Analyzing Financial Statements

  1. Objective 15-5 Describe how computing financial ratios can help users get more information from financial statements to determine the financial strengths of a business.

Financial statements present a lot of information, but how can it be used? How, for example, can statements help investors decide what stock to buy or help lenders decide whether to extend credit? Answers to such questions for various stakeholders—employees, managers, unions, suppliers, the government, customers—can be answered this way: Statements provide data, which can, in turn, reveal trends and be applied to create various ratios (comparative numbers). We can then use these trends and ratios to evaluate a firm’s financial health, its progress, and its prospects for the future.

Ratios are normally grouped into three major classifications:

  1. Solvency ratios for estimating short-term and long-term risk

  2. Profitability ratios for measuring potential earnings

  3. Activity ratios for evaluating management’s use of assets

Depending on the decisions to be made, a user may apply none, some, or all of these ratios.

Solvency Ratios: Borrower’s Ability to Repay Debt

What are the chances that a borrower will be able to repay a loan and the interest due? This question is first and foremost in the minds of bank lending officers, managers of pension funds and other investors, suppliers, and the borrowing company’s own financial managers. Solvency ratios provide measures of a firm’s ability to meet its debt obligations.

The Current Ratio and Short-Term Solvency

Short-term solvency ratios measure a company’s liquidity and its ability to pay immediate debts. The most commonly used of these is the current ratio or “banker’s ratio.” This ratio measures a firm’s ability to generate cash to meet current obligations through the normal, orderly process of selling inventories and collecting revenues from customers. It is calculated by dividing current assets by current liabilities. The higher a firm’s current ratio, the lower the risk to investors. As a general rule, a current ratio is satisfactory at 2:1 or higher—that is, if current assets more than double current liabilities. A smaller ratio may indicate that a firm will have trouble paying its bills. Of course, a large, successful firm may be able to maintain a lower current ratio.

Long-Term Solvency

Stakeholders are also concerned about long-term solvency. Has the company been overextended by borrowing so much that it will be unable to repay debts in future years? A firm that can’t meet its long-term debt obligations is in danger of collapse or takeover, a risk that makes creditors and investors quite cautious. To evaluate a company’s risk of running into this problem, creditors turn to the balance sheet to see the extent to which a firm is financed through borrowed money. Long-term solvency is calculated by dividing debt (total liabilities) by owners’ equity. The lower a firm’s debt, the lower the risk to investors and creditors. Companies with more debt may find themselves owing so much that they lack the income needed to meet interest payments or to repay borrowed money.

Sometimes, high debt not only can be acceptable but also desirable. Borrowing funds gives a firm leverage, the ability to make otherwise unaffordable investments. In leveraged buyouts, firms have willingly taken on sometimes huge debts to buy out other companies. If owning the purchased company generates profits above the cost of borrowing the purchase price, leveraging often makes sense. Unfortunately, many buyouts have caused problems because profits fell short of expected levels or because rising interest rates increased payments on the buyer’s debt.

Profitability Ratios: Earnings Power for Owners

It’s important to know whether a company is solvent in both the long and the short term, but risk alone is not an adequate basis for investment decisions. Investors also want some indication of the returns they can expect. Evidence of earnings power is available from profitability ratios, such as earnings per share and the price-earnings ratio.

Defined as net income divided by the number of shares of common stock outstanding (that is, in the hands of investors), earnings per share determines the size of the dividend that a firm can pay shareholders. As an indicator of a company’s wealth potential, investors might use this ratio to decide whether to buy or sell the firm’s stock. As the ratio goes up, stock value increases because investors know that the firm can better afford to pay dividends. Naturally, stock loses market value if financial statements report a decline in earnings per share. Another useful profitability ratio is the price earnings ratio, most commonly known as the P/E ratio. This ratio is the comparison of a firm’s current share price to its current earnings per share.

Activity Ratios: How Efficiently Is the Firm Using Its Resources?

The efficiency with which a firm uses resources is linked to profitability. As a potential investor, you want to know which company gets more mileage from its resources. Information obtained from financial statements can be used for activity ratios to measure this efficiency. For example, two firms use the same amount of resources or assets to perform a particular activity. If Firm A generates greater profits or sales, it has used its resources more efficiently and so enjoys a better activity ratio. This may apply to any important activity, such as advertising, sales, or inventory management.

Retailers, for example, often focus on inventory turnover ratios. Suppose an appliance retailer expects to sell an average of 30 refrigerators per month over the next year. One strategy would be to order 360 refrigerators to arrive on January 1. This would be a poor strategy, however, for many different reasons: The retailer would need to maintain and pay for a huge warehouse space, there would be increased risk of damage to the refrigerators that will not be sold for several months, and the retailer will have to pay for refrigerators now that will not generate revenue for several months. A better option would be to order fewer refrigerators so that they arrive in smaller quantities but more frequent intervals.

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