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Reading Financial Statements to Aid in Business Decision-Making IndustriusCFO, A C-Leveled Company

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Reading Financial Statements to Aid in Business Decision-Making

Copyright © 2015 by IndustriusCFO, A C-Leveled Company

All rights reserved. No patent liability is assumed with respect to the use of the information contained herein. Although every precaution has been taken in the preparation of this book, the publisher and authors assume no responsibility for errors or omissions. Nor is any liability assumed for damages resulting from the use of the information contained herein.

Trademarks

All terms mentioned in this book that are known to be trademarks or services have been appropriately capitalized. IndustriusCFO cannot attest to the accuracy of this information. Use of a term in this book should not be regarded as affecting the validity of any trademark or service mark.

“The Learning Company” is a fictitious entity for the purpose of illustration and any similarity or resemblance to any company, real or imagined, is coincidental and unintended.

Warning and Disclaimer

Every effort has been made to make this book as complete and accurate as possible, but no warranty or fitness is implied. The information provided is on an “as is” basis. The authors and the publisher shall have neither liability nor responsibility to any person or entity with respect to any loss or damages arising from the information contained in this book.


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Contents Financial Statements ............................................................................................................................................................. 7

Introduction ........................................................................................................................................................................ 7

The Purpose of Financial Statements ................................................................................................................................ 8

Overview of Financial Statements ..................................................................................................................................... 9

Balance Sheet ................................................................................................................................................................ 9

Income Statement ........................................................................................................................................................ 17

Cash Flow Statements ................................................................................................................................................. 20

Statements of Stockholders’ Equity ............................................................................................................................. 23

Analysis of Financial Statements ......................................................................................................................................... 26

Why Analyze Financial Statements ................................................................................................................................. 26

Types of Financial Statement Analysis ................................................................................................................................ 27

Horizontal Analysis ........................................................................................................................................................... 28

How to Create a Horizontal Analysis ........................................................................................................................... 28

Vertical Analysis ............................................................................................................................................................... 31

How to Create a Vertical Analysis ................................................................................................................................ 32

How to Create a Common-Size Vertical Analysis ........................................................................................................ 33

Ratio Analysis .................................................................................................................................................................. 37

Liquidity Ratios ............................................................................................................................................................. 40

Activity Ratios ............................................................................................................................................................... 42

Leverage Ratios ........................................................................................................................................................... 48

Profitability Ratios ........................................................................................................................................................ 50

Market Value Ratios ..................................................................................................................................................... 52

Dividend Ratios ............................................................................................................................................................ 54

Summary of Financial Ratios (Quick Reference Guide) .............................................................................................. 57

Cash Flow Statement Analysis ........................................................................................................................................ 57

Financial Accounting Standards Board (FASB) Requirements ..................................................................................... 57

Accrual Basis of Accounting ......................................................................................................................................... 59

In Conclusion ....................................................................................................................................................................... 59


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About the Authors ................................................................................................................................................................ 61

Denise DeSimone ............................................................................................................................................................ 61

Marianne Reid Anderson ................................................................................................................................................. 61

Acknowledgments and Sources ....................................................................................................................................... 61

We Want to Hear From You! ............................................................................................................................................ 61


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This book is written for business owners who need to

use, read, and understand Financial Statements

in order to more effectively run their business.


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“Financial Statements are the lighthouses of business, from a fiscal perspective.

They warn of oncoming danger, show you where you can go full steam ahead and

illuminate where and when you should proceed with caution.”

– Denise DeSimone


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Financial Statements Introduction Growing a business is a challenge; running one is impossible if you don’t understand the language of money, specifically,

accounting. In other words, if you cannot balance your own checkbook, you are going to have trouble managing, tracking

and knowing how to control your business and its future development.

Knowing how to create and understand Financial Statements helps a business to evaluate both its past and present, and

help predict its future. This understanding is the key to prudent business decision-making; which is the key to success.

Fortunately, the basics of reading Financial Statements is a science; but not rocket science. An entrepreneur need only

master a few basic concepts and learn about a few standard reports to master his or her company.

This eBook is designed to help you gain a basic understanding of how to read Financial Statements. It will not train you

to be an accountant; but will help you master the basics of Financial Statements; thereby, giving you the confidence and

basic knowledge to make sense of them for running your business.

The goal of this book is to give you two skills:

• To help you understand your Financial Statements

• To help you analyze them.

Therefore, the book is divided into two parts:

• Financial Statements (describes the “what”)

• Analysis of Financial Statements (describes the “how”)

Let’s begin by looking at the purpose of Financial Statements:


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The Purpose of Financial Statements Generally, Financial Statements show you where a company’s money came from, where it went, and where it is

now. For example, did it come from Sales, investments, or loans? How was it spent? How much was spent, how

much is available and how much is invested?

Specifically, Financial Statements tell you where in your business your money is, so you can keep track of it and

manage it effectively. For instance, through Financial Statements, you can see if your money is invested in stock,

trapped in non-performing Fixed Assets or collecting dust in an outdated Inventory.

Ultimately, well-organized, Financial Statements summarize what you need to know in a way that lets you quickly

pick out key issues. One financial statement, that we will examine first, is called a Balance Sheet. It will clearly

show an amount, for instance $100,000, is invested in overall Plant Assets, as of a specific date. You can see this

amount instantly and then decide if this is sufficient and use other Financial Statements to determine if you have

the means to invest in additional Plant Assets.

Some Financial Statements are governed by a legal framework with international standards of accounting and

auditing, and are generally prepared by a professional accountant or tax accountant. However, these are not

necessarily the Financial Statements that you need to run a business.

Instead, Financial Statements, reporting and analysis, sometimes referred to as “management accounting” is what

you need for business decision-making and is the primary focus of this book.

Fundamentally, the four main, standard Financial Statements and the type of information each provides is:

1. Balance Sheets – a company’s financial position (Assets, Liabilities and Net Worth) at the end of a time period such as for a quarter, for a year, over the past three years, and so forth.

2. Income Statements - Earnings (net income and expenses) for the period.

3. Cash Flow Statements - How and where Cash moved during the period.

4. Statement of Stockholders’ Equity - Comprehensive income (changes in Equity and value of ownership) for the

period.

Following is an overview of these Financial Statements. The final section will discuss analyzing Financial Statements.


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Overview of Financial Statements As previously stated, here are the four standard Financial Statements that we will be examining:

1. Balance Sheets – a company’s financial position (Assets, Liabilities and Net Worth) at the end of a time period such as for a quarter, for a year, over the past three years, and so forth.

2. Income Statements - Earnings (net income and expenses) for the period

3. Cash Flow Statements - How and where Cash moved during the period

4. Statement of Stockholders’ Equity - Comprehensive income (changes in Equity and value of ownership) for the

period

Let’s take a closer look at each statement, individually:

Balance Sheet

A Balance Sheet is a statement showing the Assets, Liabilities and Stockholders’ Equity of a business. It provides detailed information in a specifically defined format. As the name implies, a Balance Sheet must be in balance – meaning: The total value of the Assets must be the same as the combined total value of the Liabilities and Stockholders’ Equity. In other words:

BASIC ACCOUNTING EQUATION:

Assets = Liabilities + Stockholders’ Equity

Principle: A company’s Assets must be equal to the sum of its Liabilities and Stockholders’ Equity.

A Balance Sheet portrays the financial position of a company by showing what the company owns at a specific point-in-time, like a snapshot. The point-in-time is the date stated in the heading of the Balance Sheet and every Balance Sheet is divided into the three sections that it represents:

• Assets

• Liabilities

• Stockholders’ Equity


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By way of illustration, let’s look at some sample Balance Sheets:

Balance Sheets can be laid-out either horizontally or vertically.

In a horizontal set up, the monetary value of left side is equal to the monetary value of right side.

• On the left side of the Balance Sheet, companies list their Assets.

• On the right side, they list their Liabilities and Stockholders’ Equity.

Particulars 2014 2013 2014 2013Assets LiabilitiesCurrent Assets Current Liabilities

Cash 30.0 35.0 Payroll 30.0 25.0Accounts Receivable 20.0 15.0 Short-‐Term Debt 25.4 25.0Marketable Securities 20.0 15.0 Long-‐Term LiabilitiesInventory 50.0 45.0 Long-‐Term Debt 80.0 75.0

Total Current Assets 120.0 110.0 Total Liabilities 135.4 125.0Stockholders' Equity

Non-‐Current Assets Plant Assets 100.0 90.0Common Stock, $10 par value, 4500 shares 45.0 45.0Retained Earnings 39.6 30.0

Total Non-‐Current Assets 100.0 90.0 Total Stockholders' Equity 84.6 75.0

Total Assets 220.0 200.0 220.0 200.0Total Liabilities and Stockholders' Equity

The Learning CompanyBalance Sheet

(In Thousands of Dollars)as of December 31, 2014 and 2013

Note: Total Assets on the Left equals Total Liabilities and Stockholders’ Equity on the right.


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In a vertical set up, the monetary value of the top portion is equal to the monetary value of the bottom portion.

• In the top portion of the Balance Sheet, companies list their Assets.

• In the bottom portion, companies list their Liabilities and Stockholders’ Equity.

As you can see, the Balance Sheet is divided into the three main sections and that it balances, meaning

Total Assets = Total Liabilities + Stockholders’ Equity

Whether it is laid out horizontally or vertically, a Balance Sheet still balances.

Particulars 2014 2013AssetsCurrent Assets

Cash 30.0 35.0Accounts Receivable 20.0 15.0Marketable Securities 20.0 15.0Inventory 50.0 45.0

Total Current Assets 120.0 110.0Non-‐Current Assets

Plant Assets 100.0 90.0Total Non-‐Current Assets 100.0 90.0Total Assets 220.0 200.0LiabilitiesCurrent Liabilities

Payroll 30.0 25.0Short-‐Term Debt 25.4 25.0

Long-‐Term LiabilitiesLong-‐Term Debt 80.0 75.0

Total Liabilities 135.4 125.0Stockholders' Equity

Common Stock, $10 par value, 4500 shares 45.0 45.0Retained Earnings 39.6 30.0

Total Stockholders' Equity 84.6 75.0Total Liabilities and Stockholders' Equity 220.0 200.0



The particular point in

time of a Balance

Sheet is stated in the

header

The 3 sections of a Balance Sheet are:

Assets

Liabilities

Stockholders’ Equity (a.k.a. Equity or Capital) Total

Assets

*MUST* =

Liabilities

+ Equity

Previous year

data given as

means of

comparison


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Let’s take a closer look at each section and the Balance Sheet and this equation:

Assets:

Assets are defined as those things that a company owns and have value. Assets might include physical property

like plants, cars, trucks, machines, and Inventory, but it may also include intangible things (things that do not exist in a

physical sense, but which nevertheless have monetary value), such as trademarks and patents. Cash, in and of itself,

is also considered an Asset, as are Accounts Receivable (the money due in from customers), securities and

investments and any other item of value.

Specifically, businesses use Assets, as shown on a Balance Sheet, in their day-to-day operations for earning

money. This use typically means either a business can sell these Assets, or it can use them to make products for

sale, or to render services. As in the illustration, Assets can be divided into “Current” and “Non-Current” Assets.

The difference is how “Liquid” or readily-available the Asset is to use. For example, selling a security or investment

for Cash makes the Asset “Liquid” and “Current.” Non-Current usually means Physical Assets such as buildings or

equipment, which has value, maybe even considerable value, but is difficult to sell or turn into ready Cash.

