Ratio Analysis and Statement Evaluation https://courses.lumenlearning.com/boundless-business/chapter/ratio-anal...

Ratio Analysis and Statement Evaluation

Financial Statements

Financial Statements Across Periods

Companies prepare three financial statements according to GAAP rules: the income
statement, the balance sheet, and the cash flow statement.

Learning Objectives
Identify the three main financial statements that companies generally submit

Key Takeaways

Key Points

The income statement gives an account of what the company sold and spent in
the year ( revenues and expenses ).
The balance sheet is a financial snapshot of the company’s assets and liabilities,
and informs shareholders about its financial health.
The cash flow statement shows what came into and went out of the company in
cash. It gives a better idea than the other two financial statements about how
well the company can meet its cash obligations.
The Securities and Exchange Commission (SEC) regulates these financial
statements. Companies must file extensive reports annually (known as a 10K ),
as well as quarterly reports ( 10Q ).
A company may report its financials in a fiscal year that is different from the
calendar year.

Key Terms

10Q: A quarterly report mandated by the United States federal Securities and
Exchange Commission to be filed by publicly traded corporations.
generally accepted accounting principles: The standard framework of
guidelines for financial accounting used in any given jurisdiction; generally
known as accounting standards. GAAP includes the standards, conventions,
and rules accountants follow in recording and summarizing, and in the
preparation of financial statements.
10K: An annual report, required by the U.S. Securities and Exchange
Commission (SEC), that gives a comprehensive summary of a public company’s
performance.

Financial statements are records that outline the financial activities of a business,
individual, or any other entity. Corporations report financial statements following
Generally Accepted Accounting Principles ( GAAP ). The rules about how financial
statements should be put together are set by the Financial Accounting Standards

1 of 16 8 Aug 2019, 4:08 pm

Ratio Analysis and Statement Evaluation https://courses.lumenlearning.com/boundless-business/chapter/ratio-anal...

Board (FASB). Standardized rules ensure, to some extent, that a firm’s financial
statements accurately represent the company’s financial status.

Financial Statements Analysis: Corporations report financial statements

following Generally Accepted Accounting Principles (GAAP).

Companies generally submit three forms of financial statements. The information

contained in these statements, and how this information fluctuates across periods, is
very telling for investors and government regulatory agencies. These three financial
statements are:

The income statement (also called the “profit and loss statement”): This gives an
account of what the company sold and spent in the year. Sales (also called
“revenues”), or what the company sold in products and services, less any expenses
(expenses are divided into a number of categories) and less taxes, gives the
company’s income. The income statement summarizes all this type of activity for the
year.

The balance sheet: This is a financial snapshot of what the company owns (assets),
what it owes (liabilities), and its worth free and clear of debt (or the value of its
equity). Analyzing a balance sheet informs shareholders about the company’s
financial health.

The cash flow statement: It tells what transactions went into and came out of the
company in the form of cash. This is necessary because accounting sometimes deals
with revenues and expenses which are not real cash, such as accounts receivable and
accounts payable. Looking at the actual cash flow gives a better idea of how well the
company can meet its cash obligations.

The period represented in a given financial statement can vary. A company may
report its financials in a fiscal year that is different from the calendar year. While
some firms do follow the calendar year, others–such as retail companies–prefer not
to follow the calendar year due to seasonality of sales or expenses, et cetera.

The reporting of these financial statements is regulated by the federal agency, the

2 of 16 8 Aug 2019, 4:08 pm

Ratio Analysis and Statement Evaluation https://courses.lumenlearning.com/boundless-business/chapter/ratio-anal...

Securities and Exchange Commission (SEC). According to SEC regulations,

companies have to file an extensive report (called the 10K) on what happened during
the year. In addition to the 10K, companies have to file 10Qs every three months,
which give their quarterly financial performance. These reports can be accessed
through the SEC’s website, www.sec.gov, the company’s website, or various financial
websites, such as finance.yahoo.com.

Profitability Ratios
Profitability ratios are used to assess a business’s ability to generate earnings.

