To make your own copy to edit:

• If you want a Google Doc: in the file menu of the open document, click “Make a copy.” This will give you your own Google Doc to work from.
• If you want a PDF or Word file: in the file menu of the open document, click “Download” and select the file type you would like to have (note: depending on the file type you select, the formatting could get jumbled).
• Instructions for faculty to paste the content into their LMS are located in the course resource pages.

To make your own copy to edit:

• If you want a Google Doc: in the file menu of the open document, click “Make a copy.” This will give you your own Google Doc to work from.
• If you want a PDF or Word file: in the file menu of the open document, click “Download” and select the file type you would like to have (note: depending on the file type you select, the formatting could get jumbled).

You can see there is a lot of information here, but just looking at the bottom line without any statistical analysis, we can see that Net Income has been decreasing. In fact, using 2017 as a baseline, we can see that Net Income from Continuing Operations decreased by $3.933 billion from 2017 to 2018, a decrease of 51.56%, and then decreased again from $3.695 billion in 2018 to a measly $84 million in 2019. That’s a decrease of 97.73% from 2018 to 2019, and a decrease of 98.9% from 2017 to 2019.

It’s fairly easy to see that Pretax Income dropped in half (a 50% reduction) from 2017 to 2018 and then by more than 100% from 2018 to 2019 (from $4.345 billion to a loss of $640 million).

Interestingly, if we go look at operating expenses, we see them fairly stable at just under $20 billion for each year. Revenue was declining, but not dramatically (well, I suppose a drop of a billion dollars from 2017 to 2019 could be dramatic if you just look at the nominal drop, but it’s only a drop of 0.56%, which is about half a percent).

We see the cost of goods sold going up slightly, and the combination of declining sales and the increasing cost of goods and services is driving the overall gross profit down, which is affecting operating income. The other significant item that changed between 2018 and 2019 was Other Income/Expense, Non-Operating, which went from an income item of $2.821 billion in 2018 to an expense of $1.115 billion in 2019. Some digging into the disclosure section of Ford’s annual report (specifically Note 5 on page FS-20), along with press releases and other public information, reveals that Ford recalculated it’s defined benefit pension plan costs and, under GAAP, recognized an additional expense of almost $2 billion in 2019 for that line item that was previously showing as an income source (likely due to higher-than-expected market returns).

The point is that a horizontal analysis like this can reveal trends and hot spots that need more research.

Let’s look at the exact same data in a common size format. This is essentially a combination of an intracompany vertical and a horizontal analysis:

You can see the gross profit percentage declining, as cost of goods sold as a percentage of sales increases:

For every dollar in sales in 2017, the product cost was about 84 cents, and by 2019 the product cost for every dollar in sales had gone up to 86 cents, driving the margin down to about 14 cents per dollar.

Although operating expenses as a percentage of sales stayed fairly constant, the increased cost of goods sold drove the already thin operating margin down from 3 cents on the dollar to almost zero.

Before we look at the balance sheet, note that Ford publishes some of its metrics on the company website:

We could (and should) check these against the audited financials, but since they are easily verified, it’s likely the company is not inflating or deflating any of these measures.

We can see that revenue numbers agree with the income statement we downloaded, but we would have to do more research to find out how the company came up with “adjusted” free cash flow and “adjusted” EBIT (earnings before income tax). There is a footnote on that page that states, “Reconciliations of the non-GAAP financial measures designated as “adjusted” to the most comparable financial measures calculated in accordance with U.S. generally accepted accounting principles (“GAAP”) can be found on pages 62 and 63 of Ford’s 2019 printed annual report.

Let’s take a look at assets from the annual report:

From this information, we could calculate inventory turnover for 2019:

[latex]\dfrac{\text{Cost of Goods Sold}}{\text{Average Inventory}}=\dfrac{134,693,000,000}{\frac{11,220,000,000 + 10,786,000,000}{2}}[/latex]

It’s easier to drop all of those zeros, so

[latex]\dfrac{134,693}{\frac{22,006}{2}}=\dfrac{134,693}{\frac{11,220+10,786}{2}}=\dfrac{134,693}{11,003}=12.24[/latex]

Inventory turns over 12.24 times per year, or about once a month [latex]\left(\dfrac{365}{12.24}=29.82\text{ days}\right)[/latex].

For comparison, let’s compute the same metric for General Motors (GM) for 2019.

GM’s Cost of Goods Sold = 110,651 million

Average inventory = [latex]\dfrac{10,398 + 9,816}{2}[/latex](in millions)

Therefore, inventory turnover =[latex]\dfrac{110,651}{10,107}= 10.95[/latex]

[latex]\dfrac{365}{10.95}=33.33\text{ days}[/latex]

Based on just this analysis, it would appear that Ford is more efficient at moving inventory than GM, but not by much. In essence, both companies only hold inventory (including work in process) for about a month.

Assuming that most of Ford’s sales are credit, accounts receivable turnover for Ford for 2019 = Net Credit Sales / Average Accounts Receivable = 155,900 / [(11,195 + 9,237)] = 15.26.

Accounts receivable turn over 15.26 times per year, which is once every 24 days (365/15.26).

The same metric for GM for 2019 = 18.39 times, or just about 20 days, so GM is a bit faster at collecting accounts than Ford.

If we add liabilities into the picture, we can calculate working capital and the associated current quick ratios:

Working capital at the end of 2019 = current assets – current liabilities:

$114,047 (million) – $98,132 (million) = $15,915 million in working capital, and the current ratio would be 114/98 = 1.16 which means the company had $1.16 in current assets for every dollar in current liabilities. Excluding inventory from the calculation gives us a quick ratio of (114,047 – 10,786) / 98,132 = 1.05, still more than a 1:1 ratio.

The debt to assets ratio would be 225,307/258,537, just slightly less than 1:1. Just looking at the numbers, we see that most of the assets are debt-financed. In fact, using the accounting equation, we would expect shareholders’ equity to be 258,537 (assets) – 225,307 (liabilities) = 33,230.

In fact:

Owner’s equity, as predicted, is $33,230 million.

Although we can see there were 4.011 billion shares of stock issued as of December 31, 2019, we can’t calculate Earnings Per Share because we don’t know the shares outstanding. However, if we trust the auditors who have issued an opinion on these statements, we can find the EPS on the bottom of the income statement on the same page and the basis for the calculation in Note 8 on page FS-25 of the annual report, as well as an explanation of Class A and Class B stock.

On your own, feel free to explore these financial statements and ratios in more detail. You can calculate and compare debt to equity, return on owners’ equity, return on assets, dividend payout ratio (from the statement of retained earnings on page FS-8), and a host of other ratios. You could also perform a horizontal analysis between Ford and GM, or even between diverse companies such as Ford and Home Depot.

Depending on how deep you want to dive, and how serious you are, there are services for which you pay, like Dun & Bradstreet and Reuters that provide current industry averages. Also, there is information widely available through a brokerage or even sites like finance.yahoo.com that can provide comparative information, such as this:^[1]

Notice that Tesla stock was trading at almost 1150 times earnings, while Toyota and Honda were trading in the single digits. Ford’s P/E ratio is not being calculated because the earnings are too low, but we could take our most current EPS of $0.01 and divide the price of 7.68 by that amount to get a P/E of 768.

In the above analysis presented by Yahoo Finance, you’ll see the P/E ratio is being calculated in real time on a Trailing 12 months (TTM) basis. TTM uses the past 12 consecutive months of a company’s performance data to report financial figures. The 12 months studied do not necessarily coincide with a fiscal-year ending period.

Obviously, there is much more to financial analysis than can be covered in one module, but the information presented here will give you a good start and a basis for educating yourself about what is possible and will make you a better manager and investor.

