49
IX.
FINANCIAL STATEMENT ANALYSIS
Financial statements of a business must be analyzed and interpreted in order to
evaluate the financial condition of the company and the results of its operations.
Financial statement analysis provides information that is necessary to evaluate
the financial dimensions of management performance, detect emerging trends
and to help explain relationships contained in the basic financial statements. The
financial statements of Alamo Distributing Company will be analyzed in the
following sections. The analysis will concentrate on three major areas: A)
liquidity, B) profitability and C) capital structure.
A. Liquidity Ratios. Liquidity refers to the cash equivalence of assets and the firm's ability
to maintain sufficient near-cash resources to meet its obligations in a timely manner.
1. Current ratio: current assets
current liabilities
2. Quick Asset Ratio: cash + securities + A/R
current liabilities
3. Inventory turnover: cost of goods sold
inventory
4. Receivables turnover:
sales
accounts receivable
5. Working capital turnover:
sales
working capital
20X1
20X2
172,000
100,000
199,500
103,000
1.72
1.94
135,000
100,000
143,000
103,000
1.35
1.39
350,000
31,000
580,000
52,000
11.3
11.2
900,000
65,000
1,200,000
105,000
13.8
11.4
900,000
72,000
1,200,000
96,500
12.5
12.4
50
Overall Liquidity Evaluation
The ratios used to analyze liquidity must be evaluated as a group. The following
comparative ratios provide a composite basis for evaluating liquidity.
Alamo Distributing Company
Current ratio
Quick Asset ratio
Inventory turnover
Receivables turnover
Working Capital turnover
20X1
1.7
1.4
11.3
13.8
12.4
20X2
1.9
1.4
11.2
11.4
12.4
Change on Liquidity
Favorable impact
Essentially no change
Essentially no change
Negative impact
Essentially no change
The decrease in receivables turnover is the most negative factor in the liquidity evaluation.
The increase in receivables without a material change in current liabilities explains the
favorable trend in the current ratio. The decrease in receivables turnover will not cause a
major liquidity problem unless the firm must use short-term debt as a source of cash to
sustain operations in the next period. A projected cash flow analysis based on budgeted
sales for the next year would be necessary to evaluate this possible liquidity problem.
The increase in time required to collect receivables is shown by the alternative measure
(Days Sales Uncollected) which increased from 26.4 days to 32.0 days.
Alamo Distributing
Sales
÷ Accounts receivable
Receivables turnover
Days in a year
÷ Receivables turnover
Days Sales Uncollected
20X1
$900,000
÷ 65,000
13.8
====
365 days
÷ 13.8
26.4 days
=========
20X2
$1,200,000
÷105,000
11.4
====
365 days
÷ 11.4
32.0 days
=========
The longer collection period could indicate a problem with the collectability of receivables
or some change in credit policy. The liquidity effect of a decrease in receivables turnover
is that it takes a longer time period for the company to convert its receivables into cash.
51
B. Profitability Ratios - The principal objectives of profit- ability analysis are to evaluate
four critical factors related to profits: 1) operating efficiency; 2) asset productivity; 3)
rate of return on assets; and 4) rate of return on equity.
1. Operating Efficiency - A useful way to evaluate operating efficiency is to construct
a common sized income statement. In common size income statements, sales
are expressed as 100%, and all other items in the income statement are
expressed as a percentage of sales. Common size income statements for Alamo
Distributing Company are summarized in Exhibit 8.
EXHIBIT 8
ALAMO DISTRIBUTING COMPANY
*COMMON SIZE INCOME STATEMENTS
For Years Ending December 31, 20X1 and 20X2
20X1
20X2
Sales
100%
100%
Cost of Goods Sold
(39)
(48)
Gross Profit on Sales
61%
52%
Selling Expenses
(12)
(11)
Administrative Expenses
(26)
(21)
Income from Operations
22%
20%
Interest Expense
(6)
(5)
Income before Taxes
16%
15%
Income Tax Expense
(6)
(6)
Net Income
10%
9%
General Reference Items
20X1
20X2
% Change
Sales
$900,000
$1,200,000
+33%
Net Income
$ 90,000
$ 108,000
+20%
10%
9%
Net Income to Sales
* Developed from the income statements presented in Exhibit 2
52
Evaluation of Operating Efficiency
A company should attempt to achieve a given sales volume with the minimum possible cost.
