The aforementioned quick and current ratios are the two most important liquidity ratios, as they give us information about a company’s liquidity position, which reflects its ability to pay off its debts in the near term.

The next category of ratios, the asset management ratios, tells us how well a business is managing its assets.  Let’s look at two of them.

Inventory Turnover Ratio = Total Revenue (also known as Net Sales) divided by Inventories.

In ABC’s case we have an inventory turnover ratio of $150,000/$10,000 = 15.  This means that each item that ABC stocks is sold and restocked, or turned over, 15 times a year.  The important thing to watch for here is how ABC’s turnover ratio compares with the average for firms in its industry (a firm selling fresh bread should obviously have a much higher turnover ratio than one selling custom-made electronics).  If your firm’s turnover ratio is much lower than the industry average, it is an indication that you are holding too much inventory, which can be a costly mistake.

Days Sales Outstanding (DSO) = Receivables divided by Average Sales Per Day.  (To calculate average sales per day we simply take total sales for the year and divide by 365.)

So ABC’s DSO is $13,000/($150,000/365) = 24.33 or roughly 24 days of sales outstanding.  The DSO tells us the amount of a time that a company must wait, on average, to receive its cash after making a sale.  In addition to comparing your DSO with an industry average, it is also helpful to see how it stacks up versus the payment terms that you have agreed to with your customers.  If ABC’s contracts call for payment within 30 days, then it is doing a good job of collecting the money it is owed during that window.  If, on the other hand, you find that your firm’s DSO is significantly higher than your payment terms, your business is being deprived of valuable cash and you may want to make more of an effort to collect your receivables on time.

Now, let’s take a look at two debt management ratios that can give us clues about a company’s ability to handle its debt load.

Debt Ratio = Total Liabilities divided by Total Assets and is expressed as a percentage.

ABC’s debt ratio is $38,000/$50,000 or 76% which means that its creditors have provided over three-quarters of its financing.  Once again, the industry average can serve as a good comparison point, but in general lenders prefer to see lower debt ratios as they indicate greater protection against losses.

Times Interest Earned (TIE) = EBIT divided by Interest Expense

ABC’s TIE ratio is $40,000/$5,000 = 8.  The TIE ratio tells us how many times over a firm’s annual interest expense is covered by its operating income.  As you would expect, a higher figure indicates a healthier company and one that is less likely to have trouble paying its debts.  If your firm’s TIE ratio declines steadily over time, or abruptly all at once, this should be cause for concern to both you and your lenders.

Finally, we want to examine two profitability ratios, which show us the combined effects of liquidity, asset management, and debt on a company’s bottom line.  As with the preceding ratios, comparing your firm’s profitability ratios to your peers will prove instructive.

Basic Earning Power (BEP) = EBIT/Total Assets (expressed as a percentage)

For ABC we have BEP of $40,000/$50,000 = 80%.  BEP shows us how well a firm is using its assets to generate earnings, so a higher percentage is preferable.  Keep an eye on how your firm’s BEP changes after you acquire new assets to see if those assets have increased or decreased your earning power.

Return on Common Equity (ROE) = Net Income divided by Common Equity

ROE is one of the most, if not the most, important of the financial ratios as it tells us how well investors in a business are doing on their investment.  ABC’s ROE comes in at $23,000/$12,000 = 192% (note that this is higher than anything you are likely to see in the real world, an ROE somewhere in the 10-30% range is more normal, but ABC has the good fortune to operate in the fictitious world).  A higher ROE indicates that a company is delivering its owners a higher return on their investment and that, of course, is what all investors want to see.

If you take the time to understand and track all of these ratios for your company, you will find that your financial statements offer a wealth of valuable and easy-to-calculate information that can help you run your business more smoothly.

ABC Corp. Statement of Cash Flows for 2010

Previously, we introduced readers to the third and final of the three major financial statements, the statement of cash flows, and produced the above-referenced example for our fictitious ABC Corporation.  Now it is time to do some financial analysis to see what the statement of cash flows has to tell us about the all-important cash position of a business.

At the conclusion of our previous post we mentioned that one of the entries on the statement of cash flows may very well be the most important figure on any of the financial statements.  So without further ado, let’s reveal what that figure is and why it is so important.  The object of our scrutiny is: net cash provided by operating activities. 

While you might thank that net income (i.e. profits) would be more important as it is the famous “bottom line” number from the income statement—and a favorite of the press when discussing a company’s financial results—savvy investors­, and business owners, prefer to focus on net cash provided by operating activities.

