Funding and Debt Management
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Chapter 6 Financial Statements and Their Analysis
Entrepreneurial Finance: Fundamentals of Financial Planning and Management for Small
Business, First Edition. M. J. Alhabeeb.
© 2015 John Wiley & Sons, Inc. Published 2015 by John Wiley & Sons, Inc.
EVERY BUSINESS needs to organize its financial data for many purposes, whether these
purposes are internal or external. The internal purposes are to assess the business's
performance and status. They include
– the need for owners and shareholders for information on the status of their investment
and profitability;
– the need for management to monitor business performance according to the plans and
managerial strategies.
On the other hand, the external purposes would include the need to
– disclose key financial information for creditors, who would want to be assured of the
business ability to pay interests and pay off debt;
– know the fate of the allocated funds for the potential investors, who want to make sure
what kind of business they get their money into; and
– Examine the firm's commitments for the Internal Revenue Service, which is most
concerned about collecting its taxes, and for the regulators such as the federal and state
authorities who want to see full compliance with their rules and regulations.
In this chapter we will go over the key financial statements that are supposed to present
business financial data in a commonly acceptable way according to the Financial
Accounting Standards Board (FASB) that sets the formats and rules in this regard.
Financial statements are compilations of data designed to provide summarized information
and quick indicators of the business financial performance. The most commonly used
statements are the balance sheet and the income–expenses statement.
6.1 The Balance Sheet
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This is a statement that shows the firm's financial position at a specific time. It is
characterized by being a snap shot of the comparison between the firm's assets and
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its liabilities. In other words, the balance sheet puts what the firm owns versus what it owes
at any point in time. What identifies the balance sheet is the net worth (NW) or the owner's
equity (OE), which is the difference between assets (A) or total assets (TA), and liabilities (L)
or total liabilities (TL):
This is what we call the balance sheet formula or the basic accounting equation which can
also be written as:
Owner's equity (OE) is the claim that the business owners have against the firm's assets such
that it would increase when the firm makes profits and decrease when the firm incurs
losses. Both assets and liabilities are considered on the sheet in short and long terms. In the
short term, we have the current assets, which include the assets that can be converted to
cash within a year or less. The current liabilities are those which must be paid within a year
or less. As for the long term, we have the fixed assets and the long-term liabilities that would
stay on the books for more than a year.
Components of the Balance Sheet
As is shown on the sample balance sheet (Table 6.1), there are three parts: assets, liabilities,
and net worth or owner's equity. Assets are entered in order of their liquidity. Let us remind
ourselves that liquidity is the extent to which an asset can be converted into cash. Therefore,
the order of the types of assets we have on the sheet would be current assets first, followed
by fixed assets. Also, within the current assets, cash comes first, which includes currency,
checking account, and savings account. Marketable securities are short-term investment
instruments such as treasury bills and certificates of deposit. Account receivable includes all
the money the firm would expect to receive for the sales of its products on credit. The
inventory would include the firm's stock of raw material, partially finished products, and
finished products in storage. The prepaid expenses are those expenses such as insurance
premiums, some supplies and services that are required to be paid in advance. Fixed assets
are those assets which are gradually consumed as they contribute to the production process
over an extended period of time. This is why a portion of depreciation would be deducted
from all of them except the land, which would not depreciate. The accumulated depreciation
is entered here collectively but usually each asset would depreciate at its own rate and,
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therefore, there would be a certain depreciation subtracted from each fixed asset
individually.
As for liabilities, they are also listed in order of the time they are due to be paid. Current
liabilities would be before the long-term liabilities. Current liabilities include items in the
account payable such as the value of all the goods and services the firm purchased on credit,
also, items in the notes payable such as promissory notes
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or notes issued to suppliers when they are not being paid immediately on delivery. The
accruals include taxes due and wages and compensation due to employees. The long-term
liabilities include all debt and obligations that are not due until after a year such as a long-
term bank loan, and debenture, which is another long-term instrument that is not backed up
by any collateral.
Table 6.1 Sample Balance Sheet
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The net worth consists of all the common stock sold at par value (nominal or face value of a
stock), the preferred stock value, and the retained earnings, which is what would be left
over from the firm's earnings after paying out dividends. The
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value of the net worth, or owner's equity, would also be obtained by subtracting total
liabilities from total assets.
Balances of the Balance Sheet
The following have to be balanced in any balance sheet to assure the correct calculations.
1. Total assets have to be equal to total current assets and net fixed assets (1,752,200 =
975,000 + 777,200).