• Perform a vertical analysis of a company’s financial statements

A vertical analysis of financial statements often reports the percentage of each line item to a total amount. Vertical analysis can be used to compare and identify trends within a company from year to year (intracompany) or between different companies (intercompany).

Intracompany Analysis

On the comparative income statement, the amount of each line item is divided by the sales number, which is called the “base”.

On the comparative balance sheet, the amount of each line item is divided by total assets.

On both financial statements, percentages are presented for two consecutive years in order for the percent changes over time to be evaluated.

Intercompany Analysis

The use of percentages converts a company’s dollar amounts on its financial statements into values that can be compared to other companies whose dollar amounts may be different.

Common-size statements include only the percentages that appear in either a horizontal or vertical analysis. They often are used to compare one company to another or to compare a company to other standards, such as industry averages.

The following compares the performance of two companies using a vertical analysis on their income statements for 2019.

The common-size income statements for Jonick Corporation and Schneider Corporation show that Schneider has lower gross profit and net income from operations percentages to sales. Yet Schneider has a higher overall net income due to much greater gains on the sale of investments.

From an investor’s standpoint, Jonick is better at making money from operations. Schneider may or may not be able to sustain profits from sales of investments. Normally, if you were comparing retail or manufacturing companies, you would be more interested in profits from operations, since that is the core business function. This analysis might lead you back to more a horizontal analysis of Schneider and Jonick in order to determine why so much income is being generated from the sale of investments.

Now, take what you’ve learned and practice your knowledge.

• Perform a horizontal analysis of a company’s financial statements

Important information can result from looking at changes in the same financial statement over time, both in terms of dollar amounts and percentage differences. Comparative financial statements place two years (or more) of the same statement side by side. A horizontal analysis involves noting the increases and decreases both in the amount and in the percentage of each line item. The earlier year is typically used as the base year for calculating increases or decreases in amounts.

Subcategory, Other revenue and expenses:

A horizontal analysis of Jonick’s 2018 and 2019 income statements appears above. The first two columns show income statement amounts for two consecutive years. The amount and percentage differences for each line are listed in the final two columns, respectively.

The presentation of the changes from year to year for each line item can be analyzed to see where positive progress is occurring over time, such as increases in revenue and profit and decreases in cost. Conversely, less favorable readings may be isolated using this approach and investigated further.

In this sample comparative income statement, sales increased 20.0% from one year to the next, yet gross profit and income from operations increased quite a bit more at 33.3% and 60.0%, respectively. However, the final net income amount increased by only 7.4%. Changes between the income from operations and net income lines can be reviewed to identify the reasons for the relatively lower increase in net income.

Likewise, the following is a horizontal analysis of a firm’s 2018 and 2019 balance sheets. Again, the amount and percentage differences for each line are listed in the final two columns and can be used to target areas of interest. For instance, the increase of $344,000 in total assets represents a 9.5% change in the positive direction. Total liabilities increased by 10.0%, or $116,000, from year to year. The change in total stockholders’ equity of $228,000 is a 9.3% increase. There seems to be a relatively consistent overall increase throughout the key totals on the balance sheet. Even though the percentage increase in the equipment account was 107%, indicating the amount doubled, the nominal (just the number) increase was just $43,000. This increase in relation to total assets of $3.95 million is only 1% and could easily be just one piece of equipment, or a vehicle.

All this is to say that as with all metrics and high-level analysis, a horizontal analysis like this is a way to identify areas of concern or even areas where things are going well, but further analysis is needed to determine what is really going on if anything.

• Calculate the times interest earned ratio

The final “gearing” or “leverage” ratio is commonly called times interest earned.

[latex]\dfrac{\text{net income before tax}+\text{interest expense}}{\text{interest expense}}[/latex]

For Jonick, net income before tax (NIBT) + interest expense is $314,000 + $55,000 = $369,000. That represents the amount of accrual basis income available to pay interest and taxes and to provide a profit for the business (and by extension, the owners).

Since interest expense had been deducted in arriving at income before income tax on the income statement, it is added back in the calculation of the ratio.

Dividing that amount by the amount of interest expense gives a factor that indicates how much income is available to pay interest on borrowed funds. Let’s do the calculations:

[latex]\dfrac{\$314,000+\$55,000}{\$55,000}=\dfrac{369,000}{55,000}=6.7090909…\approx6.71[/latex]

In other words, Jonick, in 2019, earned, before taxes, 6.7 times the amount of interest incurred.

The number of times anything is earned is always more favorable when it is higher since it impacts the margin of safety and the ability to pay as earnings fluctuate, particularly if they decline.

As with all these metrics, as an investor or owner, or manager, you could devise variations. For instance, a similar ratio could be applied to preferred dividends by dividing net income by preferred dividends in order to monitor the company’s ability to pay those dividends.

[latex]\dfrac{\text{net income}}{\text{preferred dividends}}[/latex]

For example: [latex]\dfrac{248,000}{12,000}=20.7[/latex]

Intercompany means between companies, and may also include comparisons to industry averages.

Intracompany means within a single company, and can be either a horizontal analysis or vertical or often a combination of both.

• Horizontal analysis involves laying out periods of information side by side in order to analyze trends.
• Vertical analysis looks at line items in a single period as a percentage of some base amount and is sometimes referred to as common-size analysis.

You could take common-size financial statements and lay them out side by side in order to analyze the trends, such as changes in gross profit percentage.

• Calculate the debt to equity ratio

The debt-to-equity (D/E) ratio is calculated by dividing a company’s total liabilities by its shareholder equity:

[latex]\left(\dfrac{\text{company’s total liabilities}}{\text{shareholder equity}}\right)[/latex]

These numbers are available on the balance sheet of a company’s financial statements.

The ratio is used to evaluate a company’s financial leverage. The D/E ratio is an important metric used in corporate finance. It is a measure of the degree to which a company is financing its operations through debt versus wholly-owned funds. More specifically, it reflects the ability of shareholder equity to cover all outstanding debts in the event of a business downturn.

Assets are acquired either by investments from stockholders or through borrowing from other parties. Companies that are averse to debt would prefer a lower ratio. Companies that prefer to use “other people’s money” to finance assets would favor a higher ratio.

In the Jonick example, debt is 1.275 million and equity is 2.675 million.

[latex]\dfrac{1.275\text{ million}}{2.675\text{ million}}=.47663551\approx0.5[/latex]

This gives us a ratio of debt to equity of .47663551, or rounded to the nearest tenth, about 0.5, which could be stated as either 50% or ½.

If a company prefers to use borrowed money (leverage) to finance its operations, it would not be alarmed at a 1:1 ratio, or maybe even 2:1 ($2 of borrowed funds for every $1 of owner contributed capital, including retained earnings). Jonick has a ratio of 0.5:1, which could also be stated more clearly as 1:2, which means the company has only $1 of debt for every $2 of owner investment. Looking at this from a total asset standpoint, it means that for every $3 in total assets, $1 is debt financed and $2 is owner financed.

If you think of this in terms of a home purchase of say $300,000, it would mean that you have invested $200,000 of your own money and borrowed $100,000 from the bank. A ratio of 5:1, on the other hand, would mean that the homeowner had borrowed $250,000 and put $50,000 of her own money into the purchase.

So, if as an investor or business owner, you prefer to leverage (use the bank’s money to fund) your business, you would be looking at higher debt to equity ratios. If you prefer not to borrow, like Jonick, you would be expecting lower D/E indicators.

Now let’s practice what you’ve learned.

• Calculate the debt to assets ratio

Variations on the debt to equity ratio include:

• Debt to total assets [latex]\left(\dfrac{\text{company’s total debt}}{\text{company’s total assets}}\right)[/latex]
• Equity to total assets [latex]\left(\dfrac{\text{company’s equity}}{\text{company’s total assets}}\right)[/latex]

(These two as percentages should add up to 100%. If they don’t, check your data and your calculations!)

