This chapter is devoted to how external investors and creditors analyze financial statements when making resource allocation decisions, specifically, how they use percentages, ratios, and other financial metrics to assess a company’s profitability, solvency, and liquidity. Financial statement analysis is complex, and most professional analysts are well versed in accounting, finance, economics, and mathematical modeling. The purpose of this chapter is to provide a hands-on introduction of the terminology and concepts unique to this fascinating topic.
The financial statements of a hypothetical retail clothing business—Fashions By Soges—will be used to illustrate the analysis process. The discussion will focus on a single year only, so trend analysis and financial forecasting will not be addressed. Moreover, there are no footnotes accompanying these statements—which for large publicly owned corporations often exceed 100 pages.1
Finally, the dollar amounts in Soges’ financial statements have been kept purposely small for illustrative purposes. As discussed in Chapter 2, most publicly traded corporations restate their financial reports in thousands or millions of dollars to facilitate analysis. It is important to realize that absolute dollar amounts reported in financial statements are less important than the ratios and proportions of these figures among one another.
At the end of the current year, Soges prepared the four external financial statements discussed in Chapter 2 (the balance sheet, income statement, statement of retained earnings, and statement of cash flows). These statements provide the inputs for analyzing the company’s profitability, solvency, and liquidity.
Soges’ balance sheet is illustrated in Figure 4.1. Notice that the company’s assets grew from $850,000 at the beginning of the year, to $1,349,000 at the end of the year. Equity claims to assets also grew, increasing from $575,000 at the beginning of the year, to $900,000 at the end of the year.
Figure 4.1 Current year balance sheets
In earlier chapters, the balance sheet was described as a snapshot of a company’s financial position at a point in time. So ascertaining whether a company is on sound financial footing by looking at the beginning and ending snapshots of its financial position is like attempting to critique a movie by observing only the first and last frames of the film. Such would be an exercise in futility.
Although Soges’ total assets grew by nearly 60 percent during the year and its shareholders’ equity grew by nearly 57 percent, the information conveyed by these two balance sheets provides very little context or meaning. The other three statements are needed to tie them together—much like the middle frames of a movie are needed to convey a story that connects its first frame with its last.
Soges’ income statement is illustrated in Figure 4.2. It is clear that the company was profitable, given its reported net income of $156,000 from $900,000 in sales. However, without further analysis, there is no way of assessing the quality of these earnings or determining whether net income of $156,000 is adequate.
Figure 4.2 Current year income statement
Notice that earnings per share (EPS) of $1.50 is reported at the bottom of the income statement. EPS was computed by dividing Soges’ net income of $156,000 by the 104,000 shares of common stock currently owned by shareholders.
EPS is used to compute a stock’s price–earnings ratio (PE ratio). PE ratios are computed by dividing a stock’s market price by its EPS. Investors and analysts track PE ratios closely to determine whether stock prices are overvalued or undervalued. For instance, if Soges’ common stock is currently valued at $15 per share, its PE ratio is 10-to-1 ($15 per share divided by EPS of $1.50). If PE ratios for similar clothing businesses average 6-to-1, Soges’ unusually high PE ratio could be an indication that its stock is overvalued. However, it also could be a signal that investors expect Soges’ earnings to increase in the near future.2
Soges’ statement of retained earnings is shown in Figure 4.3. It reveals that retained earnings grew from $450,000 at the beginning of the year, to $600,000 at the end of the year. It also conveys that $6,000 of the company’s net income was distributed in dividends to shareholders during the year. However, without additional information, it is impossible for investors to determine whether a $6,000 dividend is sufficient.
Figure 4.3 Current statement of retained earnings
Soges’ statement of cash flows is illustrated in Figure 4.4. It provides a detailed reconciliation as to how the company’s cash balance grew from $50,000 at the beginning of the year, to $59,000 by the end of the year—an 18 percent increase.
Figure 4.4 Current year statement of cash flows
At first glance, Soges’ financial statements appear promising. The balance sheet reveals that both assets shareholders’ equity grew significantly, the income statement reports that the company was profitable, the statement of retained earnings shows that Soges paid dividends to its shareholders, and the statement of cash flows confirms that the company’s cash balance increased measurably. Nevertheless, these casual observations certainly do not constitute a meaningful analysis. Throughout the remainder of this chapter Soges’ financial statements will be used to illustrate a more rigorous assessment of its profitability, solvency, and liquidity.
