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Module 1: Finance and Financial
Performance
Topics
Introduction to Financial Management
Standard Financial Reporting
Evaluating Financial Performance
Financial Plans and Forecasts
Because it introduces the field of finance, the material in this module covers an unusually wide
spectrum of financial subjects, ranging from the definition of finance to the evaluation of
financial performance using ratio analysis.
Introduction to Financial Management
In this section, we address three important subjects in financial management. First, we critically
examine the question of what is the proper goal of the firm. Second, we examine the key
interactions between the firm and the various market entities. Third, we discuss some of the
generally recognized fundamental principals of financial management that form the foundations
of financial management analyses and decision making.
The Goal of the Firm
To measure the financial performance of a firm, it is necessary to establish a fundamental goal
against which to evaluate financial performance and financial decision making. In determining a
“proper” financial goal for the firm, three essential requirements should be satisfied. First, the
goal must be theoretically sound; second, it must be quantitative; and third, it must be easy to
apply in practice.
A review of current economic and business theory reveals two potential goals for a firm.
Traditional economic theory espouses maximizing profit, and modern finance theory advocates
maximizing shareholder wealth. Logically, there can be only one goal for evaluating financial
performance, therefore we must examine each proposed goal against the above-listed
requirements to determine which is superior.
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In comparing our two candidates, it is apparent that both goals are quantitative and relatively
easy to measure and apply in decision making. The profit maximization goal would be
quantitatively measured based on accounting profit—total revenues generated less total costs
incurred. The goal of maximizing shareholder wealth would be measured by calculating the
market capitalization value—the number of shares of stock outstanding times the current market
price per share.
When examined from the perspective of theoretical validity, however, the goal of profit
maximization exhibits several significant weaknesses. Although this goal does stress the efficient
use of capital resources, by itself it is too narrow, in that it assumes away many of the financially
significant complexities of the real world. Specifically, the profit maximization goal has the
following two major weaknesses.
1. It assumes away the inherent uncertainty of the expected returns (e.g., it ignores any
consideration of risk).
2. It disregards the timing differences as to when the profits are received (e.g., it ignores the
time value of money).
As we shall see later, both of these weaknesses are critical considerations for proper financial
decision making and cannot be disregarded. Conversely, the maximization of shareholder wealth
goal does implicitly assume consideration of the time value of money, risk, and all the other
factors that are not directly profit related, but that should be considered in rational financial
decision making. Therefore, we conclude that maximizing shareholder wealth is the superior
primary goal for all businesses.
The Firm and Its Financial Environment
Fundamental to understanding finance is recognizing that the firm is the primary creator of
wealth, which it does by interacting with various sectors of the marketplace. To explain how
these basic interactions create wealth, we will develop a simplified transaction model of the firm.
This model will begin with a new startup company and trace the basic cash transactions and the
resulting counterflows of securities, goods, and services until a sustained profit generation is
achieved. In our simplified model, the worldwide marketplace will consist of the following
players:
• the firm—the creator of value-added wealth
• the investors—the source of capital
• the supply market—the source of materials, equipment, and required services
• the labor market—the source of labor
• the customers—the purchasers of the firm’s goods and services
• the government—the controller of taxes
The Fundamental Principles of Finance
A set of principles of finance has been established, tested over the years, and become accepted as
the basic philosophical foundation upon which to build or test financial theories, concepts, and
formulas. These principles can be found in many texts, form the paradigm of financial theory,
and are widely used in today’s business practices and academic research.
Various other academics and practitioners differ on the exact number of principles and their
precise wording. Most of these differences relate to wording and to the lower-priority principles,
where it is arguable as to whether or not the subject is of sufficient merit to warrant being called
a principle of finance. Of most significance for our study of finance, however, is the almost
universal acceptance by all recognized authorities of the three core financial principles described
below.
1. Risk-return tradeoff—This principle states that rational investors or financial managers
will not accept additional risk in an investment unless they are compensated with an
acceptable corresponding additional expected return.
This principle will be a key factor in the later development of valuation formulae for
stocks, bonds, and capital project analysis.
2. Time value of money—This principle states that a dollar today is worth more than a
dollar tomorrow because the dollar received today can be reinvested to earn money today.
This fundamental concept leads to the financial convention of bringing future expected
cash flows back to the present for comparable evaluation. This concept will be significant
in the later development of valuations of future payments, annuities, perpetuities, stocks,
bonds, and project analysis.
3. Measure cash, not profit—According to this principle, cash flows, or cash received less
cash disbursed, are the proper measures of wealth. Cash is tangible; only cash in hand can
be spent or invested. Profits are intangible, an accounting concept, and cannot be spent or
invested
Cash flows, or more specifically free cash flows, are the base currency for all financial
analysis and decision making related to maximizing wealth, be it future payments,
annuities, perpetuities, stocks, bonds, or project return.
These core principles are referenced repeatedly throughout the study of finance and explicitly
used in developing advanced financial theories, concepts, and formulas. We encourage you to
refer back to these definitions from time to time to reinforce your understanding of exactly how
the principles apply.
To summarize these principles, you could combine them into this one-sentence philosophic
financial analysis mission statement: The key determinant for most financial decision making is
the net value of the incrementally generated free cash flow stream after proper discounting for
the time value of money and adjustment to compensate for risk.
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Practice Exercises
The following practice exercises will help you master the financial concepts in this section and
their application to real-world problems.
Complete the following practice exercises – Please go to My Tools -> Self Assessments -> to
complete this self assessment.
Standard Financial Reporting
In this section, we address one of the essentials of financial management—the ability of
management to measure and report their firm’s financial performance and cash flow in a standard
and consistent manner. Finance students must have at least a working knowledge of the three
standard financial statements—the income statement, the balance sheet, and the cash flow
statement—because they are the primary sources of information regarding a firm’s financial
performance.
In addition to understanding financial performance, as presented in the financial statements, you
must also understand and be able to measure the firm’s free cash flows. Referring back to core
financial principal 3, “Measure cash, not profit,” you must be able to reconcile the difference
between the two accrual-based accounting statement reports, the income statement and balance
sheet, and the calculation of free cash flows. We stress principle 3 because the discipline of
finance uses cash exclusively in analysis and decision making.
The Standard Financial Statements
Three basic financial statements, together, suffice to report the financial health of the firm. These
statements are prepared in accordance with Financial Accounting Standards Board (FASB)
pronouncements and Generally Accepted Accounting Principles (GAAP), and normally are
independently audited for conformance with these requirements. Each statement serves a specific
purpose. The purpose of the income statement is to report the firm’s net income or loss over a set
period of time—usually a month, a quarter, or a year. The purpose of the balance sheet is to
show the firm’s assets, liabilities, and residual or owners’ equity at a certain time. The purpose of
the free cash flow statement is to show the net change in actual cash, or the free cash flow,
generation or loss, over a period of time.
Reemphasizing, the income statement and cash flow statements, respectively, report earnings and
cash generated during a period of time, and the balance sheet reports asset, liability, and equity
positions at a specific time. Again, the income and cash generation represents the flow of activity
between two balance sheet positions. We will now describe each of these three standard financial
statements and illustrate them in a minipresentation.
The Income Statement—Measuring a Firm’s Profits and Losses
The income statement reports the firm’s net income or net loss (profit or loss) results obtained
from operating the business over a set period of time, typically a month, quarter, or year. Other
common names for the income statement are the profit and loss statement (P&L) and the
earnings statement. The income statement begins by identifying all sources of revenue for the
period and then sequentially subtracts all the costs that were incurred in generating that revenue.
Normally, the income statement comprises five major categories, one related to revenue and four
related to costs and expenses as shown below:
1. revenues—the proceeds from selling the product(s) or services(s)
2. costs—the costs of producing or acquiring the product(s) or service(s)
3. period expenses—the expenses incurred in marketing, administration, and R&D
4. interest—the financing costs of debt financing
5. taxes—the taxes owed based on a firm’s taxable income
The Balance Sheet—Measuring a Firm’s Book Value
The balance sheet provides a snapshot of the firm’s financial position at a specific time and
presents the firm’s asset holdings, liability obligations, and owners’ residual equity as of that
time. It is important to recognize that the balance sheet is an algebraic equation that relates and
balances the three components—assets, liabilities, and equity. In traditional accounting format,
the fundamental accounting equation is presented as follows:
Assets = liabilities + equities
Succinctly, this equation states that at any point in time the value of the firm’s assets must be
exactly equal to the value of its liabilities and equity. For a more intuitive understanding, it is
sometimes helpful to algebraically rearrange this equation to read as follows:
Assets – liabilities = equities
Interpreting the rearranged equation, we can now more clearly interpret the meaning of equity.
Equity is the residual value the owners can claim after the value of all the liability obligations
has been subtracted from the value of the firm’s assets. It is important to note that the balance
sheet measures “book” value and is not intended to represent the current market value of the
firm. Under the accounting rules, the balance sheet records the value of all assets, liabilities, and
equities at their historical purchase cost at the time of acquisition.
Assets
Assets represent the historical value of all the resources the firm owns. There are three categories
of assets in the balance sheet. These assets are listed in sequence based on the amount of time
that is expected to pass before they can be converted to cash.
1. Current assets, by definition, have an expected conversion life of less than one year.
Included in current assets are cash, marketable securities, accounts receivable,
inventories, and prepaid expenses. All of these assets are considered to be liquid, which
means they can quickly be converted into cash if required.
2. Fixed or long-term assets, by definition, have an expected conversion life of more than
one year. Included in fixed assets are equipment, buildings, and land. These assets are
considered nonliquid because normally they cannot be quickly converted into cash.
3. Other assets is a default category that includes all the firm’s remaining assets not
otherwise included in the current assets or fixed assets categories. Typical examples of
other assets are patents, long-term investments in securities, and goodwill.
Liabilities
Liabilities represent legal financial obligations of the firm. There are two major categories of
liabilities in the balance sheet. They are listed in sequence based on the amount of time that is
expected to pass before they can be liquidated through the payment of cash. These obligations
are normally incurred either from trade credit received from suppliers in the course of normal
business or from the firm’s use of debt financing to procure company assets.
1. Current liabilities, by definition, have an expected conversion life of less than one year.
Included in current liabilities are accounts payable, taxes payable, and short-term debt
financing obligations that must be paid within one year.
2. Long-term liabilities, by definition, have an expected conversion life of more than one
year. Included in long-term liabilities are long-term notes and long-term bond
obligations.
Equity
Equity includes the stockholders’ investment in the firm, both capital at par and additional paid-
in capital, and the cumulative profits and losses retained in the business from its inception up to
the date of the balance sheet.
The Cash Flow Statement and the Concept of Free Cash Flows
Although an income statement measures a company’s profits, as stated earlier, the reported
profits are not the same as cash. Accounting profit, or book profit, is calculated on a noncash
accounting accrual basis where revenues and expenses are matched in time and certain noncash
transactions such as depreciation and amortization are recorded. Under these accounting rules,
revenue is earned and cost incurred whether or not the actual cash has been received or disbursed
in that period. Therefore, in finance we require a method to translate the accrual-based
accounting profit back to its cash component. The statement that converts the accrual-based
accounting statements into a cash basis is called the free cash flow statement.
By definition, the free cash flows that are generated from the firm’s operations and investments
in assets must always be equal to the free cash flows paid to or received from the company’s
investor financing. Therefore, free cash flows can be calculated from two perspectives, the
operating perspective and the financing perspective.
Calculating Free Cash Flows: An Operating Perspective
A firm’s free cash flows, from an operating perspective, are the after-tax cash flows generated
from operations, less the firm’s after-tax cash flow investments in assets. The firm’s free cash
flows for a given period can be calculated from an operations perspective using the following
three-step process:
1. Calculate the firm’s after-tax cash flows from operations.
2. Subtract any investment (increase) in net operating working capital.
3. Subtract any investments in fixed assets (plant and equipment) and other assets.
Yields operating-perspective free cash flow
Calculating Free Cash Flows: A Financing Perspective
A firm’s free cash flows from a financing perspective are simply the net cash flows received by
the firm’s investors, or if negative, the cash flows the investors are paying into the firm. In the
latter situation, where the investors are putting money into the firm, it is because the firm’s free
cash flow from operations is negative, which in turn requires an additional infusion of capital
from the investors to maintain the firm as a going concern. The firm’s free cash flows for a given
period can be calculated from an investment perspective using the following two-part process:
Part 1. Calculations related to debt financing
Step 1 Calculate the interest payments to creditors.
Step 2 Add any decrease in debt principal.
Step 3 Subtract any increase in debt principal.
Part 2. Calculations related to equity financing
Step 4 Add any dividends paid to stockholders.
Step 5 Add any decrease in stock.
Step 6 Subtract any increase in stock.
______________________________________________________
Yields Financing-perspective free cash flow
As a final reinforcement when calculating free cash flows, remember that the free cash flow from
an operating perspective must equal the free cash flow from a financing perspective. This
identity can be used as one validity check to assure that your calculations are correct.
An Excel worksheet for the calculation of free cash flow.
Callout
Practice Exercises:
The following practice exercises will help you master the financial concepts in this section and
their application to real-world problems.
https://leocontent.umgc.edu/content/dam/course-content/equella/tus/finc/finc330/document/freecashflowstatementworksheet.xls
Complete the following practice exercises.
Evaluating Financial Performance
In this section, we will learn about one of the primary analytical tools commonly used to
evaluate the financial performance of the firm—financial ratio analysis. Its use provides a
financially sound, analytically powerful, and widely accepted approach for evaluating many
critical aspects of a firm’s financial performance.
Over the years, many standard financial ratio formulas have been developed and employed to
evaluate various and specific aspects of a firm’s financial performance. The art of this technique
now rests in organizing these ratios for effective implementation, properly applying them in
practice, and knowing the limitation of this technique. Because most textbooks cover this subject
in detail and adequately develop the theory behind each financial ratio, in this section we will
concentrate on two supplemental topics: (1) organizing the key financial ratios according to their
application and (2) providing some additional perspectives regarding the uses and limitations of
these techniques.
Organizing Financial Ratios by Application
The purpose of a financial ratio is to define a theoretically meaningful relationship between
selected activities of the firm’s financial statements that can provide insight into the firm’s
financial performance. Different practitioners and textbooks sometimes group the financial ratios
differently. There are at least 15–20 standard financial ratios plus variations of some of them.
Therefore, it is easy to lose sight of the forest for the trees.
Also, different practitioners and textbooks often group the financial ratios differently. One of the
more logical and useful ways to group these ratios is by their ability to answer the following four
key questions related to financial performance evaluation.
1. How liquid is the firm?
2. How effective is the firm in generating profits on its assets?
3. How is the firm financing its assets?
4. Are the shareholder returns adequate?
Using these four questions, the financial ratios can be grouped by category and be readily
available to analyze a firm according to four different perspectives. Here is a detailed chart that
organizes 10 key standard financial ratio formulas by the above four perspectives.
The Uses and Limitations of Financial Ratios
Who Uses Financial Ratio Analysis?
In addition to the management of the firm, a wide variety of individuals and organizations, for a
variety of purposes, use financial ratios to evaluate the financial statements of publicly traded
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firms. The following is a list of some of the major users of financial ratios and their general
purposes for doing so.
1. Investors and investment brokers use analysis to
• evaluate alternative investments’ risks versus returns
• identify trends as indicators of a firm’s future performance
• identify opportunities and risks in future investment
2. Banks use analysis to
• evaluate loans to firms
• evaluate loans to individuals (personal financial statements)
• establish interest rates (higher risk equals higher interest rate)
• manage clients’ investment portfolios
3. Government regulatory agencies use analysis to
• evaluate new public stock issues [Securities and Exchange Commission (SEC)]
• conduct government audits [General Accounting Office (GAO)]
• establish rates for government contracting [the Defense Contract Auditing
Agency (DCAA)]
4. The firm uses analysis for
• management planning
• financial planning
• credit management (who to give trade credit and on what terms)
• shareholder reporting
• evaluating potential mergers and acquisitions
• evaluating competitors
• identifying operational problems
• assuring compliance with loan covenants (normal with bank loans)
The Use of Financial Ratio Analysis
The reliability and value of the information gained from financial ratio analysis can vary
significantly, depending on how it was conducted and on the quality and comparability of the
financial statements, which provide the financial data. By itself, a ratio is just a number and not
inherently meaningful. Stand-alone financial ratios are like stand-alone numbers. They have
limited value unless associated with other references. For an obvious example, 3 by itself means
little unless associated with some base, such as 3 degrees on the centigrade temperature scale.
The two basic approaches for meaningfully associating financial ratios are trend analysis and
comparative analysis. In fact, it is the careful integration of trend analysis with ratio analysis that
provides the single most powerful technique for evaluating financial performance. Normally,
trend analysis is performed on annual or quarterly data because public companies have to report
this information to the stockholders.
Of the two sources of data, the annual data are generally considered to be the more significant
because of the annual audit requirement. The two approaches can also be used together to
provide a more comprehensive picture of financial performance, such as “a comparative analysis
of a firm’s performance against the industry average over a three-year period.”
The reliability of comparative financial ratio analysis is primarily a function of the accuracy and
comparability of the two sets of source financial data. The analyst must be aware of the
following factors.
1. Different companies may use differing, but GAAP-acceptable, accounting treatments,
which can distort comparison of the financial statements and the ratios based on them.
2. Industry standards, although useful, combine many variations in accounting treatments
and may also contain inaccurate or incomplete input information from industry members.
3. It should be obvious that comparing significantly differing firms over differing time
periods will likely add such distortion as to render any analysis highly questionable.
In summary, the more comparable the financial statements and the more comparable the firms,
the more meaningful will be the results of the financial ratio analysis—and vice versa.
Financial Ratio Limitations and Cautions
Remember that financial ratios, although important, are only one piece of the financial
performance picture and are best used in conjunction with all other available financial
information. In employing financial ratio analysis, it is important to be aware of their implicit
weaknesses and limitations, as well as their explicit strengths. Be particularly aware of the
following points in using financial ratio analysis.
1. A financial ratio is only as reliable as the accuracy of the financial data.
2. GAAP accounting allows significant variation between companies.
3. Accounting data are historical and therefore may not project current performance.
4. Industry averages can contain significant dispersion and approximations.
5. Industry classifications have problems with multi-product-line companies.
6. Many firms have pronounced seasonal and cyclical variations that can affect ratios.
7. Different fiscal year endings can affect comparability.
8. Any financial ratio evaluation is relative, not absolute.
9. Firms, to the extent possible, try to look their best at reporting time.
Callout
Practice Exercises
The following practice exercises will help you master the financial concepts in this section and
their application to real-world problems.
Complete the practice exercises.
Financial Plans and Forecasts
In this section, we examine the critical function of financial planning. Most of management’s
time is spent on addressing the crisis of the day and understanding and explaining the past
performance of the firm to themselves and other interested parties, such as the investors and the
banks. As a result, it is easy in this reaction-based environment to lose focus and direction and
become vulnerable to an unexpected future shock.
One of the key marks of superior business and financial management is the ability to project
future performance with reasonable accuracy and consistency, and to anticipate both future
opportunities and future risks in time to prepare appropriate actions or contingencies. In this
section, we expand the traditional discussion of financial planning by providing some
supplemental perspectives on the benefits, types, and methods of financial planning and by
addressing the issue of uncertainty in financial planning.
Direct Benefits of Financial Planning
Financial planning and forecasting have direct benefits—that is, the primary reasons they were
undertaken—and often some indirect and synergistic benefits, which can also be significant.
Starting with the direct benefits, there are five clear benefits to be secured from disciplined
financial planning and forecasting, which are described below.
1. Financial planning provides a clear measurement of management’s performance because
the firm’s actual financial performance can, and will, be compared against the firm’s
planned performance. At the end of the plan, it must be remembered that:
• Wall Street evaluates publicly traded firms on their performance to plan/forecast
• CEOs evaluate their managers on their performance to plan/forecast
2. Financial planning generates detailed financial projections of cash flow to determine
future financing requirements and timing.
3. Financial planning provides management a better insight into its business operations and
the expected effect of operational matters on financial performance. Properly used, this
insight can identify potential future operational opportunities and risks.
4. The more uncertain the future, the greater the need for forecasting/planning. The weaker
the firm’s financial or competitive position, the greater the need for forecasting/planning.
5. Financial planning provides a solid benchmark to
• quantitatively explain actual versus plan variances
• quantify the expected effect of economic or operational factors
• identify bad financial planning assumptions or estimates
• continuously refine the financial planning process
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Indirect Benefits of Financial Planning
In addition to the above direct benefits of projecting future financial performance and cash
requirements, the planning process also generates the following synergistic benefits for the firm.
1. It develops a comprehensive, coordinated set of critical business assumptions and facts
for management review.
2. It integrates economic assumptions with marketing sales plans and operating production
programs to assure a coherent, comprehensive picture of the firm’s strategic and tactical
objectives.
3. It nondestructively develops and tests the viability of various business tactics and
programs designed to achieve the firm’s business strategy.
Types and Methods of Financial Planning
The various types of planning, or forecasting, are generally a function of three variables, (1) the
objective of the plan, (2) the duration of the plan, and (3) the plan’s requirement for accuracy and
detail. While we are concentrating on financial planning, it is important to recognize that all
plans/forecasts have both a business function component and a financial component. The types
of planning used by most firms are summarized below.
