Financial Statement Analysis

What Is Financial Statement Analysis?

Financial statement analysis is the process of analyzing a company's financial statements for decision-
making purposes. External stakeholders use it to understand the overall health of an organization as
well as to evaluate financial performance and business value. Internal constituents use it as a monitoring
tool for managing the finances.

Analyzing Financial Statements

The financial statements of a company record important financial data on every aspect of a business’s
activities. As such they can be evaluated on the basis of past, current, and projected performance.

In general, financial statements are centered around generally accepted accounting principles (GAAP) in
the U.S. These principles require a company to create and maintain three main financial statements: the
balance sheet, the income statement, and the cash flow statement. Public companies have stricter
standards for financial statement reporting. Public companies must follow GAAP standards which
requires accrual accounting. Private companies have greater flexibility in their financial statement
preparation and also have the option to use either accrual or cash accounting.

Several techniques are commonly used as part of financial statement analysis. Three of the most
important techniques include horizontal analysis, vertical analysis, and ratio analysis. Horizontal analysis
compares data horizontally, by analyzing values of line items across two or more years. Vertical analysis
looks at the vertical affects line items have on other parts of the business and also the business’s
proportions. Ratio analysis uses important ratio metrics to calculate statistical relationships.

Financial Statements

As mentioned, there are three main financial statements that every company creates and monitors: the
balance sheet, income statement, and cash flow statement. Companies use these financial statements
to manage the operations of their business and also to provide reporting transparency to their
stakeholders. All three statements are interconnected and create different views of a company’s
activities and performance.

Balance Sheet

The balance sheet is a report of a company's financial worth in terms of book value. It is broken into
three parts to include a company’s assets, liabilities, and shareholders' equity. Short-term assets such as
cash and accounts receivable can tell a lot about a company’s operational efficiency. Liabilities include
its expense arrangements and the debt capital it is paying off. Shareholder’s equity includes details on
equity capital investments and retained earnings from periodic net income. The balance sheet must
balance with assets minus liabilities equaling shareholder’s equity. The resulting shareholder’s equity is
considered a company’s book value. This value is an important performance metric that increases or
decreases with the financial activities of a company.

Income Statement

The income statement breaks down the revenue a company earns against the expenses involved in its
business to provide a bottom line, net income profit or loss. The income statement is broken into three
parts which help to analyze business efficiency at three different points. It begins with revenue and the
direct costs associated with revenue to identify gross profit. It then moves to operating profit which
subtracts indirect expenses such as marketing costs, general costs, and depreciation. Finally it ends with
net profit which deducts interest and taxes.

Basic analysis of the income statement usually involves the calculation of gross profit margin, operating
profit margin, and net profit margin which each divide profit by revenue. Profit margin helps to show
where company costs are low or high at different points of the operations.

Cash Flow Statement

The cash flow statement provides an overview of the company's cash flows from operating activities,
investing activities, and financing activities. Net income is carried over to the cash flow statement where
it is included as the top line item for operating activities. Like its title, investing activities include cash
flows involved with firmwide investments. The financing activities section includes cash flow from both
debt and equity financing. The bottom line shows how much cash a company has available.

Free Cash Flow and Other Valuation Statements

Companies and analysts also use free cash flow statements and other valuation statements to analyze
the value of a company. Free cash flow statements arrive at a net present value by discounting the free
cash flow a company is estimated to generate over time. Private companies may keep a valuation
statement as they progress toward potentially going public.

Financial Performance

Financial statements are maintained by companies daily and used internally for business management.
In general both internal and external stakeholders use the same corporate finance methodologies for
maintaining business activities and evaluating overall financial performance.

When doing comprehensive financial statement analysis, analysts typically use multiple years of data to
facilitate horizontal analysis. Each financial statement is also analyzed with vertical analysis to
understand how different categories of the statement are influencing results. Finally ratio analysis can
be used to isolate some performance metrics in each statement and also bring together data points
across statements collectively.

Below is a breakdown of some of the most common ratio metrics:

Balance sheet: asset turnover, quick ratio, receivables turnover, days to sales, debt to assets, and debt
to equity

Income statement: gross profit margin, operating profit margin, net profit margin, tax ratio efficiency,
and interest coverage

Cash Flow: Cash and earnings before interest, taxes, depreciation, and amortization (EBITDA). These
metrics may be shown on a per share basis.

What Is Horizontal Analysis?

Horizontal analysis is used in financial statement analysis to compare historical data, such as ratios, or
line items, over a number of accounting periods. Horizontal analysis can either use absolute
comparisons or percentage comparisons, where the numbers in each succeeding period are expressed
as a percentage of the amount in the baseline year, with the baseline amount being listed as 100%. This
is also known as base-year analysis

**KEY TAKEAWAYS

 Horizontal analysis is used in the review of a company's financial statements over multiple
periods.
 It is usually depicted as a percentage growth over the same line item in the base year.
 Horizontal analysis allows financial statement users to easily spot trends and growth patterns.
 It can be manipulated to make the current period look better if specific historical periods of poor
performance are chosen as a comparison.

How Horizontal Analysis Is Used

Generally accepted accounting principles (GAAP) are based on consistency and comparability of financial
statements. Consistency is the ability to accurately review one company's financial statements over a
period of time because accounting methods and applications remain constant. Comparability is the
ability to review side-by-side two or more different companies' financials. Horizontal analysis not only
improves the review of a company's consistency over time directly, but it also improves comparability of
growth in a company to that of its competitors as well.
Horizontal analysis allows investors and analysts to see what has been driving a company's financial
performance over a number of years, as well as to spot trends and growth patterns such as seasonality.
It enables analysts to assess relative changes in different line items over time, and project them into the
future. By looking at the income statement, balance sheet, and cash flow statement over time, one can
create a complete picture of operational results, and see what has been driving a company’s
performance and whether it is operating efficiently and profitably.

The analysis of critical measures of business performance, such as profit margins, inventory turnover,
and return on equity, can detect emerging problems and strengths. For example, earnings per share
(EPS) may have been rising because the cost of goods sold (COGS) have been falling, or because sales
have been growing strongly. And coverage ratios, like the cash flow-to-debt ratio and the interest
coverage ratio can reveal whether a company can service its debt through sufficient liquidity. Horizontal
analysis also makes it easier to compare growth rates and profitability among multiple companies.

Example of Horizontal Analysis

Horizontal analysis typically shows the changes from the base period in dollar and percentage. For
example, when someone says that revenues have increased by 10% this past quarter, that person is
using horizontal analysis. The percentage change is calculated by first dividing the dollar change
between the comparison year and the base year by the line item value in the base year, then multiplying
the quotient by 100.

For example, assume an investor wishes to invest in company XYZ. The investor may wish to determine
how the company grew over the past year. Assume that in company XYZ's base year, it reported net
income of $10 million and retained earnings of $50 million. In the current year, company XYZ reported
net income of $20 million and retained earnings of $52 million. Consequently, it has an increase of $10
million in its net income and $2 million in its retained earnings year over year. Therefore, company ABC's
net income grew by 100% (($20 million - $10 million) / $10 million * 100) year over year, while its
retained earnings only grew by 4% (($52 million - $50 million) / $50 million * 100).

