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Analyzing Financial

Statements for
Profitability, Liquidity,
and Solvency
Chapter 8

2005 Accounting 1/e, Terrell/Terrell

8-1

Learning Objectives 1
and 2
Distinguish among
profitability, liquidity, and
solvency.
Calculate financial ratios
designed to measure a
companys profitability,
liquidity, and solvency.
2005 Accounting 1/e, Terrell/Terrell

8-2

Introduction
Financial
Financialstatements
statementsanalysis
analysisisisthe
theprocess
process
of
oflooking
lookingbeyond
beyondthe
theface
faceof
ofthe
thefinancial
financial
statements
statementsto
togain
gainadditional
additionalinsight
insight
into
intoaacompanys
companysfinancial
financialhealth.
health.

Ratio
Ratioanalysis
analysisisisaatechnique
techniquefor
foranalyzing
analyzing
the
therelationship
relationshipbetween
betweentwo
twoitems
itemsfrom
fromaa
companys
companysfinancial
financialstatements
statementsfor
foraagiven
givenperiod.
period.
2005 Accounting 1/e, Terrell/Terrell

8-3

Elevation Sports, Inc.


Balance Sheet
May 31, 2004

Assets:
Assets:
Current
Currentassets
assets
Cash
$128,834
Cash
$128,834
Accounts
$9,900
Accountsreceivable
receivable
$9,900
Less:
9,450
Less:Allowance
Allowancefor
fordoubtful
doubtfulaccounts
accounts 450
450
9,45
Merchandise
4,397
Merchandiseinventory
inventory
4,39
Raw
2,315
Rawmaterials
materialsinventory
inventory
2,31
Work-in-process
14,864
Work-in-processinventory
inventory
14,86
Finished
13,634
Finishedgoods
goodsinventory
inventory
13,63
Supplies
593
Suppliesinventory
inventory
593
Prepaid
12,000
Prepaidrent
rent
12,000
Prepaid
5,000
Prepaidinsurance
insurance
5,00
Total
$190,637
Totalcurrent
currentassets
assets
$190,63
2005 Accounting 1/e, Terrell/Terrell

8-4

Elevation Sports, Inc.


Balance Sheet
May 31, 2004

Property,
Property,plant,
plant,and
andequipment
equipment
Administrative
Administrativeequipment
equipment $$5,100
5,100
Selling
Sellingfurniture
furnitureand
andfixtures
fixtures 8,400
8,400
Production
89,600
Productionequipment
equipment
89,600 $103,100
$103,100
Less:
17,800
Less:Accumulated
Accumulateddepreciation
depreciation
17,800
Total
$$ 85,300
Totalproperty,
property,plant,
plant,and
andequipment
equipment
85,30
Intangible
Intangibleassets
assets
Patents
$$ 10,083
Patents
10,083
Copyrights
570
Copyrights
570
Trademarks
1,425
Trademarks
1,425
Total
$$ 12,078
Totalintangible
intangibleassets
assets
12,078
Total
$288,015
Totalassets
assets
$288,015
2005 Accounting 1/e, Terrell/Terrell

8-5

Elevation Sports, Inc.


Balance Sheet
May 31, 2004

Liabilities
Liabilitiesand
andstockholders
stockholdersequity:
equity:
Current
liabilities
Current liabilities
Accounts
$$ 6,942
Accountspayable
payable
6,94
Other
11,812
Otheraccounts
accountspayable
payable
11,81
Interest
payable
6,000
Interest payable
6,00
Payroll
taxes
payable
1,400
Payroll taxes payable
1,40
Sales
taxes
payable
560
Sales taxes payable
56
Income
taxes
payable
42,120
Income taxes payable
42,120
Current
15,000
Currentportion
portionof
oflong-term
long-termnote
notepayable
payable
15,00
Total
current
liabilities
$
83,834
Total current liabilities
$ 83,834
Long-term
liabilities:
Long-term liabilities:
Note
Notepayable
payableVail
VailNational
NationalBank
Bank $$ 60,000
60,000
Less:
Current
portion
15,000
Less: Current portion
15,000
Total
45,000
Totallong-term
long-termliabilities
liabilities
45,00
Total
liabilities
$128,834
Total liabilities
$128,834
2005 Accounting 1/e, Terrell/Terrell

8-6

Elevation Sports, Inc.