1. Long-range planning (normally five years)
• strategic business planning
• acquisition/merger planning
• long-range business planning
• capital appropriation or project planning
2. Mid-range planning (normally one-two years)
• annual budget
• financial plan
• marketing plan
• technology plan
3. Short-range planning (normally less than one year)
• quarterly forecasts/financial projections
• monthly forecasts/financial projections
• monthly, weekly, and daily cash position projections
The Basic Methodologies of Financial Planning
There are two basic methods of financial planning and forecasting, each of which has a multitude
of variations to fit a company’s specific requirements and situation. The two methods are the
trend and ratio method (percent-of-sales method) and the financial modeling method. The trend
and ratio method is far too simplistic and inaccurate to be reliable for financial planning and is
seldom used in real-world decision making. Its major weaknesses are that it assumes everything
in the business varies as a constant percent of sales and that all business parameters have a linear
relationship to sales. In general, this approach becomes complex as you attempt to adjust the plan
to reality, and it is inferior in every respect to the alternative method of financial modeling.
Financial modeling uses powerful user-friendly computerized models and programs to model the
firm’s business and financial transactions. These models range from simple Excel spreadsheet
models to complex custom-designed stochastic-based models. When financial planning is
combined with a sound business model, this method allows rigorous and flexible financial
planning to any degree of detail with superior accuracy.
Financial Planning under Conditions of Uncertainty
Uncertainties and risk are a fact of life in all financial and business planning, and they must be
addressed and accounted for to the extent possible. Financial planning must be able to address
uncertainty for both the anticipated potential events and for the completely unexpected events.
The following are two typical methods used in financial planning to address uncertainty and risk.
1. Contingency provision—plan for a specific known or potential event
o What-if approach—Revise the base plan for a single contingency.
o BEW approach—Prepare plans for three outcomes: best, expected, and worst.
2. General uncertainty provision—plan for multiple unknown and unexpected events
o Sensitivity analysis—This form of analysis varies selected key plan parameters
by percentages or dollars to project the financial impact of a significant incident
without identifying the specific cause. The four major key parameters are price,
sales volume, cost, and capital expenditures.
o Simulation—This approach applies probability and statistical analysis to each
key variable, which in conjunction with sophisticated computerized financial
models can be used to generate a probabilistic range of possible outcomes, based
on thousands of simulation runs.
Callout
Practice Exercises
The following practice exercises will help you master the financial concepts in this section and
their application to real-world problems.
Complete the following practice exercises:
1. Identify three significant benefits that the firm obtains from financial planning.
2. If you were running a financial model to determine the firm’s financing requirements,
which uncertainty approach would you use? Why?
3. What are the major disadvantages of the percent-of-sales method of financial
forecasting?
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Chapter 4 “Forecasting Financial
Statement
s” from Finance by Boundless is used under the terms of
the Creative Commons Attribution-ShareAlike 3.0 Unported license. © 2014, boundless.com. UMGC
has modified this work and it is available under the original license.
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Chapter 4
Forecasting
Financial
Statements
https://www.boundless.com/nance/forecasting-nancial-
statement
s/
Strategic Planning
AFN
Adjusting Capacity
Section 1
Role of Financial Forecasting in Planning
234
https://www.boundless.com/nance/forecasting-nancial-statements/role-of-nancial-forecasting-in-planning/
Strategic Planning
The nancial forecast is a key input to strategic
planning, a rm’s process of dening strategy and
making decisions about allocating resources.
KEY POINTS
• Using historical internal accounting and sales data, in
addition to external market and economic indicators, a
financial forecast is an economist’s best guess of what will
happen to a company in financial terms over a given time
period, which is usually one
year.
• Financial forecasting is often helped by financial modeling
processes. Financial modeling is the task of building an
abstract representation (a model) of a financial decision-
making situation.
• Assumptions play a key role in financial forecasts and can
affect the way the forecasts predict the outcomes of decisions
made on the corporate level.
Strategic Planning
Strategic planning is an organization’s process of defining its
strategy, or direction, and making decisions about allocating
resources to pursue this strategy. In order to determine the
direction of the organization, it is necessary to understand its
current position and the possible avenues through which it can
pursue a particular course of action.
A financial forecast is an estimate of future financial outcomes
for a company. Using historical internal accounting and sales data,
in addition to external market and economic indicators, a financial
forecast is an economist’s best guess of what will happen to a
company in financial terms over a given time period—which is
usually one year. Often, the forecaster’s own assumptions and
beliefs will be used to guess future growth rates and potential events
that will affect the numbers on a financial statement.
Arguably, the most difficult aspect of preparing a financial forecast
is predicting revenue. Future costs can be estimated by using
historical accounting data; variable costs are also a function of
sales. Unlike a financial plan or a budget, a financial forecast
doesn’t have to be used as a planning document. Outside analysts
can use a financial forecast to estimate a company’s success in the
coming year (Figure 4.1).
Financial forecasting is often helped by processes of financial
modeling. Financial modeling is the task of building an abstract
representation (a model) of a financial decision making situation.
This is a mathematical model designed to represent a simplified
version of the performance of a financial asset or portfolio of a
business, project, or any other investment. Financial modeling is a
235
general term that means different things to different users; the
reference usually relates either to accounting and corporate finance
applications, or to quantitative finance applications.Typically,
financial modeling is understood to mean an exercise in either asset
pricing or corporate finance, of a quantitative nature. In other
words, financial modeling is about translating a set of hypotheses
about the behavior of markets or agents into numerical predictions;
for example, a firm’s decisions about investments or investment
returns. Once again, these are assumptions that will factor into the
financial forecasting and planning for the corporation. Once the
financial statements are forecast, one can attach a value to the firm,
and see what changes need to be made to put the company in a
better financial position.
Source: https://www.boundless.com/finance/forecasting-financial-
statements/role-of-financial-forecasting-in-planning/strategic-
planning/
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236
Financial forecasting is essential for a
company’s strategic planning,
management, and organization.
Figure 4.1 Strategic Planning
AFN
AFN is “additional funds needed,” and refers to the
additional resources that will be needed for a company
to expand its operations.
KEY POINTS
• AFN is a way of calculating how much new funding will be
required, so that the firm can realistically look at whether or
not they will be able to generate the additional funding and
therefore be able to achieve the higher sales level.
• The simplified formula is: AFN = Projected increase in assets
– spontaneous increase in liabilities – any increase in
retained earnings. If this value is negative, this means the
action or project which is being undertaken will generate
extra income for the company, which can be invested
elsewhere.
• The mathematical formulas used to determine AFN are based
on showing how liabilities will grow relative to new assets and
sales when a project is undertaken and can be used as tools to
determine whether a project or operational expansion is
worthwhile.
AFN stands for “additional funds needed.” It is a concept used most
commonly in business looking to expand operations and influence.
Since a business that seeks to increase its sales level will require
more assets to meet that goal, some provision must be made to
accommodate the change in assets. To phrase it another way, the
business must have some plan to actually finance the new assets
that will be needed to increase sales.
AFN is a way of calculating how much new funding will be required,
so that the firm can realistically look at whether or not they will be
able to generate the additional funding and therefore be able to
achieve the higher sales level. Determining the amount of external
funding needed is a key part of calculating AFN. This can be
determined by mathematical formulas which use inputs that can be
found in a company’s financial statements.
The simplified formula is:
AFN = Projected increase in assets – spontaneous increase in
liabilities – any increase in retained earnings.
If this value is negative, this means the action or project which is
being undertaken will generate extra income for the company,
which can be invested elsewhere.
The more formal equation for AFN is
AFN = (A*/S0)ΔS – (L*/S0)ΔS – MS1(RR)
• A- Assets tied directly to sales
237
• L-spontaneous liabilities that are affected by sales
• S0=the previous year’s sales
• S1=total projected sales for next
year
• ΔS=the change in sales between S0 and S1
• M=profit margin
• MS1=projected net income
• RR=the retention ratio from net income (equal to 1 minus the
dividend payout ratio; disregard if dividends are not
declared).
Source: https://www.boundless.com/finance/forecasting-financial-
statements/role-of-financial-forecasting-in-planning/afn/
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Adjusting Capacity
Capacity adjustment takes into account maximum
production levels and the alteration of this level
depending on how the rm wants to grow.
KEY POINTS
• Capacity planning is the process of determining the
production capacity needed by an organization to meet
changing demands for its products.
•
Capacity utilization is a concept in economics and managerial
accounting which refers to the extent to which an enterprise
or a nation actually uses its installed productive capacity.
• When planning out how to manage capacity at the optimal
level to attain the long term goals of the firm, capacity
planning and utilization and other processes should be
analyzed.
Adjusting capacity takes into account the maximum level of output
that can be produced by a firm, and how that can be changed in
order to change the potential forecasts of a firm’s performance long
term (Figure 4.2). This involves capacity planning and management
that will keep a firm from growing too fast in sales and making sure
it is utilizing capital in the most efficient way possible. Capacity
planning is the process of determining the production capacity
238
needed by an organization to meet changing demands for its
products. In the context of capacity planning, “design capacity” is
the maximum amount of work that an organization is capable of
completing in a given period. “Effective capacity” is the maximum
amount of work that an organization is capable of completing in a
given period due to constraints such as quality problems, delays,
material handling, etc.
Capacity utilization is a concept in economics and managerial
accounting that refers to the extent to which an enterprise or a
nation actually uses its installed productive capacity. Therefore, it
refers to the relationship between actual output that ‘is’ produced
with the installed equipment and the potential output which ‘could’
be produced with it, if capacity was fully used. Implicitly, the
capacity utilization rate is also an indicator of how efficiently the
factors of production are being used. Much statistical and anecdotal
evidence shows that many industries in the developed capitalist
economies suffer from chronic excess capacity. Therefore, critics of
market capitalism argue the system is not as efficient as it may
seem, since at least 1/5 more output could be produced and sold, if
buying power was better distributed. However, a level of utilization
somewhat below the maximum prevails, regardless of economic
conditions. As a result, we look into capacity utilization to forecast a
firm’s success and growth numbers when predicting how financial
statements will look into the future. The decision makers at the firm
will be able to adjust this capacity in order to grow the firm in a way
they feel is optimal.
Source: https://www.boundless.com/finance/forecasting-financial-
statements/role-of-financial-forecasting-in-planning/adjusting-
capacity/
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239
Adjusting capacity will aect the amount of items produced on the assembly line.
Figure 4.2 Thunderbird Assembly Line
Inputs
Steps Required to Forecast
Section 2
Overview of Forecasting
240
https://www.boundless.com/nance/forecasting-nancial-statements/overview-of-forecasting–2/
Inputs
The main inputs of forecasting include time series,
cross-sectional and longitudinal data, or using
judgmental methods.
KEY POINTS
• Forecasting is the process of making statements about events
whose actual outcomes (typically) have not yet been
observed.
• Time series is a sequence of data points, measured typically
at successive time instants spaced at uniform time intervals.
• Cross-sectional data refers to data collected by observing
many subjects at the same point of time, or without regard to
differences in time.
• A longitudinal data involves repeated observations of the
same variables over long periods of time — often many
decades.
• Judgmental forecasting methods incorporate intuitive
judgements, opinions and subjective probability estimates.
Forecasting in Accounting
In corporate finance, investment banking, and the accounting
profession, financial modeling is largely synonymous with cash flow
forecasting.
This usually involves the preparation of detailed company specific
models used for decision making purposes and financial analysis.
A financial forecast is an estimate of future financial outcomes for a
company or country (for futures and currency markets). Using
historical internal accounting and sales data, in addition to external
market and economic indicators, a financial forecast is an
economist’s best guess of what will happen to a company in
financial terms over a given time period—usually one year.
Challenges
Arguably, the most difficult aspect of preparing a financial forecast
is predicting revenue. Future costs can be estimated by using
historical accounting data; variable costs are also a function of sales.
Forecasting vs. Financial Plans and Budgets
Unlike a financial plan or a budget, a financial forecast doesn’t have
to be used as a planning document. Outside analysts can use a
financial forecast to estimate a company’s success in the coming
year.
Forecasting is the process of making statements about events whose
actual outcomes (typically) have not yet been observed. A
commonplace example might be the estimation of some variable of
interest at some specified future date. Prediction is a similar, but
241
more general term. Both might refer to formal statistical methods
employing time series, cross-sectional or longitudinal data, or less
formal judgmental methods.
Time Series Data
Time series is a sequence of data points, measured typically at
successive time instants and spaced at uniform time intervals.
Examples of time series are the daily closing value of theDow
Jones index or the annual flow volume of the Nile River at Aswan.
Time series analysis comprises methods for analyzing time series
data in order to extract meaningful statistics and other
characteristics of the data. Time series forecasting is the use of a
model to predict future values based on previously observed
values. Time series are very frequently plotted via line charts.
Cross-sectional data
Cross-sectional data refers to data collected by observing many
subjects (such as individuals, firms or countries/regions) at the
same point in time, or without regard to differences in time.
Analysis of cross-sectional data usually consists of comparing the
differences among the subjects.
For example, if we want to measure current obesity levels in a
population, we could randomly draw a sample of 1,000 people from
the population (also known as a cross section of that population),
measure their weight and height, and calculate what percentage of
that sample is categorized as obese. For example, 30% of our
sample may be categorized as obese based on our measures. This
cross-sectional sample provides us with a snapshot of that
population, at that one point in time. Note that we do not know
based on one cross-sectional sample if obesity is increasing or
decreasing; we can only describe the current proportion. Cross-
sectional data differs from time series data also known as
longitudinal data, which follows one subject’s changes over the
course of time. Another variant, panel data (or time-series cross-
sectional (TSCS) data), combines both and looks at multiple
subjects and how they change over the course of time. Panel
analysis uses panel data to examine changes in variables over time
and differences in variables between subjects.
Longitudinal Data
A longitudinal study is a correlational research study that involves
repeated observations of the same variables over long periods of
time — often many decades. It is a type of observational study.
Longitudinal studies are often used in psychology to study
developmental trends across the life span, and in sociology to study
life events throughout lifetimes or generations. The reason for this
is that unlike cross-sectional studies, in which different individuals
with same characteristics are compared, longitudinal studies track
242
the same people, and therefore the differences observed in those
people are less likely to be the result of cultural differences across
generations. Because of this benefit, longitudinal studies make
observing changes more accurate, and they are applied in various
other fields. In medicine, the design is used to uncover predictors of
certain diseases. In advertising, the design is used to identify the
changes that adverts have produced in the attitudes and behaviors
of those within the target audience who have seen the advertising
campaign.
Judgmental methods
Judgmental forecasting methods incorporate intuitive judgements,
opinions and subjective probability estimates, such as Composite
forecasts, Delphi method, Forecast by analogy, Scenario building,
Statistical surveys and Technology forecasting.
Usage of forecasting can differ between areas of application: for
example, in hydrology, the terms “forecast” and “forecasting” are
sometimes reserved for estimates of values at certain specific future
times, while the term “prediction” is used for more general
estimates, such as the number of times floods will occur over a long
period.
Source: https://www.boundless.com/finance/forecasting-financial-
statements/overview-of-forecasting—2/inputs—2/
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243
Steps Required to Forecast
Steps of forecast include problem denition, cash ow
forecast, prot forecast, balance sheet forecast and
prot determination.
KEY POINTS
•
It is important to note those earlier identified ‘threats’ to your
business to ensure that as you forecast you can see the
deviation of the best and worst models.
• Three key forecasts include problem definition, cash flow
forecast, profit forecast, and balance sheet forecast.
• By completing these scenarios you gain an insight into the
various risks that a business faces.
Problem definition
It is important to note those earlier identified ‘threats’ to your
business to ensure that, as you forecast, you can see the deviation of
the best and worst models. For example, if a business has previously
identified the threat of a diminishing cheap labor force, then its
forecast needs to reflect that the price of labor (or any other
resource, such as power) is going to go up. There are three key
forecasts involved.
Cash flow forecast
This seeks to forecast a bank balance after a period – typically 12
months. This forecast shows the sources and application of funds.
Profit forecast
This modifies the cash flow in an attempt to calculate taxable
income and, in the process, forecast a businesses income tax
liability. There are two differences between a cash flow and a profit
forecast. The cash flow forecast includes all expenditure in the
period, whereas the profit forecast looks to match revenue with the
costs associated with generating that revenue. To achieve this, one
uses non-cash expenses to estimate some of the costs associated
with running a business.
These two forecasts are reconciled with a forecast balance sheet.
Balance sheet forecast
While we have based this example on a smaller business and, while
forecasting balance sheets demonstrates completeness and a high
level of technical integrity in forecasting, we feel the process is
complex and better left to a professional. We also feel that the
additional benefit is outweighed by the costs for a small business.
It is always easier to forecast the future performance of a business if
your business is already up and running as there are past trading
244
results to look at. When a completely
new venture is being planned, a certain
amount of imagination is required.
However, this is in no way a license to
be overly optimistic.
Basic Steps
By completing these scenarios you gain
an insight into the various risks that a
business faces. Spreadsheet programs
make this quite easy if they are well set
up (Figure 4.3).
1. The sales forecast This is the dominant influence on the
performance of your business. Also, many expenses have a
link to the level of activity in a business. For existing
businesses, past sales are the best predictor of future sales,
for new businesses it is less simple. However, once the
business is established, you will find you have a better
understanding between the business’s products and its
markets. The most important thing is to keep detailed
records of sales as it is these that will provide you with the
growing ability to forecast income accurately.
• Forecast the number of units you expect to sell
• Begin with an analysis of current performance
• Divide sales into appropriate categories
• Consider factors that affect each category
• Internal factors might include staffing changes (for service
industries)
• External factors might include the impact of inflation –
current relevance
• Now attempt to forecast unit sales in cash category
2. Multiply by unit price
3. Determine market price
4. Cost plus
• Expected mark-up
• Expected revenue per unit sold
• Statistical review of the market
• Determination of units sold
• Seasonal sales pattern
• Cash flow
245
Forecasting steps to success
Figure 4.3 Steps
• Every business needs cash (sometimes called liquidity) to
keep going.
• Forecasting cash flow lets us anticipate liquidity problems
and helps identify solutions.
5. Profit determination
The essential difference between cash flow and profit is that cash
flow includes all items of income and expense, whereas profit seeks
to match income and costs related to the generation of the income
in a period of time; usually 12 months.
To facilitate the calculation of profit (and hence, the income tax
due) the cash flow statements were split into four sections. We now
take the total of income and the operational costs into a Profit
Statement. We add depreciation to the operational costs and
subtract our adjusted operational costs from income. This
difference will indicate a profit (where the difference is positive) or
a loss (where the difference is negative).
Where there is profit, we need to then calculate income tax. This
calculation depends on the legal structure adopted for the business.
Where a business is registered for Goods and Services Tax, we take
only the net payments and receipts into account.
Source: https://www.boundless.com/finance/forecasting-financial-
statements/overview-of-forecasting–2/steps-required-to-forecast–2/
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246
Sales Forecast Input
Production Schedule Input
COGS Input
Other Expenses Input
Pro Forma
Income Statement
Section 3
Forecasting the Income Statement
247
https://www.boundless.com/nance/forecasting-nancial-statements/forecasting-the-income-statement/
Sales Forecast Input
Target volume, price, and contribution margin per unit
are the key inputs to a sales forecast.
KEY POINTS
• Net sales are operating revenues earned by a company for
selling its products or rendering its services.
• Gross sales are the sum of all sales during a time period. Net
sales are gross sales minus sales returns, sales allowances,
and sales discounts.
• The purpose of profit-based sales target metrics is to ensure
that marketing and sales objectives mesh with profit
targets.
Sales
Net sales are operating revenues earned by a company for selling its
products or rendering its services. Also referred to as revenue, they
are reported directly on the income statement as Sales or Net sales.
For financial ratios that use income statement sales values, “sales”
refers to net sales, not gross sales. Sales are the unique transactions
that occur in professional selling or during marketing initiatives.
The term sales in a marketing, advertising or a general business
context often refers to a contract in which a buyer has agreed to
purchase some products at a set time in the future. “Outstanding
orders” refers to sales orders that have not been filled.
A sale is a transfer of property for money or credit. In double-entry
bookkeeping, a sale of merchandise is recorded in the general
journal as a debit to cash or accounts receivable and a credit to the
sales account. A discount from list price might be noted if it applies
to the sale (discount expense debit).
Fees for services are recorded
separately from sales of
merchandise, but the bookkeeping
transactions for recording sales of
services are similar to those for
recording sales of tangible goods
(Figure 4.4).
Forecasting: Gross Sales and Net Sales
Net sales = Gross sales – (Customer discounts, returns, allowances)
Gross sales are the sum of all sales during a time period. Net sales
are gross sales minus sales returns, sales allowances, and sales
discounts. Gross sales do not normally appear on an income
statement. The sales figures reported on an income statement are
net sales.
248
Increasing sales
revenue is one of
the goals of
businesses.
