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Chapter 3
Standardizing Financial Statements
https://www.boundless.com/nance/analyzing-nancial-
statements--2/
Balance Sheets
Income Statements
Section 1
Standardizing Financial Statements
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Balance Sheets A standard company balance sheet has three parts: assets, liabilities, and ownership equity; Asset = Liabilities + Equity.
KEY POINTS
• A balance sheet or statement of financial position is a summary of the financial balances of a sole proprietorship, a business partnership, a corporation, or other business organization, such as an LLC or an LLP.
• A standard company balance sheet has three parts: assets, liabilities, and ownership equity.
• Assets are followed by the liabilities. The difference between the assets and the liabilities is known as "equity" or the net assets or the net worth or capital of the company and according to the accounting equation, net worth must equal assets minus liabilities.
Balance sheet
In financial accounting, a balance sheet or statement of financial
position is a summary of the financial balances of a sole
proprietorship, a business partnership, a corporation or other
business organization, such as an LLC or an LLP. Assets, liabilities
and ownership equity are listed as of a specific date, such as the end
of its financial year. A balance sheet is often described as a
"snapshot of a company's financial condition." Of the four basic
financial statements, the balance sheet is the only statement which
applies to a single point in time of a business' calendar year.
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Figure 3.1 Balance sheet
Balance sheet shows nancial position of a company.
A standard company balance sheet has three parts: assets,
liabilities, and ownership equity. The main categories of assets are
usually listed first, and typically in order of liquidity. Assets are
followed by the liabilities. The difference between the assets and the
liabilities is known as "equity" or the net assets or the net worth or
the capital of the company and according to the accounting
equation, net worth must equal assets minus liabilities (Figure 3.1).
Types
A balance sheet summarizes an organization or individual's assets,
equity, and liabilities at a specific point in time. We have two forms
of balance sheet. They are the report form and the account form.
Individuals and small businesses tend to have simple balance
sheets. Larger businesses tend to have more complex balance
sheets, and these are presented in the organization's annual report.
Large businesses also may prepare balance sheets for segments of
their businesses. A balance sheet is often presented alongside one
for a different point in time (typically the previous year) for
comparison.
Personal Balance Sheet
A personal balance sheet lists current assets, such as cash in
checking accounts and savings accounts; long-term assets, such as
common stock and real estate; current liabilities, such as loan debt
and mortgage debt due; or overdue, long-term liabilities, such as
mortgage and other loan debt. Securities and real estate values are
listed at market value rather than at historical cost or cost basis.
Personal net worth is the difference between an individual's total
assets and total liabilities.
U.S. Small Business Balance Sheet
A small business balance sheet lists current assets, such as cash,
accounts receivable, and inventory; fixed assets, such as land,
buildings, and equipment; intangible assets, such as patents; and
liabilities, such as accounts payable, accrued expenses, and long-
term debt. Contingent liabilities, such aswarranties are noted in
the footnotes to the balance sheet. The small business's equity is the
difference between total assets and total liabilities.
Public Business Entities Balance Sheet Structure
Guidelines for balance sheets of public business entities are given by
the International Accounting Standards Board and numerous
country-specific organizations/companies.
Balance sheet account names and usage depend on the
organization's country and the type of organization. Government
organizations do not generally follow standards established for
individuals or businesses.
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If applicable to the business, summary values for the following
items should be included in the balance sheet: Assets are all the
things the business owns, including property, tools, cars, etc.
Assets:
1. Current assets
• Cash and cash equivalents
• Accounts receivable
• Inventories
• Prepaid expenses for future services that will be used
within a year
2. Non-current assets (fixed assets)
• Property, plant, and equipment.
• Investment property, such as real estate held for
investment purposes.
• Intangible assets.
• Financial assets (excluding investments accounted for
using the equity method, accounts receivables, and cash
and cash equivalents).
• Investments accounted for using the equity method
• Biological assets, which are living plants or animals. Bearer
biological assets are plants or animals which bear
agricultural produce for harvest, such as apple trees grown
to produce apples and sheep raised to produce wool.
Liabilities:
• Accounts payable.
• Provisions for warranties or court decisions.
• Financial liabilities (excluding provisions and accounts
payable), such as promissory notes and corporate bonds.
• Liabilities and assets for current tax.
• Deferred tax liabilities and deferred tax assets.
• Unearned revenue for services paid for by customers but not
yet provided.
Equity:
• Issued capital and reserves attributable to equity holders of
the parent company (controlling interest).
• Non-controlling interest in equity.
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• Regarding the items in equity section, the following
disclosures are required:
• Numbers of shares authorized, issued and fully paid, and
issued but not fully paid.
• Par value of shares.
• Reconciliation of shares outstanding at the beginning and the
end of the period/
• Description of rights, preferences, and restrictions of shares.
• Treasury shares, including shares held by subsidiaries and
associates.
• Shares reserved for issuance under options and contracts.
• A description of the nature and purpose of each reserve within
owners' equity
Source: https://www.boundless.com/finance/analyzing-financial-
statements--2/standardizing-financial-statements--2/balance-
sheets--2/
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Income Statements Income statement is a company's nancial statement that indicates how the revenue is transformed into the net income.
KEY POINTS
• Income statement displays the revenues recognized for a specific period, and the cost and expenses charged against these revenues, including write offs (e.g., depreciation and amortization of various assets) and taxes.
• The income statement can be prepared in one of two methods: The Single Step income statement and Multi-Step income statement.
• The income statement includes revenue, expenses, COGS, SG&A, depreciation, other revenues and expenses, finance costs, income tax expense, and net income.
Income Statement
Income statement (also referred to as profit and loss statement
[P&L]), revenue statement, a statement of financial performance,
an earnings statement, an operating statement, or statement of
operations) is a company's financial statement. This indicates how
the revenue (money received from the sale of products and services
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before expenses are taken out, also known as the "top line") is
transformed into the net income (the result after all revenues and
expenses have been accounted for, also known as "Net Profit" or the
"bottom line"). It displays the revenues recognized for a specific
period, and the cost and expenses charged against these revenues,
including write offs (e.g., depreciation and amortization of various
assets) and taxes. The purpose of the income statement is to show
managers and investors whether the company made or lost money
during the period being reported.
The important thing to remember about an income statement is
that it represents a period of time. This contrasts with the balance
sheet, which represents a single moment in time (Figure 3.2).
TwoMethods
• The Single Step income statement takes a simpler approach,
totaling revenues and subtracting expenses to find the bottom
line.
• The Multi-Step income statement (as the name implies) takes
several steps to find the bottom line, starting with the gross
profit. It then calculates operating expenses and, when
deducted from the gross profit, yields income from
operations. Adding to income from operations is the
difference of other revenues and other expenses. When
combined with income from operations, this yields income
before taxes. The final step is to deduct taxes, which finally
produces the net income for the period measured.
Operating Section
• Revenue - cash inflows or other enhancements of assets of an
entity during a period from delivering or producing goods,
rendering services, or other activities that constitute the
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Income statement shows gains or losses of a company during a period.
Figure 3.2 Income
statement
entity's ongoing major operations. It is usually presented as
sales minus sales discounts, returns, and allowances. Every
time a business sells a product or performs a service, it obtains
revenue. This often is referred to as gross revenue or sales
revenue.
• Expenses - cash outflows or other using-up of assets or
incurrence of liabilities during a period from delivering or
producing goods, rendering services, or carrying out other
activities that constitute the entity's ongoing major operations.
• Cost of Goods Sold (COGS)/Cost of Sales - represents the
direct costs attributable to goods produced and sold by a
business (manufacturing or merchandizing). It includes
material costs, direct labor, and overhead costs (as in
absorption costing), and excludes operating costs (period
costs), such as selling, administrative, advertising or R&D, etc.
• Selling, General and Administrative expenses (SG&A or SGA) -
consist of the combined payroll costs. SGA is usually
understood as a major portion of non-production related
costs, in contrast to production costs such as direct labour.
• Selling expenses - represent expenses needed to sell products
(e.g., salaries of sales people, commissions, and travel
expenses; advertising; freight; shipping; depreciation of sales
store buildings and equipment, etc.).
• General and Administrative (G&A) expenses - represent
expenses to manage the business (salaries of officers/
executives, legal and professional fees, utilities, insurance,
depreciation of office building and equipment, office rents,
office supplies, etc.).
• Depreciation/Amortization - the charge with respect to fixed
assets/intangible assets that have been capitalized on the
balance sheet for a specific (accounting) period. It is a
systematic and rational allocation of cost rather than the
recognition of market value decrement.
• Research & Development (R&D) expenses - represent
expenses included in research and development.
• Expenses recognized in the income statement should be
analyzed either by nature (raw materials, transport costs,
staffing costs, depreciation, employee benefit, etc.) or by
function (cost of sales, selling, administrative, etc.).
Non-operating Section
• Other revenues or gains - revenues and gains from other than
primary business activities (e.g., rent, income from patents).
• Other expenses or losses - expenses or losses not related to
primary business operations, (e.g., foreign exchange loss).
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• Finance costs - costs of borrowing from various creditors (e.g.,
interest expenses, bank charges).
• Income tax expense - sum of the amount of tax payable to tax
authorities in the current reporting period (current tax
liabilities/tax payable) and the amount of deferred tax
liabilities (or assets).
• Irregular items - are reported separately because this way
users can better predict future cash flows - irregular items
most likely will not recur. These are reported net of taxes.
Bottom Line
Bottom line is the net income that is calculated after subtracting the
expenses from revenue. Since this forms the last line of the income
statement, it is informally called "bottom line." It is important to
investors as it represents the profit for the year attributable to the
shareholders.
Source: https://www.boundless.com/finance/analyzing-financial-
statements--2/standardizing-financial-statements--2/income-
statements--2/
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Classication
Section 2
Ratio Analysis Overview
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Classication Ratio analysis consists of calculating nancial performance using ve basic types of ratios: protability, liquidity, activity, debt, and market.
KEY POINTS
• Ratio analysis consists of the calculation of ratios from financial statements and is a foundation of financial analysis.
• A financial ratio, or accounting ratio, shows the relative magnitude of selected numerical values taken from those financial statements.
• The numbers contained in financial statements need to be put into context so that investors can better understand different aspects of the company's operations. Ratio analysis is one method an investor can use to gain that understanding.
Classification
Financial statements are generally insufficient to provide
information to investors on their own; the numbers contained in
those documents need to be put into context so that investors can
better understand different aspects of the company's operations.
Ratio analysis is one of three methods an investor can use to gain
that understanding (Figure 3.3).
Financial statement analysis is the process of understanding the
risk and profitability of a firm through analysis of reported financial
information. Ratio analysis is a foundation for evaluating and
pricing credit risk and for doing fundamental company valuation. A
financial ratio, or accounting ratio, is derived from a company’s
financial statements and is a calculation showing the relative
magnitude of selected numerical values taken from those financial
statements.
There are various types of financial ratios, grouped by their
relevance to different aspects of a company’s business as well as to
their interest to different audiences. Financial ratios may be used
internally by managers within a firm, by current and potential
shareholders and creditors of a firm, and other audiences interested
in understanding the strengths and weaknesses of a company,
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Financial ratio analysis allows an observer to put the data provided by a company in context. This allows the observer to gauge the strength of dierent aspects of the company's operations.
Figure 3.3
Business Analysis
and Protability
especially compared to the company over time or compared to other
companies.
Types of Ratios
Most analysts think of financial ratios as consisting of five basic
types:
• Profitability ratios measure the firm's use of its assets and
control of its expenses to generate an acceptable rate of
return.
• Liquidity ratios measure the availability of cash to pay debt.
• Activity ratios, also called efficiency ratios, measure the
effectiveness of a firm’s use of resources, or assets.
• Debt, or leverage, ratios measure the firm's ability to repay
long-term debt.
• Market ratios are concerned with shareholder audiences. They
measure the cost of issuing stock and the relationship between
return and the value of an investment in company’s shares.
Source: https://www.boundless.com/finance/analyzing-financial-
statements--2/ratio-analysis-overview--2/classification--2/
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161
Operating Margin
Prot Margin
Return on Total Assets
Basic Earning Power (BEP) Ratio
Return on Common Equity
Section 3
Protability Ratios
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Operating Margin The operating margin is a ratio that determines how much money a company is actually making in prot and equals operating income divided by revenue.
