HOW TO ANALYZE FINANCIAL STATEMENTS
Imagine that you are a nurse or a physician and you work in the emergency room of a busy hospital. Patients arrive with all kinds of serious injuries or illnesses, barely alive or perhaps even dead. Others arrive with less urgent injuries, minor complaints, or vaguely suspected ailments. Your training and experience have taught you to perform a quick triage, to prioritize the most endangered patients by their vital signs—respiration, pulse, blood pressure, temperature, and reflexes. A more detailed diagnosis follows based on more thorough medical tests.
We check the financial health of a company in much the same fashion by analyzing the financial statements. The vital signs are tested mostly by various financial ratios that are calculated from the financial statements. These vital signs can be classified into three main categories:
1. Short-term liquidity.
2. Long-term solvency.
We explain each of these three categories in turn.
In the emergency room the first question is: Can this patient survive? Similarly, the first issue in analyzing financial statements is: Can this company survive? Business survival means being able to pay the bills, meet the payroll, and come up with the rent. In other words, is there enough liquidity to provide the cash needed to pay current financial commitments? “Yes” means survival. “No” means bankruptcy. The urgency of this question is why current assets (which are expected to turn into cash within a year) and current liabilities (which are expected to be paid in cash within a year) are shown separately on the balance sheet. Net current assets (current assets less current liabilities) is known as working capital. Because most businesses cannot operate without positive working capital, the question of whether current assets exceed current liabilities is crucial.
When current assets are greater than current liabilities, there is sufficient liquidity to enable the enterprise to survive. However, when current liabilities exceed current assets the enterprise may well be in immanent danger of bankruptcy. The financial ratio used to measure this risk is current assets divided by current liabilities, and is known as the current ratio. It is expressed as “2.5 to 1” or “2.51” or just “2.5.” Keeping the current ratio from dropping below 1 is the bare minimum to indicate survival, but it lacks any margin of safety. A company must maintain a reasonable margin of safety, or cushion, because the current ratio, like all financial ratios, is only a rough approximation. For this reason, in most cases a current ratio of 2 or more just begins to provide credible evidence of liquidity.
An example of a current ratio can be found in the current sections of the balance sheets shown earlier in this chapter:
The current ratio is 120,600/40,000, or 3. This is only a rough approximation for several reasons. First, a company can, quite legitimately, improve its current ratio. In the earlier case of Nutrivite, assume the business wanted its balance sheet to reflect a higher current ratio. One way to do so would be to pay off $20,000 on the bank loan on December 31. This would reduce current assets to $100,600 and current liabilities to $20,000. Then the current ratio is changed to $100,600/$20,000, or 5. By perfectly legitimate means, the current ratio has been improved from 3 to 5. This technique is widely used by companies that want to put their best foot forward in the balance sheet, and it always works provided that the current ratio was greater than 1 to start with.
Current assets usually include:
• Cash and Cash Equivalents.
• Securities expected to become liquid by maturing or being sold within a year.
• Accounts Receivable (which Nutrivite did not have, because it did not sell to its customers on credit).
Current liabilities usually include:
• Accounts Payable.
• Other current payables, such as taxes, wages, or insurance.
• The current portion of long-term debt.
Some items included in Current Assets need a further explanation. These are:
• Cash Equivalents are near-cash securities such as U.S. Treasury bills maturing in three months or less.
• Accounts Receivable are amounts owed by customers and should be reported on the balance sheet at “realizable value,” which means “the amount reasonably expected to be collected in cash.” Any accounts whose collectability is in doubt must be reduced to realizable value by deducting an allowance for doubtful debts.
• Inventories in some cases may not be liquid in a crisis (except at fire-sale prices). This condition is especially likely for goods of a perishable, seasonal, high-fashion, or trendy nature or items subject to technological obsolescence, such as computers. Since inventory can readily lose value, it must be reported on the balance sheet at the “lower of cost or market value,” or what the inventory cost to acquire (including freight and insurance), or the cost of replacement, or the expected selling price less costs of sale—whichever is lowest.