Figure 4.4 Sales
• sales returns are refunds to customers for returned
merchandise/credit notes
• debit notes
• sales journal entries non-current, current batch-processed
transactions, predictive analytics in strategic management/
administration/governance research metaframeworks
• sales allowances are reductions in sales price for merchandise
with minor defects, the allowance agreed upon after the
customer has purchased the merchandise
• sales discounts allowed are reduced payments from the
customer based on invoice payment terms such as 2/10, n/30
(2% discount if paid within 10 days, net invoice total due in 30
days)
• interest received for amounts in arrears
• includes/excludes amounts capital goods & services, non-
capital goods & services, input valued-added tax, with cost of
non-capital goods sold
• input vat – output vat
• sales of portfolio items and capital gains taxes
• Sales Returns and Allowances and Sales Discounts are contra-
revenue accounts
Sales Forecasting
In launching a program, managers often start with an idea of the
dollar profit they desire and ask what sales levels will be required to
reach it. Target volume is the unit sales quantity required to meet
an earnings goal. Target revenue is the corresponding figure for
dollar sales. Both of these metrics can be viewed as extensions of
break-even analysis. Increasingly, marketers are expected to
generate volumes that meet the target profits of their firm. This will
often require them to revise sales targets as prices and costs change.
• Target volume: the volume of sales necessary to generate the
profits specified in a company’s plans.
• Target Volume = [Fixed costs + Target Profits] /
Contribution per Unit
• The formula for target volume will be familiar to those who
have performed break-even analysis. The only change is to
add the required profit target to the fixed costs. From another
perspective, the break-even volume equation can be viewed as
a special case of the general target volume calculation — one
in which the profit target is zero, and a company seeks only to
cover its fixed costs.
• In target volume calculations, the company broadens this
objective to solve for a desired profit.
249
• Target Revenue = Target Volume * Selling Price per Unit; or
• Target Revenue = 100 * [ { Fixed Costs + Target Profits } /
Contribution Margin ]
The purpose of profit-based sales target metrics is to ensure that
marketing and sales objectives mesh with profit targets. In target
volume and target revenue calculations, managers go beyond break-
even analysis (the point at which a company sells enough to cover
its fixed costs) to determine the level of unit sales or revenues
needed not only to cover a firm’s costs but also to attain its profit
targets.
Source: https://www.boundless.com/finance/forecasting-financial-
statements/forecasting-the-income-statement/sales-forecast-
input/
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Production Schedule Input
Production schedule can be divided into raw materials,
work in process, nished goods and goods for resale.
KEY POINTS
• A good purchased as a “raw material” goes into the
manufacture of a product.
• A good only partially completed during the manufacturing
process is called “work in process”.
• When the good is completed as to manufacturing but not yet
sold or distributed to the end-user, it is called a “finished
good”.
• Inventory management is primarily about specifying the
shape and percentage of stocked goods.
• Basic reasons for keeping an inventory involve time,
uncertainty and economics of scales.
Production schedule inputs:
• A good purchased as a “raw material” goes into the
manufacture of a product.
• A good only partially completed during the manufacturing
process is called “work in process.”
250
• When the good is completed as to manufacturing but not yet
sold or distributed to the end user, it is called a “finished
good.” (Figure 4.5)
Raw materials – materials and components scheduled for use in
making a product.
A raw material is the basic material from which a product is
manufactured or made, frequently used with an extended meaning.
For example, the term is used to denote material that came from
nature and is in an unprocessed or minimally processed state.
Latex, iron ore, logs, and crude oil, and salt water are examples. The
use of raw material by non-human species includes twigs and found
objects as used by birds to make nests.
Work in process, WIP – materials and components that have
begun their transformation to finished goods.
Work in process (WIP) or in-process inventory includes the set at
large of unfinished items for products in a production process.
These items are not yet completed but either just being fabricated or
waiting in a queue for further processing or in a buffer storage. The
term is used in production and supply chainmanagement.
Optimal production management aims to minimize work in
process. Work in process requires storage space, represents bound
capital not available for investment, and carries an inherent risk of
earlier expiration of shelf life of the products. A queue leading to a
production step shows that the step is well buffered for shortage in
supplies from preceding steps, but may also indicate insufficient
capacity to process the output from these preceding steps.
Finished goods – goods ready for sale to customers.
Finished goods are goods that have completed the manufacturing
process but have not yet been sold or distributed to the end user.
Finished goods is a relative term. In a Supply chain
management flow, the finished goods of a supplier can constitute
the raw material of a buyer.
251
Production budget is important for inventory and sales revenue
Figure 4.5 Production budget
Goods for resale – returned goods that are salable.
Inventory management
Inventory management is primarily about specifying the shape and
percentage of stocked goods. It is required at different locations
within a facility or within many locations of a supply network to
precede the regular and planned course of production and stock of
materials.
The scope of inventory management concerns the fine lines between
replenishment lead time, carrying costs of inventory, asset
management, inventory forecasting, inventory valuation, inventory
visibility, future inventory price forecasting, physical inventory,
available physical space for inventory, quality management,
replenishment, returns and defective goods, and demand
forecasting. Balancing these competing requirements leads to
optimal inventory levels, which is an on-going process as the
business needs shift and react to the wider environment.
Inventory management involves a retailer seeking to acquire and
maintain a proper merchandise assortment while ordering,
shipping, handling, and related costs are kept in check. It also
involves systems and processes that identify inventory
requirements, set targets, provide replenishment techniques, report
actual and projected inventory status, and handle all functions
related to the tracking and management of material. This would
include the monitoring of material moved into and out of stockroom
locations and the reconciling of the inventory balances. It also may
include ABC analysis, lot tracking, cycle counting support, etc.
Management of the inventories, with the primary objective of
determining/controlling stock levels within the physical
distribution system, functions to balance the need for product
availability against the need for minimizing stock holding and
handling costs (Figure 4.6).
There are three basic reasons for keeping an inventory:
• Time: The time lags present in the supply chain, from supplier
to user at every stage, requires that you maintain certain
amounts of inventory to use in this lead time. However, in
252
Production schedule plays an important role in nancial forecasting.
Figure 4.6 Production schedule
practice, inventory is to be maintained for consumption
during variations in lead time. Lead time itself can be
addressed by ordering that many days in advance.
• Uncertainty: Inventories are maintained as buffers to meet
uncertainties in demand, supply and movements of goods.
• Economies of scale: Ideal condition of “one unit at a time at a
place where a user needs it, when he needs it” principle tends
to incur lots of costs in terms of logistics. So bulk buying,
movement, and storing brings in economies of scale, thus
inventory.
EXAMPLE
By taking the Costs-To-Date divided by the Cost Estimate, the
“percentage complete” for the project is calculated. For
example: Assume a project is estimated to cost $70,000 by the
time the work is complete, Assume at the end of December,
$35,000 has been spent to date for the project, $35,000
divided by $70,000 is 50%, therefore, the project can be
considered 50% complete at December 31.
Source: https://www.boundless.com/finance/forecasting-financial-
statements/forecasting-the-income-statement/production-schedule-
input/
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253
COGS Input
COGS is dicult to forecast due to the sheer amount of
expenses included and diering methods of estimating
each.
KEY POINTS
• Costs include all costs of purchase, costs of conversion, and
other costs incurred in bringing the inventories to their
present location and condition.
• The key components of cost generally include: parts – raw
materials and supplies used, labor – including associated
costs such as payroll taxes and benefits, and overhead of the
business allocable to production.
• A miscalculation or faulty estimation can be amplified
drastically, causing a vastly different forecasted amount of
income than what will actually come to pass.
Cost of goods sold (COGS) refer to the inventory costs of the goods a
business has sold during a particular period. Costs include all costs
of purchase, costs of conversion, and other costs incurred in
bringing the inventories to their present location and condition.
Costs of goods made by the business include material, labor, and
allocated overhead. The costs of those goods not yet sold are
deferred as costs of inventory until the inventory is sold or written
down in value.
Because costs of goods sold is a major expense for most companies,
it is an extremely important input to a forecast of the income
statement. A miscalculation or faulty estimation can be amplified
drastically, causing a vastly different forecasted amount of income
than what will actually come to pass. Specifically, underestimating
the costs associated with goods to be sold can cause the forecasted
income to be much higher than what it actually will be, and vice
versa. Also, because cost of goods sold is such a broad input,
encompassing many separate expenses with different methods of
estimating each, it becomes difficult to accurately forecast all phases
(Figure 4.7).
Parts, RawMaterials, and Supplies Used
Most businesses make more than one of a particular item.
Therefore, costs are incurred for multiple items rather than a
particular item sold. Determining how much of each of these
components to allocate to particular goods requires either tracking
the particular costs or making some allocations of costs. Parts and
raw materials are often tracked to particular sets (e.g., batches or
production runs) of goods, then allocated to each item.
254
Labor and Associated Costs
Labor costs include direct labor and indirect labor. Direct labor
costs are the wages paid to those employees who spend all their
time working directly on the product being manufactured. Indirect
labor costs are the wages paid to other factory employees involved
in production. Costs of payroll taxes and employee benefits are
generally included in labor costs, but may be treated as overhead
costs. Labor costs may be allocated to an item or set of items based
on timekeeping records.
Overhead of the Business Allocable to Production
Determining overhead costs often involves making assumptions
about what costs should be associated with production activities
and what costs should be associated with other activities.
Traditional methods attempt to make these assumptions based on
past experience and management judgment as to factual
relationships. Activity based costing attempts to allocate costs based
on those factors that drive the business to incur the costs.
Variable production overheads are allocated to units produced
based on actual use of production facilities. Fixed production
overheads are often allocated based on normal capacities or
expected production. More or fewer goods may be produced than
expected when developing cost assumptions (like burden rates).
These differences in production levels often result in too much or
too little cost being assigned to the goods produced. This also gives
rise to variances.
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statements/forecasting-the-income-statement/cogs-input/
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255
The cost of goods
sold in a given
accounting period
is recorded on a
company’s income
statement.
Figure 4.7 A
Sample Income
Statement
Other Expenses Input
Other expenses include SG&A, depreciation,
amortization, R&D, nance costs, income tax expense,
discontinued operations expenses.
KEY POINTS
• Other expenses include operation expenses section and non-
operation expenses section.
• Operation section expenses include SG&A, depreciation,
amortization, and R&D expenses.
• Non-operation section expenses include finance costs,
income tax expense, and discontinued operations expenses.
• SG&A is usually understood as a major portion of non-
production related costs, in contrast to production costs such
as direct labour.
Selling, General, and Administrative expenses (SG&A or
SGA)
• Selling, General, and Administrative expenses (SG&A or SGA)
consist of the combined payroll costs. SGA is usually
understood as a major portion of non-production related
costs, in contrast to production costs such as direct labor.
• Selling expenses – represent expenses needed to sell products
(e.g. salaries of sales people, commissions and travel
expenses, advertising, freight, shipping, depreciation of sales
store buildings and equipment, rent, and all expenses and
taxes directly related to producing and selling product, etc.)
• General expenses- general operating expenses and taxes that
are directly related to the general operation of the company,
but don’t relate to the other two categories.
• Administrative expenses – executive salaries, general support,
and all associated taxes related to the overall administration
of the company (Figure 4.8).
Depreciation
1. The decrease in value of assets (fair value depreciation).
2. The allocation of the cost of assets to periods in which the
assets are used (depreciation with the matching principle).
256
Operational expenses and
non-operational expenses
are the main cash outow
of a business.
Figure 4.8 Expenses
The former affects values of businesses and entities. The latter
affects net income. Generally, the cost is allocated, as depreciation
expense, among the periods in which the asset is expected to be
used. Such expense is recognized by businesses for financial
reporting and tax purposes. Methods of computing depreciation
may vary by asset for the same business. Methods and lives may be
specified in accounting and/or tax rules in a country. Several
standard methods of computing depreciation expense may be used,
including fixed percentage, straight line, and declining balance
methods. Depreciation expense generally begins when the asset is
placed in service.
Amortization
Amortization (or amortization) is the process of decreasing or
accounting for an amount over a period. When used in the context
of a home purchase, amortization is the process by which loan
principal decreases over the life of a loan. With each mortgage
payment that is made, a portion of the payment is applied towards
reducing the principal, and another portion of the payment is
applied towards paying the interest on the loan. An amortization
table shows this ratio of principal and interest and demonstrates
how a loan’s principal amount decreases over time. Amortization is
generally known as depreciation of intangible assets of a firm.
Research & Development (R&D) Expenses
The term R&D or research and development refers to a specific
group of activities within a business. The activities that are
classified as R&D differ from company to company, but there are
two primary models. In one model, the primary function of an R&D
group is to develop new products. In the other model, the primary
function of an R&D group is to discover and create new knowledge
about scientific and technological topics for the purpose of
uncovering and enabling development of valuable new products,
processes, and services.
Non-operating section
• Other expenses or losses – expenses or losses not related to
primary business
operations, (e.g. foreign exchange loss).
• Finance costs – costs of borrowing from various creditors (e.g.
interest expenses, bank charges).
• Income tax expense – sum of the amount of tax payable to tax
authorities in the current reporting period (current tax
liabilities/ tax payable) and the amount of deferred tax
liabilities (or assets).
• Discontinued operations are the most common type of
irregular items. Shifting business location(s), stopping
257
• production temporarily, or changes due to technological
improvement do not qualify as discontinued operations.
Discontinued
operations must be shown separately.
• Extraordinary items are both unusual (abnormal) and
infrequent, for example, unexpected natural disaster,
expropriation, prohibitions under new regulations.
EXAMPLE
Extraordinary items: natural disaster might not qualify
depending on location.
Source: https://www.boundless.com/finance/forecasting-financial-
statements/forecasting-the-income-statement/other-expenses-input/
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Pro Forma Income Statement
A pro forma income statement is planned and prepared
in advance to of a transaction to project the future
status of the company.
KEY POINTS
• The pro forma accounting is a statement of the company’s
financial activities while excluding “unusual and
nonrecurring transactions” when stating how much money
the company actually made.
• Income statement is a company’s financial statement that
indicates how the revenue is transformed into the net income
during a certain period of time.
• Pro forma Income statement includes revenue, COGS,
operational expenses and non-operational expenses.
Pro forma
The term pro forma, Latin for “as a matter of form” or “for the
sake of form”, is a term applied to practices or documents that are
done as a pure formality, perfunctorily, or seek to satisfy the
minimum requirements or to conform to a convention or doctrine.
It has different meanings in different fields.
258
Pro forma financial statements are prepared in advance of a
planned transaction, such as a merger, an acquisition, a new capital
investment, or a change in capital structure like an incurrence of
new debt or issuance of equity.
The pro forma models the anticipated results of the transaction,
with particular emphasis on the projected cash flows, net revenues
and (for taxable entities) taxes. Consequently, pro forma statements
summarize the projected future status of a company, based on the
current financial statements. For example, when a transaction with
a material effect on a company’s financial condition is
contemplated, the Finance Department will prepare, for
management and Board review, a business plan containing pro
forma financial statements demonstrating the expected effect of the
proposed transaction on the company’s financial viability. Lenders
and investors will require such statements to structure or confirm
compliance with debt covenants, such as debt service reserve
coverage and debt to equity ratios. Similarly, when a new
corporation is envisioned, its founders will prepare pro forma
financial statements for the information of prospective investors.
Pro forma accounting is a statement of the company’s financial
activities while excluding “unusual and nonrecurring transactions”
when stating how much money the company actually made.
Expenses often excluded from pro forma results include company
restructuring costs, a decline in the value of the company’s
investments, or other accounting charges, such as adjusting the
current balance sheet to fix faulty accounting practices in previous
years.
Income Statement
The income statement is a company’s financial statement that
indicates how the revenue is transformed into the net income (the
result after all revenues and expenses have been accounted for, also
known as Net Profit or the “bottom line”). It displays the revenues
recognized for a specific period, and the cost and expenses charged
against these revenues, includingwrite-offs (e.g., depreciation and
amortization of various assets) and taxes.
Pro Forma Income Statement
(Figure 4.9)Pro forma figures should be clearly labeled as such and
the reason for any deviation from reported past figures clearly
explained. A pro forma Income statement could be planned and
prepared in advance, which includes the items below:
Operating Section:
• Revenue – Cash inflows or other enhancements of assets of an
entity during a period from delivering or producing goods,
rendering services, or other activities that constitute the
259
entity’s ongoing major operations. It is usually presented as
sales minus sales discounts, returns, and allowances.
• Expenses – Cash outflows or other using-up of assets or
incurrence of liabilities during a period from delivering or
producing goods, rendering services, or carrying out other
activities that constitute the entity’s ongoing major operations.
• Cost of Goods Sold (COGS) / Cost of Sales – represents the
direct costs attributable to goods produced and sold by a
business (manufacturing or merchandizing). It includes
material costs, direct labour, and overhead costs (as in
absorption costing).
• Selling, General and Administrative expenses (SG&A or SGA) –
consist of the combined payroll costs. SGA is usually
understood as a major portion of non-production related
costs, in contrast to production costs such as direct labour.
• Depreciation / Amortization – the charge with respect to fixed
assets / intangible assets that have been capitalized on the
balance sheet for a specific (accounting) period. It is a
systematic and rational allocation of cost rather than the
recognition of market value decrement.
• Research & Development (R&D) expenses – expenses included
in research and development.
Non-Operating Section:
• Other revenues or gains – income from other than primary
business activities (e.g. rent, income from patents). It also
includes gains that are either unusual or infrequent, but not
both (e.g. gain from sale of securities or gain from disposal of
fixed assets)
260
Pro forma income
statement is an
estimate for the prots
or losses of a company.
Figure 4.9 Income
statement
• Other expenses or losses – not related to primary business
operations, (e.g. foreign exchange loss).
• Finance costs – costs of borrowing from various creditors (e.g.
interest expenses, bank charges).
• Income tax expense – sum of the amount of tax payable to tax
authorities in the current reporting period (current tax
liabilities / tax payable) and the amount of deferred tax
liabilities (or assets).
• Irregular items – these are reported separately because this
way users can better predict future cash flows – irregular items
most likely will not recur. These are reported net of taxes.
• Discontinued operations is the most common type of irregular
items. Shifting business location(s), stopping production
temporarily, or changes due to technological improvement do
not qualify as discontinued operations. Discontinued
operations must be shown separately.
Source: https://www.boundless.com/finance/forecasting-financial-
statements/forecasting-the-income-statement/pro-forma-income-
statement/
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261
Pro Forma Balance
Sheet
Balance Sheet Analysis
Section 4
Forecasting the Balance Sheet
262
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Pro Forma Balance Sheet
A pro forma balance sheet summarizes the projected
future status of a company after a planned transaction,
based on the current nancial statements.
KEY POINTS
• The pro forma accounting is a statement of the company’s
financial activities while excluding “unusual and
nonrecurring transactions” when stating how much money
the company actually made.
• In business, pro forma financial statements are prepared in
advance of a planned transaction, such as a merger, an
acquisition, a new capital investment, or a change in capital
structure such as incurrence of new debt or issuance of
equity.
• Pro forma figures should be clearly labeled as such and the
reason for any deviation from reported past figures clearly
explained.
Pro Forma Financial Statements
In business, pro forma financial statements are prepared in advance
of a planned transaction, such as a merger, an acquisition, a
new capital investment, or a change in capital structure such as
incurrence of new debt or issuance of equity. The pro forma models
the anticipated results of the transaction, with particular emphasis
on the projected cash flows, net revenues and (for taxable entities)
taxes. Consequently, pro forma statements summarize the projected
future status of a company, based on the current financial
statements. For example, when a transaction with a material effect
on a company’s financial condition is contemplated, the Finance
Department will prepare, for management and Board review, a
business plan containing pro forma financial statements
demonstrating the expected effect of the proposed transaction on
the company’s financial viability.
263
Simple balance sheet
including basic items
Figure 4.10 Balance
Sheet
Pro Forma Balance Sheet
If applicable to the business, summary values for the following
items should be included in the pro forma balance sheet
(Figure 4.10):
• Assets
• Current assets
• Cash and cash equivalents
• Accounts receivable
• Inventories
• Prepaid expenses for future services that will be used within a
year
• Non-current assets (Fixed assets)
• Property, plant and equipment
• Investment property, such as real estate held for investment
purposes
• Intangible assets
• Financial assets (excluding investments accounted for using
the equity method, accounts receivables, and cash and cash
equivalents)
• Investments accounted for using the equity method
• Biological assets, which are living plants or animals. Bearer
biological assets are plants or animals which bear agricultural
produce for harvest, such as apple trees grown to produce
apples and sheep raised to produce wool.
• Liabilities
• Accounts payable
• Provisions for warranties or court decisions
• Financial liabilities (excluding provisions and accounts
payable), such as promissory notes and corporate bonds
• Liabilities and assets for current tax
• Deferred tax liabilities and deferred tax assets
• Unearned revenue for services paid for by customers, but not
yet provided
• Equity
• The net assets shown by the balance sheet equals the third
part of the balance sheet, which is known as the shareholders’
equity. It comprises:
• Issued capital and reserves attributable to equity holders of
the parent company (controlling interest)
264
• Non-controlling interest in equity
• Formally, shareholders’ equity is part of the company’s
liabilities: they are funds “owing” to shareholders (after
payment of all other liabilities). Usually, however, “liabilities”
is used in the more restrictive sense of liabilities excluding
shareholders’ equity. The balance of assets and liabilities
(including shareholders’ equity) is not a coincidence. Records
of the values of each account in the balance sheet are
maintained using a system of accounting known as double-
entry bookkeeping. In this sense, shareholders’ equity by
construction must equal assets minus liabilities, and are a
residual.
