Meaning of Financial Statements

Financial statements are basically reports that depict financial and accounting information relating to
businesses. A company’s management uses it to communicate with external stakeholders. These include
shareholders, tax authorities, regulatory bodies, investors, creditors, etc.

These statements basically include the following reports:

1. Balance sheet

2. Profit and Loss statement

3. Statement of cash flow

4. Income sheet

Nature of Financial Statements Analysis

Financial statements are prepared using facts relating to events, which are recorded chronologically.
Thus, we have to first record all these facts in monetary terms. Then, we have to process them using all
applicable rules and procedures. Finally, we can now use all this data to generate financial statements.

Based on this understanding, the nature of financial statements depends on the following points:

1. Recorded facts: We need to first record facts in monetary form to create the statements. For
this, we need to account for figures of accounts like fixed assets, cash, trade receivables, etc.

2. Accounting conventions: Accounting Standards prescribe certain conventions applicable in the

process of accounting. We have to apply these conventions while preparing these statements.
For example, the valuation of inventory at cost price or market price, depending on whichever is
lower.

3. Postulates: Apart from conventions, even postulates play a big role in the preparation of these
statements. Postulates are basically presumptions that we must make in accounting. For
 example, the going concern postulate presumes a business will exist for a long time. Hence, we
have to treat assets on a historical cost basis.

4. Personal judgments: Even personal opinions and judgments play a big role in the preparation of
these statements. Thus, we have to rely on our own estimates while calculating things like
depreciation.

Now that we understand the meaning and nature of financial statements, a glance at their objectives
would be appreciable.

Browse more Topics under Financial Statements Of A Company

 Forms and Content of Balance Sheets and Peculiar Items

 Types of Financial Statement

 Uses of Financial Statement and Their Limitations

Objectives of Financial Statements

Stakeholders of a company heavily rely on financial statements to understand its functioning. They
portray the true state of affairs of the company. Here are some objectives of financial statements:

 These statements show an accurate state of a company’s economic assets and liabilities.
External stakeholders like investors and authorities generally do not possess this information
otherwise.

 They help in predicting the extent of a company’s capacity to earn profits. Shareholders and
investors can use this data to make their financial decisions.

 These statements depict the effectiveness of a company’s management. How well a company is
performing depends on its profitability, which these statements show.

 They even help readers of these statements know the accounting policies used in them. This
helps in understanding statements more comprehensively.

 These statements also provide information relating to the company’s cash flows. Investors and
creditors can use this data to predict the company’s liquidity and cash requirements.

 Finally, they explain the social impact of businesses. This is because it shows how the company’s
external factors affect its functioning.
Horizontal Analysis: Definition

Horizontal analysis is an approach to analyzing financial statements.

It compares historical data, which includes ratios and line items, over a series of accounting periods. The
accounting period can be a month, a quarter, or a year.

This method of analysis is also known as trend analysis.

The horizontal method of analysis is used to identify changes in financial statements over time and
assess those changes.

A base year is initially selected as a benchmark. Either the data of the rest of the years is expressed as a
percentage of the base year or an absolute comparison is performed. The base year comparison is
known as base year analysis.

This method of analysis makes it easy for the financial statement user to spot patterns and trends over
the years.

An absolute comparison involves comparing the amount of the same line of the item to its amounts in
the other accounting periods. For example, comparing the accounts receivables of one year to those of
the previous year. Any changes are analyzed then.

In percentage comparison, the increase or decrease in amounts is expressed as a percentage of the

amount in the base year.

For example, if the base year amount of cash is $100, a 10% increase would make the current
accounting period’s amount $110, whereas a 10% decrease would be $90.

Different ratios, such as earnings per share (EPS) or current ratio, are also compared for different
accounting periods.

Horizontal Analysis: Explanation

Horizontal analysis focuses on the dollar and percentage changes that occur in specific accounts from
year to year.

Determining the percentage change is important because it links the degree of change to the actual
amounts involved. In this way, percentage changes are better for comparative purposes with other firms
than are actual dollar changes.

For example, a $1 million increase in General Motors' cash balance is likely to represent a much smaller
percentage increase than a corresponding $1 million increase in American Motors' cash balance.

To calculate percentage changes, you can use the following formula:

Percentage change = (Amount of dollar change / Base year amount) x 100

The base year is always the first year in the comparison.

For example, suppose that Safeway's total current assets were $1,729,146,000 in 2018 and
$1,861,389,000 in 2019. This represents a dollar increase of $132,243,000 and a percentage increase of
7.65%, which is calculated as follows:

Percentage change = ($1,861,389,000 - $1,729,146,000 / 1,729,149,000) x 100

= 7.65%

You can also use horizontal analysis in conjunction with both the balance sheet and the income
statement.

In the example shown below, comparative balance sheets and income statements are given for Safeway
Stores. The tables show the dollar and percentage changes.

Several interesting balance sheet changes are apparent in the tables below. In 2019, Safeway Stores
increased its operating of fixed assets. There were rises of more than 12% in all categories of property
other than transport equipment.

This increase in capital expenditures is also reflected on the liability side of the balance sheet. In
particular, notes and debentures increased by over 53%.

In this discussion and analysis of operations, Safeway's management noted that the increase was due to
a growing trend toward mortgage financing.

Comparative Balance Sheets With Horizontal Analysis

Comparative Income Statements With Horizontal Analysis

Horizontal analysis of income statements also produces worthwhile information.

For example, in Safeway Stores' balance sheets, both sales and the cost of sales increased from 2018 to
2019.

However, the percentage increase in sales was greater than the percentage increase in the cost of sales.
This led to an increase in gross profit from 2018 to 2019.

Operating and administrative expenses also increased slightly and interest expense increased by over
12%. This resulted in only a slight increase in net income for 2019 over 2018.

The Usefulness of Horizontal Analysis

Consistency and comparability are generally accepted accounting principles (GAAP).

Consistency is important when performing horizontal analysis of financial statements. When the
same accounting standards are used over the years, the financial statements of the company are easier
to compare and trends are easily analyzed.

Comparability means that a company’s financial statements can be compared to those of another
company in the same industry.

Horizontal analysis enables investors, analysts, and other stakeholders in the company to see how well
the company is performing financially.

A company’s financial performance over the years is assessed and changes in different line items and
ratios are analyzed. Negative changes and trends are further investigated.

Horizontal analysis also makes it easier to detect when a business is underperforming.

For example, if a company starts generating low profits in a particular year, expenses can be analyzed
for that year. This makes it easier to spot inefficiencies and specific areas of underperformance.

Ratios such as asset turnover, inventory turnover, and receivables turnover are also important because
they help analysts to fully gauge the performance of a business.

For example, a low inventory turnover would imply that sales are low, the company is not selling its
inventory, and there is a surplus. This could also be due to poor marketing or excess inventory due to
seasonal demand.

Ratios such as earnings per share, return on assets, and return on equity are similarly invaluable. These
ratios make problems related to the growth and profitability of a company evident and clear.

Liquidity ratios are needed to check if the company is liquid enough to settle its debts and pay back
any liabilities. Horizontal analysis makes it easy to detect these changes and compare growth rates and
profitability with other companies in the industry.

Example

Let’s take a look at this simple example before we discuss any further.

Each item in a financial statement is compared to the base year. In this case, if management compares
direct sales between 2007 and 2006 (the base year), it is clear that there is an increase of 3.2%.

This result would be concerning for the company's management. They would investigate this if they
expected at least a 10% increase.

To provide another example, consider an investor who is seeking to invest and finds company C.
Company C’s figures for the previous year are as follows: net income $2m and retained earnings $10m.

The current year's details are the following: net income $4m and retained earnings $12m. Net income
has grown by 100% and retained earnings have increased by only 20%.

The investor now needs to make a decision based on their analysis of the figures, as well as a
comparison to other similar figures.
Criticisms of Horizontal Analysis

Regardless of how useful trend analysis may be, it is regularly criticized.

One reason is that analysts can choose a base year where the company's performance was poor and
base their analysis on it. In this way, the current accounting period (or any other accounting period) can
be made to appear better.

Another problem with horizontal analysis is that some companies change the way they present
information in their financial statements. This can create difficulties in detecting troublesome areas,
making it hard to spot changes in trends.

Horizontal Analysis: Discussion

To conclude, it is always worth performing horizontal analysis, but it should never be relied upon too
heavily. Other factors should also be considered, and only then should a decision be made.

Horizontal Analysis of Financial Statements FAQs

What is horizontal analysis?

Horizontal analysis is the use of financial information over time to compare specific data between
periods to spot trends. This can be useful because it allows you to make comparisons across different
sets of numbers.

How is the horizontal analysis performed?

By looking at the numbers provided by a company, you should see whether there are any large
differences between one year and the next. It is also possible to perform this analysis with time series
data to make direct comparisons with other companies.

When should the horizontal analysis be performed?

When Financial Statements are released, it is important to compare numbers from different periods in
order to spot trends and changes over time. This can be useful in checking whether a company is
performing well or badly, and identify areas where it may improve.

What does horizontal analysis involve?

Horizontal analysis involves looking at Financial Statements over time in order to spot trends and
changes. This can be useful in identifying areas of concern for a business, as well as improving the
performance of companies that are struggling.

Why is horizontal analysis important?

Horizontal analysis is important because it allows you to compare data between different periods and
makes it easier to identify changes in trends. This can be helpful in making decisions about whether to
invest in a company or not.
Common Size Analysis

A financial analysis tool that expresses each line item as a percentage of the base amount for a given
period

What is Common Size Analysis?

Common size analysis, also referred as vertical analysis, is a tool that financial managers use to
analyze financial statements. It evaluates financial statements by expressing each line item as a
percentage of a base amount for that period. The analysis helps to understand the impact of each item
in the financial statements and its contribution to the resulting figure.
The technique can be used to analyze the three primary financial statements, i.e., balance sheet, income
statement, and cash flow statement. In the balance sheet, the common base item to which other line
items are expressed is total assets, while in the income statement, it is total revenues.

Summary

 Common size analysis evaluates financial statements by expressing each line item as a
percentage of a base amount for that period.

 The formula for common size analysis is the amount of the line item divided by the amount of
the base item. For example, cost of goods sold (line item) divided by revenue (base item).

 Benefits of common size analysis is that it allows investors to identify large changes in a
company’s financial statements, as well as the ability to compare companies of different sizes.

Formula for Common Size Analysis

Common size financial statement analysis is computed using the following formula:

Types of Common Size Analysis

Common size analysis can be conducted in two ways, i.e., vertical analysis and horizontal analysis.
Vertical analysis refers to the analysis of specific line items in relation to a base item within the same
financial period. For example, in the balance sheet, we can assess the proportion of inventory by
dividing the inventory line using total assets as the base item.

