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Accrual Accounting and Financial Statements

Site: Saylor Academy
Course: BUS101: Introduction to Business
Book: Accrual Accounting and Financial Statements
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Date: Friday, April 19, 2024, 6:54 AM

Description

Read the following sections to learn how to evaluate your company's success based on the income statement and ratio analysis. Focus on the income statement, and work through the business scenario with the College Shop. This activity will give you a chance to determine this company actually made any money.

Table of contents

Accrual Accounting

Learning Objectives

  1. Understand the difference between cash-basis and accrual accounting.
  2. Understand the purpose of a statement of cash flows and describe its format.


In this section, we're going to take a step further into the world of accounting by examining the principles of accrual accounting. In our Stress-Buster illustration, we've assumed that all your transactions have been made in cash: You paid cash for your inputs (plastic treasure chests and toys) and for your other expenses, and your customers paid cash when they bought Stress-Buster packs. In the real world, of course, things are rarely that simple. In the following cases, timing plays a role in making and receiving payments:

  • Customers don't always pay in cash; they often buy something and pay later. When this happens, the seller is owed money and has an account receivable (it will receive something later).
  • Companies don't generally pay cash for materials and other expenses - they often pay later. If this is the case, the buyer has an account payable (it will pay something later).
  • Many companies manufacture or buy goods and hold them in inventory before selling them. Under these circumstances, they don't report payment for the goods until they've been sold.
  • Companies buy long-term assets (also called fixed assets), such as cars, buildings, and equipment, which they plan to use over an extended period (as a rule, for more than one year).


What Is Accrual Accounting?

In situations such as these, firms use accrual accounting: a system in which the accountant records a transaction when it occurs, without waiting until cash is paid out or received. Here are a few basic principles of accrual accounting:

  • A sale is recognized on the income statement when it takes place, regardless of when cash is collected.
  • An expense is recognized on the income statement when it's incurred, regardless of when payment is made.
  • An item manufactured for later sale or bought for resale becomes part of inventory and appears on the balance sheet until it's actually sold; at that point, it goes on the income statement under cost of goods sold.
  • A long-term asset that will be used for several years - for example, a vehicle, machine, or building - appears on the balance sheet. Its cost is spread over its useful life - the number of years that it will be used. Its annual allocated cost appears on the income statement as a depreciation expense.


Going to School on a New Business Idea

As we saw in our Stress-Buster illustration, it's easier to make sense of accounting concepts when you see some real - or at least realistic - numbers being put to realistic use. So let's now assume that you successfully operated the Stress-Buster Company while you were in college. Now fast-forward to graduation, and rather than work for someone else, you've decided to set up a more ambitious business - some kind of retail outlet - close to the college. During your four years in school, you noticed that there was no store near campus that met the wide range of students' specific needs. Thus the mission of your proposed retail business: to provide products that satisfy the specific needs of college students.

Figure 12.13 The College Shop



You've decided to call your store "The College Shop". Your product line will range from things needed to outfit a dorm room (linens, towels, small appliances, desks, rugs, dorm refrigerators) to things that are just plain fun and make student life more enjoyable (gift packages, posters, lava lamps, games, inflatable furniture, bean bag chairs, message boards, shower radios, backpacks). And of course you'll also sell the original Stress-Buster Fun Pack. You'll advertise to students and parents through the college newspaper and your own Web site.


Accrual-Basis Financial Statements

At this point, we're going to repeat pretty much the same process that we went through with your first business. First, we'll prepare a beginning balance sheet that reflects your new company's assets, liabilities, and owner's equity on your first day of business - January 1, 20X6. Next, we'll prepare an income statement and a statement of owner's equity. Finally, we'll create a balance sheet that reflects the company's financial state at the end of your first year of business.

Although the process should now be familiar, the details of our new statements will be more complex - after all, your transactions will be more complicated: You're going to sell and buy stuff on credit, maintain an inventory of goods to be sold, retain assets for use over an extended period of time, borrow money and pay interest on it, and deal with a variety of expenses that you didn't have before (rent, insurance, etc.).


Beginning Balance Sheet

Your new beginning balance sheet contains the same items as the one that you created for Stress-Buster - cash, loans, and owner's equity. But because you've already performed a broader range of transactions before you opened for business, you'll need some new categories:

  • You've bought furniture and equipment that you'll use over the next five years. You'll allocate the cost of these long-term assets by depreciating them. Because you estimate that this furniture and equipment will have a useful life of five years, you allocate one-fifth of the cost per year for five years.
  • You've purchased an inventory of goods for later resale.
  • You've taken out two types of loans: one that's current because it's payable in one year and one that's long term because it's due in five years.

