Dr. BALAMURUGAN MUTHURAMAN INTER-COMPANY EVALUATION OF FINANCIAL STATEMENTS Chapter 5

CLASSIFIED FINANCIAL STATEMENTS Information in financial statements may be used to evaluate two important goals of management – Maintaining adequate liquidity – Achieving satisfactory profitability A series of ratios are used to evaluate these two goals

EVALUATING LIQUIDITY Liquidity means having enough cash on hand to pay bills when they become due and to cover unexpected needs for cash Two measures of liquidity – Working capital – Current ratio

WORKING CAPITAL … is the amount by which total current assets exceed total current liabilities

WORKING CAPITAL Current assets – Assets that will be converted to cash or used up within one year or one operating cycle, whichever is longer Current liabilities – Debts that must be paid or obligations that must be performed within one year or one operating cycle, whichever is longer

WORKING CAPITAL By definition, current liabilities are paid out of current assets The excess of current assets over current liabilities is the net current assets on hand to continue operations Total Current Assets – Total Current Liabilities = Net Current Assets Available to Continue Business Operations Total Current Assets – Total Current Liabilities = Working Capital If then Working Capital = Net Current Assets Available to Continue Business Operations

WORKING CAPITAL Working capital is used to buy inventory, obtain credit, and finance expanded sales Lack of working capital can lead to a company's failure Compute working capital for Shafer Auto Parts Corporation

CURRENT RATIO Is closely related to working capital Believed by many to be a good indicator of a company’s ability to – Pay its bills – Repay outstanding debt … is the ratio of current assets to current liabilities

CURRENT RATIO Compute the current ratio for Shafer Auto Parts Corporation This means that Shafer has $2.90 of current assets for each $1.00 of current liabilities For proper analysis, this ratio must be compared with ratios from previous years and with ratios from successful companies in the same industry

Current Ratio Very low current ratio – Unfavorable Means the company may not have the ability to pay its bills and outstanding debt when due High current ratio – Can be unfavorable May indicate the company is not using its assets effectively

Evaluating Profitability Profitability means the ability to earn a satisfactory income Common profitability measures – Profit margin – Asset turnover – Return on assets – Debt to equity – Return on equity

PROFIT MARGIN … shows the percentage of each sales dollar that results in net income Compute the profit margin for Shafer Auto Parts This means that on each dollar of net sales, Shafer Auto Parts made 5.0 cents

Asset Turnover … measures how efficiently assets are used to produce sales It shows how many dollars of sales were generated by each dollar of assets A high asset turnover means a company uses its assets productively This ratio shows a meaningful relationship between an income statement figure and a balance sheet figure

Asset Turnover Compute asset turnover for Shafer Auto Parts Corporation Average total assets is computed by adding total assets at the beginning of the year to total assets at the end of the year and dividing by 2 This means that Shafer produces $1.90 in sales for each $1.00 invested in average total assets

Return on Assets … measures how efficiently a company uses its assets to produce income

Return on Assets Combines profit margin and asset turnover Indicates how efficiently the company is using all its assets Indicates income- generating strength of the company’s resources Return on assets overcomes the limitations of profit margin and asset turnover ratios – Profit margin does not consider the assets necessary to produce income – Asset turnover ratio does not take into account the amount of net income produced

Return on Assets Compute return on assets for Shafer Auto Parts Corporation Average total assets is computed by adding total assets at the beginning of the year to total assets at the end of the year and dividing by 2 This means that for each dollar invested by the owner, Shafer’s assets generate 9.4 cents of net income Or, Difference between 9.4 and 9.5 due to rounding

Debt to Equity … shows the portion of the company financed by creditors in comparison to that financed by stockholders A company with a high debt to equity ratio is riskier in poor economic times because it must continue to repay creditors A company with a low debt to equity ratio is safer because the stockholders do not have to be repaid and dividends can be deferred

Debt to Equity The assets of a company are financed by – Creditors (creating liabilities) – Investors A debt to equity ratio of 1.0 means that half the company’s assets are financed by creditors and half are financed by investors Represents assets financed by investors Represents assets financed by creditors

Debt to Equity Compute debt to equity for Shafer Auto Parts Corporation A ratio less than 1.0 (or 100%) means that less than half of the company’s assets are financed by creditors and more than half are financed by investors For every 61.4 cents of financing from creditors, $1.00 of financing came from investors