Financial Decision Making 8 questions 4 papers

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6 Analyzing Financial Reports

Warren Buffe� is one of the most successful investors and businesspeople in the world.

Na� Harnik/Associated Press

© lucky336/iStock/Thinkstock

Learning Objec�ves

A�er reading this chapter, you should be able to:

Explain how financial ra�os are used. Describe the limita�ons of financial ra�os. Describe the various types of financial ra�os. Explain how internal reports are used to make decisions.

Introduc�on A�er the budget commi�ee of Best General Company reviews each of the company's financial statements, it can use basic financial ra�o analysis tools to recognize trends within the company's financial results. These tools enable a comparison of the company's results quarter to quarter or year to year. The commi�ee can also compare the company's results to compe�tors using these tools, and these comparisons will help them formulate recommenda�ons for key execu�ves.

Using financial ra�o analysis, the budget commi�ee can measure the rela�onships between line items to:

test the company's liquidity (ability to convert an asset to cash quickly so the company can make debt payments), discover the level of ac�vity for various key aspects of the company (such as the �me it takes for customers to pay their bills), determine the company's leverage (the amount of debt the company uses to fund its opera�ons), and measure the company's profitability (how much money the company makes in comparison to various ac�vi�es or assets).

As we will see in this chapter, financial ra�os are a key tool in the analysis done by many managers and investors.

In "World of Business," we introduce one of the world's most famous investors and execu�ves, Warren Buffet, and how he learned about using financial ra�os.

World of Business

The Success of the Oracle of Omaha

Warren Buffe�, one of today's premier investors and execu�ves, is known as the "Oracle of Omaha" because of his tremendous success. His mul�billion dollar company, Berkshire Hathaway, has helped many of its shareholders to become millionaires. Shares of the company that sold for $5,900 in November 1990 were worth $171,432 as of December 15, 2013.

Buffet uses fundamental analysis, a technique that was championed by his mentor, Benjamin Graham (1894–1976), at Columbia Business School, to make his investment decisions. (Graham is widely considered the father of financial ra�o analysis, and wrote or co-wrote two books that are s�ll considered classics: Security Analysis [2008], wri�en with David Dodd and originally published in 1934, and The Intelligent Investor [2006], first published in 1949.)

Fundamental analysis uses financial ra�os, among other tools, to analyze a company's results. The ra�os analyze not only the financial health of a company, but also its management and compe��ve advantages. Further, fundamental analysts also review current economic and poli�cal condi�ons to determine their impact on the company's current or past results, and to make projec�ons about future results.

One of Buffet's strategies was to not just buy a few shares of stock, but instead buy en�re companies and then serve on their Boards of Directors. Among the more than 50 en��es currently owned by Berkshire Hathaway are GEICO Auto Insurance, Benjamin Moore & Co., and Fruit of the Loom.

The insurance provider GEICO has been one of Buffet's most lucra�ve investments. His first purchase of GEICO was in the 1970s, and he con�nued buying shares through 1981. At that point, he had stock valued at $45.7 million, which represented a 30% stake. He bought the rest of the company for $2.3 billion in 1995. Buffe� reported in Berkshire's 2009 report that GEICO's market share had increased from 2.5% to 8.1% since the deal.

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Buffe� is well known for two quotes that explain his stock buying approaches. He explains his primary strategy: "Most people get interested in stocks when everyone else is. The �me to get interested is when no one else is. You can't buy what is popular and do well." He also says, "Only buy something that you'd be perfectly happy to hold if the market shut down for 10 years." Buffet has also famously advised investors to only buy into companies whose businesses they understand.

Consider This:

1. Why do you think Buffet's buy and hold strategy has been so successful? Do you think his ac�ons help or harm the companies he buys? 2. Based on what you've learned about his inves�ng strategy, what types of informa�on would you expect Buffet to look for when reviewing a

company's financial reports?

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6.1 How Financial Ra�os Are Used As discussed in Chapter 1, various stakeholders, both internal and external to a company, will use financial ra�os in different ways:

Execu�ves and managers use financial ra�os to make key business decisions. For example, the Best General Company budget commi�ee can use these ra�os to determine the company's liquidity and profitability. By reviewing these trends, the commi�ee will know where improvement is needed and can make budget recommenda�ons for the next year. Creditors use financial ra�os to determine whether a company is a good risk before lending the company money. Vendors and suppliers use financial ra�os to determine whether to offer the company credit terms. Financial analysts use financial ra�os to evaluate a company and prepare reports for investors and creditors. Financial reporters use financial ra�os to develop stories about companies. Compe�tors use financial ra�os to compare the results of their companies to those of others in the same industry.

All stakeholders use these ra�os as a tool to compare results. However, a financial ra�o on its own does not reveal much about a company. It is cri�cal to compare the financial ra�o calcula�on either to similar calcula�ons for prior accoun�ng periods (to determine trends for the company), or to similar companies or to the industry as a whole (to determine how well the company performed compared to others). In "World of Business," we introduce sources for finding informa�on about industry trends.

As we explore ra�os in this chapter, we will discuss what they are and how to use the results from these ra�os to make informed managerial decisions. We will con�nue to use the financial statements of Best General Company to calculate each ra�o.

World of Business

Sources for Industry Sta�s�cs

One way managers determine how well their company is performing compared to similar companies is to use industry financial ra�os as a benchmark for their company. For example, if profitability ra�os show their company is earning less profit than those of compe�tors, managers must inves�gate why the company is not as profitable.

Where do managers get their informa�on? Table 6.1 lists sources for industry data that can be found in most business libraries.

Table 6.1: Sources for industry data

Source Informa�on provided

Almanac of Business and Industrial Financial Ra�os. Englewood Cliffs, NJ: Pren�ce Hall. Annual publica�on.

Informa�on about 180 different types of businesses are collected using the tax returns of almost five million U.S. and interna�onal companies. Readers can find calcula�ons for 50 opera�ng and financial ra�os in 199 industries. It also provides performance indicators for the past 10 years.

Industry Norms and Key Business Ra�os. Murray Hill, NJ: Dun & Bradstreet Credit Services. Annual publica�on.

Managers can find coverage for over 800 lines of businesses. The data includes 14 key business ra�os, balance sheets and income statements, and common-sized financial figures.

IRS Corporate Financial Ra�os. Evanston, IL: Schonfeld and Associates. Annual publica�on.

Managers can find 76 key financial ra�os calculated from the latest income statement and balance sheet data available from IRS corporate tax returns.

RMA Annual Statement Studies. Philadelphia, PA: Risk Management Associa�on. Annual publica�on.

Managers can find informa�on about more than 500 business lines. Common-sized financial statements for each industry are included with 16 commonly used financial ra�os.

Consider This:

1. What type of informa�on would you be likely to seek when using one of these sources? 2. Think of a project you have done for your boss. What types of informa�on did you need to gather, and would any of these sources have been

helpful? If so, which, and why?

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When analyzing a company like GE that operates in many different industries, it can be difficult to choose compe�tors for comparison.

Gene J. Puskar/Associated Press

6.2 The Limita�ons of Financial Ra�os Before we explore financial ra�os in detail, it is important to note a few of the factors that limit their usefulness. Some�mes the way the company is structured can make it difficult to analyze a par�cular type of business. Infla�on can impact the analysis of business trends. Seasonality and accoun�ng methods can also limit the usefulness of these ra�os. We take a closer look at these and other limita�ons below.

Conglomerates

Some companies operate divisions in mul�ple, some�mes widely different, industries. For example, General Electric (GE) has divisions in avia�on, power and water, electrical technologies, wind energy, fiber op�cs, imaging, appliances, and ligh�ng. Samsung makes everything from mobile phones to computers and cameras to home appliances.

When analyzing a company that operates in many different industries, deciding which industry ra�os to use may be difficult. It may also be difficult to determine which compe�tors to include for useful comparisons.

Infla�on

When making comparisons over a number of years, infla�on can distort the results. This can impact profits (for example, if cost of goods sold go up, profits go down) and ul�mately affect the ra�o analysis when comparing month to month, quarter to quarter, or year to year.

Seasonality

Some industries have dras�cally different results during certain seasons. For example, it can be a challenge to analyze the financial results from quarter to quarter for any manufacturing or retail company that sells most of its product during the holiday season. Likewise, landscapers and landscape suppliers have busy seasons and extremely slow seasons.

Since seasonality factors can influence financial results, managers must be aware of any seasonal factors that affect an industry before deciding which financial ra�os to use and how to use them to determine trends and compare results. For example, the 2008 recession in the United States impacted financial results for several seasons. As we climb out of this recession it's important to note that a major growth spurt for a par�cular company may primarily be a product of economic recovery, not necessarily a seasonal improvement. The company may not necessarily be gaining market share, and the growth may not be sustainable. For example, the growth a company saw from the holiday season of 2012 to 2013 may be more related to coming out of a recession than a permanent increase in holiday season growth.

Accoun�ng Methods

As discussed in earlier chapters, companies in the same industry may use different accoun�ng methods. This can impact how and when a company recognizes revenue. For example, a company that sells computers and offers installa�on and training services would recognize some of the revenue at the �me the equipment is purchased, but would need to wait un�l installa�on is complete to recognize another por�on of that revenue. The final por�on for training would be recognized when training is completed.

A company with mixed revenue streams would state its accoun�ng methodology for recognizing revenue in the notes to the financial statements.

Another variable might be the way that a company manages its equipment. For example, one company might buy its equipment while another might primarily depend on leases. This will likely create a difference for some asset values as well.

How a company values inventory—some companies may use LIFO method, whereas others may use FIFO—can also result in a crucial difference in asset values. Whether a company uses a fiscal or calendar year can create difficul�es when comparing financial results.

Also note that a change in accoun�ng method will make comparing year to year results more difficult. For example, suppose a company switched from using LIFO to FIFO for inventory valua�on. Prior years' results would not be comparable un�l adjus�ng for the accoun�ng method change.

In sum, before star�ng to calculate financial ra�os, review the accoun�ng methods used to determine whether there could be significant differences among the companies being compared.

Fixed Assets at Cost

Assets are valued at cost and may not reflect the current market value of assets. This can distort ra�os that use asset values, especially when comparing a company with primarily older assets to a company just star�ng up. The company with older assets will likely have many of those assets fully depreciated or near full deprecia�on, while the newer company may just have purchased many similar types of assets.

Projec�ons About Future Trends

Financial ra�os are based on historical financial results and may not be predic�ve of a future financial trend. Some ra�os may provide a posi�ve picture of a company's financial results, while others give a nega�ve outlook.

