4.4: Analysis

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Statement of Financial Position/Balance Sheet (SFP/BS)

The SFP/BS is made up of many line items, comprised of many general ledger accounts, using different measurement bases (historical cost, fair value, and other valuation methods previously discussed in this chapter), and with significant adjusting entries for accruals and application of the company's accounting policies. For this reason, the SFP/BS does not present a clear-cut, definitive report of a company's exact financial state. Its purpose is to provide an overview as a starting point for further analysis. Some types of analysis typically undertaken by management are discussed below.

Comparative SFP/BS

Arranging previous reporting data beside the current data is a useful tool with which to analyze trends. Some companies also include the percentage change for each line item to allow certain changes in amounts to become highly visible. This enables analysts to narrow down possible areas of poor performance where further investigation will be undertaken to determine the reasons why.

Ratio Analyses

Ratio analysis is simply where relationships between selected financial data (presented in the numerator and denominator of the formula) provide key information about a company. Ratios from current year financial statements may be more useful when they are used to compare with benchmark ratios. Examples of benchmark ratios are ratios from other companies, ratios from the industry sector the company operates in, or historical and future ratio targets set by management as part of the company's strategic plan.

Care must be taken when interpreting ratios, because companies within an industry sector may use different accounting policies that will affect the comparison of ratios. In the end, ratios are based on current and past performance and are merely indicators. Further investigation is needed to gather more business intelligence about the reasons why certain variances are occurring.

Below are some common ratios used to analyze the SFP/BS and SCF financial statements:

Ratio	Formula	Purpose
Liquidity ratios – ability to pay short term obligations
Current ratio	$\dfrac{\text{Current assets}}{\text{ Current liabilities }}$	ability to pay short term debt
Quick ratio (or acid test ratio)	$\dfrac{\text{Cash*, marketable securities and net receivables}}{\text{ Current liabilities }}$	ability to pay short term debt using near-cash assets

* Cash includes cash equivalents, if any.

Ratio	Formula	Purpose
Activity ratios – ability to effectively use assets
Accounts receivable turnover	$\dfrac{\text{Net sales}}{\text {Average net accounts receivable }}$	how quickly accounts receivable is collected
In days	$\dfrac{365}{\text{Accounts receivable turnover }}$	average # of days to collect accounts receivable
Days' sales uncollected	$ \dfrac{\text{Accounts receivable }}{\text{ Net sales }} \times 365 $	average # of days that sales are uncollected (this can be compared to the credit terms of the company)
Inventory turnover	$\dfrac{\text{Cost of goods sold}}{\text{Inventory turnover }}$	how quickly inventory is sold
In days	$\dfrac{365}{\text{Inventory turnover }}$	average number of days to sell inventory
Days' sales in inventory	$ \dfrac{\text{ Ending inventory }}{\text{ Cost of Goods Sold }} \times 365 $	average # of days for inventory to convert to sales
Asset turnover	$ \dfrac{\text{Net sales}}{\text{Average total assets the ability of assets to generate sales }} $	the ability of assets to generate sales

Ratio	Formula	Purpose
Profitability ratios – ability to generate profits
Return on total assets	$ \dfrac{\text{Net income }}{\text{Average total assets}} \times 100 \% $	overall profitability of assets
Return on common shareholders' equity	$ \dfrac{\text { Net income }- \text { Preferred dividends }}{\text { Average common shareholders' equity }} \times 100 \% $	overall profitability of common shareholders' investment
Earnings per share	$ \dfrac{\text{Net income − Preferred dividends}}{\text{Weighted average common shares outstanding (WACS)}} $	net income for each common share
Payout ratio	$ \dfrac{\text { Cash dividends }}{\text { Net income }} \times 100 \% $	percentage of earnings distributed as dividends

Ratio	Formula	Purpose
Coverage – ability to pay long-term obligations
Debt ratio	$ \dfrac{\text { Total liabilities }}{\text { Total assets }} \times 100 \% $	percentage of assets provided by creditors
Equity ratio	$ \dfrac{\text { Total equity }}{\text { Total assets }} \times 100 \% $	percentage of assets provided by investors
Cash debt coverage ratio	$ \dfrac{\text { Net cash from operating activities }}{\text { Average total liabilities }} \times 100 \% $	the ability to pay debt from net cash from operating activities (statement of cash flows)
Book value per common share	$ \dfrac{\text { Common shareholders' equity }}{\text { # of common shares outstanding }} $	the amount per common share if company liquidated at reported amounts.

