profitability, liquidity and solvency

8 - 8 - 11© 2005 © 2005 Accounting 1/eAccounting 1/e, Terrell/Terrell, Terrell/Terrell

Analyzing Financial Analyzing Financial Statements for Statements for

Profitability, Liquidity, Profitability, Liquidity, and Solvencyand Solvency

Chapter 8Chapter 8


Learning Objectives 1 Learning Objectives 1 and 2and 2

Distinguish among Distinguish among profitability, liquidity, and profitability, liquidity, and

solvency.solvency.Calculate financial ratiosCalculate financial ratiosdesigned to measure adesigned to measure acompany’s profitability,company’s profitability,liquidity, and solvency.liquidity, and solvency.


IntroductionIntroduction

Ratio analysisRatio analysis is a technique for analyzing is a technique for analyzingthe relationship between two items from athe relationship between two items from a

company’s financial statements for a given period.company’s financial statements for a given period.

Financial statements analysisFinancial statements analysis is the process is the processof looking beyond the face of the financialof looking beyond the face of the financial

statements to gain additional insightstatements to gain additional insightinto a company’s financial health.into a company’s financial health.


Elevation Sports, Inc.Elevation Sports, Inc.Balance SheetBalance SheetMay 31, 2004May 31, 2004

Assets:Assets:Current assetsCurrent assets

CashCash $128,834$128,834Accounts receivableAccounts receivable $9,900$9,900Less: Allowance for doubtful accountsLess: Allowance for doubtful accounts – 450 – 450 9,450 9,450Merchandise inventoryMerchandise inventory 4,397 4,397Raw materials inventoryRaw materials inventory 2,315 2,315Work-in-process inventoryWork-in-process inventory 14,864 14,864Finished goods inventoryFinished goods inventory 13,634 13,634Supplies inventorySupplies inventory 593 593Prepaid rentPrepaid rent 12,000 12,000Prepaid insurancePrepaid insurance 5,000 5,000

Total current assetsTotal current assets $190,637$190,637



Property, plant, and equipmentProperty, plant, and equipmentAdministrative equipmentAdministrative equipment $ 5,100$ 5,100Selling furniture and fixturesSelling furniture and fixtures 8,400 8,400Production equipmentProduction equipment 89,600 89,600 $103,100$103,100Less: Accumulated depreciationLess: Accumulated depreciation – 17,800 – 17,800

Total property, plant, and equipmentTotal property, plant, and equipment $ 85,300$ 85,300Intangible assetsIntangible assets

PatentsPatents $ 10,083$ 10,083CopyrightsCopyrights 570 570TrademarksTrademarks 1,425 1,425

Total intangible assetsTotal intangible assets $$ 12,078 12,078Total assetsTotal assets $288,015$288,015



Liabilities and stockholders’ equity:Liabilities and stockholders’ equity:Current liabilitiesCurrent liabilities

Accounts payableAccounts payable $ 6,942$ 6,942Other accounts payableOther accounts payable 11,812 11,812Interest payableInterest payable 6,000 6,000Payroll taxes payablePayroll taxes payable 1,400 1,400Sales taxes payableSales taxes payable 560 560Income taxes payableIncome taxes payable 42,120 42,120Current portion of long-term note payableCurrent portion of long-term note payable 15,000 15,000Total current liabilitiesTotal current liabilities $ 83,834$ 83,834

Long-term liabilities:Long-term liabilities:Note payable – Vail National BankNote payable – Vail National Bank $ 60,000$ 60,000Less: Current portionLess: Current portion 15,000 15,000Total long-term liabilitiesTotal long-term liabilities 45,000 45,000

Total liabilitiesTotal liabilities $128,834$128,834



Stockholders’ equityStockholders’ equityPaid-in capital:Paid-in capital:Common stock, $10 par value,Common stock, $10 par value, 100,000 shares authorized, 4,000100,000 shares authorized, 4,000 shares issued and outstandingshares issued and outstanding $ 60,000$ 60,000Paid-in capital in excess of parPaid-in capital in excess of par – – common stockcommon stock 40,000 40,000

Total paid-in capitalTotal paid-in capital $100,000$100,000Retained earningsRetained earnings 59,181 59,181

Total stockholders’ equityTotal stockholders’ equity 159,181 159,181Total liabilities and stockholders’ equityTotal liabilities and stockholders’ equity $288,015$288,015


Elevation Sports, Inc.Elevation Sports, Inc.Income StatementIncome Statement

For the Year Ended May 31, For the Year Ended May 31, 20042004

Net salesNet sales $527,146$527,146Cost of goods soldCost of goods sold 295,834 295,834Gross profitGross profit $231,312$231,312Selling expensesSelling expenses $48,334$48,334Administrative expensesAdministrative expenses 72,189 72,189Total operating expensesTotal operating expenses 120,523 120,523Operating incomeOperating income $110,789$110,789Other revenues and expenses:Other revenues and expenses: Interest revenueInterest revenue $ 512$ 512 Interest expenseInterest expense (6,000 (6,000))Total other revenues and expensesTotal other revenues and expenses (5,488 (5,488))Income before income taxesIncome before income taxes $105,301$105,301Income taxesIncome taxes 42,120 42,120Net incomeNet income $ 63,181$ 63,181Earnings per shareEarnings per share $ 15.79$ 15.79


Profitability RatiosProfitability Ratios

Profitability ratios measure a firm’sProfitability ratios measure a firm’spast performance and help predictpast performance and help predict

its future profitability level.its future profitability level.