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Whether posi�ve or nega�ve, managers, vendors, or creditors will consider the ra�os most relevant to the decision they are trying to make. For example, a creditor trying to make a decision about whether to lend a company money may put more weight on liquidity ra�os—that is, how much cash a company will have available to pay its bills—than profitability ra�os. As we explore each ra�o, we will discuss the types of decisions that might be predicated on each one.

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The values of assets and liabili�es on the balance sheet are cri�cal to calcula�ng many of the financial ra�os.

Many line items on the income statement are used for financial ra�o calcula�ons.

Many line items on the statement of cash flows are used for financial ra�o calcula�ons.

6.3 Types of Financial Ra�os Hundreds of different financial ra�os exist on the Internet and in financial analysis textbooks. As noted above, in this chapter, we will focus on the most commonly used ra�os in four key areas:

1. Liquidity ra�os: These ra�os measure the availability of cash to fund opera�ons and pay short-term or current debt. 2. Ac�vity ra�os: These ra�os measure how efficiently and effec�vely an organiza�on uses its resources. 3. Leverage ra�os: These ra�os measure whether a company can repay its long-term debt. 4. Profitability ra�os: These measure the company's rates of return from various perspec�ves.

As we explore each of these types of ra�os, we will use Best General Company as our example. We will calculate the ra�os from Chapter 2's balance sheet, Chapter 3's income statement, and Chapter 4's statement of cash flows. We repeat these figures here as Figures 6.1, 6.2, and 6.3.

Figure 6.1: Best General Company balance sheet

Figure 6.2: Best General Company income statement

Figure 6.3: Best General Company statement of cash flows

Liquidity Ra�os and How to Calculate Them

Liquidity ra�os measure the quality of current assets and whether these assets are sufficient to meet current obliga�ons as they become due. Essen�ally, these help determine whether a company has enough current assets to quickly turn into cash to meet its current liabili�es—its short-term (less than 12 months) bills.

Liquidity ra�os may be more cri�cal for companies whose cash inflows are erra�c, such as retail companies, airline companies, and manufacturing companies. For example, retail and manufacturing companies are dependent on consumer purchases, which o�en are driven by seasonal celebra�ons, such as Christmas, or periodic needs, such as back-to-school purchases. Airlines, also, are busiest during seasonal periods.

All these industries can experience great fluctua�ons in sales volume and resultant cash flow problems. This is because the more erra�c cash flow is for a company, the more cri�cal it is that the company have a financial cushion to be able to pay its bills in �mes where sales are slow. Liquidity ra�os may therefore be less cri�cal for companies with a stable cash flow, such as u�lity companies, or companies that provide the basics of daily life, including food, fuel, and healthcare.

The liquidity ra�os we will explore include the current ra�o, the quick ra�o (also known as the acid test ra�o), and the current cash debt coverage ra�o.

Current Ra�o

The current ra�o seeks to determine whether the company has the ability to pay its current obliga�ons. Generally, the higher the current ra�o, the be�er the company will appear to creditors.

The current ra�o is calculated by dividing total current assets by total current liabili�es. These numbers can be found on the balance sheet. Here is what the formula looks like:

Current Ratio = Total Current Assets Total Current Liabilities

We prac�ce using this formula by calcula�ng the current ra�o for Best General Company, using the balance sheet in Figure 6.1.

Current Ratio = $62,000 $55,300 = 1.12

Any number higher than 1.0 means that the company has more than enough current assets to pay its current bills. Creditors prefer to see a number of at least 1.2 to 1.5 to be sure there is some cushion in case of an economic downturn.

Managers and investors may ques�on the way the company is using its current assets when the number is higher than 2.0, because that may mean the company is not taking full advantage of the assets on hand. For example, if a company holds so much cash that it can pay its bills twice, managers and investors may wonder if there is a be�er use for the cash, such as inves�ng it to grow the company.

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As the numbers above indicate, Best General Company maintains a current ra�o that is a bit lower than creditors like to see, but s�ll above 1.0. To reach the more desirable level of 1.2 to 1.5, the budget commi�ee needs to recommend ac�ons that could either increase current assets, such as genera�ng more cash by developing a new target market, or reducing current liabili�es by reducing short-term debt.

Quick Ra�o

The quick ra�o, also called the acid test ra�o, is a stricter, more conserva�ve measure of whether the company has the money to pay its bills. This ra�o includes only the most liquid assets—cash, cash equivalents (such as cer�ficates of deposit, money market funds, and marketable securi�es), and accounts receivable. All these assets can be quickly converted to cash if needed.

The primary current asset le� out of this calcula�on is inventory, because inventory may or may not be liquid, depending on the industry and the economic environment.

The quick ra�o is calculated by dividing the sum of cash, cash equivalents, and accounts receivable by total current liabili�es. These numbers can all be found on the balance sheet. Here is what the formula looks like:

Quick Ratio = Cash + Cash Equivalents + Accounts Receivable Total Current Liabilities

We prac�ce using this formula by calcula�ng the quick ra�o for Best General Company.

Best General Company Quick Ratio = $8,400 + $7,800 $55,300 = 0.29

Generally, creditors prefer to see a value of at least 1.0 for this ra�o. If the number is lower than 1.0, it means that the company may be too dependent on the sales of inventory. If the economy slows down and inventory cannot be sold, the company may need to take on short-term debt to meet its obliga�ons.

As the numbers indicate above, Best General Company's quick ra�o is significantly below 1.0. If the managers of Best General Company find they need to borrow money, they will probably not be offered the best interest rates. Mai, the purchasing manager, would assist the budget commi�ee with developing recommenda�ons to reduce inventory on hand to generate the needed cash to improve the company's creditworthiness.

Some industries do tradi�onally have lower quick ra�os, so the Best General Company budget commi�ee should find out what quick ra�o is common for its industry and develop recommenda�ons to a�ain that level.

Current Cash Debt Coverage Ra�o

Creditors and investors also need to look at whether cash from opera�ng ac�vi�es is enough to pay the short-term obliga�ons of a company. The current cash debt coverage ra�o uses informa�on from both the balance sheet (Figure 6.1) and the statement of cash flows (Figure 6.3). Using this ra�o, a manager or analyst can be�er determine whether the actual opera�ons of the company are sufficient to pay its bills.

The current cash debt coverage ra�o is calculated by dividing net cash provided by opera�ng ac�vi�es by average current liabili�es. Net cash provided by opera�ng ac�vi�es can be found on the statement of cash flows. The average current liabili�es will need to be calculated by adding the current year balance and prior year balance and then dividing by 2. Here is what the formula looks like:

Current Cash Debt Coverage Ratio = Net Cash Provided by Operating Activities Average Current Liabilities

We prac�ce using this formula by calcula�ng the current cash debt coverage ra�o for Best General Company.

First we calculate the average current liabili�es for the company:

Best General Company = $55,200 + $55,300 2 = $55,250

Then we calculate the current cash debt coverage ra�o for the company:

Best General Company Current Cash Debt Coverage Ratio = $3,450 $55,250 = 0.06

As with the current ra�o and quick ra�o, the higher the current cash debt coverage ra�o, the be�er. If the company has a nega�ve cash flow from opera�ons, this may be a warning sign that the company is headed for financial difficul�es, if not bankruptcy.

Bob, the financial analyst leading the Best General Company budget commi�ee, would certainly need to recommend significant changes to improve the cash flow from opera�ng ac�vi�es. A company in this posi�on would likely need to find new sources of revenue, as well as develop plans to cut opera�ng costs, to improve its financial picture.

Table 6.2 summarizes the liquidity ra�os we have discussed.

Table 6.2: Summary of liquidity ra�os

Ra�o Purpose Calcula�on

Current ra�o Determines whether the company has the ability to pay its current bills

Total Current Assets Total Current Liabili�es

Quick (acid test) ra�o

More conserva�ve measure of the company's ability to pay its current bills

Cash + Cash Equivalents + Accounts Receivables Total Current Liabili�es

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Current cash debt coverage ra�o

Measures the company's ability to pay its current bills with cash from opera�ng ac�vi�es

Net Cash Provided by Opera�ng Ac�vi�es Average Current Liabili�es

Task Box 6.1: Calcula�ng Liquidity Ra�os

Analyzing Industry Compe�tors, Part K

Prac�ce calcula�ng liquidity ra�os using the financial statements of the two companies that you have chosen to compare and analyze (see Task Box 2.9 (h�p://content.thuzelearning.com/books/AUOMM622.14.1/sec�ons/sec2.3#task2.9) ).

Do the companies have the ability to pay their current liabili�es? If so, why? If not, why not?

Will the bank loan them money? If so, will the loans be made at prevailing interest rates or will the company likely need to pay higher interest rates? Why do you reach that conclusion?

Ac�vity Ra�os and How to Calculate Them

Ac�vity ra�os measure how effec�vely a company uses its resources by comparing financial results for certain key ac�vi�es. These ra�os, also called turnover ra�os, help gauge how well a company is managing its assets and liabili�es.

We will explore four turnover ra�os that measure the turnover of accounts receivable, inventory, total assets, and accounts payable. The turnover ra�os measure how many days it takes to collect assets, sell inventory, or pay liabili�es.

Accounts Receivable Turnover Ra�o

The accounts receivable turnover ra�o measures how many �mes receivables turn over during the year. The higher the number, the shorter the �me between sales of products and collec�on of cash from customers.

The ra�o can indicate whether the company may experience a liquidity problem if cash collec�ons from customers slow down. If cash inflow slows, the company could have a problem paying its bills. Some companies solve the problem by selling their accounts receivable at a discount. They get less total cash for the receivables, but they can get a needed cash influx more quickly.

The limita�on of this ra�o is that it looks at a 12-month period and does not track fluctua�ons in companies whose cash inflow may be seasonally driven. One way to adjust for this is to calculate the turnover on a quarter-to-quarter or month-to-month basis.

Seasonal companies will need to stock their shelves to different levels depending on the �me of year. For example, a toy store sells toys throughout the year but may sell as much as 50% of its inventory during the holiday rush in November and December. A ra�o that tries to smooth this out over 12 months will not accurately reflect this company's ability to move, or turn over, its inventory at the most crucial �me of the year. If managers want to test this company's turnover, the most crucial �me to test would be the fourth quarter of the current year compared to the fourth quarter of the previous year, to see how well the company did during its most important quarter from year to year.