Balance Sheet
May 31, 2004

Stockholders
Stockholdersequity
equity
Paid-in
Paid-incapital:
capital:
Common
Commonstock,
stock,$10
$10par
parvalue,
value,
100,000
100,000shares
sharesauthorized,
authorized,4,000
4,000
shares
$$ 60,000
sharesissued
issuedand
andoutstanding
outstanding
60,000
Paid-in
Paid-incapital
capitalin
inexcess
excessof
ofpar
par
common
40,000
commonstock
stock
40,000
Total
$100,000
Totalpaid-in
paid-incapital
capital
$100,000
Retained
59,181
Retainedearnings
earnings
59,181
Total
159,181
Totalstockholders
stockholdersequity
equity
159,181
Total
$288,
Totalliabilities
liabilitiesand
andstockholders
stockholdersequity
equity
$288

2005 Accounting 1/e, Terrell/Terrell

8-7

Elevation Sports, Inc.


Income Statement
For the Year Ended May 31,
2004
Net
Netsales
sales
Cost
Costof
ofgoods
goodssold
sold
Gross
Grossprofit
profit
Selling
$48,334
Sellingexpenses
expenses
$48,334
Administrative
expenses
72,189
Administrative expenses
72,189
Total
Totaloperating
operatingexpenses
expenses
Operating
income
Operating income
Other
Otherrevenues
revenuesand
andexpenses:
expenses:
Interest
$$ 512
Interestrevenue
revenue
512
Interest
(6,000
Interestexpense
expense
(6,000))
Total
Totalother
otherrevenues
revenuesand
andexpenses
expenses
Income
Incomebefore
beforeincome
incometaxes
taxes
Income
Incometaxes
taxes
Net
income
Net income
Earnings
Earningsper
pershare
share
2005 Accounting 1/e, Terrell/Terrell

$527,146
$527,146
295,834
295,834
$231,312
$231,312
120,523
120,523
$110,789
$110,789

(5,488
(5,488))
$105,301
$105,301
42,120
42,120
$$ 63,181
63,181
$$ 15.79
15.79
8-8

Profitability Ratios
Profitability
Profitabilityisisthe
theease
easewith
withwhich
which
aacompany
companygenerates
generatesincome.
income.
Profitability
Profitabilityratios
ratiosmeasure
measureaafirms
firms
past
pastperformance
performanceand
andhelp
helppredict
predict
its
itsfuture
futureprofitability
profitabilitylevel.
level.

2005 Accounting 1/e, Terrell/Terrell

8-9

Profitability Ratios

This
Thisratio
ratiomeasures
measureshow
howefficiently
efficientlythe
the
company
companyuses
usesits
itsassets
assetsto
toproduce
produceprofits.
profits.
Return
Returnon
onassets
assets=
=
Net
Netincome
incomebefore
beforetaxes
taxes
Total
Totalassets
assets
$105,301
$105,301
$288,015
$288,015=
=36.56%
36.56%
2005 Accounting 1/e, Terrell/Terrell

8 - 10

Profitability Ratios

This
Thisratio
ratiomeasures
measuresthe
thepercentage
percentageof
of
income
incomebefore
beforeincome
incometaxes
taxesproduced
produced
by
byaagiven
givenlevel
levelof
ofrevenue.
revenue.
Profit
Profitmargin
marginbefore
beforeincome
incometax
tax=
=
Net
Netincome
incomebefore
beforetaxes
taxes
Sales
Sales
$105,301
$105,301
$527,146
$527,146=
=19.98%
19.98%
2005 Accounting 1/e, Terrell/Terrell

