Introduction to Financial Ratios

When computing financial ratios and when doing other financial statement analysis always keep in mind that the financial statements reflect the accounting principles. This means assets are generally not reported at their current value. It is also likely that many brand names and unique product lines will not be included among the assets reported on the balance sheet, even though they may be the most valuable of all the items owned by a company. These examples are signals that financial ratios and financial statement analysis have limitations. It is also important to realize that an impressive financial ratio in one industry might be viewed as less than impressive in a different industry. Our explanation of financial ratios and financial statement analysis is organized as follows:

Balance Sheet o General discussion

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Common-size balance sheet Financial ratios based on the balance sheet

Income Statement o General discussion

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Common-size income statement Financial ratios based on the income statement

Statement of Cash Flows

General Discussion of Balance Sheet

The balance sheet reports a company's assets, liabilities, and stockholders' equity as of a specific date, such as December 31, 2013, March 31, 2013, etc. The accountants' cost principle and the monetary unit assumption will limit the assets reported on the balance sheet. Assets will be reported (1) only if they were acquired in a transaction, and (2) generally at an amount that is not greater than the asset's cost at the time of the transaction. This means that a company's creative and effective management team will not be listed as an asset. Similarly, a company's outstanding reputation, its unique product lines, and brand names developed within the company will not be reported on the balance sheet. As you may surmise, these items are often the most valuable of all the things owned by the company. (Brand names purchased from another company will be recorded in the company's accounting records at their cost.) The accountants' matching principle will result in assets such as buildings, equipment, furnishings, fixtures, vehicles, etc. being reported at amounts less than cost. The reason is these assets are depreciated.

Depreciation reduces an asset's book value each year and the amount of the reduction is reported as Depreciation Expense on the income statement. While depreciation is reducing the book value of certain assets over their useful lives, the current value (or fair market value) of these assets may actually be increasing. (It is also possible that the current value of some assets such as computers may be decreasing faster than the book value.) Current assets such as Cash, Accounts Receivable, Inventory, Supplies, Prepaid Insurance, etc. usually have current values that are close to the amounts reported on the balance sheet. Current liabilities such as Notes Payable (due within one year), Accounts Payable, Wages Payable, Interest Payable, Unearned Revenues, etc. are also likely to have current values that are close to the amounts reported on the balance sheet. Long-term liabilities such as Notes Payable (not due within one year) or Bonds Payable (not maturing within one year) will often have current values that differ from the amounts reported on the balance sheet. Stockholders' equity is the book value of the company. It is the difference between the reported amount of assets and the reported amount of liabilities. For the reasons mentioned above, the reported amount of stockholders' equity will therefore be different from the current or market value of the company. By definition the current assets and current liabilities are "turning over" at least once per year. As a result, the reported amounts are likely to be similar to their current value. The long-term assets and long-term liabilities arenot "turning over" often. Therefore, the amounts reported for long-term assets and long-term liabilities will likely be different from the current value of those items. The remainder of our explanation of financial ratios and financial statement analysis will use information from the following balance sheet:

Common-Size Balance Sheet

One technique in financial statement analysis is known as vertical analysis. Vertical analysis results in common-size financial statements. A common-size balance sheet is a balance sheet where every dollar amount has been restated to be a percentage of total assets. We will illustrate this by taking Example Company's balance sheet (shown above) and divide each item by the total asset amount $770,000. The result is the following common-size balance sheet for Example Company:

The benefit of a common-size balance sheet is that an item can be compared to a similar item of another company regardless of the size of the companies. A company can also compare its percentages to the industry's average percentages. For example, a company with Inventory at 4.0% of total assets can look to its industry statistics to see if its percentage is reasonable. (Industry percentages might be available from an industry association, library reference desks, and from bankers. Many banks have memberships in Risk Management Association (RMA), an organization that collects and distributes statistics by industry.) A common-size balance sheet also allows two businesspersons to compare the magnitude of a balance sheet item without either one revealing the actual dollar amounts.

Financial Ratios Based on the Balance Sheet

Financial statement analysis includes financial ratios. Here are three financial ratios that are based solely on current asset and current liability amounts appearing on a company's balance sheet:

Four financial ratios relate balance sheet amounts for Accounts Receivable and Inventory to income statement amounts. To illustrate these financial ratios we will use the following income statement information:

The next financial ratio involves the relationship between two amounts from the balance sheet: total liabilities and total stockholders' equity:

General Discussion of Income Statement

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The income statement has some limitations since it reflects accounting principles. For example, a company's depreciation expense is based on the cost of the assets it has acquired and is using in its business. The resulting depreciation expense may not be a good indicator of the economic value of the asset being used up. To illustrate this point let's assume that a company's buildings and equipment have been fully depreciated and therefore there will be no depreciation expense for those buildings and equipment on its income statement. Is zero expense a good indicator of the cost of using those buildings and equipment? Compare that situation to a company with new buildings and equipment where there will be large amounts of depreciation expense. The remainder of our explanation of financial ratios and financial statement analysis will use information from the following income statement:

Common-Size Income Statement

Financial statement analysis includes a technique known as vertical analysis. Vertical analysis results in common-size financial statements. A common-size income statement presents all of the income statement amounts as a percentage of net sales. Below is Example Corporation's common-size income statement after each item from the income statement above was divided by the net sales of $500,000:

The percentages shown for Example Corporation can be compared to other companies and to the industry averages. Industry averages can be obtained from trade associations, bankers, and library reference desks. If a company competes with a company whose stock is publicly traded, another source of information is that company's "Management's Discussion and Analysis of Financial Condition and Results of Operations" contained in its annual report to the Securities and Exchange Commission (SEC). This annual report is the SEC Form 10-K and is usually accessible under the "Investor Relations" tab on the corporation's website.