Many of the ratios identified above will be illustrated throughout the remaining chapters of this course.

Note that ratios are not particularly meaningful without historical trends or industry standards. Some general benchmarks signifying a reasonably healthy financial state are:

Current ratio	2:1
Quick ratio	1:1
Days' sales uncollected	1.3 times the credit policy in days

For example, if the credit policy were 30 days, a reasonable day's sales uncollected ratio would be 30 days × 1.3 = 39 days that a sale would remain uncollected.

Inventory turnover 5 times per year (or in days, every $365 \div 5=73$ days)

Again, it is important to understand that the general benchmarks identified above are guidelines only. Industry standard ratios are superior in every way, if available, since ratios are only as good as what they are being compared to (the benchmark). If the comparative ratio is not accurate for that industry, the analysis will be meaningless. (This is often referred to as "garbage in; garbage out.") As a result, management can make incorrect decisions on that basis, seriously impairing a company's potential future performance and sustainability.

Below are the ratio calculations for Watson Ltd. as at December 31, 2020, based on the financial data presented in the previous section of this chapter. The material in this chapter is intended as a high-level review. In-depth discussions are included in the introductory accounting course, and students are encouraged to review that material at this time, if needed.

Ratio	Formula	Calculation	Results
Liquidity ratios – ability to pay short term obligations
Current ratio	$\dfrac{\text{Current assets}}{\text{ Current liabilities }}$	$ \dfrac{1,314,880}{384,720}=3.42 \text { to } 1 $	reasonable
Quick ratio (or acid test ratio)	$\dfrac{\text{Cash*, marketable securities and net receivables}}{\text{ Current liabilities }}$	$ \begin{array}{l} \dfrac{307,500+12,000+249,510+18,450}{384,720} \\ =1.53 \text { to } 1 \end{array} $	reasonable

Ratio	Formula	Calculation	Results
Activity ratios – ability to effectively use assets
Accounts receivable turnover	$\dfrac{\text{Net sales}}{\text {Average net accounts receivable }}$	$ \dfrac{3,500,000}{((249,510+165,000) \div 2)}=16.89 \text { times } / \text { year } $	reasonable
In days	$\dfrac{365}{\text{Accounts receivable turnover }}$	$ \dfrac{365}{16.89}=\text { every } 21 \text { days } $	reasonable
Days' sales uncollected	$ \dfrac{\text { Accounts receivable }}{\text { Net sales }} \times 365 $	$ \dfrac{249,510}{3,500,000} \times 365=26 \text { days } $ days	reasonable, given the typical credit policy of net 30 days
Inventory turnover	\(\dfrac{\text { Cost of goods sold }}{\text { Average inventory }}	$\dfrac{2,100,000}{((708,970+650,000) \div 2)}=3.09$ times )\	this would be low, if the industry standard is around 5 times
In days	$\dfrac{365}{\text { Inventory turnover }} $	$ \dfrac{365}{3.09}=$ every 118 \) days	possibly too low if standard is 5 times or every 73 days
Days' sales in inventory	$\dfrac{\text { Ending inventory }}{\text { Cost of Goods Sold }} \times 365 $	$ \dfrac{708,970}{2,100,000} \times 365=123$ days	the total # of days to sell inventory and collect the cash from accounts receivable is 123 + 26 = 149 days
Asset turnover	$\dfrac{\text { Net sales }}{\text { Average total assets }} $	$ \dfrac{3,500,000}{((1,780,580+1,654,250) \div 2)}=2.04 $	depends on industry average and company trends

Ratio	Formula	Calculation	Results
Profitability ratios – ability to generate profits
Return on total assets	$\dfrac{\text { Net income }}{\text { Average total assets }} \times 100 \% $	$ \dfrac{77,000}{((1,780,580+1,654,250) \div 2)}=4.48 \%$	depends on industry average and company trends
Return on common shareholders' equity	$\dfrac{\text { Net income }- \text { Preferred dividends }}{\text { Average common shareholders' equity }} \times 100 \%$	$\begin{array}{l}\dfrac{(77,000-30,000)}{((862,500+18,450+84,410+}=5.48 \% \\ 680,300+18,450+50,000) \div 2)\end{array}$	depends on industry average and company trends
Earnings per share	$\begin{array}{l}\dfrac{\text { Net income }- \text { Preferred dividends }}{\text { Weighted average common }} \\ \text { shares outstanding (WACS) }\end{array}$	$\dfrac{(77,000-30,000)}{225,000}=\$ 20.89$ per share per share WACS $(250,000+200,000) \div 2=225,000$ shares assuming that sale of the shares occurred mid year	depends on industry average and company trends
Payout ratio	\(\dfrac{\text { Cash dividends }}{\text { Net income }} \times 100 \% \(	$ \dfrac{42,590}{77,000} \times 100 \%=55.3 \%$	depends on industry average and company trends

