FINANCIAL ACCOUTING

(BA-IT, BB-APPR & BAA)

FINANCIAL STATEMENT ANALYSIS

4.1 Introduction to Financial Analysis.
Financial analysis is the process of examining a company’s performance in the context of its industry and
economic environment in order to arrive at a decision or recommendation. Often, the decisions and
recommendations addressed by financial analysts pertain to providing capital to companies—specifically,
whether to invest in the company’s debt or equity securities and at what price. An investor in debt
securities is concerned about the company’s ability to pay interest and to repay the principal lent.
An investor in equity securities is an owner with a residual interest in the company and is concerned
about the company’s ability to pay dividends and the likelihood that its share price will increase.
Overall, a central focus of financial analysis is evaluating the company’s ability to earn a return on its
capital that is at least equal to the cost of that capital, to profitably grow its operations, and to generate
enough cash to meet obligations and pursue opportunities.
Fundamental financial analysis starts with the information found in a company’s financial reports. These
financial reports include audited financial statements, additional disclosures required by regulatory
authorities, and any accompanying (unaudited) commentary by management. Basic financial statement
analysis—as presented in this reading—provides a foundation that enables the analyst to better
understand other information gathered from research beyond the financial reports.

4.2 limitation of Financial analysis.

The limitations of financial statements are those factors that a user should be aware of before relying on
them to an excessive extent. Knowledge of these factors could result in a reduction of invested funds in
a business, or actions taken to investigate further. The following are all limitations of financial statements.
I. Financial Statements Are Derived from Historical Costs
Transactions are initially recorded at their cost. This is a concern when reviewing the balance sheet,
where the values of assets and liabilities may change over time. Some items, such as marketable
securities, are altered to match changes in their market values, but other items, such as fixed assets, do
not change. Thus, the balance sheet could be misleading if a large part of the amount presented is based
on historical costs.
II. Financial Statements Are Not Adjusted for Inflation
If the inflation rate is relatively high, the amounts associated with assets and liabilities in the balance
sheet will appear inordinately low, since they are not being adjusted for inflation. This mostly applies to
long-term assets.
III. Financial Statements Do Not Contain Some Intangible Assets
Many intangible assets are not recorded as assets. Instead, any expenditures made to create an
intangible asset are immediately charged to expense. This policy can drastically underestimate the value
of a business, especially one that has spent a large amount to build up a brand image or to develop new
products. It is a particular problem for startup companies that have created intellectual property, but which
have so far generated minimal sales.
IV. Financial Statements Only Cover a Specific Period of Time
A user of financial statements can gain an incorrect view of the financial results or cash flows of a
business by only looking at one reporting period. Any one period may vary from the normal operating
results of a business, perhaps due to a sudden spike in sales or seasonality effects. It is better to view a
large number of consecutive financial statements to gain a better view of ongoing results.
V. Financial Statements May Not Be Comparable

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If a user wants to compare the results of different companies, their financial statements are not always
comparable, because the entities use different accounting practices. These issues can be located by
examining the disclosures that accompany the financial statements.

vi. Financial Statements Could be Wrong Due to Fraud

The management team of a company may deliberately skew the results presented. This situation can
arise when there is undue pressure to report excellent results, such as when a bonus plan calls for
payouts only if the reported sales level increases. One might suspect the presence of this issue when the
reported results spike to a level exceeding the industry norm, or well above a company’s historical trend
line of reported results.
vii. Financial Statements Do Not Cover Non-Financial Issues
The financial statements do not address non-financial issues, such as the environmental attentiveness
of a company's operations, or how well it works with the local community. A business reporting excellent
financial results might be a failure in these other areas.
viii. Financial Statements May Not Have Been Verified
If the financial statements have not been audited, this means that no one has examined the accounting
policies, practices, and controls of the issuer to ensure that it has created accurate financial statements.
An audit opinion that accompanies the financial statements is evidence of such a review.
ix. Financial Statements Have No Predictive Value
The information in a set of financial statements provides information about either historical results or the
financial status of a business as of a specific date. The statements do not necessarily provide any value
in predicting what will happen in the future. For example, a business could report excellent results in one
month, and no sales at all in the next month, because a contract on which it was relying has ended.
Financial statements are normally quite useful documents, but it can pay to be aware of the preceding
issues before relying on them too much.

4.3. Financial Analysis techniques

1. Trend Ratios or Trend Analysis.

2. Common Size Statements
3. Cash Flow Analysis.
4. Ratio Analysis.
A brief explanation of the tools or techniques of financial statement analysis presented below.
1. Common Size Statements
A vertical presentation of financial information is followed for preparing common-size statements.
Besides, the Tshs value of financial statement contents are not taken into consideration. But, only
percentage is considered for preparing common size statement.
The total assets or total liabilities or sales is taken as 100 and the balance items are compared to the
total assets, total liabilities or sales in terms of percentage. Thus, a common size statement shows the
relation of each component to the whole. Separate common size statement is prepared for profit and loss
account as Common Size Income Statement and for balance sheet as Common Size Balance Sheet.
2. Trend Analysis
The ratios of different items for various periods are find out and then compared under this analysis. The
analysis of the ratios over a period of years gives an idea of whether the business concern is trending
upward or downward. This analysis is otherwise called as Pyramid Method.