Operating efficiency results are measured by relating expense items in the income statement
to sales on a percentage basis. In the common size income statement, sales are expressed
as 100%, and all other items in the income statement are expressed as a percentage of
sales. By relating all income statement items to sales, the common size statements permit
comparison of expense levels and profit measures on a relative basis. With amounts
converted to a percentage basis, it is easier to pinpoint areas of improvement or deterioration
in profitability.
In Exhibit 8, it is apparent that cost of goods sold has increased significantly as a percentage
of sales (from 39% to 48%). This change is responsible for the decrease in gross profit
percentage (from 61% to 52%). This decrease in profitability was partially offset by selling
and administrative expenses which decreased as a percentage of sales (from 38% on a
combined basis to 32%). The decrease in gross profit percentage could have been caused
by an increase in the cost of inventory that the firm was unable to pass on to customers in
the form of higher selling prices. The change in gross profit percentage could also be caused
by a shift in product mix such that a higher proportion of total sales is derived from less
profitable product lines. An investor or creditor that analyzes the income statements of
Alamo Distributing Company would see only the effect of decreasing profitability without
knowing the exact causes. Management of the company would know or could determine the
causes underlying the decreased profitability.
On a comparative basis, any of the percentage relationships in the common size income
statement can be evaluated separately. To concentrate on operating efficiency, three ratios
are important indicators.
Ratio
How Computed
Alamo Distr.
20X1
20X2
Gross profit margin
Gross profit ÷ sales
61%
52%
Operating expense ratio
Selling and admin.
expenses ÷ sales
38%
32%
Operating Profit Margin
Operating Income/Sales
22%
20%
Net profit margin
Net income ÷ sales
10%
9%
As an overall evaluation, operating efficiency declined during 20X2 compared with 20X1.
Principal factors were the decrease in gross profit margin (a negative factor), the decrease in
the operating expense ratio (a positive result), and the decrease in net profit margin (a
negative factor). The evaluation of operating efficiency is negative even though sales and
net income increased in dollar amount. In 20X2, 9¢ of every sales dollar was retained as
profit, whereas 10¢ of every sales dollar was retained as profit in 20X1.
53
2. Asset Productivity. Sales divided by assets measures the revenue productivity of
resources employed by a company. The revenue productivity of total resources is
an important factor in evaluating profitability. Asset productivity is measured by a
ratio called asset turnover. This ratio is computed as sales divided by total assets.
Alamo Distributing
Sales
÷ Total Assets
Asset Turnover
20X1
$900,000
750,000
1.20
20X2
$1,200,000
929,500
1.29
Some analysts prefer to use a measure of average assets for a period instead of
the total assets at a balance sheet date as done here. The balance sheet date
approach is simpler and will be used throughout the financial statement ratio
material in this chapter. The asset turnover ratios indicate that each dollar of
assets produced $1.20 of sales in 20X1 and $1.29 of sales in 20X2. The basic
concept of asset productivity is that resources are used to generate or support
sales volume.
3. Return on Assets. Profitability is affected by operating efficiency and asset
productivity. A comprehensive measure of profitability that considers both profits
and resources employed to earn profits is the rate of return on assets. Rate of
return on assets is computed as net income divided by assets.
Alamo Distributing
Net Income
÷ Total Assets
Rate of return on assets
20X1
$ 90,000
750,000
12.0%
20X2
$108,000
929,500
11.6%
Rate of return on assets is influenced by net profit margin and asset turnover.
The following equations show this relationship.
