LO 17.1 Financial Statement Analysis

Working Capital

Working capital measures the financial health of an organization in the short-term by finding the difference between current assets and current liabilities. A company will need enough current assets to cover current liabilities; otherwise, they may not be able to continue operations in the future. Before a lender extends credit, they will review the working capital of the company to see if the company can meet their obligations. A larger difference signals that a company can cover their short-term debts and a lender may be more willing to extend the loan. On the other hand, too large of a difference may indicate that the company may not be correctly using their assets to grow the business. The formula for working capital is:

Using Banyan Goods, working capital is computed as follows for the current year:

In this case, current assets were $200,000, and current liabilities were $100,000. Current assets were far greater than current liabilities for Banyan Goods and they would easily be able to cover short-term debt.

The dollar value of the difference for working capital is limited given company size and scope. It is most useful to convert this information to a ratio to determine the company’s current financial health. This ratio is the current ratio.

Current Ratio

Working capital expressed as a ratio is the current ratio. The current ratio considers the amount of current assets available to cover current liabilities. The higher the current ratio, the more likely the company can cover its short-term debt. The formula for current ratio is:

The current ratio in the current year for Banyan Goods is:

A 2:1 ratio means the company has twice as many current assets as current liabilities; typically, this would be plenty to cover obligations. This may be an acceptable ratio for Banyan Goods, but if it is too high, they may want to consider using those assets in a different way to grow the company.

Quick Ratio

The quick ratio, also known as the acid-test ratio, is similar to the current ratio except current assets are more narrowly defined as the most liquid assets, which exclude inventory and prepaid expenses. The conversion of inventory and prepaid expenses to cash can sometimes take more time than the liquidation of other current assets. A company will want to know what they have on hand and can use quickly if an immediate obligation is due. The formula for the quick ratio is:

The quick ratio for Banyan Goods in the current year is:

A 1.6:1 ratio means the company has enough quick assets to cover current liabilities.

Another category of financial measurement uses solvency ratios.

Debt to Equity Ratio

The debt-to-equity ratio shows the relationship between debt and equity as it relates to business financing. A company can take out loans, issue stock, and retain earnings to be used in future periods to keep operations running. It is less risky and less costly to use equity sources for financing as compared to debt resources. This is mainly due to interest expense repayment that a loan carries as opposed to equity, which does not have this requirement. Therefore, a company wants to know how much debt and equity contribute to its financing. Ideally, a company would prefer more equity than debt financing. The formula for the debt to equity ratio is:

The information needed to compute the debt-to-equity ratio for Banyan Goods in the current year can be found on the balance sheet.

This means that for every $1 of equity contributed toward financing, $1.50 is contributed from lenders. This would be a concern for Banyan Goods. This could be a red flag for potential investors that the company could be trending toward insolvency. Banyan Goods might want to get the ratio below 1:1 to improve their long-term business viability.

Times Interest Earned Ratio

Times interest earned measures the company’s ability to pay interest expense on long-term debt incurred. This ability to pay is determined by the available earnings before interest and taxes (EBIT) are deducted. These earnings are considered the operating income. Lenders will pay attention to this ratio before extending credit. The more times over a company can cover interest, the more likely a lender will extend long-term credit. The formula for times interest earned is:

The information needed to compute times interest earned for Banyan Goods in the current year can be found on the income statement.

The $43,000 is the operating income, representing earnings before interest and taxes. The 21.5 times outcome suggests that Banyan Goods can easily repay interest on an outstanding loan and creditors would have little risk that Banyan Goods would be unable to pay.

Another category of financial measurement uses efficiency ratios.

Accounts Receivable Turnover

Accounts receivable turnover measures how many times in a period (usually a year) a company will collect cash from accounts receivable. A higher number of times could mean cash is collected more quickly and that credit customers are of high quality. A higher number is usually preferable because the cash collected can be reinvested in the business at a quicker rate. A lower number of times could mean cash is collected slowly on these accounts and customers may not be properly qualified to accept the debt. The formula for accounts receivable turnover is:

Many companies do not split credit and cash sales, in which case net sales would be used to compute accounts receivable turnover. Average accounts receivable is found by dividing the sum of beginning and ending accounts receivable balances found on the balance sheet. The beginning accounts receivable balance in the current year is taken from the ending accounts receivable balance in the prior year.