Despite these requirements designed to report inventory at a realistic amount, inventory is regarded as an asset subject to inherent liquidity risk, especially in difficult economic times and especially for items that are perishable, seasonal, high-fashion, trendy, or subject to obsolescence. For these reasons the current ratio is often modified by excluding inventory to get what is called the quick ratio or acid test ratio:
• In the case of Nutrivite, the quick ratio as of December 31 is $40,600/ $40,000, or 1. This indicates that Nutrivite has a barely adequate quick ratio, with no margin of safety at all. It is a red flag or warning signal.
The current ratio and the quick ratio deal with all or most of the current assets and current liabilities. There are also short-term liquidity ratios that focus more narrowly on individual components of current assets and current liabilities. These are the turnover ratios, which consist of:
• Accounts Receivable Turnover.
• Inventory Turnover.
• Accounts Payable Turnover.
Turnover, which means “making liquid,” is a key factor in liquidity. Faster turnover allows a company to do more business without increasing assets. Increased turnover means that less cash is tied up in assets, and that improves liquidity. Moving to the other side of the balance sheet, slower turnover of liabilities conserves cash and thereby increases liquidity. Or more simply, achieving better turnover of working capital can significantly improve liquidity. Turnover ratios thus provide valuable information. The working capital turnover ratios are described next.
Accounts Receivable Turnover
The equation is:
So, if Credit Sales are $120,000 and Accounts Receivable are $30,000, then
On average, Accounts Receivable turn over 4 times a year, or every 91 days.
The 91-day turnover period is found by dividing a year, 365 days, by the Accounts Receivable Turnover ratio of 4. This average of 91 days is how long it takes to collect Accounts Receivable. That is fine if our credit terms call for payment 90 days from invoice but not fine if credit terms are 60 days, and it is alarming if credit terms are 30 days.
Accounts Receivable, unlike vintage wines or antiques, do not improve with age. Accounts Receivable Turnover should be in line with credit terms; turnover sliding out of line with credit terms signals increasing danger to liquidity.
Inventory turnover is computed as follows:
If Cost of Goods Sold is $100,000 and Inventory is $20,000, then
or about 70 days. Note that the numerator for calculating Accounts Receivable Turnover is Credit Sales but for Inventory Turnover is Cost of Goods Sold. The reason is that both Accounts Receivable and Sales are measured in terms of the selling price of the goods involved. That makes Accounts Receivable Turnover a consistent ratio, where the numerator and denominator are both expressed at selling prices in an “apples-to-apples” manner. Inventory Turnover is also an “apples-to-apples” comparison in that both numerator, Cost of Goods Sold, and denominator, Inventory, are expressed in terms of the cost, not the selling price, of the goods.
In our example, the Inventory Turnover was 5, or about 70 days. Whether this is good or bad depends on industry standards. Companies in the auto-retailing or the furniture-manufacturing industry would accept this ratio. In the supermarket business or in gasoline retailing, however, 5 would fall far below their norm of about 25 times a year, or roughly every 2 weeks. As with Accounts Receivable Turnover, an Inventory Turnover that is out of line is a red flag.
Accounts Payable Turnover
This measure’s equation is:
If Cost of Goods Sold is $100,000 and Accounts Payable is $16,600, then
which is about 6, or around 60 days. Again, note the consistency of the numerator and denominator, both stated at the cost of the goods purchased. Accounts Payable Turnover is evaluated by comparison with industry norms. An Accounts Payable Turnover that is appreciably faster than the industry norm is fine, if liquidity is satisfactory, because prompt payments to suppliers usually earn cash discounts, which in turn lower the Cost of Goods Sold and thus lead to higher income. However, such faster-than-normal Accounts Payable Turnover does diminish liquidity and is therefore unwise when liquidity is tight. Accounts Payable Turnover that is slower than the industry norm enhances liquidity and is therefore wise when liquidity is tight but inadvisable when liquidity is fine, because it sacrifices cash discounts from suppliers and thus reduces income.
This concludes our survey of the ratios relating to short-term liquidity— the current ratio; quick, or acid test, ratio; Accounts Receivable Turnover; Inventory Turnover; and Accounts Payable Turnover. If these ratios are seriously deficient, our diagnosis may be complete. The subject business may be almost defunct, and even desperate measures may be insufficient to revive it. If these ratios are favorable, then short-term liquidity does not appear to be a threat and the financial doctor should proceed to the next set of tests, which measure long-term solvency.
