4.4 Analysis
Statement of Financial Position/Balance Sheet (SFP/BS)
The SFP/BS is made up of many line items, comprised of many general ledger accounts, using different measurement bases (historical cost, fair value, and other valuation methods previously discussed in this chapter), and with significant adjusting entries for accruals and application of the company’s accounting policies. For this reason, the SFP/BS does not present a clear-cut, definitive report of a company’s exact financial state. Its purpose is to provide an overview as a starting point for further analysis. Some types of analysis typically undertaken by management are discussed below.
Comparative SFP/BS
Arranging previous reporting data beside the current data is a useful tool with which to analyze trends. Some companies also include the percentage change for each line item to allow certain changes in amounts to become highly visible. This enables analysts to narrow down possible areas of poor performance where further investigation will be undertaken to determine the reasons why.
Ratio Analyses
Ratio analysis is simply where relationships between selected financial data (presented in the numerator and denominator of the formula) provide key information about a company. Ratios from current year financial statements may be more useful when they are used to compare with benchmark ratios. Examples of benchmark ratios are ratios from other companies, ratios from the industry sector the company operates in, or historical and future ratio targets set by management as part of the company’s strategic plan.
Care must be taken when interpreting ratios, because companies within an industry sector may use different accounting policies that will affect the comparison of ratios. In the end, ratios are based on current and past performance and are merely indicators. Further investigation is needed to gather more business intelligence about the reasons why certain variances are occurring.
Below are some common ratios used to analyze the SFP/BS and SCF financial statements:
| Liquidity ratios – ability to pay short term obligations | ||
|---|---|---|
| Ratio | Formula | Purpose |
| Current ratio | = Current assets ÷ Current liabilities | ability to pay short term debt |
| Quick ratio (or acid test ratio) | = (Cash*, marketable securities and net receivables) ÷ Current liabilities
*Cash includes cash equivalents, if any. |
ability to pay short term debt using near-cash assets |
| Activity ratios – ability to effectively use assets | ||
|---|---|---|
| Ratio | Formula | Purpose |
| Accounts receivable turnover | Net sales ÷ Average net accounts receivable | how quickly accounts receivable is collected |
| In days | 365 ÷ Accounts receivable turnover | average # of days to collect accounts receivable |
| Days’ sales uncollected | (Accounts receivable ÷ Net sales) × 365 | average # of days that sales are uncollected (this can be compared to the credit terms of the company) |
| Inventory turnover | Cost of good sold ÷ Average inventory | how quickly inventory is sold |
| In days | 365 ÷ Inventory turnover | average number of days to sell inventory |
| Days’ sales in inventory | (Ending inventory ÷ Cost of goods sold) × 365 | average # of days for inventory to convert to sales |
| Asset turnover | Net sales ÷ Average total assets | the ability of assets to generate sales |
| Profitability ratios – ability to generate profits | ||
|---|---|---|
| Ratio | Formula | Purpose |
| Return on total assets | (Net income ÷ Average total assets) × 100% | overall profitability of assets |
| Return on common shareholders’ equity | [(Net income – Preferred dividends) ÷ (Average common shareholders’ equity (includes retained earnings/deficit))] × 100% |
overall profitability of common shareholders’ investment |
| Earnings per share | (Net income – Preferred dividends) ÷ Weighted average common shares outstanding (WACS) | net income for each common share |
| Payout ratio | (Cash dividends ÷ Net income) × 100% | percentage of earnings distributed as dividends |
| Coverage – ability to pay long-term obligations | ||
|---|---|---|
| Ratio | Formula | Purpose |
| Debt ratio | (Total liabilities ÷ Total assets) × 100% | percentage of assets provided by creditors |
| Equity ratio | (Total equity ÷ Total assets) × 100% | percentage of assets provided by investors |
| Cash debt coverage ratio | (Net cash from operating activities ÷ Average total liabilities) × 100% | the ability to pay debt from net cash from operating activities (statement of cash flows) |
| Book value per common share | Common shareholders’ equity ÷ # of common shares outstanding | the amount per common share if company liquidated at reported amounts. |
Many of the ratios identified above will be illustrated throughout the remaining chapters of this course.
Note that ratios are not particularly meaningful without historical trends or industry standards. Some general benchmarks signifying a reasonably healthy financial state are:
| Current ratio | 2:1 |
| Quick ratio | 1:1 |
| Days’ sales uncollected | 1.3 times the credit policy in days |
For example, if the credit policy were 30 days, a reasonable day’s sales uncollected ratio would be 30 days × 1.3 = 39 days that a sale would remain uncollected.
Again, it is important to understand that the general benchmarks identified above are guidelines only. Industry standard ratios are superior in every way, if available, since ratios are only as good as what they are being compared to (the benchmark). If the comparative ratio is not accurate for that industry, the analysis will be meaningless. (This is often referred to as “garbage in; garbage out.”) As a result, management can make incorrect decisions on that basis, seriously impairing a company’s potential future performance and sustainability.