Learning Objectives
Compare the information given by calculating the various profitability ratios

Key Takeaways

Key Points

Profitability ratios are used to compare companies in the same industry, since
profit margins will vary widely from industry to industry.
Taxes should not be included in these ratios, since tax rates will vary from
company to company.
The profit margin shows the relationship between profit and sales and is mostly
used for internal comparison.
Profit Margin = Net Profit / Net Sales. It shows the relationship between profit
and sales and is mostly used for internal comparison.
ROE = Net Income / Shareholder Equity. It measures a firm’s efficiency at
generating profits from every unit of shareholders’ equity.
The BEP ratio compares earnings before income and taxes to total assets. BEP
= EBIT / Total Assets.

Key Terms

profitability: The capacity to make a profit.

Cost of Goods Sold: Cost of goods sold (COGS) refer to the inventory costs of
those goods a business has sold during a particular period.
financial leverage: The degree to which an investor or business is utilizing
borrowed money.

Profitability Ratios

Profitability ratios show how much profit the company takes in for every dollar of
sales or revenues. They are used to assess a business’s ability to generate earnings as
compared to expenses over a specified time period.

3 of 16 8 Aug 2019, 4:08 pm

Ratio Analysis and Statement Evaluation https://courses.lumenlearning.com/boundless-business/chapter/ratio-anal...

Increasing Profits: Profitability ratios are used to assess a business’s ability to

generate earnings.

Profitability ratios are going to vary from industry to industry, so comparisons

should be between other companies in the same field. When comparing companies in
the same industry, the company with the higher profit margin is able to sell at a
higher price or lower expenses. They tend to be more attractive to investors.

Net Profit Margins and Returns on Sales

Many analysts focus on net profit margins or returns on sales, which are calculated
by taking the net income after taxes and dividing by the revenues or sales. This ratio
uses the bottom line on the income statement to calculate profit for every dollar of
sales or revenues. The operating margin takes the profit before taxes further up the
income statement and divides by revenues. Operating margins are also important,
since they focus on the operating income and operating expenses. Other profitability
ratios include:

Return on Assets: The return on assets ratio (ROA) is found by dividing the net
income by total assets. The higher the ratio, the better the company is at using
their assets to generate income (i.e., how many dollars of earnings they derive
from each dollar of assets they control). It is also a measure of how much the
company relies on assets to generate profit. The return on assets gives an
indication of the company’s capital intensity, which will depend on the
industry. Companies that require large initial investments will generally have
reduced return on assets.
Profit Margin: The profit margin is one of the most used profitability ratios.
The profit margin refers to the amount of profit that a company earns through
sales. The profit margin ratio is broadly the ratio of profit to total sales times
one hundred percent. The higher the profit margin, the more profit a company
earns on each sale. The profit margin is mostly used for internal comparison. It
is difficult to accurately compare the net profit ratio for different entities. A low
profit margin indicates a low margin of safety and a higher risk that a decline in
sales will erase profits and result in a net loss or a negative margin.
Return on Equity: The return on equity (ROE) measures profitability related to
ownership. It measures a firm’s efficiency at generating profits from every unit
of the shareholders’ equity. ROEs between 15 percent and 20 percent are
generally considered good. The ROE is equal to the net income divided by the

4 of 16 8 Aug 2019, 4:08 pm

Ratio Analysis and Statement Evaluation https://courses.lumenlearning.com/boundless-business/chapter/ratio-anal...

shareholder equity.
Basic Earning Power Ratio: The basic earning power ratio (or BEP ratio)
compares earnings separately from the influence of taxes or financial leverage
to the assets of the company. The BEP is equal to the earnings before interest
and taxes divided by the total assets. The BEP differs from the ROA in that it
includes the non-operating income.
Gross Profit Ratio: This indicates what portion of each sales dollar is available
to meet expenses and generate profit after taking into account the cost of goods
sold. Generally, it is calculated as the selling price of an item minus the cost of
goods sold (production or acquisition costs).

Liquidity Ratios
Liquidity ratios measure how quickly assets can be turned into cash in order to pay
the company’s short-term obligations.

