Explanation of Financial Ratios Based on Balance Sheet
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Transcript of Explanation of Financial Ratios Based on Balance Sheet
8/2/2019 Explanation of Financial Ratios Based on Balance Sheet
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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