Analyzing Financial Statements• Balance Sheet

– The financial condition of the company on a certain date (a snapshot on that date)

• Income Statement– The financial performance of the company over a

period of time (the accounting period)

• Cash Flow Statement– Sources and Uses of Cash over the accounting period

• Financial Ratios– Compares financial data to create insightful

relationships about the company’s financial health and operating performance.

Types of Financial Ratios• Liquidity

Measures a firms ability to meet it near-term obligations.

• Working capital or EfficiencyIndication of how well a firm is using it’s assets to generate profits.

• Capital Structure or SolvencyProvide indications on how a firms is financing it’s investment in assets.

• Profitability or OperatingUsed to measure if a company is generating sufficient returns on it’s investments.

• Investment or Market TestMeasures used by many investors to compare a company’s earnings and dividend

payments to it’s stock price.

Liquidity Ratios

Liquidity measures the financial strength of an organization and it’s ability to pay it’s debts.

• LiquidityThe measure of a company’s ability to meet current

obligations when they are due.Current obligations are all current expenses

• Salaries Payable; Accounts Payable; and Rent Payable

The two common Liquidity Ratios:• Current ratio;

• Quick, or Acid Test

Liquidity Ratios

• Current RatioCurrent Ratio = Current Assets

Current Liabilities– Current Assets include cash; marketable securities; accounts receivable;

inventory; and prepaid expenses.

• Quick RatioQuick Ratio = Quick Assets

Current Liabilities– Uses only the most liquid assets; cash, marketable securities and accounts

receivable.

Working Capital Ratios

Measures how effectively a company utilizes it’s assets to generate profits

• Inventory– Inventory turnover

• Accounts Receivable– Accounts Receivable Turnover– Average Collection Period

• Accounts Payable– Accounts payable payment period

• Assets– Fixed Asset Turnover– Total Asset Turnover

Inventory• Inventory Turnover

Inventory Turnover = COGS Average Inventory

• This tells how many times the inventory turned-over during the accounting period. The more times the inventory is turned, or used, the more efficient the company.– Inventory is expensive to purchase and hold.– Faster turnover means less risk of obsolescence.– On the other hand, the company must avoid stockouts and lost

business.

Accounts Receivable• Accounts Receivable Turnover

Accounts Receivable Turnover = Annual Credit Sales

Average Accounts Receivables

– Indicator of how well credit sales are collected. The more times Accounts Receivable is turned over, the more efficient the company and more working capital is available.

• Average Collection PeriodAverage Collection Period = Average Accounts Receivables

(Annual Credit Sales – Calculates the average number of days it takes to collect payments due.

– Can indicate a problem if higher than the credit terms that are offered.

– A low number may indicate a company is only selling to customers who pay quickly. There may be untapped opportunities for new customers.

Accounts Payable

• Accounts Payable Payment PeriodAccounts Payable Payment Period = Average Accounts Payable

(Annual Credit Purchase– The amount of credit purchases is not usually available in financial

statements; use Cost-of-Goods-Sold or other figure as a replacement.

– Identifies the average number of days from receipt of goods or services until they are paid.

– The longer the Period the more working capital is held and available to the company.

– This is non-interest borrowing except for the loss of Prompt Payment Discounts.

Assets

• Fixed Asset TurnoverFixed Asset Turnover = Sales Revenue

Average Fixed Assets

• Total Asset TurnoverTotal Asset Turnover = Sales Revenue

Average Total Assets– These ratios indicate how effectively a company is utilizing it’s assets,

both current assets and non-current assets to generate Revenues.

Capital Structure Ratios

Provide indications on how a firms is financing it’s investments in assets.

• Total Debt– Total Debt to Owners’ Equity– Total Debt to Total Assets

• Long-term Debt– Long-term Debt to Total Capitalization

• Interest Expense– Times Interest Earned

• Debt Financing: requires repayment of the principle and interest.

• Equity Financing: No obligation to repay and no interest.

