio is known as the current ratio, which is equal to:

Current Assets ÷ Current Liabilities.

This ratio reveals whether the firm can cover its short-term debts; it is an indication of a firm’s market liquidity and ability to meet creditor’s demands. Acceptable current ratios vary from industry to industry. For a healthy business, a current ratio will generally fall between 1.5 and 3. If current liabilities exceed current assets (i.e., the current ratio is below 1), then the company may have problems meeting its short-term obligations. If the current ratio is too high, the company may be inefficiently using its current assets or its short-term financing facilities. This may also indicate problems in working capital management.

The acid test ratio (or quick ratio) is similar to current ratio except in that it ignores inventories. It is equal to:

(Current Assets – Inventories) Current Liabilities.

Typically the quick ratio is more meaningful than the current ratio because inventory cannot always be relied upon to convert to cash. A ratio of 1:1 is recommended. Low values for the current or quick ratios (values less than 1) indicate that a firm may have difficulty meeting current obligations. Low values, however, do not indicate a critical problem. If an organization has good long-term prospects, it may be able to borrow against those prospects to meet current obligations.

A firm may improve its liquidity ratios by raising the value of its current assets, reducing the value of current liabilities, or negotiating delayed or lower payments to creditors.

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Cash: Cash is the most liquid asset in a business.

Debt Utilization Ratios

Debt ratios provide information about a company’s long-term financial health.

Learning Objectives

Explain the methods and usage of debt utilization ratios

Key Takeaways

Key Points

  • Generally speaking, the more debt a company has (as a percentage of assets ), the less healthy it is financially.
  • Debt Ratio = Total Debt / Total Assets. It shows the percentage of a company’s assets that are provided through debt. The higher the ratio, the greater the risk the company has undertaken.
  • Debt-to- Equity Ratio (D/E) = Debt (i.e. Liabilities ) / Equity. It shows the split of shareholders ‘ equity and debt that are used to finance the company’s assets.
  • The DCR shows the ratio of cash available for debt servicing to interest, principal, and lease payments. The higher this ratio, the easier it is for a company to take on new debt.

Key Terms

  • Interest: The price paid for obtaining or price received for providing money or goods in a credit transaction, calculated as a fraction of the amount or value of what was borrowed.
  • debt: Money that one person or entity owes or is required to pay to another, generally as a result of a loan or other financial transaction.
  • amortization: The reduction of loan principle over a series of payments.
  • debt financing: funding obtained by borrowing assets

Debt utilization ratios provide a comprehensive picture of the company’s solvency or long-term financial health. The debt ratio is a financial ratio that indicates the percentage of a company’s assets that are provided via debt. It is the ratio of total debt (the sum of current liabilities and long-term liabilities) and total assets (the sum of current assets, fixed assets, and other assets such as “goodwill”).

Debt Ratio = Total Debt / Total Assets

For example, a company with $2 million in total assets and $500,000 in total liabilities would have a debt ratio of 25%. The higher the ratio, the greater the risk associated with the firm’s operation. In addition, high debt to assets ratio may indicate low borrowing capacity of a firm, which in turn will lower the firm’s financial flexibility. Like all financial ratios, a company’s debt ratio should be compared with their industry average or other competing firms.

The debt-to-equity ratio (D/E) is a financial ratio indicating the relative proportion of shareholders’ equity and debt used to finance a company’s assets. When used to calculate a company’s financial leverage, the debt usually includes only the Long Term Debt (LTD). D/E = Debt(liabilities)/Equity.

The debt service coverage ratio (DSCR), also known as debt coverage ratio (DCR), is the ratio of cash available for debt servicing to interest, principal, and lease payments. It is a popular benchmark used in the measurement of an entity’s ability to produce enough cash to cover its debt (including lease) payments. The higher this ratio is, the easier it is to obtain a loan. In general, it is calculated as:

DSCR = (Annual Net Income + Amortization/Depreciation + Interest Expense + other non-cash and discretionary items (such as non-contractual management bonuses)) / (Principal Repayment + Interest payments + Lease payments)

A similar debt utilization ratio is the times interest earned (TIE), or interest coverage ratio. It is a measure of a company’s ability to honor its debt payments. It may be calculated as either EBIT or EBITDA, divided by the total interest payable. EBIT is earnings before interest and taxes, and EBITDA is earnings before interest, taxes, depreciation, and amortization.

