deals with the analysis of financial statements by investors,
creditors and other interested parties. Management is always one of those
interested parties, because how others perceive the company will effect their
business and stock price.
The financial ratios described in this chapter are used on a
daily basis by thousands of investors. There's really nothing difficult about
them, and all the information you need is required disclosure in the financial
statements prepared under GAAP.
After you complete this chapter you should be able to analyze
the financial statements of any company, including all publicly traded
companies. Many students use this information to help understand and analyze
their company retirement plans. Even if you're not an investor today, chances
are that someday you will be. If you already have a portfolio or retirement
plan, this information will be extremely valuable to you.
Many web sites are devoted to investing. You can find out
more about ratios with a search on the internet.
Investing in the stock market and Evaluating management
When investors purchase stock in a company they are investing in future
. You can't invest in past income, because it is past. That's like
betting on yesterday's horse race or ball game. So all investing is actually a
bet on the future prospects of a business.
The PE ratio (Price/Earnings) is a direct reflection of looking to the
future. Essentially the PE ratio is a measure of how confident investors are
about the future prospects of a business. The higher the PE ratio, the more
confident investors are. But only to a certain extent.
Each unit of PE basically represents one year of earnings, paid forward, in
advance to purchase one share of stock. So a PE of 5 means investors are willing
to pay forward an amount equal to 5 years of earnings to buy a share of that
company's stock. A PE of 10 represents buying forward 10 years of earnings. It's
common to see PE ratios that range 12-20 years.
The PE ratio is so important that it's listed every day in the Wall Street
Journal for every stock they list. So what has that got to do with evaluating
There are a number of ratios that can be used to evaluate a company's
management. And when investors look at those ratios they decide how good a job
management is doing. If the ratios go up, investors are willing to pay more for
the stock, resulting in a higher PE ratio. If ratios go down the opposite
Since a PE of 10 represents 10 years forward earnings, you have to feel like
management is going to do a good job over the next 10 years to recoup your
How to analyze a financial statement
There are a couple of steps, and a caution to observe, when you
analyze financial statements. And after you've done an analysis you still have
to interpret the meaning of your analysis, and the significance of your
analysis. First, the caution...
Several ratios use an average. When an average is used it is
a simple average. In all these ratios you will take the balance in an
account at the start and end of year, add them together and divide by 2. That's
a simple average. For instance, the Receivable Turnover Rate is
| Net Sales _
Average Accounts Receivable
Average accounts receivable is:
AR start of year balance + AR end of year
Some people calculate these using the end of year balance,
rather than an average. The textbook shows one possible set of formulae. If you
search the Internet you will find many other formulae that can be used to
evaluate financial information.
Steps to financial statement analysis
All financial ratios and measures use information from the
balance sheet and/or income statement. Many of the use either an average,
discussed above, or a significant subtotal, such as current assets, quick assets
or current liabilities. You should be able to identify and calculate these
amounts before beginning.
Current assets are those that will be available to conduct
business and pay bills in the near future, within the coming year. Long term
assets are those that will benefit the company beyond the current year. In a
classified balance sheet, the current assets will be subtotaled already.
Current assets consist of:
> Accounts Receivable
> Notes Receivable
> Short Term Investments
> Prepaid Expenses
Quick Assets are used to calculate the Quick Ratio.
Cash, Accounts and Notes Receivable, and Short Term Investments are quick
Current liabilities are those that will come due within the next
year. They are matched to current assets, because the money generated from
current assets will pay the current liabilities.
Current liabilities consist of:
> Current portion of Notes Payable
> Accounts Payable
> Accrued Expenses Payable (taxes, interest, payroll)
> Unearned Revenue
In order to calculate ratios you should be able to identify
the current and quick assets, and current liabilities in any balance sheet.
Measures of Liquidity
Liquidity refers to how quickly a company can turn its assets
into cash, and its ability to pay it's current debts on time. Highly liquid
assets can be turned into cash very quickly. Some of these are called cash
equivalents, because they are very liquid. For instance, a US Treasury bill
or note can be converted into cash immediately at almost any bank, so it is
considered equivalent to cash.
Other assets can be turned into cash, but more slowly. The
company expects to collect its accounts and notes receivable, but that may take
30-60 days, or longer. Inventory takes even longer to turn into money. It could
take six months or more to convert inventory into cash, depending on the type of
merchandise. Automobiles and jewelry sell slower than eggs and milk.