Learning Objectives

Compare the current ratio to the quick ratio

Key Takeaways

Key Points

Liquidity ratios should fall within a certain range—too low and the company
cannot pay off its obligations, or too high and the company is not utilizing its
cash efficiently.
Current Ratio = Current Assets / Current Liabilities. This ratio examines
whether a firm can cover its short-term debts. If below 1, the company may
have difficulty meeting short-term obligations.
Acid Test Ratio (or Quick Ratio) = [Current Assets – Inventories ] / Current
Liabilities. More stringent and meaningful than the Current Ratio, since it does
not include inventory. A ratio of 1:1 is recommended, but not necessarily a
minimum.
A company can improve its liquidity ratios by raising the value of its current
assets, reducing current liabilities by paying off debt, or negotiating delayed
payments to creditors.

Key Terms

liquidity ratio: total cash and equivalents divided by short-term borrowings

liquidity: An asset’s ability to become solvent without affecting its value; the
degree to which it can be easily converted into cash.
creditor: A person to whom a debt is owed.

Liquidity ratios measure a company’s ability to pay short-term obligations of one

year or less (i.e., how quickly assets can be turned into cash). A high liquidity ratio
indicates that a business is holding too much cash that could be utilized in other
areas. A low liquidity ratio means a firm may struggle to pay short-term obligations.

One such ratio is known as the current ratio, which is equal to:

5 of 16 8 Aug 2019, 4:08 pm

Ratio Analysis and Statement Evaluation https://courses.lumenlearning.com/boundless-business/chapter/ratio-anal...

Current Assets ÷ Current Liabilities.

This ratio reveals whether the firm can cover its short-term debts; it is an indication
of a firm’s market liquidity and ability to meet creditor’s demands. Acceptable
current ratios vary from industry to industry. For a healthy business, a current ratio
will generally fall between 1.5 and 3. If current liabilities exceed current assets (i.e.,
the current ratio is below 1), then the company may have problems meeting its short-
term obligations. If the current ratio is too high, the company may be inefficiently
using its current assets or its short-term financing facilities. This may also indicate
problems in working capital management.

The acid test ratio (or quick ratio) is similar to current ratio except in that it ignores
inventories. It is equal to:

(Current Assets – Inventories) Current Liabilities.

Typically the quick ratio is more meaningful than the current ratio because inventory
cannot always be relied upon to convert to cash. A ratio of 1:1 is recommended. Low
values for the current or quick ratios (values less than 1) indicate that a firm may
have difficulty meeting current obligations. Low values, however, do not indicate a
critical problem. If an organization has good long-term prospects, it may be able to
borrow against those prospects to meet current obligations.

A firm may improve its liquidity ratios by raising the value of its current assets,
reducing the value of current liabilities, or negotiating delayed or lower payments to
creditors.

Cash: Cash is the most liquid asset in a business.

6 of 16 8 Aug 2019, 4:08 pm

Ratio Analysis and Statement Evaluation https://courses.lumenlearning.com/boundless-business/chapter/ratio-anal...

Debt Utilization Ratios

Debt ratios provide information about a company’s long-term financial health.

Learning Objectives

Explain the methods and usage of debt utilization ratios

Key Takeaways

Key Points

Generally speaking, the more debt a company has (as a percentage of assets ),
the less healthy it is financially.
Debt Ratio = Total Debt / Total Assets. It shows the percentage of a company’s
assets that are provided through debt. The higher the ratio, the greater the risk
the company has undertaken.
Debt-to- Equity Ratio (D/E) = Debt (i.e. Liabilities ) / Equity. It shows the split
of shareholders ‘ equity and debt that are used to finance the company’s assets.
The DCR shows the ratio of cash available for debt servicing to interest,
principal, and lease payments. The higher this ratio, the easier it is for a
company to take on new debt.

Key Terms

Interest: The price paid for obtaining or price received for providing money or
goods in a credit transaction, calculated as a fraction of the amount or value of
what was borrowed.
debt: Money that one person or entity owes or is required to pay to another,
generally as a result of a loan or other financial transaction.
amortization: The reduction of loan principle over a series of payments.
debt financing: funding obtained by borrowing assets

Debt utilization ratios provide a comprehensive picture of the company’s solvency or

long-term financial health. The debt ratio is a financial ratio that indicates the
percentage of a company’s assets that are provided via debt. It is the ratio of total
debt (the sum of current liabilities and long-term liabilities) and total assets (the sum
of current assets, fixed assets, and other assets such as “goodwill”).

