Analyzing Financial
Statements for Profitability,
Liquidity, and Solvency
Chapter 8
© 2005 Accounting 1/e, Terrell/Terrell
8-1
Learning Objectives 1 and 2
Distinguish among profitability,
liquidity, and solvency.
Calculate financial ratios
designed to measure a
company’s profitability,
liquidity, and solvency.
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Introduction
Financial statements analysis is the process
of looking beyond the face of the financial
statements to gain additional insight
into a company’s financial health.
Ratio analysis is a technique for analyzing
the relationship between two items from a
company’s financial statements for a given period.
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Elevation Sports, Inc.
Balance Sheet
May 31, 2004
Assets:
Current assets
Cash
Accounts receivable
Less: Allowance for doubtful accounts
Merchandise inventory
Raw materials inventory
Work-in-process inventory
Finished goods inventory
Supplies inventory
Prepaid rent
Prepaid insurance
Total current assets
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$9,900
– 450
$128,834
9,450
4,397
2,315
14,864
13,634
593
12,000
5,000
$190,637
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Elevation Sports, Inc.
Balance Sheet
May 31, 2004
Property, plant, and equipment
Administrative equipment
$ 5,100
Selling furniture and fixtures 8,400
Production equipment
89,600
Less: Accumulated depreciation
Total property, plant, and equipment
Intangible assets
Patents
Copyrights
Trademarks
Total intangible assets
Total assets
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$103,100
– 17,800
$ 10,083
570
1,425
$ 85,300
$ 12,078
$288,015
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Elevation Sports, Inc.
Balance Sheet
May 31, 2004
Liabilities and stockholders’ equity:
Current liabilities
Accounts payable
Other accounts payable
Interest payable
Payroll taxes payable
Sales taxes payable
Income taxes payable
Current portion of long-term note payable
Total current liabilities
Long-term liabilities:
Note payable – Vail National Bank $ 60,000
Less: Current portion
15,000
Total long-term liabilities
Total liabilities
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$
6,942
11,812
6,000
1,400
560
42,120
15,000
$ 83,834
45,000
$128,834
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Elevation Sports, Inc.
Balance Sheet
May 31, 2004
Stockholders’ equity
Paid-in capital:
Common stock, $10 par value,
100,000 shares authorized, 4,000
shares issued and outstanding
$ 60,000
Paid-in capital in excess of par
– common stock
40,000
Total paid-in capital
$100,000
Retained earnings
59,181
Total stockholders’ equity
Total liabilities and stockholders’ equity
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159,181
$288,015
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Elevation Sports, Inc.
Income Statement
For the Year Ended May 31, 2004
Net sales
Cost of goods sold
Gross profit
Selling expenses
$48,334
Administrative expenses
72,189
Total operating expenses
Operating income
Other revenues and expenses:
Interest revenue
$ 512
Interest expense
(6,000)
Total other revenues and expenses
Income before income taxes
Income taxes
Net income
Earnings per share
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$527,146
295,834
$231,312
120,523
$110,789
(5,488)
$105,301
42,120
$ 63,181
$ 15.79
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Profitability Ratios
Profitability is the ease with which
a company generates income.
Profitability ratios measure a firm’s
past performance and help predict
its future profitability level.
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Profitability Ratios
This ratio measures how efficiently the
company uses its assets to produce profits.
Return on assets =
Net income before taxes ÷ Total assets
$105,301 ÷ $288,015 = 36.56%
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Profitability Ratios
This ratio measures the percentage of
income before income taxes produced
by a given level of revenue.
Profit margin before income tax =
Net income before taxes ÷ Sales
$105,301 ÷ $527,146 = 19.98%
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Profitability Ratios
This ratio calculates the amount of sales
produced for a given level of assets used.
Total asset turnover =
Sales ÷ Total assets
$527,146 ÷ $288,015 = 1.83 times
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Profitability Ratios
Return on
assets
Profit margin
Total asset
=
×
before income tax
turnover
Net income
before taxes =
÷ Total assets
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Net income
before taxes
÷ Sales
Sales ÷
×
Total assets
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Profitability Ratios
This ratio measures the amount of after-tax
net income generated by a dollar of sales.
Profit margin after income tax =
Net income after taxes ÷ Sales
$63,181 ÷ $527,146 = 11.98%
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Profitability Ratios
This ratio indicates how much after-tax income
was generated for a given level of equity.
Return on equity after taxes =
Net income after taxes ÷ Stockholders’ equity
$63,181 ÷ $159,181= 38.69%
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Profitability Ratios
This ratio calculates how much before-tax income
was generated for a given level of equity.
Return on equity before taxes =
(Net income after taxes + Income taxes)
÷ Stockholders’ equity
$105,301 ÷ $159,181= 66.15%
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Liquidity Ratios
An asset’s liquidity describes the ease
with which it can be converted to cash.
Liquidity ratios evaluate a firm’s ability
to generate sufficient cash to
meet its short-term obligations.
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Liquidity Ratios
This ratio measures the company’s ability to
meet its current liabilities with current assets.
Current ratio =
Current assets ÷ Current liabilities
$190,637 ÷ $83,834 = 2.27 to 1
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Liquidity Ratios
This ratio is a stringent test of liquidity
that compares highly liquid current
assets to current liabilities.
Acid-test ratio = (Cash + Receivables
+ Trading securities) ÷ Current liabilities
($128,384 + $9,450 + $0) ÷ $83,834= 1.64 to 1
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Liquidity Ratios
This ratio indicates the level of sales
generated for a given level of working capital.