2. Total liabilities have to be equal to total current liabilities and total long-term liabilities
(920,000 = 753,000 + 167,000).
3. Net worth or owner's equity as the difference between total assets and total liability has
to match the net worth or owner's equity as the sum of the items under the net worth
section such as the common stock, preferred stock, and retained earnings.
4. The sum of total liabilities and the net worth has to be equal to total assets.
The Cash Flow Cycle
The cash flow cycle describes the actual net cash that flows into (cash inflow) and out of
(cash outflow) a firm through its operation and finances. Figure 6.1 shows cash as the core
of this cycle that is divided into two domains, the production and sale flow domain, and the
debt and equity domain. Both domains involve both inflow and outflow of cash. Cash has to
be spent in order for the firm to carry out production. It takes the form of paying for
material, labor, transportation, marketing, administrative expense and alike. When
products are sold, they either bring immediate cash or delayed cash through the accounts
receivable if they are sold on credit. The firm also gives out and takes in cash when buying
and selling assets, respectively. Spending cash would also occur when materials for
production are purchased either by cash. They can also be purchased on credit through the
accounts payable. Another outflow of cash would be paying the accrued wages for labor
required for production. As for the second domain of flow on the right-hand side of Figure
6.1, there are four items in which cash goes in two ways, from and to the firm. The firm
would get cash from loans, and pay cash in terms of loan payments. It would get cash when
it sells its stock, and gives away cash when it distributes dividends. Same two ways as in the
case of paying and receiving interests. Finally, the firm gives away cash to government in
terms of taxes due, and could receive some cash back in case it has a tax refund. Solid
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arrows are to indicate the outflow of cash from the firm and dashed arrows are to indicate
the inflow of cash into the firm.
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Figure 6.1 Cash Flow Cycle
6.2 Income–Expenses Statement
Income statement shows the firm's financial position over a period of time, usually a year,
through the comparison between the in-resources (revenue and income) and the out-
resources (expenses). While the balance sheet is characterized by being a snap shot of the
firm's finances, the income–expenses statement is characterized by offering an extended
look at what is going on with the key elements of the firm's financial performance. Just like
the balance sheet, which is identified by the net worth or the owner's equity, the income
statement is identified by the net gain (NG) (also called net profit), which is the difference
between income (I) and expenses (E):
For managerial purposes, income statement is usually prepared on a monthly basis. But for
firms that trade its stock publicly, a quarterly statement is usually prepared for
stockholders.
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In the sample income statement (Table 6.2), the first entry is the total amount of revenue
from selling the firm's product. The first deduction is the value of all returned merchandise
and other allowances such as customer's prompt payment discount or sale price late
application. After discounting all of the returns and allowances we
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obtain the net sale, from which we deduct the cost of the sold product and all the expenses
related to the sale. The result is the gross profit which would be subject to the deduction of
all of the operating expenses such as, for example, depreciation, rent, property taxes,
utilities, salaries, advertising, and insurance. What we get after taking away all the
operating expenses is the operating income, or as it is often called, earnings before interests
and taxes (EBIT). Two of the major obligations for any business are paying the interest on all
business loans and also paying the due taxes to the government. The term “income or
earnings before taxes” is related to the EBIT after paying the obligation of interest only, and
when the second obligation (taxes) are paid, the EBIT would be free of both and it would be
called “income or earnings after taxes” or “net income” or “net profit”. This is the bottom
line for companies which do not sell stock. As for those companies which have to deal with
stock selling and have stockholders waiting for their dividends, the bottom line of the
income statement would be going further beyond the net profit line to calculate both
earnings per share (EPS) and dividend per share (DPS). EPS would be obtained by dividing
net profit or income after taxes by number of shares outstanding. The DPS would be
obtained by dividing the dividend portion of the net profit by number of shares outstanding.
This would mean that the company has to divide its net profit into
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two parts. One part is to be given to stockholders as dividend and the other part is to be
retained by the company for growth purposes. Assuming, for our example, that this
company has 150,000 shares, EPS and DPS would be 2.17 and 1.64, respectively.
Table 6.2 Sample Income Statement
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6.3 Financial Statement Analysis
As we have seen, financial statements report important information on the firm's financial
and operational performance. This information can be even more effective if it is analyzed
Assuming the company has 150,000 shares.a
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further for many purposes. Financial statement analysis can help the following parties:
– Managers who would need the statements information to be examined and analyzed
further in order to monitor the performance of their company, assess their own
managerial strategies, and know if any changes are needed, and in what direction.
