Chapter 5
INTER-COMPANY EVALUATION OF
FINANCIAL STATEMENTS
Dr. BALAMURUGAN MUTHURAMAN
2015-2016
1
CLASSIFIED FINANCIAL STATEMENTS
• Information in financial statements may be
used to evaluate two important goals of
management
– Maintaining adequate liquidity
– Achieving satisfactory profitability
• A series of ratios are used to evaluate these
two goals
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EVALUATING LIQUIDITY
Liquidity means having enough cash on hand
to pay bills when they become due and to
cover unexpected needs for cash
• Two measures of liquidity
– Working capital
– Current ratio
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3
WORKING CAPITAL
… is the amount by which total current assets
exceed total current liabilities
Working Capital
 Total Current Assets - Total Current Liabilitie s
2015-2016
WORKING CAPITAL
• Current assets
– Assets that will be converted to cash or used up
within one year or one operating cycle, whichever
is longer
• Current liabilities
– Debts that must be paid or obligations that must be
performed within one year or one operating cycle,
whichever is longer
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WORKING CAPITAL
• By definition, current liabilities are paid out of
current assets
• The excess of current assets over current liabilities is
the net current assets on hand to continue operations
Total Current Assets – Total Current Liabilities
= Net Current Assets Available to Continue Business Operations
If
Total Current Assets – Total Current Liabilities
= Working Capital
then
Working Capital = Net Current Assets Available to Continue
Business Operations
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WORKING CAPITAL
• Working capital is used to buy inventory, obtain
credit, and finance expanded sales
• Lack of working capital can lead to a company's
failure
Compute working capital for Shafer Auto Parts Corporation
Current assets
Current liabilities
Working capital
$124,356
– 42,683
$ 81,673
2015-2016
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CURRENT RATIO
… is the ratio of current assets to current
liabilities
Current Assets
Current Ratio 
Current Liabilitie s
• Is closely related to working capital
• Believed by many to be a good indicator of a
company’s ability to
– Pay its bills
– Repay outstanding debt
2015-2016
8
CURRENT RATIO
Compute the current ratio for Shafer Auto Parts Corporation
Current Assets
Current Ratio 
Current Liabilitie s
$124,356

 2.9
$42,683
This means that Shafer has $2.90 of current
assets for each $1.00 of current liabilities
For proper analysis, this ratio must be compared with ratios from previous
years and with ratios from successful companies in the same industry
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Current Ratio
• Very low current ratio
– Unfavorable
• Means the company may not have the ability to pay its
bills and outstanding debt when due
• High current ratio
– Can be unfavorable
• May indicate the company is not using its assets
effectively
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10
Evaluating Profitability
Profitability means the ability to earn a
satisfactory income
• Common profitability measures
–
–
–
–
–
Profit margin
Asset turnover
Return on assets
Debt to equity
Return on equity
2015-2016
11
PROFIT MARGIN
… shows the percentage of each sales dollar
that results in net income
Net Income
Profit Margin 
Net Sales
Compute the profit margin for Shafer Auto Parts
$14,500
Profit Margin 
 .050 (5.0%)
$289,656
This means that on each dollar of net sales,
Shafer Auto Parts made 5.0 cents
2015-2016
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Asset Turnover
… measures how efficiently assets are used to
produce sales
Net Sales
Asset Turnover 
Average Total Assets
This ratio shows a meaningful relationship between an
income statement figure and a balance sheet figure
• It shows how many dollars of sales were generated
by each dollar of assets
• A high asset turnover means a company uses its
assets productively
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Asset Turnover
Compute asset turnover for Shafer Auto
Parts Corporation
Net Sales
Asset Turnover 
Average Total Assets
$289,656
$289,656
Asset Turnover 

 1.9 times
($158,916  $148,620)  2 $153,768
Average total assets is computed by adding
total assets at the beginning of the year to
total assets at the end of the year and dividing
by 2
2015-2016
This means that Shafer
produces $1.90 in sales
for each $1.00 invested
in average total assets
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Return on Assets
… measures how efficiently a company
uses its assets to produce income
Net Income
Return on Assets 
Average Total Assets
2015-2016
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Return on Assets
• Combines profit margin and asset turnover
Net Income
Net Sales
x
Profit Margin
x
Indicates incomegenerating strength
of the company’s
resources
Net Sales
Net Income
=
Average Total Assets
Average Total Assets
Asset Turnover
=
Return on Assets
Indicates how efficiently
the company is using all
its assets
• Return on assets overcomes the limitations of profit margin and asset
turnover ratios
–
–
Profit margin does not consider the assets necessary to produce income
Asset turnover ratio does not take into account the amount of net income produced
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Return on Assets
Compute return on assets for Shafer Auto Parts
Corporation
Net Income
Return on Assets 
Average Total Assets
$14,500
$14,500
Return on Assets 

 .094 (9.4%)
($158,916  $148,620)  2 $153,768
Average total assets is computed by adding
total assets at the beginning of the year to
total assets at the end of the year and dividing
by 2
Or, Profit Margin  Asset Turnover
5.0%

1.9 times
2015-2016
This means that for each dollar
invested by the owner, Shafer’s
assets generate 9.4 cents of net
income
 Return on Assets
 9.5% Difference between
9.4 and 9.5 due to
rounding
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Debt to Equity
…
shows
the
portion
of
the
company
financed by creditors in comparison to that financed
by stockholders
Total Liabilitie s
Debt to Equity 
Stockholde rs' Equity
• A company with a high debt to equity ratio is riskier in poor economic
times because it must continue to repay creditors
• A company with a low debt to equity ratio is safer because the stockholders
do not have to be repaid and dividends can be deferred
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Debt to Equity
• The assets of a company are financed by
– Creditors (creating liabilities)
– Investors
• A debt to equity ratio of 1.0 means that half the company’s
assets are financed by creditors and half are financed by
investors
Represents assets financed by creditors
Total Liabilitie s
$45,253
Debt to Equity 

 1.0
Stockholde rs' Equity $45,253
Represents assets financed by investors
2015-2016
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Debt to Equity
Compute debt to equity for Shafer Auto Parts
Corporation
Total Liabilitie s
Debt to Equity 
Stockholde rs' Equity
$60,483
Debt to Equity 
 .614 (61.4%)
$98,433
A ratio less than 1.0 (or 100%) means that
less than half of the company’s assets are
financed by creditors and more than half
are financed by investors
2015-2016
For every 61.4 cents of
financing from creditors,
$1.00 of financing came
from investors
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