Net sales to working capital = Sales ÷
(Current assets – Current liabilities)
$527,146 ÷ ($190,637 – $83,834) = 4.94 times
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Liquidity Ratios
It measures how quickly a company
collects its accounts receivable.
Accounts receivable turnover =
Net credit sales ÷ Accounts receivable
Net credit sales = $151,650 – $2,426 = $149,224
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Liquidity Ratios
Receivable turnover =
$149,224 ÷ $9,450 = 15.79 times
Average collection period =
365 ÷ 15.79 = 23.27 days
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Liquidity Ratios
This ratio indicates the number of times
total merchandise inventory is purchased
(or finished goods inventory is produced)
and sold during a period.
Inventory turnover =
Cost of sales ÷ Inventory
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Liquidity Ratios
Inventory turnover =
$295,834 ÷ ($4,397 + $13,634) = 16.41 times
Average number of days
Elevation Sports, Inc., holds its inventory
= 365 ÷ 16.41 = 22.24 days
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Solvency Ratios
Solvency is a company’s ability to meet the
obligations created by its long-term debt.
Solvency ratios are of most interest to
stockholders, long-term creditors,
and company management.
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Solvency Ratios
It measures what proportion of a
company’s assets is financed by debt.
Assets = Liabilities + Owners’ equity
100% = Some % +
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Some %
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Solvency Ratios
Total liabilities ÷ Total assets
$128,834 ÷ $288,015 = 44.73%
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Solvency Ratios
This ratio is also called the
times-interest-earned ratio.
It indicates a company’s ability to
make its periodic interest payments.
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Solvency Ratios
Coverage ratio =
Earnings before interest expense
and income taxes ÷ Interest expense
($105,301 + $6,000) ÷ $6,000 = 18.55 times
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Learning Objective 3
Locate industry averages.
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Industry Averages
This chapter emphasizes the Almanac of
Business and Industrial Financial Ratios.
The Almanac includes all
companies, public and private.
Information provided in the Almanac
for each industry is four pages.
It consists of two tables.
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Industry Averages
Table I provides an analysis of all
companies in the particular industry,
regardless of whether they had
any net income for the year.
Table II provides the same information
items as Table I, but it considers
only companies that showed
a net income for the year.
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Learning Objective 4
Evaluate a company’s ratios
using a comparison to
industry averages.
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Comparison of Elevation Sports,
Inc., to Industry Averages
Ratio
Return on assets
Profit margin before income taxes
Total asset turnover
Profit margin after income tax
Return on equity after income taxes
Return on equity before income taxes
Current ratio
Quick ratio
Net sales to working capital
Receivables turnover
Inventory turnover
Debt ratio
Coverage ratio
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Elevation
Sports, Inc.
Total
Industry
Industry
with Assets
$250-$500,000
36.6%
20.0%
1.8
12.0%
39.7%
43.5%
2.3
1.7
4.9
15.8
16.4
44.7%
18.6
10.1%
4.2%
1.9
3.4%
19.3%
23.9%
1.6
0.4
7.3
28.6
2.5
65.8%
5.3
16.1%
6.1%
2.3
5.7%
40.5%
43.1%
1.9
0.5
5.9
31.7
2.1
68.2%
6.7
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Company Analysis
Compare ratios to the industry averages.
Look for company trends.
Consider the industry environment.
Draw conclusions.
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Learning Objective 5
Use ratio values from
consecutive time periods
to evaluate the profitability,
liquidity, and solvency
of a business.
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Trend Analysis of
Selected Ratios
Ratio
2002
2001
2000
1996
Return on assets
Profit margin before taxes
Total asset turnover
Profit margin after taxes
Return on equity after taxes
Return on equity before taxes
Current ratio
Quick ratio
Net sales to working capital
Receivables turnover
Inventory turnover
Debt ratio
Total liabilities to net worth
137.4
142.5
96.4
147.5
137.9
136.7
91.7
515.8
126.5
0
144.5
94.6
91.7
150.4
141.3
106.4
146.3
145.1
144.2
95.4
69.3
140.3
0
135.3
87.1
81.2
153.7
150.1
102.4
155.4
158.3
156.8
84.0
131.4
147.7
0
129.0
99.2
98.7
100.0
100.0
100.0
100.0
100.0
100.0
100.0
100.0
100.0
0
100.0
100.0
100.0
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Learning Objective 6
Draw conclusions about the
credit-worthiness and
investment-attractiveness
of a company.
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Draw Conclusions
The evaluation process by nature
depends upon individual perception.
1. Family Dollar Stores, Inc., is an industry
leader in profitability and solvency.
2. Family Dollar has improved the
distribution element of its supply chain.
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Draw Conclusions
3. Part of the company profitability and
liquidity will depend upon its increasing
the inventory turnover ratio.
4. If we choose to invest in a general
merchandise discounter, Family Dollar
Stores, Inc., might be one to consider.
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Learning Objective 7
State the limitations
of ratio analysis.
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Limitations of Ratio Analysis
1. Attempting to predict the future using past
results depends upon the predictive
value of the information used.
2. The financial statements used to compute
the ratios are based on historical cost.
3. Figures from the balance sheet used to
calculate the ratios are year-end numbers.
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Limitations of Ratio Analysis
4. Industry peculiarities create difficulty
in comparing the ratios of a company
in one industry with those of a
company in another industry.
5. Lack of uniformity concerning what is
to be included in the numerators and
denominators make comparisons
extremely difficult.
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End of Chapter 8
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