Financial Ratios Based on the Income Statement

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Statement of Cash Flows

The statement of cash flows is a relatively new financial statement in comparison to the income statement or the balance sheet. This may explain why there are not as many well-established financial ratios associated with the statement of cash flows. We will use the following cash flow statement for Example Corporation to illustrate a limited financial statement analysis

The cash flow from operating activities section of the statement of cash flows is also used by some analysts to assess the quality of a company's earnings. For a company's earnings to be of "quality" the amount of cash flow from operating activities must be consistently greater than the company's net income. The reason is that under accrual accounting, various estimates and assumptions are made regarding both revenues and expenses. When it comes to cash, however, the money is either in the bank or it isn't.

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What are the typical items reported as current liabilities?

Here are the typical items that are reported as current liabilities on a corporation's balance sheet: 1. Accounts payable. These are the amounts that are due to vendors who have supplied goods or services. The accounts payable are supported by the vendor invoices that have been approved and processed, but have not yet been paid. 2. Deferred revenues. This reports the amounts that a customer has prepaid and will be earned by the company within one year of the balance sheet date. An example is a retailer's unredeemed gift cards. 3. Accrued compensation. Included in this are payroll related items such as the amounts due to employees and the amounts to be remitted for payroll taxes. 4. Other accrued expenses or liabilities. This reports the amounts that the company owes for items not recorded in accounts payable or accrued compensation. Examples include the interest expense that the company has incurred (but has not yet paid) and repairs that took place but the vendor's invoice has not been fully processed. 5. Accrued income taxes and perhaps some deferred income taxes. 6. Short-term notes. These include the loans from banks that will become due within one year of the balance sheet date. 7. The current portion of long-term debt. The principal payments of a mortgage loan or an equipment loan that must be paid within one year of the date of the balance sheet are reported in this item. To be reported as a current liability the item must be due within one year of the balance sheet date (unless the company's operating cycle is longer). However, there is no requirement that the current liabilities be presented in the order in which they will be paid. Hence, the current portion of long-term debt might be listed last, but the principal payment might be due within several days of the balance sheet date.

What is the interest coverage ratio?

The interest coverage ratio is a financial ratio used to measure a company's ability to pay the interest on its debt. (The required principal payments are not included in the calculation.) The interest coverage ratio is also known as the times interest earned ratio. The interest coverage ratio is computed by dividing 1) a corporation's annual income before interest and income tax expenses, by 2) its annual interest expense.
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To illustrate the interest coverage ratio, let's assume that a corporation's most recent annual income statement reported net income after tax of $650,000; interest expense of $150,000; and income tax expense of $100,000. Given these assumptions, the corporation's annual income before interest and income tax expenses is $900,000 (net income of $650,000 + interest expense of $150,000 + income tax expense of $100,000). Since the interest expense was $150,000 the corporation's interest coverage ratio is 6 ($900,000 divided by $150,000 of annual interest expense). A large interest coverage ratio indicates that a corporation will be able to pay the interest on its debt even if its earnings were to decrease. A small interest coverage ratio sends a caution signal. Since the interest coverage ratio is based on the net income under the accrual method of accounting, we recommend that you also review the cash provided by operating activities (which is found on the corporation's statement of cash flows) for the same time period.

What is the meaning of base year?

In accounting, base year may refer to the year in which a U.S. business had adopted the LIFO cost flow assumption for valuing its inventory and its cost of goods sold. Under the dollar-value LIFO technique a company's current inventory is restated to base-year prices in order to determine whether the quantity of inventory has increased or decreased. Base year is also the initial year in a series of annual amounts. For instance, an accountant might prepare a chart that displays the dollar amounts of a company's sales, gross profit, and net income for each of the years 2010 through 2012. In addition the accountant might add a price index for each line which expresses each line's amounts as a percentage of the 2010 amount. In this example the base year is 2010. Assuming that the sales for the years 2010 and 2011 and 2012 were $924,000 and $942,480 and $979,440, each of these would be divided by the $924,000 of sales in the base year 2010. The result would be the following index: 100 (for the base year 2010) and 102 (for 2011) and 106 (for 2012).

What is a current liability?

A current liability is an obligation that is 1) due within one year of the date of a company's balance sheet and 2) will require the use of a current asset or will create another current liability. If a company's operating cycle is longer than one year, current liabilities are those obligation's due within the operating cycle. Current liabilities are usually presented in the following order:
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1. the principal portion of notes payable that will become due within one year 2. accounts payable 3. the remaining current liabilities such as payroll taxes payable, income taxes payable, interest payable and other accrued expenses The parties who are owed the current liabilities are referred to as creditors. If the creditors have a lien on company assets, they are known as secured creditors. The creditors without a lien are referred to as unsecured creditors. The amount of current liabilities is used to determine a company's working capital (current assets minus current liabilities) and the company's current ratio (current assets divided by current liabilities).

