Financial Statement Analysis

The financial statement analysis is crucial because it gives shareholders useful information to help them make decisions. It will assist the company’s management in making key investment decisions. It will assist the company in deciding whether or not to borrow, as well as whether or not the company is on the proper track in terms of money. Overall, financial statement analysis is similar to our annual medical examination. It will assist the businessman in keeping a careful eye on a few characteristics and understanding how to protect against future troubles.

Profitability Ratios
Gross Profit Rate = Gross Profit ÷ Net Sales.

Calculates how much gross profit is generated from sales. Gross profit is equal to net sales minus the cost of sales.

Return on Sales = Net Income ÷ Net Sales.

Also called “net profit margin”,  it measures the percentage of income derived from dollar sales. Generally, the higher the ROS the better.

Return on Assets = Net Income ÷ Average Total Assets.

ROA is used in evaluating management’s efficiency in using assets to generate income.

Return on Stockholders’ Equity = Net Income ÷ Average Stockholders’ Equity.

Calculates the percentage of income derived for every dollar of owners’ equity.

Liquidity Ratios
Current Ratio = Current Assets ÷ Current Liabilities.

Measures the ability of a company to pay short-term obligations using current assets

Acid Test Ratio = Quick Assets ÷ Current Liabilities.

Also called “quick ratio”, the ability of a company to pay short-term obligations using the more liquid types of current assets or “quick assets” (cash, marketable securities, and current receivables).

Cash Ratio = ( Cash + Marketable Securities ) ÷ Current Liabilities.

Calculates the ability of a company to pay its current liabilities using cash and marketable securities. Marketable securities are short-term debt instruments that are as good as cash.

Net Working Capital = Current Assets – Current Liabilities.

Checks if a company can meet its current obligations with its current assets.

Management Efficiency Ratios
Receivable Turnover = Net Credit Sales ÷ Average Accounts Receivable.

Calculates the efficiency of extending credit and collecting the same. It indicates the average number of times in a year a company collects its open accounts. A high ratio implies an efficient credit and collection process.

Days Sales Outstanding = 360 Days ÷ Receivable Turnover.

Also called “receivable turnover in days”, “collection period”. It measures the average number of days it takes a company to collect a receivable. The shorter the DSO, the better. Take note that some use 365 days instead of 360.

Inventory Turnover = Cost of Sales ÷ Average Inventory

Represents the number of times inventory is sold and replaced. Take note that some authors use Sales in lieu of Cost of Sales in the above formula. A high ratio indicates that the company is efficient in managing its inventories.

Days Inventory Outstanding = 360 Days ÷ Inventory Turnover.

Also called “inventory turnover in days”. It represents the number of days inventory sits in the warehouse. In other words, it measures the number of days from the purchase of inventory to the sale of the same.

Accounts Payable Turnover = Net Credit Purchases ÷ Ave. Accounts Payable,

Represents the number of times a company pays its accounts payable during a period. A low ratio is favoured because it is better to delay payments as much as possible so that the money can be used for more productive purposes.

Days Payable Outstanding = 360 Days ÷ Accounts Payable Turnover.

Also known as “accounts payable turnover in days”, “payment period”. It measures the average number of days spent before paying obligations to suppliers. Unlike DSO and DIO, the longer the DPO the better (as explained above).

Operating Cycle = Days Inventory Outstanding + Days Sales Outstanding.

Calculates the number of days a company makes 1 complete operating cycle, i.e. purchase merchandise, sell them, and collect the amount due. A shorter operating cycle means that the company generates sales and collects cash faster.

Cash Conversion Cycle = Operating Cycle – Days Payable Outstanding.

It measures how fast a company converts cash into more cash. It represents the number of days a company pays for purchases, sells them, and collects the amount due. Generally, like the operating cycle, the shorter the CCC the better.

Total Asset Turnover = Net Sales ÷ Average Total Assets.

Measures the overall efficiency of a company in generating sales using its assets. The formula is similar to ROA, except that net sales are used instead of net income.

Leverage Ratios
Debt Ratio = Total Liabilities ÷ Total Assets.

Measures the portion of company assets that are financed by debt (obligations to third parties). The debt ratio can also be computed using the formula: 1 minus Equity Ratio.

Equity Ratio = Total Equity ÷ Total Assets.

Determines the portion of total assets provided by equity (i.e. owners’ contributions and the company’s accumulated profits). Equity ratio can also be computed using the formula: 1 minus Debt Ratio. The reciprocal of equity ratio is known as equity multiplier, which is equal to total assets divided by total equity.

Debt-Equity Ratio = Total Liabilities ÷ Total Equity.

Evaluates the capital structure of a company. A D/E ratio of more than 1 implies that the company is a leveraged firm; less than 1 implies that it is a conservative one.

Times Interest Earned = EBIT ÷ Interest Expense.

Measures the number of times interest expense is converted to income, and if the company can pay its interest expense using the profits generated. EBIT is earnings before interest and taxes.

Valuation and Growth Ratios Earnings per Share = ( Net Income – Preferred Dividends ) ÷ Average Common Shares Outstanding.

EPS shows the rate of earnings per share of common stock. Preferred dividends are deducted from net income to get the earnings available to common stockholders.