Ratio analysis

Examples of External Uses of Statement

Analysis

 Trade Creditors -- Focus on the liquidity of the firm.

 Bondholders -- Focus on the long-term cash flow of the firm.
 Shareholders -- Focus on the profitability and long-term health of the firm.
 Examples of Internal Uses of Statement
Analysis

 Plan-- Focus on assessing the current financial position

and evaluating potential firm opportunities.
 Control-- Focus on return on investment for various
assets and asset efficiency.
 Understand -- Focus on understanding how suppliers of
funds analyze the firm.
 Primary Types of Financial Statements

Balance Sheet
 A summary of a firm’s financial position on a given date that
shows total assets = total liabilities + owners’ equity.

Income Statement
 A summary of a firm’s revenues and expenses over a specified
period, ending with net income or loss for the period.
Use of Financial Ratios

A Financial Ratio is an index Types of Comparisons

that relates two accounting
Internal Comparisons
numbers and is obtained by
dividing one number by the External Comparisons
other.
 Liquidity Ratios

Balance Sheet Ratios Current

Current Assets
Current Liabilities
Liquidity Ratios
For Basket Wonders December 31, 2007

Shows a firm’s ability to

cover its current liabilities
with its current assets.
$1,195 = 2.39
$500
 Liquidity Ratios

Balance Sheet Ratios Acid-Test (Quick)

Current Assets - Inv
Current Liabilities
Liquidity Ratios
For Basket Wonders December 31, 2007

Shows a firm’s ability to

meet current liabilities with
its most liquid assets.
$1,195 - $696 = 1.00
$500
 Financial Leverage Ratios

Balance Sheet Ratios Debt-to-Equity

Total Debt
Shareholders’ Equity
Financial Leverage
For Basket Wonders December 31, 2007
Ratios

Shows the extent to which the

firm is financed by debt. $1,030 = .90
$1,139
 Financial Leverage Ratios

Balance Sheet Ratios Debt-to-Total-Assets

Total Debt
Total Assets
Financial Leverage
For Basket Wonders December 31, 2007
Ratios

Shows the percentage of the

firm’s assets that are
supported by debt financing. $1,030 = .47
$2,169
 Financial Leverage Ratios

Balance Sheet Ratios Total Capitalization

(i.e., LT-Debt + Equity)

Long-term Debt
Financial Leverage Total Capitalization

Ratios For Basket Wonders December 31, 2007

Shows the relative importance of long-term debt to the

long-term financing of the firm.

$530 = .32
$1,669
 Coverage Ratios

Income Statement Interest Coverage

Ratios EBIT
Interest Charges

Coverage Ratios For Basket Wonders December 31, 2007

Indicates a firm’s ability to

cover interest charges.
$210 = 3.56
$59
 Activity Ratios

Income Statement / Receivable Turnover

(Assume all sales are credit sales.)
Balance Sheet Annual Net Credit Sales
Ratios Receivables

For Basket Wonders December 31, 2007

Activity Ratios
Indicates quality of receivables and how successful
the firm is in its collections.

$2,211 = 5.61
$394
 Activity Ratios

Income Statement / Avg Collection Period

Balance Sheet Days in the Year
Receivable Turnover
Ratios
For Basket Wonders December 31, 2007

Activity Ratios
Average number of days that receivables are
outstanding.
(or RT in days)
365 = 65 days
5.61
 Activity Ratios

Income Statement / Payable Turnover (PT)

(Assume annual credit
Balance Sheet purchases = $1,551.)
Ratios Annual Credit Purchases
Accounts Payable

For Basket Wonders December 31, 2007

Activity Ratios

Indicates the promptness of payment to suppliers by

the firm.