Profitability
Revenues are increases in assets that result from providing goods and services to customers for a profit, whereas expenses are decreases in assets that result from consuming resources to generate revenue. Thus, when analyzing a company’s profitability, it is important to measure how efficiently it consumed resources to generate revenue and to increase equity claims to assets. Soges’ income statement in Figure 4.2 reports net income of $156,000. The company was definitely profitable, but how efficiently did it consume resources throughout the year to achieve this outcome?
In addressing this question think of two cars, each of which was driven 18,000 miles in the current year. To say that both cars were effective at traveling the same distance says nothing about how efficient each car was in doing so. For instance, if the first car averaged 36 mpg, it would have consumed 500 gallons of fuel during the year. If the second car averaged 12 mpg, it would have consumed 1,500 gallons of fuel—making it 300 percent less efficient than the first car in traveling the same distance. So, when evaluating a company’s profitability, it is important to focus beyond the bottom line—the distance traveled—by taking into account the resources it consumed, its relative size, and the amount of equity capital provided by its shareholders. Four of the most commonly used measures to evaluate a corporation’s profitability are its:
- Gross profit percentage;
- Net income percentage;
- Return on equity;
- Return on assets.
Gross Profit Percentage
The gross profit percentage expresses gross profit as a percentage of net sales. In Figure 4.5, Soges’ gross profit percentage is computed as 60 percent. This implies that after deducting the cost of goods sold from net sales, 60 cents of every sales dollar is available to cover the remaining expenses that the company incurred during the year.
Figure 4.5 Gross profit percentage
To determine whether Soges’ gross profit percentage is good or bad, a benchmark of comparison is helpful to see how the company performed relative to other retail clothing businesses of similar size.3 The industry average for similar retail clothing businesses—those with annual sales and total assets similar in amount to Soges—is only 40 percent. Thus, it appears that Soges’ gross profit percentage is relatively strong.
Net Income Percentage
The net income percentage expresses net income as a percentage of net sales. In Figure 4.6, Soges’ net income percentage is computed as 17.3 percent.
Figure 4.6 Net income percentage
Thus, after deducting the cost of goods sold from net sales, and after covering all of the other costs that the company incurred during the year, approximately 17 cents of every sales dollar is available to retain and reinvest in new assets, or to distribute as dividends to shareholders. The benchmark industry average for this statistic is 4 percent, so it appears that Soges was extraordinarily efficient at consuming resources to generate revenue.
Return on Equity
Thus far, only Soges’ income statement has been used to assess its profitability. Using data from both the income statement and the balance sheet provides an expanded perspective of a company’s profitability.
Return on equity expresses net income as a percentage of average shareholders’ equity reported in the balance sheet. In Figure 4.7, Soges’ return on equity is computed as 21.2 percent. This means that for every dollar of assets financed by shareholders, management was able to generate slightly more than 21 cents in net income. The benchmark industry average is 18 cents, so it appears that Soges’ management team is fairly efficient at converting the shareholder investment into profit.
Figure 4.7 Return on equity
Notice return on equity is computed by dividing net income by a corporation’s average shareholders’ equity. For Soges, average shareholders’ equity was computed by adding its beginning shareholders’ equity ($575,000) to its ending shareholders’ equity ($900,000), and dividing the result by 2. The beginning and ending shareholders’ equity figures are snapshots taken at two points in time, whereas net income is a measure of profitability for an entire year. Thus, the argument for using average shareholders’ equity in the denominator is to make it more compatible with net income reported in the numerator. Doing so expresses net income earned for the entire year as a percentage of average shareholders’ equity for the entire year.
Return on Assets
Return on assets expresses operating income as a percentage of average total assets reported in the balance sheet. In Figure 4.8, Soges’ return on assets is computed as 24.8 percent. This statistic measures how efficiently management squeezed operating income out of assets under its control—regardless of whether assets were financed with debt or with equity. Thus, Soges earned nearly 25 cents in operating income for every dollar of resources at its disposal. The benchmark industry average is only 12 percent, so at first glance, it appears that assets are being managed efficiently to generate profit.