It is worth noting, however, that there are some rare exceptions to these guidelines. For example, large gas and electric utilities typically have current ratios less than 1 and quick ratios less than 0.5. This is due to utilities’ exceptional characteristics:
• They usually require deposits before providing service to customers, and they can shut off service to customers who do not pay on time. Customers are reluctant to go without necessities such as gas and electricity and therefore tend to pay their utility bills ahead of most other bills. These factors sharply reduce the risk of uncollectible accounts receivable for gas and electric utility companies.
• Inventories of gas and electric utility companies are not subject to much risk from changing fashion trends, deterioration, or obsolescence.
• Under regulation, gas and electric utility companies are stable, low-risk businesses, largely free from competition and consistently profitable.
This reduced risk and increased predictability of gas and electric utility companies make short-term liquidity and safety margins less crucial. In turn, the ratios indicating short-term liquidity become less important, because short-term survival is not a significant concern for these businesses.
Long-term solvency focuses on a firm’s ability to pay the interest and principal on its long-term debt. There are two commonly used ratios relating to servicing long-term debt. One measures ability to pay interest, the other the ability to repay the principal. The ratio for interest compares the amount of income available for paying interest with the amount of the interest expense. This ratio is called Interest Coverage or Times Interest Earned.
The amount of income available for paying interest is simply earnings before interest and before income taxes. (Business interest expense is deductible for income tax purposes; therefore, income taxes are based on earnings after interest, otherwise known as earnings before income taxes.) Earnings before interest and taxes is known as EBIT. The ratio for Interest Coverage or Times Interest Earned is EBIT/Interest Expense. For instance, assume that EBIT is $120,000 and interest expense is $60,000. Then:
This shows that the business has EBIT sufficient to cover 2 times its interest expense. The cushion, or margin of safety, is therefore quite substantial. Whether a given interest coverage ratio is acceptable depends on the industry. Different industries have different degrees of year-to-year fluctuations in EBIT. Interest coverage of 2 times may be satisfactory for a steady and mature firm in an industry with stable earnings, such as regulated gas and electricity supply. However, when the same industry experiences the uncertain forces of deregulation, earnings may become volatile, and interest coverage of 2 may prove to be inadequate. In more-turbulent industries, such as movie studios and Internet retailers, an interest coverage of 2 may be regarded as insufficient.
The long-term solvency ratio that reflects a firm’s ability to repay principal on long-term debt is the “Debt to Equity” ratio. The long-term capital structure of a firm is made up principally of two types of financing: (1) long-term debt and (2) owner equity. Some hybrid forms of financing mix characteristics of debt and equity but usually can be classified as mainly debt or equity in nature. Therefore the distinction between debt and equity is normally clear.
If long-term debt is $150,000 and equity is $300,000, then the debt-equity relationship is usually measured as:
Long-term debt is frequently secured by liens on property and has priority on payment of periodic interest and repayment of principal. There is no priority for equity, however, for dividend payments or return of capital to owners. Holders of long-term debt thus have a high degree of security in receiving full and punctual payments of interest and principal. But, in good times or bad, whether income is high or low, long-term creditors are entitled to receive no more than these fixed amounts. They have reduced their risk of gain or loss in exchange for more certainty. By contrast, owners of equity enjoy no such certainty. They are entitled to nothing except dividends, if declared, and, in the case of bankruptcy, whatever funds might be left over after all obligations have been paid. Theirs is a totally at-risk investment. They prosper in good times and suffer in bad times. They accept these risks in the hope that in the long run gains will substantially exceed losses.