The number can also be distorted if the company sells primarily to customers who pay cash rather than buy using store credit. An employee a�emp�ng to calculate the accounts receivable turnover for his own company should use the number for net sales on store credit rather than the net sales number from the income statement. For example, suppose a company sells $1 million in product and 50% of the sales are on store credit. Those sales on store credit would be added to the accounts receivable account. When calcula�ng this ra�o, $500,000 would be used as the net credit sales number to measure the accounts receivable turnover.

The accounts receivable turnover ra�o is calculated by dividing net credit sales (or the net sales number from the income statement in Figure 6.2, if net credit sales are not known) by average accounts receivable. Here is what the formula looks like:

Accounts Receivable Turnover Ratio = Net Credit Sales ( or Net Sales ) Average Accounts Receivable

Average accounts receivable is calculated by adding the prior year's accounts receivable balance found on the balance sheet (Figure 6.1) plus the current year's accounts receivable balance and then dividing by 2.

In addi�on to calcula�ng the turnover ra�o, a manager can pinpoint the number of days unpaid customer balances remain in accounts receivable by dividing 365 by the accounts receivable turnover ra�o just calculated. Calcula�ng this number for three to five years can help determine whether collec�ons from customers are slowing down, which can be an indica�on of cash flow problems ahead.

Here is what the formula for days unpaid customer accounts in receivables looks like:

Days Unpaid Customer Accounts in Receivables = 365 Accounts Receivable Turnover Ratio

We prac�ce calcula�ng the accounts receivable turnover ra�o and the days unpaid customer accounts in receivables number for Best General Company.

First we need to calculate average accounts receivable:

Best General Company Average Accounts Receivable = $7,200 + $7,800 2 = $7,500

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Next we calculate the accounts receivable turnover ra�o:

Best General Company Accounts Receivable Turnover Ratio = $100,000 $7,500 = 13.33

Finally we calculate the number of days it takes for customers to pay their acounts in receivables:

Best General Company Days Sales in Receivables = 365 13.33 = 27.4 days

Best General Company is taking 27.4 days to collect from the customers who buy using store credit rather than pay with cash or a third-party credit card. Since this is less than 30 days, the ra�o shows an acceptable collec�on policy. Most customers are paying quickly, and the company is genera�ng a reasonable cash flow from customers who pay using credit. The quicker a company gets paid, the be�er the cash flow.

The budget commi�ee could review industry sta�s�cs to find out what is normal for companies similar to Best General Company, but usually collec�ng from customers in under 30 days is considered good. Whether the turnover is good or bad will be based on what the normal collec�on rate is for the industry.

Inventory Turnover Ra�o

The inventory turnover ra�o measures the liquidity of inventory. Using this ra�o, analysts can determine how many �mes the company sold and replaced its inventory during an accoun�ng period.

To calculate the ra�o, use the cost of goods sold number from the income statement (Figure 6.2). Then calculate the average inventory on hand by adding the beginning inventory (inventory as of the first of the year, which will be the same as the ending inventory for the prior year and can be found on the balance sheet) and ending inventory (ending inventory for the current year, which can also be found on the balance sheet) and then divide the total by 2. Here is what the formula looks like:

Inventory Turnover Ratio = Cost of Goods Sold Average Inventory

Once the turnover ra�o is found, use the next formula to determine the number of days inventory is held by the company before being sold. Here is what the formula looks like:

Days Sales in Inventory = 365 Inventory Turnover Ratio

There are some limita�ons to this calcula�on because some inventory may move quickly and other inventory may sit on the shelves for months. An external financial report reader has no way to dis�nguish among the different types of inventory. However, execu�ves and managers in the company will likely get reports that show inventory turnover numbers for each product line, so they can track inventory turnover by product.

We prac�ce using the inventory turnover by calcula�ng ra�os for the Best General Company.

First we need to calculate average inventory for Best General Company:

Best General Company Average Inventory = $38,000 + $40,000 2 = $39,000

Next we calculate the inventory turnover ra�o:

Best General Company Inventory Turnover Ratio = $73,000 $39,000 = 1.87

Finally we calculate the number of days sales in inventory:

Best General Company Days Sales in Inventory = 365 1.87 = 195.2 days

This ra�o shows it is taking, on average, 195 days for Best General Company to sell each piece of inventory. Some types of inventory may sell faster and some types may sell slower. However, taking over three months to sell inventory would make it hard for any company to maintain its cash flow.

The Best General Company budget commi�ee members would need to inves�gate further which inventory is selling slowly and which inventory is selling more quickly. Mai, as the purchasing manager, would likely be tasked with this project. The commi�ee would then need to make recommenda�ons for changes in its inventory purchasing or manufacturing processes, in addi�on to changes in marke�ng and sales. We know from reviewing the balance sheet that inventory on hand increased from 2012 to 2013, so that, too, shows a trend in the wrong direc�on.

Total Asset Turnover Ra�o

The total asset turnover ra�o measures how efficiently a company is using its assets to generate sales. The turnover number equals the amount generated in sales for every dollar invested. The ra�o is calculated by dividing net sales found on the income statement by the average of total assets found on the balance sheet. (The average of total assets is calculated by adding the total assets from the prior year to the total assets of the current year and then dividing by 2.) Here is what the formula looks like:

Total Asset Turnover Ratio = Net Sales Average Total Assets

Let's prac�ce using this formula by calcula�ng the total asset turnover ra�o for Best General Company.

First, we need to calculate average of total assets for the current year:

Best General Company Total Average Assets = 197,200 + 198,100 2 = 197,650

Next, let's prac�ce using this formula by calcula�ng the total asset turnover ra�o for Best General Company:

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Best General Company Total Asset Turnover Ratio = $100,000 $197,650 = 0.51

Best General Company is genera�ng $0.51 in revenue for every $1.00 spent on assets. Whether this is a reasonable number depends on what is common for other companies in this field. Manufacturing companies, which must maintain factories, generally have a lower asset turnover ra�o because their fixed asset costs (such as factories) are much higher than a company that purchases, rather than produces, its inventory.

Accounts Payable Turnover Ra�o

The accounts payable turnover ra�o, also known as the creditors turnover ra�o, measures the number of �mes the accounts payables are paid during an accoun�ng period. Once that turnover ra�o is known, we can use it to calculate the number of days it takes for a company to pay its bills.

Ideally, to calculate this ra�o, we use the net credit purchases number, but external financial report readers will not have access to that informa�on. If the net credit purchases number is not available, use the Cost of Goods Sold number found on the income statement (which will reflect the total purchases).

The accounts payable turnover ra�o is calculated by dividing net credit purchases (or Cost of Goods Sold) by the Average Accounts Payable. (Average Accounts Payable can be calculated by adding the prior year's Accounts Payable on the balance sheet to the current year's Accounts Payable and dividing by 2.) Here is what the formula looks like:

Accounts Payable Turnover Ratio = Net Credit Purchases (or Costs of Goods Sold ) Average Accounts Payable

Then the days in payables is calculated.

Days in Payables = 365 Accounts Payable Turnover Ratio

We prac�ce using this ra�o by calcula�ng the ra�o for Best General Company.

First we need to calculate average accounts payable for Best General Company:

Best General Company Average Accounts Payable = $9,400 + $8,900 2 = $9,150

Next we calculate the accounts payable turnover ra�o:

Best General Company Accounts Payable Turnover Ratio = $73,000 $9,150 = 7.98

Finally we calculate the number of days in payables:

Best General Company Days in Payables = 365 7.98 = 45.7 days

Best General Company takes an average of 45.7 days to pay its bills. Vendors and suppliers look carefully at this number when nego�a�ng contracts. The number of days it will take them to get paid can be a big factor in the costs of supplying goods or services to a company.

Accoun�ng managers also keep a close eye on this number to be sure the turnover ra�o meets the goals set for the department. Higher-level execu�ves and managers also watch this number because it can impact their ability to do business with others, including creditors, suppliers, and vendors.

Table 6.3 summarizes the ac�vity ra�os we have discussed.

Table 6.3: Ac�vity ra�os

Ra�o Purpose Calcula�on

Accounts receivable turnover ra�o

Determines how long it takes for customers to pay their bills

Net Credit Sales ( or Net Sales ) Average Accounts Receivable*

Inventory turnover ra�o

Determines how long it takes for the company to sell its products or services

Cost of Goods Sold Average Inventory*

Total assets turnover ra�o

Determines the efficiency of the company's use of its assets

Net Sales Average Total Assets

Accounts payable turnover ra�o

Determines how long it takes for the company to pay its current bills

Net Credit Purchases ( or Cost of Goods Sold ) Average Accounts Payable*

**Divide 365 by turnover ra�o to find number of days in accounts receivable, inventory, and accounts payable

Task Box 6.2: Prac�cing Ac�vity Ra�os

Analyzing Industry Compe�tors, Part L

Prac�ce using the ac�vity ra�os by calcula�ng them for the two companies you have chosen to compare. How do the companies compare in terms of collec�ng from customers, selling inventory, efficiently using their assets to generate sales, and paying their bills? Explain why you've reached those conclusions.

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Leverage Ra�os and How to Calculate Them

Leverage ra�os measure how much total debt a company owes to its creditors and whether it can pay its long-term debt obliga�ons. Leverage is the degree to which the business borrows money. By using leverage, a company's cash can go a lot further.

For example, when a company buys a building using leverage (a mortgage) and cash, it will likely only use a small por�on of its cash as a down payment and borrow the rest. Suppose the building cost $4 million and the company must put down 20%, or $800,000. It then finances the rest with a mortgage. While it may be easy for a large company with billions of dollars in cash to buy the building using cash, most companies do not have $4 million si�ng around for the purchase of a building. Even if a company does have that much cash on hand, it will likely ask whether that is a good use of it. Leverage ra�os can help determine that answer.

Businesses with a lot of debt (or leverage) in rela�on to their equity can be more vulnerable to an economic downturn than those with lower levels of debt. Debt will need to be paid regardless of whether a company is genera�ng revenue to pay that debt. So a higher level of debt makes a company more vulnerable in a downturn when revenues tend to decrease. Banks will see this higher level of debt as risk, so companies carrying high levels of debt will likely pay higher interest rates as well. This can make leverage more expensive for them.

The levels of debt carried by companies will vary by industry. When looking at debt measures, an analyst can draw a conclusion about the financial health of a company only by comparing its debt levels to those of other companies in the same industry. For example, manufacturing companies that must buy significant amounts of plant and equipment to operate will carry higher levels of debt than service companies that do not have the same fixed-cost obliga�ons.

