When computing financial ratios and when doing other financial statement analysis always keep

in mind that the financial statements reflect the accounting principles. This means assets are
generally not reported at their current value. It is also likely that many brand names and unique
product lines will not be included among the assets reported on the balance sheet, even though
they may be the most valuable of all the items owned by a company.

These examples are signals that financial ratios and financial statement analysis have limitations.
It is also important to realize that an impressive financial ratio in one industry might be viewed
as less than impressive in a different industry.

Our explanation of financial ratios and financial statement analysis is organized as follows:

 Balance Sheet

o General discussion

o Common-size balance sheet

o Financial ratios based on the balance sheet

 Income Statement

o General discussion

o Common-size income statement

o Financial ratios based on the income statement

 Statement of Cash Flows

General Discussion of Balance Sheet

The balance sheet reports a company's assets, liabilities, and stockholders' equity as of a specific
date, such as December 31, 2010, September 28, 2010, etc.

The accountants' cost principle and the monetary unit assumption will limit the assets reported
on the balance sheet. Assets will be reported

   (1) only if they were acquired in a transaction, and

   (2) generally at an amount that is not greater than the asset's cost at the time of the transaction.

This means that a company's creative and effective management team will not be listed as an
asset. Similarly, a company's outstanding reputation, its unique product lines, and brand names
developed within the company will not be reported on the balance sheet. As you may surmise,
these items are often the most valuable of all the things owned by the company. (Brand names
purchased from another company will be recorded in the company's accounting records at their
cost.)

The accountants' matching principle will result in assets such as buildings, equipment,
furnishings, fixtures, vehicles, etc. being reported at amounts less than cost. The reason is these
assets are depreciated. Depreciation reduces an asset's book value each year and the amount of
the reduction is reported as Depreciation Expense on the income statement.

While depreciation is reducing the book value of certain assets over their useful lives, the current
value (or fair market value) of these assets may actually be increasing. (It is also possible that the
current value of some assets–such as computers–may be decreasing faster than the book value.)

Current assets such as Cash, Accounts Receivable, Inventory, Supplies, Prepaid Insurance, etc.
usually have current values that are close to the amounts reported on the balance sheet.

Current liabilities such as Notes Payable (due within one year), Accounts Payable, Wages
Payable, Interest Payable, Unearned Revenues, etc. are also likely to have current values that are
close to the amounts reported on the balance sheet.
Long-term liabilities such as Notes Payable (not due within one year) or Bonds Payable (not
maturing within one year) will often have current values that differ from the amounts reported on
the balance sheet.

Stockholders' equity is the book value of the company. It is the difference between the
reported amount of assets and the reported amount of liabilities. For the reasons mentioned
above, the reported amount of stockholders' equity will therefore be different from the current or
market value of the company.

By definition the current assets and current liabilities are "turning over" at least once per year. As
a result, the reported amounts are likely to be similar to their current value. The long-term assets
and long-term liabilities are not "turning over" often. Therefore, the amounts reported for long-
term assets and long-term liabilities will likely be different from the current value of those items.

The remainder of our explanation of financial ratios and financial statement analysis will use
information from the following balance sheet:

Example Company
Balance Sheet
December 31, 2010

LIABILITIES
ASSETS
Current Assets Current Liabilities
Cash $   2,100  Notes Payable $   5,000 
Petty Cash 100  Accounts Payable 35,900 
Temporary Investments 10,000  Wages Payable 8,500 
Accounts Receivable - net 40,500  Interest Payable 2,900 
 Inventory 31,000  Taxes Payable 6,100 
Supplies 3,800  Warranty Liability 1,100 
Prepaid Insurance      1,500  Unearned Revenues      1,500 
Total Current Assets    89,000  Total Current Liabilities    61,000 
-
Investments    36,000  Long-term Liabilities
Notes Payable 20,000 
Property, Plant & Equipment Bonds Payable   400,000 
Land 5,500  Total Long-term Liabilities   420,000 
Land Improvements  6,500 
Buildings 180,000 
Equipment 201,000  Total Liabilities   481,000 
Less: Accum Depreciation    (56,000)
Prop, Plant & Equip - net   337,000 
-
Intangible Assets STOCKHOLDERS' EQUITY
Goodwill 105,000  Common Stock 110,000 
Trade Names   200,000  Retained Earnings 229,000 
Total Intangible Assets   305,000  Less: Treasury Stock    (50,000)
Total Stockholders' Equity   289,000 
Other Assets      3,000 
-
Total Liab. & Stockholders'
Total Assets $770,000  $770,000 
Equity

