FEAR out Taking the FEAR of Financial Statement Analysis Toni Drake, CCE TRM Financial Services, Inc.
FINANCIAL STATEMENTS Components of a Financial Statement Balance Sheet Income Statement Statement of Retained Earnings Statement of Cash Flows Notes What to look for in Financial Statements/Annual Reports 1. What is fluff and what is fact? 2. Are the financial statements audited, unaudited or a compilation? 3. Can you obtain at least three years of financial statements? 4. What type of Auditor s Opinion was given to the Financial Statement? 5. Does the company change CPA s every year? 6. Large outstanding tax liabilities, such as federal, state, local, property, etc. 7. Large increase in long-term liabilities. 8. Substantial litigation costs. 9. Large accounts payable in relationship to size of business or size or receivables. 10. Large accounts receivable reserve. Allowance for doubtful accounts. 2
BALANCE SHEET The balance sheet indicates a company s financial position at a point in time. A snapshot. ASSETS are things of value that a company owns. Assets include cash, and physical property, such as plants, vehicles, inventory, and equipment. It also includes things that can t be touched but nevertheless exist and have value, such as patents or trademarks. LIABILITIES are everything that is owed by a company. Liabilities can include financial obligations such as accounts payable, notes payable, bank debt; payroll owed to employees, of taxes. It can also include obligations to provide goods and services to customers in the future. EQUITY or net worth is the difference between assets owned and liabilities owed. Equity is the money that would be left if a company sold all of its assets and paid all of its liability. The money left would belong to the shareholders, or owners, or the company. A company s balance sheet is set up similar to the account equation: ASSETS = LIABILITIES + EQUITY Assets are generally listed on the balance sheet based on their liquidity. In other words, how quickly they can be converted to cash. Current assets are assets which a company expects to convert to cash within an operating cycle, usually one year. Long-term assets are those assets which are not expected to convert into cash within the operating cycle, but are meant to be kept for a longer period of time. Fixed assets are long term assets that are used to operate the business but are not available for sale. Liabilities are categorized as either current or long-term. Current liabilities are obligations that will be paid in the current operating cycle, usually one year. Long-term liabilities are obligations that will become due in more than one year in the future. 3
Shareholders Equity is the amount than owners or shareholders invested in the company plus or minus the company s earnings or losses since the company s inception. On the balance sheet, equity totals the difference of assets and liabilities. 4
INCOME STATEMENTS The income statement reflects a company s net profit or loss over a period of time. Revenue is the first item reflected on an income statement. Revenue can come from operations or other sources. Cost of goods sold indicates the costs of the goods or services which derive the operating revenue. Gross profit is the difference of gross revenue and cost of goods sold. This is the first tier of profit on the income statement. Operating expenses are expenses that are incurred in order to support the business. These expenses might include payroll, rent, office supplies, depreciation, etc. Operating Profit or Loss is the difference between gross profit and operating expenses. This figure is the profit/loss derived from the actual operations of the business. Other income and expenses include interest income and expense. This could also include items such as the income or loss from sale of assets. This is any income that is not the result of the actual operations of the business. Net profit before taxes difference between Operating Profit/loss and other income and expenses. Tax expense includes all taxes, federal, state, and local that is incurred. Net profit/loss is the final bottom line figure on the income statement after taxes are deducted from the net profit before taxes. 5