Criticism of Horizontal Analysis

Depending on which accounting period an analyst starts from and how many accounting periods are
chosen, the current period can be made to appear unusually good or bad. For example, the current
period's profits may appear excellent when only compared with those of the previous quarter, but are
actually quite poor if compared to the results for the same quarter in the preceding year.

A common problem with horizontal analysis is that the aggregation of information in the financial
statements may have changed over time, so that revenues, expenses, assets, or liabilities may shift
between different accounts and therefore appear to cause variances when comparing account balances
from one period to the next. Indeed, sometimes companies change the way they break down their
business segments to make the horizontal analysis of growth and profitability trends more difficult to
detect. Accurate analysis can be affected by one-off events and accounting charges.

What Is Vertical Analysis?

Vertical analysis is a method of financial statement analysis in which each line item is listed as a
percentage of a base figure within the statement. Thus, line items on an income statement can be
stated as a percentage of gross sales, while line items on a balance sheet can be stated as a percentage
of total assets or liabilities, and vertical analysis of a cash flow statement shows each cash inflow or
outflow as a percentage of the total cash inflows.

How Vertical Analysis Works

Vertical analysis makes it much easier to compare the financial statements of one company with
another, and across industries. This is because one can see the relative proportions of account balances.
It also makes it easier to compare previous periods for time series analysis, in which quarterly and
annual figures are compared over a number of years, in order to gain a picture of whether performance
metrics are improving or deteriorating.
For example, by showing the various expense line items in the income statement as a percentage of
sales, one can see how these are contributing to profit margins and whether profitability is improving
over time. It thus becomes easier to compare the profitability of a company with its peers.

Vertical analysis is used in order to gain a picture of whether performance metrics are improving or
deteriorating.

Financial statements that include vertical analysis clearly show line item percentages in a separate
column. These types of financial statements, including detailed vertical analysis, are also known as
common-size financial statements and are used by many companies to provide greater detail on a
company’s financial position. Common-size financial statements often incorporate comparative financial
statements that include columns comparing each line item to a previously reported period.

Example of Vertical Analysis

For example, suppose XYZ Corporation has gross sales of $5 million and cost of goods sold of $1 million
and general and administrative expenses of $2 million and a 25% tax rate, its income statement will look
like this if vertical analysis is used:

Sales 5,000,000 100%

Cost of goods sold 1,000,000 20%

Gross profit 4,000,000 80%

General and Administrative Expenses 2,000,000 40%

Operating Income 2,000,000 40%

Taxes (%25) 500,000 10%

Net income 1,500,000 30%

**KEY TAKEAWAYS

 Vertical analysis makes it easier to understand the correlation between single items on a
balance sheet and the bottom line, expressed in a percentage.
 Vertical analysis can become a more potent tool when used in conjunction with horizontal
analysis, which considers the finances of a certain period of time.

Vertical vs. Horizontal Analysis

Another form of financial statement analysis used in ratio analysis is horizontal analysis or trend
analysis. This is where ratios or line items in a company's financial statements are compared over a
certain period of time by choosing one year's worth of entries as a baseline, while every other year
represents percentage differences in terms of changes to that baseline.

For example, the amount of cash reported on the balance sheet on December 31 of 2018, 2017, 2016,
2015, and 2014 will be expressed as a percentage of the December 31, 2014, amount. Instead of dollar
amounts, you might see 141, 135, 126, 118, and 100.

This shows that the amount of cash at the end of 2018 is 141% of the amount it was at the end of 2014.
By doing the same analysis for each item on the balance sheet and income statement, one can see how
each item has changed in relationship to the other items.

Common Size Financial Statement Definition

What Is a Common Size Financial Statement?

A common size financial statement displays all items as percentages of a common base figure rather
than as absolute numerical figures. This type of financial statement allows for easy analysis between
companies or between time periods for the same company. The values on the common size statement
are expressed as ratios or percentages of a statement component, such as revenue or income.
While most firms don't report their statements in common size format, it is beneficial for analysts to
compute it to compare two or more companies of differing size or different sectors of the economy.
Formatting financial statements, in this way, reduces bias that can occur and allows for the analysis of a
company over various time periods, revealing, for example, what percentage of sales is the cost of
goods sold, and how that value has changed over time. Common size financial statements commonly
include the income statement, balance sheet, and cash flow statement.

Understanding Common Size Financial Statements

Common size financial statements reduce all figures to a comparable figure, such as a percentage of
sales or assets. Each financial statement uses a slightly different convention in standardizing figures.

Common size financial statements make it easier to determine what drives a company's profits, and
then compare it to similar businesses.

Common Size Balance Sheet Statement

The balance sheet provides a snapshot overview of the firm's assets, liabilities and shareholders' equity
for the reporting period. A common size balance sheet is set up with the same logic as the common size
income statement. The balance sheet equation is assets equals liabilities plus stockholders' equity.

As a result, analysts define the balance sheet as a percentage of assets. Another version of the common
size balance sheet shows asset line items as a percentage of total assets, liabilities as a percentage of
total liabilities and stockholders' equity as a percentage of total stockholders' equity.

Common Size Cash Flow Statement

The cash flow statement provides an overview of the firm's sources and uses of cash. The cash flow
statement is divided among cash flows from operations, cash flows from investing and cash flows from
financing. Each section provides additional information about the sources and uses of cash in each
business activity.

One version of the common size cash flow statement expresses all line items as a percentage of total
cash flow. The more popular version expresses cash flow in terms of total operational cash flow for
items in cash flows from operations, total investing cash flows for cash flows from investing activities,
and total financing cash flows for cash flows from financing activities.

Common Size Income Statement

The income statement (also referred to as the profit and loss (P&L) statement) provides an overview of
flows of sales, expenses, and net income during the reporting period. The income statement equation is
sales, minus expenses and adjustments equal net income. This is why the common size income
statement defines all items as a percentage of sales. The term "common size" is most often used when
analyzing elements of the income statement, but the balance sheet and the cash flow statement can
also be expressed as a common size statement.

**KEY TAKEAWAYS

 A common size financial statement displays all items as percentages of a common base figure,
rather than as absolute numerical figures.
 Common size statements let analysts compare companies of different sizes, in different
industries, or across time in an apples-to-apples way.
 Common size financial statements commonly include the income statement, balance sheet, and
cash flow statement.

Real-World Example of a Common Size Income Statement

For example, if a company has a simple income statement with gross sales of $100,000, cost of goods
sold of $50,000, taxes of $1,000 and net income of $49,000, the common size statement would read as
follows:
Sales 1.00

Cost of goods sold 0.50

Taxes 0.01

Net Income 0.49

What Are Liquidity Ratios?

Liquidity ratios are an important class of financial metrics used to determine a debtor's ability to pay off
current debt obligations without raising external capital. Liquidity ratios measure a company's ability to
pay debt obligations and its margin of safety through the calculation of metrics including the current
ratio, quick ratio, and operating cash flow ratio.

Current liabilities are analyzed in relation to liquid assets to evaluate the coverage of short-term debts in
an emergency.