What is a current asset?

A current asset is cash and any other company asset that will be turning to cash within one year from the date shown in the heading of the company's balance sheet. (If a company has an operating cycle that is longer than one year, an asset that will turn to cash within the length of its operating cycle is considered to be a current asset.) Current assets are generally listed first on a company's balance sheet and will be presented in the order of liquidity. That means they will appear in the following order: cash (which includes currency, checking accounts, petty cash), temporary investments, accounts receivable, inventory, supplies, and prepaid expenses. (Supplies and prepaid expenses will not literally be converted to cash. They are included because they will allow the company to avoid paying cash for these items during the upcoming year.) It is important that the amount of each current asset not be overstated. For example, accounts receivable, inventories, and temporary investments should have valuation accounts so that the amounts reported will not be greater than the amounts that will be received when the assets turn to cash. This is important because the amount of company's working capital and its current ratio are computed using the current assets' reported amounts. Current assets are also referred to as short term assets.

What is liquidity?
Liquidity refers to a company's ability to pay its bills from cash or from assets that can be turned into cash very quickly. The quick ratio, also known as the acid-test ratio, is an indicator of a company's liquidity.
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Where should a business report cash which is restricted to purchase a longterm asset?
The cash which a business has restricted to purchase a long-term asset should be reported on the balance sheet under the asset heading Investments. Investments is the first of the long-term asset headings and it is positioned immediately after current assets. The cash restricted for a long-term asset is not reported as part of the company's current assets because the cash is not available to pay current liabilities. Expressed another way, when the business restricts its cash for the purchase of a long-term asset, the business must reduce the amount it reports as working capital (which is current assets minus current liabilities).

What is the average collection period?

The average collection period is the average number of days between 1) the date that a credit sale is made, and 2) the date that the money is received from the customer. The average collection period is also referred to as thedays' sales in accounts receivable. The average collection period can be calculated as follows: 365 days in a year divided by the accounts receivable turnover ratio. Assuming that a company has an accounts receivable turnover ratio of 10 times per year, the average collection period is 36.5 days (365 divided by 10). An alternate way to calculate the average collection period is: the average accounts receivable balance divided by average credit sales per day. If a company offers credit terms of net 30 days, the company may find that its average collection period is actually 45 days or more. Monitoring the average collection period is important for a company's cash flow and its ability to meet its obligations when they come due.

How do you calculate the payback period?

The payback period is calculated by counting the number of years it will take to recover the cash invested in a project. Let's assume that a company invests $400,000 in more efficient equipment. The cash savings from the
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new equipment is expected to be $100,000 per year for 10 years. The payback period is 4 years ($400,000 divided by $100,000 per year). A second project requires an investment of $200,000 and it generates cash as follows: $20,000 in Year 1; $60,000 in Year 2; $80,000 in Year 3; $100,000 in Year 4; $70,000 in Year 5. The payback period is 3.4 years($20,000 + $60,000 + $80,000 = $160,000 in the first three years + $40,000 of the $100,000 occurring in Year 4). Note that the payback calculation uses cash flows, not net income. Also, the payback calculation does not address a project's total profitability. Rather, the payback period simply computes how fast a company will recover its cash investment.

What will cause a change in net working capital?

Net working capital or working capital is defined as current assets minus current liabilities. Therefore, a change in the total amount of current assets without a change of the same amount in current liabilities will result in a change in the amount of working capital. Similarly, a change in the total amount of current liabilities without an identical change in the total amount of current assets will cause a change in working capital. For instance, if the owner makes an additional investment of $20,000 in her company, the company's total current assets will increase by $20,000 but there is no increase in its current liabilities. As a result, the company's working capital increases by $20,000. (The other change is an increase in the owner's capital account.) If a company borrows $50,000 and agrees to repay the loan in 90 days, the company's working capital has notincreased. The reason is that the current asset Cash increased by $50,000 and the current liability Loans Payable also increased by $50,000. The use of $30,000 to buy merchandise for inventory will not change the amount of working capital. The reason is that the total amount of current assets will not change. The current asset Cash decreases by $30,000 and the current asset Inventory increases by $30,000. If a company sells a product for $3,400 which is in its inventory at a cost of $2,500 the company's working capital will increase by $900. Working capital increased because 1) the current asset accounts Cash or Accounts Receivable will increase by $3,400 and Inventory will decrease by $2,500; 2) current liabilities will not change. Owner's equity will increase by $900. The use of $100,000 for the construction of a storage building will reduce working capital because the current asset Cash decreased and a long-term asset Storage Building has increased.
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What is the difference between liquidity and liquidation?