– Shareholders who would love to know if certain criteria or a group of indicators are
devised to help them in their decisions to invest in a company or to transfer funds or
sign on any financial decisions.
– Creditors who would also find such indicators and indices, that are summarizing the
performance of businesses, very helpful in knowing the worth of the borrowing
company and its ability to pay interest and pay off the loans on time.
– Local, state, and federal governments, which for regulatory reasons and reasons related
to tax collection, would also be interested in knowing and using any precise and
summarized indicators of business performance to assess the firms' abilities to honor
their obligations.
Transforming the information into indicators or indices is not the aim per se but it is the tool
to direct the efforts to the areas of potential problems. These indicators have to be
interpreted for a meaningful conclusion and the interpretation usually involves a certain
comparison. Comparisons could be multidirectional too. A numerical indicator or a ratio
can be compared to the same indicators of similar companies at the same time. It can also be
compared to itself within a company throughout different times to assess the progress. The
comparison of indicators of similar companies at the same time is called cross-sectional
analysis. It can be further compared to the entire industry using its average value, its
maximum or minimum,
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or it can be compared to an agreed upon standard. Similar indicators produced by different
methods of calculations can also be compared.
Indicators or ratios can also be compared in a time-series type of comparison in which an
indicator is compared across time such as comparing the present to the past, or to the
future, using the projected values. This comparison is particularly practical and effective in
examining the trends of data and their type and pace of progression. Further benefits can be
obtained by combining many comparisons such as the time-series comparison of an
indicator across the industry. For example, the development and trend of the EPS of a
company for the last 10 years is compared to the EPS across five similar companies in the
same industry during the same 10 years.
Once again, the ultimate benefit of the analysis of financial statements and their calculated
indicators is in the interpretation. For example, an indicator or ratio has to be known if it is
better to be low or high, how low or high from a certain standard, and if there is an
acceptable minimum or maximum value. Also, which standard is more relative, the industry
standard, the national, or the global? Data in the financial statements can be analyzed in
several ways. We will briefly describe two types of analysis, the vertical and horizontal, and
will discuss in depth the most common and practical, the third type, ratio analysis.
Vertical Analysis
Vertical analysis is based on the comparison of entries of the financial statement to a
common ground or a selected reference point in the same statement. It is a way to see how
the data in one statement relates to a major entry on that statement. For example, in the
balance sheet, the selected reference point could be the value of total assets in the firm, and
many other variables on the sheet can be calculated as a percentage of the total assets value.
We can, for instance, see what percentage of the total assets would the firm's inventory or
equipment be? Let us answer this question by going back to our sample balance sheet where
inventory was $450,000 and equipment was $350,000 and the total assets were $1,752,200.
This would indicate that the firm puts almost 26% of its assets in inventory and almost 20%
of its assets in equipment. This would allow the firm to see the weight of each element and
by that, it could see the total picture and how all of these entries on the balance sheet are
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related to each other, also how such a picture is related to the firm's economic strength. The
same can be done with the income statement. The common denominator and the
appropriate reference point on the income statement could be the value of net sales. All
other entries can be related to the net sales, and they can give a meaningful conclusion. Let
us calculate the weight of advertising or
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net profit, for instance.
The firm is spending 1.2% of its net sales on advertising, and earning a net profit equal to
21.5% of its net sales.
Horizontal Analysis
Unlike the vertical analysis that compares several entries to a selected common ground in
the same statements, the horizontal analysis compares the entries across time, especially a
comparison to a selected base time. It is to show the change in variables or the statement's
entries over a period of time. It can also be done to both statements, balance sheet and
income statement, as long as there is a reference point of time in which we have the data to
which we can compare. Let us assume that the sample balance sheet and income statement
were for the year 2014 and that we want to see how inventory and equipment on the
balance sheet, and advertising and net profit on the income statement, have changed since
2009. Suppose that we go back to the 2009 statements and find the entries we want (see
Tables 6.3 and 6.4).
The conclusion is that in 2014, and according to the firm's balance sheets, inventory volume
has decreased by a little more than 20% since 2009, while equipment has increased by a
little more than 67% since 2009. According to the firm's income statement, amount spend on
advertising has increased by 40% in 5 years, while net sales has increased by more than 54%
between 2009 and 2014.
