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This means that a company's creative and effective management team will not be
listed as an asset. Similarly, a company's outstanding reputation, its unique product
lines, and brand names developed within the company will not be reported on the
balance sheet. As you may surmise, these items are often the most valuable of all
the things owned by the company. (Brand names purchased from another company
will be recorded in the company's accounting records at their cost.)
The accountants' matching principle will result in assets such as buildings,
equipment, furnishings, fixtures, vehicles, etc. being reported at amounts less than
cost. The reason is these assets are depreciated. Depreciation reduces an asset's
book value each year and the amount of the reduction is reported as Depreciation
Expense on the income statement.
While depreciation is reducing the book value of certain assets over their useful
lives, the current value (or fair market value) of these assets may actually be
increasing. (It is also possible that the current value of some assetssuch as
computersmay be decreasing faster than the book value.)
Current assets such as Cash, Accounts Receivable, Inventory, Supplies, Prepaid
Insurance, etc. usually have current values that are close to the amounts reported
on the balance sheet.
Current liabilities such as Notes Payable (due within one year), Accounts Payable,
Wages Payable, Interest Payable, Unearned Revenues, etc. are also likely to have
current values that are close to the amounts reported on the balance sheet.
Long-term liabilities such as Notes Payable (not due within one year) or Bonds
Payable (not maturing within one year) will often have current values that differ
from the amounts reported on the balance sheet.
Stockholders' equity is the book value of the company. It is the difference between
the reported amount of assets and the reported amount of liabilities. For the
reasons mentioned above, the reported amount of stockholders' equity will
therefore be different from the current or market value of the company.
By definition the current assets and current liabilities are "turning over" at least
once per year. As a result, the reported amounts are likely to be similar to their
current value. The long-term assets and long-term liabilities are not "turning over"
often. Therefore, the amounts reported for long-term assets and long-term liabilities
will likely be different from the current value of those items.
The remainder of our explanation of financial ratios and financial statement analysis
will use information from the following balance sheet:
Example Company
Balance Sheet
December 31, 2011
ASSETS
LIABILITIES
Current Assets
Current Liabilities
Cash
Petty Cash
$ 2,100
100
Notes Payable
$ 5,000
Accounts Payable
35,900
Temporary Investments
10,000
Wages Payable
8,500
40,500
Interest Payable
2,900
Inventory
31,000
Taxes Payable
6,100
Supplies
3,800
Warranty Liability
1,100
Prepaid Insurance
1,500
Unearned Revenues
1,500
89,000
61,000
Investments
36,000
5,500
Land Improvements
6,500
Buildings
180,000
Equipment
201,000
(56,000)
337,000
Long-term Liabilities
Notes Payable
20,000
Bonds Payable
400,000
Total Liabilities
420,000
481,000
STOCKHOLDERS'
EQUITY
Intangible Assets
Goodwill
105,000
Common Stock
110,000
Trade Names
200,000
Retained Earnings
229,000
305,000
(50,000)
3,000
-
289,000
Total Assets
$770,000
$770,000
PART 2
Financial statement analysis includes financial ratios. Here are three financial ratios
that are based solely on current asset and current liability amounts appearing on a
company's balance sheet:
Financial
Ratio
Working
Capital
How to Calculate It
=Current Assets Current
Liabilities
=$89,000 $61,000
$28,000
=
1.46
=
Quick Ratio
(Acid Test
Ratio)
=
This ratio is similar to the current ratio except that Inventory, Supplies, and
Prepaid Expenses are excluded. This indicates the relationship between the amount
of assets that can quickly be turned into cash versus the amount of current
liabilities.
Four financial ratios relate balance sheet amounts for Accounts Receivable and
Inventory to income statement amounts. To illustrate these financial ratios we will
use the following income statement information:
Example Corporation
Income Statement
For the year ended December 31, 2011
Sales (all on credit)
Cost of Goods Sold
Gross Profit
Financial
Ratio
$500,00
0
380,00
0
120,00
0
Operating Expenses
Selling Expenses
Administrative Expenses
Total Operating Expenses
35,000
45,000
80,000
Operating Income
Interest Expense
40,000
12,000
28,000
5,000
$ 23,000
How to Calculate It
Accounts
Receivable
Turnover
=
Days' Sales in =365 days in Year Accounts
Accounts
Receivable Turnover in Year
Receivable
365 days 11.90
=
30.67 days
=
=Cost of Goods Sold for the Year The number of times per year
Average Inventory for the that Inventory turns over. Keep
Year
in mind that the result is an
average, since sales and
=$380,000 $30,000 (a
inventory levels are likely to
computed average)
fluctuate during the year. Since
inventory is at cost (not sales
12.67
value), it is important to use the
=
Cost of Goods Sold. Also be sure
to use the average balance of
inventory during the year.