For Jonick, total debt for 2019 was $1.275 million and assets were $3.95 million, for a ratio of .32278481:

[latex]\dfrac{1.275\text{ million}}{3.95\text{ million}}=.32278481[/latex]

That would be about .323 rounded to the nearest thousandths, and converted to a percentage would be 32.3%, meaning that portion of the assets are financed (which is reflected in the debt to equity ratio of 1:2).

We would then expect equity to total assets to be 67.7%. In fact, equity of $2.675 million divided by assets of $3.95 million is .67721519:

[latex]\dfrac{2.675\text{ million}}{3.95\text{ million}}=.67721519\approx 67.7\%[/latex].

In addition, investors may calculate specific other leverage ratios, such as debt to fixed assets, or the inverse, which would be fixed assets to debt, or another variation such as fixed assets to long-term debt.

For Jonick, fixed assets for 2019 were $1.093 million and long term debt was $911,000, giving an approximate ratio of 1.2:1. This is often stated simply as 1.2 or 1.2 times; fixed assets are 1.2 times the amount of long-term borrowings.

Again, the numbers by themselves are not necessarily indicative of the health of a business. They must be assessed in relation to other metrics, in relation to other periods, and in relation to other businesses, industry averages, and expectations.

Now, let’s practice what you have learned.

Solvency analysis evaluates a company’s future financial stability by looking at its ability to pay its long-term debts.

Both investors and creditors are interested in the solvency of a company. Investors want to make sure the company is in a strong financial position and can continue to grow, generate profits, distribute dividends, and provide a return on investment. Creditors are concerned with being repaid and look to see that a company can generate sufficient revenues to cover both short and long-term obligations.

In this section, we’ll look at three common indicators of solvency:

• Debt to Equity
• Debt to Assets (and Equity to Assets)
• Times Interest Earned

These ratios that measure “leverage” are also called “gearing” ratios.

• Calculate the dividend payout ratio

The dividend payout ratio is the ratio of the total amount of dividends paid out to shareholders relative to the net income of the company[latex]\left(\dfrac{\text{common stock dividends}}{\text{net income}}\right)[/latex]. The amount that is not paid to shareholders is retained by the company to pay off debt or to reinvest in core operations.

In this example, the dividend payout ratio would be [latex]\dfrac{\$8,000}{\$248,000} = 3.23\%[/latex].

For another useful analysis of dividends, we could calculate dividends per share on common stock:

[latex]\dfrac{\text{common stock dividends}}{\text{common stock shares outstanding}}[/latex]

For example: [latex]\dfrac{8,000}{\frac{83,000}{\$10}}=\$0.96[/latex]

Shares outstanding are usually disclosed on the face of the financial statements, but in the case of Jonick, we can figure out the number of shares outstanding even though it isn’t disclosed overtly, by dividing the common stock dollar amount by the par value per share given ($83,000 in common stock with a $10 par value would be 8,300 shares issued and outstanding).

Therefore, $8,000 in dividends equates to an annual dividend payout of $0.96 per share.

If this was a publicly traded company or if there was a readily available market value per share (e.g. an offer to buy the company on the table or a recent purchase), we could also calculate the dividend yield by dividing the dividend per share by the market price per share.

For this example, assume we have an established market price per share of $70.

With a dividend payout of $0.96 and a market price of $70, the dividend yield would be [latex]\dfrac{.96}{70} = 0.01371429…[/latex] or approximately 1.4%.

For an investor looking for income, rather than growth, this number would allow a comparison between different alternatives. For instance, if low-risk tax-exempt municipal bonds were paying 2%, an investor might opt for the bonds over an investment in the stock.

Now, let’s practice what you’ve learned.

• Calculate free cash flow

Free cash flow (FCF) represents the cash a company generates after accounting for cash outflows to support operations and maintain its capital assets.

The formula for free cash flow is:

[latex]\text{operating cash flow}-\text{capital expenditures}​[/latex]

Assume the following statement of cash flows for Jonick Company:

Free cash flow would be negative $1,000 (143,000 operating cash − 144,000 capital expenditures).

Because FCF accounts for investments in property, plant, and equipment, it can be lumpy and uneven over time. Just looking at the balance sheet, we see that Buildings (net of accumulated depreciation) increased significantly from 2018 to 2019. Also, although the mortgage note payable did not increase, the company issued bonded indebtedness that increased cash and may have been used to purchase a new building.

As you can see, metrics like this don’t often give the whole picture. They are most useful to identify hot spots, trends, and opportunities.

For example, take a look at this information for Ford Motor Company:

Notice net income (before any extraordinary items) has dropped from $7 billion to $84 million. However, after adjusting from accrual basis to cash, operating cash flows have stayed fairly constant.

In addition, the company invests in fixed assets at a fairly constant pace:

And so, Free Cash Flow is also fairly constant, ranging from $9 billion in 2015 to $10 billion in 2019.

Free Cash Flow by itself, as with any metric, won’t tell you the whole story. In this case, we can see that Ford Motor Company has cash to use for dividends, debt payments, and other things in addition to reinvesting in capital assets, but we don’t know for sure if that is adequate. We’ll have to look at a much larger picture of the company to determine that.

Variations on Free Cash Flow

A variation of Free Cash Flow subtracts dividends from cash flows from operating income as well as capital expenditures. The resulting number would represent cash available for debt repayment and expansion. You probably wouldn’t want to compare one company’s Free Cash Flow computed after dividends with another company that computes a more traditional FCF, but for an intra-company analysis over time, you could use whichever measure makes the most sense, as long as you are consistent.

Investment bankers and analysts who need to evaluate a company’s expected performance with different capital structures will use variations of free cash flow like Levered Free Cash Flow which is adjusted for interest payments and borrowings, and Free Cash Flow per Share. Some investors calculate a quick estimate of Free Cash Flow by simply adding depreciation expense back to net income to get a rough estimate of cash from operations and from that, they subtract capital expenditures. Again, if all you are looking at is trend analysis, or if you are comparing companies using the same methodology for each, this quick method may be adequate. In any case, it is important to know exactly what you are comparing.

• Calculate earnings per share and the price-earnings ratio

Earnings per share (EPS) measures the dollar amount of net income associated with each share of common stock outstanding.

In its basic form, the calculation is net income − preferred stock dividends divided by number of shares of common stock outstanding.

Or the formula: [latex]\dfrac{\text{net income} -\text{preferred stock dividends}}{\text{common shares}}[/latex]

Preferred dividends are removed from the net income amount since they are distributed prior to common shareholders having any claim on company profits.

Shares outstanding are usually disclosed on the face of the financial statements. In the case of Jonick, we can figure out the number of shares outstanding even though it isn’t disclosed overtly, by dividing the common stock dollar amount by the par value per share given (83,000 in common stock with a $10 par value would be 8300 shares issued and outstanding).

Therefore, for Jonick Company, EPS would be $248,000 in net income minus $12,000 in preferred stock dividends divided by $8,300 outstanding shares of stock = $28.43 of earnings for each share of stock.

Price Earnings Ratio

Earning per share can also be expressed as a price/earnings ratio by dividing the current price per share by EPS.

If this was a publicly traded company or if there was a readily available market value per share (e.g. an offer to buy the company on the table or a recent purchase), we could also calculate the dividend yield by dividing the dividend per share by the market price per share.

For this example, assume we have an established market price per share of $70.

The P/E ratio would be [latex]\dfrac{70}{28.43} = 2.46[/latex], which indicates that the stock is selling at about 2.5 times earnings. This kind of ratio is only good for comparing one stock to another or to compare a stock against an industry trend. For example, in August 2018, the average P/E ratio of the financial services industry was 14.26. You might consider buying a financial services stock with a market price of $50/share and with a P/E of 10 because that stock is trading at 10 times earnings (so earnings are presumably $5/share). All other things being equal, it should be trading closer to the industry average of 14.26, which would mean you might expect the price to come up to $71.30. In other words, a lower than expected P/E ratio might mean that a stock is under-priced.

