Example 16 1 Given income statement Given balance sheet

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Example 16 4 Calculate the working capital for each year Solution: Working capital = current assets – current liabilities Year 1: $ $ = $ Year 2: $ $ = - $

Example 16 5 Calculate the current ratio for each year Solution: Current ratio = Current assets / current liabilities Year 1: $ / $ = 0.95 Year 2: $ / $ = 1.03 (Industry average = 1.5) The ratio, and therefore the company’s ability to meet its short-term obligations has improved, though it is low compared to the industry’s average

Example 16 6 Calculate the quick ratio (or acid-test ratio) for each year Solution: Quick ratio = Cash equivalents + Market securities + Net receivables Current liabilities Year 1 = $ $ $ = 0.95 $ Year 2 = $ $ $ = 1.03 $ (The industry average = 0.80) The industry average of 0.80 is higher than the company’s quick ratio, which indicates that the company may have trouble meeting short-term needs

Long-term solvency 7 Long-term solvency focuses on a firm’s ability to pay the interest and principal on its long-term debt. Two common ratios relating to servicing long-term debt. One measures ability to pay interest, the other the ability to repay the principal. The ratio for interest compares the amount of income available for paying interest with the amount of the interest expense. This ratio is called Interest Coverage or Times Interest Earned.

Long-term solvency 8 The amount of income available for paying interest is simply earnings before interest and before income taxes, known as EBIT. For instance, assume that EBIT is $120,000 and interest expense is $60,000. This shows that the business has EBIT sufficient to cover 2 times its interest expense. The cushion, or margin of safety, is therefore quite substantial. Times Interest Earned is EBIT/Interest Expense

Long-term solvency 9 The long-term solvency ratio that reflects a firm’s ability to repay principal on long-term debt is the “Debt to Equity” ratio. Debt to assets ratio, is often used as a primary indicator of the firm’s debt management. The lower the ratio, the lower the firm’s risks because the organization will usually be better able to meet its obligations for interest and debt payments Debt to equity ratio = Total liabilities / stockholders’ equity Debt to assets ratio = Total liabilities / total assets

Example Calculate the debt to equity ratio for each year Solution: Debt /Equity = Total liabilities / stockholders’ equity Year 1 = $1,300,000 / $ 1,150,000 = 1.13 Year 2 = $ 1,345,000 / $ 1,270,000 = 1.06 The ratio indicates the degree of protection to creditors in case of insolvency. The lower this ratio the better the company’s position. In this company's case, the ratio is very high, indicating that a majority of funds of creditors. However, the ratio is improving

Example Calculate the debt to asset ratio for each year Solution: Debt to assets ratio = Total liabilities / total assets Year 1 = $ 1,300,000 / $2,450,000 = 53.1 % Year 2 = $ 1,345,000 / $ 2,615,000 = 51.4 % This ratio indicates that more than half of the assets are financed by creditors

Example Calculate the earnings before interest and taxes (EBIT) for year 1 Solution: EBIT = Earnings + Interest Expense + Tax Expense = $ 200,000 + $ 10, ,000 = $ 300,000 A measure of a company’s earning power from ongoing operations, equal to earnings before deduction of interest payments and income taxes. EBIT excludes income and expenditure from unusual, non-recurring or discontinued activities

Example Calculate the times interest earned for year 1 Solution: Times interest earned = Earnings before interest and taxes (EBIT) Interest = $ 300,000 / $ 10,000 = 30 times This ratio reflects the ability of a company to cover interest charges. It uses income before interest and taxes to reflect the amount of income available to cover interest expense

Profitability 14 Profitability is the lifeblood of a business. Businesses that earn incomes can survive, grow, and prosper. Businesses that incur losses cannot stay in operation, and will last only until their cash runs out.

Profitability 15 Therefore, in order to assess business viability, it is important to analyze profitability. When analyzing profitability, it is usually done in two phases, which are: 1. Profitability in relation to sales: o Gross profit represents the profit that a company produces from the sale of inventory Gross margin or gross profit = sales – cost of goods sold

Profitability 16 o gross margin percentage o Significant decrease in this ratio from year to year require investigation; consistent deterioration may indicate a need for stringent cost control programs Gross margin percentage = (gross margin / sales) * 100 Profit margin on sales = net income / net sales

Profitability Profitability in relation to investment o Return on assets, often termed return on investment or ROI o This ratio focuses on operations, specifically, the effectiveness of resources used in generating profit Return on investment = Net income + Interest expense (1-Tax rate) / Long term liabilities + Equity

Example Calculate the gross margin for year 1 Solution: Gross margin = sales – cost of goods sold = $ 1,800,000 - $ 1,000,000 = $ 800,000

Example Calculate the gross margin percentage for year 1 Solution: Gross margin percentage = gross margin / sales = $ 800,000 / $ 1,800,000 = % This ratio is a good indication of how profitable a company is at the most fundamental level. Companies with higher gross margins will have more money lest over to spend on other business operations, such as research and development or marketing

Example Calculate the net profit margin (profit margin on sales) for year 1 Solution: Net profit margin = Net income / net sales = $ 200,000 / $ 1,800,000 = % This ratio indicates profit rate and, when used with the asset turnover ratio, indicates rate of return on assets

Example Calculate the return on investment (return on assets) for year 1 Solution: Return on investment = Net income + Interest expense (1-tax rate) Long-term liabilities + Equity = $ 200,000 + $ 10,000 (1-0.31) $ 650,000 + $ 1,270,000 = 0.11 times ROI measures the performance of the firm without regard to the method of financing

22 PART F ETHICS

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34 THE END