The Financial Statements

What are Financial Statements?

Financial statements (or financial reports) are formal records of the financial activities and position of a
business, person, or entity.

Relevant financial information is presented in a structured manner and in a form which is easy to
understand. They typically include three (3) basic financial statements:

1. A Balance Sheet or statement of financial position, reports on a company's assets,

liabilities and owner's equity at a given point in time.
2. An Income Statement or profit and loss report (P&L report), or statement of financial
performance, reports on a company's revenue, expenses and profits over a stated period. A
statement of financial performance provides information on the operation of the enterprise. 
3. A Cash Flow Statement reports on a company's cash flow activities, particularly its operating,
investing and financing activities over a stated period.

Notably, a balance sheet represents a single point in time, where the income statement and the
cash flow statement each represent activities over a stated period.

For large corporations, these statements may be complex and may include an extensive set of footnotes
to the financial statements and management discussion and analysis. The notes typically describe
each item on balance sheet, income statement and cash flow statement in further detail. Notes to
financial statements are considered an integral part of the financial statements.

Purpose for Financial Statements

"The objective of financial statements is to provide information about the financial position,
performance and changes in financial position of an enterprise that is useful to a wide range of
users in making economic decisions." Financial statements should be understandable, relevant,
reliable and comparable. Reported assets, liabilities, equity, income and expenses are directly related to
an organization's financial position.

Financial statements may be used by users for different purposes:

o Owners and managers require financial statements to make important business decisions

that affect its continued operations. Financial analysis is then performed on these
statements to provide management with a more detailed understanding of the figures. 
o Prospective investors make use of financial statements to assess the viability of investing
in a business. Financial analyses are often used by investors and are prepared by
professionals (financial analysts), thus providing them with the basis for making investment
decisions.
o Financial institutions (banks and other lending companies) use them to decide whether
to grant a company with fresh working capital or extend debt securities (such as a long-term
bank loan) to finance expansion and other significant expenditures.

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The Balance Sheet (or Statement of Financial Position)
What is a Balance Sheet?
A Balance Sheet or Statement of Financial Position  gives a statement of a business’s assets, liabilities and shareholders
equity at a specific point in time. They offer a snapshot of what your business owns and what it owes as well as the
amount invested by its owners, reported on a single day. A balance sheet tells you a business’s worth at a given time,
so you can better understand its financial position.

The balance sheet is used alongside other important financial statements such as income statement and
statement of cash flows in conducting fundamental analysis or calculating financial ratios.

Formula Used for a Balance Sheet

The balance sheet adheres to the following accounting equation, where assets on one side, and liabilities plus
shareholders' equity on the other, balance out:

Assets = Liabilities + Owner's or Shareholders’ Equity

What's On the Balance Sheet?

A balance sheet reports the assets, liabilities and shareholders equity of your business at a given point in time.
The items reported on the balance sheet correspond to the accounts outlined on your chart of accounts. A
balance sheet is made up of the following elements:

Assets
Within the assets segment, accounts are listed from top to bottom in order of their liquidity – that is, the ease
with which they can be converted into cash. They are divided into current assets, which can be converted to
cash in one year or less; and non-current or long-term assets, which the full value will not be realized within
the accounting year. 

Here is the general order of accounts within current assets:

 Cash and cash equivalents are the most liquid assets and can include Cash deposited in banks,
Petty Cash Fund, Cash on hand, and short-term certificates of deposit.
 Marketable securities are equity and debt securities for which there is a liquid
market. Examples of marketable securities include commercial paper, banker's acceptances,
Treasury bills, and other money market instruments.
 Accounts receivable refers to money that customers owe the company, perhaps including an
allowance for doubtful accounts since a certain proportion of customers can be expected not to
pay.
 Inventory is goods available for sale, valued at the lower of the cost or market price.
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  Prepaid expenses represent the value that has already been paid for, such as insurance,
advertising contracts or rent.

Non-current assets include the following:

 Long-term investments are securities that a company intends to hold for more than a year. It
represents the company's investments, including stocks, and bonds.
 Fixed assets include land, machinery, equipment, buildings and other durable, generally capital-
intensive assets.
 Intangible assets include non-physical (but still valuable) assets such as intellectual property
(e.g. patents) and goodwill. In general, intangible assets are only listed on the balance sheet if
they are acquired, rather than developed in-house. 

Liabilities
Liabilities are the money that a company owes to outside parties, from bills it has to pay to suppliers to interest
on bonds it has issued to creditors to rent, utilities and salaries. Current liabilities are those that are due within
one year and are listed in order of their due date. Non-current or Long-term liabilities are due at any point
after one year.

Current liabilities accounts might include:

 current portion of long-term debt

 bank indebtedness
 interest payable
 wages payable
 customer prepayments
 dividends payable and others
 accounts payable

Non-current liabilities can include:

 Long-term debt: interest and principal on bonds issued

 Pension fund liability: the money a company is required to pay into its employees' retirement
accounts
 Deferred tax liability: taxes that have been accrued but will not be paid for another year
(Besides timing, this figure reconciles differences between requirements for financial reporting
and the way tax is assessed, such as depreciation calculations.)

Owners' Equity or  Shareholders' Equity

Shareholders' equity is the money attributable to a business' owners, or its shareholders. It is also known as
"net assets," since it is equivalent to the total assets of a company minus its liabilities, that is, the debt it owes to
non-shareholders.

 Owner's Capital
 Capital or Common Stocks (only for Corporation)
 Preferred Stocks (only for Corporation)

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 Retained earnings are the net earnings a company either reinvests in the business or use to pay
off debt; the rest is distributed to shareholders in the form of dividends. (only for Corporation)

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The Income Statement (or Statement of Financial Performance)
What is an Income Statement?
An Income Statement (also referred to as a profit and loss statement, statement of profit or loss, revenue
statement, Statement of Financial Performance, earnings statement, statement of earnings, operating statement,
or statement of operations) is one of financial statements of a company and shows the company's revenues and
expenses during a particular period.