Obviously, then, you need to prepare a more sophisticated balance sheet than the one you created for your first business. We call this new kind of balance sheet a classified balance sheet because it classifies assets and liabilities into separate categories.


Types of Assets

On a classified balance sheet, assets are listed in order of liquidity - how quickly they can be converted into cash. They're also broken down into two categories:

  1. Current assets - assets that you intend to convert into cash within a year
  2. Long-term assets - assets that you intend to hold for more than a year

Your current assets will be cash and inventory, and your long-term assets will be furniture and equipment. We'll take a closer look at the assets section of your beginning balance sheet, but it makes sense to analyze your liabilities first.


Types of Liabilities

Liabilities are grouped in much the same manner as assets:

  1. Current liabilities - liabilities that you'll pay off within one year
  2. Long-term liabilities - liabilities that don't become due for more than one year

Recall that your liabilities come from your two loans: one which is payable in a year and considered current, and one which is long term and due in five years.

Now we're ready to review your beginning balance sheet, which is shown in Figure 12.14 "Beginning Balance Sheet for The College Shop". Once again, your balance sheet balances: Your total assets of $275,000 equal your total liabilities plus owner's equity of $275,000.

Figure 12.14 Beginning Balance Sheet for The College Shop



Liabilities and Owner's Equity

Let's begin our analysis of your beginning balance sheet with the liabilities and owner's-equity sections. We're assuming that, thanks to a strong business plan, you've convinced a local bank to loan you a total of $125,000 - a short-term loan of $25,000 and a long-term loan of $100,000. Naturally, the bank charges you interest (which is the cost of borrowing money); your rate is 8 percent per year. In addition, you personally contributed $150,000 to the business (thanks to a trust fund that paid off when you turned 21).


Assets

Now let's turn to the assets section of your beginning balance sheet. What do you have to show for your $275,000 in liabilities and owner's equity? Of this amount, $50,000 is in cash - that is, money deposited in the company's checking and other bank accounts. You used another $75,000 to pay for inventory that you'll sell throughout the year. Finally, you spent $150,000 on several long-term assets, including a sign for the store, furniture, store displays, and computer equipment. You expect to use these assets for five years, at which point you'll probably replace them.


Income Statement

Finally, let's look at your income statement, which is shown in Figure 12.15 "Income Statement for The College Shop, Year Ended December 31". Like your College Shop balance sheet, your College Shop income statement is more complex than the one you prepared for Stress-Buster, and the amounts are much larger. In addition, the statement covers a full calendar year.

Figure 12.15 Income Statement for The College Shop, Year Ended December 31



Note, by the way, that the income statement that we prepared for The College Shop is designed for a merchandiser - a company that makes a profit by selling goods. How can you tell? Businesses that sell services (such as accounting firms or airlines) rather than merchandise don't have lines labeled cost of goods sold on their statements.

The format of this income statement also highlights the most important financial fact in running a merchandising company: you must sell goods at a profit (called gross profit) that is high enough to cover your operating costs, interest, and taxes. Your income statement, for example, shows that The College Shop generated $225,000 in gross profit through sales of goods. This amount is sufficient to cover your operating expense, interest, and taxes and still produce a net income of $30,000.


A Few Additional Expenses

Note that The College Shop income statement also lists a few expenses that the Stress-Buster didn't incur:

  • Depreciation expense. Recall that before opening for business, you purchased some long-term assets (store sign, displays, furniture, and equipment) for a total amount of $150,000. In estimating that you would use these assets for five years (your estimate of their useful lives), you spread the cost of $150,000 over five years. For each of these five years, then, your income statement will show $30,000 in depreciation expense ($150,000 ÷ 5 years = $30,000).
  • Interest expense. When you borrowed money from the bank, you agreed to pay interest at an annual rate of 8 percent. Your interest expense of $10,000 ($125,000 × 0.08) is a cost of financing your business and appears on your income statement after the subheading operating income.
  • Income taxes. Your company has to pay income taxes at a rate of 25 percent of net income before taxes. This amount of $10,000 ($40,000 × 25%) appears on your income statement after the subheading net income before income taxes. It's subtracted from income before income taxes before you arrive at your "bottom line," or net income.