To learn more about the balance sheet, go to:

 Explanation of Balance Sheet

 Drills for Balance Sheet

 Crossword Puzzles for Balance Sheet

Common–Size Balance Sheet
One technique in financial statement analysis is known as vertical analysis. Vertical analysis
results in common-size financial statements. A common-size balance sheet is a balance sheet
where every dollar amount has been restated to be a percentage of total assets. We will illustrate
this by taking Example Company's balance sheet (shown above) and divide each item by the
total asset amount $770,000. The result is the following common-size balance sheet for Example
Company:

Example Company
Balance Sheet
December 31, 2010

LIABILITIES
ASSETS
Current Assets Current Liabilities
Cash 0.3% Notes Payable 0.6%
Petty Cash 0.0% Accounts Payable 4.7%
Temporary Investments 1.3% Wages Payable 1.1%
Accounts Receivable - net 5.3% Interest Payable 0.4%
Inventory 4.0% Taxes Payable 0.8%
Supplies 0.5% Warranty Liability 0.1%
Prepaid Insurance     0.2% Unearned Revenues     0.2%
Total Current Assets   11.6% Total Current Liabilities     7.9%
-
Investments     4.7% Long-term Liabilities
Notes Payable 2.6%
Property, Plant & Equipment Bonds Payable   52.0%
Land 0.7% Total Long-term Liabilities   54.6%
 Land Improvements  0.8%
Buildings 23.4%
Equipment 26.1% Total Liabilities   62.5%
Less: Accum Depreciation   (7.3%)
Prop, Plant & Equip - net   43.7%
-
Intangible Assets STOCKHOLDERS' EQUITY
Goodwill 13.6% Common Stock 14.3%
Trade Names   26.0% Retained Earnings 29.7%
Total Intangible Assets   39.6% Less: Treasury Stock   (6.5%)
Total Stockholders' Equity   37.5%
Other Assets     0.4%
-
Total Assets 100.0% Total Liab. & Stockholders' Equity 100.0%

The benefit of a common-size balance sheet is that an item can be compared to a similar item of
another company regardless of the size of the companies. A company can also compare its
percentages to the industry's average percentages. For example, a company with Inventory at
4.0% of total assets can look to its industry statistics to see if its percentage is reasonable.
(Industry percentages might be available from an industry association, library reference desks,
and from bankers. Generally banks have memberships in Robert Morris Associates, an
organization that collects and distributes statistics by industry.) A common-size balance sheet
also allows two businesspersons to compare the magnitude of a balance sheet item without either
one revealing the actual dollar amounts.

Calculate 24 Financial Ratios using our Business Forms

Whether you are a business person or student of business, our

Master Set of 80 Business Forms will assist you in preparing
financial ratios, financial statements, break-even calculations,
depreciation, standard cost variances, and much, much more.
 Working Capital = Current Assets – Current Liabilities An indicator of whether the
company will be able to meet its
= $89,000 – $61,000 current obligations (pay its bills,
meet its payroll, make a loan
= $28,000 payment, etc.) If a company has
current assets exactly equal to
current liabilities, it has no working
capital. The greater the amount of
working capital the more likely it will
be able to make its payments on
time.
Current Ratio = Current Assets ÷ Current Liabilities This tells you the relationship of
current assets to current liabilities. A
= $89,000 ÷ $61,000 ratio of 3:1 is better than 2:1. A 1:1
ratio means there is no working
= 1.46 capital.
Quick Ratio = [(Cash + Temp. Investments + This ratio is similar to the current
(Acid Test Ratio) Accounts Receivable) ÷ Current ratio except that Inventory,
Liabilities] : 1 Supplies, and Prepaid Expenses are
excluded. This indicates the
= [($2,100 + $100 + $10,000 + relationship between the amount of
$40,500) ÷ $61,000] : 1 assets that can quickly be turned
into cash versus the amount of
= [$52,700 ÷ $61,000] : 1 current liabilities.