Again, as with any metric, EPS and P/E need to be assessed in a broader context. Now let’s practice what you’ve learned.

• Calculate the rate of return on shareholder’s equity

Return on equity (ROE) measures financial performance by dividing net income by shareholders’ equity. Because shareholders’ equity is equal to a company’s assets minus its debt, ROE is considered the return on net assets (as opposed to return on total assets).

The goal of investing in a corporation is for stockholders to accumulate wealth as a result of the company making a profit. The ratio looks at how well the investments of preferred and common stockholders are being used to reach that goal.

The following formula shows how to calculate ROE:

[latex]\dfrac{\text{net income}}{\text{average total stockholders' equity}}[/latex]

For example: [latex]\dfrac{248,000}{\frac{2,675,000+2,447,000}{2}}=9.7\%[/latex]

In our example, Jonick Company shows a ROE of 9.7%, which means the owners, who together have invested about $2.5 million, are seeing the company achieve in 2019 a return on that invested capital of almost 10%.

ROE ratios vary significantly from one industry group or sector to another. For instance, utility companies overall may have a lower ROE but be more stable and less risky, whereas tech firms overall may have a higher expected ROE but the individual stocks may be riskier and more volatile.

Inconsistent profits (e.g. a net loss one year, high profits the next) can skew ROE on an annual basis. The extent of leverage (debt financing) can also affect ROE. As with any measure, this one has to be applied thoughtfully and in conjunction with other metrics.

Common variations of this metric include Return on Common Stockholders Equity (which would treat preferred stock more like debt) and Return on Invested Capital (ROIC). The formula for ROIC is (net income – dividends) / (debt + equity).

• Calculate gross and net profit margins

Gross profit is the difference between sales and cost of goods sold.

The gross profit percentage is gross profit divided by sales and measures how effectively a company generates gross profit from sales or controls cost of merchandise sold.

The calculation for gross profit percentage is as follows:

[latex]\dfrac{\text{gross profit}}{\text{sales}}[/latex]

For example: [latex]\dfrac{580,000}{994,000}=58.4\%[/latex]

Similarly, you could calculate a net profit and net profit percentage:

The calculation for net profit is as follows:

[latex]\dfrac{\text{net profit}}{\text{sales}}[/latex]

For example: [latex]\dfrac{248,000}{994,000}=24.9\%[/latex]

The gross profit ratio looks at the main cost of a merchandising business—what it pays for the items it sells. The lower the cost of merchandise sold (or COGS), the higher the gross profit, which can then be used to pay operating expenses and to generate profit.

The net profit ratio shows what percentage of sales are left over after all expenses are paid by the business.

In addition, you could calculate ratios based on operating income, net income before tax, or any other subtotal or line item on the income statement.

Let’s try a few calculations to practice this ratio.

Profitability ratios are a class of financial metrics used to assess a business’s ability to generate earnings relative to its revenue, operating costs, balance sheet assets, or shareholders’ equity over time, using data from a specific point in time.

Profitability ratios are one of the most popular metrics used in financial analysis, and they generally fall into two categories—return ratios and margin ratios.

Return ratios offer several different ways to examine how well a company generates a return for its shareholders and include return on assets (ROA) and return on equity (ROE).

Margin ratios give insight, from several different angles, on a company’s ability to turn sales into a profit. For instance, gross margin measures how much a company makes after accounting for COGS. The net profit margin is a company’s ability to generate earnings after all expenses and taxes.

Other ratios that measure profitability (the ability to make a profit) that will be covered in this section include:

• Earnings per share
• Price-earnings ratio
• Dividend payout ratio
• Free cash flow

In addition, once you get the hang of margin ratios, you could calculate margins on operating income, pre-tax income, or any other point on the income statement relative to sales or some other base, depending on what you are trying to analyze.

For most profitability ratios, having a higher value relative to a competitor’s ratio or relative to the same ratio from a previous period indicates that the company is doing well. Profitability ratios are most useful when compared to similar companies, the company’s own history, or average ratios for the company’s industry.

• Calculate the rate of return on total assets

Return on assets measures how effectively a company uses its assets to generate income. It is roughly equivalent to an investor’s overall portfolio rate of return.

To calculate return on assets, add interest expense back to net income, and divide by average total assets.

[latex]\dfrac{\text{interest expense} + \text{net income}}{\text{average total assets}}[/latex]

In our hypothetical example, net income is $248,000. Interest expense relates to financed assets, and it is added back to net income since how the assets are paid for should be irrelevant. This also makes the calculation more comparable between companies that use debt financing and companies that use equity financing.

Adding back $55,000 in interest expense gives us $303,000 in investment income, divided by $3,778,000—the average of beginning and ending total assets [latex]=\dfrac{\left(3,950,000+3,606,000\right)}{2}[/latex]—equals a rate of return on assets of .08020116 or roughly 8%. The higher the rate of return, the better, and this will vary from industry to industry and also according to current economic conditions. For instance, if the Federal Reserve is using monetary policy to depress overall interest rates, 8% might be a good rate of return. If however, the stock market is returning 10% or better, an 8% rate of return might not be appealing to an investor.

However, as with any high-level metric, this ratio has to be considered both in a larger context (e.g. over a long period of time) and as part of a larger analysis (e.g. other metrics, such as earnings per share or dividend payout may still make this an appealing investment.)

Now that you have learned about the rate of return on total assets, let’s practice your understanding.

• Calculate the Asset Turnover ratio

The asset turnover ratio can be used as an indicator of how effectively a company uses its assets to generate revenue.

Use the following to calculate the asset turnover ratio: [latex]\dfrac{\text{net sales or revenue}}{\text{average total assets}}[/latex]

Note: Long-term investments are not usually included in the calculation because they are not productivity assets used to generate sales to customers.

In this case, we’ll reduce total assets by long-term investments. The adjusted long-term assets will be $2,004,000 for 2019 ($3,950,000-$1,946,000) and $1,784,000 ($3,606,000 – $1,822,000) for 2018, and the average of those two amounts is $1,894,000 (($2,004,000+$1,784,000)/2).

Sales of $994,000 divided by average total assets of $1,894,000 comes to 52.5%.

This ratio looks at the value of most of a company’s assets and how well they are leveraged to produce sales. The goal of owning the assets is to generate revenue that ultimately results in cash flow and profit.

The higher the asset turnover ratio, the more efficient a company is at generating revenue from its assets. Conversely, if a company has a low asset turnover ratio, it indicates it is not efficiently using its assets to generate sales.

Sometimes, investors and analysts are more interested in measuring how quickly a company turns its fixed assets or current assets into sales. In these cases, the analyst can use specific ratios, such as the fixed-asset turnover ratio or the working capital ratio to calculate the efficiency of these asset classes.

While the asset turnover ratio considers average total assets in the denominator, the fixed asset turnover ratio looks at only fixed assets. The fixed asset turnover ratio (FAT) is, in general, used by analysts to measure operating performance. This efficiency ratio compares net sales (income statement) to fixed assets (balance sheet) and measures a company’s ability to generate net sales from property, plant, and equipment (PP&E). The fixed asset balance is used net of accumulated depreciation. A higher fixed asset turnover ratio indicates that a company has more effectively utilized its investment in fixed assets to generate revenue.

The asset turnover ratio should be used to compare stocks that are similar and should be used in trend analysis to determine whether asset usage is improving or deteriorating.