Statement of Owner's Equity

Our next step is to prepare a statement of owner's equity, which is shown in Figure 12.16 "Statement of Owner's Equity for The College Shop". Note that the net income of $30,000 from the income statement was used to arrive at the year-end balance in owner's equity.

Figure 12.16 Statement of Owner's Equity for The College Shop



End-of-First-Year Balance Sheet

We'll conclude with your balance sheet for the end of your first year of operations, which is shown in Figure 12.17 "End-of-Year Balance Sheet for The College Shop". First, look at your assets. At year's end, you have a cash balance of $70,000 and inventory of $80,000. You also have an accounts receivable of $90,000 because many of your customers have bought goods on credit and will pay later. In addition, the balance sheet now shows two numbers for long-term assets: the original cost of these assets, $150,000, and an accumulated depreciation amount of $30,000, which reflects the amount that you've charged as depreciation expense since the purchase of the assets. The carrying value of these long-term assets is now $120,000 ($150,000 - $30,000), which is the difference between their original cost and the amount that they've been depreciated. Your total assets are thus $360,000.

Figure 12.17 End-of-Year Balance Sheet for The College Shop



The total of your liabilities of $180,000 plus owner's equity of $180,000 also equals $360,000. Your liabilities consist of a long-term loan of $100,000 (which is now due in four years) and accounts payable of $80,000 (money that you'll have to pay out later for purchases that you've made on credit). Your owner's equity (your investment in the business) totals $180,000 (the $150,000 you originally put in plus the $30,000 in first-year earnings that you retained in the business).


Statement of Cash Flows

Owners, investors, and creditors can learn a lot from your balance sheet and your income statement. Indeed, each tells its own story. The balance sheet tells what assets your company has now and where they came from. The income statement reports earned income on an accrual basis (recognizing revenues when earned and expenses as incurred regardless of when cash is received or paid). But the key to surviving in business is generating the cash you need to keep it up and running. It's not unusual to hear reports about companies with cash problems. Sometimes they arise because the products in which the firm has invested aren't selling as well as it had forecast. Maybe the company tied up too much money in a plant that's too big for its operations. Maybe it sold products to customers who can't pay. Maybe management just overspent. Whatever the reason, cash problems will hamper any business. Owners and other interested parties need a financial statement that helps them understand a company's cash flow.

The statement of cash flows tells you where your cash came from and where it went. It furnishes information about three categories of activities that cause cash either to come in (cash inflows) or to go out (cash outflows):

  1. Cash flows from operating activities come from the day-to-day operations of your main line of business.
  2. Cash flows from investing activities result from buying or selling long-term assets.
  3. Cash flows from financing activities result from obtaining or paying back funds used to finance your business.

A cash flow statement for The College Shop would look like the one in Figure 12.18 "Statement of Cash Flows for The College Shop". You generated $45,000 in cash from your company's operations (a cash inflow) and used $25,000 of this amount to pay off your short-term loan (a cash outflow). The net result was an increase in cash of $20,000. This $20,000 increase in cash agrees with the change in your cash during the year as it's reported in your balance sheets: You had an end-of-the-year cash balance of $70,000 and a beginning-of-the-year balance of $50,000 ($70,000 − $50,000 = $20,000). Because you didn't buy or sell any long-term assets during the year, your cash flow statement shows no cash flows from investing activities.

Figure 12.18 Statement of Cash Flows for The College Shop

Statement of Cash Flows for The College Shop


Key Takeaways

  • There are two different methods for reporting financial transactions:
    • Companies using cash-basis accounting recognize revenue as earned only when cash is received and recognize expenses as incurred only when cash is paid out.
    • Companies using accrual accounting recognize revenues when they're earned (regardless of when the cash is received) and expenses when they're incurred (regardless of when the cash is paid out).
  • An item manufactured for later sale or bought for resale appears on the balance sheet as an asset called inventory. When it's sold, it goes on the income statement as an expense under the category cost of goods sold.
  • The difference between sales and cost of goods sold is called gross profit.
  • A merchandising company's gross profit must be high enough to cover its operating costs, interest, and taxes.
  • An asset that will be used for several years (say, a truck) appears on the balance sheet as a long-term asset. Its cost is allocated over its useful life and appears on the income statement as a depreciation expense.
  • A classified balance sheet separates assets and liabilities into two categories - current and long-term:
    • Current assets include those that you intend to convert into cash within a year; long-term assets include those that you plan to hold for more than a year.
    • Current liabilities include those that you'll pay off within a year; long-term liabilities include those that do not become due for more than a year.
  • The statement of cash flows shows how much cash the business has coming in and going out.
  • The statement of cash flows furnishes information about three categories of activities that cause cash either to come in or to go out: operating activities, investing activities, and financing activities.


