Explanation of the Topic...

Financial Ratios

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Part 1 Introduction to Financial Ratios, 1a. Discussion of Balance Sheet, 1b. Common-Size Balance Sheet
Part 2 1c. Financial Ratios Based on the Balance Sheet
Part 3 2a. General Discussion of Income Statement, 2b. Common-Size Income Statement,
2c. Financial Ratios Based on the Income Statement
Part 4 Statement of Cash Flows

2a. General Discussion of Income Statement




The income statement has some limitations since it reflects accounting principles. For example, a company's depreciation expense is based on the cost of the assets it has acquired and is using in its business. The resulting depreciation expense may not be a good indicator of the economic value of the asset being used up. To illustrate this point let's assume that a company's buildings and equipment have been fully depreciated and therefore there will be no depreciation expense for those buildings and equipment on its income statement. Is zero expense a good indicator of the cost of using those buildings and equipment? Compare that situation to a company with new buildings and equipment where there will be large amounts of depreciation expense.


The remainder of our explanation of financial ratios and financial statement analysis will use information from the following income statement:



Example Corporation
Income Statement
For the year ended December 31, 2006

Sales (all on credit) $500,000
Cost of Goods Sold   380,000
Gross Profit   120,000

Operating Expenses
Selling Expenses 35,000
Administrative Expenses    45,000
Total Operating Expenses    80,000

Operating Income 40,000
Interest Expense    12,000

Income before Taxes 28,000
Income Tax Expense     5,000
Net Income after Taxes $ 23,000

Earnings per Share
(based on 100,000 shares outstanding)		 $     0.23


(To learn more about the income statement, go to Explanation of Income Statement, Drills for Income Statement, and Crossword Puzzle for Income Statement.)



2b. Common–Size Income Statement

Financial statement analysis includes a technique known as vertical analysis. Vertical analysis results in common-size financial statements. A common-size income statement presents all of the income statement amounts as a percentage of net sales. Below is Example Corporation's common-size income statement after each item from the income statement above was divided by the net sales of $500,000:



Example Corporation
Income Statement
For the year ended December 31, 2006

Sales (all on credit) 100.0%
Cost of Goods Sold   76.0%
Gross Profit   24.0%

Operating Expenses
Selling Expenses 7.0%
Administrative Expenses    9.0%
Total Operating Expenses  16.0%

Operating Income 8.0%
Interest Expense    2.4%

Income before Taxes 5.6%
Income Tax Expense    1.0%
Net Income after Taxes    4.6%


The percentages shown for Example Corporation can be compared to other companies and to the industry averages. Industry averages can be obtained from trade associations, bankers, and library reference desks. If a company competes with a company whose stock is publicly traded, another source of information is that company's "Management's Discussion and Analysis of Financial Condition and Results of Operations" contained in its annual report to stockholders. Generally the annual report as well as reports to the Securities and Exchange Commission are available on the company's website.



2c. Financial Ratios Based on the Income Statement



Financial Ratio
How to Calculate It
What It Tells You
Gross Margin
=

=

=
 Gross Profit ÷ Net Sales

$120,000 ÷ $500,000

24.0%

 Indicates the percentage of sales dollars available for expenses and profit after the cost of merchandise is deducted from sales. The gross margin varies between industries and often varies between companies within the same industry.
Profit Margin
(after tax)
=

=

=
 Net Income after Tax ÷ Net Sales

$23,000 ÷ $500,000

4.6%

 Tells you the profit per sales dollar after all expenses are deducted form sales. This margin will vary between industries as well as between companies in the same industry.
Earnings Per Share (EPS)
=


=

=
 Net Income after Tax ÷ Weighted Average Number of Common Shares Outstanding

$23,000 ÷ 100,000

$0.23

Expresses the corporation's net income after taxes on a per share of common stock basis. The computation requires the deduction of preferred dividends from the net income if a corporation has preferred stock. Also requires the weighted average number of shares of common stock during the period of the net income.
Times Interest Earned
=



=

=
 Earnings for the Year before Interest and Income Tax Expense ÷ Interest Expense for the Year

$40,000 ÷ $12,000

3.3

 Indicates a company's ability to meet the interest payments on its debt. In the example the company is earning 3.3 times the amount it is required to pay its lenders for interest.
Return on Stockholders' Equity (after tax)
=



=

=
 Net Income for the Year after Taxes ÷ Average Stockholders' Equity during the Year

$23,000 ÷ $278,000 (a computed average)

8.3%

 Reveals the percentage of profit after income taxes that the corporation earned on its average common stockholders' balances during the year. If a corporation has preferred stock, the preferred dividends must be deducted from the net income.


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