**KEY TAKEAWAYS

 Liquidity ratios are an important class of financial metrics used to determine a debtor's ability to
pay off current debt obligations without raising external capital.
 Common liquidity ratios include the quick ratio, current ratio, and days sales outstanding.
 Liquidity ratios determine a company's ability to cover short-term obligations and cash flows,
while solvency ratios are concerned with a longer-term ability to pay ongoing debts.

What Do Liquidity Ratios Tell You?

Liquidity is the ability to convert assets into cash quickly and cheaply. Liquidity ratios are most useful
when they are used in comparative form. This analysis may be internal or external.

For example, internal analysis regarding liquidity ratios involves using multiple accounting periods that
are reported using the same accounting methods. Comparing previous time periods to current
operations allows analysts to track changes in the business. In general, a higher liquidity ratio shows a
company is more liquid and has better coverage of outstanding debts.

Alternatively, external analysis involves comparing the liquidity ratios of one company to another or an
entire industry. This information is useful to compare the company's strategic positioning in relation to
its competitors when establishing benchmark goals. Liquidity ratio analysis may not be as effective when
looking across industries as various businesses require different financing structures. Liquidity ratio
analysis is less effective for comparing businesses of different sizes in different geographical locations.

Common Liquidity Ratios

What Is Working Capital?

Working capital, also known as net working capital (NWC), is the difference between a company’s
current assets, such as cash, accounts receivable (customers’ unpaid bills) and inventories of raw
materials and finished goods, and its current liabilities, such as accounts payable. Net operating working
capital is a measure of a company's liquidity and refers to the difference between operating current
assets and operating current liabilities. In many cases these calculations are the same and are derived
from company cash plus accounts receivable plus inventories, less accounts payable and less accrued
expenses.

Working capital is a measure of a company's liquidity, operational efficiency and its short-term financial
health. If a company has substantial positive working capital, then it should have the potential to invest
and grow. If a company's current assets do not exceed its current liabilities, then it may have trouble
growing or paying back creditors, or even go bankrupt.

KEY TAKEAWAYS

 A company has negative working capital If the ratio of current assets to liabilities is less than
one.
  Positive working capital indicates that a company can fund its current operations and invest in
future activities and growth.
 High working capital isn't always a good thing. It might indicate that the business has too much
inventory or is not investing its excess cash.

The Formula for Working Capital

WC = Current Assets – Current Liabilities

To calculate the working capital, compare a company's current assets to its current liabilities. Current
assets listed on a company's balance sheet include cash, accounts receivable, inventory and other assets
that are expected to be liquidated or turned into cash in less than one year. Current liabilities include
accounts payable, wages, taxes payable, and the current portion of long-term debt. Current assets are
available within 12 months. Current liabilities are due within 12 months.

The standard formula for working capital is current assets minus current liabilities.

Working capital that is in line with or higher than the industry average for a company of comparable size
is generally considered acceptable. Low working capital may indicate a risk of distress or default.

Changes in Working Capital Affect a Company's Cash Flow

Most major new projects, such as an expansion in production or into new markets, require an
investment in working capital. That reduces cash flow. But cash will also fall if money is collected too
slowly, or if sales volumes are decreasing – which will lead to a fall in accounts receivable. Companies
that are using working capital inefficiently can boost cash flow by squeezing suppliers and customers.

The Current Ratio

The current ratio measures a company's ability to pay off its current liabilities (payable within one year)
with its current assets such as cash, accounts receivable and inventories. The higher the ratio, the better
the company's liquidity position:

The Quick Ratio

The quick ratio measures a company's ability to meet its short-term obligations with its most liquid
assets and therefore excludes inventories from its current assets. It is also known as the "acid-test
ratio":

Another way to express this is:

The Importance Of Analyzing Accounts Receivable

In studying financial statements, investors often focus on revenues, net income, and earnings per share.
Although investigating a business’s revenues and profits is a good way to get a picture of its overall
health, analyzing the accounts receivable allows you to go a step deeper in your analysis.

Accounts Receivable: What Is It and Why Does It Matter?

In the simplest terms, accounts receivable measures the money that customers owe to a business for
goods or services already provided. Because the business expects the money in the future, accountants
include accounts receivable as an asset on the business’s balance sheet. (Learn more in Breaking Down
the Balance Sheet). However, most businesses do not expect to collect 100 percent of the money shown
in accounts receivable.

Given this risk of non-payment, why do business continue providing goods and services without
requiring payment in advance? When dealing with regular and reliable customers, a business can
benefit from selling its goods and services on credit. It may be able to make more sales that way and
also reduce transaction costs. For example, the business can invoice reliable customers periodically
instead of processing numerous small payments.

The problem is when accounts receivable reflects money owed by unreliable customers. Customers can
default on their payments, forcing the business to accept a loss. In order to account for this risk,
businesses base their financial reporting on the assumption that not all of their accounts receivable will
be paid by customers. Accountants refer to this portion as the allowance for bad debts.

On face value, it is impossible to know whether the accounts receivable of a business are indicative of
healthy or unhealthy business practices. Investors can only gain this knowledge through careful analysis.

What Is the Receivables Turnover Ratio?

The accounts receivable turnover ratio is an accounting measure used to quantify a company's
effectiveness in collecting its receivables or money owed by clients. The ratio shows how well a
company uses and manages the credit it extends to customers and how quickly that short-term debt is
collected or is paid. The receivables turnover ratio is also called the accounts receivable turnover ratio.

The Formula and Calculation

1. Add the value of accounts receivable at the beginning of the desired period to the value at the
end of the period and divide the sum by two. The result is the denominator in the formula.
2. Divide the value of net credit sales for the period by the average accounts receivable during the
same period.
3. Net credit sales are the revenue generated from sales that were done on credit minus any
returns from customers.

**KEY TAKEAWAYS

 The accounts receivable turnover ratio is an accounting measure used to quantify a company's
effectiveness in collecting its receivables or money owed by clients.
 A high receivables turnover ratio can indicate that a company’s collection of accounts receivable
is efficient and that the company has a high proportion of quality customers that pay their debts
quickly.
 A low receivables turnover ratio might be due to a company having a poor collection process,
bad credit policies, or customers that are not financially viable or creditworthy.
 A company’s receivables turnover ratio should be monitored and tracked to determine if a trend
or pattern is developing over time.

Receivables Turnover Ratio Inferences

Companies that maintain accounts receivables are indirectly extending interest-free loans to their
clients since accounts receivable is money owed without interest. If a company generates a sale to a
client, it could extend terms of 30 or 60 days, meaning the client has 30 to 60 days to pay for the
product.

The receivables turnover ratio measures the efficiency with which a company collects on their
receivables or the credit it had extended to its customers. The ratio also measures how many times a
company's receivables are converted to cash in a period. The receivables turnover ratio could be
calculated on an annual, quarterly, or monthly basis.

High Accounts Receivable

A high receivables turnover ratio can indicate that a company’s collection of accounts receivable is
efficient and that the company has a high proportion of quality customers that pay their debts quickly. A
high receivables turnover ratio might also indicate that a company operates on a cash basis.