On the other hand, horizontal analysis refers to the analysis of specific line items and comparing them to
a similar line item in the previous or subsequent financial period. Although common size analysis is not
as detailed as trend analysis using ratios, it does provide a simple way for financial managers to analyze
financial statements.

Balance Sheet Common Size Analysis

The balance sheet common size analysis mostly uses the total assets value as the base value. A financial
manager or investor can use the common size analysis to see how a firm’s capital structure compares to
rivals. They can make important observations by analyzing specific line items in relation to the total
assets.

For example, if the value of long-term debt in relation to the total assets value is high, it may signal that
the company may become distressed.

Let’s take the example of ABC Company, with the following balance sheet:
From the table above, we calculate that cash represents 14.5% of total assets while inventory represents
12%. In the liabilities section, accounts payable is 15% of total assets, and so on.

Income Statement Common Size Analysis

The base item in the income statement is usually the total sales or total revenues. Common size analysis
is used to calculate net profit margin, as well as gross and operating margins. The ratios tell investors
and finance managers how the company is doing in terms of revenues, and can be used to make
predictions of future revenues and expenses. Companies can also use this tool to analyze competitors to
know the proportion of revenues that goes to advertising, research and development, and other
essential expenses.

We can also analyze ABC Company’s income statement:

By looking at this common size income statement, we can see that the company spent 10% of revenues
on research and development and 3% on advertising.

Net income represents 10% of total revenues, and this margin can be compared to the previous year’s
margin to see the company’s year-over-year performance.

What are the Benefits of Common Size Analysis?

One of the benefits of using common size analysis is that it allows investors to identify large changes in a
company’s financial statements. It mainly applies when the financials are compared over a period of two
or three years. Any significant movements in the financials across several years can help investors
decide whether to invest in the company.
For example, large drops in the company’s profits in two or more consecutive years may indicate that
the company is going through financial distress. Similarly, considerable increases in the value of assets
may mean that the company is implementing an expansion or acquisition strategy, potentially making
the company attractive to investors.

Common size analysis is also an excellent tool to compare companies of different sizes but in the same
industry. Looking at their financial data can reveal their strategy and their largest expenses that give
them a competitive edge over other comparable companies.

For example, some companies may sacrifice margins to gain a large market share, which increases
revenues at the expense of profit margin. Such a strategy may allow the company to grow faster than
comparable companies.

When comparing any two common size ratios, it is important to make sure that they are computed by
using the same base figure. Failure to do so will render the comparison meaningless.
Analysis and Interpretation of Financial Statements

Read this chapter, which discusses how to analyze financial statements and demonstrates the use of
ratios and the horizontal and vertical analysis tools that everyone from creditors to investors, vendors,
and top management use when they want to identify the strengths and weaknesses in an organization.
Analysis tools can help you compare companies of different sizes, companies in different industries, and
the same company over time.

Trend percentages

Trend percentages, also referred to as index numbers, help you to compare financial information over
time to a base year or period. You can calculate trend percentages by:

 Selecting a base year or period.

 Assigning a weight of 100 per cent to the amounts appearing on the base-year financial
statements.

 Expressing the corresponding amounts on the other years' financial statements as a percentage
of base-year or period amounts. Compute the percentages by dividing non-base-year amounts
by the corresponding basemyear amounts and then multiplying the result by 100.

The following information for Syno tech illustrates the calculation of trend percentages:

(USD millions) 2008 2009 2010

$10,029.
Net sales $9,105.5 $10,498.8
8

Cost of goods sold 4,696.0 5,223.7 5,341.3

Gross profit $4,409.5 $4,806.1 $5,157.5

Operating expenses 3,353.6 4,369.9 4,012.0

Income before income taxes $1,055.9 $436.2 $1,145.5

If 2008 is the base year, to calculate trend percentages for each year divide net sales by USD 9,105.5
million; cost of goods sold by USD 4,696.0 million; gross profit by USD 4,409.5 million; operating
expenses by USD 3,353.6 million; and income before income taxes by USD 1,055.9 million. After all
divisions have been made, multiply each result by 100. The resulting percentages reflect trends as
follows:

2008 2009 2010

Net sales 100.0% 119.2% 115.3%

 Cost of goods sold 100.0 111.2 113.7

Gross profit 100.0 109.0 117.0

Operating expenses 100.0 130.3 119.6

Income before income taxes 100.0 41.3 108.5

These trend percentages indicate the changes taking place in the organization and highlight the
direction of these changes. For instance, the percentage of sales is increasing each year compared to the
base year. Cost of goods sold increased at a lower rate than net sales in 2008 and 2010, causing gross
profit to increase at a higher rate than net sales. Operating expenses in 2009 increased due to the
provision for restructured operations, causing a significant decrease in income before income taxes.
Percentages provide clues to an analyst about which items need further investigation or analysis. In
reviewing trend percentages, a financial statement user should pay close attention to the trends in
related items, such as the cost of goods sold in relation to sales. Trend analysis that shows a constantly
declining gross margin (profit) rate may be a signal that future net income will decrease.

As useful as trend percentages are, they have one drawback. Expressing changes as percentages is
usually straightforward as long as the amount in the base year or period is positive - that is, not zero or
negative. Analysts cannot express a USD 30,000 increase in notes receivable as a percentage if the
increase is from zero last year to USD 30,000 this year. Nor can they express an increase from a loss last
year of USD 10,000 to income this year of USD 20,000 in percentage terms.

Proper analysis does not stop with the calculation of increases and decreases in amounts or percentages
over several years. Such changes generally indicate areas worthy of further investigation and are merely
clues that may lead to significant findings. Accurate predictions depend on many factors, including
economic and political conditions; management's plans regarding new products, plant expansion, and
promotional outlays; and the expected activities of competitors. Considering these factors along with
horizontal analysis, vertical analysis, and trend analysis should provide a reasonable basis for predicting
future performance.
Ratio analysis

Logical relationships exist between certain accounts or items in a company's financial statements. These
accounts may appear on the same statement or on two different statements. We set up the dollar
amounts of the related accounts or items in fraction form called ratios. These ratios include: (1) liquidity
ratios; (2) equity, or longterm solvency, ratios; (3) profitability tests; and (4) market tests.

Liquidity ratios indicate a company's short-term debt-paying ability. Thus, these ratios show interested
parties the company's capacity to meet maturing current liabilities.

Current (or working capital) ratio Working capital is the excess of current assets over current liabilities.
The ratio that relates current assets to current liabilities is the current (or working capital) ratio. The
current ratio indicates the ability of a company to pay its current liabilities from current assets and, thus,
shows the strength of the company's working capital position.

You can compute the current ratio by dividing current assets by current liabilities:

Current ratio = Current assets Current liabilities Current ratio = Current assets Current liabilities

The ratio is usually stated as a number of dollars of current assets to one dollar of current liabilities
(although the dollar signs usually are omitted). Thus, for Synotech in 2010, when current assets totaled
USD 2,846.7 million and current liabilities totaled USD 2,285.2 million, the ratio is 1.25:1, meaning that
the company has USD 1.25 of current assets for each USD 1.00 of current liabilities.

The current ratio provides a better index of a company's ability to pay current debts than does the
absolute amount of working capital. To illustrate, assume that we are comparing Synotech to Company
B. For this example, use the following totals for current assets and current liabilities:

Synotech Company B

Current assets (a) $2,846.7 $120.0

Current liabilities (b) 2,285.2 53.2

Working capital (a – b) $ 561.5 $ 66.8

Current ratio (a/b) 1.25:1 2.26:1

Synotech has eight times as much working capital as Company B. However, Company B has a superior
debtpaying ability since it has USD 2.26 of current assets for each USD 1.00 of current liabilities.

Short-term creditors are particularly interested in the current ratio since the conversion of inventories
and accounts receivable into cash is the primary source from which the company obtains the cash to pay
short-term creditors. Long-term creditors are also interested in the current ratio because a company
that is unable to pay short-term debts may be forced into bankruptcy. For this reason, many bond
indentures, or contracts, contain a provision requiring that the borrower maintain at least a certain
minimum current ratio. A company can increase its current ratio by issuing long-term debt or capital
stock or by selling noncurrent assets.

A company must guard against a current ratio that is too high, especially if caused by idle cash, slow-
paying customers, and/or slow-moving inventory. Decreased net income can result when too much
capital that could be used profitably elsewhere is tied up in current assets.

Refer to Exhibit 133. The Synotech data in Column (4) indicate that current liabilities are increasing more
rapidly than current assets. We could also make such an observation directly by looking at the change in
the current ratio. Synotech's current ratios for 2010 and 2009 follow:

December 31

Amount of
(USD millions) 2010 2009
increase

Net sales (a) $10,498.8 $10,029.8 $469.0

Net accounts receivable:

January 1 $ 1,340.3 $1,259.5 $80.8

December 31 1,277.30 1,340.30 (63)

Total (b) $ 2,617.6 $ 2,599.8 $17.8

Synotech's working capital decreased by USD 167.1 million, or 22.9 per cent (USD 167.1/USD 728.6), and
its current ratio decreased from 1.35:1 to 1.25:1. Together, these figures reflect that its current liabilities
increased faster than its current assets.

Acid-test (quick) ratio The current ratio is not the only measure of a company's short-term debt-paying
ability. Another measure, called the acid-test (quick) ratio, is the ratio of quick assets (cash, marketable
securities, and net receivables) to current liabilities. Analysts exclude inventories and prepaid expenses
from current assets to compute quick assets because they might not be readily convertible into cash.
The formula for the acid-test ratio is:

Acid − test ratio = Quick assets Current liabilities Acid − test ratio = Quick assets Current liabilities

Short-term creditors are particularly interested in this ratio, which relates the pool of cash and
immediate cash inflows to immediate cash outflows.

The acid-test ratios for 2010 and 2009 for Synotech are:
 December 31

Amount of increase or
(USD millions) 2010 2009
(decrease)

Quick assets (a) $1,646.6 $1,648.3 $(1.7)

Current liabilities (b) 2,285.6 2,103.8 181.8

Net quick assets (a –

$(639.0) $(455.5) $(183.5)
b)

Acid-test ratio (a/b) .72:1 .78:1

In deciding whether the acid-test ratio is satisfactory, investors consider the quality of the marketable
securities and receivables. An accumulation of poor-quality marketable securities or receivables, or
both, could cause an acidtest ratio to appear deceptively favorable. When referring to marketable
securities, poor quality means securities likely to generate losses when sold. Poor-quality receivables
may be uncollectible or not collectible until long past due. The quality of receivables depends primarily
on their age, which can be assessed by preparing an aging schedule or by calculating the accounts
receivable turnover. (Covered in Chapter 9.)

