Ch. 7_Introduction to Financial Ratios Lectures

8/13/2019 Ch. 7_Introduction to Financial Ratios Lectures

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Introduction to Financial Ratios

When computing financial ratios and when doing other financial statement analysis always keep in mind

that the financial statements reflect theaccounting principles.This meansassetsare 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 Sheeto General discussiono Common-size balance sheeto Financial ratios based on the balance sheet

Income Statemento General discussiono Common-size income statemento Financial ratios based on the income statement

Statement of Cash Flows

General Discussion of Balance Sheet

The balance sheet reports a company's assets, liabilities, and stockholders' equity as of a specific date,

such as December 31, 2013, March 31, 2013, etc.

The accountants'cost principleand themonetary unit assumptionwill 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 withinthe 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 principlewill result in assets such as buildings, equipment, furnishings, fixtures,

vehicles, etc. being reported at amounts less than cost. The reason is these assets aredepreciated.
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Depreciation reduces an asset'sbook valueeach 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 theiruseful lives,the current value (or

fair market value) of these assets may actually be increasing. (It is also possible that thecurrent valueof

some assets such as computers may be decreasing faster than the book value.)

Current assetssuch 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 liabilitiessuch 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.

Long-term liabilitiessuch as Notes Payable (not due within one year) or Bonds Payable (not maturing

within one year) will often have current values that differfrom the amounts reported on the balance sheet.

Stockholders' equityis thebook value of the company.It is the difference between the reported amount of

assets and the reported amount of liabilities. For the reasons mentioned 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 arenot"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:
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Common-Size Balance Sheet

One technique in financial statement analysis is known as vertical analysis. Vertical analysis 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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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 withInventoryat 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. Many banks have memberships in Risk

Management Association (RMA), an organization that collects and distributes statistics 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.

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:
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Four financial ratios relate balance sheet amounts forAccounts ReceivableandInventoryto income

statement amounts. To illustrate these financial ratios we will use the following income statement

information:
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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 remainder of our explanation of financial ratios and financial statement analysis will use information

from the following income statement:

Common-Size Income Statement

Financial statement analysis includes a technique known as vertical analysis. Vertical analysis results in

common-size financial statements. A common-size income statement 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:


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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 the Securities and Exchange Commission (SEC). This

annual report is the SEC Form 10-K and is usually accessible under the "Investor Relations" tab on the

corporation's website.


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Financial Ratios Based on the Income Statement


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Statement of Cash Flows

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 many well-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

The cash flow from operating activities section of the statement of cash flows is also used by some analysts

to assess the quality of a company's earnings. For a company's earnings to be of "quality" the amount of

cash flow from operating activities must be consistently greater than the company's net income. The reason

is that under accrual accounting, various estimates and assumptions are made regarding both revenues

and expenses. When it comes to cash, however, the money is either in the bank or it isn't.
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What are the typical items reported ascurrent liabilities?

Here are the typical items that are reported as current liabilities on a corporation's balance sheet:

1. Accounts payable. These are the amounts that are due to vendors who have supplied goods or

services. The accounts payable are supported by the vendor invoices that have been approved and

processed, but have not yet been paid.

2. Deferred revenues. This reports the amounts that a customer has prepaid and will be earned by the

company within one year of the balance sheet date. An example is a retailer's unredeemed gift cards.

3. Accrued compensation. Included in this are payroll related items such as the amounts due to

employees and the amounts to be remitted for payroll taxes.

4. Other accrued expenses or liabilities. This reports the amounts that the company owes for items not

recorded in accounts payable or accrued compensation. Examples include the interest expense that the

company has incurred (but has not yet paid) and repairs that took place but the vendor's invoice has not

been fully processed.

5. Accrued income taxes and perhaps some deferred income taxes.

6. Short-term notes. These include the loans from banks that will become due within one year of the

balance sheet date.

7. The current portion of long-term debt. Theprincipalpayments of a mortgage loan or an equipment

loan that must be paid within one year of the date of the balance sheet are reported in this item.

