13

Analyzing Financial Results

13.1 Analysis Methods

13.2 Assessing Profitability

13.3 Determining Ability to Pay Debt

13.4 Measuring Liquidity

13.5 Making Decisions

13.1 Analysis Methods

You’ve completed the financial statements for your company; now it’s time to take a deeper look at what the numbers mean. In this subchapter, we provide an overview of financial analysis and show you how to use it.

SEE ALSO 2.3, “Analyzing Transactions”

Looking at Previous Periods

Comparing data to a prior period—often called trend analysis or comparative analysis—is one way to put your company’s financials into perspective. In comparative analysis, you’re looking at the financial statements of the current period and at least one prior period and evaluating any significant or unusual increases or decreases. It’s useful to look at changes in both amounts and percentages. Although larger companies may have the resources to do this quarterly or even monthly, if you can do it annually, you’ll be in good shape.

With trend analysis, you’re usually comparing financial statements over a longer period of time—say 5 years at least. The goal here is to get a sense for the larger trends in performance. Are sales going up? Are expenses being held in line? Are receivable collections slowing?

Following is an example of comparative analysis for Star Shore and Company. Both the balance sheet and the income statement are compared with the previous year to gauge performance.

SEE ALSO 11.4, “Generating Financial Statements”

STAR SHORE AND COMPANY
COMPARATIVE BALANCE SHEETS DECEMBER 31

STAR SHORE AND COMPANY COMPARATIVE
INCOME STATEMENTS FOR THE PERIOD ENDING 12/31

If you look at the income statement, Star Shore and Company didn’t appear to have a great year. Sales dipped slightly, and both cost of goods sold (COGS) and operating expenses grew significantly, resulting in a decrease in net income. At first glance, the slight decline in performance from the previous year doesn’t appear to have affected the balance sheet as much. Receivables are down as expected, but debt is also down, suggesting that Star has had the wherewithal to pay down its loans.

Inventory has ticked up, which could reflect the impact of lower than anticipated sales. It might also mean that the company is carrying too much stock and levels might need to be reevaluated.

It looks like the owner’s equity has gone up, although it is not attributable to net income, which decreased as well. This suggests that the owners might have increased their investment in the company to shore up cash reserves and pay down some debt and expenses.

To study this further and determine whether this is an off year or the start of something more serious, Star Shore and Company might want to consider doing a trend analysis going back 5 years or so.

STAR SHORE AND COMPANY
TREND ANALYSIS

Even without converting these numbers to percentages, it’s clear that last year—Year 4—stands out as a particularly good year for Star Shore and Company. Performance in the current year—Year 5—doesn’t look quite so bad when you compare with Years 1 through 3. So is it the start of a downward trend, or was Year 4’s stellar performance an aberration? This would bear more examination.

Other Comparisons

Certain types of analysis help narrow down the source of fluctuations in a company’s performance. Have changes resulted from something specific your business has done or from factors that are affecting its entire industry? A retail store’s sales might be trending up sharply with the rest of its industry during boom times, but its expenditures may still not be cost-effective when compared with its peers.

Looking at ratios between certain items on your own financial statements, as well as comparing your results to even larger companies in your industry, gives you a fuller picture of how you’re doing.

What’s Happening in the Industry?

Another method to examine how your business is doing is to look at the financial performance of the competition or averages for your industry published by sources such as Dun & Bradstreet, Value Line, Standard & Poor’s, or RMA’s Annual Statement Studies, which offer investment research, corporate/industry data, and other business information. Are your profit margins in line with what’s expected? Are other companies in your industry experiencing a slump in sales or a spike in production costs? Looking at your company’s performance side by side with industry competitors might give you a good idea.

Common-Size Financial Statements

Sometimes it helps to look at different accounts in relation to a key performance number such as sales. In common-size financial statements, all account totals are shown as a percentage of a certain item to get a fix on how your business is doing.

Let’s look at an example. Kenner Bakery created common-size financial statements that show its income statement amounts as a percentage of sales.

Common-size financial statements are particularly useful when comparing different-size businesses. If Kenner wanted to know how it was doing in comparison to Pain au France chain, for example, converting the statements and setting them side by side would show these results.