Cash flow liquidity ratio Another approach to measuring short-term liquidity is the cash flow liquidity
ratio. The numerator, as an approximation of cash resources, consists of (1) cash and marketable
securities, or liquid current assets, and (2) net cash provided by operating activities, or the cash
generated from the company's operations. This reflects the company's ability to sell inventory and
collect accounts receivable. The formula for the cash flow liquidity ratio is:

Cash also marketable securities + Net cash provided by operating activities Current liabilities Cash also
marketable securities + Net cash provided by operating activities Current liabilities

For 2010, Synotech has USD 298.0 million in cash and cash equivalents, USD 71.3 million in marketable
securities, USD 2,285.2 million in current liabilities, and USD 1,101.0 million in cash provided by
operating activities (taken from the statement of cash flows in its annual report). Its cash flow liquidity
ratio is:

USD 298.0+ USD 71.3+ USD 1,101.0 USD 2,285:2=.64 time USD 298.0+ USD 71.3+ USD 1,101.0 USD 2,28
5:2=.64 time

This indicates that the company is going to have to rely on some other sources of funding to pay its
current liabilities. The company's liquid current assets will only cover about two-thirds of the current
liabilities. Possibly net cash provided by operations will be substantially higher in 2011.

Accounts receivable turnover Turnover is the relationship between the amount of an asset and some
measure of its use. Accounts receivable turnover is the number of times per year that the average
amount of receivables is collected. To calculate this ratio, divide net credit sales (or net sales) by average
net accounts receivable; that is, accounts receivable after deducting the allowance for uncollectible
accounts:

Accounts receivable turnover = Net credit sales ( net sales ) Average net accounts receivable Accounts
receivable turnover = Net credit sales ( net sales ) Average net accounts receivable

When a ratio compares an income statement item (like net credit sales) with a balance sheet item (like
net accounts receivable), the balance sheet item should be an average. Ideally, analysts calculate
average net accounts receivable by averaging the end-of-month balances or end-of-week balances of
net accounts receivable outstanding during the period. The greater the number of observations used,
the more accurate the resulting average. Often, analysts average only the beginning-of-year and end-of-
year balances because this information is easily obtainable from comparative financial statements.
Sometimes a formula calls for the use of an average balance, but only the year-end amount is available.
Then the analyst must use the year-end amount.

In theory, the numerator of the accounts receivable turnover ratio consists of only net credit sales
because those are the only sales that generate accounts receivable. However, if cash sales are relatively
small or their proportion to total sales remains fairly constant, analysts can obtain reliable results by
using total net sales. In most cases, the analyst may have to use total net sales because the separate
amounts of cash sales and credit sales are not reported on the income statement.

December 31

Amount of
(USD millions) 2010 2009
increase

Net sales (a) $10,498.8 $10,029.8 $469.0

Net accounts receivable:

January 1 $1,340.3 $1,259.5 $80.8

December 31 1,277.30 1,340.30 (63)

Total (b) $2,617.6 $2,599.8 $17.8

Average net receivables (c) (b/2 = c) $ 1,308.8 $1,299.9

Turnover of accounts receivable (a/c) 8.02 7.72

Synotech's accounts receivable turnover ratios for 2010 and 2009 follow. Net accounts receivable on
2009 January 1, totaled USD 1,259.5 million.
The accounts receivable turnover ratio provides an indication of how quickly the company collects
receivables. The accounts receivable turnover ratio for 2010 indicates that Synotech collected, or turned
over, its accounts receivable slightly more than eight times. The ratio is better understood and more
easily compared with a company's credit terms if we convert it into a number of days, as is illustrated in
the next ratio.

Number of days' sales in accounts receivable The number of days' sales in accounts receivable ratio is
also called the average collection period for accounts receivable. Calculate it as follows:

Number of days' sales per accounts receivable = Number of days per year (365) Accounts receivable
turnover Number of days' sales per accounts receivable = Number of days per year (365) Accounts
receivable turnover

The turnover ratios for Synotech show that the number of days' sales in accounts receivable decreased
from about 47 days (365/7.72) in 2009 to 46 days (365/8.02) in 2010. The change means that the
average collection period for the company's accounts receivable decreased from 47 to 46 days.

An accounting perspective:
Business insight

The number of days' sales in accounts receivable ratio measures the average liquidity of accounts
receivable and indicates their quality. Generally, the shorter the collection period, the higher the quality
of receivables. However, the average collection period varies by industry; for example, collection periods
are short in utility companies and much longer in some retailing companies. A comparison of the
average collection period with the credit terms extended customers by the company provides further
insight into the quality of the accounts receivable. For example, receivables with terms of 2/10, n/30
and an average collection period of 75 days need to be investigated further. It is important to determine
why customers are paying their accounts much later than expected.

Inventory turnover A company's inventory turnover ratio shows the number of times its average
inventory is sold during a period. You can calculate inventory turnover as follows:

Inventory turnover = Cost of goods sold Average inventory Inventory turnover = Cost of goods
sold Average inventory

When comparing an income statement item and a balance sheet item, measure both in comparable
dollars. Notice that we measure the numerator and denominator in cost rather than sales dollars.
(Earlier, when calculating accounts receivable turnover, we measured both numerator and denominator
in sales dollars.) Inventory turnover relates a measure of sales volume to the average amount of goods
on hand to produce this sales volume.

Synotech's inventory on 2009 January 1, was USD 856.7 million. The following schedule shows that the
inventory turnover decreased slightly from 5.85 times per year in 2009 to 5.76 times per year in 2010.
To convert these turnover ratios to the number of days it takes the company to sell its entire stock of
inventory, divide 365 by the inventory turnover. Synotech's average inventory sold in about 63 and 62
(365/5.76 and 365/5.85) in 2010 and 2009, respectively.
 December 31

Amount of increase or
(USD millions) 2010 2009
(decrease)

Cost of goods sold (a) Merchandise inventory: $5,341.3 $5,223.7 $117.6

January 1 $929.8 $856.7 $ 73.1

December 31 924.8 929.8 (5.0)

Total (b) $1,854.6 $1,786.5 $ 68.1

Average inventory (c) (b/2 = c) $927.3 $893.3

Turnover of inventory (a/c) 5.76 5.85

Other things being equal, a manager who maintains the highest inventory turnover ratio is the most
efficient. Yet, other things are not always equal. For example, a company that achieves a high inventory
turnover ratio by keeping extremely small inventories on hand may incur larger ordering costs, lose
quantity discounts, and lose sales due to lack of adequate inventory. In attempting to earn satisfactory
income, management must balance the costs of inventory storage and obsolescence and the cost of
tying up funds in inventory against possible losses of sales and other costs associated with keeping too
little inventory on hand.

An accounting perspective:
Business insight

Cabletron Systems develops, manufactures, installs, and supports a wide range of standards-based

LAN and WAN connectivity hardware and software products. For the year ended 2009 December 31,
both its number of day's sales in accounts receivable and its inventory turnover rate increased as
compared to the prior year. In its 2009 annual report, the company explained these increases as follows:

Accounts receivable, net of allowance for doubtful accounts, were USD 210.9 million, or 66 days of sales
outstanding, at 2009 December 31 compared to USD 228.4 million at 2008 December 31, or 54 days
sales outstanding. The increase in days of sales outstanding was a result of the timing of sales and
related collections.

Worldwide inventories were USD 98.1 million at 2009 December 31 or 63 days of inventory, compared
to USD 85.0 million, or 37 days of inventory, at 2008 December 31. The increase of days in inventory was
due to the increase in finished goods inventory purchased to protect against an anticipated shortage of
supply components.
Total assets turnover Total assets turnover shows the relationship between the dollar volume of sales
and the average total assets used in the business. We calculate it as follows:

Total assets turnover = Net sales Average total assets Total assets turnover = Net sales Average total
assets

This ratio measures the efficiency with which a company uses its assets to generate sales. The larger the
total assets turnover, the larger the income on each dollar invested in the assets of the business. For
Synotech, the total asset turnover ratios for 2010 and 2009 follow. Total assets as of 2009 January 1,
were USD 7,370.9 million.

Amount of
(USD millions) 2010 2009
increase

Net sales (a) Total assets: $10,498.8 $10,029.8 $469.0

January 1 $9,170.8 $7,370.9 $1,799.9

December 31 9,481.8 9,170.8 311.0

Total (b) $18,652.6 $16,541.7 $2,110.9

Average total assets (c) (b/2 = c) $9,331.8 $8,270.9

Turnover of total assets (a/c) 1.13:1 1.21:1

Each dollar of total assets produced USD 1.21 of sales in 2009 and USD 1.13 of sales in 2010. In other
words, between 2009 and 2010, the company had a decrease of USD .08 of sales per dollar of
investment in assets.

Equity, or long-term solvency, ratios show the relationship between debt and equity financing in a
company.

Equity (stockholders' equity) ratio The two basic sources of assets in a business are owners
(stockholders) and creditors; the combined interests of the two groups are total equities. In ratio
analysis, however, the term equity generally refers only to stockholders' equity. Thus, the equity
(stockholders' equity) ratio indicates the proportion of total assets (or total equities) provided by
stockholders (owners) on any given date. The formula for the equity ratio is:

Equity ratio = Stockholders' equity Total assets ( total equities ) Equity ratio = Stockholders'
equity Total assets ( total equities )

Synotech's liabilities and stockholders' equity from Exhibit 133 follow. The company's equity ratio
increased from 22.0 per cent in 2009 to 25.7 per cent in 2010. Exhibit 133 shows that stockholders
increased their proportionate equity in the company's assets due largely to the retention of earnings
(which increases retained earnings).

2010 2009

December 31 December 31

(USD millions) Amount Per cent Amount Per cent

Current liabilities $2,285.2 24.1% $2,103.8 22.9%

Long-term liabilities 4,755.8 50.2 5,051.3 55.1

Total liabilities $7,041.0 74.3 $7,155.1 78.0

Total stockholders' equity 2,440.8 25.7 2,015.7 22.0

Total equity (equal to total assets) $9,481.8 100% $9,170.8 100.0%

The equity ratio must be interpreted carefully. From a creditor's point of view, a high proportion of
stockholders' equity is desirable. A high equity ratio indicates the existence of a large protective buffer
for creditors in the event a company suffers a loss. However, from an owner's point of view, a high
proportion of stockholders' equity may or may not be desirable. If the business can use borrowed funds
to generate income in excess of the net after-tax cost of the interest on such funds, a lower percentage
of stockholders' equity may be desirable.

To illustrate the effect of higher leveraging (i.e. a larger proportion of debt), assume that Synotech could
have financed an increase in its productive capacity with USD 40 million of 6 per cent bonds instead of
issuing 5 million additional shares of common stock. The effect on income for 2010 would be as follows,
assuming a federal income tax rate of 40 per cent:

Net income as presently stated (Exhibit 134) $762,000,000

Deduct additional interest on debt (0.06 x $40 million) 2,400,000

$759,600,000

Add reduced taxes due to interest deduction (.4 x 2,400,000) 960,000

Adjusted net income $760,560,000

As shown, increasing leverage by issuing bonds instead of common stock reduces net income. However,
there are also fewer shares of common stock outstanding. Assume the company has 183 million shares
of common stock outstanding. Earnings per share (EPS) with the additional debt would be USD 4.16 (or
USD 760,560,000/183 million shares), and EPS with the additional stock would be USD 4.05 (or USD
762,000,000/188 million shares).