Return on Assets = (Profit Margin) X (Asset Turnover)
{Net Income} / {Assets} = ({Net Income} /{Sales}) X ({Sales}/{Assets})
({Net Income} / {Assets}) = {Net Income} / {Assets}
54
For Alamo Distributing Company, this relationship can be used to examine
the decline in rate of return on assets.
Alamo Distributing
For year 20X1
For year 20X2
Profit
Asset
Margin X Turnover
10%
1.20
9%
1.29
=
Return
on Assets
12.0%
11.6%
On a comparative basis, the rate of return on assets in 20X2 is not
significantly below the 20X1 ratio of 12.0%. The 11.6% rate of return on
assets in 20X2 is partly attributable to the improvement in asset turnover, or
otherwise rate of return on assets would have decreased significantly. In
general, the overall profitability of Alamo Distributing deteriorated in 20X2.
4. Return on Equity. Another rate of return measure that is significant to the
financial management of a company is rate of return on owners' equity. This
ratio is computed as net income divided by owners' equity.
Alamo Distributing
Net Income
÷ Owners' equity
Return on owners' equity
20X1
$ 90,000
338,000
26.6%
20X2
$108,000
426,000
25.4%
Return on owners’ equity measures the profitability of the owners' interest in
total assets. Return on equity is influenced by profit margin, asset turnover
and the relationship between total debt and owners' equity. If a firm
increases its assets with debt financing, then the owners' equity would
represent a smaller percentage of total resources. As profits increase in this
case, the return on owners' equity would also increase.
C. Capital Structure Ratios. The capital structure of a company refers to the
sources of financing used to acquire assets and is shown by the liabilities and
55
owners' equity section of the balance sheet. In analyzing capital structure, there
are two primary concerns: the amount of debt relative to the owners' equity; the
ability to service the principal and the interest requirements on debt. The
following ratios are useful in evaluating these considerations:
Capital Structure Ratios
Debt to Equity
How Computed
Total liabilities ÷ Total owners' equity
Times interest earned
Operating Income ÷ interest expense
Debt service margin
(Cash provided by operations) ÷
(installments due on long-term debt)
1. Debt to Equity Ratio. The proportion of total debt relative to equity is an
important indicator of the credit risk to which a company is exposed. Credit
risk is the possibility that interest and debt repayment cannot be satisfied with
available cash flows.
Alamo Distributing
Total liabilities
÷ Total owners' equity
Debt to equity ratio
20X1
$412,000
338,000
1.22
20X2
$503,500
426,000
1.18
For Alamo Distributing, the debt to equity ratio for 20X2 indicates that the firm
has $1.18 of liabilities for every $1.00 of owners' equity. The decrease in the
debt to equity ratio indicates that debt has become a smaller proportion of
total financing, as shown by the following percentage relationships.
Alamo Distributing
20X1
20X2
Total liabilities
Total owners' equity
Total Sources of Assets
55%
45
100%
54%
46
100%
2. Times Interest Earned. Interest on current and long-term liabilities is
reported in the income statement as an expense that is subtracted from
56
operating income. Income from operations must be sufficient to cover the
required interest expense before there can be profits to the stock- holders of
a corporation. "Times interest earned" is a ratio that indicates the adequacy
of income from operations to cover required interest charges.
Alamo Distributing
Income from operations
÷ Interest expense
Times interest earned
20X1
$202,000
52,000
3.88
20X2
$236,500
65,000
3.64
3. Debt Service Margin. This ratio measures the adequacy of cash provided by
operations to cover required annual installment payments on the principal
amount of long-term liabilities. As indicated in the earlier cash flow discussion, cash provided by operations should be viewed as a major source of
cash used to retire long-term debt. Long-term debt scheduled to mature in
annual installments will be classified as a current liability to the extent that
payments are due within one year from a given balance sheet date.
Alamo Distributing
Cash provided by operations
÷ Installment due on long-term debt
Debt service margin
20X1
*$285,000
60,000
4.75
20X2
$177,500
32,000
5.55
*(cash flow for 20X1 is an assumed amount)
For Alamo Distributing Company, the debt service margin for 20X2 indicates
that $5.55 of cash provided by operations was generated to service each $1
of long-term debt that will mature in the next year. This increase in debt
service margin from 4.74 to 5.55 indicates less pressure to use operating
cash flows for debt service purposes.