3. Cash Flow Analysis

Cash flow analysis is based on the movement of cash and bank balances. In other words, the movement
of cash instead of movement of working capital would be considered in the cash flow analysis. There are
two types of cash flows. They are actual cash flows and notional cash flows.

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 4. Ratio Analysis
Ratio analysis is an attempt of developing meaningful relationship between individual items (or group of
items) in the balance sheet or profit and loss account. Ratio analysis is not only useful to internal parties
of business concern but also useful to external parties. Ratio analysis highlights the liquidity, solvency,
profitability and capital gearing.

4.3.1 Trend analysis

Financial statement analysis reviews financial information found on financial statements to make informed
decisions about the business. The income statement, statement of retained earnings, balance sheet, and
statement of cash flows, among other financial information, can be analyzed. The information obtained
from this analysis can benefit decision-making for internal and external stakeholders and can give a
company valuable information on overall performance and specific areas for improvement. The analysis
can help them with budgeting, deciding where to cut costs, how to increase revenues, and future capital
investments opportunities.

When considering the outcomes from analysis, it is important for a company to understand that data
produced needs to be compared to others within industry and close competitors. The company should
also consider their past experience and how it corresponds to current and future performance
expectations. Three common analysis tools are used for decision-making; horizontal analysis, vertical
analysis, and financial ratios.

For our discussion of financial statement analysis, we will use Banyan Goods. Banyan Goods is a
merchandising company that sells a variety of products. Figure shows the comparative income
statements and balance sheets for the past two years.
Comparative Income Statements and Balance Sheets.

Keep in mind that the comparative income statements and balance sheets for Banyan Goods are
simplified for our calculations and do not fully represent all the accounts a company could maintain.
Let’s begin our analysis discussion by looking at horizontal analysis.

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A.Horizontal Analysis

Horizontal analysis (also known as trend analysis) looks at trends over time on various financial statement
line items. A company will look at one period (usually a year) and compare it to another period. For
example, a company may compare sales from their current year to sales from the prior year. The trending
of items on these financial statements can give a company valuable information on overall performance
and specific areas for improvement. It is most valuable to do horizontal analysis for information over
multiple periods to see how change is occurring for each line item. If multiple periods are not used, it can
be difficult to identify a trend. The year being used for comparison purposes is called the base year
(usually the prior period). The year of comparison for horizontal analysis is analyzed for dollar and percent
changes against the base year.

The dollar change is found by taking the dollar amount in the base year and subtracting that from the
year of analysis.

Using Banyan Goods as our example, if Banyan wanted to compare net sales in the current year (year
of analysis) of ?120,000 to the prior year (base year) of ?100,000, the dollar change would be as
follows:
\(\text{Dollar change}=?120,000–?1000,000=?20,000\)

The percentage change is found by taking the dollar change, dividing by the base year amount, and
then multiplying by 100.

Let’s compute the percentage change for Banyan Goods’ net sales.

This means Banyan Goods saw an increase of ?20,000 in net sales in the current year as compared to
the prior year, which was a 20% increase. The same dollar change and percentage change calculations
would be used for the income statement line items as well as the balance sheet line
items. Figure shows the complete horizontal analysis of the income statement and balance sheet for
Banyan Goods.

Income Statements and Horizontal Analysis.

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Depending on their expectations, Banyan Goods could make decisions to alter operations to produce
expected outcomes. For example, Banyan saw a 50% accounts receivable increase from the prior year
to the current year. If they were only expecting a 20% increase, they may need to explore this line item
further to determine what caused this difference and how to correct it going forward. It could possibly be
that they are extending credit more readily than anticipated or not collecting as rapidly on outstanding
accounts receivable. The company will need to further examine this difference before deciding on a
course of action. Another method of analysis Banyan might consider before making a decision is vertical
analysis.

B. Vertical Analysis

Vertical analysis shows a comparison of a line item within a statement to another line item within that
same statement. For example, a company may compare cash to total assets in the current year. This
allows a company to see what percentage of cash (the comparison line item) makes up total assets (the
other line item) during the period. This is different from horizontal analysis, which compares across years.
Vertical analysis compares line items within a statement in the current year. This can help a business to
know how much of one item is contributing to overall operations. For example, a company may want to
know how much inventory contributes to total assets. They can then use this information to make
business decisions such as preparing the budget, cutting costs, increasing revenues, or capital
investments.

The company will need to determine which line item they are comparing all items to within that statement
and then calculate the percentage makeup. These percentages are considered common-size because
they make businesses within industry comparable by taking out fluctuations for size. It is typical for an
income statement to use net sales (or sales) as the comparison line item. This means net sales will be
set at 100% and all other line items within the income statement will represent a percentage of net sales.

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On the balance sheet, a company will typically look at two areas: (1) total assets, and (2) total liabilities
and stockholders’ equity. Total assets will be set at 100% and all assets will represent a percentage of
total assets. Total liabilities and stockholders’ equity will also be set at 100% and all line items within
liabilities and equity will be represented as a percentage of total liabilities and stockholders’ equity. The
line item set at 100% is considered the base amount and the comparison line item is considered the
comparison amount. The formula to determine the common-size percentage is:

For example, if Banyan Goods set total assets as the base amount and wanted to see what percentage
of total assets were made up of cash in the current year, the following calculation would occur.