To be reported as a current liability the item must be due within one year of the balance sheet date

(unless the company's operating cycle is longer). However, there is no requirement that the current

liabilities be presented in the order in which they will be paid. Hence, the current portion of long-term

debt might be listed last, but the principal payment might be due within several days of the balance

sheet date.

What is the interest coverage ratio?The interest coverage ratiois a financial ratio used to measure a company's ability to pay the interest

on its debt. (The required principal payments are not included in the calculation.) The interest coverage

ratio is also known as the times interest earned ratio.

The interest coverage ratio is computed by dividing 1) a corporation's annual income before interest

and income tax expenses, by 2) its annual interest expense.


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To illustrate the interest coverage ratio, let's assume that a corporation's most recent annual income

statement reported net income after tax of $650,000; interest expense of $150,000; and income tax

expense of $100,000. Given these assumptions, the corporation's annual income before interest and

income tax expenses is $900,000 (net income of $650,000 + interest expense of $150,000 + income tax

expense of $100,000). Since the interest expense was $150,000 the corporation's interest coverage ratio

is 6 ($900,000 divided by $150,000 of annual interest expense).

A large interest coverage ratio indicates that a corporation will be able to pay the interest on its debt

even if its earnings were to decrease. A small interest coverage ratio sends a caution signal.

Since the interest coverage ratio is based on the net income under the accrual method of accounting, we

recommend that you also review the cash provided by operating activities (which is found on the

corporation's statement of cash flows) for the same time period.

What is the meaning of base year?In accounting, base yearmay refer to the year in which a U.S. business had adopted the LIFO cost flow

assumption for valuing its inventory and its cost of goods sold. Under the dollar-value LIFO technique

a company's current inventory is restated to base-yearprices in order to determine whether the quantity

of inventory has increased or decreased.

Base yearis also the initial year in a series of annual amounts. For instance, an accountant might

prepare a chart that displays the dollar amounts of a company's sales, gross profit, and net income for

each of the years 2010 through 2012. In addition the accountant might add a price index for each line

which expresses each line's amounts as a percentage of the 2010 amount. In this example the base yearis 2010. Assuming that the sales for the years 2010 and 2011 and 2012 were $924,000 and $942,480

and $979,440, each of these would be divided by the $924,000 of sales in the base year 2010. The

result would be the following index: 100 (for the base year 2010) and 102 (for 2011) and 106 (for

2012).

What is a current liability?

A current liability is an obligation that is 1) due within one year of the date of a company's balance

sheet and 2) will require the use of a current asset or will create another current liability. If a company's

operating cycle is longer than one year, current liabilities are those obligation's due within the operating

cycle.

Current liabilities are usually presented in the following order:


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1. the principal portion of notes payable that will become due within one year

2. accounts payable

3. the remaining current liabilities such as payroll taxes payable, income taxes payable, interest payable

and other accrued expenses

The parties who are owed the current liabilities are referred to as creditors. If the creditors have a lien

on company assets, they are known as secured creditors. The creditors without a lien are referred to as

unsecured creditors.

The amount of current liabilities is used to determine a company's working capital(current assets

minus current liabilities) and the company's current ratio(current assets divided by current liabilities).

What is a current asset?

A current asset is cash and any other company asset that will be turning to cash within one year from

the date shown in the heading of the company's balance sheet. (If a company has an operating cycle that

is longer than one year, an asset that will turn to cash within the length of its operating cycle is

considered to be a current asset.)

Current assets are generally listed first on a company's balance sheet and will be presented in the order

of liquidity. That means they will appear in the following order: cash (which includes currency,

checking accounts, petty cash), temporary investments, accounts receivable, inventory, supplies, and

prepaid expenses. (Supplies and prepaid expenses will not literally be converted to cash. They are

included because they will allow the company to avoid paying cash for these items during the

upcoming year.)

It is important that the amount of each current asset not be overstated. For example, accounts

receivable, inventories, and temporary investments should have valuation accounts so that the amounts

reported will not be greater than the amounts that will be received when the assets turn to cash. This is

important because the amount of company's working capital and its current ratio are computed using

the current assets' reported amounts.