Profitability is the ease with whichProfitability is the ease with whicha company generates income.a company generates income.



This ratio measures how efficiently theThis ratio measures how efficiently thecompany uses its assets to produce profits.company uses its assets to produce profits.

Return on assets =Return on assets =Net income before taxes ÷ Total assetsNet income before taxes ÷ Total assets

$105,301 ÷ $288,015 = 36.56%$105,301 ÷ $288,015 = 36.56%



This ratio measures the percentage ofThis ratio measures the percentage ofincome before income taxes producedincome before income taxes produced

by a given level of revenue.by a given level of revenue.

Profit margin before income tax =Profit margin before income tax =Net income before taxes ÷ SalesNet income before taxes ÷ Sales

$105,301 ÷ $527,146 = 19.98%$105,301 ÷ $527,146 = 19.98%



This ratio calculates the amount of salesThis ratio calculates the amount of salesproduced for a given level of assets used.produced for a given level of assets used.

Total asset turnover =Total asset turnover =Sales ÷ Total assetsSales ÷ Total assets

$527,146 ÷ $288,015 = 1.83 times$527,146 ÷ $288,015 = 1.83 times



Return onReturn onassetsassets

Profit marginProfit marginbefore income taxbefore income tax==

Net incomeNet incomebefore taxesbefore taxes

÷ Total assets÷ Total assets==

Net incomeNet incomebefore taxesbefore taxes

÷ Sales÷ SalesSales ÷Sales ÷

Total assetsTotal assets××

Total assetTotal assetturnoverturnover××



This ratio measures the amount of after-taxThis ratio measures the amount of after-taxnet income generated by a dollar of sales.net income generated by a dollar of sales.

Profit margin after income tax =Profit margin after income tax =Net income after taxes ÷ SalesNet income after taxes ÷ Sales

$63,181 ÷ $527,146 = 11.98%$63,181 ÷ $527,146 = 11.98%



This ratio indicates how much after-tax incomeThis ratio indicates how much after-tax incomewas generated for a given level of equity.was generated for a given level of equity.

Return on equity after taxes =Return on equity after taxes =Net income after taxes ÷ Stockholders’ equityNet income after taxes ÷ Stockholders’ equity

$63,181 ÷ $159,181= 38.69%$63,181 ÷ $159,181= 38.69%



This ratio calculates how much before-tax incomeThis ratio calculates how much before-tax incomewas generated for a given level of equity.was generated for a given level of equity.

Return on equity before taxes =Return on equity before taxes =(Net income after taxes + Income taxes)(Net income after taxes + Income taxes)

÷ Stockholders’ equity÷ Stockholders’ equity

$105,301 ÷ $159,181= 66.15%$105,301 ÷ $159,181= 66.15%


Liquidity RatiosLiquidity Ratios

Liquidity ratios evaluate a firm’s abilityLiquidity ratios evaluate a firm’s abilityto generate sufficient cash toto generate sufficient cash to

meet its short-term obligations. meet its short-term obligations.

An asset’s liquidity describes the easeAn asset’s liquidity describes the easewith which it can be converted to cash.with which it can be converted to cash.



This ratio measures the company’s ability toThis ratio measures the company’s ability tomeet its current liabilities with current assets.meet its current liabilities with current assets.

Current ratio =Current ratio =Current assets ÷ Current liabilitiesCurrent assets ÷ Current liabilities

$190,637 ÷ $83,834 = 2.27 to 1$190,637 ÷ $83,834 = 2.27 to 1



This ratio is a stringent test of liquidityThis ratio is a stringent test of liquiditythat compares highly liquid currentthat compares highly liquid current

assets to current liabilities.assets to current liabilities.

Acid-test ratio = (Cash + ReceivablesAcid-test ratio = (Cash + Receivables+ Trading securities) ÷ Current liabilities+ Trading securities) ÷ Current liabilities

($128,384 + $9,450 + $0) ÷ $83,834= 1.64 to 1($128,384 + $9,450 + $0) ÷ $83,834= 1.64 to 1



This ratio indicates the level of salesThis ratio indicates the level of salesgenerated for a given level of working capital.generated for a given level of working capital.