Liquidity usually refers to a company's ability to pay its bills when they become due. Liquidity is often evaluated by comparing a company's current assets to its current liabilities. Working capital, the current ratio, and the quick ratio are referred to as liquidity ratios or short-term solvency ratios, since their calculations use some or all of the current assets and the current liabilities. Sometimes a company's accounts receivable turnover ratio, inventory turnover ratio, and free cash flow are also used to assess a company's liquidity. Liquidation is a term commonly used when a company sells parts of its business for cash, or when it sells assets in order to pay debts. Liquidation may also involve the winding down or the closing of a business.

What are the reasons for high inventory days?

The days sales in inventory is high when the inventory turnover is low. Since inventory turnover is associated with sales and average inventory, changes in either sales or inventory can cause a high amount of inventory days. For example, if a company has maintained its inventory quantities, but economic factors cause a significant drop in its sales, the company's inventory days will increase dramatically. If a retailer increases its inventory in order to generate additional sales, but sales do not increase, there will also be an increase in the number of inventory days.

What is separation of duties?

The separation of duties is one of several steps to improve the internal control of an organization's assets. For example, the internal control of cash is improved if the money handling duties are separated from the record keeping duties. By separating these duties the likelihood of theft is reduced because it
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will now require two dishonest people working together to admit to each other that they are dishonest, plan the theft, and to then carry out the theft. One person will have to remove the cash and the other person will have to falsify the records. Without the separation of duties, the theft of cash is easier. One dishonest person can steal the money and enter a fictitious amount into the records---thereby concealing the theft. Another step in improving internal control over cash is to use a cash register, issue receipts, and have two people present when cash is handled.

What is the difference between accounts payable and accrued expenses payable?
I would use the liability account Accounts Payable for suppliers' invoices that have been received and must be paid. As a result, the balance in Accounts Payable is likely to be a precise amount that agrees with supporting documents such as invoices, agreements, etc. I would use the liability account Accrued Expenses Payable for the accrual type adjusting entries made at the end of the accounting period for items such as utilities, interest, wages, and so on. The balance in the Accrued Expenses Payable should be the total of the expenses that were incurred as of the date of the balance sheet, but were not entered into the accounts because an invoice has not been received or the payroll for the hourly wages has not yet been processed, etc. The amounts recorded in Accrued Expenses Payable will often be estimated amounts supported by logical calculations.

How does an expense affect the balance sheet?

An expense will decrease the amount of assets or increase the amount of liabilities, and will reduce the amount of owner's or stockholders' equity. For example an expense might 1) reduce a company's assets such as Cash, Prepaid Expenses, or Inventory, 2) increase the credit balance in a contra-asset account such as Allowance for Doubtful Accounts or Accumulated Depreciation, 3) increase the balance in the liability account Accounts Payable, or increase the amount of accrued expenses payable such as Wages Payable, Interest Payable, and so on. In addition to the change in the assets or liabilities, an expense will reduce the credit balance in the Owner Capital account of a sole proprietorship, or will reduce the credit balance in the Retained Earnings account of a corporation.
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Where do I record the refund of a registration fee?

If the registration fee refers to a fee expense that you had originally paid but the amount is now being refunded to you, I would credit the same expense account that you had originally charged or debited, and would debit Cash. If the registration fee refers to an amount you are refunding because someone had originally registered for one of your programs, I would 1) credit Cash for the amount you are paying out as the refund, and 2) debit a contra-revenue account such as Refunds of Registration Fee Revenues. This will allow you to easily track the total amounts of refunds that you make during a year. On the other hand, if it is rare for your organization to refund registration fees, you could simply 1) debit the amount you are refunding to the normal revenue account such as Registration Fee Revenues, and 2) credit Cash.

How can working capital be improved?

Working capital can be improved by 1) earning profits, 2) issuing common stock or preferred stock for cash, 3) replacing short-term debt with long-term debt, 4) selling long-term assets for cash, 5) settling short-term debts for less than the stated amounts, and 6) collecting more of the accounts receivables than was anticipated and then reducing the balance required in the current asset account Allowance for Doubtful Accounts. I am sure there are additional ways to increase working capital. The concept is to increase the amount of current assets and/or to decrease the amount of current liabilities.

What is a customer deposit?

A customer deposit could be an amount paid by a customer to a company prior to the company providing it with goods or services. In other words, the company receives the money prior to earning it. The company receiving the money has an obligation to provide the goods or services to the customer or to return the money. For example, Ace Manufacturing Co. might agree to produce an expensive, custom-made machine for one of its customers. Ace requires that the customer pay $50,000 before Ace begins to design and construct the machine. The $50,000 payment is made in December 2012 and the machine must be finished by June 30, 2013. The $50,000 is a down payment toward the machine's price of $400,000. In December 2012, Ace will debit Cash for $50,000 and will credit Customer Deposits, a current
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liability account. (The customer will record the $50,000 payment with a debit to a long-term asset account such as Construction Work in Progress or Downpayment on New Equipment, and will credit Cash.)

What is solvency?
I use the term solvency to mean 1) that a company is able to pay its obligations when they come due and 2) that a company is able to continue in business. Some people look to a company's working capital in deciding whether a company is solvent. They conclude that a company with a positive amount of working capital is solvent. In other words, a company that is solvent has more current assets than it has current liabilities. Stated another way a company that is solvent will have a current ratio that is greater than 1:1. Others look at a company's total assets and total liabilities in deciding whether a company is solvent. They might conclude that if a company's total assets are greater than its total liabilities, the company is solvent. I suspect that the definition of solvency varies among people in the same country and from country to country. You should check the legal system in your country to find the appropriate meaning.