Net income can be subject to distortions—either intentional or unintentional—through tactics like not properly recognizing bad loans or misrepresenting the value of assets.  Because it is much harder to misstate profits and working capital, it always pays to look at net cash provided by operating activities, which reflects the effects of changes in working capital on a firm’s net income.  There are many examples of companies that have reported positive net income even when they are on the brink of declaring bankruptcy; in almost all of these cases though, net cash from operating activities began to deteriorate much earlier, providing an early clue that the firm was in trouble.

In the case of ABC Corp. we can see that while it had a positive net income of $23,000, its operating activities provided a negative $2,000 of cash flow.  This should cause us some concern as we continue to work our through the rest of the statement.

At the bottom of the next section, we see that ABC’s investing activities also resulted in a negative cash flow, in this case the figure is $6,500.  And in the last section we finally see some positive cash flow, to the tune of $3,500, as a result of ABC’s financing activities. The end result of all of this is that ABC saw its cash balance decline by $5,000 during the course of the year.

So what are we to make of all of this?  ABC’s operating activities drained it of $2,500 in cash yet it spent $8,500 on new fixed assets (a long-term investment), and it covered part of these costs by increasing its debt load (the $3,500 in additional notes payable).

The situation at ABC is clearly not sustainable and this is reflected in the fact that its cash balance at the end of year declined by 42% ($5,000/$12,000).  If ABC keeps on this same path for too much longer, it will eventually run out of cash.  In order to remedy the situation, ABC needs to take a hard look at refining its core operating activities, in addition to determining whether it has the right mix of assets to support its business, and whether or not its debt load is sustainable.  And of course, if you start to see your company’s cash position weakening, it is time to think about all of these things before the situation gets too dire.

So that concludes our series on the major financial statements that most firms produce, and that most lenders and investors want to see.  We once again remind readers that this series is intended as an introduction to financial statements and a beginning look at their analysis.  We hope that you are now better armed to analyze and make decisions about your firms’ financial matters, and encourage you to read further on these topics in a financial management textbook.

As we can note from the above sample of our fictitious ABC Corporation, the statement of cash flows is broken down into three categories—operating activities, investing activities, and financing activities—plus a summary section at the bottom.  If you are now familiar with the balance sheet and income statement from our previous posts, you should recognize most of the line items here because what the statement of cash flows does is pull information from those two statements in order to analyze their effects on ABC’s cash position.  As we go through the entries below, you may want to refer back to  ABC’s balance sheet and income statement to see where the numbers are coming from.

Net Income – Is the “bottom line” figure from the income statement.

Increases in Accounts Receivable, Inventories, Accounts Payable, and Accrued Payroll – These are all calculated by taking the difference between these figures on two successive balance sheets (e.g. 2010 and 2009 year-end).  For simplicity’s sake we only provided one year’s balance sheet for ABC Corp., but once your business has produced two or more balance sheets you would simply use the two most recent ones in order to make these calculations.  One important thing to note here is that an increase in a current asset decreases cash while an increase in a current liability increases cash.  For example, if your inventory (a current asset) increased, your cash would have to decrease by a like amount to pay for that inventory.

Cash Used to Acquire Fixed Assets – Calculated by taking the difference between the “Fixed Assets” entries on the two most recent balance sheets.

Sale of Short-Term Investments – Reflects short-term investments that have been converted to cash.

Increase in Notes Payable – Indicates the amount of additional short-term debt ABC has taken on.

Net Change in Cash – Equals the sum of the net cash provided by operating, investing, and financing activities.

Cash at Beginning of Year – Equals the Cash figure at the top of the most recent balance sheet.

Cash at End of Year – Cash at beginning of year minus the net change in cash.

Next, we will teach you how to analyze the statement of cash flows and show you why one item on it just might be the single most important figure to look at when analyzing any company.

ABC Corp. Income Statement Dec. 31, 2010

  Earnings Before Interest & Taxes (EBIT) $40,000 Interest Expense $5,000 Taxes (30%) $12,000 Net Income $23,000

In our previous post we presented readers with the income statement of the fictitious ABC Corporation duplicated above.  In that entry we gave a brief explanation of each of the items on the income statement that may be helpful to review before proceeding further into this post, which is aimed at teaching you to analyze the income statement for information about the financial situation of a business.

Let’s start our income statement analysis by calculating a very important financial ratio, gross profit margin (also known as gross margin).  The math here is about as easy as it gets, gross profit margin is equal to gross profit divided by total revenue.  In ABC’s case we come up with a gross profit margin of 0.60 or 60% ($90,000/$150,000).  Gross profit margin can be thought of as a measure of efficiency, it tells us how much money is left over from sales after accounting for the cost of the goods sold.  While average profit margins vary greatly from industry to industry, as a general rule a higher gross profit margin indicates a more efficient company within its field.