Debt Ratio = Total Debt / Total Assets

For example, a company with $2 million in total assets and $500,000 in total
liabilities would have a debt ratio of 25%. The higher the ratio, the greater the risk
associated with the firm’s operation. In addition, high debt to assets ratio may
indicate low borrowing capacity of a firm, which in turn will lower the firm’s financial
flexibility. Like all financial ratios, a company’s debt ratio should be compared with
their industry average or other competing firms.

The debt-to-equity ratio (D/E) is a financial ratio indicating the relative proportion
of shareholders’ equity and debt used to finance a company’s assets. When used to
calculate a company’s financial leverage, the debt usually includes only the Long

7 of 16 8 Aug 2019, 4:08 pm

Ratio Analysis and Statement Evaluation https://courses.lumenlearning.com/boundless-business/chapter/ratio-anal...

Term Debt (LTD). D/E = Debt(liabilities)/Equity.

The debt service coverage ratio (DSCR), also known as debt coverage ratio (DCR), is
the ratio of cash available for debt servicing to interest, principal, and lease
payments. It is a popular benchmark used in the measurement of an entity’s ability
to produce enough cash to cover its debt (including lease) payments. The higher this
ratio is, the easier it is to obtain a loan. In general, it is calculated as:

DSCR = (Annual Net Income + Amortization/Depreciation + Interest Expense +

other non-cash and discretionary items (such as non-contractual
management bonuses)) / (Principal Repayment + Interest payments + Lease
payments)

A similar debt utilization ratio is the times interest earned (TIE), or interest coverage
ratio. It is a measure of a company’s ability to honor its debt payments. It may be
calculated as either EBIT or EBITDA, divided by the total interest payable. EBIT is
earnings before interest and taxes, and EBITDA is earnings before interest, taxes,
depreciation, and amortization.

Leverage Ratios: Leverage ratios for some investment banks

Comparisons Within an Industry

Most financial ratios have no universal benchmarks, so meaningful analysis involves
comparisons with competitors and industry averages.

8 of 16 8 Aug 2019, 4:08 pm

Ratio Analysis and Statement Evaluation https://courses.lumenlearning.com/boundless-business/chapter/ratio-anal...

Learning Objectives
Explain how to effectively use financial statement analysis

Key Takeaways

Key Points

Ratios allow easier comparison between companies than using absolute values
of certain measures. They negate the impact of scale in profitability or solvency.
Firms should generally try to meet or exceed the industry average, over time, in
their ratios.
Industry trends, changes in price levels, and future economic conditions should
all be considered when using financial ratios to analyze a firm’s performance.

Key Terms

bankruptcy: A legally declared or recognized condition of insolvency of a

person or organization.
solvency: The state of having enough funds or liquid assets to pay all of one’s
debts; the state of being solvent.

Financial statement analysis (or financial analysis) is the process of reviewing and
analyzing a company’s financial statements to make better economic decisions. These
statements include the income statement, balance sheet, statement of cash flows, and
a statement of retained earnings. Financial statement analysis is a method or process
involving specific techniques for evaluating risks, performance, financial health, and
future prospects of an organization.

Financial statements can reveal much more information when comparisons are made
with previous statements, rather than when considered individually. Horizontal
analysis compares financial data, such as an income statements, over a period of
several quarters or years. When comparing past and present financial information,
one will want to look for variations such as higher or lower earnings. Moreover, it is
often useful to compare the financial statements of companies in related industries.

Ratios of risk such as the current ratio, the interest coverage, and the equity
percentage have no theoretical benchmarks. It is, therefore, common to compare
them with the industry average over time. If a firm has a higher equity ratio than the
industry, this is considered less risky than if it is below the average. Similarly, if the
equity ratio increases over time, it is a good sign in relation to insolvency risk.