KENNER BAKERY
COMMON-SIZE INCOME STATEMENTS
FOR THE YEAR ENDED 12/31

As you can see, Kenner’s sales are dwarfed by the $42 million the Pain au France chain earned. The larger firm also has a heftier gross profit at 35 percent, perhaps due to lower costs from being able to buy in bulk and produce in large quantities. However, Kenner is doing a better job in terms of controlling selling and administrative expenses, and as a result, both its operating income and net income represent a slightly higher return on sales. So for a small company, it is not doing badly.

Ratio Analysis

Comparing different income and expense items can tell you much about the financial health of your organization. A number of simple formulas or financial ratios can help you uncover your company’s hidden strengths and weaknesses. Ratio analysis helps you determine if you’re earning an adequate return or if you have too much debt. In fact, this is the very tool banks, financial institutions, and potential investors turn to when deciding whether to invest or do business with you or any company.

Ratios, as we discuss in upcoming sections, can be used to assess profitability, the ability of a company to pay its debt, and its liquidity. For example, say you want to look at the profitability of Kenner Bakery in the previous example. A good start is its gross profit margin. You can compute this ratio by dividing gross profit of $142,500 by sales of $570,000, which gives you 25 percent. Not bad for a bakery. But not quite as good as the impressive 35 percent gross profit ($14,700,000 ÷ $42,000,000) of the behemoth Pain au France chain. To do a complete analysis, of course, you need to look at more than one ratio, as we explain in the rest of this chapter.

Automating the Process

If you have a computerized accounting system, you’ll likely be able to automatically prepare many of these analyses. Most accounting software programs can calculate year-to-year comparisons, measure liquidity, do ratio analysis, look at trends, and provide other useful data for making business decisions. The speed at which these computations are performed can also enhance your ability to move quickly to take advantage of opportunities and solve problems.

Some software programs and online offerings are even specifically designed for financial analysis, computing dozens of ratios and comparisons, as well as producing common-size financial statements and a variety of charts and graphs for reporting or presentations. In addition, some software makers, such as Sage Peachtree, offer business analytics that enable you to compare your results and challenges to those of other companies in the same industry.

Limitations of Financial Analysis

No matter which method you choose—and whether you’re doing the work manually or by computer—it’s important to remember financial analysis doesn’t have all the answers. For starters, it’s only as good as the numbers behind it. Choices in inventory method, credit policy, and a host of other variables all have an impact in how these numbers look when analyzed and can cause ratios and other measurements to vary. Financial analysis should be treated as one tool of many in evaluating the performance of a business and not as an oracle.

That said, informed analysis of financial results using comparisons and ratios can be invaluable in managing a company and assessing performance. In the next several subchapters, we look at some of the most commonly used ratios and what they tell you.

13.2 Assessing Profitability

Your company made a profit last year, but is that the whole story? In this subchapter, you learn how to use ratios to look behind the numbers to assess how well things are really going.

Profit Margins

Profit margins are one of the first relationships you look at when you’ve completed your income statement. Margin measures return on sales and how well you’re managing expenses. You can compute the profit margin a number of ways, depending on what you’d like to learn.

Gross profit margin gives you the margin return after deducting the cost of sales:

Sales – COGS ÷ Sales = Gross profit margin

Or again, using Kenner Bakery:

$570,000 – $427,500 ÷ $570,000 = 25%

Operating margin shows you your percentage return after COGS and operating expenses and is often thought to be a better gauge of overall performance, since it takes into account the cost of running the business.

Sales – COGS – Operating expenses ÷ Sales = Operating profit margin

$570,000 – $427,500 – $102,600 ÷ $570,000 = 7%

You can also compute the straight profit margin, which measures the relationship between your bottom line (net income) and sales:

Net income ÷ Sales = Profit margin

$11,400 ÷ $570,000 = 2%

In general, companies like discounters or supermarkets that do high-volume business have low profit margins. High-end, low-volume businesses such as luxury goods stores or aircraft manufacturers tend to have higher profit margins.