Net sales to working capital = Sales ÷Net sales to working capital = Sales ÷(Current assets – Current liabilities)(Current assets – Current liabilities)

$527,146 ÷ ($190,637 – $83,834) = 4.94 times$527,146 ÷ ($190,637 – $83,834) = 4.94 times



It measures how quickly a companyIt measures how quickly a companycollects its accounts receivable.collects its accounts receivable.

Accounts receivable turnover =Accounts receivable turnover =Net credit sales ÷ Accounts receivableNet credit sales ÷ Accounts receivable

Net credit sales = $151,650 – $2,426 = $149,224Net credit sales = $151,650 – $2,426 = $149,224



Receivable turnover =Receivable turnover =$149,224 ÷ $9,450 = 15.79 times$149,224 ÷ $9,450 = 15.79 times

Average collection period =Average collection period =365 ÷ 15.79 = 23.27 days365 ÷ 15.79 = 23.27 days



This ratio indicates the number of timesThis ratio indicates the number of timestotal merchandise inventory is purchasedtotal merchandise inventory is purchased(or finished goods inventory is produced)(or finished goods inventory is produced)

and sold during a period.and sold during a period.

Inventory turnover =Inventory turnover =Cost of sales ÷ InventoryCost of sales ÷ Inventory



Inventory turnover = Inventory turnover = $295,834 ÷ ($4,397 + $13,634) = 16.41 times$295,834 ÷ ($4,397 + $13,634) = 16.41 times

Average number of daysAverage number of daysElevation Sports, Inc., holds its inventory Elevation Sports, Inc., holds its inventory

= 365 ÷ 16.41 = 22.24 days = 365 ÷ 16.41 = 22.24 days


Solvency RatiosSolvency Ratios

Solvency ratios are of most interest toSolvency ratios are of most interest tostockholders, long-term creditors,stockholders, long-term creditors,

and company management.and company management.

Solvency is a company’s ability to meet the Solvency is a company’s ability to meet the obligations created by its long-term debt.obligations created by its long-term debt.



It measures what proportion of aIt measures what proportion of acompany’s assets is financed by debt.company’s assets is financed by debt.

Assets = Liabilities + Owners’ equity Assets = Liabilities + Owners’ equity 100% = Some % + Some %100% = Some % + Some %



Total liabilities ÷ Total assetsTotal liabilities ÷ Total assets

$128,834 ÷ $288,015 = 44.73%$128,834 ÷ $288,015 = 44.73%



This ratio is also called theThis ratio is also called thetimes-interest-earned ratio.times-interest-earned ratio.

It indicates a company’s ability toIt indicates a company’s ability tomake its periodic interest payments.make its periodic interest payments.



Coverage ratio = Coverage ratio = Earnings before interest expenseEarnings before interest expense

and income taxes ÷ Interest expenseand income taxes ÷ Interest expense

($105,301 + $6,000) ÷ $6,000 = 18.55 times($105,301 + $6,000) ÷ $6,000 = 18.55 times


Learning Objective 3Learning Objective 3

Locate industry averages.Locate industry averages.


Industry AveragesIndustry Averages

The The AlmanacAlmanac includes all includes allcompanies, public and private.companies, public and private.

Information provided in theInformation provided in the AlmanacAlmanacfor each industry is four pages.for each industry is four pages.

It consists of two tables.It consists of two tables.

This chapter emphasizes theThis chapter emphasizes the Almanac ofAlmanac ofBusiness and Industrial Financial RatiosBusiness and Industrial Financial Ratios..


Industry AveragesIndustry Averages

Table II provides the same informationTable II provides the same informationitems as Table I, but it considersitems as Table I, but it considers

only companies that showedonly companies that showeda net income for the year.a net income for the year.

Table I provides an analysis of allTable I provides an analysis of allcompanies in the particular industry,companies in the particular industry,

regardless of whether they hadregardless of whether they hadany net income for the year.any net income for the year.



Evaluate a company’s Evaluate a company’s ratiosratios

using a comparison tousing a comparison toindustry averages.industry averages.


Comparison of Elevation Comparison of Elevation Sports, Inc., to Industry Sports, Inc., to Industry

AveragesAveragesReturn on assetsReturn on assetsProfit margin before income taxesProfit margin before income taxesTotal asset turnoverTotal asset turnoverProfit margin after income taxProfit margin after income taxReturn on equity after income taxesReturn on equity after income taxesReturn on equity before income taxesReturn on equity before income taxesCurrent ratioCurrent ratioQuick ratioQuick ratioNet sales to working capitalNet sales to working capitalReceivables turnoverReceivables turnoverInventory turnoverInventory turnoverDebt ratioDebt ratioCoverage ratioCoverage ratio

36.6%36.6%20.0%20.0% 1.81.812.0%12.0%39.7%39.7%43.5%43.5% 2.32.3 1.71.7 4.94.915.815.816.416.444.7%44.7%18.618.6

10.1%10.1% 4.2%4.2% 1.91.9 3.4%3.4%19.3%19.3%23.9%23.9% 1.61.6 0.40.4 7.37.328.628.6 2.52.565.8%65.8% 5.35.3

16.1%16.1% 6.1%6.1% 2.32.3 5.7%5.7%40.5%40.5%43.1%43.1% 1.91.9 0.50.5 5.95.931.731.7 2.12.168.2%68.2% 6.76.7

RatioRatio ElevationElevationSports, Inc.Sports, Inc.