Exercises

  1. (AACSB) Analysis
    To earn money to pay some college expenses, you ran a lawn-mowing business during the summer. Before heading to college at the end of August, you wanted to find out how much money you earned for the summer. Fortunately, you kept good accounting records. During the summer, you charged customers a total of $5,000 for cutting lawns (which includes $500 still owed to you by one of your biggest customers). You paid out $1,000 for gasoline, lawn mower repairs, and other expenses, including $100 for a lawn mower tune-up that you haven't paid for yet. You decided to prepare an income statement to see how you did. Because you couldn't decide whether you should prepare a cash-basis statement or an accrual statement, you prepared both. What was your income under each approach? Which method (cash-basis or accrual) more accurately reflects the income that you earned during the summer? Why?

  2. (AACSB) Analysis
    Identify the categories used on a classified balance sheet to report assets and liabilities. How do you determine what goes into each category? Why would a banker considering a loan to your company want to know whether an asset or liability is current or long-term?

  3. (AACSB) Analysis
    You review a company's statement of cash flows and find that cash inflows from operations are $150,000, net outflows from investing are $80,000, and net inflows from financing are $60,000. Did the company's cash balance increase or decrease for the year? By what amount? What types of activities would you find under the category investing activities? Under financing activities? If you had access to the company's income statement and balance sheet, why would you be interested in reviewing its statement of cash flows? What additional information can you gather from the statement of cash flows?

Creative Commons License This text was adapted by Saylor Academy under a Creative Commons Attribution-NonCommercial-ShareAlike 3.0 License without attribution as requested by the work's original creator or licensor.

Financial Statement Analysis

Learning Objective

  1. Evaluate a company's performance using financial statements and ratio analysis.

Now that you know how financial statements are prepared, let's see how they're used to help owners, managers, investors, and creditors assess a firm's performance and financial strength. You can glean a wealth of information from financial statements, but first you need to learn a few basic principles for "unlocking" it.


The Comparative Income Statement

Let's fast-forward again and assume that your business - The College Shop - has just completed its second year of operations. After creating your second-year income statement, you decide to compare the numbers from this statement with those from your first statement. So you prepare the comparative income statement in Figure 12.19 "Comparative Income Statement for The College Shop", which shows income figures for year 2 and year 1 (accountants generally put numbers for the most recent year in the inside column).

Figure 12.19 Comparative Income Statement for The College Shop



Vertical Percentage Analysis

What does this statement tell us about your second year in business? Some things look good and some don't. Your sales went up from $500,000 to $600,000 (a 20 percent increase - not bad). But your profit was down - from $30,000 to $18,000 (a bad sign). As you stare at the statement, you're asking yourself the question: Why did my profit go down even though my sales went up? Does this result make sense? Is there some way of comparing two income statements that will give me a more helpful view of my company's financial health? One way is called vertical percentage analysis. It's useful because it reveals the relationship of each item on the income statement to a specified base - generally sales - by expressing each item as a percentage of that base.

Figure 12.20 "Comparative Income Statement Using Vertical Percentage Analysis" shows what comparative income statements look like when you use vertical percentage analysis showing each item as a percentage of sales. Let's see if this helps clarify things. What do you think accounted for the company's drop in income even though The College Shop sales went up?

Figure 12.20 Comparative Income Statement Using Vertical Percentage Analysis



The percentages help you to analyze changes in the income statement items over time, but it might be easier if you think of the percentages as pennies. In year 1, for example, for every $1.00 of sales, $0.55 went to pay for the goods that you sold, leaving $0.45 to cover your other costs and leave you a profit. Operating expenses (salaries, rent, advertising, and so forth) used up $0.35 of every $1.00 of sales, while interest and taxes took up $0.02 each. After you covered all your costs, you had $0.06 profit for every $1.00 of sales.