Figure 4.8 Return on assets
Notice that operating income (income before interest and income taxes) is used in the numerator instead of net income. Given that interest expense and income taxes are determined by factors other than management’s ability to manage assets efficiently, they are left out of the computation.4 The argument for using average total assets in the denominator is the same as using average shareholders’ equity to calculate return on equity.
It is important to realize that return on assets does not tell the whole story about how efficiently assets have been managed to generate profit. Return on assets should always be broken into its two primary components—asset turnover and the operating income percentage. Figure 4.9 illustrates these components of return on assets for Soges. Notice that Soges’ asset turnover, multiplied by its operating income percentage, equals the return on assets computed previously in Figure 4.8 (0.819 × 30.2% = 24.8%).
Figure 4.9 Components of return on assets
Asset turnover (sales divided by average total assets) measures how many dollars of sales management generated from the assets it controlled. Soges was able to generate only 81.9 cents in sales from each asset dollar, whereas the benchmark industry average is $2 in sales. Thus, it appears that management was not very efficient at using assets to generate sales.
The operating income percentage (operating income divided by sales) measures management’s efficiency at generating operating income from sales. For every dollar of sales that Soges generated in the current year, it earned 30.2 cents in operating income. The benchmark industry average is only 6 cents. Thus, even though Soges generated a relatively low volume of sales from its assets, it was very efficient at converting those sales into operating income.
It is always important to understand industry characteristics when analyzing financial statements. For instance, retail grocery stores and retail jewelry stores both average a return on assets of approximately 12 percent, albeit for very different reasons. Grocery stores have extremely high asset turnovers, but very low operating income percentages. In other words, there is very little profit in a can of beans, so grocery stores must sell a lot of cans to survive—as evidenced by their use of a dozen checkout lanes to service multiple customers pushing grocery carts filled with beans. Jewelry stores have extremely low asset turnovers but very high operating income percentages. There is a lot of profit in a gold watch, so jewelry store can survive by selling relatively few watches—as evidenced by their use of one or two sales clerks and the absence of customers pushing carts overflowing with gold watches.
In the retail clothing industry, high asset turnover with relatively low operating income percentages is the norm. Oddly, Soges’ asset turnover is relatively low, and its operating income percentage is unusually high. This anomaly would grab the attention of most financial analysts. It will be revisited later in the chapter.
Chapter 3 examined timing differences that exist between the income statement and the statement of cash flows. Due to timing differences, sales are not a measure of cash inflow, nor are expenses a measure of cash outflow. Accordingly, net income and net cash flow are not interchangeable concepts, and profitability measures are not very useful for assessing solvency or liquidity.
Solvency generally refers to a company’s potential to generate enough cash flow to satisfy its long-term needs, whereas liquidity—discussed in the following section—usually refers to a company’s ability to satisfy its cash flow obligations in the immediate future. Two of the most commonly used measures to evaluate solvency are a company’s:
- Debt-to-assets percentage;
- Times interest earned.
Before discussing these measures, it is important to understand that they are directly related to a company’s degree of financial leverage. Financial leverage refers to a company’s reliance upon debt financing. Companies that rely heavily on debt financing have high degrees of financial leverage, whereas companies that rely very little on debt financing have low degrees of financial leverage.5 High degrees of financial leverage put a company’s long-term cash flow potential at risk. Indeed, companies buried in debt face a higher risk of defaulting on their legal obligations and being forced into bankruptcy than companies with little or no debt. Thus, solvency issues are of great importance to long-term creditors.
Debt-to-Assets Percentage
The debt-to-assets percentage expresses a company’s total liabilities as a percentage of its total assets. A high debt-to-assets percentage is indicative of a high degree of financial leverage, and a greater risk of experiencing solvency problems.6
Soges’ debt-to-assets percentage is 33.3 percent at the end of the current year, as shown in Figure 4.10. This means that one-third of its assets are financed with debt, and two-thirds are financed with equity, which is somewhat higher than the benchmark industry average of 25 percent.