Days' Sales in =365 days in Year Inventory
The average number of days
Inventory
Turnover in Year
that it took to sell the average
inventory during the year. This
365 days 12.67
statistic is only as good as the
=
Inventory Turnover figure.
28.81
Inventory
Turnover
=
The next financial ratio involves the relationship between two amounts from the
balance sheet: total liabilities and total stockholders' equity:
Financial
Ratio
Debt to
How to Calculate It
=(Total liabilities Total
Equity
Stockholders' Equity) : 1
( $481,000 $289,000) : 1
=
1.66 : 1
=
The income statement has some limitations since it reflects accounting principles.
For example, a company's depreciation expense is based on the cost of the assets it
has acquired and is using in its business. The resulting depreciation expense may
not be a good indicator of the economic value of the asset being used up. To
illustrate this point let's assume that a company's buildings and equipment have
been fully depreciated and therefore there will be no depreciation expense for those
buildings and equipment on its income statement. Is zero expense a good indicator
of the cost of using those buildings and equipment? Compare that situation to a
company with new buildings and equipment where there will be large amounts of
depreciation expense.
The remainder of our explanation of financial ratios and financial statement analysis
will use information from the following income statement:
Example Corporation
Income Statement
For the year ended December 31, 2011
Sales (all on credit)
Cost of Goods Sold
Gross Profit
$500,000
380,000
120,000
Operating Expenses
Selling Expenses
Administrative Expenses
Total Operating Expenses
35,000
45,000
80,000
Operating Income
Interest Expense
40,000
12,000
28,000
5,000
$ 23,000
0.23
Financial Ratio
Gross Margin
Profit Margin
(after tax)
Earnings Per
Share (EPS)
Times Interest
Earned
= 3.3
Return on
Stockholders'
Equity (after
tax)
= Net Income for the Year after Taxes Reveals the percentage of profit after
Average Stockholders' Equity
income taxes that the corporation
during the Year
earned on its average common
stockholders' balances during the
= $23,000 $278,000 (a computed
year. If a corporation has preferred
average)
stock, the preferred dividends must
be deducted from the net income.
= 8.3%
The income statement has some limitations since it reflects accounting principles.
For example, a company's depreciation expense is based on the cost of the assets it
has acquired and is using in its business. The resulting depreciation expense may
not be a good indicator of the economic value of the asset being used up. To
illustrate this point let's assume that a company's buildings and equipment have
been fully depreciated and therefore there will be no depreciation expense for those
buildings and equipment on its income statement. Is zero expense a good indicator
of the cost of using those buildings and equipment? Compare that situation to a
company with new buildings and equipment where there will be large amounts of
depreciation expense.
The statement of cash flows is a relatively new financial statement in comparison to
the income statement or the balance sheet. This may explain why there are not as
many well-established financial ratios associated with the statement of cash flows.
We will use the following cash flow statement for Example Corporation to illustrate a
limited financial statement analysis:
Example Corporation
Statement of Cash Flows
For the Year Ended December 31, 2011
Cash Flow from Operating Activities:
Net Income
Add: Depreciation Expense
Increase in Accounts Receivable
Decrease in Inventory
Decrease in Accounts Payable
Cash Provided (Used) in Operating Activities
$23,000
4,000
(6,000)
9,000
(5,000)
25,000
(28,000)
7,000
(21,000)
10,000
(5,000)
(8,000)
(3,000)
Financial Ratio
1,000
1,200
$ 2,200
How to Calculate It
The cash flow from operating activities section of the statement of cash flows is also
used by some analysts to assess the quality of a company's earnings. For a
company's earnings to be of "quality" the amount of cash flow from operating
activities must be consistently greater than the company's net income. The reason
is that under accrual accounting, various estimates and assumptions are made
regarding both revenues and expenses. When it comes to cash, however, the
money is either in the bank or it isn't.