Below are the ratio calculations for Watson Ltd. as at December 31, 2020, based on the financial data presented in the previous section of this chapter. The material in this chapter is intended as a high-level review. In-depth discussions are included in the introductory accounting course, and students are encouraged to review that material at this time, if needed.
| Liquidity ratios – ability to pay short term obligations | |||
|---|---|---|---|
| Ratio | Formula | Calculation | Results |
| Current ratio | Current assets ÷ Total liabilities | 1,314,880 ÷ 384,720 = 3.42 to 1 | reasonable |
| Quick ratio (or acid test ratio) | Cash, marketable securities and net receivables ÷ Current liabilities |
(307,500 + 12,000 + 249,510 + 18,450) ÷ 384,720 = 1.53 to 1 | reasonable |
| Activity ratios – ability to effectively use assets | |||
|---|---|---|---|
| Ratio | Formula | Calculation | Results |
| Accounts receivable turnover | Net sales ÷ Average net accounts receivable | 3,500,000 ÷ ((249,510 + 165,000) ÷ 2) = 16.89 times / year |
reasonable |
| In days | 365 ÷ Accounts receivable turnover | 365 ÷ 16.89 = every 21 days | reasonable |
| Days’ sales uncollected | (Accounts receivable ÷ Net sales) × 365 | (249,510 ÷ 3,500,000) × 365 = 26 days |
reasonable, given the typical credit policy of net 30 days |
| Inventory turnover | Cost of goods sold ÷ Average inventory | 2,100,000 ÷ ((708,970 + 650,000) ÷ 2) = 3.09 times |
this would be low, if the industry standard is around 5 times |
| In days | 365 ÷ Inventory turnover | 365 ÷ 3.09 = every 118 days | possibly too low if standard is 5 times or every 73 days |
| Days’ sales in inventory | (Ending inventory ÷ Costs of Goods Sold) × 365 | (708,970 ÷ 2,100,000) × 365 = 123 days |
the total # of days to sell inventory and collect the cash from accounts receivable is 123 + 26 = 149 days |
| Asset turnover | Net sales ÷ Average total assets | 3,500,000 ÷ ((1,780,580 + 1,654,250) ÷2) = 2.04 |
depends on industry average and company trends |
| Profitability ratios – ability to generate profits | |||
|---|---|---|---|
| Ratio | Formula | Calculation | Results |
| Return on total assets | (Net income ÷ Average total assets) × 100% | 77,000 ÷ ((1,780,580 +1,654,250) ÷2) = 4.48% |
depends on industry average and company trends |
| Return on common shareholders’ equity | (Net income – Preferred dividends) ÷ Average common shareholders’ equity (includes retained earnings/deficit×100% | (77,000 – 30,000) ÷ ((862,500 + 18,450 + 84,410 + 680,300 + 18,450 + 50,000) ÷2) = 5.48% |
depends on industry average and company trends |
| Earnings per share | (Net income – Preferred dividends) ÷ Weighted average common shares outstanding (WACS) | (77,000 – 30,000) ÷ 225,000 = $29.89 per shareWACS shares assuming that sale of the shares occurred mid year |
depends on industry average and company trends |
| Payout ratio | (Cash dividends ÷ Net income) × 100% |
(42,590 ÷ 77,000) × 100% = 55.3% |
depends on industry average and company trends |
| Coverage – ability to pay long-term obligations | |||
|---|---|---|---|
| Ratio | Formula | Calculation | Results |
| Debt ratio | (Total liabilities ÷ Total assets) × 100% | (630,720 ÷ 1,780,580) × 100% = 35.42% |
low |
| Equity ratio | (Total equity ÷ Total assets) × 100% | 1,149,860 ÷ 1,780,580 = 64.58% OR 100% – 35.42% debt ratio = 64.58% |
high |
| Cash debt coverage ratio | (Net cash provided by operating activities ÷ Average total liabilities) × 100% |
101,660 ÷ ((8630,720 + 721,000) ÷2) = 15.04% |
unfavourable due to negative cashflow from operating activities |
| Book value per common share | Common shareholders’ equity ÷ # of shares outstanding | (862,500 + 18,450 + 84,410) ÷ 250,000 = $3.86 |
depends on industry average and company trends and assumes no preferred shares dividends are in arrears |
Cash Flow Ratio
It is critical to monitor the trends regarding cash flows over time. If trends are tracked, ratio analyses can be a powerful tool to evaluate a company’s cash flows. Below are some of the cash flow ratios currently used in business:
| Liquidity ratios – ability to pay short term obligations: | ||
|---|---|---|
| Ratio | Formula | Purpose |
| Current cash debt coverage ratio | Net cash flow from operating activities ÷ Average current liabilities | ability to pay short term debt from its day-to-day operations. A ratio of 1:1 is reasonable. |
| Financial flexibility – ability to react to unexpected expenses and investment opportunities: | ||
| Cash debt coverage ratio | Net cash flow from operating activities ÷ Average total liabilities | the ability to pay debt from net cash from operating activities (statement of cash flows) |
Free Cash Flow Analyses
Free cash flow is the remaining cash flow from the operating activities section after deducting cash spent on capital expenditures such as purchasing property, plant, and equipment. Some companies also deduct cash paid dividends. The remaining cash flow represents cash available to do other things, such as expand operations, pay off long-term debt, or reduce the number of outstanding shares. Below is the calculation using the data from Watson Ltd. statement of cash flows:
| Watson Ltd. Free Cash Flow December 31, 2020 |
|
|---|---|
| Cash flow provided by operating activities | $(101,660) |
| Less capital expenditures | 0 |
| Dividends | $(42,590) |
| Free cash flow | $(144,250) |
It is no surprise that Watson has no free cash flow and no financial flexibility, since its operating activities are in a negative position. Note that the dividend deduction in the free cash flow calculation is optional, since dividends can be waived at management’s discretion. In Watson’s case, it met its current year dividend cash requirements by selling more common shares to raise additional cash. The capital expenditures should be for those relating to daily operations that are intended to sustain ongoing operations. For this reason, capital expenditures purchased as investments are usually excluded from the free cash flow analysis.