A high ratio can also suggest that a company is conservative when it comes to extending credit to its
customers. Conservative credit policy can be beneficial since it could help the company avoid extending
credit to customers who may not be able to pay on time.

On the other hand, if a company’s credit policy is too conservative, it might drive away potential
customers to the competition who will extend them credit. If a company is losing clients or suffering
slow growth, they might be better off loosening their credit policy to improve sales, even though it
might lead to a lower accounts receivable turnover ratio.

Low Accounts Receivable

A low receivables turnover ratio might be due to a company having a poor collection process, bad credit
policies, or customers that are not financially viable or creditworthy.

Typically, a low turnover ratio implies that the company should reassess its credit policies to ensure the
timely collection of its receivables. However, if a company with a low ratio improves its collection
process, it might lead to an influx of cash from collecting on old credit or receivables.

Tracking Receivables Turnover Ratio

A company’s receivables turnover ratio should be monitored and tracked to determine if a trend or
pattern is developing over time. Also, companies can track and correlate the collection of receivables to
earnings to measure the impact the company’s credit practices have on profitability.

For investors, it's important to compare the accounts receivable turnover of multiple companies within
the same industry to get a sense of what's the normal or average turnover ratio for that sector. If one
company has a much higher receivables turnover ratio than the other, it may prove to be a safer
investment.

Receivables Turnover Ratio Limitations

Like any metric attempting to gauge the efficiency of a business, the receivables turnover ratio comes
with a set of limitations that are important for any investor to consider before using it.

A limitation to consider is that some companies use total sales instead of net sales when calculating
their turnover ratio, which inflates the results. While this is not always necessarily meant to be
deliberately misleading, investors should try to ascertain how a company calculates its ratio or calculate
the ratio independently.

Another limitation to the turnover ratio is that accounts receivables can vary dramatically throughout
the year. For example, companies that are seasonal will likely have periods with high receivables along
with perhaps a low turnover ratio and periods when the receivables are fewer and can be more easily
managed and collected.

In other words, if an investor chooses a starting and ending point for calculating the receivables
turnover ratio arbitrarily, the ratio may not reflect the company's effectiveness of issuing and collecting
credit. As such, the beginning and ending values selected when calculating the average accounts
receivable should be carefully chosen so to accurately reflect the company's performance. Investors
could take an average of accounts receivable from each month during a 12-month period to help
smooth out any seasonal gaps.

Any comparisons of the turnover ratio should be made with companies that are in the same industry,
and ideally, have similar business models. Companies of different sizes may often have very different
capital structures, which can greatly influence turnover calculations, and the same is often true of
companies in different industries.

Lastly, a low receivables turnover might not necessarily indicate that the company’s issuing of credit and
collecting of debt is lacking. For example, if the company's distribution division is operating poorly, it
might be failing to deliver the correct goods to customers in a timely manner. As a result, customers
might delay paying their receivable, which would decrease the company’s receivables turnover ratio.

Example Receivables Turnover Ratio

Let's say Company A had the following financial results for the year:

Net credit sales of $800,000

$64,000 in accounts receivables on January 1st or the beginning of the year

$72,000 in accounts receivables on December 31st or at the end of the year

We can calculate the receivables turnover ratio in the following way:

We can interpret the ratio to mean that Company A collected its receivables 11.76 times on average that
year. In other words, the company converted its receivables to cash 11.76 times that year. A company
could compare several years to ascertain whether 11.76 is an improvement or an indication of a slower
collection process.

A company could also determine the average duration of accounts receivable or the number of days it
takes to collect them during the year. In our example above, we would divide the ratio of 11.76 by 365
days to arrive at the average duration. The average accounts receivable turnover in days would be 365 /
11.76 or 31.04 days.

For Company A, customers on average take 31 days to pay their receivables. If the company had a 30-
day payment policy for its customers, the average accounts receivable turnover shows that on average
customers are paying one day late.

A company could improve its turnover ratio by making changes to its collection process. A company
could also offer its customers discounts for paying early. It's important for companies to know their
receivables turnover since its directly tied to how much cash they'll available to pay their short term
liabilities.

What Is Days Sales Outstanding – DSO?

Days sales outstanding (DSO) is a measure of the average number of days that it takes a company to
collect payment after a sale has been made. DSO is often determined on a monthly, quarterly or annual
basis, and can be calculated by dividing the amount of accounts receivable during a given period by the
total value of credit sales during the same period, and multiplying the result by the number of days in
the period measured.

Days sales outstanding is an element of the cash conversion cycle and is often referred to as days
receivables or average collection period.

The Formula for Days Sales Outstanding Is

What Does Days Sales Outstanding Tell You?

Due to the high importance of cash in running a business, it is in a company's best interest to collect on
its outstanding account receivables as quickly as possible. While companies can most often expect with
relative certainty that they will, in fact, receive outstanding receivables, because of the time value of
money principle, money that a company spends time waiting to receive is money lost. By quickly turning
sales into cash, a company has a chance to put the cash to use again more quickly.

A high DSO number shows that a company is selling its product to customers on credit and taking longer
to collect money. This may lead to cash flow problems because of the long duration between the time of
a sale and the time the company receives payment. A low DSO value means that it takes a company
fewer days to collect its accounts receivable. In effect, the ability to determine the average length of
time that a company’s outstanding balances are carried in receivables can in some cases tell a great deal
about the nature of the company’s cash flow.

It is important to remember that the formula for calculating DSO only accounts for credit sales. While
cash sales may be considered to have a DSO of 0, they are not factored into DSO calculations because
they represent no time between a sale and the company’s receipt of payment. If they were factored into
the calculation, they would decrease the DSO, and companies with a high proportion of cash sales would
have lower DSOs than those with a high proportion of credit sales.

Days sales outstanding (DSO) is a measure of the average number of days that it takes a company to
collect payment after a sale has been made.

DSO indicates the number of sales a company has made during a specific time period; how quickly
customers are paying; if the company’s collections department is working well; if the company is
maintaining customer satisfaction, or if credit is being given to customers that are not creditworthy.

Generally speaking, a DSO under 45 days is considered low; however, what qualifies as a high or low
DSO may often vary depending on business type and structure.

Applications of DSO

Days sales outstanding has a wide variety of applications. It can indicate the dollar amount of sales a
company has made during a specific time period; how quickly customers are paying; if the company’s
collections department is working well; if the company is maintaining customer satisfaction; or if credit
is being given to customers that are not creditworthy.

While looking at an individual DSO value for a company can provide a good benchmark for quickly
assessing a company’s cash flow, trends in DSO are much more useful than an individual DSO value. If a
company’s DSO is increasing, it may indicate a few things. It may be that customers are taking more time
to pay their expenses, suggesting either that customer satisfaction is declining, that salespeople within
the company are offering longer terms of payment to drive increased sales, or that the company is
allowing customers with poor credit to make purchases on credit.