Cash in the current year is ?110,000 and total assets equal ?250,000, giving a common-size percentage
of 44%. If the company had an expected cash balance of 40% of total assets, they would be exceeding
expectations. This may not be enough of a difference to make a change, but if they notice this deviates
from industry standards, they may need to make adjustments, such as reducing the amount of cash on
hand to reinvest in the business. Figure shows the common-size calculations on the comparative income
statements and comparative balance sheets for Banyan Goods.
Income Statements and Vertical Analysis.

Even though vertical analysis is a statement comparison within the same year, Banyan can use
information from the prior year’s vertical analysis to make sure the business is operating as expected.
For example, unearned revenues increased from the prior year to the current year and made up a larger

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portion of total liabilities and stockholders’ equity. This could be due to many factors, and Banyan Goods
will need to examine this further to see why this change has occurred. Let’s turn to financial statement
analysis using financial ratios.

4.3.2 Ratio Analysis

Accounting ratios, or financial ratios, are comparisons made between one set of figures from a company’s
financial statement with another. We use accounting ratios to determine whether a business can pay its
debt and how profitable it is.

Additionally, accounting ratios are used to predict whether a company is likely to go bankrupt soon.
Overall, the aim when studying these ratios is to analyze trends.

Accounting ratios are indicators of a commercial entity’s performance and financial situation. We calculate
the majority of ratios from data that the firm’s financial statements provide.

Financial ratio sources could be the balance sheet, income statement, or statement of cash flows. The
statement of changes in equity is also a source. The data comes from either within the company’s
financial statements or its accounting statements.

1.1 Types of financial statements and their components

Financial Statements represent a formal record of the financial activities of an entity. These are written
reports that quantify the financial strength, performance and liquidity of a company. Financial Statements
reflect the financial effects of business transactions and events on the entity.

Four Types of Financial Statements

The four main types of financial statements are:

1. Statement of Financial Position

Statement of Financial Position, also known as the Balance Sheet, presents the financial position of an
entity at a given date. It is comprised of the following three elements:
§ Assets: Something a business owns or controls (e.g. cash, inventory, plant and machinery, etc)
§ Liabilities: Something a business owes to someone (e.g. creditors, bank loans, etc)
§ Equity: What the business owes to its owners. This represents the amount of capital that
remains in the business after its assets are used to pay off its outstanding liabilities. Equity
therefore represents the difference between the assets and liabilities.

Example of a balance sheet

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2. Income Statement
Income Statement, also known as the Profit and Loss Statement, reports the company's financial
performance in terms of net profit or loss over a specified period. Income Statement is composed of the
following two elements:
§ Income: What the business has earned over a period (e.g. sales revenue, dividend income,
etc)
§ Expense: The cost incurred by the business over a period (e.g. salaries and
wages, depreciation, rental charges, etc)
Net profit or loss is arrived by deducting expenses from income.

3. Cash Flow Statement

Cash Flow Statement, presents the movement in cash and bank balances over a period. The
movement in cash flows is classified into the following segments:

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 § Operating Activities: Represents the cash flow from primary activities of a business.
§ Investing Activities: Represents cash flow from the purchase and sale of assets other than
inventories (e.g. purchase of a factory plant)
§ Financing Activities: Represents cash flow generated or spent on raising and repaying share
capital and debt together with the payments of interest and dividends.

4. Statement of Changes in Equity

Statement of Changes in Equity, also known as the Statement of Retained Earnings, details the
movement in owners' equity over a period. The movement in owners' equity is derived from the
following components:
§ Net Profit or loss during the period as reported in the income statement
§ Share capital issued or repaid during the period
§ Dividend payments
§ Gains or losses recognized directly in equity (e.g. revaluation surpluses)
§ Effects of a change in accounting policy or correction of accounting error

1.2 Types of ratio

The four (4) major categories in the financial ratios list include the following :
1. Liquidity Ratios
2. Activity Ratios
3. Debt Ratios
4. Profitability Ratios

4.3.1 Profitability Ratio

The fourth classification of ratios are known as profitability ratios. Profitability Ratios are of great
importance to investors since they measure how effectively management is generating profits from
corporate assets and from owner's investments. The most common profitability ratios include; gross profit
margin ratio, net profit margin ratio, return on total assets ratio, and the return on equity ratio. Let's explain
each separately, beginning with the Gross Profit Margin.

GROSS PROFIT MARGIN:

The gross profit margin provides an indication of how well a company is setting its product's prices and
controlling its production costs. Here's how the gross profit margin is calculated;

Gross Profit Margin = Sales - Cost of goods sold

Sales

As you can see, two items are required before a company can calculate its gross profit margin; Sales and
Cost of Goods Sold. As indicated earlier, sales represent a company's total receipts from selling its
products or services to customers. In other words, when a company sells products or services to its
customers, the company is said to be making sales. Cost of Goods Sold, as the name implies, represents
the costs incurred on all products sold. Furthermore, a business can only recognize, as an expense, the
costs of the products it sells. Unsold products are still owned by a business and considered inventory.

