Previous Quiz

Module 5 – Analyzing Financial Statements (II) Copy


(This video chapter begins at 04:56 and ends at 06:25. Click on the blue dot at the 04:56 timestamp to play the video for this module.)

Analyzing Financial Statements (II)

In this module, we are going to learn more ratios and calculations for analyzing financial statements. Here are the topics for this module:

  • Long-term analysis ratios
  • Coverage ratios
  • Leverage ratios
  • Calculating return on investment (ROI)

Our first topic in this module is calculating the long-term analysis ratio.

Our focus quote for this module:

“Life is a game. Money is how we keep score.”-Ted Turner

 

Long-Term Analysis Ratios

Long-term analysis is helpful in determining how well the company is going to perform over time as it relates to the organization’s financial obligations. These are the formulas in calculating long-term performance:

Ratio Calculation Formula Result
Current Assets to Total Debt
  • Current Assets
  • = Current Assets to Total Debt Ratio
  • Current + Long-Term Debt
  • This ratio determines the degree of protection linked to short- and long-term debt. More net working capital protects short-term creditors.
Stockholders’ Equity Ratio
  • Stockholders’ Equity
  • = Stockholders’ Equity Ratio
  • Total Assets
  • This ratio determines the relative financial strength and long-run liquidity.
Total Debt to Net Worth
  • Current + Deferred Debt
  • = Total Debt to Net Worth Ratio
  • Tangible Net Worth
  • This ratio measures the organization’s total liabilities against its tangible net worth.

 

 

 

Coverage Ratios

Coverage ratios show how many times a company’s earnings can cover the fixed-interest payments on its long-term debt. The Times Interest Earned Ratio calculates this and the formula is the following:

 

EBIT
  • = Times Interest Earned Ratio
I

 

EBIT is earnings before interest and taxes

I is the interest amount payable on the debt

 

 

Leverage Ratios

Leverage ratios calculate the proportion of the owner’s contribution and the contribution from creditors. Three formulas help you calculate ratios:

Ratio Calculation Formula Result
Equity Ratio
  • Common Shareholders’ Equity
  • = Equity Ratio
  • Total Capital Employed
  • This ratio shows how much of the total capitalization actually comes from the owners.
Debt to Equity Ratio
  • Debt + Preferred Long-Term
  • = Debt to Equity Ratio
Common Stockholders’ Equity
  • With this ratio, a high ratio means less protection for creditors. A low ratio means more protection for the creditors.
Debt Ratio
  • Current + Long-Term Debt
  • = Debt Ratio
  • Total Assets
  • This ratio determines how much of the assets are financed.

 

 

Calculating Return on Investment (ROI)

Calculating the return on investment (ROI) is a very useful tool in determining if an investment is worth the effort. This calculation uses the project return on the investment promises and subtracts the cost of the investment, leaving either a gain or a loss. That figure is then divided by the cost of the investment.

If the calculation produces a large percent, or whole number, then the investment would be a good one to make. Of course, this would have to be approved by an authorized agent within your company. If the calculation produces a small percentage then it would not be a good investment to make.

A zero means the investment would break-even. Here is the formula:

  • ROI = (Gain from investment – cost of investment) / cost of investment

Whenever you need to make a purchasing decision, it is always a good practice to determine the return on investment. Presenting this information to your manager ahead of the purchase would make you look very wise. In addition, taking the time to calculate the ROI demonstrates that you care about the organization.

There are other return calculations you can use. Here are a few:

  • Return on assets (ROA)
  • Return on capital employed (ROCE)
  • Return on equity (ROE)
  • Return on gross invested capital (ROGIC)
  • Return on investment capital (ROIC)

 

 

Practical Illustration

Jenny was working on her company’s financial reports and needed to include key financial ratios. The first was the long-term analysis ratio. This ratio shows how well the company will perform over an extended period of time, given its financial obligations. Next she needed to include the coverage ratios. These demonstrate how many times the company can pay the interest on its debt with its current earnings. Next, Jenny made sure to put in the leverage ratios. These calculated the proportion of the owner’s contribution and the contribution from creditors to the company. Together, these ratios helped describe the financial situation of the company and the impact of its debt.