STATEMENT OF RETAINED EARNINGS The Statement of Retained Earnings gives a picture of the company s profit or loss since the inception of the company. These profits are either kept in the account or are paid out as dividends to the shareholders. CASH FLOW STATEMENT Cash flow statements report a company s cash inflows and outflows. This is an important report because a company must have cash on hand in order to pay its expenses in a timely manner and make purchases as needed to expand. A company can have a net profit but have no cash. Conversely, a company can reflect a net loss but have substantial cash in order to operate the business. Cash flow statement is compiled from the information in the balance sheet and income statement. The bottom line of the cash flow statement indicates the net increase or decrease in cash for the period. Cash flow statements are generally divided into three types of cash inflows and outflows. These three types of activities are: (1) operating activities, (2) investing activities; and (3) financing activities. 6
NOTES TO THE FINANCIAL STATEMENTS The footnotes to the financial statements are what help the financial statement to make sense. They explain the numbers. Without the notes, understanding the financial statement would be difficult. Below are some highlights to look for in the footnotes to the financial statements: Significant accounting policies and practices Companies are required to disclose the accounting policies that are most important to the portrayal of the company s financial condition and results. These often require management s most difficult, subjective, or complex judgments. Income Taxes The footnotes provide detailed information about the company s current and deferred income taxes. The information is broken down by level; federal, state, local and/or foreign, and the main items that affect the company s effective tax rate are described. Pension plans and other retirement programs The footnotes discuss the company s pension plans and other retirement or post-employment benefit programs. The notes contain specific information about the assets and costs of these programs, and indicate whether and by how much the plans ore over- of under-funded. Stock Options The notes contain information about stock options granted to officers and employees, including the method of accounting for stock-based compensation and the effect of the method on reported results. MANAGEMENT S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION (MD & A) The MD&A section of the annual report is a narrative explanation of a company s financial performance. It is prepared by management and is its opportunity to provide interested parties, such as investors or potential investors, its view of the financial performance and condition of the company. Very often the MD&A reveals management s view of what the financial statements show and do not show, as well as important trends and risks that have shaped the past performance or are reasonably likely to shape the company s future. 7
Common Size Analysis Common sizing is a method in which one can analyze the financial strength and performance of a company. It is important to have three years of financial statements in order to make common sizing analysis meaningful. There are two types of common sizing. Vertical Analysis - Compares each amount with a base amount selected from the same year. On the balance sheet, total assets are assigned a value of 100 percent. Because total assets equal liabilities and owner's equity, the amount for total liabilities and owner's equity is also give 100 percent. All assets accounts are compared to total assets. Same is true for liabilities and owner's equity. This helps to analyze the "make up" of our balance sheet accounts. In the income statement, sales are the 100 percent figure. All other items are compared to sales. Helps to tell how efficiently we are selling. Are we getting the Best Bang" for our buck. Horizontal Analysis - compares several annual balance sheets or income statements. The change in an account on a statement is compared to a base amount for a selected base year. Compares one period to another so that you can see the trend that a company is going toward. It is very important to see a trend with a company rather than simply look at one period of time. 8
Ratio Analysis Ratio analysis is a method to use formulas to measure a company s financial strength and efficiency in particular areas. There are basically three types of ratios. Liquidity Ratios - Short-term debt. Can the company pay its debts when they come due? Most unsecured trade creditors are most interested in liquidity ratios. Solvency Ratios - Long term debt. Does the company have enough total assets to cover its total debt? Would there be anything left as equity? Efficiency Ratios - How well is management doing in operating the business? Can also tell us what direction the company is going in. 9
