Financial Ratio Analysis with Formulas

Financial ratio analysis is the mathematical relationship between two selected numerical values pulled from a company’s financial statement. There are many ratios used in business to figure such things out as a company’s solvency, profitability, asset turnover, etc. Financial analysts use financial ratios to compare strengths and weaknesses of different entities.

Financial ratios compares values between companies, industries, time periods for a particular company and between a single company and its industry average.  In order to effectively use ratios, they must be benchmarked against something else such as another company.

Financial ratios can be expressed as a decimal value, 0.20 or as an equivalent percent value, 20%.  Ratios that are usually less than 1, are normally expressed as a percentage.

The values we use in calculating financial ratios come from the income statement, balance sheet, statement of cash flows or statement of retained earnings.
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Understanding the Cash Flow Statement – a Beginner’s Guide

A company’s cash flow statement records the movement of cash over a period of time.  Along with the balance sheet and income statement, the cash flow statement is a required element of a company’s financial reports.  The report allows for management and investors to see how a company’s operations are running, where the money is coming from and how it is being spent.

All cash transactions affect the cash flow statement in some way or another. Money that goes out like paying for salaries, equipment, loan, etc. lowers the cash. Money that comes in such as receiving customer wire transfers, interest income, stock purchases, etc. increases cash.

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Common Public Filings

A public company’s financial statements are filed periodically with the U.S. Securities and Exchange Commission (SEC).  Financial professionals and investors rely on these statements to make informed valuations as a potential investment.

Most Common Public Filings by Corporations

Below is a list of the more common filings a company must submit on a periodic basis.

  • 10-K: This covers the annual performance of a company and is due after the end of the fiscal year. It contains the income statement, balance sheet, cash flow statement, footnotes to the financial statements, management discussion and analysis and an Auditor’s report.
  • 10-Q: This a company’s quarterly performance that is due upon completion of the end of the quarter. This statement is unaudited and includes many of the reports found in the 10-K.
  • 8-K: This is an interim report that is due after any material event or corporate change happens in the quarter.
  • Annual Report: This is pretty much a shortened version of the 10-K with more of a focus placed on the marketing of the company presented in fancy charts and photos.
  • 13D: Notification of a holding of more than 5% of any class of a company’s shares by a single investor or group working in conjunction with each other.
  • 4: Statement of changes in beneficial ownership
  • 5: Annual statement of changes in beneficial ownership
  • 144: Registration document that discloses when insiders buy or sell stock.
  • Proxy Statement: This statement is presented around the time when the annual meeting is held.  t includes management compensation & stock options, Auditor changes, and related-party transactions.
understanding-the-income-statement-for-beginners

Understanding the Income Statement

The income statement is one of the main financial statements for a business. We also touched on the balance sheet and how it shows the overall health of the company at a specified period.

The income statement, also known as a profit and loss (P&L) statement, differs as it shows shows the movement of cash and the business’s profitability. The statement indicates how the revenue results into the net income. The income statement reports on the making and selling activities during a period of time. All business activities that generate income or result in a loss for a company is reported on the Income Statement.

The basic equation of the income statement

Sales – Costs & Expenses = Income

Two Basic Formats of the Income Statement

There are two basic formats for the income statement that are used in financial reporting presentations; 1. multi step 2. single step. What’s the difference between the two statements? In the multi step income statement, there are four elements that reflect profitability; gross, operating, pretax and after tax.  In the  single step income statement, the gross and operating income figures are not stated but they can be calculated from the data provided.