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Leverage Ratios: Leverage ratios for some investment banks

Comparisons Within an Industry

Most financial ratios have no universal benchmarks, so meaningful analysis involves comparisons with competitors and industry averages.

Learning Objectives

Explain how to effectively use financial statement analysis

Key Takeaways

Key Points

  • Ratios allow easier comparison between companies than using absolute values of certain measures. They negate the impact of scale in profitability or solvency.
  • Firms should generally try to meet or exceed the industry average, over time, in their ratios.
  • Industry trends, changes in price levels, and future economic conditions should all be considered when using financial ratios to analyze a firm’s performance.

Key Terms

  • bankruptcy: A legally declared or recognized condition of insolvency of a person or organization.
  • solvency: The state of having enough funds or liquid assets to pay all of one’s debts; the state of being solvent.

Financial statement analysis (or financial analysis) is the process of reviewing and analyzing a company’s financial statements to make better economic decisions. These statements include the income statement, balance sheet, statement of cash flows, and a statement of retained earnings. Financial statement analysis is a method or process involving specific techniques for evaluating risks, performance, financial health, and future prospects of an organization.

Financial statements can reveal much more information when comparisons are made with previous statements, rather than when considered individually. Horizontal analysis compares financial data, such as an income statements, over a period of several quarters or years. When comparing past and present financial information, one will want to look for variations such as higher or lower earnings. Moreover, it is often useful to compare the financial statements of companies in related industries.

Ratios of risk such as the current ratio, the interest coverage, and the equity percentage have no theoretical benchmarks. It is, therefore, common to compare them with the industry average over time. If a firm has a higher equity ratio than the industry, this is considered less risky than if it is below the average. Similarly, if the equity ratio increases over time, it is a good sign in relation to insolvency risk.

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Refining Operation: Ratio analyses can be used to compare between companies within the same industry. For example, comparing the ratios of BP and Exxon Mobil would be appropriate, whereas comparing the ratios of BP and General Mills would be inappropriate.

The main purpose of conducting financial analysis is to measure a business’s profitability and solvency. The actual metrics tracked and methods applied vary from stakeholder to stakeholder, depending on his or her interests and needs. For example, equity investors are interested in the long-term earnings power of the organization and perhaps the sustainability and growth of dividend payments. Creditors want to ensure the interest and principal is paid on the organizations debt securities (e.g., bonds) when due.

Most analytical measures are expressed as percentages or ratios, which allows for easy comparison with other businesses in the industry regardless of absolute company size. Vertical analysis, which is a proportional analysis of financial statements, lists each line item in the financial statement as the percentage of another line item. For example, on an income statement each line item will be listed as a percentage of gross sales. This technique is also referred to as normalization or common-sizing.

When using these analytical measures, one should take the following factors into consideration:

  1. Industry trends;
  2. Changes in price levels;
  3. Future economic conditions.

Ratios must be compared with other firms in the same industry to see if they are in line.

Performance per Share

Valuation ratios describe the value of shares to shareholders, and include the EPS ratio, the P/E ratio, and the dividend yield ratio.

Learning Objectives

Identify the ratio analysis tools used for shares of stock

Key Takeaways

Key Points

  • EPS (Earnings Per Share) = Net Income / Average Common Shares. This ratio gives the earnings per outstanding share of a company’s stock.
  • P/E Ratio = Market Price per Share / Annual Earnings per Share. This ratio is widely used to measure the relative value of companies. The higher the P/E ratio, the more investors are paying for each unit of net income.
  • Current Dividend Yield = Most Recent Full Year Dividend / Current Share Price. Displays the earnings distributed to stock holders in relation to the value of the stock.
  • Market To Book ratio is used to compare a company’s current market price to its book value.

Key Terms

  • stockholder: One who owns stock.
  • dividend: A pro rata payment of money by a company to its shareholders, usually made periodically (e.g., quarterly or annually).