Comparative Evaluation in Statement Analysis
57
The analysis and interpretation of financial statements involve a process of
comparative evaluation. Measures of profitability, liquidity and capital structure
are studied to determine the existence of potential financial problems or failure to
achieve desired performance levels. One form of comparative evaluation is to
relate ratios for the current period to the same ratios for one or more past
periods. Most analysts believe that from three to five accounting periods are
required to provide an adequate comparative base. Reviews of past financial
performance should involve the current year (or interim period) and at least the
two preceding accounting periods of a comparable duration. For internal
analysis purposes, management will also compare actual financial results with
budgeted amounts to evaluate performance.
Financial statement ratios for a particular company may also be comparatively
evaluated in terms of industry standards. Industry standards are representative
measures for firms in the same line of business or industry. Industry standards
are available from trade associations and groups which compile financial
statement ratios for many industries. Financial statement studies for several
types of industry and business activity are published by Dun and Bradstreet and
Robert Morris Associates. For any given line of business, these studies will
report a median ratio for the survey group. The median ratio is usually
accompanied by two other measures showing the median of the upper 50% and
the median of the lower 50%. Financial statement ratios for manufacturing
companies in numerous industries are provided by the recent Dun and
Bradstreet summary in the supplementary section of the text.
For management purposes, the most relevant evaluation is to compare the most
recent financial results of the company with its past performance or planned
results. Comparison of actual results with past performance is a control
procedure designed to detect emerging problems or areas of company
operations requiring further investigation. Comparison of actual results with
budget amounts is also a control procedure that indicates relative accuracy of
planning systems and gives feedback that can improve future plans. Financial
analysis with the ratios illustrated in this chapter expands the information content
of the basic financial statements. Investors, creditors and other external users of
financial statements can use the same form of statement analysis to serve their
own information needs. Management uses the tools of financial statement
analysis to evaluate cash flows, liquidity, profitability and capital structure. The
primary difference is that management uses the information to control operations,
make decisions and develop future plans. Thus, financial statement analysis is
an integral part of management accounting.
Review Problem - Ratio Analysis
58
Refer to the Vann Corporation financial statements on the next page. Using the
budgeted financial statements for 20X3, compute the ratios listed below and
designate the comparative change in each ratio as favorable, unfavorable, or
essentially no change in relation to actual results for 20X2.
Ratio
20X2
1. Current Ratio
1.8
2. Quick asset ratio
.9
3. Accounts receivable
turnover (and Days)
20X3
Calculations Evaluation
16.0
4. Inventory turnover
(And Days Supply)
8.0
5. Working Capital turnover
8.7
6. Gross profit margin
17.0%
7. Operating profit margin
3.7%
8. Net profit margin
2.7%
9. Asset turnover
2.0
10.
Return on assets
5.4%
11.
Return on equity
10.9%
12.
Debt to equity ratio
1.0
13.
Times interest earned
3.7
14.