Why aren't retained earnings distributed as dividends to the stockholders?

A corporation's earnings are usually retained instead of being distributed to the stockholders in the form of dividends because the corporation is in need of money to strengthen its financial position, to expand its operations, or to keep up with the inflation in its present size of operations. The stockholders may prefer to forego dividends in order to see its stock value increase from the corporation's wise use of the retained earnings. This is especially true of U.S. individuals in high federal and state income tax brackets. These stockholders might end up paying 40% of the dividend amount in income taxes. They would rather have their stock appreciate in value with no tax payments and later sell their shares of stock at the lower capital gains tax rates.

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What is financial leverage?

Financial leverage refers to the use of debt to acquire additional assets. Financial leverage is also known as trading on equity. Below are two examples to illustrate the use of financial leverage, or simply leverage. Mary uses $400,000 of her cash to purchase 40 acres of land with a total cost of $400,000. Mary is not using financial leverage. Sue uses $400,000 of her cash and borrows $800,000 to purchase 120 acres of land having a total cost of $1,200,000. Sue is using financial leverage. Sue is controlling $1,200,000 of land with only $400,000 of her own money. If the properties owned by Mary and Sue increase in value by 25% and are then sold, Mary will have a $100,000 gain on her $400,000 investment, a 25% return. Sue's land will sell for $1,500,000 and will result in a gain of $300,000. Sue's $300,000 gain on her $400,000 investment results in Sue having a 75% return. When assets increase in value leverage works well. When assets decline in value the use of leverage works against you. Let's assume that the properties owned by Mary and Sue decrease in value by 10% from their cost and are then sold. Mary will have a loss of $40,000 on her $400,000 investment---a loss of 10% on Mary's investment. Sue will have a loss of $120,000 ($1,200,000 X 10%) on her $400,000 investment. This is a loss of 30% ($120,000 divided by $400,000) on Sue's investment.

What is turnover?
Turnover is used in some countries to mean sales. Turnover is also used in certain financial ratios. For example, the inventory turnover ratio is calculated by dividing the cost of goods sold during a year by the average inventory during the same year. The accounts receivable turnover ratio is computed by dividing the credit sales during a year by the average balance in Accounts Receivable during the same year.

What is the debt to total assets ratio?

The debt to total assets ratio is an indicator of financial leverage. It tells you the percentage of total assets that were financed by creditors, liabilities, debt. The debt to total assets ratio is calculated by dividing a corporation's total liabilities by its total assets.
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Let's assume that a corporation has $100 million in assets, $40 million in liabilities, and $60 million in stockholders' equity. Its debt to total assets ratio will be 0.4 ($40 million of liabilities divided by $100 million of assets), or 0.4 to 1. In this example, the debt to total assets ratio tells you that 40% of the corporation's assets are financed by the creditors or debt (and therefore 60% is financed by the owners). A higher percentage indicates more leverage and more risk. Another ratio, the debt to equity ratio, is often used instead of the debt to total assets ratio. The debt to equity ratio uses the same inputs but provides a different view. Using the information above, the debt to equity ratio will be .67 to 1 ($40 million of liabilities divided by $60 million of stockholders' equity).

Are liabilities always a bad thing?

Liabilities are obligations and are usually defined as a claim on assets. However, liabilities and stockholders' equity are also the sources of assets. Generally, liabilities are considered to have a lower cost than stockholders' equity. On the other hand, too many liabilities result in additional risk. Some liabilities have low interest rates and some have no interest associated with them. For example, some of a company's accounts payable may allow payment in 30 days. With those payables it is better to have the liability and to keep your cash in the bank until they become due. In our personal lives, our first house was probably purchased with a down payment and mortgage loan. That mortgage loan was a big liability, but it allowed us to upgrade our living space. I viewed my mortgage loan liability as a good thing because it allowed me to own a nice home in a beautiful neighborhood. So some liabilities are goodespecially the ones that have a very low interest rate. Too many liabilities could cause financial hardships.

What are pro forma financial statements?

A pro forma financial statement is one based on certain assumptions and projections. For example, a corporation might want to see the effects of three different financing options. Therefore, it prepares projected balance sheets, income statements, and statements of cash flows. These projected financial statements are referred to as pro forma financial statements.

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What is the difference between net income and comprehensive income?

The difference between net income and comprehensive income is known as other comprehensive income. Other comprehensive income includes unrealized gains and losses on certain investments in securities, foreign currency items, and certain pension liability adjustments. Net income is reported on the income statement and is included in the retained earnings section of stockholders' equity. Other comprehensive income items are not reported on the income statement, and are included in the accumulated other comprehensive income section of stockholders' equity. The accounting for comprehensive income is provided in the Statement of Financial Accounting Standards No. 130, Reporting Comprehensive Income, available for reading at www.FASB.org/st.

What is the advantage of issuing bonds instead of stock?