8 - 11

Profitability Ratios

This
Thisratio
ratiocalculates
calculatesthe
theamount
amountof
ofsales
sales
produced
producedfor
foraagiven
givenlevel
levelof
ofassets
assetsused.
used.
Total
Totalasset
assetturnover
turnover=
=
Sales
Sales
Total
Totalassets
assets
$527,146
$527,146
$288,015
$288,015=
=1.83
1.83times
times
2005 Accounting 1/e, Terrell/Terrell

8 - 12

Profitability Ratios

Return
Profit
Returnon
on =
Profitmargin
margin Total
Totalasset
asset
assets
before
turnover
assets
beforeincome
incometax
tax
turnover
Net
Netincome
income
before
beforetaxes
taxes =

Total
Totalassets
assets

Net
Netincome
income
before
beforetaxes
taxes

Sales
Sales

2005 Accounting 1/e, Terrell/Terrell

Sales

Sales

Total
Totalassets
assets
8 - 13

Profitability Ratios

This
Thisratio
ratiomeasures
measuresthe
theamount
amountof
ofafter-tax
after-tax
net
netincome
incomegenerated
generatedby
byaadollar
dollarof
ofsales.
sales.
Profit
Profitmargin
marginafter
afterincome
incometax
tax=
=
Net
Netincome
incomeafter
aftertaxes
taxes
Sales
Sales
$63,181
$63,181
$527,146
$527,146=
=11.98%
11.98%
2005 Accounting 1/e, Terrell/Terrell

8 - 14

Profitability Ratios

This
Thisratio
ratioindicates
indicateshow
howmuch
muchafter-tax
after-taxincome
income
was
wasgenerated
generatedfor
foraagiven
givenlevel
levelof
ofequity.
equity.
Return
Returnon
onequity
equityafter
aftertaxes
taxes=
=
Net
Netincome
incomeafter
aftertaxes
taxes
Stockholders
Stockholdersequity
equity
$63,181
$63,181
$159,181=
$159,181=38.69%
38.69%
2005 Accounting 1/e, Terrell/Terrell

8 - 15

Profitability Ratios

This
Thisratio
ratiocalculates
calculateshow
howmuch
muchbefore-tax
before-taxincome
income
was
wasgenerated
generatedfor
foraagiven
givenlevel
levelof
ofequity.
equity.
Return
Returnon
onequity
equitybefore
beforetaxes
taxes=
=
(Net
(Netincome
incomeafter
aftertaxes
taxes+
+Income
Incometaxes)
taxes)

Stockholders
Stockholdersequity
equity
$105,301
$105,301
$159,181=
$159,181=66.15%
66.15%
2005 Accounting 1/e, Terrell/Terrell

8 - 16

Liquidity Ratios
An
Anassets
assetsliquidity
liquiditydescribes
describesthe
theease
ease
with
withwhich
whichititcan
canbe
beconverted
convertedto
tocash.
cash.
Liquidity
Liquidityratios
ratiosevaluate
evaluateaafirms
firmsability
ability
to
togenerate
generatesufficient
sufficientcash
cashto
to
meet
meetits
itsshort-term
short-termobligations.
obligations.

2005 Accounting 1/e, Terrell/Terrell

8 - 17

Liquidity Ratios

This
Thisratio
ratiomeasures
measuresthe
thecompanys
companysability
abilityto
to
meet
meetits
itscurrent
currentliabilities
liabilitieswith
withcurrent
currentassets.
assets.
Current
Currentratio
ratio=
=
Current
Currentassets
assets
Current
Currentliabilities
liabilities
$190,637
$190,637
$83,834
$83,834=
=2.27
2.27to
to11
2005 Accounting 1/e, Terrell/Terrell

