Financial Statements and Ratios: Notes
1. Uses of the income statement for evaluation
Investors use the income statement to help judge their return on investment and
creditors (lenders) use it to help make loan decisions. To make their business decisions
financial statement users evaluate a firm’s risk , operating capability and financial
flexibility. Risk is the uncertainty about the future earnings potential of a firm. A firm’s
risk factor affects the expected investment return that is needed to attract investors and
affects the interest rate that lenders charge on that firm’s loans.
External users evaluate a firm’s operating capability and financial flexibility because
these factors help determine the firm’s level of risk.
Operating capability refers to a firm’s ability to continue a given level of operations in the
future.
Financial flexibility refers to a firm’s ability to adapt to change in the future.
1. Ratios (income statement)
Managers and external users may perform ratio analysis to help evaluate a firm’s
operating performance. Ratios can be used as benchmarks to compare a firm’s
performance with that of previous periods and with that of other firms. Two ratios that
reflect profitability and are therefore related to risk, operating capability and financial
flexibility are the firm’s profit margin and gross profit margin.
The formula for a firm’s profit margin or return on sales is:
Profit Margin = Net Income
Net Sales
The formula for a firm’s gross profit margin or gross profit percentage is:
Gross Profit Margin = Gross Profit
Net Sales
2.
Statement of Changes in Owner’s Equity
The statement of changes in owner’s equity summarises the transactions that
affected owner’s equity during the accounting period. The statement bridges the gap
between the income statement and the amount of owner’s capital reported on the
balance sheet.
3. Why the Balance Sheet is important
Although the income statement provides useful information for business decision-making
managers and external users also study the balance sheet or statement of financial
position.
A balance sheet provides information that helps internal and external users evaluate a
firm’s ability to achieve its primary goals of earning a satisfactory profit and remaining
solvent. The income statement and the balance sheet provide different types of
information. The income statement reports on a firm’s actions over period of time. The
balance sheet presents a firm’s financial position on a specific date allowing users to
evaluate the firm’s assets, liabilities and owner’s equity as at that date.
Supposing you were trying to determine whether a firm can earn a satisfactory
profit.
You would need to determine whether the firm has the assets, liabilities and owner’s
equity needed to earn a satisfactory profit. You would also need to evaluate whether the
firm has been able to use its resources in the past to earn such a profit. Because a firm’s
income statement and balance sheet provide this financial information, analysing both
statements will help you make an informed decision.
Using the balance sheet for evaluation
A manager is concerned with a firm’s balance sheet because it is used to evaluate his or
her own performance. External users analyse a firm’s balance sheet to determine
whether a firm has the right amount and mix of assets, liabilities and owner’s equity to
justify making an investment in the firm.
3. Evaluating liquidity
Liquidity is a measure of how quickly a firm can convert its assets into cash to pay its
bills. The need for adequate liquidity is a major reason a firm prepares a cash budget.
External users assess how well a firm manages its liquidity by assessing its working
capital.
Working capital = Current Assets – Current Liabilities
The Current (Working Capital) ratio and the Quick ratio are commonly used to assess a
firm’s liquidity.
The Current Ratio shows the relationship between current assets and current liabilities.
The current ratio is calculated as follows:
Current Ratio =
Current Assets
Current Liabilities
The use of a ratio allows the comparison of different sized firms. When assessing the
current ratio users should pay attention to factors such as:
•
•
•
industry structure,
the length of the firm’s operating cycle, and
the ‘mix’ of current assets.
The Quick Ratio (or Acid-Test) is a more convincing indicator of a firm’s short-term debt
paying ability. The quick ratio uses only those current assets that can be quickly
converted into cash. Quick assets include cash, short-term marketable securities,
accounts receivable and short-term notes receivable. Quick assets typically exclude
inventory and prepaid expenses because they cannot be quickly converted into cash.
The quick ratio is calculated as follows:
Quick Ratio =
Quick Assets
Current Liabilities
The quick ratio shows potential liability problems when a firm has a poor mix of current
assets.
When assessing the quick ratio users should pay attention to factors such as:
•
•
industry structure, and
the length of the firm’s operating cycle.