FYI: Many businesses have non-monetary Assets which include Intangible Assets such as trademarks,

patents, goodwill, etc. which are difficult to set a specific value and are definitely part of the overall value of a

company, but unfortunately, these cannot be transferred into ready Cash. Any item having no monetary value

is irrelevant to the financial state of a company at a point-in-time and is therefore not taken into consideration

on a Balance Sheet. Normally, if a non-monetary thing has a potential effect on items on a Balance Sheet,

then this information is listed in the footnotes or documentation that accompanies the Balance Sheet or other

Financial Statements.

Generally, we list Assets in order of Liquidity, or how quickly they will be converted into Cash. Therefore, a

breakdown of Assets into the categories of Current Assets (those that can be converted to Cash quickly) and

Non-Current or Long-Term Assets (which take more time to convert to Cash) is necessary to place them on

Balance Sheet at proper place. Current Assets and Non-Current or Long-Term Assets are, typically, subtotaled in

the Asset list.

As you can see in following illustration:


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Current Assets are things a company expects to convert to Cash within one period. Normally, this period is one

year. A good example of Current Assets is Inventory. Most companies expect to sell their Inventory for Cash

within one year. However, there may be situations where a company stocks nonperishable inventories as a part

of their business strategy; in expectation that the Inventory will maintain or increase in value in the future.

Non-Current Assets are things a company does not expect to convert to Cash within one year or that would take

longer than one year to sell. This type of Asset includes Fixed Assets, and the Assets used to operate the business

which are not available for sale, such as cars, office furniture, buildings and other property.












Note: The

three

main

sections

of Assets,

Liabilities

and

Equity are

further

sub-

divided


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Liabilities:

Liabilities can be thought of as money that a company owes and is obliged to pay to others to acquire Assets and

to run a business. Liabilities include all kinds of obligations, such as money borrowed, rent for use of a building,

money owed to suppliers, environmental cleanup costs, payroll, as well as, taxes owed to the government.

Liabilities may also include obligations to provide goods or services to customers in the future.

Therefore, to keep things in balance, if one thing on your Balance Sheet is an Asset or a positive item, then its

opposite is a Liability. (Equity is a special type of Liability that we will cover later.) From an economic perspective,

each dollar of Assets must be “funded” by a dollar of Liabilities or Equity. This principle is what we described earlier

as “in balance” and is the standard way accountants and bookkeepers note a transaction, to verify that the

accounts balance. (You can think of this as you would think of a quid pro quo or “give & take” transaction. For

example, if you purchase something on credit, you receive it from the seller or manufacturer and it becomes an

Asset to the business; but you also need to convey the Debt, or short-term Liability of the money that went to the

seller or manufacturer. For every amount of value that you receive, you in turn, give an amount of value as

payment, keeping the company’s books in balance.

Liabilities can also be divided into two categories based on their due date: Current Liabilities and long-term Liabilities. We list them on Balance Sheet based on their due dates, just as we list Assets in order of liquidity.

Current Liabilities are obligations that a company expects to payoff within the year. On the Asset side, their

counterparts are Current Assets. Long-term Liabilities are obligations due more than one year out. On the

Asset side, their counterparts are the fixed Assets.

The following illustration identifies the categories of Assets and Liabilities:


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Capital or Stockholders’ Equity

Stockholders’ Equity is also known as a company’s Capital or Net Worth. This section lists the money that would

be leftover if a company sold all of its Assets and paid off all of its Liabilities. Therefore, we use the word Net

Worth. This leftover money belongs to the stockholders, or the owners, of the company. It can also accumulate over

time because of a constantly profitable business. A positive Net Worth means you’ve made a profit; negative means

you’ve lost money.

A company may or may not distribute its earnings. Business circumstance and liquidity (Cash) needs dictate the

decision to distribute earnings. When companies distribute earnings instead of retaining them, these distributions are

called dividends. A full distribution of earnings seldom occurs. Generally, only a part of the earnings becomes a

dividend.












Categories of

Assets and

Current Assets:

Convertible to Cash

in one year

Non-Current Assets:

Convertible to Cash

in more than one

Current Liabilities:

Payable in one year

Long-Term

Liabilities: Payable in

more than one year


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In summary, one must strictly think of a balance as a snapshot. It is not like a movie that records the happenings of a

company from the start to the end of a period; it only shows a snapshot of a company’s Assets, Liabilities and

Stockholders’ Equity at the end of the reporting period. It doesn’t show the Flow into and out of the company’s accounts

during the reported period. For this information, businesses use Income Statements and Cash Flow Statements.

Since Balance Sheets show the financial status at a specific point in time. Let’s look at the Income Statement which

shows how a company performed over a specified period of time.


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Income Statement Income Statements are typically prepared at the end of a business period (such as a Fiscal Year or Quarter) to assess

profit or loss. It can be thought of like a motion picture. It reports how a company performed during the period presented,

and shows whether that company’s operations have resulted in a profit or loss. Therefore, it shows how much money a

company made and spent over the period. The period is shown in the header of the Income Statement.

To state this another way, it is a financial report that shows how much revenue a company earned over a specific

period (usually a year). An Income Statement also outlines the costs and expenses associated with earning the

revenue. Typically, the final figure of this statement shows the company’s net earnings or losses. This final figure tells

you how much the company earned or lost over the period.

Drawing an Income Statement

To better understand how Income Statements are set up, it may be helpful to think of them as a set of stairs.

We start at the top with the total amount of Sales made during the accounting period. Then we will go down, one step

at a time. At each step, we make a deduction for costs or expenses associated with corresponding revenue. This

means that each step will bring a revenue and an expense pair, or an expense item into the picture. At the last step,

after deducting all expenses, we will learn how much the company earned or lost during the period. People often call

Particulars 2014 2013Sales 100.0 110.0

Sales Returns and allowances 20.0 8.0Net Sales 80.0 102.0

Cost of Goods Sold 50.0 60.0Gross Profit 30.0 42.0

Operating ExpensesSelling Expenses 11.0 13.0General Expenses 4.0 7.0Total Operating Expenses 15.0 20.0

Income from Operations 15.0 22.0Non-‐Operating Income 3.0Income Before Interest Expense and Taxes 18.0 22.0

Interest Expense 2.0 2.0Income Before Taxes 16.0 20.0

Income Taxes (40% rate) 6.4 8.0Net Income 9.6 12.0

The Learning CompanyIncome Statement

(In thousand of dollars)For the years Ended Dec 2014 and 2013

The period of

time is

shown in the

header

Step 1:

Step 2:

Step 3:

Step 4:

Step 5:

Step 6:


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this “the bottom line.” It is the company’s net earnings or loss.

Let’s take a closer look at each step:

Step 1. At the top of the Income Statement is the total amount of money brought in from Sales of products or

services. This is the gross revenue or Sales and often referred to as the “top line.” It’s “gross” because we

have not deducted expenses from it, therefore a “gross” or unrefined number. Similar to your pay stub from

your paycheck, which starts out listing your gross pay, then lists all your deductions and taxes down to your

net pay. Likewise we start with gross revenue or Sales and in each subsequent step, we will further refine it,

approaching the net figure at the last step.

Step 2. The next line lists money the company does not expect to collect on certain Sales. This could be, for

instance, Sales discounts or merchandise returns or bad checks. Therefore, it is a deductible item because it

is non-collectable. Since it is a loss of revenue, we subtract it from Sales to arrive at the company’s net

revenue or “Net Sales.”

Step 3. This step typically shows the costs associated with the Sales also known as the “Cost of Goods Sold.” This is

the amount of money spent to produce the goods or services sold during the period. By deducting the Cost of

Goods Sold, we get “Gross Profit” or “gross margin.” It is “gross” because there are still additional expenses

that need to be deducted to arrive at our last step.

Step 4. The next step deals with Operating Expenses. It is a comparatively bigger step on the stairs, simply because

there can be a great number of them. Operating expenses are the expenses that go toward supporting a

company’s operations for a given period. Operating expenses are different from the cost of Sales

because operating expenses cannot be linked directly to the production of the products or services rendered.

In our example, the operating expenses are divided into Selling Expenses and General Expenses. Selling

expenses include those expenses spent to make a sale and can include marketing costs, travel, and

commissions. General expenses can include salaries, research and development and depreciation or

amortization.

Note: Depreciation or Amortization takes into account the wear-&-tear on Assets such as machinery, tools

and furniture, which are used over a long term or over a number of periods. Therefore, we also spread the

cost of these Assets over the periods they are used. The depreciation deducted from Gross Profit in a period

is determined as a fraction of the original cost of the Assets. This fractional amount is usually placed in a

savings or depreciation account so that it is there to be used as a replacement cost at the end of the life of

the equipment.


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After all of the operating expenses are deducted from Gross Profit, we arrive at the figure of operating profit

before interest and income tax expenses, also known as “income from operations.” In our example, Income

from Operation equals Gross Profit minus Total Operating Expenses.

Step 5. Next, we still need to account for interest income and interest expenses. Interest income is the money

companies make from keeping their Cash in interest-bearing savings accounts or other investments.

Interest expense is the money companies paid in interest for money they borrow. We add or subtract

the interest income and expense to arrive at the figure of the “Income Before Taxes.”

Step 6. In the final step, income tax is deducted and we arrive at the bottom line or the last step of the stair: net profit

or net losses. Here we finally know about the profit or loss of a company. Specifically, whether or not the

company made or lost money and, as in our example, whether they did better or worse than the previous

year.

FYI: Earnings per Share (EPS) - Some Income Statements also report Earnings per Share (or “EPS”). This figure is the

earnings per share of investment made in the company. Earnings per Share ratio is discussed and defined in the section

on Analyzing Financial Statements.


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Cash Flow Statements Cash Flow Statements - In many businesses, income and Cash Flow are not always the same, which leads to the need

for a Cash Flow statement showing the exchange of money between a company and the outside world over a

period. The Cash Flow statement reconciles opening balance of Cash (as opposed to non-Cash items such as credit

Sales) at the start of the period with the closing balance of Cash at the end of a period.

Understanding Cash management is critically important for a person running a business. One must be a good manager

of Cash to build a business successfully because Cash is vital to the operation of every business.

The final information one looks for in the Cash Flow statement is the net increase or decrease in Cash for the period.

This information is very important from a financial point of view. Financial analysts focus this information to judge the

ability of a business to generate Cash. The information is also of vital importance for the person in business because it

tells him/her about their business’ liquidity strength. The Cash Flow statement aids the businessperson to answer vital questions like: Where was money obtained? Where

was money put and for what purpose? Additionally, the information contained in the Cash Flow statement is important

to answer many critical questions, such as:

• Is my business growing, or simply maintaining its competitive position?

• Will my business be able to meet its financial obligations?

• Where did my business obtain funds?

• What use was made of net income?

• What is the internal capacity of my business to generate funds?

• How was the expansion in plant [do you mean plant expansion?] financed?

• Is my business expanding faster than it can generate funds?

• Is there a balance in the dividend policy and operating policy of my business?

• Is my business’ Cash position sound?

The pattern of Cash utilization can determine a firm's success or failure. A businessperson must control his/her

company's Cash Flow so that bills can be paid on time and extra money can be put into the purchase of Inventory and

new equipment or invested to generate additional earnings.

The Cash Flow Statements report on the company’s Cash movements during a period, categorizing them into three

areas that Cash Flows through a business from its operating, investing and financing activities.