We explore five leverage ra�os in this sec�on: the debt to equity ra�o, the interest coverage ra�o, the debt to capital ra�o, the cash debt coverage ra�o, and the cash flow coverage ra�o.

Debt to Equity Ra�o

When a company decides to take on a major project that will require an infusion of cash that the company does not have on hand, execu�ves must decide whether to raise that cash by (1) taking on more debt or (2) selling shares of stock (equity). If company management chooses to use debt, it may sell bonds or take a long-term loan, such as a mortgage on a new plant or other building. When a company uses such leverage, it must pay back both the principal and interest. However, when a company chooses to sell stock (equity), it does not have to pay back the investors or make interest payments.

Therefore, companies need to find the right mix of debt and equity financing. Too much debt can be risky—it could mean that during a downturn the company might not be able to pay the interest on the debt. It can also be costly—ongoing interest payments must be made regardless of whether the company is earning enough money to pay. In addi�on to the interest payments, the company will likely need to pay down part of the principal each year.

The debt to equity ra�o indicates how much a company allocates each year to debt versus equity. It is calculated by dividing Total Liabili�es by Total Shareholders' Equity (two line items on the balance sheet). Here is what the formula looks like:

Debt to Equity Ratio = Total Liabilities Total Shareholders' Equity

We prac�ce calcula�ng this ra�o using the balance sheet of Best General Company.

Best General Company's Debt to Equity Ratio = $169,750 $27,450 = 6.18

Generally, lenders and creditors look for a number close to 1.0 for this ra�o, which would be an equal split between debt and equity. Best General Company is heavily laden with debt and a very small propor�on of shareholders' equity. Few companies with this debt to equity ra�o would be able to seek addi�onal debt for future cash needs. Best General Company should consider recommenda�ons to either lower the company's debt burden or increase cash investments in the company.

Interest Coverage Ra�o

The interest coverage ra�o measures whether the company can pay its interest on both short-term and long-term debt using its earnings. The ra�o is calculated by dividing Earnings Before Interest and Taxes (EBIT) (found on the income statement) by Interest Expense (found on the income statement). Here is what the formula looks like:

Interest Coverage Ratio = Earnings Before Interest and Taxes ( EBIT ) Interest Expense

The higher the ra�o, the be�er. An interest coverage ra�o of less than 1.5 could mean the company may have difficulty mee�ng its debt obliga�ons. If the number is below 1.0, the company is not genera�ng enough revenues to pay its interest expenses and could be near bankruptcy.

We prac�ce calcula�ng the interest coverage ra�o for the Best General Company. Best General Company does not show this number on the income statement, so we must first calculate the EBIT before calcula�ng the ra�o. We see at the bo�om of the statement of cash flows that the company paid $800 in interest and $150 in taxes. To calculate EBIT, we would add $2,500 in Other Income to the opera�ng profit of $4,500 to find earnings before interest and taxes. We will assume that the $800 in Other Expenses were for interest, so we only need to subtract $100 from the Other Expenses of $900. So EBIT would be $4,500 + $2,500 − $100 = $6,900:

Best General Company's Interest Coverage Ratio = $6,900 $800 = 8.63

We can see from calcula�ng this ra�o that the company earns 8.63 �mes the interest, which is more than enough to pay its interest expenses. Looking only at this ra�o, the budget commi�ee can see the company is genera�ng more than enough cash to avoid defaul�ng on debt.

Debt to Capital Ra�o

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The debt to capital ra�o measures what por�on of a company's capital comes from debt financing. Lenders monitor this number closely and o�en place debt to capital ra�o requirements in the terms of credit agreements for a company. If a company's debt builds above what lenders allow, the lender can call the loan, which means the company must repay the loan immediately. If a loan is called, the company must then seek other financing to pay it off, which likely will have less favorable terms with a higher interest rate. Managers must keep a close watch on these lenders' terms to avoid a problem with their lenders and their company borrowings.

The debt to capital ra�o is calculated by dividing total debt by total capital. We divide total liabili�es by the sum of total liabili�es plus shareholders' equity on the balance sheet. Some analysts break this down in a more complex way, but most believe the informa�on gathered from the simpler form of the ra�o is sufficient. Here is what the formula looks like:

Debt to Capital Ratio = Total Liabilities Total Liabilities + Shareholders' Equity

Generally, lenders look for a debt to capital ra�o of 0.35 or less. If a debt to capital ra�o falls above 0.50, lenders consider the company to be a much higher credit risk, which means the company could have a harder �me ge�ng a loan or have to pay much higher interest rates. Again, this is dependent on industries. Some industries do have much higher debt to capital ra�os than others, so it is important to know what is common in the industry the financial report reader is analyzing.

We prac�ce calcula�ng the debt to capital ra�o using the balance sheet of the Best General Company.

Best General Company's Debt to Capital Ratio = $169,750 $197,200 = 0.86

Clearly, Best General Company carries a higher level of debt than is preferred by lenders. The company would likely be considered a high credit risk and may have difficulty ge�ng new financing.

Cash Debt Coverage Ra�o

The cash debt coverage ra�o measures whether a company can pay its debt over the long term. Long-term liabili�es include all debt that will need to be paid beyond the current 12-month period. If long-term debt is too high, the company will eventually have trouble paying off its debt and mee�ng its interest obliga�ons.

The cash debt coverage ra�o is calculated by dividing Net Cash Provided by Opera�ng Ac�vi�es (found on the statement of cash flows) by Average Total Liabili�es (based on informa�on on the balance sheet). Average Total Liabili�es is calculated by adding the current total liabili�es to the prior year's total liabili�es and dividing by 2. The formula looks like this:

Cash Debt Coverage Ratio = Net Cash Provided by Operating Activities Average Total Liabilities

This number shows what percentage of a company's cash from opera�ons is needed to meet its debt obliga�ons. If opera�ons do not provide enough cash, the company would need to either borrow money or issue shares of stock to raise cash. Therefore, the higher the ra�o, the be�er.

If the Net Cash Provided by Opera�ng Ac�vi�es is a nega�ve number, the company likely is going to have a hard �me paying its liabili�es. Some startup companies or companies in the early growth phase may have cash to use from investors un�l their product is developed and ready for sale on the market. If this is the case, a nega�ve cash flow would not be as cri�cal.

We prac�ce calcula�ng this ra�o using the numbers for the Best General Company.

First we calculate the average total liabili�es:

Best General Company's Average Total Liabilities = $174,200 + $169,750 2 = $171,975

Then we calculate the cash debt coverage ra�o:

Best General Company's Cash Debt Coverage Ratio = $3,450 $171,975 = 0.02

As we have seen with other ra�os, the company is not genera�ng enough cash to pay its debts. The Best General Company budget commi�ee must develop recommenda�ons for genera�ng cash through new revenues and reducing opera�ng expenses. However, as is true for all ra�os, the commi�ee must know what is common for the industry to know how well the company is actually doing. Remember, no company needs to pay all its debt obliga�ons in one year. This ra�o does include long-term debt.

Cash Flow Coverage Ra�o

Businesses need cash to do more than just pay their debt obliga�ons. They must also use cash for expansion to grow the business, including building new plants and buying tools and equipment. The cash flow coverage ra�o shows what percentage of a company's cash requirements are paid from its opera�ng ac�vi�es. It measures the company's ability to pay its bills and grow the company. If the company pays dividends, that too will be taken into considera�on when calcula�ng this ra�o.

To calculate this ra�o, collect informa�on from the statement of cash flows, the balance sheet, and the income statement. To calculate the company's cash requirements, add the following accounts:

Accounts/item Loca�on

Capital Expenditures Inves�ng Ac�vi�es sec�on of the Statement of Cash Flows

+ Cash Dividends Financing Ac�vi�es sec�on of the Statement of Cash Flows

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+ Interest Expense Income Statement

+ Current Por�on of Long-Term Debt Balance Sheet

+ Short-Term Borrowing Balance Sheet

= Cash Requirements

Then divide Cash Provided by Opera�ng Ac�vi�es by the Cash Requirements. The formula looks like this:

Cash Flow Coverage Ratio = Net Cash Provided by Operating Activities Cash Requirements

We prac�ce calcula�ng this ra�o using the financial statements of Best General Company.

First, we must calculate the cash requirements:

Best General Company Cash Requirements = $800 (Interest Expense) + $26,000 (Short-Term Debt) = $26,800

Then we can calculate the cash flow coverage ra�o:

Best General Company's Cash Flow Coverage Ratio = $3,450 $26,800 = 0.13

The budget commi�ee needs to compare these numbers to what is common in Best General Company's industry to know how well the company is doing. One thing that is clear is that the company is not genera�ng enough cash from its opera�ng ac�vi�es to pay all its cash needs in a 12-month period. This is a cri�cal issue for the commi�ee to address.

Table 6.4 summarizes the leverage ra�os we have discussed.

Table 6.4: Leverage ra�os

Ra�o Purpose Calcula�on

Debt to equity ra�o

Measure how much debt a company carries versus its equity for debt

Total Liabili�es Total Shareholders' Equity

Interest coverage ra�o

Measures whether a company can pay its interest expenses Earnings Before Interest and Taxes ( EBIT ) Interest Expense

Debt to capital ra�o

Measures what por�on of the company's capital comes from debt Total Liabili�es Total Liabili�es + Total Shareholders' Equity

Cash debt coverage ra�o

Measures a company's ability to pay all debt obliga�ons by the cash generated from its opera�ons

Net Cash Provided by Opera�ng Ac�vi�es Average Total Liabili�es

Cash flow coverage ra�o

Measures a company's ability to meet all cash requirements from its opera�ons

Net Cash Provided by Opera�ng Ac�vi�es Cash Requirements

Task Box 6.3: Calcula�ng Leverage Ra�os

Analyzing Industry Compe�tors, Part M

Prac�ce calcula�ng leverage ra�os using the financial statements for the two companies you have chosen to analyze. Compare their debt levels and their ability to pay those debts. Which company is in a be�er posi�on? Why?

Profitability Ra�os and How to Calculate Them

Now we will look at profitability ra�os, which are commonly used to determine whether a company is profitable. Managers use these ra�os to be certain goals have been met and to measure their company's success in the industry.

Managers also have an obliga�on to manage profitability to benefit investors, for whom knowing whether a company is profitable is cri�cal in making a decision about whether they want to invest in a company or sell the investment they already have. Investors not only include those who buy the stock on the open market, but also private investors.