8 - 18

Liquidity Ratios

This
Thisratio
ratioisisaastringent
stringenttest
testof
ofliquidity
liquidity
that
thatcompares
compareshighly
highlyliquid
liquidcurrent
current
assets
assetsto
tocurrent
currentliabilities.
liabilities.
Acid-test
Acid-testratio
ratio=
=(Cash
(Cash+
+Receivables
Receivables
+
+Trading
Tradingsecurities)
securities)
Current
Currentliabilities
liabilities
($128,384
($128,384+
+$9,450
$9,450+
+$0)
$0)
$83,834=
$83,834=1.64
1.64to
to11
2005 Accounting 1/e, Terrell/Terrell

8 - 19

Liquidity Ratios

This
Thisratio
ratioindicates
indicatesthe
thelevel
levelof
ofsales
sales
generated
generatedfor
foraagiven
givenlevel
levelof
ofworking
workingcapital.
capital.
Net
Netsales
salesto
toworking
workingcapital
capital=
=Sales
Sales

(Current
(Currentassets
assetsCurrent
Currentliabilities)
liabilities)
$527,146
$527,146
($190,637
($190,637$83,834)
$83,834)=
=4.94
4.94times
times
2005 Accounting 1/e, Terrell/Terrell

8 - 20

Liquidity Ratios

ItItmeasures
measureshow
howquickly
quicklyaacompany
company
collects
collectsits
itsaccounts
accountsreceivable.
receivable.
Accounts
Accountsreceivable
receivableturnover
turnover=
=
Net
Netcredit
creditsales
sales
Accounts
Accountsreceivable
receivable
Net
Netcredit
creditsales
sales=
=$151,650
$151,650$2,426
$2,426=
=$149,224
$149,224
2005 Accounting 1/e, Terrell/Terrell

8 - 21

Liquidity Ratios

Receivable
Receivableturnover
turnover=
=
$149,224
$149,224
$9,450
$9,450=
=15.79
15.79times
times
Average
Averagecollection
collectionperiod
period=
=
365
365
15.79
15.79=
=23.27
23.27days
days

2005 Accounting 1/e, Terrell/Terrell

8 - 22

Liquidity Ratios

This
Thisratio
ratioindicates
indicatesthe
thenumber
numberof
oftimes
times
total
totalmerchandise
merchandiseinventory
inventoryisispurchased
purchased
(or
(orfinished
finishedgoods
goodsinventory
inventoryisisproduced)
produced)
and
andsold
soldduring
duringaaperiod.
period.
Inventory
Inventoryturnover
turnover=
=
Cost
Costof
ofsales
sales
Inventory
Inventory
2005 Accounting 1/e, Terrell/Terrell

8 - 23

Liquidity Ratios

Inventory
Inventoryturnover
turnover=
=
$295,834
$295,834
($4,397
($4,397+
+$13,634)
$13,634)=
=16.41
16.41times
times
Average
Averagenumber
numberof
ofdays
days
Elevation
ElevationSports,
Sports,Inc.,
Inc.,holds
holdsits
itsinventory
inventory
=
=365
365
16.41
16.41=
=22.24
22.24days
days

2005 Accounting 1/e, Terrell/Terrell

8 - 24

Solvency Ratios
Solvency
Solvencyisisaacompanys
companysability
abilityto
tomeet
meetthe
the
obligations
obligationscreated
createdby
byits
itslong-term
long-termdebt.
debt.
Solvency
Solvencyratios
ratiosare
areof
ofmost
mostinterest
interestto
to
stockholders,
stockholders,long-term
long-termcreditors,
creditors,
and
andcompany
companymanagement.
management.

2005 Accounting 1/e, Terrell/Terrell

8 - 25

Solvency Ratios

ItItmeasures
measureswhat
whatproportion
proportionof
ofaa
companys
companysassets
assetsisisfinanced
financedby
bydebt.
debt.
Assets
Assets=
=Liabilities
Liabilities+
+Owners
Ownersequity
equity
100% = Some % +

2005 Accounting 1/e, Terrell/Terrell

Some %

8 - 26

Solvency Ratios

Total
Totalliabilities
liabilities
Total
Totalassets
assets
$128,834
$128,834
$288,015
$288,015=
=44.73%
44.73%

2005 Accounting 1/e, Terrell/Terrell

8 - 27

Solvency Ratios

This
Thisratio
ratioisisalso
alsocalled
calledthe
the
times-interest-earned
times-interest-earnedratio.
ratio.
ItItindicates
indicatesaacompanys
companysability
abilityto
to
make
makeits
itsperiodic
periodicinterest
interestpayments.
payments.