= 0.86 : 1

Four financial ratios relate balance sheet amounts for Accounts Receivable and Inventory to
income statement amounts. To illustrate these financial ratios we will use the following income
statement information:
 Sales (all on credit) $500,000
Cost of Goods Sold   380,000
Gross Profit   120,000
Operating Expenses
Selling Expenses 35,000
Administrative Expenses    45,000
Total Operating Expenses    80,000
Operating Income 40,000
Interest Expense    12,000
Income before Taxes 28,000
Income Tax Expense     5,000
Net Income after Taxes $ 23,000

To learn more about the income statement, go to:

 Explanation of Income Statement

 Drills for Income Statement

 Crossword Puzzle for Income Statement

How to Calculate It What It Tells You

Financial Ratio
Accounts = Net Credit Sales for the Year ÷ The number of times per year that
Receivable Average Accounts Receivable for the accounts receivables turn over.
Turnover the Year Keep in mind that the result is an
average, since credit sales and
= $500,000 ÷ $42,000 (a computed accounts receivable are likely to
average) fluctuate during the year. It is
important to use the average
= 11.90 balance of accounts receivable
during the year.
Days' Sales in = 365 days in Year ÷ Accounts The average number of days that it
 Accounts Receivable Turnover in Year took to collect the average amount
Receivable of accounts receivable during the
= 365 days ÷ 11.90 year. This statistic is only as good as
the Accounts Receivable Turnover
= 30.67 days figure.
Inventory = Cost of Goods Sold for the Year ÷ The number of times per year that
Turnover Average Inventory for the Year Inventory turns over. Keep in mind
that the result is an average, since
= $380,000 ÷ $30,000 (a computed sales and inventory levels are likely
average) to fluctuate during the year. Since
inventory is at cost (not sales value),
= 12.67 it is important to use the Cost of
Goods Sold. Also be sure to use the
average balance of inventory during
the year.
Days' Sales in = 365 days in Year ÷ Inventory The average number of days that it
Inventory Turnover in Year took to sell the average inventory
during the year. This statistic is only
= 365 days ÷ 12.67 as good as the Inventory Turnover
figure.
= 28.81

The next financial ratio involves the relationship between two amounts from the balance sheet:
total liabilities and total stockholders' equity:

How to Calculate It What It Tells You

Financial Ratio
Debt to Equity = (Total liabilities ÷ Total Stockholders' The proportion of a company's
Equity) : 1 assets supplied by the company's
creditors versus the amount
= ( $481,000 ÷ $289,000) : 1 supplied the owner or stockholders.
In this example the creditors have
= 1.66 : 1 supplied $1.66 for each $1.00
supplied by the stockholders.
The income statement has some limitations since it reflects accounting principles. For example, a
company's depreciation expense is based on the cost of the assets it has acquired and is using in
its business. The resulting depreciation expense may not be a good indicator of the economic
value of the asset being used up. To illustrate this point let's assume that a company's buildings
and equipment have been fully depreciated and therefore there will be no depreciation expense
for those buildings and equipment on its income statement. Is zero expense a good indicator of
the cost of using those buildings and equipment? Compare that situation to a company with new
buildings and equipment where there will be large amounts of depreciation expense.

The remainder of our explanation of financial ratios and financial statement analysis will use
information from the following income statement:

Example Corporation
Income Statement
For the year ended December 31, 2010

Sales (all on credit) $500,000

Cost of Goods Sold   380,000
Gross Profit   120,000
Operating Expenses
Selling Expenses 35,000
Administrative Expenses    45,000
Total Operating Expenses    80,000
Operating Income 40,000
Interest Expense    12,000
Income before Taxes 28,000
Income Tax Expense     5,000
Net Income after Taxes $ 23,000
Earnings per Share $     0.23
(based on 100,000 shares
outstanding)
To learn more about the income statement, go to:

 Explanation of Income Statement

 Drills for Income Statement

 Crossword Puzzle for Income Statement

Common–Size Income Statement

Financial statement analysis includes a technique known as vertical analysis. Vertical analysis
results in common-size financial statements. A common-size income statement presents all of the
income statement amounts as a percentage of net sales. Below is Example Corporation's
common-size income statement after each item from the income statement above was divided by
the net sales of $500,000:

Example Corporation
Income Statement
For the year ended December 31, 2010

Sales (all on credit) 100.0%

Cost of Goods Sold   76.0%
Gross Profit   24.0%
Operating Expenses
Selling Expenses 7.0%
Administrative Expenses    9.0%
Total Operating Expenses  16.0%
Operating Income 8.0%
Interest Expense    2.4%
Income before Taxes 5.6%
Income Tax Expense    1.0%
Net Income after Taxes    4.6%
The percentages shown for Example Corporation can be compared to other companies and to the
industry averages. Industry averages can be obtained from trade associations, bankers, and
library reference desks. If a company competes with a company whose stock is publicly traded,
another source of information is that company's "Management's Discussion and Analysis of
Financial Condition and Results of Operations" contained in its annual report to the Securities
and Exchange Commission (SEC). This annual report is the SEC Form 10-K and is usually
accessible under the "Investor Relations" tab on the corporation's website.