Creditors may also look at profitability ra�os, but for them the more cri�cal ra�os are those related to whether the company will be able to pay its debt obliga�ons.

The profitability ra�os we explore include the price/earnings ra�o, the net profit ra�o, cash flow margin, the dividend yield ra�o, return on assets ra�o, and return on equity ra�o.

Price/Earnings Ra�o

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When it comes to the financial press, the ra�o probably discussed most o�en is the price/earnings (P/E) ra�o, which measures the price of a company's stock versus its earnings. Two numbers are used in this calcula�on: the earnings per share and the current price of the stock.

The earnings per share shows how much profit the company earned per share of stock held by investors. Investors include those who bought stock on the public market, as well as those who started the company, employees of the company, and anyone else who owns stock.

This ra�o is very important to managers who want to a�ract investors to the company, especially if managers are considering issuing new stock. The higher the price of the stock, the more money can be raised if new stock is to be issued or shares held by the company are to be sold.

The number of shares on the market for a 12-month period can vary greatly because shares can be issued throughout the year to employees or outside investors. Shares can also be bought back from the public. The company will include a weighted average number of shares on the market at the bo�om of its income statement along with an earnings per share number. We discussed this in Chapter 3.

The second number needed is the current price of the stock. This price is listed on financial websites that quote stock prices, such as Yahoo Finance or Google Finance. The basic calcula�on for the price/earnings ra�o is simple. Divide the price of the stock by the earnings per share. Here is what the formula looks like:

Price / Earnings (P / E) Ratio = Market Price per Share Earnings per Share

O�en, the price/earnings ra�o for companies is published online.

Let's prac�ce calcula�ng the price/earnings ra�o for IBM and 3M. (Best General Company is not sold on the public markets, so there would be no way to calculate its price/earnings ra�o.) The calcula�ons in this chapter will use the price from December 31, 2012. An analyst can use the price per share from any date that enables him to make the decision he needs to make.

IBM's Price/Earnings Ratio = $191.55 $14.37 = 13.33 3M's Price/Earnings Ratio = $92.85 $6.32 = 14.69

Investors were willing to pay 13.33 �mes the earnings per share to buy IBM's stock on that date and 14.69 �mes the earnings per share to buy 3M's stock. Generally, investors consider a stock with a P/E ra�o over 15 to be riskier, but in some industries, a P/E of 20 to 25 is considered acceptable.

Note: In addi�on to the basic price/earnings ra�o, an investor may also want to look at the trailing price/earnings ra�o, which is calculated using informa�on from the previous four quarters or 12 months of earnings. This ra�o looks at the numbers from an historical perspec�ve. Another important ra�o is the leading or projected price/earnings ra�o, which is based on analysts' expecta�ons for the future of earnings of the company. Of course, it is important to note that any price/earnings ra�o based on future projec�ons is only as good as the analyst making the projec�on.

Net Profit Ra�o

The net profit ra�o measures the percentage of sales that resulted in a profit for the owners of the company. Essen�ally, this number measures the cushion a company has to con�nue opera�ng in bad �mes. The ra�o provides managers with a way to quickly assess whether a company will be able to meet a downturn in the economy, fight off strong compe��on, or con�nue to operate in a �me of slowing sales.

To calculate net profit ra�o, divide the Net Profit (Net Income) at the bo�om of the income statement by the Net Sales at the top of the income statement. The formula looks like this:

Net Profit Ratio = Net Profit ( Net Income ) Net Sales

We prac�ce calcula�ng the net profit ra�o for Best General Company.

Best General Company's Net Profit Ratio = $3,550 $100,000 = 0.04

The company earns in net profits $0.04 of every $1.00 it sells. The company has very li�le cushion to maintain profitability in a downturn. The budget commi�ee will certainly want to recommend ways to improve the net profit ra�o with strategies for increasing revenue, as well as cu�ng costs and expenses. To determine what the appropriate net profit ra�o is for any business, managers need to research the industry benchmarks and compare results to similar businesses.

Dividend Yield Ra�o

Investors want to know how much they are earning from the dividends a company pays. The dividend yield ra�o determines the effec�ve return an investor gets from the dividends paid. The ra�o is calculated by dividing the Dividends per Share (which can be found on the income statement) by the Price per Share (which can be found on a financial website). The formula looks like this:

Dividend Yield Ratio = Dividend per Share Market Price per Share

Since Best General Company is not a public company, we prac�ce calcula�ng the dividend yield ra�o using the income statements of IBM and 3M.

IBM's Dividend Yield Ratio = $3.30 $191.55 = 0.017 3M's Dividend Yield Ratio = $2.36 $92.85 = 0.025

IBM's dividend yield as of December 31, 2012 was 1.7%, and 3M's was 2.5%. Note that a company's dividend yield ra�o changes almost daily as its stock price goes up and down. Investors who use their por�olios to generate cash, such as re�rees who live on their cash flow from investments, watch dividend yield closely. The higher the ra�o, the happier investors will be. Investors will compare the dividend yield ra�o to investments in similar companies and likely choose the companies with the highest yields.

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Cash Flow Margin

Managers can test opera�ng performance in rela�onship to cash generated from opera�ons and sales. Remember, it is cash that a company needs to pay its debt and invest in new assets. Cash flow margin is calculated by dividing cash flow from opera�ng ac�vi�es (found on the statement of cash flows) by the net sales (found on the income statement). The formula looks like this:

Cash Flow Margin = Net Cash Provided by Operating Activities Net Sales

We prac�ce calcula�ng the cash flow margin for Best General Company:

Best General Company's Cash Flow Margin = $3,450 $100,000 = 3.5%

Best General Company cash flow from opera�ons in 2013 was 3.5%. This is a narrow margin and a downturn in the economy could push this into nega�ve territory. As we saw when calcula�ng the quick ra�o, Best General Company is having difficulty genera�ng enough cash from opera�ons to pay its debt or invest in new assets. The budget commi�ee would need to develop recommenda�ons to improve Best General Company's cash posi�on.

Return on Assets Ra�o

Managers, investors, and creditors want to know whether the company is managing its assets well. The return on assets (ROA) ra�o indicates how much a company earns from its assets or capital invested and how well the company uses its assets to generate a profit.

The return on assets ra�o is calculated by dividing the Net Income from the bo�om line of the income statement by the Total Assets on the balance sheet. Here is what the formula looks like:

Return on Assets Ratio = Net Income ( Net Profit ) Total Assets

We prac�ce calcula�ng the return on assets ra�o using the financial statements of Best General Company.

Best General Company's Return on Assets Ratio = $3,550 $197,200 = 0.02

Best General Company generates a return of 2 cents on every $1 of assets. To decide whether this is a good return, a manager or analyst compares the return on assets to other similar companies or to the industry. Note that the return on assets ra�o can vary significantly by type of industry. Manufacturing companies tend to use their capital to maintain manufacturing opera�ons with factories and high-priced equipment. They will tend to have a lower return on assets ra�o than service companies that don't have to invest a lot of fixed assets.

Return on Equity Ra�o

The return on equity (ROE) ra�o measures the return a company earns for its investors. The ra�o is calculated by dividing the Net Income by the Shareholders' Equity on the balance sheet. Here is what the formula looks like:

Return on Equity Ratio = Net Income ( Net Profit ) Total Shareholders' Equity

Note that this ra�o has limits because it looks only at income and does not include the impact of debt on profitability or its future earnings poten�al. The return on assets ra�o gives investors and creditors a be�er outlook for the company as a whole.

We prac�ce calcula�ng the return on equity ra�o using the financial statements of Best General Company:

Best General Company's Return on Equity Ratio = $3,550 $27,450 = 0.13

Best General Company earns just $0.13 for every $1.00 the owners of the company invested in the company. To determine if this is a reasonable return, an analyst needs to compare the return on equity to other similar companies.

Table 6.5 summarizes the profitability ra�os we have discussed.

Table 6.5: Profitability ra�os

Ra�o Purpose Calcula�on

Price/earnings (P/E) ra�o

Compares the market value of the stock to the earnings per share Market Price per Share Earnings per Share

Net profit ra�o Measures the percentage of profit the company earned from sales Net Profit ( Net Income ) Net Sales

Dividend yield ra�o

Measures the dividends paid to the shareholders versus the market value of the shares

Dividend per Share of Stock Market Price per Share of stock

Cash flow margin Measures opera�ng performance in rela�onship to cash generated from opera�ons and sales

Net Cash Flow from Opera�ng Ac�vi�es Net Sales

Return on assets ra�o

Measures how well a company is using its assets Net Income Total Assets

Return on equity ra�o

Measures how well a company is earning revenue for its investors Net Income Total Shareholders' Equity

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Task Box 6.4: Calcula�ng Profitability Ra�os

Analyzing Industry Compe�tors, Part N

Calculate the profitability ra�os for the two companies you have chosen to analyze. Which company is doing a be�er job for its investors? Why do you reach that conclusion?

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This budgeted income statement is for the fic��ous Everyday Foods Company. Comparing year-to-date budget to actual numbers helps managers determine where they may be off target. This exercise can also help them plan correc�ons to stay on budget or revise budget projec�ons, if necessary.

Comparing budget to actual numbers on a monthly basis helps managers quickly find where they may be off target. By reviewing budgets versus actual on a monthly basis, managers can make necessary changes more quickly to stay on target.

6.4 How Internal Reports Are Used to Make Decisions Employees and managers will have access to more informa�on and a greater variety of reports for their own company. In this sec�on, we will discuss and review examples of some common internal reports that managers use. Since there are no government requirements for internal repor�ng, the reports shown here may be different from those managers see in their jobs. A manager should always meet with her accoun�ng team to discuss the types of internal reports that will be useful for the departments she manages.

Budget vs. Actual Reports

Most companies go through a yearly exercise to develop a budget for the next year. This one-year budget is based on the results of the prior year with an adjustment for infla�on and the addi�on of any new projects.

Generally, the budge�ng process starts with the marke�ng and sales team, who forecast what sales will be for the next year, which sets a maximum for the budget. Generally, a company does not plan to spend more than the income it expects to make, unless it is a growth company developing new products without much income. In that case, the company will likely develop a budget based on the money it expects to get from investors, lenders, or both.

Budge�ng more than a company expects to earn is a recipe for financial suicide. Note that some companies even create a five-year budget projec�on. However, any long-term projec�on requires a lot of guesswork.