Company Performance Per Share

The below ratios describe the value of shares of stock to stockholders, both in terms of dividends and their general ownership value:

  • Earnings Per Share (EPS) is the amount of earnings per each outstanding share of a company’s stock. Companies are required to report EPS for each of the major categories of the income statement, including: continuing operations, discontinued operations, extraordinary items, and net income. EPS = Net Income / Average Common Shares.
  • Price to Earnings (P/E) ratio relates market price to earnings per share. The P/E ratio is a widely used metric used for measuring the relative value of companies. A higher P/E ratio means that investors are paying more for each unit of net income; therefore, the stock is more expensive compared to one with a lower P/E ratio. The P/E ratio also shows the number of years of earnings which would be required to pay back the purchase price—ignoring inflation, earnings growth and the time value of money. P/E Ratio = Market Price Per Share / Annual Earnings Per Share .
  • Dividend Yield ratio shows the earnings distributed to stockholders related to the value of the stock, as calculated on a per-share basis. The dividend yield or the dividend-price ratio of a share is the company’s total annual dividend payments divided by its market capitalization—or the dividend per share, divided by the price per share. It is often expressed as a percentage. Current Dividend Yield = Most Recent Full Year Dividend / Current Share Price.
  • Dividend Payout ratio shows the portion of earnings distributed to stockholders. Dividend payout ratio is the fraction of net income a firm pays to its stockholders in dividends: Dividend Payout Ratio = Dividends / Net Income for the Same Period. The part of earnings not paid to investors is left for investment to provide for future earnings growth. Investors seeking high current income and limited capital growth prefer companies with a high dividend payout ratio. However, investors seeking capital growth may prefer a lower payout ratio, because capital gains are taxed at a lower rate. High growth firms in early life generally have low or zero payout ratios. As they mature, they tend to return more of the earnings back to investors.
  • Market To Book ratio is used to compare a company’s current market price to its book value. The calculation can be performed in two ways, but the result should be the same using either method. In the first method, the company’s market capitalization can be divided by the company’s total book value from its balance sheet (Market Capitalization / Total Book Value). The second method, using per-share values, is to divide the company’s current share price by the book value per share, which is its book value divided by the number of outstanding shares (Share Price / Book Value Per Share). A higher market to book ratio implies that investors expect management to create more value from a given set of assets, all else equal. This ratio also gives some idea of whether an investor is paying too much for what would be left if the company went bankrupt immediately.

Activity Ratios

Activity ratios provide useful insights regarding an organization’s ability to leverage existing assets efficiently.

Learning Objectives

Calculate activity ratios to determine organizational efficiency

Key Takeaways

Key Points

  • Organizations are largely systems of assets that produce outputs. The efficiency of how those assets are used can be measured via activity ratios.
  • There are a number of different activity ratios commonly used by stakeholders and managers to assess overall organizational efficiency, most importantly asset turnover, inventory turnover, and degree of operating leverage.
  • Different businesses and industries tend to focus more on some activity ratios than others. Knowing what ratio is relevant based on the operation or process is an important consideration for managerial accountants.
  • Inventory turnover is highly relevant for industries selling perishable or time sensitive goods. On the other hand, manufacturing facilities tend to be more concerned with fixed asset turnover.

Key Terms

  • leverage: To use in such a way to capture maximum value.
  • perishable: A good that has an expiration date, or can go bad.

Why Firms Measure Activity

Activity ratios are essentially indicators of how a given organization leverages their existing assets to generate value. When considering the nature of a business, the general concept is to generate value through utilizing various production processes, employee talent, and intellectual property. Through identifying the profit compared to the investment in these core assets, the overall efficiency of the organization’s utilization can be derived.

How to Measure Activity

There are a number of ways to measure activity. Each calculation has different inputs and different implications. Some examples include:

  • Average collection period – (Accounts Receivable)/(Daily Average Credit Sales)
  • Degree of Operating Leverage (DOL) – (Percent Change in Net Operating Income)/(Percent Change in Sales)
  • DSO Ratio – (Accounts Receivable)/(Daily Average Sales)
  • Average Payment Period – (Accounts Payable)/(Average Daily Credit Purchases)
  • Asset Turnover – (Net Sales)/(Total Assets)
  • Stock Turnover Ratio – (Cost of Goods Sold)/(Average Inventory)
  • Receivables Turnover Ratio – (Net Credit Sales)/(Average Net Receivables)
  • Inventory Conversion Ratio – (365 Days)/(Inventory Turnover)
  • Receivables Conversion Period – (Receivables/Net Sales)(365 Days)
  • Payable Conversion Period – (Receivables/Net Sales)(365 Days)
  • Cash Conversion Cycle – Inventory Conversion Period + Receivable Conversion Period – Payable Conversion Period

Using Activity Ratios

By tracking these metrics over time, and comparing them to the competition, organizations and stakeholders can gauge their competitiveness and overall capacity to leverage assets in the current industry. Understanding how to use these ratios, and what the implications are, is central to financial and managerial accounting at the strategic level.

