Unit 2: Financial Statement Analysis
A critical focus for a company's management is increasing their analysis of how well the business is performing in key financial areas. For this analysis to be as useful as possible, it must include more than just evaluating the current financial package. Management should compare the financial indicators over a period of time. This means past performance is used to identify positive and negative trends. You also want to compare your performance against other companies in your market. Just looking at the "raw" numbers may not give you the best picture for evaluation. That's why we will turn our discussion to calculating and using financial ratios. A ratio is simply a way to clearly show a relationship between numbers, allowing us to compare the results better.
Completing this unit should take you approximately 5 hours.
Upon successful completion of this unit, you will be able to:
- calculate financial ratios given a company's financial package;
- evaluate a firm's performance over time;
- compare a firm's performance to other companies in the same industry segment; and
- recognize areas where financial performance can be improved.
- calculate financial ratios given a company's financial package;
2.1: Ratio Analysis
The best way to analyze the performance of individual financial components is to "Common Size" them. This allows a comparison of each individual item, as a percent (%) of sales, and helps to identify specific trends. For example, if sales increased, but the cost of goods sold shows a higher % of sales than in the prior period, we can conclude that this is an area for improvement.
Remember that ratios provide a way to level our view of performance without thinking in terms of dollars, market share, size, etc. They can level the playing field, especially when we consider outside firms in our analysis. We are going to consider:
- Profitability Ratios
- Asset Management Ratios
- Liquidity Ratios
- Debt Management Ratios
- Market Value Ratios
- The DuPont Equation, ROE, ROA, and Growth
The Numbers
Just a note on how to 'read' and use the various ratios that you are calculating. For example:
Current Ratio for 2016 = Current Assets / Current Liabilities
= $1,946,802 / $1,328,960 = 1.5
This can be referred to as:
Percentage: Current Assets are 150% of Current Liabilities
-or-
Rate: Current Assets are 1.5 times as great as Current Liabilities
-or-
Proportion: The relationship of Current Assets to Current Liabilities is 1.5:1
One way to assist stakeholders in their analysis of the financial performance of a firm is to provide a methodology that allows for a meaningful insight into historic trends, future forecasts, and a comparison of performance between firms.
2.2: Profitability Ratios
If you've been in business a few years, you can look at your financial performance over that period and begin to see trends. For example, if sales have been increasing yearly or the cost of goods sold has been decreasing, you can negotiate quantity discounts or identify other suppliers. There is no doubt that you are interested in how profitable your company is. After all, you are in this business to make money. To truly understand how the different functions in your business impact profits, we'll consider a few important ratios: Operating Margin (OM), Profit Margin (PM), Return on Total Assets (ROTA), Basic Earning Power (BEP), and Return on Common Equity (ROE).
A business goal is to not only generate revenue from its products and services, but also to do so profitably. The analysis of profitability ratios allows us to evaluate how well the firm is doing in allocating resources to generate returns. Pay particular attention to the review of return on total assets (ROTA) and return on common equity (ROCE) which are of interest to shareholders.
2.3: Asset Management Ratios
Companies invest money in assets that will be used to support the business' goals and contribute to helping them generate revenue. A retail store invests in inventory to support their day-to-day sales to customers. Airlines invest in planes and hangars. Manufacturing companies have facilities and manufacturing equipment. A barber shop or hair salon invests in space and chairs. All of these businesses spent money to acquire needed assets. Simple so far.
The question that owners or shareholders must answer is, "have you invested enough, or too much?" Consider the retail stores. They try to forecast what products their customers will want, when they would like to buy them, and how much they are likely to purchase. If the store's forecast is accurate, they will realize a return on their investment in inventory. If they ordered too much inventory, it has cost the store money, they may need to take a mark-down on the sales, or they may have to write the excess inventory off, resulting in a loss to the business.
A key question for management is how good their decisions are to invest the firm's capital in various assets. Assets should be used to generate revenue for the company, and a return on the investment for shareholders. Watch this short video to see an explanation of the Asset Turnover Ratio.
Companies take in money from shareholders and invest in assets, like plants and equipment, that will be used to support the business goals. Now, we will learn about turnover ratios. Note that the higher the turns, the more efficiently the company managed its resources.
Inventory is a critical asset that requires consistent management by the firm. Too much inventory and the carrying costs will erode profitability, while too little inventory can impact production and customer satisfaction. There are a few methods for determining costs, and a review of the section on inventory costs will be helpful.
2.4: Liquidity Ratios
We've discussed profitability and asset management ratios as one area of review as we work to improve our firm's financial performance. Remember that ratios provide a way to level our view of performance without thinking in terms of dollars, market share, size, etc. They can level the playing field, especially when we consider outside firms in our analysis. We are going to consider liquidity ratios next. Liquidity is an evaluation of your ability to meet short-term debt obligations. Two of those ratios are the Current Ratio and the Quick Ratio, also known as the Acid-Test Ratio.