Current assets are also referred to as short term assets.

What is liquidity?Liquidity refers to a company's ability to pay its bills from cash or from assets that can be turned into

cash very quickly.

The quick ratio, also known as the acid-test ratio, is an indicator of a company's liquidity.


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new equipment is expected to be $100,000 per year for 10 years. The payback period is 4 years

($400,000 divided by $100,000 per year).

A second project requires an investment of $200,000 and it generates cash as follows: $20,000 in Year

1; $60,000 in Year 2; $80,000 in Year 3; $100,000 in Year 4; $70,000 in Year 5. The payback period

is 3.4 years($20,000 + $60,000 + $80,000 = $160,000 in the first three years + $40,000 of the $100,000

occurring in Year 4).

Note that the payback calculation uses cash flows, not net income. Also, the payback calculation does

not address a project's total profitability. Rather, the payback period simply computes how fast a

company will recover its cash investment.

What will cause a change in net working

capital?Net working capital or working capitalis defined as current assets minus current liabilities. Therefore,

a change in the total amount of current assets without a change of the same amount in current liabilities

will result in a change in the amount of working capital. Similarly, a change in the total amount of

current liabilities without an identical change in the total amount of current assets will cause a change

in working capital.

For instance, if the owner makes an additional investment of $20,000 in her company, the company's

total current assets will increase by $20,000 but there is no increase in its current liabilities. As a result,

the company's working capital increases by $20,000. (The other change is an increase in the owner'scapital account.)

If a company borrows $50,000 and agrees to repay the loan in 90 days, the company's working capital

has notincreased. The reason is that the current asset Cash increased by $50,000 and the current liability

Loans Payable also increased by $50,000.

The use of $30,000 to buy merchandise for inventory will not change the amount of working capital.

The reason is that the total amount of current assets will not change. The current asset Cash decreases

by $30,000 and the current asset Inventory increases by $30,000.

If a company sells a product for $3,400 which is in its inventory at a cost of $2,500 the company's

working capital will increase by $900. Working capital increased because 1) the current asset

accounts Cash or Accounts Receivable will increase by $3,400 and Inventory will decrease by $2,500;

2) current liabilities will not change. Owner's equity will increase by $900.

The use of $100,000 for the construction of a storage building will reduce working capital because the

current asset Cash decreased and a long-term assetStorage Building has increased.


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What is the difference between liquidityand liquidation?

Liquidity usually refers to a company's ability to pay its bills when they become due. Liquidity is often

evaluated by comparing a company's current assets to its current liabilities. Working capital, the current

ratio, and the quick ratio are referred to as liquidity ratiosor short-term solvency ratios, since their

calculations use some or all of the current assets and the current liabilities. Sometimes a company's

accounts receivable turnover ratio, inventory turnover ratio, and free cash flow are also used to assess a

company's liquidity.

Liquidation is a term commonly used when a company sells parts of its business for cash, or when it

sells assets in order to pay debts. Liquidation may also involve the winding down or the closing of a

business.

What are the reasons for high inventorydays?

The days sales in inventory is high when the inventory turnover is low.

Since inventory turnover is associated with sales and average inventory, changes in either sales or

inventory can cause a high amount of inventory days.

For example, if a company has maintained its inventory quantities, but economic factors cause a

significant drop in its sales, the company's inventory days will increase dramatically.

If a retailer increases its inventory in order to generate additional sales, but sales do not increase, there

will also be an increase in the number of inventory days.

What is separation of duties?

Theseparation of dutiesis one of several steps to improve the internal control of an organization's

assets. For example, the internal control of cash is improved if the money handling duties are separated

from the record keeping duties. By separating these duties the likelihood of theft is reduced because it


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will now require two dishonest people working together to admit to each other that they are dishonest,

plan the theft, and to then carry out the theft. One person will have to remove the cash and the other

person will have to falsify the records.

