Analyzing Financial Statements For Profitability Liquidity and Solvency

Analyzing Financial
Statements for Profitability,

Liquidity, and Solvency
Chapter 8
© 2005 Accounting 1/e, Terrell/Terrell 8-1

Learning Objectives 1 and 2
Distinguish among profitability,

liquidity, and solvency.
Calculate financial ratios

designed to measure a
company’s profitability,
liquidity, and solvency.
Introduction
Financial statements analysis is the process

of looking beyond the face of the financial
statements to gain additional insight
into a company’s financial health.
Ratio analysis is a technique for analyzing

the relationship between two items from a
company’s financial statements for a given period.

Elevation Sports, Inc.
Balance Sheet
May 31, 2004
Assets:
Current assets
Cash $128,834
Accounts receivable $9,900
Less: Allowance for doubtful accounts – 450 9,450
Merchandise inventory 4,397
Raw materials inventory 2,315
Work-in-process inventory 14,864
Finished goods inventory 13,634
Supplies inventory 593
Prepaid rent 12,000
Prepaid insurance 5,000
Total current assets $190,637

Balance Sheet
May 31, 2004
Property, plant, and equipment

Administrative equipment $ 5,100
Selling furniture and fixtures 8,400
Production equipment 89,600 $103,100
Less: Accumulated depreciation – 17,800
Total property, plant, and equipment $ 85,300
Intangible assets
Patents $ 10,083
Copyrights 570
Trademarks 1,425
Total intangible assets $ 12,078
Total assets $288,015

Balance Sheet
May 31, 2004
Liabilities and stockholders’ equity:
Current liabilities
Accounts payable $ 6,942
Other accounts payable 11,812
Interest payable 6,000
Payroll taxes payable 1,400
Sales taxes payable 560
Income taxes payable 42,120
Current portion of long-term note payable 15,000
Total current liabilities $ 83,834
Long-term liabilities:
Note payable – Vail National Bank $ 60,000
Less: Current portion 15,000
Total long-term liabilities 45,000
Total liabilities $128,834
Balance Sheet
May 31, 2004
Stockholders’ equity
Paid-in capital:
Common stock, $10 par value,
100,000 shares authorized, 4,000
shares issued and outstanding $ 60,000
Paid-in capital in excess of par
– common stock 40,000
Total paid-in capital $100,000
Retained earnings 59,181
Total stockholders’ equity 159,181
Total liabilities and stockholders’ equity $288,015

Income Statement
For the Year Ended May 31, 2004
Net sales $527,146
Cost of goods sold 295,834
Gross profit $231,312
Selling expenses $48,334
Administrative expenses 72,189
Total operating expenses 120,523
Operating income $110,789
Other revenues and expenses:
Interest revenue $ 512
Interest expense (6,000)
Total other revenues and expenses (5,488)
Income before income taxes $105,301
Income taxes 42,120
Net income $ 63,181
Earnings per share $ 15.79
Profitability Ratios
Profitability is the ease with which

a company generates income.
Profitability ratios measure a firm’s

past performance and help predict
its future profitability level.

This ratio measures how efficiently the

company uses its assets to produce profits.
Return on assets =
Net income before taxes ÷ Total assets
$105,301 ÷ $288,015 = 36.56%
© 2005 Accounting 1/e, Terrell/Terrell 8 - 10

This ratio measures the percentage of

income before income taxes produced
by a given level of revenue.
Profit margin before income tax =

Net income before taxes ÷ Sales
$105,301 ÷ $527,146 = 19.98%

This ratio calculates the amount of sales

produced for a given level of assets used.
Total asset turnover =

Sales ÷ Total assets
$527,146 ÷ $288,015 = 1.83 times

Return on Profit margin Total asset

= ×
assets before income tax turnover
Net income Net income

Sales ÷
before taxes = before taxes ×
Total assets
÷ Total assets ÷ Sales

This ratio measures the amount of after-tax

net income generated by a dollar of sales.
Profit margin after income tax =

Net income after taxes ÷ Sales
$63,181 ÷ $527,146 = 11.98%

This ratio indicates how much after-tax income

was generated for a given level of equity.
Return on equity after taxes =

Net income after taxes ÷ Stockholders’ equity
$63,181 ÷ $159,181= 38.69%

This ratio calculates how much before-tax income

was generated for a given level of equity.
Return on equity before taxes =

(Net income after taxes + Income taxes)
÷ Stockholders’ equity
$105,301 ÷ $159,181= 66.15%

Liquidity Ratios
An asset’s liquidity describes the ease

with which it can be converted to cash.
Liquidity ratios evaluate a firm’s ability

to generate sufficient cash to
meet its short-term obligations.

