Financial Statement Ratio Analysis

1 Management Accounting | 319 Financial Statement Ratio Analysis Financial statements as prepared by the accountant are documents containing much valuable information. Some of the information requires little or no Analysis to understand. If the income Statement show an operating loss, the seriousness of that problem is fairly self evident. However, for the most, part some Analysis is required to fully understand the Financial condition of a company. In this chapter, an important tool of Financial Statement Analysis will be presented, Ratio Analysis . Another Financial Statement Analysis tool, the Statement of cash flow will be presented in the next Analysis of Financial Statements There are three groups of individuals that have a keen interest in Financial Statement Analysis : (1) Investors are interested in Financial statements to evaluate current earnings and to predict future earnings.

2 Financial statements influence greatly the price at which stock is bought and sold. (2) Bankers before granting loans usually require that Financial statements be submitted. Whether or not a loan is made depends heavily on a company s Financial condition and its prospects for the future. (3) Perhaps the group that has the most interest in Financial Statement Analysis is management. Management needs to discover quickly any area of mismanagement so that corrective action can be quickly taken. Also, Financial Statement Analysis can provide support that the past decisions made have been the right statements in addition to showing the results of operations also show the effect of specific decisions. Each element of the Financial Statement as discussed 320 | CHAPTER SEVENTEEN Financial Statement Ratio Analysisin chapter 2 has one or more decisions underlying it.

3 Financial Statement Analysis is one approach to identifying and evaluating these profit is adequate or more than adequate, is it still necessary for management to analyze the Financial statements closely? The answer is yes. Even though profit is satisfactory or excellent, this year s set of decisions may have set in motion forces which, unless counteracted, may have future disastrous consequences on profit and survival success. Also, poor performance in just one area could eliminate any future profit. Unless corrected, mismanagement in just one area will eventually result in poor performance in other areas. In Figure , the consequences of poor mismanagement is indicated:Figure Consequence of Poor Decision-makingBusiness FunctionNature of MismanagementPossible Consequences in other FunctionsProductionInadequate capacityPoor quality of materialMarketing - loss of salesMarketing - loss of salesMarketingInadequate creditExcessive pricesInadequate advertisingProduction Unused plant capacity Unused plant capacity Excess inventoryFinance Funds shortageFinanceExcessive debtFinance - decreased ROIF inance - poor creditMarketing - loss of salesProduction - inadequate inventory; The survival of the business in the long run requires a balanced and coordinated effort in all business functions.

4 Broadly speaking, it is management s task to manage the capital of the business; that is, the resources, (assets) and the sources of assets (debt and equity capital). In general, there are five broad areas as indicated by Financial statements that must be managed: assets, liabilities, capital, revenue, and are the Financial Statement tools that are available to discover broad areas of mismanagement that need corrective action? The major tools as typically presented in books on Financial Statement Analysis are:1. ratios analysis2. Trend analysis3. Common size statementsIn this chapter, we are primarily concerned with Ratio Analysis . The ratios that have been recognized to be of value or are following:Income Statement ratios Operating ratioManagement Accounting | 321 Profit margin percentage Gross profit percentageBalance Sheet ratios Current Ratio Debt/equity ratioInter Statement ratios Return on investment (assets) Return on Investment (equity) Investment turnover Ratio Inventory turnover Accounts receivable turnover Earnings per share Price earnings ratioManagement should be concerned with good management and decision making in every element of Financial statements.

5 For example, the appropriate use of ratios is indicated in Figure Matching of ratios and DecisionsDecision Area Where Specific ratios May be UsedAreas of Capital : ManagementRatios that may be usedASSETS Current assetsCurrent ratioQuick ratioInventory turnover Fixed assetsLIABILITIES Current liabilitiesCurrent Ratio Long term liabilitiesDebt/equity ratioCAPITAL Contributed capitalEarnings per shareBook value per sharePrice earnings Ratio Net incomeReturn on investment (assets)Return on investment (equity)Profit margin percentageGross profit percentageA Ratio is a quotient of one magnitude divided by another of the same kind. It is the relation of one amount to another. A Ratio may be expressed in different ways. For 322 | CHAPTER SEVENTEEN Financial Statement Ratio Analysisexample, if an a given organization the number of men and women are 80 and 20, then respectively we could say:Men are 80% of the organization (80/100)Men are.