IMPORTANT TERMS AND DEFINITIONS CASH AND CASH EQUIVALENTS: Cash and cash equivalents represent physical cash, bank account balances, and very short-term investments, which might be government securities or commercial paper. MARKETABLE SECURITIES: Investment of temporary cash balances in short-term money market securities with minimal risk and maturity of less than one year. Typical marketable securities are treasury bills, commercial paper, and certificates of deposit. ACCOUNTS RECEIVABLE: Amounts owed to the company for goods and services sold by the company. The receivables category typically includes an allowance for accounts that the company expects may not be paid. These amounts are based on the company s past experience or industry averages. NOTES RECEIVABLE: Obligations owed to the company by another entity. INVENTORIES: Goods available for sale or materials for producing goods. Inventory can be in one of three categories: raw materials, work-in-process, or finished goods. Inventories may be valued by different methods. OTHER CURRENT ASSETS: These are items in which the company will derive some benefit within the next operating cycle, usually one year, and include items such as prepaid insurance, prepaid income tax, and prepaid interest. PROPERTY, PLANT AND EQUIPMENT: Property and equipment, often call fixed assets, include: land, buildings, equipment, and leasehold improvements. These assets are recorded at historical cost, and then depreciated over the time period in which they benefit the company. Land is not depreciated because it is assumed to have an infinite life. INTANGIBLES: Intangibles are costs incurred or recorded previously which could provide a future benefit to the company. They include goodwill, patents and copyrights, and noncompete agreements. ACCOUNTS PAYABLE AND ACCRUED EXPENSES: Accounts payable are claims that others have on a company for the payment of goods or services rendered. Payables would include purchases on credit of raw materials, supplies, services, etc. Accrued expenses or accrued liabilities are amounts owed for goods and services, whose benefits have been received but are to be paid in the future. Some accrued expenses include payroll and payroll taxes, property taxes, rent, etc. Amounts accrued are usually estimates while payable are definite amounts. Accrued liabilities are usually liabilities for which no bills have been yet received. 10
LOANS AND NOTES PAYABLE: Amounts due within an operating cycle on loans or notes. CURRENT MATURITES OF LONG-TERM DEBT: The amount of the long-term debt that is due within an operating cycle. LONG-TERM DEBT: Debt that becomes due in a period of time the exceeds the current operating cycle. DEFERRED INCOME TAXES: This represent a reconciliation between the company s tax accounting and financial reporting. Companies may use one set of rules for calculating income and income tax liability and another set of rules for preparing financial statements for the annual report. They may use difference types of depreciation for the financial statements and for tax purposes because it lowers the current year s tax liability. These taxes are not eliminated, just deferred to future years. This account records the difference between the taxes paid and the taxes that would be owed. COMMON STOCK: Common stock is the value of stock that has been sold to the public, recorded at par or a stated value at the time the stock was issued. Par value is an arbitrary figure assigned by the company. This entry allows how many shared of a company are authorized to be sold and how many shares have actually been issued. PREFERRED STOCK: some companies sell preferred shares, which differ significantly from common stock. Preferred shareholders are entitled to receive a fixed dividend before common holder, and have a priority in case the company is liquidated. Common and preferred stock are often called Capital Stock. ADDITIONAL PAID-IN CAPITAL: Additional paid-in capital is the additional amount paid by the original purchaser of a company s stock in excess of the par value of the stock. RETAINED EARNINGS: Retained earnings are the accumulation of all of the net income or net loss of a company since its inception. At the end of each accounting period, net income or loss is transferred to the retained earnings account. TREASURY STOCK: Treasury stock is the shares that a company reacquires of its own stock. REVENUES, GROSS REVENUES, OR SALES: This is the total amount of sales recorded by a company during an accounting period. COST OF GOOD SOLD: This is the cost of inventory, or other direct costs associated with the sale of a product. GROSS PROFIT: Sales less the cost of goods sold. 11