Since investors place heavy emphasis on EPS amounts, many companies in recent years have introduced
large portions of debt into their capital structures to increase EPS, especially since interest rates have
been relatively low in recent years.

We should point out, however, that too low a percentage of stockholders' equity (too much debt) has its
dangers. Financial leverage magnifies losses per share as well as EPS since there are fewer shares of
stock over which to spread the losses. A period of business recession may result in operating losses and
shrinkage in the value of assets, such as receivables and inventory, which in turn may lead to an inability
to meet fixed payments for interest and principal on the debt. As a result, the company may be forced
into liquidation, and the stockholders could lose their entire investments.

Stockholders' equity to debt (debt to equity) ratio Analysts express the relative equities of owners and
creditors in several ways. To say that creditors held a 74.3 per cent interest in the assets of Synotech on
2010 December 31, is equivalent to saying stockholders held a 25.7 per cent interest. Another way of
expressing this relationship is the stockholders' equity to debt ratio:

Stockholders' equity for debt ratio = Stockholders 'equity Total debt Stockholders' equity for debt
ratio = Stockholders 'equity Total debt

Such a ratio for Synotech would be .28:1 (or USD 2,015.7 million/USD 7,155.1 million) on 2009
December 31, and .35:1 (or USD 2,440.8 million/USD 7,041.0 million) on 2010 December 31. This ratio is
often inverted and called the debt to equity ratio. Some analysts use only long-term debt rather than
total debt in calculating these ratios. These analysts do not consider short-term debt to be part of the
capital structure since it is paid within one year.

Profitability is an important measure of a company's operating success. Generally, we are concerned

with two areas when judging profitability: (1) relationships on the income statement that indicate a
company's ability to recover costs and expenses, and (2) relationships of income to various balance
sheet measures that indicate the company's relative ability to earn income on assets employed. Each of
the following ratios utilizes one of these relationships.

Rate of return on operating assets The best measure of earnings performance without regard to the
sources of assets is the relationship of net operating income to operating assets, the rate of return on
operating assets. This ratio shows the earning power of the company as a bundle of assets. By
disregarding both nonoperating assets and nonoperating income elements, the rate of return on
operating assets measures the profitability of the company in carrying out its primary business
functions. We can break the ratio down into two elements—the operating margin and the turnover of
operating assets.
 Operating margin reflects the percentage of each dollar of net sales that becomes net operating
income. Net operating income excludes nonoperating income elements such as extraordinary items,
cumulative effect on prior years of changes in accounting principle, losses or gains from discontinued
operations, interest revenue, and interest expense. Another name for net operating income is "income
before interest and taxes" (IBIT). The formula for operating margin is:

Operating margin = Net operatingincome Net sales Operating margin = Net operatingincome Net
sales

Turnover of operating assets shows the amount of sales dollars generated for each dollar invested in
operating assets. Operating assets are all assets actively used in producing operating revenues.
Typically, we use year-end operating assets, even though in theory an average would be
better. Nonoperating assets are owned by a company but not used in producing operating revenues,
such as land held for future use, a factory building rented to another company, and long-term bond
investments. Analysts do not use these nonoperating assets in evaluating earnings performance. Nor do
they use total assets that include nonoperating assets not contributing to the generation of sales. The
formula for the turnover of operating assets is:

Turnover of operating assets = Net sales Operating assets Turnover of operating assets = Net
sales Operating assets

The rate of return on operating assets of a company is equal to its operating margin multiplied by
turnover of operating assets. The more a company earns per dollar of sales and the more sales it makes
per dollar invested in operating assets, the higher is the return per dollar invested. To find the rate of
return on operating assets, use the following formulas:

Operating margin × Turnover of operating assets = Rate of return on operating assets Operating
margin × Turnover of operating assets = Rate of return on operating assets

or

Rate of return on operating assets = Net operating income Net sales × Net sales Operating assets Rate
of return on operating assets = Net operating income Net sales × Net sales Operating assets

Because net sales appears in both ratios (once as a numerator and once as a denominator), we can
cancel it out, and the formula for rate of return on operating assets becomes:

Rate of return on operating assets = Net operating income Operating assets Rate of return on
operating assets = Net operating income Operating assets

For analytical purposes, the formula should remain in the form that shows margin and turnover
separately, since it provides more information.

The rates of return on operating assets for Synotech for 2010 and 2009 are:

Amount of
(USD millions) 2010 2009 increase or
(decrease)
Net operating income (a)* $1,382.4 $682.7 $699.7

Net sales (b) $10,498.8 $10,029.8 $469.0

Operating assets (c) † $9,481.8 $9,170.8 $311.0

Operating margin (a/b) 13.17% 6.81%

Turnover of operating assets (b/c) 1.11 times 1.09 times

Rate of return on operating assets (a/c) 14.58% 7.44%

*Calculated as income before income taxes plus net interest expense. This method excludes
nonoperating items.

†When companies have no nonoperating assets, total assets are used in the calculation

Net income to net sales (return on sales) ratio Another measure of a company's profitability is the net
income to net sales ratio, calculated as follows:

Net income by net sales = Net income Net sales Net income by net sales = Net income Net sales

This ratio measures the proportion of the sales dollar that remains after deducting all expenses. The
computations for Synotech for 2010 and 2009 are:

An accounting perspective:
Business insight

Companies that are to survive in the economy must attain some minimum rate of return on operating
assets. However, they can attain this minimum rate of return in many different ways. To illustrate,
consider a grocery store and a jewelry store, each with a rate of return of 8 per cent on operating assets.
The grocery store normally would attain this rate of return with a low margin and a high turnover, while
the jewelry store would have a high margin and a low turnover, as shown here:

Margin x Turnover = Rate of return on operating assets

Grocery store 1% x 8.0 times = 8%

Jewelry store 20 x 0.4 =8

Amount of increase
(USD millions) 2010 2009
or (decrease)
 Net income (a) $ 762.0 $206.4 $555.6

Net sales (b) $10,498. $10,029. $469.0

8 8

Ratio of net income to net sales (a/b) 7.26% 2.06%

Although the ratio of net income to net sales indicates that the net amount of profit increased on each
sales dollar, exercise care in using and interpreting this ratio. The net income includes all nonoperating
items that may occur only in a particular period; therefore, net income includes the effects of such
things as extraordinary items, changes in accounting principle, effects of discontinued operations, and
interest charges. Thus, a period that contains the effects of an extraordinary item is not comparable to a
period that contains no extraordinary items. Also, since interest expense is deductible in the
determination of net income while dividends are not, the methods used to finance a company's assets
affect net income.

Return on average common stockholders' equity From the stockholders' point of view, an important
measure of the income-producing ability of a company is the relationship of return on average common
stockholders' equity, also called rate of return on average common stockholders' equity, or simply
the return on equity (ROE). Although stockholders are interested in the ratio of operating income to
operating assets as a measure of management's efficient use of assets, they are even more interested in
the return the company earns on each dollar of stockholders' equity. The formula for return on average
common stockholders' equity if no preferred stock is outstanding is:

Return on average common stockholders' equity = Net income Average common

stockholders'equity Return on average common stockholders' equity = Net income Average common
stockholders'equity

When a company has preferred stock outstanding, the numerator of this ratio becomes net income
minus the annual preferred dividends, and the denominator becomes the average book value of
common stock. As described in Chapter 12, the book value of common stock is equal to total
stockholders' equity minus (1) the liquidation value (usually equal to par value) of preferred stock and
(2) any dividends in arrears on cumulative preferred stock. Thus, the formula becomes:

Return on average common stockholders' equity = (Net income − Preferred stock dividends) Average
book value of commonstock Return on average common stockholders' equity = (Net income − Preferred
stock dividends) Average book value of commonstock

Synotech has preferred stock outstanding. The ratios for the company follow. Total common
stockholders' equity on 2009 January 1, was USD 1,697.4 million. Preferred dividends were USD 25.7
million in 2010 and USD 25.9 million in 2009.

(USD millions) 2010 2009 Amount of

increase or
 (decrease)

Net income – Preferred stock dividends $ 736.3 $ 180.5 $ 555.8 (a)

Total common stockholders' equity (book value of common stock):*

January 1 $1,531.5 $1,697.4 $(165.9)

December 31 1,969.6 1,531.5 438.1

Total (b) $3,501.1 $3,228.9 $272.2

Average common stockholders' equity (c) (b/2 = c): $1,750.6 $1,614.5

Return on common stockholders' equity (a/c) 42.06% 11.18%

*Total stockholders' equity – par value of preferred stock

The stockholders would regard the increase in the ratio from 11.18 per cent to 42.06 per cent favorably.
This ratio indicates that for each dollar of capital invested by a common stockholder, the company
earned approximately 42 cents in 2010.

An accounting perspective:
Business insight

Company 1 Company 2

Return on assets 12.0% 12.0%

Return on stockholders' equity 6.4 8.0

Sometimes, two companies have the same return on assets but have different returns on stockholders'
equity, as shown here:

The difference of 1.6 per cent in Company 2's favor is the result of Company 2's use of borrowed funds,
particularly long-term debt, in its capital structure. Use of these funds (or preferred stock with a fixed
return) is called trading on the equity. When a company is trading profitably on the equity, it is
generating a higher rate of return on its borrowed funds than it is paying for the use of the funds. The
excess, in this case 1.6 per cent, is accruing to the benefit of the common stockholders, because their
earnings are being increased.
Companies that magnify the gains from this activity for the stockholders are using leverage. Using
leverage is a risky process because losses also can be magnified, to the disadvantage of the common
stockholders. We discussed trading on the equity and leverage in Chapter 15.

Cash flow margin The cash flow margin measures a company's overall efficiency and performance.
The cash flow margin indicates the ability of a company to translate sales into cash. Measuring the
amount of cash a company generates from every dollar of sales is important because a company needs
cash to service debt, pay dividends, and invest in new capital assets. The formula for the cash flow
margin is:

Cash flow margin = Net cash provided by operating activities Net sales Cash flow margin = Net cash
provided by operating activities Net sales

Thus, we calculate Synotech's 2010 cash flow margin as follows:

USD 1,101.0 million net cash provided by operating activities USD 10,498.8 million net sales =10.49 per
cent USD 1,101.0 million net cash provided by operating activities USD 10,498.8 million net
sales =10.49 per cent

Earnings per share of common stock Probably the measure used most widely to appraise a company's
operations is earnings per share (EPS) of common stock. EPS is equal to earnings available to common
stockholders divided by the weighted average number of shares of common stock outstanding. The
financial press regularly publishes actual and forecasted EPS amounts for publicly traded corporations,
together with period-toperiod comparisons. The Accounting Principles Board noted the significance
attached to EPS by requiring that such amounts be reported on the face of the income
statement.52 (Chapter 13 illustrates how earnings per share should be presented on the income
statement.)

