Introduction to Management. Understanding Financial Reports and Financial Ratios. How to Read A Financial Report. Goal is to understand what data is included in financial reports. Use the data to analyze the firm’s position relative to competitors, and the industry as a whole.
Understanding Financial Reports and Financial Ratios
Goal is to understand what data is included in financial reports.
Use the data to analyze the firm’s position relative to competitors, and the industry as a whole.
Balance Sheet-shows what the company owns and what it owes at the time of the report.
Income Statement-a report on how a company performed during the period(s) presented, and shows whether the company’s operations have resulted in a profit or loss.
Note terminology differences exist! Net Revenue=Net SalesNet Income=Net Profit after Tax
Ratio analysis: involves evaluating a set of financial ratios, looking at trends in those ratios, and comparing them to the average values for other companies in the industry.
Three categories of ratios are especially important:
Provides a Lenders Perspective: Is the company able to meet its financial obligations on time? How much is on hand that can be converted to cash to pay the bills?
These figures are of prime interest to credit managers of commercial companies and financial institutions.
Provides Management Perspective: How effective are the operations of the firm? How effective is the company at using and controlling its assets? How “actively” are the firm’s assets being deployed?
These figures are useful for credit, marketing and investment purposes.
Provides The Owners Perspective: Is the firm yielding advantageous returns or results? How profitable is a company in relation to the assets and the sales that made its profits possible?
Those interested in mergers and acquisitions consider this key data for selecting candidates.
Current Ratio –
Formula: Current assets / Current liabilities.
This ratio measures the degree to which current assets cover current liabilities, and is a measure of the financial liquidity, or cash generating ability, of a firm.
The higher the ratio, more assurance exists that the retirement of current liabilities can be made. A low current ratio typically means that a company may have difficulty meeting its obligations (debts or liabilities) that are payable over the next year with the assets that it can turn into cash over the next year.
A ratio >1 shows liquidity. It shows that there is leeway in the current assets available to pay for current liabilities.
A current ratio of 2 or more generally indicates a strong financial condition.
Quick Ratio (Acid test ratio) –
Formula: (Current assets-Inventories) / Current liabilities
This ratio answers the question "Can this firm meet its current obligations from its liquid assets if suddenly all sales stop?” More stringent than “current ratio,” it excludes inventories (typically the least liquid of current assets) to concentrate on the more liquid assets of the firm.
Usually an acid test ratio of 1.0 or higher is considered satisfactory by lenders and investors.
An investor should be wary if the quick ratio is below 0.5, out of line with its industry, and/or showing a declining trend.
Note: Net worth =Total assets - total liabilities.
Current Liabilites to Net Worth
Formula: Current liabilities/Net worth (%)
This ratio indicates the amount due to creditors within a year as a percentage of owners' (or stockholder's) capital. In other words, it contrasts the funds that creditors temporarily are risking with the funds permanently invested by the owners. The smaller the net worth and the larger the liabilities, the less security for the creditors.
As a rule of thumb, should not exceed 60 percent; higher percentages mean significant pressure on future cash flows.
Total Liabilites to Net Worth
Formula: Total liabilities/Net worth (%)
This ratio helps to clarify the impact of long-term debt, which can be seen by comparing this ratio with Current Liabilities: Net Worth. The difference will pinpoint the relative size of long-term debt, which, if sizable, can burden a firm with substantial interest charges.
In general, total liabilities shouldn’t exceed net worth (100%) since in such cases creditors have more at stake than owners.
Current Liabilities to Inventories
Formula: Current Liabilities/Inventories (%)
Indicates reliance on the available inventory for payment of debt.
Note: Fixed Assets=(Total Property, plant, Equipment)-Accumulated Depreciation
Fixed Assets to Net Worth
Formula: Fixed Assets/Net Worth (%)
Indicates the extent to which the owners' cash is frozen in the form of brick and mortar and machinery, and the extent to which funds are available for the firm's operations.
A ratio higher than 0.75 indicates possible over-investment and that the firm is vulnerable to unexpected events and changes in the business climate.
Collection Period (days)
Formula: Accounts Receivable/Sales x 365
Indicates the average time period for which receivables are outstanding. The quality of the receivables of a company can be determined by this relationship when compared with selling terms and industry norms.
Generally, where most sales are for credit, any collection period more than one-third over normal selling terms (ie, 40.0 for 30-day terms) is indicative of some slow-turning receivables.
Sales to Inventory (Inventory Turnover)
Formula: Annual Net Sales/Inventory (times)
Indicates the rapidity at which merchandise is being moved and the effect on the flow of funds into the business.
This figure varies widely from industry to industry, and is only meaningful when compared with industry norms. Low figures are usually the biggest problem, as they indicate excessively high inventories (and inventory usually has a rate of return of zero). However, extremely high turnover compared to industry norms might reflect insufficient merchandise to meet customer demand and result in lost sales.
NOTE: often times, service industries (software, hotels, consulting, etc) report $0 inventory, so this is meaningless for these industries.
Asset to Sales (%)
Formula = (Total Assets/Net Sales)*100
This ratio indicates whether a company is handling too high a volume of sales in relation to investment. This figure varies widely from industry to industry, and is only meaningful when compared with industry norms.
Abnormally low percentages (above the upper quartile) can indicate overtrading which may lead to financial difficulty if not corrected. Extremely high percentages (below the lower quartile) can be the result of overly conservative sales efforts or poor sales management.
Accounts Payable to Sales (%)
Formula = Accounts Payable/Annual Net Sales*100
This ratio measures the speed with which a company pays vendors relative to sales. Numbers higher than typical industry ratios suggest that the company is using suppliers to float operations.
This ratio is especially important to short-term creditors since a high percentage could indicate potential problems in paying vendors.
Return on Sales (Profit Margin)
Formula: Net After Tax Profit (or Net Income) / Annual Net Sales
This ratio indicates the level of profit from each dollar of sales, and therefore measures the efficiency of the operation. This ratio can be used as a predictor of the company's ability to withstand changes in prices or market conditions.
Return on Assets
Formula: Net After Tax Profit (or Net Income) / Total Assets
A critical indicator of profitability. Companies which use their assets efficiently will tend to show a ratio higher than the industry norm.
Return on Net Worth (Return on Equity)
Formula:Net After Tax Profit (or Net Income) / Net Worth
This is the 'final measure' of profitability to evaluate overall return. This ratio measures return relative to investment in the company. Put another way, Return on Net Worth indicates how well a company leverages the investment in it.
Generally, a relationship of at least 10 percent is regarded as a desirable objective for providing dividends plus funds for future growth.
In isolation, a financial ratio is a useless piece of information. In context, however, a financial ratio can give a financial analyst an excellent picture of a company's situation and the trends that are developing.
A ratio gains utility by comparison to other data and standards.
Two Useful Comparisons:
Quartiles: each ratio has three points, or “cut-off” values that divide an array of values into four equal sized groups, called quartiles.
Upper Median: mid-point of the upper half of all companies sampled
Median: the midpoint of all companies samples
Lower Median: mid-point of the lower half of all companies sampled
25% of ratios
- Upper Median (UQ)
25% of ratios
Upper Middle Quartile
25% of ratios
Lower Middle Quartile
- Lower Median (LQ)
25% of ratios