For some business, inventory turnover is an incredibly important metric. A business selling farmed produce, for example, must have a highly sophisticated value chain with minimal warehousing and storage. Inventory turnover must be rapid, as the goods being sold are perishable. Fashion industries are similarly reliant on inventory turnover, as the seasonality of both fashion styles and climate create a strong necessity for careful activity management.

For other businesses, asset turnover is a central activity metric. A manufacturing facility producing semiconductors, for example, will invest heavily in the production facility and related equipment. Ensuring maximum production and annual sales contracts is integral to maintaining profitability, and maximizing utilization of those fixed assets will enormously impact profitability.

Sample Evaluation

Most of the ratios discussed can be calculated using information found in the three main financial statements.

Learning Objectives

Apply financial ratio analysis to Bounded Inc.

Key Takeaways

Key Points

  • Keep in mind that for most ratios, the number must be compared against competitors and industry standards for it to be meaningful.
  • The ROE (Return on Equity ) measures the firm’s ability to generate profits from every unit of shareholder equity.
  • ROEs between 15 percent and 20 percent are generally considered good.

Key Terms

  • ROA: The return on assets (ROA) percentage shows how profitable a company’s assets are in generating revenue.

Consider the company Bounded Inc., a magazine publisher, to illustrate the financials of a company. The following information is based on the company’s FY (financial year) 2011 performance:

  • Cash: $3,230
  • Cost of Goods Sold: $2,390
  • Current Assets: $1,000
  • Current Liabilities: $3,500
  • Depreciation: $800
  • Fixed Assets: $8,600
  • Interest Payments: $300
  • Inventory: $2,010
  • Long-term Debt: $3,000
  • Sales: $5,000

Using the information above, we can compile the balance sheet and the income statement. We can also calculate some financial ratios to determine the company’s financial situation. Keep in mind that for most ratios, the number must be compared against competitors and industry standards for it to be meaningful:

ROA (Return on Assets) = Net Income / Total Assets = 1,057 / 13,840 = 7.6%

This means that for every dollar of assets the company controls, it derives $0.076 of profit. This would need to be compared to others in the same industry to determine whether this is a high or low figure.

Profit Margin = Net Income / Net Sales = 1,057/5,000 = 21.1 percent

This figure would need to be compared to competitors. A lower profit margin indicates a low margin of safety.

ROE (Return on Equity) = Net Income / Shareholder Equity = 1,057/7,340 = 14.4 percent

The ROE measures the firm’s ability to generate profits from every unit of shareholder equity. 0.144 (or 14 percent) is not a bad figure, but by no means a very good once, since ROE’s between 15 to 20 percent are generally considered good.

BEP Ratio = EBIT / Total Assets = 1,810/13,840 = 0.311

Current Ratio = Current Assets / Current Liabilities = 5,240/3,500 = 1.497

This demonstrates that the company does not seem to be in a tight position in terms of liquidity.

Quick Ratio = (Current Assets-Inventories) / Current Liabilities = (5,240 – 2,010) / 3,500 = 0.923

Despite having a current ratio of about 1.0, the quick ratio is slightly below 1.0. This means that the company may face liquidity problems should payment of current liabilities be demanded immediately. But it does not seem to be a huge cause for concern.

Debt Ratio = Total Debt / Total Assets = 6,500/13,840 = 47 percent

This indicates the percentage of a company’s assets that are provided via debt. The higher the ratio, the greater risk will be associated with the firm’s operation.

D/E Ratio = Long-term Debt/Equity = 3,000/7,340 = 40.9 percent

This shows the relative proportion of shareholders’ equity and debt used to finance a company’s assets. Once again, comparisons should be made between companies in the same industry in order to determine whether this is a low or high figure.

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Financial Statement: One form of financial statement is the income statement.