There are several advantages of issuing bonds or other debt instead of stock when acquiring assets. One advantage is that the interest on bonds and other debt is deductible on the corporation's income tax return. Dividends on stock are not deductible on the income tax return. A second advantage of financing assets with bonds instead of stock is that the ownership interest in the corporation will not be diluted by adding more owners. Bondholders and other lenders are not owners of the assets or of the corporation. Therefore, all of the gain in the value of the assets belongs to the stockholders. The bondholders will receive only the agreed upon interest. This is related to the concept of leverage or trading on equity. By issuing debt, the corporation gets to control a large asset by using other people's money instead of its own. If the asset ends up being very profitable, all of its earnings minus the interest, will enhance the owners' financial position.

Which financial ratios are considered to be efficiency ratios?

I consider the efficiency ratios to be the ratios also known as asset turnover ratios, activity ratios, or asset management ratios.
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These efficiency ratios include 1) accounts receivable turnover ratio, and the related ratio days' credit sales in accounts receivable; 2) inventory turnover, and the related ratio days' cost of sales in inventory; 3) total asset turnover; and 4) fixed asset turnover. The accounts receivable turnover ratio and the inventory turnover ratio are also used in the context of a firm's liquidity. The total asset turnover and fixed asset turnover are indicators of a company's effectiveness in utilizing its assets.

What is trend analysis?

In the analysis of financial information, trend analysis is the presentation of amounts as a percentage of a base year. If I want to see the trend of a company's revenues, net income, and number of clients during the years 2006 through 2012, trend analysis will present 2006 as the base year and the 2006 amounts will be restated to be 100. The amounts for the years 2007 through 2012 will be presented as the percentages of the 2006 amounts. In other words, each year's amounts will be divided by the 2006 amounts and the resulting percentage will be presented. For example, revenues for the years 2006 through 2012 might have been $31,691,000; $40,930,000; $50,704,00; $63,891,000; $79,341,000; $101,154,000; $120,200,000. These revenue amounts will be restated to be 100, 129, 160, 202, 250, 319, and 379. Let's assume that the net income amounts divided by the 2006 amount ended up as 100, 147, 206, 253, 343, 467, and 423. The number of clients when divided by the base year amount are 100, 122, 149, 184, 229, 277, and 317. From this trend analysis we can see that revenues in 2012 were 379% of the 2006 revenues, net income in 2012 was 467% of the 2006 net income, and the number of clients in 2012 was 317% of the number in 2006. Using the restated amounts from trend analysis makes it much easier to see how effective and efficient the company has been during the recent years. Trend analysis can also include the monitoring of a company's financial ratios over a period of many years.

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Where can I find financial ratios for my industry?

One source for financial ratios by industry is the RMA Annual Statement Studies Financial Ratio Benchmarks. RMA is the acronym for Risk Management Association and formerly for Robert Morris Associates. Your banker and many larger libraries subscribe to this publication. It contains the financial ratios for 740 industries based on the financial statements of more than 265,000 small and mid-sized companies. Another source for your industry's financial ratios is your industry's trade association, if it collects financial information from its members. In addition to comparing your company's financial ratios to its industry, you will want to compare your company's financial ratios to its own past and future financial ratios. Spotting a trend early can be very beneficial.

How can I determine the difference in earnings from using LIFO instead of FIFO?
The difference in a corporation's earnings from using LIFO instead of FIFO can be determined by the amounts reported in the balance sheet account LIFO Reserve. Generally, the LIFO Reserve information is found in the notes to the financial statements.

What is the effect on financial ratios when using LIFO instead of FIFO?
During periods of significantly increasing costs, LIFO when compared to FIFO will cause lower inventory costs on the balance sheet and a higher cost of goods sold on the income statement. This will mean that the profitability ratios will be smaller under LIFO than FIFO. The profitability ratios include profit margin, return on assets, and return on stockholders' equity. The inventory turnover ratio will be higher when LIFO is used during periods of increasing costs. The reason is that the cost of goods sold will be higher and the inventory costs will be lower under LIFO than under FIFO.
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If I want a gross margin of 25%, what percent should I mark up my product?

To achieve a gross margin or gross profit percentage of 25%, you will need to mark up your product's cost by 33.333%. The following illustrates how this is calculated. Assume a product has a cost of $75 and a selling price of $100. Since the gross profit is defined as selling price minus the cost of goods sold, this product will have a gross profit of $25 ($100 minus $75). The gross margin or gross profit percentage is 25% (gross profit of $25 divided by selling price of $100). The mark up of $25 on the cost of $75 equals 33.333% ($25 divided by $75). Let's prove this with one more example. Assume you have a product that you purchased for $9. If you mark it up by 33.333%, you will have a markup of $3 and the product will sell for $12. The income statement will show a sale of $12 minus its cost of $9 for a gross profit of $3. The gross profit of $3 divided by the selling price of $12 equals a 25% gross margin or gross profit percentage or gross profit ratio.

