Every set of financial statements, from those of global corporations down to Mom and Dad enterprises, can quickly and easily divulge a set of key statistics which will allow you to analyze the organization’s profitability, efficiency, liquidity and solvency. Armed with this information you will be able to make more knowledgeable investment decisions, or simply be aware of how your own business is performing in crucial areas.
• Example Inc. financial statements
Here are the financial statements of a fictitious company, Example Inc, at the end of the year:
Sales revenue $510,000
Cost of good sold $320,000
Gross profit $190,000
Expenses $105,000 (including Interest Expense of $10,000)
Profit before tax $85,000
Company tax $25,000
Net profit after tax $60,000
Fixed assets $110,000
Current Assets: Cash $45,000, Accounts Receivable $55,000, Inventory $35,000
Total Current Assets $135,000
Total Assets $245,000
Current liabilities: Accounts Payable $65,000
Non-current liabilities: Long-term bank loan $130,000
Shareholders’ Equity $50,000 (5,000 shares at $10)
Total Liabilities $245,000
Declared dividend is $6 per share, with each one currently trading at $120 on the exchange.
Now consider the following key financial ratios, which tell a very interesting story.
• Profitability statistics
Gross profit (GP)
Example Inc. had a gross profit margin (sales value minus the purchase or production cost of the goods sold) of $190,000. It sounds good, but is it really? The best way to find out is to calculate it as a percentage of total sales, which in this case is $190,000/$510,000 = 37%. If Example Inc. were a convenience store this would be an excellent result, but if it were a computer retailer it would be a poor performance. Average ratios vary according to business type.
Return on assets (ROA)
The equity of Example Inc’s owners has been invested in assets in order to generate income. These assets are fixed assets (such as premises, machinery, furniture and equipment) and current assets (cash at banks, inventory for resale and amounts receivable from debtors). By calculating the ratio of net income to total assets, an analyst can check how hard these assets are working. In this case it is $60,000/$245,000, which is a ratio of 1 to 4.1, or 24% in percentage terms.
Return on equity (ROE)
This ratio calculates how much income has been generated using the owners’ original investment. In Example Inc’s case the result is $60,000/$50,000 = 1.2 or 120%. In other words, the company is returning 20% above the original investment in a single year, an exceptional achievement.
Dividends and earnings per share
Example Inc. plans to pay a dividend of $6 per share. However, its actual earnings per share (EPS) are twice that, an amount of $60,000/5,000 = $12, but the company needs to retain some earning to reinvest in the business. Future investors in the company, who have yet to purchase their shares, will be interested in the ratio between the earnings per share and the current share price. This is called price/earnings ratio (PE) and it is $12:$120 = 1 to 10 or 10%. In other words, the business is currently producing a 10% return on the share price, a very tidy investment if current results can be maintained.
• Efficiency statistics
Efficiency ratios try to work out how well the company’s assets are being used. Inventory sitting idle in the warehouse and uncollected customer accounts both have a negative impact on the bottom line. So owners and investors should be interested in how quickly the company’s inventory is turned over and how long it takes to collect debts.
Inventory turnover period
Step One: establish an average daily cost of goods sold (COGS). Divide the COGS on the income statement ($320,000) by 365 to produce an average daily COGS of $877. Step Two: calculate average inventory value. If the opening inventory year was $38,000 (closing inventory from last year’s balance sheet) the average is ($38,000 + $35,000)/2 = $36,500. Dividing this figure by the average daily COGS ($36,500/$877 = 42) reveals that inventory is turned over approximately once every 42 days. Not bad, as long as they are not selling fresh fish.
This is similar to the inventory turnover calculation. First, establish average daily credit sales by dividing annual credit sales by 365. Example Inc makes all its sales on credit, and $510,000 /365 = $1,397. The opening accounts receivable balance (from the prior year balance sheet) was $51,000, so the average is ($51,000 + $55,000)/2 = $53,000. Dividing this result by $1,397 demonstrates that it takes an average of 38 days to collect a customer account, not a particularly brilliant outcome if official credit terms offered are 30 days from delivery of goods.
• Liquidity statistics
Example Inc is on the receiving end of credit from its suppliers. They will be interested in how well the company can cover its financial obligations in the short term. There are three main levels of liquidity ratio: current ratio, quick ratio and cash ratio
This is the most generous of the three ratios. Current assets are divided by current liabilities, in Example Inc’s case $135,000/$65,000 = 2.1. In other words, Example Inc’s liquid assets (cash, accounts receivable and inventory) cover its short term debts more than twice over, which appears to be a comfortable position.
This is a slightly tougher test, which ignores inventory on the basis that it could be very difficult to sell quickly for a reasonable value, if it needed to be converted into cash to meet debts. So now the calculation is ($45,000 + $55,000)/$65,000 = 1.5. Suppliers and lenders can still relax, when the total of cash plus debtors exceeds total creditors by 50%.
This is the most stringent test of liquidity, recognizing only cash and money market securities such as treasury bills, which can be readily converted into cash. Example Inc. has only $45,000 in cash to cover $65,000 in unpaid creditors, which amounts to 69% coverage.
• Solvency statistics
Prospective investors might be interested in how much reliance the company has on debt, especially long-term debt, rather than equity. Potential lenders will want to find out the organization’s capacity to pay interest charges on current or future debts. So both groups need to test the company’s solvency ratios.
Debt to equity ratio
The label of this ratio clearly explains it, although some analysts use total liabilities (excluding equity) as the debt figure, rather than confining the calculation to long-term debt. For Example Inc. the long-term debt to equity ratio is $130,000:$50,000, or 2.6 to 1, and this would be considered a highly-geared company mainly financed by debt, and therefore relatively risky.
Interest coverage ratio
A prospective lender or investor could be interested in how well a company can cover its interest charges, especially if it is highly-geared. In order to do this they would take the company’s earnings before interest expense and tax, and compare it with the interest expense (or possible future interest expense). Example Inc’s current coverage is ($85,000 + $10,000)/$10,000, which means that it can cover its interest charges 9.5 times. This is fairly reassuring, although an additional loan would add more interest and change the result.
There are almost as many statistics and ratio calculations are there are types of company, investor and lender. Analysts will choose which ones are relevant to their own situation or that of the clients they are advising. It is vital to know what method has been used in each calculation, since there are no hard and fast rules. Different accounting methods can also affect the figures even before calculations begin, and comparisons are most effective when confined to single industry group or company size range, or within a single entity but assessed over a period of years.