• Regarding the items in equity section, the following
disclosures are required:
• Numbers of shares authorized, issued and fully paid, and
issued but not fully paid
• Par value of shares
• Reconciliation of shares outstanding at the beginning and the
end of the period
• Description of rights, preferences, and restrictions of shares
• Treasury shares, including shares held by subsidiaries and
associates
• Shares reserved for issuance under options and contracts
• A description of the nature and purpose of each reserve within
owners’ equity
Lenders and investors will require such statements to structure or
confirm compliance with debt covenants such as debt service
reserve coverage and debt to equity ratios. Similarly, when a new
corporation is envisioned, its founders will prepare pro forma
financial statements for the information of prospective investors.
Pro forma figures should be clearly labeled as such and the reason
for any deviation from reported past figures clearly explained.
EXAMPLE
For example, when a transaction with a material effect on a
company’s financial condition is contemplated, the Finance
Department will prepare, for management and board review, a
business plan containing pro forma financial statements
demonstrating the expected effect of the proposed transaction
on the company’s financial viability.
Source: https://www.boundless.com/finance/forecasting-financial-
statements/forecasting-the-balance-sheet/pro-forma-balance-sheet/
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265
Balance Sheet Analysis
Balance sheet analysis is process of understanding the
risk and protability of a rm through analysis of
reported nancial information.
KEY POINTS
• Balance sheet is a summary
of the financial balances of a sole
proprietorship, a business partnership, a corporation or other
business organization.
Assets, liabilities and ownership
equity are listed as of a specific
date, such as the end of its
financial year.
•
Balance sheet analysis (or financial analysis) the process of
understanding the risk and profitability of a firm (business,
sub-business or project) through analysis of reported
financial information, particularly annual and quarterly
reports.
• Financial ratio analysis should be based on regrouped and
adjusted financial statements. Two types of ratio analysis are
performed: 3.1) Analysis of risk and 3.2) analysis of
profitability.
• Balance sheet analysis consists of 1) reformulating reported
Balance sheet, 2) analysis and adjustments of measurement
errors, and 3) financial ratio analysis on the basis of
reformulated and adjusted Balance sheet.
Balance sheet
In financial accounting, a
balance sheet or statement of
financial position is a summary
of the financial balances of a sole
proprietorship, a business
partnership, a corporation or
other business organization.
Assets, liabilities and ownership
equity are listed as of a specific
date, such as the end of its
financial year. A balance sheet is
often described as a “snapshot of
a company’s financial
condition”. Of the four basic financial statements, the balance sheet
is the only statement which applies to a single point in time of a
business’ calendar year.
A business operating entirely in cash can measure its profits by
withdrawing the entire bank balance at the end of the period, plus
any cash in hand. However, many businesses are not paid
immediately; they build up inventories of goods and they acquire
buildings and equipment. In other words: businesses have assets
and so they cannot, even if they want to, immediately turn these
266
Classied balance sheet
Figure 4.11 Balance sheet
into cash at the end of each period. Often, these businesses owe
money to suppliers and to tax authorities, and the proprietors do
not withdraw all their original capital and profits at the end of each
period. In other words businesses also have liabilities (Figure 4.11).
Balance sheet analysis
Balance sheet analysis (or financial analysis) the process of
understanding the risk and profitability of a firm (business, sub-
business or project) through analysis of reported financial
information, particularly annual and quarterly reports.
Balance sheet analysis consists of 1) reformulating reported Balance
sheet, 2) analysis and adjustments of measurement errors, and 3)
financial ratio analysis on the basis of reformulated and adjusted
Balance sheet. The two first steps are often dropped in practice,
meaning that financial ratios are just calculated on the basis of the
reported numbers, perhaps with some adjustments. Financial
statement analysis is the foundation for evaluating and pricing
credit risk and for doing fundamental company valuation.
Financial ratio analysis should be based on regrouped and adjusted
financial statements. Two types of ratio analysis are performed: 3.1)
Analysis of risk and 3.2) analysis of profitability:
3.1) Analysis of risk typically aims at detecting the underlying credit
risk of the firm. Risk analysis consists of liquidity and solvency
analysis. Liquidity analysis aims at analyzing whether the firm has
enough liquidity to meet its obligations when they should be paid. A
usual technique to analyze liquidity risk is to focus on ratios such as
the current ratio and interest coverage. Cash flow analysis is also
useful. Solvency analysis aims at analyzing whether the firm is
financed so that it is able to recover from a losses or a period of
losses.
3.2) Analysis of profitability refers to the analysis of return on
capital, for example return on equity, ROE, defined as earnings
divided by average equity. Return on equity, ROE, could be
decomposed: ROE = RNOA + (RNOA -NFIR) *NFD/E
Purposes of balance sheet analysis
“The objective of financial statements is to provide information
about the financial position, performance and changes in financial
position of an enterprise that is useful to a wide range of users in
making economic decisions.” Financial statements should be
understandable, relevant, reliable and comparable. Reported assets,
liabilities, equity, income and expenses are directly related to an
organization’s financial position.
Financial statements are intended to be understandable by readers
who have “a reasonable knowledge of business and economic
activities and accounting and who are willing to study the
267
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Chapter 3
Standardizing
Financial
Statements
https://www.boundless.com/nance/analyzing-nancial-
statement
s–2/
Balance Sheets
Income Statements
Section 1
Standardizing Financial Statements
151
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Balance Sheets
A standard company balance sheet has three parts:
assets, liabilities, and ownership equity; Asset =
Liabilities + Equity.
KEY POINTS
• A balance sheet or statement of financial position is a
summary of the financial balances of a sole proprietorship, a
business partnership, a corporation, or other business
organization, such as an LLC or an LLP.
•
A standard company balance sheet has three parts: assets,
liabilities, and ownership
equity.
• Assets are followed by the liabilities. The difference between
the assets and the liabilities is known as “equity” or the net
assets or the net worth or capital of the company and
according to the accounting equation, net worth must equal
assets minus
liabilities.
Balance sheet
In financial accounting, a balance sheet or statement of financial
position is a summary of the financial balances of a sole
proprietorship, a business partnership, a corporation or other
business organization, such as an LLC or an LLP. Assets, liabilities
and ownership equity are listed as of a specific date, such as the end
of its financial year. A balance sheet is often described as a
“snapshot of a company’s financial condition.” Of the four basic
financial statements, the balance sheet is the only statement which
applies to a single point in time of a business’ calendar year.
152
Figure 3.1 Balance sheet
Balance sheet shows nancial position of a company.
A standard company balance sheet has three parts: assets,
liabilities, and ownership equity. The main categories of assets are
usually listed first, and typically in order of liquidity. Assets are
followed by the liabilities. The difference between the assets and the
liabilities is known as “equity” or the net assets or the net worth or
the capital of the company and according to the accounting
equation, net worth must equal assets minus liabilities (Figure 3.1).
Types
A balance sheet summarizes an organization or individual’s assets,
equity, and liabilities at a specific point in time. We have two forms
of balance sheet. They are the report form and the account form.
Individuals and small businesses tend to have simple balance
sheets. Larger businesses tend to have more complex balance
sheets, and these are presented in the organization’s annual report.
Large businesses also may prepare balance sheets for segments of
their businesses. A balance sheet is often presented alongside one
for a different point in time (typically the previous year) for
comparison.
Personal Balance Sheet
A personal balance sheet lists current assets, such as cash in
checking accounts and savings accounts; long-term assets, such as
common stock and real estate; current liabilities, such as loan debt
and mortgage debt due; or overdue, long-term liabilities, such as
mortgage and other loan debt. Securities and real estate values are
listed at market value rather than at historical cost or cost basis.
Personal net worth is the difference between an individual’s total
assets and total liabilities.
U.S. Small Business Balance Sheet
A small business balance sheet lists current assets, such as cash,
accounts receivable, and inventory; fixed assets, such as land,
buildings, and equipment; intangible assets, such as patents; and
liabilities, such as accounts payable, accrued expenses, and long-
term debt. Contingent liabilities, such aswarranties are noted in
the footnotes to the balance sheet. The small business’s equity is the
difference between total assets and total liabilities.
Public Business Entities Balance Sheet Structure
Guidelines for balance sheets of public business entities are given by
the International Accounting Standards Board and numerous
country-specific organizations/
companies.
Balance sheet account names and usage depend on the
organization’s country and the type of organization. Government
organizations do not generally follow standards established for
individuals or businesses.
153
If applicable to the business, summary values for the following
items should be included in the balance sheet: Assets are all the
things the business owns, including property, tools, cars, etc.
Assets:
1. Current assets
• Cash and cash equivalents
• Accounts receivable
• Inventories
• Prepaid expenses for future services that will be used
within a year
2. Non-current assets (fixed assets)
• Property, plant, and
equipment.
• Investment property, such as real estate held for
investment purposes.
• Intangible
assets.
• Financial assets (excluding investments accounted for
using the equity method, accounts receivables, and cash
and cash equivalents).
• Investments accounted for using the equity method
• Biological assets, which are living plants or animals. Bearer
biological assets are plants or animals which bear
agricultural produce for harvest, such as apple trees grown
to produce apples and sheep raised to produce wool.
Liabilities:
• Accounts
payable.
• Provisions for warranties or court decisions.
• Financial liabilities (excluding provisions and accounts
payable), such as promissory notes and corporate bonds.
• Liabilities and assets for current tax.
• Deferred tax liabilities and deferred tax assets.
• Unearned revenue for services paid for by customers but not
yet provided.
Equity:
• Issued capital and reserves attributable to equity holders of
the parent company (controlling interest).
• Non-controlling interest in equity.
154
• Regarding the items in equity section, the following
disclosures are required:
• Numbers of shares authorized, issued and fully paid, and
issued but not fully paid.
• Par value of shares.
• Reconciliation of shares outstanding at the beginning and the
end of the period/
• Description of rights, preferences, and restrictions of shares.
• Treasury shares, including shares held by subsidiaries and
associates.
• Shares reserved for issuance under options and contracts.
• A description of the nature and purpose of each reserve within
owners’ equity
Source: https://www.boundless.com/finance/analyzing-financial-
statements–2/standardizing-financial-statements–2/balance-
sheets–2/
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Boundless is an openly licensed educational resource
Income Statements
Income statement is a company’s nancial statement
that indicates how the revenue is transformed into the
net
income.
KEY POINTS
• Income statement displays the revenues recognized for a
specific period, and the cost and expenses charged against
these revenues, including write offs (e.g., depreciation and
amortization of various assets) and taxes.
• The income statement can be prepared in one of two
methods: The Single Step income statement and Multi-Step
income statement.
• The income statement includes revenue, expenses, COGS,
SG&A, depreciation, other revenues and expenses, finance
costs, income tax expense, and net income.
Income Statement
Income statement (also referred to as profit and loss statement
[P&L]), revenue statement, a statement of financial performance,
an earnings statement, an operating statement, or statement of
operations) is a company’s financial statement. This indicates how
the revenue (money received from the sale of products and services
155
before expenses are taken out, also known as the “top line”) is
transformed into the net income (the result after all revenues and
expenses have been accounted for, also known as “Net Profit” or the
“bottom line”). It displays the revenues recognized for a specific
period, and the cost and expenses charged against these revenues,
including write offs (e.g., depreciation and amortization of various
assets) and taxes. The purpose of the income statement is to show
managers and investors whether the company made or lost money
during the period being reported.
The important thing to remember about an income statement is
that it represents a period of time. This contrasts with the balance
sheet, which represents a single moment in time (Figure 3.2).
TwoMethods
• The Single Step income statement takes a simpler approach,
totaling revenues and subtracting expenses to find the bottom
line.
• The Multi-Step income statement (as the name implies) takes
several steps to find the bottom line, starting with the gross
profit. It then calculates operating expenses and, when
deducted from the gross profit, yields income from
operations. Adding to income from operations is the
difference of other revenues and other expenses. When
combined with income from operations, this yields income
before taxes. The final step is to deduct taxes, which finally
produces the net income for the period measured.
Operating Section
• Revenue – cash inflows or other enhancements of assets of an
entity during a period from delivering or producing goods,
rendering services, or other activities that constitute the
156
Income statement
shows gains or
losses of a
company during a
period.
Figure 3.2 Income
statement
entity’s ongoing major operations. It is usually presented as
sales minus sales discounts, returns, and allowances. Every
time a business sells a product or performs a service, it obtains
revenue. This often is referred to as gross revenue or sales
revenue.
• Expenses – cash outflows or other using-up of assets or
incurrence of liabilities during a period from delivering or
producing goods, rendering services, or carrying out other
activities that constitute the entity’s ongoing major operations.
• Cost of Goods Sold (COGS)/Cost of Sales – represents the
direct costs attributable to goods produced and sold by a
business (manufacturing or merchandizing). It includes
material costs, direct labor, and overhead costs (as in
absorption costing), and excludes operating costs (period
costs), such as selling, administrative, advertising or R&D, etc.
• Selling, General and Administrative expenses (SG&A or SGA) –
consist of the combined payroll costs. SGA is usually
understood as a major portion of non-production related
costs, in contrast to production costs such as direct labour.
• Selling expenses – represent expenses needed to sell products
(e.g., salaries of sales people, commissions, and travel
expenses; advertising; freight; shipping; depreciation of sales
store buildings and equipment, etc.).
• General and Administrative (G&A) expenses – represent
expenses to manage the business (salaries of officers/
executives, legal and professional fees, utilities, insurance,
depreciation of office building and equipment, office rents,
office supplies, etc.).
• Depreciation/Amortization – the charge with respect to fixed
assets/intangible assets that have been capitalized on the
balance sheet for a specific (accounting) period. It is a
systematic and rational allocation of cost rather than the
recognition of market value decrement.
• Research & Development (R&D) expenses – represent
expenses included in research and development.
• Expenses recognized in the income statement should be
analyzed either by nature (raw materials, transport costs,
staffing costs, depreciation, employee benefit, etc.) or by
function (cost of sales, selling, administrative, etc.).
Non-operating Section
• Other revenues or gains – revenues and gains from other than
primary business activities (e.g., rent, income from patents).
• Other expenses or losses – expenses or losses not related to
primary business operations, (e.g., foreign exchange loss).
157
• Finance costs – costs of borrowing from various creditors (e.g.,
interest expenses, bank charges).
• Income tax expense – sum of the amount of tax payable to tax
authorities in the current reporting period (current tax
liabilities/tax payable) and the amount of deferred tax
liabilities (or
assets).
• Irregular items – are reported separately because this way
users can better predict future cash flows – irregular items
most likely will not recur. These are reported net of taxes.
Bottom Line
Bottom line is the net income that is calculated after subtracting the
expenses from revenue. Since this forms the last line of the income
statement, it is informally called “bottom line.” It is important to
investors as it represents the profit for the year attributable to the
shareholders.
Source: https://www.boundless.com/finance/analyzing-financial-
statements–2/standardizing-financial-statements–2/income-
statements–2/
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158
Classication
Section 2
Ratio Analysis Overview
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Classication
Ratio analysis consists of calculating nancial
performance using ve basic types of ratios:
protability, liquidity, activity, debt, and market.
KEY POINTS
• Ratio analysis consists of the calculation of ratios from
financial statements and is a foundation of financial analysis.
• A financial ratio, or accounting ratio, shows the relative
magnitude of selected numerical values taken from those
financial
statements.
• The numbers contained in financial statements need to be
put into context so that investors can better understand
different aspects of the company’s operations. Ratio analysis
is one method an investor can use to gain that understanding.
Classification
Financial statements are generally insufficient to provide
information to investors on their own; the numbers contained in
those documents need to be put into context so that investors can
better understand different aspects of the company’s operations.
Ratio analysis is one of three methods an investor can use to gain
that understanding (Figure 3.3).
Financial statement analysis is the process of understanding the
risk and profitability of a firm through analysis of reported financial
information. Ratio analysis is a foundation for evaluating and
pricing credit risk and for doing fundamental company valuation. A
financial ratio, or accounting ratio, is derived from a company’s
financial statements and is a calculation showing the relative
magnitude of selected numerical values taken from those financial
statements.
There are various types of financial ratios, grouped by their
relevance to different aspects of a company’s business as well as to
their interest to different audiences. Financial ratios may be used
internally by managers within a firm, by current and potential
shareholders and creditors of a firm, and other audiences interested
in understanding the strengths and weaknesses of a company,
160
Financial ratio
analysis allows an
observer to put the
data provided by a
company in
context. This allows
the observer to
gauge the strength
of dierent aspects
of the company’s
operations.
Figure 3.3
Business Analysis
and Protability
especially compared to the company over time or compared to other
companies.
Types of Ratios
Most analysts think of financial ratios as consisting of five basic
types:
• Profitability ratios measure the firm’s use of its assets and
control of its expenses to generate an acceptable rate of
return.
• Liquidity ratios measure the availability of cash to pay debt.
• Activity ratios, also called efficiency ratios, measure the
effectiveness of a firm’s use of resources, or assets.
• Debt, or leverage, ratios measure the firm’s ability to repay
long-term debt.
• Market ratios are concerned with shareholder audiences. They
measure the cost of issuing stock and the relationship between
return and the value of an investment in company’s shares.
Source: https://www.boundless.com/finance/analyzing-financial-
statements–2/ratio-analysis-overview–2/classification–2/
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161
Operating Margin
Prot Margin
Return on Total Assets
Basic Earning Power (BEP) Ratio
Return on Common Equity
Section 3
Protability Ratios
162
https://www.boundless.com/nance/analyzing-nancial-statements–2/protability-ratios–2/
Operating Margin
The operating margin is a ratio that determines how
much money a company is actually making in prot and
equals operating income divided by revenue.
KEY POINTS
• The operating margin equals operating income divided by
revenue.
• The operating margin shows how much profit a company
makes for each dollar in revenue. Since revenues and
expenses are considered ‘operating’ in most companies, this
is a good way to measure a company’s profitability.
• Although It is a good starting point for analyzing many
companies, there are items like interest and taxes that are not
included in operating income. Therefore, the operating
margin is an imperfect measurement a company’s
profitability.
Operating Margin
The financial job of a company is to earn a profit, which is different
than earning revenue. If a company doesn’t earn a profit, their
revenues aren’t helping the company grow. It is not only important
to see how much a company has sold, it is important to see how
much a company is making.
The operatingmargin (also called the operating profit margin or
return on sales) is a ratio that shines a light on how much money a
company is actually making in profit. It is found by dividing
operating income by revenue, where operating income is revenue
minus operating expenses (Figure 3.4).
The higher the ratio is, the more profitable the company is from its
operations. For example, an operating margin of 0.5 means that for
every dollar the company takes in revenue, it earns $0.50 in
profit.
A company that is not making any money will have an operating
margin of 0: it is selling its products or services, but isn’t earning
any profit from those
sales.
However, the operating margin is not a perfect measurement. It
does not include things like capital investment, which is necessary
for the future profitability of the company. Furthermore, the
operating margin is simply revenue. That means that it does not
include things like interest and income tax expenses. Since non-
operating incomes and expenses can significantly affect the
financial well-being of a company, the operating margin is not the
163
The operating margin is found by dividing net operating income by total revenue.
Figure 3.4 Operating Margin Formula
only measurement that investors scrutinize. The operating margin
is a useful tool for determining how profitable the operations of a
company are, but not necessarily how profitable the company is as a
whole.
Source: https://www.boundless.com/finance/analyzing-financial-
statements–2/profitability-ratios–2/operating-margin–2/
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Prot Margin
Prot margin measures the amount of prot a company
earns from its sales and is calculated by dividing prot
(gross or net) by sales.
KEY POINTS
• Profit margin is the profit divided by revenue.
• There are two types of profit margin: gross profit margin and
net profit
margin.
• A higher profit margin is better for the company, but there
may be strategic decisions made to lower the profit margin or
to even have it be negative.
Profit Margin
Profit margin is one of the most used profitability ratios. Profit
margin refers to the amount of profit that a company earns through
sales.
The profit margin ratio is broadly the ratio of profit to total sales
times 100%. The higher the profit margin, the more profit a
company earns on each sale.
Since there are two types of profit (gross and net), there are two
types of profit margin calculations. Recall that gross profit is simply
164
the revenue minus the cost of goods sold (COGS). Net profit is the
gross profit minus all other expenses. The gross profit margin
calculation uses gross profit (Figure 3.5) and the net profit margin
calculation uses net profit (Figure 3.6). The difference between the
two is that the gross profit margin shows the relationship between
revenue and COGS, while the net profit margin shows the
percentage of the money spent by customers that is turned into
profit.
Companies need to have a positive profit margin in order to earn
income, although having a negative profit margin may be
advantageous in some instances (e.g. intentionally selling a new
product below cost in order to gain market share).
The profit margin is mostly used for internal comparison. It is
difficult to accurately compare the net profit ratio for different
entities. Individual businesses’ operating and financing
arrangements vary so much that different entities are bound to have
different levels of expenditure. Comparing one business’
arrangements with another has little meaning. A low profit margin
indicates a low margin of safety. There is a higher risk that a decline
in sales will erase profits and result in a net loss or a negative
margin.
Source: https://www.boundless.com/finance/analyzing-financial-
statements–2/profitability-ratios–2/profit-margin–2/
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165
The percentage of gross prot earned on the
company’s sales.
Figure 3.5 Gross Prot Margin
The percentage of net prot (gross prot minus all
other expenses) earned on a company’s sales.