6 8 of the organizationThe Ratio of men to women is 4:1 Men are 4/5ths of the organizationConcerning Financial statements absolute values are often difficult to grasp and remember. Amounts on Financial statements in many cases are more meaningful when compared with other amounts. For example, if the number of men in an organization is 4,092 and the women are 1,023, it would be easier to say that men are 80% of the organization (4,092/5,115) or that they out number the women 4 to some cases ratios make predictions possible. Some ratios tend to remain constant from year to year. If variable expenses have averaged 80% of sales and if we predict sales will be $1,000,000 next year, then we are able to say that we expect variable expenses to be $800, objective now will be to define and discuss some of the more important Ratio - The current Ratio is: Current assetsCurrent Ratio = Current liabilitiesThis Ratio is almost always of critical importance.

7 It provides an indicator of the ability to pay short-term debt. In accounting, the different between current assets and current liabilities is call working capital. If current liabilities exceed current assets, then at that moment in time the company is not able to pay in full its current debts. Inadequate working capital has been cited as one of the major reasons businesses fail. That the Ratio should be greater than 1 is universally agreed upon. But how much greater than 1 remains the question. A general rule of thumb is that the Ratio should be at least 2:1. However, differences in industries and management decision-making may require a considerably different standard is possible to approach the current Ratio from two different viewpoints:1. A banker s viewpoint2.

8 A management viewpointFrom a banker s viewpoint the higher the Ratio the better the Ratio . A high Ratio indicates a high degree of liquidity and a better ability to repay short term a management point of view, the real issue is not the Ratio itself but the factors that create the Ratio . Accountants tend to define working capital as current assets less current liabilities. From a management s viewpoint, the questions are: (1) What are the decisions that directly affect current assets and (2) what are the decisions that affect current liabilities?Concerning current assets, the major elements are cash, accounts receivable, and inventory. The decisions that affect current assets most directly were discussed Management Accounting | 323in chapter 2.

9 Accounts receivable are created by the use of credit terms and inventory levels are largely determined by order size and safety stock most cases, the most important short term debt is accounts payable. The amount of accounts payable is generally determined by the credit terms that supplier offer. If a company, for example, purchases $1,200,000 in raw materials each year and the creditor offers 30 days to pay, then the on the average we would expect accounts payable to be $100, business that has a considerably higher current Ratio than another company is not necessarily in a better Financial condition. To illustrate, let us assume the following: Company A Company BCurrent Assets Cash $ 1,000 $20,000 Accounts receivable $ 9,000 $15,000 Merchandise inventory $30,000 $ 5,000 Total $40,000 $40,000 Current Liabilities Accounts payable $15,000 $ 5,000 Notes payable $ 5,000 $25,000 $20,000 $30,000 Current Ratio 2 A with the better current Ratio is not superior to company B regarding its ability to pay short term debt.

10 For this reason, the quick Ratio (cash + receivables / current liabilities) is often regarded as a better measure to pay short term debt. In the above example, the quick ratios are; Company A Company B Quick Ratio .5 Ratio - The debt/equity ratios is: Total debtD/E Ratio = Total equity The debt/equity Ratio is an important Ratio in that it provides a measure of the risk assumed in a given business. As the amount of debt capital increases relative to equity capital, the greater is the risk. The term risk here refers either to the risk of not being able to repay principal or the ability to pay interest. Studies have shown that a major factor for businesses failing or going into bankruptcy is because these businesses assumed too much debt and have yet to earn a satisfactory profit or no profit at all.