Asking the Right Questions

Now, compare these figures to those for year 2. Where is the major discrepancy? It's in Cost of goods sold. Instead of using $0.55 of every $1.00 of sales to buy the goods you sold, you used $0.64. As a result, you had $0.09 less ($0.64 – $0.55) to cover other costs. This is the major reason why you weren't as profitable in year 2 as you were in year 1: your Gross profit as a percentage of sales was lower in year 2 than it was in year 1. Though this information doesn't give you all the answers you'd like to have, it does, however, raise some interesting questions. Why was there a change in the relationship between Sales and Cost of goods sold? Did you have to pay more to buy goods for resale and, if so, were you unable to increase your selling price to cover the additional cost? Did you have to reduce prices to move goods that weren't selling well? (If your costs stay the same but your selling price goes down, you make less on each item sold.) Answers to these questions require further analysis, but at least you know what the useful questions are.


Ratio Analysis

Vertical percentage analysis helps you analyze relationships between items on your income statement. But how do you compare your financial results with those of other companies in your industry or with the industry overall? And what about your balance sheet? Are there relationships on this statement that also warrant investigation? Should you further examine any relationships between items on your income statement and items on your balance sheet? These issues can be explored by using ratio analysis, a technique for evaluating a company's financial performance.

First, remember that a ratio is just one number divided by another, with the result expressing the relationship between the two numbers. Let's say, for example, that you want to know the relationship between the cost of going to a movie and the cost of renting a DVD movie. You could make the following calculation:

\frac{\text{Cost of going to a movie}}{\text{Cost of renting a DVD}}  =  \dfrac{$8}{$4}  =2 (or 2 to 1)

Going to a movie costs two times as much as renting a DVD.

Ratio analysis is also used to assess a company's performance over time and to compare one company to similar companies or to the overall industry in which it operates. You don't learn much from just one ratio, or even a number of ratios covering the same period. Rather, the value in ratio analysis lies in looking at the trend of ratios over time and in comparing the ratios for several time periods with those of competitors and the industry as a whole. There are a number of different ways to categorize financial ratios. Here's just one set of categories:

  • Profit margin ratios tell you how much of each sales dollar is left after certain costs are covered.
  • Management efficiency ratios tell you how efficiently your assets are being managed.
  • Management effectiveness ratios tell you how effective management is at running the business and measure overall company performance.
  • Financial condition ratios help you assess a firm's financial strength.

Using each of these categories, we can find dozens of different ratios, but we'll focus on a few examples.


Profit Margin Ratios

We've already determined the two most common profit margin ratios - gross profit margin and net profit margin - when we used vertical percentage analysis to determine the relationship to Sales of each item on The College Shop's income statement. We were examining gross profit when we found that Gross profit for year 1 was 45 percent of Sales and that, in year 2, it had declined to 36 percent. We can express the same relationships as ratios:

\text{Gross profit margin}= \frac{\text{Gross profit}}{\text{Sales}}

Year 1:  \dfrac{$225,000}{$500,000} = 45\%

Year 2:  \dfrac{$213,000}{$600,000} = 36\% (rounded)

We can see that gross profit margin declined (a situation that, as we learned earlier, probably isn't good). But how can you tell whether your gross profit margin for year 2 is appropriate for your company? For one thing, we can use it to compare The College Shop's results to those of its industry. When we make this comparison, we find that the specialized retail industry (in which your company operates) reports an average gross profit margin of 41 percent. For year 1, therefore, we had a higher ratio than the industry; in year 2, though we had a lower ratio, we were still in the proverbial ballpark.

It's worthwhile to track gross profit margin, whether for your company or for companies that you might invest in or lend money to. In particular, you'll gain some insight into changes that might be occurring in a business. For instance, what if you discover that a firm's gross profit margin has declined? Is it because it's costing more for the company to buy or make its products, or is it because its competition is forcing it to lower its prices?


Net Profit Margin

Net profit is the money that a company earns after paying all its expenses, including the costs of buying or making its products, running its operations, and paying interest and taxes. Look again at Figure 12.20 "Comparative Income Statement Using Vertical Percentage Analysis". Using vertical percentage analysis, we found that for The College Shop, net profit as a percentage of sales was 6 percent in year 1 but declined to 3 percent in year 2. Expressed as ratios, these relationships would look like this:

\text{Gross profit margin}= \frac{\text{Gross profit}}{\text{Sales}}

Year 1 :  \dfrac{$30,000}{$500,000} =6\%

Year 2:  \dfrac{$18,000}{$600,000} =3\% (rounded)

You realize that a declining net profit margin isn't good, but you wonder how you compare with your industry. A little research informs you that average net profit margin in the industry is 7 percent. You performed nearly as well as the industry in year 1 but fell further from your target in year 2. What does this information tell you? That a goal for year 3 should be trying to increase your net profit margin.


