Module 4 – Analyzing Financial Statements (I) Copy

(This video chapter begins at 03:36 and ends at 04:55. Click on the blue dot at the 03:36 timestamp to play the video for this module.)

Analyzing Financial Statements (I)

While a financial statement reports the financial status of the business, it does not automatically give the condition or financial health of the business. Ratios are calculations that help to simplify the many numbers on the various financial statements into a number that is easier to understand. Understanding the various ratios that can be calculated will help you examine and analyze financial statements, giving a clear picture of the financial health of the business.

Our focus quote for this module:

“Rule No. 1: Never lose money. Rule No. 2: Never forget rule No. 1.” – Warren Buffett

This module discusses five basic ratios that will help you analyze the financial statements of your organization. The following are the topics discussed in this module:

Income ratios
Profitability ratios
Liquidity ratios
Working capital ratios
Bankruptcy ratios

Understanding the income ratio is our first topic of discussion. Let us learn how to calculate and interpret this ratio.

Income Ratios

Income ratios help to determine the level of income to various factors like wages, assets, etc.

Here are some income ratio calculations and their uses:

Ratio Calculation	Formula	Result
Net Income Increases to Pay Increases	Net Income Increases to Pay Increases = change in net income / change in salaries, wages and benefits	Shows when net income is increasing faster than wages (in dollar terms).
Net Income per Employee	Profits per Employee (Net Income per Employee) = net income / number of employees	Shows the average profit generated per person employed in the company.
Net Income to Assets	Net Income to Assets = net profit before taxes / total assets.	This ratio provides a way for evaluating the efficiency of financial management of the average dollar invested in the firm’s assets, and determines if the dollar came from investors or creditors.
Non-Operating Income to Net Income	Non-operating Income to Net Income = non-operating income / net income	Increasing ratios may mean that the business is moving away from its core business.
Operating Income to Wages and Salaries	Operating Income to Wages and Salaries = operating income / (salaries + wages + benefits)	This ratio shows the relationship between operating income and amount of wages and salaries paid.

Profitability Ratios

Profitability ratios help to determine how well the company is doing in terms of the profits generated by the company. There are many ratios. Here is a list of common profitability ratios.

Ratio Calculation	Formula	Result
Cash Debt Coverage Ratio	Cash Debt Coverage = (cash flow from operations – dividends) / total debt.	This ratio shows the percent of debt that current cash flow can retire.
Cash Return on Assets	Cash Return on Assets (excluding interest) = (cash flows from operations before interest and taxes) / total assets.	A higher cash return on assets ratio indicates a greater cash return.
Cash Return to Shareholders	Cash Return to Shareholders = cash flow from operations / shareholders’ equity	The cash return to shareholders ratio indicates a return earned by shareholders.

Ratio Calculation	Formula	Result
Cash Debt Coverage Ratio	Cash Debt Coverage = (cash flow from operations – dividends) / total debt.	This ratio shows the percent of debt that current cash flow can retire.
Cash Return on Assets	Cash Return on Assets (excluding interest) = (cash flows from operations before interest and taxes) / total assets.	A higher cash return on assets ratio indicates a greater cash return.
Cash Return to Shareholders	Cash Return to Shareholders = cash flow from operations / shareholders’ equity	The cash return to shareholders ratio indicates a return earned by shareholders.

Liquidity Ratios

Liquidity ratios determine the ability of an organization to meet its short-term financial debt in a timely manner. Here are some liquidity ratios you may find useful:

Ratio Calculation	Formula	Result
Acid Test Ratio (Quick Ratio)	Acid Test Ratio = (cash + marketable securities) / current liabilities	The acid test ratio measures the immediate amount of cash available to satisfy short term debt
Accounts Payable Turnover Ratio	Accounts Payable Turnover Ratio = total supplier purchases / average accounts payable	The accounts payable turnover ratio shows the number of times that accounts payable are paid throughout the year.
Cash Debt Coverage	Cash Debt Coverage = (cash flow from operations – dividends) / total debt	The cash debt coverage ratio shows the percent of debt that current cash flow can retire
Debt Income Ratio	Debt Income Ratio = total debt / net income	The debt income ratio shows the amount of total debt in proportion to net income
Quick Assets	Quick Assets = cash + marketable securities + accounts receivable	Quick assets are the amount of assets that can be quickly converted to cash

Working Capital Ratios

Working capital is the organizations ability to use capital after their debt has been satisfied. Here are the formulas for calculating working capital.

Ratio Calculation	Formula	Result
Working Capital	Working Capital = current assets – current liabilities	This calculation shows the liquid reserve available to satisfy contingencies and uncertainties
Working Capital ratio	Working Capital Ratio = current assets / current liabilities	This ratio evaluates the liquidity, or ability to meet short term debts
Working Capital Provided by Net Income	Working Capital from Operations to Total Liabilities = working capital provided from operations / current liabilities	This ratio measures the amount of internally generated working capital that is available to satisfy obligations
Working Capital From Operations to Total Liabilities	Working Capital Provided by Net Income = net income – depreciation	A high ratio indicates that a company’s liquidity position is improved because net profits result in liquid funds

Bankruptcy Ratios

Bankruptcy ratios help to determine if the company is not generating enough income to cover its debts. These calculations could help to determine a course of action to avoid bankruptcy or to seek bankruptcy protection, if the situation warrants it. Here are some calculations that help to determine if a company is heading toward bankruptcy.

Ratio Calculation

Formula

Result

Working Capital to Total Assets

Net Working Capital	= Working Capital to Total Assets Ratio

Total Assets

This ratio records net liquid assets relative to total capitalization. This is the most valuable indicator of bankruptcy.

Retained Earnings to Total Assets

Retained Earnings	= Retained Earnings to Total Assets Ratio

Total Assets

A negative ratio indicates potential financial problems.

EBIT to Total Assets

EBIT	= EBIT to Total Assets Ratio

Total Assets

This ratio shows the productivity of the assets.

Equity to Debt

Market Value of Common + Preferred Stock	= Equity to Debt Ratio

Total Current + Long-Term Debt

This ratio shows you by how much assets can decline in value before it becomes insolvent.

Cash Flow to Debt

Cash Flow	= Cash Flow to Debt Ratio

Total Debt

This ratio shows potential insolvency issues.

Practical Illustration

Henry was reviewing a financial statement that was sent to him, and saw some numbers that puzzled him. He decided to ask a colleague to explain some of the meanings behind the figures in the report. Henry learned that the income ratios were simply representations of the income to things like wages. Next he looked at the profitability ratios. They represented the gain or loss in profits of the company. Liquidity ratios represented the company’s ability to pay off its short-term debt. The working capital ratios showed the company’s use of capital after paying off its debts, and the bankruptcy ratios helped demonstrate whether or not the company was creating enough income to pay off its debts. After understanding the figures, Henry could better visualize the state of the company.