Ratio	Formula	Calculation	Results
Coverage – ability to pay long-term obligations
Debt ratio	$\dfrac{\text { Total liabilities }}{\text { Total assets }} \times 100 \%$	$\dfrac{630,720}{1,780,580} \times 100 \%=35.42 \%$	low
Equity ratio	$\dfrac{\text { Total equity }}{\text { Total assets }} \times 100 \%$	\[\dfrac{1,149,860}{1,780,580}=64.58 \%\] OR \[\begin{array}{l} 100 \%-35.42 \% \text { debt ratio } \\ =64.58 \% \end{array}\]	high
Cash debt coverage ratio	$\dfrac{\text { Net cash provided by operating activities }}{\text { Average total liabilities }} \times 100 \%$	$\dfrac{101,660}{((630,720+721,000) \div 2)}=(15.04 \%)$	unfavourable due to negative cashflow from operating activities
Book value per common share	$\dfrac{\text { Common shareholders' equity }}{\# \text { of shares outstanding }}$	$\dfrac{(862,500+18,450+84,410)}{250,000}=\$ 3.86$	depends on industry average and company trends and assumes no preferred shares dividends are in arrears

Cash Flow Ratio

It is critical to monitor the trends regarding cash flows over time. If trends are tracked, ratio analyses can be a powerful tool to evaluate a company's cash flows. Below are some of the cash flow ratios currently used in business:

Ratio	Formula	Purpose
Liquidity ratios – ability to pay short term obligations:

Current cash debt coverage ratio	$ \dfrac{Net cash flow from operating activities}{Average current liabilities}$	ability to pay short term debt from its day-to-day operations. A ratio of 1:1 is reasonable.

Financial flexibility – ability to react to unexpected expenses and investment opportunities:

Cash debt coverage ratio	$ \dfrac{Net cash flow from operating activities}{Average total liabilities}$	the ability to pay debt from net cash from operating activities (statement of cash flows)

Free Cash Flow Analyses

Free cash flow is the remaining cash flow from the operating activities section after deducting cash spent on capital expenditures such as purchasing property, plant, and equipment. Some companies also deduct cash paid dividends. The remaining cash flow represents cash available to do other things, such as expand operations, pay off long-term debt, or reduce the number of outstanding shares. Below is the calculation using the data from Watson Ltd. statement of cash flows:

Watson Ltd.
Free Cash Flow
December 31, 2020

Cash flow provided by operating activities	$	(101,660)
Less capital expenditures		0
Dividends	$	(42,590)
Free cash flow	$	(144,250)

It is no surprise that Watson has no free cash flow and no financial flexibility, since its operating activities are in a negative position. Note that the dividend deduction in the free cash flow calculation is optional, since dividends can be waived at management's discretion. In Watson's case, it met its current year dividend cash requirements by selling more common shares to raise additional cash. The capital expenditures should be for those relating to daily operations that are intended to sustain ongoing operations. For this reason, capital expenditures purchased as investments are usually excluded from the free cash flow analysis.

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Ratio	Formula	Purpose
Liquidity ratios – ability to pay short term obligations
Current ratio	\(\dfrac{\text{Current assets}}{\text{ Current liabilities }}\)	ability to pay short term debt
Quick ratio (or acid test ratio)	\(\dfrac{\text{Cash*, marketable securities and net receivables}}{\text{ Current liabilities }}\)	ability to pay short term debt using near-cash assets