KEY POINTS
• The operating margin equals operating income divided by revenue.
• The operating margin shows how much profit a company makes for each dollar in revenue. Since revenues and expenses are considered 'operating' in most companies, this is a good way to measure a company's profitability.
• Although It is a good starting point for analyzing many companies, there are items like interest and taxes that are not included in operating income. Therefore, the operating margin is an imperfect measurement a company's profitability.
Operating Margin
The financial job of a company is to earn a profit, which is different
than earning revenue. If a company doesn't earn a profit, their
revenues aren't helping the company grow. It is not only important
to see how much a company has sold, it is important to see how
much a company is making.
The operatingmargin (also called the operating profit margin or
return on sales) is a ratio that shines a light on how much money a
company is actually making in profit. It is found by dividing
operating income by revenue, where operating income is revenue
minus operating expenses (Figure 3.4).
The higher the ratio is, the more profitable the company is from its
operations. For example, an operating margin of 0.5 means that for
every dollar the company takes in revenue, it earns $0.50 in profit.
A company that is not making any money will have an operating
margin of 0: it is selling its products or services, but isn't earning
any profit from those sales.
However, the operating margin is not a perfect measurement. It
does not include things like capital investment, which is necessary
for the future profitability of the company. Furthermore, the
operating margin is simply revenue. That means that it does not
include things like interest and income tax expenses. Since non-
operating incomes and expenses can significantly affect the
financial well-being of a company, the operating margin is not the
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The operating margin is found by dividing net operating income by total revenue.
Figure 3.4 Operating Margin Formula
only measurement that investors scrutinize. The operating margin
is a useful tool for determining how profitable the operations of a
company are, but not necessarily how profitable the company is as a
whole.
Source: https://www.boundless.com/finance/analyzing-financial-
statements--2/profitability-ratios--2/operating-margin--2/
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Prot Margin Prot margin measures the amount of prot a company earns from its sales and is calculated by dividing prot (gross or net) by sales.
KEY POINTS
• Profit margin is the profit divided by revenue.
• There are two types of profit margin: gross profit margin and net profit margin.
• A higher profit margin is better for the company, but there may be strategic decisions made to lower the profit margin or to even have it be negative.
Profit Margin
Profit margin is one of the most used profitability ratios. 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 100%. The higher the profit margin, the more profit a
company earns on each sale.
Since there are two types of profit (gross and net), there are two
types of profit margin calculations. Recall that gross profit is simply
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the revenue minus the cost of goods sold (COGS). Net profit is the
gross profit minus all other expenses. The gross profit margin
calculation uses gross profit (Figure 3.5) and the net profit margin
calculation uses net profit (Figure 3.6). The difference between the
two is that the gross profit margin shows the relationship between
revenue and COGS, while the net profit margin shows the
percentage of the money spent by customers that is turned into
profit.
Companies need to have a positive profit margin in order to earn
income, although having a negative profit margin may be
advantageous in some instances (e.g. intentionally selling a new
product below cost in order to gain market share).
The profit margin is mostly used for internal comparison. It is
difficult to accurately compare the net profit ratio for different
entities. Individual businesses' operating and financing
arrangements vary so much that different entities are bound to have
different levels of expenditure. Comparing one business'
arrangements with another has little meaning. A low profit margin
indicates a low margin of safety. There is a higher risk that a decline
in sales will erase profits and result in a net loss or a negative
margin.
Source: https://www.boundless.com/finance/analyzing-financial-
statements--2/profitability-ratios--2/profit-margin--2/
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165
The percentage of gross prot earned on the company's sales.
Figure 3.5 Gross Prot Margin
The percentage of net prot (gross prot minus all other expenses) earned on a company's sales.
Figure 3.6 Net Prot Margin
Return on Total Assets The return on assets ratio (ROA) measures how eectively assets are being used for generating prot.
KEY POINTS
• ROA is net income divided by total assets.
• The ROA is the product of two common ratios - profit margin and asset turnover.
• A higher ROA is better, but there is no metric for a good or bad ROA. An ROA depends on the company, the industry and the economic environment.
• ROA is based on the book value of assets, which can be starkly different from the market value of assets.
Return on Assets
The return on assets ratio (ROA) is found by dividing net income
by total assets (Figure 3.7). The higher the ratio, the better the
company is at using their assets to generate income. ROA was
developed by DuPont to show how effectively assets are being used.
It is also a measure of how much the company relies on assets to
generate profit.
Components of ROA
ROA can be broken down into multiple parts (Figure 3.7). The ROA
is the product of two other common ratios - profit margin and asset
turnover. When profit margin and asset turnover are multiplied
together, the denominator of profit margin and the numerator of
asset turnover cancel each other out, returning us to the original
ratio of net income to total assets.
Profit margin is net income divided by sales, measuring the percent
of each dollar in sales that is profit for the company. Asset turnover
is sales divided by total assets. This ratio measures how much each
dollar in asset generates in sales. A higher ratio means that each
dollar in assets produces more for the company.
Limits of ROA
ROA does have some drawbacks. First, it gives no indication of how
the assets were financed. A company could have a high ROA, but
166
The return on assets ratio is net income divided by total assets. That can then be broken down into the product of prot margins and asset turnover.
Figure 3.7 Return on Assets
still be in financial straits because all the assets were paid for
through leveraging. Second, the total assets are based on the
carrying value of the assets, not the market value. If there is a large
discrepancy between the carrying and market value of the assets,
the ratio could provide misleading numbers. Finally, there is no
metric to find a good or bad ROA. Companies that operate in capital
intensive industries will tend to have lower ROAs than those who do
not. The ROA is entirely contextual to the company, the industry
and the economic environment.
Source: https://www.boundless.com/finance/analyzing-financial-
statements--2/profitability-ratios--2/return-on-total-assets--2/
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Basic Earning Power (BEP) Ratio The Basic Earning Power ratio (BEP) is Earnings Before Interest and Taxes (EBIT) divided by Total Assets.
KEY POINTS
• The higher the BEP ratio, the more effective a company is at generating income from its assets.
• Using EBIT instead of operating income means that the ratio considers all income earned by the company, not just income from operating activity. This gives a more complete picture of how the company makes money.
• BEP is useful for comparing firms with different tax situations and different degrees of financial leverage.
BEP Ratio
Another profitability ratio is the Basic Earning
Power ratio (BEP). The purpose of BEP is to
determine how effectively a firm uses its assets
to generate income.
The BEP ratio is simply EBIT divided by total
assets (Figure 3.8). The higher the BEP ratio,
167
BEP is calculated as the ratio of Earnings Before Interest and Taxes to Total Assets.
Figure 3.8 Basic
Earnings Power Ratio
the more effective a company is at generating income from its
assets.
This may seem remarkably similar to the return on assets ratio
(ROA), which is operating income divided by total assets. EBIT, or
earnings before interest and taxes, is a measure of how much money
a company makes, but is not necessarily the same as operating
income:
EBIT = Revenue – Operating expenses+ Non-operating income
Operating income = Revenue – Operating expenses
The distinction between EBIT and Operating Income is non-
operating income. Since EBIT includes non-operating income (such
as dividends paid on the stock a company holds of another), it is a
more inclusive way to measure the actual income of a company.
However, in most cases, EBIT is relatively close to Operating
Income.
The advantage of using EBIT, and thus BEP, is that it allows for
more accurate comparisons of companies. BEP disregards different
tax situations and degrees of financial leverage while still providing
an idea of how good a company is at using its assets to generate
income.
BEP, like all profitability ratios, does not provide a complete picture
of which company is better or more attractive to investors. Investors
should favor a company with a higher BEP over a company with a
lower BEP because that means it extracts more value from its
assets, but they still need to consider how things like leverage and
tax rates affect the company.
Source: https://www.boundless.com/finance/analyzing-financial-
statements--2/profitability-ratios--2/basic-earning-power-bep-
ratio--2/
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Return on Common Equity Return on equity (ROE) measures how eective a company is at using its equity to generate income and is calculated by dividing net prot by total equity.
KEY POINTS
• ROE is net income divided by total shareholders' equity.
• ROE is also the product of return on assets (ROA) and financial leverage.
• ROE shows how well a company uses investment funds to generate earnings growth. There is no standard for a good or bad ROE, but a higher ROE is better.
Return on Equity
Return on equity (ROE) is a financial ratio that measures how good
a company is at generating profit.
ROE is the ratio of net income to equity. From the fundamental
equation of accounting, we know that equity equals net assets
minus net liabilities. Equity is the amount of ownership interest in
the company, and is commonly referred to as shareholders' equity,
shareholders' funds, or shareholders' capital.
In essence, ROE measures how efficient the company is at
generating profits from the funds invested in it. A company with a
high ROE does a good job of turning the capital invested in it into
profit, and a company with a low ROE does a bad job. However, like
many of the other ratios, there is no standard way to define a good
ROE or a bad ROE. Higher ratios are better, but what counts as
"good" varies by company, industry, and economic environment.
ROE can also be broken down into other components for easier use.
(Figure 3.9) ROE is the product of the net margin (profit margin),
asset turnover, and financial leverage. Also note that the product of
net margin and asset turnover is return on assets, so ROE is ROA
times financial leverage.
Breaking ROE into parts allows us to understand how and why it
changes over time. For example, if the net margin increases, every
sale brings in more money, resulting in a higher overall ROE.
Similarly, if the asset turnover increases, the firm generates more
sales for every unit of assets owned, again resulting in a higher
overall ROE. Finally, increasing financial leverage means that the
169
The return on equity is a ratio of net income to equity. It is a measure of how eective the equity is at generating income.
Figure 3.9 Return on Equity
firm uses more debt financing relative to equity financing. Interest
payments to creditors are tax deductible, but dividend payments to
shareholders are not. Thus, a higher proportion of debt in the firm's
capital structure leads to higher ROE. Financial leverage benefits
diminish as the risk of defaulting on interest payments increases. So
if the firm takes on too much debt, the cost of debt rises as creditors
demand a higher risk premium, and ROE decreases. Increased
debt will make a positive contribution to a firm's ROE only if the
matching return on assets (ROA) of that debt exceeds the interest
rate on the debt.
Source: https://www.boundless.com/finance/analyzing-financial-
statements--2/profitability-ratios--2/return-on-common-equity--2/
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170
Inventory Turnover Ratio
Days Sales Outstanding
Fixed Assets Turnover Ratio
Total Assets Turnover Ratio
Section 4
Asset Management Ratios
171
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Inventory Turnover Ratio Inventory turnover is a measure of the number of times inventory is sold or used in a time period, such as a year.
KEY POINTS
• Inventory turnover = Cost of goods sold/Average inventory.
• Average days to sell the inventory = 365 days /Inventory turnover ratio.
• A low turnover rate may point to overstocking, obsolescence, or deficiencies in the product line or marketing effort.
• Conversely, a high turnover rate may indicate inadequate inventory levels, which may lead to a loss in business as the inventory is too low.
Inventory Turnover
In accounting, the Inventory turnover is a measure of the number of
times inventory is sold or used in a time period, such as a year. The
equation for inventory turnover equals the cost of goods sold
divided by the average inventory. Inventory turnover is also known
as inventory turns, stockturn, stock turns, turns, and stock
turnover.
Inventory Turnover Equation
The formula for inventory turnover:
• Inventory turnover = Cost of goods sold/Average inventory
The formula for average inventory:
• Average inventory = (Beginning inventory + Ending
inventory)/2
The average days to sell the inventory is calculated as follows:
• Average days to sell the inventory = 365 days / Inventory
turnover ratio
Application in Business
A low turnover rate may point to overstocking, obsolescence, or
deficiencies in the product line or marketing effort. However, in
some instances a low rate may be appropriate, such as where higher
inventory levels occur in anticipation of rapidly rising prices or
expected market shortages (Figure 3.10).
Conversely, a high turnover rate may indicate inadequate inventory
levels, which may lead to a loss in business as the inventory is too
low. This often can result in stock shortages.