Return on Assets

Return on assets (ROA) tells you how much of a return you’re making on your assets and is a pretty good measure of overall profitability. You can compute it as follows:

Net income ÷ Average total assets = Return on assets

As an example, Trident Engineering has income of $50,000 on sales of $867,000 for the year. Trident’s average assets for the year ending 12/31 totaled $90,000. Its ROA would be 50,000 ÷ 90,000 = 55.5 percent.

Just because your company is showing a profit doesn’t mean it’s making the best use of the resources invested. Generally, the higher the ROA number, the better you’re doing. However, firms that must invest substantially in machinery or other capital equipment tend to have lower average ROAs, and this is not necessarily a problem if prior to the investment it was determined the projected ROA was acceptable and/or necessary.

Return on Equity

Return on equity (ROE) measures profitability in terms of return on investment. As with the ROA, return on equity tells investors what they’re getting back for what they put in. There are variations on this formula, but the simplest version is as follows:

Net income ÷ Average equity = Return on equity

Trident Engineering is a partnership with average equity of $65,000 during the year. This would put its ROE (Net income $50,000 ÷ Average equity $65,000) at roughly 77 percent.

As with the ROA, the higher the ROE number, the better you’re doing. A ROE of 2, for instance, would mean you’re earning a return of two times your investment. Because Trident is a new business, its partners are happy with its current ROE and expect it to improve in the future. Typically, all ratios involving net income and a balance sheet item use the average of the balance sheet item (for example, beginning assets at January 1 and ending assets at December 31 ÷ 2), but to keep the examples simple, we’re just using the ending balance.

Earnings per Share

Earnings per share (EPS) is another version of return on equity. The difference is that EPS looks at return on individual shares of stock. This enables investors to see what kind of return they’re getting on their specific investment—which is what makes it such a popular and widely used measure.

Here’s the formula:

Net income ÷ Average shares outstanding = Earnings per share

While accounting for common stock is largely beyond the scope of this book, it’s worth mentioning this ratio because it’s so prevalent in the business world.

Price-Earnings Ratio

The price-earnings (P/E) ratio might be the one you hear about the most, although it has less to do with the performance of your company than how the stock market values it. To compute the P/E ratio, divide market value per share by the earnings per share:

Market value per share ÷ Earnings per share = P/E ratio

A high-price earnings ratio means your company is an expensive stock in terms of what it’s earning. On the other hand, a low P/E could suggest the market undervalues your stock.

Profitability ratios, particularly when taken together, give you a good idea of what kind of return a company is earning, as well as a window into how it is managing both its assets and investments and controlling operating expenses. But this is far from the whole picture, as upcoming sections illustrate.

13.3 Determining Ability to Pay Debt

You want your company to make money, but not at the cost of too much debt. This subchapter helps you evaluate your business’s reliance on creditors and investors and shows you how to measure your ability to pay them back.

Debt to Assets Ratio

To learn how much of your company’s assets are financed by creditors, use the debt to assets ratio:

Total liabilities ÷ Total assets = Debt to assets ratio

By taking both current and long-term liabilities as a percentage of total assets, you are able to assess your ability to repay debt and how much leeway you have to withstand losses.

For example, if Trident Engineering has total assets of $80,000 and debt totaling $40,000, we could safely say that creditors provided half of its assets. Generally, the higher the debt to assets ratio, the more highly leveraged a company is said to be and the greater the risk it might be unable to meet loan payments as they come due should operations slow down. If Trident had total liabilities of $60,000 instead of $40,000, its debt to assets ratio would be 75 percent. The adequacy of this ratio depends on your particular company and its industry.

Debt to Equity Ratio

This ratio is another useful gauge of liquidity:

Total liabilities ÷ Total equity = Debt to equity ratio

As an example, say Trident had equity of only $15,000. Its debt to equity ratio would be $65,000 (debt) ÷ $15,000 for a 4:3 debt to equity ratio. This would indicate thin equity and a significantly overleveraged company.

Equity to Assets Ratio

The equity to assets ratio looks at how much of your company’s assets are provided by equity, or how much investors are at risk if the company isn’t profitable:

Total equity ÷ Total assets = Equity to assets ratio

To return to our Trident example, we would take:

$65,000 ÷ $80,000 = 8.1%

Like Trident’s creditors, its investors are still on the hook for a relatively large chunk of money in relation to total assets. We know that Trident is a new business and investors have indicated they are satisfied with the company’s return on equity, so this probably isn’t a problem. New businesses aren’t expected to immediately recoup their investments; if Trident has the same ratio in 10 years and the investors are less comfortable with performance, it could become more of a concern.