Smart companies then use these numbers throughout the year to gauge how well they are doing on a month-by-month basis. Some companies even compare their budgeted numbers to their actual numbers on a week-by-week basis if they are in an industry that changes that rapidly. For example, many major retailers, including Walmart, review their results week by week and adjust inventory ordering accordingly.

These companies prepare a budget vs. actual report for each of their managers based on the projected income statement. In doing so, they flag line items that do not match the budget. For example, line items over budget may print out in red ink, whereas line items under budget may print out in green ink. If the line item is within expected norms, it would print out in black ink. If color isn't possible, a company may use ↑ and ↓ arrows or another symbol that means something to its management team.

For example, suppose the line item for Sales is printed in red ink. The managers responsible for sales would need to find out why they are not mee�ng expecta�ons and fix the problem as soon as possible. If they determine that the lower sales are based on external forces, such as a downturn in the economy, the company may need to readjust its budget forecast and lower spending to avoid a major loss at the end of the year.

If the Sales line item prints out in green ink, that too could be a sign of a possible problem that needs to be fixed. If the company planned for a certain ac�vity level, it may need to adjust that level to meet unexpected demand. For example, a manufacturing company may need to expand its manufacturing hours to produce addi�onal product. A retail company may need to hire more sales staff to serve the influx of customers.

Whether a line item prints out in red or green (or with other designa�ons used to indicate a variance from the budget), decisions likely will need to be made for the actual use of assets and the company's ac�vity levels. Flags also may alert managers to rising costs for goods or services to be sold or to any other line item that shows a difference from what was budgeted.

A company would need to decide when the flag should appear, such as when an item is a certain percentage higher or lower than budgeted, or it may decide that a dollar amount difference should be flagged, or a combina�on of both measurements may be used. Spreadsheet programs can be designed to automa�cally generate flags. Figures 6.4 and 6.5 show the Budget versus Actual reports for a company called the Everyday Foods Company. Figure 6.4 shows the year-to-date report. Figure 6.5 shows a monthly report.

Figure 6.4: Everyday Foods Company year-to-date budgeted income statement

Figure 6.5: Everyday Foods Company monthly budgeted income statement

Note that in Figures 6.4 and 6.5, Cost of Goods Sold and Gross Profit percentage change of budget are both shown in red. The Costs of Goods Sold is higher than budgeted. This could be a sign that prices for goods being purchased for sale are higher than an�cipated. Management would want to quickly assess the reason for the difference and fix it. This may mean finding a new supplier or it may mean a sales price adjustment is needed. If neither is possible, the company would need to adjust its profit expecta�ons.

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The accounts receivable aging schedule gives managers a tool to discover which customers are behind on their payments. Based on company policy, some customer accounts will be frozen un�l the customer is up to date on payments.

The percentage change of budget for commission expenses are also shown in red in Figures 6.4 and 6.5. The sales manager would need to determine why commissions are higher than budgeted. Three of the line items are in green in Figures 6.4 and 6.5 because no money has been spent in those areas. As long as that is normal for the company because those expenses occur during other months, it is not a problem. If the report may be missing expenses that were not recorded, the manager for that department would need to discuss the missing expenses with the accoun�ng department. Deprecia�on does not show an expense on the monthly report. Many companies adjust deprecia�on expenses at the end of a quarter or end of a year, so it is common to see $0 on a monthly report.

Generally, it is easier to fix an accoun�ng problem as quickly as possible, while the informa�on is s�ll readily available. The other line items that are green are subtotals impacted by other ac�vity line items, so no specific ac�on would be needed.

Aging Schedule

Another key report accoun�ng and sales managers need to see is the aging schedule showing the customers who have not paid their bills on �me. This report shows when customers pay. If customers are behind, sales managers may want to cut off any new charges un�l the customer's payments are up to date. Figure 6.6 shows an example of an accounts receivable aging schedule.

Looking at the aging schedule in Figure 6.6, a manager could quickly see that three customers are more than 60 days late and two customers are over 90 days late. The sales managers may want to alert their sales staff not to accept addi�onal charges from the late payers. When a company decides to no longer accept orders from certain customers, the decision should be consistent for all customers and made according to the company's credit policies. The aging schedule helps managers to implement the credit rules.

Figure 6.6: Accounts receivable aging schedule

These two report samples, a budget versus actual report and an aging schedule, provide financial report readers with key informa�on collected by the financial accoun�ng staff. The reports do not require addi�onal input by staff. Once the design of an internal financial report has been developed, the report can be run in seconds each �me the execu�ve or managerial staff needs it.

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Summary and Resources

Chapter Summary

In this chapter, we explored how financial ra�os are used by key stakeholders, including managers, execu�ves, creditors, investors, vendors, financial analysts, financial reporters, and compe�tors. Creditors can use these ra�os to make a decision about whether to lend to a company, and if they do decide to lend, at what interest rate. Vendors and suppliers can determine whether to sell to a company on credit and how much credit they should offer the company. Investors use financial ra�os to help them determine whether to buy or sell stocks. The accuracy of ra�os does have some limita�ons and can be inaccurate because of factors such as infla�on, seasonality, accoun�ng methods, cost of fixed assets, and projec�ons about future trends. To measure how well a company is doing using ra�os, we examined how to calculate the following:

1. Liquidity ra�os: These ra�os measure the availability of cash to fund opera�ons and pay debt. 2. Ac�vity ra�os: These ra�os measure how efficiently and effec�vely an organiza�on uses it resources. 3. Leverage ra�os: These ra�os measure whether a company can repay its long-term debt. 4. Profitability ra�os: These measure the company's rates of return from various perspec�ves.

Companies do not operate in a vacuum. These ra�os do not mean much unless the manager compares them among similar companies and for the industry. The ra�os can also be used to measure trends for the same company by calcula�ng them for a three- to five-year period. We also discussed the value of internal financial repor�ng, which does not have the same restric�ons to meet GAAP standards as external financial repor�ng does. The primary purpose of internal repor�ng is to help execu�ves and managers make decisions. To give an example of how internal reports can be used, we provided samples of budget versus actual reports and an aging schedule for accounts receivable.

Takeaways for Chapter 6

Managers use ra�os to measure how well the company is doing in four key areas: liquidity, periodic ac�vity, leverage/debt, and profitability. Managers know a company does not operate in a vacuum, so ra�os for one accoun�ng period do not mean much; instead, they can be used to determine trends by comparing period to period within one company or to determine how the company is doing versus its compe�tors. Managers must consider the impact financial ra�os may have on the ability of the company to borrow money and sa�sfy their investors, creditors, and vendors.

Discussion Ques�ons

1. A�er you have calculated the current ra�os for Company A in the scenario above, would that company be a good risk for a bank loan? Why or why not? 2. A�er you have calculated the days in inventory for Company B in the scenario above, do you think the company may have trouble genera�ng cash from its

inventory and why or why not? 3. A�er you have calculated the interest coverage ra�o for Company A in the scenario above, do you think the company would have trouble paying its interest and

why or why not? 4. If a bank is planning to lend money to a company, which ra�os would it most likely use to make a determina�on? Why? 5. Investors are trying to decide whether to buy a stock. Which ra�os should they use and why should they choose those ra�os?

Further Reading/Resources

Graham, B., Dodd, D., & Buffe�, W. (2008). Security analysis, Sixth edi�on. New York, NY: McGraw-Hill.

Graham, B., Zweig, J., & Buffe�, W. (2006). The intelligent investor, Revised edi�on. New York, NY: Collins Business.

Industry norms and key business ra�os. Murray Hill, NJ: Dun & Bradstreet Credit Services. Annual.

IRS corporate financial ra�os. Evanston, IL: Shonfeld and Associates. Annual.

RMA annual statement studies. Philadelphia, PA: Risk Management Associa�on. Annual.

Troy, L. Almanac of business and industrial financial ra�os. Englewood Cliffs, NJ: Pren�ce Hall. Annual.

Key Terms

Click on each key term to see the defini�on.

accounts payable turnover ra�o (creditors turnover ra�o) (h�p://content.thuzelearning.com/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/c

Measures the number of �mes the accounts payables are paid during an accoun�ng period.

accounts receivable turnover ra�o (h�p://content.thuzelearning.com/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/c

Measures how many �mes receivables turn over during the year. The higher the number, the shorter the �me between sales of products and collec�on of cash from customers.

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ac�vity ra�os (h�p://content.thuzelearning.com/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/c

Measure how effec�vely a company uses its resources by comparing financial results for certain key ac�vi�es. These ra�os, also called turnover ra�os, help gauge how well a company is managing its assets and liabili�es.

budget vs. actual report (h�p://content.thuzelearning.com/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/c

A report that compares a company's budget to the actual numbers. This can be done monthly, quarterly, yearly, or at whatever interval a manager determines would be helpful for decision making.

cash debt coverage ra�o (h�p://content.thuzelearning.com/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/c

Measures whether a company can pay its debt over the long term. Long-term liabili�es include all debt that will need to be paid beyond the current 12-month period. If long-term debt is too high, the company will eventually have trouble paying off its debt and mee�ng its interest obliga�ons.

cash flow coverage ra�o (h�p://content.thuzelearning.com/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/c

Shows what percentage of a company's cash requirements are paid from its opera�ng ac�vi�es. It measures the company's ability to pay its bills and grow the company. If the company pays dividends, then that, too, will be taken into considera�on when calcula�ng this ra�o.

cash flow margin (h�p://content.thuzelearning.com/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/c

Measures how effec�vely a company converts its sales into cash.

current cash debt coverage ra�o (h�p://content.thuzelearning.com/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/c

Measures whether the actual opera�ons of the company are sufficient to pay its bills.

current ra�o (h�p://content.thuzelearning.com/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/c

Seeks to determine whether the company has the ability to pay its current obliga�ons. Generally, the higher the current ra�o, the be�er the company will appear to creditors.

debt to capital ra�o (h�p://content.thuzelearning.com/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/c

Measures what por�on of a company's capital comes from debt financing. Lenders monitor this number closely and o�en place debt to capital ra�o requirements in the terms of credit agreements for a company.

debt to equity ra�o (h�p://content.thuzelearning.com/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/c

Measures how much a company allocates each year to debt versus equity.

dividend yield ra�o (h�p://content.thuzelearning.com/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/c

Determines the effec�ve return an investor gets from the dividends paid.

financial ra�o analysis (h�p://content.thuzelearning.com/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/c

A group of financial tools used by managers to analyze informa�on in a company's financial statements. These ra�os can be used to compare current results to the results of previous years, as well as to compare the company's results to the industry and to compe�tors.

interest coverage ra�o (h�p://content.thuzelearning.com/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/c

Measures whether the company can pay its interest on both short-term and long-term debt using its earnings.