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Some compilers of industry data (e.g., Dun & Bradstreet) use sales
as the numerator instead of cost of sales. Cost of sales yields a more
realistic turnover ratio, but it is often necessary to use sales for
purposes of comparative analysis. Cost of sales is considered to be
more realistic because of the difference in which sales and the cost
of sales are recorded. Sales are generally recorded at market value
(i.e., the value at which the marketplace paid for the good or service
provided by the firm). In the event that the firm had an exceptional
year and the market paid a premium for the firm's goods and
services, then the numerator may be an inaccurate measure.
However, cost of sales is recorded by the firm at what the firm
actually paid for the materials available for sale. Additionally, firms
may reduce prices to generate sales in an effort to cycle inventory.
In this article, the terms "cost of sales" and "cost of goods sold" are
synonymous.
An item whose inventory is sold (turns over) once a year has a
higher holding cost than one that turns over twice, or three times,
or more in that time. Stock turnover also indicates the briskness of
the business. The purpose of increasing inventory turns is to reduce
inventory for three reasons.
1. Increasing inventory turns reduces holding cost. The
organization spends less money on rent, utilities, insurance,
theft, and other costs of maintaining a stock of good to be
sold.
2. Reducing holding cost increases net income and profitability
as long as the revenue from selling the item remains
constant.
3. Items that turn over more quickly increase responsiveness to
changes in customer requirements while allowing the
replacement of obsolete items. This is a major concern in
fashion industries.
When making comparison between firms, it's important to take
note of the industry, or the comparison will be distorted. Making
comparison between a supermarket and a car dealer, will not be
appropriate, as a supermarket sells fast moving goods, such as
173
A low turnover rate may point to overstocking, obsolescence, or deciencies in the product line or marketing eort.
Figure 3.10
Inventory
sweets, chocolates, soft drinks, so the stock turnover will be higher.
However, a car dealer will have a low turnover due to the item being
a slow moving item. As such, only intra-industry comparison will be
appropriate.
Source: https://www.boundless.com/finance/analyzing-financial-
statements--2/asset-management-ratios--2/inventory-turnover-
ratio--2/
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Days Sales Outstanding Days sales outstanding (also called DSO or days receivables) is a calculation used by a company to estimate their average collection period.
KEY POINTS
• Days sales outstanding is a financial ratio that illustrates how well a company's accounts receivables are being managed.
• DSO ratio = accounts receivable / average sales per day, or DSO ratio = accounts receivable / (annual sales / 365 days).
• Generally speaking, higher DSO ratio can indicate a customer base with credit problems and/or a company that is deficient in its collections activity. A low ratio may indicate the firm's credit policy is too rigorous, which may be hampering sales.
Days Sales Outstanding
In accountancy, days sales outstanding (also called DSO or days
receivables) is a calculation used by a company to estimate their
average collection period. It is a financial ratio that illustrates
how well a company's accounts receivables are being managed. The
days sales outstanding figure is an index of the relationship between
outstanding receivables and credit account sales achieved over a
given period.
174
Typically, days sales outstanding is calculated monthly. The days
sales outstanding analysis provides general information about the
number of days on average that customers take to pay invoices.
Generally speaking, though, higher DSO ratio can indicate a
customer base with credit problems and/or a company that is
deficient in its collections activity. A low ratio may indicate the
firm's credit policy is too rigorous, which may be hampering sales.
Days sales outstanding is considered an important tool in
measuring liquidity. Days sales outstanding tends to increase as a
company becomes less risk averse. Higher days sales outstanding
can also be an indication of inadequate analysis of applicants for
open account credit terms. An increase in DSO can result in cash
flow problems, and may result in a decision to increase the creditor
company's bad debt reserve (Figure 3.11).
A DSO ratio can be expressed as:
• DSO ratio = accounts receivable / average sales per day, or
• DSO ratio = accounts receivable / (annual sales / 365 days)
For purposes of this ratio, a year is considered to have 365 days.
Days sales outstanding can vary from month to month and over the
course of a year with a company's seasonal business cycle. Of
interest, when analyzing the performance of a company, is the trend
in DSO. If DSO is getting longer, customers are taking longer to pay
their bills, which may be a warning that customers are dissatisfied
with the company's product or service, or that sales are being made
to customers that are less credit worthy or that sales people have to
offer longer payment terms in order to generate sales. Many
financial reports will state Receivables Turnover defined as Net
Credit Account Sales / Trade Receivables; divide this value into the
time period in days to get DSO.
However, days sales outstanding is not the most accurate indication
of the efficiency of accounts receivable department. Changes in
175
A low ratio may indicate the rm's credit policy is too rigorous, which may be hampering sales.
Figure 3.11 Days
Sales Outstanding
sales volume influence the outcome of the days sales outstanding
calculation. For example, even if the overdue balance stays the
same, an increase of sales can result in a lower DSO. A better way to
measure the performance of credit and collection function is by
looking at the total overdue balance in proportion of the total
accounts receivable balance (total AR = Current + Overdue), which
is sometimes calculated using the days' delinquent sales
outstanding (DDSO) formula.
Source: https://www.boundless.com/finance/analyzing-financial-
statements--2/asset-management-ratios--2/days-sales-
outstanding--2/
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Fixed Assets Turnover Ratio Fixed-asset turnover is the ratio of sales to value of xed assets, indicating how well the business uses xed assets to generate sales.
KEY POINTS
• Fixed asset turnover = Net sales / Average net fixed assets.
• The higher the ratio, the better, because a high ratio indicates the business has less money tied up in fixed assets for each unit of currency of sales revenue. A declining ratio may indicate that the business is over-invested in plant, equipment, or other fixed assets.
• Fixed assets, also known as a non-current asset or as property, plant, and equipment (PP&E), is a term used in accounting for assets and property that cannot easily be converted into cash.
Fixed Assets
Fixed assets, also known as a non-current asset or as property,
plant, and equipment (PP&E), is a term used in accounting for
assets and property that cannot easily be converted into cash. This
can be compared with current assets, such as cash or bank accounts,
176
which are described as liquid assets. In most cases, only tangible
assets are referred to as fixed.
Moreover, a fixed/non-current asset also can be defined as an asset
not directly sold to a firm's consumers/end-users. As an example, a
baking firm's current assets would be its inventory (in this case,
flour, yeast, etc.), the value of sales owed to the firm via credit (i.e.,
debtors or accounts receivable), cash held in the bank, etc. Its non-
current assets would be the oven used to bake bread, motor vehicles
used to transport deliveries, cash registers used to handle cash
payments, etc. Each aforementioned non-current asset is not sold
directly to consumers.
These are items of value that the organization has bought and will
use for an extended period of time; fixed assets normally include
items, such as land and buildings, motor vehicles, furniture, office
equipment, computers, fixtures and fittings, and plant and
machinery. These often receive favorable tax treatment
(depreciation allowance) over short-term assets. According to
International Accounting Standard (IAS) 16, Fixed Assets are assets
which have future economic benefit that is probable to flow into the
entity and which have a cost that can be measured reliably.
The primary objective of a business entity is to make a profit and
increase the wealth of its owners. In the attainment of this objective,
it is required that the management will exercise due care and
diligence in applying the basic accounting concept of “Matching
Concept.” Matching concept is simply matching the expenses of a
period against the revenues of the same period.
The use of assets in the generation of revenue is usually more than a
year–that is long term. It is, therefore, obligatory that in order to
accurately determine the net income or profit for a period
depreciation, it is charged on the total value of asset that
contributed to the revenue for the period in consideration and
charge against the same revenue of the same period. This is
essential in the prudent reporting of the net revenue for the entity
in the period.
177
Turn tables should help you remember turnover. Fixed- asset turnover indicates how well the business is using its xed assets to generate sales.
Figure 3.12
Turn Tables
Fixed-asset Turnover
Fixed-asset turnover is the ratio of sales (on the profit and loss
account) to the value of fixed assets (on the balance sheet). It
indicates how well the business is using its fixed assets to generate
sales (Figure 3.12).
Fixed asset turnover = Net sales / Average net fixed assets
Generally speaking, the higher the ratio, the better, because a high
ratio indicates the business has less money tied up in fixed assets
for each unit of currency of sales revenue. A declining ratio may
indicate that the business is over-invested in plant, equipment, or
other fixed assets.
Source: https://www.boundless.com/finance/analyzing-financial-
statements--2/asset-management-ratios--2/fixed-assets-turnover-
ratio--2/
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Total Assets Turnover Ratio Total asset turnover is a nancial ratio that measures the eciency of a company's use of its assets in generating sales revenue.
KEY POINTS
• Total assets turnover = Net sales revenue / Average total assets.
• Net sales are operating revenues earned by a company for selling its products or rendering its services.
• Anything tangible or intangible that is capable of being owned or controlled to produce value and that is held to have positive economic value is considered an asset.
• Companies with low profit margins tend to have high asset turnover, while those with high profit margins have low asset turnover.
Total assets turnover
This is a financial ratio that measures the efficiency of a company's
use of its assets in generating sales revenue or sales income to the
company (Figure 3.13).
178
Companies with low profit margins tend to have high asset
turnover, while those with high profit margins have low asset
turnover. Companies in the retail industry tend to have a very high
turnover ratio due mainly to cut-throat and competitive pricing.
Total assets turnover = Net sales revenue / Average total assets
• "Sales" is the value of "Net Sales" or "Sales" from the
company's income statement".
• Average Total Assets" is the average of the values of "Total
assets" from the company's balance sheet in the beginning
and the end of the fiscal period. It is calculated by adding up
the assets at the beginning of the period and the assets at the
end of the period, then dividing that number by two.
Net sales
• In bookkeeping, accounting, and finance, Net sales are
operating revenues earned by a company for selling its
products or rendering its services. Also referred to as revenue,
they are reported directly on the income statement as Sales or
Net sales.
• In financial ratios that use income statement sales values,
"sales" refers to net sales, not gross sales. Sales are the unique
transactions that occur in professional selling or during
marketing initiatives.
Total assets
In financial accounting, assets are economic resources. Anything
tangible or intangible that is capable of being owned or controlled to
produce value, and that is held to have positive economic value, is
considered an asset. Simply stated, assets represent value of
ownership that can be converted into cash (although cash itself is
also considered an asset).
The balance sheet of a firm records the monetary value of the assets
owned by the firm. It is money and other valuables belonging to an
individual or business.
Two major asset classes are tangible assets and intangible assets.
179
Asset turnover measures the eciency of a company's use of its assets in generating sales revenue or sales income to the company.
Figure 3.13 Assets
• Tangible assets contain various subclasses, including current
assets and fixed assets. Current assets include inventory,
while fixed assets include such items as buildings and
equipment.
• Intangible assets are non-physical resources and rights that
have a value to the firm because they give the firm some kind
of advantage in the market place.
EXAMPLE
Examples of intangible assets are goodwill, copyrights, trademarks, patents, computer programs, and financial assets, including such items as accounts receivable, bonds and stocks.
Source: https://www.boundless.com/finance/analyzing-financial-
statements--2/asset-management-ratios--2/total-assets-turnover-
ratio--2/
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180
Current Ratio
Quick, or Acid Test, Ratio
Section 5
Liquidity Ratios
181
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Current Ratio Current ratio is a nancial ratio that measures whether or not a rm has enough resources to pay its debts over the next 12 months.
KEY POINTS
• The liquidity ratio expresses a company's ability to repay short-term creditors out of its total cash. The liquidity ratio is the result of dividing the total cash by short-term borrowings.
• The current ratio is a financial ratio that measures whether or not a firm has enough resources to pay its debts over the next 12 months.
• Current ratio = current assets / current liabilities.
• Acceptable current ratios vary from industry to industry and are generally between 1.5 and 3 for healthy businesses.
Liquidity Ratio
Liquidity ratio expresses a company's ability to repay short-term
creditors out of its total cash. The liquidity ratio is the result of
dividing the total cash by short-term borrowings. It shows the
number of times short-term liabilities are covered by cash. If the
value is greater than 1.00, it means it is fully covered (Figure 3.14).
Liquidity ratio may refer to:
• Reserve requirement - a bank
regulation that sets the minimum
reserves each bank must hold.
• Acid Test - a ratio used to determine
the liquidity of a business entity.