At its most basic level, liquidity represents how quickly a company can convert assets to cash. Consider the asset section of the balance sheet. The categories of assets are listed in order of their liquidity. That's why cash is the first asset listed. After you read, you should be able to explain the idea of liquidity, especially the current ratio (CR).
Suppliers and lenders are interested in the liquidity of the business, or how easy it is for the company to pay its short-term obligations. Watch this short video on the Current Ratio for a better understanding.
Certainly, every business needs to monitor its cash position and record all transactions where cash comes into the firm and goes out. The cash ratio is a way to evaluate this position and determine the amount of cash available to meet the firm's obligations. Take a look at this short review of the Cash Ratio.
Potential lenders are interested in determining the ability of a borrower to cover the interest charges on the amount of money that is loaned out. One way to measure this is to calculate the Times Interest Earned financial ratio. This short video demonstrates this calculation.
2.5: Debt Management Ratios
One of the fundamental decisions any business makes concerns the amount of capital that the business requires and where that capital will come from. There are two basic sources of capital: debt (money you borrow and must pay back) and equity (ownership).
In finance, we use the term leverage, which means that we are leveraging other people's money to use in our business. The alternative to leverage is to use all your own money. A certain amount of leverage is expected in business, but deciding how much to use is critical.
As our use of debt (leverage) increases:
- Return on Equity increases – the formula for ROE is net income (earnings) / owner's equity. So, the more of your own equity you use to generate earnings, the lower your return on equity. As you use less of your own money, the return on equity increases. That's the good news.
- Risk of returns increases – as you use more leverage (debt), the risk of returns increases. What's the risk? If you are using too much debt, there is a greater risk that you will default on your payments. This will result in the bankruptcy of the business, and the owner(s) will lose everything.
Most of us are pretty familiar with the concept of debt. We use debt to buy a car, finance our education, or buy a house. Businesses do the same, although the debt is much higher! Every business must answer: "do we have too little, or too much debt?" This text explains two critical ratios: total debt to total assets and the times-interest-earned ratio. After you read, you should be able to explain how debt impacts a firm's ability to perform.
We have already discussed the need for management to make decisions on investing capital to secure assets to generate a return for shareholders. The debt ratio is a way to determine how much of these assets have been financed using debt.
A business needs capital to finance the acquisition of assets, support ongoing operations, and invest in new opportunities. One of the critical financial decisions that a manager must make is to determine how much of the required capital will come from equity and how much will come from debt. One measure of this is the calculation of the Debt to Equity ratio. Watch this brief video on the Debt-to-Equity ratio to gain a better understanding.
2.6: Market Value Ratios
So far in this unit, we have evaluated several financial ratios that can be used to evaluate and assess the business' health. These ratios are like a "report card" on the business. They are a way to look at the decisions that the business has made on behalf of stakeholders and determine whether or not they were fiscally good decisions.
In this next section, we look at two important ratios that help us see the value created or lost for the firm. The price to earnings ratio looks at the selling price for a share of the firm's stock and measures it against the earnings, or profit generated, per share. If the market believes that the earnings are strong and there is an expectation that they will grow, they are willing to pay more for each share of stock.
The ratio of the market value of the firm (stocks) to its book value is another method that can be used to evaluate a company's financial performance. The book value of the firm can be found on the balance sheet and is recorded as owner's/shareholder's equity. If the market looks at the book value and determines that there has been a good investment in assets, the company is demonstrating a reasonable return on its investments, and there are good prospects for future growth. If the analysis is positive, then the share price will increase.
We can look to the market to assess how well a company is doing in creating value for shareholders. For publicly traded firms, the stock price is one indicator that we look at. You will learn how to calculate two ratios that reflect how the market views the firm's performance and future prospects.
2.7: The DuPont Equation
Earlier, we discussed the return on equity. The calculation for ROE is fairly straightforward: the net income generated by the business, divided by the equity required (book value of equity).
However, while the calculation is simple, the number of decisions that must be made, and the various operations within the business that can affect ROE will require some attention. The DuPont Equation calculates ROE by evaluating the contribution made by various key activities.
Earlier, you learned how to calculate the return on equity or the return generated for shareholders on their investments in the company. Improving the firm's ROE is important to management and shareholders, and it is worth learning what basic management actions affect this ratio. In this text, you will see how specific decisions can influence this ratio.
Managers strive to find ways to provide information to the various parts of the operation that will assist those decision-makers in focusing their efforts on activities that can produce the greatest returns for shareholders. One method is through the DuPont Equation described in this video.
Study Session
This study session is an excellent way to review what you've learned so far and is presented by the professor who created the course. Watch this as you work through the unit and prepare for the final exam.
We also recommend reviewing this Study Guide before taking the Unit 2 Assessment.
Unit 2 Assessment
- Receive a grade
Take this assessment to see how well you understood this unit.
- This assessment does not count towards your grade. It is just for practice!
- You will see the correct answers when you submit your answers. Use this to help you study for the final exam!
- You can take this assessment as many times as you want, whenever you want.