Times Interest Earned Ratio

Can your company make its current interest payments as they become due? The times interest earned ratio gives you an indication:

Income before interest expense and taxes ÷ Annual interest expense = Times interest earned ratio

When computing it, note that you take net income before interest and taxes, because interest is a tax deduction.

Cash Debt Coverage Ratio

This useful ratio measures your company’s ability to repay its liabilities without liquidating the business. It tells you how long it would take to generate cash from operations to pay down debt:

Net cash from operating activities ÷ Average total liabilities = Cash debt coverage ratio

You can pull the net cash provided by operating activities from your company’s annual cash flow statement. You can compute average total liabilities from interim financials or average the last 2 years’ financial statements.

If Trident Engineering has average liabilities of $40,000 and generated cash flow from operations of $20,000, its ratio would be 0.50. This means it would take about 2 years to generate enough cash through operations. The higher the ratio, the less leveraged your company is.

13.4 Measuring Liquidity

Liquidity ratios measure your company’s ability to pay its expenses and obligations in the short term as well as meeting any unexpected needs for cash. In this subchapter, we introduce some different liquidity ratios and show you how to use them.

Current Assets Ratio

The current assets ratio is one of the most common ratios. You can use it to measure your company’s ability to pay short-term (or current) debt and expenses.

Current assets ÷ Current liabilities = Current assets ratio

If your company has current assets of $80,000 and current liabilities of $50,000, your current assets ratio would be 1.6 to 1. This means that for every $1 of current liabilities, you have $1.60 worth of assets.

How do you determine if your current ratio is adequate? Obviously, a higher current ratio gives you more breathing room, but that might not necessarily represent the best use of resources. The adequacy of your current ratio depends on your particular business and industry.

One drawback of the current assets ratio is that it doesn’t specify what kind of current assets are included. Slow-moving inventory or prepaid expenses would not be as readily available to pay creditors as cash.

Quick Ratio

The quick (or acid test) ratio tries to remedy one of the drawbacks of the current assets ratio by including only those current assets that are extremely liquid—cash and equivalents (like short-term securities) and net accounts receivable. These are considered quick assets. This ratio is known as the acid test ratio because it’s the most stringent liquidity test you can use.

Quick assets ÷ Current liabilities = Quick ratio

To compute the quick ratio using numbers from our previous example, assume current assets of $80,000 were composed as follows:

Cash	$18,000
Marketable Securities	$10,000
Accounts Receivable (Net)	$22,000
Inventory	$26,000
Prepaid Assets	$4,000

Using these numbers, quick assets would total:

$18,000 + $10,000 + $22,000 = $50,000

The quick ratio would be computed as:

$50,000 ÷ $50,000 = 1 to 1

This would result in a slightly more realistic but less comfortable ratio of 1 to 1.

SEE ALSO 3.1, “Classifying Cash”

SEE ALSO 4.3, “Accounts Receivable”

SEE ALSO 5.1, “Accounting for Inventory”

Inventory Turnover

Turnover ratios measure how efficiently and quickly assets can be converted into cash. Inventory turnover measures how many times, on average, inventory is sold during the period. Here’s the formula:

Cost of goods sold ÷ Average inventory = Inventory turnover

To keep things simple, we’ll assume our inventory averaged $30,000 over the year (computed by averaging beginning and ending inventory balances). COGS for the period was $105,000.

$105,000 ÷ $30,000 = 3.5

This means that inventory turned over 3.5 times during the year. You would then want to compare this amount to the average for your industry to see whether it was fast or slow.

As an added check, you can also compute average selling time by dividing 365 days by the inventory turnover rate:

365 ÷ 3.5 = 104 days

You could also compare this figure to competitors and others in your industry.