It indicates how the revenues are transformed into the net income or net profit (the result after all revenues and
expenses have been accounted for). The purpose of the income statement is to show managers and
investors whether the company made money (profit) or lost money (loss) during the period being reported.

The format of the income statement statement will vary according to the complexity of the business activities.
However, most companies will have the following elements in their income statements:

A. Revenues and Gains

       1. Revenues from company activities
       2. Gains (e.g., gain on the sale of long-term assets, gain from lawsuits)

B. Expenses and Losses

       1. Expenses involved in company activities
       2. Losses (e.g., loss on the sale of long-term assets, loss from lawsuits)

An income statement represents a period of time (as does the cash flow statements). This contrasts with balance
sheet, which represents a single moment in time.

What are Revenue and Gain?

Revenue is the income generated from normal business operations, usually from the sale of goods and
services to customers. It is the top line or gross income figure from which costs are subtracted to determine net
income.

Gain is the increase in net profit resulting from something other than the day to day earnings from recurrent
operations, and are not associated with investments or withdrawals. Typical gains refer to nontypical and
nonrecurring transactions, for instance, gain on sale of land, change in a stock's market price, a gift or a
chance discovery.

What are Expense and Loss?

Expense is the cost of operations that a company incurs to generate revenue. As the popular saying goes, “it costs
money to make money.” Common expenses include payments to suppliers, employee wages, factory leases, and
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equipment depreciation.

It is the reduction in value of an asset as it is used to generate revenue. If the underlying asset is to be used over
a long period of time, the expense takes the form of depreciation, and is charged ratably over the useful life of
the asset. If the expense is for an immediately consumed item, such as a salary, then it is usually charged
to expense as incurred.

Loss is a decrease in net income that is outside the normal operations of the business. Losses can result
from a number of activities such as; sale of an asset for less than its carrying amount, the write-down of
assets, or a loss from lawsuits.

The Statement of Retained Earnings (only for Corporation)

What Is a Statement of Retained Earnings?
The statement of retained earnings (retained earnings statement) is a financial statement that outlines
the changes in retained earnings for a company over a specified period. This statement reconciles the
beginning and ending retained earnings for the period, using information such as net income from the
other financial statements, and is used by analysts to understand how corporate profits are utilized.

The statement of retained earnings is also known as a statement of changes in owner's equity, an
equity statement, or a statement of changes in shareholders' equity. It is prepared in accordance
with generally accepted accounting principles (GAAP).

What is a Retained Earnings?

Retained earnings (RE) is the amount of net income left over for the business after it has paid out
dividends to its shareholders. A business generates earnings that can be positive (profits) or negative
(losses). 
Positive profits give a lot of room to the business owner(s) or the company management to utilize the
surplus money earned. Often this profit is paid out to shareholders, but it can also be re-invested back into
the company for growth purposes. The money not paid to shareholders counts as retained earnings.

Understanding Statement of Retained Earnings

This statement of retained earnings can appear as a separate statement or as an inclusion on either a
balance sheet or an income statement. The statement is a financial document that includes information
regarding a firm’s retained earnings, along with the net income and amounts distributed to
stockholders in the form of dividends. An organization’s net income is noted, showing the amount that
will be set aside to handle certain obligations outside of shareholder dividend payments, as well as

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any amount directed to cover any losses. Each statement covers a specified time period, as noted
in the statement.

The Net Cash Flow

When you studied income statements in accounting, the emphasis was probably on the firm’s net
income. In finance, however, we focus on net cash flow. The value of an asset (or a whole firm) is
determined by the cash flow it generates. The firm’s net income is important, but cash flow is even more
important because dividends must be paid in cash and because cash is necessary to purchase the assets
required to continue operations.

As we discussed in Topic 1, the firm’s goal should be to maximize its stock price. Since the value of any
asset, including a share of stock, depends on the cash flow produced by the asset, managers should
strive to maximize the cash flow available to investors over the long run. A business’s net cash flow
generally differs from its accounting profit because some of the revenues and expenses listed on the
income statement were not paid in cash during the year. The relationship between net cash flow and net
income can be expressed as follows:

Net cash flow = Net income - Noncash revenues + Noncash charges

The primary examples of noncash charges are depreciation and amortization. These items reduce net
income but are not paid out in cash, so we add them back to net income when calculating net cash
flow. At the same time, some revenues may not be collected in cash during the year, and these items
must be subtracted from net income when calculating net cash flow.

Typically, depreciation and amortization are by far the largest noncash items, and in many cases the other
noncash items roughly net out to zero. For this reason, many analysts assume that net cash flow equals
net income plus depreciation and amortization:

Net cash flow = Net income + Depreciation and amortization.

The Statement of Cash Flows
What is a Cash Flow Statement?
Statement of cash flows, or the cash flow statement, is a financial statement that summarizes the
amount of cash and cash equivalents entering and leaving a company. The cash flow statement
(CFS) measures how well a company manages its cash position, meaning how well the company
generates cash to pay its debt obligations and fund its operating expenses. The cash flow statement
complements the balance sheet and income statement and is a mandatory part of a company's financial
reports.

The Structure of the Cash Flow Statement

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The main components of the cash flow statement are:

1. Cash from operating activities;

2. Cash from investing activities; and
3. Cash from financing activities.

Cash From Operating Activities

The operating activities on the CFS include any sources and uses of cash from business activities. In
other words, it reflects how much cash is generated from a company's products or services.

These operating activities might include:

 Receipts from sales of goods and services

 Interest payments
 Income tax payments
 Payments made to suppliers of goods and services used in production
 Salary and wage payments to employees
 Rent payments
 Any other type of operating expenses

Cash flow is calculated by making certain adjustments to net income by adding or subtracting
differences in revenue, expenses, and credit transactions (appearing on balance sheet and income
statement) resulting from transactions that occur from one period to the next. These adjustments
are made because non-cash items are calculated into net income (income statement) and total
assets and liabilities (balance sheet). So, because not all transactions involve actual cash items,
many items have to be re-evaluated when calculating cash flow from operations.