The asset turnover ratio may be artificially deflated when a company makes large asset purchases in anticipation of higher growth. Likewise, selling off assets to prepare for declining growth will artificially inflate the ratio. Many other factors (such as seasonality) can also affect a company’s asset turnover ratio during interim periods (such as comparing quarterly results of a retailer).

Now, check your understanding of how to calculate the Asset Turnover ratio.

• Calculate inventory turnover and number of days sales in inventory

Inventory turnover is a ratio showing how many times a company has sold and replaced inventory during a given period. A company can then divide the days in the period by the inventory turnover formula to calculate the days it takes to sell the inventory on hand. Calculating inventory turnover can help businesses make better decisions on pricing, manufacturing, marketing, and purchasing new inventory.

Inventory turnover is calculated as follows:

[latex]\dfrac{\text{cost of merchandise sold}}{\text{average inventory}}[/latex]

For example: [latex]\dfrac{414,000}{\frac{\left(55,000+48,000\right)}{2}}=8.0[/latex]

The more often inventory is sold, the more cash generated by the firm to pay bills and debts. Inventory turnover is also a measure of a firm’s operational performance. If the company’s line of business is to sell merchandise, the more often it does so, the more operationally successful it is.

Inventory turnover shows how quickly a company can sell its inventory, measuring that velocity by number of times per year the inventory theoretically rolls over completely. Obviously, individual items will differ. For instance, in a grocery store, milk will turn over relatively quickly (we hope) while Holiday cards may turn over much more slowly.

Meanwhile, days of inventory (DSI) looks at the average time a company can turn its inventory into sales. DSI is essentially the inverse of inventory turnover for a given period—calculated as (Average Inventory / COGS) x 365. Basically, DSI is the number of days it takes to turn inventory into sales, while inventory turnover determines how many times in a year inventory is sold or used.

It’s a relatively simple calculation. Just take the number of days in a year and divide that by the inventory turnover.

In our example, an inventory turnover of 8 times per year translates to 45.6 days (365/8).

• Calculate accounts receivable turnover and number of days sales in receivables

Accounts receivable turnover is the number of times per year a business collects its average accounts receivable. The ratio is used to evaluate the ability of a company to efficiently issue credit to its customers and collect funds from them in a timely manner.

To calculate receivables turnover, add together beginning and ending accounts receivable to arrive at the average accounts receivable for the measurement period, and divide into the net credit sales for the year. The formula is as follows:

[latex]\dfrac{\text{Net Annual Credit Sales}}{\frac{\text{Beginning Accounts Receivable} + \text{Ending Accounts Receivable}}{2}}[/latex]

For example: [latex]\dfrac{994,000}{\frac{108,000 + 91,000}{2}}=10.0[/latex]

The more often customers pay off their invoices, the more cash is available to the firm to pay bills and debts, and less possibility that customers will never pay at all.

A high turnover ratio could indicate a credit policy, an aggressive collections department, a number of high-quality customers, or a combination of those factors.

A low receivable turnover may be caused by a loose or nonexistent credit policy, an inadequate collections function, and/or a large proportion of customers having financial difficulties. A low turnover level could also indicate an excessive amount of bad debt and therefore an opportunity to collect excessively old accounts receivable that are unnecessarily tying up working capital. It may be useful to track accounts receivable turnover on a trend line in order to see if turnover is slowing down; if so, an increase in funding for the collections staff may be required, or at least a review of why turnover is worsening.

Average Collection Period

The days’ sales in accounts receivable ratio (also known as the average collection period) tells you the number of days it took on average to collect the company’s accounts receivable during the past year.

The days’ sales in accounts receivable is calculated as follows: the number of days in the year (use 360 or 365) divided by the accounts receivable turnover ratio during a past year.

In our example, this would be [latex]\dfrac{365}{10} = 36.5[/latex] days on average to collect cash from a sale on account.

This ratio, like any other, is a high-level indicator, designed to bring attention to problem areas.

It is possible that within the average accounts receivable balances some receivables are 60, 90, or even 120 days or more past due that are skewing the average. Therefore, it is best to review an aging of accounts receivable by customer to understand the detail behind the days’ sales in accounts receivable ratio.

Now, let’s check your understanding of this topic.

• Calculate the cash turnover ratio

The cash turnover ratio (CTR) is an efficiency ratio that shows the number of times cash is turned over in an accounting period. The cash turnover ratio works most effectively for companies that do not offer credit sales, however, for the sake of consistency, we’ll calculate the ratio for our prototypical Jonick company.

The formula for calculating the cash turnover ratio is as follows:

[latex]\dfrac{\text{Revenue}}{\text{Average Cash and Cash Equivalents}}[/latex]

• For Jonick, sales for 2019 were $994,000.
• Cash at December 31, 2019 was: $373,000
• Cash at December 31, 2018 was: $331,000
• So the average cash was [latex]\dfrac{373,000+331,000}{2}=\$352,000[/latex]
• That means the cash turnover ratio for 2019 was [latex]\dfrac{994,000}{352,000} = 2.82[/latex]

The cash turnover ratio indicates how many times a company went through its cash balance over an accounting period and the efficiency of a company’s cash in the generation of revenue. Additionally, the cash turnover ratio is often used by accountants for budgeting purposes.

In this case, over the course of one year (2019), the company generated in revenue almost three times the amount of cash. Another way to look at this is to divide the number of days in the year by the cash turnover ratio to get an estimate of the number of days that it takes for a company to replenish its cash balance. In this case, 365 days / 2.82 times per year = approximately 130 days.

A higher cash turnover ratio is desirable, as it indicates a greater frequency of cash replenishment through revenue. However, it is important to note there is no one ideal cash turnover ratio number. As with other ratios, it should be compared to competitors and industry benchmarks.

The key drawback of the cash turnover ratio is that it does not account for credit sales, which are sales made by customers in which the payment is delayed. The cash turnover ratio is most appropriate for companies that do not offer credit sales. Using the cash turnover ratio for companies that offer credit sales skews the CTR by making it larger than it really is.

Additionally, accumulating cash for future acquisitions skews the cash turnover ratio lower. The CTR is best used if the company’s cash balance year-over-year does not see significant changes.

We’ll cover additional ways to measure a company’s liquidity in the next reading but first, let’s test out your knowledge of CTR.

By assessing a company’s use of credit, inventory, and assets, efficiency ratios can help small business owners and managers conduct business better. These ratios can show how quickly the company is collecting money for its credit sales or how many times inventory turns over in a given time period. This information can help management decide whether the company’s credit terms are appropriate and whether its purchasing efforts are handled in an efficient manner. Indicators of efficiency include:

• Inventory turnover and number of days’ sales in inventory that gauge how effectively a company manages its inventory.
• Accounts receivable turnover and number of days’ sales in receivables that look at the firm’s ability to collect its accounts receivable.
• Asset turnover ratio that indicates how efficient a company is at generating revenue from its assets.

There are some other, lesser known and lesser used efficiency measures as well, such as Inventory/Total Assets that shows the portion of assets tied up in inventory (generally, a lower ratio is considered better) and accounts payable turnover, and industry specific metrics, such as a special efficiency ratio for banks that is simply expenses divided by revenue. So, if a bank spent $5 billion and had revenues of $10 billion, its efficiency ratio would be 50%. The lower the efficiency ratio, the more efficient the bank is.

• Calculate the current ratio

The current ratio measures the ability of a firm to pay its current liabilities with its cash and/or other current assets that can be converted to cash within a relatively short period of time.

The calculation for the current ratio is as follows:

[latex]\dfrac{\text{current assets}}{\text{current liabilities}}[/latex]

For example: [latex]\dfrac{911,000}{364,000}=2.5[/latex]

Interpretation: This company has 2.5 times more in current assets than it has in current liabilities. The premise is that current assets are liquid; that is, they can be converted to cash in a relatively short period of time to cover short-term debt.