The formula is the following:
LR = liquid assets / short-term liabilities
Current Ratio
The current ratio is a financial ratio that measures whether or not a
firm has enough resources to pay its debts over the next 12 months.
It compares a firm's current assets to its current liabilities. It is
expressed as follows:
Current ratio = current assets / current liabilities
• Current asset is an asset on the balance sheet that can either
be converted to cash or used to pay current liabilities within
12 months. Typical current assets include cash, cash
equivalents, short-term investments, accounts receivable,
inventory, and the portion of prepaid liabilities that will be
paid within a year.
182
A high liquidity means the company has the ability to meet its short term obligations.
Figure 3.14 Liquidity
• Current liabilities are often understood as all liabilities of the
business that are to be settled in cash within the fiscal year or
the operating cycle of a given firm, whichever period is longer.
The current ratio is an indication of a firm's market liquidity and
ability to meet creditor's demands. Acceptable current ratios vary
from industry to industry and are generally between 1.5 and 3 for
healthy businesses. If a company's current ratio is in this range,
then it generally indicates good short-term financial strength. If
current liabilities exceed current assets (the current ratio is below
1), then the company may have problems meeting its short-term
obligations. If the current ratio is too high, then the company may
not be efficiently using its current assets or its short-term financing
facilities. This may also indicate problems in working capital
management.
Low values for the current or quick ratios (values less than 1)
indicate that a firm may have difficulty meeting current obligations.
However, low values 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. Some types of
businesses usually operate with a current ratio less than one. For
example, if inventory turns over much more rapidly than the
accounts payable do, then the current ratio will be less than one.
This can allow a firm to operate with a low current ratio.
If all other things were equal, a creditor, who is expecting to be paid
in the next 12 months, would consider a high current ratio to be
better than a low current ratio. A high current ratio means that the
company is more likely to meet its liabilities which fall due in the
next 12 months.
Source: https://www.boundless.com/finance/analyzing-financial-
statements--2/liquidity-ratios--2/current-ratio--2/
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183
Quick, or Acid Test, Ratio The Acid Test or Quick Ratio measures the ability of a company to use its assets to retire its current liabilities immediately.
KEY POINTS
• Quick Ratio = (Cash and cash equivalent + Marketable securities + Accounts receivable) / Current liabilities.
• Acid Test Ratio = (Current assets - Inventory) / Current liabilities.
• Ideally, the acid test ratio should be 1:1 or higher, however this varies widely by industry. In general, the higher the ratio, the greater the company's liquidity.
Quick ratio
In finance, the Acid-test (also known as quick ratio or liquid ratio)
measures the ability of a company to use its near cash or quick
assets to extinguish or retire its current liabilities immediately.
Quick assets include those current assets that presumably can be
quickly converted to cash at close to their book values. A company
with a Quick Ratio of less than 1 cannot pay back its current
liabilities.
Quick Ratio = (Cash and cash equivalent + Marketable securities +
Accounts receivable) / Current liabilities.
Cash and cash equivalents are the most liquid assets found within
the asset portion of a company's balance sheet. Cash equivalents are
assets that are readily convertible into cash, such as money market
holdings, short-term government bonds or Treasury bills,
marketable securities, and commercial paper. Cash equivalents are
distinguished from other investments through their short-term
existence. They mature within 3 months, whereas short-term
investments are 12 months or less and long-term investments are
any investments that mature in excess of 12 months. Another
important condition that cash equivalents need to satisfy, is the
184
Cash is the most liquid asset in a business.
Figure 3.15 Cash
investment should have insignificant risk of change in value. Thus,
common stock cannot be considered a cash equivalent, but
preferred stock acquired shortly before its redemption date can be
(Figure 3.15).
Acid test ratio
Acid test often refers to Cash ratio instead of Quick ratio: Acid Test
Ratio = (Current assets - Inventory) / Current liabilities.
Note that Inventory is excluded from the sum of assets in the Quick
Ratio, but included in the Current Ratio. Ratios are tests of viability
for business entities but do not give a complete picture of the
business' health. A business with large Accounts Receivable that
won’t be paid for a long period (say 120 days), and essential
business expenses and Accounts Payable that are due immediately,
the Quick Ratio may look healthy when the business could actually
run out of cash. In contrast, if the business has negotiated fast
payment or cash from customers, and long terms from suppliers, it
may have a very low Quick Ratio and yet be very healthy.
The acid test ratio should be 1:1 or higher, however this varies
widely by industry. The higher the ratio, the greater the company's
liquidity will be (better able to meet current obligations using liquid
assets).
Source: https://www.boundless.com/finance/analyzing-financial-
statements--2/liquidity-ratios--2/quick-or-acid-test-ratio--2/
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185
Total Debt to Total Assets
Times-Interest-Earned Ratio
Section 6
Debt Management Ratios
186
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Total Debt to Total Assets The debt ratio is expressed as Total debt / Total assets.
KEY POINTS
• The debt ratio measures the firm's ability to repay long-term debt by indicating the percentage of a company's assets that are provided via debt.
• Debt ratio = Total debt / Total assets.
• The higher the ratio, the greater risk will be associated with the firm's operation.
Financial Ratios
Financial ratios quantify many aspects of a business and are an
integral part of the financial statement analysis. Financial ratios are
categorized according to the financial aspect of the business which
the ratio measures.
Financial ratios allow for comparisons:
• Between companies
• Between industries
• Between different time periods for one company
• Between a single company and its industry average
Ratios generally are not useful unless they are benchmarked against
something else, like past performance or another company. Thus,
the ratios of firms in different industries, which face different risks,
capital requirements, and competition, are usually hard to compare.
Debt ratios
Debt ratios measure the firm's ability to repay long-term debt. It 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')
(Figure 3.16).
• Debt ratio = Total debt / Total assets
187
Debt ratio is an index of a business operation.
Figure 3.16 Debt
Or alternatively:
• Debt ratio = Total liability / Total assets
The higher the ratio, the greater risk will be 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.
Total liabilities divided by total assets. The debt/asset ratio shows
the proportion of a company's assets which are financed through
debt. If the ratio is less than 0.5, most of the company's assets are
financed through equity. If the ratio is greater than 0.5, most of the
company's assets are financed through debt. Companies with high
debt/asset ratios are said to be "highly leveraged," not highly liquid
as stated above. A company with a high debt ratio (highly leveraged)
could be in danger if creditors start to demand repayment of debt.
EXAMPLE
For example, a company with 2 million in total assets and 500,000 in total liabilities would have a debt ratio of 25%.
Source: https://www.boundless.com/finance/analyzing-financial-
statements--2/debt-management-ratios--2/total-debt-to-total-
assets--2/
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188
Times-Interest-Earned Ratio Times Interest Earned ratio (EBIT or EBITDA divided by total interest payable) measures a company's ability to honor its debt payments.
KEY POINTS
• Times interest earned (TIE) or Interest Coverage ratio 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.
• Interest Charges = Traditionally "charges" refers to interest expense found on the income statement.
• EBIT = Revenue – Operating expenses (OPEX) + Non- operating income.
• EBITDA = Earnings before interest, taxes, depreciation and amortization.
• Times Interest Earned or Interest Coverage is a great tool when measuring a company's ability to meet its debt obligations.
Times interest earned (TIE), or interest coverage ratio, 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.
Times-Interest-Earned = EBIT or EBITDA / Interest charges
(Figure 3.17)
Times-Interest-Earned = EBIT or EBITDA / Interest charges
• Interest Charges = Traditionally "charges" refers to interest
expense found on the income statement.
• EBIT = Earnings Before Interest and Taxes, also called
operating profit or operating income. EBIT is a measure of a
firm's profit that excludes interest and income tax expenses. It
is the difference between operating revenues and operating
expenses. When a firm does not have non-operating income,
then operating income is sometimes used as a synonym for
EBIT and operating profit.
189
Times Interest Earned ratio indicates the ability of a company to cover its interest expenses using EBIT.
Figure 3.17 Interest
• EBIT = Revenue – Operating Expenses (OPEX) + Non-
operating income.
• Operating income = Revenue – Operating expenses.
• EBITDA = Earnings Before Interest, Taxes, Depreciation and
Amortization. The EBITDA of a company provides insight on
the operational of the business. It shows the profitability of a
company regarding its present assets and operations with the
products it produces and sells, taking into account possible
provisions that need to be done.
If EBITDA is negative, then the business has serious issues. A
positive EBITDA, however, does not automatically imply that the
business generates cash. EBITDA ignores changes in Working
Capital (usually needed when growing a business), capital
expenditures (needed to replace assets that have broken down),
taxes, and interest.
Times Interest Earned or Interest Coverage is a great tool when
measuring a company's ability to meet its debt obligations. When
the interest coverage ratio is smaller than 1, the company is not
generating enough cash from its operations EBIT to meet its
interest obligations. The Company would then have to either use
cash on hand to make up the difference or borrow funds. Typically,
it is a warning sign when interest coverage falls below 2.5x.
Source: https://www.boundless.com/finance/analyzing-financial-
statements--2/debt-management-ratios--2/times-interest-earned-
ratio--2/
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190
Price/Earnings Ratio
Market/Book Ratio
Section 7
Market Value Ratios
191
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Price/Earnings Ratio Price to earnings ratio (market price per share / annual earnings per share) is used as a guide to the relative values of companies.
KEY POINTS
• P/E ratio = Market price per share / Annual earnings per share.
• The P/E ratio is a widely used valuation multiple used as a guide to the relative values of companies; for example, a higher P/E ratio means that investors are paying more for each unit of current net income, so the stock is more expensive than one with a lower P/E ratio.
• Different types of P/E include: trailing P/E or P/E ttm, trailing P/E from continued operations, and forward P/E or P/Ef.
Price/Earnings Ratio
In stock trading, the price-to-earnings ratio of a share (also called
its P/E, or simply "multiple") is the market price of that share
divided by the annual earnings per share (EPS).
The P/E ratio is a widely used valuation multiple used as a guide to
the relative values of companies; a higher P/E ratio means that
investors are paying more for each unit of current net income, so
the stock is more "expensive" than one with a lower P/E ratio. The
P/E ratio can be regarded as being expressed in years. The price is
in currency per share, while earnings are in currency per share per
year, so the P/E ratio shows the number of years of earnings that
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
(Figure 3.18)
The price per share in the numerator is the market price of a single
share of the stock. The earnings per share in the denominator may
192
P/E ratio = market price per share/ annual earning per share
Figure 3.18 Price
to Earnings Ratio
vary depending on the type of P/E. The types of P/E include the
following:
• Trailing P/E or P/E ttm: Here, earning per share is the net
income of the company for the most recent 12 month period,
divided by the weighted average number of common shares in
issue during the period. This is the most common meaning of
P/E if no other qualifier is specified. Monthly earnings data
for individual companies are not available, and usually
fluctuate seasonally, so the previous four quarterly earnings
reports are used, and earnings per share are updated
quarterly. Note, each company chooses its own financial year
so the timing of updates will vary from one to another.
• Trailing P/E from continued operations: Instead of net
income, this uses operating earnings, which exclude earnings
from discontinued operations, extraordinary items (e.g. one-
off windfalls and write-downs), and accounting changes.
Longer-term P/E data, such as Shiller's, use net earnings.
• Forward P/E, P/Ef, or estimated P/E: Instead of net income,
this uses estimated net earnings over the next 12 months.
Estimates are typically derived as the mean of those published
by a select group of analysts (selection criteria are rarely
cited). In times of rapid economic dislocation, such estimates
become less relevant as the situation changes (e.g. new
economic data is published, and/or the basis of forecasts
becomes obsolete) more quickly than analysts adjust their
forecasts.
By comparing price and earnings per share for a company, one can
analyze the market's stock valuation of a company and its shares
relative to the income the company is actually generating. Stocks
with higher (or more certain) forecast earnings growth will usually
have a higher P/E, and those expected to have lower (or riskier)
earnings growth will usually have a lower P/E. Investors can use the
P/E ratio to compare the value of stocks; for example, if one stock
has a P/E twice that of another stock, all things being equal
(especially the earnings growth rate), it is a less attractive
investment. Companies are rarely equal, however, and comparisons
between industries, companies, and time periods may be
misleading. P/E ratio in general is useful for comparing valuation of
peer companies in a similar sector or group.