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Therefore, Cash Flow Statements generally have three main areas (Cash Flows):

1. Operating activities

2. Investing activities

3. Financing activities The Cash Flow statement discloses Cash in these specific categories. The most important of the Flow categories in a

Cash Flow statement is Cash from operating activities. This category is the primary focus of the person operating the

business. The Cash Flow from operations must be positive (net inFlow) to make the business viable in the future and to

make it an attractive investment for the person running the business. Each part reviews the Cash Flow from one there particular type of business activity. See the following Cash Flow

Statement illustration:

A Cash Flow statement such as this, categorized by three separate types of Cash Flow, gives a business a holistic

view of total Flows into and out of the business. Cash Flow Statements are therefore fundamental tools to use when

Cash flows from operating activitiesNet Income 182$ Add/(deduct) to reconcile net income to net cash flow

Depreciation 23$ Increase in accounts payable 9$ Increase in other liabilities 24$ Increase in Accounts Receivable (35)$ Increase in Inventory (86)$

Net cash provided by operating activities 117$ Cash flows from investing activities

Cash paid to purchase fixed assets (225)$ Sale of marketable securities 28$

Net cash provided by investing activities (197)$ Cash flows from financing activities

Decrease in notes payable (36)$ Issuance of long-‐term-‐debt 54$ Sale of common stock 78$ Cash paid for dividends (40)$

Net Cash used in financing activities 56$ Net decrease in cash and cash equivalents (24)$

Cash and cash equivalents at beginning of the year 51$ Cash and cash equivalents at end of the year 27$

The Learning CompanyStatement of Cash Flows

For the Year Ended December 31, 2014(in Thousands of Dollars)

Operating

Activities

Investing

Activities

Financing

Activities

Change

over time


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making decisions about a company’s Cash management. A Cash Flow statement is a “Flow” statement. It is not a snapshot like a Balance Sheet. It shows changes over time

rather than an absolute dollar amount at a particular point in time. Information from a company’s Balance Sheet and

Income Statement is used to prepare a Cash Flow statement. It is reordering of information from a company’s Balance

Sheet and Income Statement in order to provide a different view of the business.

Now, let’s look at each section, specifically,

Operating Activities

Operating activities are defined as the company’s primary business activities, for example the production and delivery

of goods and services. They reflect the Cash effects of transactions, which are included in the final determination of

net income. These activities basically include all activities not classified as either financing or investing activities.

Cash Flow from operating activities is the first part of a Cash Flow statement. It analyzes a company’s Cash Flow

from net income or losses. Typically, this section of the Cash Flow statement reconciles the net income with the

actual Cash the company received from or used in its operating activities. To do this, it adjusts net income for any

non-Cash items like depreciation expenses and adjusts for any Cash used or provided by other operating Assets and

Liabilities.

As discussed earlier, the most important aspect of Cash Flow in the statement is Cash from operating activities

(a.k.a. Cash from operations). The Cash Flow from operations must be positive (net inFlow) to make the

business viable in the future and to make it an attractive investment for the person running the business.

Investing Activities

This is the second part of a Cash Flow statement. It shows the Cash Flow from all investing activities, which

generally includes purchases or Sales of long-term Assets, such as plants, properties, and investment securities,

etc. For example, if the Learning Company buys a piece of machinery, its Cash Flow statement would reflect this

activity as a Cash outFlow from investing activities. The Cash Flow is categorized as investing activity because it

used Cash for investing in the business. Similarly, if the company decided to sell off some investments, it would also

be considered an inFlow from investing activities. This is because it provided the business with Cash.

Financing Activities

This is the third part of a Cash Flow statement. Financing activities show the Cash Flow from all financing activities.

Financing activities include the activities relating to the receipt and repayment of funds provided by creditors and

investors. Examples of this would be in the issuance of Debt or Equity securities, the repayment of Debt, and the

distribution of dividends. This means the sources of Cash Flow include Cash inFlow resulting from sale of stock and

bonds or borrowing. Likewise, the repayment of a bank loan would generate Cash Out-Flow in this category.

Businesspeople who intend on expanding their venture need Cash which can be done through Equity or borrowing –


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both are financing activities. When a company issues stock or borrows money, it receives Cash. As we stated above,

the two Cash receipts are from financing activities.

IMPORTANT: When you borrow from a bank, you will have to pay interest (i.e. Cash Out-Flow in future.) An unwise

investment or use of these financed funds in a non-productive investment activity may trap a business in a future

regular pattern of interest payments. In extreme situations, this may even result in bankruptcy.

Statements of Stockholders’ Equity Statements of Stockholders’ Equity - The fourth financial statement, called a Statement of Stockholders’ Equity

shows how shares, total Equity and ownership types have changed over time. It reconciles the activity in the Equity

section of the Balance Sheet from period-to-period. The changes in Stockholders’ Equity represent company profits or

losses, dividends and (or) stock issue.

The specifics of Statements of Stockholders’ Equity can be extremely varied depending on the way any individual

company is organized as it pertains to ownership, stock, preferred stock, paid-in-capital and how this capital is

increased or diluted over time and explains what happened to cause any changes in each “snap-shot” of a Balance

Sheet from moment-to-moment.

Note: This statement is particularly important if you “own stock” in a company but do not have voting rights associated

with that stock and therefore no control or say in the running of the business; particularly with respect to ownership,

dilution of stock by issuing additional shares and so forth. Be sure you know your rights, before investing in the stock of

a company.

Common Stock $10 par

Paid-‐In-‐Capital in Excess of Par

Retained Earnings

Treasury Stock

Total Shareholders'

EquityBalance on January 1 45,000$ 39,600$ 84,600$ Issued Shares for Cash 3,000$ 12,000$ 15,000$ Purchase of Treasury Stock 13,000$ 13,000$ Net Income 4,000$ 4,000$ Cash Dividends (1,500)$ (1,500)$ Stock Dividends 1,150$ 4,000$ (5,750)$ (600)$ Balance on December 31 49,150$ 16,000$ 36,350$ 13,000$ 114,500$

The Learning CompanyStatement of Stockholders' EquityFor period ending January 31, 2015Columns list types of

equity in company

Rows list how the equity

changed over the year


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As you can see in the illustration, when there is a change in Stockholders’ Equity over a year, the statement identifies

what happened to the Equity over the period that caused the change.

A Note about the Footnotes of Financial Statements

A company’s Financial Statements all come with a set of footnotes. It is very important to read the footnotes in the

Appendix of a set of Financial Statements or statements. Because, the footnotes to Financial Statements give vital

information. Here are some of the highlights which might be found in footnotes, as well as, why they are important:

• Significant accounting policies and practices - Companies are required to disclose the

accounting policies which are most important to disclose in the company’s financial condition

and results. The company’s management chooses its accounting policies. The choice of

accounting policies often requires difficult, subjective and complex judgments by the

management.

• Nonmonetary Assets – describes any Assets such as Intangible Assets that cannot be

converted into ready Cash but may still influence the overall valuation of a company.

• Income taxes - The footnotes also state detailed information about the company’s current

and deferred income taxes. Details include a break-down of total tax into federal, state, local

and/or foreign taxes.

• Pension plans and other retirement programs - Footnotes may also discuss pension

plans and other retirement or post-employment benefit programs.

• Stock options - Information about stock options granted to officers for performance

improvement may be included in the footnotes. It would also state the effect of stock

option plans on business results being reported on by the Financial Statements.

Now that we have examined what Financial Statements are and what kinds of information they hold, let’s look at

how this information can analyzed to help the business decision-making process.


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We analyze Financial Statements in order to

take care of the money already invested, as well as,

the money which is to be invested in the future.

– Denise DeSimone


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Analysis of Financial Statements This section examines the following information to help you analyze your Financial Statements,

• Why analyze financial Statements

• The three common types of analysis

• How to compute each type of analysis

• Based on the results of the analysis, how to determine what the results mean to you and your company.

Why Analyze Financial Statements Sometimes, as business owners, we are so busy with the day-to-day operations of running a business, we forget to

take a step back and look at our business as whole. By analyzing Financial Statements, we can spot trends over time,

identify the mix of Assets and Liabilities within a certain period of time and evaluate relationships among items to

determine efficient operations.

Ultimately, an analysis of Financial Statements is an evaluation of:

• A firm's past financial performance

• Its prospects for the future

The points above relate to two very basic questions in running a business: • How well my business is performing?

• What will happen to it in future?

The search for answer to these questions begins with an analysis of the firm's Financial Statements.

Formally defined, analysis of Financial Statements is the selection, evaluation, and interpretation of financial data, along

with other pertinent information, to assist in investment and financial decision-making, as well as, indicate how and

where to improve the overall performance of the business.

In general, an analysis of Financial Statements is vital for a person running a business. This analysis tells this business

owner where he or she stands in his/her financial environment.

Business owners can use financial analysis both internally and externally. They can use them internally to evaluate issues

such as employee performance, the efficiency of operations and credit policies, and they can use them externally to

evaluate potential investments and the creditworthiness of borrowers, amongst other things. Analysis discloses both the

external and internal financial situation and most importantly, it points to the financial destination of the business in near

future, and to long-term trends.

Analysis can also indicate the relative liquidity, Debt, and profitability of a firm, as well as, indicate how investors perceive

the firm and can help detect emerging problems and strengths in a firm.


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Besides analyzing the past performance, analysis helps determine the strategy of a company moving forward.

For example, using financial ratios in conjunction with the budgeting process can be particularly helpful in determining

costs or changes in process to increase savings and operate more efficiently. Thereby, achieving an objective of the

budgeting process to determine the firm's game plan. Or, as in the case of the Sales to Inventory ratio. This ratio is a

measure of the ability of a firm to turn Inventory into Sales. Generally, the higher the ratio, the more efficiently the

business is using Inventory and turning over its Inventory without the cost of becoming obsolete.

In addition to analyzing your company’s own financials, you also need to analyze and compare your company’s

performance to industry peers, also known as, benchmarking. Industry data regarding your peers can be found through

the IndustriusCFO® system at www.industriuscfo.com.

Types of Financial Statement Analysis Typically, when Financial Statements are prepared they show past information so you can see the change over time.

A business owner usually uses many instruments to evaluate the financial health of a business. Three of the most

commonly-used evaluation instruments are:

• Horizontal Analysis – analyzes the trend of the company financials over a period of time by showing each line

item as a percentage from the previous period.

• Vertical Analysis – compares the relationship between a single item on the Financial Statements to the total

transactions within one given period, also indicated as a percentage. You can perform a Vertical Analysis on both

an Income Statement and a Balance Sheet.

• Ratio Analysis – analyzes financial ratios or numeric relationships based on a company’s financial information

and is used to compare a company’s performance from one period to another (current year vs. last year).

Analysis of Financial Statements is a great value to people running a business in order to accurately determine the

strength of a business and where there is room for improvement. In the absence of analysis, such data may lead one to

draw erroneous conclusions about the firm's financial condition and result in poor rather than strong decision-making.

For example, an Assets to Sales ratio is a measure of a firm's productive use of Assets where a low percentage rate

compared to the average for the industry usually indicates highly efficient use of Assets. Likewise, a high percentage

rate indicates the need to improve the use of Assets.

The following sections give a detail explanation of each type of analysis, how it is computed and what the results can

mean:


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Horizontal Analysis With a Horizontal Analysis, also, known as a “trend analysis,” you can more readily spot trends in your financial data

over time. For example, a $2 million profit year looks very impressive following a $0.25 million profit year, but not after

a $10 million profit year. Horizontal analysis stresses the trends in earnings, Assets and Liabilities over a period of time, such as, from year-to-year

or over several years. For a business owner, this information about trends is useful in identifying areas of wide

divergence. These identified areas become those areas of your business that require further attention, amending a course

of actions, and for the fine-tuning of an adopted strategy.