The next figure we want to calculate is operating income or operating profit, as it is sometimes referred to.  Once again, the math is simple: operating income is equal to gross profit minus operating expenses ($90,000 – $5,000 – $45,000 = $40,000 in our example).  Operating income puts a dollar figure on the amount of money that a business is generating from its core activities and is closely watched by lenders and investors as a gauge of a firm’s ability to repay loans or pay dividends to investors.  If a business is experiencing growth in its operating revenues, then it will have more money available for expansion, debt repayment, or any other management initiatives.  The converse is also true of course, so if your business’s operating income has been steadily declining this should give some cause for concern.

Now let’s go ahead and calculate ABC’s operating margin, which is equal to operating income divided by total revenue ($40,000/$150,00) or 26.67%.  Operating margin tells us how much a company keeps from each dollar of sales, before it has to pay interest and taxes.  As with profit margins averages will vary among different industries, but the higher the figure, the better.  Looking at your company’s operating margins over time, by comparing different years’ income statements, can be an effective tool to measure how effective your firm is at keeping what it earns in sales revenue.  If your revenues are increasing but your margins are shrinking, it may be time to assess whether those additional revenues are worth the money it costs to acquire them.

So hopefully now you have an idea of what the income statement can tell you about your business and how to calculate some simple, yet important, ratios that will also be of interest to lenders and investors. As with our discussion of balance sheets, this series on the income statement is not meant to have been an exhaustive analysis.  We have left out a discussion of some of the more complex items that can appear on the income statements of large corporations, such as amortization and depreciation, although we may cover these in future posts. In any event you should now have the tools to understand a good deal about your own company’s income statement, and if you wish to read further, we’d once again recommend an introductory undergraduate or MBA-level financial management textbook.

As with our sample balance sheet, your company’s income statement will not look exactly like this one (it may be missing some of our entries and contain some additional line items), but it should follow the same general pattern.  It will start with a figure labeled total revenue or perhaps net sales—which is essentially the same thing—at the top, and then break down various expenses before concluding with a net income (or loss) figure on the bottom line.  This is why people often refer to a company’s profitability as “the bottom line”.

Let’s go through ABC’s example line by line and see if we can start to get an understanding of some of the major items that you can except to see on an income statement.

Total Revenue (or Net Sales) – This is pretty straightforward; the figure represents the total amount of money that the business brought in for the period covered by the income statement. If the company has any other income streams, they will also be listed, such as interest income, income from investments, or other income.

Cost of Goods Sold (COGS) – COGS tells us how much money we spent to acquire and produce the goods that we sold to generate the revenues included in the line above.

Gross Profit – Is equal to total revenue minus COGS.

The next section of our income statement breaks down a group of costs known as operating expenses, which include things like salaries, office supplies, and other items that are essential to the day-to-day functioning of a business.  If an expense can’t be included under COGS (i.e. it is not directly related to the production of a good or service) then it should appear as an operating expense.  ABC’s operating expenses are divided into the following two entries.

Research and Development (R&D) – These costs are often thought of as those that pertain to the future of a business, such as the testing and development of a new product or prototype.

Selling, General, and Administrative Expenses (SG&A) – This broad category encompasses all of a firm’s personnel costs (salary, benefits, and the like) as well as things like advertising and travel expenditures. Sometimes these and other like expenses are detailed out as separate line items.

We now move on to the operating income section of the income statement, which in our case contains these four items.

Earnings Before Interest & Taxes (EBIT) – This figure shows us a company’s total profit before accounting for interest and taxes that it has to pay.  Although this may not seem like a useful metric, and indeed there are many who argue that it is not, because everyone has to pay taxes and all borrowers must pay interest on their loans, some people find it helpful to isolate a company’s ability to generate profit and to compare similar companies with different tax rates and barrowing habits.

Interest Expense ­– The amount of money that a company pays as interest on its loans during the period covered by the income statement.

Taxes – We’re all familiar with this one, on the income statement the figure represents the total tax bill for the period and is sometimes expressed as a percentage (i.e. a tax rate) as well as a dollar figure. S-corporations, remember, do not pay taxes, but rather pass the tax liability through to the shareholders.

Net Income – Often referred to as a company’s “bottom line” because of its position on the income statement, net income is what is left over from total revenue after subtracting all expenses.

That brings us to the end of ABC’s statement and of this week’s post.  Next week we’ll dive deeper into how to analyze and interpret the income statement.