A current ratio is judged as satisfactory on a relative basis. If the company prefers to have a lot of debt and not use its own money, it may consider 2.5 to be too high – too little debt for the amount of assets it has. If a company is conservative in terms of debt and wants to have as little as possible, 2.5 may be considered low – too little asset value for the amount of liabilities it has. For an average tolerance for debt, a current ratio of 2.5 may be considered satisfactory. The point is whether the current ratio is considered acceptable is subjective and will vary from company to company.

Also, the current ratio, like working capital, may include items like inventory and prepaid expenses that are not all that liquid, especially if the company has slow-moving items in inventory (like a yacht builder or home builder). In those cases, the quick ratio or acid test ratio may be better measures of short-term liquidity.

• Calculate the common variations of the current ratio

The Quick Ratio, sometimes called the Acid Test Ratio, measures the firm’s ability to pay its current liabilities with its cash and other current assets that can be converted to cash within an extremely short period of time. Quick assets include cash, accounts receivable, and marketable securities but do not include inventory or prepaid items.

The calculation for the quick ratio is as follows:

[latex]\dfrac{\text{quick assets}}{\text{current liabilities}}[/latex]

For example: [latex]\dfrac{373,000+248,000+108,000}{364,000}=2.0[/latex]

For Jonick, quick assets are cash, marketable securities, and accounts receivable, and so he calculation is:

[latex]\dfrac{(373,000 + 248,000 + 108,000)}{364,000}=\dfrac{729,000}{364,000}=2.00274725...[/latex]

After rounding, we can see that this company has 2.0 times more in its highly liquid current assets, which include cash, marketable securities, and accounts receivable than it has in current liabilities. The premise is these current assets are the most liquid and can be immediately converted to cash to cover short-term debt. Current assets such as inventory and prepaid items would take too long to sell to be considered quick assets.

A quick ratio is judged as satisfactory on a relative basis. If the company prefers to have a lot of debt and not use its own money, it may consider 2.0 to be too high—too little debt for the amount of assets it has. If a company is conservative in terms of debt and wants to have as little as possible, 2.0 may be considered low—too little asset value for the amount of liabilities it has. For an average tolerance for debt, a current ratio of 2.0 may be considered satisfactory. The point is that whether the quick ratio is considered acceptable is subjective and will vary from company to company.

Compare the quick ratio to the current ratio of 2.5. The quick ratio indicates that for every dollar of debt coming due within the next 12 months, there was $2 of highly liquid assets. The current ratio indicates that there was $2.50 of current assets, both highly liquid and slightly less liquid, to cover every $1 of current liabilities.

The quick ratio will always be more conservative than the current ratio.

Most industries should have acid test ratios that exceed 1:1 (indicating a dollar of quick assets for every dollar of current liabilities). However, very high ratios are not necessarily a positive thing. High acid test ratios could indicate that cash has accumulated rather than being reinvested, returned to owners/shareholders, or put to productive use.

Liquidity analysis looks at a company’s available cash and its ability to quickly convert other current assets into cash to meet short-term operating needs such as paying expenses and debts as they become due. Cash is the most liquid asset; other current assets such as accounts receivable and inventory may also generate cash in the near future.

Creditors and investors often use liquidity ratios to gauge how well a business is performing. Since creditors are primarily concerned with a company’s ability to repay its debts, they want to see if there is enough cash and equivalents available to meet the current portions of debt.

The most common measures of liquidity are:

• Working Capital
• Current Ratio
• Quick Ratio and Acid-Test Ratio
• Cash Turnover Ratio

Working capital and the current and quick ratios evaluate a company’s ability to pay its current liabilities.

The cash turnover ratio is an indicator of the number of times cash is turned over in an accounting period and is most relevant for companies that don’t extend credit.

• Calculate working capital

Working capital is a measure of a company’s liquidity, operational efficiency, and its short-term financial health. If a company has substantial positive working capital, then it should have the potential to invest and grow. If a company’s current assets do not exceed its current liabilities, then it may have trouble growing or paying back creditors, or even go bankrupt.

Working capital is the difference between a company’s current assets, such as cash, accounts receivable (customers’ unpaid bills) and inventories of raw materials and finished goods, and its current liabilities, such as accounts payable. Working capital reflects the company’s liquidity and refers to the difference between operating current assets and operating current liabilities. In many cases, these calculations are the same and are derived from company cash plus accounts receivable plus inventories, less accounts payable, and less accrued expenses.

The calculation for working capital is as follows:

[latex]\text{current assets} - \text{current liabilities} = \text{working capital}[/latex]

For example, Jonick Company has $911,000 in current assets and $364,000 in current liabilities, so working capital is $547,000. In other words, on December 31, 2019, at the close of business, there was a healthy amount of working capital. In fact, just at a glance, there was enough cash in the bank on December 31, 2019, to pay all of the current liabilities.

It’s important to note that even with a large amount of working capital, some of that is not actually liquid; for instance, salaries and accounts payable may need to be paid off in less than a month, but inventory may take longer than that to liquidate, and prepaid insurance, although considered a current asset, is not actually available to pay current bills (as you may recall, it is an expense that has been paid in advance, which is theoretically the exact opposite of an account payable – an expense not yet paid.)

• Identify common sources of information for financial statement analysis

For publicly traded companies, your most reliable source of information for financial statement analysis will be the Form 10-K filed with the SEC that includes the annual report, and the easiest way to find the form is to go to the official company website.

For instance, if you are interested in analyzing Ford Motor Company, start by finding the official investor’s page:

• Ford’s Investor Overview
• Ford’s Financials and Filings

From there, look for the Form 10-K or the annual report:

• Ford’s 2019 Annual report (if you scroll to the bottom of this page, you can find a PDF version of the report)

Additionally, there are some services, like Morningstar, that have computed some of the ratios and compiled additional information, and may even allow you to download financial information into Excel or some other format; however, your best source of information will always be the audited financial statements contained in the official annual report.

You’ll find the annual report has three basic sections from which you can glean information:

• Management’s Discussion and Analysis.
• The financial statements.
• Notes to the financial statements.

Most of what we will focus on in this module will be the quantitative data that comes from the basic financial statements. We will be looking at the financials from a high-level, using ratios and percentages.

Ratios and percentages are related. In fact, they are simply fractions, stated in different ways.

For instance, say you have five pens sitting on your desk. Two of them are black and three are blue. The ratio of black pens to blue pens is 2:3. There are two black pens for every three blue pens. Another way to look at this is that ⅖ of the pens are black, and ⅗ pens are blue. The fraction ⅖, stated as two-fifths, is really just an expression of a division problem that is: 2 divided by 5. Running the problem in a calculator gives you 0.4.

Often in business, instead of stating a fraction as a decimal (e.g. ⅖ = 0.4), we multiply the decimal by 100 to come up with a “percentage”. The term per cent literally means “per 100” which means to divide by 100. So, 0.4 multiplied by 100 is 40. We state that as 40 percent, or 40%, which literally means 40 divided by 100, which is 0.4.

So, 2:3 and ⅖ and 0.4 and 40% are all different ways of saying the same thing.

• Ratio: stated as a ratio: 2:3 which means 2 of one thing and 3 of another for a total of 5.
• Fraction: ⅖ which means 2 of 5 things.
• Percentage: 40% which means 0.4 which is 4/10 which, reduced to its lowest form is ⅖.

Sometimes a ratio might be stated with just a single number, like 3, which likely means 3:1. Say your soccer team scored 6 goals and the other team scored 2. The ratio is 3:1 (as with fractions, we reduce the ratio as far as we can, so 6:2 becomes 3:1), but you might just say you scored 3 times as many goals. In other words, a ratio expressed as “3 times” is simply 3:1.

What is 3:1 as a percentage?

3:1 = ¾ + ¼. Three divided by four = 0.75. 0.75 * 100 = 75, which is 75%.