When computing the accounts receivable turnover for Banyan Goods, let’s assume net credit sales make up $100,000 of the $120,000 of the net sales found on the income statement in the current year.

An accounts receivable turnover of four times per year may be low for Banyan Goods. Given this outcome, they may want to consider stricter credit lending practices to make sure credit customers are of a higher quality. They may also need to be more aggressive with collecting any outstanding accounts.

Total Asset Turnover

Total asset turnover measures the ability of a company to use their assets to generate revenues. A company would like to use as few assets as possible to generate the most net sales. Therefore, a higher total asset turnover means the company is using their assets very efficiently to produce net sales. The formula for total asset turnover is:

Average total assets are found by dividing the sum of beginning and ending total assets balances found on the balance sheet. The beginning total assets balance in the current year is taken from the ending total assets balance in the prior year.

Banyan Goods’ total asset turnover is:

The outcome of 0.53 means that for every $1 of assets, $0.53 of net sales are generated. Over time, Banyan Goods would like to see this turnover ratio increase.

Inventory Turnover

Inventory turnover measures how many times during the year a company has sold and replaced inventory. This can tell a company how well inventory is managed. A higher ratio is preferable; however, an extremely high turnover may mean that the company does not have enough inventory available to meet demand. A low turnover may mean the company has too much supply of inventory on hand. The formula for inventory turnover is:

Cost of goods sold for the current year is found on the income statement. Average inventory is found by dividing the sum of beginning and ending inventory balances found on the balance sheet. The beginning inventory balance in the current year is taken from the ending inventory balance in the prior year.

Banyan Goods’ inventory turnover is:

1.6 times is a very low turnover rate for Banyan Goods. This may mean the company is maintaining too high an inventory supply to meet a low demand from customers. They may want to decrease their on-hand inventory to free up more liquid assets to use in other ways.

Days’ Sales in Inventory

Days’ sales in inventory expresses the number of days it takes a company to turn inventory into sales. This assumes that no new purchase of inventory occurred within that time period. The fewer the number of days, the more quickly the company can sell its inventory. The higher the number of days, the longer it takes to sell its inventory. The formula for days’ sales in inventory is:

Banyan Goods’ days’ sales in inventory is:

243 days is a long time to sell inventory. While industry dictates what is an acceptable number of days to sell inventory, 243 days is unsustainable long-term. Banyan Goods will need to better manage their inventory and sales strategies to move inventory more quickly.

The last category of financial measurement examines profitability ratios.

Profit Margin

Profit margin represents how much of sales revenue has translated into income. This ratio shows how much of each $1 of sales is returned as profit. The larger the ratio figure (the closer it gets to 1), the more of each sales dollar is returned as profit. The portion of the sales dollar not returned as profit goes toward expenses. The formula for profit margin is:

For Banyan Goods, the profit margin in the current year is:

This means that for every dollar of sales, $0.29 returns as profit. If Banyan Goods thinks this is too low, the company would try and find ways to reduce expenses and increase sales.

Return on Total Assets

The return on total assets measures the company’s ability to use its assets successfully to generate a profit. The higher the return (ratio outcome), the more profit is created from asset use. Average total assets are found by dividing the sum of beginning and ending total assets balances found on the balance sheet. The beginning total assets balance in the current year is taken from the ending total assets balance in the prior year. The formula for return on total assets is:

For Banyan Goods, the return on total assets for the current year is:

The higher the figure, the better the company is using its assets to create a profit. Industry standards can dictate what is an acceptable return.

Return on Equity

Return on equity measures the company’s ability to use its invested capital to generate income. The invested capital comes from stockholders investments in the company’s stock and its retained earnings and is leveraged to create profit. The higher the return, the better the company is doing at using its investments to yield a profit. The formula for return on equity is:

Average stockholders’ equity is found by dividing the sum of beginning and ending stockholders’ equity balances found on the balance sheet. The beginning stockholders’ equity balance in the current year is taken from the ending stockholders’ equity balance in the prior year. Keep in mind that the net income is calculated after preferred dividends have been paid.

For Banyan Goods, we will use the net income figure and assume no preferred dividends have been paid. The return on equity for the current year is:

Or, with formulas combined:

Return on equity = $35,000 / [($90,000 + $100,000) / 2] = 0.37 (rounded) or 37%

The higher the figure, the better the company is using its investments to create a profit. Industry standards can dictate what is an acceptable return.