Table 6.3 Inventory and Equipment Expenses Between 2009 and 2014 (from Balance Sheets)
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Horizontal analysis calculates the percentage change of the entries between two time
periods. The general formula can be written as:
where %Δ refers to the percentage change, Entry is any entry on any financial statement, a is the earlier time period, and b is the later time period.
6.4 Ratio Analysis
Ratio analysis is the third type of financial statement analysis, which is widely used and
more practical. Its major purpose is to analyze the firm's financial statements by the way of
constructing and calculating a variety of ratios which would serve as general indicators to
assess the firm's performance. Ratio analysis would also consider two points of view, the
cross-sectional where the comparison of those financial indicators is made at the same point
in time, but across different statements, and the time series where the indicators are
analyzed as trends extending over a period of time, but for the same statement. The
financial ratios here are related to the way the firm employs and manages its capital and
conducts its operations to achieve its goals. Regarding the term of analysis, most financial
ratios are related to the short-run analysis, as they address specific aspects of performance
such as the ratios of profitability, liquidity, operations. As for the long-run analysis, ratios of
debt would be a typical example.
Profitability Ratios
Table 6.4 Advertising Expenses and Net Profits Between 2009 and 2014 (from Income Statements)
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These are also called efficiency ratios since the major objective is to assess how efficiently
firms utilize their assets and ultimately how they are able to attract investors and gain their
capitals.
Gross Profit Margin Ratio (GPMR)
This ratio shows how much gross profit, GP (sales after paying for the cost of goods sold) is
generated by each dollar of net sales, NS (gross sales minus all returned goods).
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Example
If gross profit is $83,420 and net sales is $185,377, then GPMR would be:
a gross profit margin of 45% means that out of each dollar of net sales, 45¢ would be the
gross profit.
Operating Profit Margin Ratio (OPMR)
Instead of the gross profit in the last ratio, this ratio shows the operating profits as they are
related to the net sales. Operating profit is another term for operating income which is the
same as EBIT or earnings before income and takes.
Example
If operating income is $45,000 and net sales is $300,000, then OPMR is:
which means that 15¢ out of each dollar of net sales in this firm goes to the operating
income budget.
New Profit Margin Ratio (NPMR)
This time net profit is related to the net sales. It tells how much net profit the firm earns out
of its volume of sales.
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Example
Suppose that the net profit in one firm is $35,287 and net sales is $298,971, the NPMR would
be
or 11.8%, meaning that out of each dollar of net sales this firm would have a little less than
12¢ as net profit. This measure is important especially because it paints a picture to the
profit after all expenses, including interest and taxes, have been paid for.
Return on Investment Ratio (ROIR)
It is also known as the return on assets (ROA). It relates net profit (i.e., after interest and
taxes) to total assets (TA) of the firm.
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Example
Let us use the previous net profit figure of $35,287 against a total asset of $250,000 to
calculate ROIR:
which says that each dollar of the total asset value would give 14¢ in net profit.
Return on Equity Ratio (ROER)
In this ratio, net profit (NP) is related to owner's equity (OE) on its format of both preferred
and common stock. It basically tells stockholders a crucial piece of information, that is, how
much of their money the firm would turn into net profit.
Example
Suppose that owner's equity value is at $79,500. The net profit of $35,287 would be forming
an ROER as:
which tells shareholders that this firm is able to turn 44¢ of each dollar of their investment
into a net profit.
Sales–Asset Ratio (SAR)
This is another efficiency ratio. It shows how efficient the use of resources is, as an
important aspect of the firm's performance, and its ability to generate profits.
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Example
Suppose the volume of sales for a firm reached $46,890 and its records indicate that the
value of its total asset at the beginning of the year was $60,522 and at the end of the year
was $50,177. The firm's SAR would be dividing the sales (S) by the average value of assets
since we have two readings:
This ratio says that the firm is working hard to put its assets to use in producing and selling
its products.
Sales–Net Working Capital (SNWC)
This time we relate sales to the net working capital (NWC), which is basically the firm's
short-run net worth or the difference
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between the current assets and the current liabilities. That current sense of measure is what
gives this ratio its more important meanings:
Example
Suppose that the working capital in the firm of the last example is $3590, its SNWC would
be:
This ratio reflects how the volume of sales relates to the firm's current net worth. In other
words, how the NWC has been put to use.
Market-Based Ratios
These ratios reflect the firm's performance as it is associated with the related market and,
therefore, the ratios would be looked at with great interest by current investors, potential
investors, as well as by managers.