9 of 16 8 Aug 2019, 4:08 pm

Ratio Analysis and Statement Evaluation https://courses.lumenlearning.com/boundless-business/chapter/ratio-anal...

Refining Operation: Ratio analyses can be used to compare between companies

within the same industry. For example, comparing the ratios of BP and Exxon Mobil
would be appropriate, whereas comparing the ratios of BP and General Mills would
be inappropriate.

The main purpose of conducting financial analysis is to measure a business’s

profitability and solvency. The actual metrics tracked and methods applied vary from
stakeholder to stakeholder, depending on his or her interests and needs. For
example, equity investors are interested in the long-term earnings power of the
organization and perhaps the sustainability and growth of dividend payments.
Creditors want to ensure the interest and principal is paid on the organizations debt
securities (e.g., bonds) when due.

Most analytical measures are expressed as percentages or ratios, which allows for
easy comparison with other businesses in the industry regardless of absolute
company size. Vertical analysis, which is a proportional analysis of financial
statements, lists each line item in the financial statement as the percentage of
another line item. For example, on an income statement each line item will be listed
as a percentage of gross sales. This technique is also referred to as normalization or
common-sizing.

When using these analytical measures, one should take the following factors into
consideration:

1. Industry trends;
2. Changes in price levels;
3. Future economic conditions.

Ratios must be compared with other firms in the same industry to see if they are in
line.

Performance per Share

Valuation ratios describe the value of shares to shareholders, and include the EPS

10 of 16 8 Aug 2019, 4:08 pm

Ratio Analysis and Statement Evaluation https://courses.lumenlearning.com/boundless-business/chapter/ratio-anal...

ratio, the P/E ratio, and the dividend yield ratio.

Learning Objectives
Identify the ratio analysis tools used for shares of stock

Key Takeaways

Key Points

EPS (Earnings Per Share) = Net Income / Average Common Shares. This ratio
gives the earnings per outstanding share of a company’s stock.
P/E Ratio = Market Price per Share / Annual Earnings per Share. This ratio is
widely used to measure the relative value of companies. The higher the P/E
ratio, the more investors are paying for each unit of net income.
Current Dividend Yield = Most Recent Full Year Dividend / Current Share
Price. Displays the earnings distributed to stock holders in relation to the value
of the stock.
Market To Book ratio is used to compare a company’s current market price to
its book value.

Key Terms

stockholder: One who owns stock.

dividend: A pro rata payment of money by a company to its shareholders,
usually made periodically (e.g., quarterly or annually).

Company Performance Per Share

The below ratios describe the value of shares of stock to stockholders, both in terms
of dividends and their general ownership value:

Earnings Per Share (EPS) is the amount of earnings per each outstanding
share of a company’s stock. Companies are required to report EPS for each of
the major categories of the income statement, including: continuing operations,
discontinued operations, extraordinary items, and net income. EPS = Net
Income / Average Common Shares.
Price to Earnings (P/E) ratio relates market price to earnings per share. The
P/E ratio is a widely used metric used for measuring the relative value of
companies. A higher P/E ratio means that investors are paying more for each
unit of net income; therefore, the stock is more expensive compared to one with
a lower P/E ratio. The P/E ratio also shows the number of years of earnings
which would be required to pay back the purchase price—ignoring inflation,
earnings growth and the time value of money. P/E Ratio = Market Price Per
Share / Annual Earnings Per Share .
Dividend Yield ratio shows the earnings distributed to stockholders related to
the value of the stock, as calculated on a per-share basis. The dividend yield or
the dividend-price ratio of a share is the company’s total annual dividend
payments divided by its market capitalization—or the dividend per share,
divided by the price per share. It is often expressed as a percentage. Current
Dividend Yield = Most Recent Full Year Dividend / Current Share Price.

11 of 16 8 Aug 2019, 4:08 pm

Ratio Analysis and Statement Evaluation https://courses.lumenlearning.com/boundless-business/chapter/ratio-anal...