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The "Sales" account and the "Cost of Goods Sold" account both appear on a company's income
statement. The Widget Manufacturing Company's income statement section needed for calculating its
gross profit margin is presented below.

Sales from Widgets $112,500

Cost of Goods Sold (COGS) $ 85,040

Gross Margin $ 27,460

Using the above figures, we can calculate the Widget Company's Gross Profit Margin as of December
31, 200Y.

Gross Profit Margin = Sales - Cost of goods sold $112,500 - $ 85,040

Sales $112,500

0.24

As you can see, the company's gross profit margin is 0.24 . This means, $0.24 cents is made from every
one dollar ($1.00) generated in sales. In other words, a cost of $0.76 ($1.00-$0.24) is incurred by the
company for every $1.00 it takes in from sales. Let's drive the point home by saying;

For every one dollar generated by the company, $0.76 cents is used to pay for the products it sells and
the other $0.24 cents remains in the company to pay for its operating expenses, income taxes, dividends,
etc...

Note: the higher the gross profit margin, the more stable a company is considered. Moreover, a higher
gross profit margin indicates the company is making more from each sale. On the other hand, the lower
a company's gross profit margin, the less money it makes from each sale, and therefore the less stable
the company appears. The next profitability ratio is called the Net Profit Margin.

NET PROFIT MARGIN

The Net Profit Margin ratio shows a company's after tax profit per dollar of sales. Sub-par profit margins
indicate the firm's selling prices are relatively low or that its expenses are relatively high, or both. Here's
how the net profit margin is calculated;

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 Net Profit Margin = Net income after taxes
Sales

As you can see, two items are required before a company can calculate its net profit margin; Sales and
Net Income After Taxes. As indicated earlier, sales represent the company's total receipts from selling its
products or services to customers. In other words, when a company sells products or services to its
customers, the company is said to be generating sales. Net Income After Taxes is calculated by
subtracting a company's cost of goods sold, operating expenses, and tax obligations from
its revenues (Sales).

The sales account and the net income after taxes account both appear on a company's income statement.
The Widget Manufacturing Company's income statement section, needed for calculating the net profit
margin, is presented below.

WIDGET MANUFACTURING COMPANY

CONDENSED INCOME STATEMENT
FOR YEAR ENDING DEC. 31, 200Y

Sales from Widgets $112,500

Cost of Goods Sold (COGS) $ 85,040

Gross Margin $ 27,460

Operating Expenses (Marketing & Administrative) $ 18,950

Net Income Before Taxes $ 8,510

Less: Income Taxes $ 4,163

Net Income After Taxes $ 4,347

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Using the above figures, we can calculate the Widget Company's Net Profit Margin as of December 31,
200Y.

Net Profit Margin = Net income after taxes = $ 4,347

Sales $112,500

= 0.04

As you can see, the company's gross profit margin is 0.04 . This means, $0.04 cents is made from every
one dollar ($1.00) generated in sales. In other words, a cost of $0.96 ($1.00-$0.04) is incurred by the
company for every $1.00 it takes in from sales. Let's drive the point home by saying;

For every one dollar generated by the company, $0.96 cents is used to pay for buying products, paying
operating expenses, and for paying taxes. The other $0.04 cents remain in the company or is distributed
to its owners.

Note: the higher the net profit margin, the more stable a company is considered. Moreover, a higher net
profit margin indicates a company is more profitable, after all expenses and taxes have been paid. On
the other hand, the lower a company's net profit margin, the less money it will have to pay for taxes and
expenses, and therefore the less stable the company appears. The next profitability ratio is called Return
on Total Assets.

RETURN ON TOTAL ASSETS:

Return on Total Assets is a ratio that measures how well a company is using its assets to generate
profits. Below depicts how the Return on Total Assets Ratio is calculated;

Return on Total Assets = Net income after taxes

Total assets

As you can see, two items are required before a company can its calculate return on total assets; namely,
Total Assets and Net Income After Taxes. As indicated earlier, Total Assets are the sum of a company's
total current assets and its total fixed assets. Net Income After Taxes is calculated by subtracting a
company's cost of goods sold, operating expenses and tax obligations from its revenues.

Total assets are shown on a company's balance sheet, while net income after taxes appears on its
income statement. The Widget Manufacturing Company's balance sheet and income statement sections,
needed for calculating their Return on Total Assets , are presented below.

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 FROM THE BALANCE SHEET FROM THE INCOME STATEMENT

ASSETS:

Current Assets:

Cash $ 2,550 Sales from Widgets $112,500

Marketable securities $ 2,000 Cost of Goods Sold $ 85,040

Account Receivable (Net) $16,675 Gross Margin $ 27,460

Inventories $26,470

Total Current Assets $47,695 Operating Expenses $ 18,950

Fixed Assets: Net Income Before Taxes $ 8,510

Plant & Equipment $41,000

Less: Accumulated Depreciation $ 11,000 Less: Income Taxes $ 4,163

Net Plant & Equipment $30,000

Net Income After Taxes $ 4,347

TOTAL ASSETS $77,695

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Using the above figures, we can calculate the Widget Company's Return on Total Assets as of
December 31, 200Y.