From the firm’s point of view, long-term debt obligations are a burden that must be carried whether income is low, absent, or even negative. But long-term debt obligations are a blessing when income is lush since they receive no more than their fixed payments, even if incomes soar. The greater the proportion of long-term debt and smaller the proportion of equity in the capital structure, the more the incomes of the equity holders will fluctuate according to how good or bad times are. The proportion of long-term debt to equity is known as leverage. The greater the proportion of long-term debt to equity, the more leveraged the firm is considered to be. The more leveraged the firm is, the more equity holders prosper in good times and the worse they fare in bad times. Because increased leverage leads to increased volatility of incomes, increased leverage is regarded as an indicator of increased risk, though a moderate degree of leverage is thus considered desirable. The debt-to-equity ratio is evaluated according to industry standards and each industry’s customary volatility of earnings. For example, a debt-to-equity ratio of 80% would be considered conservative in banking (where leverage is customarily above 80% and earnings are relatively stable) but would be regarded as extremely risky for toy manufacturing or designer apparel (where earnings are more volatile). The well-known junk bonds are an example of long-term debt securities where leverage is considered too high in relation to earnings volatility. The increased risk associated with junk bonds explains their higher interest yields. This illustrates the general financial principle that the greater the risk, the higher the expected return.
In summary, the ratios used to assess long-term solvency are Interest Coverage and Long-Term Debt to Equity.
Next, we consider the ratios for analyzing profitability.
Profitability is the lifeblood of a business. Businesses that earn incomes can survive, grow, and prosper. Businesses that incur losses cannot stay in operation, and will last only until their cash runs out. Therefore, in order to assess business viability, it is important to analyze profitability.
When analyzing profitability, it is usually done in two phases, which are:
1. Profitability in relation to sales.
2. Profitability in relation to investment.
Profitability in Relation to Sales
The analysis of profitability in relation to sales recognizes the fact that:
or, rearranging terms:
Therefore, Expenses and Income are measured in relation to their sum, which is Sales. The expenses, in turn, may be broken down by line item. As an example, we use the Nutrivite Income Statement for the first three years of operation.
These income statements show a steady increase in Sales and Gross Profits each year. Despite this favorable result, the Net Income has remained virtually unchanged at about $84,000 for each year. To learn why this is the case, we need to convert expenses and income to percentages of sales. The income statements converted to percentages of sales are known as “common size” income statements and look like the following:
From the percentage figures above it is easy to see why the Net Income failed to increase, despite the substantial growth in Sales and Gross Profit. Total Expenses rose by 3.8 percentage points, from 13.9% of Sales in Year 1 to 17.7% of Sales in Year 3. In particular, the increase in Total Expenses relative to Sales was driven mainly by increases in Salaries (2.1 percentage points), Rent (1 percentage point) and Phone and Utilities (0.9 percentage point). As a result, Income before Taxes relative to Sales fell by 3.8 percentage points from Year 1 to Year 3. The good news is that the drop in Income before Taxes caused a reduction of Income Tax Expense relative to Sales of 1.6 percentage points from Year 1 to Year 3. The net effect was a drop in Net Income, relative to Sales, of 2.2 percentage points from Year 1 to Year 3.
This useful information shows that:
1. The profit stagnation is not related to Sales or Gross Profit.
2. It is entirely due to the disproportionate increase in Total Expenses.
3. Specific causes are the expenses for Salaries, Rent, and Phone and Utilities.
4. Action to correct the profit slump requires analyzing these particular expense categories.
The use of percent-of-sales ratios is a simple but powerful technique for analyzing profitability. Generally used ratios include:
• Gross Profit.
• Operating Expenses:
a. In total.
• Selling, General, and Administrative Expenses (often called SG&A).
• Operating Income.
• Income before Taxes.
• Net Income.
The second category of profitability ratios is profitability in relation to investment.
Profitability in Relation to Investment
To earn profits, usually a firm must invest capital in items such as plant, equipment, inventory, and /or research and development. Up to this point we have analyzed profitability without considering invested capital. That was a useful simplification in the beginning, but, since profitability is highly dependent on the investment of capital, it is now time to bring invested capital into the analysis.
We start with the balance sheet. Recall that Working Capital is Current Assets less Current Liabilities. So we can simplify the balance sheet by including a single category for Working Capital in place of the separate categories for Current Assets and Current Liabilities. An example of a simplified balance sheet follows:
A simplified Income Statement for Example Company for the year 200X is summarized below:
The first ratio we will consider is EBIT (also known as Operating Profit) to Total Assets. This ratio is often referred to as Return on Total Assets (ROTA), and it can be expressed as either before tax (more usual) or after tax. From the Example Company, the calculations are as follows:
This ratio indicates the raw (or basic) earning power of the business. Raw earning power is independent of whether assets are financed by equity or debt. This independence exists because:
1. The numerator (EBIT) is free of interest expense.
2. The denominator, Total Assets, is equal to total capital regardless of how much capital is equity and how much is debt.