OPERATING EXPENSES: Operating expenses are typically the expenses associated with the operations of the company. These might include rent, salaries, payroll taxes, office supplies, telephone insurance, research and development, depreciation, etc. OPERATING INCOME/LOSS: Gross income less the operating income. This is the income or loss a company has from the core is its operations. OTHER INCOME/EXPENSES: Companies may make and lose profit through activities that are not a part of operations. These items include interest income/expense, gain or loss on the sales of asset, etc. NET INCOME/LOSS BEFORE TAXES: This is the net income/loss that is derived after adding or subtracting other income/loss from the operating income. NET INCOME/LOSS: This is the final income or loss all entries including taxes have been deducted. 12
PLEASE NOTE THAT ALL OF THE FOLLOWING WORKSHEET PAGES ARE TAKEN FROM UNDERSTANDING FINANCIAL STATEMENTS, EIGHTH EDITION, BY LYN M. FRASER AND AILEEN ORMISTON. 13
CONSOLIDATED BALANCE SHEET (000) R.E.C., Inc. 2007 % 2006 % ASSETS CURRENT ASSETS Cash and cash equivalents 9,333 9.8% 10,386 13.7% Receivables: Trade, less allowance for doubtful accounts 2007 -- 448; 2006 -- 417 8,960 9.4% 8,350 11.0% - 0.0% - 0.0% Inventory 47,041 49.4% 36,769 48.4% Prepaid expenses 512 0.5% 759 1.0% Other - 0.0% - 0.0% Total current assets 65,846 69.1% 56,264 74.1% FIXED ASSETS Plant, property, and equipment at cost Land 811 0.9% 811 1.1% Building 18,273 19.2% 11,928 15.7% Equipment 21,523 22.6% 13,768 18.1% - 0.0% - 0.0% - 0.0% - 0.0% - 0.0% - 0.0% - 0.0% - 0.0% Gross plant, property, and equipment 40,607 42.6% 26,507 34.9% Less accumulated depreciation and amortization 11,528 12.1% 7,530 9.9% TOTAL FIXED ASSETS 29,079 30.5% 18,977 25.0% OTHER ASSETS - 0.0% - 0.0% Other 373 0.4% 668 0.9% TOTAL OTHER ASSETS 373 0.4% 668 0.9% TOTAL ASSETS 95,298 100.0% 75,909 100.0% LIABILITIES AND SHAREHOLDERS' EQUITY CURRENT LIABILITIES Note payable to bank 5,614 5.9% 6,012 7.9% Current maturities of long-term debt 1,884 2.0% 1,516 2.0% Trade accounts payable 14,294 15.0% 7,591 10.0% Accrued expenses 5,669 5.9% 5,313 7.0% Total current liabilities 27,461 28.8% 20,432 26.9% LONG-TERM DEBT Less current maturities 21,059 22.1% 16,975 22.4% DEFERRED INCOME TAXES 843 0.9% 635 0.8% DEFERRED REVENUE - 0.0% - 0.0% TOTAL LIABILITIES 49,363 51.8% 38,042 50.1% SHAREHOLDERS' EQUITY Common stock, par value 1 per share; authorized 10,000,000 shares; issued 14
and outstanding 2007--4,803,000 shares; 2006--4,594,000 shares 4,803 5.0% 4,594 6.1% Additional paid-in capital 957 1.0% 910 1.2% Retained earnings 40,175 42.2% 32,363 42.6% TOTAL SHAREHOLDER'S EQUITY 45,935 48.2% 37,867 49.9% TOTAL LIABILITIES AND EQUITY 95,298 100.0% 75,909 100.0% 15
CONSOLIDATED STATEMENT OF INCOME(000) R.E.C., Inc. 2007 % 2006 % 2005 % NET SALES Net sales 215,600 100.0% 153,000 100.0% 140,700 100.0% Cost of goods sold Gross Profit Margin 129,364 60.0% 86,236 40.0% 91,879 60.1% 61,121 39.9% 81,606 58.0% 59,094 42.0% OPERATING EXPENSES S&A, lease, D&A, and R&M Advertising Total operating expenses Operating Profit Margin 52,735 24.5% 14,258 6.6% 66,993 31.1% 19,243 8.9% 38,523 25.2% 10,792 7.1% 49,315 32.2% 11,806 7.7% 38,297 27.2% 9,541 6.8% 47,838 34.0% 11,256 8.0% OTHER INCOME (EXPENSE) Interest expense 2,585 1.2% 2,277 1.5% 1,274 0.9% Interest income 422 0.2% 838 0.5% 738 0.5% Income before taxes 17,080 7.9% 10,367 6.8% 10,720 7.6% Federal and state income taxes 7,686 3.6% 4,457 2.9% 4,824 3.4% Net Profit Margin 9,394 4.4% 5,910 3.9% 5,896 4.2% NET INCOME PER COMMON AND COMMON EQUIVALENT SHARE 2007 2006 2005 Primary 1.96 1.29 1.33 WEIGHTED AVERAGE COMMON AND COMMON EQUIVALENT SHARES OUTSTANDING 2007 2006 2005 Primary 4,792 4,581 4,433 16