Figure 3.6 Net Prot Margin
Return on Total Assets
The return on assets ratio (ROA) measures how
eectively assets are being used for generating prot.
KEY POINTS
• ROA is net income divided by total assets.
• The ROA is the product of two common ratios – profit margin
and asset
turnover.
• A higher ROA is better, but there is no metric for a good or
bad ROA. An ROA depends on the company, the industry and
the economic environment.
• ROA is based on the book value of assets, which can be
starkly different from the market value of assets.
Return on Assets
The return on assets ratio (ROA) is found by dividing net income
by total assets (Figure 3.7). The higher the ratio, the better the
company is at using their assets to generate income. ROA was
developed by DuPont to show how effectively assets are being used.
It is also a measure of how much the company relies on assets to
generate profit.
Components of ROA
ROA can be broken down into multiple parts (Figure 3.7). The ROA
is the product of two other common ratios – profit margin and asset
turnover. When profit margin and asset turnover are multiplied
together, the denominator of profit margin and the numerator of
asset turnover cancel each other out, returning us to the original
ratio of net income to total assets.
Profit margin is net income divided by sales, measuring the percent
of each dollar in sales that is profit for the company. Asset turnover
is sales divided by total assets. This ratio measures how much each
dollar in asset generates in sales. A higher ratio means that each
dollar in assets produces more for the company.
Limits of ROA
ROA does have some drawbacks. First, it gives no indication of how
the assets were financed. A company could have a high ROA, but
166
The return on assets ratio is net income divided by total assets. That can then be
broken down into the product of prot margins and asset turnover.
Figure 3.7 Return on Assets
still be in financial straits because all the assets were paid for
through leveraging. Second, the total assets are based on the
carrying value of the assets, not the market value. If there is a large
discrepancy between the carrying and market value of the assets,
the ratio could provide misleading numbers. Finally, there is no
metric to find a good or bad ROA. Companies that operate in capital
intensive industries will tend to have lower ROAs than those who do
not. The ROA is entirely contextual to the company, the industry
and the economic environment.
Source: https://www.boundless.com/finance/analyzing-financial-
statements–2/profitability-ratios–2/return-on-total-
assets–2/
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Basic Earning Power (BEP)
Ratio
The Basic Earning Power ratio (BEP) is Earnings Before
Interest and Taxes (EBIT) divided by Total Assets.
KEY POINTS
• The higher the BEP ratio, the more effective a company is at
generating income from its assets.
• Using EBIT instead of operating income means that the ratio
considers all income earned by the company, not just income
from operating activity. This gives a more complete picture of
how the company makes money.
• BEP is useful for comparing firms with different tax
situations and different degrees of financial leverage.
BEP Ratio
Another profitability ratio is the Basic Earning
Power ratio (BEP). The purpose of BEP is to
determine how effectively a firm uses its assets
to generate income.
The BEP ratio is simply EBIT divided by total
assets (Figure 3.8). The higher the BEP ratio,
167
BEP is calculated as
the ratio of Earnings
Before Interest and
Taxes to Total Assets.
Figure 3.8 Basic
Earnings Power Ratio
the more effective a company is at generating income from its
assets.
This may seem remarkably similar to the return on assets ratio
(ROA), which is operating income divided by total assets. EBIT, or
earnings before interest and taxes, is a measure of how much money
a company makes, but is not necessarily the same as operating
income:
EBIT = Revenue – Operating expenses+ Non-operating income
Operating income = Revenue – Operating expenses
The distinction between EBIT and Operating Income is non-
operating income. Since EBIT includes non-operating income (such
as dividends paid on the stock a company holds of another), it is a
more inclusive way to measure the actual income of a company.
However, in most cases, EBIT is relatively close to Operating
Income.
The advantage of using EBIT, and thus BEP, is that it allows for
more accurate comparisons of companies. BEP disregards different
tax situations and degrees of financial leverage while still providing
an idea of how good a company is at using its assets to generate
income.
BEP, like all profitability ratios, does not provide a complete picture
of which company is better or more attractive to investors. Investors
should favor a company with a higher BEP over a company with a
lower BEP because that means it extracts more value from its
assets, but they still need to consider how things like leverage and
tax rates affect the company.
Source: https://www.boundless.com/finance/analyzing-financial-
statements–2/profitability-ratios–2/basic-earning-power-bep-
ratio–2/
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168
Return on Common Equity
Return on equity (ROE) measures how eective a
company is at using its equity to generate income and
is calculated by dividing net prot by total equity.
KEY POINTS
• ROE is net income divided by total shareholders’ equity.
• ROE is also the product of return on assets (ROA) and
financial leverage.
• ROE shows how well a company uses investment funds to
generate earnings growth. There is no standard for a good or
bad ROE, but a higher ROE is better.
Return on Equity
Return on equity (ROE) is a financial ratio that measures how good
a company is at generating profit.
ROE is the ratio of net income to equity. From the fundamental
equation of accounting, we know that equity equals net assets
minus net liabilities. Equity is the amount of ownership interest in
the company, and is commonly referred to as shareholders’ equity,
shareholders’ funds, or shareholders’ capital.
In essence, ROE measures how efficient the company is at
generating profits from the funds invested in it. A company with a
high ROE does a good job of turning the capital invested in it into
profit, and a company with a low ROE does a bad job. However, like
many of the other ratios, there is no standard way to define a good
ROE or a bad ROE. Higher ratios are better, but what counts as
“good” varies by company, industry, and economic environment.
ROE can also be broken down into other components for easier use.
(Figure 3.9) ROE is the product of the net margin (profit margin),
asset turnover, and financial leverage. Also note that the product of
net margin and asset turnover is return on assets, so ROE is ROA
times financial leverage.
Breaking ROE into parts allows us to understand how and why it
changes over time. For example, if the net margin increases, every
sale brings in more money, resulting in a higher overall ROE.
Similarly, if the asset turnover increases, the firm generates more
sales for every unit of assets owned, again resulting in a higher
overall ROE. Finally, increasing financial leverage means that the
169
The return on equity is a ratio of net income to equity. It is a measure of how
eective the equity is at generating income.
Figure 3.9 Return on Equity
firm uses more debt financing relative to equity financing. Interest
payments to creditors are tax deductible, but dividend payments to
shareholders are not. Thus, a higher proportion of debt in the firm’s
capital structure leads to higher ROE. Financial leverage benefits
diminish as the risk of defaulting on interest payments increases. So
if the firm takes on too much debt, the cost of debt rises as creditors
demand a higher risk premium, and ROE decreases. Increased
debt will make a positive contribution to a firm’s ROE only if the
matching return on assets (ROA) of that debt exceeds the interest
rate on the debt.
Source: https://www.boundless.com/finance/analyzing-financial-
statements–2/profitability-ratios–2/return-on-common-equity–2/
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170
Inventory
Turnover Ratio
Days
Sales Outstanding
Fixed Assets Turnover Ratio
Total Assets Turnover Ratio
Section 4
Asset Management Ratios
171
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Inventory Turnover Ratio
Inventory turnover is a measure of the number of times
inventory is sold or used in a time period, such as a
year.
KEY POINTS
• Inventory turnover = Cost of goods sold/Average inventory.
• Average days to sell the inventory = 365 days /Inventory
turnover ratio.
• A low turnover rate may point to overstocking, obsolescence,
or deficiencies in the product line or marketing effort.
• Conversely, a high turnover rate may indicate inadequate
inventory levels, which may lead to a loss in business as the
inventory is too low.
Inventory Turnover
In accounting, the Inventory turnover is a measure of the number of
times inventory is sold or used in a time period, such as a year. The
equation for inventory turnover equals the cost of goods sold
divided by the average inventory. Inventory turnover is also known
as inventory turns, stockturn, stock turns, turns, and stock
turnover.
Inventory Turnover Equation
The formula for inventory turnover:
• Inventory turnover = Cost of goods sold/Average inventory
The formula for average inventory:
• Average inventory = (Beginning inventory + Ending
inventory)/2
The average days to sell the inventory is calculated as follows:
• Average days to sell the inventory = 365 days / Inventory
turnover ratio
Application in Business
A low turnover rate may point to overstocking, obsolescence, or
deficiencies in the product line or marketing effort. However, in
some instances a low rate may be appropriate, such as where higher
inventory levels occur in anticipation of rapidly rising prices or
expected market shortages (Figure 3.10).
Conversely, a high turnover rate may indicate inadequate inventory
levels, which may lead to a loss in business as the inventory is too
low. This often can result in stock shortages.
172
Some compilers of industry data (e.g., Dun & Bradstreet) use sales
as the numerator instead of cost of sales. Cost of sales yields a more
realistic turnover ratio, but it is often necessary to use sales for
purposes of comparative analysis. Cost of sales is considered to be
more realistic because of the difference in which sales and the cost
of sales are recorded. Sales are generally recorded at market value
(i.e., the value at which the marketplace paid for the good or service
provided by the firm). In the event that the firm had an exceptional
year and the market paid a premium for the firm’s goods and
services, then the numerator may be an inaccurate measure.
However, cost of sales is recorded by the firm at what the firm
actually paid for the materials available for sale. Additionally, firms
may reduce prices to generate sales in an effort to cycle inventory.
In this article, the terms “cost of sales” and “cost of goods sold” are
synonymous.
An item whose inventory is sold (turns over) once a year has a
higher holding cost than one that turns over twice, or three times,
or more in that time. Stock turnover also indicates the briskness of
the business. The purpose of increasing inventory turns is to reduce
inventory for three reasons.
1. Increasing inventory turns reduces holding cost. The
organization spends less money on rent, utilities, insurance,
theft, and other costs of maintaining a stock of good to be
sold.
2. Reducing holding cost increases net income and profitability
as long as the revenue from selling the item remains
constant.
3. Items that turn over more quickly increase responsiveness to
changes in customer requirements while allowing the
replacement of obsolete items. This is a major concern in
fashion industries.
When making comparison between firms, it’s important to take
note of the industry, or the comparison will be distorted. Making
comparison between a supermarket and a car dealer, will not be
appropriate, as a supermarket sells fast moving goods, such as
173
A low turnover rate
may point to
overstocking,
obsolescence, or
deciencies in the
product line or
marketing eort.
Figure 3.10
Inventory
sweets, chocolates, soft drinks, so the stock turnover will be higher.
However, a car dealer will have a low turnover due to the item being
a slow moving item. As such, only intra-industry comparison will be
appropriate.
Source: https://www.boundless.com/finance/analyzing-financial-
statements–2/asset-management-ratios–2/inventory-turnover-
ratio–2/
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Days Sales Outstanding
Days sales outstanding (also called DSO or days
receivables) is a calculation used by a company to
estimate their average collection period.
KEY POINTS
• Days sales outstanding is a financial ratio that illustrates how
well a company’s accounts receivables are being managed.
• DSO ratio = accounts receivable / average sales per day, or
DSO ratio = accounts receivable / (annual sales / 365 days).
• Generally speaking, higher DSO ratio can indicate a customer
base with credit problems and/or a company that is deficient
in its collections activity. A low ratio may indicate the firm’s
credit policy is too rigorous, which may be hampering sales.
Days Sales Outstanding
In accountancy, days sales outstanding (also called DSO or days
receivables) is a calculation used by a company to estimate their
average collection period. It is a financial ratio that illustrates
how well a company’s accounts receivables are being managed. The
days sales outstanding figure is an index of the relationship between
outstanding receivables and credit account sales achieved over a
given period.
174
Typically, days sales outstanding is calculated monthly. The days
sales outstanding analysis provides general information about the
number of days on average that customers take to pay invoices.
Generally speaking, though, higher DSO ratio can indicate a
customer base with credit problems and/or a company that is
deficient in its collections activity. A low ratio may indicate the
firm’s credit policy is too rigorous, which may be hampering sales.
Days sales outstanding is considered an important tool in
measuring liquidity. Days sales outstanding tends to increase as a
company becomes less risk averse. Higher days sales outstanding
can also be an indication of inadequate analysis of applicants for
open account credit terms. An increase in DSO can result in cash
flow problems, and may result in a decision to increase the creditor
company’s bad debt reserve (Figure 3.11).
A DSO ratio can be expressed as:
• DSO ratio = accounts receivable / average sales per day, or
• DSO ratio = accounts receivable / (annual sales / 365 days)
For purposes of this ratio, a year is considered to have 365 days.
Days sales outstanding can vary from month to month and over the
course of a year with a company’s seasonal business cycle. Of
interest, when analyzing the performance of a company, is the trend
in DSO. If DSO is getting longer, customers are taking longer to pay
their bills, which may be a warning that customers are dissatisfied
with the company’s product or service, or that sales are being made
to customers that are less credit worthy or that sales people have to
offer longer payment terms in order to generate sales. Many
financial reports will state Receivables Turnover defined as Net
Credit Account Sales / Trade Receivables; divide this value into the
time period in days to get DSO.
However, days sales outstanding is not the most accurate indication
of the efficiency of accounts receivable department. Changes in
175
A low ratio may
indicate the rm’s
credit policy is too
rigorous, which
may be hampering
sales.
Figure 3.11 Days
Sales Outstanding
sales volume influence the outcome of the days sales outstanding
calculation. For example, even if the overdue balance stays the
same, an increase of sales can result in a lower DSO. A better way to
measure the performance of credit and collection function is by
looking at the total overdue balance in proportion of the total
accounts receivable balance (total AR = Current + Overdue), which
is sometimes calculated using the days’ delinquent sales
outstanding (DDSO) formula.
Source: https://www.boundless.com/finance/analyzing-financial-
statements–2/asset-management-ratios–2/days-sales-
outstanding–2/
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Fixed Assets Turnover Ratio
Fixed-asset turnover is the ratio of sales to value of
xed assets, indicating how well the business uses
xed assets to generate sales.
KEY POINTS
• Fixed asset turnover = Net sales / Average net fixed assets.
• The higher the ratio, the better, because a high ratio indicates
the business has less money tied up in fixed assets for each
unit of currency of sales revenue. A declining ratio may
indicate that the business is over-invested in plant,
equipment, or
other fixed assets.
• Fixed assets, also known as a non-current asset or as
property, plant, and equipment (PP&E), is a term used in
accounting for assets and property that cannot easily be
converted into cash.
Fixed Assets
Fixed assets, also known as a non-current asset or as property,
plant, and equipment (PP&E), is a term used in accounting for
assets and property that cannot easily be converted into cash. This
can be compared with current assets, such as cash or bank accounts,
176
which are described as liquid assets. In most cases, only tangible
assets are referred to as fixed.
Moreover, a fixed/non-current asset also can be defined as an asset
not directly sold to a firm’s consumers/end-users. As an example, a
baking firm’s current assets would be its inventory (in this case,
flour, yeast, etc.), the value of sales owed to the firm via credit (i.e.,
debtors or accounts receivable), cash held in the bank, etc. Its non-
current assets would be the oven used to bake bread, motor vehicles
used to transport deliveries, cash registers used to handle cash
payments, etc. Each aforementioned non-current asset is not sold
directly to consumers.
These are items of value that the organization has bought and will
use for an extended period of time; fixed assets normally include
items, such as land and buildings, motor vehicles, furniture, office
equipment, computers, fixtures and fittings, and plant and
machinery. These often receive favorable tax treatment
(depreciation allowance) over short-term assets. According to
International Accounting Standard (IAS) 16, Fixed Assets are assets
which have future economic benefit that is probable to flow into the
entity and which have a cost that can be measured reliably.
The primary objective of a business entity is to make a profit and
increase the wealth of its owners. In the attainment of this objective,
it is required that the management will exercise due care and
diligence in applying the basic accounting concept of “Matching
Concept.” Matching concept is simply matching the expenses of a
period against the revenues of the same period.
The use of assets in the generation of revenue is usually more than a
year–that is long term. It is, therefore, obligatory that in order to
accurately determine the net income or profit for a period
depreciation, it is charged on the total value of asset that
contributed to the revenue for the period in consideration and
charge against the same revenue of the same period. This is
essential in the prudent reporting of the net revenue for the entity
in the period.
177
Turn tables
should help you
remember
turnover. Fixed-
asset turnover
indicates how
well the
business is
using its xed
assets to
generate sales.
Figure 3.12
Turn Tables
Fixed-asset Turnover
Fixed-asset turnover is the ratio of sales (on the profit and loss
account) to the value of fixed assets (on the balance sheet). It
indicates how well the business is using its fixed assets to generate
sales (Figure 3.12).
Fixed asset turnover = Net sales / Average net fixed assets
Generally speaking, the higher the ratio, the better, because a high
ratio indicates the business has less money tied up in fixed assets
for each unit of currency of sales revenue. A declining ratio may
indicate that the business is over-invested in plant, equipment, or
other fixed assets.
Source: https://www.boundless.com/finance/analyzing-financial-
statements–2/asset-management-ratios–2/fixed-assets-turnover-
ratio–2/
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Total Assets Turnover Ratio
Total asset turnover is a nancial ratio that measures
the eciency of a company’s use of its assets in
generating sales revenue.
KEY POINTS
• Total assets turnover = Net sales revenue / Average total
assets.
• Net sales are operating revenues earned by a company for
selling its products or rendering its services.
• Anything tangible or intangible that is capable of being
owned or controlled to produce value and that is held to have
positive economic value is considered an asset.
•
Companies with low profit margins tend to have high asset
turnover, while those with high profit margins have low asset
turnover.
Total assets turnover
This is a financial ratio that measures the efficiency of a company’s
use of its assets in generating sales revenue or sales income to the
company (Figure 3.13).
178
Companies with low profit margins tend to have high asset
turnover, while those with high profit margins have low asset
turnover. Companies in the retail industry tend to have a very high
turnover ratio due mainly to cut-throat and competitive pricing.
Total assets turnover = Net sales revenue / Average total assets
• “Sales” is the value of “Net Sales” or “Sales” from the
company’s income statement”.
• Average Total Assets” is the average of the values of “Total
assets” from the company’s balance sheet in the beginning
and the end of the fiscal period. It is calculated by adding up
the assets at the beginning of the period and the assets at the
end of the period, then dividing that number by two.
Net sales
• In bookkeeping, accounting, and finance, Net sales are
operating revenues earned by a company for selling its
products or rendering its services. Also referred to as revenue,
they are reported directly on the income statement as Sales or
Net sales.
• In financial ratios that use income statement sales values,
“sales” refers to net sales, not gross sales. Sales are the unique
transactions that occur in professional selling or during
marketing initiatives.
Total assets
In financial accounting, assets are economic resources. Anything
tangible or intangible that is capable of being owned or controlled to
produce value, and that is held to have positive economic value, is
considered an asset. Simply stated, assets represent value of
ownership that can be converted into cash (although cash itself is
also considered an asset).
The balance sheet of a firm records the monetary value of the assets
owned by the firm. It is money and other valuables belonging to an
individual or
business.
Two major asset classes are tangible assets and intangible assets.
179
Asset turnover
measures the
eciency of a
company’s use of
its assets in
generating sales
revenue or sales
income to the
company.
Figure 3.13 Assets
• Tangible assets contain various subclasses, including current
assets and fixed assets. Current assets include inventory,
while fixed assets include such items as buildings and
equipment.
• Intangible assets are non-physical resources and rights that
have a value to the firm because they give the firm some kind
of advantage in the market place.
EXAMPLE
Examples of intangible assets are goodwill, copyrights,
trademarks, patents, computer programs, and financial assets,
including such items as accounts receivable, bonds and stocks.
Source: https://www.boundless.com/finance/analyzing-financial-
statements–2/asset-management-ratios–2/total-assets-turnover-
ratio–2/
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180
Current Ratio
Quick, or Acid Test, Ratio
Section 5
Liquidity Ratios
181
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Current Ratio
Current ratio is a nancial ratio that measures whether
or not a rm has enough resources to pay its debts over
the
next 12 months.
KEY POINTS
• The liquidity ratio expresses a company’s ability to repay
short-term creditors out of its total cash. The liquidity ratio is
the result of dividing the total cash by short-term borrowings.
• The current ratio is a financial ratio that measures whether or
not a firm has enough resources to pay its debts over the next
12 months.
• Current ratio = current assets / current liabilities.
• Acceptable current ratios vary from industry to industry and
are generally between 1.5 and 3 for healthy businesses.
Liquidity Ratio
Liquidity ratio expresses a company’s ability to repay short-term
creditors out of its total cash. The liquidity ratio is the result of
dividing the total cash by short-term borrowings. It shows the
number of times short-term liabilities are covered by cash. If the
value is greater than 1.00, it means it is fully covered (Figure 3.14).
Liquidity ratio may refer to:
• Reserve requirement – a bank
regulation that sets the minimum
reserves each bank must hold.
• Acid Test – a ratio used to determine
the liquidity of a business entity.
The formula is the
following:
LR = liquid assets / short-term liabilities
Current Ratio
The current ratio is a financial ratio that measures whether or not a
firm has enough resources to pay its debts over the next 12 months.
It compares a firm’s current assets to its current liabilities. It is
expressed as follows:
Current ratio = current assets / current liabilities
• Current asset is an asset on the balance sheet that can either
be converted to cash or used to pay current liabilities within
12 months. Typical current assets include cash, cash
equivalents, short-term investments, accounts receivable,
inventory, and the portion of prepaid liabilities that will be
paid within a year.
182
A high liquidity means
the company has the
ability to meet its short
term obligations.
