Chapter 14Analyzing Financial Statements and Calculating the Ratio Analysis |
| About This Chapter |
This chapter introduces techniques for Financial Statement Analysis, and includes the following sections:
F Overview, page 272, introduces the need for analyzing Financial Statements and calculating the Ratio Analysis.
F Analyzing Financial Reports, page 272, provides examples of the Two‑year Balance Sheet and Two-year Income Statement Comparison Reports.
F Ratio Analysis, page 277, describes the four different categories of Ratio Analysis, and provides formulas for each ratio included in them.
F Chapter 11, Balance Sheet Five-year Comparison Reports
F Chapter 12,Income Statement Five‑year and Quarterly Comparison Reports
F Chapter 13, Analyzing Financial Statements Using PivotTable and PivotChart Reports.
Two-year Balance Sheet Comparison Reports
Figure 14‑1: Assets
F Decrease in Cash
F Increase in Accounts Receivable
F Increase in Inventories
F Decrease in Prepaid Expenses
A net increase in the Current Assets could be negative sign when the firm has less cash in its bank accounts, an increase in Accounts Receivable could be a sign of slow collections and/or bad debts, an increase in Inventories might indicate bad inventories and/or customer returns, and so on.
On the other hand, the firm may have recently expanded its business activity, and the firm's directors expect to raise cash from stockholders or the stock market, or possibly raise cash by taking good long-term loans with excellent interest rates while increasing sales and inventories.
As can be seen in Figure 14‑2, cell D47 indicates a decrease in Total Liabilities and cell D52 anincrease in Stockholder Equity.
Figure 14‑2: Liabilities and Stockholder Equity
Analyzing the decrease in Total Liabilities shows that a decrease in Long‑term Liabilities has been adjusted by an increase in Current Liabilities.
An increase in Short-term Liabilities with a concurrent decrease in cash is a very bad sign for the stability of the firm. The firm might find itself in a situation when expensive money (at a high interest rate) is used for paying short-term loans and Accounts Payable, while at the same time the decrease of Long-term Liabilities could mean that it will be difficult to raise money for business activities at low interest rates.
Two-year Income Statement Comparison Report
When analyzing the Income Statement results over two years, you may notice a substantial increase in the firm's profitability during 2003. This is an increase of over 55% (see cell H39 in Figure 14‑3). The increase in the Net Income is much higher when checking the increase in the Operating Income before income taxes.
Figure 14‑3: Income Statement Report
Using vertical analysis (that is, checking the percentage in each subtotal in column H) gives immediate information about what the reasons are for the dramatic increase in the Net Income – the good news is that the Net Income before Operations jumped impressively.
Ratio Analysis
Ratio Analysis provides tools to decision makers, both inside and outside the firm, for analyzing Financial Statements by highlighting the major important parameters that expose the strongest and weakness of the firm business activity results.
In this section, you will learn about twelve Ratios Analysis, which can be bunched into four categories.
F Liquidity Ratios, as described on page
F Asset Management Ratios, as described on page
F Profitability Ratios, as described on page
F Leverage Ratios, as described on page
Figure 14‑4: Financial Ratios
Category 1: Liquidity Ratios
F Current Ratio, as described below
F Quick Ratio, as described on page
The quickest way to turn Current Assets to cash depends mainly on the ability to collect the Accounts Receivable balances, as well as the Inventory quality and level.
Current Ratio
Cell B11 in Figure 14‑5 contains the following formula:
=CurrentAssets / CurrentLiabilities
Cell C11 contains the following formula:
=OFFSET(CurrentAssets,0,1)/OFFSET(CurrentLiabilities,0,1)
Figure 14‑5: Current Ratio – Current Assets/Current Liabilities
The cell range Names were defined in worksheet31 – Balance Sheet.
Quick Ratio
In this ratio, the Inventories are taken out the Current Assets. The formula for (Current Assets-Inventories / Current Liabilities) is:
=(CurrentAssets-Inventories) / CurrentLiabilities
Category 2: Asset Management Ratios
The ratios in this category indicate the ability to analyze the profitability balances of the Financial Statements.
There are three ratios in this category:
F Inventory Turnover Ratio, as described below
F Asset Turnover Ratio, as described on page
F Receivable Turnover Days Ratio, as described on page
The firm's profitability depends on the ability to shorten Accounts Receivable balances' collecting time and how fast Inventory can be sold to customers.
Inventory Turnover Ratio
Keeping high levels of inventory increases expenses, including:
F Storing expenses
F Inventory management
F Expensive money invested in Inventory is not available.
The formula for Cost of Goods/Inventories is:
=TotalCOG / Inventories
Asset Turnover Ratio
=TotalSales / Assets
Receivable Turnover Days Ratio
As "time is money", the faster you collect Accounts Receivable balances and turn them to cash, the faster you reduce interest expenses and eliminate the possibility of turning uncollectible accounts into bad debts.
The formula for (Accounts Receivable*365 / Total Credit Sales) is:
=(AccountsReceivable*365) / TotalSales
Category 3: Profitability Ratios
The ratios in this category indicate the ability to measure management's ability to produce profit.
There are five ratios in this category:
F Earnings per Share Ratio, as described on page
F Return on Assets Ratio, as described on page
F Return on Equity Ratio, as described on page
F Return on Sales Ratio, as described on page
F Gross Profit Margin Ratio, as described on page
Investors expect to gain the most profit from investments. Profitability ratiosmeasure how much an investors or potential investors can make on their investments, and reduce the risk level to which they are exposed.
Profitability ratios are very important for long-term investment decisions.
Earnings per Share Ratio
The formula for Income Available for common stock/Shares of common stock is:
=NetIncome / CapitalStock
Return on Assets Ratio
This ratio measures the ability to produce profits from Assets. The formula for Net Operating Income/Total Assets is:
=OperatingIncome/Assets
Return on Equity Ratio
This ratio is also known as the Return on Investments ratio. The formula for Net Income/Shareholders' Equity is:
=NetIncome/StockholdersEquity
Return on Sales Ratio
The formula for Net Income/Total Sales is:
=NetIncome/TotalSales
Gross Profit Margin Ratio
The formula for Gross Income/Total Sales is:
=GrossIncome/TotalSales
Category 4: Leverage Ratios
F Debt to Equity Ratio, as described below
F Debt Ratio, as described below
Leverage means using external sources (both long- and short-term loans) for the business activities.
Debt to Equity Ratio
The formula for Current Liabilities + Long term Liabilities/Shareholders' Equity is:
=(CurrentLiabilities+LongTermLiabilities)/StockholdersEquity
Debt Ratio
The formula for Current Liabilities + Long-term Liabilities/Current Assets is:
=(CurrentLiabilities+LongTermLiabilities)/CurrentAssets
Getting More from the Ratio Analysis
F Did working capital improve?
F Is there a tendency of investment surplus in Fixed Assets?
F Is there an improvement in the profitability measure?
Figure 14‑6: Comparing Analysis Ratios Figures Between Two Periods