Management Efficiency Ratios

These ratios reveal the way in which assets (shown on the balance sheet) are being used to generate income (shown on the income statement). To compute this group of ratios, therefore, you must look at both statements. In Figure 12.19 "Comparative Income Statement for The College Shop", we produced a comparative income statement for The College Shop's first two years. Figure 12.21 "Comparative Balance Sheet for The College Shop" is a comparative balance sheet for the same period.

Figure 12.21 Comparative Balance Sheet for The College Shop



As you can see from Figure 12.21 "Comparative Balance Sheet for The College Shop", running even a small business entails a substantial investment in assets. Even if you rent space, for example, you must still buy furniture and equipment. To have products on hand to sell, you need to tie up money in inventory. And once you've sold them, you may have money tied up in accounts receivable while you're waiting for customers to pay you. Thus, investing in assets is a normal part of doing business. Managing your assets efficiently is a basic requirement of business success. Let's look at a representative management efficiency ratio. The inventory turnover ratio measures a firm's efficiency in selling its inventory.

You don't make money from unsold inventory. You make money when you sell inventory, and the faster you sell it, the more money you make. To determine how fast your inventory is "turning," you need to examine the relationship between sales and inventory. Another way to calculate inventory turnover is to divide Cost of goods sold by inventory (rather than dividing Sales by inventory). We don't discuss this method here because the available industry data used for comparative purposes reflect Sales rather than Cost of goods sold. Let's see how well The College Shop is doing in moving its inventory:

\text{Inventory turnover} = \dfrac{\text{Sales}}{\text{Inventory}}

Year 1 :  \dfrac{$500,000}{$80,000}  = 6.25 times

Year 2 : \dfrac{$600,000}{$110,000} = 5.45 times

For year 1, The College Shop converted its inventory into sales 6.25 times: on average, your entire inventory was sold and replaced 6.25 times during the year. For year 2, however, inventory was converted into sales only 5.45 times. The industry did better, averaging turnover of 6.58 times. Before we discuss possible reasons for the drop in The College Shop's inventory turnover ratio, let's look at an alternative way of describing this ratio. Simply convert this ratio into the average number of days that you held an item in inventory. In other words, divide 365 days by your turnover ratio:

Year 1 : 365 / 6.25= 58 days

Year 2 : 365 / 5.45= 67 days

Industry: 365 / 6.58 = 55 days

The College Shop was doing fine in year 1 (relative to the industry), but something happened in year 2 to break your stride. Holding onto inventory for an extra 9 days (67 days for year 2 minus 58 days for year 1) is costly. What happened? Perhaps inventory levels were too high because you overstocked. It's good to have products available for customers, but stocking too much inventory is costly. Maybe some of your inventory takes a long time to sell because it's not as appealing to customers as you thought. If this is the case, you may have a problem for the next year because you'll have to cut prices (and reduce profitability) in order to sell the same slow-moving inventory.

Optimal inventory turnover varies by industry and even by company. A supermarket, for example, will have a high inventory turnover because many of its products are perishable and because it makes money by selling a high volume of goods (making only pennies on each sale). A company that builds expensive sailboats, by contrast, will have a low inventory turnover: it sells few boats but makes a hefty profit on each one. Some companies, such as Dell Computer, are known for keeping extremely low inventory levels. Because computers are made to order, Dell maintains only minimal inventory and so enjoys a very high ratio of sales to inventory.


Management Effectiveness Ratios

"It takes money to make money," goes the old saying, and it's true. Even the smallest business uses money to grow. Management effectiveness ratios address the question: how well is a company performing with the money that owners and others have invested in it?

These ratios are widely regarded as the best measure of corporate performance. You can give a firm high marks for posting good profit margins or for turning over its inventory quickly, but the final grade depends on how much profit it generates with the money invested by owners and creditors. Or, to put it another way, that grade depends on the answer to the question: is the company making a sufficiently high return on its assets?

Like management efficiency ratios, management effectiveness ratios examine the relationship between items on the income statement and items on the balance sheet. From the income statement you always need to know the "bottom line" - net profit. The information that you need from the balance sheet varies according to the ratio that you're trying to calculate, but it's always some measure of the amount of capital used in the business. Common measures of capital investment include total equity, total assets, or a combination of equity and long-term debt. Let's see whether The College Shop made the grade. Did it generate a reasonable profit on the assets invested in the company?

