Analyzing financial statements
Component percentages
Instead of using monetary amounts, we use percentages to compare the values to a single base amount. We divide all amounts on the statement by the base amount.
We choose the base amount based on the statement:
- Income statement Net sales
- Balance sheet Net assets
Comparison of Income statement and component percentages
Ratio analysis
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Ratios are used to evaluate the financial performance of a company.
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They are used to compare the company's performance to:
- Industry averages
- Historical data Without these benchmark values, no insights can be made.
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We can only compare ratios for two firms if they are comparable in terms of industry, operations and accounting policies.
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A company's accounting policies influences its ratios.
Profitability ratios
Involves net income.
| Ratio | Formula | Interpretation |
|---|---|---|
| Net Profit Margin | Net Income : Revenue | Every revenue dollar generates profit. |
| Gross profit margin | (Net income - COGS) : Revenue | Every revenue dollar generates profit. |
| Return on Assets (ROA) | Net Income : Total Assets | Efficiency in using assets. |
| Return on Equity (ROE) | Net Income : Average Equity | Every equity dollar generates profit. |
| Earnings per Share (EPS) | Net Income : Shares Outstanding | Amount of earnings attributable to each share of stock. |
| Quality of Income | O Cash Flow : Net income | Proportion of income in cash, ability to finance cash needs. |
Asset turnover ratios
| Ratio | Formula | Interpretation |
|---|---|---|
| Total Asset Turnover | Operating revenue : Total Assets (sales:) | Every asset dollar generates sales. |
| Fixed Asset Turnover | Net Sales : Fixed Assets | Efficiency in using fixed assets. |
| Receivable Turnover | Net Sales : Receivables | Every receivable dollar generates sales. |
| Inventory Turnover | COGS : Inventory | Efficiency in managing inventory. |
| Average days to Sell Inventory | 365 : Inventory Turnover Ratio | Number of days it takes to sell the inventory. |
Using ratios to analyze operating cycle
Liquidity ratios
Involves current assets and current liabilities.
| Ratio | Formula | Interpretation |
|---|---|---|
| Cash | Cash Eqv. : Current Liabilities | Ability to pay off short-term debts without selling inventory. |
| Current | Current Assets : Current Liabilities | Ability to pay off short-term debts with current assets (Short-term Liquidity). Ideal range: 1.1-2 |
| Quick | (Current Assets - Inventory) : Current Liabilities | Stricter liquidity ratio. Ideal range: 1-2 |
Solvency ratios
Involves debt.
| Ratio | Formula | Interpretation |
|---|---|---|
| Debt to Equity | Total Liabilities : Total Equity | Amount of debt per dollar of equity. |
| Time interest earned | NI + Interest Expense + Income tax Expense : Interest Expense | Ability to meet interest payments. |
| Cash coverage | O Cash Flow : Interest Expense | Cash from operations to meet interest payments |
Market ratios
Involves Market price (per share outstanding).
| Ratio | Formula | Interpretation |
|---|---|---|
| Dividend yield | Dividend : Market price (per share) | Return on investment from dividends. |
| Price/Earnings | Market price : Earnings (per share) | Expected growth rate of earnings. |