Additionally, too sharp of an increase in DSO can cause a company serious cash flow problems. If a
company is accustomed to paying its expenses at a certain rate on the basis of consistent payments on
its accounts receivable, a sharp rise in DSO can disrupt this flow and force the company to make drastic
changes.
Generally, when looking at a given company’s cash flow, it is helpful to track that company’s DSO over
time to determine if its DSO is trending in any particular direction or if there are any patterns in the
company’s cash flow history. DSO may often vary on a monthly basis, particularly if the company is
affected by seasonality. If a company has a volatile DSO, this may be cause for concern, but if a
company’s DSO dips during a particular season each year, this is often less of a reason to worry.

Example of Days Sales Outstanding

As a hypothetical example, suppose that during the month of July, Company A made a total of $500,000
in credit sales and had $350,000 in accounts receivable. There are 31 days in July, so Company A’s DSO
for July can be calculated as:

With a DSO of 21.7, Company A has a short average turnaround in converting its receivables into cash.
Generally speaking, a DSO under 45 days is considered low; however, what qualifies as a high or low
DSO may often vary depending on business type and structure.

Limitations of DSO

Like any metric attempting to gauge the efficiency of a business, days sales outstanding comes with a set
of limitations that are important for any investor to consider before using it.

Most simply, when using DSO to compare the cash flows of multiple companies, one should compare
companies within the same industry, ideally when they have similar business models and revenue
numbers as well. As mentioned above, companies of different sizes often have very different capital
structures, which can greatly influence DSO calculations, and the same is often true of companies in
different industries.

DSO is not particularly useful in comparing companies with significant differences in the proportion of
sales that are credit, as determining the DSO of a company with a low proportion of credit sales does
not indicate much about that company’s cash flow. Comparing such companies with those that have a
high proportion of credit sales also does not usually indicate much importance.

Furthermore, DSO is not a perfect indicator of a company’s accounts receivable efficiency, as fluctuating
sales volumes can affect DSO, with any increase in sales frequently lowering the DSO value. Delinquent
Days Sales Outstanding (DDSO) is a good alternative for credit collection assessment for use alongside
DSO. Like any metric measuring a company’s performance, DSO should not be considered alone, but
instead should be used with other metrics as well.

How to Analyze a Company's Inventory

Important to facility operations, inventory represents products a company possesses on its premises or
goods consigned to third parties. Inventory plays an important role in the smooth functioning of a
company's business since it acts as a buffer between the production and completion of customers'
orders. Investors can find data on inventory in public filings of a company on its investor relations
website or through the Securities and Exchange Commission (SEC) website.

While a company's balance sheet contains one line that shows end-of-period inventory balances,
footnotes to financial statements show more details on inventory. These details typically include a
description of how a company accounts for its inventory and detailed balances for different
subcategories within an inventory account.

Types of Inventory

Inventory represents a current asset since a company typically intends to sell its finished goods within a
short amount of time, typically a year. Inventory has to be physically counted or measured before it can
be put on a balance sheet. Companies typically maintain sophisticated inventory management systems
capable of tracking real-time inventory levels. Inventory is accounted for using one of three methods:
first-in-first-out (FIFO) costing, last-in-first-out (LIFO) costing, or weighted-average costing.

An inventory account typically consists of four separate categories: raw materials, work in process,
finished goods, and merchandise. Raw materials represent various materials a company purchases for
its production process. These materials must undergo significant work before a company can transform
them into finished goods ready for sale. Work in process represents raw materials in the process of
being transformed into a finished product. Finished goods are completed products readily available for
sale to a company's customers. Merchandise represents finished goods a company buys from a supplier
for future resale.

How to Calculate the Inventory Turnover Ratio

Managing inventory levels is important for companies to show whether sales efforts are effective or
whether costs are being controlled. The inventory turnover ratio is an important measure of how well a
company generates sales from its inventory.

What Is Inventory?

Inventory is the account of all the goods a company has in its stock, including raw materials, work-in-
progress materials, and finished goods that will ultimately be sold. Inventory typically includes finished
goods, such as clothing in a department store. However, inventory can also include raw materials that
go into the production of finished goods, called work-in-progress. For example, the cloth used to make
the clothing would be inventory for the clothing manufacturer.

What Is Inventory Turnover and How Is It Interpreted?

Inventory turnover is the number of times a company sells and replaces its stock of goods during a
period. Inventory turnover provides insight as to how the company manages costs and how effective
their sales efforts have been.

The higher the inventory turnover, the better since a high inventory turnover typically means a company
is selling goods very quickly and that demand for their product exists.

Low inventory turnover, on the other hand, would likely indicate weaker sales and declining demand for
a company’s products.

Inventory turnover provides insight as to whether a company is managing its stock properly. The
company may have overestimated demand for their products and purchased too many goods as shown
by low turnover. Conversely, if inventory turnover is very high, they might not be buying enough
inventory and may be missing out on sales opportunities.

Inventory turnover also shows whether a company’s sales and purchasing departments are in sync.
Ideally, inventory should match sales. It can be quite costly for companies to hold onto inventory that
isn’t selling, which is why inventory turnover can be an important indicator of sales effectiveness but
also for managing operating costs. Alternatively, for a given amount of sales, using less inventory to do
so will improve inventory turnover.

KEY TAKEAWAYS

 Inventory includes all the goods a company has in its stock that will ultimately be sold.
 Inventory turnover indicates how many times a company sells and replaces its stock of goods
during a particular period.
 The formula for inventory turnover ratio is the cost of goods sold divided by the average
inventory for the same period.
 Calculating Inventory Turnover
 Like a typical turnover ratio, inventory turnover details how much inventory is sold over a
period. To calculate the inventory turnover ratio, cost of goods sold is divided by the average
inventory for the same period.

Cost of Goods Sold ÷ Average Inventory or Sales ÷ Inventory

Average inventory is used in the ratio because companies might have higher or lower inventory levels at
certain times in the year. For example, retailers like Best Buy Co. Inc. (BBY) would likely have higher
inventory leading up to the holidays in Q4 and lower inventory levels in Q1 following the holidays.

Cost of goods sold (COGS) is a measurement of the production costs of goods and services for a
company. COGS can include the cost of materials, labor costs directly related to goods produced, and
any factory overhead or fixed costs that are directly used in the production of goods.

What Is Days Sales Of Inventory – DSI?

The days sales of inventory (DSI) is a financial ratio that indicates the average time in days that a
company takes to turn its inventory, including goods that are a work in progress, into sales.

DSI is also known as the average age of inventory, days inventory outstanding (DIO), days in inventory
(DII), days sales in inventory or days inventory and is interpreted in multiple ways. Indicating the
liquidity of the inventory, the figure represents how many days a company’s current stock of inventory
will last. Generally, a lower DSI is preferred as it indicates a shorter duration to clear off the inventory,
though the average DSI varies from one industry to another.

Formula and Calculating DSI

To manufacture a salable product, a company needs raw material and other resources which form the
inventory and come at a cost. Additionally, there is a cost linked to the manufacturing of the salable
product using the inventory. Such costs include labor costs and payments towards utilities like
electricity, which is represented by the cost of goods sold (COGS) and is defined as the cost of acquiring
or manufacturing the products that a company sells during a period. DSI is calculated based on the
average value of the inventory and cost of goods sold during a given period or as of a particular date.
Mathematically, the number of days in the corresponding period is calculated using 365 for a year and
90 for a quarter. In some cases, 360 days is used instead.