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inventory turnover ra�o (h�p://content.thuzelearning.com/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/c

Measures the liquidity of inventory. Using this ra�o, a manager can determine how many �mes the company sold and replaced its inventory during an accoun�ng period.

leverage (h�p://content.thuzelearning.com/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/c

The degree to which the business borrows money. By using leverage, a company's cash can go a lot further. For example, when a company buys a building using leverage (a mortgage) and cash, it will likely only use a small por�on of its cash as a down payment and borrow the rest.

leverage ra�os (h�p://content.thuzelearning.com/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/c

Measure how much total debt a company owes to its creditors and whether it can pay its long-term debt obliga�ons.

liquidity ra�os (h�p://content.thuzelearning.com/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/c

Measure the ability to generate enough money to pay the bills.

net profit ra�o (h�p://content.thuzelearning.com/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/c

Measures the percentage of sales that resulted in a profit for the owners of the company.

price/earnings (P/E) ra�o (h�p://content.thuzelearning.com/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/c

Measures the price of a company's stock versus its earnings.

profitability ra�os (h�p://content.thuzelearning.com/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/c

Enable managers to determine whether a company is profitable. Managers use these ra�os to test the company's profitability to be certain goals have been met and to compare their company's profitability to that of similar companies as a benchmark to measure its success within its industry.

quick ra�o (acid test ra�o) (h�p://content.thuzelearning.com/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/c

A stricter, more conserva�ve measure of whether the company has the money to pay its bills than the current ra�o. This ra�o includes only the most liquid assets— cash, cash equivalents (such as cer�ficates of deposit, money market funds, and marketable securi�es) and Accounts Receivables. All these assets can be quickly converted to cash if needed to pay the bills.

return on assets (ROA) ra�o (h�p://content.thuzelearning.com/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/c

How much a company earns from its assets or capital invested and how well the company uses its assets to generate a profit.

return on equity (ROE) ra�o (h�p://content.thuzelearning.com/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/c

Measures the return a company earns for its investors.

total asset turnover ra�o (h�p://content.thuzelearning.com/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/c

Measures how efficiently a company is using its assets to generate sales. The turnover number equals the amount generated in sales for every dollar invested.

turnover ra�os (h�p://content.thuzelearning.com/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/c

Measure how effec�vely a company uses its resources by comparing financial results for certain key ac�vi�es. These ra�os, also called ac�vity ra�os, help gauge how well a company is managing its assets and liabili�es.

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Glossary

account format One type of format for a balance sheet. Assets are shown on the le� and Liabili�es and Equity are shown on the right.

accounts payable An account that tracks bills to be paid by the company.

accounts payable turnover ra�o (creditors turnover ra�o) Measures the number of �mes the accounts payables are paid during an accoun�ng period.

accounts receivable An account that tracks the money due from customers who bought from the company on credit.

accounts receivable turnover ra�o Measures how many �mes receivables turn over during the year. The higher the number, the shorter the �me between sales of products and collec�on of cash from customers.

accrual accoun�ng A method of accoun�ng in which expenses and revenues are shown in the appropriate month. Revenues must be recognized in the month they are earned and expenses must be recognized in the month they are used, which is not necessarily the month that cash changed hands.

accrued payroll Account that tracks payroll due to employees not yet paid.

accrued payroll taxes Taxes collected from employees that need to be paid to the local, state, or federal government.

accumulated deprecia�on An account that tracks the deprecia�on of an asset over the years the asset is owned.

Accumulated Other Comprehensive Income (Loss) A line item that shows income or losses that have not yet been realized. These unrealized gains or losses can be from things such as unrealized pension costs, unrealized gains or losses on securi�es, and unrealized gains or losses on foreign currency exchanges or other foreign investments.

acquisi�ons Items (or other companies) that a company plans to buy or has recently bought.

ac�vity ra�os Measure how effec�vely a company uses its resources by comparing financial results for certain key ac�vi�es. These ra�os, also called turnover ra�os, help gauge how well a company is managing its assets and liabili�es.

actuarial assump�ons Es�mates of the value of an asset or person. Insurance companies commonly use these to determine the cost of an insurance policy. Companies also use these when trying to determine a value for a financial asset that has an uncertain value, such as the future payments on re�ree benefits.

aging schedule A report generated that lists the customers who purchased items on company credit and the amounts owed. The amounts owed are grouped by the age of the debt.

allowances An account used to track a discount or rebate given to the customer.

amor�za�on The reduc�on in the value of an intangible asset, such as a copyright or a patent, over a period of �me that is due to the "using up" of that asset. It can also be the process of decreasing the amount owed on a long-term debt.

analyst call Conversa�ons among key execu�ves and analysts to discuss a summary of the company's financial results at the end of a quarter or year.

annual report Document sent to shareholders to provide them with informa�on about the company's financial ac�vi�es throughout the previous year.

arm's-length transac�on A transac�on that involves a buyer and a seller who can act independently of each other and have no rela�onship to each other.

assets Items a company owns.

audit An impar�al, third-party review of a company's opera�ons and financial statements to confirm that the reports are materially correct and that proper internal controls are being used.

average cos�ng One method for valuing inventory. As inventory is purchased the cost of the new inventory is averaged with the cost of the other inventory on hand.

bad debt Debt the company is owed by its customers that it does not expect to collect from them.

balance sheet Also known as a statement of financial posi�on, this statement shows a company's assets (what the company owns), its liabili�es (what the company owes), and its equity (what claims investors have on the assets). It is essen�ally a snapshot of the company's financial posi�on as of a par�cular date.

bonds payable An account that tracks bonds that must be repaid.

budget vs. actual report A report that compares a company's budget to the actual numbers. This can be done monthly, quarterly, yearly, or at whatever interval a manager determines would be helpful for decision making.

capital The net worth of a company.

carryforwards A deduc�on for losses that could not all be taken in the current year but can be taken in future years.

cash debt coverage ra�o Measures whether a company can pay its debt over the long term. Long-term debt liabili�es include all debt that will need to be paid beyond the current 12-month period. If long-term debt is too high, the company will eventually have trouble paying off its debt and mee�ng its interest obliga�ons.

cash flow coverage ra�o Shows what percentage of a company's cash requirements are paid from its opera�ng ac�vi�es. It measures the company's ability to pay its bills and grow the company. If the company pays dividends, then that, too, will be taken into considera�on when calcula�ng this ra�o.

cash flow margin Measures how effec�vely a company converts its sales into cash.

cer�fied public accountant (CPA) Accountant who has passed the Uniform Cer�fied Public Accountant exam and completed required educa�on and experience requirements. Only CPAs are licensed to provide public opinions on financial statements.

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commitments Contractual agreements.

common-sized balance sheet Document that converts the financial results into percentages to make it easier to compare companies, no ma�er what their sizes.

common-sized income statement Document that enables users to analyze the key line items that lead to profit or loss from a different perspec�ve by calcula�ng each number on the income statement as a percentage.

confirmatory value A quality that relevant financial report informa�on has when it can confirm or change past or present expecta�ons for the company.

con�ngencies Pending legal ma�ers.

con�ngent liabili�es Liabili�es that a company should accrue when it determines that an event is likely to happen.

cost of goods or services sold The costs directly associated to produce the products or services to be sold by the business.

credit A type of entry in an accoun�ng system. For some types of accounts it will increase its balance; for other types of accounts it will decrease its balance.

credit cards payable An account that tracks money due to credit card companies that has not yet been paid.

current assets or liabili�es Accounts that will be used or paid within the next twelve months.

current cash debt coverage ra�o Measures whether the actual opera�ons of the company are sufficient to pay its bills.

current ra�o Seeks to determine whether the company has the ability to pay its current obliga�ons. Generally, the higher the current ra�o, the be�er the company will appear to creditors.

debit A type of entry in an accoun�ng system. For some types of accounts it will increase its balance; for other types of accounts it will decrease its balance.

debt to capital ra�o Measures what por�on of a company's capital comes from debt financing. Lenders monitor this number closely and o�en place debt to capital ra�o requirements in the terms of credit agreements for a company.

debt to equity ra�o Measures how much a company allocates each year to debt versus equity.

defaults on senior securi�es Debt payments that are not made on �me, such as bond interest or principal payments.

deferred income An account that tracks income received by the company, but not yet earned.

deferred taxes Taxes that are not paid immediately, but instead are paid at some point in the future. These can represent tax deduc�ons that could not be taken in the current tax year, but could be taken in the future.

deprecia�on The reduc�on of the value of an asset over the life span of the asset.

disposi�ons Sales of a por�on of the assets of a company, such as the sale of a division or a factory.

dividend yield ra�o Determines the effec�ve return an investor gets from the dividends paid.

EBITDA A profit line seen on some companies' income statements that shows earnings before interest, taxes, deprecia�on, and amor�za�on.

Electronic Data Gathering, Analysis, and Retrieval (EDGAR) System that collects, validates, and indexes reports from public companies who must report to the U.S. Securi�es and Exchange Commission. Anyone can search this database online to get detailed financial reports from public companies.

equity Claims investors have against the assets of a company, usually in the form of stock owned by the investors.

expenses The money spent on opera�ng the business.

external financial reports Informa�on about the financial health of a company provided to individuals or ins�tu�ons who do not work for the company, including bankers, vendors, investors, and compe�tors.

FIFO (First In, First Out) An inventory valua�on method that assumes the first item put on the shelves will be the first item sold. Companies whose products spoil quickly or become obsolete use this method of inventory valua�on.

Financial Accoun�ng Standards Board (FASB) Organiza�on that develops and updates the GAAP rules and sets standards for U.S. companies to follow; its board members are appointed by the SEC.

Financial Industry Regulatory Authority (FINRA) Organiza�on that regulates the actual trading of securi�es and monitors securi�es brokers.

financial posi�on format A format that is used interna�onally but is not commonly found in the United States, although it may be used by foreign companies that do business in the United States. The key difference with this format is the addi�on of two lines that do not appear on the account or report formats: working capital and net assets.

financial ra�o analysis A group of financial tools used by managers to analyze informa�on in a company's financial statements. These ra�os can be used to compare current results to the results of previous years, as well as compare the company's results to the industry and to compe�tors.

financial statements Documents that provide a summary of the financial health of a company for a specific period of �me. They give both internal and external readers informa�on needed to make financial decisions about a company.

financing ac�vi�es Cash that flowed into or out of the business from transac�ons involving debt or stock.