Without the separation of duties, the theft of cash is easier. One dishonest person can steal the

money andenter a fictitious amount into the records---thereby concealing the theft.

Another step in improving internal control over cash is to use a cash register, issue receipts, and have

two people present when cash is handled.

What is the difference between accountspayable and accrued expenses payable?

I would use the liability accountAccounts Payablefor suppliers' invoices that have been received and

must be paid. As a result, the balance in Accounts Payable is likely to be a precise amount that agrees

with supporting documents such as invoices, agreements, etc.

I would use the liability accountAccrued Expenses Payablefor the accrual type adjusting entries made

at the end of the accounting period for items such as utilities, interest, wages, and so on. The balance in

the Accrued Expenses Payable should be the total of the expenses that were incurred as of the date of

the balance sheet, but were not entered into the accounts because an invoice has not been received or

the payroll for the hourly wages has not yet been processed, etc. The amounts recorded in Accrued

Expenses Payable will often be estimated amounts supported by logical calculations.

How does an expense affect the balancesheet?

An expense will decrease the amount of assets or increase the amount of liabilities, and will reduce the

amount of owner's or stockholders' equity.

For example an expense might 1) reduce a company's assets such as Cash, Prepaid Expenses, or

Inventory, 2) increase the credit balance in a contra-asset account such as Allowance for DoubtfulAccounts or Accumulated Depreciation, 3) increase the balance in the liability account Accounts

Payable, or increase the amount of accrued expenses payable such as Wages Payable, Interest Payable,

and so on.

In additionto the change in the assets or liabilities, an expense will reduce the credit balance in the

Owner Capital account of a sole proprietorship, or will reduce the credit balance in the Retained

Earnings account of a corporation.


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Where do I record the refund of aregistration fee?

If the registration fee refers to a fee expense that you had originally paid but the amount is now being

refunded to you, I would credit the same expense account that you had originally charged or debited,

and would debit Cash.

If the registration fee refers to an amount you are refunding because someone had originally registered

for one of your programs, I would 1) credit Cash for the amount you are paying out as the refund, and

2) debit a contra-revenue account such as Refunds of Registration Fee Revenues. This will allow you

to easily track the total amounts of refunds that you make during a year. On the other hand, if it is rare

for your organization to refund registration fees, you could simply 1) debit the amount you are

refunding to the normal revenue account such as Registration Fee Revenues, and 2) credit Cash.

How can working capital be improved?

Working capital can be improved by 1) earning profits, 2) issuing common stock or preferred stock for

cash, 3) replacing short-term debt with long-term debt, 4) selling long-term assets for cash, 5) settling

short-term debts for less than the stated amounts, and 6) collecting more of the accounts receivables

than was anticipated and then reducing the balance required in the current asset account Allowance for

Doubtful Accounts.

I am sure there are additional ways to increase working capital. The concept is to increase the amount

of current assets and/or to decrease the amount of current liabilities.

What is a customer deposit?

A customer deposit could be an amount paid by a customer to a company prior to the company

providing it with goods or services. In other words, the company receives the money prior to earning it.

The company receiving the money has an obligation to provide the goods or services to the customer or

to return the money.

For example, Ace Manufacturing Co. might agree to produce an expensive, custom-made machine for

one of its customers. Ace requires that the customer pay $50,000 before Ace begins to design and

construct the machine. The $50,000 payment is made in December 2012 and the machine must be

finished by June 30, 2013. The $50,000 is a down payment toward the machine's price of $400,000.

In December 2012, Ace will debit Cash for $50,000 and will credit Customer Deposits, a current


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liability account. (The customer will record the $50,000 payment with a debit to a long-term asset

account such as Construction Work in Progress or Downpayment on New Equipment, and will credit

Cash.)

What is solvency?

I use the term solvency to mean 1) that a company is able to pay its obligations when they come due

and 2) that a company is able to continue in business.

Some people look to a company's working capital in deciding whether a company is solvent. They

conclude that a company with a positive amount of working capital is solvent. In other words, a

company that is solvent has more current assets than it has current liabilities. Stated another way a

company that is solvent will have a current ratio that is greater than 1:1.