As a result, there are two methods of calculating cash flow: the direct method and the indirect method. 

Direct Cash Flow Method

The direct method uses actual cash inflows and outflows from the company's operations, instead of
modifying the operating section from accrual accounting to a cash basis. It measures only the cash
that's been received, which is typically from customers and the cash payments or outflows, such
as to suppliers. The inflows and outflows are netted to arrive at the cash flow.

Indirect Cash Flow Method

With the indirect method, cash flow from operating activities is calculated by first taking the net income
off of a company's income statement. Because a company’s income statement is prepared on an
accrual basis, revenue is only recognized when it is earned and not when it is received. Net income is
not an accurate representation of net cash flow from operating activities, so it becomes necessary
to adjust earnings before interest and taxes (EBIT) for items that affect net income, even though no
actual cash has yet been received or paid against them. The indirect method also makes adjustments to
add back non-operating activities that do not affect a company's operating cash flow.

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For example, depreciation is not really a cash expense; it is an amount that is deducted from the total
value of an asset that has previously been accounted for. That is why it is added back into net income
for calculating cash flow.

Accounts Receivable and Cash Flow

Changes in accounts receivable (AR) on the balance sheet from one accounting period to the next
must also be reflected in cash flow. If accounts receivable decreases, this implies that more cash
has entered the company from customers paying off their credit accounts—the amount by which AR
has decreased is then added to net Income. If accounts receivable increases from one accounting
period to the next, the amount of the increase must be deducted from net Income because, although
the amounts represented in AR are revenue, they are not cash.

Inventory Value and Cash Flow

An increase in inventory on the other hand, signals that a company has spent more money to
purchase more raw materials. If the inventory was paid with cash, the increase in the value of inventory
is deducted from net Income. A decrease in inventory would be added to net income. If inventory
was purchased on credit, an increase in accounts payable would occur on balance sheet, and the
amount of the increase from one year to the other would be added to net income.

The same logic holds true for taxes payable, salaries payable, and prepaid insurance. If something
has been paid off, then the difference in the value owed from one year to the next has to be subtracted
from net income. If there is an amount that is still owed, then any differences will have to be added to net
earnings.

Cash From Investing Activities

Investing activities include any sources and uses of cash from a company's investments. A purchase or
sale of an asset, loans made to vendors or received from customers, or any payments related to a merger
or acquisition is included in this category. In short, changes in equipment, assets, or investments
relate to cash from investing.

Usually, cash changes from investing are a "cash out" item, because cash is used to buy new
equipment, buildings, or short-term assets such as marketable securities. However, when a
company divests an asset, the transaction is considered "cash in" for calculating cash from investing.

Cash From Financing Activities

Cash from financing activities includes the sources of cash from investors or banks, as well as the uses of
cash paid to shareholders. Payment of dividends, and the repayment of debt principal (loans) are
included in this category.

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Changes in cash from financing are "cash in" when capital is raised, and they're "cash out" when
dividends are paid. Thus, if a company issues a bond to the public, the company receives cash
financing; however, when interest is paid to bondholders the company is reducing its cash.

Purpose of Financial Statements

The objective of financial statements is to provide information about the financial position, performance
and changes in financial position of an enterprise that is useful to a wide range of users in making
economic decisions (IASB Framework).

Financial Statements provide useful information to a wide range of users:

Managers require Financial Statements to manage the affairs of the company by assessing its financial
performance and position and taking important business decisions.

Shareholders use Financial Statements to assess the risk and return of their investment in the company and
take investment decisions based on their analysis.

Prospective Investors need Financial Statements to assess the viability of investing in a company. Investors

may predict future dividends based on the profits disclosed in Financial Statements. Furthermore, risks
associated with the investment may be gauged from Financial Statements. For instance, fluctuating profits
indicate higher risk. Therefore, Financial Statements provide a basis for the investment decisions of potential
investors.

Financial Institutions (e.g. banks) use Financial Statements to decide whether to grant a loan or credit to a
business. Financial institutions assess the financial health of a business to determine the probability of a bad
loan. Any decision to lend must be supported by a sufficient asset base and liquidity.

Suppliers need Financial Statements to assess the credit worthiness of a business and ascertain whether to
supply goods on credit. Suppliers need to know if they will be repaid. Terms of credit are set according to the
assessment of their customers' financial health.

Customers use Financial Statements to assess whether a supplier has the resources to ensure the steady supply
of goods in the future. This is especially vital where a customer is dependant on a supplier for a specialized
component.

Employees use Financial Statements for assessing the company's profitability and its consequence on their
future remuneration and job security.

Competitors compare their performance with rival companies to learn and develop strategies to improve their
competitiveness.

General Public may be interested in the effects of a company on the economy, environment and the local
community.

Governments require Financial Statements to determine the correctness of tax declared in the tax returns.
Government also keeps track of economic progress through analysis of Financial Statements of
businesses from different sectors of the economy.
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What is Financial Statement Analysis?
Financial statement analysis is the process of analyzing a company's financial statements for
decision-making purposes. External stakeholders use it to understand the overall health of an
organization as well as to evaluate financial performance and business value. Internal constituents use it
as a monitoring tool for managing the finances.

Several techniques are commonly used as part of financial statement analysis. Three of the most
important techniques include horizontal analysis, vertical analysis, and ratio analysis. Horizontal
analysis compares data horizontally, by analyzing values of line items across two or more years. Vertical
analysis looks at the vertical affects line items have on other parts of the business and also the
business’s proportions. Ratio analysis uses important ratio metrics to calculate statistical
relationships.

The Horinzontal Analysis

Horizontal analysis (also known as trend analysis) is a financial statement analysis technique that shows
changes in the amounts of corresponding financial statement items over a period of time. It is a useful
tool to evaluate the trend situations.

The statements for two or more periods are used in horizontal analysis. The earliest period is usually used as
the base period and the items on the statements for all later periods are compared with items on the
statements of the base period. The changes are generally shown both in dollars and percentage.