Inventory Turnover Rate
Turnover refers to how often a sales or collection cycle happens
in a given year. Let's think about grocery store inventory for a minute. Milk
spoils quickly and a grocery store will only stock enough milk to meet its
demand for a short period of time, perhaps one week. If they store sells its
entire stock of milk each week, we would say that their milk inventory turns
over 52 times each year. The number of days sales in inventory for milk would be
7. Let's recap:
Turnover = 52 times
Days in Inventory = 7 days
A company may analyze a single product, like milk, because
they have detailed inventory records. The information contained in financial
statements relates to the entire inventory. So you, and other investors, can
only draw some large, general inferences. However, a few rules of thumb hold
> A higher turnover rate is better
> Fewer days in inventory is better
These would indicate better inventory management.
caveat - L. a warning
as in caveat emptor
let the buyer beware caveat
Financial statements don't tell the whole story. A high turnover
rate is a good thing, but empty shelves can mean lost sales, and that's a bad
thing. Good inventory management means stocking an adequate supply of
merchandise to meet demand, but not too much excess.
Inventory is an asset with it's own problems. It must be
stored and protected until it is sold. It must often be paid for before it is
sold. It can be damaged, stolen or become spoiled or obsolete. These are all
risks associated with inventory and the cost of these losses have to be made up
Ratios tell part of a story, but not the whole story. How can
you answer some of these questions? You would probably have to visit the store
on a regular basis, and observe how they handle inventory, note the condition of
merchandise, how well the shelves are stocked and tended, and check the
dumpsters to see how much spoiled or damaged goods ar being thrown away each
Accounts Receivable Turnover Rate
AR turnover is similar to inventory turnover. It is the other
end of the sales cycle - the collections side. The AR turnover tells us how good
a job management is doing collecting accounts receivable. If the company has a
30 day payment policy, their AR turnover rate should be about 12 (once a month),
and their number of days in AR should be around 30.
If the turnover rate is too low (days in AR too high), the
company is having problems enforcing its credit policies. This is the credit
manager's responsibility. The company needs to review its credit policy and
start enforcing it. They might also have too many old, uncollectible accounts
receivable that need to be turned over to a collection agency.
EBIT means Earnings Before Interest and Taxes. It is also
referred to as Operating Income, and is used in these ratios:
> Interest coverage ratio,
> Operating expense ratio, and
> Return on assets
Stock pricing and P/E ratio
Stock price is a difficult thing to predict. Many subtle factors can effect a
stock's price, but they all have one thing in common. They all have to do with
the future. A stock investment give the stockholder rights to future earnings,
not past earnings. As a matter of fact, the entire financial market is about the
The P/E ratio is integral to stock pricing. It's so important to investors
that the Wall Street Journal publishes the P/E ratio for every stock, on a daily
basis. If you check the Journal, the P/E ratio is right next to the stock
The P/E ratio is also called the Price-Earnings ratio. It is the market price
divided by the most current earnings per share (EPS). A P/E ratio from 12 to 20
is about average. What are we really saying here? If the P/E is 12, that means
the investor is willing to pay 12 times the current DPS to buy one share of
stock. That's the same as paying forward for 12 years of future earnings, just
to get on the ride.
Let's say a company has 10,000,000 shares of stock outstanding, and a P/E ratio
of 15. If EPS is $2.00 then the price of the stock is $2.00 x 15 = $30.00 per
share. To make it easier, let's also assume that the company expects to have the
same earnings in the coming year.
Assume that the company loses a lawsuit and must pay $1,000,000 in damages.
What effect will this have on stock price? There are a couple of ways to
calculate this. Previous earnings must have been 10,000,000 shares x $2.00 EPS =
$20,000,000. So we can recalculate current earnings as follows:
The revised EPS is $19,000,000 / 10,000,000 shares = $1.90.
The revised stock price is $1.90 x 15 = $28.50 per share
The lawsuit had an impact on earnings, as follows.
Lawsuit $1,000,000 / 10,000,000 shares = $0.10 per share.
We could also do this:
Effect of lawsuit per share $0.10 x 15 P/E = $1.50
Original stock price $30.00 - $1.50 = $28.50
If you look over the calculations above, you will see there are several ways
to arrive at the solution. They all reflect the relationships between a
company's earnings, the number of shares outstanding, and investors' perception
of the company's future earnings potential (P/E ratio).
If investors think the company's earning potential is improving they are
willing to pay more for the stock, which is reflected in a higher P/E ratio. The
opposite is also true. If they think the company's earnings are impaired the P/E
ratio will go down. That is a much more complex discussion that we have time for
here, but investors look at a large variety of things to determine P/E ratio -
strength of the market for the company's product, the quality of the company's
management, liklihood of continued business success, etc.