Others look at a company's total assets and total liabilities in deciding whether a company is solvent.

They might conclude that if a company's total assets are greater than its total liabilities, the company is

solvent.

I suspect that the definition of solvency varies among people in the same country and from country to

country. You should check the legal system in your country to find the appropriate meaning.

Why aren't retained earnings distributedas dividends to the stockholders?A corporation's earnings are usually retained instead of being distributed to the stockholders in the form

of dividends because the corporation is in need of money to strengthen its financial position, to expand

its operations, or to keep up with the inflation in its present size of operations.

The stockholders may prefer to forego dividends in order to see its stock value increase from the

corporation's wise use of the retained earnings. This is especially true of U.S. individuals in high

federal and state income tax brackets. These stockholders might end up paying 40% of the dividend

amount in income taxes. They would rather have their stock appreciate in value with no tax paymentsand later sell their shares of stock at the lower capital gains tax rates.


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Let's assume that a corporation has $100 million in assets, $40 million in liabilities, and $60 million in

stockholders' equity. Its debt to total assets ratio will be 0.4 ($40 million of liabilities divided by $100

million of assets), or 0.4 to 1. In this example, the debt to total assets ratio tells you that 40% of the

corporation's assets are financed by the creditors or debt (and therefore 60% is financed by the owners).

A higher percentage indicates more leverage and more risk.

Another ratio, the debt to equity ratio, is often used instead of the debt to total assets ratio. The debt to

equity ratio uses the same inputs but provides a different view. Using the information above, the debt to

equity ratio will be .67 to 1 ($40 million of liabilities divided by $60 million of stockholders' equity).

Are liabilities always a bad thing?

Liabilities are obligations and are usually defined as a claim on assets. However, liabilities and

stockholders' equity are also the sources of assets. Generally, liabilities are considered to have a lower

cost than stockholders' equity. On the other hand, too many liabilities result in additional risk.

Some liabilities have low interest rates and some have no interest associated with them. For example,

some of a company's accounts payable may allow payment in 30 days. With those payables it is better

to have the liability and to keep your cash in the bank until they become due.

In our personal lives, our first house was probably purchased with a down payment and mortgage loan.

That mortgage loan was a big liability, but it allowed us to upgrade our living space. I viewed my

mortgage loan liability as a good thing because it allowed me to own a nice home in a beautiful

neighborhood.

So some liabilities are good

especially the ones that have a very low interest rate. Too many liabilitiescould cause financial hardships.

What are pro forma financial statements?

A pro forma financial statement is one based on certain assumptions and projections.

For example, a corporation might want to see the effects of three different financing options. Therefore,it prepares projected balance sheets, income statements, and statements of cash flows. These projected

financial statements are referred to as pro forma financial statements.


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What is the difference between netincome and comprehensive income?

The difference between net incomeand comprehensive incomeis known as other comprehensive

income.

Other comprehensive incomeincludes unrealized gains and losses on certain investments in securities,

foreign currency items, and certain pension liability adjustments.

Net incomeis reported on the income statement and is included in the retained earnings section of

stockholders' equity. Other comprehensive incomeitems are not reported on the income statement, and

are included in the accumulated other comprehensive incomesection of stockholders' equity.

The accounting for comprehensive income is provided in the Statement of Financial Accounting

Standards No. 130,Reporting Comprehensive Income, available for reading atwww.FASB.org/st.

What is the advantage of issuing bondsinstead of stock?

There are several advantages of issuing bonds or other debt instead of stock when acquiring assets. One

advantage is that the interest on bonds and other debt is deductible on the corporation's income tax

return. Dividends on stock are not deductible on the income tax return.

A second advantage of financing assets with bonds instead of stock is that the ownership interest in the

corporation will not be diluted by adding more owners. Bondholders and other lenders are not owners

of the assets or of the corporation. Therefore, all of the gain in the value of the assets belongs to the

stockholders. The bondholders will receive only the agreed upon interest. This is related to the concept

of leverage or trading on equity. By issuing debt, the corporation gets to control a large asset by using

other people's money instead of its own. If the asset ends up being very profitable, all of its earnings

minus the interest, will enhance the owners' financial position.