\text{Return on assets} = \dfrac{\text{Net Profit}}{\text{Total assets}}

Year 1 :  \dfrac{$30,000}{$360,000}  = 8.3\%

Year 2:  \dfrac{$18,000}{$368,000}  = 4.9\%

Because the industry average return on assets is 7.9 percent, The College Shop gets an "A" for its first year's performance. It slipped in the second year but is probably still in the "B" range.


Financial Condition Ratios

Financial condition ratios measure the financial strength of a company. They assess its ability to pay its current bills; and to determine whether its debt load is reasonable, they examine the proportion of its debt to its equity.


Current Ratio

Let's look first at a company's ability to meet current obligations. The ratio that evaluates this ability is called the current ratio, which examines the relationship between a company's current assets and its current liabilities. The balance of The College Shop's current assets and current liabilities appears on the comparative balance sheet in Figure 12.21 "Comparative Balance Sheet for The College Shop". By calculating its current ratio, we'll see whether the business is likely to have trouble paying its current liabilities.

\text{Current ratio} = \dfrac{\text{Current assets}}{\text{Current liabilities}}

Year 1:  \dfrac{$240,000}{$80,000}  = 3 to 1

Year 2:  \dfrac{$278,000}{$70,000}  = 4 to 1

The College Shop's current ratio indicates that, in year 1, the company had $3.00 in current assets for every $1.00 of current liabilities. In the second year, the company had $4.00 of current assets for every $1.00 of current liabilities. The average current ratio for the industry is 2.42. The good news is that The College Shop should have no trouble meeting its current obligations. The bad news is that, ironically, its current ratio might be too high: companies should have enough liquid assets on hand to meet current obligations, but not too many. Holding excess cash can be costly when there are alternative uses for it, such as paying down loans or buying assets that can generate revenue. Perhaps The College Shop should reduce its current assets by using some of its cash to pay a portion of its debt.


Debt-to-Equity Ratio


Now let's look at the way The College Shop is financed. The debt-to-equity ratio (also called debt ratio) examines the riskiness of a company's capital structure - the relationship between funds acquired from creditors (debt) and funds invested by owners (equity):

\text{Total debt to equity} =  \dfrac{\text{Total liabilities}}{\text{Total equity}}

Year 1:  \dfrac{$180,000}{$180,000}  = 1

Year 2:  \dfrac{$170,000}{$198,000}  = 0.86

In year 1, the ratio of 1 indicates that The College Shop has an equal amount of equity and debt (for every $1.00 of equity, it has $1.00 of debt). But this proportion changes in year 2, when the company has more equity than debt: for every $1.00 of equity, it now has $0.85 in debt. How does this ratio compare to that of the industry? The College Shop, it seems, is heavy on the debt side: the industry average of 0.49 indicates that, on average, companies in the industry have only $0.49 of debt for every $1.00 of equity. Its high debt-to-equity ratio might make it hard for The College Shop to borrow more money in the future.

How much difference can this problem make to a business when it needs funding? Consider the following example. Say that you have two friends, both of whom want to borrow money from you. You've decided to loan money to only one of them. Both are equally responsible, but you happen to know that one has only $100 in the bank and owes $1,000. The other also has $100 in the bank but owes only $50. To which one would you lend money? The first has a debt-to-equity ratio of 10 ($1,000 debt to $100 equity) and the second a ratio of 0.50 ($50 debt to $100 equity). You - like a banker - will probably lend money to the friend with the better debt-to-equity ratio, even though the other one needs the money more.

It's possible, however, for a company to make its interest payments comfortably even though it has a high debt-to-equity ratio. Thus, it's helpful to compute the interest coverage ratio, which measures the number of times that a firm's operating income can cover its interest expense. We compute this ratio by examining the relationship between interest expense and operating income. A high-interest coverage ratio indicates that a company can easily make its interest payments; a low ratio suggests trouble. Here are the interest coverage ratios for The College Shop:

\text{Interest coverage} =  \dfrac{\text{Operating income}}{\text{Interest expense}}

Year 1 :  \dfrac{$50,000}{$10,000}   = 5 times

Year 2 :  \dfrac{$33,000}{$10,000}   = 3.3 times

As the company's income went down, so did its interest coverage (which isn't good). But the real problem surfaces when you compare the firm's interest coverage with that of its industry, which is much higher - 14.5. This figure means that companies in the industry have, on average, $14.50 in operating income to cover each $1.00 of interest that it must pay. Unfortunately, The College Shop has only $3.30.