SEE ALSO 5.2, “Determining Inventory Quantity”

Accounts Receivable Turnover

Accounts receivable turnover measures the liquidity of accounts receivable in terms of how often they are collected during the period. You can compute it using the following formula:

Net credit sales ÷ Average accounts receivable (net) = Accounts receivable turnover

With net receivables of $22,000, let’s assume sales of $87,000, of which $72,000 are credit sales:

$72,000 ÷ $22,000 = 3.27

An accounts receivable turnover of 3.3 times seems rather low, but you would need to compare it to other companies in the industry to see if that is, in fact, the case. In general, the faster the turnover, the better. Some companies, however, particularly retailers, accept slow payments on credit that result in higher interest returns and, hence, have lower accounts receivable turnover rates.

Average Age of Accounts Receivable

You can also compute the average collection time for receivables by dividing the turnover rate by 365 days. This can be a useful ratio to use when evaluating the adequacy of bad debt allowance.

365 days ÷ Accounts receivable turnover rate = Average age of accounts receivable

Using the numbers from the previous example, we get:

365 ÷ 3.3 = 111 days

You could conclude that receivables are collected on average every 111 days.

SEE ALSO 4.3, “Accounts Receivable”

Asset Turnover

This ratio looks at how well a company uses its assets to generate sales. It is computed as follows:

Net sales ÷ Average assets = Asset turnover

You can compute average assets using beginning and ending total assets for the period. For example, if your company had $170,000 in assets at the beginning of the period and $120,000 at the end, its average assets would be $145,000. Factor net sales of $560,000 into that, and you have:

$560,000 ÷ $145,000 = 3.86

This looks like a very healthy asset turnover, but because numbers can vary widely by industry, you would want to compare it to your competitors to truly gauge how you’re doing.

13.5 Making Decisions

All this financial data you’ve generated can also be useful for decision-making. Should you add a new product? Discontinue an old one? Can you afford to buy new equipment, or should you lease it? In this subchapter, we go over some simple ways to help you decide.

Measuring Costs and Benefits

Every choice you make about the course of your business is going to have a financial impact. Even something as simple as adding a new product, while offering potential revenue, also brings added expenses. To evaluate the potential costs and benefits of these different alternatives, you use what’s called incremental analysis.

If you operate a doll factory, Teeny Tots, the decision about whether to make or buy the clothing the dolls wear would be an example of an incremental decision. What you choose to do depends on a number of factors, including …

By quantifying and comparing these factors, you should be able to arrive at an informed decision. The following sections show you how to use incremental analysis in making different decisions.

Taking on New Business

If you run your own business, from time to time you’re likely to be faced with opportunities to expand or change your business. How should you evaluate them?

Let’s use our doll factory example again. Assume you’ve already decided that setting up a separate production area to sew doll clothing or even hiring the additional workers needed would be prohibitive. But now, a customer is asking if you can increase his order by 1,000 more dolls a month. He usually has 5,000 but now he wants 6,000. The catch is that instead of paying the usual $5/unit cost, he wants to pay $3 for the additional 1,000. The dolls currently cost you $3.75 to make, broken down as follows:

Type	Cost per Unit
Direct Materials	$1.50
Direct Labor	$.70
Overhead	$.30
Selling Expense	$1.00
Administrative Expense	$.25
Total	$3.75

Assuming the same per-unit cost, it would appear that the additional 1,000 dolls will run you $3,750 to make. But remember, the customer only wants to pay $3 each for the additional 1,000, which would bring in only $3,000 in revenue:

1,000 × $3 = $3,000

At first it wouldn’t seem worth it to make the additional dolls and sell them for $3, because unit costs appear to result in a $750 loss (selling price of $3,000 less $3,750 cost to make the additional 1,000). However, this is not the way you would analyze the problem, as we show in the following table:

First, the overhead would be spread over a larger number of dolls lowering the per unit cost, lets say to 25¢ from 30¢ for both old and new dolls. Second, because there are no additional selling or administrative expenses associated with the order (the customer came to you), these costs are considered sunk costs and excluded from the computation. The relevant costs would include those that go into the product—direct material, labor, and overhead. These three combined add up to $2.45 per unit for a total cost of $2,450. When that price is subtracted from the sales price of $3,000, you can see you earn an additional $550 in profit.

