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
statementstotogain
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
Cash $128,834
$128,834
Accounts
Accountsreceivable
receivable $9,900
$9,900
Less:
Less:Allowance
Allowancefor fordoubtful
doubtfulaccounts
accounts 450
450 9,450
9,45
Merchandise
Merchandiseinventory
inventory 4,397
4,39
Raw
Rawmaterials
materialsinventory
inventory 2,315
2,31
Work-in-process
Work-in-processinventory
inventory 14,864
14,86
Finished
Finishedgoods
goodsinventory
inventory 13,634
13,63
Supplies
Suppliesinventory
inventory 593
593
Prepaid
Prepaidrent
rent 12,000
12,000
Prepaid
Prepaidinsurance
insurance 5,000
5,00
Total
Totalcurrent
currentassets
assets $190,637
$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 $$5,1005,100
Selling
Sellingfurniture
furnitureand
andfixtures
fixtures 8,400
8,400
Production
Productionequipment
equipment 89,600
89,600 $103,100
$103,100
Less:
Less:Accumulated
Accumulateddepreciation
depreciation 17,800
17,800
Total
Totalproperty,
property,plant,
plant,and
andequipment
equipment $$ 85,300
85,30
Intangible
Intangibleassets
assets
Patents
Patents $$ 10,083
10,083
Copyrights
Copyrights 570
570
Trademarks
Trademarks 1,425
1,425
Total
Totalintangible
intangibleassets
assets $$ 12,078
12,078
Total
Totalassets
assets $288,015
$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
Accountspayable
payable $$ 6,942
6,94
Other
Otheraccounts
accountspayable
payable 11,812
11,81
Interest payable
Interest payable 6,000
6,00
Payroll taxes payable
Payroll taxes payable 1,400
1,40
Sales taxes payable
Sales taxes payable 560
56
Income taxes payable
Income taxes payable 42,120
42,120
Current
Currentportion
portionofoflong-term
long-termnote
notepayable
payable 15,000
15,00
Total current liabilities
Total current liabilities $ 83,834
$ 83,834
Long-term liabilities:
Long-term liabilities:
Note
Notepayable
payableVail
VailNational
NationalBank
Bank $$ 60,000
60,000
Less: Current portion
Less: Current portion 15,000
15,000
Total
Totallong-term
long-termliabilities
liabilities 45,000
45,00
Total liabilities
Total liabilities $128,834
$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
sharesissued
issuedand
andoutstanding
outstanding $$ 60,000
60,000
Paid-in
Paid-incapital
capitalin
inexcess
excessof
ofpar
par
common
commonstockstock 40,000
40,000
Total
Totalpaid-in
paid-incapital
capital $100,000
$100,000
Retained
Retainedearnings
earnings 59,181
59,181
Total
Totalstockholders
stockholdersequity
equity 159,181
159,181
Total
Totalliabilities
liabilitiesand
andstockholders
stockholdersequity
equity $288,
$288

2005 Accounting 1/e, Terrell/Terrell 8-7

 Elevation Sports, Inc.
Income Statement
For the Year Ended May 31,
2004
Net
Netsales
sales $527,146
$527,146
Cost
Costofofgoods
goodssold
sold 295,834
295,834
Gross
Grossprofit
profit $231,312
$231,312
Selling
Sellingexpenses
expenses $48,334
$48,334
Administrative expenses
Administrative expenses 72,189
72,189
Total
Totaloperating
operatingexpenses
expenses 120,523
120,523
Operating income
Operating income $110,789
$110,789
Other
Otherrevenues
revenuesandandexpenses:
expenses:
Interest
Interestrevenue
revenue $$ 512512
Interest
Interestexpense
expense (6,000
(6,000))
Total
Totalother
otherrevenues
revenuesand
andexpenses
expenses (5,488
(5,488))
Income
Incomebefore
beforeincome
incometaxes
taxes $105,301
$105,301
Income
Incometaxes
taxes 42,120
42,120
Net income
Net income $$ 63,181
63,181
Earnings
Earningsperpershare
share $$ 15.79
15.79
2005 Accounting 1/e, Terrell/Terrell 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
measureshowhowefficiently
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
measuresthethepercentage
percentageof
of
income
incomebefore
beforeincome
incometaxes
taxesproduced
produced
by
byaagiven
givenlevel
levelof
ofrevenue.
revenue.