Which financial ratios are considered tobe efficiency ratios?

I consider the efficiency ratios to be the ratios also known as asset turnover ratios, activity ratios,

or asset management ratios.
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These efficiency ratios include 1) accounts receivable turnover ratio, and the related ratio days' credit

sales in accounts receivable; 2) inventory turnover, and the related ratio days' cost of sales in inventory;

3) total asset turnover; and 4) fixed asset turnover.

The accounts receivable turnover ratio and the inventory turnover ratio are also used in the context of a

firm's liquidity.

The total asset turnover and fixed asset turnover are indicators of a company's effectiveness in utilizing

its assets.

What is trend analysis?

In the analysis of financial information, trend analysis is the presentation of amounts as a percentage of

a base year.

If I want to see the trend of a company's revenues, net income, and number of clients during the years

2006 through 2012, trend analysis will present 2006 as the base year and the 2006 amounts will be

restated to be 100. The amounts for the years 2007 through 2012 will be presented as the percentages of

the 2006 amounts. In other words, each year's amounts will be divided by the 2006 amounts and the

resulting percentage will be presented. For example, revenues for the years 2006 through 2012

might have been $31,691,000; $40,930,000; $50,704,00; $63,891,000; $79,341,000; $101,154,000;

$120,200,000. These revenue amounts will be restated to be 100, 129, 160, 202, 250, 319, and 379.

Let's assume that the net income amounts divided by the 2006 amount ended up as 100, 147, 206, 253,

343, 467, and 423. The number of clients when divided by the base year amount are 100, 122, 149, 184,229, 277, and 317.

From this trend analysis we can see that revenues in 2012 were 379% of the 2006 revenues, net income

in 2012 was 467% of the 2006 net income, and the number of clients in 2012 was 317% of the number

in 2006. Using the restated amounts from trend analysis makes it much easier to see how effective and

efficient the company has been during the recent years.

Trend analysis can also include the monitoring of a company's financial ratios over a period of many

years.


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Where can I find financial ratios for myindustry?

One source for financial ratios by industry is the RMA Annual Statement Studies Financial Ratio

Benchmarks. RMA is the acronym for Risk Management Association and formerly for Robert Morris

Associates. Your banker and many larger libraries subscribe to this publication. It contains the financial

ratios for 740 industries based on the financial statements of more than 265,000 small and mid-sized

companies.

Another source for your industry's financial ratios is your industry's trade association, if it collects

financial information from its members.

In addition to comparing your company's financial ratios to its industry, you will want to compare your

company's financial ratios to its own past and future financial ratios. Spotting a trend early can be

very beneficial.

How can I determine the difference inearnings from using LIFO instead ofFIFO?

The difference in a corporation's earnings from using LIFO instead of FIFO can be determined by the

amounts reported in the balance sheet accountLIFO Reserve. Generally, the LIFO Reserve information

is found in the notes to the financial statements.

What is the effect on financial ratioswhen using LIFO instead of FIFO?

During periods of significantly increasing costs, LIFO when compared to FIFO will cause lower

inventory costs on the balance sheet and a higher cost of goods sold on the income statement.

This will mean that the profitability ratios will be smaller under LIFO than FIFO. The profitability

ratios include profit margin, return on assets, and return on stockholders' equity.

The inventory turnover ratio will be higher when LIFO is used during periods of increasing costs. The

reason is that the cost of goods sold will be higher and the inventory costs will be lower under LIFO

than under FIFO.


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For example, if a corporation without preferred stock has stockholders' equity on December 31 of

$12,421,000 and it has 1,000,000 shares of common stock outstanding on that date, its book value per

share is $12.42.

Keep in mind that the book value per share will not be the same as the market value per share. One

reason is that a corporation's stockholders' equity is simply the difference between the total amount of

assets reported on the balance sheet and the total amount of liabilities reported. Long term assets are

generally reported at original cost less accumulated depreciation and some valuable assets such as trade

names might not be listed on the balance sheet.