Price–Earnings Ratio P/E
This is one of the most common and important ratios. It relates the market price of the
firm's common stock (SP) to its EPS.
It reflects the investor's confidence in the firm's financial performance and, therefore, the
higher the P/E, the higher the appraisal given by the stock market.
Example
If the market price per share of common stock is $65 and this firm has a $7.45 EPS, then the
firm's P/E is:
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which means that this firm's common stock is selling in the stock market for nearly nine
times its earnings.
Price–Earnings–Growth Ratio (PEG)
This ratio employs the previous P/E and relates it to the firm's expected growth rate per year
(EGR). It reflects the firm's potential value of a share of stock.
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Example
Suppose that the previous firm of a P/E of 8.72 expects an annual growth rate of 8%, then its
PEG would be:
It is theorized that PEG takes the following meanings:
If PEG = 1–2: The firm's stock is in a normal range of values.
If PEG < 1: The firm's stock is undervalued.
If PEG > 2: The firm's stock is overvalued.
Earnings Per Share Ratio (EPS)
This ratio is more important to the common stockholders, in particular, because it is
calculated by dividing the net profit (after subtracting the dividends of preferred stock) by
the outstanding number of shares of common stock.
Example
Suppose that a firm has a net profit of $600,000. It pays 7% of it as dividend for preferred
stockholders and it distributes the rest among the 40,000 shares of common stock. Its EPS
would be:
This means that for each share of common stock that the investors own, they earn $13.95.
Dividend Yield Ratio (DY)
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This ratio is obtained by dividing dividends of common stock per share (DPS) by the stock
price.
If the DPS is $1.95 and the stock price is $35, then the dividend yield is:
which says that common stockholders receive only 5.6% as dividend out of what each share
of their stock sells for in the market.
Cash Flow Per Share Ratio (CFPS)
This ratio is just like EPS except that it uses cash flow instead of net profit, and the reason
for this according to some financial analysts is that real operating cash flow (OCF) is a much
more reliable measure than net profit that includes a lot of account receivable. A measure of
cash available as
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related to the number of shares of common stock is a good indicator of the firm's financial
health.
Example
Suppose that a firm has an OCF of $65,000 and its shares of common stock reached 500,000
shares outstanding. Its CFPS would be:
which means the CFPS in this firm is 13¢.
Payout Ratio (PYOR)
This ratio shows how much EPS would be paid out as cash dividends for common
stockholders (D ).
Example
Let us suppose that for the previous firm with an EPS of $13.95 there is $3.10 paid out as
cash DPS. The PYOR then would be:
which means that 22¢ out of each dollar earned per share is being paid out as dividends.
Book Value Per Share Ratio (BVPS)
This ratio shows the stockholder's equity or net worth (NW) for each share they hold.
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Example
Suppose the net worth in a firm is $230,000 and there are 20,000 shares outstanding. BVPS
would be:
This means that each share is worth $11.50 of the firm's net worth.
Price–Book Value Ratio (PBVR)
It shows how the market price of a stock (SP) is related to the BVPS.
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Example
Suppose that the stock of the firm in the last example is sold for $20 in the market, the PBVR
would be:
A PBVR of $1.74 means that this firm is worth 74% more than the shareholders put into it.
Generally PBV can be read like this:
PBVR > 1: Firm is utilizing assets efficiently.
PBVR < 1: Firm is utilizing assets inefficiently.
PBVR = 1: Firm is utilizing on the margin.
Price/Sales Ratio (P/S)
This ratio shows how many dollars it takes to buy a dollar's worth of the firm's revenue. It is
calculated by dividing the market capitalization (MC, stock price × no. of shares) by the
firm's revenue for the last year (TR).
Example
If we take the stock price and number of shares from the last examples: SP = $20 and no. of
shares = 20,000, and if we suppose that the revenue of this firm last year was $650,000, then
market capitalization (MC) would be:
A price/sales ratio of 62% is good and it refers to the case where the investors can get more
than what they invest in. Generally, market analysts came up with the criteria that P/S ratio
should be less if not equal to 75%.
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and firms with price/sales ratios more than 150% should be avoided by investors.
Tobin's Q
Tobin's Q Ratio is named after the economist James Tobin who came up with this ratio as an
improvement over the traditional PBV. Tobin believes that both debt and equity of the firm
should be included in the top of the ratio and for the bottom, instead of depending on the
firm's book value it should be the firm's entire assets in their replacement cost, which is
adjusted for inflation. In this case, Tobin's Q would reflect where the firm stands accurately.
where TA is the market value of the firm's total assets and TA is the replacement value of
total assets.