The numerator figure represents the valuation of the inventory. The denominator (Cost of Sales /
Number of Days) represents the average per day cost being spent by the company for manufacturing a
salable product. The net factor gives the average number of days taken by the company to clear the
inventory it possesses.

Two different versions of the DSI formula can be used depending upon the accounting practices. In the
first version, the average inventory amount is taken as the figure reported at the end of the accounting
period, such as at the end of the fiscal year ending June 30. This version represents DSI value “as of” the
mentioned date. In another version, the average value of Start Date Inventory and End Date Inventory is
taken, and the resulting figure represents DSI value “during” that particular period. Therefore,

COGS value remains the same in both the versions.

KEY TAKEAWAYS

 Days sales of inventory (DSI) is the average number of days it takes for a firm to sell off
inventory.
 DSI is a metric that analysts use to determine the efficiency of sales.
 A high DSI can indicate that a firm is not properly managing its inventory or that it has inventory
that is difficult to sell.

What DSI Tells You?

Since DSI indicates the duration of time a company’s cash is tied up in its inventory, a smaller value of
DSI is preferred. A smaller number indicates that a company is more efficiently and frequently selling off
its inventory, which means rapid turnover leading to the potential for higher profits (assuming that sales
are being made in profit). On the other hand, a large DSI value indicates that the company may be
struggling with obsolete, high-volume inventory and may have invested too much into the same. It is
also possible that the company may be retaining high inventory levels in order to achieve high order
fulfillment rates, such as in anticipation of bumper sales during an upcoming holiday season.

DSI is a measure of the effectiveness of inventory management by a company. Inventory forms a

significant chunk of the operational capital requirements for a business. By calculating the number of
days that a company holds onto the inventory before it is able to sell it, this efficiency ratio measures
the average length of time that a company’s cash is locked up in the inventory.

However, this number should be looked upon cautiously as it often lacks context. As can be seen from
the above examples of DSI values calculated for brick and mortar retail (Walmart), online retail
(Amazon) and technology (Microsoft) sector companies, DSI tends to vary greatly among industries
depending on various factors like product type and business model. Therefore, it is important to
compare the value among the same sector peer companies. Companies in the technology, automobile,
and furniture sectors can afford to hold on to their inventories for long, but those in the business of
perishable or fast moving consumer goods (FMCG) cannot. Therefore, sector-specific comparisons
should be made for DSI values.

One must also note that a high DSI value may be preferred at times depending on the market dynamics.
If a short supply is expected for a particular product in the next quarter, a business may be better off
holding on to its inventory and then selling it later for a much higher price, thus leading to improved
profits in the long run.

For example, a drought situation in a particular soft water region may mean that authorities will be
forced to supply water from another area where water quality is hard. It may lead to a surge in demand
for water purifiers after a certain period, which may benefit the companies if they hold onto inventories.

Irrespective of the single-value figure indicated by DSI, the company management should find a
mutually beneficial balance between optimal inventory levels and market demand.

Solvency Ratio vs. Liquidity Ratios: An Overview

Liquidity ratios and the solvency ratio are tools investors use to make investment decisions. Liquidity
ratios measure a company's ability to convert its assets into cash. On the other hand, the solvency ratio
measures a company's ability to meet its financial obligations.

The solvency ratio includes financial obligations in both the long and short term, whereas liquidity ratios
focus more on a company's short-term debt obligations and current assets.

Fixed Assets to Long-Term Liabilities

The fixed-assets- to long-term-liabilities ratio is a way of measuring the solvency of a company. A

company's long-term debts are often secured with fixed assets, which is why creditors are interested in
this ratio. This ratio is calculated by dividing the value of fixed assets by the amount of long-term debt.
For example, if your business has $500,000 of fixed assets and $125,000 in long-term debt, the ratio
would be 4 ($500,000/$125,000 = 4). As with the interest coverage ratio, a bigger number is better, with
a low number indicating your fixed assets may not cover your debt.
What Is the Debt-To-Equity Ratio – D/E?

The debt-to-equity (D/E) ratio is calculated by dividing a company’s total liabilities by its shareholder
equity. These numbers are available on the balance sheet of a company’s financial statements.

The ratio is used to evaluate a company's financial leverage. The D/E ratio is an important metric used in
corporate finance. It is a measure of the degree to which a company is financing its operations through
debt versus wholly-owned funds. More specifically, it reflects the ability of shareholder equity to cover
all outstanding debts in the event of a business downturn.

The debt-to-equity ratio is a particular type of gearing ratio.

KEY TAKEAWAYS

 The debt-to-equity (D/E) ratio compares a company’s total liabilities to its shareholder equity
and can be used to evaluate how much leverage a company is using.
 Higher leverage ratios tend to indicate a company or stock with higher risk to shareholders.
 However, the D/E ratio is difficult to compare across industry groups where ideal amounts of
debt will vary.
 Investors will often modify the D/E ratio to focus on long-term debt only because the risk of
long-term liabilities are different than for short-term debt and payables.

Information From the Debt-To-Equity Ratio

Given that the debt-to-equity ratio measures a company’s debt relative to the value of its net assets, it is
most often used to gauge the extent to which a company is taking on debt as a means of leveraging its
assets. A high debt/equity ratio is often associated with high risk; it means that a company has been
aggressive in financing its growth with debt.

If a lot of debt is used to finance growth, a company could potentially generate more earnings than it
would have without that financing. If leverage increases earnings by a greater amount than the debt’s
cost (interest), then shareholders should expect to benefit. However, if the cost of debt financing
outweighs the increased income generated, share values may decline. The cost of debt can vary with
market conditions. Thus, unprofitable borrowing may not be apparent at first.

What Is the Times Interest Earned Ratio?

The times interest earned (TIE) ratio is a measure of a company's ability to meet its debt obligations
based on its current income. The formula for a company's TIE number is earnings before interest and
taxes (EBIT) divided by the total interest payable on bonds and other debt.

The result is a number that shows how many times a company could cover its interest charges with its
pretax earnings.

TIE is also referred to as the interest coverage ratio.

Understanding the Times Interest Earned (TIE) Ratio

Obviously, no company needs to cover its debts several times over in order to survive. However, the TIE
ratio is an indication of a company's relative freedom from the constraints of debt. Generating enough
cash flow to continue to invest in the business is better than merely having enough money to stave off
bankruptcy.

A company's capitalization is the amount of money it has raised by issuing stock or debt, and those
choices impact its TIE ratio. Businesses consider the cost of capital for stock and debt and use that cost
to make decisions.

How to Calculate Times Interest Earned (TIE)

Assume, for example, that XYZ Company has $10 million in 4% debt outstanding and $10 million in
common stock. The company needs to raise more capital to purchase equipment. The cost of capital for
issuing more debt is an annual interest rate of 6%. The company's shareholders expect an annual
dividend payment of 8% plus growth in the stock price of XYZ.
Companies that have consistent earnings, like utilities, tend to borrow more because they are good
credit risks.

The business decides to issue $10 million in additional debt. Its total annual interest expense will be: (4%
X $10 million) + (6% X $10 million), or $1 million annually. The company's EBIT is $3 million.