Return on Total Assets = Net income after taxes = $ 4,347

Total assets $77,695

= 0.06

As you can see, the company's Return on Total Assets is 0.06 . This means, the company made $0.06
cents on every dollar it invested into assets. Let's drive the point home by saying;

For every one dollar invested into assets, the company generated 6 cents in after tax profits.

Remember, a company purchases assets so that it can generate profits. Therefore, the higher the Return
on Total Assets ratio, the more stable a company is considered. Moreover, a higher Return on Total
Assets ratio indicates a company is using its assets more efficiently to generate profits. On the other
hand, the lower a company's Return on Total Assets ratio, the less they are using their assets to generate
profits, and therefore the less stable the company appears. The next profitability ratio is called Return on
Equity.

RETURN ON EQUITY:

Return on equity ratio is a measure of the rate of return on investment, in the enterprise, the owners
have made. Below depicts how the return on equity ratio is calculated;

Return on Equity = Net income after taxes

Total Equity

As you can see, two items are required before a company can calculate its return on equity; namely,
Total Equity and Net Income After Taxes. As indicated earlier, Total Equity represents all the
investments made into the company by its owners. Net Income After Taxes is calculated by subtracting
a company's cost of goods sold, operating expenses and tax obligations from its revenues.

Total Equity is shown on a company's balance sheet, while a company's Net Income After Taxes
appears on its income statement. The Widget Manufacturing Company's balance sheet and income
statement sections, needed for calculating the Return on Equity ratio, is presented below.

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 FROM THE INCOME STATEMENT FROM THE BALANCE SHEET

Equity:
Sales from Widgets $112,500 Common Shares $25,000
Cost of Goods Sold $ 85,040 Retained Earnings $ 7,820
Gross Margin $ 27,460 TOTAL EQUITY $32,820

Operating Expenses $ 18,950

Net Income Before Taxes $ 8,510

Less: Income Taxes $ 4,163

Net Income After Taxes $ 4,347

Using the above figures, we can calculate the Widget Company's Return on Equity as of December 31,
200Y.

Return on Equity = Net income after taxes = $ 4,347

Total Equity $32,820

= 0.13

As you can see, the company's return on equity is 0.13 . This means, the company made $0.13 cents
on every dollar the owners invested. Let's drive the point home by saying;

For every one dollar invested by the owners, the company generated 13 cents in after tax profit.

Remember, owners invest into a company so they can generate profits for themselves and their
company. Therefore, the higher the return on equity ratio, the more stable a company is considered.
Moreover, a higher return on equity indicates a company is using its owner's funds wisely to generate
profits. On the other hand, the lower a company's return on equity ratio, the less efficient the owner's
funds are being utilized to generate profits, and therefore the less stable the company appears.

Profitability Ratios Summary:

In summary, profitability ratios are of great importance to investors since they measure how effectively
management is generating profits from the company's assets and from the owner's investments. The

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most common profitability ratios include; gross profit margin ratio, net profit margin ratio, return on total
assets ratio, and the return on equity ratio. The gross profit margin is calculated by subtracting the cost
of goods sold from the sales and dividing by the sales. The net profit margin is calculated by dividing a
company's net income after taxes by its sales. Return on Total Assets is calculated by dividing a
company's net income after taxes by its total assets. Return on Equity is calculated by dividing a
company's net income after taxes by its total equity. Below summarizes the profitability ratios for the
Widget Manufacturing Company as of December 31, 200Y.

Gross Profit Margin = Sales - Cost of goods sold = $112,500 - $ 85,040

Sales $112,500

= 0.24

Net Profit Margin = Net income after taxes = $ 4,347

Sales $112,500

= 0.04

Return on Total Assets = Net income after taxes = $ 4,347

Total assets $77,695

= 0.06

Return on Equity = Net income after taxes = $ 4,347

Total Equity $32,820

= .13

4.3.2 liquidity Ratio

The first classification of ratios are known as Liquidity Ratios. As mentioned earlier, Liquidity Ratios
measure a company's ability to provide sufficient cash to cover its short term obligations (debt). The
most common liquidity ratios include; the current ratio and the quick ratio. Lets look at each type of
liquidity ratio, beginning with the current ratio.

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CURRENT RATIO:

The current ratio indicates the extent to which the claims of short-term creditors are covered by assets
that are expected to be converted to cash in a period roughly corresponding to the maturity of the
liabilities. Here's how the current ratio is calculated.

Current Ratio = Current Assets

Current Liabilities

As mentioned under the balance sheet section, a current liability represents money a company owes and
is due in the near future- less than one year. A current asset, on the other hand, is cash or others short-
term assets that can be converted into cash in the near future (IE less than a year). Inventory, for
example, is a current asset that is purchased and sold by a company to obtain cash.

By dividing the current assets by the current liabilities, we can determine whether or not a company has
the ability to pay off its short-term debt (current liabilities). Below shows the current assets and current
liabilities for The Widget Manufacturing Company.