The calculation of EPS may be fairly simple or highly complex depending on a corporation's capital
structure. A company has a simple capital structure if it has no outstanding securities (e.g. convertible
bonds, convertible preferred stocks, warrants, or options) that can be exchanged for common stock. If a
company has such securities outstanding, it has a complex capital structure. Discussion of EPS for a
corporation with a complex capital structure is beyond the scope of this text.

A company with a simple capital structure reports a single basic EPS amount, which is calculated as
follows:

EPS of common stock = Earnings available for common stockholders Weighted − average number of
common shares outstanding EPS of common stock = Earnings available for common
stockholders Weighted − average number of common shares outstanding

The amount of earnings available to common stockholders is equal to net income minus the current
year's preferred dividends, whether such dividends have been declared or not.

Determining the weighted-average number of common shares The denominator in the EPS fraction is
the weighted-average number of common shares outstanding for the period. If the number of common
shares outstanding did not change during the period, the weighted-average number of common shares
outstanding would, of course, be the number of common shares outstanding at the end of the period.
The balance in the Common Stock account of Synotech (Exhibit 133) was USD 219.9 million on 2010
December 31. The common stock had a USD 1.20 par value. Assuming no common shares were issued or
redeemed during 2010, the weighted-average number of common shares outstanding would be 183.2
million (or USD 219.9 million/USD 1.20 per share). (Normally, common treasury stock reacquired and
reissued are also included in the calculation of the weighted-average number of common shares
outstanding. We ignore treasury stock transactions to simplify the illustrations.)

If the number of common shares changed during the period, such a change increases or decreases the
capital invested in the company and should affect earnings available to stockholders. To compute the
weighted-average number of common shares outstanding, we weight the change in the number of
common shares by the portion of the year that those shares were outstanding. Shares are outstanding
only during those periods that the related capital investment is available to produce income.

To illustrate, assume that during 2009 Synotech's common stock balance increased by USD 14.0 million
(11.7 million shares). Assume that the company issued 9.5 million of these shares on 2009 April 1, and
the other 2.2 million shares on 2009 October 1. The computation of the weighted-average number of
common shares outstanding would be:

171.5 million shares x 1 year 171.500 million

9.5 million shares x ¾ year (April – December) 7.125 million

2.2 million shares x ¼ year (October – December) 0.55

Weighted-average number of common shares outstanding 179.125 million

An alternate method looks at the total number of common shares outstanding, weighted by the portion
of the year that the number of shares was outstanding, as follows:

171.5 million shares x ¼ year (January – March) 42.875 million

181.0 million shares x ½ year (April – September) 90.500 million

183.2 million shares x 1/3 year (October – December) 45.800 million

Weighted-average number of shares outstanding 179.175 million

Another alternate method is:

171.5 million shares x 3 months = 514.5 million share-months

181.0 million shares x 6 months = 1,086.0 million share-months

183.2 million shares x 3 months = 549.6 million share-months

 12 months 2,150.1 million share-months

2,150.1 million share-months/12 months = 179.175 million

Note that all three methods yield the same result. In 2010, the balance in the common stock account did
not change as it had during 2009. Therefore, the weighted-average number of common shares
outstanding during 2010 is equal to the number of common shares issued, 183.2 million. The EPS of
common stock for the Synotech are:

Amount of increase or
(USD millions) 2010 2009
(decrease)

Net income-preferred dividends (a) USD 736.3 USD 180.50 USD 555.80

Average number of shares of common stock (b) 183.2 179.13 4.03

EPS of common stock (a,b) USD 4.02 USD 1.01

Synotech's stockholders would probably view the increase of approximately 298.0 per cent ([USD 4.02 -
USD 1.01]/USD 1.01) in EPS from USD 1.01 to USD 4.02 favorably.

EPS and stock dividends or splits Increases in shares outstanding as a result of a stock dividend or stock
split do not require weighting for fractional periods. Such shares do not increase the capital invested in
the business and, therefore, do not affect income. All that is required is to restate all prior calculations
of EPS using the increased number of shares. For example, assume a company reported EPS for 2010 as
USD 1.20 (or USD 120,000/100,000 shares) and earned USD 180,000 in 2011. The only change in
common stock over the two years was a two-for-one stock split on 2011 December 1, which doubled the
shares outstanding to 200,000. The firm would restate EPS for 2010 as USD 0.60 (or USD
120,000/200,000 shares) and as USD 0.90 (USD 180,000/200,000 shares) for 2011.

Basic EPS and diluted EPS In the merger wave of the 1960s, corporations often issued securities to
finance their acquisitions of other companies. Many of the securities issued were calls on common or
possessed equity kickers. These terms mean that the securities were convertible to, or exchangeable for,
shares of their issuers' common stock. As a result, many complex problems arose in computing EPS.
Until 1997, APB Opinion No. 15 provided guidelines for solving these problems. In 1997, FASB Statement
No. 128, "Earnings per Share" replaced APB Opinion No. 15. A company with a complex capital structure
must present at least two EPS calculations, basic EPS and diluted EPS. Because of the complexities
involved in the calculations, we reserve further discussion of these two EPS calculations for an
intermediate accounting text.

Times interest earned ratio Creditors, especially long-term creditors, want to know whether a borrower
can meet its required interest payments when these payments come due. The times interest earned
ratio, or interest coverage ratio, is an indication of such an ability. It is computed as follows:
 Time interest earned ratio = Income beforeinterest including taxes ( IBIT ) Interest expense Time
interest earned ratio = Income beforeinterest including taxes ( IBIT ) Interest expense

The ratio is a rough comparison of cash inflows from operations with cash outflows for interest expense.
Income before interest and taxes (IBIT) is the numerator because there would be no income taxes if
interest expense is equal to or greater than IBIT. (To find income before interest and taxes, take net
income from continuing operations and add back the net interest expense and taxes.) Analysts disagree
on whether the denominator should be (1) only interest expense on long-term debt, (2) total interest
expense, or (3) net interest expense. We will use net interest expense in the Synotech illustration.

For Synotech, the net interest expense is USD 236.9 million. With an IBIT of USD 1,382.4 million, the
times interest earned ratio is 5.84, calculated as:

USD1,382.4USD236.9=5.84 time ���1,382.4���236.9=5.84 time

The company earned enough during the period to pay its interest expense almost 6 times over.

Low or negative interest coverage ratios suggest that the borrower could default on required interest
payments. A company is not likely to continue interest payments over many periods if it fails to earn
enough income to cover them. On the other hand, interest coverage of 5 to 10 times or more suggests
that the company is not likely to default on interest payments.

Times preferred dividends earned ratio Preferred stockholders, like bondholders, must usually be
satisfied with a fixed-dollar return on their investments. They are interested in the company's ability to
make preferred dividend payments each year. We can measure this ability by computing the times
preferred dividends earned ratio as follows:

Time preferred dividends earned ratio = Net income Annual preferred dividends Time preferred
dividends earned ratio = Net income Annual preferred dividends

Synotech has a net income of USD 762.0 million and preferred dividends of USD 25.7 million. The
number of times the annual preferred dividends are earned for 2010 is:

USD762.0USD25.7=29.65:1, or 29.65 times USD⁡762.0USD⁡25.7=29.65:1, or 29.65 times

The higher this rate, the higher is the probability that the preferred stockholders will receive their
dividends each year.

Analysts compute certain ratios using information from the financial statements and information about
the market price of the company's stock. These tests help investors and potential investors assess the
relative merits of the various stocks in the marketplace.

The yield on a stock investment refers to either an earnings yield or a dividends yield.

Earnings yield on common stock You can calculate a company's earnings yield on common stock as
follows:

Earnings yield on common stock=EPSCurrent market price per share of common stockEarnings yield on
common stock=EPSCurrent market price per share of common stock
Assume Synotech has common stock with an EPS of USD 5.03 and that the quoted market price of the
stock on the New York Stock Exchange is USD 110.70. The earnings yield on common stock would be:

USD5.03USD110.7=4.54 per cent ���5.03���110.7=4.54 per cent

Price-earnings ratio When inverted, the earnings yield on common stock is the price-earnings ratio. To
compute the price-earnings ratio:

Price − earnings ratio = Current market price per share of commonstock EPS Price − earnings
ratio = Current market price per share of commonstock EPS

USD110.7USD 5.03=22.01:1USD110.7USD 5.03=22.01:1

Investors would say that this stock is selling at 22 times earnings, or at a multiple of 22. These investors
might have a specific multiple in mind that indicates whether the stock is underpriced or overpriced.
Different investors have different estimates of the proper price-earnings ratio for a given stock and also
different estimates of the future earnings prospects of the company. These different estimates may
cause one investor to sell stock at a particular price and another investor to buy at that price.

Payout ratio on common stock Using dividend yield, investors can compute the payout ratio on
common stock. Assume that Synotech's dividends per share were USD 1.80 and earnings per share were
USD 5.03. To calculate payout ratio on common stock, divide the dividend per share of common stock
by EPS. The payout ratio of stock in 2010 is:

Payout ratio on common stock= Dividend per share of common stock EPS Payout ratio on common
stock= Dividend per share of common stock EPS

USD1.80USD5.03=35.8 per centUSD⁡1.80USD⁡5.03=35.8 per cent

A payout ratio of 35.8 per cent means that the company paid out 35.8 per cent of its earnings in the
form of dividends. Some investors are attracted by the stock of companies that pay out a large
percentage of their earnings. Other investors are attracted by the stock of companies that retain and
reinvest a large percentage of their earnings. The tax status of the investor has a great deal to do with
this preference. Investors in high tax brackets often prefer to have the company reinvest the earnings
with the expectation that this reinvestment results in share price appreciation.