This means that the TIE ratio for XYZ Company is 3, or three times the annual interest expense.

Factoring in Consistent Earnings

As a rule, companies that generate consistent annual earnings are likely to carry more debt as a
percentage of total capitalization. If a lender sees a history of generating consistent earnings, the firm
will be considered a better credit risk.

Utility companies, for example, generate consistent earnings. Their product is not an optional expense
for consumers or businesses. Some utility companies raise 60% or more of their capital by issuing debt.

Startup firms and businesses that have inconsistent earnings, on the other hand, raise most or all of the
capital they use by issuing stock. Once a company establishes a track record of producing reliable
earnings, it may begin raising capital through debt offerings as well.

Preferred Dividend Coverage Ratio

The preferred dividend coverage ratio is a financial measure that calculates a corporation’s ability to pay
the dividends owed to its preferred shareholders based on its net income. In other words, it shows
investors and shareholders how well the company is doing by comparing profits to preferred dividends.
If the company has sufficient profits to pay the dividends, it’s deemed to be doing well.

Definition – What is the Preferred Dividend Coverage Ratio?

This coverage ratio, also called times preferred dividend earned ratio, looks at the company’s net
income to see if it is sufficient to meet the fixed dividend amount payable on its outstanding preferred
shares. Thus, it is useful to all current and potential shareholders, as well as debt holders, as an
important component in evaluating a company’s financial health.

Banks and other creditors will use this ratio to evaluate how much additional debt the company can
handle. Even common stock shareholders should be aware of this coverage ratio, as it could have an
effect on common stock dividends.

Ideally, the company will have much more profits than it needs to cover this dividend payment, but this
isn’t always the case. A coverage ratio of 1 signifies the company will be able to meet its preferred
dividend obligation, while a number less than 1 means it cannot and is a serious problem.

There are three important pieces of information needed to calculate the preferred dividend coverage
ratio: net income, the fixed dividend rate on preferred shares and par value of the preferred shares.
Each of these can be obtained from company financial statements, such as the annual report and the
prospectus.

Formula

The preferred dividend coverage ratio formula is calculated by dividing the net income or total profits
for the year by the preferred dividend amount for that year.

Preferred Dividend Coverage Ratio = Net Income / Annual Preferred Dividend Amount

Before we can calculate this preferred dividend coverage ratio equation, we compute the preferred
dividends for the year. We can do this by multiplying the annual dividend rate by the par value of the
shares. Both of these factors can be found in the preferred stock issue’s prospectus. Now, you can divide
the net income, by this number to find the coverage ratio. You may also want to look at the PDC ratio on
a quarterly basis. To calculate for the quarter, divide the annual net income and the annual dividend
dollar amount by four, then solve the coverage ratio equation with those figures.
Example

ABC, Inc. is an established cloud storage solution provider with a track record among investors for
paying the highest preferred dividend in the sector. Larry is a money manager looking for opportunities
in his high-income portfolio. He is trying to determine if adding ABC, Inc. to his portfolio is a good long-
term position. One of the tools Larry uses in his search for such investments is the PDC ratio. It gives him
an idea of how stable the company is and assures him if the dividend can be expected to last for his
investors.

Larry pulls ABC, Inc.’s annual report to find the company’s net income was $20 million. Then, he looks at
the preferred issue’s prospectus to find it was issued for a total par value of $10,000,000 at 5%.

Preferred Dividend Coverage Ratio Example

Seeing that ABC, Inc. could cover 40 times their annual preferred dividend obligation with their annual
profits, proves to Larry that there is a very good chance the dividend will be paid. It also illustrates that
ABC, Inc. is in great financial shape.

Analysis and Interpretation

So, what is the preferred dividend coverage ratio used for? The number shows if the amount of income
the company makes is sufficient to cover one of its most important obligations. Think of it like a
homeowner’s net income supporting his mortgage payment each month. If he is spending the majority
of his money to meet his mortgage obligation, any small change in his income like too many sick days off
from work could mean he cannot make his mortgage payment.

The same is true for companies that have issued preferred stock. If they are barely making enough to
cover their preferred dividend payments, they certainly won’t be able to afford paying common
shareholders a dividend and may even run the risk of more serious issues if the situation continues.

When the preferred dividend ratio is high, it shows us that a company has ample net income to meet
the obligation to preferred shareholders.

Usage Explanations and Cautions

If the preferred dividend coverage ratio is found to be low, further investigation into the company’s
financial statements is needed to determine overall strength. It’s possible they just had a bad quarter.
Comparing the coverage ratio over several years or quarters can give a better idea of the company’s
stability.

Whether it’s a money manager looking to add to his portfolio or a bank trying to underwrite a new loan
for a company, when there are preferred shares outstanding, the preferred dividend coverage ratio is an
important tool in evaluating the how well a company can meet it’s obligation to its preferred
shareholders.

What Are Profitability Ratios?

Profitability ratios are a class of financial metrics that are used to assess a business's ability to generate
earnings relative to its revenue, operating costs, balance sheet assets, and shareholders' equity over
time, using data from a specific point in time.

KEY TAKEAWAYS

 Profitability ratios consist of a group of metrics that assess a company's ability to generate
revenue relative to its revenue, operating costs, balance sheet assets, and shareholders' equity.
 Profitability ratios also show how well companies use their existing assets to generate profit and
value for shareholders.
 Higher ratio results are often more favorable, but ratios provide much more information when
compared to results from other, similar companies, the company's own historical performance,
or the industry average.

What Do Profitability Ratios Tell You?

For most profitability ratios, having a higher value relative to a competitor's ratio or relative to the same
ratio from a previous period indicates that the company is doing well. Ratios are most informative and
useful when used to compare a subject company to other, similar companies, the company's own
history, or average ratios for the company's industry as a whole.

For example, gross profit margin is one of the most often-used profitably or margin ratios. Some
industries experience seasonality in their operations, such as the retail industry. Retailers typically
experience significantly higher revenues and earnings during the year-end holiday season. It would not
be useful to compare a retailer's fourth-quarter gross profit margin with its first-quarter gross profit
margin because it would not reveal directly comparable information. Comparing a retailer's fourth-
quarter profit margin with its fourth-quarter profit margin from the same period a year before would be
far more informative.

Asset Turnover Ratio

The asset turnover ratio is an efficiency ratio that measures a company’s ability to generate sales from
its assets by comparing net sales with average total assets. In other words, this ratio shows how
efficiently a company can use its assets to generate sales.

The total asset turnover ratio calculates net sales as a percentage of assets to show how many sales are
generated from each dollar of company assets. For instance, a ratio of .5 means that each dollar of
assets generates 50 cents of sales.

Formula

The asset turnover ratio is calculated by dividing net sales by average total assets.

Net sales, found on the income statement, are used to calculate this ratio returns and refunds must be
backed out of total sales to measure the truly measure the firm’s assets’ ability to generate sales.

Average total assets are usually calculated by adding the beginning and ending total asset balances
together and dividing by two. This is just a simple average based on a two-year balance sheet. A more
in-depth, weighted average calculation can be used, but it is not necessary.