Dollar and percentage changes are computed by using the following formulas:

Horizontal analysis may be conducted for balance sheet, income statement, schedules of current and fixed
assets and statement of retained earnings.

In above analysis, 2007 is the base year and 2008 is the comparison year. All items on the balance
sheet and income statement for the year 2008 have been compared with the items of balance sheet and
income statement for the year 2007.

The actual changes in items are compared with the expected changes. For example, if management
expects a 30% increase in sales revenue but actual increase is only 10%, it needs to be
investigated.

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The Vertical Analysis
Vertical analysis (also known as common-size analysis) is a popular method of financial statement
analysis that shows each item on a statement as a percentage of a base figure within the statement.

To conduct a vertical analysis of balance sheet, the total of assets and the total of liabilities and
stockholders’ equity are generally used as base figures. All individual assets (or groups of assets if
condensed form balance sheet is used) are shown as a percentage of total assets. The current liabilities, long
term debts and equities are shown as a percentage of the total liabilities and stockholders’ equity.

To conduct a vertical analysis of income statements, sales figure is generally used as the base and all other
components of income statement like cost of sales, gross profit, operating expenses, income tax, and net income
etc. are shown as a percentage of sales.

In a vertical analysis the percentage is computed by using the following formula:

Percentage of base = (Amount of individual item/Amount of base item) × 100

A basic vertical analysis needs an individual statement for a reporting period but comparative statements may
be prepared to increase the usefulness of the analysis.

Vertical analysis states financial statements in a comparable common-size format (percentage

form). One of the advantages of common-size analysis is that it can be used for inter-company
comparison of enterprises with different sizes because all items are expressed as a percentage of
some common number. For example, suppose company A and company B belong to same
industry. A is a small company and B is a large company. Company A’s sales and gross profit are
$100,000 and $30,000 respectively whereas company B’s sales and gross profit are $1,000,000 and
$300,000 respectively. If vertical analysis is conducted and sales figure is used as base, it would
show a gross profit percentage of 30% for both the companies as shown below:

The Ratio Analysis: Introduction

Ratio analysis is a quantitative method of gaining insight into a company's liquidity, solvency, operational
efficiency, and profitability by studying its financial statements such as balance sheet and income
statement. Generally, financial ratios are classified on the basis of function or test, on the basis of
financial statements, and on the basis of importance. 

Classification of financial ratios on the basis of function:

On the basis of function or test, the ratios are classified as liquidity ratios, solvency ratios, profitability
ratios and activity ratios or efficiency ratios. 

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Liquidity Ratios:

Liquidity ratios measure the adequacy of current and liquid assets and help evaluate the ability of
the business to pay its short-term debts. The ability of a business to pay its short-term debts is
frequently referred to as short-term solvency position or liquidity position of the business.

Generally a business with sufficient current and liquid assets to pay its current liabilities as and
when they become due is considered to have a strong liquidity position and a businesses with
insufficient current and liquid assets is considered to have weak liquidity position.

Short-term creditors like suppliers of goods and commercial banks use liquidity ratios to know whether the
business has adequate current and liquid assets to meet its current obligations. Financial institutions
hesitate to offer short-term loans to businesses with weak short-term solvency position.

Four commonly used liquidity ratios are given below:

1. Current ratio
2. Quick ratio or acid test ratio

Unfortunately, liquidity ratios are not true measure of liquidity because they tell about the quantity but
nothing about the quality of the current assets and, therefore, should be used carefully. For a useful
analysis of liquidity, these ratios are used in conjunction with activity ratios. Examples of activity
ratios are receivables turnover ratio, accounts payable turnover ratio and inventory turnover ratio, etc.

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Solvency ratios:

Solvency ratios (also known as long-term solvency ratios) measure the ability of a business to survive
for a long period of time. These ratios are very important for stockholders and creditors.

Solvency ratios are normally used to:

 Analyze the capital structure of the company;

 Evaluate the ability of the company to pay interest on long term borrowings;
 Evaluate the ability of the the company to repay principal amount of the long term loans
(debentures, bonds, medium and long term loans etc.); and
 Evaluate whether the internal equities (stockholders’ funds) and external equities (creditors’
funds) are in right proportion.

Some frequently used long-term solvency ratios are given below:

1. Debt ratio (or Debt to asset ratio)

2. Debt to equity ratio
3. Times-interest earned (TIE) ratio  (or  Interest coverage ratio)

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Profitability ratios:

Profit is the primary objective of all businesses. All businesses need a consistent improvement in
profit to survive and prosper. A business that continually suffers losses cannot survive for a long period.

Profitability ratios measure the efficiency of management in the employment of business resources

to earn profits. These ratios indicate the success or failure of a business enterprise for a particular
period of time.

Profitability ratios are used by almost all the parties connected with the business.

A strong profitability position ensures common stockholders a higher dividend income and appreciation in
the value of the common stock in future.

Creditors, financial institutions and preferred stockholders expect a prompt payment of interest and fixed
dividend income if the business has good profitability position.

Management needs higher profits to pay dividends and reinvest a portion in the business to increase the
production capacity and strengthen the overall financial position of the company.

Some important profitability ratios are given below:

1. Gross profit (NP) ratio

2. Net profit (GP) ratio
3. Return on Investment (ROI)
4. Return on asset (ROA)
5. Return on equity (ROE)
6. Earnings per share (EPS) ratio (sometimes classified as Valuation ratio)

Activity ratios:

Activity ratios (also known as efficiency or turnover ratios) measure the efficiency of a firm or

company in generating revenues by converting its production into cash or sales. Generally a fast
conversion increases revenues and profits.

Activity ratios show how frequently the assets are converted into cash or sales and, therefore, are
frequently used in conjunction with liquidity ratios for a deep analysis of liquidity.