The P/E ratio of a company is a significant focus for management in
many companies and industries. Managers have strong incentives
to increase stock prices, firstly as part of their fiduciary
responsibilities to their companies and shareholders, but also
because their performance based remuneration is usually paid in
the form of company stock or options on their company's stock (a
form of payment that is supposed to align the interests of
management with the interests of other stock holders). The stock
193
price can increase in one of two ways: either through improved
earnings, or through an improved multiple that the market assigns
to those earnings. In turn, the primary driver for multiples such as
the P/E ratio is through higher and more sustained earnings growth
rates.
Companies with high P/E ratios but volatile earnings may be
tempted to find ways to smooth earnings and diversify risk; this is
the theory behind building conglomerates. Conversely, companies
with low P/E ratios may be tempted to acquire small high growth
businesses in an effort to "rebrand" their portfolio of activities and
burnish their image as growth stocks and thus obtain a higher P/E
rating.
EXAMPLE
As an example, if stock A is trading at 24 and the earnings per share for the most recent 12 month period is three, then stock A has a P/E ratio of 24/3, or eight.
Source: https://www.boundless.com/finance/analyzing-financial-
statements--2/market-value-ratios--2/price-earnings-ratio--2/
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Market/Book Ratio The price-to-book ratio is a nancial ratio used to compare a company's current market price to its book value.
KEY POINTS
• The calculation can be performed in two ways: 1) the company's market capitalization can be divided by the company's total book value from its balance sheet, 2) using per-share values, is to divide the company's current share price by the book value per share.
• A higher P/B ratio implies that investors expect management to create more value from a given set of assets, all else equal.
• Technically, P/B can be calculated either including or excluding intangible assets and goodwill.
Price/Book Ratio
The price-to-book ratio, or P/B ratio, is a financial ratio 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 either way.
In the first way, the company'smarket capitalization can be
divided by the company's total book value from its balance sheet.
194
• Market Capitalization / Total Book Value
The second way, using per-share values, is to divide the company's
current share price by the book value per share (i.e. its book value
divided by the number of outstanding shares).
• Share price / Book value per share
As with most ratios, it varies a fair amount by industry. Industries
that require more infrastructure capital (for each dollar of profit)
will usually trade at P/B ratios much lower than, for example,
consulting firms. P/B ratios are commonly used to compare banks,
because most assets and liabilities of banks are constantly valued at
market values.
A higher P/B ratio implies that investors expect management to
create more value from a given set of assets, all else equal (and/or
that the market value of the firm's assets is significantly higher than
their accounting value). P/B ratios do not, however, directly provide
any information on the ability of the firm to generate profits or cash
for shareholders. (Figure 3.19)
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. For companies in distress, the book value is usually
calculated without the intangible assets that would have no resale
value. In such cases, P/B should also be calculated on a "diluted"
basis, because stock options may well vest on the sale of the
company, change of control, or firing of management.
It is also known as the market-to-book ratio and the price-to-equity
ratio (which should not be confused with the price-to-earnings
ratio), and its inverse is called the book-to-market ratio.
Total Book Value vs Tangible Book Value
Technically, P/B can be calculated either including or excluding
intangible assets and goodwill. When intangible assets and goodwill
195
A higher P/B ratio implies that investors expect management to create more value.
Figure 3.19 S&P P/B ratio
are excluded, the ratio is often specified to be "price to tangible
book value" or "price to tangible book".
Source: https://www.boundless.com/finance/analyzing-financial-
statements--2/market-value-ratios--2/market-book-ratio--2/
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196
The DuPont Equation
ROE and Potential Limitations
Assessing Internal Growth and Sustainability
Dividend Payments and Earnings Retention
Relationships between ROA, ROE, and Growth
Section 8
The DuPont Equation, ROE, ROA, and Growth
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The DuPont Equation The DuPont equation is an expression which breaks return on equity down into three parts: prot margin, asset turnover, and leverage.
KEY POINTS
• By splitting ROE into three parts, companies can more easily understand changes in their returns on equity over time.
• As profit margin increases, every sale will bring more money to a company's bottom line, resulting in a higher overall return on equity.
• As asset turnover increases, a company will generate more sales per asset owned, resulting in a higher overall return on equity.
• Increased financial leverage will also lead to an increase in return on equity, since using more debt financing brings on higher interest payments, which are tax deductible.
The DuPont Equation
The DuPont equation is an expression which breaks return on
equity down into three parts. The name comes from the DuPont
Corporation, which created and implemented this formula into
their business operations in the 1920s. This formula is known by
many other names, including DuPont analysis, DuPont identity, the
DuPont model, the DuPont method, or the strategic profit model
(Figure 3.20).
Under DuPont analysis, return on equity is equal to the profit
margin multiplied by asset turnover multiplied by financial
leverage. By splitting ROE (return on equity) into three parts,
companies can more easily understand changes in their ROE over
time (Figure 3.21).
198
A ow chart representation of the DuPont Model.
Figure 3.20 DuPont Model
Components of the DuPont Equation: Profit Margin
Profit margin is a measure of profitability. It is an indicator of a
company's pricing strategies and how well the company controls
costs. Profit margin is calculated by finding the net profit as a
percentage of the total revenue. As one feature of the DuPont
equation, if the profit margin of a company increases, every sale will
bring more money to a company's bottom line, resulting in a higher
overall return on equity.
Components of the DuPont Equation: Asset Turnover
Asset turnover is a financial ratio that measures how efficiently a
company uses its assets to generate sales revenue or sales income
for the company. Companies with low profit margins tend to have
high asset turnover, while those with high profit margins tend to
have low asset turnover. Similar to profit margin, if asset turnover
increases, a company will generate more sales per asset owned,
once again resulting in a higher overall return on equity.
Components of the DuPont Equation: Financial Leverage
Financial leverage refers to the amount of debt that a company
utilizes to finance its operations, as compared with the amount of
equity that the company utilizes. As was the case with asset
turnover and profit margin, Increased financial leverage will also
lead to an increase in return on equity. This is because the increased
use of debt as financing will cause a company to have higher
interest payments, which are tax deductible. Because dividend
payments are not tax deductible, maintaining a high proportion of
debt in a company's capital structure leads to a higher return on
equity.
The DuPont Equation in Relation to Industries
The DuPont equation is less useful for some industries, that do not
use certain concepts or for which the concepts are less meaningful.
On the other hand, some industries may rely on a single factor of
the DuPont equation more than others. Thus, the equation allows
analysts to determine which of the factors is dominant in relation to
a company's return on equity. For example, certain types of high
turnover industries, such as retail stores, may have very low profit
margins on sales and relatively low financial leverage. In industries
such as these, the measure of asset turnover is much more
important.
199
In the DuPont equation, ROE is equal to prot margin multiplied by asset turnover multiplied by nancial leverage.
Figure 3.21 The DuPont Equation
High margin industries, on the other hand, such as fashion, may
derive a substantial portion of their competitive advantage from
selling at a higher margin. For high end fashion and other luxury
brands, increasing sales without sacrificing margin may be critical.
Finally, some industries, such as those in the financial sector,
chiefly rely on high leverage to generate an acceptable return on
equity. While a high level of leverage could be seen as too risky from
some perspectives, DuPont analysis enables third parties to
compare that leverage with other financial elements that can
determine a company's return on equity.
EXAMPLE
A company has sales of 1,000,000. It has a net income of 400,000. Total assets have a value of 5,000,000, and shareholder equity has a value of 10,000,000. Using DuPont analysis, what is the company's return on equity? Profit Margin = 400,000/1,000,000 = 40%. Asset Turnover = 1,000,000/5,000,000 = 20%. Financial Leverage = 5,000,000/10,000,000 = 50%. Multiplying these three results, we find that the Return on Equity = 4%.
Source: https://www.boundless.com/finance/analyzing-financial-
statements--2/the-dupont-equation-roe-roa-and-growth/the-dupont-
equation/
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200
ROE and Potential Limitations Return on equity measures the rate of return on the ownership interest of a business and is irrelevant if earnings are not reinvested or distributed.
KEY POINTS
• Return on equity is an indication of how well a company uses investment funds to generate earnings growth.
• Returns on equity between 15% and 20% are generally considered to be acceptable.
• Return on equity is equal to net income (after preferred stock dividends but before common stock dividends) divided by total shareholder equity (excluding preferred shares).
• Stock prices are most strongly determined by earnings per share (EPS) as opposed to return on equity.
Return On Equity
Return on equity (ROE) measures the rate of return on the
ownership interest or shareholders' equity of the common stock
owners. It is a measure of a company's efficiency at generating
profits using the shareholders' stake of equity in the business. In
other words, return on equity is an indication of how well a
company uses investment funds to generate earnings growth. It is
also commonly used as a target for executive compensation, since
ratios such as ROE tend to give management an incentive to
perform better. Returns on equity between 15% and 20% are
generally considered to be acceptable.
The Formula
Return on equity is equal to net income, after preferred stock
dividends but before common stock dividends, divided by total
shareholder equity and excluding preferred shares (Figure 3.22).
Expressed as a percentage, return on equity is best used to compare
companies in the same industry. The decomposition of return on
equity into its various factors presents various ratios useful to
companies in fundamental analysis (Figure 3.23).
201
ROE is equal to after-tax net income divided by total shareholder equity.
Figure 3.22 Return On Equity
This is an expression of return on equity decomposed into its various factors.
Figure 3.23 ROE Broken Down
The practice of decomposing return on equity is sometimes referred
to as the "DuPont System."
Potential Limitations of ROE
Just because a high return on equity is calculated does not mean
that a company will see immediate benefits. Stock prices are most
strongly determined by earnings per share (EPS) as opposed to
return on equity. Earnings per share is the amount of earnings per
each outstanding share of a company's stock. EPS is equal to profit
divided by the weighted average of common shares (Figure 3.24).
The true benefit of a high return on equity comes from a company's
earnings being reinvested into the business or distributed as a
dividend. In fact, return on equity is presumably irrelevant if
earnings are not reinvested or distributed.
EXAMPLE
A small business' net income after taxes is $10,000. The total shareholder equity in the business is $50,000. What is the return on equity? ROE = 10,000/50,000 ROE = 20%
Source: https://www.boundless.com/finance/analyzing-financial-
statements--2/the-dupont-equation-roe-roa-and-growth/roe-and-
potential-limitations--2/
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202
EPS is equal to prot divided by the weighted average of common shares.
Figure 3.24 Earnings Per Share
Assessing Internal Growth and Sustainability Sustainable— as opposed to internal— growth gives a company a better idea of its growth rate while keeping in line with nancial policy.
KEY POINTS
• The internal growth rate is a formula for calculating the maximum growth rate a firm can achieve without resorting to external financing.
• Sustainable growth is defined as the annual percentage of increase in sales that is consistent with a defined financial policy.
• Another measure of growth, the optimal growth rate, assesses sustainable growth from a total shareholder return creation and profitability perspective, independent of a given financial strategy.
Internal Growth and Sustainability
The true benefit of a high return on equity arises when retained
earnings are reinvested into the company's operations. Such
reinvestment should, in turn, lead to a high rate of growth for the
company. The internal growth rate is a formula for calculating
maximum growth rate that a firm can achieve without resorting to
external financing. It's essentially the growth that a firm can supply
by reinvesting its earnings (Figure 3.26).
We find the internal growth rate by dividing net income by the
amount of total assets (or finding return on assets) and subtracting
the rate of earnings retention. However, growth is not necessarily
favorable. Expansion may strain managers' capacity to monitor and
handle the company's operations. Therefore, a more commonly
used measure is the sustainable growth rate.
Sustainable growth is defined as the annual percentage of increase
in sales that is consistent with a defined financial policy, such as
target debt to equity ratio, target dividend payout ratio, target
profit margin, or target ratio of total assets to net sales (Figure 3.
25).
203
The internal growth rate is equal to return on assets minus the retention rate.
Figure 3.26 Internal Growth Rate
The sustainable growth rate is equal to return on equity minus retention rate.
