## Module 03 Analyzing Financial Statements (I)

**Module Three: Analyzing Financial Statement (I)**

While financial statements report the financial status of the business, it does not automatically give the condition or financial health of the business. Ratios are calculations that help to simplify the many numbers on various financial statements into a number that is easier to understand. Understanding the various ratios that can be calculated will help you examine and analyze financial statements, giving a clear picture of the business's financial health. This module discusses five fundamental ratios that help you analyze your organization's financial statements. The following are the topics discussed in this module:

- Income ratios
- Profitability ratios
- Liquidity ratios
- Working capital ratios
- Bankruptcy ratios

Understanding the income ratio is our first topic of discussion. But first, let us learn how to calculate and interpret this ratio.

**Income Ratios**

Income ratios help to determine income level to various factors like wages, assets, etc.

Here are some income ratio calculations and their uses:

**Ratio Calculation - Formula - Result**

Net Income Increases to Pay Increases - Net Income Increases to Pay Increases = change in net income/change in salaries, wages, and benefits - This shows when net income increases faster than wages (in dollar terms).

Net Income per Employee - Profits per Employee (Net Income per Employee) = net income/number of employees - This shows the average profit generated per person employed in the company.

Net Income to Assets - Net Income to Assets = net profit before taxes / total assets. - This ratio provides a way for evaluating the efficiency of financial management of the average dollar invested in the firm's assets and determines if the dollar came from investors or creditors.

Non-Operating Income to Net Income - Non-operating Income to Net Income = non-operating income / net income - Increasing ratios may mean the business is moving away from its core business.

Operating Income to Wages and Salaries - Operating Income to Wages and Salaries = operating income / (salaries + wages + benefits) - This ratio shows the relationship between operating income and the number of wages and salaries paid.

**Profitability Ratios**

Profitability ratios help to determine how well the company is doing in terms of the profits generated by the company. There are many ratios. Here is a list of common profitability ratios.

**Ratio Calculation - Formula - Result**

Cash Debt Coverage Ratio - Cash Debt Coverage = (cash flow from operations - dividends) / total debt. - This ratio shows the percent of the current cash flow debt that can retire.

Cash Return on Assets - Cash Return on Assets (excluding interest) = (cash flows from operations before interest and taxes) / total assets. - A higher cash return on assets ratio indicates a more significant cash return.

Cash Return to Shareholders - Cash Return to Shareholders = cash flow from operations/shareholders equity - The cash return to shareholders ratio indicates a return earned by shareholders.

Contribution Margin Ratio - Contribution Margin Ratio = (sales - variable costs)/sales - The contribution margin ratio indicates the percentage of sales available to cover fixed costs and profits.

Gross Profit Margin - Gross Profit Margin Ratio = gross profit/sales - This ratio provides clues to company pricing, cost structure, and production efficiency

Operating Margin - Operating Margin = net profits from operations/sales - This ratio determines whether the fixed costs are too high for the production volume.

Profit Margin Ratio - Pretax Margin Ratio = net profit before taxes/sales - This ratio shows how much profit the company makes for every dollar of sales.

**Liquidity Ratios**

Liquidity ratios determine the ability of an organization to meet its short-term financial debt promptly. Here are some liquidity ratios you may find helpful:

**Ratio Calculation - Formula - Result**

Acid Test Ratio (Quick Ratio) - Acid Test Ratio = (cash + marketable securities) / current liabilities - The acid test ratio measures the immediate amount of cash immediately available to satisfy the short-term debt

Accounts Payable Turnover Ratio - Accounts Payable Turnover Ratio = total supplier purchases / average accounts payable - The accounts payable turnover ratio shows the times accounts payable are paid throughout the year.

Cash Debt Coverage - Cash Debt Coverage = (cash flow from operations - dividends) / total debt - The cash debt coverage ratio shows the percent of the debt that current cash flow can retire

Debt Income Ratio - Debt Income Ratio = total debt / net income - The debt-income ratio shows the amount of total debt in proportion to net income

Quick Assets - Quick Assets = cash + marketable securities + accounts receivable - Quick assets are the number of assets that can be quickly converted to cash.

**Working Capital Ratios**

Working capital is the organization's ability to use capital after its debt has been satisfied. Here are the formulas for calculating working capital.

**Ratio Calculation - Formula - Result**

Working Capital - Working Capital = current assets - current liabilities - This calculation shows the liquid reserve available to satisfy contingencies and uncertainties

Working Capital ratio - Working Capital Ratio = current assets / current liabilities - This ratio evaluates the liquidity, or ability to meet short-term debts

Working Capital Provided by Net Income - Working Capital from Operations to Total Liabilities = working capital provided from operations / current liabilities - This ratio measures the degree internally generated working capital is available to satisfy obligations.

Working Capital From Operations to Total Liabilities - Working Capital Provided by Net Income = net income - depreciation - A high ratio indicates that a company's liquidity position is improved because net profits result in liquid funds.

**Bankruptcy Ratios**

Bankruptcy ratios help to determine if the company is not generating enough income to cover its debts. These calculations could help to determine a course of action to avoid bankruptcy or to seek bankruptcy protection if the situation warrants it. Here are some calculations that help to determine if a company is heading toward bankruptcy.

**Ratio Calculation - Formula - Result**

Working Capital to Total Assets - Net Working Capital = Working Capital to Total Assets Ratio

Total Assets

This ratio records net liquid assets relative to total capitalization. This ratio is the most valuable indicator of bankruptcy.

Retained Earnings to Total Assets - Retained Earnings = Retained Earnings to Total Assets Ratio

Total Assets

A negative ratio indicates potential financial problems.

EBIT to Total Assets - EBIT = EBIT to Total Assets Ratio

Total Assets

This ratio shows the productivity of the assets.

Equity to Debt - Market Value of Common + Preferred Stock = Equity to Debt Ratio

Total Current + Long-Term Debt

This ratio shows you how much assets can decline in value before it becomes insolvent.

Cash Flow to Debt - Cash Flow = Cash Flow to Debt Ratio

Total Debt

This ratio shows potential insolvency issues.

## Lesson Summary

Financial statement analysis provides an in-depth look into the financial health and status of a business. This module covers five fundamental ratios that help you analyze your organization's financial statements: Income Ratios, Profitability Ratios, Liquidity Ratios, Working Capital Ratios, and Bankruptcy Ratios. Each provide key insight and are calculated using a variety of factors, such as net income, wages, benefits, assets, liabilities, cash flow, etc. These ratios give you a better understanding of the businessâ€™s overall financial picture.

- Income Ratios - show when net income increases faster than wages and the average profit generated per person employed
- Profitability Ratios - various ratios to determine the efficiency of financial management, cash return on assets, return to shareholders, contribution margins, and more
- Liquidity Ratios - quickly convert assets to cash, accounts payable turnover, cash debt coverage, and more
- Working Capital Ratios - working capital calculation, working capital to total assets, net working capital, working capital provided by net income, and more
- Bankruptcy Ratios - net working capital, retained earnings to total assets, EBIT to total assets, equity to debt, and cash flow to debt

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