Dividend yield on common stock The dividend paid per share of common stock is also of much interest
to common stockholders. When the current annual dividend per share of common stock is divided by
the current market price per share of common stock, the result is called the dividend yield on common
stock. Synotech's 2010 December 31, common stock price was USD 110.70 per share. Its dividends per
share were USD 1.80. The company's dividend yield on common stock was:

Dividend yield on of common stock = Dividend per share of common stock Current market price per
share of commonstock Dividend yield on of common stock = Dividend per share of common
stock Current market price per share of commonstock

USD 1.80USD 110.7=1.63 per cent USD 1.80USD 110.7=1.63 per cent

Dividend yield on preferred stock Preferred stockholders, as well as common stockholders, are
interested in dividend yields. The computation of the dividend yield on preferred stock is similar to the
common stock dividend yield computation. Assume that Synotech's dividend per share of preferred
stock is USD 5.10 with a current market price of USD 84.00 per share. We compute the dividend yield on
preferred stock as follows:

Dividend yield on preferred stock = Dividend per share of preferredstock Current market price per
share of preferred stock Dividend yield on preferred stock = Dividend per share of
preferredstock Current market price per share of preferred stock

USD 5.10USD 84.00=6.07 per cent USD 5.10USD 84.00=6.07 per cent

Through the use of dividend yield rates, we can compare different preferred stocks having different
annual dividends and different market prices.

Cash flow per share of common stock Investors calculate the cash flow per share of common
stock ratio as follows:

Cash flow per share of common stock = Net cash provided by operating activities Average number of
shares of common stock outstanding Cash flow per share of common stock = Net cash provided by
operating activities Average number of shares of common stock outstanding

Currently, FASB Statement No. 95 does not permit the use of this ratio for external reporting purposes.
However, some mortgage and investment banking firms do use this ratio to judge the company's ability
to pay dividends and pay liabilities. The cash flow per share of common stock ratio for Synotech is as
follows:

Fiscal Year

2010 2009

Cash provided by operating activities (a) $1,101.0 $972.3

Average shares outstanding (b) (assumed) 146.6 145.2

Cash flow per share of common stock (a)/(b) $7.51 $6.70

Final considerations in financial statement analysis

Standing alone, a single financial ratio may not be informative. Investors gain greater insight by
computing and analyzing several related ratios for a company. Exhibit 135 summarizes the ratios
presented in this chapter, and Exhibit 136 presents them graphically.

Financial analysis relies heavily on informed judgment. As guides to aid comparison, percentages and
ratios are useful in uncovering potential strengths and weaknesses. However, the financial analyst
should seek the basic causes behind changes and established trends.
An accounting perspective:
Uses of technology

Most companies calculate some of the ratios we have discussed, if not all of them. To efficiently and
effectively perform these calculations, accountants use computers. Some programs that gather
information in the preparation of financial statements calculate the ratios at the end of a period.
Accountants also create spreadsheets to perform this task. Remember, to interpret the numbers
correctly, investors and management must compare these ratios with the industry in which the
company operates.

Liquidity ratios Formula Significance

Current, or working capital, Current assets + Current

Test of debt-paying ability
ratio liabilities

Quick assets (cash +

marketable securities + Test of immediate debt-paying
Acid-test (quick) ratio
net receivables) + ability
Current liabilities

(Cash and marketable

securities + Net cash
Test of short-term, debt-paying
Cash flow liquidity ratio provided by operating
ability
activities) + Current
liabilities

Net credit sales (or net

Test of quality of accounts
Accounts receivable turnover sales) + Average net
receivable
accounts receivable

Number of days in year

Number of days' sales in (365) + Accounts
Test of quality of accounts
accounts accounts receivable (average
receivable
receivable) collection period of
receivable turnover

Test of whether or not a sufficient

Cost of goods sold +
Inventory turnover volume of business is being
Average inventory
generated relative to inventory

Test of whether or not the volume

Net sales + Average total of business generated is adequate
Total assets turnover
assets relative to amount of capital
invested in the business
Equity, or Long-term Solvency, Ratios

Stockholders' equity +
Equity (stockholders' equity) Index of long-run solvency and
Total assets (or total
ratio safety
equities)

Measure of the relative proportion

Stockholders' equity to debt Stockholders' equity +
of stockholders' and of creditors'
(debt to equity) ratio Total debt
equities

Profitability Tests

Net operating income +

Operating assets or
Rate of return on operating
Operating margin x Measure of managerial
assets
Turnover operating
assets

Net income to net sales Indicator of the amount of net

Net income + Net sales
(return on sales) profit on each dollar of sales

Measure of what a given company

Net income + Average
Return on average common earned for its stockholders from all
common stockholders'
stockholders' equity sources as a percentage of
equity
common stockholders' investment

Net cash provided by Measure of the ability of a firm to

Cash flow margin
operating activities + Net sales translate sales into cash

Earnings available to
common stockholders' +
EPS of common stock Weighted-average Measure of the return to investors
number of common
shares outstanding

Test of the likelihood that expense

Income before interest
Times interest earned ratio creditors will continue to receive
and taxes + Interest
their interest payments

Test of the likelihood that

Time preferred dividends Net income + Annual
preferred stockholders will receive
earned ratio preferred dividends
their dividend each year
 Market Tests

EPS + Current market

Earnings yield on common Comparison with other common
price per share of
stock stocks
common stock

Current market price per Index of whether a stock is

Price-earnings ratio share of common stock + relatively cheap or expensive based
EPS on the ratio

Index of whether company pays

Pay cut ratio on common Dividend per share of out a large percentage of earnings
stock common stock + EPS as dividends or reinvests most of
its earnings

Dividend per share of

Dividend yield on common common stock + Current Comparisons with other common
stock market price per share of stocks
common stock

Dividend per share of

Dividend yield on preferred preferred stock + Comparison with other preferred
stock Current market price per stocks
share of preferred stock

Net cash provided by

operating activities +
Cash flow per share of Test of ability to pay dividends and
Average number of share
common stock liabilities
of common stock
outstanding

Exhibit 135: Summary of ratios

Analysts must be sure that their comparisons are valid - especially when the comparisons are of items
for different periods or different companies. They must follow consistent accounting practices if valid
interperiod comparisons are to be made. Comparable intercompany comparisons are more difficult to
secure. Accountants cannot do much more than disclose the fact that one company is using FIFO and
another is using LIFO for inventory and cost of goods sold computations. Such a disclosure alerts
analysts that intercompany comparisons of inventory turnover ratios, for example, may not be
comparable.

Also, when comparing a company's ratios to industry averages provided by an external source such as
Dun &
Bradstreet, the analyst should calculate the company's ratios in the same manner as the reporting
service. Thus, if Dun & Bradstreet uses net sales (rather than cost of goods sold) to compute inventory
turnover, so should the analyst. Net sales is sometimes preferable because all companies do not
compute and report cost of goods sold amounts in the same manner.

Facts and conditions not disclosed by the financial statements may, however, affect their interpretation.
A single important event may have been largely responsible for a given relationship. For example,
competitors may put a new product on the market, making it necessary for the company under study to
reduce the selling price of a product suddenly rendered obsolete. Such an event would severely affect
the percentage of gross margin to net sales. Yet there may be little chance that such an event will
happen again.

Analysts must consider general business conditions within the industry of the company under study. A
corporation's downward trend in earnings, for example, is less alarming if the industry trend or the
general economic trend is also downward.

Investors also need to consider the seasonal nature of some businesses. If the balance sheet date
represents the seasonal peak in the volume of business, for example, the ratio of current assets to
current liabilities may be much lower than if the balance sheet date is in a season of low activity.

Potential investors should consider the market risk associated with the prospective investment. They
can determine market risk by comparing the changes in the price of a stock in relation to the changes in
the average price of all stocks.

Potential investors should realize that acquiring the ability to make informed judgments is a long process
and does not occur overnight. Using ratios and percentages without considering the underlying causes
may lead to incorrect conclusions.

Relationships between financial statement items also become more meaningful when standards are
available for comparison. Comparisons with standards provide a starting point for the analyst's thinking
and lead to further investigation and, ultimately, to conclusions and business decisions. Such standards
consist of (1) those in the analyst's own mind as a result of experience and observations, (2) those
provided by the records of past performance and financial position of the business under study, and (3)
those provided about other enterprises. Examples of the third standard are data available through trade
associations, universities, research organizations (such as Dun & Bradstreet and Robert Morris
Associates), and governmental units (such as the Federal Trade Commission).

In financial statement analysis, remember that standards for comparison vary by industry, and financial
analysis must be carried out with knowledge of specific industry characteristics. For example, a
wholesale grocery company would have large inventories available to be shipped to retailers and a
relatively small investment in property, plant, and equipment, while an electric utility company would
have no merchandise inventory (except for repair parts) and a large investment in property, plant, and
equipment.

Even within an industry, variations may exist. Acceptable current ratios, gross margin percentages, debt
to equity ratios, and other relationships vary widely depending on unique conditions within an industry.
Therefore, it is important to know the industry to make comparisons that have real meaning.
Exhibit 136: Graphic depiction of financial statement analysis utilizing financial rations

The bankruptcies of companies like General Motors and Lehman Brothers, with the resulting significant
losses to employees, stockholders, and other members of the general public, have caused important
changes in corporate governance, standards of accounting, and auditing procedures and standards.
These changes have come about as a result of self-regulation, oversight by the Public Company
Accounting Oversight Board, regulation by the Securities and Exchange Commission, regulation by the
stock exchanges, and legislation passed by Congress, and by some combination of these actions. Further
changes are likely.

Financial statements are likely to become more "transparent". This means they will reveal more clearly
the results of operations and the financial condition of the company. There is likely to be an increased
focus on the balance sheet and on the quality and measurement of assets and the extent and nature of
liabilities as well as on a proper identification of other risks. The quality of earnings will continue to be of
paramount importance. There have been too many situations where companies have had to restate
their earnings for prior years because they did not properly disclose material facts or properly
implement the revenue recognition and/or expense recognition principles that were covered in Chapter
5.

An accounting perspective:
Business insight

The Enron situation was the focus of a massive investigation that led to significant changes in corporate
governance, accounting rules, and auditing procedures. Enron was formed in 1985 and became a major
player in the energy industry. Its stock reached a high of about USD 90 per share in August 2000. Top
executives began selling stock shortly thereafter, while at least for a short period during the ensuing fall
in the stock's price, employees were prevented from doing so. In October of 2001, the disclosure of off-
balance sheet partnerships, with attendant liabilities for Enron, resulted in a USD 1.2 billion write-off in
stockholder's equity. In November of 2001, Enron revealed that it had overstated earnings by USD 586
million since 1997. In December 2001, Enron filed for bankruptcy. Enron stock became almost worthless,
selling for under USD 1. Employees of Enron not only lost their jobs, but many also lost their retirement
savings because they consisted largely of Enron stock. Individual and pension fund investors as a group
lost billions of dollars. The state of Florida's pension fund lost about USD 340 million. Enron's external
auditor, Arthur Andersen & Co., was accused of shredding documents pertaining to Enron after the US
Justice Department confirmed its investigation and was indicated in March of 2002 for that action.

External auditors, internal auditors, audit committee members, and members of Boards of Directors are
likely to ask much tougher questions of management. They are also more likely to investigate
questionable transactions.

Audit committees may be required to publicly disclose their activities that were performed to carry out
their duties.