Total Debt• Total Debt to Owners’ Equity

Total Debt to Owners’ Equity = Total Debt Owners’ Equity

– Total Debt = Current liabilities + non-current liabilities– Measures the relationship between borrowed funds and equity financing– A company with a higher percentage than similar companies may use too much

borrowing compared to owner financing.

• Total Debt to Total AssetsTotal Debt to Total Assets = Total Debt

Total Assets– Measures the extent to which total asset are financed by borrowed funds (as

opposed to owners equity) – A company with a higher percentage than similar companies may have problems

borrowing more money.

Long-term Debt• Long-term Debt to Total Capitalization

Long-term Debt to Total Capitalization = Non-current liabilities Total Capitalization

– Total Capitalization = Long-term Debt + Owners’ Equity– It measures the percentage of Long-term debt to all permanently invested

capital from all sources.– Some analyst include deferred taxes in total capitalization since it may

essentially be a permanent investment in the company.

• The ratio will vary by business and industry.– A small corporation may have a high ratio due to a high level of borrowed

funds and a low amount of equity financing.– A larger, publicly traded corporation will have a lower ratio due to a high

level of equity financing.

Interest Expense

Times Interest EarnedTimes Interest Earned Ratio = Earnings Before Interest and Taxes (EBIT)

Interest Expense

–EBIT is found on the Income Statement as the net Operating Profit before subtracting interest expense and taxes.

–Measures the ratio of the Operating Profit available to service debt.

–The higher the number the greater the safety margin and the lower the risk a company can pay it’s debts.

Profitability Ratios

Used to measure if a company is generating sufficient returns on it’s investments.

• Sales– Gross Profit Margin– Operating Profit Margin– Net Profit Margin

• Equity– Return on Equity (ROE)

• Assets– Return on Assets (ROA)

Sales

• Gross Profit MarginGross Profit Margin = Gross Profit

Net Sales Revenue

– Gross Profit = Nets Sales - COGS

– Net Sales Revenue = Sales Revenues - returns.

– Represents the markup on Cost of Goods Sold

– Represents the amount of net sales that will cover operating expenses, interest and taxes.

– A common measure used by engineering and sales managers. New products or services must almost always must meet a minimum Gross Profit Margin before it is offered.

Sales

Operating Profit MarginOperating Profit Margin = Net operating income

Net Sales Revenue

– Used as a measure of operating efficiency in relation to sales revenues.

• Net Profit MarginNet Profit Margin = Net Income

Net Sales Revenue

– Measures the relationship of net profit to sales revenues.

– Will show how many cents on each sales revenue dollar becomes profit.

Equity and Assets

• Return on Equity (ROE)Return on Equity = Net Income

Owners’ Equity

– Measures the percentage of owners’ equity that becomes profit.

– Measures a company’s return on owner financing.

• Return on Assets (ROA)Return on Equity = Net Income

Total Assets

– Measure a company’s return on it’s investment in total assets.

Investment/Market Test Ratios

• Measures used by many investors to compare a company’s earnings and dividend payments to stock prices.– Earnings per Share– Price to Earnings– Dividend Yield

Investment/Market Test Ratios• Earnings per Share (EPS)

EPS = Net Income

Average number of shares of common stock

– Calculating the number of shares of common stock is complicated by stock options, warrants and convertible securities.

• Price to Earnings (P/E)P/E = AverageMarket Price per Share

Earnings per Share

– Indicates how many time Earnings investors are willing to pay for shares.

• Dividend YieldDividend Yield = Dividends per Share

Market Price per Share

– The percent yield in dividends per dollar paid for a share of stock.

Analyzing the Results

Ratio analysis is a tool that can provide insights into a company’s performance not readily available on the financial statements.

• Compare to benchmarks– Historical benchmarks– External benchmarks

Financing a Business Entity

• Equity Financing– Cash from Owners– Stock

• Debt Financing– Borrowed funds

• Bank Loans, Bonds, Leasing

– Leverage