Debt service margin
1.7
VANN CORPORATION
COMPARATIVE FINANCIAL STATEMENTS
59
December 31, 20X2 and 20X3
Balance Sheets
20X2 20X3
(Actual) (Budget)
Cash
Accounts Receivable (net)
Inventory (at FIFO cost)
Prepaid Expenses
Increase
(Decrease)
$130,000
120,000
200,000
40,000
-----------$490,000
600,000
(140,000)
$950,000
$ 60,000
158,000
240,000
35,000
-----------$493,000
690,000
(185,000)
$998,000
($ 70,000)
38,000
40,000
(5,000)
-----------$ 3,000
90,000
(45,000)
$ 48,000
Total Liabilities
Common Stock
Retained Earnings
TOTAL LIABILITIES & EQUITY
$190,000
30,000
50,000
-----------$270,000
210,000
-----------$480,000
300,000
170,000
$950,000
$ 205,000
75,000
40,000
-----------$320,000
185,000
-----------$505,000
310,000
183,000
$998,000
$ 15,000
45,000
(10,000)
-----------$ 50,000
(25,000)
-----------$ 25,000
10,000
13,000
$ 48,000
Income Statements
Sales
Cost of Goods Sold
Gross Profit on Sales
Operating Expenses
Operating Income
Interest Expense
Net Income
20X2
$1,920,000
(1,593,600)
$ 326,400
(256,400)
$ 70,000
(19,000)
$ 51,000
Total Current Assets
Fixed Assets (at cost)
Accumulated Depreciation
TOTAL ASSETS
Accounts Payable
Notes Payable - current
Accrued Liabilities
Total Current Liabilities
Notes Payable - long-term
Retained Earnings
20X2
Balance, January 1
Net Income for year
Cash Dividends
Balance, December 31
$134,000
51,000
(15,000)
$170,000
20X3
$2,300,000
(1,955,000)
$ 345,000
(289,000)
$ 56,000
(21,000)
$ 35,000
20X3
$170,000
35,000
(22,000)
$183,000
VANN CORPORATION
CASH FLOW ANALYSIS
$380,000
(361,400)
$ 18,600
(32,000)
($14,000)
(2,000)
($16,000)
60
For Budget Year 20X3
Sources of Cash
Net income for 20X3
Adjustments to net income:
Depreciation expense
Increase in accounts receivable
Increase in inventory
Decrease in prepaid expenses
Increase in accounts payable
Decrease in accrued liabilities
Cash Provided by Operations
$35,000
45,000
(38,000)
(40,000)
5,000
15,000
(10,000)
$12,000
Other Sources of Cash:
Increase in notes payable - current
Increase in common stock
Total Sources of Cash
45,000
10,000
$67,000
Uses of Cash
Acquire fixed assets
Reduce notes payable - long-term
Cash dividends
Total Uses of Cash
Decrease in Cash Balance
$90,000
25,000
22,000
(137,000)
($70,000)
Summary of Cash Flow Analysis
Cash provided by operations
Less: Reductions in notes payable - long-term
Cash dividends
Balance available for investment
External financing: short-term debt
common stock
Cash available for investment
Cash invested: acquire equipment
Decrease in Cash Balance
$12,000
(25,000)
(22,000)
($35,000)
45,000
10,000
$20,000
(90,000)
($70,000)
FINANCIAL STATEMENT RATIO ANALYSIS
61
LIQUIDITY ANALYSIS
COMPUTATIONAL GUIDELINE
1) Current ratio
Current assets ÷ Current liabilities
T
2) Quick asset ratio
Quick assets ÷ Current liabilities
T
3)Accounts receivable
turnover
Sales ÷ Accounts
receivable
T
3a)
Days supply of receivables
(Days Sales Outstanding)
4) Inventory turnover
4a)
RESULT
365 ÷ ratio #3 =
(collection period)
days
Cost of goods sold ÷ Inventory
T
Days supply of inventory
5) Working capital turnover
365 ÷ ratio #4 (holding period)
days
Sales ÷ Working capital
T
PROFITABILITY ANALYSIS
6)
Gross profit margin
Gross profit ÷ Sales
%
7)
Operating profit margin
Operating income ÷
Sales
%
8)
Net profit margin
Net Income ÷ Sales
%
9)
Asset turnover
Sales ÷ Total Assets
T
10)
Return on assets
Net Income ÷Total Assets
%
11)
Return on equity
Net Income ÷ Equity
%
CAPITAL STRUCTURE ANALYSIS
12)
13)
14)
**
Debt to equity ratio
Times interest earned
Debt service margin
Total liabilities ÷
Owners' equity
T
NIBIT** ÷ Interest
expense
T
Operating Cash Flow ÷
Notes Payable (Current)
T
NIBIT stands for Net Income Before Interest and Taxes