Figure 3.25 Sustainable Growth Rate
We find the sustainable growth rate by dividing net income by
shareholder equity (or finding return on equity) and subtracting the
rate of earnings retention. While the internal growth rate assumes
no financing, the sustainable growth rate assumes you will make
some use of outside financing that will be consistent with whatever
financial policy being followed. In fact, in order to achieve a higher
growth rate, the company would have to invest more equity capital,
increase its financial leverage, or increase the target profit margin.
Optimal Growth Rate
Another measure of growth, the optimal growth rate, assesses
sustainable growth from a total shareholder return creation and
profitability perspective, independent of a given financial strategy.
The concept of optimal growth rate was originally studied by Martin
Handschuh, Hannes Lösch, and Björn Heyden. Their study was
based on assessments on the performance of more than 3,500
stock-listed companies with an initial revenue of greater than 250
million Euro globally, across industries, over a period of 12 years
from 1997 to 2009 (Figure 3.27).
Due to the span of time included in the study, the authors
considered their findings to be, for the most part, independent of
specific economic cycles. The study found that return on assets,
return on sales and return on equity do in fact rise with increasing
revenue growth of between 10% to 25%, and then fall with further
increasing revenue growth rates. Furthermore, the authors
attributed this profitability increase to the following facts:
1. Companies with substantial profitability have the
opportunity to invest more in additional growth, and
2. Substantial growth may be a driver for additional
profitability, whether by attracting high performing young
professionals, providing motivation for current employees,
204
ROA, ROS and ROE tend to rise with revenue growth to a certain extent.
Figure 3.27 Revenue Growth and Protability
attracting better business partners, or simply leading to more
self-confidence.
However, according to the study, growth rates beyond the
"profitability maximum" rate could bring about circumstances that
reduce overall profitability because of the efforts necessary to
handle additional growth (i.e., integrating new staff, controlling
quality, etc).
EXAMPLE
A company's net income is 750,000 and its total shareholder equity is 5,000,000. Its earnings retention rate is 80%. What is its sustainable growth rate? Sustainable Growth Rate = (750,000/5,000,000) x (1-0.80). Sustainable Growth Rate = 3%
Source: https://www.boundless.com/finance/analyzing-financial-
statements--2/the-dupont-equation-roe-roa-and-growth/assessing-
internal-growth-and-sustainability--2/
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Dividend Payments and Earnings Retention The dividend payout and retention ratios oer insight into how much of a rm's prot is distributed to shareholders versus retained.
KEY POINTS
• Many corporations retain a portion of their earnings and pay the remainder as a dividend.
• Dividends are usually paid in the form of cash, store credits, or shares in the company.
• Cash dividends are a form of investment income and are usually taxable to the recipient in the year that they are paid.
• Dividend payout ratio is the fraction of net income a firm pays to its stockholders in dividends.
• Retained earnings can be expressed in the retention ratio.
Dividend Payments and Earnings Retention
Dividends are payments made by a corporation to its shareholder
members. It is the portion of corporate profits paid out to
stockholders. On the other hand, retained earnings refers to the
portion of net income which is retained by the corporation rather
205
than distributed to its owners as dividends. Similarly, if the
corporation takes a loss, then that loss is retained and called
variously retained losses, accumulated losses or accumulated
deficit. Retained earnings and losses are cumulative from year to
year with losses offsetting earnings. Many corporations retain a
portion of their earnings and pay the remainder as a dividend.
A dividend is allocated as a fixed amount per share. Therefore, a
shareholder receives a dividend in proportion to their shareholding.
Retained earnings are shown in the shareholder equity section in
the company's balance sheet–the same as its issued share capital.
Public companies usually pay dividends on a fixed schedule, but
may declare a dividend at any time, sometimes called a "special
dividend" to distinguish it from the fixed schedule dividends.
Dividends are usually paid in the form of cash, store credits
(common among retail consumers' cooperatives), or shares in the
company (either newly created shares or existing shares bought in
the market). Further, many public companies offer dividend
reinvestment plans, which automatically use the cash dividend to
purchase additional shares for the shareholder.
Cash dividends (most common) are those paid out in currency,
usually via electronic funds transfer or a printed paper check. Such
dividends are a form of investment income and are usually taxable
to the recipient in the year they are paid. This is the most common
method of sharing corporate profits with the shareholders of the
company. For each share owned, a declared amount of money is
distributed. Thus, if a person owns 100 shares and the cash
dividend is $0.50 per share, the holder of the stock will be paid $50.
Dividends paid are not classified as an expense but rather a
deduction of retained earnings. Dividends paid do not show up on
an income statement but do appear on the balance sheet
(Figure 3.28).
Stock dividends are those paid out in the form of additional stock
shares of the issuing corporation or another corporation (such as its
subsidiary corporation). They are usually issued in proportion to
shares owned (for example, for every 100 shares of stock owned, a
5% stock dividend will yield five extra shares). If the payment
involves the issue of new shares, it is similar to a stock split in that it
increases the total number of shares while lowering the price of
each share without changing the market capitalization, or total
value, of the shares held.
206
The dividend payout ratio is equal to dividend payments divided by net income for the same period.
Figure 3.28 Dividend Payout Ratio
Dividend Payout and Retention Ratios
Dividend payout ratio is the fraction of net income a firm pays to its
stockholders in dividends:
The part of the earnings not paid to investors is left for investment
to provide for future earnings growth. These retained earnings can
be expressed in the retention ratio. Retention ratio can be found by
subtracting the dividend payout ratio from one, or by dividing
retained earnings by net income (Figure 3.29).
Source: https://www.boundless.com/finance/analyzing-financial-
statements--2/the-dupont-equation-roe-roa-and-growth/dividend-
payments-and-earnings-retention--2/
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207
Retained earnings can be found on the balance sheet, under the owners' (or shareholders') equity section.
Figure 3.29 Example Balance Sheet
Relationships between ROA, ROE, and Growth Return on assets is a component of return on equity, both of which can be used to calculate a company's rate of growth.
KEY POINTS
• Return on equity measures the rate of return on the shareholders' equity of common stockholders.
• Return on assets shows how profitable a company's assets are in generating revenue.
• In other words, return on assets makes up two-thirds of the DuPont equation measuring return on equity.
• Capital intensity is the term for the amount of fixed or real capital present in relation to other factors of production. Rising capital intensity pushes up the productivity of labor.
Return On Assets Versus Return On Equity
In review, return on equity measures the rate of return on the
ownership interest (shareholders' equity) of common stockholders.
Therefore, it shows how well a company uses investment funds to
generate earnings growth. Return on assets shows how profitable a
company's assets are in generating revenue. Return on assets is
equal to net income divided by total assets (Figure 3.30).
This percentage shows what the company can do with what it has
(i.e., how many dollars of earnings they derive from each dollar of
assets they control). This is in contrast to return on equity, which
measures a firm's efficiency at generating profits from every unit of
shareholders' equity. Return on assets is, however, a vital
component of return on equity, being an indicator of how profitable
a company is before leverage is considered. In other words, return
on assets makes up two-thirds of the DuPont equation measuring
return on equity.
ROA, ROE, and Growth
In terms of growth rates, we use the value known as return on
assets to determine a company's internal growth rate. This is the
maximum growth rate a firm can achieve without restoring to
external financing. We use the value for return on equity, however,
in determining a company's sustainable growth rate, which is the
maximum growth rate a firm can achieve without issuing new
equity or changing its debt-to-equity ratio.
208
Return on assets is equal to net income divided by total assets.
Figure 3.30 Return On Assets
Capital Intensity and Growth
Return on assets gives us an indication of the capital intensity of the
company. "Capital intensity" is the term for the amount of fixed or
real capital present in relation to other factors of production,
especially labor. The use of tools and machinery makes labor more
effective, so rising capital intensity pushes up the productivity of
labor. While companies that require large initial investments will
generally have lower return on assets, it is possible that increased
productivity will provide a higher growth rate for the company.
Capital intensity can be stated quantitatively as the ratio of the
total money value of capital equipment to the total potential output.
However, when we adjust capital intensity for real market
situations, such as the discounting of future cash flows, we find
that it is not independent of the distribution of income. In other
words, changes in the retention or dividend payout ratios can lead
to changes in measured capital intensity.
EXAMPLE
A company has net income of 500,000. It has total assets valued at 3,000,000. Its retention rate is 80%, and its shareholder equity is equal to $1,500,000. What is the company's ROA and internal growth rate? What is the company's ROE and sustainable growth rate? ROA = 500,000/3,000,000 = 17% Internal growth rate = 17% x 80% = 13% ROE = 17% x (3,000,000/1,500,000) = 34% Sustainable growth rate = 34% x 80% = 27.2%
Source: https://www.boundless.com/finance/analyzing-financial-
statements--2/the-dupont-equation-roe-roa-and-growth/
relationships-between-roa-roe-and-growth--2/
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209
Evaluating Financial Statements
Industry Comparisons
Benchmarking
Trend Analysis
Limitations of Financial Statement Analysis
Section 9
Using Financial Ratios for Analysis
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Evaluating Financial Statements With a few exceptions, the majority of the data used in ratio analysis comes from evaluation of the nancial statements.
KEY POINTS
• Ratio analysis is a tool for evaluating financial statements but also relies on the numbers in the reported financial statements being put into order to be used for comparison. With a few exceptions, the majority of the data used in ratio analysis comes from the financial statements.
• Prior to the calculation of financial ratios, reported financial statements are often reformulated and adjusted by analysts to make the financial ratios more meaningful as comparisons across time or across companies.
• In terms of reformulation, earnings might be separated into recurring and non-recurring items. In terms of adjustment of financial statements, analysts may adjust earnings numbers up or down when they suspect the reported data is inaccurate due to issues like earnings management.
Ratio analysis is a tool for evaluating financial statements but also
relies on the numbers in the reported financial statements being put
into order (Figure 3.31)
to be used as ratios for
comparison over time or
across companies.
Financial statements are
used as a way to discover
the financial position and financial results of a business. With a few
exceptions, such as ratios involving stock price, the majority of the
data used in ratio analysis comes from the financial statements.
Ratios put this financial statement information in context.
Prior to the calculation of financial ratios, reported financial
statements are often reformulated and adjusted by analysts to make
the financial ratios more meaningful as comparisons across time or
across companies. In terms of reformulation, one common
reformulation is to divide reported items into recurring or normal
items and non-recurring or special items. In this way, earnings
could be separated into normal or core earnings and transitory
earnings with the idea that normal earnings are more permanent
and hence more relevant for prediction and valuation. In terms of
adjustment of financial statements, analysts may adjust earnings
numbers up or down when they suspect the reported data is
inaccurate due to issues like earnings management.
211
Evaluating nancial statements involves getting the numbers in order and then using these gures to perform ratio analysis.
Figure 3.31 Putting Numbers in Order
The evaluation of a company’s financial statement analysis is a form
of fundamental analysis that is bottoms up. While analysis of a
company’s prospects can include a number of factors, including
understanding the economic situation or the industry or sentiment
about the company or its products, ratio analysis of a company
relies on the specific company financials.
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statements--2/using-financial-ratios-for-analysis--2/evaluating-
financial-statements--2/
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Industry Comparisons While ratio analysis can be quite helpful in comparing companies within an industry, cross-industry comparisons should be done with caution.
KEY POINTS
• One of the advantages of ratio analysis is that it allows comparison across companies. However, while ratios can be quite helpful in comparing companies within an industry and even across some similar industries, cross-industry comparisons may not be helpful and should be done with caution.
• An industry represents a classification of companies by economic activity, but "industry" can be too broad or narrow a definition for ratio analysis comparison. When comparing ratios, companies should be comparable in terms of having similar characteristics in the statistics being analyzed.
• Valuation using multiples only reveals patterns in relative values. For multiples to be useful, the statistic involved must bear a logical, meaningful relationship to the market value observed, which is something that can vary across industry.
One of the advantages of ratio analysis is that it allows comparison
across companies, an activity which is often called benchmarking.
However, while ratios can be quite helpful in comparing companies
212
within an industry and even across some similar industries,
comparing ratios of companies across different industries may not
be helpful and should be done with caution (Figure 3.32).
An industry represents a classification of companies by economic
activity. At a very broad level, industry is sometimes classified into
three sectors: primary or extractive, secondary or manufacturing,
and tertiary or services. At a very detailed level are classification
systems like the ISIC (International Standard Industrial
Classification).