Dividend Payout ratio shows the portion of earnings distributed to

stockholders. Dividend payout ratio is the fraction of net income a firm pays to
its stockholders in dividends: Dividend Payout Ratio = Dividends / Net
Income for the Same Period. The part of earnings not paid to investors is left
for investment to provide for future earnings growth. Investors seeking high
current income and limited capital growth prefer companies with a high
dividend payout ratio. However, investors seeking capital growth may prefer a
lower payout ratio, because capital gains are taxed at a lower rate. High growth
firms in early life generally have low or zero payout ratios. As they mature, they
tend to return more of the earnings back to investors.
Market To Book ratio is used to compare a company’s current market price to
its book value. The calculation can be performed in two ways, but the result
should be the same using either method. In the first method, the company’s
market capitalization can be divided by the company’s total book value from its
balance sheet (Market Capitalization / Total Book Value). The second method,
using per-share values, is to divide the company’s current share price by the
book value per share, which is its book value divided by the number of
outstanding shares (Share Price / Book Value Per Share). A higher market to
book ratio implies that investors expect management to create more value from
a given set of assets, all else equal. This ratio also gives some idea of whether an
investor is paying too much for what would be left if the company went
bankrupt immediately.

Activity Ratios
Activity ratios provide useful insights regarding an organization’s ability to leverage
existing assets efficiently.

Learning Objectives
Calculate activity ratios to determine organizational efficiency

Key Takeaways

Key Points

Organizations are largely systems of assets that produce outputs. The efficiency
of how those assets are used can be measured via activity ratios.
There are a number of different activity ratios commonly used by stakeholders
and managers to assess overall organizational efficiency, most importantly
asset turnover, inventory turnover, and degree of operating leverage.
Different businesses and industries tend to focus more on some activity ratios
than others. Knowing what ratio is relevant based on the operation or process
is an important consideration for managerial accountants.
Inventory turnover is highly relevant for industries selling perishable or time
sensitive goods. On the other hand, manufacturing facilities tend to be more
concerned with fixed asset turnover.

Key Terms

leverage: To use in such a way to capture maximum value.

12 of 16 8 Aug 2019, 4:08 pm

Ratio Analysis and Statement Evaluation https://courses.lumenlearning.com/boundless-business/chapter/ratio-anal...

perishable: A good that has an expiration date, or can go bad.

Why Firms Measure Activity

Activity ratios are essentially indicators of how a given organization leverages their
existing assets to generate value. When considering the nature of a business, the
general concept is to generate value through utilizing various production processes,
employee talent, and intellectual property. Through identifying the profit compared
to the investment in these core assets, the overall efficiency of the organization’s
utilization can be derived.

How to Measure Activity

There are a number of ways to measure activity. Each calculation has different inputs
and different implications. Some examples include:

Average collection period – (Accounts Receivable)/(Daily Average Credit Sales)

Degree of Operating Leverage (DOL) – (Percent Change in Net Operating
Income)/(Percent Change in Sales)
DSO Ratio – (Accounts Receivable)/(Daily Average Sales)
Average Payment Period – (Accounts Payable)/(Average Daily Credit
Purchases)
Asset Turnover – (Net Sales)/(Total Assets)
Stock Turnover Ratio – (Cost of Goods Sold)/(Average Inventory)
Receivables Turnover Ratio – (Net Credit Sales)/(Average Net Receivables)
Inventory Conversion Ratio – (365 Days)/(Inventory Turnover)
Receivables Conversion Period – (Receivables/Net Sales)(365 Days)
Payable Conversion Period – (Receivables/Net Sales)(365 Days)
Cash Conversion Cycle – Inventory Conversion Period + Receivable Conversion
Period – Payable Conversion Period

Using Activity Ratios

By tracking these metrics over time, and comparing them to the competition,
organizations and stakeholders can gauge their competitiveness and overall capacity
to leverage assets in the current industry. Understanding how to use these ratios, and
what the implications are, is central to financial and managerial accounting at the
strategic level.

For some business, inventory turnover is an incredibly important metric. A business

selling farmed produce, for example, must have a highly sophisticated value chain
with minimal warehousing and storage. Inventory turnover must be rapid, as the
goods being sold are perishable. Fashion industries are similarly reliant on inventory
turnover, as the seasonality of both fashion styles and climate create a strong
necessity for careful activity management.