What is the difference between gross profit margin and gross margin?
The use of the terms such as gross margin and gross profit margin often varies by the person using the terms. Some people prefer to use gross margin instead of gross profit when referring to the dollars of gross profit. Often they want to avoid the use of the word profit because the selling and administrative expenses must also be covered. Recall that gross profit is defined as Net Sales minus Cost of Goods Sold. Others use the term gross margin to mean the gross profit as a percentage of net sales. Perhaps the term gross profit margin means the gross profit percentage or the gross margin ratio.

What is the book value per share of stock?

If a corporation does not have preferred stock outstanding, the book value per share of stock is a corporation's total amount of stockholders' equity divided by the number of common shares of stock outstanding on that date.
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For example, if a corporation without preferred stock has stockholders' equity on December 31 of $12,421,000 and it has 1,000,000 shares of common stock outstanding on that date, its book value per share is $12.42. Keep in mind that the book value per share will not be the same as the market value per share. One reason is that a corporation's stockholders' equity is simply the difference between the total amount of assets reported on the balance sheet and the total amount of liabilities reported. Long term assets are generally reported at original cost less accumulated depreciation and some valuable assets such as trade names might not be listed on the balance sheet.

What is the difference between gross margin and contribution margin?

Gross Margin is the Gross Profit as a percentage of Net Sales. The calculation of the Gross Profit is: Sales minus Cost of Goods Sold. The Cost of Goods Sold consists of the fixed and variable product costs, but it excludes all of the selling and administrative expenses. Contribution Margin is Net Sales minus the variable product costs and the variable period expenses. TheContribution Margin Ratio is the Contribution Margin as a percentage of Net Sales. Let's illustrate the difference between gross margin and contribution margin with the following information: company had Net Sales of $600,000 during the past year. Its inventory of goods was the same quantity at the beginning and at the end of year. Its Cost of Goods Sold consisted of $120,000 of variable costs and $200,000 of fixed costs. Its selling and administrative expenses were $40,000 of variable and $150,000 of fixed expenses. The company's Gross Margin is: Net Sales of $600,000 minus its Cost of Goods Sold of $320,000 ($120,000 + $200,000) for a Gross Profit of $280,000 ($600,000 - $320,000). The Gross Margin or Gross Profit Percentage is the Gross Profit of $280,000 divided by $600,000, or 46.7%. The company's Contribution Margin is: Net Sales of $600,000 minus the variable product costs of $120,000 and the variable expenses of $40,000 for a Contribution Margin of $440,000. The Contribution Margin Ratio is 73.3% ($440,000 divided by $600,000).

What is the earnings per share (EPS) ratio?

The earnings per share ratio, or simply earnings per share, or EPS, is a corporation's net income after tax that is available to its common stockholders divided by the weighted average number of shares of
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common stock that are outstanding during the period of the earnings. Net income available for common stock is the corporation's net income after income taxes minus the required dividend for the corporation's preferred stock, if it has preferred stock outstanding. Additional information on the calculations and presentation of a corporation's earnings per share are contained in the Financial Accounting Standards Board's Statement of Financial Accounting Standards No. 128, Earnings per Share.

What is the working capital ratio?

Some use the term working capital ratio to mean working capital or net working capital. Working capital is defined as current assets minus current liabilities. When used in this manner, working capital ratio is not really a ratio. Rather, it is simply a dollar amount. For example, if a company has $900,000 of current assets and has $400,000 of current liabilities, its working capital is $500,000. If a company has $900,000 of current assets and has $900,000 of current liabilities, it has no working capital. Other people use the term working capital ratio to mean the current ratio, which is defined as the amount of current assets divided by the amount of current liabilities.

What is the difference between gross margin and markup?

Gross margin or gross profit is defined as sales minus cost of goods sold. If a retailer sells a product for $10 which had a cost of $8, the gross profit or gross margin is $2. The gross profit ratio or the gross margin ratioexpresses the gross profit or gross margin amount as a percentage of sales. In our example the gross margin ratio is 20% ($2 divided by $10). Markup is used several ways. Some retailers use markup to mean the difference between a product's cost and its selling price. In our example, the product had a cost of $8 and it had a markup of $2 resulting in a selling price of $10. The $2 markup is the same as the $2 gross profit. However, the markup percentage is often expressed as a percentage of cost. In our example the $2 markup is divided by the cost of $8 resulting in a markup of 25%. (Some retailers may use the term markup to mean the increase in the original selling. For example, if the $10 selling price was increased to $11 because of high demand and limited supply, they would say the markup was $1.)

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What is credit analysis and financial analysis?

Credit analysis is associated with the decision to grant credit to a customer. It is also part of a bank's lending procedures for making a loan and monitoring the borrower's creditworthiness. I believe that financial analysis has a broader focus than credit analysis. Financial analysis would also include calculations such as return on equity, return on assets, price earnings ratios, dividend yield, comparisons with industry averages, trend analysis, and so on. Financial analysis would often be associated with investors, management, and creditors.

What is the difference between vertical analysis and horizontal analysis?