For instance, a large increase in Sales returns and allowances coupled with a decrease in Sales over two years would

be cause for concern. The problem may be lower quality, or defective goods. If this is the case, you need to address

and solve the problem or the company’s reputation and future may be at stake. The ability to spot this trend over time,

empowers you to intervene and be pro-active in solving the problem. No company lives in a bubble so it is also helpful

to compare these results with those of competitors in order to determine whether the problem is industry-wide, or just

within the company itself. If no problems exist industry-wide, one will observe a shortfall in Sales and rise in the dollar

amount of Sales returns.

Once a problem is identified, businesses can devise a strategy to cope with it. Therefore the key to analysis is to identify

potential problems and areas of high efficiency to give the data necessary to legitimize change within the business.

In a Horizontal Analysis, we state both the dollar amount of change and the percentage of change, because either one

alone might be misleading.

For example, although interest expense from one year to the next may have increased 100 percent, this probably does

not require further investigation; because, the dollar amount of increase is only $1,000. Similarly, a large change in

dollar amount might result in only a small percentage change which, ultimately, will not cause concern for the business

owner.

How to Create a Horizontal Analysis When Financial Statements are prepared, they often contain current data, as well as, the previous period so that the

reader of the financial statement can compare to see where there was change, either up or down.

With a Horizontal Analysis, this comparison goes one step further; it depicts the amount of change as a percentage

to more readily show the difference over time as well as the dollar amount.

The following illustration depicts a Horizontal Analysis:


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Note that the line-items are a condensed Balance Sheet, and that the amounts are shown as dollar amounts and

as percentages and the first year is established as a baseline.

A baseline is established because a financial analysis covering a span of many years may become cumbersome. It

would require the arrangement and calculation of interlinked numbers and dates. Particularly, interlinks among the

numbers make financial analysis tiresome and complex for a typical businessperson. A solution is to create

comparative Financial Statements, which depicts the results of Horizontal Analysis and show the trends relative to

only one base year. The baseline acts as a peg for the other figures while calculating percentages. For example, in

this illustration, the year 2012 is chosen as a representative year of the firm’s activity and is therefore chosen as

the base. Each account of the baseline year is assigned an index of 100%.

Once the baseline is established, the percentage for each respective account is found by:

1. Subtracting the previous year amount from the current year amount 2. Dividing the account's amount by the previous year amount

3. Multiplying by 100 to derive the percentage.

$ % $ % $ %Assets

Current Assets 463,000 120% 210,000 110% 100,000 100%Plant Assets 365,000 50% 243,000 35% 180,000 100%

Total Assets 828,000 83% 453,000 62% 280,000 100%

LiabilitiesCurrent Liabilities 306,000 118% 140,200 92% 73,000 100%Long-‐Term Liabilities 340,000 115% 157,800 102% 78,000 100%

Total Liabilities 646,000 117% 298,000 97% 151,000 100%

Stockholders' EquityCommon Stock 120,000 9% 110,000 10% 100,000 100%Retained Earnings 62,000 38% 45,000 55% 29,000 100%

Total Stockholders' Equity 182,000 17% 155,000 20% 129,000 100%

Total Liabilities and Stockholders' Equity 828,000 83% 453,000 62% 280,000 100%

2014 2013 2012

The Learning CompanyTrend Analysis of the Balance Sheet

(Expressed as a Percent)Dec. 31, 2014, 2013 and 2012


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For example, if we let 2012 be the base year in the Balance Sheet of Learning Company, Current Assets would be

given an index of 100%.

Then for 2013, to derive the percentage of change, we look at each line item:

In this case,

Current Assets for 2013 are $210,000 subtract the baseline amount of $100,000:

$210,000 - $100,000 = $110,000

Determines the difference of $110,000.

Divide this difference by the baseline amount, so

$110,000 / $100,000 = 1.1

Multiply by 100 to calculate the percentage:

1.1*100 = 110%

And we can see that Current Assets grew by 110% from 2012 to 2013.

To calculate 2014, we DO NOT go back to the baseline to do the calculations; instead 2013 becomes the new baseline,

so we can see percentage growth from year-to-year.

In our illustration,

The calculation to determine the Current Assets 2014 percentage change becomes:

$463,000 - $210,000 = $253,000

Determines the difference of 253,000.

Divide this difference by the baseline amount, so

$253,000 / $210,000 = 1.2


1.1*100 = 120%

And we can see that Current Assets grew by 120% from 2013 to 2014.

By seeing the trend, which is a remarkable growth of over 100% from one year to the next, we can also see that the

trend itself, is not that remarkable of only 10% change from 2013 at 110% to 120% in 2014. Which could indicate, that


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perhaps growth is starting to stagnate or level-off.

Therefore, additional analysis is required.

Vertical Analysis Vertical analysis is the comparison of various line items within a single period. It compares each line item to the

total and calculates what the percentage or portion the line item is of the total. It can be done with the

company’s own Financial Statements or with the use of the Common Size statements. Both are described in

this section:

The following illustration shows a Vertical Analysis of a company’s own Balance Sheet:

The Learning Company Vertical Analysis of the Balance Sheet

(Expressed as a Percent) Dec. 31, 2014, 2013 and 2012

2014 2013 2012 $ % $ % $ % Assets Current Assets 463,000 56% 210,000 46% 100,000 36% Plant Assets 365,000 44% 243,000 54% 180,000 64% Total Assets 828,000 100% 453,000 100% 280,000 100%

Liabilities Current Liabilities 306,000 47% 140,200 47% 73,000 48% Long-Term Liabilities 340,000 53% 157,800 53% 78,000 52% Total Liabilities 646,000 100% 298,000 100% 151,000 100%

Stockholders’ Equity Common Stock 120,000 66% 110,000 71% 100,000 78% Retained Earnings 62,000 34% 45,000 29% 29,000 22% Total Stockholders’ Equity 182,000 100% 155,000 100% 129,000 100%

Total Liabilities and Stockholders’ Equity 828,000 100% 453,000 100% 280,000 100%

Note that in this illustration, each line item is shown as a percentage of the total for its category. For example,

in 2012, Current Assets are 36% of Total Assets for that year; whereas in 2014, Current Assets are 56% of

Total Assets. While you can still compare from one year to the next, the calculation to determine the

percentage is within the same period i.e. down the column (unlike Horizontal Analysis where the calculation is


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based on the difference in items from one year to the next).

Also Note that in this illustration, the Balance Sheet is a condensed version. You may also want to do a Vertical

Analysis on a full Balance Sheet to more clearly highlight potentially problematic areas. For instance, if you

break out all Current Assets and see that the line item of Accounts Receivable is a large percentage of Total

Assets, then you’ll know that there is a problem with collections and that you need to look into ways of

receiving payment in a more timely manner.

How to Create a Vertical Analysis

A Vertical Analysis can be completed on both an Income Statement and a Balance Sheet. Unlike Horizontal

Analysis, a Vertical Analysis is confined within one year (or one vertical column of the Balance Sheet); so we

only need one period of data to derived the percentages and complete the analysis.

In our sample Balance Sheet, we want to determine the percentage or portion a line item is of the total

category.

For example, for 2014, to derive the percentage of Current Assets:

Current Assets are $463,000 and Total Assets are $828,000

Divide Current Assets by Total Assets

$463,000 / $828,000 = .56


.56 * 100 = 56%

And so we can see that Current Assets are 56% of Total Assets. This high percentage means most of your

Assets are liquid and it may be time to either invest that money or use it to purchase additional Plant Assets.

Likewise, to complete a Vertical Analysis of Current Liabilities:

In 2014, Current Liabilities are $306,000 and Total Liabilities are $646,000

Divide Current Liabilities by Total Liabilities

$306,000 / $646,000 = .47

Multiply by 100 to calculate the percentage

.47 * 100 = 47%

And so we can see that Current Liabilities are 47% of Total Liabilities. In this case, you may want to double-

check if this is wise or if you are actually paying more interest than if you re-financed and move some of the

Current Liabilities to Long-Term Liabilities for a better interest rate and a lower monthly payment.

When creating a Vertical Analysis of an Income Statement, the amounts of individual items are calculated as a

percentage of Total Sales.

The following illustration depicts a Vertical Analysis of an Income Statement:


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Through the use of percentages of Total Sales, you can readily see that Sale Returns and Allowances is a

whopping 20% of Total Sales in 2014. When, only a year ago in 2013, Sale Return and Allowances was only 7%,

meaning that there is most likely more instances of defective items. Then, consider that in 2014, 50% of Cost of

Goods Sold was 50% where it was 55% a year ago. Clearly, while Cost of Goods decreased, quality has suffered

and therefore, the Net Income, also known as “the Bottom Line” has suffered as well.

As a business owner in this situation, you would need to examine the situation in more detail and work with the

supplier or change suppliers to receive higher quality materials or investigate to see if this situation is a

coincidence based on other factors, either way, this is a clear indication that action is required.

How to Create a Common-Size Vertical Analysis With a “Common-Size” Vertical Analysis, you can take the Vertical Analysis of two companies, for example, your own and

that of a peer, and by using the percentages calculated in the Vertical Analysis, you can compare apples-to-apples

regardless of the sizes of the companies.

Particulars 2014 2013Sales 100,000$ 100% 110,000$ 100%

Sales Returns and Allowances 20,000$ 20% 8,000$ 7%Net Sales 80,000$ 102,000$

Cost of Goods Sold 50,000$ 50% 60,000$ 55%Gross Profit 30,000$ 42,000$

Operating ExpensesSelling Expenses 11,000$ 11% 13,000$ 12%General Expenses 4,000$ 4% 7,000$ 6%Total Operating Expenses 15,000$ 20,000$

Income from Operations 15,000$ 22,000$ Non-‐Operating Income -‐$ -‐$ Income Before Interest Expense and Taxes 15,000$ 22,000$

Interest Expense 2,000$ 2% 2,000$ 2%Income Before Taxes 13,000$ 20,000$

Income Taxes (40% rate) 5,200$ 5% 8,000$ 7%Net Income 7,800$ 8% 12,000$ 11%

The Learning CompanyVertical Analysis of Income StatementFor the years Ended Dec 2014 and 2013


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For example, note the following Vertical Analysis of two companies:

As we can see in the illustration, Company 2 does significantly more in Net Sales, so in able to compare the two, we

select an item such as Net Sales of Company 1 to act as a peg or fixed reference for the analysis and then use the

percentages to determine, who is actually, the more efficient or successful company as noted in the following illustration:

Note, in order to compare Company 1 and Company 2, we use a common Net Sales figure to make the companies the

"same size" aka "Common Size" then use the %'s calculated in the Vertical Analysis to determine would-be values and

see comparative difference between companies. For instance, by comparing at the same Net Sales, we can see that

Company 2 is spending significantly more, per $1 million in Sales, on Cost of Goods.

In this case, if you are the business owner of Company 1, the analysis serves as a reality check that you are receiving

Cost of Goods at a reasonable price. Whereas, if you are the business owner of Company 2, the analysis serves to inform

you that you are either being over charged for Cost of Goods or perhaps you need to change suppliers. Either way, as a

business owner, you are made aware that a problem exists and needs your attention.