Ratio	Formula	Purpose
Activity ratios – ability to effectively use assets
Accounts receivable turnover	\(\dfrac{\text{Net sales}}{\text {Average net accounts receivable }}\)	how quickly accounts receivable is collected
In days	\(\dfrac{365}{\text{Accounts receivable turnover }}\)	average # of days to collect accounts receivable
Days' sales uncollected	\( \dfrac{\text{Accounts receivable }}{\text{ Net sales }} \times 365 \)	average # of days that sales are uncollected (this can be compared to the credit terms of the company)
Inventory turnover	\(\dfrac{\text{Cost of goods sold}}{\text{Inventory turnover }}\)	how quickly inventory is sold
In days	\(\dfrac{365}{\text{Inventory turnover }}\)	average number of days to sell inventory
Days' sales in inventory	\( \dfrac{\text{ Ending inventory }}{\text{ Cost of Goods Sold }} \times 365 \)	average # of days for inventory to convert to sales
Asset turnover	\( \dfrac{\text{Net sales}}{\text{Average total assets the ability of assets to generate sales }} \)	the ability of assets to generate sales

Ratio	Formula	Purpose
Profitability ratios – ability to generate profits
Return on total assets	\( \dfrac{\text{Net income }}{\text{Average total assets}} \times 100 \% \)	overall profitability of assets
Return on common shareholders' equity	\( \dfrac{\text { Net income }- \text { Preferred dividends }}{\text { Average common shareholders' equity }} \times 100 \% \)	overall profitability of common shareholders' investment
Earnings per share	\( \dfrac{\text{Net income − Preferred dividends}}{\text{Weighted average common shares outstanding (WACS)}} \)	net income for each common share
Payout ratio	\( \dfrac{\text { Cash dividends }}{\text { Net income }} \times 100 \% \)	percentage of earnings distributed as dividends

Ratio	Formula	Calculation	Results
Profitability ratios – ability to generate profits
Return on total assets	\(\dfrac{\text { Net income }}{\text { Average total assets }} \times 100 \% \)	\( \dfrac{77,000}{((1,780,580+1,654,250) \div 2)}=4.48 \%\)	depends on industry average and company trends
Return on common shareholders' equity	\(\dfrac{\text { Net income }- \text { Preferred dividends }}{\text { Average common shareholders' equity }} \times 100 \%\)	\(\begin{array}{l}\dfrac{(77,000-30,000)}{((862,500+18,450+84,410+}=5.48 \% \\ 680,300+18,450+50,000) \div 2)\end{array}\)	depends on industry average and company trends
Earnings per share	\(\begin{array}{l}\dfrac{\text { Net income }- \text { Preferred dividends }}{\text { Weighted average common }} \\ \text { shares outstanding (WACS) }\end{array}\)	\(\dfrac{(77,000-30,000)}{225,000}=\$ 20.89\) per share per share WACS \((250,000+200,000) \div 2=225,000\) shares assuming that sale of the shares occurred mid year	depends on industry average and company trends
Payout ratio	\(\dfrac{\text { Cash dividends }}{\text { Net income }} \times 100 \% \(	\( \dfrac{42,590}{77,000} \times 100 \%=55.3 \%\)	depends on industry average and company trends

Ratio	Formula	Calculation	Results
Coverage – ability to pay long-term obligations
Debt ratio	\(\dfrac{\text { Total liabilities }}{\text { Total assets }} \times 100 \%\)	\(\dfrac{630,720}{1,780,580} \times 100 \%=35.42 \%\)	low
Equity ratio	\(\dfrac{\text { Total equity }}{\text { Total assets }} \times 100 \%\)	\[\dfrac{1,149,860}{1,780,580}=64.58 \%\] OR \[\begin{array}{l} 100 \%-35.42 \% \text { debt ratio } \\ =64.58 \% \end{array}\]	high
Cash debt coverage ratio	\(\dfrac{\text { Net cash provided by operating activities }}{\text { Average total liabilities }} \times 100 \%\)	\(\dfrac{101,660}{((630,720+721,000) \div 2)}=(15.04 \%)\)	unfavourable due to negative cashflow from operating activities
Book value per common share	\(\dfrac{\text { Common shareholders' equity }}{\# \text { of shares outstanding }}\)	\(\dfrac{(862,500+18,450+84,410)}{250,000}=\$ 3.86\)	depends on industry average and company trends and assumes no preferred shares dividends are in arrears

Ratio	Formula	Purpose
Liquidity ratios – ability to pay short term obligations:

Current cash debt coverage ratio	\( \dfrac{Net cash flow from operating activities}{Average current liabilities}\)	ability to pay short term debt from its day-to-day operations. A ratio of 1:1 is reasonable.

Financial flexibility – ability to react to unexpected expenses and investment opportunities:

Cash debt coverage ratio	\( \dfrac{Net cash flow from operating activities}{Average total liabilities}\)	the ability to pay debt from net cash from operating activities (statement of cash flows)