ASSETS: LIABILITIES:

Current Assets: Current Liabilities:

Cash $ 2,550 Accounts Payable $ 9,500

Marketable securities $ 2,000 Short-term Bank Loan $11,375

Account Receivable (Net) $16,675 Total Current Liabilities $20,875

Inventories $26,470

Total Current Assets $47,695

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Using the values shown in the total current assets account and total current liabilities account we can
calculate the company's current ratio as follows:

Current Ratio = Current Assets = $47,695

Current Liabilities $20,875

= 2.28

As you can see, The Widget Manufacturing Company has a current ratio of 2.28. That is, for every
$1.00 the company owes in current liabilities, it has $2.28 worth of current assets. Therefore, if the
Widget Manufacturing Company's short-term debt was due tomorrow, they would NOT have any
difficulty in paying their creditors. Moreover, they would simply use the cash in their bank account ,
redeem their marketable securities, collect cash from customers who owe them (Accounts Receivable)
and sell more products to customers.

Banks like to see a current ratio of at least 2 to 1 ; that is, for every $1.00 a company owes in short-term
debt, it has $2.00 in current assets. Note: the higher the current ratio, the stronger the company is
thought to be.

QUICK RATIO:

Some conservative minded investors don't like to use the current ratio as a indicator of whether or not a
company has the ability to pay its short term obligations (debt). Instead, the quick ratio is used. The
quick ratio is similar to the current ratio with one exception; that is, the quick ratio measures a
company's ability to pay its short-term debt, without relying on the sale of its inventory. Therefore, in
calculating a quick ratio, business owners must subtract the inventory from the current assets. The
formula used to calculate the quick ratio is as follows;

Quick Ratio = Current Assets - Inventories

Current Liabilities

The three items required in calculating the quick ratio can be obtained from a company's balance sheet.
Below shows the values of Widget Manufacturing Company's current assets and current liabilities on
December 31, 200Y.

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 ASSETS: LIABILITIES:

Current Assets: Current Liabilities:

Cash $ 2,550 Accounts Payable $ 9,500

Marketable securities $ 2,000 Short-term Bank Loan $11,375

Account Receivable (Net) $16,675 Total Current Liabilities $20,875

Inventories $26,470

Total Current Assets $47,695

As you can see, as of December 31, 200Y, the company's total current assets are valued at $47,695,
inventory valued at $26,470, and current liabilities are valued at $20,875. Using these amounts, the
Widget Manufacturing Company would calculate its quick ratio as follows:

Quick Ratio = Current Assets - Inventories = $47,695 - $26,470

Current Liabilities $20,875

= 1.02

As shown above, the Widget Manufacturing Company has a quick ratio of 1.02. This means; for every
$1.00 owed by the company in short-term debt, it has $1.02 of current assets (excluding inventory). In
theory, if the Widget Manufacturing Company did not sell any more products, then it would have the
ability to pay all of its short-term debt using its current assets; other than inventory. Note: the higher the
quick ratio, the stronger the company is perceived to be. For further detail, please refer
to our detailed article on the Quick Ratio.

Liquidity Ratio Summary:

In summary, the liquidity ratios consist of the Current Ratio and the Quick Ratio. The current ratio is
calculated by dividing the current assets by the current liabilities. The quick ratio is calculated by

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dividing the current assets (excluding inventory) by the current liabilities. Below summarizes the current
ratio and the quick ratio for the Widget Manufacturing Company as of December 31, 200Y.

Current Ratio = Current Assets = $47,695

Current Liabilities $20,875

= 2.28

Quick Ratio = Current Assets - Inventories = $47,695 - $26,470

Current Liabilities $20,875

= 1.02

4.3.3 Activity Ratio/ Efficiency Ratio

The second classification of ratios are known as the Activity Ratios. Activity Ratios indicate how much a
company has invested in a particular type of asset (or group of assets), relative to the revenue the
asset is producing. The most common activity ratios include; the average collection period and the
inventory turnover ratio. Lets look at each separately; beginning with the average collection period ratio.

AVERAGE COLLECTION PERIOD (Receivable days)

The average collection period ratio indicates the average length of time (in days) a business must wait
before it receives payment from customers who buy merchandise on credit. Below shows how a
business would calculate its average collection period ratio.

Average Collection Period = Accounts Receivable X 360 days

Sales

The formula is made up of three components; accounts receivable, sales, and finally 360 days. An
account receivable is a promise made by a customer to pay for a product or service at a later point in
time. Sales represent a company's total receipts from selling the products or services it offers to
customers. In other words, when a company sells products or services to its customers, the company is
said to be making sales. The 360 days represent the average number of days a business operates
during a normal business year. Below shows the values needed in order to calculate the average
collection period ratio for the Widget Manufacturing Company.

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 From Balance Sheet From Income Statement

CURRENT ASSETS: REVENUE:

Cash $ 2,550 Sales $112,500

Marketable securities $ 2,000 Cost of Goods Sold(COGS) $ 85,040

Account Receivable (Net) $16,675 Gross Margin $ 27,460

Inventories $26,470

Total Current Assets $47,695

Using the above figures, we can calculate the average collection period ratio for the Widget
Manufacturing Company as of December 31, 200Y.