What is the difference between grossmargin and contribution margin?

Gross Marginis the Gross Profit as a percentage of Net Sales. The calculation of the Gross Profit is:

Sales minus Cost of Goods Sold. The Cost of Goods Soldconsists of the fixed and variable product

costs, but it excludes all of the selling and administrative expenses.

Contribution Marginis Net Sales minus the variableproduct costs and the variableperiod expenses.

TheContribution Margin Ratiois the Contribution Margin as a percentage of Net Sales.

Let's illustrate the difference between gross margin and contribution margin with the following

information: company had Net Sales of $600,000 during the past year. Its inventory of goods was the

same quantity at the beginning and at the end of year. Its Cost of Goods Sold consisted of $120,000 of

variable costs and $200,000 of fixed costs. Its selling and administrative expenses were $40,000 of

variable and $150,000 of fixed expenses.

The company's Gross Marginis: Net Sales of $600,000 minus its Cost of Goods Sold of $320,000

($120,000 + $200,000) for a Gross Profit of $280,000 ($600,000 - $320,000). The Gross Margin or

Gross Profit Percentage is the Gross Profit of $280,000 divided by $600,000, or 46.7%.

The company's Contribution Marginis: Net Sales of $600,000 minus the variable product costs of

$120,000 and the variable expenses of $40,000 for a Contribution Margin of $440,000. The

Contribution Margin Ratio is 73.3% ($440,000 divided by $600,000).

What is the earnings per share (EPS)ratio?

The earnings per share ratio, or simply earnings per share, or EPS, is a corporation's net income after

tax that is available to its common stockholders divided by the weighted average number of shares of


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What is credit analysis and financialanalysis?

Credit analysis is associated with the decision to grant credit to a customer. It is also part of a bank's

lending procedures for making a loan and monitoring the borrower's creditworthiness.

I believe that financial analysis has a broader focus than credit analysis. Financial analysis would also

include calculations such as return on equity, return on assets, price earnings ratios, dividend yield,

comparisons with industry averages, trend analysis, and so on. Financial analysis would often be

associated with investors, management, and creditors.

What is the difference between verticalanalysis and horizontal analysis?

Vertical analysis reports each amount on a financial statement as a percentage of another item. For

example, the vertical analysis of the balance sheetmeans every amount on the balance sheet is restated

to be a percentage of total assets. If inventory is $100,000 and total assets are $400,000 then inventory

is presented as 25 ($100,000 divided by $400,000). If cash is $8,000 then it will be presented as 2

($8,000 divided by $400,000). The total of the assets will now add up to 100. If the accounts payable

are $88,000 they will be presented as 22 ($88,000 divided by $400,000). If owner's equity is $240,000

it will be presented as 60 ($240,000 divided by $400,000). The restated amounts from the vertical

analysis of the balance sheet will be presented as a common-size balance sheet. A common-size balance

sheet allows you to compare your company's balance sheet to another company's balance sheet or to the

average for its industry.

Vertical analysis of an income statementresults in every income statement amount being presented as a

percentage of sales. If sales were $1,000,000 they would be restated to be 100 ($1,000,000 divided by

$1,000,000). If the cost of goods sold is $780,000 it will be presented as 78 ($780,000 divided by sales

of $1,000,000). If interest expense is $50,000 it will be presented as 5 ($50,000 divided by $1,000,000).

The restated amounts are known as a common-size income statement. A common-size income

statement allows you to compare your company's income statement to another company's or to the

industry average.

Horizontal analysislooks at amounts on the financial statements over the past years. For example, the

amount of cash reported on the balance sheet at December 31 of 2012, 2011, 2010, 2009, and 2008 willbe expressed as a percentage of the December 31, 2008 amount. Instead of dollar amounts you might

see 134, 125, 110, 103, and 100. This shows that the amount of cash at the end of 2012 is 134% of the

amount it was at the end of 2008. The same analysis will be done for each item on the balance sheet

and for each item on the income statement. This allows you to see how each item has changed in

relationship to the changes in other items. Horizontal analysis is also referred to as trend analysis.