2005 Accounting 1/e, Terrell/Terrell

8 - 28

Solvency Ratios

Coverage
Coverageratio
ratio=
=
Earnings
Earningsbefore
beforeinterest
interestexpense
expense
and
andincome
incometaxes
taxes
Interest
Interestexpense
expense
($105,301
($105,301+
+$6,000)
$6,000)
$6,000
$6,000=
=18.55
18.55times
times

2005 Accounting 1/e, Terrell/Terrell

8 - 29

Learning Objective 3

Locate industry averages.

2005 Accounting 1/e, Terrell/Terrell

8 - 30

Industry Averages
This
Thischapter
chapteremphasizes
emphasizesthe
theAlmanac
Almanacof
of
Business
Businessand
andIndustrial
IndustrialFinancial
FinancialRatios
Ratios..
The
TheAlmanac
Almanacincludes
includesall
all
companies,
companies,public
publicand
andprivate.
private.
Information
Informationprovided
providedin
inthe
theAlmanac
Almanac
for
foreach
eachindustry
industryisisfour
fourpages.
pages.
ItItconsists
consistsof
oftwo
twotables.
tables.
2005 Accounting 1/e, Terrell/Terrell

8 - 31

Industry Averages
Table
TableIIprovides
providesan
ananalysis
analysisof
ofall
all
companies
companiesin
inthe
theparticular
particularindustry,
industry,
regardless
regardlessof
ofwhether
whetherthey
theyhad
had
any
anynet
netincome
incomefor
forthe
theyear.
year.
Table
TableIIIIprovides
providesthe
thesame
sameinformation
information
items
itemsas
asTable
TableI,I,but
butititconsiders
considers
only
onlycompanies
companiesthat
thatshowed
showed
aanet
netincome
incomefor
forthe
theyear.
year.
2005 Accounting 1/e, Terrell/Terrell

8 - 32

Learning Objective 4

Evaluate a companys
ratios
using a comparison to
industry averages.
2005 Accounting 1/e, Terrell/Terrell

8 - 33

Comparison of Elevation
Sports, Inc., to Industry
Averages
Ratio

Elevation
Sports, Inc.

Return on assets
36.6%
Profit margin before income taxes 20.0%
Total asset turnover
1.8
Profit margin after income tax
12.0%
Return on equity after income taxes39.7%
Return on equity before income taxes
43.5%
Current ratio
2.3
Quick ratio
1.7
Net sales to working capital
4.9
Receivables turnover
15.8
Inventory turnover
16.4
Debt ratio
44.7%
Coverage ratio
18.6
2005 Accounting 1/e, Terrell/Terrell

Industry
Total
with Assets
Industry $250-$500,000

10.1%
4.2%
1.9
3.4%
19.3%
23.9%
1.6
0.4
7.3
28.6
2.5
65.8%
5.3

16.1%
6.1%
2.3
5.7%
40.5%
43.1%
1.9
0.5
5.9
31.7
2.1
68.2%
6.7
8 - 34

Company Analysis

Compare
Compareratios
ratiosto
tothe
theindustry
industryaverages
averages
average
Look
Lookfor
forcompany
companytrends.
trends.
Consider
Considerthe
theindustry
industryenvironment.
environment.
Draw
Drawconclusions.
conclusions.
2005 Accounting 1/e, Terrell/Terrell