However, in terms of ratio analysis and comparing companies, it is
most helpful to consider whether the companies being compared
are comparable in the financial metrics being evaluated in the
ratios. Different businesses will have different ratios for different
reasons. A peer group is a set of companies or assets which are
selected as being sufficiently comparable to the company or assets
being valued (usually by virtue of being in the same industry or by
having similar characteristics in terms of earnings growth and
return on investment). From the investor perspective, peers can
include companies that are not only direct product competitors but
are subject to similar cycles, suppliers, and other external factors.
Valuation using multiples involves estimating the value of an asset
by comparing it to the values assessed by the market for similar or
comparable assets in the peer group. A valuation multiple is simply
an expression of market value of an asset relative to a key statistic
that is assumed to relate to that value. To be useful, that statistic –
whether earnings, cash flow, or some other measure – must bear a
logical relationship to the market value observed; to be seen, in fact,
as the driver of that market value. The price to earnings ratio, for
example, is a common multiple but can differ across companies that
have different capital structures; this could make it difficult to
compare this particular ratio across industries.
213
Comparing ratios of companies within an industry can allow an analyst to make like to like (apples to apples) comparisons. Comparisons across industries may be like to unlike (apples to oranges) comparisons, and thus less useful.
Figure 3.32 Industry
Additionally, there could be problems with the valuation of an
entire industry, making ratio analysis of a company relative to an
industry less useful. The use of multiples only reveals patterns in
relative values, not absolute values such as those obtained from
discounted cash flow valuations. If the peer group as a whole is
incorrectly valued (such as may happen during a stock market
"bubble"), then the resulting multiples will also be misvalued.
Source: https://www.boundless.com/finance/analyzing-financial-
statements--2/using-financial-ratios-for-analysis--2/industry-
comparisons--2/
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Benchmarking Comparing the nancial ratios of a company to those of the top performer in its class is a type of benchmarking.
KEY POINTS
• Financial ratios allow for comparisons and, therefore, are intertwined with the process of benchmarking, comparing one's business to that of relevant others or of the same company at a different point in time processes on a specific indicator or series of indicators.
• Benchmarking can be done in many ways and ratio analysis is only one of these. One benefit of ratio analysis as a component of benchmarking is that many financial ratios are well-established calculations derived from verified data.
• Benchmarking using ratio analysis can be useful to various audiences; for example, investors and managers interested in incorporate quantitative comparisons of a company to peers.
Benchmarking
Financial ratios allow for comparisons and, therefore, are
intertwined with the process of benchmarking, comparing one's
business to that of others or of the same company at a different
point in time. In many cases, benchmarking involves comparisons
of one company to the best companies in a comparable peer group
214
or the average in that peer group or industry. In the process of
benchmarking, an analyst or manager identifies the best firms in
their industry, or in another industry where similar processes exist,
and compares the results and processes of those studied to one's
own results and processes on a specific indicator or series of
indicators (Figure 3.33).
Benchmarking can be done in many ways, and ratio analysis is only
one of these. One benefit of ratio analysis as a component of
benchmarking is that many financial ratios are well-established
calculations derived from verified data. In benchmarking as a
whole, benchmarking can be done on a variety of processes,
meaning that definitions may change over time within the same
organization due to changes in leadership and priorities. The most
useful comparisons can be made when metrics definitions are
common and consistent between compared units and over time.
Benchmarking using ratio analysis can be useful to various
audiences. From an investor perspective, benchmarking can involve
comparing a company to peer companies that can be considered
alternative investment opportunities from the perspective of an
investor. In this process, the investor may compare the focus
company to others in the peer group (leaders, averages) on certain
financial ratios relevant to those companies and the investor’s
investment style. From a management perspective, benchmarking
using ratio analysis may be a way for a manager to compare their
company to peers using externally recognizable, quantitative data.
Source: https://www.boundless.com/finance/analyzing-financial-
statements--2/using-financial-ratios-for-analysis--2/
benchmarking--2/
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215
Ratios can be used to compare entities within the same industry.
Figure 3.33 Benchmarking Measures Performance
Trend Analysis Trend analysis consists of using ratios to compare company performance on an indicator over time, often to forecast or inform future events.
KEY POINTS
• Trend analysis is the practice of collecting information and attempting to spot a pattern or trend in the same metric historically, either by examining it in tables or charts. Often this trend analysis is used to predict or inform decisions around future events.
• Trend analysis can be performed in different ways in finance. Fundamental analysis relies on historical financial statement analysis, often in the form of ratio analysis.
• Trend analysis using financial ratios can be complicated by changes to companies and accounting over time. For example, a company may change its business model and begin to operate in a new industry or it may change the end of its financial year or the way it accounts for inventories.
In addition to using financial ratio analysis to compare one
company with others in its peer group, ratio analysis is often used to
compare the company’s performance on certain measures over
time. Trend analysis is the practice of collecting information and
attempting to spot a pattern, or trend, in the information. This often
involves comparing the same metric historically, either by
examining it in tables or charts. Often this trend analysis is used to
forecast or inform decisions around future events, but it can be used
to estimate uncertain events in the past (Figure 3.34).
Trend analysis can be performed in different ways in finance. For
example, in technical analysis the direction of prices of a particular
company’s public stock is calculated through the study of past
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Determining the popularity and demand for specic subject over time through trend analysis.
Figure 3.34 Trend Analysis
market data, primarily price, and volume. Fundamental analysis, on
the other hand, relies not on sentiment measures (like technical
analysis) but on financial statement analysis, often in the form of
ratio analysis. Creditors and company managers also use ratio
analysis as a form of trend analysis. For example, they may examine
trends in liquidity or profitability over time.
Trend analysis using financial ratios can be complicated by the fact
that companies and accounting can change over time. For example,
a company may change its business model so that it begins to
operate in a new industry or it may change the end of its financial
year or the way it accounts for inventories. When examining
historical trends in ratios, analysts will often make adjustments to
the ratios for these reasons, perhaps performing some ratio analysis
in which they segment out business segments that are not
consistent over time or they separate recurring from non-recurring
items.
Source: https://www.boundless.com/finance/analyzing-financial-
statements--2/using-financial-ratios-for-analysis--2/trend-
analysis--2/
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Limitations of Financial Statement Analysis Financial statement analyses can yield a limited view of a company because of accounting, market, and management related limitations of such analyses.
KEY POINTS
• Ratio analysis is hampered by potential limitations with accounting and the data in the financial statements themselves. This can include errors as well as accounting mismanagement, which involves distorting the raw data used to derive financial ratios.
• Proponents of the stronger forms of the efficient-market hypothesis, technical analysts, and behavioral economists argue that fundamental analysis is limited as a stock valuation tool, all for their own distinct reasons.
• Ratio analysis can also omit important aspects of a firm’s success, such as key intangibles, like brand, relationships, skills and culture. These are primary drivers of success over the longer term even though they are absent from conventional financial statements.
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KEY POINTS (cont.)
• Other disadvantages of this type of analysis is that if used alone it can present an overly simplistic view of the company by distilling a great deal of information into a single number
Limitations of Financial Statement Analysis
Ratio analysis using financial statements includes accounting, stock
market, and management related limitations. These limits leave
analysts with remaining questions about the company
(Figure 3.35).
First of all, ratio analysis is hampered by potential limitations with
accounting and the data in the financial statements themselves.
This can include errors as well as accounting mismanagement,
which involves distorting the raw data used to derive financial
ratios. While accounting measures may have more external
standards and oversights than many other ways of benchmarking
companies, this is still a limit.
Ratio analysis using financial statements as a tool for performing
stock valuation can be limited as well. The efficient-market
hypothesis (EMH), for example, asserts that financial markets are
"informationally efficient." In consequence of this, one cannot
consistently achieve returns in excess of average market returns on
a risk-adjusted basis, given the information available at the time the
investment is made. While the weak form of this hypothesis argues
that there can be a long run benefit to information derived from
fundamental analysis, stronger forms argue that fundamental
analysis like ratio analysis will not allow for greater financial
returns.
In another view on stock markets, technical analysts argue that
sentiment is as much if not more of a driver of stock prices than is
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Financial Statements can be analyzed using ratios made from the data they provide, in order to make decisions about a nancial entity. This method has both strengths and limitations.
Figure 3.35 A sample page from a nancial statement.
the fundamental data on a company like its financials. Behavioral
economists attribute the imperfections in financial markets to a
combination of cognitive biases such as overconfidence,
overreaction, representative bias, information bias, and various
other predictable human errors in reasoning and information
processing. These audiences also see limits to ratio analysis as a
predictor of stock market returns.
At the management and investor level, ratio analysis using financial
statements can also leave out a number of important aspects of a
firm’s success, such as key intangibles, like brand, relationships,
skills, and culture. These are primary drivers of success over the
longer term even though they are absent from conventional
financial statements.
Other disadvantages of this type of analysis is that if used alone it
can present an overly simplistic view of the company by distilling a
great deal of information into a single number or series of numbers.
Also, changes in the information underlying ratios can hamper
comparisons across time and inconsistencies within and across the
industry can also complicate comparisons.
Source: https://www.boundless.com/finance/analyzing-financial-
statements--2/using-financial-ratios-for-analysis--2/limitations-of-
financial-statement-analysis/
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Impact of Ination on Financial Statement Analysis
Disination
Deation
Section 10
Considering Ination's Distortionary Eects
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Impact of Ination on Financial Statement Analysis General price level changes creates distortions in nancial statements. Ination accounting is used in countries with high ination.
KEY POINTS
• Many of the historical numbers appearing on financial statements are not economically relevant because prices have changed since they were incurred.
• Since the numbers on financial statements represent dollars expended at different points of time and, in turn, embody different amounts of purchasing power, they are simply not additive.
• Reported profits may exceed the earnings that could be distributed to shareholders without impairing the company's ongoing operations.
• Future earnings are not easily projected from historical earnings. Future capital needs are difficult to forecast and may lead to increased leverage, which increases the risk to the business.
• The asset values for inventory, equipment and plant do not reflect their economic value to the business.
Inflation's Impact on Financial Statements
In most countries, primary financial statements are prepared on the
historical cost basis of accounting without regard either to
changes in the general level of prices. Accountants in the United
Kingdom and the United States have discussed the effect of inflation
on financial statements since the early 1900s (Figure 3.36).
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German Hyperination Data
Figure 3.36 Hyperination Graph
General price level changes in financial reporting creates distortions
in financial statements such as:
• Many of the historical numbers appearing on financial
statements are not economically relevant because prices have
changed since they were incurred.
• Since the numbers on financial statements represent dollars
expended at different points of time and, in turn, embody
different amounts of purchasing power, they are simply not
additive. Hence, adding cash of $10,000 held on December
31, 2002, with $10,000 representing the cost of land acquired
in 1955 (when the price level was significantly lower) is a
dubious operation because of the significantly different
amount of purchasing power represented by the two identical
numbers.
• Reported profits may exceed the earnings that could be
distributed to shareholders without impairing the company's
ongoing operations.
• The asset values for inventory, equipment and plant do not
reflect their economic value to the business.
• Future earnings are not easily projected from historical
earnings.
• The impact of price changes on monetary assets and liabilities
is not clear.
• Future capital needs are difficult to forecast and may lead to
increased leverage, which increases the risk to the business.
• When real economic performance is distorted, these
distortions lead to social and political consequences that
damage businesses (examples: poor tax policies and public
misconceptions regarding corporate behavior).
Inflation accounting, a range of accounting systems designed to
correct problems arising from historical cost accounting in the
presence of inflation, is a solution to these problems. This type of
accounting is used in countries experiencing high inflation or
hyperinflation. For example, in countries such as these the
International Accounting Standards Board requires corporate
financial statements to be adjusted for changes in purchasing power
using a price index.
Source: https://www.boundless.com/finance/analyzing-financial-
statements--2/considering-inflation-s-distortionary-effects--2/impact-
of-inflation-on-financial-statement-analysis/
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Disination Disination is a decrease in the ination rate; a slowdown in the rate of increase of the general price level of goods, services.