Independence allows the ratio to be measured and compared:
• For any business, from one period to another.
• For any period, from one business to another.
These comparisons remain valid, even if the debt to equity ratio may vary from one period to the next and from one business to another.
Now that we have measured basic earning power regardless of the debt to equity ratio, our next step is to take the debt to equity ratio into consideration. First, it is important to note that long-term debt is normally a less expensive form of financing than equity because:
1. Whereas Dividends paid to stockholders are not a tax deduction for the paying company, Interest Expense paid on Long-Term Debt is. Therefore the net after-tax cost of Interest is reduced by the related tax deduction. This is not the case for Dividends, which are not deductible.
2. Debt is senior to equity, which means that debt obligations for interest and principal must be paid in full before making any payments on equity, such as dividends. This makes debt less risky than equity to the investors, and so debt holders are willing to accept a lower rate of return than holders of the riskier equity securities.
This contrast can be seen from the simplified financial statements of Example Company above. The interest of $3,000 on the Long-Term Debt of $30,000 is 10% before tax. But after the 40% tax deduction the interest after tax is only $1,800 ($3,000 − 40% tax on $3,000), and this $1,800 represents an after-tax interest rate of 6% on the Long-Term Debt of $30,000. For comparison let us turn to the rate of return on the Equity. The Net Income, $19,800, represents a 22% rate of return on the Equity of $90,000. This 22% rate of return is a financial ratio known as Return on Equity, sometimes abbreviated ROE. Return on Equity is an important and widely used financial ratio.
There is much more to be said about Return on Equity, but first it may be helpful to recap briefly the main points we have covered about profitability in relation to investment.
The EBIT of $36,000 represented a 30% return on total assets, before income tax, and this $36,000 was shared by three parties, as follows:
1. Long-Term Debt holders received Interest of $3,000, representing an interest cost of 10% before income tax, and 6% after income tax.
2. City, state, and /or federal governments were paid Income Taxes of $13,200.
3. Stockholder Equity increased by the Net Income of $19,800, which represented a 22% Return on Equity.
If there had been no Long-Term Debt, there would have been no Interest Expense. The EBIT of $36,000 less income tax at 40% would provide a Net Income of $21,600, which is larger than the prior Net Income of $19,800 by $1,800. This $1,800 equals the $3,000 amount of Interest before tax less the 40% tax, which is $1,200. In the absence of Long-Term Debt, the Total Assets would have been funded entirely by equity, which would have required equity to be $120,000. In turn, with Net Income of $21,600, the revised Return on Equity would be
The increase in the Return on Equity, from this 18% to 22% was attributable to the use of Long-Term Debt. The Long-Term Debt had a cost after taxes of only 6% versus the Return on Assets after tax of 18%. When a business earns 18% after tax, it is profitable to borrow at 6% after tax. This in turn improves the Return on Equity from 18% to 22%, which illustrates the advantage of leverage: A business earning 18% on assets can, with a little leverage, earn 22% on equity.
But what if EBIT is only $3,000? The entire $3,000 would be used up to pay the interest of $3,000 on the Long-Term Debt. The Net Income would be $0, resulting in a 0% Return on Equity. This illustrates the disadvantage of leverage. Without Long-Term Debt, the EBIT of $3,000 less 40% tax would result in Net Income of $1,800. Return on Equity would be $1,800 divided by equity of $120,000, which is 1.5%. A Return on Equity of 1.5% may not be impressive, but it is certainly better than the 0% that resulted with Long-Term Debt.
Leverage is a fair-weather friend: It boosts Return on Equity when earnings are robust but depresses ROE when earnings are poor. Leverage makes the good times better but the bad times worse. Therefore, it should be used in moderation and in businesses with stable earnings. In businesses with volatile earnings, leverage should be used sparingly and cautiously.
We have now described all of the main financial ratios, and they are summarized in Exhibit 1.1.