In our pen example, ⅖ are black, and ⅗ are blue, which is 5/5, which is 100%. One hundred percent of the pens are either blue or black.

If you had dumped those pens out of a box of 100 mixed pens, you might extrapolate that the contents of the box, if counted carefully, would yield 40 black pens (40% of 100) and 60 blue pens (60% of 100). That may or may not be the truth. It could be that the pens are 50/50 in the box, and it was just some quirk of random selection that landed two black pens and three blue pens on your desk, as well as the fact that there was no way you were going to get two and a half blue and two and a half black. In fact, you could have gotten just one black and four blues, or vice versa, or less likely, five black or five blues. Also, our analysis can not reveal the presence of one or more red or green, or purple pens in the box.

In any case, using ratios, however, they may be expressed, is a useful way of making a high-level analysis of financial information.

Businesses publish financial statements to communicate information about their operating performance and economic health. The income statement shows the profitability of a business by presenting its revenue and expenses for a period of time and summarizes its profitability in one final result: net income. The retained earnings statement reports all of the profit a business has accumulated since it began operations. The balance sheet is a comprehensive summary report that lists a business’s assets, liabilities, owner investments, and accumulated profit.

Once the financial statements are available, the next step is to analyze them to glean useful information about a corporation’s performance over time and its current financial health. These insights help business managers and investors make decisions about future courses of action. Areas of weakness may be identified and followed up with appropriate measures for improvement. Elements of strength should be reinforced and continued.

Much of this financial statement analysis is accomplished using ratios that reveal how one amount relates to another. One or more amounts are divided by other amount(s), yielding a decimal or percentage amount. However, no ratio is particularly meaningful by itself; it needs to be compared to something else, such as desired or expected results, previous results, other companies’ results, or industry standards. This comparison lets you know where you stand in terms of whether you are doing better, worse, or the same as what you have expected or hoped for.

For this module on financial statement analysis, we’ll be using the following statements from a hypothetical company:

• Define financial statement analysis

We previously introduced the four financial statements. We discussed how these statements provide information about a company’s performance and financial position. Here, we extend this discussion by showing you specific tools you can use to analyze financial statements in order to make a more meaningful evaluation of a company.

Ratio Analysis

Ratio analysis expresses the relationship among selected items of financial statement data. A ratio expresses the mathematical relationship between one quantity and another. For analysis of the primary financial statements, we classify ratios as:

• Liquidity ratios measure the short-term ability of the company to pay its maturing obligations and to meet unexpected cash needs.
• Operating efficiency ratios measure how efficiently a firm is paying its bills, collecting cash from customers, and turning inventory into sales.
• Profitability ratios measure the income or operating success of a company for a given period of time.
• Solvency ratios measure the ability of the company to survive over a long period of time.

Comparative Analysis

A single ratio by itself is not very meaningful. Accordingly, we will use various comparisons to shed light on company performance:

1. Intracompany comparisons covering two years for the same company.
2. Industry-average comparisons based on average ratios for particular industries.
3. Intercompany comparisons based on comparisons with a competitor in the same industry.

Financial statement analysis is the process of analyzing a company’s financial statements for decision-making purposes. External stakeholders use it to understand the overall health of an organization and  to evaluate financial performance and business value. Internal constituents use it as a monitoring tool for managing the finances.

Several techniques are commonly used as part of financial statement analysis. Three of the most important techniques include horizontal analysis, vertical analysis, and ratio analysis. Horizontal analysis compares data horizontally, by analyzing values of line items across two or more years. Vertical analysis looks at the vertical effects line items have on other parts of the business and also the business’s proportions. Ratio analysis uses important ratio metrics to calculate statistical relationships.

What we will study in this module are indicators, similar to watching the dashboard on your car.  The speedometer gives you information, as does the temperature gauge and the gas gauge.  Even if the car seems to be running fine, a sudden spike in engine temperature could give you a heads up to coming trouble, and at the garage, a mechanic may run further diagnostics using more sophisticated tools.

What you’ll be learning to do in this Module is run diagnostics on companies using the financial statements.

To make your own copy to edit:

• If you want a Google Doc: in the file menu of the open document, click “Make a copy.” This will give you your own Google Doc to work from.
• If you want a PDF or Word file: in the file menu of the open document, click “Download” and select the file type you would like to have (note: depending on the file type you select, the formatting could get jumbled).

First, the direct method:

Next, the indirect method:

The only real difference is that the direct method reports cash flows from operations as if we’d been recording sales, purchases, and other expenses using the cash basis of accounting, which is the advantage of the direct method over the indirect method: the direct method shows operating cash receipts and payments.

The Statement of Financial Accounting Standards No. 95 encourages use of the direct method but permits use of the indirect method. Whenever given a choice between the indirect and direct methods in similar situations, accountants choose the indirect method almost exclusively. The American Institute of Certified Public Accountants reports that approximately 98% of all companies choose the indirect method of cash flows.

The reason is that the information in it is difficult to assemble; companies simply do not collect and store information in the manner required for this format. Using the direct method may require the chart of accounts to be restructured in order to collect different types of information. The indirect method, as you will see, can be more easily derived from existing accounting reports.

To make your own copy to edit:

• If you want a Google Doc: in the file menu of the open document, click “Make a copy.” This will give you your own Google Doc to work from.
• If you want a PDF or Word file: in the file menu of the open document, click “Download” and select the file type you would like to have (note: depending on the file type you select, the formatting could get jumbled).
• Instructions for faculty to paste the content into their LMS are located in the course resource pages.

• Explain required disclosures, including non-cash activities

What happens if we purchase a building by signing a mortgage with no cash down payment? Or if we convert bonds payable to common stock, how would we account for these transactions? These transactions do not involve cash but they are significant enough for investors to need to know. We will report them in a separate section at the bottom of the statement of cash flows. For example, assume a company did purchase a $100,000 building by paying $20,000 down in cash and signed a note for the balance of $80,000. This would be reported as follows (note: the $20,000 down payment would be including in the investing section of the statement of cash flows):

In addition to disclosing transactions that do not otherwise appear on the statement of cash flows (non-cash transactions), companies using the direct approach must supplement the cash flow statement with a reconciliation of income to cash from operations. This reconciliation may be found in notes accompanying the financial statements. For our Rumble Corp. example it would look like this:

As you can see, it’s basically just the top portion of the statement prepared using the indirect method.

Companies using the indirect method have to disclose cash paid for interest and income taxes, since those numbers are not apparent on the face of the statement as they were under the direct method.

• Demonstrate the use of a worksheet to create the Statement of Cash Flows

In order to ensure accuracy and make the process as efficient as possible, accountants have developed a worksheet process to create the statement of cash flows. We’ll demonstrate that process here using the indirect method because that is its most common use and the indirect method is the most common presentation.

First, we look at the beginning and ending balance sheets:

We’re showing credit balances on this spreadsheet as negative numbers (in parenthesis), but different accountants may do this differently. Also notice the December 31, 20X0 balance is presented as the January 1, 20X1 balance. Again, that is personal preference.

We’ll add a template to the bottom of this balance sheet spreadsheet that we will use to capture the changes in cash:

And now we fill in the worksheet one line at a time, starting with accounts receivable.

Every debit will have to have a credit. Accounts receivable decreased by $15, so we credit that account on the spreadsheet and debit the corresponding line on the statement of cash flows.

Next, we record the purchase of equipment for cash by debiting the balance sheet line and crediting the corresponding line on the statement of cash flows (cash used for investing):

Next, we know that we sold equipment and recorded a gain on the sale:

Bit by bit, we are reconstructing the ending balance sheet by recording the changes to each account caused by cash transactions.