Figure 3.14 Liquidity
• Current liabilities are often understood as all liabilities of the
business that are to be settled in cash within the fiscal year or
the operating cycle of a given firm, whichever period is longer.
The current ratio is an indication of a firm’s market liquidity and
ability to meet creditor’s demands. Acceptable current ratios vary
from industry to industry and are generally between 1.5 and 3 for
healthy businesses. If a company’s current ratio is in this range,
then it generally indicates good short-term financial strength. If
current liabilities exceed current assets (the current ratio is below
1), then the company may have problems meeting its short-term
obligations. If the current ratio is too high, then the company may
not be efficiently using its current assets or its short-term financing
facilities. This may also indicate problems in working capital
management.
Low values for the current or quick ratios (values less than 1)
indicate that a firm may have difficulty meeting current obligations.
However, low values do not indicate a critical problem. If an
organization has good long-term prospects, it may be able to borrow
against those prospects to meet current obligations. Some types of
businesses usually operate with a current ratio less than one. For
example, if inventory turns over much more rapidly than the
accounts payable do, then the current ratio will be less than one.
This can allow a firm to operate with a low current ratio.
If all other things were equal, a creditor, who is expecting to be paid
in the next 12 months, would consider a high current ratio to be
better than a low current ratio. A high current ratio means that the
company is more likely to meet its liabilities which fall due in the
next 12 months.
Source: https://www.boundless.com/finance/analyzing-financial-
statements–2/liquidity-ratios–2/current-ratio–2/
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183
Quick, or Acid Test, Ratio
The Acid Test or Quick Ratio measures the ability of a
company to use its assets to retire its current liabilities
immediately.
KEY POINTS
• Quick Ratio = (Cash and cash equivalent + Marketable
securities +
Accounts receivable) / Current liabilities.
• Acid Test Ratio = (Current assets – Inventory) / Current
liabilities.
• Ideally, the acid test ratio should be 1:1 or higher, however
this varies widely by industry. In general, the higher the ratio,
the greater the company’s liquidity.
Quick ratio
In finance, the Acid-test (also known as quick ratio or liquid ratio)
measures the ability of a company to use its near cash or quick
assets to extinguish or retire its current liabilities immediately.
Quick assets include those current assets that presumably can be
quickly converted to cash at close to their book values. A company
with a Quick Ratio of less than 1 cannot pay back its current
liabilities.
Quick Ratio = (Cash and cash equivalent + Marketable securities +
Accounts receivable) / Current liabilities.
Cash and cash equivalents are the most liquid assets found within
the asset portion of a company’s balance sheet. Cash equivalents are
assets that are readily convertible into cash, such as money market
holdings, short-term government bonds or Treasury bills,
marketable securities, and commercial paper. Cash equivalents are
distinguished from other investments through their short-term
existence. They mature within 3 months, whereas short-term
investments are 12 months or less and long-term investments are
any investments that mature in excess of 12 months. Another
important condition that cash equivalents need to satisfy, is the
184
Cash is the most liquid
asset in a business.
Figure 3.15 Cash
investment should have insignificant risk of change in value. Thus,
common stock cannot be considered a cash equivalent, but
preferred stock acquired shortly before its redemption date can be
(Figure 3.15).
Acid test ratio
Acid test often refers to Cash ratio instead of Quick ratio: Acid Test
Ratio = (Current assets – Inventory) / Current liabilities.
Note that Inventory is excluded from the sum of assets in the Quick
Ratio, but included in the Current Ratio. Ratios are tests of viability
for business entities but do not give a complete picture of the
business’ health. A business with large Accounts Receivable that
won’t be paid for a long period (say 120 days), and essential
business expenses and Accounts Payable that are due immediately,
the Quick Ratio may look healthy when the business could actually
run out of cash. In contrast, if the business has negotiated fast
payment or cash from customers, and long terms from suppliers, it
may have a very low Quick Ratio and yet be very healthy.
The acid test ratio should be 1:1 or higher, however this varies
widely by industry. The higher the ratio, the greater the company’s
liquidity will be (better able to meet current obligations using liquid
assets).
Source: https://www.boundless.com/finance/analyzing-financial-
statements–2/liquidity-ratios–2/quick-or-acid-test-ratio–2/
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185
Total Debt to Total Assets
Times-Interest-Earned Ratio
Section 6
Debt Management Ratios
186
https://www.boundless.com/nance/analyzing-nancial-statements–2/debt-management-ratios–2/
Total Debt to Total Assets
The debt ratio is expressed as Total debt / Total assets.
KEY POINTS
• The debt ratio measures the firm’s ability to repay long-term
debt by indicating the percentage of a company’s assets that
are provided via debt.
• Debt ratio = Total debt / Total assets.
• The higher the ratio, the greater risk will be associated with
the firm’s operation.
Financial Ratios
Financial ratios quantify many aspects of a business and are an
integral part of the financial statement analysis. Financial ratios are
categorized according to the financial aspect of the business which
the ratio measures.
Financial ratios allow for comparisons:
• Between companies
• Between industries
• Between different time periods for one company
• Between a single company and its industry average
Ratios generally are not useful unless they are benchmarked against
something else, like past performance or another company. Thus,
the ratios of firms in different industries, which face different risks,
capital requirements, and competition, are usually hard to compare.
Debt ratios
Debt ratios measure the firm’s ability to repay long-term debt. It is a
financial ratio that indicates the percentage of a company’s assets
that are provided via debt. It is the ratio of total debt (the sum of
current liabilities and long-term liabilities) and total assets (the sum
of current assets, fixed assets, and other assets such as ‘goodwill’)
(Figure 3.16).
• Debt ratio = Total debt / Total assets
187
Debt ratio is an
index of a business
operation.
Figure 3.16 Debt
Or alternatively:
• Debt ratio = Total liability / Total assets
The higher the ratio, the greater risk will be associated with the
firm’s operation. In addition, high debt to assets ratio may indicate
low borrowing capacity of a firm, which in turn will lower the firm’s
financial flexibility. Like all financial ratios, a company’s debt ratio
should be compared with their industry average or other competing
firms.
Total liabilities divided by total assets. The debt/asset ratio shows
the proportion of a company’s assets which are financed through
debt. If the ratio is less than 0.5, most of the company’s assets are
financed through equity. If the ratio is greater than 0.5, most of the
company’s assets are financed through debt. Companies with high
debt/asset ratios are said to be “highly leveraged,” not highly liquid
as stated above. A company with a high debt ratio (highly leveraged)
could be in danger if creditors start to demand repayment of debt.
EXAMPLE
For example, a company with 2 million in total assets and
500,000 in total liabilities would have a debt ratio of 25%.
Source: https://www.boundless.com/finance/analyzing-financial-
statements–2/debt-management-ratios–2/total-debt-to-total-
assets–2/
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188
Times-Interest-Earned Ratio
Times Interest Earned ratio (EBIT or EBITDA divided by
total interest payable) measures a company’s ability to
honor its debt payments.
KEY POINTS
• Times interest earned (TIE) or Interest Coverage ratio is a
measure of a company’s ability to honor its debt payments. It
may be calculated as either EBIT or EBITDA divided by the
total interest payable.
• Interest Charges = Traditionally “charges” refers to interest
expense found on the income statement.
• EBIT = Revenue – Operating expenses (OPEX) + Non-
operating income.
• EBITDA = Earnings before interest, taxes, depreciation and
amortization.
• Times Interest Earned or Interest Coverage is a great tool
when measuring a company’s ability to meet its debt
obligations.
Times interest earned (TIE), or interest coverage ratio, is a measure
of a company’s ability to honor its debt payments. It may be
calculated as either EBIT or EBITDA, divided by the total interest
payable.
Times-Interest-Earned = EBIT or EBITDA / Interest charges
(Figure 3.17)
Times-Interest-Earned = EBIT or EBITDA / Interest charges
• Interest Charges = Traditionally “charges” refers to interest
expense found on the income statement.
• EBIT = Earnings Before Interest and Taxes, also called
operating profit or operating income. EBIT is a measure of a
firm’s profit that excludes interest and income tax expenses. It
is the difference between operating revenues and operating
expenses. When a firm does not have non-operating income,
then operating income is sometimes used as a synonym for
EBIT and operating profit.
189
Times Interest Earned
ratio indicates the ability
of a company to cover
its interest expenses
using EBIT.
Figure 3.17 Interest
• EBIT = Revenue – Operating Expenses (OPEX) + Non-
operating income.
• Operating income = Revenue – Operating expenses.
• EBITDA = Earnings Before Interest, Taxes, Depreciation and
Amortization. The EBITDA of a company provides insight on
the operational of the business. It shows the profitability of a
company regarding its present assets and operations with the
products it produces and sells, taking into account possible
provisions that need to be done.
If EBITDA is negative, then the business has serious issues. A
positive EBITDA, however, does not automatically imply that the
business generates cash. EBITDA ignores changes in Working
Capital (usually needed when growing a business), capital
expenditures (needed to replace assets that have broken down),
taxes, and interest.
Times Interest Earned or Interest Coverage is a great tool when
measuring a company’s ability to meet its debt obligations. When
the interest coverage ratio is smaller than 1, the company is not
generating enough cash from its operations EBIT to meet its
interest obligations. The Company would then have to either use
cash on hand to make up the difference or borrow funds. Typically,
it is a warning sign when interest coverage falls below 2.5x.
Source: https://www.boundless.com/finance/analyzing-financial-
statements–2/debt-management-ratios–2/times-interest-earned-
ratio–2/
CC-BY-SA
Boundless is an openly licensed educational resource
190
Price/Earnings Ratio
Market/Book Ratio
Section 7
Market Value Ratios
191
https://www.boundless.com/nance/analyzing-nancial-statements–2/market-value-ratios–2/
Price/Earnings Ratio
Price to earnings ratio (market price per share / annual
earnings per share) is used as a guide to the relative
values of companies.
KEY POINTS
• P/E ratio = Market price per share / Annual earnings per
share.
• The P/E ratio is a widely used valuation multiple used as a
guide to the relative values of companies; for example, a
higher P/E ratio means that investors are paying more for
each unit of current net income, so the stock is more
expensive than one with a lower P/E ratio.
• Different types of P/E include: trailing P/E or P/E ttm,
trailing P/E from continued operations, and forward P/E or
P/Ef.
Price/Earnings Ratio
In stock trading, the price-to-earnings ratio of a share (also called
its P/E, or simply “multiple”) is the market price of that share
divided by the annual earnings per share (EPS).
The P/E ratio is a widely used valuation multiple used as a guide to
the relative values of companies; a higher P/E ratio means that
investors are paying more for each unit of current net income, so
the stock is more “expensive” than one with a lower P/E ratio. The
P/E ratio can be regarded as being expressed in years. The price is
in currency per share, while earnings are in currency per share per
year, so the P/E ratio shows the number of years of earnings that
would be required to pay back the purchase price, ignoring
inflation, earnings growth, and the time value of money.
P/E ratio = Market price per share / Annual earnings per share
(Figure 3.18)
The price per share in the numerator is the market price of a single
share of the stock. The earnings per share in the denominator may
192
P/E ratio = market
price per share/
annual earning per
share
Figure 3.18 Price
to Earnings Ratio
vary depending on the type of P/E. The types of P/E include the
following:
• Trailing P/E or P/E ttm: Here, earning per share is the net
income of the company for the most recent 12 month period,
divided by the weighted average number of common shares in
issue during the period. This is the most common meaning of
P/E if no other qualifier is specified. Monthly earnings data
for individual companies are not available, and usually
fluctuate seasonally, so the previous four quarterly earnings
reports are used, and earnings per share are updated
quarterly. Note, each company chooses its own financial year
so the timing of updates will vary from one to another.
• Trailing P/E from continued operations: Instead of net
income, this uses operating earnings, which exclude earnings
from discontinued operations, extraordinary items (e.g. one-
off windfalls and write-downs), and accounting changes.
Longer-term P/E data, such as Shiller’s, use net
earnings.
• Forward P/E, P/Ef, or estimated P/E: Instead of net income,
this uses estimated net earnings over the next 12 months.
Estimates are typically derived as the mean of those published
by a select group of analysts (selection criteria are rarely
cited). In times of rapid economic dislocation, such estimates
become less relevant as the situation changes (e.g. new
economic data is published, and/or the basis of forecasts
becomes obsolete) more quickly than analysts adjust their
forecasts.
By comparing price and earnings per share for a company, one can
analyze the market’s stock valuation of a company and its shares
relative to the income the company is actually generating. Stocks
with higher (or more certain) forecast earnings growth will usually
have a higher P/E, and those expected to have lower (or riskier)
earnings growth will usually have a lower P/E. Investors can use the
P/E ratio to compare the value of stocks; for example, if one stock
has a P/E twice that of another stock, all things being equal
(especially the earnings growth rate), it is a less attractive
investment. Companies are rarely equal, however, and comparisons
between industries, companies, and time periods may be
misleading. P/E ratio in general is useful for comparing valuation of
peer companies in a similar sector or group.
The P/E ratio of a company is a significant focus for management in
many companies and industries. Managers have strong incentives
to increase stock prices, firstly as part of their fiduciary
responsibilities to their companies and shareholders, but also
because their performance based remuneration is usually paid in
the form of company stock or options on their company’s stock (a
form of payment that is supposed to align the interests of
management with the interests of other stock holders). The stock
193
price can increase in one of two ways: either through improved
earnings, or through an improved multiple that the market assigns
to those earnings. In turn, the primary driver for multiples such as
the P/E ratio is through higher and more sustained earnings growth
rates.
Companies with high P/E ratios but volatile earnings may be
tempted to find ways to smooth earnings and diversify risk; this is
the theory behind building conglomerates. Conversely, companies
with low P/E ratios may be tempted to acquire small high growth
businesses in an effort to “rebrand” their portfolio of activities and
burnish their image as growth stocks and thus obtain a higher P/E
rating.
EXAMPLE
As an example, if stock A is trading at 24 and the earnings per
share for the most recent 12 month period is three, then stock
A has a P/E ratio of 24/3, or eight.
Source: https://www.boundless.com/finance/analyzing-financial-
statements–2/market-value-ratios–2/price-earnings-ratio–2/
CC-BY-SA
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Market/Book Ratio
The price-to-book ratio is a nancial ratio used to
compare a company’s current market price to its book
value.
KEY POINTS
• The calculation can be performed in two ways: 1) the
company’s market capitalization can be divided by the
company’s total book value from its balance sheet, 2) using
per-share values, is to divide the company’s current share
price by the book value per share.
• A higher P/B ratio implies that investors expect management
to create more value from a given set of assets, all else equal.
• Technically, P/B can be calculated either including or
excluding intangible assets and goodwill.
Price/Book Ratio
The price-to-book ratio, or P/B ratio, is a financial ratio used to
compare a company’s current market price to its book value. The
calculation can be performed in two ways, but the result should be
the same either way.
In the first way, the company’smarket capitalization can be
divided by the company’s total book value from its balance sheet.
194
• Market Capitalization / Total Book Value
The second way, using per-share values, is to divide the company’s
current share price by the book value per share (i.e. its book value
divided by the number of outstanding shares).
• Share price / Book value per share
As with most ratios, it varies a fair amount by industry. Industries
that require more infrastructure capital (for each dollar of profit)
will usually trade at P/B ratios much lower than, for example,
consulting firms. P/B ratios are commonly used to compare banks,
because most assets and liabilities of banks are constantly valued at
market values.
A higher P/B ratio implies that investors expect management to
create more value from a given set of assets, all else equal (and/or
that the market value of the firm’s assets is significantly higher than
their accounting value). P/B ratios do not, however, directly provide
any information on the ability of the firm to generate profits or cash
for shareholders. (Figure 3.19)
This ratio also gives some idea of whether an investor is paying too
much for what would be left if the company went bankrupt
immediately. For companies in distress, the book value is usually
calculated without the intangible assets that would have no resale
value. In such cases, P/B should also be calculated on a “diluted”
basis, because stock options may well vest on the sale of the
company, change of control, or firing of management.
It is also known as the market-to-book ratio and the price-to-equity
ratio (which should not be confused with the price-to-earnings
ratio), and its inverse is called the book-to-market ratio.
Total Book Value vs Tangible Book Value
Technically, P/B can be calculated either including or excluding
intangible assets and goodwill. When intangible assets and goodwill
195
A higher P/B ratio implies that investors expect management to create more value.
Figure 3.19 S&P P/B ratio
are excluded, the ratio is often specified to be “price to tangible
book value” or “price to tangible book”.
Source: https://www.boundless.com/finance/analyzing-financial-
statements–2/market-value-ratios–2/market-book-ratio–2/
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196
The DuPont Equation
ROE and Potential Limitations
Assessing
Internal Growth and Sustainability
Dividend Payments and Earnings Retention
Relationships between
ROA, ROE, and Growth
Section 8
The DuPont Equation, ROE, ROA, and
Growth
197
https://www.boundless.com/nance/analyzing-nancial-statements–2/the-dupont-equation-roe-roa-and-growth/
The DuPont Equation
The DuPont equation is an expression which breaks
return on equity down into three parts: prot margin,
asset turnover, and leverage.
KEY POINTS
• By splitting ROE into three parts, companies can more easily
understand changes in their returns on equity
over time.
• As profit margin increases, every sale will bring more money
to a company’s bottom line, resulting in a higher overall
return on equity.
• As asset turnover increases, a company will generate more
sales per asset owned, resulting in a higher overall return on
equity.
• Increased financial leverage will also lead to an increase in
return on equity, since using more debt financing brings on
higher interest payments, which are tax deductible.
The DuPont Equation
The DuPont equation is an expression which breaks return on
equity down into three parts. The name comes from the DuPont
Corporation, which created and implemented this formula into
their business operations in the 1920s. This formula is known by
many other names, including DuPont analysis, DuPont identity, the
DuPont model, the DuPont method, or the strategic profit model
(Figure 3.20).
Under DuPont analysis, return on equity is equal to the profit
margin multiplied by asset turnover multiplied by financial
leverage. By splitting ROE (return on equity) into three parts,
companies can more easily understand changes in their ROE over
time (Figure 3.21).
198
A ow chart representation of the DuPont Model.
Figure 3.20 DuPont Model
Components of the DuPont Equation: Profit Margin
Profit margin is a measure of profitability. It is an indicator of a
company’s pricing strategies and how well the company controls
costs. Profit margin is calculated by finding the net profit as a
percentage of the total revenue. As one feature of the DuPont
equation, if the profit margin of a company increases, every sale will
bring more money to a company’s bottom line, resulting in a higher
overall return on equity.
Components of the DuPont Equation: Asset Turnover
Asset turnover is a financial ratio that measures how efficiently a
company uses its assets to generate sales revenue or sales income
for the company. Companies with low profit margins tend to have
high asset turnover, while those with high profit margins tend to
have low asset turnover. Similar to profit margin, if asset turnover
increases, a company will generate more sales per asset owned,
once again resulting in a higher overall return on equity.
Components of the DuPont Equation: Financial Leverage
Financial leverage refers to the amount of debt that a company
utilizes to finance its operations, as compared with the amount of
equity that the company utilizes. As was the case with asset
turnover and profit margin, Increased financial leverage will also
lead to an increase in return on equity. This is because the increased
use of debt as financing will cause a company to have higher
interest payments, which are tax deductible. Because dividend
payments are not tax deductible, maintaining a high proportion of
debt in a company’s capital structure leads to a higher return on
equity.
The DuPont Equation in Relation to Industries
The DuPont equation is less useful for some industries, that do not
use certain concepts or for which the concepts are less meaningful.
On the other hand, some industries may rely on a single factor of
the DuPont equation more than others. Thus, the equation allows
analysts to determine which of the factors is dominant in relation to
a company’s return on equity. For example, certain types of high
turnover industries, such as retail stores, may have very low profit
margins on sales and relatively low financial leverage. In industries
such as these, the measure of asset turnover is much more
important.
199
In the DuPont equation, ROE is equal to prot margin multiplied by asset turnover
multiplied by nancial leverage.
Figure 3.21 The DuPont Equation
High margin industries, on the other hand, such as fashion, may
derive a substantial portion of their competitive advantage from
selling at a higher margin. For high end fashion and other luxury
brands, increasing sales without sacrificing margin may be critical.
Finally, some industries, such as those in the financial sector,
chiefly rely on high leverage to generate an acceptable return on
equity. While a high level of leverage could be seen as too risky from
some perspectives, DuPont analysis enables third parties to
compare that leverage with other financial elements that can
determine a company’s return on equity.
EXAMPLE
A company has sales of 1,000,000. It has a net income of
400,000. Total assets have a value of 5,000,000, and
shareholder equity has a value of 10,000,000. Using DuPont
analysis, what is the company’s return on equity? Profit
Margin = 400,000/1,000,000 = 40%. Asset Turnover =
1,000,000/5,000,000 = 20%. Financial Leverage =
5,000,000/10,000,000 = 50%. Multiplying these three
results, we find that the Return on Equity = 4%.
Source: https://www.boundless.com/finance/analyzing-financial-
statements–2/the-dupont-equation-roe-roa-and-growth/the-dupont-
equation/
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200
ROE and Potential
Limitations
Return on equity measures the rate of return on the
ownership interest of a business and is irrelevant if
earnings are not reinvested or distributed.
KEY POINTS
• Return on equity is an indication of how well a company uses
investment funds to generate earnings growth.