Some important activity ratios are:

1. Accounts Receivable turnover ratio

2. Days sales outstanding or Average collection period
3. Inventory turnover ratio
4. Days sales of inventory
5. Fixed assets turnover ratio
6. Asset turnover ratio
7. Accounts payable turnover ratio
8. Days payable outstanding or Average payment period
9. Cash conversion cycle

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The Ratio Analysis: Liquidity Ratios
What Are Liquidity Ratios?
Liquidity ratios are an important class of financial metrics used to determine a debtor's ability to
pay off current debt obligations without raising external capital. 

Liquidity ratios measure a company's ability to pay debt obligations and its margin of safety through the
calculation of metrics including the current ratio, quick ratio, and operating cash flow ratio.

Current liabilities are analyzed in relation to liquid assets to evaluate the coverage of short-term debts in
an emergency.

Understanding Liquidity Ratios

Liquidity is the ability to convert assets into cash quickly and cheaply. Liquidity ratios are most
useful when they are used in comparative form. This analysis may be internal or external.

For example, internal analysis regarding liquidity ratios involves using multiple accounting periods

that are reported using the same accounting methods. Comparing previous time periods to current
operations allows analysts to track changes in the business. In general, a higher liquidity ratio shows a
company is more liquid and has better coverage of outstanding debts.

Alternatively, external analysis involves comparing the liquidity ratios of one company to another or

an entire industry. This information is useful to compare the company's strategic positioning in relation to
its competitors when establishing benchmark goals. Liquidity ratio analysis may not be as effective when
looking across industries as various businesses require different financing structures. Liquidity ratio
analysis is less effective for comparing businesses of different sizes in different geographical
locations.

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Common Liquidity Ratios

The Current Ratio

The current ratio measures a company's ability to pay off its current liabilities (payable within one
year) with its current assets such as cash, accounts receivable and inventories. The higher the
ratio, the better the company's liquidity position:

The Quick Ratio

The quick ratio measures a company's ability to meet its short-term obligations with its most liquid
assets and therefore excludes inventories from its current assets. It is also known as the "acid-
test ratio":

The Ratio Analysis: Solvency Ratios

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What Is the Solvency Ratio?
Solvency ratios measure the ability of a company to pay its long-term liabilities, such as debt and
the interest on that debt. It's one of many financial ratios that can be used to assess the overall health of
a company.

Solvency ratios are any form of financial ratio analysis that measures the long-term health of a
business. In other words, solvency ratios prove (or disprove) that business firms can honor their
debt obligations.

Solvency ratios also help the business owner keep an eye on downtrends that could suggest the
potential for bankruptcy in the future. It helps analysts keep a close eye on how much debt a company
is taking on in comparison to its assets and earnings.

How Do You Calculate Solvency Ratios?

There are several solvency ratios that managers can use. Some of these ratios are technical—of use
primarily to auditors or corporate analysts. Others are easily assessed by accountants, business
managers, and investors alike. Here are three simple equations to begin your solvency ratio
analysis.

Debt Ratio
The debt ratio measures how much of the firm's asset base is financed using debt. You calculate this
by dividing a company's debt by its assets. If a firm's debt-to-assets ratio is 0.5, that means, for every
$1 of debt, there are $2 worth of assets. The higher the debt ratio, the more leveraged a company
is, implying greater financial risk.

Debt ratios vary widely across industries. For example, if a company has total assets of $100 million and
total debt of $30 million, its debt ratio is 30% or 0.30. Is this company in a better financial situation
than one with a debt ratio of 40%? The answer depends on the industry.

A debt ratio of 30% may be too high for an industry with volatile cash flows, in which most
businesses take on little debt. A company with a high debt ratio relative to its peers would probably find it
expensive to borrow and could find itself in a crunch if circumstances change.

Equity Ratio
This ratio is calculated by dividing total equity by total assets. This tells managers how effectively a
company funds its assets with shareholder equity, as opposed to debt. The higher the ratio, the
less debt is needed to fund asset acquisition. The lower the ratio result, the more debt a company has
used to pay for its assets.

When a company's shareholder equity ratio approaches 100%, it means the company has financed
almost all of its assets with equity instead of taking on debt.

Calculating the ratio for a company is more meaningful if you compare it with other companies in its
industry. Each industry has its own standard or normal level of shareholders' equity to assets.
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Times-interest earned (TIE) ratio or 
Interest Coverage Ratio
This measures a company's ability to meet its long-term debt obligations. It's calculated by dividing
corporate income, or "earnings," before interest and income taxes (commonly abbreviated EBIT) by
interest expense related to long-term debt. 

The interest coverage ratio measures how many times a company can cover its current interest
payment with its available earnings. In other words, it measures the margin of safety a company has for
paying interest on its debt during a given period. The interest coverage ratio is used to determine how
easily a company can pay its interest expenses on outstanding debt.

The lower the ratio, the more the company is burdened by debt expense. When a company's interest
coverage ratio is only 1.5 or lower, its ability to meet interest expenses may be questionable.

How Solvency Ratios Work

If one of the ratios shows limited solvency, that should raise a red flag for managers. If several of these
ratios point to low solvency, that's a major issue, especially if the broader economic climate is fairly
upbeat. A company that struggles with solvency when things are good is unlikely to fare well in a
stressful economic environment.

For business owners, it should spur an effort to reduce debt, increase assets, or both. For a potential
investor, these are serious indications of problems ahead, and a troubling sign about the direction the
stock price could take. Traders may even take this as a sign to short the stock, though traders would
consider many other factors beyond solvency before making such a decision.

Difference Between Solvency Ratios and Liquidity Ratios

 Solvency Ratios                                        vs.           Liquidity Ratios
Solvency Ratios      Liquidity Ratios
Measures financial health of company      Measures financial health of company
Focuses on long-term stability      Focuses on short-term stability
Includes all assets, such as inventory      Emphasizes cash and cash-like holdings
Solvency ratios are sometimes confused with liquidity ratios. Both assess a company's financial
health, but they aren't the same thing.

Solvency ratios assess the company's long-term health by evaluating long-term debt and the
interest on that debt; liquidity ratios assess the company's short-term ability to meet current obligations
and turn assets into cash quickly.

A company with high liquidity could easily rise to meet sudden financial emergencies, but that doesn't tell
a manager how easily a company can honor all of its debt obligations on a decades-long
timeline. Conversely, a company with solid solvency is on stable ground for the long-term, but it's
unclear how it would fair under a sudden cash crunch.

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The Ratio Analysis: Profitability Ratios
What Are Profitability Ratios?
Profitability ratios are a class of financial metrics that are used to assess a business's ability to
generate earnings relative to its revenue, operating costs, balance sheet assets, or shareholders'
equity over time, using data from a specific point in time.

Every firm is most concerned with its profitability. One of the most frequently used tools of
financial ratio analysis is profitability ratios. They are used to determine the company's bottom line for
its managers and its return on equity to its investors. Profitability measures are important to company
managers and owners alike. Management has to have a measure of profitability in order to steer the
business in the right direction. If a business has outside investors who have purchased stock in the
company, the company management has to show profitability to those equity investors.

Profitability ratios, as discussed and illustrated below, show a company's overall efficiency in using its
assets and performance at the end of each quarter or year. Profitability ratios are divided into two
types: margin ratios and return ratios. Ratios that show margins represent the firm's ability to translate
sales dollars into profits at various stages of measurement. Ratios that show returns represent the
firm's ability to measure the overall efficiency of the firm in generating returns for its
shareholders.

Managers generally use either trend or industry analysis. Trend analysis involves, in this case, looking
at the business's profitability ratios over time and looking for positive and negative
trends. Industry analysis is the comparison of a business's profitability ratios to those of other
businesses in the same industry sector.

Margin Ratios
Gross Profit Margin

The gross profit margin calculates the cost of goods sold as a percent of sales—both numbers
can be found on the income statement. This ratio looks at how well a company controls the cost of its
inventory and the manufacturing of its products and subsequently passes on the costs to its
customers. The larger the gross profit margin, the better for the company.

Calculate gross profit margin by first subtracting the cost of goods sold from sales. If sales are
$100 and the cost of goods sold is $60, the gross profit is $40. Then divide gross profit by sales which
would be: $40 / $100 = 40%. The gross profit margin, which is the amount of sales revenue that can be
devoted to utilities, inventory, and manufacturing costs is 40% of sales.

Formula:

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Net Profit Margin

When doing a simple profitability ratio analysis, the net profit margin is the most often margin ratio
used. The net profit margin shows how much of each sales dollar remains as net income after all
expenses are paid. For example, if the net profit margin is 5%, that means that 5 cents of every dollar of
sales made are profit. The net profit margin measures profitability after consideration of all
expenses including taxes, interest, and depreciation. 

Both terms of the equation come from the income statement.

Formula:

Return Ratios

Return on Investment (ROI)

Return on Investment (ROI) is a performance measure used to evaluate the efficiency of an

investment or compare the efficiency of a number of different investments. ROI tries to directly
measure the amount of return on a particular investment, relative to the investment’s cost. To calculate
ROI, the benefit (or return) of an investment is divided by the cost of the investment. The result is
expressed as a percentage or a ratio.

The return on investment formula is as follows:

"Current Value of Investment” refers to the proceeds obtained from the sale of the investment of interest.
Because ROI is measured as a percentage, it can be easily compared with returns from other
investments, allowing one to measure a variety of types of investments against one another.

ROI is a popular metric because of its versatility and simplicity. Essentially, ROI can be used as a
rudimentary gauge of an investment’s profitability. This could be the ROI on a stock investment, the ROI a
company expects on expanding a factory, or the ROI generated in a real estate transaction. The
calculation itself is not too complicated, and it is relatively easy to interpret for its wide range of
applications. If an investment’s ROI is net positive, it is probably worthwhile. But if other
opportunities with higher ROIs are available, these signals can help investors eliminate or select
the best options. Likewise, investors should avoid negative ROIs, which imply a net loss.

Return on Assets (ROA)

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The return on assets (ROA) ratio is an important profitability ratio because it measures the efficiency
with which the company is managing its investment in assets and using them to generate
profit. It measures the amount of profit earned relative to the firm's level of investment in total
assets. The return on assets ratio is related to the asset management category of financial ratios.

Net income is taken from the income statement, and total assets are taken from balance sheet. The
higher the percentage, the better, because that means the company is doing a good job using its
assets to generate sales.

Formula:

Return on Equity (ROE)

The return on equity (ROE) ratio is perhaps the most important of all the financial ratios to a publicly-
held company's investors. It measures the return on the money the investors have put into the
company. It is the ratio potential investors look at when deciding whether or not to invest in the
company.  

Net income comes from the income statement, and stockholder's equity comes from the balance sheet. In
general, the higher the percentage, the better, with some exceptions, as it shows that the company
is doing a good job using the investors' money.

Whether ROE is deemed good or bad will depend on what is normal industry average. For example,
utilities have many assets and debt on the balance sheet compared to a relatively small amount of net
income. A normal ROE in the utility sector could be 10% or less. A technology or retail firm with smaller
balance sheet accounts relative to net income may have normal ROE levels of 18% or more.

A good rule of thumb is to target an ROE that is equal to or just above the average to those of
other businesses in the same industry sector.

Formula:

Earnings per share (EPS)

Earnings per share (EPS) is calculated as a company's profit divided by the outstanding shares of its
common stock. The resulting number serves as an indicator of a company's profitability. The higher
a company's EPS, the more profitable it is considered.

The earnings per share metric are one of the most important variables in determining a share's
price. By dividing a company's share price by its earnings per share, an investor can see the value of a
stock in terms of how much the market is willing to pay for each dollar of earnings. EPS is one of
the many indicators you could use to pick stocks. 
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The earnings per share value are calculated as the net income (also known as profits or earnings) divided
by the available shares. 

Formula:

The Ratio Analysis: Activity or Efficiency Ratios

What Is an Activity Ratio?
An activity ratio is a type of financial metric that indicates how efficiently a company is leveraging the
assets on its balance sheet, to generate revenues and cash. Commonly referred to as efficiency
ratios, activity ratios help analysts gauge how a company handles assets management which is key to its
operational fluidity and overall fiscal health.

Understanding Activity Ratios

Activity ratios are most useful when employed to compare two competing businesses within the
same industry to determine how a particular company stacks up amongst its peers. But activity ratios
may also be used to track a company's fiscal progress over multiple recording periods, to detect
changes over time. These numbers can be mapped to present a forward-looking picture of a company's
prospective performance.

The activity ratios show the connection between sales and a given asset. It indicates the investment in
one particular group of assets and the revenue the assets are producing.

Assets such as raw materials and machinery are introduced to generate sales and thereby,
profits. The activity ratios show the speed at which the assets are converted into sales.

Activity ratios play an active role in evaluating the operating efficiency of the business as it not only
shows how the company generates revenue but also how well the company is managing the
components in its balance sheet.

What Are the Different Activity Ratios?

Accounts Receivable Turnover Ratio

The accounts receivables turnover ratio, also known as debtor’s ratio, is an activity ratio that measures
how many times a business can turn its accounts receivables into cash.

It is calculated by dividing the net credit sales during a specific period by the average accounts
receivables. The average accounts receivable is calculated by adding the value of the accounts
receivable at the beginning of the desired period to the value at the end and then dividing it by two.
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Formula:

Accounts Receivable Turnover = Net Credit Sales / Average Accounts Receivable

The ratio indicates the efficiency with which the business is able to collect credit it issues its
customers.

A high ratio may indicate the company operates on a cash basis or has quality customers that pay
off their debts quickly, while a low ratio can suggest a bad credit policy and poor collecting process. It
helps in assessing if its credit policies are helping or hurting the business.

Days Sales Outstanding (DSO)

This is commonly known as "Average Collection Period." The days sales outstanding is the average
number of days required to collect invoiced amounts from customers. The measure is used to
determine the effectiveness of a company's credit granting policies and collection efforts. 

Formula: 

Days Sales Outstanding (DSO) = Average Accounts Receivable ÷ (Net credit sales ÷ 360 or 365
days)

The average balance of accounts receivable is calculated by adding the opening balance in

accounts receivable (AR) and ending balance in accounts receivable and dividing that total by
two. When calculating the average collection period for an entire year, 360 or 365 may be used as the
number of days in one year.

For example, a company has average accounts receivable of $1,000,000 and annual sales of $6,000,000.
The calculation of its average collection period is:

DSO = $1,000,000 Average receivables ÷ ($6,000,000 Sales ÷365 days) = 60.8 Average days to collect
receivables  

A lower days sales outstanding is generally more favorable than a higher one. A low average
collection period indicates the organization collects payments faster. There is a downside to this,
though, as it may indicate its credit terms are too strict. Customers may seek suppliers or service
providers with more lenient payment terms.

Inventory Turnover Ratio

The inventory turnover ratio details the efficiency with which inventory is managed. The ratio shows
how well the business manages its inventory levels and how frequently they are replenished.

It is calculated by dividing the cost of goods sold by the average inventory for the same period.

Formula:

Inventory Turnover Ratio = Cost of Goods Sold / Average Inventory

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A low inventory turnover ratio may indicate overstocking, poor marketing or a declining demand for the
product. A high ratio is an indicator of good inventory management and a higher demand for the
product.

Days Sales of Inventory (DSI)

The days sales of inventory (DSI) is a financial ratio that indicates the average time in days that a company takes to
turn its inventory, including goods that are a work in progress, into sales.

DSI is also known as the average age of inventory, days inventory outstanding (DIO), days in inventory (DII), days
sales in inventory or days inventory and is interpreted in multiple ways. Indicating the liquidity of the inventory, the
figure represents how many days a company’s current stock of inventory will last. Generally, a lower DSI is preferred as
it indicates a shorter duration to clear off the inventory, though the average DSI varies from one industry to
another.

Formula:

DSI is a measure of the effectiveness of inventory management by a company. Since DSI indicates

the duration of time a company’s cash is tied up in its inventory, a smaller value of DSI is preferred. A
smaller number indicates that a company is more efficiently and frequently selling off its
inventory, which means rapid turnover leading to the potential for higher profits (assuming that sales are
being made in profit). On the other hand, a large DSI value indicates that the company may be
struggling with obsolete, high-volume inventory and may have invested too much into the same. It
is also possible that the company may be retaining high inventory levels in order to achieve high order
fulfillment rates, such as in anticipation of bumper sales during an upcoming holiday season.

Fixed Asset Turnover Ratio

This ratio measures the business’ ability to generate sales from fixed assets such as property,
plant and equipment. To calculate the ratio, you need to divide the net sales by the total property, plant,
and equipment net of accumulated depreciation.

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Formula:

Fixed Asset Turnover Ratio = Net Sales / (Fixed Assets – Accumulated Depreciation)

A high turnover ratio indicates the assets are being utilized efficiently for generating sales.

Asset Turnover Ratio

The asset turnover ratio measures the efficiency with which a company utilizes its assets to
generate sales. The ratio calculates net sales as a percentage of assets.

Formula:

Asset Turnover Ratio = Sales / Average Total Assets

This ratio is calculated at the end of a financial year and can vary widely from one industry to another. The
higher the asset turnover ratio, the better the company is performing.

The asset turnover ratio is also a primary component of DuPont analysis. Started by the DuPont
Corporation in the 1920s, the analysis helps in understanding how companies can increase return for their
shareholders. It breaks down Return on Equity (ROE) into asset turnover, profit margin and
financial leverage.

Accounts Payable Turnover Ratio

The accounts payable turnover ratio is a short-term liquidity measure used to quantify the rate at which a company pays
off its suppliers. Accounts payable turnover shows how many times a company pays off its accounts payable during
a period. The accounts payable turnover ratio shows how efficient a company is at paying its suppliers and
short-term debts.

A decreasing turnover ratio indicates that a company is taking longer to pay off its suppliers than
in previous periods. The rate at which a company pays its debts could provide an indication of the
company's financial condition. A decreasing ratio could signal that a company is in financial distress.
Alternatively, a decreasing ratio could also mean the company has negotiated different payment
arrangements with its suppliers.

When the turnover ratio is increasing, the company is paying off suppliers at a faster rate than in
previous periods. An increasing ratio means the company has plenty of cash available to pay off
its short-term debt in a timely manner. As a result, an increasing accounts payable turnover ratio could
be an indication that the company managing its debts and cash flow effectively.

Formula:

Accounts payable turnover ratio = Total purchases / Average accounts payable

Calculate the average accounts payable for the period by subtracting the accounts payable balance at the
beginning of the period from the accounts payable balance at the end of the period. Divide the result by
26
two to arrive at the average accounts payable. Take total supplier purchases for the period and divide it by
the average accounts payable for the period.

Days Payable Outstanding (DPO)

The ratio measures the number of days a business takes to pay its invoices and bills to its
vendors, suppliers or other companies. 

Formula:

Days Payable Outstanding = Accounts Payable / (Cost of Sales/ Number of Days)

The number of days is taken as 360 or 365 days for a year. The ratio indicates how well the cash flow is
being managed.

A ratio is usually beneficial for the business. When a business takes longer to pay its bills, it has
available cash for a longer period for managing operations, producing more goods and its short-
term investments. However, taking too long to pay can result in unhappy creditors and refusal of further
credit. It can also indicate that your business is struggling to pay its creditors.

A low ratio indicates that the business is either not utilizing its credit period efficiently or has short-term
arrangements with creditors.

Cash Conversion Cycle (CCC)

The cash conversion cycle (CCC) is a metric that expresses the time (measured in days) it takes for a
company to convert its investments in inventory and other resources into cash flows from
sales. Also called the Net Operating Cycle or simply Cash Cycle, CCC attempts to measure how long
each net input dollar is tied up in the production and sales process before it gets converted into cash
received.

This metric takes into account how much time the company needs to sell its inventory, how much time it
takes to collect receivables, and how much time it has to pay its bills without incurring penalties.

CCC is one of several quantitative measures that help evaluate the efficiency of a company's operations
and management. A trend of decreasing or steady CCC values over multiple periods is a good sign while
rising ones should lead to more investigation and analysis based on other factors. 

Since CCC involves calculating the net aggregate time involved across the above three stages of the cash
conversion lifecycle, the mathematical formula for CCC is represented as:

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Boosting sales of inventory for profit is the primary way for a business to make more earnings. But
how does one sell more stuff? If cash is easily available at regular intervals, one can churn out more sales
for profits, as frequent availability of capital leads to more products to make and sell. A company can
acquire inventory on credit, which results in accounts payable (AP). A company can also sell
products on credit, which results in accounts receivable (AR). Therefore, cash isn't a factor until
the company pays the accounts payable and collects the accounts receivable. Thus timing is an
important aspect of cash management. 

Essentially, CCC represents how fast a company can convert the invested cash from start (investment) to
end (returns). The lower the CCC, the better.

Inventory management, sales realization, and payables are the three key ingredients of business.
If any of these goes for a toss – say, inventory mismanagement, sales constraints, or payables
increasing in number, value, or frequency – the business is set to suffer. Beyond the monetary value
involved, CCC accounts for the time involved in these processes that provides another view of the
company’s operating efficiency. In addition to other financial measures, the CCC value indicates how
efficiently a company’s management is using the short-term assets and liabilities to generate and redeploy
the cash and gives a peek into the company’s financial health with respect to the cash management. 

Importance of Financial Statement Analysis

The financial statement analysis is important for different reasons. The importance of financial statement
analysis can be presented as follows:

1. Holding Of Share
Shareholders are the owners of the company. Time and again, they may have to take decisions
whether they have to continue with the holdings of the company's share or sell them out. The financial
statement analysis is important as it provides meaningful information to the shareholders in taking
such decisions.

2. Decisions And Plans

The management of the company is responsible for taking decisions and formulating plans and policies
for the future. They, therefore, always need to evaluate its performance and effectiveness of their

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action to realize the company's goal in the past. For that purpose, financial statement analysis is
important to the company's management.

3. Extension Of Credit
The creditors are the providers of loan capital to the company.Therefore they may have to
take decisions as to whether they have to extend their loans to the company and demand for
higher interest rates. The financial statement analysis provides important information to them for their
purpose.

4.Investment Decision
The prospective investors are those who have surplus capital to invest in some profitable opportunities.
Therefore, they often have to decide whether to invest their capital in the company's share. The
financial statement analysis is important to them because they can obtain useful information for their
investment decision making purpose.

Limitations of Financial Statement analysis

1. Not a Substitute of Judgement

An analysis of financial statement cannot take place of sound judgement. It is only a means to reach
conclusions. Ultimately, the judgements are taken by an interested party or analyst on his/ her intelligence
and skill.

2. Based on Past Data

Only past data of accounting information is included in financial statements, which are analyzed. The
future cannot be just like past. Hence, the analysis of financial statements cannot provide a basis for
future estimation, forecasting, budgeting and planning.

3. Reliability of Figures

Sometimes, the contents of financial statements are manipulated by window dressing. If so, the analysis
of financial statements results in misleading or meaningless.

4. Change in Accounting Methods

There must be uniform accounting policies and methods for number of years. If there are frequent
changes, the figures of different periods will be different and incomparable. In such a case, the analysis
has no value and meaning.

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5. Changes in the Value of Money

The purchasing power of money is reduced from one year to subsequent year due to inflation. It creates
problems in comparative study of financial statements of different years.

6. No Assessment of Managerial Ability

The results of the analysis of financial statements should not be taken as an indication of good or bad
management. Hence, the managerial ability can not be assessed by analysis.

7. Change of Business Condition

The conditions and circumstances of one firm can never be similar to another firm. Likewise, the business
condition and circumstances of one year to subsequent can never be similar. Hence, it is very difficult for
analysis and comparison of one firm with another.

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