KEY POINTS
• Disinflation occurs when the increase in the “consumer price level” slows down from the previous period when the prices were rising. Disinflation is the reduction in the general price level in the economy but for a very short period of time.
• The causes of disinflation may be a decrease in the growth rate of the money supply. If the central bank of a country enacts tighter monetary policy, the supply of money reduces, and money becomes more upscale and the demand for money remains constant.
• Disinflation may result from a recession. The central bank adopts contractionary monetary policy, goods, and services are more expensive. Even though the demand for commodities fall, the supply still remains unaltered.Thus, the prices would fall over a period of time leading to disinflation.
Disinflation is a decrease in the rate of inflation–a slowdown in the
rate of increase of the general price level of goods and services in a
nation's gross domestic product over time. Disinflation occurs
when the increase in the “consumer price level” slows down from
the previous period when the prices were rising. Disinflation is the
reduction in the general price level in the economy but for a very
short period of time. Disinflation takes place only when an economy
is suffering from recession (Figure 3.37).
If the inflation rate is not very high to start with, disinflation can
lead to deflation–decreases in the general price level of goods and
services. For example if the annual inflation rate for the month of
January is 5% and it is 4% in the month of February, the prices
disinflated by 1% but are still increasing at a 4% annual rate. Again,
223
Disination is a decrease in the rate of ination as illustrated in the yellow region of this graph.
Figure 3.37 Disination
if the current rate is 1% and it is -2% for the following month, prices
disinflated by 3% (i.e., 1%-[-2]%) and are decreasing at a 2% annual
rate.
The causes of disinflation are either a decrease in the growth rate of
the money supply, or a business cycle contraction (recession). If the
central bank of a country enacts tightermonetary policy, (i.e., the
government start selling its securities) this reduces the supply of
money in an economy. This contraction of the monetary policy is
known as a "quantitative tightening technique." When the
government sell its securities in the market, the supply of money
reduces, and money becomes more upscale and the demand for
money remains constant. During a recession, competition among
businesses for customers becomes more intense, and so retailers are
no longer able to pass on higher prices to their customers. The main
reason is that when the central bank adopts contractionary
monetary policy, its becomes expensive to annex money, which
leads to the fall in the demand for goods and services in the
economy. Even though the demand for commodities fall, the supply
of commodities still remains unaltered. Thus the prices fall over a
period of time leading to disinflation.
When the growth rate of unemployment is below the natural rate of
growth, this leads to an increase in the rate of inflation; whereas,
when the growth rate of unemployment is above the natural rate of
growth it leads to a decrease in the rate of inflation also known as
disinflation. This happens when people are jobless, and they have a
very small portion of money to spend, which indirectly implies
reduction in the supply of money in an economy.
Source: https://www.boundless.com/finance/analyzing-financial-
statements--2/considering-inflation-s-distortionary-effects--2/
disinflation--2/
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224
Deation Deation is a decrease in the general price level of goods and services and occurs when the ination rate falls below 0%.
KEY POINTS
• In the IS/LMmodel (Investment and Saving equilibrium/ Liquidity Preference and Money Supply equilibrium model), deflation is caused by a shift in the supply-and-demand curve for goods and services, particularly a fall in the aggregate level of demand.
• In more recent economic thinking, deflation is related to risk: where the risk-adjusted return on assets drops to negative, investors and buyers will hoard currency rather than invest it. This can produce a liquidity trap.
• In monetarist theory, deflation must be associated with either a reduction in the money supply, a reduction in the velocity of money or an increase in the number of transactions. But any of these may occur separately without deflation.
• In mainstream economics, deflation may be caused by a combination of the supply and demand for goods and the supply and demand for money; specifically the supply of money going down and the supply of goods going up.
KEY POINTS (cont.)
• The effects of deflation are: decreasing nominal prices for goods and services, increasing buying power of cash money and all assets denominated in cash terms, possibly decreasing investment and lending if cash holdings are seen as preferable, and benefiting recipients of fixed incomes.
In economics, deflation is a decrease in the general price level of
goods and services. This occurs when the inflation rate falls below
0% (a negative inflation rate). Inflation reduces the real value of
money over time; conversely, deflation increases the real value of
money – the currency of a national or regional economy. In turn,
this allows one to buy more goods with the same amount of money
over time.
Economists generally believe that deflation is a problem in a
modern economy because they believe it may lead to a
deflationary spiral (Figure 3.38).
In the IS/LMmodel (Investment and Saving equilibrium/ Liquidity
Preference and Money Supply equilibrium model), deflation is
caused by a shift in the supply-and-demand curve for goods and
services, particularly with a fall in the aggregate level of demand.
That is, there is a fall in how much the whole economy is willing to
buy, and the going price for goods. Because the price of goods is
225
falling, consumers have an incentive to delay purchases and
consumption until prices fall further, which in turn reduces overall
economic activity. Since this idles the productive capacity,
investment also falls, leading to further reductions in aggregate
demand. This is the deflationary spiral.
An answer to falling aggregate demand is stimulus, either from the
central bank, by expanding the money supply; or by the fiscal
authority to increase demand, and to borrow at interest rates which
are below those available to private entities.
In more recent economic thinking, deflation is related to risk: where
the risk-adjusted return on assets drops to negative, investors and
buyers will hoard currency rather than invest it, even in the most
solid of securities. This can produce a liquidity trap. A central
bank cannot normally charge negative interest for money, and even
charging zero interest often produces less stimulative effect than
slightly higher rates of interest. In a closed economy, this is because
charging zero interest also means having zero return on government
securities, or even negative return on short maturities. In an open
economy it creates a carry trade, and devalues the currency. A
devalued currency produces higher prices for imports without
necessarily stimulating exports to a like degree.
In monetarist theory, deflation must be associated with either a
reduction in the money supply, a reduction in the velocity of money
or an increase in the number of transactions. But any of these may
occur separately without deflation. It may be attributed to a
dramatic contraction of the money supply, or to adherence to a gold
standard or to other external monetary base requirements.
In mainstream economics, deflation may be caused by a
combination of the supply and demand for goods and the supply
and demand for money, specifically: the supply of money going
down and the supply of goods going up. Historic episodes of
deflation have often been associated with the supply of goods going
up (due to increased productivity) without an increase in the supply
of money, or (as with the Great Depression and possibly Japan in
the early 1990s) the demand for goods going down combined with a
226
Annual ination (in blue) and deation (in green) rates in the United States from 1666 to 2004
Figure 3.38 US historical ination rates
decrease in the money supply. Studies of the Great Depression by
Ben Bernanke have indicated that, in response to decreased
demand, the Federal Reserve of the time decreased the money
supply, hence contributing to deflation.
The effects of deflation are thus: decreasing nominal prices for
goods and services, increasing buying power of cash money and all
assets denominated in cash terms, possibly decreasing investment
and lending if cash holdings are seen as preferable (aka hoarding),
and benefiting recipients of fixed incomes.
Source: https://www.boundless.com/finance/analyzing-financial-
statements--2/considering-inflation-s-distortionary-effects--2/
deflation--2/
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227
Discrepancies
Extraordinary Gains/Losses
Section 11
Other Distortions
228
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Discrepancies A discrepancy is an accounting error that was not caused intentionally, meaning the books don't properly match.
KEY POINTS
• At the end of each month when you get your bank or credit card statement, you will need to reconcile each account in your accounting program against the statement.
• You will want to double check that you entered the correct starting and ending balances for the account, and if you did, go back through all the transactions until you find the problem. Then correct it and you can proceed with your reconciliation.
• In accounting, reconciliation refers to a process that compares two sets of records (usually the balances of two accounts) to make sure they are in agreement.
• It depends on the type of discrepancies, most accounting discrepancies are due to the lack of accuracy (decimal places) when breaking down a large figure. Although more decimal places in your calculations can help solve discrepancies it can look rather unsightly on a report.
At the end of each month when you get your bank or credit card
statement, you will need to reconcile each account in your
accounting program against the statement. This process double
checks everything you entered for the month, making sure you
didn’t miss any transactions, enter duplicate transactions, or enter
the wrong amount for a transaction. It also marks the checks that
cleared that month as such, so you know how many outstanding
checks you have floating out in the world.
A discrepancy is an accounting error that was not caused
intentionally. An accounting error can include discrepancies in
dollar figures, or might be an error in using accounting policy
incorrectly (i.e., a compliance error). Discrepancies should not be
confused with fraud, which is an intentional error in an accounting
item, usually to hide or alter data for personal gain. A discrepancy
just means something doesn’t match. You will have the option to go
back and locate the discrepancy, or to reconcile anyway. Unless the
discrepancy is very small you should go back and correct the
problem. You will want to double check that you entered the correct
starting and ending balances for the account, and if you did, go back
through all the transactions until you find the problem. Then
correct it and you can proceed with your reconciliation.
In accounting, reconciliation refers to a process that compares two
sets of records (usually the balances of two accounts) to make sure
they are in agreement. Reconciliation is used to ensure that the
money leaving an account matches the actual money spent, this is
229
done by making sure the balances match at the end of a particular
accounting period. Well reconciliations refers to two sets of records
(what is being put in the well compared to what actual costs are
being spent). The two numbers are compared to assure that they
balance at the end of the accounting cycle. There is usually a
difference. A robust reconciliation process improves the accuracy of
the financial reporting function and allows the Finance Department
to publish financial reports with confidence (Figure 3.39).
It depends on the type of discrepancies, most accounting
discrepancies are due to the lack of accuracy (decimal places) when
breaking down a large figure. Although more decimal places in your
calculations can help solve discrepancies it can look rather unsightly
on a report.
Source: https://www.boundless.com/finance/analyzing-financial-
statements--2/other-distortions--2/discrepancies--2/
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230
Bank reconciliation statement
Figure 3.39 Reconciliation of discrepancies
Extraordinary Gains/Losses Extra gains or losses are nonrecurring, onetime, unusual, non-operating gains or losses that are recorded by a business during the period.
KEY POINTS
• Extra gains or losses are nonrecurring, onetime, unusual, non-operating gains or losses that are recorded by a business during the period.
• No items may be presented in the income statement as extraordinary items under IFRS regulations, but are permissible under US GAAP. (IAS 1.87) The amount of each of these gains or losses, net of the income tax effect, is reported separately in the income statement.
• Examples of extraordinary items are casualty losses, losses from expropriation of assets by a foreign government, gain on life insurance, gain or loss on the early extinguishment of debt, gain on troubled debt restructuring, and write-off of an intangible asset.
Extraordinary Gains and Losses
Extraordinary items are both unusual (abnormal) and
infrequent, for example, unexpected natural disaster, expropriation,
prohibitions under new regulations. It is notable that a natural
disaster might not qualify depending on location (e.g., frost damage
would not qualify in Canada but would in the tropics).
Extra gains or losses are the result of unforeseen and atypical
events. They are nonrecurring, onetime, unusual, non-operating
gains, or losses that are recorded by a business during the period.
No items may be presented in the income statement as
extraordinary items under IFRS regulations, but are permissible
under US GAAP (Figure 3.40). (IAS 1.87) The amount of each of
these gains or losses, net of the income tax effect, is reported
separately in the income statement. Net income is reported before
and after these gains and losses. As a result, extraordinary gains or
losses don't skew the company's regular earnings. These gains and
losses should not be recorded very often but, in fact, many
businesses record them every other year or so, causing much
231
This income statement is a very brief example prepared in accordance with IFRS; no extraordinary items are presented.
Figure 3.40 Income statement in accordance with IFRS
consternation to investors. In addition to evaluating the regular
stream of sales and expenses that produce operating profit,
investors also have to factor into their profit performance analysis
the perturbations of these irregular gains and losses reported by a
business.
Examples of extraordinary items are casualty losses, losses from
expropriation of assets by a foreign government, gain on life
insurance, gain or loss on the early extinguishment of debt, gain on
troubled debt restructuring, and write-off of an intangible asset.
Write down and write off of receivables and inventory are not
extraordinary, because they relate to normal business operational
activities.They would be considered extraordinary, however, if they
resulted from an Act of God (e.g., casualty loss arising from an
earthquake) or governmental expropriation.
Source: https://www.boundless.com/finance/analyzing-financial-
statements--2/other-distortions--2/extraordinary-gains-losses--2/
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