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Example
If the market value of total assets of a firm is $127 million and its replacement cost is $150
million, its Tobin's Q would be:
Tobin referred to the rule of thumb for this ratio:
If Tobin's Q > 1: Firms would have the capacity and incentive to invest more.
If Tobin's Q < 1: Firms cannot invest and may acquire assets through merger.
Operational Ratios
This group of ratios is called activity ratios. They deal with the extent to which the firm is
able to convert various accounts into cash or sales. These accounts include inventory,
accounts receivable, accounts payable, fixed assets, and total asset turnover.
Inventory Turnover Ratio (ITR)
This ratio relates the cost of goods sold (COGS) to the value of inventory (INY).
Often inventory is calculated as average of the inventory at the beginning of the year and at
the end of the year.
Example
If cost of goods sold is $130,000 and the average value of inventory is $53,560, then ITR
would be:
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An ITR of 2.43 means that the firm moves its inventory 2.43 times a year. ITR can also be
expressed as the “average age of inventory” (AAINY), which tells how many days the
average inventory stays in stock. This would be done by dividing the number of days of a
year (365) by the ITR.
So, if we divide 2.43 by 365 we get:
which means that it would take 150 days for this firm to carry its inventory.
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Account Receivable Turnover Ratio (ART)
It is also called average collection period which shows the extent to which customers pay
their credit bills. It is the account receivable (AR) divided by the average daily sales (DS):
Example
If the account receivable is $550,000 and the annual sales is $3,650,000, we can get ART by
first getting the daily sales by dividing the annual sales by 365:
which means that it would take the firm 55 days to collect its bills. This time is not good
unless the firm has a 60-day collection standard, but it is usually 30 days.
Account Payable Turnover Ratio (APT)
This ratio is also called average payment period. It is similar to the ART, in that it divides the
account payable (APY) by the average daily purchase (DP).
Example
Suppose that a firm's account payable shows $480,000 and its daily purchases are estimated
as $15,517. Its APT would be:
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That means that there would be 31 days on average for the firm to pay its bills, which would
be a very good standard.
Fixed Asset Turnover Ratio (FAT)
This ratio relates the volume of sales (NS) to the firm's fixed assets (FA).
Example
Suppose a firm has a total value of fixed assets equal to $79,365 and its net sales is
estimated at $133,773. Its FAT would be:
which means that this firm is able to generate 1.7 times sales value more than the value of
its fixed assets.
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Total Asset Turnover Ratio (TAT)
This ratio is just like FAT except that this time the net sales value is related to all assets in the
firm instead of only the fixed assets.
Example
Suppose that all assets in the last example is $140,593, then the TAT would be:
A TAT of 95% means that a firm is able to turn over 95% of its asset value into net sales.
Liquidity Ratios
Liquidity ratios show the firm's ability to handle and pay for its short-term liabilities and
obligations. The more liquid assets the firm can lay its hands on, the easier and smoother
the entire performance would be. Liquidity ratios include the current ratio, the quick ratio,
the net working capital ratio (NWCR), and the cash ratio.
Current Ratio (CR)
This ratio is probably the most popular among the financial ratios for its direct relevance. It
simply describes how current assets (CA) are related to current liabilities (CL):
Example
Suppose that the current assets are valued at $1.5 million and current liabilities are
estimated at $980,711, the firm's current ratio would be:
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A current ratio of 1.53 means that this firm has a dollar and 53¢ in its current assets value
to meet each dollar of its current obligations. Generally, the current ratio is recommended
by most financial analysts to be 2 or more.
This firm has to dedicate 65¢ out of each dollar of its current assets in order to pay for its
current creditor's claims.
Acid-Test Ratio (QR)
This ratio is also called the “quick” ratio. It is similar to the current ratio mentioned above
except that the value of inventory is taken away from the current assets.
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Example
If the entire inventory in the firm of the last example was estimated at $380,664, the quick
ratio would be:
which means that the firm has a dollar and 14¢ for each dollar of its creditor's claims. It is
noteworthy here to mention that if there are any prepaid items, they would also be
subtracted along with the inventory value from the current assets.
Net Working Capital Ratio (NWCR)
Net working capital (NWC) is the short-run net worth of a firm. It is the difference between
the current assets and current liabilities. If we divide the NWC by the available total assets
(TA), we get the NWCR that shows the firm's potential cash capacity.