For other businesses, asset turnover is a central activity metric. A manufacturing

facility producing semiconductors, for example, will invest heavily in the production
facility and related equipment. Ensuring maximum production and annual sales
contracts is integral to maintaining profitability, and maximizing utilization of those
fixed assets will enormously impact profitability.

13 of 16 8 Aug 2019, 4:08 pm

Ratio Analysis and Statement Evaluation https://courses.lumenlearning.com/boundless-business/chapter/ratio-anal...

Sample Evaluation
Most of the ratios discussed can be calculated using information found in the three
main financial statements.

Learning Objectives
Apply financial ratio analysis to Bounded Inc.

Key Takeaways

Key Points

Keep in mind that for most ratios, the number must be compared against
competitors and industry standards for it to be meaningful.
The ROE (Return on Equity ) measures the firm’s ability to generate profits
from every unit of shareholder equity.
ROEs between 15 percent and 20 percent are generally considered good.

Key Terms

ROA: The return on assets (ROA) percentage shows how profitable a

company’s assets are in generating revenue.

Consider the company Bounded Inc., a magazine publisher, to illustrate the

financials of a company. The following information is based on the company’s FY
(financial year) 2011 performance:

Cash: $3,230
Cost of Goods Sold: $2,390
Current Assets: $1,000
Current Liabilities: $3,500
Depreciation: $800
Fixed Assets: $8,600
Interest Payments: $300
Inventory: $2,010
Long-term Debt: $3,000
Sales: $5,000

Using the information above, we can compile the balance sheet and the income
statement. We can also calculate some financial ratios to determine the company’s
financial situation. Keep in mind that for most ratios, the number must be compared
against competitors and industry standards for it to be meaningful:

ROA (Return on Assets) = Net Income / Total Assets = 1,057 / 13,840 = 7.6%

This means that for every dollar of assets the company controls, it derives $0.076 of
profit. This would need to be compared to others in the same industry to determine
whether this is a high or low figure.

Profit Margin = Net Income / Net Sales = 1,057/5,000 = 21.1 percent

14 of 16 8 Aug 2019, 4:08 pm

Ratio Analysis and Statement Evaluation https://courses.lumenlearning.com/boundless-business/chapter/ratio-anal...

This figure would need to be compared to competitors. A lower profit margin

indicates a low margin of safety.

ROE (Return on Equity) = Net Income / Shareholder Equity = 1,057/7,340 = 14.4

percent

The ROE measures the firm’s ability to generate profits from every unit of
shareholder equity. 0.144 (or 14 percent) is not a bad figure, but by no means a very
good once, since ROE’s between 15 to 20 percent are generally considered good.

BEP Ratio = EBIT / Total Assets = 1,810/13,840 = 0.311

Current Ratio = Current Assets / Current Liabilities = 5,240/3,500 = 1.497

This demonstrates that the company does not seem to be in a tight position in terms
of liquidity.

Quick Ratio = (Current Assets-Inventories) / Current Liabilities = (5,240 – 2,010) /

3,500 = 0.923

Despite having a current ratio of about 1.0, the quick ratio is slightly below 1.0. This
means that the company may face liquidity problems should payment of current
liabilities be demanded immediately. But it does not seem to be a huge cause for
concern.

Debt Ratio = Total Debt / Total Assets = 6,500/13,840 = 47 percent

This indicates the percentage of a company’s assets that are provided via debt. The
higher the ratio, the greater risk will be associated with the firm’s operation.

D/E Ratio = Long-term Debt/Equity = 3,000/7,340 = 40.9 percent

This shows the relative proportion of shareholders’ equity and debt used to finance a
company’s assets. Once again, comparisons should be made between companies in
the same industry in order to determine whether this is a low or high figure.

15 of 16 8 Aug 2019, 4:08 pm

Ratio Analysis and Statement Evaluation https://courses.lumenlearning.com/boundless-business/chapter/ratio-anal...

Financial Statement: One form of financial statement is the income statement.

16 of 16 8 Aug 2019, 4:08 pm