In our example, we used Net Sales as the baseline; however, logically, any of the items in a financial report can be used

Common-‐Size Vertical Analysis of Income Statements

Company 1: $ %Net Sales (NS) 1,000,000Cost of Goods 250,000 25%Gross Margin 750,000Operating Expenses 500,000 50%Net Profit 250,000 25%

Company 2: $ %Net Sales (NS) 2,500,000Cost of Goods 1,000,000 40%Gross Margin 1,500,000Operating Expenses 1,200,000 48%Net Profit 300,000 12%

Company 1: $ % Company 2: $ %Net Sales (NS) 1,000,000 Net Sales (NS) 1,000,000Cost of Goods 250,000 25% Cost of Goods 400,000 40%Gross Margin 750,000 Gross Margin 600,000Operating Expenses 500,000 50% Operating Expenses 480,000 48%Net Profit 250,000 25% Net Profit 120,000 12%


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as a base value for a Vertical Analysis. However, choosing a base value is a critical decision for the analyst; it must be in

accordance with his/her needs and the objective of the analysis. For example, a person analyzing the pattern of financing

will be more interested in the Liability side of the Balance Sheet when placed in the context of other items.

Another advantage of converting Financial Statements into percentages of a particular peg item is the possibility of

comparison through common-size Financial Statements of one’s own data. The common-size data makes comparison

easy over a set of periods.

The following illustration shows an example of a Common-Size Income Statement:

Note, by setting the Net Sales to a common-size percentage, comparisons of change from one year to the next are more

clearly evident. For example the change in Sales Returns and Allowances appears quite significant, but Net Income has

only a .2% change from one year to the next due to increases in items such as Income from Operations. Without analysis,

a business owner may only see the .2% change and not think it a substantial change, however upon closer examination,

the change in Cost of Goods is a clear indication that a problem exists and must be dealt with in a timely manner.

In summary, Vertical Analysis discloses the internal structure of a business by showing the relationship between Income

Statement amounts i.e. revenue and expense items. On the Balance Sheet side of analysis, it tells a business owner the

Particulars 2014 2013Sales 100,000$ 125.5% 110,000$ 107.8%

Sales Returns and Allowances 20,000$ 25.0% 8,000$ 7.8%Net Sales 80,000$ 100.0% 102,000$ 100.0%

Cost of Goods Sold 50,000$ 62.5% 60,000$ 58.8%Gross Profit 30,000$ 37.5% 42,000$ 41.2%

Operating ExpensesSelling Expenses 11,000$ 13.8% 13,000$ 12.7%General Expenses 4,000$ 5.0% 7,000$ 6.9%Total Operating Expenses 15,000$ 18.8% 20,000$ 19.6%

Income from Operations 15,000$ 18.7% 22,000$ 21.6%Non-‐Operating Income 3,000$ 3.8% -‐$ Income Before Interest Expense and Taxes 18,000$ 22.5% 22,000$ 21.6%

Interest Expense 2,000$ 2.5% 2,000$ 2.0%Income Before Taxes 16,000$ 20.0% 20,000$ 19.6%

Income Taxes (40% rate) 6,400$ 8.0% 8,000$ 7.9%Net Income 9,600$ 12.0% 12,000$ 11.8%


Common-‐Size AnalysisFor the years Ended Dec 2014 and 2013


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mix of Assets and the mix of Liabilities operating to generate Cash.

Therefore, a Vertical Analysis will furnish a picture of the mix of Assets, financed by the mix of Liabilities, which produces

a particular pattern of income generation through a set of business operations.

A Vertical Analysis can also make it possible to evaluate the composition of:

1. The Assets held by a business

2. Liabilities that have financed these Assets

The Vertical Analysis is not sufficient as a standalone analysis. A good analyst will combine it with other techniques

to gain insight into the business affairs. Techniques such as Ratio Analysis as discussed in the next section.


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Ratio Analysis Horizontal and Vertical Analyses compare one figure to another within the same category and ignore figures from different

categories. However it is also essential (and much insight can be gained) by comparing figures from different categories.

This is accomplished through Ratio Analysis. Ratio Analysis is a comparison of relationships among account balances.

Fundamentally, analysis of Financial Statements involves the calculation of various ratios:

A ratio is defined as: A relationship between two numbers of the same kind, usually expressed as "a to b" or a : b, sometimes expressed arithmetically as a quotient of the two numbers. A ratio explicitly indicates how many times the first number contains the second (not necessarily an integer).

So for example, in an Assets to Sales Ratio = Total Assets / Net Sales

For instance, say you have $100,000 in Total Assets, and $1,000,000 in Net Sales, your Assets to Sales would be

100,000 / 1,000,000 or 1 : 10 or 1/10 = .10 or 10%

In other words: Financial Ratios are relationships among entries from a company's financial information, used for

comparison purposes.

At a very basic level, ratios are employed to make two types of comparisons: Industry comparisons and trend analysis.

• Trend analysis- Comparing a company’s performance from one period to another (current year vs last year,

etc.). Trend analysis examines ratios over comparable periods. A firm's present ratio is compared with its past in order to

project expected future ratios and to determine whether the company's financial condition is improving or

deteriorating over time. This analysis determines the future viability of the business.

• Industry comparisons- Comparing a company’s performance to industry peers (benchmarking).

In industry comparisons, the ratios of a firm are compared with those of similar firms or with industry averages in

order to gain insight into its relative performance. Industry average ratios are available from a number of sources,

such as Bradstreet, Robert Morris Associates and IndustriusCFO.

Financial Ratios are important because they give you a standardized measure which can be compared so that

performance can be monitored over time and against industry peers.

So as in our example, once you determine a ratio such as Assets to Sales, then, you refer to some comparative data to

determine how your company is performing on this key performance indicator (KPI) or ratio. There may be a general rule

of thumb, or you could compare to previous year’s performance, or compare against industry peers in benchmarking. The

rule of thumb here is, the smaller the # or percentage, the better – as it’s telling you that your company is able to generate

more Sales with less assets, whereby a less efficient firm is generating equal Sales with more assets.

As in another example, consider Company A & Company B. Company A is able to generate 1M in Net Sales with $100k in


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Total Assets. Company B is able to generate 1M in Net Sales with $500k in Total Assets. Company A has Assets to Sales

of .10 or 10%, Company B’s is .50 or 50%. Therefore, since we know the general rule of thumb is, the smaller the Assets

to Sales #, Company A is more efficient their use of Total Assets to generate Net Sales, the higher the number, efficiency

decreases.

The information resulting from this analysis is used by interested parties (such as creditors, investors, and managers) to

determine the strength or weakness of a firm's financial position. The analysis states a firm’s financial position relative to

that of others firms, both peers and competitors and in relation to the firm’s own past performance. The analysis

culminates in the creation of a firm’s financial reputation by the way in which an entity's financial position and operating

results are viewed by investors and creditors. Certainly, it will have an impact on the firm's general power to access credit,

find investors, and determine a growth or exit strategy, amongst other business operations.

After completing the analysis of Financial Statements, the owner of a business should consult with management to chalk

out, discuss, and amend plans for capturing opportunities and avoiding possible threats for the firm. A primary focus

should be problem areas identified in the analysis, and their possible solutions.

Note that the Income Statement shows a company's profit or loss, while the Balance Sheet itemizes the value of its

Assets, Liabilities, and owners' Equity. Together, the two statements provide the means to answer two critical questions:

1. How much did the firm make or lose?

2. How much is the firm presently worth based on historical values found on the Balance Sheet?

Ratio analysis is defined as the calculations that measure an organization's financial health; it brings complex information

from the Income Statement and Balance Sheet into sharper focus for the owner. Particularly, it can measure and compare

the organization's productivity, profitability, and financing mix with other similar entities.

Again, looking at ratios in isolation is as useful as staring at a blank paper; it gives you almost no information. However,

placed in the context of other reported items and the reported items of the competitors, it can provide meaningful

indications.

There are many ratios that an analyst can use, depending upon the nature of relationship between the figures and the

objectives of the analysis.

There are five general classes of financial ratios:

1. Liquidity Ratios

2. Activity Ratios

3. Leverage Ratios

4. Profitability Ratios

5. Market Value Ratios

Some of the most useful ratios in each of the five categories are discussed next.


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For the purposes of illustration of financial ratios, let’s use a standard Balance Sheet:

And a standard Income Statement:













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Liquidity Ratios Liquidity ratios are the ratios that measure the speed with which a company can turn its Assets into Cash to meet

short-term Debt. It is a company's ability to meet its maturing short-term obligations. Particularly, it is essential

knowledge for conducting business activity in the face of adverse conditions such as during a labor strike, or due to an

economic recession.

Liquidity ratios compare Current (short-term) Assets to Current Liabilities in order to indicate the speed with which a

company can turn its Assets into Cash to meet Debts as they fall due. High liquidity ratios satisfy a creditor's need for

safety. However, they may also indicate that the organization is not using its Current Assets efficiently or that it is not

putting its liquidity to use to make money.

On the other hand, poor liquidity is analogous to a person who has a fever; it is a symptom of a fundamental business

problem. It must receive the owner’s attention to avoid big problems prior to the business being unavoidably detained in a

trap.

Liquidity ratios are static in nature: You must look at expected future Cash Flows in order to have a more accurate view of

the situation. If future Cash Out-Flows are expected to be high relative to In-Flows, the liquidity position of the company

will deteriorate, and vice versa.

Particulars 2014 2013Sales 100.0 110.0

Sales Returns and allowances 20.0 8.0Net Sales 80.0 102.0

Cost of Goods Sold 50.0 60.0Gross Profit 30.0 42.0

Operating ExpensesSelling Expenses 11.0 13.0General Expenses 4.0 7.0Total Operating Expenses 15.0 20.0

Income from Operations 15.0 22.0Non-‐Operating Income 3.0Income Before Interest Expense and Taxes 18.0 22.0

Interest Expense 2.0 2.0Income Before Taxes 16.0 20.0

Income Taxes (40% rate) 6.4 8.0Net Income 9.6 12.0


(In thousand of dollars)For the years Ended Dec 2014 and 2013


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Let us have a closer look at the ratios within this category:

Liquidity: Net Working Capital Net Working Capital (or simply, ‘working capital’) is equal to Current Assets LESS Current Liabilities. We already know

the definition of Current Assets and Current Liabilities:

Current Assets are those Assets which are expected to be converted into Cash or used up within one period or one year;

whereas Current Liabilities are those Liabilities which must be paid within one period or one year.

Typically, Current Liabilities are paid out of Current Assets.

Therefore, there exists a need to match them. The value of Net Working Capital matches them in order to have a meaningful

dollar amount. This dollar amount, known as net working capital, is a safety cushion to creditors. A large balance is required

when a company has difficulty borrowing on short notice. For example, a labor strike can create periods of unproductive

efforts to bring the business back on track. A good liquidity position will keep the business afloat in these types of situations.

Net Working Capital for the Learning Company for 2014 is

Current Assets – Current Liabilities = Net Working Capital

In our Balance Sheet illustration, Current Assets is $120,000 and our Current Liabilities is made up of

Payroll and Short Term Debt equaling $55,400 so the Net Working Capital is

$120,000 - $55,400 = $64,600

It was $60,000 in the previous year ($110,000 – $50,000). Therefore, the liquidity position has improved from one year to

the next. This increase in net working capital is a favorable sign. Our sample company, The Learning Company, is doing

well on liquidity front.

Note that the Net Working Capital is expressed as a difference of two dollar amounts. Therefore, it is measured in

dollars as well. It is simply a comparison which uses subtraction, unlike ratios, which uses division.