Again, consider an example on a more personal level. Let's say that following graduation, you have a regular interest payment due on some student loans. If you get a fairly low-paying job and your income is only 3 times the amount of your interest payment, you'll have trouble making your payments. If, on the other hand, you land a great job and your income is 15 times the amount of your interest payments, you can cover them much more comfortably.


What Have the Ratios Told Us?

So, what have we learned about the performance of The College Shop? What do we foresee for the company in the future? To answer this question, let's identify some of the basic things that every businessperson needs to do in order to achieve success:

  • Make a good profit on each item you sell.
  • Move inventory: the faster you sell inventory, the more money you make.
  • Provide yourself and others with a good return on investment: make investing in your business worthwhile.
  • Watch your cash: if you run out of cash and can't pay your bills, you're out of business.

The ratios that we've computed in this section allow us to evaluate The College Shop on each of these dimensions, and here's what we found:

  • Profit margin ratios (gross profit margin and net profit margin) indicate that the company makes a reasonable profit on its sales, though profitability is declining.
  • One management efficiency ratio (inventory turnover) suggests that inventory is moving quickly, though the rate of turnover is slowing.
  • One management effectiveness ratio (return on assets) tells us that the company generated an excellent return on its assets in its first year and a good return in its second year. But again, the trend is downward.
  • Financial condition ratios (current ratio, total debt-to-equity, and interest coverage) paint a picture of a company heading for financial trouble. While meeting current bills is not presently a problem, the company has too much debt and isn't earning enough money to make its interest payments comfortably. Moreover, repayment of a big loan in a few years will put a cash strain on the company.

What, then, does the future hold for The College Shop? It depends. If the company returns to year-1 levels of gross margin (when it made $0.45 on each $1.00 of sales), and if it can increase its sales volume, it might generate enough cash to reduce its long-term debt. But if the second-year decline in profitability continues, it will run into financial difficulty in the next few years. It could even be forced out of business when the bank demands payment on its long-term loan.


Key Takeaways

  • Two common techniques for evaluating a company's financial performance are vertical percentage analysis and ratio analysis.
  • Vertical percentage analysis reveals the relationship of each item on the income statement to a specified base - generally sales - by expressing each item as a percentage of that base.
  • The percentages help you to analyze changes in the income statement items over time.
  • Ratios show the relationship of one number to another number - for example, gross profit to sales or net profit to total assets.
  • Ratio analysis is used to assess a company's performance and financial condition over time and to compare one company to similar companies or to an overall industry.
  • Ratios can be divided into four categories: profit margin ratios, management efficiency ratios, management effectiveness ratios, and debt-to-equity ratios.

  • Profit margin ratios show how much of each sales dollar is left after certain costs are covered.
    • Two common profitability ratios are the gross profit margin (which shows how much of each sales dollar remains after paying for the goods sold) and net profit margin (which shows how much of each sales dollar remains after all costs are covered).

  • Management efficiency ratios tell you how efficiently your assets are being managed.
    • One of the ratios in this category - inventory turnover - measures a firm's efficiency in selling its inventory by looking at the relationship between sales and inventory.

  • Management effectiveness ratios tell you how effective management is at running the business and measure overall company performance by comparing net profit to some measure of the amount of capital used in the business.
    • The return on assets ratio, for instance, compares net profit to total assets to determine whether the company generated a reasonable profit on the assets invested in it.
    • Financial condition ratios are used to assess a firm's financial strength.
  • The current ratio (which compares current assets to current liabilities) provides a measure of a company's ability to meet current liabilities.
  • The debt-to-equity ratio examines the riskiness of a company's capital structure by looking at the amount of debt that it has relative to total equity.
  • Finally, the interest coverage ratio (which measures the number of times a firm's operating income can cover its interest expense) assesses a company's ability to make interest payments on outstanding debt.


Exercises

  1. (AACSB) Analysis

    The accountant for my company just ran into my office and told me that our gross profit margin increased while our net profit margin decreased. She also reported that while our debt-to-equity ratio increased, our interest coverage ratio decreased. She was puzzled by the apparent inconsistencies. Help her out by providing possible explanations for the behavior of these ratios.

  2. Which company is more likely to have the higher inventory turnover ratio: a grocery store or an automobile manufacturer? Give an explanation for your answer.