Liquidity Ratios
This ratio measures the company’s ability to

meet its current liabilities with current assets.
Current ratio =
Current assets ÷ Current liabilities
$190,637 ÷ $83,834 = 2.27 to 1

Liquidity Ratios
This ratio is a stringent test of liquidity

that compares highly liquid current
assets to current liabilities.
Acid-test ratio = (Cash + Receivables

+ Trading securities) ÷ Current liabilities
($128,384 + $9,450 + $0) ÷ $83,834= 1.64 to 1

Liquidity Ratios
This ratio indicates the level of sales

generated for a given level of working capital.
Net sales to working capital = Sales ÷

(Current assets – Current liabilities)
$527,146 ÷ ($190,637 – $83,834) = 4.94 times

Liquidity Ratios
It measures how quickly a company

collects its accounts receivable.
Accounts receivable turnover =

Net credit sales ÷ Accounts receivable
Net credit sales = $151,650 – $2,426 = $149,224

Liquidity Ratios
Receivable turnover =
$149,224 ÷ $9,450 = 15.79 times
Average collection period =

365 ÷ 15.79 = 23.27 days

Liquidity Ratios
This ratio indicates the number of times

total merchandise inventory is purchased
(or finished goods inventory is produced)
and sold during a period.
Inventory turnover =
Cost of sales ÷ Inventory

Liquidity Ratios
Inventory turnover =
$295,834 ÷ ($4,397 + $13,634) = 16.41 times
Average number of days

Elevation Sports, Inc., holds its inventory
= 365 ÷ 16.41 = 22.24 days

Solvency Ratios
Solvency is a company’s ability to meet the

obligations created by its long-term debt.
Solvency ratios are of most interest to

stockholders, long-term creditors,
and company management.

Solvency Ratios
It measures what proportion of a

company’s assets is financed by debt.
Assets = Liabilities + Owners’ equity

100% = Some % + Some %

Solvency Ratios
Total liabilities ÷ Total assets
$128,834 ÷ $288,015 = 44.73%

Solvency Ratios
This ratio is also called the

times-interest-earned ratio.
It indicates a company’s ability to

make its periodic interest payments.

Solvency Ratios
Coverage ratio =
Earnings before interest expense
and income taxes ÷ Interest expense
($105,301 + $6,000) ÷ $6,000 = 18.55 times

Learning Objective 3
Locate industry averages.

Industry Averages
This chapter emphasizes the Almanac of

Business and Industrial Financial Ratios.
The Almanac includes all

companies, public and private.
Information provided in the Almanac

for each industry is four pages.
It consists of two tables.

Industry Averages
Table I provides an analysis of all

companies in the particular industry,
regardless of whether they had
any net income for the year.
Table II provides the same information

items as Table I, but it considers
only companies that showed
a net income for the year.
Evaluate a company’s ratios

using a comparison to
industry averages.

Comparison of Elevation Sports,
Inc., to Industry Averages
Industry
Elevation Total with Assets
Ratio Sports, Inc. Industry $250-$500,000
Return on assets 36.6% 10.1% 16.1%

Profit margin before income taxes 20.0% 4.2% 6.1%
Total asset turnover 1.8 1.9 2.3
Profit margin after income tax 12.0% 3.4% 5.7%
Return on equity after income taxes 39.7% 19.3% 40.5%
Return on equity before income taxes 43.5% 23.9% 43.1%
Current ratio 2.3 1.6 1.9
Quick ratio 1.7 0.4 0.5
Net sales to working capital 4.9 7.3 5.9
Receivables turnover 15.8 28.6 31.7
Inventory turnover 16.4 2.5 2.1
Debt ratio 44.7% 65.8% 68.2%
Coverage ratio 18.6 5.3 6.7
Company Analysis
Compare ratios to the industry averages.
Look for company trends.
Consider the industry environment.
Draw conclusions.

Use ratio values from

consecutive time periods
to evaluate the profitability,
liquidity, and solvency
of a business.

Trend Analysis of
Selected Ratios
Ratio 2002 2001 2000 1996
Return on assets 137.4 150.4 153.7 100.0
Profit margin before taxes 142.5 141.3 150.1 100.0
Total asset turnover 96.4 106.4 102.4 100.0
Profit margin after taxes 147.5 146.3 155.4 100.0
Return on equity after taxes 137.9 145.1 158.3 100.0
Return on equity before taxes 136.7 144.2 156.8 100.0
Current ratio 91.7 95.4 84.0 100.0
Quick ratio 515.8 69.3 131.4 100.0
Net sales to working capital 126.5 140.3 147.7 100.0
Receivables turnover 0 0 0 0
Inventory turnover 144.5 135.3 129.0 100.0
Debt ratio 94.6 87.1 99.2 100.0
Total liabilities to net worth 91.7 81.2 98.7 100.0
Draw conclusions about the

credit-worthiness and
investment-attractiveness
of a company.

