8 - 1 © 2005 Accounting 1/e, Terrell/Terrell Analyzing Financial Statements for Profitability, Liquidity, and Solvency Chapter 8

8 - 2 © 2005 Accounting 1/e, Terrell/Terrell Learning Objectives 1 and 2 Distinguish among profitability, liquidity, and solvency. Calculate financial ratios designed to measure a company’s profitability, liquidity, and solvency.

8 - 3 © 2005 Accounting 1/e, Terrell/Terrell Introduction Ratio analysis is a technique for analyzing the relationship between two items from a company’s financial statements for a given period. 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.

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

8 - 5 © 2005 Accounting 1/e, Terrell/Terrell Elevation Sports, Inc. 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

8 - 6 © 2005 Accounting 1/e, Terrell/Terrell Elevation Sports, Inc. 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

8 - 7 © 2005 Accounting 1/e, Terrell/Terrell Elevation Sports, Inc. Balance Sheet May 31, 2004 Stockholders’ equity Paid-in capital: Common stock, $10 par value, 100,000 shares authorized, 4, ,000 shares authorized, 4,000 shares issued and outstanding$ 60,000 shares issued and outstanding$ 60,000 Paid-in capital in excess of par – common stock 40,000 – 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

8 - 8 © 2005 Accounting 1/e, Terrell/Terrell Elevation Sports, Inc. 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 revenue$ 512 Interest expense (6,000) 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

8 - 9 © 2005 Accounting 1/e, Terrell/Terrell Profitability Ratios Profitability ratios measure a firm’s past performance and help predict its future profitability level. Profitability is the ease with which a company generates income.

© 2005 Accounting 1/e, Terrell/Terrell Profitability Ratios 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 Profitability Ratios 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%

© 2005 Accounting 1/e, Terrell/Terrell Profitability Ratios 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

© 2005 Accounting 1/e, Terrell/Terrell Profitability Ratios Return on assets Profit margin before income tax = Net income before taxes ÷ Total assets = Net income before taxes ÷ Sales Sales ÷ Total assets × Total asset turnover×

© 2005 Accounting 1/e, Terrell/Terrell Profitability Ratios 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%

© 2005 Accounting 1/e, Terrell/Terrell Profitability Ratios 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%

© 2005 Accounting 1/e, Terrell/Terrell Profitability Ratios 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%

© 2005 Accounting 1/e, Terrell/Terrell Liquidity Ratios Liquidity ratios evaluate a firm’s ability to generate sufficient cash to meet its short-term obligations. An asset’s liquidity describes the ease with which it can be converted to cash.

© 2005 Accounting 1/e, Terrell/Terrell 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

© 2005 Accounting 1/e, Terrell/Terrell 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

© 2005 Accounting 1/e, Terrell/Terrell 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

© 2005 Accounting 1/e, Terrell/Terrell 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

© 2005 Accounting 1/e, Terrell/Terrell Liquidity Ratios Receivable turnover = $149,224 ÷ $9,450 = times Average collection period = 365 ÷ = days

© 2005 Accounting 1/e, Terrell/Terrell 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

© 2005 Accounting 1/e, Terrell/Terrell Liquidity Ratios Inventory turnover = $295,834 ÷ ($4,397 + $13,634) = times Average number of days Elevation Sports, Inc., holds its inventory = 365 ÷ = days

© 2005 Accounting 1/e, Terrell/Terrell Solvency Ratios Solvency ratios are of most interest to stockholders, long-term creditors, and company management. Solvency is a company’s ability to meet the obligations created by its long-term debt.

© 2005 Accounting 1/e, Terrell/Terrell Solvency Ratios It measures what proportion of a company’s assets is financed by debt. Assets = Liabilities + Owners’ equity Assets = Liabilities + Owners’ equity 100% = Some % + Some % 100% = Some % + Some %

© 2005 Accounting 1/e, Terrell/Terrell Solvency Ratios Total liabilities ÷ Total assets $128,834 ÷ $288,015 = 44.73%

© 2005 Accounting 1/e, Terrell/Terrell Solvency Ratios This ratio is also called the times-interest-earned ratio. It indicates a company’s ability to make its periodic interest payments.

© 2005 Accounting 1/e, Terrell/Terrell Solvency Ratios Coverage ratio = Earnings before interest expense and income taxes ÷ Interest expense ($105,301 + $6,000) ÷ $6,000 = times

© 2005 Accounting 1/e, Terrell/Terrell Learning Objective 3 Locate industry averages.

© 2005 Accounting 1/e, Terrell/Terrell Industry Averages The Almanac includes all companies, public and private. Information provided in the Almanac for each industry is four pages. It consists of two tables. This chapter emphasizes the Almanac of Business and Industrial Financial Ratios.

© 2005 Accounting 1/e, Terrell/Terrell Industry Averages Table II provides the same information items as Table I, but it considers only companies that showed a net income for the year. Table I provides an analysis of all companies in the particular industry, regardless of whether they had any net income for the year.

© 2005 Accounting 1/e, Terrell/Terrell Learning Objective 4 Evaluate a company’s ratios using a comparison to industry averages.

© 2005 Accounting 1/e, Terrell/Terrell Comparison of Elevation Sports, Inc., to Industry Averages Return on assets Profit margin before income taxes Total asset turnover Profit margin after income tax Return on equity after income taxes Return on equity before income taxes Current ratio Quick ratio Net sales to working capital Receivables turnover Inventory turnover Debt ratio Coverage ratio 36.6%20.0% %39.7%43.5% % % 4.2% 4.2% % 3.4%19.3%23.9% % % 6.1% 6.1% % 5.7%40.5%43.1% % RatioElevation Sports, Inc. TotalIndustryIndustry with Assets $250-$500,000

© 2005 Accounting 1/e, Terrell/Terrell Company Analysis Compare ratios to the industry averages. Look for company trends. Consider the industry environment. Draw conclusions.

© 2005 Accounting 1/e, Terrell/Terrell Learning Objective 5 Use ratio values from consecutive time periods to evaluate the profitability, liquidity, and solvency of a business.

© 2005 Accounting 1/e, Terrell/Terrell Trend Analysis of Selected Ratios Return on assets Profit margin before taxes Total asset turnover Profit margin after taxes Return on equity after taxes Return on equity before taxes Current ratio Quick ratio Net sales to working capital Receivables turnover Inventory turnover Debt ratio Total liabilities to net worth Ratio

© 2005 Accounting 1/e, Terrell/Terrell Learning Objective 6 Draw conclusions about the credit-worthiness and investment-attractiveness of a company.

© 2005 Accounting 1/e, Terrell/Terrell Draw Conclusions 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. The evaluation process by nature depends upon individual perception.

© 2005 Accounting 1/e, Terrell/Terrell 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.

© 2005 Accounting 1/e, Terrell/Terrell Learning Objective 7 State the limitations of ratio analysis.

© 2005 Accounting 1/e, Terrell/Terrell Limitations of Ratio Analysis 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. 1. Attempting to predict the future using past results depends upon the predictive value of the information used.

© 2005 Accounting 1/e, Terrell/Terrell Limitations of Ratio Analysis 5. Lack of uniformity concerning what is to be included in the numerators and denominators make comparisons extremely difficult. 4. Industry peculiarities create difficulty in comparing the ratios of a company in one industry with those of a company in another industry.

© 2005 Accounting 1/e, Terrell/Terrell End of Chapter 8