FAQ: Financial Ratio Analysis

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1 Question 1: What is horizontal analysis of financial statement data? Answer 1: Horizontal analysis is a method of financial ratio analysis. Horizontal analysis is comparing each item on the financial statements to itself. The reason this is called horizontal analysis is because a comparison of two figures across columns, from one period to another, is being used. Horizontal analysis is comparing an item to itself in different years, and it is accomplished by showing changes among years using both dollar amounts and percentages. Showing changes in dollar amounts will help focus on key items that have effect on profit or financial position. Showing changes among years as a percentage will help the analyst to gain a perspective of the different changes that are going on. Percent = Amount of change / Base (old year) Question 2: What is vertical analysis of financial statement data? Answer 2: Vertical analysis is a method used in financial ratio analysis where each item on the financial statement is shown as a percentage of a total base. On the balance sheet, the total base would either be total assets or total liabilities and stockholder's equity. On the income statement, the total base would be total sales. In the example of the Smith Company's balance sheet, the cash percentage for 2005 is calculated like this: $13,000 $53,462 = 24.4% In other words, the cash balance amount is divided by the total asset amount. Smith Company Comparative Balance Sheet December 31, 2005 and December 31, % 2004 % Assets Current Assets: Cash $13, $14, Accounts Receivable, net 12, , Inventory 17, ,

2 Prepaid Expenses Total Current Assets $42, , Property, Plant & Equipment Equipment, net 10, , Total Assets $53, , Liabilities Current Liabilities: Notes Payable 10, , Accounts Payable Total Current Liabilities 10, , Long-Term Liabilities Mortgage Payable 18, , Total Liabilities 28, , Stockholder's Equity Common Stock $15 par value 15, , Retained Earnings 9, , Total Stockholder's Equity 24, , Total Liabilities and Stockholder's Equity 53, , Question 3: Why are common-size financial statements used? Answer 3: The common-size financial statement is a method used in financial ratio analysis. Common-size financial statements only show percentages on the statements. When common-size financial statements are used, it makes it easier to see an increase or decrease in account without the numbers being used. Common-size financial statements are used to compare businesses of different sizes. These percentages are calculated by using vertical analysis. To calculate these percentages, a certain item on the financial statement is used. This item on the balance sheet is usually Total Assets for the asset section and Total Liabilities and Stockholder's Equity for the liability section and stockholder's equity section. 2

3 Looking at the Smith Company's balance sheet, first convert the dollar amounts to percentages by using vertical analysis. In the example of the Smith Company's balance sheet, the cash percentage for the 2005 is calculated like this: $13,000 $53,462 = 24.4% In other words, the cash balance amount is divided by the total asset amount. Smith Company Comparative Balance Sheet December 31, 2005 and December 31, % 2004 % Assets Current Assets: Cash $13, $14, Accounts Receivable, net 12, , Inventory 17, , Prepaid Expenses Total Current Assets $42, , Property, Plant & Equipment Equipment, net 10, , Total Assets $53, , Liabilities Current Liabilities: Notes Payable 10, , Accounts Payable Total Current Liabilities 10, , Long-Term Liabilities Mortgage Payable 18, , Total Liabilities 28, , Stockholder's Equity Common Stock $15 par value 15, ,

4 Retained Earnings 9, , Total Stockholder's Equity 24, , Total Liabilities and Stockholder's Equity 53, , After this is completed, remove the dollar amounts from the balance sheet. Here is an example of the common-size financial statement for the Smith Company (shown). Smith Company Common-Size Financial Statement December 31, 2005 and December 31, % 2004 % Assets Current Assets: Cash Accounts Receivable, net Inventory Prepaid Expenses Total Current Assets Property, Plant & Equipment Equipment, net Total Assets Liabilities Current Liabilities: Notes Payable Accounts Payable Total Current Liabilities Long-Term Liabilities Mortgage Payable Total Liabilities Stockholder's Equity Common Stock $15 par value

5 Retained Earnings Total Stockholder's Equity Total Liabilities and Stockholder's Equity Question 4: What is the purpose of trend analysis? Answer 4: Trend analysis is a special form of horizontal analysis. In determining trends, several years of financial statements must be analyzed. Trend analysis is the converting of dollar amounts to percentage amounts. There must be a base year to change the dollar amount to a percentage. The base year is usually the earliest year shown on the financial statements. This means the base year will always equal 100%. The following is an example of using trend analysis. The year 2003 is being used as the base year Sales 223, , ,000 Cost of Goods Sold 98,000 93,000 85,000 Gross Profit 125, ,000 90,000 Trend analysis: Percentage = Year / Base year Sales 127% 113% 100% Cost of Goods Sold 115% 109% 100% Gross Profit 138% 116% 100% For the year 2004, the percentage in sales would be determined by: 198, ,000. Over a period of years, an analysis is made of these types of percentages. They are compared to the company's history and to the industry averages to determine if any trends are developing with the company. Question 5: What does the term financial leverage mean? Answer 5: Leverage means buying assets with money obtained by borrowing or by issuing preferred stock. The borrowed capital can be 5