Example
Suppose that the total asset for the firm in the last example is $49,950,592 and its current
assets and liabilities stay at $1,500,000 and $980,771, respectively. Its NWC would be:
and its NWCR would be:
which means that this firm has 10¢ in current net worth out of each dollar of its total assets.
Cash–Current Liabilities Ratio (CCL)
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This ratio tracks down only cash and marketable securities (C + MS) that are available at
hand and weighs them against the due current obligations and liabilities.
Example
If we keep the current liabilities of the last firm at $980,71 and assume that cash is counted
as $27,500 and marketable securities estimated at $31,342, the firm's CCL would be:
which says that this firm holds, at hand, some liquid asset in terms of cash and marketable
securities equal to 6¢ to meet each dollar of its current liabilities.
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The Interval Ratio (InR)
This ratio is another expression of the CCL but in terms of time. It reveals in how many days
the firm is able to meet its short-term obligations. It is obtained by dividing not only cash
and marketable securities, but also account receivable (AR), all divided by the daily
expenditures on current liabilities, CLPD which stands for current liabilities per day.
Example
Let us consider the $18,500 in account receivable in the last example. Also consider that the
average daily expenditure on obligations is calculated at $1250.
An interval ratio of 62 days means that the firm can continue to meet its average spending
of $1250 on obligations each day for 2 months tapping on its reserve of cash, marketable
securities, and account receivable.
Debt Ratios
They are also called leverage ratios. Because of the increased financial leverage and risk that
comes with using more debt in the firm's financing, debt ratios take a higher importance.
Those ratios indicate the extent to which the firm's assets are tied to the creditor's claims
and, therefore, the firm's ability to meet the fixed payments that are due to pay off debt.
Debt–Asset Ratio (D/A)
It is a direct measure of the percentage of the firm's total assets that belong to creditors. In
other words, how much of other people's money (OTM) is used to generate business profits.
It is obtained simply by dividing total liabilities or debt (TD) by total assets (TA).
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Example
If a firm has a total debt of $734,000 and its total assets are estimated at $1,930,570, its debt
to asset ratio would be:
which means that 38% of the firm's assets is financed with debt.
Debt–Equity Ratio (D/E)
This ratio weighs the firm's total debt (TD) to its owner's equity (E). It shows the percentage
of owner's equity that is generated by debt.
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Example
If the firm in the last example has an equity estimated at $1,200,000, then its D/E would be:
A D/E of 61% means that for every dollar of owner's equity in the firm, there is 61¢ owed to
creditors.
Solvency Ratio (Sol)
Solvency ratio is the reversal of the D/A. It is actually dividing total assets by total debt. It
shows to what extent the firm's total assets can handle its total liabilities or debt.
Example
Let us reverse the previous D/A, and see what kind of solvency ratio we get:
This solvency ratio means that the firm actually owns 2.6 times more than it owes and,
therefore, it is solvent. Solvency criteria are:
Sol > 1: Firm is solvent.
Sol <: firm is insolvent.>
Sol = 1: Firm is on the margin when its total debt is equal to its total assets.
Times Interest Earned Ratio (TIE)
This ratio measures the extent to which a firm is able to pay its interest payments. It is
obtained by dividing the firm's operating income (OY) or EBIT by the annual amount of
interest due to creditors.
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Example
Suppose that operating income is $170,000 and total annual interest payments are $35,000.
The TIE would be:
This means that this firm has an operating income larger almost by five times than the
interest payment due. We can also say that for every dollar of interest the firm pays to
creditors, it has almost $5 for it in the form of its operating income.
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Operating Income-Fixed Payments Ratio (OYFP)
This ratio is an expanded TIE. Instead of only interest payment in the denominator, all other
fixed payments are added to the interest payments, such as payment for principle (P), the
payments for preferred stocks as dividends (D ), and scheduled lease payments (L).
Example
Consider the following fixed payments as additions to the interest payment in the last
example:
P: $22,000
D : $51,000
L: $11,000
Then the OYFP would be:
Still, this firm's operating income is 1.43 times more than all the fixed payments due.
Note that the principle payment, lease payment, and preferred stock payment have to be
before tax status. If they are after tax, then they have to be converted to before tax by
dividing them by (1−T).
where T is the corporate tax rate.