• Returns on equity between 15% and 20% are generally
considered to be acceptable.
• Return on equity is equal to net income (after preferred stock
dividends but before common stock dividends) divided by
total shareholder equity (excluding preferred shares).
• Stock prices are most strongly determined by earnings per
share (EPS) as opposed to return on equity.
Return On Equity
Return on equity (ROE) measures the rate of return on the
ownership interest or shareholders’ equity of the common stock
owners. It is a measure of a company’s efficiency at generating
profits using the shareholders’ stake of equity in the business. In
other words, return on equity is an indication of how well a
company uses investment funds to generate earnings growth. It is
also commonly used as a target for executive compensation, since
ratios such as ROE tend to give management an incentive to
perform better. Returns on equity between 15% and 20% are
generally considered to be acceptable.
The Formula
Return on equity is equal to net income, after preferred stock
dividends but before common stock dividends, divided by total
shareholder equity and excluding preferred shares (Figure 3.22).
Expressed as a percentage, return on equity is best used to compare
companies in the same industry. The decomposition of return on
equity into its various factors presents various ratios useful to
companies in fundamental analysis (Figure 3.23).
201
ROE is equal to after-tax net
income divided by total
shareholder equity.
Figure 3.22 Return On Equity
This is an expression of return on equity decomposed into its various factors.
Figure 3.23 ROE Broken Down
The practice of decomposing return on equity is sometimes referred
to as the “DuPont System.”
Potential Limitations of ROE
Just because a high return on equity is calculated does not mean
that a company will see immediate benefits. Stock prices are most
strongly determined by earnings per share (EPS) as opposed to
return on equity. Earnings per share is the amount of earnings per
each outstanding share of a company’s stock. EPS is equal to profit
divided by the weighted average of common shares (Figure 3.24).
The true benefit of a high return on equity comes from a company’s
earnings being reinvested into the business or distributed as a
dividend. In fact, return on equity is presumably irrelevant if
earnings are not reinvested or distributed.
EXAMPLE
A small business’ net income after taxes is $10,000. The total
shareholder equity in the business is $50,000. What is the
return on equity? ROE = 10,000/50,000 ROE = 20%
Source: https://www.boundless.com/finance/analyzing-financial-
statements–2/the-dupont-equation-roe-roa-and-growth/roe-and-
potential-limitations–2/
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202
EPS is equal to prot divided by the weighted average of common shares.
Figure 3.24 Earnings Per Share
Assessing Internal Growth
and Sustainability
Sustainable— as opposed to internal— growth gives a
company a better idea of its growth rate while keeping
in line with nancial policy.
KEY POINTS
• The internal growth rate is a formula for calculating the
maximum growth rate a firm can achieve without resorting to
external financing.
• Sustainable growth is defined as the annual percentage of
increase in sales that is consistent with a defined financial
policy.
•
Another measure of growth, the optimal growth rate, assesses
sustainable growth from a total shareholder return creation
and profitability perspective, independent of a given financial
strategy.
Internal Growth and Sustainability
The true benefit of a high return on equity arises when retained
earnings are reinvested into the company’s operations. Such
reinvestment should, in turn, lead to a high rate of growth for the
company. The internal growth rate is a formula for calculating
maximum growth rate that a firm can achieve without resorting to
external financing. It’s essentially the growth that a firm can supply
by reinvesting its earnings (Figure 3.26).
We find the internal growth rate by dividing net income by the
amount of total assets (or finding return on assets) and subtracting
the rate of earnings retention. However, growth is not necessarily
favorable. Expansion may strain managers’ capacity to monitor and
handle the company’s operations. Therefore, a more commonly
used measure is the sustainable growth
rate.
Sustainable growth is defined as the annual percentage of increase
in sales that is consistent with a defined financial policy, such as
target debt to equity ratio, target dividend payout ratio, target
profit margin, or target ratio of total assets to net sales (Figure 3.
25).
203
The internal growth rate is equal to return on assets minus the retention
rate.
Figure 3.26 Internal Growth Rate
The sustainable growth rate is equal to return on equity minus retention rate.
Figure 3.25 Sustainable Growth Rate
We find the sustainable growth rate by dividing net income by
shareholder equity (or finding return on equity) and subtracting the
rate of earnings retention. While the internal growth rate assumes
no financing, the sustainable growth rate assumes you will make
some use of outside financing that will be consistent with whatever
financial policy being followed. In fact, in order to achieve a higher
growth rate, the company would have to invest more equity capital,
increase its financial leverage, or increase the target profit margin.
Optimal Growth Rate
Another measure of growth, the optimal growth rate, assesses
sustainable growth from a total shareholder return creation and
profitability perspective, independent of a given financial strategy.
The concept of optimal growth rate was originally studied by Martin
Handschuh, Hannes Lösch, and Björn Heyden. Their study was
based on assessments on the performance of more than 3,500
stock-listed companies with an initial revenue of greater than 250
million Euro globally, across industries, over a period of 12 years
from 1997 to 2009 (Figure 3.27).
Due to the span of time included in the study, the authors
considered their findings to be, for the most part, independent of
specific economic cycles. The study found that return on assets,
return on sales and return on equity do in fact rise with increasing
revenue growth of between 10% to 25%, and then fall with further
increasing revenue growth rates. Furthermore, the authors
attributed this profitability increase to the following facts:
1. Companies with substantial profitability have the
opportunity to invest more in additional growth, and
2. Substantial growth may be a driver for additional
profitability, whether by attracting high performing young
professionals, providing motivation for current employees,
204
ROA, ROS and ROE tend to rise with revenue growth to a certain extent.
Figure 3.27 Revenue Growth and Protability
attracting better business partners, or simply leading to more
self-confidence.
However, according to the study, growth rates beyond the
“profitability maximum” rate could bring about circumstances that
reduce overall profitability because of the efforts necessary to
handle additional growth (i.e., integrating new staff, controlling
quality, etc).
EXAMPLE
A company’s net income is 750,000 and its total shareholder
equity is 5,000,000. Its earnings retention rate is 80%. What
is its sustainable growth rate? Sustainable Growth Rate =
(750,000/5,000,000) x (1-0.80). Sustainable Growth Rate =
3%
Source: https://www.boundless.com/finance/analyzing-financial-
statements–2/the-dupont-equation-roe-roa-and-growth/assessing-
internal-growth-and-sustainability–2/
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Dividend Payments and
Earnings Retention
The dividend payout and retention ratios oer insight
into how much of a rm’s prot is distributed to
shareholders versus retained.
KEY POINTS
• Many corporations retain a portion of their earnings and pay
the remainder as a dividend.
• Dividends are usually paid in the form of cash, store credits,
or shares in the company.
• Cash dividends are a form of investment income and are
usually taxable to the recipient in the year that they are paid.
• Dividend payout ratio is the fraction of net income a firm
pays to its stockholders in dividends.
• Retained earnings can be expressed in the retention ratio.
Dividend Payments and Earnings Retention
Dividends are payments made by a corporation to its shareholder
members. It is the portion of corporate profits paid out to
stockholders. On the other hand, retained earnings refers to the
portion of net income which is retained by the corporation rather
205
than distributed to its owners as dividends. Similarly, if the
corporation takes a loss, then that loss is retained and called
variously retained losses, accumulated losses or accumulated
deficit. Retained earnings and losses are cumulative from year to
year with losses offsetting earnings. Many corporations retain a
portion of their earnings and pay the remainder as a dividend.
A dividend is allocated as a fixed amount per share. Therefore, a
shareholder receives a dividend in proportion to their shareholding.
Retained earnings are shown in the shareholder equity section in
the company’s balance sheet–the same as its issued share capital.
Public companies usually pay dividends on a fixed schedule, but
may declare a dividend at any time, sometimes called a “special
dividend” to distinguish it from the fixed schedule dividends.
Dividends are usually paid in the form of cash, store credits
(common among retail consumers’ cooperatives), or shares in the
company (either newly created shares or existing shares bought in
the market). Further, many public companies offer dividend
reinvestment plans, which automatically use the cash dividend to
purchase additional shares for the shareholder.
Cash dividends (most common) are those paid out in currency,
usually via electronic funds transfer or a printed paper check. Such
dividends are a form of investment income and are usually taxable
to the recipient in the year they are paid. This is the most common
method of sharing corporate profits with the shareholders of the
company. For each share owned, a declared amount of money is
distributed. Thus, if a person owns 100 shares and the cash
dividend is $0.50 per share, the holder of the stock will be paid $50.
Dividends paid are not classified as an expense but rather a
deduction of retained earnings. Dividends paid do not show up on
an income statement but do appear on the balance sheet
(Figure 3.28).
Stock dividends are those paid out in the form of additional stock
shares of the issuing corporation or another corporation (such as its
subsidiary corporation). They are usually issued in proportion to
shares owned (for example, for every 100 shares of stock owned, a
5% stock dividend will yield five extra shares). If the payment
involves the issue of new shares, it is similar to a stock split in that it
increases the total number of shares while lowering the price of
each share without changing the market capitalization, or total
value, of the shares held.
206
The dividend payout ratio is equal to dividend payments divided by net income
for the same period.
Figure 3.28 Dividend Payout Ratio
Dividend Payout and Retention Ratios
Dividend payout ratio is the fraction of net income a firm pays to its
stockholders in dividends:
The part of the earnings not paid to investors is left for investment
to provide for future earnings growth. These retained earnings can
be expressed in the retention ratio. Retention ratio can be found by
subtracting the dividend payout ratio from one, or by dividing
retained earnings by net income (Figure 3.29).
Source: https://www.boundless.com/finance/analyzing-financial-
statements–2/the-dupont-equation-roe-roa-and-growth/dividend-
payments-and-earnings-retention–2/
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207
Retained earnings can be found on
the balance sheet, under the
owners’ (or shareholders’) equity
section.
Figure 3.29 Example Balance Sheet
Relationships between ROA,
ROE, and Growth
Return on assets is a component of return on equity,
both of which can be used to calculate a company’s
rate of growth.
KEY POINTS
• Return on equity measures the rate of return on the
shareholders’ equity of common stockholders.
• Return on assets shows how profitable a company’s assets are
in generating revenue.
• In other words, return on assets makes up two-thirds of the
DuPont equation measuring return on equity.
• Capital intensity is the term for the amount of fixed or real
capital present in relation to other factors of production.
Rising capital intensity pushes up the productivity of labor.
Return On Assets Versus Return On Equity
In review, return on equity measures the rate of return on the
ownership interest (shareholders’ equity) of common stockholders.
Therefore, it shows how well a company uses investment funds to
generate earnings growth. Return on assets shows how profitable a
company’s assets are in generating revenue. Return on assets is
equal to net income divided by total assets (Figure 3.30).
This percentage shows what the company can do with what it has
(i.e., how many dollars of earnings they derive from each dollar of
assets they control). This is in contrast to return on equity, which
measures a firm’s efficiency at generating profits from every unit of
shareholders’ equity. Return on assets is, however, a vital
component of return on equity, being an indicator of how profitable
a company is before leverage is considered. In other words, return
on assets makes up two-thirds of the DuPont equation measuring
return on equity.
ROA, ROE, and Growth
In terms of growth rates, we use the value known as return on
assets to determine a company’s internal growth rate. This is the
maximum growth rate a firm can achieve without restoring to
external financing. We use the value for return on equity, however,
in determining a company’s sustainable growth rate, which is the
maximum growth rate a firm can achieve without issuing new
equity or changing its debt-to-equity ratio.
208
Return on assets is equal to net
income divided by total assets.
Figure 3.30 Return On Assets
Capital Intensity and Growth
Return on assets gives us an indication of the capital intensity of the
company. “Capital intensity” is the term for the amount of fixed or
real capital present in relation to other factors of production,
especially labor. The use of tools and machinery makes labor more
effective, so rising capital intensity pushes up the productivity of
labor. While companies that require large initial investments will
generally have lower return on assets, it is possible that increased
productivity will provide a higher growth rate for the company.
Capital intensity can be stated quantitatively as the ratio of the
total money value of capital equipment to the total potential output.
However, when we adjust capital intensity for real market
situations, such as the discounting of future cash flows, we find
that it is not independent of the distribution of income. In other
words, changes in the retention or dividend payout ratios can lead
to changes in measured capital intensity.
EXAMPLE
A company has net income of 500,000. It has total assets
valued at 3,000,000. Its retention rate is 80%, and its
shareholder equity is equal to $1,500,000. What is the
company’s ROA and internal growth rate? What is the
company’s ROE and sustainable growth rate? ROA =
500,000/3,000,000 = 17% Internal growth rate = 17% x 80%
= 13% ROE = 17% x (3,000,000/1,500,000) = 34%
Sustainable growth rate = 34% x 80% = 27.2%
Source: https://www.boundless.com/finance/analyzing-financial-
statements–2/the-dupont-equation-roe-roa-and-growth/
relationships-between-roa-roe-and-growth–2/
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209
Evaluating Financial Statements
Industry Comparisons
Benchmarking
Trend Analysis
Limitations of Financial Statement Analysis
Section 9
Using Financial Ratios for Analysis
210
https://www.boundless.com/nance/analyzing-nancial-statements–2/using-nancial-ratios-for-analysis–2/
Evaluating Financial
Statements
With a few exceptions, the majority of the data used in
ratio analysis comes from evaluation of the nancial
statements.
KEY POINTS
• Ratio analysis is a tool for evaluating financial statements but
also relies on the numbers in the reported financial
statements being put into order to be used for comparison.
With a few exceptions, the majority of the data used in ratio
analysis comes from the
financial statements.
•
Prior to the calculation of financial ratios, reported financial
statements are often reformulated and adjusted by analysts to
make the financial ratios more meaningful as comparisons
across time or
across companies.
• In terms of reformulation, earnings might be separated into
recurring and non-recurring items. In terms of adjustment of
financial statements, analysts may adjust earnings numbers
up or down when they suspect the reported data is inaccurate
due to issues like earnings management.
Ratio analysis is a tool for evaluating financial statements but also
relies on the numbers in the reported financial statements being put
into order (Figure 3.31)
to be used as ratios for
comparison over time or
across companies.
Financial statements are
used as a way to discover
the financial position and financial results of a business. With a few
exceptions, such as ratios involving stock price, the majority of the
data used in ratio analysis comes from the financial statements.
Ratios put this financial statement information in context.
Prior to the calculation of financial ratios, reported financial
statements are often reformulated and adjusted by analysts to make
the financial ratios more meaningful as comparisons across time or
across companies. In terms of reformulation, one common
reformulation is to divide reported items into recurring or normal
items and non-recurring or special items. In this way, earnings
could be separated into normal or core earnings and transitory
earnings with the idea that normal earnings are more permanent
and hence more relevant for prediction and valuation. In terms of
adjustment of financial statements, analysts may adjust earnings
numbers up or down when they suspect the reported data is
inaccurate due to issues like earnings management.
211
Evaluating nancial statements involves getting
the numbers in order and then using these
gures to perform ratio analysis.
Figure 3.31 Putting Numbers in Order
The evaluation of a company’s financial statement analysis is a form
of fundamental analysis that is bottoms up. While analysis of a
company’s prospects can include a number of factors, including
understanding the economic situation or the industry or sentiment
about the company or its products, ratio analysis of a company
relies on the specific company financials.
Source: https://www.boundless.com/finance/analyzing-financial-
statements–2/using-financial-ratios-for-analysis–2/evaluating-
financial-statements–2/
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Industry Comparisons
While ratio analysis can be quite helpful in comparing
companies within an industry, cross-industry
comparisons should be done with caution.
KEY POINTS
• One of the advantages of ratio analysis is that it allows
comparison across companies. However, while ratios can be
quite helpful in comparing companies within an industry and
even across some similar industries, cross-industry
comparisons may not be helpful and should be done with
caution.
• An industry represents a classification of companies by
economic activity, but “industry” can be too broad or narrow
a definition for ratio analysis comparison. When comparing
ratios, companies should be comparable in terms of having
similar characteristics in the statistics being analyzed.
• Valuation using multiples only reveals patterns in relative
values. For multiples to be useful, the statistic involved must
bear a logical, meaningful relationship to the market value
observed, which is something that can vary across industry.
One of the advantages of ratio analysis is that it allows comparison
across companies, an activity which is often called benchmarking.
However, while ratios can be quite helpful in comparing companies
212
within an industry and even across some similar industries,
comparing ratios of companies across different industries may not
be helpful and should be done with caution (Figure 3.32).
An industry represents a classification of companies by economic
activity. At a very broad level, industry is sometimes classified into
three sectors: primary or extractive, secondary or manufacturing,
and tertiary or services. At a very detailed level are classification
systems like the ISIC (International Standard Industrial
Classification).
However, in terms of ratio analysis and comparing companies, it is
most helpful to consider whether the companies being compared
are comparable in the financial metrics being evaluated in the
ratios. Different businesses will have different ratios for different
reasons. A peer group is a set of companies or assets which are
selected as being sufficiently comparable to the company or assets
being valued (usually by virtue of being in the same industry or by
having similar characteristics in terms of earnings growth and
return on investment). From the investor perspective, peers can
include companies that are not only direct product competitors but
are subject to similar cycles, suppliers, and other external factors.
Valuation using multiples involves estimating the value of an asset
by comparing it to the values assessed by the market for similar or
comparable assets in the peer group. A valuation multiple is simply
an expression of market value of an asset relative to a key statistic
that is assumed to relate to that value. To be useful, that statistic –
whether earnings, cash flow, or some other measure – must bear a
logical relationship to the market value observed; to be seen, in fact,
as the driver of that market value. The price to earnings ratio, for
example, is a common multiple but can differ across companies that
have different capital structures; this could make it difficult to
compare this particular ratio across industries.
213
Comparing ratios of companies
within an industry can allow an
analyst to make like to like
(apples to apples) comparisons.
Comparisons across industries
may be like to unlike (apples to
oranges) comparisons, and thus
less useful.
Figure 3.32 Industry
Additionally, there could be problems with the valuation of an
entire industry, making ratio analysis of a company relative to an
industry less useful. The use of multiples only reveals patterns in
relative values, not absolute values such as those obtained from
discounted cash flow valuations. If the peer group as a whole is
incorrectly valued (such as may happen during a stock market
“bubble”), then the resulting multiples will also be misvalued.
Source: https://www.boundless.com/finance/analyzing-financial-
statements–2/using-financial-ratios-for-analysis–2/industry-
comparisons–2/
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Benchmarking
Comparing the nancial ratios of a company to those of
the top performer in its class is a type of benchmarking.
KEY POINTS
•
Financial ratios allow for comparisons and, therefore, are
intertwined with the process of benchmarking, comparing
one’s business to that of relevant others or of the same
company at a different point in time processes on a specific
indicator or series of indicators.
• Benchmarking can be done in many ways and ratio analysis is
only one of these. One benefit of ratio analysis as a
component of benchmarking is that many financial ratios are
well-established calculations derived from verified data.
•
Benchmarking using ratio analysis can be useful to various
audiences; for example, investors and managers interested in
incorporate quantitative comparisons of a company to peers.
Benchmarking
Financial ratios allow for comparisons and, therefore, are
intertwined with the process of benchmarking, comparing one’s
business to that of others or of the same company at a different
point in time. In many cases, benchmarking involves comparisons
of one company to the best companies in a comparable peer group
214
or the average in that peer group or industry. In the process of
benchmarking, an analyst or manager identifies the best firms in
their industry, or in another industry where similar processes exist,
and compares the results and processes of those studied to one’s
own results and processes on a specific indicator or series of
indicators (Figure 3.33).
Benchmarking can be done in many ways, and ratio analysis is only
one of these. One benefit of ratio analysis as a component of
benchmarking is that many financial ratios are well-established
calculations derived from verified data. In benchmarking as a
whole, benchmarking can be done on a variety of processes,
meaning that definitions may change over time within the same
organization due to changes in leadership and priorities. The most
useful comparisons can be made when metrics definitions are
common and consistent between compared units and over time.
Benchmarking using ratio analysis can be useful to various
audiences. From an investor perspective, benchmarking can involve
comparing a company to peer companies that can be considered
alternative investment opportunities from the perspective of an
investor. In this process, the investor may compare the focus
company to others in the peer group (leaders, averages) on certain
financial ratios relevant to those companies and the investor’s
investment style. From a management perspective, benchmarking
using ratio analysis may be a way for a manager to compare their
company to peers using externally recognizable, quantitative data.
Source: https://www.boundless.com/finance/analyzing-financial-
statements–2/using-financial-ratios-for-
analysis–2/
benchmarking–2/
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215
Ratios can be used to compare entities within the same industry.
Figure 3.33 Benchmarking Measures Performance
Trend Analysis
Trend analysis consists of using ratios to compare
company performance on an indicator over time, often
to forecast or inform future events.
KEY POINTS
• Trend analysis is the practice of collecting information and
attempting to spot a pattern or trend in the same metric
historically, either by examining it in tables or charts. Often
this trend analysis is used to predict or inform decisions
around future events.
• Trend analysis can be performed in different ways in finance.
Fundamental analysis relies on historical financial statement
analysis, often in the form of ratio analysis.
• Trend analysis using financial ratios can be complicated by
changes to companies and accounting over time. For
example, a company may change its business model and
begin to operate in a new industry or it may change the end of
its financial year or the way it accounts for inventories.