4. Evaluating financial flexibility
Financial flexibility is the ability of a firm to adapt to change. The current ratio and the
acid test ratio can be used to assess short-term financial flexibility. To assess long-term
financial flexibility, financial statement users use the Debt Ratio to evaluate the firm’s
debt levels. The debt ratio shows the percentage of total assets provided by debt finance
(outside borrowings).
The debt ratio is calculated as follows:
Debt Ratio = Total Liabilities
Total Assets
The higher a firm’s debt ratio, the lower its financial flexibility: because a higher debt
ratio indicates that a firm may not be able to borrow money as easily or cheaply to adapt
to business opportunities. Generally, the higher the debt ratio, the higher the ‘risk’ and
the higher the ‘returns’ to owners.
The desired mix between debt and owner’s equity depends on factors such as:
•
•
•
the type of business,
the country in which the firm is located,
the state and expected state of the local economy, and
•
the world economic climate.
5. Relationship between the income statement and the balance sheet
It is very important to know that many important business questions can only be
answered by analysing a firm’s income statement and balance sheet together. For
example, both statements must be included when analysing whether a firm has made a
satisfactory return to its owners
6. Evaluations using the income statement and the balance sheet
Managers, investors and lenders use information from a firm’s financial statements to
calculate ratios for measuring a firm’s financial success. The numerator of each ratio is
an income statement amount showing a ‘flow’ into or out of the firm during the
accounting period. The denominator is a balance sheet amount showing the ‘resources’
used to obtain the ‘flow’.
7. Evaluating profitability
Decision-makers use profitability ratios to assess how well a firm has met its profit
objectives in relation to the resources invested.
Return on Total Assets compares net income earned with total assets to show whether
a firm has used its economic resources efficiently.
Return on total assets is calculated as follows:
Return on Total Assets =
Net Income + Interest Expense
Average Total Assets
Interest expense is added back to net income because interest is a financing cost paid to
lenders and not an operating expense of earning revenue. Average total assets are used
as the denominator because a firm uses its assets to earn income over the entire
accounting period.
Return on Owner’s Equity measures whether a firm’s managers have earned a
satisfactory return on the owner’s investment in the firm. Return on owner’s equity is
calculated as follows:
Return on Owner’s Equity =
Net Income
Average Owner’s Equity
Interest is not added back to net income because net income is a measure of a firm’s
profits available to owners after incurring the financial cost relating to lenders.
8. Evaluating operating capability
Operating capability refers to a firm’s ability to sustain a given level of operations.
Activity ratios are used to measure the duration of the parts of the firm’s operating cycle.
This analysis allows users to evaluate the liquidity of selected current assets. Inventory
Turnover measures how quickly a firm purchases, sells and replaces inventory
throughout its accounting period.
Inventory turnover is calculated as follows:
Inventory Turnover =
Cost of Goods Sold
Average Inventory
As a general rule, the higher the inventory turnover, the more efficient the firm is in its
purchasing and sales activities and the less cash it needs to invest in inventory.
We can also calculate the Number of Days in the Selling Period as follows:
No of Days in the Selling Period = No of Days in Business Year
Inventory Turnover
This ratio measures the average time it takes the firm to sell its inventory Accounts
Receivable Turnover measures how efficiently a firm collects cash from its credit
customers.
Accounts receivable turnover is calculated as follows:
Accounts Receivable =
Net Credit Sales
Turnover Average Accounts Receivable
We can also calculate the Number of Days in the Collection Period as follows:
No of Days in the Collection =
Period
No of Days in Business Year
Accounts Receivable Turnover
This ratio measures the average time it takes the firm to collect its accounts receivable.
The number of days in the firm’s operating cycle can be calculated by adding the
number of days in the firm’s selling period to the number of days in the firm’s collection
period.
9. Limitations of the income statement and the balance sheet
When using ratio analysis we must remember the limitations of the concepts and
principles that underly a firm’s financial statements. This is particularly relevant with
relation to how firms value their assets and measure revenues and expenses.
Income statements and balance sheets are based on accrual accounting and do not
provide much information about a firm’s cash management. Thus, firms often prepare a
cash flow statement to allow users to better assess their cash management
performance.