Question

Financial statements contain a lot of information. The numbers could be very large, but does large always mean good? As an example, suppose a company that has operating revenues of one billion dollars has only $100,000 in it's bank account compared to let's say a company that has operating revenues of one million dollars that has the same $100,000 in the bank. Do you think the two companies are equally financially positioned? Looking at only one piece of information is not enough. To see if the company is a solid investment, we can use some analytical tools.  

Explain how to calculate the following ratios and discuss what each ratio will tell the financial statement reader.

Liquidity: Current Ratio

Profitability: Earnings per Share

Answer 1

Financial statements contain a lot of information. The number could be very large but we it doesn't mean that it is actually large. To understand financial statements we need to analyse financial ratios.

Financial ratios are relationships determined from a company's financial information and used for comparison purposes. Examples include such often referred to measures as return on investment (ROI), return on assets (ROA), and debt-to-equity, to name just three. These ratios are the result of dividing one account balance or financial measurement with another. Usually these measurements or account balances are found on one of the company's financial statements—balance sheet, income statement, cashflow statement, and/or statement of changes in owner's equity. Financial ratios can provide small business owners and managers with a valuable tool with which to measure their progress against predetermined internal goals, a certain competitor, or the overall industry. In addition, tracking various ratios over time is a powerful means of identifying trends in their early stages. Ratios are also used by bankers, investors, and business analysts to assess a company's financial status.

Financial ratios can be broken down into four main categories—1) profitability or return on investment; 2) liquidity; 3) leverage, and 4) operating or efficiency—with several specific ratio calculations prescribed within each.

PROFITABILITY OR RETURN ON INVESTMENT RATIOS

Profitability ratios provide information about management's performance in using the resources of the small business. Many entrepreneurs decide to start their own businesses in order to earn a better return on their money than would be available through a bank or other low-risk investments. If profitability ratios demonstrate that this is not occurring—particularly once a small business has moved beyond the start-up phase—then entrepreneurs for whom a return on their money is the foremost concern may wish to sell the business and reinvest their money elsewhere. However, it is important to note that many factors can influence profitability ratios, including changes in price, volume, or expenses, as well as the purchase of assets or the borrowing of money. Some specific profitability ratios follow, along with the means of calculating them and their meaning to a small business owner or manager.

Gross profitability: Gross Profits/Net Sales—measures the margin on sales the company is achieving. It can be an indication of manufacturing efficiency, or marketing effectiveness.

Net profitability: Net Income/Net Sales—measures the overall profitability of the company, or how much is being brought to the bottom line. Strong gross profitability combined with weak net profitability may indicate a problem with indirect operating expenses or non-operating items, such as interest expense. In general terms, net profitability shows the effectiveness of management. Though the optimal level depends on the type of business, the ratios can be compared for firms in the same industry.

Return on assets: Net Income/Total Assets—indicates how effectively the company is deploying its assets. A very low return on asset, or ROA, usually indicates inefficient management, whereas a high ROA means efficient management. However, this ratio can be distorted by depreciation or any unusual expenses.

Return on investment 1: Net Income/Owners' Equity—indicates how well the company is utilizing its equity investment. Due to leverage, this measure will generally be higher than return on assets. ROI is considered to be one of the best indicators of profitability. It is also a good figure to compare against competitors or an industry average.

Earnings per share: Net Income/Number of Shares Outstanding—states a corporation's profits on a per-share basis. It can be helpful in further comparison to the market price of the stock.

Investment turnover: Net Sales/Total Assets—measures a company's ability to use assets to generate sales. Although the ideal level for this ratio varies greatly, a very low figure may mean that the company maintains too many assets or has not deployed its assets well, whereas a high figure means that the assets have been used to produce good sales numbers.

Sales per employee: Total Sales/Number of Employees—can provide a measure of productivity. This ratio will vary widely from one industry to another. A high figure

relative to one's industry average can indicate either good personnel management or good equipment.

LIQUIDITY RATIOS

Liquidity ratios demonstrate a company's ability to pay its current obligations. In other words, they relate to the availability of cash and other assets to cover accounts payable, short-term debt, and other liabilities. All small businesses require a certain degree of liquidity in order to pay their bills on time, though start-up and very young companies are often not very liquid. In mature companies, low levels of liquidity can indicate poor management or a need for additional capital.

Current ratio: Current Assets/Current Liabilities—measures the ability of an entity to pay its near-term obligations. "Current" usually is defined as within one year. Though the ideal current ratio depends to some extent on the type of business, a general rule of thumb is that it should be at least 2:1.

Quick ratio (or "acid test"): Quick Assets (cash, marketable securities, and receivables)/Current Liabilities—provides a stricter definition of the company's ability to make payments on current obligations. Ideally, this ratio should be 1:1.

Cash to total assets: Cash/Total Assets—measures the portion of a company's assets held in cash or marketable securities.

Sales to receivables (or turnover ratio): Net Sales/Accounts Receivable—measures the annual turnover of accounts receivable.

Days' receivables ratio: 365/Sales to receivables ratio—measures the average number of days that accounts receivable are outstanding. This number should be the same or lower than the company's expressed credit terms. Other ratios can also be converted to days, such as the cost of sales to payables ratio.

Cost of sales to payables: Cost of Sales/Trade Payables—measures the annual turnover of accounts payable. Lower numbers tend to indicate good performance, though the ratio should be close to the industry standard.

Cash turnover: Net Sales/Net Working Capital (current assets less current liabilities)—reflects the company's ability to finance current operations, the efficiency of its working capital employment, and the margin of protection for its creditors.

LEVERAGE RATIOS

Leverage ratios look at the extent to which a company has depended upon borrowing to finance its operations. As a result, these ratios are reviewed closely by bankers and investors. Most leverage ratios compare assets or net worth with liabilities.

Debt to equity ratio: Debt/Owners' Equity—indicates the relative mix of the company's investor-supplied capital.

Debt ratio: Debt/Total Assets—measures the portion of a company's capital that is provided by borrowing.

Fixed to worth ratio: Net Fixed Assets/Tangible Net Worth—indicates how much of the owner's equity has been invested in fixed assets, i.e., plant and equipment. It is important to note that only tangible assets (physical assets like cash, inventory, property, plant, and equipment) are included in the calculation, and that they are valued less depreciation.

Interest coverage: Earnings before Interest and Taxes/Interest Expense—indicates how comfortably the company can handle its interest payments.

EFFICIENCY RATIOS

By assessing a company's use of credit, inventory, and assets, efficiency ratios can help small business owners and managers conduct business better. These ratios can show how quickly the company is collecting money for its credit sales or how many times inventory turns over in a given time period.

Annual inventory turnover: Cost of Goods Sold for the Year/Average Inventory—shows how efficiently the company is managing its production, warehousing, and distribution of product, considering its volume of sales.

Inventory holding period: 365/Annual Inventory Turnover—calculates the number of days, on average, that elapse between finished goods production and sale of product.

Inventory to assets ratio Inventory/Total Assets—shows the portion of assets tied up in inventory. Generally, a lower ratio is considered better.

Accounts receivable turnover Net (credit) Sales/Average Accounts Receivable—gives a measure of how quickly credit sales are turned into cash.

Collection period 365/Accounts Receivable Turnover—measures the average number of days the company's receivables are outstanding, between the date of credit sale and collection of cash.