8 - 35

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

8 - 36

Trend Analysis of
Selected Ratios
Ratio

2002

Return on assets
137.4
Profit margin before taxes 142.5
Total asset turnover
96.4
Profit margin after taxes
147.5
Return on equity after taxes137.9
Return on equity before taxes
136.7
Current ratio
91.7
Quick ratio
515.8
Net sales to working capital 126.5
Receivables turnover
0
Inventory turnover
144.5
Debt ratio
94.6
Total liabilities to net worth 91.7
2005 Accounting 1/e, Terrell/Terrell

2001

2000

1996

150.4
141.3
106.4
146.3
145.1
144.2
95.4
69.3
140.3
0
135.3
87.1
81.2

153.7
150.1
102.4
155.4
158.3
156.8
84.0
131.4
147.7
0
129.0
99.2
98.7

100.0
100.0
100.0
100.0
100.0
100.0
100.0
100.0
100.0
0
100.0
100.0
100.0
8 - 37

Learning Objective 6

Draw conclusions about the


credit-worthiness and
investment-attractiveness
of a company.
2005 Accounting 1/e, Terrell/Terrell

8 - 38

Draw Conclusions
The
Theevaluation
evaluationprocess
processby
bynature
nature
depends
dependsupon
uponindividual
individualperception.
perception.
1.
1.Family
FamilyDollar
DollarStores,
Stores,Inc.,
Inc.,isisan
anindustry
industry
leader
leaderin
inprofitability
profitabilityand
andsolvency.
solvency.
2.
2.Family
FamilyDollar
Dollarhas
hasimproved
improvedthe
the
distribution
distributionelement
elementof
ofits
itssupply
supplychain.
chain.
2005 Accounting 1/e, Terrell/Terrell

8 - 39

Draw Conclusions
3.
3.Part
Partof
ofthe
thecompany
companyprofitability
profitabilityand
and
liquidity
liquiditywill
willdepend
dependupon
uponits
itsincreasing
increasing
the
theinventory
inventoryturnover
turnoverratio.
ratio.
4.
4.IfIfwe
wechoose
chooseto
toinvest
investin
inaageneral
general
merchandise
merchandisediscounter,
discounter,Family
FamilyDollar
Dollar
Stores,
Stores,Inc.,
Inc.,might
mightbe
beone
oneto
toconsider.
consider.
2005 Accounting 1/e, Terrell/Terrell

8 - 40

Learning Objective 7

State the limitations


of ratio analysis.

2005 Accounting 1/e, Terrell/Terrell

8 - 41

Limitations of Ratio Analysis


1.
1.Attempting
Attemptingto
topredict
predictthe
thefuture
futureusing
usingpast
past
results
resultsdepends
dependsupon
uponthe
thepredictive
predictive
value
valueof
ofthe
theinformation
informationused.
used.
2.
2.The
Thefinancial
financialstatements
statementsused
usedto
tocompute
compute
the
theratios
ratiosare
arebased
basedon
onhistorical
historicalcost.
cost.
3.
3.Figures
Figuresfrom
fromthe
thebalance
balancesheet
sheetused
usedto
to
calculate
calculatethe
theratios
ratiosare
areyear-end
year-endnumbers.
numbers.
2005 Accounting 1/e, Terrell/Terrell

8 - 42

Limitations of Ratio Analysis


4.
4.Industry
Industrypeculiarities
peculiaritiescreate
createdifficulty
difficulty
in
incomparing
comparingthe
theratios
ratiosof
ofaacompany
company
in
inone
oneindustry
industrywith
withthose
thoseof
ofaa
company
companyin
inanother
anotherindustry.
industry.
5.
5.Lack
Lackof
ofuniformity
uniformityconcerning
concerningwhat
whatisis
to
tobe
beincluded
includedin
inthe
thenumerators
numeratorsand
and
denominators
denominatorsmake
makecomparisons
comparisons
extremely
extremelydifficult.
difficult.
2005 Accounting 1/e, Terrell/Terrell

8 - 43

End of Chapter 8

2005 Accounting 1/e, Terrell/Terrell

8 - 44