Liquidity: Current Ratio

The Current Ratio is equal to Current Assets divided by Current Liabilities. This ratio, which can be subject to seasonal

fluctuations, is used to measure the ability of an enterprise to meet its Current Liabilities out of Current Assets.

A high ratio is needed when the firm has difficulty borrowing on short notice. A limitation of this ratio is that it may rise just

prior to financial distress because of a company's desire to improve its Cash position by, for example, selling fixed Assets.

Such dispositions have a detrimental effect upon productive capacity. Another limitation of the Current Ratio is that it will be

excessively high when Inventory is carried on the last-in, first-out (LIFO) basis.

The Learning Company’s Current Ratio for 2014 is:


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Current Assets / Current Liabilities = Current Ratio

$120,000 / $55,400 = 2.17

The Current ratio is calculated by dividing Current Assets by Current Liabilities. The Current ratio for 2014 is 2.17; it

indicates that for every $1 of Current Liabilities, the firm has 2.17 of Current Assets on hand. In 2013, the Current ratio

was 2.2, a slightly higher amount of Current Assets for each dollar of Current Liabilities. The ratio showed a slight decline

over the year.

Note that the Current ratio has no units. It is just a comparison using division.

Liquidity: Quick Ratio A Quick Ratio is a stringent measure of liquidity which eliminates Inventory while assessing liquidity. It is also known as

the acid-test ratio. It is found by dividing the most liquid Current Assets (Cash, marketable securities, and accounts

receivable) by Current Liabilities. Note that Inventory is *NOT* included because of the length of time needed to convert

Inventory into Cash. Prepaid expenses are also *NOT* included because they are not readily convertible into Cash.

This means that two items, both the Inventory and prepaid expenses, are eliminated in order to arrive at a dollar amount for

highly liquid Assets which are capable of covering Current Liabilities promptly.

The formula to calculate Quick Ratio is:

Current Assets – (Inventory + Prepaid Expenses)/Current Liabilities = Quick Ratio

Therefore, the Quick Ratio for the Learning Company in 2014 is:

Current Assets – (Inventory + Prepaid Expenses)/Current Liabilities = Quick Ratio

$120,000-($50,000+0)/$55,400 =

$70,000/$55,400 = 1.26

This ratio was 1.3 in 2013 ($65,000/$50,000); it went down slightly over the year.

Because this ratio eliminates Inventory (the least liquid Current Asset), it measures how well an organization can meet its

current obligations without resorting to the sale of its Inventory.

Activity Ratios Another name for Activity Ratios is Asset Utilization Ratios. These ratios are used to determine how quickly various

accounts are converted into Sales or Cash. Overall, Liquidity Ratios generally do not give an adequate picture of a


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company's real liquidity because differences exist in the kinds of Current Assets and Liabilities the company holds.

Therefore, it is more useful to evaluate the activity of specific current accounts. Examples of items put to analysis would be

Receivables, Inventory and Total Assets.

In a mathematical sense, Asset Utilization Ratios measure how well a firm uses its Assets to generate each dollar of

Sales. Obviously, companies using their Assets more productively will have higher returns on Assets than their less

efficient competitors. Similarly, a businessperson can use Asset Utilization Ratios to pinpoint areas of inefficiency in their

operations.

Let us have a closer look at the ratios in this category.

Activity: Accounts Receivable Ratios

Put quite simply, no payments means no profits. Any business owner knows this very well and therefore, he or she is

interested in their business’ Accounts Receivable Ratio.

Accounts Receivable Ratios consist of two items:

• Accounts Receivable Turnover Ratio

• Average Collection Period.

The Accounts Receivable Turnover Ratio tells us the number of times Accounts Receivable is collected during the year. It

can be found by dividing Net Credit Sales or Total Sales by the Average Accounts Receivable.

Find the Average Accounts Receivable by adding the beginning and ending accounts receivable numbers and dividing the

sum by 2. Then, divide this average by either Total Sales or the Net Credit Sales (just be consistent from one year to the

next so you are comparing like numbers.

In general, the higher the Accounts Receivable Turnover Ratio, the better: it shows quick collection from customers and re-

investment of the received money. However, an excessively high ratio may indicate an over stringent credit policy which is

an imprudent use of funds.

Learning Company's Average Accounts Receivable for 2014 is:

(Beginning Accounts Receivable + Ending Accounts Receivable)/2 =

($15,000 + $20,000) / 2 =

35,000 / 2 = $17,500

Likewise,

The Accounts Receivable Turnover Ratio for 2014 is:

Average Accounts Receivable / Total Sales =


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17,500/100,000 = .175

In 2013, the Accounts Receivable Turnover Ratio was .816. The drop in this ratio indicates a serious problem in collection

from customers. The issue may be due to loose billing and collection practices. Therefore, the company should evaluate its

credit policy in order to control the problem.

To see the whole picture, the company should also examine the average length of time that it takes to collect on

Receivables by determining the Collection Period.

The Collection Period is the number of days it takes to collect on Receivables. Typically, it is the number of days Sales

remain in Accounts Receivable before receiving payment.

To calculate the Average Collection Period, take the number of working days possible in a year, and multiply it by the

Average Accounts Receivable, then divide by net credit Sales or Total Sales:

(Number of Working Days * Average Accounts Receivable)/Total Sales

The Learning Company's Average Collection Period for 2014 is:

(300 * $17,500) / $100,000 =

52,500,000 / $100,000 = 55.5 days

Therefore, if it took 55 and a half days for a sale to be converted into Cash. In 2013, the collection period was 44.7 days.

This substantial increase in collection days in 2014 is dangerously long – almost 2 months (60 days) and therefore the

balances may become uncollectible. A possible cause might be that the company is selling to highly marginal customers with

bad or dubious credit or means of payment.

In response to this information, the owner should identify delinquent customer balances and prepare an Aging Schedule. An

Aging Schedule is a list of the accounts receivable according to the length of time they are outstanding. The Aging Schedule

would be helpful in taking remedial actions for collections and halt future Sales until prior payment is received.

The company may also want to consider its credit terms, rather than payment being due in 30 days, make terms due in

only 15 days.

Activity: Inventory Ratios For a business, holding an optimum level of Inventory is vital because it avoids unnecessary trapping of Cash in

Inventory but a business must have enough Inventory on hand to cover Sales.

Specifically, if a company is holding excess Inventory, it means funds that could be invested elsewhere are being tied up

in Inventory and there will also be carrying costs for storage of the goods. Moreover, there’s a risk of the Inventory

becoming obsolete. On the other hand, if Inventory is too low, the company may lose customers. Therefore, holding an


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optimum level of Inventory is essential to the success of a business.

Before proceeding further, a business owner must understand Inventory Valuation. Inventory represents goods, raw

materials, parts, components, or feedstock, amongst other things. Businesses use different accounting techniques to

assign value to their Inventory. These techniques are used in managing Inventory quantities, and its valuation.

Two very common methods used for managing Inventory are known as FIFO and LIFO.

• FIFO stands for first-in, first-out. It means that the oldest Inventory items are recorded as sold first.

• LIFO stands for last in, first-out. This means that the most recently produced or purchased items are recorded as

sold first. Practically, this method reduces income taxes in times of inflation by decreasing net income. Therefore,

companies tend to use LIFO.

The difference between the cost of an Inventory calculated under the FIFO and LIFO methods is called the LIFO reserve.

Essentially, it is the amount by which a company has deferred income tax by adopting LIFO.

A businessperson has two major ratios for evaluating Inventory:

• Inventory Turnover

• Average Age of Inventory

Inventory Turnover is calculated by Average Value of Inventory divided by Cost of Goods. Inventory Turnover indicates

how many times a firm sells and replaces its Inventory over the course of a year. A high Inventory Turnover ratio may

indicate great efficiency but may also suggest the possibility of lost Sales due to insufficient stock levels.

In the same way we determined the average of accounts receivable above, average value of Inventory is determined by

adding the beginning and ending inventories and dividing the sum by 2.


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For the Learning Company, the Average Value of Inventory in 2014 is

(Beginning Value of Inventory + Ending Value of Inventory) /2 = Average Value of Inventory

($45,000 + $50,000) / 2 =

$95,000 / 2 = $47,500

Likewise,

The Inventory Turnover is calculated by

Average Value of Inventory / Cost of Goods = Inventory Turnover

$47,500 / $50,000= .95

In 2013, it was 1.26 times.

This decline in the Inventory Turnover indicates the stockpiling of goods. The Inventory is turning over less frequently.

Therefore, it is essential that the business owner identify the specific items of non-selling Inventory. Specifically, items that

are obsolete, damaged, or unpopular to determine if a sale or more marketing will help move the Inventory. However, a

stockpile of goods may not be a concern at the introduction stage of a product in stock.

Average Age of Inventory shows how many days it takes, on average, to move items from going into Inventory to being

sold out of Inventory.

The Average Age of Inventory is calculated by:

365 days in a year / Inventory Turnover

The Average Age of Inventory in 2014 is:

365 days in a year / Inventory Turnover

365 /. 95 = 346.75 days

The Learning Company is holding Inventory for almost an entire year. A longer holding period shows a strong risk of

obsolescence. This length of time shows an incredible risk and is an issue that needs to be addressed to either move

Inventory faster or stockpile less of it and held more in accordance with the typical Sales cycle. In 2013, it was 289.7 days.

So, over the past year the average age of Inventory has increased even more, showing a perpetual problem that has not

been resolved and, in fact, has worsened.

Activity: Operating Cycle The Operating Cycle of a business is the number of days it takes to convert Inventory and Receivables to Cash.


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Therefore, every business desires a short operating cycle or an earlier conversion of Inventory into Cash.

An Operating Cycle is calculated by:

Age of Inventory + Collection Period = Operating Cycle

The operating cycle for the Learning Company in 2012 is:

Age of Inventory + Collection Period = Operating Cycle

346.75 + 55.5 = 402.25

In 2013, it was 334.4 days. This increase in length of the operating cycle is a significantly unfavorable trend; because, it

ties up money in Non-Cash Assets for a longer period and risks loss in obsolete Inventory and in delinquent, unpaid receipts.

Activity: Total Asset Turnover Ratio

Total Asset Turnover is a financial ratio that measures the efficiency of a company's use of its Assets in generating Sales Revenue or Sales Income to the company.

A business owner has a keen interest in how well his Assets generate earnings. Normally, companies with low profit

margins tend to have high Asset Turnover, while those with high profit margins have low Asset Turnover. Retail

businesses tend to have a very high Turnover Ratio due competitive pricing.

For a business owner, the Total Asset Turnover ratio is helpful in evaluating a company's ability to use its Asset base

efficiently to generate revenue.

A low ratio may be due to many factors. For instance, if the company’s investment in Assets is excessive when compared

to the value of the output or Sales being produced. In this case, the company might want to consolidate its present

operation.

The Total Asset Turnover ratio is computed as:

Total Sales / Average Total Assets = Total Asset Turnover Ratio

In 2014 the Total Asset Turnover ratio for the Learning Company is:

Total Sales / ((Beginning Total Assets + Ending Total Assets) / 2) =

$100,000 / (($200,000 + $220,000) / 2)) =

$100,000 / $210,000 = .476

In 2013, the ratio was 0.485. Therefore, the company's use of Assets has declined significantly. A business owner will

want to try and pinpoint the reasons for this ineffective use of Assets to generate Sales. A cause could be, for instance,

that the machines are in need of repairs.


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Liquidity, Activity and Earnings For a business owner, one interesting and important point to note is that a trade-off exists between liquidity risk and

return. Maintaining a proper balance between liquidity and return is important for the overall financial health of a business.