Management's letter to the stockholders contained in the annual report, and usually signed by the CEO,
contains the views of management regarding current operations, operating results, and plans for the
future. This letter is likely to become even more important in the future than it is now. There could be
financial penalties if this letter is purposely misleading in that its contents are not supported by the
financial statements or they misrepresent significant facts. To the extent these letters are more
conservative rather than being unrealistic, individuals analyzing financial statements will be able to rely
on their content to a greater extent in the future. The SarbanesOxley Act of 2002 in the US sets more
stringent standards for financial reporting for public companies and their managers. Boards, and
independent auditors, along with strict penalties for non-compliance.

Financial statement analysis is going to have increasing importance. There will be more focus on the
cash flow statement, covered in Chapter 16, and its "cash flow from operating activities", since this
amount is considered by some to be "cash earnings". Some consider this amount to be less susceptible
to manipulation than is net income.

Management may disclose in an accounting policy statement, its policies regarding their business
practices and those accounting policies that were followed in preparing the financial statements.
Conflicts of interest will be identified and discouraged.
Professional financial analysts, such as those working for stock brokerage firms and those employed to
help evaluate possible merger and acquisition candidates, typically go "beyond the numbers" in
analyzing a company. They usually visit the company, interview management, and assess the physical
facilities and plans for the future. They are interested in evaluating such factors as the competence and
integrity of management. Professional financial analysts form an overall impression of the company by
giving all of the data and other information the "smell test". In other words, does everything seem
legitimate or are there possible significant hidden factors that have not yet been identified which makes
one think that something is not right.

The future looks bright. Needed changes will be made to maintain public confidence in financial
reporting.

Protecting the public interest should be paramount in the future.

This chapter concludes our coverage of financial accounting. It is likely you will continue on with studies
in managerial accounting. It is important to realize that it is impossible to completely separate financial
and managerial accounting information into neat packages. Managers use both the published financial
statements and managerial accounting information in making decisions. Also, some of the concepts
covered in managerial accounting (e.g. job costing and process costing) have a direct impact on the
formal financial statements. Many accountants are attracted to managerial accounting because it is not
constrained by having to conform to generally accepted accounting principles. Instead, management
accountants can provide to management whatever information in whatever form management
requests.

Understanding the learning objectives

• A company's financial statements are analyzed internally by management and externally by investors,
creditors, and regulatory agencies.

• Management's analysis of financial statements primarily relates to parts of the company.

Management is able to obtain specific, special-purpose reports to aid in decision making.

• External users focus their analysis of financial statements on the company as a whole. They must rely
on the general-purpose financial statements that companies publish.

• Financial statement analysis consists of applying analytical tools and techniques to financial
statements and other relevant data to obtain useful information.

• This information is the significant relationships between data and trends in those data assessing the
company's past performance and current financial position.

• The information is useful for making predictions that may have a direct effect on decisions made by
many users of financial statements.

• Present and potential company investors use this information to assess the profitability of the firm.

• Outside parties and long-term creditors sometimes are interested in a company's solvency, and thus
use the information in predicting the company's solvency.
• Published reports are one source of financial information. Published reports include financial
statements, explanatory notes, letters to stockholders, reports of independent accountants, and
management's discussion and analysis (MDA).

• Government reports are another source of financial information and include Form 10-K, Form 10-Q,
and Form 8-K. These reports are available to the public for a small charge.

• Financial service information, business publications, newspapers, and periodicals offer meaningful
financial information to external users. Moody's Investors Services; Standard & Poor's; Dun &
Bradstreet, Inc.; and Robert Morris Associates all provide useful industry information. Business
publications, such as The Wall Street Journal and Forbes, also report industry financial news.

• Horizontal analysis is the calculation of dollar changes or percentage changes in comparative

statement items or totals. Use of this analysis helps detect changes in a company's performance and
highlights trends.

• Vertical analysis consists of a study of a single financial statement in which each item is expressed as a
percentage of a significant total. Use of this analysis is especially helpful in analyzing income statement
data such as the percentage of cost of goods sold to sales or the percentage of gross margin to sales.

• Trend analysis compares financial information over time to a base year. The analysis is calculated by:

(a) Selecting a base year or period.

(b) Assigning a weight of 100 per cent to the amounts appearing on the base-year financial statements.

(c) Expressing the corresponding amounts shown on the other years' financial statements as a
percentage of base-year or period amounts. The percentages are computed by dividing nonbase-year
amounts by the corresponding base-year amounts and then multiplying the results by 100.

Trend analysis indicates changes that are taking place in an organization and highlights the direction of
these changes.

• Liquidity ratios indicate a company's short-term debt-paying ability. These ratios include (1) current,
or working capital, ratio; (2) acid-test (quick) ratio; (3) cash flow liquidity ratio; (4) accounts receivable
turnover; (5) number of days' sales in accounts receivable; (6) inventory turnover; and (7) total assets
turnover.

• Equity, or long-term solvency, ratios show the relationship between debt and equity financing in a
company. These ratios include (1) equity (stockholders' equity) ratio and (2) stockholders' equity to debt
ratio.

• Profitability tests are an important measure of a company's operating success. These tests include (1)
rate of return on operating assets, (2) net income to net sales, (3) net income to average common
stockholders' equity, (4) cash flow margin, (5) earnings per share of common stock, (6) times interest
earned ratio, and (7) times preferred dividends earned ratio.

• Market tests help investors and potential investors assess the relative merits of the various stocks in
the marketplace. These tests include (1) earnings yield on common stock, (2) price-earnings ratio, (3)
dividend yield on common stock, (4) payout ratio on common stock, (5) dividend yield on preferred
stock, and (6) cash flow per share of common stock.

• For a complete summary and a graphic depiction of all liquidity, long-term solvency, profitability, and
market test ratios, see Exhibit 135 and Exhibit 136.

• Need for comparative data: Analysts must be sure that their comparisons are valid - especially when
the comparisons are of items for different periods or different companies.

• Influence of external factors: A single important event, such as the unexpected placing of a product
on the market by a competitor, may affect the interpretation of the financial statements. Also, the
general business conditions and the possible seasonal nature of the business must be taken into
consideration, since these factors could have an impact on the financial statements.

• Impact of inflation: Since financial statements fail to reveal the impact of inflation on the reporting
entity, one must make sure that the items being compared are all comparable; that is, the impact of
inflation has been taken into consideration.

• Need for comparative standards: In financial statement analysis, remember that standards for
comparison vary by industry, and financial analysis must be carried out with knowledge of specific
industry characteristics.

Analysis of Financial Statements

Guide to analyzing financial statements for financial analysts

Written by CFI Team

Updated December 5, 2022

Reviewed by Jeff Schmidt

Guide to Financial Statement Analysis

One of the main tasks of an analyst is to perform an extensive analysis of financial statements. In this
free guide, we will break down the most important types and techniques of financial statement analysis.

This guide is designed to be useful for both beginners and advanced finance professionals, with the main
topics covering: (1) the income statement, (2) the balance sheet, (3) the cash flow statement, and (4)
rates of return.

1. Income Statement Analysis

Most analysts start their financial statement analysis with the income statement. Intuitively, this is
usually the first thing we think about with a business… we often ask questions such as, “How much
revenue does it have?” “Is it profitable?” and “What are the margins like?”

In order to answer these questions, and much more, we will dive into the income statement to get
started.

There are two main types of analysis we will perform: vertical analysis and horizontal analysis.

Vertical Analysis

With this method of analysis, we will look up and down the income statement (hence, “vertical”
analysis) to see how every line item compares to revenue, as a percentage.

For example, in the income statement shown below, we have the total dollar amounts and the
percentages, which make up the vertical analysis.
As you see in the above example, we do a thorough analysis of the income statement by seeing each
line item as a proportion of revenue.

The key metrics we look at are:

 Cost of Goods Sold (COGS) as a percent of revenue

 Gross profit as a percent of revenue

 Depreciation as a percent of revenue

 Selling General & Administrative (SG&A) as a percent of revenue

 Interest as a percent of revenue

 Earnings Before Tax (EBT) as a percent of revenue

 Tax as a percent of revenue

 Net earnings as a percent of revenue

To learn how to perform this analysis step-by-step, please check out our Financial Analysis
Fundamentals Course.

Key Highlights

 One of the main tasks of a financial analyst is to perform an extensive analysis of a company’s
financial statements. This usually begins with the income statement but also includes the
balance sheet and cash flow statement.

 The main goal of financial analysis is to measure a company’s financial performance over time
and against its peers.

 This analysis can then be used to forecast a company’s financial statements into the future.
Horizontal Analysis

Now it’s time to look at a different way to evaluate the income statement. With horizontal analysis, we
look at the year-over-year (YoY) change in each line item.

In order to perform this exercise, you need to take the value in Period N and divide it by the value in
Period N-1 and then subtract 1 from that number to get the percent change.

For the below example, revenue in Year 3 was $55,749, and in Year 2, it was $53,494. The YoY change in
revenue is equal to $55,749 / $53,494 minus one, which equals 4.2%.

To see exactly how to perform this horizontal analysis of financial statements, please enroll in
our Financial Analysis Fundamentals Course now!

2. Balance Sheet and Leverage Ratios

Let’s move on to the balance sheet. In this section of financial statement analysis, we will evaluate the
operational efficiency of the business. We will take several items on the income statement and compare
them to accounts on the balance sheet.

The balance sheet metrics can be divided into several categories, including liquidity, leverage, and
operational efficiency.

The main liquidity ratios for a business are:

 Quick ratio

 Current ratio

 Net working capital

The main leverage ratios are:

 Debt to equity
  Debt to capital

 Debt to EBITDA

 Interest coverage

 Fixed charge coverage ratio

The main operating efficiency ratios are:

 Inventory turnover

 Accounts receivable days

 Accounts payable days

 Total asset turnover

 Net asset turnover

Using the above financial ratios, we can determine how efficiently a company is generating revenue and
how quickly it’s selling inventory.

Using the financial ratios derived from the balance sheet and comparing them historically versus
industry averages or competitors will help you assess the solvency and leverage of a business.

In our course on Analysis of Financial Statements, we explore all the above metrics and ratios in great
detail.

3. Cash Flow Statement Analysis

With the income statement and balance sheet under our belt, let’s look at the cash flow statement and
all the insights it tells us about the business.

The cash flow statement will help us understand the inflows and outflows of cash over the time period
we’re looking at.

Cash flow statement overview

The cash flow statement, or statement of cash flow, consists of three components:

 Cash from operations

 Cash used in investing

 Cash from financing

Each of these three sections tells us a unique and important part of the company’s sources and uses of
cash over a specific time period.

Many investors consider the cash flow statement the most important indicator of a company’s
performance.

Today, investors quickly flip to this section to see if the company is actually making money or not and
what its funding requirements are.
It’s important to understand how different ratios can be used to properly assess the operation of an
organization from a cash management standpoint.