In addition to using financial ratio analysis to compare one
company with others in its peer group, ratio analysis is often used to
compare the company’s performance on certain measures over
time. Trend analysis is the practice of collecting information and
attempting to spot a pattern, or trend, in the information. This often
involves comparing the same metric historically, either by
examining it in tables or charts. Often this trend analysis is used to
forecast or inform decisions around future events, but it can be used
to estimate uncertain events in the past (Figure 3.34).
Trend analysis can be performed in different ways in finance. For
example, in technical analysis the direction of prices of a particular
company’s public stock is calculated through the study of past
216
Determining the popularity and demand for specic subject over time through trend
analysis.
Figure 3.34 Trend Analysis
market data, primarily price, and volume. Fundamental analysis, on
the other hand, relies not on sentiment measures (like technical
analysis) but on financial statement analysis, often in the form of
ratio analysis. Creditors and company managers also use ratio
analysis as a form of trend analysis. For example, they may examine
trends in liquidity or profitability over time.
Trend analysis using financial ratios can be complicated by the fact
that companies and accounting can change over time. For example,
a company may change its business model so that it begins to
operate in a new industry or it may change the end of its financial
year or the way it accounts for inventories. When examining
historical trends in ratios, analysts will often make adjustments to
the ratios for these reasons, perhaps performing some ratio analysis
in which they segment out business segments that are not
consistent over time or they separate recurring from non-recurring
items.
Source: https://www.boundless.com/finance/analyzing-financial-
statements–2/using-financial-ratios-for-analysis–2/trend-
analysis–2/
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Limitations of Financial
Statement Analysis
Financial statement analyses can yield a limited view of
a company because of accounting, market, and
management related limitations of such analyses.
KEY POINTS
• Ratio analysis is hampered by potential limitations with
accounting and the data in the financial statements
themselves. This can include errors as well as accounting
mismanagement, which involves distorting the raw data used
to derive financial ratios.
• Proponents of the stronger forms of the efficient-market
hypothesis, technical analysts, and behavioral economists
argue that fundamental analysis is limited as a stock
valuation tool, all for their own distinct reasons.
• Ratio analysis can also omit important aspects of a firm’s
success, such as key intangibles, like brand, relationships,
skills and culture. These are primary drivers of success over
the longer term even though they are absent from
conventional financial statements.
217
KEY POINTS (cont.)
• Other disadvantages of this type of analysis is that if used
alone it can present an overly simplistic view of the company
by distilling a great deal of information into a single number
Limitations of Financial Statement Analysis
Ratio analysis using financial statements includes accounting, stock
market, and management related limitations. These limits leave
analysts with remaining questions about the company
(Figure 3.35).
First of all, ratio analysis is hampered by potential limitations with
accounting and the data in the financial statements themselves.
This can include errors as well as accounting mismanagement,
which involves distorting the raw data used to derive financial
ratios. While accounting measures may have more external
standards and oversights than many other ways of benchmarking
companies, this is still a limit.
Ratio analysis using financial statements as a tool for performing
stock valuation can be limited as well. The efficient-market
hypothesis (EMH), for example, asserts that financial markets are
“informationally efficient.” In consequence of this, one cannot
consistently achieve returns in excess of average market returns on
a risk-adjusted basis, given the information available at the time the
investment is made. While the weak form of this hypothesis argues
that there can be a long run benefit to information derived from
fundamental analysis, stronger forms argue that fundamental
analysis like ratio analysis will not allow for greater financial
returns.
In another view on stock markets, technical analysts argue that
sentiment is as much if not more of a driver of stock prices than is
218
Financial Statements can be analyzed using ratios made from the data they
provide, in order to make decisions about a nancial entity. This method has both
strengths and limitations.
Figure 3.35 A sample page from a nancial statement.
the fundamental data on a company like its financials. Behavioral
economists attribute the imperfections in financial markets to a
combination of cognitive biases such as overconfidence,
overreaction, representative bias, information bias, and various
other predictable human errors in reasoning and information
processing. These audiences also see limits to ratio analysis as a
predictor of stock market returns.
At the management and investor level, ratio analysis using financial
statements can also leave out a number of important aspects of a
firm’s success, such as key intangibles, like brand, relationships,
skills, and culture. These are primary drivers of success over the
longer term even though they are absent from conventional
financial statements.
Other disadvantages of this type of analysis is that if used alone it
can present an overly simplistic view of the company by distilling a
great deal of information into a single number or series of
numbers.
Also, changes in the information underlying ratios can hamper
comparisons across time and inconsistencies within and across the
industry can also complicate comparisons.
Source: https://www.boundless.com/finance/analyzing-financial-
statements–2/using-financial-ratios-for-analysis–2/limitations-of-
financial-statement-analysis/
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Impact of Ination on Financial Statement Analysis
Disination
Deation
Section 10
Considering Ination’s Distortionary Eects
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Impact of Ination on
Financial Statement Analysis
General price level changes creates distortions in
nancial statements. Ination accounting is used in
countries with high ination.
KEY POINTS
• Many of the historical numbers appearing on financial
statements are not economically relevant because prices have
changed since they were incurred.
• Since the numbers on financial statements represent dollars
expended at different points of time and, in turn, embody
different amounts of purchasing power, they are simply not
additive.
• Reported profits may exceed the earnings that could be
distributed to shareholders without impairing the company’s
ongoing operations.
• Future earnings are not easily projected from historical
earnings. Future capital needs are difficult to forecast and
may lead to increased leverage, which increases the risk to
the business.
• The asset values for inventory, equipment and plant do not
reflect their economic value to the business.
Inflation’s Impact on Financial Statements
In most countries, primary financial statements are prepared on the
historical cost basis of accounting without regard either to
changes in the general level of prices. Accountants in the United
Kingdom and the United States have discussed the effect of inflation
on financial statements since the early 1900s (Figure 3.36).
221
German Hyperination Data
Figure 3.36 Hyperination Graph
General price level changes in financial reporting creates distortions
in financial statements such as:
• Many of the historical numbers appearing on financial
statements are not economically relevant because prices have
changed since they were incurred.
• Since the numbers on financial statements represent dollars
expended at different points of time and, in turn, embody
different amounts of purchasing power, they are simply not
additive. Hence, adding cash of $10,000 held on December
31, 2002, with $10,000 representing the cost of land acquired
in 1955 (when the price level was significantly lower) is a
dubious operation because of the significantly different
amount of purchasing power represented by the two identical
numbers.
• Reported profits may exceed the earnings that could be
distributed to shareholders without impairing the company’s
ongoing operations.
• The asset values for inventory, equipment and plant do not
reflect their economic value to the business.
• Future earnings are not easily projected from historical
earnings.
• The impact of price changes on monetary assets and liabilities
is not clear.
• Future capital needs are difficult to forecast and may lead to
increased leverage, which increases the risk to the business.
• When real economic performance is distorted, these
distortions lead to social and political consequences that
damage businesses (examples: poor tax policies and public
misconceptions regarding corporate behavior).
Inflation accounting, a range of accounting systems designed to
correct problems arising from historical cost accounting in the
presence of inflation, is a solution to these problems. This type of
accounting is used in countries experiencing high inflation or
hyperinflation. For example, in countries such as these the
International Accounting Standards Board requires corporate
financial statements to be adjusted for changes in purchasing power
using a price index.
Source: https://www.boundless.com/finance/analyzing-financial-
statements–2/considering-inflation-s-distortionary-effects–2/impact-
of-inflation-on-financial-statement-analysis/
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Disination
Disination is a decrease in the ination rate; a
slowdown in the rate of increase of the general price
level of goods, services.
KEY POINTS
• Disinflation occurs when the increase in the “consumer price
level” slows down from the previous period when the prices
were rising. Disinflation is the reduction in the general price
level in the economy but for a very short period of time.
• The causes of disinflation may be a decrease in the growth
rate of the money supply. If the central bank of a country
enacts tighter monetary policy, the supply of money reduces,
and money becomes more upscale and the demand for money
remains constant.
• Disinflation may result from a recession. The central bank
adopts contractionary monetary policy, goods, and services
are more expensive. Even though the demand for
commodities fall, the supply still remains unaltered.Thus, the
prices would fall over a
period of time leading to disinflation.
Disinflation is a decrease in the rate of inflation–a slowdown in the
rate of increase of the general price level of goods and services in a
nation’s gross domestic product over time. Disinflation occurs
when the increase in the “consumer price level” slows down from
the previous period when the prices were rising. Disinflation is the
reduction in the general price level in the economy but for a very
short period of time. Disinflation takes place only when an economy
is suffering from recession (Figure 3.37).
If the inflation rate is not very high to start with, disinflation can
lead to deflation–decreases in the general price level of goods and
services. For example if the annual inflation rate for the month of
January is 5% and it is 4% in the month of February, the prices
disinflated by 1% but are still increasing at a 4% annual rate. Again,
223
Disination is a decrease in the rate of ination as illustrated in the yellow region of
this graph.
Figure 3.37 Disination
if the current rate is 1% and it is -2% for the following month, prices
disinflated by 3% (i.e., 1%-[-2]%) and are decreasing at a 2% annual
rate.
The causes of disinflation are either a decrease in the growth rate of
the money supply, or a business cycle contraction (recession). If the
central bank of a country enacts tightermonetary policy, (i.e., the
government start selling its securities) this reduces the supply of
money in an economy. This contraction of the monetary policy is
known as a “quantitative tightening technique.” When the
government sell its securities in the market, the supply of money
reduces, and money becomes more upscale and the demand for
money remains constant. During a recession, competition among
businesses for customers becomes more intense, and so retailers are
no longer able to pass on higher prices to their customers. The main
reason is that when the central bank adopts contractionary
monetary policy, its becomes expensive to annex money, which
leads to the fall in the demand for goods and services in the
economy. Even though the demand for commodities fall, the supply
of commodities still remains unaltered. Thus the prices fall over a
period of time leading to disinflation.
When the growth rate of unemployment is below the natural rate of
growth, this leads to an increase in the rate of inflation; whereas,
when the growth rate of unemployment is above the natural rate of
growth it leads to a decrease in the rate of inflation also known as
disinflation. This happens when people are jobless, and they have a
very small portion of money to spend, which indirectly implies
reduction in the supply of money in an economy.
Source: https://www.boundless.com/finance/analyzing-financial-
statements–2/considering-inflation-s-distortionary-effects–2/
disinflation–2/
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224
Deation
Deation is a decrease in the general price level of
goods and services and occurs when the ination rate
falls below 0%.
KEY POINTS
• In the IS/LMmodel (Investment and Saving equilibrium/
Liquidity Preference and Money Supply equilibrium model),
deflation is caused by a shift in the supply-and-demand curve
for goods and services, particularly a fall in the aggregate
level of demand.
• In more recent economic thinking, deflation is related to risk:
where the risk-adjusted return on assets drops to negative,
investors and buyers will hoard currency rather than invest it.
This can produce a liquidity trap.
• In monetarist theory, deflation must be associated with either
a reduction in the money supply, a reduction in the velocity of
money or an increase in the number of transactions. But any
of these may occur separately without deflation.
•
In mainstream economics, deflation may be caused by a
combination of the supply and demand for goods and the
supply and demand for money; specifically the supply of
money going down and the supply of goods going up.
KEY POINTS (cont.)
• The effects of deflation are: decreasing nominal prices for
goods and services, increasing buying power of cash money
and all assets denominated in cash terms, possibly decreasing
investment and lending if cash holdings are seen as
preferable,
and benefiting recipients of fixed incomes.
In economics, deflation is a decrease in the general price level of
goods and services. This occurs when the inflation rate falls below
0% (a negative inflation rate). Inflation reduces the real value of
money over time; conversely, deflation increases the real value of
money – the currency of a national or regional economy. In turn,
this allows one to buy more goods with the same amount of money
over time.
Economists generally believe that deflation is a problem in a
modern economy because they believe it may lead to a
deflationary spiral (Figure 3.38).
In the IS/LMmodel (Investment and Saving equilibrium/ Liquidity
Preference and Money Supply equilibrium model), deflation is
caused by a shift in the supply-and-demand curve for goods and
services, particularly with a fall in the aggregate level of demand.
That is, there is a fall in how much the whole economy is willing to
buy, and the going price for goods. Because the price of goods is
225
falling, consumers have an incentive to delay purchases and
consumption until prices fall further, which in turn reduces overall
economic activity. Since this idles the productive capacity,
investment also falls, leading to further reductions in aggregate
demand. This is the deflationary spiral.
An answer to falling aggregate demand is stimulus, either from the
central bank, by expanding the money supply; or by the fiscal
authority to increase demand, and to borrow at interest rates which
are below those available to private entities.
In more recent economic thinking, deflation is related to risk: where
the risk-adjusted return on assets drops to negative, investors and
buyers will hoard currency rather than invest it, even in the most
solid of securities. This can produce a liquidity trap. A central
bank cannot normally charge negative interest for money, and even
charging zero interest often produces less stimulative effect than
slightly higher rates of interest. In a closed economy, this is because
charging zero interest also means having zero return on government
securities, or even negative return on short maturities. In an open
economy it creates a carry trade, and devalues the currency. A
devalued currency produces higher prices for imports without
necessarily stimulating exports to a like degree.
In monetarist theory, deflation must be associated with either a
reduction in the money supply, a reduction in the velocity of money
or an increase in the number of transactions. But any of these may
occur separately without deflation. It may be attributed to a
dramatic contraction of the money supply, or to adherence to a gold
standard or to other external monetary base requirements.
In mainstream economics, deflation may be caused by a
combination of the supply and demand for goods and the supply
and demand for money, specifically: the supply of money going
down and the supply of goods going up. Historic episodes of
deflation have often been associated with the supply of goods going
up (due to increased productivity) without an increase in the supply
of money, or (as with the Great Depression and possibly Japan in
the early 1990s) the demand for goods going down combined with a
226
Annual ination (in blue) and deation (in green) rates in the United States
from 1666 to 2004
Figure 3.38 US historical ination rates
decrease in the money supply. Studies of the Great Depression by
Ben Bernanke have indicated that, in response to decreased
demand, the Federal Reserve of the time decreased the money
supply, hence contributing to deflation.
The effects of deflation are thus: decreasing nominal prices for
goods and services, increasing buying power of cash money and all
assets denominated in cash terms, possibly decreasing investment
and lending if cash holdings are seen as preferable (aka hoarding),
and benefiting recipients of fixed incomes.
Source: https://www.boundless.com/finance/analyzing-financial-
statements–2/considering-inflation-s-distortionary-effects–2/
deflation–2/
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227
Discrepancies
Extraordinary Gains/Losses
Section 11
Other Distortions
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Discrepancies
A discrepancy is an accounting error that was not
caused intentionally, meaning the books don’t properly
match.
KEY POINTS
• At the end of each month when you get your bank or credit
card statement, you will need to reconcile each account in
your accounting program against the statement.
• You will want to double check that you entered the correct
starting and ending balances for the account, and if you did,
go back through all the transactions until you find the
problem. Then correct it and you can proceed with your
reconciliation.
• In accounting, reconciliation refers to a process that
compares two sets of records (usually the balances of two
accounts) to make sure they are in agreement.
•
It depends on the type of discrepancies, most accounting
discrepancies are due to the lack of accuracy (decimal places)
when breaking down a large figure. Although more decimal
places in your calculations can help solve discrepancies it can
look rather unsightly
on a report.
At the end of each month when you get your bank or credit card
statement, you will need to reconcile each account in your
accounting program against the statement. This process double
checks everything you entered for the month, making sure you
didn’t miss any transactions, enter duplicate transactions, or enter
the wrong amount for a transaction. It also marks the checks that
cleared that month as such, so you know how many outstanding
checks you have floating out in the world.
A discrepancy is an accounting error that was not caused
intentionally. An accounting error can include discrepancies in
dollar figures, or might be an error in using accounting policy
incorrectly (i.e., a compliance error). Discrepancies should not be
confused with fraud, which is an intentional error in an accounting
item, usually to hide or alter data for personal gain. A discrepancy
just means something doesn’t match. You will have the option to go
back and locate the discrepancy, or to reconcile anyway. Unless the
discrepancy is very small you should go back and correct the
problem. You will want to double check that you entered the correct
starting and ending balances for the account, and if you did, go back
through all the transactions until you find the problem. Then
correct it and you can proceed with your reconciliation.
In accounting, reconciliation refers to a process that compares two
sets of records (usually the balances of two accounts) to make sure
they are in agreement. Reconciliation is used to ensure that the
money leaving an account matches the actual money spent, this is
229
done by making sure the balances match at the end of a particular
accounting period. Well reconciliations refers to two sets of records
(what is being put in the well compared to what actual costs are
being spent). The two numbers are compared to assure that they
balance at the end of the accounting cycle. There is usually a
difference. A robust reconciliation process improves the accuracy of
the financial reporting function and allows the Finance Department
to publish financial reports with confidence (Figure 3.39).
It depends on the type of discrepancies, most accounting
discrepancies are due to the lack of accuracy (decimal places) when
breaking down a large figure. Although more decimal places in your
calculations can help solve discrepancies it can look rather unsightly
on a report.
Source: https://www.boundless.com/finance/analyzing-financial-
statements–2/other-distortions–2/discrepancies–2/
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230
Bank reconciliation statement
Figure 3.39 Reconciliation of discrepancies
Extraordinary Gains/Losses
Extra gains or losses are nonrecurring, onetime,
unusual, non-operating gains or losses that are
recorded by a business during the period.
KEY POINTS
• Extra gains or losses are nonrecurring, onetime, unusual,
non-operating gains or losses that are recorded by a business
during the period.
•
No items may be presented in the income statement as
extraordinary items under IFRS regulations, but are
permissible under US GAAP. (IAS 1.87) The amount of each
of these gains or losses, net of the income tax effect, is
reported separately in the income statement.
• Examples of extraordinary items are casualty losses, losses
from expropriation of assets by a foreign government, gain on
life insurance, gain or loss on the early extinguishment of
debt, gain on troubled debt restructuring, and write-off of an
intangible asset.
Extraordinary Gains and Losses
Extraordinary items are both unusual (abnormal) and
infrequent, for example, unexpected natural disaster, expropriation,
prohibitions under new regulations. It is notable that a natural
disaster might not qualify depending on location (e.g., frost damage
would not qualify in Canada but would in the tropics).
Extra gains or losses are the result of unforeseen and atypical
events. They are nonrecurring, onetime, unusual, non-operating
gains, or losses that are recorded by a business during the period.
No items may be presented in the income statement as
extraordinary items under IFRS regulations, but are permissible
under US GAAP (Figure 3.40). (IAS 1.87) The amount of each of
these gains or losses, net of the income tax effect, is reported
separately in the income statement. Net income is reported before
and after these gains and losses. As a result, extraordinary gains or
losses don’t skew the company’s regular earnings. These gains and
losses should not be recorded very often but, in fact, many
businesses record them every other year or so, causing much
231
This income statement is a very brief example prepared in accordance with IFRS;
no extraordinary items are presented.
Figure 3.40 Income statement in accordance with IFRS
consternation to investors. In addition to evaluating the regular
stream of sales and expenses that produce operating profit,
investors also have to factor into their profit performance analysis
the perturbations of these irregular gains and losses reported by a
business.
Examples of extraordinary items are casualty losses, losses from
expropriation of assets by a foreign government, gain on life
insurance, gain or loss on the early extinguishment of debt, gain on
troubled debt restructuring, and write-off of an intangible asset.
Write down and write off of receivables and inventory are not
extraordinary, because they relate to normal business operational
activities.They would be considered extraordinary, however, if they
resulted from an Act of God (e.g., casualty loss arising from an
earthquake) or governmental expropriation.
Source: https://www.boundless.com/finance/analyzing-financial-
statements–2/other-distortions–2/extraordinary-gains-losses–2/
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PLEASE READ CAREFULLY
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Read this article by investopedia in its entirety:
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Discussion 1 – Accounting
Why is accounting important? Who governs accounting? How consistent is accounting among companies in the same industry? Can show an example of where accounting rules may be applied differently and yet consistent with GAAP? Why do we care as a society about accounting rules? Show by way of example, what happens when a company does not follow legitimate accounting practices.
Explain the value of financial ratios and why they are important? How are they used by companies, by investors, by analysts?
·
Please respond to each part of this multi-part discussion topic
PLEASE READ CAREFULLY
– Please use APA (7th edition) formatting
– All questions and each part of the question should be answered in detail (Go into depth)
– Response to questions must demonstrate understanding and application of concepts covered in class,
– Use in-text citations and at LEAST 2 resources per discussion from the school materials that I provided to support all answers. Include at least 2 references and include in-text citations.
– Responses MUST be organized (Should be logical and easy to follow)
Minimum 1.5 Page
Read this article by investopedia in its entirety:
https://www.investopedia.com/financial-edge/0910/6-basic-financial-ratios-and-what-they-tell-you.aspx
Discussion 1 – Accounting
Why is accounting important? Who governs accounting? How consistent is accounting among companies in the same industry? Can show an example of where accounting rules may be applied differently and yet consistent with GAAP? Why do we care as a society about accounting rules? Show by way of example, what happens when a company does not follow legitimate accounting practices.
Explain the value of financial ratios and why they are important? How are they used by companies, by investors, by analysts?
·
Please respond to each part of this multi-part discussion topic