$1551
= 16.5
$94
 Activity Ratios

Income Statement / PT in Days

Balance Sheet Days in the Year
Ratios Payable Turnover

For Basket Wonders December 31, 2007

Activity Ratios

Average number of days that payables are

outstanding.
365 = 22.1 days
16.5
 Activity Ratios

Income Statement / Inventory Turnover

Balance Sheet Cost of Goods Sold
Ratios Inventory

For Basket Wonders December 31, 2007

Activity Ratios

Indicates the effectiveness of the inventory

management practices of the firm.
$1,599 = 2.30
$696
 Profitability Ratios

Income Statement / Gross Profit Margin

Balance Sheet Gross Profit
Ratios Net Sales

For Basket Wonders December 31, 2007

Profitability Ratios

Indicates the efficiency of operations and firm pricing

policies.
$612 = .277
$2,211
 Profitability Ratios

Income Statement / Net Profit Margin

Balance Sheet Net Profit after Taxes
Ratios Net Sales

For Basket Wonders December 31, 2007

Profitability Ratios

Indicates the firm’s profitability after taking account

of all expenses and income taxes.
$91 = .041
$2,211
 Profitability Ratios

Income Statement / Return on Investment

Balance Sheet Net Profit after Taxes
Ratios Total Assets

For Basket Wonders December 31, 2007

Profitability Ratios
Indicates the profitability on the assets of the firm
(after all expenses and taxes).

$91 = .042
$2,160
 Profitability Ratios

Income Statement / Return on Equity

Balance Sheet Net Profit after Taxes
Ratios Shareholders’ Equity

For Basket Wonders December 31, 2007

Profitability Ratios
Indicates the profitability to the shareholders of the
firm (after all expenses and taxes).

$91 = .08
$1,139
Limitations of Ratio Analysis:

 ratio analysis information is historic – it is not current

 ratio analysis does not take into account external factors such as a
worldwide recession
 ratio analysis does not measure the human element of a firm
 ratio analysis can only be used for comparison with other firms of the same
size and type
 it may be difficult to compare with other businesses as they may not be
willing to share the information
What Is Horizontal Analysis

 Horizontal analysis is used in financial statement analysis to compare

historical data, such as ratios, or line items, over a number of accounting
periods.

 Horizontal analysis can either use absolute comparisons or percentage

comparisons, where the numbers in each succeeding period are expressed as
a percentage of the amount in the baseline year, with the baseline amount
being listed as 100%. This is also known as base-year analysis.
 For example, assume an investor wishes to invest in company XYZ.
 The investor may wish to determine how the company grew over the past
year. Assume that in company XYZ's base year, it reported net income of $10
million and retained earnings of $50 million. In the current year, company
XYZ reported net income of $20 million and retained earnings of $52 million.
 Consequently, it has an increase of $10 million in its net income and $2
million in its retained earnings year over year.
 Therefore, company ABC's net income grew by 100% (($20 million - $10
million) / $10 million * 100) year over year, while its retained earnings only
grew by 4% (($52 million - $50 million) / $50 million * 100).
Vertical Analysis

 Vertical analysis is a method of financial statement analysis in which each line

item is listed as a percentage of a base figure within the statement.

 Thus, line items on an income statement can be stated as a percentage of gross

sales, while line items on a balance sheet can be stated as a percentage of total

assets or liabilities, and vertical analysis of a cash flow statement shows each

cash inflow or outflow as a percentage of the total cash inflows.

Bank Reconciliation

 A bank reconciliation statement is a document that compares the cash balance on

a company’s balance sheet to the corresponding amount on its bank statement.

 Reconciling the two accounts helps identify whether accounting changes are

needed. Bank reconciliations are completed at regular intervals to ensure that the

company’s cash records are correct.

 They also help detect fraud and any cash manipulations.

 Deposits in transit: Cash and checks that have been received and recorded by
the company but have not yet been recorded on the bank statement.
 Outstanding checks: Checks that have been issued by the company to
creditors but the payments have not yet been processed.
 Bank service fees: Banks deduct charges for services they provide to
customers but these amounts are usually relatively small.
 Interest income: Banks pay interest on some bank accounts.
 Not sufficient funds (NSF) checks: When a customer deposits a check into an
account but the account of the issuer of the check has an insufficient amount
to pay the check, the bank deducts from the customer’s account the check
that was previously credited. The check is then returned to the depositor as an
NSF check.
 Example
 XYZ Company is closing its books and must prepare a bank reconciliation for
the following items:
 Bank statement contains an ending balance of $300,000 on February 28, 2018,
whereas the company’s ledger shows an ending balance of $260,900
 Bank statement contains a $100 service charge for operating the account
 Bank statement contains interest income of $20
 XYZ issued checks of $50,000 that have not yet been cleared by the bank
 XYZ deposited $20,000 but this did not appear on the bank statement
 A check for the amount of $470 issued to the office supplier was misreported
in the cash payments journal as $370.
 A note receivable of $9,800 was collected by the bank.
 A check of $520 deposited by the company has been charged back as NSF.