Vertical analysis reports each amount on a financial statement as a percentage of another item. For example, the vertical analysis of the balance sheet means every amount on the balance sheet is restated to be a percentage of total assets. If inventory is $100,000 and total assets are $400,000 then inventory is presented as 25 ($100,000 divided by $400,000). If cash is $8,000 then it will be presented as 2 ($8,000 divided by $400,000). The total of the assets will now add up to 100. If the accounts payable are $88,000 they will be presented as 22 ($88,000 divided by $400,000). If owner's equity is $240,000 it will be presented as 60 ($240,000 divided by $400,000). The restated amounts from the vertical analysis of the balance sheet will be presented as a common-size balance sheet. A common-size balance sheet allows you to compare your company's balance sheet to another company's balance sheet or to the average for its industry. Vertical analysis of an income statement results in every income statement amount being presented as a percentage of sales. If sales were $1,000,000 they would be restated to be 100 ($1,000,000 divided by $1,000,000). If the cost of goods sold is $780,000 it will be presented as 78 ($780,000 divided by sales of $1,000,000). If interest expense is $50,000 it will be presented as 5 ($50,000 divided by $1,000,000). The restated amounts are known as a common-size income statement. A common-size income statement allows you to compare your company's income statement to another company's or to the industry average. Horizontal analysis looks at amounts on the financial statements over the past years. For example, the amount of cash reported on the balance sheet at December 31 of 2012, 2011, 2010, 2009, and 2008 will be expressed as a percentage of the December 31, 2008 amount. Instead of dollar amounts you might see 134, 125, 110, 103, and 100. This shows that the amount of cash at the end of 2012 is 134% of the amount it was at the end of 2008. The same analysis will be done for each item on the balance sheet and for each item on the income statement. This allows you to see how each item has changed in relationship to the changes in other items. Horizontal analysis is also referred to as trend analysis. Vertical analysis, horizontal analysis and financial ratios are part of financial statement analysis.
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What is the definition of capital market?

Often, capital market refers to the structured market for trading stocks and bonds. Examples are the New York Stock Exchange, the American Stock Exchange, NASDAQ, and the New York Bond Exchange. However, capital market can also include less structured markets such as private placements for stocks, bonds, and other debt.

What is the difference between cash flow and free cash flow?
A corporation's cash flow from operations is available from the first section of the statement of cash flows. Usually the calculation begins with the accrual accounting net income followed by adding back depreciation expense and then adjusting for the changes in the balances of current assets and current liabilities. Free cash flow is often defined as the cash flow from operations (or net cash flows from operating activities) minus the cash necessary for capital expenditures. Occasionally, dividends to stockholders are also deducted.

When calculating inventory turnover, do you use sales or the cost of goods sold?
I calculate the inventory turnover by using the cost of goods sold. I use the cost of goods sold because inventory is in the general ledger at its cost and it is reported on the balance sheet at cost. Since inventory is the cost of goods on hand, it makes sense to relate it to the cost of goods sold. Assume that during the past year a company's inventory had an average cost of $10,000. (This was the average of the amounts in the asset account Inventory and the average of the amounts reported on the balance sheet during the past year.) Also assume that during the year the company has sales of $60,000 and its cost of goods sold was $40,000. On average, the inventory turned over 4 times ($40,000 of cost of goods sold during the year divided by $10,000 the average cost of goods on hand during the year.)
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What are common-size financial statements?

Common-size financial statements usually involve the balance sheet and the income statement. These two financial statements become "common-size" when their dollar amounts are expressed in percentages. For example, a common-size balance sheet will report all of the balance sheet amounts as a percentage of the "Total Assets" amount. If Cash was $80,000 and Total Assets were $1,000,000 then Cash will appear as 8% and Total Assets will appear as 100%. If the Current Assets were $350,000 they will appear as 35%. If Current Liabilities were $180,000 then on the common-size statement they will appear as 18%. By having all of the balance sheet amounts as a percentage of Total Assets, you can compare your company's current asset percentage (and all other line items) to your industry's percentage or to any other company's percentages. It doesn't matter if the other company is larger or smaller than your company, because all amounts are in percentages of Total Assets. Hence, the name "common-size." A common-size income statement will show all of the income statement amounts as a percentage of net sales. If net sales are $10,000,000 and the cost of goods sold is $7,800,000, the common-size income statement will report net sales as 100% and the cost of goods sold as 78%. If SG&A expenses are $1,300,000 they will appear as 13%. Having the income statement in percentages of net sales allows you to compare your company's SG&A expenses and its gross profit to your industry percentages and to other companies regardless of size.

How is working capital defined and measured?

Working capital is the amount of current assets minus the amount of current liabilities as of specific date. These amounts are obtained from your company's balance sheet. For example, if your company's balance sheet reports current assets of $450,000 and current liabilities of $320,000 then your company's working capital is $130,000. Even with a significant amount of working capital, a company can experience a cash shortage if its current assets are not turning to cash. For example, if a company has most of its current assets in the form of inventory, that inventory needs to be sold. Similarly, if a company has a large amount of receivables that are not being collected, the working capital amount isn't much consolation when you can't meet Friday's payroll. There are several financial ratios that pertain to working capital. They include the current ratio, quick ratio, accounts receivable turnover ratio, days sales in accounts receivable, inventory turnover ratio, and days sales in inventory. Monitor your current assets daily to keep the cash coming into your checking account. If you do the right things each day, your financial ratios have a better chance of being respectable at the end of the month.

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