TotalTotalIndustryIndustry

IndustryIndustrywith Assetswith Assets

$250-$500,000$250-$500,000


Company AnalysisCompany Analysis

Compare ratios to the industry averages.Compare ratios to the industry averages.

Look for company trends.Look for company trends.

Consider the industry environment.Consider the industry environment.

Draw conclusions.Draw conclusions.



Use ratio values fromUse ratio values fromconsecutive time periodsconsecutive time periods

to evaluate the profitability,to evaluate the profitability,liquidity, and solvencyliquidity, and solvency

of a business.of a business.


Trend Analysis ofTrend Analysis ofSelected RatiosSelected Ratios

Return on assetsReturn on assetsProfit margin before taxesProfit margin before taxesTotal asset turnoverTotal asset turnoverProfit margin after taxesProfit margin after taxesReturn on equity after taxesReturn on equity after taxesReturn on equity before taxesReturn on equity before taxesCurrent ratioCurrent ratioQuick ratioQuick ratioNet sales to working capitalNet sales to working capitalReceivables turnoverReceivables turnoverInventory turnoverInventory turnoverDebt ratioDebt ratioTotal liabilities to net worthTotal liabilities to net worth

150.4150.4141.3141.3106.4106.4146.3146.3145.1145.1144.2144.2 95.495.4 69.369.3140.3140.3 00135.3135.3 87.187.1 81.281.2

153.7153.7150.1150.1102.4102.4155.4155.4158.3158.3156.8156.8 84.084.0131.4131.4147.7147.7 00129.0129.0 99.299.2 98.798.7

100.0100.0100.0100.0100.0100.0100.0100.0100.0100.0100.0100.0100.0100.0100.0100.0100.0100.0 00100.0100.0100.0100.0100.0100.0

RatioRatio 20012001 20002000 19961996137.4137.4142.5142.5 96.496.4147.5147.5137.9137.9136.7136.7 91.791.7515.8515.8126.5126.5 00144.5144.5 94.694.6 91.791.7

20022002



Draw conclusions about theDraw conclusions about thecredit-worthiness andcredit-worthiness and

investment-attractivenessinvestment-attractivenessof a company.of a company.


Draw ConclusionsDraw Conclusions

1. Family Dollar Stores, Inc., is an industry1. Family Dollar Stores, Inc., is an industryleader in profitability and solvency.leader in profitability and solvency.

2. Family Dollar has improved the2. Family Dollar has improved thedistribution element of its supply chain.distribution element of its supply chain.

The evaluation process by natureThe evaluation process by naturedepends upon individual perception.depends upon individual perception.


Draw ConclusionsDraw Conclusions

3. Part of the company profitability and3. Part of the company profitability andliquidity will depend upon its increasingliquidity will depend upon its increasing

the inventory turnover ratio.the inventory turnover ratio.

4. If we choose to invest in a general4. If we choose to invest in a generalmerchandise discounter, Family Dollarmerchandise discounter, Family DollarStores, Inc., might be one to consider.Stores, Inc., might be one to consider.



State the limitationsState the limitationsof ratio analysis.of ratio analysis.


Limitations of Ratio AnalysisLimitations of Ratio Analysis

2. The financial statements used to compute2. The financial statements used to computethe ratios are based on historical cost.the ratios are based on historical cost.

3. Figures from the balance sheet used to3. Figures from the balance sheet used tocalculate the ratios are year-end numbers.calculate the ratios are year-end numbers.

1. Attempting to predict the future using past1. Attempting to predict the future using pastresults depends upon the predictiveresults depends upon the predictive

value of the information used.value of the information used.


Limitations of Ratio AnalysisLimitations of Ratio Analysis

5. Lack of uniformity concerning what is5. Lack of uniformity concerning what isto be included in the numerators andto be included in the numerators and

denominators make comparisonsdenominators make comparisonsextremely difficult.extremely difficult.

4. Industry peculiarities create difficulty4. Industry peculiarities create difficultyin comparing the ratios of a companyin comparing the ratios of a company

in one industry with those of ain one industry with those of acompany in another industry.company in another industry.


End of Chapter 8End of Chapter 8