While liquidity risk is minimized by holding greater Current Assets than Non-Current Assets, this will force the rate of return

to decline because the return on Current Assets is typically less than the rate earned on productive fixed Assets. Additionally,

excessively high liquidity may mean losing good investment opportunities.

It must be pointed out that high profitability does not necessarily infer a strong Cash Flow position. That is why a Cash

Flow Statement is prepared to know specifically about the Cash Flow; an Income Statement is not sufficient to tell the

story of Cash circulating in a business.

The most important Cash Flow measurement is Cash Flow from operations. A business must analyze Cash issues with

keen observations. For example, even though income may be high, Cash problems may still exist because of maturing

Debt, the need to replace Assets, troubles collecting Accounts Receivable, among others.

A business owner needs to analyze Cash Flows, as well as, Balance Sheets and Income Statements to see the entire

picture of financial activity in the company.

Leverage Ratios Any business owner, obviously, does not want his or her business to go bankrupt. One can judge solvency of a business

by using Leverage ratios.

Leverage ratios are also called Solvency Ratios and Long-Term Debt Ratios. Solvency is defined as a company's

ability to meet its long-term obligations as they become due. This analysis of solvency concentrates on the long-term

financial and operating structure of the business. Solvency is necessarily dependent on profitability since in the end, a firm

will not be able to meet its Debts unless it is profitable. In a situation where Debt is excessive, a business should seek

additional financing from Equity sources such as investors rather than creditors.

Let us have a closer look at the different kinds of ratios classified as leverage ratios.

Leverage: Debt Ratio

A business owner must pay close attention to the composition of financing for the business.

Debt Ratio is a financial ratio that indicates the percentage of a company's Assets that are financed using Debt. It is

the ratio of Total Debts to Assets, including Fixed Assets and Intangible Assets, such as goodwill. Therefore, the Debt

Ratio compares Total Liabilities (Total Debt) to Total Assets.

Debt Ratio shows the percentage of total funds obtained from creditors.

Creditors like a low Debt Ratio because there is a greater cushion for creditor losses if the firm goes bankrupt. The lower


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the Debt Ratio, the more solvent the company. Likewise, a high Debt-to-Assets Ratio may indicate a low borrowing

capacity of a firm. Therefore, a high Debt Ratio means lower financial flexibility for a business. As with all financial ratios, it

makes sense to compare this ratio with that of others in the industry to gain insight.

The Debt Ratio is calculated by:

Total Liabilities / Total Assets = Debt Ratio

For the Learning Company, in 2014, the Debt ratio is:

$135,400 / $220,000 = .62

In 2013, it was 0.63. Since the Debt Ratio has decreased slightly, there is a slight improvement in the ratio. However, the

Debt Ratio is still significantly over .5 or 50%. This means over half or 62% of Assets are being leveraged for Debt.

Leverage: Debt-to-Equity Ratio

The Debt-to-Equity Ratio (D/E) is a financial ratio indicating the relative proportion of Stockholders’ Equity and Debt used

to finance a company's Assets.

The interest expense of a business increases with a rise in the Debt of the company for financing. To gauge solvency in

the face of Debt, a business uses Debt and Equity in a suitable proportion. The Debt/Equity Ratio is a significant measure

of solvency since a high degree of Debt in the capital structure may make it difficult for the company to meet interest

charges and principal payments at maturity. Furthermore, with a high Debt position comes the risk of running out of Cash, less

financial flexibility, and a greater difficulty in obtaining funds.

The Debt/Equity ratio is computed as follows:

Total Liabilities / Total Equity = Debt-to-Equity Ratio

For Learning Company, the Debt/Equity ratio in 2014 was

$135,400 / $86,000 = 1.60

In 2013, it was 1.67. It is therefore almost a constant ratio. A desirable Debt/Equity ratio depends on many factors like the

rates of other companies in the industry and the access to further loans and Debt financing, among others.

Leverage: Times Interest Earned Ratio

The Times Interest Earned Ratio (Operating Income divided by Interest Expense) is a measure of the safety margin a

company has with respect to the interest payments it must make to its creditors. The Times Interest Earned Ratio

reflects the number of times Before-Tax Earnings cover Interest Expense.

The Times Interest Earned Ratio is computed as follows:


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Operating Income (also known as Operating Income Before Interest Expense and Taxes)

divided by Interest Expense = Times Interest Earned Ratio

In 2014, Times Interest Earned was

$18,000 / $2,000 = 9

Meaning the interest of The Learning Company was covered 9 times. However, in 2013 it was covered 11 times

($22,000/$2000 = 11). The decline in the coverage is a negative indicator since fewer earnings are available to meet

interest charges. A low times interest earned ratio indicates that even a small decrease in earnings may lead the company

into financial straits since they will not be able to make the interest payments on their Debt.

Profitability Ratios Profitability ratios measure how much operating income or net income an organization is able to generate relative

to its Assets, Owners' Equity, and Sales.

Common Profitability Ratios include Profit Margin, Return on Assets, and Return on Equity. Investors will be reluctant to

associate themselves with an entity with poor earning potential. Creditors will also steer clear of companies with deficient

profitability since the amounts owed to the creditors by the company may not be paid.

Let us have a close look at some major ratios that measure operating results.

The numerator (top number) used in these examples is always the net income after taxes.

Profitability: Gross Profit Margin In essence, Gross Profit Margin is the gap between the Net Sales and Cost of Goods divided by the Net Sales. It

reveals the percentage of each dollar left over after the business has paid for its goods. The higher the Gross Profit

earned, the better.

First, calculate the Gross Profit

Net Sales - Cost of Goods Sold = Gross Profit.

For 2014, the Gross Profit was

80,000 – 50,000 = 30,000

To calculate the Gross Profit Margin,

Gross Profit / Net Sales = Gross Profit Margin

The Gross Profit margin for the Learning Company in 2012 is


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30,000/80,000 = .38

In 2013, the Gross Profit Margin was 0.41. Therefore, the business is earning less Gross Profit on each Sales dollar than

just a year before which can have a significant impact on the company in the future should it need to borrow financing.

Profitability: Profit Margin The Profit Margin, computed by dividing Net Income by Net Sales, shows the overall percentage profits earned by the

company. It is based solely upon data obtained from the Income Statement. The higher the profit margin, the better the

cost controls within the company and the higher the return on every dollar of revenue. This indicates the profitability

generated from revenue and hence is an important measure of operating performance.

Profit Margin is computed as:

Net Income / Net Sales = Profit Margin

In 2014, the Learning Company's profit margin is:

9,600 / 80,000 = 0.12

In 2013, the ratio was also 0.12 (12,000/ 102,000). Therefore, the earning power of the business remained the same for

both years.

Profitability: Return on Investment

Return on Investment (ROI) is a key, but rough, measure of performance. It shows the extent to which earnings are

achieved on the investment made in the business, though in a somewhat distorted way; because it emphasizes the overall

worth of the business for either valuation for resale or to attract additional investors and not necessarily the effective worth of

the business. Two ratios evaluate the return on investment:

• Return on Total Assets (ROA) – Evaluates how much profit a company is able to keep for every dollar it makes

i.e. if the company is using money wisely.

• Return on Equity (ROE) – Evaluates how effective an investment into a company is for its owners or

stockholders.

The Return on Total Assets (ROA) depicts the efficiency with which management has used resources to generate

income. In general, the higher the ROA the better because it means a company is making more money on less investments.

ROA is calculated as follows:

Net Income / Total Assets = Return on Assets (ROA)


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For the Learning Company in 2014, the ROA is:

$9,600/$220,000 = 0.0435 or 4.4%

In 2013, the return was 0.0623 or 6.2%. Therefore, productivity of Assets has decreased. The Learning Company, with a

low return on Assets, is probably not using its Assets very productively—a key managerial failing and impacting the

potential valuation of the company for acquisition.

Regarding Return on Equity (ROE), which determines the profitability or effectiveness of the use of the investment

has had in making a company profitable, again, the higher the better to show the worthiness of the investment.

ROE is calculated by:

Net Income / Average Equity = Return on Equity

(Average Equity is found by adding the Beginning Total Equity

and the Ending Total Equity and then dividing this sum by 2).

In 2014, the ROE for the Learning Company was:

First, calculate the Average Equity:

($75,000 + $84,600) / 2 = $79,800

Then calculate the ROE:

$9600 / $79,800 = 0.123 or 12%

Depending on the status of the market and in comparison to peers, a business owner or stockholder can surmise if this is

a sufficient amount to earn on the investment.

Market Value Ratios Market Value Ratios are the final group of ratios we will examine. These ratios focus on the relation of firm's Stock Price to its Earnings per Share. They also include dividend-related ratios (ratios that shed light on that earnings that

go to the Equity holders.)

Let us have a close look at the ratios in this final category by first calculating the Earnings per Share

Market Value: Earnings per Share

Earnings per Share (EPS) is the amount of earnings per each outstanding share of a company's stock. The calculation

of EPS tells you how much money stockholders would receive if the company decided to distribute all of the net earnings

for the period.


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In the United States, the Financial Accounting Standards Board (FASB) requires companies' Income Statements to report

EPS. EPS indicates the amount of earnings for each common share held. When preferred stock is included in the capital

structure, net income must be reduced by the preferred dividends to determine the amount applicable to common stock.

When preferred stock does not exist, as is the case with the Learning Company, Earnings per Share is

equal to:

Net Income / the number of common shares outstanding = Earnings per Share (EPS)

The 2014 Earnings per Share is:

$9600 / 45,000 = $2.13

In 2013, earnings per share was $2.67. The decline in earnings per share should be of concern to investors.

Almost all of the Learning Company's Profitability Ratios have declined in 2014 relative to 2013. This is a very negative

sign.

Market Value: Price/Earnings

Price/Earnings (P/E) ratio is equal to the market price per share divided by the earnings per share.

Let us assume that the market price per share of the Learning Company stock was $20 on December 31, 2014, and $22 on December 31, 2013.

Therefore, the P/E ratio in 2014 is

Market Price per Share / Earnings per Share =

$20 / $2.13 = $9.39

The ratio in 2013 was $8.24. The rise in the P/E indicates that the market has a favorable opinion of the company.

Market Value: Book Value per Share

Book Value per Share is the value of a company if it were to liquidate immediately by selling all its Assets and pay off all its Liabilities. The Book Value is what would remain and then it would be divided by number of shares

outstanding to determine Book Value per Share.

To calculate the Learning Company’s Book Value per Share in 2014:

First, calculate Net Assets which is equal to Total Assets – Intangible Assets (such as Good Will) since

Intangible Assets are difficult to appraise. For the Learning Company, Net Assets = Total Assets since the

company does not have Intangible Assets:


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Total Assets – Intangible Assets = Net Assets

$220,000 – 0 = $220,000

Then calculate the Book Value:

Net Assets – Total Liabilities = Book Value

$220,000 - $135,400 = 84,600

Then, calculate the Book Value per Share (no preferred shares to consider in this example)

Book Value / Shares Outstanding =

$84,600 /45000 = $1.88

The book value per share in 2013 was $1.667 (75,000/45000) and is considerably lower than the Current market price of

$20.

This means the Learning Company's stock is favorably regarded by investors, because its market price exceeds book

value.

Dividend Ratios Many stockholders have invested in a company’s shares primarily (or at least in part) because they are interested in

receiving dividends. For stockholders, two pertinent ratios are:

Dividend Yield – the annual amount of dividends paid divided by the average market price per share.

Dividend Payout Ratio – annual dividends divided by earnings per share.