Single Step Formatted Income Statement

Net Sales

Materials and Production

Marketing and Administrative

Research and Development Expenses

Other Income and Expenses

Pretax Income

Taxes

Net Income

 

Multi Step Formatted Income Statement

Net Sales

Cost of Goods Sold

Gross Margin/Income

Sales & Marketing, Research & Development, General & Administrative Expensesunderstanding the income statement

Income from Operations

Other Income & Expenses

Pretax Income

Taxes

Net Income

Financial Income Statement Example

Financial_Income_Statement_Example

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Understanding what makes up the Income Statement

Sales or Revenues are recorded when a business actually ships products to its customers; not when cash is exchanged.  After the customer is shipped the product, they have an obligation to pay for the product and the company that produced the product has a right to collect its funds. If the product is paid on account, then it will show on the Balance Sheet in accounts receivable.

Net Sales is reported on the Income Statement. This amount is what the company will receive for the product. The net sales amount includes the list price minus any discounts offered to the customer. This is known as the “top line” revenue as the income process begins here.

Please note that orders and sales don’t mean the same thing. Orders aren’t guaranteed income, they just represent a strong interest to buy. Orders, however, turn into sales and is reported on the Income Statement.

Costs are what you spend to make a product for inventory. Costs include raw materials, manufacturing overhead, worker’s wages, etc. When inventory is sold to a customer, the cost is taken out of inventory (on the balance sheet) and entered in the Income Statement; this is called cost of goods sold (COGS).

The COGS is accumulated in inventory until the product(s) are sold. Once sold, they become expensed and shown on the Income Statement.

Gross Margin (gross profit or manufacturing margin) is the amount left over from sales after cost of goods sold are subtracted. The greater and more consistent the gross margin is, the more potential there is for a positive “bottom line” or net income.

Net Sales – COGS = Gross Margin

Expenses are the expenditures that don’t associate with making a product. Expenses pay for developing and selling products and the administration side of the business. Examples of expenses are sales salary, research and development, legal fees, buying office paper, etc.

Operating Expenses (SG&A – sales, general and administrative) are expenditures that a company makes to generate an income. Typically, financial analysts assume that there is great control over this category and therefore it is watched very closely for signs and trends. The trend of SG&A expenses, as a % of sales, affects managerial efficiency positively and negatively. Operating expenses include;

  1. Sales & Marketing expense
  2. Research & Development (R&D) expenses
  3. General & Administrative (G&A) expenses

Income From Operations is what is left over after expenses and costs are subtracted from the net sales. This amount reflects a company’s earnings from its normal operations before any non-operating income or expenses takes place.

Gross Margin – Operating Expenses = Income From Operations

Non-operating Income & Expenses are the aspects of an organization’s income and expenses that are derived from activities not related to its core operations. Non-operating income includes such things as dividend income and investment gains. Non-operating expenses include interest charges and costs of borrowing.

Net Income (net profit or net earnings) is simply the sales less any costs and expenses associated with a company. This is also known as the “bottom line.”   The “bottom line” is a common indicator for profitability. Also note that a company can be profitable but be insolvent (no cash to pay expenses).

Accrual vs Cash Basis Accounting

There are two ways accounting is handled for a company. Most businesses use the accrual basis which is when income and expenses are recorded when the transaction happens, not when cash trades hands. Cash basis accounting is recorded when cash is spent or received, this is the simplest accounting. In our definitions above, we considered the accrual basis as it is required by the IRS if a business maintains inventory for products to sell.

How the Income Statement & Balance Sheet are Linked

If a company’s Income Statement shows a net income then the retained earnings are increased on the Balance Sheet. In turn, there must be an increase in assets or decrease in liabilities on the Balance Sheet to remain in balance. Therefore, the Income Statement represents a period where all business activities will increase assets or decrease liabilities on the Balance Sheet.

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Overview of the Four Financial Statements in Basic Terms

There are four important financial statements issued on behalf of a business; they summarize the business’s financial activities during a specific time or time period. The Generally Accepted Accounting Principles (GAAP) adheres to the four main financial statements; Balance Sheet, Income Statement, Statement of Cash Flows and Statement of Owner’s Equity. Private companies and small businesses aren’t required to prepare financial statements but they do aid in such operations such as financing and investing.