Profit
Profitmargin
marginbefore
beforeincome
incometax
tax==
Net
Netincome
incomebefore
beforetaxes
taxesSales
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
producedforforaagiven
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
Returnon
on = Profit
Profitmargin
margin Total
Totalasset
asset
assets
assets before
beforeincome
incometax
tax turnover
turnover

Net
Netincome
income Net
Netincome
income Sales
Sales

before
beforetaxes
taxes = before
beforetaxes
taxes
Total
Totalassets
assets

Total
Totalassets
assets Sales
Sales

2005 Accounting 1/e, Terrell/Terrell 8 - 13

 Profitability Ratios

This
Thisratio
ratiomeasures
measuresthe
theamount
amountofofafter-tax
after-tax
net
netincome
incomegenerated
generatedby
byaadollar
dollarof
ofsales.
sales.

Profit
Profitmargin
marginafter
afterincome
incometax
tax==
Net
Netincome
incomeafter
aftertaxes
taxesSales
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
taxesStockholders
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
meetitsitsshort-term
short-termobligations.
obligations.

2005 Accounting 1/e, Terrell/Terrell 8 - 17

 Liquidity Ratios

This
Thisratio
ratiomeasures
measuresthethecompanys
companysability
abilityto
to
meet
meetitsitscurrent
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
salesAccounts
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
36515.79
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
Costofofsales
salesInventory
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
36516.41
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
interesttoto
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 % + Some %

2005 Accounting 1/e, Terrell/Terrell 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
taxesInterest
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
providesanananalysis
analysisofofall
all
companies
companiesin inthe
theparticular
particularindustry,
industry,
regardless
regardlessofofwhether
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
companiesthatthatshowed
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 Industry
Elevation Total with Assets
Ratio Sports, Inc. Industry $250-$500,000

Return on assets 36.6% 10.1% 16.1%

Profit margin before income taxes 20.0% 4.2% 6.1%
Total asset turnover 1.8 1.9 2.3
Profit margin after income tax 12.0% 3.4% 5.7%
Return on equity after income taxes39.7% 19.3% 40.5%
Return on equity before income taxes
43.5% 23.9% 43.1%
Current ratio 2.3 1.6 1.9
Quick ratio 1.7 0.4 0.5
Net sales to working capital 4.9 7.3 5.9
Receivables turnover 15.8 28.6 31.7
Inventory turnover 16.4 2.5 2.1
Debt ratio 44.7% 65.8% 68.2%
Coverage ratio 18.6 5.3 6.7
2005 Accounting 1/e, Terrell/Terrell 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 2001 2000 1996
Return on assets 137.4 150.4 153.7 100.0
Profit margin before taxes 142.5 141.3 150.1 100.0
Total asset turnover 96.4 106.4 102.4 100.0
Profit margin after taxes 147.5 146.3 155.4 100.0
Return on equity after taxes137.9 145.1 158.3 100.0
Return on equity before taxes 136.7 144.2 156.8 100.0
Current ratio 91.7 95.4 84.0 100.0
Quick ratio 515.8 69.3 131.4 100.0
Net sales to working capital 126.5 140.3 147.7 100.0
Receivables turnover 0 0 0 0
Inventory turnover 144.5 135.3 129.0 100.0
Debt ratio 94.6 87.1 99.2 100.0
Total liabilities to net worth 91.7 81.2 98.7 100.0
2005 Accounting 1/e, Terrell/Terrell 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
processbybynature
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
Partofofthe
thecompany
companyprofitability
profitabilityand
and
liquidity
liquiditywill
willdepend
dependupon
uponits
itsincreasing
increasing
the
theinventory
inventoryturnover
turnoverratio.
ratio.

4.
4.IfIfwe
wechoose
choosetotoinvest
investin
inaageneral
general
merchandise
merchandisediscounter,
discounter,Family
FamilyDollar
Dollar
Stores,
Stores,Inc.,
Inc.,might
mightbebeone
onetotoconsider.
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
usedtotocompute
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
comparingthetheratios
ratiosofofaacompany
company
in
inone
oneindustry
industrywith
withthose
thoseofofaa
company
companyininanother
anotherindustry.
industry.

5.
5.Lack
Lackofofuniformity
uniformityconcerning
concerningwhat
whatisis
totobe
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