Figure 4.10 Debt-to-assets percentage
Soges’ long-term obligations could relate to the financing of its land and building. Many independent clothing retailers rent floor space, which could explain Soges’ higher-than-average reliance on debt financing. Useful information pertaining to corporation’s long-term obligations is disclosed in the footnotes that accompany the financial statements of actual companies.
Times Interest Earned
Times interest earned—sometimes referred to as the interest coverage ratio—measures earnings before interest, taxes, depreciation, and amortization (EBITDA) as a multiple interest expense.7 In Figure 4.11, Soges’ EBITDA is 24 times its current interest expense, which is 800 percent more than the benchmark industry average of 3 times. Thus, even though Soges’ 33.3 percent debt-to-assets percentage is somewhat higher than average, the corporation’s ability to generate $292,000 of EBITDA to cover its $12,000 interest expense appears outstanding, even if EBITDA decreases significantly in the future.
Figure 4.11 Times interest earned
Liquidity
Liquidity generally refers to a company’s ability to satisfy its cash flow obligations in the immediate future. Thus, liquidity concerns are of particular interest to short-term creditors. Given the short-term time horizon associated with liquidity, measures to assess it focus on a company’s current assets and current liabilities.
Current assets were described in Chapter 2 as resources that provide continuous sources of cash flow to satisfy recurring obligations incurred in daily operations—such as acquiring inventory, paying utility bills, buying insurance, compensating employees, paying taxes, and servicing short-term debts. Most current assets convert into cash in one year or less. Current liabilities were described in Chapter 2 as obligations requiring settlement in the same time period that current assets covert into cash.
To remain a sustainable going concern, a company’s current assets must consistently generate enough cash to settle its current liabilities. Five of the most commonly used measures to evaluate liquidity are a company’s:
- Current ratio;
- Quick ratio;
- Accounts receivable turnover and days;
- Inventory turnover and days;
- Trade payable turnover and days.
The current ratio is computed by dividing a company’s current assets by its current liabilities. Soges’ current ratio of 3.2-to-1 at the end of the year is computed in Figure 4.12. Given that current assets are intended to provide a continuous source of cash flow used to satisfy recurring obligations incurred in daily operations, Soges’ current assets have the potential to generate $3.20 for every dollar of current liabilities due in the near future. The benchmark industry average is only 1.4-to-1.
Figure 4.12 Current ratio
Quick Ratio
Not all current assets are equally liquid. Inventory, for example, is often replaced by an account receivable when sold—not cash—and prepaid expenses provide a future cash savings, but they do not convert directly into cash. The quick ratio is a more conservative measure of liquidity than the current ratio. It is computed by dividing only a company’s most liquid current assets by its current liabilities. The assets considered most liquid—often referred to collectively as financial assets—include cash, certain marketable securities, and accounts receivable net of management’s estimate uncollectible accounts.8
Soges’ quick ratio of 2.5-to-1 is computed in Figure 4.13. The $559,000 financial assets figure in the numerator is the sum of the company’s cash ($59,000) and its net accounts receivable ($500,000) at the end of the year. Soges’ financial assets have the potential to generate $2.50 for every dollar of current liabilities due in the near future. The benchmark industry average is only 0.60-to-1.
Figure 4.13 Quick ratio
Two of Soges’ liquidity measures—the current ratio and the quick ratio—indicate that the company’s short-term cash flow position is very strong. That said, it is important to bear in mind that both of these ratios were computed using only balance sheet information. Thus, these measures are static snapshots of the company’s liquidity at the end of the current year. They provide no insight regarding how quickly the company’s current assets are converting to cash, or how quickly the company’s current liabilities are being settled. Using data from both the income statement and the balance sheet provides information about how efficiently receivables, inventories, and trade payables are being managed.
Accounts Receivable Turnover and Days
Soges’ accounts receivable turnover is computed in Figure 4.14 by dividing its sales of $900,000 by its average accounts receivable of $300,000.
Figure 4.14 Accounts receivable turnover and days
The resulting computations show that Soges turned over its accounts receivable only 3 times during the entire year—meaning that the company’s average receivable balance of $300,000 was collected and converted to cash just 3 times in 365 days.9 Dividing 365 days by Soges’ turnover statistic reveals that its credit accounts remain outstanding an average of 122 days before being collected.