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understanding-the-balance-sheet-for-beginners

Understanding the Balance Sheet for Beginners

One of the main financial reports of a business is called a balance sheet or statement of financial position. The balance sheet is simply a snapshot or summary of a company’s financial at a specific time. The balance sheet is the only financial statement that applies to a single point in a year. This allows entities like creditors to see what a company currently owns and owes.

There are three components that make up the balance sheet statement; assets, liabilities and owner’s (shareholder’s) equity.

Assets (has) = Liabilities (owes) + Shareholders Equity (worth)

Staying true to its title, the balance sheet must…balance out.  This means that the total assets should equal liabilities plus owner’s equity. If you add an asset to the equation, you must add a liability or increase owner’s equity at the same time.

Balance Sheet Example

Balance_Sheet_Example

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Understanding Assets on a Balance Sheet

Simply put, assets are what a company has including cash, stock or inventory, buildings, machinery, etc. Assets on a balance sheet are shown according to their liquidity. The most liquid asset is shown first, which is cash and least liquid is last, usually fixed assets.

Current assets are assets that are anticipated to be converted to cash within twelve months from the date of the transaction.  Current assets are listed on the balance sheet in descending order of liquidity;

  1. Cash – Cash is the most liquid asset; this includes bank deposits and petty cash. All cash, and any transaction on the balance sheet, must be converted to US dollars (USD).
  2. Accounts Receivable – Is the money owed to a business by its customer because they have provided a service or shipped out a product. Generally, payments terms are 30 or 60 days but shorter terms have been set due to the economy.balance sheet
  3. Inventory – Is a finished product ready for sale. In addition, the materials used to make the product is considered inventory. There are three types of inventory; raw materials, work-in-process and finished good inventory. Raw material inventory are materials that are in stock and will be used in a product but haven’t thus far. Work-in-process (WIP) inventory is partially finished products in the production cycle. Finished good inventory is completed products ready to be sold to a customer.
  4. Prepaid Expenses – are payments that have already been paid out but service or product(s) haven’t been received yet. Examples of prepaid expenses are insurance premiums, salary advances and utility deposits.

Other Assets (non-current assets) – Is a category when assets cannot be properly labeled as a current or fixed asset; this includes intangible assets such as a patent.

Fixed Assets – These assets are the least liquid and generally the largest.  These include land, building, equipment, furniture, vehicles, office equipment, computers and material handling machinery. These assets are not intended to be used towards a sale. They are reported on a balance sheet at their original purchase price or less the depreciation (decline in useful value due to wear and tear).

Accumulated Depreciation – Is the sum of all depreciation charges taken since the asset was acquired.

Net Fixed Assets – Is the total of the purchase price of fixed assets less the depreciation charges taken over the years.

Understanding Liabilities on a Balance Sheet

Liabilities are a  company’s legal obligations that arise during the course of business operations. Liabilities are settled through the transfer of economic benefits such as money, goods or services.  They include money owed to lenders, suppliers, employees, etc.  Liabilities are categorized on the balance sheet by to whom the debt is owed and whether the debt is short-term (within 1 year) or long-term.

Current liabilities are debts that must be settled within the fiscal year or the operating cycle, whichever period is longer.  Current liabilities are shown on a balance sheet depending on whom the debt is owed.

  1. Accounts Payable – are debts owed to a business or supplier that are purchased on credit and must be paid within 1 year.  If a business does not pay cash for an item or service, this will be recorded as short-term money owed, accounts payable.
  2. Accrued Expenses – are monetary obligations that is not paid immediately to a entity.
  3. Notes Payable – Is created when a company signs a note for the purpose of borrowing money or extending its payment period with a bank or creditor.
  4. Current Portion of Debt – Is the amount due within 12 months for a long-term debt such as a mortgage on a building
  5. Income Taxes Payable – Income taxes that a company owes the government for a percentage of profit.  Typically taxes are owed every quarter.