Financial Ratios Based on the Income Statement

Financial Ratio How to Calculate It What It Tells You

Gross Margin = Gross Profit ÷ Net Sales Indicates the percentage of sales
dollars available for expenses and
= $120,000 ÷ $500,000 profit after the cost of merchandise
is deducted from sales. The gross
= 24.0% margin varies between industries
and often varies between
companies within the same
industry.
Profit Margin = Net Income after Tax ÷ Net Sales Tells you the profit per sales dollar
(after tax) after all expenses are deducted from
= $23,000 ÷ $500,000 sales. This margin will vary between
industries as well as between
= 4.6% companies in the same industry.

Earnings Per = Net Income after Tax ÷ Weighted Expresses the corporation's net
Share (EPS) Average Number of Common Shares income after taxes on a per share of
Outstanding common stock basis. The
computation requires the deduction
= $23,000 ÷ 100,000 of preferred dividends from the net
income if a corporation has
= $0.23 preferred stock. Also requires the
weighted average number of shares
of common stock during the period
 of the net income.
Times Interest = Earnings for the Year before Interest Indicates a company's ability to
Earned and Income Tax Expense ÷ Interest meet the interest payments on its
Expense for the Year debt. In the example the company is
earning 3.3 times the amount it is
= $40,000 ÷ $12,000 required to pay its lenders for
interest.
= 3.3

Return on = Net Income for the Year after Taxes Reveals the percentage of profit
Stockholders' ÷ Average Stockholders' Equity after income taxes that the
Equity (after tax) during the Year corporation earned on its average
common stockholders' balances
= $23,000 ÷ $278,000 (a computed during the year. If a corporation has
average) preferred stock, the preferred
dividends must be deducted from
= 8.3% the net income.

The income statement has some limitations since it reflects accounting principles. For example, a
company's depreciation expense is based on the cost of the assets it has acquired and is using in
its business. The resulting depreciation expense may not be a good indicator of the economic
value of the asset being used up. To illustrate this point let's assume that a company's buildings
and equipment have been fully depreciated and therefore there will be no depreciation expense
for those buildings and equipment on its income statement. Is zero expense a good indicator of
the cost of using those buildings and equipment? Compare that situation to a company with new
buildings and equipment where there will be large amounts of depreciation expense.

The statement of cash flows is a relatively new financial statement in comparison to the income
statement or the balance sheet. This may explain why there are not as many well-established
financial ratios associated with the statement of cash flows.

We will use the following cash flow statement for Example Corporation to illustrate a limited
financial statement analysis:
 Example Corporation
Statement of Cash Flows
For the Year Ended December 31, 2010

Cash Flow from Operating Activities:

Net Income $23,000 
Add: Depreciation Expense 4,000 
Increase in Accounts Receivable (6,000)
Decrease in Inventory 9,000 
Decrease in Accounts Payable    (5,000)
Cash Provided (Used) in Operating Activities   25,000 
Cash Flow from Investing Activities
Capital Expenditures (28,000)
Proceeds from Sale of Property     7,000 
Cash Provided (Used) by Investing Activities  (21,000)
Cash Flow from Financing Activities:
Borrowings of Long-term Debt 10,000 
Cash Dividends (5,000)
Purchase of Treasury Stock    (8,000)
Cash Provided (Used) by Financing Activities    (3,000)
Net Increase in Cash 1,000 
Cash at the beginning of the year     1,200 
Cash at the end of the year $  2,200 

Financial Ratio How to Calculate It What It Tells You

Free Cash Flow = Cash Flow Provided by Operating This statistic tells you how much
Activities – Capital Expenditures cash is left over from operations
after a company pays for its capital
= $25,000 – $28,000 expenditures (additions to property,
plant and equipment). There can be
= ( $3,000) variations of this calculation. For
example, some would only deduct
capital expenditures to keep the
present level of capacity. Others
would also deduct dividends that
are paid to stockholders, since they
are assumed to be a requirement.