The benchmark industry average for accounts receivable turnover is 36 times, whereas the average amount of time that credit accounts remain outstanding is 10 days. Based on this information, it appears that Soges is doing a very poor job of managing its credit accounts.
Inventory Turnover and Days
Soges’ inventory turnover is computed in Figure 4.15 by dividing its cost of goods sold of $360,000 by its average inventory balance of $95,000.10
Figure 4.15 Inventory turnover & days
The resulting computations show that Soges turned over its inventory only 3.8 times during the entire year—meaning that the company’s average inventory of $95,000 was sold and replenished less than 4 times in 365 days. Dividing 365 days by the turnover statistic in Figure 4.15 reveals that Soges’ inventory items remain in stock an average of 96 days before being sold.
The benchmark industry average for inventory turnover is 12 times, whereas the average amount of time that inventory remains in stock is 37 days. Based on this information, it appears that Soges is mismanaging inventory, as well.
Trade Payable Turnover and Days
As discussed in Chapter 2, trade accounts payable result from purchasing inventory on credit. Soges’ trade payable turnover is computed in Figure 4.16 by dividing its inventory purchases of $400,000 by its average trade payable balance of $135,000.11
Figure 4.16 Trade payable turnover & days
The resulting computations convey that Soges turned over its trade payables 2.96 times during the entire year—meaning that the company’s average trade payable balance of $135,000 was settled with cash approximately 3 times in 365 days. Dividing 365 days by the turnover statistic in Figure 4.16 reveals that Soges’ trade payables remain outstanding an average of 123 days before being paid.
The benchmark industry average for trade payable turnover is 24 times, whereas the average amount of time that trade payables remains outstanding is 15 days. Based on this information, it appears that Soges’ largest current assets—accounts receivable and inventory—are not providing the continuous cash flow required to satisfy inventory purchases on a timely basis. Indeed, cash is tied up in inventory for 96 days before being sold, after which it remains tied up in accounts receivable for another 122 days before being collected.12 Meanwhile, the company is struggling to settle its trade payables every 123 days. This situation is not sustainable. So what exactly went wrong?
Profit Rich but Cash Poor
The predicament faced by Soges is a classic example of being profit rich but cash poor. Figure 4.17 provides a recap of Soges’ profitability, solvency, and liquidity measures.
Figure 4.17 Financial analysis recap
In terms of profitability, the company’s performance was stellar. Its gross profit percentage, net income percentage, operating income percentage, and return on assets were outstanding, and its return on equity was on the high-end of normal. Solvency measures seem to indicate that Soges’ long-term cash flow potential is favorable, with a debt-to-assets percentage in the normal range accompanied by an exceptionally strong interest coverage ratio. Even its current and quick ratios imply that the company should not encounter any liquidity problems satisfying its current obligations as they come due—but these two measures are static snapshots of liquidity taken from the balance sheet.
Problems in Paradise
An examination of Soges’ turnover measures conveys an entirely different story regarding its liquidity—accounts receivable are not being collected in a timely manner, inventory is not selling fast enough, and payments of trade payables are being delayed well beyond what is acceptable. A hint that these problems existed arose during the analysis of Soges’ profitability. The company’s only red flag was its alarmingly weak asset turnover statistic (computed by dividing sales by average total assets)—which means that the company has too much invested in assets given its current level of sales. An important question is whether any specific assets have grown too large relative to its sales.
Soges’ balance sheet in Figure 4.1 reveals that accounts receivable and inventory comprise 46 percent of total assets at the end of the year—by comparison, they accounted for just 21 percent of total assets at the beginning of the year. Together, these two accounts increased during the year by more than 350 percent. These two accounts grew because they were not turning over. Had the company’s accounts receivable and inventory turnover measures been more in line with industry averages, its asset turnover would have been normal, and its liquidity problems would not have existed. Unfortunately, the timing differences between Soges’ income statement and its statement of cash flows are severe—as evidenced by comparing its operating income of $272,000 into its negative cash flow from operating activities of $175,000.13
Liquidity problems resulting from timing differences are not uncommon. They frequently occur when companies experience rapid growth accompanied by a surge in their inventories and accounts receivable. As growth levels off, inventory investment stabilizes, accounts receivable are collected, and liquidity problems usually subside.