Long-term debt – Is a loan with an overall term of more than 12 months from the date of the balance sheet.

Understanding Shareholder’s Equity

Shareholder’s Equity (also known as net worth or book value) is the total assets minus the liabilities (current + long-term).  Shareholder’s equity are made up of two components:

  1. Capital Stock – the original investment the owner(s) contributed towards the company.
  2. Retained Earnings – All earnings of the company that have been retained and has not been paid out as dividends.

Capital Stock is the number of shares authorized that are issued by a company’s charter;  includes both common stock and preferred stock.

Retained Earnings – is all of the company’s profits that have not been paid out to the shareholders as dividends. Dividends are paid from the retained earnings.  Accumulated deficit is when a company has not made a profit which will result in a negative retained earnings.

Owner’s (Shareholder’s) Equity is the sum of the investment made in the stock of the company plus any net profits minus dividends that has been paid out to shareholders.

  • A decrease in owner’s equity happens when there is either a loss or it pays dividends.
  • An increase in owner’s equity occurs when the company makes a profit or sells new stock to investors.
basic-accounting-principles

12 Basic Accounting Principles – GAAP

Understanding the twelve basic accounting principles that is very important as it affects the preparation of financial statements.  The following accounting rules and assumptions dictate what, when and how to measure financial items.

These rules were created by the Financial Accounting Standards Board (FASB) and are called Generally Accepted Accounting Principles (GAAP). GAAP refers to the standard guidelines for financial accounting used in any given jurisdiction. GAAP includes the standards, conventions, and rules accountants follow in preparing and reporting financial statements.

List of 12 Basic Accounting Principles

  1. Accounting Entity – is the business unit for which the financial statements are being prepared.  The gaap accounting principlesaccounting entity recognizes that there is a business entity that is separate from its owner(s). In addition, the economic unit engages in identifiable economic activities and controls economic resources.
  2. Going Concern – Accounts assume that the life of the business entity is infinitely long and will never dissipate. In some cases, if there is a clear sign that a business may go bankrupt, the accountant must issue a qualified opinion stating the potential of a demise.
  3. Measurement – Accounting only deals with things that can be measured, quantifiable. Therefore, aspects that are crucial to profits may be overlooked such as customer loyalty.
  4. Units of Measure – The US Dollar (USD) is the standard value used in financial statements for companies in the United States. Any foreign transactions must be translated to USD based on the current exchange rate.
  5. Historical Cost – The transactions that results in what a business owns and owes are recorded at their original cost. This may cause the company’s books to be understated.  For example, a company can own a manufacturing facility that is valued at $25,000,000 but carry it on the books for their purchase price of $7,000,000.
  6. Materiality – The concept of materiality allows you to violate another accounting principle if the value is so tiny that the financial reports will not have an impact. Materiality is a judgment call by the accountant.
  7. Estimates and Judgments – Often times, it is okay to guess due to the nature that businesses are complex. It is legal, if the accounting is the best you can do, the expected error would not affect the financial reports and the “guesses” are consistent for each period.
  8. Consistency – Each individual enterprise must choose a single method of accounting and reporting consistently over time.
  9. Conservatism –  Accountants must agree more with an understatement than an overvaluation. This accounting guideline states that if doubt exists between two alternatives, the accountant should choose the result with a lesser asset amount and/or a lesser profit.
  10. Periodicity – Is the activity within the scope of an accounting period that must be recorded within the time period on a financial statement.  Normally the life of a business can be divided into periods of time (month, quarter or year).
  11. Substance Over Form – This is a concept where the entity is accounting for items according to their substance and economic reality and not just its form.
  12. Accrual Basis of Presentation – In accrual accounting, if a business transaction makes money in a period then all of its associated costs and business expenses should also be reported in that particular period. All businesses with inventory must use the accrual basis. The alternative for business that don’t carry inventory is “cash basis” accounting in which transactions are recorded as they are physically received or paid out.