Below is an example of the cash flow statement and its three main components. Linking the 3
statements together in Excel is the building block of financial modeling. To learn more, please see
our online courses to learn the process step by step.

4. Rates of Return and Profitability Analysis

In this part of our analysis of financial statements, we unlock the drivers of financial performance. By
using a “pyramid” of ratios, we are able to demonstrate how you can determine the profitability,
efficiency, and leverage drivers for any business.
This is the most advanced section of our financial analysis course, and we recommend that you watch a
demonstration of how professionals perform this analysis.

The course includes a hands-on case study and Excel templates that can be used to calculate individual
ratios and a pyramid of ratios from any set of financial statements.

The key insights to be derived from the pyramid of ratios include:

 Return on equity ratio (ROE)

 Profitability, efficiency and leverage ratios

 Primary, secondary and tertiary ratios

 Dupont analysis

By constructing the pyramid of ratios, you will gain an extremely solid understanding of the business and
its financial statements.

Enroll in our financial analysis course to get started now!

More Financial Statement Analysis

We hope this guide on the analysis of financial statements has been a valuable resource for you. If you’d
like to keep learning with free CFI resources, we highly recommend these additional guides to improve
your financial statement analysis:

 How to Link the 3 Financial Statements

 Guide to Financial Modeling

 How to be a World-class Financial Analyst

 Interactive Career Map

 See all accounting resources

What Is Financial Ratio Analysis?

Financial ratio analysis uses the data contained in financial documents like the balance
sheet and statement of cash flows to assess a business's financial strength. These financial ratios help
business owners and average investors assess profitability, solvency, efficiency, coverage, market value,
and more.

Key Takeaways

 Financial ratio analysis assesses the performance of the firm's financial functions of liquidity,
asset management, solvency, and profitability.

 Financial ratio analysis is a powerful analytical tool that can give the business firm a complete
picture of its financial performance on both a trend and an industry basis.

 The information gleaned from a firm's financial statements by ratio analysis is useful for financial
managers, competitors, and average investors.

 Financial ratio analysis is only useful if data is compared to past performance or to other
companies in the same industry.

What Is Financial Ratio Analysis?

Financial ratios are useful tools that help business managers, owners, and potential investors analyze
and compare financial health. They are one tool that makes financial analysis possible across a firm's
history, an industry, or a business sector.

Financial ratio analysis uses the data gathered from these ratios to make decisions about improving a
firm's profitability, solvency, and liquidity.

Types of Financial Ratios

There are six categories of financial ratios that business managers normally use in their analysis. Within
these six categories are multiple financial ratios that help a business manager and outside investors
analyze the financial health of the firm.

Note

It's important to note that financial ratios are only meaningful in comparison to other ratios for different
time periods within the firm. They can also be used for comparison to the same ratios in other
industries, for other similar firms, or for the business sector.

Liquidity Ratios

The liquidity ratios answer the question of whether a business firm can meet its current debt obligations
with its current assets. There are three major liquidity ratios that business managers look at:

 Working capital ratio: This ratio is also called the current ratio (current assets - current
liabilities). These figures are taken off the firm's balance sheet. It measures whether the
business can pay its short-term debt obligations with its current assets.
  Quick ratio: This ratio is also called the acid test ratio (current assets - inventory/current
liabilities). These figures come from the balance sheet. The quick ratio measures whether the
firm can meet its short-term debt obligations without selling any inventory.

 Cash ratio: This liquidity ratio (cash + cash equivalents/current liabilities) gives analysts a more
conservative view of the firm's liquidity since it uses only cash and cash equivalents, such as
short-term marketable securities, in the numerator. It indicates the ability of the firm to pay off
all its current liabilities without liquidating any other assets.1

Efficiency Ratios

Efficiency ratios, also called asset management ratios or activity ratios, are used to determine how
efficiently the business firm is using its assets to generate sales and maximize profit or shareholder
wealth. They measure how efficient the firm's operations are internally and in the short term. The four
most commonly used efficiency ratios calculated from information from the balance sheet and income
statement are:

 Inventory turnover ratio: This ratio (sales/inventory) measures how quickly inventory is sold and
restocked or turned over each year. The inventory turnover ratio allows the financial manager to
determine if the firm is stocking out of inventory or holding obsolete inventory.

 Days sales outstanding: Also called the average collection period (accounts receivable/average
sales per day), this ratio allows financial managers to evaluate the efficiency with which the firm
is collecting its outstanding credit accounts.

 Fixed assets turnover ratio: This ratio (sales/net fixed assets) focuses on the firm's plant,
property, and equipment, or its fixed assets, and assesses how efficiently the firm uses those
assets.

 Total assets turnover ratio: The total assets turnover ratio (sales/total assets) rolls the evidence
of the firm's efficient use of its asset base into one ratio. It allows analysts to gauge how
efficiently the asset base is generating sales and profitability.2

Solvency Ratios

A business firm's solvency, or debt management, ratios allow the analyst to appraise the position of the
business firm's debt financing or financial leverage that they use to finance their operations. The
solvency ratios gauge how much debt financing the firm uses as compared to either its retained earnings
or equity financing. There are two major solvency ratios:

 Total debt ratio: The total debt ratio (total liabilities/total assets) measures the percentage of
funds for the firm's operations obtained by a combination of current liabilities plus its long-term
debt.

 Debt-to-equity ratio: This ratio (total liabilities/total assets - total liabilities) is most important if
the business is publicly traded. The information from this ratio is essentially the same as from
the total debt ratio, but it presents the information in a form that investors can more readily
utilize when analyzing the business.3

Coverage Ratios
The coverage ratios measure the extent to which a business firm can cover its debt obligations and meet
the associated costs. Those obligations include interest expenses, lease payments, and, sometimes,
dividend payments. These ratios work with the solvency ratios to give a financial manager a full picture
of the firm's debt position. Here are the two major coverage ratios:

 Times interest earned ratio: This ratio (earnings before interest and taxes (EBIT)/interest
expense) measures how well a business can service its total debt or cover its interest payments
on debt.4

 Debt service coverage ratio: The DSCR (net operating income/total debt service charges) is a
valuable summary ratio that allows the firm to get an idea of how well the firm can cover all of
its debt service obligations.5

Profitability Ratios

Profitability ratios are the summary ratios for the business firm. When profitability ratios are calculated,
they sum up the effects of liquidity management, asset management, and debt management on the
firm. The four most common and important profitability ratios are:

 Net profit margin: This ratio (net income/sales) shows the profit per dollar of sales for the
business firm.

 Return on total assets (ROA): The ROA ratio (net income/sales) indicates how efficiently every
dollar of total assets generates profit.6

 Basic earning power (BEP): BEP (EBIT/total assets) is similar to the ROA ratio because it
measures the efficiency of assets in generating sales. However, the BEP ratio makes the
measurement free of the influence of taxes and debt.7

 Return on equity (ROE): This ratio (net income/common equity) indicates how much money
shareholders make on their investment in the business firm. The ROE ratio is most important for
publicly traded firms.8

Market Value Ratios

Market Value Ratios are usually calculated for publicly held firms and are not widely used for very small
businesses. Some small businesses are, however, traded publicly. There are three primary market value
ratios:

 Earnings per share (EPS): As the name implies, this measurement conveys the business's
earnings on a per-share basis. It is calculated by dividing the net income by the outstanding
shares of common stock.

 Price/earnings ratio (P/E): The P/E ratio (stock price per share/earnings per share) shows how
much investors are willing to pay for the stock of the business firm per dollar of profits. 9

 Price/cash flow ratio: A business firm's value is dependent on its free cash flows. The price/cash
flow ratio (stock price/cash flow per share) assesses how well the business generates cash flow.

 Market/book ratio: This ratio (stock price/book value per share) gives the analyst another
indicator of how investors view the value of the business firm.
  Dividend yield: The dividend yield divides a company's annual dividend payments by its stock
price to help investors estimate their passive income. Dividends are typically paid quarterly, and
each payment can be annualized to update the dividend yield throughout the year. 10

 Dividend payout ratio: The dividend payout ratio is similar to the dividend yield, but it's relative
to the company's earnings rather than the stock price. To calculate this ratio, divide the dollar
amount of dividends paid to investors by the company's net income.11

How Does Financial Ratio Analysis Work?

Financial ratio analysis is used to extract information from the firm's financial statements that can't be
evaluated simply from examining those statements. Ratios are generally calculated for either a quarter
or a year.

Note

To calculate financial ratios, an analyst gathers the firm's balance sheet, income statement, and
statement of cash flows, along with stock price information if the firm is publicly traded. Usually, this
information is downloaded to a spreadsheet program.

Small businesses can set up their spreadsheet to automatically calculate each of these financial ratios.

Interpretation of Financial Ratio Analysis

One ratio calculation doesn't offer much information on its own. Financial ratios are only valuable if
there is a basis of comparison for them. Each ratio should be compared to past periods of data for the
business. The ratios can also be compared to data from other companies in the industry.

It is only after comparing the financial ratios to other time periods and to the companies' ratios in the
industry that an analyst can draw conclusions about the firm performance.12

For example, if a firm's debt-to-asset ratio for one time period is 50%, that doesn't tell a useful story
unless it's compared to previous periods, especially if the debt-to-asset ratio was much lower or higher
historically. In this scenario, the debt-to-asset ratio shows that 50% of the firm's assets are financed by
debt. The financial manager or an investor wouldn't know if that is good or bad unless they compare
it to the same ratio from previous company history or to the firm's competitors.

Note

Performing an accurate financial ratio analysis and comparison helps companies gain insight into their
financial position so that they can make necessary financial adjustments to enhance their financial
performance.

There are other financial analysis techniques that owners and potential investors can combine with
financial ratios to add to the insights gained. These include analyses such as common size analysis and a
more in-depth analysis of the statement of cash flows.13

Who Uses Financial Ratio Analysis?

Several stakeholders might need to use financial ratio analysis:

  Financial managers: Financial managers must have the information that financial ratio analysis
imparts about the performance of the various financial functions of the business firm. Ratio
analysis is a valuable and powerful financial analysis tool.

 Competitors: Other business firms find the information about the other firms in their industry
important for their own competitive strategy.

 Investors: Current and potential investors (whether publicly traded or financed by venture
capital) need the financial information gleaned from ratio analysis to determine whether or not
they want to invest in the business.

Frequently Asked Questions (FAQs)

What are 5 key financial ratios?

Five of the most important financial ratios for new investors include the price-to-earnings ratio, the
current ratio, return on equity, the inventory turnover ratio, and the operating margin.

Why is financial ratio analysis important?

Financial ratio analysis quickly gives you insight into a company's financial health. Rather than having to
look at raw revenue and expense data, owners and potential investors can simply look up financial ratios
that summarize the information they want to learn.