Another cost you must evaluate is the opportunity cost of manufacturing the additional dolls. Your factory easily has the capacity and there are no other pending orders, so assuming no additional costs, you would still clear $550 by taking the order. You would most likely accept the additional order, priced as requested on a one-time basis.

When evaluating new business decisions, you should also take any changes in the gross margin into account as this would go directly to the bottom line. In our example, the added production does not significantly impact the gross margin, which remains at 25 percent. If it had significantly brought down the margins and profitability, this could impact the business even if you were not selling them at a loss, so it’s worth keeping an eye on.

SEE ALSO 5.3, “Figuring Inventory Costs”

Discontinuing a Product

Sometimes what you need to decide doesn’t involve new business as much as whether to continue with an old one. The same type of analysis you used in evaluating a new line can help you decide whether to discontinue a product as well. Once again, you’ll need to weigh the relevant costs, opportunity costs, and sunk costs of each option.

Let’s say Teeny Tots also produces custom-made dolls designed to look like their owners. The cost breakdown for these dolls is as follows:

Last year, Teeny Tots made 200 of these dolls at a cost of $8,000 and sold them for $100 each for total revenues of $20,000. But these dolls required quite a bit of labor, which reduced the amount of time that could be spent on other Teeny Tots products. The company is now thinking of dropping the doll but doesn’t know if it could make up the difference with its other products.

This would free the manufacturing capacity and labor to produce as many as 30,000 of the popular minidolls from the previous example, which retail at $5. Their costs break down as follows:

To decide whether to discontinue, you could look at the relevant costs of the custom-made dolls because the other costs are sunk costs and will be there anyway. That would give you total costs of $7,750 ($38.75 × 200) on revenues of $20,000 ($100 × 200) for a gross profit of $12,250.

The opportunity cost of continuing this line would be the amount that could be earned if the $5 retail dolls were made instead. Using the relevant costs of $2.50 for 3,000 dolls gives you costs of $7,500. The dolls could be sold at $15,000 ($5 × 3,000), which would bring in a profit of $7,500. All things being equal, Teeny Tots should probably continue the custom-made dolls even though they are expensive and time-consuming, because they bring in a higher profit than alternative products.

How Many Must Sell?

When you’re looking at the costs for a new product, one of the first things you need to know is the break-even point—or the point when you will make money.

Computing the break-even point is fairly simple. You need to know the unit cost of making your product, the sales price, and what your fixed costs are for the year. Then you can place those numbers in this formula:

Fixed costs ÷ [1 – (Average cost ÷ Average price)] = Break-even point

If your company sells coats priced at $100 that cost you $20 to make and your fixed costs are $40,000 a year, you could compute the break-even point as follows:

$40,000 ÷ [1 – ($20 ÷ $100)] = $50,000

To find out how many coats you would have to make, you would divide the break-even point by the price:

$50,000 ÷ $100 = 500 coats

If this is a new product you’re considering, you should also consider the opportunity costs of choosing or not choosing to make it.

Make or Buy?

Sometimes you’ll have to decide whether it makes more sense to make or buy a product or rent or own an asset. When faced with this choice, it’s best to create a schedule to compare the costs of your options. For example, let’s say a small businessman is trying to decide whether it would be more cost-effective to buy a computer system or purchase some components and build a custom-made one. He or she would need to consider the costs of one versus the other as shown in the following table.

At first glance, it would appear cheaper to build the computer system as opposed to buying it. But that’s before we consider the opportunity costs of making and buying.

Let’s assume that if the employees, materials, and overhead not going into making our own computer were diverted to other production with a potential to generate $2,000 in income. This amount then could be considered an opportunity cost of making the project and would change our analysis as follows:

After considering opportunity costs, we can see that buying the machine would prove more economical.

This same analysis can be used to decide whether to buy or lease an asset as well. All you have to do is substitute a “Lease” costs column for the “Make” column.

Whether you choose to automate this process or do it yourself, financial analysis is a tool that can be used in a variety of ways, from evaluating a company’s financial performance to helping a business owner make decisions about the future. But that doesn’t mean it is foolproof. Ratios, comparisons, and cost-benefit analyses are only as good as the numbers being evaluated. And as with any formula or financial report, the numbers are only a part of the story. A healthy dose of judgment and business sense should always be factored in.