6 invested to earn a higher return than the cost of borrowing the money. Then the net income and the return on common stockholder's equity will increase. For example, if you borrow money at 5% and earn interest at 7%, there will be a benefit from doing so. If the return on assets falls below the average cost of borrowed capital, the leverage will reduce net income and the return on common stockholders' equity. When this occurs, one option would be to pay off loans that have high interest rates, possibly by refinancing with a lower interest rate loan. Leverage is most often achieved through debt financing, which includes both current liabilities and long-term liabilities. One advantage of debt financing is that interest payments are deductible in determining taxable income. Leverage can also be accomplished by issuing preferred stock. Preferred stock dividends are not deductible for income tax purposes; the advantage gained by this approach will not be as great as it will be in the case of debt financing. Question 6: What are liquidity ratios? Answer 6: Liquidity ratios give information about a company's ability to pay its short-term debts. Creditors that extend credit for a short period of time would be interested in these ratios. These creditors would want to see a high current ratio. One limitation for the current ratio is that inventory is included in the calculation. Current ratio = Current Assets Current Liabilities Another liquidity ratio is the acid test ratio, or quick ratio. This ratio looks at assets that are easily turned into cash. The ration is used to determine if the current liabilities can be paid immediately if the creditors are so inclined to demand payment. This ratio includes all the current assets except for the inventory and prepaid expenses. Acid test ratio = Current Assets Inventory prepaid Expenses Current Liabilities Question 7: Why are investors interested in the price/earnings ratio? Answer 7: The market value of an organization's stock will change based on the expectations of the investors regarding the future earnings per 6

7 share. The price/earnings ratio divides the market price of a share of common stock by earnings per share. The price/earnings ratio considers investors' estimation of an organization's future earnings. This ratio will be higher if investors think that earnings will rise significantly in the future. This is why investors are willing to pay more per share of stock. If this ratio is low, it indicates the investors think that the organization's future earnings will not be robust. Sometimes a low ratio mirrors the market's belief that an organization has poor-quality earnings. Question 8: What are asset turnover ratios? Answer 8: Asset turnover ratios show if the company is efficiently using its assets. There are several ratios that measure asset turnover. The accounts receivable turnover measures how many times a business turns over its assets in the accounting period. The higher the turnover, the better it usually is for the company. A high turnover means the company is not having its money tied up for a long period of time in the accounts receivables. Accounts receivable turnover = Net Credit Sales Average Accounts Receivable To get the average accounts receivable, add the accounts receivable balance at the first of the year to the accounts receivable balance at the end of the year and divide the sum by 2. The average collection period ratio tells how many days an account receivable stays on the books. Average collection period = 365 days Average Accounts Receivable Another ratio that tells how well a company is using its assets is the inventory turnover ratio. This ratio calculates the number of times the inventory turns over in an accounting period. Inventory turnover: Cost of Goods Sold Average Inventory To get the average inventory, add the inventory balance at the first of the 7

8 year to the inventory balance at the end of the year and divide the sum by 2. The asset turnover ratio shows how well a company is using its assets to generate sales. Asset turnover = Net Sales Total Assets Question 9: What are debt management ratios? Answer 9: Debt management ratios tell the long-term solvency of a company. These ratios tell how the company is using long-term debt. There are several ratios in this category. Debt to total assets = Total Liabilities Total Assets Creditors like to see a low ratio because that would mean they are in better position to pay their debts. Stockholders like to see a high ratio which would indicate an attempt to maximize their return. In an effort to measure the risk of the creditors to the risk that is taken by the stockholder, the debt to stockholder's equity ratio is used. Debt to Stockholder's Equity Ratio = Total Liabilities Stockholder's Equity Another ratio that interests creditors is the times interest earned. Creditors are interested in this ratio because it measures the amount of risk to creditors from a company defaulting on interest payments. Times interest earned = Income Before Taxes and Interest Expenses Interest Expense Question 10: What are profitability ratios? Answer 10: Profitability ratios indicate how well a company can produce profits. There are several different ratios to measure profitability. One is the gross profit rate ratio. This ratio tells how much profit from each sales dollar is made to cover administrative and selling expenses. Gross profit rate ratio = Sales Cost of Goods Sold Net Sales 8

9 Another ratio is the return on total assets. This ratio tells how well a company is using its assets to turn a profit. Return on Total Assets = Net Income Before Interest and Taxes Total Assets Return on common stockholder's equity tells about the profits that are earned for each dollar that is invested in the company's common stock. Return on common stockholder's equity = (Net Income Before Taxes) (Preferred Dividends) Common Stockholder's Equity 9