CONSOLIDATED STATEMENTS OF CASH FLOWS(000) R.E.C., Inc. 2007 2006 2005 CASH FLOWS FROM OPERATING ACTIVITIES Net income 9,394 Adjustment to reconcile net income to net cash provided by (used in) operating activities: Depreciation and amortization 3,998 Deferred income taxes 208 5,910 5,896 2,984 2,501 136 118 - - - - - - - - - Changes in assets and liabilities: Receivables (610) (3,339) (448) Inventory (10,272) (7,006) (2,331) Prepaid expenses 247 295 (82) Trade accounts payable 6,703 (1,051) 902 Accrued expenses 356 (1,696) (927) Income taxes - - - Net cash provided by (used in) operating activities 10,024 (3,767) 5,629 CASH FLOWS FROM INVESTING ACTIVITIES Additions to property, plant, and equipment (14,100) (4,773) (3,982) Other investing activities 295 - - Net cash used in investing activities (13,805) (4,773) (3,982) CASH FLOWS FROM FINANCING ACTIVITIES Sale of common stock 256 Increase(decrease) in short-term borrowings (30) Additions to long-term borrowings 5,600 Reductions of long-term borrowings (1,516) Dividends paid (1,582) Net cash provided by financing activities 2,728 183 124 1,854 1,326 7,882 629 (1,593) (127) (1,862) (1,841) 6,464 111 Increase in cash and cash equivalents (1,053) (2,076) 1,758 CASH AND CASH EQUIVALENTS Beginning 10,386 Ending 9,333 12,462 10,386 10,704 12,462 17
R.E.C., Inc. 2007 2006 Category Current ratio - Pg. 198 2.40 2.75 Liquidity Quick ratio - Pg. 200 0.68 0.95 Liquidity Cash flow liquidity ratio - Pg. 200 0.70 0.32 Liquidity 38,385 35,832 Liquidity Working capital - Pg. 48 Average collection period - Pg. 201 15 20 Activity/Efficiency Inventory in days - Pg. 202 131 144 Activity/Efficiency Days Payable Outstanding - Pg. 202 40 30 Activity/Efficiency Trade cycle - Pg. 202 146 164 Activity/Efficiency Cash conversion cycle - Pg. 202 106 134 Activity/Efficiency Fixed asset turnover - Pg. 204 7.41 8.06 Activity/Efficiency Total asset turnover - Pg. 204 2.26 2.02 Activity/Efficiency Debt ratio - Pg. 204 51.8% 50.1% Leverage/Debt Debt to Equity - Pg. 205 1.07 1.0 Leverage/Debt Long-term debt to total capitalization - Pg. 205 31.4% 31.0% Leverage/Debt Times interest earned - Pg.206 7.4 5.2 Leverage/Debt Cash flow adequacy - Pg. 207 4.6-1.6 Leverage/Debt Gross profit margin - Pg. 207 40.0% 39.9% Profitability Operating profit margin - Pg. 207 8.9% 7.7% Profitability Net profit margin - Pg. 207 4.4% 3.9% Profitability Cash flow margin - Pg. 208 4.6% -2.5% Profitability Return on investment(assets) - Pg. 208 9.9% 7.8% Profitability Return on equity - Pg. 208 20.5% 15.6% Profitability Cash return on assets - Pg. 209 10.5% -5.0% Profitability Price-to-earnings ratio - Pg. 211 15.3 13.2 Profitability OPERATING CYCLE IN DAYS Receivable 15 20 accounts receivable/average daily sales Inventory 131 144 Inventory/average daily sales NET TRADE CYCLE 146 164 Accounts payable (subtract) 40 30 Accounts payable/average daily sales CASH CONVERSATION CYCLE 106 134 Current l-t debt average 2007 2006 2008 2,678 2,678 2007 2009 2,678 2,678 2008 2010 2009 18
Total Divide by 5 years 2011 2012 1,884 2,678 1,884 1,884 2010 1,884 1,884 2011 11,008 11,802 2,202 2,360 Market Value Ratios 2007 2006 Earnings per share 1.96 1.29 Market value 30.0 17.0 19
OG Corporation Balance Sheet % % Current assets Cash 50,000 8.8% 40,000 8.9% Accounts receivable 80,000 14.0% 60,000 13.3% Inventories 180,000 31.6% 110,000 24.4% Total current assets 310,000 54.4% 210,000 46.7% Fixed assets Plant & Equipment 300,000 52.6% 260,000 57.8% Less accumulated depreciation (40,000) -7.0% (20,000) -4.4% Total fixed assets 260,000 45.6% 240,000 53.3% Total assets 570,000 100.0% 450,000 100.0% Current liabilities Accounts payable 100,000 17.5% 150,000 33.3% Accrued liabilities 70,000 12.3% 50,000 11.1% Total current liabilities 170,000 29.8% 200,000 44.4% Long term liabilities Mortgage payable 80,000 14.0% - 0.0% Total long term liabilities 80,000 14.0% - 0.0% Total liabilities 250,000 43.9% 200,000 44.4% Owners equity Common stock 130,000 22.8% 90,000 20.0% Retained earnings 190,000 33.3% 160,000 35.6% Total owners equity 320,000 56.1% 250,000 55.6% Total liabilities and equity 570,000 100.0% 450,000 100.0% 20
OG Corporation Income Statement % % Net Sales 680,000 100.0% 600,000 100.00% Cost of goods sold 410,000 60.3% 330,000 55.00% Gross profit 270,000 39.7% 270,000 45.00% Operating expenses 190,000 27.9% 192,000 32.00% Operating income 80,000 11.8% 78,000 13.00% Interest expense 7,000 1.0% 2,000 0.30% Profit before taxes 73,000 10.7% 76,000 12.70% Taxes (.30) 22,000 3.2% 22,800 3.80% Net Income 51,000 7.5% 53,200 8.90% 21