Summary
This chapter provided a hands-on introduction of basic financial analysis techniques used by investors and creditors. It was intended to achieve two goals. The first goal was to demonstrate how financial statement information is used to compute percentages, ratios, and other financial metrics to gain insight pertaining to a company’s profitability, solvency, and liquidity. The second goal was to illustrate how timing differences between income and cash flow can cause companies to be profit rich, but cash poor.14
The importance of understanding timing differences is not confined to investors and creditors. In later chapters, timing differences will be revisited from a managerial perspective and examined in a budgetary context.
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1Footnotes that accompany actual financial statements are essential to performing financial analysis at an advanced level. Much of the information they convey is highly technical and well beyond the scope of this book.
2Likewise, if stocks of similar clothing companies have PE ratios averaging 15-to-1 (i.e., their stocks are selling at 15 times earnings), it could be that Soges’ stock is undervalued. However, it could also be signal that investors expect Soges’ earnings to decrease in the near future. Determining PE ratios for small privately held corporations (like Soges) is challenging because the per share market values of their stocks are not readily available.
3Current industry data are readily available. For instance, Dun & Bradstreet, Inc. prepares Key Business Ratios annually for more than 800 types of businesses, and Robert Morris Associates publishes Annual Statement Studies from a database of several thousand companies grouped into hundreds of industry classifications and sorted by size.
4It is not uncommon for some analysts to use net income in the numerator rather than operating income. Given that interest expense (and its deductibility for tax purposes) is associated with debt financing but not equity financing, operating income is considered by many to be a better measure of a management’s ability control resources, regardless of how those resources were financed.
5A company’s degree of financial leverage can actually be measured and quantified. Doing so is a common practice at more advanced levels of financial analysis than discussed here.
6Many analysts also examine the debt-to-equity percentage when assessing a company’s solvency.
7EBITDA is computed by adding depreciation and amortization expenses to earnings before interest and taxes (EBIT). These expenses are added to EBIT because they do not require any future cash payments. Soges incurred no amortization expense, so only the $20,000 depreciation expense is added to its $272,000 EBIT—its operating income—reported in the Figure 4.2 income statement.
8Included with cash reported in the balance sheet are certain cash equivalents, such as money market accounts, certificates of deposit, and short-term U.S. Treasury Bills. Marketable securities are not considered cash equivalents; moreover, not all marketable securities are included in the computation of the quick ratio. Reporting accounts receivable in the balance sheet net of management’s estimate of uncollectible accounts was discussed in Chapter 2.
9The $900,000 sales figure was taken from the income statement in Figure 4.2. The average accounts receivable balance of $300,000 was computed by adding the accounts receivable at the beginning of the year ($100,000) to accounts receivable at the end of the year ($500,000), and dividing the result by 2. The accounts receivable amounts were taken from the balance sheet in Figure 4.1.
10The $360,000 cost of goods sold figure was taken from the income statement in Figure 4.2. The average inventory balance of $95,000 was computed by adding inventory on hand at the beginning of the year ($75,000) to inventory on hand at the end of the year ($115,000), and dividing the result by 2. The inventory amounts were taken from the balance sheet in Figure 4.1.
11Inventory purchases of $400,000 were computed by subtracting inventory at the beginning of the year ($75,000) from inventory at the end of the year ($115,000), and adding the result to cost of goods sold ($360,000). The average trade payables balance of $135,000 was computed by adding the company’s trade payables at the beginning of the year ($85,000) to its trade payables at the end of the year ($185,000), and dividing the result by 2. The inventory and trade payable figures were taken from the balance sheet in Figure 4.1. The cost of goods sold figure was taken from the income statement in Figure 4.2.
12The cyclical process of recovering cash invested in inventory was described in Chapter 2 as an operating cycle. Soges’ operating cycle takes 218 days to complete—96 days to sell the merchandise it has in stock, plus 122 days to collect cash from its customers. The benchmark industry average for similar clothing businesses is 47 days—37 days to sell inventory, plus 10 days to collect cash from customers.
13The operating income figure appears in the Figure 4.2 income statement. The negative cash flow from operating activities figure appears in the Figure 4.4 statement of cash flows.
14Timing differences also can cause companies to be profit poor, but cash rich.