Vertical analysis, horizontal analysis and financial ratios are part of financial statement analysis.


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What is the definition of capital market?

Often, capital marketrefers to the structured market for trading stocks and bonds. Examples are the

New York Stock Exchange, the American Stock Exchange, NASDAQ, and the New York Bond

Exchange.

However, capital marketcan also include less structured markets such as private placements for stocks,

bonds, and other debt.

What is the difference between cash flowand free cash flow?

A corporation's cash flow from operations is available from the first section of the statement of cash

flows. Usually the calculation begins with the accrual accounting net income followed by adding back

depreciation expense and then adjusting for the changes in the balances of current assets and current

liabilities.

Free cash flow is often defined as the cash flow from operations (or net cash flows from operating

activities) minus the cash necessary for capital expenditures. Occasionally, dividends to stockholders

are also deducted.

When calculating inventory turnover, doyou use sales or the cost of goods sold?

I calculate the inventory turnover by using the cost of goods sold. I use the cost of goods sold because

inventory is in the general ledger at its cost and it is reported on the balance sheet at cost. Since

inventory is the cost of goods on hand, it makes sense to relate it to the cost of goods sold.

Assume that during the past year a company's inventory had an average cost of $10,000. (This was the

average of the amounts in the asset account Inventory and the average of the amounts reported on the

balance sheet during the past year.) Also assume that during the year the company has sales of $60,000

and its cost of goods sold was $40,000. On average, the inventory turned over 4 times ($40,000

of costof goods sold during the year divided by $10,000 the averagecost of goods on handduring the

year.)


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What are common-size financial statements?

Common-size financial statements usually involve the balance sheet and the income statement. These

two financial statements become "common-size" when their dollar amounts are expressed in

percentages.

For example, a common-size balance sheet will report all of the balance sheet amounts as a percentage

of the "Total Assets" amount. If Cash was $80,000 and Total Assets were $1,000,000 then Cash willappear as 8% and Total Assets will appear as 100%. If the Current Assets were $350,000 they will

appear as 35%. If Current Liabilities were $180,000 then on the common-size statement they will

appear as 18%. By having all of the balance sheet amounts as a percentage of Total Assets, you can

compare your company's current asset percentage (and all other line items) to your industry's

percentage or to any other company's percentages. It doesn't matter if the other company is larger or

smaller than your company, because all amounts are in percentages of Total Assets. Hence, the name

"common-size."

A common-size income statement will show all of the income statement amounts as a percentage of net

sales. If net sales are $10,000,000 and the cost of goods sold is $7,800,000, the common-size incomestatement will report net sales as 100% and the cost of goods sold as 78%. If SG&A expenses are

$1,300,000 they will appear as 13%. Having the income statement in percentages of net sales allows

you to compare your company's SG&A expenses and its gross profit to your industry percentages and

to other companies regardless of size.

How is working capital defined and measured?

Working capital is the amount of current assets minus the amount of current liabilities as of specific

date. These amounts are obtained from your company's balance sheet. For example, if your company's

balance sheet reports current assets of $450,000 and current liabilities of $320,000 then your company's

working capital is $130,000.

Even with a significant amount of working capital, a company can experience a cash shortage if its

current assets are not turning to cash. For example, if a company has most of its current assets in the

form of inventory, that inventory needs to be sold. Similarly, if a company has a large amount of

receivables that are not being collected, the working capital amount isn't much consolation when you

can't meet Friday's payroll.

There are several financial ratios that pertain to working capital. They include the current ratio, quick

ratio, accounts receivable turnover ratio, days sales in accounts receivable, inventory turnover ratio, and

days sales in inventory.

Monitor your current assets daily to keep the cash coming into your checking account. If you do the

right things each day, your financial ratios have a better chance of being respectable at the end of the

month.

Ch. 7_Introduction to Financial Ratios Lectures

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