Average Collection Period = Accounts Receivable X 360 days

Sales

= $ 16,675 X 360
$112,500

= 53.36 or 54 days (rounded up to the nearest day)

Therefore, when a customer buys products on credit from the Widget Manufacturing Company, it will
take, on average, 54 days before the company receives cash from the customer. If the company's
credit granting policy requires customers to pay within 30 days from the date of purchase, then we can
conclude the following;

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Customers, on average, are taking 24 extra days to pay for purchases placed on credit (54 days - 30
days = 24 days). In other words, customers are not paying on time.

Note: the lower the average collection period, the faster a company receives its money from customers,
and the stronger a company appears. On the other end of the continuum, the higher the average
collection period ratio, the longer customers take to pay their bills, and the less stable a company
appears.

INVENTORY TURNOVER RATIO:

The second type of activity ratio is known as the Inventory Turnover Ratio. The inventory turnover
ratio provides an indication on whether a company has excessive or inadequate goods (products) in
inventory. The ratio calculates the number of times per year a company uses or consumes an average
stock of goods.

Often businesses have too much inventory on hand in relation to demand. In this instance, a company
may experience cash flow problems since they are required to finance the inventory until it's sold and
cash is received. Other businesses may have insufficient inventory on hand which may lead to
dissatisfied customers and eventual loss of customers due to unfilled orders.

It's your responsibility as a business owner to monitor your inventory levels so that you do not carry too
much or too little. You may use the inventory turnover ratio to assist you with this task. Here's how the
inventory turnover ratio is calculated.

Inventory Turnover Cost of Goods Sold = $85,040

Average Inventory * ($22,500 + $26,470) / (2)

= 3.5 times

The two items needed to calculate the inventory turnover ratio are sales and average inventory. Cost of
Goods Sold, as the name implies, represents the costs incurred on all products sold. Furthermore, a
business can only recognize, as an expense, the costs of the products sold. Unsold products are still
owned by a business and considered inventory. Average inventory is calculated by adding a company's
beginning inventory to its ending inventory and dividing by two (2). Beginning inventory represents the
value of the inventory at the start of the business year (January 1, 200Y), while the ending inventory
represents the value of the inventory at the end of the business year (December 31, 200Y). In this
example, we are assuming the company's beginning inventory on January 1, 200Y is valued at $22,500
(taken from the Assumptions Section of our example) . The $26,470 shown on the balance as of
December 31, 200Y is considered the company's ending inventory. Below shows the values needed in
order to calculate the Inventory turnover ratio for the Widget Manufacturing Company.

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 From Balance Sheet From Income Statement

CURRENT ASSETS: REVENUE:

Cash $ 2,550 Sales $112,500

Marketable securities $ 2,000 Cost of Goods Sold(COGS) $ 85,040

Account Receivable (Net) $16,675 Gross Margin $ 27,460

Inventories $26,470

Total Current Assets $47,695

As you can see, inventory appears on the balance sheet, while cost of goods sold appears on a
company's income statement. Using the above figures, we can calculate the inventory turnover ratio for
the Widget Manufacturing Company as of December 31, 200Y.

Inventory Turnover Cost of Goods Sold = $85,040

Average Inventory * ($22,500 + $26,470) / (2)

= 3.5 times

Therefore, the Widget Manufacturing Company has an Inventory Turnover Ratio of 3.5 times. That is,
the company used its inventory 3.5 times during 200Y.

Note: if a company's inventory turnover ratio is too high, it may mean a company is running out of
inventory at various times throughout the business year. Also, in many cases, businesses with a high
inventory turnover ratio will experience a loss of sales to competitors. On the other hand, the lower an
inventory turnover ratio, the less cash required by a company to finance its inventory, and therefore the
stronger a company generally appears.

Activity Ratios Summary:

In summary, the activity ratios consist of the average collection period ratio and the inventory turnover

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ratio. The average collection period ratio is calculated by dividing the accounts receivable by the sales.
The inventory turnover ratio is calculated by dividing the cost of goods sold by the average inventory (IE
beginning inventory + ending inventory/2). Below summarizes the calculation of the average collection
period ratio and the inventory turnover ratio for the Widget Manufacturing Company as of December 31,
200Y.

Average Collection Period = Accounts Receivable X 360 days

Sales

= $ 16,675 X 360
$112,500

= 53.79 days or 54 days

Inventory Turnover = Cost of Goods Sold

Average Inventory

= $85,040
($22,500 + $26,470) / (2)

= 3.5 times

4.3.4 Leverage Ratio

LEVERAGE RATIOS:

The third classification of ratios are known as Leverage Ratios. Both long-term and short-term creditors
are concerned with the amount of leverage a company employs, since it indicates the firm's risk exposure
in meeting its debt obligations. The most common leverage ratios include; debt ratio, and debt to equity
ratio. Lets look at each ratio separately, beginning with the debt ratio.

DEBT RATIO (leverage ratio):

The debt ratio measures the extent to which borrowed funds have been used to finance a company's
operation. Below depicts how the debt ratio is calculated.

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 Debt Ratio = Total Debt = $44,875
Total Assets $77,695

= 0.58

As you can see, two values are needed to calculate the debt ratio. Total Debt is better known as the
amount a company owes to all its creditors. These include all current liabilities and long-term liabilities
(economic burdens). Total assets, in their simplest form, represent all the items a company owns
(economic resources).

