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 The information found in basic financial statements and notes can – and should – be used to give insight into the financial strength and earnings capacity of your business. This extends beyond such single statement captions as "net income" and requires that relationships between the numbers be examined. While a practically unlimited number of such ratios and comparisons are possible, most readers pay attention to only a small group of these.
The nature of the analysis depends on the reader's perspective. For example, the short-term note holder would be mainly concerned with the company's ability to pay its current obligations. The holder of long-term debt might look to both historical and projected earnings and cash flows. The owners would share a viewpoint similar to that of the long-term debt holder, with perhaps more concern for earnings, cash flows and growth trends. The company's management is usually concerned with all these factors, and also needs financial information that helps in decision-making.
Here is a selection of financial ratios that are often computed to analyze a business.
Return on Equity: Measures the annual percentage yield on the investment made by the owners.
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Ratio |
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Example |
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Net income (Income Stmt) |
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465,000 |
= |
9.2% |
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Avg. stockholders' equity (Balance Sheet) |
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(5,239,000 + 4,860,000) / 2 |
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Return on Assets: Measures the annual percentage yield on the gross investment in the business financed collectively by the owners and the creditors. The relationship between the return on assets and on equity is indicative of the effect of the business's financial leverage – if the leverage is positive, the return on equity will be greater than the return on assets. Businesses that perform in this manner make effective use of debt financing to increase returns to their owners.
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Ratio |
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Example |
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Net income (Income Stmt) |
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465,000 |
= |
4.1% |
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Avg. total assets (Balance Sheet) |
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(11,636,000 + 11,004,000) / 2 |
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Current Ratio: Measures the ability to pay current liabilities as they mature. A ratio of 1:1 or greater corresponds to positive working capital.
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Ratio |
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Example |
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Current assets (Balance Sheet) |
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2,292,000 |
= |
1.19:1 |
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Current liabilities (Balance Sheet) |
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1,924,000 |
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Debt-Service Ratio: Measures the company's ability to pay both the interest and the current principal installments on its outstanding debt and suggests the degree of safety for creditors concerning currently due debt service obligations.
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Ratio |
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Example |
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Income before interest and taxes (Income Stmt) |
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840,000 + 242,000 |
= |
1.9 |
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Interest expense plus amounts of scheduled debt repayments (Income Stmt and Stmt of Cash Flows) |
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242,000 + 322,000 |
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Times |
Average Collection Period: Measures the average number of days' sales that are uncollected in accounts receivable, providing an idea of how successful the company is in collecting amounts due from its customers.
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Ratio |
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Example |
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Avg. accounts receivable (Balance Sheet) |
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(1,178,000 + 1,175,000) / 2 |
= |
54.1 |
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Avg. daily sales (Income Stmt) |
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7,934,000 / 365 |
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Days |
Number of Day's Sales in Inventory: An indicator of the amount of inventory maintained relative to the average number of days' shipments that would be filled. This measure can be used to assess the efficiency of the company's distribution system.
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Ratio |
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Example |
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Avg. inventory (Balance Sheet) |
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(458,000 + 424,000) / 2 |
= |
23.6 |
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Avg. daily cost of sales (Income Stmt) |
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6,816,000 / 365 |
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Days |
Financial analysis involves many different approaches: the ratios analysis discussed above is only one of several means of gaining an understanding of a company. Other approaches, such as the careful study of the financial statement notes, examination of the company's accounting policies, and analysis of operations by division or product line should also be considered.
We want your financial statements to be used and useful. Please contact your Rea representative to learn more.
-By J.W. Wilson, CPA (Director, Dublin office)
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