OG Corporation (Indirect Method) Cash flow from operating activities: Net income Noncash revenue and expense included in net income: Depreciation Cash provided by (used for) current operating assets and liabilities: Increase in accounts receivable Increase in inventory Decrease in accounts payable Increase in accured liabilities Net cash provided by (used for) operating activities 51,000 20,000 71,000 (20,000) (70,000) (50,000) 20,000 (120,000) (49,000) Cash flow from investing activities: Property, plant, & equipment Net cash provided by (used for) investing activities (40,000) (40,000) Cash flow from financing activities: Sale of common stock Mortgage loan Dividends paid Net cash provided by (used for) financing activities Increase (decrease) in cash 40,000 80,000 (21,000) 99,000 10,000 Reconcile cash 22
Beginning cash Increase in cash Ending cash 40,000 10,000 50,000 Reconcile retained earnings Beginning retained earnings + Net income - Dividends paid Ending retained earnings 160,000 51,000 (21,000) 190,000 23
OG Corporation (Ratios) Worksheet Activity ratios: (measures the liquidity of specific assets and the efficiency of managing assets) Average Collection Period = (accounts receivable / sales) X 360 Inventory Carrying Period = (inventory / cost of goods sold) x 360 Fixed Asset Turnover = net sales / net PP&E Total Asset Turnover (B) = net sales / total assets Accounts Payable Outstanding = (accounts payable / cost of goods sold) X 360 24
Liquidity ratios: (measures short-term solvency) Current ratio = current assets / current liabilities Quick or Acid-Test Ratio = (cash + marketable securities + receivables) / current liabilities Cash Flow Liquidity Ratio = (cash + marketable securities + cash flow from operating activities) / current liabilities Leverage ratios: (measures how the firm is financed and its ability to cover interest and other fixed charge Debt Ratio = total liabilities / total assets Debt to Equity = total liabilities / equity 25
Times Interest Earned = EBIT / interest EBIT=Earnings before interest and taxes Financial Leverage (C) = assets / equity Profitability ratios: (measures overall performance - earning power - efficiency - return on investment) Gross Profit Margin = gross profit / net sales Operating Profit Margin = EBIT / net sales 26
Net Profit Margin (Earning Power) (A) = net income / net sales Profitability of Investments 1) Return on assets (Margins & Turnover) (A x B) = [net income + interest X (1-tax rate)] / assets 2) Return on equity (Net Profit Margin x Total Asset Turnover x Financial Leverage) (A x B x C) = net income / equity 27
OG Corporation (Ratios) Solutions Activity ratios: (measures the liquidity of specific assets and the efficiency of managing assets) Average Collection Period = (accounts receivable / sales) X 360 80,000 680,000 60,000 600,000 Inventory Carrying Period = (inventory / cost of goods sold) x 360 180,000 410,000 110,000 330,000 Fixed Asset Turnover = net sales / net PP&E 680,000 260,000 600,000 240,000 Total Asset Turnover (B) = net sales / total assets 680,000 570,000 600,000 450,000 Accounts Payable Outstanding = (accounts payable / cost of goods sold) X 360 100,000 410,000 28
150,000 330,000 Liquidity ratios: (measures short-term solvency) Current ratio = current assets / current liabilities 310,000 170,000 210,000 200,000 Quick or Acid-Test Ratio = (cash + marketable securities + receivables) / current liabilities 130,000 170,000 100,000 200,000 Cash Flow Liquidity Ratio = (cash + marketable securities + cash flow from operating activities) / current liabilities 1,000 170,000 Leverage ratios: (measures how the firm is financed and its ability to cover interest and other fixed charges Debt Ratio = total liabilities / total assets 250,000 570,000 200,000 450,000 Debt to Equity = total liabilities / equity 250,000 320,000 29
200,000 250,000 Times Interest Earned = EBIT / interest 80,000 7,000 78,000 2,000 Financial Leverage (C) 570,000 = assets / equity 320,000 450,000 250,000 Profitability ratios: (measures overall performance - earning power - efficiency - return on investment) Gross Profit Margin = gross profit / net sales 270,000 680,000 270,000 600,000 Operating Profit Margin = EBIT / net sales EBIT=Earnings before interest and taxes 80,000 680,000 78,000 600,000 30
Net Profit Margin (Earning Power) (A) = net income / net sales 51,000 680,000 53,200 600,000 Profitability of Investments 1) Return on assets (Margins & Turnover) (A x B) = [net income + interest X (1-tax rate)] / assets A x B A x B 2) Return on equity (Net Profit Margin x Total Asset Turnover x Financial Leverage) (A x B x C) = net income / equity A x B x C A x B x C 31