Both figures needed in calculating the debt ratio can be found on a company's balance sheet under the
sections entitled total liabilities and total assets. Therefore, the Widget Manufacturing Company would
refer to the following section of its balance sheet when calculating the December 31, 200Y debt ratio.

ASSETS: LIABILITIES:

Current Assets: Current Liabilities:

Cash $ 2,550 Accounts Payable $ 9,500

Marketable securities $ 2,000 Short-term Bank Loan $11,375

Account Receivable (Net) $16,675 Total Current Liabilities $20,875

Inventories $26,470

Total Current Assets $47,695 Total Long Term Debt $24,000

TOTAL LIABILITIES $44,875

Fixed Assets:

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 Plant & Equipment $41,000

Less: Accumulated Depreciation $11,000

Net Plant & Equipment $30,000

TOTAL ASSETS $77,695

As you can see, Total Current Liabilities are $20,875 while Total Long-term Liabilities are $24,000.
Together, total liabilities or total debt for the company as of December 31, 200Y is $44,875. The total
assets are comprised of current assets and fixed assets. Therefore, the company's total assets as of
December 31, 200Y are $77,695. The company would calculate its debt ratio as of December 31, 200Y
as follows;

Debt Ratio = Total Debt = $44,875

Total Assets $77,695

= 0.58

The debt ratio for the Widget Manufacturing Company is 0.58. This means, 58% of the company's total
assets are financed through creditors such as banks, suppliers of inventory, loans from family
members, government (taxes payable), shareholders (dividends payable), and any other type of debt
the company may have. Also, we may look at the debt ratio from a dollar point of view by saying; for
every $0.58 cents the company owes, it owns $1.00 worth of assets.

As you might suspect, the lower the debt ratio, the more stable a company is considered. Moreover, if
your company owes less debt, in relation to a competitor, for example, then your financial position is
stronger and more stable. On the other hand, the higher a company's debt ratio, the more money it
owes, and therefore the less stable the company appears. Moreover, companies with high debt ratios
generally pay more interest on borrowed funds which reduces their net income. In addition, more cash
is required to pay the monthly principal and interest payments associated with the debt.

DEBT-TO-EQUITY RATIO:

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The second leverage ratio is known as the debt-to-equity ratio. The debt-to-equity ratio measures the
"investments" provided by creditors versus the investments provided by the company's owners. Below
depicts how the debt-to-equity ratio is calculated;

Debt-to-Equity = Total Debt

Total Equity

As you can see, two values are needed to calculate the debt-to-equity ratio. As indicated earlier, total
debt is better known as the amount a company owes to all its creditors. These include all current
liabilities and all long-term liabilities. The total equity represents all the investments made by the owners
of the company.

Both items needed in calculating the debt-to-equity ratio can be found on a company's balance sheet
under the sections entitled, "total liabilities" and "total equity". Therefore, the Widget Manufacturing
company would refer to the following section of its balance sheet when calculating its December 31,
200Y debt-to-equity ratio.

LIABILITIES:

Current Liabilities:

Accounts Payable $ 9,500

Short-term Bank Loan $11,375

Total Current Liabilities $20,875

Total Long Term Debt $24,000

TOTAL LIABILITIES $44,875

EQUITY:

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 Common Shares $25,000

Retained Earnings $ 7,820

TOTAL EQUITY $32,820

Total Liabilities & Equity $77,695

As you can see, Total Current Liabilities are $20,875 while Total Long-term Liabilities are $24,000.
Together, the total liabilities or total debt for the company as of December 31, 200Y is $44,875. The
total equity for our example is comprised of the common shares of $25,000 and retained earnings of
$7,820. Therefore, total equity as of December 31, 200Y is $32,820. The Widget Manufacturing
Company would calculate their debt-to-equity ratio as of December 31, 200Y as follows;

Debt-to-Equity = Total Debt = $44,875

Total Equity $32,820

= 1.37

As you can see, the debt-to-equity ratio is 1.37. This means that for every $1.00 invested by the owners
of the company, creditors (such as banks, suppliers of product, vendors, and other entities the
company owes) have invested $1.37

Note: the lower the debt-to-equity ratio, the more stable a company is considered. Moreover, if your
company owes less debt, in relation to a competitor, for example, then your financial position is
stronger and more stable. On the other hand, the higher a company's debt-to-equity ratio, the more
money it owes, and therefore the less stable the company appears. In a nutshell, we can say that the
Widget Company's creditors have invested more into the operation than the company's owners.

Leverage Ratio Summary:

In summary, the leverage ratios consist of the debt ratio and the debt-to-equity ratio. The debt ratio is
calculated by dividing a company's total debt by the company's total assets. The debt-to-equity ratio is
calculated by dividing a company's total debt by the company's total equity. Below summarizes the debt
ratio and the debt-to-equity ratio for the Widget Manufacturing Company as of December 31, 200Y;

Debt Ratio = Total Debt = $44,875 = 0.58

Total Assets $77,695

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 Debt-to-Equity = Total Debt = $44,875 = 1.37
Total Equity $32,820

Read on
1. limitations of using ratios for financial analysis
2. How ratios can be used for measuring performance

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