Form 8-K A form filed by public companies with the SEC to report special events, such as a change in officers of the company.

Form 10-K An annual form filed by public companies with the SEC that provides comprehensive details about the company's business and financial condi�ons.

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Form 10-Q A quarterly form filed by public companies with the SEC that provides comprehensive details about the company's business and financial condi�ons.

freight charges Any costs incurred for shipping the products to the company.

generally accepted accoun�ng principles (GAAP) Rules companies must follow when collec�ng and presen�ng their financial data and results.

generally accepted audi�ng standards Rules auditors must follow when reviewing the company's books and financial opera�ons.

going-concern problem A situa�on that indicates that a company may not be able to stay in business for the long-term; generally, it is an indica�on that the company may con�nue to lose money, have a cash deficiency, or suffer a significant contract dispute.

goodwill An intangible asset (an asset that cannot be touched but that has value for the company). When a company shows goodwill on its balance sheet, it means it paid more for at least one company than its tangible assets were worth. O�en these intangible assets include things like customer base, desirable loca�ons, or popular technology, products, or services.

gross profit Profit a�er the cost of goods sold is subtracted.

gross profit margin Percentage of profit a�er the cost of goods sold is subtracted.

income before taxes Net income before the expense of taxes is subtracted.

income from opera�ons (opera�ng income) Net income a�er all expense from opera�ons have been subtracted.

income statement Also known as a statement of earnings, or a profit and loss statement, this statement provides informa�on about a company's revenues and expenses over a specific period of �me.

intangible assets Things the company owns that cannot be felt or touched, such as copyrights and patents.

interest coverage ra�o Measures whether the company can pay its interest on both short-term and long-term debt using its earnings.

internal financial reports Confiden�al reports that can only be shared with employees of the company or the company's board of directors. They provide more details about the company's financial results.

Interna�onal Accoun�ng Standards Board (IASB) The independent standard-se�ng body of the Interna�onal Financial Repor�ng Standards Founda�on. The board's 15 full-�me members develop and publish Interna�onal Financial Repor�ng Standards. The board members come from various countries and work closely with stakeholders around the world, including investors, analysts, regulators, business leaders, accoun�ng standard-se�ers, and others in the accountancy profession.

interna�onal financial repor�ng standards (IFRS) A set of rules that most interna�onal companies follow. The IRFS are similar in many ways to the U.S. GAAP. There is a move interna�onally to converge the U.S. GAAP and the IRFS rules.

inventories Products the company has on hand to sell to its customers.

inventory turnover ra�o Measures the liquidity of inventory. Using this ra�o, a manager can determine how many �mes the company sold and replaced its inventory during an accoun�ng period.

inves�ng ac�vi�es Cash that flowed into or out of the business from transac�ons involving the purchase or sale of long-term assets.

leasehold improvements Renova�ons done by companies when they lease a property; the renova�ons are assets whose expense will be gradually wri�en off over a period of �me.

leverage The degree to which the business borrows money. By using leverage, a company's cash can go a lot further. For example, when a company buys a building using leverage (a mortgage) and cash, it will likely only use a small por�on of its cash as a down payment and borrow the rest.

leverage ra�os Measure how much total debt a company owes to its creditors and whether it can pay its long-term debt obliga�ons.

liabili�es Debts a company owes to its lenders.

LIFO (Last In, First Out) An inventory valua�on method that assumes the last piece of inventory purchased is the first piece of inventory sold. This method works for companies selling inventory that does not spoil or become obsolete.

liquidity All assets that can easily be bought or sold to raise cash.

liquidity ra�os Measure the ability to generate enough money to pay the bills.

loans payable An account that tracks long-term debts that are paid over a number of years, such as mortgages and car loans.

long-term assets or liabili�es Assets whose useful life will be more than 12 months or debts that will be paid over more than 12 months.

lower of cost or market method A method of inventory cos�ng in which the company calculates both the cost of the product when purchased and the current value of the product. The value shown on the balance sheet would be whichever one is lower.

Management's Discussion and Analysis (MD&A) A sec�on of the annual report in which the management team discusses the successes and failures of the company in the previous year, as well as future plans for the company.

market segment informa�on Informa�on about where the company sells its products and to whom the products are sold.

marketable securi�es Assets that can quickly be turned into cash, such as money market funds and tradable stocks and bonds.

material If an omission or misstatement could influence the decisions a financial report reader may make about the company, that informa�on is described as material.

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material misstatements Errors in the financial statements that could have an impact on the value of the company.

maturity The date at which �me a financial instrument, such as a bond or cer�ficate of deposit, will cease to exist. The principal is repaid with interest on the maturity date.

mergers The decision of two or more companies to join forces and become one en�ty.

net profit margin The percentage of net profit.

net profit (or loss) The bo�om line of an income statement that shows whether the business experienced a gain or a loss.

net profit ra�o Measures the percentage of sales that resulted in a profit for the owners of the company.

Notes to the Financial Statements Part of the annual report that provides details about the line items on the financial statements.

opera�ng ac�vi�es Cash that flowed into or out of the business from transac�ons involving the day-to-day opera�ons of the business.

opera�ng lease obliga�ons A type of lease for equipment, such as copiers, considered an asset to the company.

opera�ng profit margin The percentage of profit a�er subtrac�ng opera�ng expenses.

opera�ons All the day-to-day ac�vi�es in running a business.

periodic inventory method A physical count of the inventory on hand. Depending on the type of business, this could be done daily, weekly, monthly, or yearly.

perpetual inventory method A method for coun�ng inventory as it is sold. Companies that use this method usually make changes to the inventory in stock at the cash register.

predic�ve value A quality that relevant financial report informa�on has when it can be used to form expecta�ons of the future of the company.

prepaid expenses Expenses that are paid in advance. For example, a 12-month insurance policy paid at the beginning of the year. This is held as an asset and reduced monthly as the expense for each month is recorded.

price/earnings (P/E) ra�o Measures the price of a company's stock versus its earnings.

private companies Companies whose shares of stock are held by and traded privately among individuals. O�en private companies are wholly owned by family members or a close-knit group of investors. These companies are not required to report their financial results publicly.

profitability ra�os Enable managers to determine whether a company is profitable. Managers use these ra�os to test the company's profitability to be certain goals have been met and to compare their company's profitability to that of similar companies as a benchmark to measure its success within its industry.

property, plant, and equipment A line item on the balance sheet that shows the net value of all the property, plants, and equipment a company owns.

proxy materials Documents that give shareholders informa�on they will need to vote on issues that will be discussed at the annual mee�ng. They include details about the board of directors and key execu�ve personnel, including their backgrounds and compensa�on.

public companies Companies whose shares of stock are sold on the public stock markets. Public companies must provide financial reports periodically to the public.

Public Company Accoun�ng Oversight Board (PCAOB) A private-sector, non-profit corpora�on created by the Sarbanes-Oxley Act to oversee the auditors of public companies. Even though the PCAOB is a private en�ty, it has many government-like regulatory func�ons in rela�on to se�ng rules for auditors and how they do their work, which is similar to the role of the FASB for se�ng GAAP rules.

purchase discounts The discounts a company receives when it purchases the goods it plans to sell.

purchase returns and allowances An account that tracks returns of products purchased.

purchases The goods bought by the company to be sold to customers of the company.

quick ra�o (acid test ra�o) A stricter, more conserva�ve measure of whether the company has the money to pay its bills than the current ra�o. This ra�o includes only the most liquid assets—cash, cash equivalents (such as cer�ficates of deposit, money market funds, and marketable securi�es) and accounts receivables. All these assets can be quickly converted to cash if needed to pay the bills.

related-party revenue Revenue that comes from a company selling goods to another en�ty in which the seller controls the management of opera�ng policies. For example, if the parent company of a toy manufacturer sells the raw materials needed for manufacturing the toys to its subsidiary, the parent company cannot count that sale of raw materials as revenue.

report format One type of format a balance sheet. Assets are shown first, liabili�es and equity are shown below.

retained earnings An account that tracks profits reinvested into the company.

return on assets (ROA) ra�o How much a company earns from its assets or capital invested and how well the company uses its assets to generate a profit.

return on equity (ROE) ra�o Measures the return a company earns for its investors.

returns Products returned by purchasers.

revenue The total income from the sales of products or services.

rounding A mathema�cal decision made to use less-exact (but easier-to-use) numbers.

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sales The revenue earned from selling products or services.

sales discounts An account of any discounts offered to the customer to reduce the retail price.

sales returns and allowances An account that tracks returns of merchandise.

sales taxes collected An account that tracks taxes that have been collected from customers that need to be paid to the local, state, or federal government.

Sarbanes-Oxley Act of 2002 Also known as the Public Company Accoun�ng Reform and Investor Protec�on Act, sets new or enhanced standards for external repor�ng.

Securi�es and Exchange Commission (SEC) The part of the federal government that monitors company financial reports and makes sure they meet the standards set by the FASB and the SEC. The agency also enforces and regulates the securi�es industry, which includes the stock and op�on markets.

short-term debt All debt payments that must be made in the next 12 months.

specific iden�fica�on method A way of calcula�ng inventory values by adding up the value of each product in inventory (based on the purchase and sold details of each).

statement of cash flows This statement reveals how much cash flowed into and out of the business. The statement allows managers to determine whether the company received more or less cash in the current year versus the prior year.

statement of shareholder's equity Document that details the claims owners have against the company's assets. It can be found at the bo�om of the income statement or on a separate page.

stock Shares of ownership in a company that is sold to insiders and outsiders.

straight-line deprecia�on method A way to value inventory. The company determines an asset's life span and then divides the cost of that asset by the number of years it will have a useful life to the company.

subsidiary ac�vi�es The ac�vi�es of a company wholly owned by a large corpora�on.

tangible assets Things the company owns that one can touch and feel, such as vehicles, furniture, and equipment.

total asset turnover ra�o Measures how efficiently a company is using its assets to generate sales. The turnover number equals the amount generated in sales for every dollar invested.

treasury stock Stock that has been bought back by the company from stockholders.

turnover ra�os Measure how effec�vely a company uses its resources by comparing financial results for certain key ac�vi�es. These ra�os, also called ac�vity ra�os, help gauge how well a company is managing its assets and liabili�es.

volume discounts Discounts offered when a significant volume of merchandise is purchased at the same �me or over a promised period of �me. The volume is nego�ated between buyer and seller.

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