6.5 The Dupont Model
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The DuPont model (Figure 6.2) is a system of financial analysis that has been used by
financial managers since its invention by the financial analysts of DuPont Corporation in the
1920s of the last century. It can be described as a collective method of financial analysis
although it has been characterized by some analysts as the complete system of financial
ratios' utilization. The basic premise of this model is to combine the firm's two financial
statements:
1. The income–expense statement.
2. The balance sheet.
Also, to incorporate the impact of three important elements:
a. The profits on sale represented by the NPM ratio.
b. The efficiency of asset utilization represented by the TAT.
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c. The leverage impact represented by the equity multiplier (EM).
Figure 6.2 The DuPont Model
The model has two major objectives:
1. To analyze what determines the size of return that investors look forward to receive
from the firms they invest in. This objective is achieved by breaking down the return on
equity (ROE) into two components: the return on investment (ROI) and the equity
multiplier (EM).
2. To further break down the elements of ROE into subelements: The return on investment
is obtained by multiplying the NPM by the TAT.
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Furthermore, NPM is obtained by dividing net profits by net sales, and TAT is obtained by
dividing net sales by total assets.
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The equity multiplier (EM) is the ratio of total assets to owner's equity.
On substituting all of the elements, we get:
The DuPont diagram shows how the various elements are taken from the two financial
statements, balance sheet and income–expenses statement to conclude with the return of
equity.
A Final Word About Ratios
We discussed a large number of ratios over five categories covering almost every possible
aspect of business performance. These ratios are not to be memorized but essentially to be
understood, used, and interpreted well. They are mathematical terms of one amount
divided by another and, therefore, they must be understood as such. The interpretation has
simply to be focused on reading the numerator as part of the denominator or the
denominator as the whole inclusive to the numerator part. They are not more than how the
top part above of the division line relates to the bottom part below the line. Business
performance has many aspects and this is a reason to say that using many ratios would be
much wiser for analysis than using one or two ratios only. Comparison has to be consistent
in terms of the time period comparing firms, size, and line of product among many other
aspects. Comparison can be made horizontally by the cross-sectional approach to compare
the same ratio across firms, and vertically by the time-series approach to compare ratios of
the same firm, but over years. Data have to be from sources that were already checked and
approved and better be from audited statements. Because of many overlaps, ratios for
particular purposes of financial analysis have to be chosen carefully to present redundancy.
6.6 Summary
Chapter 6 explained the financial statements and their analysis. The most common and most
practical financial statements were detailed. The first was the balance sheet and the second
was the income–expense statement. They were both articulated with examples and
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calculations. In the financial statement analysis, three types of analysis were addressed: the
vertical, horizontal, and the elaborately explained, ratio analysis. Five categories of ratios
were carefully explained with examples. Profitability ratios included GPMR; OPMR; net
profit margin ratio; return on investment ratio; return on equity ratio; and sales to NWC.
The second category of ratios was the market-based ratios that included price/earnings ratio;
PEG; EPS; dividend yield; CFPS; PYOR; BVPS; PBV; price/sales ratio; and Tobin's Q ratio. The
third category was
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the operational ratios. This category included the ITR; ART; FAT; and TAT. The next ratio
category was the liquidity ratios, which included current ratio; acid test; NWCR; CCL; and the
interval ratio. The last ratio category was the debt ratio, which included five ratios: first was
debt–asset ratio, and then debt–equity ratio; solvency ratio; TIE; and OYFP. To wrap it all up,
the DuPont model was presented as a complete system to utilize ratio analysis. Finally, there
was the last word about the financial ratios and their use.
Key Concepts
Balance sheet Income statement Net worth
Net gain Current assets Current liabilities
Fixed assets Long-term liabilities Accounts receivable
Prepaid expenses Depreciation Notes payable
Accruals Debenture Par value
Retained earnings Cash flow cycle EBIT
EAT Earnings per share Dividend per share
Vertical analysis Horizontal analysis Profitability ratios
Gross profit margin Operating profit margin Net profit margin
Return on investment ratio (ROIR) Return on equity
Price–earning ratio Dividend yield Cash flow per share
Payout ratio Tobin's Q ratio Inventory turnover ratio
Account receivable turnover Account payable turnover
Fixed asset turnover Liquidity Total asset turnover
Acid test Net working capital ratio Internal ratio
Leverage ratio Solvency ratio Times interest earned ratio
The DuPont model
Discussion Questions
1. What is the significance of financial statements, and who would benefit from them?
2. What are the most common financial statements? Briefly describe each of them.
3. What would immediately identify the balance sheet and the income–expense
statement?
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