Draw Conclusions
The evaluation process by nature

depends upon individual perception.
1. Family Dollar Stores, Inc., is an industry

leader in profitability and solvency.
2. Family Dollar has improved the

distribution element of its supply chain.

Draw Conclusions
3. Part of the company profitability and

liquidity will depend upon its increasing
the inventory turnover ratio.
4. If we choose to invest in a general

merchandise discounter, Family Dollar
Stores, Inc., might be one to consider.

State the limitations

of ratio analysis.

Limitations of Ratio Analysis
1. Attempting to predict the future using past

results depends upon the predictive
value of the information used.
2. The financial statements used to compute

the ratios are based on historical cost.
3. Figures from the balance sheet used to

calculate the ratios are year-end numbers.
Limitations of Ratio Analysis
4. Industry peculiarities create difficulty

in comparing the ratios of a company
in one industry with those of a
company in another industry.
5. Lack of uniformity concerning what is

to be included in the numerators and
denominators make comparisons
extremely difficult.
End of Chapter 8

Analyzing Financial Statements For Profitability Liquidity and Solvency

Transféré par

Informations du document

Titre original

Copyright

Formats disponibles

Partager ce document

Partager ou intégrer le document

Options de partage

Avez-vous trouvé ce document utile ?

Ce contenu est-il inapproprié ?

Droits d'auteur :

Formats disponibles

Analyzing Financial Statements For Profitability Liquidity and Solvency

Transféré par

Droits d'auteur :

Formats disponibles

Analyzing Financial

Statements for Profitability,

© 2005 Accounting 1/e, Terrell/Terrell 8-1

Distinguish among profitability,

Calculate financial ratios

Financial statements analysis is the process

Ratio analysis is a technique for analyzing

© 2005 Accounting 1/e, Terrell/Terrell 8-3

© 2005 Accounting 1/e, Terrell/Terrell 8-4

Property, plant, and equipment

© 2005 Accounting 1/e, Terrell/Terrell 8-5

© 2005 Accounting 1/e, Terrell/Terrell 8-7

Profitability is the ease with which

Profitability ratios measure a firm’s

© 2005 Accounting 1/e, Terrell/Terrell 8-9

This ratio measures how efficiently the

$105,301 ÷ $288,015 = 36.56%

© 2005 Accounting 1/e, Terrell/Terrell 8 - 10

This ratio measures the percentage of

Profit margin before income tax =

$105,301 ÷ $527,146 = 19.98%

This ratio calculates the amount of sales

Total asset turnover =

$527,146 ÷ $288,015 = 1.83 times

© 2005 Accounting 1/e, Terrell/Terrell 8 - 12

Return on Profit margin Total asset

Net income Net income

© 2005 Accounting 1/e, Terrell/Terrell 8 - 13

This ratio measures the amount of after-tax

Profit margin after income tax =

$63,181 ÷ $527,146 = 11.98%

© 2005 Accounting 1/e, Terrell/Terrell 8 - 14

This ratio indicates how much after-tax income

Return on equity after taxes =

$63,181 ÷ $159,181= 38.69%

© 2005 Accounting 1/e, Terrell/Terrell 8 - 15

This ratio calculates how much before-tax income

Return on equity before taxes =

$105,301 ÷ $159,181= 66.15%

An asset’s liquidity describes the ease

Liquidity ratios evaluate a firm’s ability

© 2005 Accounting 1/e, Terrell/Terrell 8 - 17

This ratio measures the company’s ability to

$190,637 ÷ $83,834 = 2.27 to 1

© 2005 Accounting 1/e, Terrell/Terrell 8 - 18

This ratio is a stringent test of liquidity

Acid-test ratio = (Cash + Receivables

($128,384 + $9,450 + $0) ÷ $83,834= 1.64 to 1

This ratio indicates the level of sales

Net sales to working capital = Sales ÷

$527,146 ÷ ($190,637 – $83,834) = 4.94 times

© 2005 Accounting 1/e, Terrell/Terrell 8 - 20

It measures how quickly a company

Accounts receivable turnover =

Net credit sales = $151,650 – $2,426 = $149,224

© 2005 Accounting 1/e, Terrell/Terrell 8 - 21

Average collection period =

© 2005 Accounting 1/e, Terrell/Terrell 8 - 22

This ratio indicates the number of times

© 2005 Accounting 1/e, Terrell/Terrell 8 - 23

Average number of days

© 2005 Accounting 1/e, Terrell/Terrell 8 - 24

Solvency is a company’s ability to meet the