Accumulated depreciation is the next line on the balance sheet as we work our way from top to bottom. We record depreciation expense as a credit to accumulated depreciation (an increase) and a debit to depreciation expense on the statement of cash flows (which will be an add-back to net income).

Then we adjust the current liability accounts:

The long-term borrowing increased cash and was a financing activity:

And issuing stock for cash also represents cash provided by a financing activity:

We now post net income to retained earnings:

Dividends reduce retained earnings:

And the final step is to post the change in cash:

And now the numbers are all in place, everything is accounted for, and all we have to do is place the numbers into the proper format along with some supplemental information we’ll have to get from the general ledger:

Subcategory, Cash flows from financing activities

Congratulations! You’ve now worked all the way through the worksheet and created the Statement of Cash Flows.

• Prepare a Statement of Cash Flows in proper form (both direct and indirect)

In previous sections, we’ve compiled the individual sections of the statement of cash flows for Rumble Corp. so now let’s put them all together and add one final step – the reconciliation of beginning and ending cash and cash equivalents:

Subcategory, Cash flows from financing activities

Notice how the three pieces fit together and reconcile the change in beginning and ending cash from the balance sheet:

If all the steps were done correctly, the bottom line of the statement of cash flows will equal the current cash balance on the balance sheet.

• Prepare a Statement of Cash Flows in Proper Form (both direct and indirect)

Let’s practice a bit more.

Accountants follow specific procedures when preparing a statement of cash flows. After determining the change in cash, the first step in preparing the statement of cash flows is to calculate the cash flows from operating activities, using either the direct or indirect method. The second step is to analyze all of the noncurrent accounts and additional data for changes resulting from investing and financing activities. The third step is to arrange the information gathered in steps 1 and 2 into the proper format for the statement of cash flows.

In this section, we’ll take the three parts of the Rumble Corp. statement of cash flows and put them together, and then we’ll review the systematic process that we accountants use to compile the statement.

• Calculate cash flows from investing activities

Investing activities would include any changes to long-term assets including fixed assets (also called property, plant, and equipment), long-term investments in notes receivable, or stocks or bonds of other companies, and intangible assets (patents, trademarks, etc.). Where would we find this information? We would look on the balance sheet. If there was a change in any long-term asset (increase or decrease during the year), we need to account for that item in the Investing section. For our purposes, we will use the balance sheet and any additional information provided to us.

When analyzing the investing section, a negative cash flow is not necessarily a bad thing — you would need to look into the individual items of the investing section. We could have a negative cash flow if we purchased a new building for cash but this would be a good thing for our company and should not be determined to be bad since the cash flow from investing could be negative. Same if the reverse were true. What if we sold all of our long-term assets and did not purchase any new assets? Would this be a good thing for our company since we have a positive cash flow or a signal that something is going very wrong?

Here is the balance sheet for Rumble Corp.:

Purchases of equipment are investing activities. We would know from an analysis of the general ledger that there were both increases and decreases in the equipment account(s).

That account decreased by the cost basis of the assets we sold at a gain that had a cost basis of $160 and increased by new purchases of $580. Thus, the net increase of $420.

Let’s look at that calculation of the gain on sale of assets:

Proceeds from the sale of assets are cash flows FROM investing activities.

Therefore, the investing section of the statement of cash flows for Rumble Corp. would look like this:

The net change in the fixed asset accounts was an increase of $430, but that corresponds to a decrease in cash. If we had financed these purchases, we would have to disclose the non-cash portion of the increase in the fixed asset accounts in a supplementary disclosure.

• Calculate cash flows from financing activities

Financing activities would include any changes to long-term liabilities (and short-term notes payable from the bank) and equity accounts (common stock, paid in capital accounts, treasury stock, etc.). We would get most of the information from the balance sheet, but it may be necessary to use the Statement of Retained Earnings as well for any information on dividends. As with investing, if there has been a change in a long-term liability or equity (increase or decrease during the year), we must account for the item in the Financing section of the statement of cash flows.

When analyzing the financing section, just like with investing, a negative cash flow is not necessarily a bad thing and a positive cash flow is not always a good thing. Once again, you need to look at the transactions themselves to help you decide how the positive or negative cash flow would affect the company.

To summarize our investing and financing sections, review this chart (remember, use the wording “provided” if positive cash flow and “used” if negative cash flow):

Here is the balance sheet for Rumble Corp.:

We’ve now accounted for the changes in all of the accounts except long (and short) term debt and changes in common stock. Those changes are considered financing activities. For Rumble Corp., we see an increase in long-term debt of $500 and an increase in common stock of $1,000. Once again, we need to dive into the accounting records to see what the changes are because the $500 increase in debt could have been due to $600 in borrowing and $100 in repayment, but let’s assume for purposes of this example that the company borrowed $500 on a long-term note and issued additional stock that brought in $1,000 in new capital.

In addition, the company paid out dividends in the amount of $460, which is also considered a financing activity.

The financing section of our statement of cash flows would look like this:

• Identify Cash Flows using the indirect method

The indirect method adjusts net income (rather than adjusting individual items in the income statement) for (1) changes in current assets (other than cash) and current liabilities, and (2) items that were included in net income but did not affect cash.

The most common example of an operating expense that does not affect cash is depreciation expense. The journal entry to record depreciation debits an expense account and credits an accumulated depreciation account. This transaction has no effect on cash and, therefore, should not be included when measuring cash from operations. Because accountants deduct depreciation in computing net income, net income understates cash from operations. Under the indirect method, since net income is a starting point in measuring cash flows from operating activities, depreciation expense must be added back to net income.

Consider the following example. Company A had net income for the year of $20,000 after deducting depreciation of $10,000, yielding $30,000 of positive cash flows. Thus, Company A had $30,000 of positive cash flows from operating activities. Company B had a net loss for the year of $4,000 but after deducting $10,000 of depreciation, it had $6,000 of positive cash flows from operating activities, as shown here:

Companies may add other expenses and losses back to net income because they do not actually use company cash in addition to depreciation. The items added back include amounts of depletion that were expensed, amortization of intangible assets such as patents and goodwill, and losses from disposals of long term assets or retirement of debt.

To illustrate the add back of losses from disposals of noncurrent assets, assume that Rumble Corp. sold a piece of equipment for $150. The equipment had a cost basis of $160 and had accumulated depreciation of $100. The cash would be reported in the investing section as proceeds from the sale of a long term asset. The difference between the book value of $60 and the cash received $150 is the gain of $90 which was reported on the income statement but is not a cash item.

Therefore, Rumble subtracts the gain from net income in converting net income to cash flows from operating activities.

The same process would apply to losses on sales of long term assets or retirement of debt. Since the cash will be accounted for in later cash flow sections we want to remove the effect from net income so any accrual-basis losses will be added back to net income.

As a general rule, an increase in a current asset (other than cash) decreases cash inflow or increases cash outflow. Thus, when accounts receivable increases, sales revenue on a cash basis decreases (some customers who bought merchandise have not yet paid for it). When inventory increases, cost of goods sold on a cash basis increases (increasing cash outflow). When a prepaid expense increases, the related operating expense on a cash basis increases. (For example, a company not only paid for insurance expense but also paid cash to increase prepaid insurance.) The effect on cash flows is just the opposite for decreases in these other current assets.

An increase in a current liability increases cash inflow or decreases cash outflow. Thus, when accounts payable increases, cost of goods sold on a cash basis decreases (instead of paying cash, the purchase was made on credit). When an accrued liability (such as salaries payable) increases, the related operating expense (salaries expense) on a cash basis decreases. (For example, the company incurred more salaries than it paid.) Decreases in current liabilities have just the opposite effect on cash flows. A short term notes payable from a bank would be treated as a financing activity and not an operating activity.

To summarize, the indirect method for calculating the operating activities of a statement of cash flows includes:

Here is the income statement for Rumble Corp.: