Financial Accounting

Module 6 Analyzing Financial Statements

Note: This summary is longer and more comprehensive than most Module Summaries,
as it will be helpful for you to have a list of all the ratios we covered in this module in
one place.

• Analyzing financial statements is critical in order to understand the performance

of a business. To do so, we can use different types of ratios that uncover
important relationships between financial statement items.
• Ratios are typically most useful when making comparisons to other companies or
to the past performance of the company itself. Therefore, it’s important to first get
an overall understanding of the company and the industry in which it operates.
• One of the most commonly evaluated ratios is a firm’s return on equity or ROE,
ACCT-remediation-M6Summary-01
which shows the return that a business generated during a period on the equity
invested in the business by the owners of the business.

Net Income
Return on Equity (ROE) =
Owners’ Equity

• The DuPont Framework expands the ROE formula to consist of three factors:

The Dupont Framework

Return on Equity (ROE) = Profitability × Efficiency × Leverage

Profit Margin Asset Turnover Leverage

Net Income Sales Assets

Sales Assets Equity

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 • The DuPont Framework measures profitability using Profit Margin, efficiency
using Asset Turnover, and leverage using the Leverage Ratio (or Equity
Multiplier), as shown above. Although they are not used in the DuPont
Framework, there are many other ratios that measure profitability, efficiency, and
leverage, which can provide useful insights in financial statement analysis.
• PROFITABILITY RATIOS:
o Profitability reveals how much profit is left from each dollar of sales after
all expenses have been subtracted. Profit margin is calculated by dividing
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net income by the total sales for the period.

Net Income
Profit Margin =
Sales

o The gross profit margin ratio tells us what percentage of our revenue is left
to cover other expenses after the cost of goods sold is subtracted. Recall
that gross profit is equal to sales minus cost of goods sold.

Gross Profit
Gross Profit Margin =
Sales

o Earnings before interest after taxes or EBIAT, is a measure of how much

income the business has generated while ignoring the effect of financing
and capital structure, or the proportion of debt that the business has.
• EFFICIENCY RATIOS:
o To measure Operating Efficiency, asset turnover tells us how well a
business is using its assets to produce sales. A business that can create
more revenue with fewer assets is more efficient. This ratio uses both the
income statement and the balance sheet; we typically use the average of
the beginning and ending balance sheet amounts to estimate the average
level of assets during the period.

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 o Inventory turnover helps understand how efficiently a business is
managing its inventory levels. Excess inventory costs money to store and
uses up the firm’s cash that could be used for other investments. A higher
inventory turnover represents more efficient inventory management.

Cogs
Inventory Turnover =
Average Inventory

Here we used average inventory balance instead of the ending balance

displayed on the balance sheet. This is especially significant and provides
better results than using the ending balance, especially for a firm that is
growing quickly, as the level of inventory could have fluctuated during
the year.
o Days Inventory relates to inventory turnover. The only difference is that it
is expressed as the average number of days the inventory is held before it
is sold rather than how many times the inventory turned over during the
period. At times it may be more intuitive to consider and discuss ratios and
changes to these ratios when the terms are expressed in days.

Average Inventory 365

Days Inventory = Days Inventory =
Cogs / 365 Inventory Turnover
or

o The accounts receivable turnover or AR turnover indicates a business’

efficiency in collecting receivables from customers. Uncollected
receivables represent cash that is tied up and can’t be used for other
purposes. A higher AR turnover represents more efficient cash collections.

Credit Sales
Accounts Receivable Turnover =
Average Accounts Receivable

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 o The average collection period, sometimes referred to as Days Sales
Outstanding or Days Sales in Receivables, is the average number of days
it took for a business to collect payment from a customer. This helpful
measure can be compared to the cash collection policy of the firm. If
payment is expected from customers within 30 days, but the average
collection period is 40 days, it may be a sign of concern.

or

o To measure Accounts payable turnover, or AP turnover we look at how

long it takes us to pay our vendors. Vendors include suppliers of inventory
and also suppliers of services or other non-inventory items. One input for
this ratio is credit purchases, which can be estimated by looking at COGS.
We are also assuming that all goods are bought on credit and not paid for
with cash. In both cases other adjustments may have to be made.

(where credit purchases data is available) (where credit purchases data is

NOT available)

o Another way to gauge our accounts payable is to look at days purchases

outstanding. Again this simply shows the AP turnover measured in
average days outstanding.

(where credit purchases data is available) (where credit purchases data is

NOT available)

It can also be calculated by:

365
Days Purchases Outstanding =
Accounts Payable Turnover

• The days purchases outstanding, days inventory, and average collection period
combine into what is called a cash conversion cycle. This metric, is a measure of
how long it takes a business from the time it has to pay for inventory from its
suppliers until it collects cash from its customers.

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 Days Average Collection Days Purchases Cash Conversion
Inventory + Period − Outstanding = Cycle

• LEVERAGE RATIOS:
o Financial Leverage, also known as the Equity Multiplier, is calculated
as average total assets divided by average total equity and measures the
impact of all non-equity financing, or debt of all sorts, on the firm’s ROE. If
all of the assets are financed by equity, the multiplier is 1. As liabilities,
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which are forms of debt, increase, the multiplier increases from 1
demonstrating the leverage impact of the debt.

Average Total Assets

Leverage =
Average Total Equity

o Another very common indicator of leverage is the debt to equity ratio.

Average Total Liabilities

Debt to Equity =
Average Total Equity

• OTHER RATIOS:
o The current ratio helps us understand the business’ ability to pay its
short term obligations. It focuses on the business’ more liquid assets and
liabilities, or those that are convertible to cash or coming due, within
a year.

Current Assets
Current Ratio =
Current Liabilities

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 o The quick ratio is similar to the current ratio except only highly liquid
current assets can be used in the nominator. It’s also sometimes called
an acid test ratio.

Current Assets − Inventory

Quick Ratio =
Current Liabilities

o The interest coverage ratio, also known as the times interest earned, is
a good way to gauge how capable a business is of making the interest
payments on its debt. For this, we use a common income number called
EBIT (Earnings Before Interest and Taxes). This number has to be
calculated from the income statement by adding back interest expense
and tax expense for the period to net income.

EBIT EBIT
Interest Coverage Ratio = Times Interest Earned =
Interest Expense Interest Expense
or

o Something to consider is the impact of Seasonality in a business’

performance, as it can cause repeating fluctuations. Comparing financial
statements for a full period to those for several smaller periods throughout
the year can help reveal these performance cycles.
• Ratios can be very useful when comparing one company to another because
they allow you to eliminate to a large extent the impact of size differences that
exists among companies. Most ratios, however, are in some ways influenced by
managerial judgment in recording transactions that have a great impact on the
financial statement. As a financial analyst, in some cases you will need to make
adjustments to the financial statements to account for the differences before they
can be used for comparisons.
• The impact of policy differences is most noticeable on how companies
recognize revenue; whether purchased assets are expensed or capitalized; and
how a long-lived asset will be depreciated.

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