In 2014 for the Learning company, let’s assume, the annual dividend is $2.00 per share (paid quarterly at

$.50 (50 cents per share) = $2 per year

The average Market Price per Share was $20 and the Earnings per Share was $2.13.

Meaning, the Dividend Yield is

Annual Dividend /Market Price =

$2/$20 = .1 or 10%

And the Dividend Payout Ratio =

Annual Dividend / Earnings per Share

$2/$2.13 = .94 or 94%


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While a 10% yield is strong, it is only being obtained by a 94% payout of earnings which means the company is not

retaining any earnings for future growth and is instead paying far too much in dividends or not making enough to support

this current payout.

Likewise in 2013, the Dividend Yield was 11% ($2/$22) and the Dividend Payout Ratio was 75% ($2/$2.67).

The change in yield and payout is, of course, unattractive to stockholders which means the company is at risk of losing its

investors.

Inferences from all Ratios By analyzing the Learning Company’s Financial Statements, we have found the decline in the Current and Quick Ratios that

indicates there has been a slight deterioration in liquidity. However, Net Working Capital has improved, which is a positive

sign.

A significant decrease in the Activity Ratios has taken place, which indicates a need to use better credit and Inventory

policies. The Learning Company should improve on its collection efforts. We have also found the company is carrying

Inventory longer. This increased age in Inventory may point to obsolescence problems.

On the Debt front, the company's leverage has improved, though fewer earnings are available to meet interest charges,

which may lead to financial inflexibility. The Learning Company's profitability has also declined over the year, which has

resulted in a down trend in the return on the owner's investment and the Return on Assets. A quick reason for the earnings

decrease may be the company's higher cost of short-term financing. In addition, as Receivables and Inventory Turnover are

less times per year, earnings will drop from a lack of Sales.


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Limitations of Ratio Analysis Financial Statement analysis is an attempt to work with reported financial figures in order to assess the financial strengths

and weaknesses of a business. Particular sets of ratios shed light on only certain areas of a business. Moreover, there is

no associated benefit to computing ratios of unrelated items such as Sales Returns to Income Taxes. Despite the

usefulness of such information to a businessperson, ratio analysis also has its limitations. Some of the limitations are:

1. If a company is engaged in multiple lines of business, it is difficult to identify its industry group. Therefore,

comparing their ratios with those of other companies becomes meaningless.

2. The data of published industry average ratios are only approximations. This estimation places a limit on accuracy of the

comparisons with an industry.

3. A company has a unique set of operating and accounting practices; these practices differ from company to company. This

distorts the otherwise smooth working of financial ratios. Some of the differing practices might include a company’s policy

of charging depreciation by different methods and choosing Inventory valuation methods.

4. Certain ratios are not good indicators of the affairs of a company because the management may hedge or exaggerate

their financial figures.

5. Financial Statements are based on historical costs and do not take inflation into account. A set of nice looking ratios

and trends is not a guarantee against loss.

6. A ratio may look good despite inherent lack of quality in its components. For example, the Current Ratio may be high

even though Inventory (a component of Current Assets), is obsolete goods.

7. Ratios are static. They do not consider future trends and viability.


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Summary of Financial Ratios (Quick Reference Guide) For your reference, here is a summary of the financial ratios and calculations described in this section:

Cash Flow Statement Analysis A financial analysis is essentially incomplete without information about Cash! Therefore, we will take one more look at the

Cash Flow Statement because of the extreme importance of Cash Flow to a business. Cash Flow analysis is an

evaluation of the firm's Cash Flow Statement. It is carried out to determine the impact that the sources and uses of funds

have on the firm's operations and financial condition. The resulting information is used in decision-making that involves

corporate investments, operations, and financing.

Financial Accounting Standards Board (FASB) Requirements Businesses have obvious interest in putting Cash to work in order to generate more Cash. Cash is the most significant

Liquidity RatiosNet Working Capital Current Assets -‐ Current LiabilitiesCurrent Ratio Current Assets : Current LiabilitiesQuick Ratio Current Assets -‐ (Inventory + Prepaid Expenses) : Current Liabilities

Activity RatiosAccounts Receivable Turnover Ratio Average Accounts Receivable : Total SalesAverage Collection Period (Number of Working Days * Average Accounts Receivable)/Total SalesInventory Turnover Average Value of Inventory : Cost of Goods Average Age of Inventory 365 days in a year / Inventory TurnoverOperating Cycle Age of Inventory + Collection PeriodTotal Asset Turnover Ratio Total Sales : Average Total Assets

Leverage RatiosDebt Ratio Total Liabilities : Total AssetsDebt-‐to-‐Equity Ratio (D/E) Total Liabilities : Total EquityTimes Interest Earned Ratio Operating Income : Interest Expense

Profitability RatiosGross Profit Margin Gross Profit : Net SalesProfit Margin Net Income : Net SalesReturn on Total Assets Net Income : Total AssetsReturn on Equity Net Income : Average Equity

Market Value RatiosEarnings per Share Net Income : number of common shares outstanding Price-‐to-‐Earnings Ratio (P/E) Market Price per Share : Earnings per Share Book Value per Share Book Value : Shares Outstanding Dividend Yield Annual Dividend : Market Price Dividend Payout Ratio Annual Dividend / Earnings per Share

Summary of Table of Financial Ratios


58

element in the world of financial reporting. As we have already stated, the tracking of money (Cash) invested in business

is the primary purpose of creating Financial Statements. Therefore, company management and interested external parties

have always recognized the need for a Cash Flow Statement, such as the one illustrated below:

In recognition of the fact that Cash Flow information is an integral part of both investment and credit decisions, and to help

investors and creditors get a fuller picture of the state of the company, the Financial Accounting Standards Board (FASB)

has made it mandatory for enterprises to include a Cash Flow Statement of as part of their Financial Statements. This

statement of Cash Flow reports the Cash receipts, payments, and net change in Cash on hand resulting from the operating,

investing and financing activities of an enterprise during a given period. Primarily and essentially, a Cash Flow Statement

reconciles the beginning and ending Cash balances of a business.

Cash flows from operating activitiesNet Income 182$ Add/(deduct) to reconcile net income to net cash flow

Depreciation 23$ Increase in accounts payable 9$ Increase in other liabilities 24$ Increase in Accounts Receivable (35)$ Increase in Inventory (86)$

Net cash provided by operating activities 117$ Cash flows from investing activities

Cash paid to purchase fixed assets (225)$ Sale of marketable securities 28$

Net cash provided by investing activities (197)$ Cash flows from financing activities

Decrease in notes payable (36)$ Issuance of long-‐term-‐debt 54$ Sale of common stock 78$ Cash paid for dividends (40)$

Net Cash used in financing activities 56$ Net decrease in cash and cash equivalents (24)$

Cash and cash equivalents at beginning of the year 51$ Cash and cash equivalents at end of the year 27$

The Learning CompanyStatement of Cash Flows

For the Year Ended December 31, 2014(in Thousands of Dollars)


59

Accrual Basis of Accounting Commonly, businesses use the “accrual basis of accounting” under Generally Accepted Accounting Principles (GAAP).

This method requires that Revenue be recorded when it is earned and that Expenses be recorded when they are

incurred. Revenue or Sales, may also include Credit Sales that have not yet been collected in Cash. Similarly, it may

include accounting for Expenses incurred that also may not have been paid in Cash, yet. Therefore, under the accrual

basis of accounting, net income will generally not indicate the Net Cash Flow from operating activities. Nevertheless, Cash is the king in the financial world and the primary purpose of Financial Statements is to keep track of the money.

One way to arrive at Net Cash Flow from Operating Activities is to report Revenues and Expenses on a Cash basis. This

adjustment is carried out by eliminating from the Financial Statements those transactions that did not result in a

corresponding increase or decrease in Cash On Hand.

See the example below to better understand why we need adjustments to get the actual value of Cash Flow from items

based on an accrual basis:

During 2014, If The Learning Company earned $2,100,000 in Total Credit Sales, of which $100,000 remained

uncollected as of the end of its financial period and if the Cost of Sales was $ 1,700,000; then, is the Gross

Profit from the same as the Cash collected from it? Let’s take a look at the following illustration:

Note: There is a significant difference in the Actual Cash Collected amount versus the Gross Profit as reported in an

Income Statement alone. Thereby, illustrating quite clearly, the need for a Cash Flow Statement and Cash Flow analysis

to clearly understand the financial situation taking place within a business; since, a Cash Flow Statement focuses only on

transactions involving the Cash receipts and payments under three classes of receipts and payments: operating,

investing, and financing activities.

In Conclusion Although we have discussed each type of financial statement separately, they are not stand-alone reports. These

Credit Sales 2,100,000$ Less Credit Sales Uncollected 100,000$

Actual Cash Collected 2,000,000$

vs. Information from Income Statement alone:Credit Sales 2,100,000$

Less Cost of Sales 1,700,000$ Gross Profit 400,000$

The Learning CompanyYear End 2014


60

statements are all part of an interrelated framework of dollar amounts and percentages. For example, the changes in

Assets on the Balance Sheet are also reflected in the Revenues and Expenses. Cash Flow provides more information

about Cash Assets listed on a Balance Sheet, but it also affects an Income Statement indirectly (even though, strictly

speaking, Cash Flow is not equivalent to Net Income.)

Therefore, no one financial statement tells the complete story. They jointly provide very useful financial information for

investors and can be a businessperson’s best tool when it comes to investing wisely and making correct business

decisions.


61

About the Authors Denise DeSimone Denise DeSimone, Chairman of C-leveled, has an uncanny ability to launch ventures with tremendous success. Since

graduating from the University of Pittsburgh with a BA degree in 1983, she has founded eight companies including C-

leveled. Revenues have increased by millions at every company she’s touched. Her companies have been named among

the 2008 Best Places to work in Pittsburgh as well as the Top 100 Fastest Growing Businesses. Most recently she is the

recipient of the Ernest & Young 2008 Entrepreneur of the Year for Western Pa, West Virginia, and upstate New York,

Pennsylvania’s Best 50 Women in Business for 2009, and Pittsburgh Women in Business Award Winner 2011. Her

achievements include 2007 Southwestern Pennsylvania’s Top 5 Women Entrepreneur Recognition, and Deloitte &

Touche Fast 50 Growth Companies. Denise also serves on a multitude of boards, panels and commissions.

Marianne Reid Anderson A best-selling, award-winning technical writer, Marianne Reid Anderson, has written for IBM, Ashton-Tate, Microsoft,

Amerinet, and the Centers for Disease Control. As co-Author for the original Microsoft Excel Step-By-Step Guide for

Microsoft Press, the guide was translated into twenty-seven languages and made the Microsoft Press Best-Sellers’ List.

She was awarded Excellence in Training Materials by the Society of Technical Communicators for the Windows 3.0

Class-in-a-Box. Her list of most recently published works can be found on her Linkedin profile.

Acknowledgments and Sources Ms. DeSimone and Ms. Anderson would like to thank the many individuals who assisted with the writing of this eBook;

specifically, Jeff Lizik, Mark Anthony, Paula Green, Tom Anderson and the staff of C-Leveled, LLC.

Ms. DeSimone and Ms. Anderson also used and recommend www.investopedia.com and www.ehow.com as excellent

sources of information in the writing of this book.

We Want to Hear From You! At IndustriusCFO, your satisfaction is our top priority and your feedback is our most valuable asset. Please let us know

what you think of this book at [email protected].

Be sure and be involved with us on social media.

Our website is www.industriuscfo.com

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