Analysis

This ratio measures how efficiently a firm uses its assets to generate sales, so a higher ratio is always
more favorable. Higher turnover ratios mean the company is using its assets more efficiently. Lower
ratios mean that the company isn’t using its assets efficiently and most likely have management or
production problems.

For instance, a ratio of 1 means that the net sales of a company equals the average total assets for the
year. In other words, the company is generating 1 dollar of sales for every dollar invested in assets.

Like with most ratios, the asset turnover ratio is based on industry standards. Some industries use assets
more efficiently than others. To get a true sense of how well a company’s assets are being used, it must
be compared to other companies in its industry.

The total asset turnover ratio is a general efficiency ratio that measures how efficiently a company uses
all of its assets. This gives investors and creditors an idea of how a company is managed and uses its
assets to produce products and sales.

Sometimes investors also want to see how companies use more specific assets like fixed assets and
current assets. The fixed asset turnover ratio and the working capital ratio are turnover ratios similar to
the asset turnover ratio that are often used to calculate the efficiency of these asset classes.
Example

Sally’s Tech Company is a tech start up company that manufactures a new tablet computer. Sally is
currently looking for new investors and has a meeting with an angel investor. The investor wants to
know how well Sally uses her assets to produce sales, so he asks for her financial statements.

Here is what the financial statements reported:

Beginning Assets: $50,000

Ending Assets: $100,000

Net Sales: $25,000

The total asset turnover ratio is calculated like this:

Asset Turnover Ratio Formula

As you can see, Sally’s ratio is only .33. This means that for every dollar in assets, Sally only generates 33
cents. In other words, Sally’s start up in not very efficient with its use of assets.

Return on Total Assets (ROTA)

What Is Return on Total Assets?

Return on total assets (ROTA) is a ratio that measures a company's earnings before interest and taxes
(EBIT) relative to its total net assets. It is defined as the ratio between net income and total average
assets, or the amount of financial and operational income a company receives in a financial year as
compared to the average of that company's total assets.

The ratio is considered to be an indicator of how effectively a company is using its assets to generate
earnings. EBIT is used instead of net profit to keep the metric focused on operating earnings without the
influence of tax or financing differences when compared to similar companies.

KEY TAKEAWAYS

 The return on total assets shows how effectively a company uses its assets to generate earnings.
 The ROTA metric can be used to determine which companies are reporting the most efficient
use of their assets as compared with their earnings.
 Some concern exists about ROTA relying on the book value of total assets rather than their
market value, giving a return that looks higher than it should be in reality.

Understanding Return on Total Assets

The greater a company's earnings in proportion to its assets (and the greater the coefficient from this
calculation), the more effectively that company is said to be using its assets. The ROTA, expressed as a
percentage or decimal, provides insight into how much money is generated from each dollar invested
into the organization.

This allows the organization to see the relationship between its resources and its income, and it can
provide a point of comparison to determine if an organization is using its assets more or less effectively
than it had previously. In circumstances where the company earns a new dollar for each dollar invested
in it, the ROTA is said to be one, or 100 percent.

The Formula for Return on Total Assets – ROTA Is

To calculate ROTA, divide net income by average total assets. The same ratio can also be represented as
the product of profit margin and total asset turnover.
How to Calculate ROTA

To calculate ROTA, obtain the net income figure from a company's income statement, and then add
back interest and/or taxes that were paid during the year. The resulting number result is the company's
EBIT.

The EBIT number should then be divided by the company's total net assets to show the earnings that the
company has generated for each dollar of assets on its books.

Total assets include contra accounts for this ratio, meaning that allowance for doubtful accounts and
accumulated depreciation are both subtracted from the total asset balance before calculating the ratio.

Limitations of Using Return on Total Assets (ROTA)

Over time, the value of an asset may diminish or increase. In the case of real estate, the value of the
asset may rise. On the other hand, most mechanical pieces of a business, such as vehicles or other
machinery, generally depreciate over time as wear and tear affect their value.

Since the ROTA formula uses the book values of assets from the balance sheet, it may be significantly
understating the fixed assets' actual market value. This leads to a higher ratio result that shows a return
on total assets that is higher than it should be because the denominator (total assets) is too low.

Another limitation is how the ratio works with financed assets. If a debt was used to buy an asset, the
ROTA could look favorable, while the company may actually be having trouble making its interest
expense payments.

The ratio inputs can be adjusted to reflect the assets' functional values while accounting for the interest
rate currently being paid to a financial institution. For example, if an asset was acquired with funds from
a loan with an interest rate of 5% and the return on the associated asset was a gain of 20%, then the
adjusted ROTA would be 15%.

Since many newer companies have higher amounts of debt associated with their assets, these
adjustments may make the business look less attractive in the eyes of investors. Once those debts begin
to clear, the ROTA will appear to improve accordingly.

What Is Return on Equity – ROE?

Return on equity (ROE) is a measure of financial performance calculated by dividing net income by
shareholders' equity. Because shareholders' equity is equal to a company’s assets minus its debt, ROE
could be thought of as the return on net assets.

Formula and Calculation for ROE

ROE is expressed as a percentage and can be calculated for any company if net income and equity are
both positive numbers. Net income is calculated before dividends paid to common shareholders and
after dividends to preferred shareholders and interest to lenders.

Net Income is the amount of income, net of expense, and taxes that a company generates for a given
period. Average Shareholders' Equity is calculated by adding equity at the beginning of the period. The
beginning and end of the period should coincide with that which the net income is earned.

Net income over the last full fiscal year, or trailing 12 months, is found on the income statement—a sum
of financial activity over that period. Shareholders' equity comes from the balance sheet—a running
balance of a company’s entire history of changes in assets and liabilities.

It is considered the best practice to calculate ROE based on average equity over the period because of
this mismatch between the two financial statements. Learn more about how to calculate ROE.

What Does ROE Tell You?

Return on equity (ROE) deemed good or bad will depend on what’s normal for a stock’s peers. For
example, utilities will have a lot of assets and debt on the balance sheet compared to a relatively small
amount of net income. A normal ROE in the utility sector could be 10% or less. A technology or retail
firm with smaller balance sheet accounts relative to net income may have normal ROE levels of 18% or
more.

A good rule of thumb is to target an ROE that is equal to or just above the average for the peer group.
For example, assume a company, TechCo, has maintained a steady ROE of 18% over the last few years
compared to the average of its peers, which was 15%. An investor could conclude that TechCo’s
management is above average at using the company’s assets to create profits.

Relatively high or low ROE ratios will vary significantly from one industry group or sector to another.
When used to evaluate one company to another similar company the comparison will be more
meaningful. A common shortcut for investors to consider a return on equity near the long-term average
of the S&P 500 (14%) as an acceptable ratio and anything less than 10% as poor.

KEY TAKEAWAYS

 Return on equity measures how effectively management is using a company’s assets to create
profits.
 A good or bad ROE will depend on what’s normal for the industry or company peers.
 As a shortcut, investors can consider a return on equity near the long-term average of the S&P
500 (14%) as an acceptable ratio and anything less than 10% as poor.
 ROE is considered a measure of how effectively management is using a company’s assets to
create profits.