How to do common ratio analysis of the financials

Do Common Ratio Analysis of the Financials You will learn 16 common ratios which are used to analyze financial statements.

Steps

Preparation

1. Open a new workbook in Excel from the desktop, from the dock, or from within your Applications folder inside the Microsoft folder. Double click on Excel (either the green X on the dock or the app title in the folder) and select File New Workbook.
2. In Preferences, in General, set R1C1 to unchecked or Off; in Ribbon, set Ribbon to checked or On; and in View, set Show Formula Bar by default to checked or On.
3. Click in the far upper-left corner above the 1 of row 1 and to the left of column A. Doing so will select the entire worksheet. Format the number of cells to decimal places 2, show comma. Format the cells alignment left. Format Cells Font size to 9,10 or 12, bold. Color the cells the lightest sky blue. Title the worksheet, “Acctg Ratios” and save the workbook as “Financial Ratios” into an appropriate folder such as ‘wikiHow Articles’.
4. Make this selection: select columns A:C and Format Column Width 7.35″.

The Tutorial

1. Make these entries: enter the Column Headers in columns A:C and Format Cells Font underline them:
   • Enter to cell A1 the label, Ratio or Other Measurement
   • Enter to cell B1 the label, Method of Computation
   • Enter to cell C1 the label, What It Shows
2. Enter the Ratios:
   • Enter to cell A2, 01) Return on Total Assets
   • Enter to cell B2, (Net Income + Interest Expense) / Average Investment in Assets
   • Enter to cell C2, Productivity of assets
   • Enter to cell A3, 02) Return on Common Stockholder’s Equity
   • Enter to cell B3, (Net Income – Preferred Stock Dividends) / Average Common Stockholder’s Equity
   • Enter to cell C3, Earning power on residual Owner’s Equity
   • Enter to cell A4, 03) Earnings per Share of Common Stock
   • Enter to cell B4, (Net Income – Preferred Stock Dividends) / Average Number of Shares of Common Stock OUTSTANDING
   • Enter to cell C4, Amount earned on each share of Common Stock
   • Enter to cell A5, 04) Price-Earnings Ratio for Common Stock
   • Enter to cell B5, Market Price per Share / Earnings per Share
   • Enter to cell C5, Whether market price of common stock is in line with earnings
   • Enter to cell A6, 05) Dividend Yield on Common Stock
   • Enter to cell B6, Dividends per Share / Market Price per Share
   • Enter to cell C6, Return to Common Stockholders based on Current Market Price of Common Stock
   • Enter to cell A7, 06) Dividend Payout Ratio for Common Stock
   • Enter to cell B7, Dividends per Share / Earnings per Share
   • Enter to cell C7, Percentage of Earnings distributed as Dividends
   • Enter to cell A8, 07) Number of Times Interest Earned (before Income Taxes
   • Enter to cell B8, Operating Income / Annual Interest Expense
   • Enter to cell C8, Coverage of Interest Expense (particularly on Long-term Debt)
   • Enter to cell A9, 08) Times Preferred Stock Dividends Earned
   • Enter to cell B9, Net Income / Annual Preferred Stock Dividends
   • Enter to cell C9, Adequacy of Earnings to pay Preferred Stock Dividends
   • Enter to cell A10, 09) Equity (Book Value) per Share of Common Stock
   • Enter to cell B10, Common Stockholder’s Equity / Number of Shares of Common Stock OUTSTANDING
   • Enter to cell C10, Amount of Net Assets allocable to each share of Common Stock
   • Enter to cell A11, 10) Current Ratio
   • Enter to cell B11, Current Assets / Current Liabilities
   • Enter to cell C11, Short-term debt-paying ability
   • Enter to cell A12, 11) Quick Ratio (acid test)
   • Enter to cell B12, Quick Assets / Current Liabilities (see Tips below)
   • Enter to cell C12, Short-term liquidity
   • Enter to cell A13, 12) Inventories Turnover
   • Enter to cell B13, Cost of Goods Sold / Average Inventories
   • Enter to cell C13, Ability to control investment in Inventories
   • Enter to cell A14, 13) Accounts Receivable Turnover
   • Enter to cell B14, Net Sales on credit / Average Accounts Receivable
   • Enter to cell C14, Possible excessive Accounts Receivable; effectiveness of collection policy
   • Enter to cell A15, 14) Debt Ratio
   • Enter to cell B15, Total Liabilities / Total Assets
   • Enter to cell C15, Extent of borrowing and trading on the equity (financial leverage)
   • Enter to cell A16, 15) Equity Ratio
   • Enter to cell B16, Total Stockholder’s Equity / Total Assets
   • Enter to cell C16; Protection to creditors and extent of trading on the equity (financial leverage)
   • Enter to cell A17, 16) Debt to Equity Ratio
   • Enter to cell B17, Total Liabilities / Total Stockholder’s Equity
   • Enter to cell C17, Relationship between borrowed capital and equity capital
3. Make these selections: select columns A:C and Format Column Autofit Selection

Your worksheet should resemble the above image.

There are some useful techniques involving simple math which can help you perform a financial statement analysis for your business. You’ll need the three main financial statements for reference—the balance sheet, income statement, and statement of cash flows.

Each of the following methods gives visibility into trends that your business may have. The information you receive can allow you to make changes to steer your company towards more profitability and efficiency.

Ratios

There are many different types of ratios developed when conducting a financial analysis. Efficiency ratios let you see how well your business uses its assets.

• Inventory turnover—how often your inventory turns over in a year
• Accounts receivable turnover—how often your accounts receivable are collected and paid
• Accounts payable turnover—measures how fast you pay off your creditors
• Asset turnover—exhibits your asset utilization in generating revenue

Liquidity ratios are ratios that indicate whether a company can pay off its short term debts by converting current assets into cash.

The most common liquidity ratios are:

• Current ratio—describes the ability to pay off current liabilities
• Quick ratio—subtracts inventory from current assets to express a more strict indicator of the ability to pay current liabilities
• Cash ratio—the percentage of cash you have for short term debts

Solvency ratios demonstrate the ability of a business to pay its long term obligations. Common solvency ratios are:

• Debt to equity—the amount of equity that can cover debts
• Debt to asset—indicates assets that are funded by debt

Profitability ratios are measurements of whether a company is turning a profit and how much is being generated. The most used ratios are:

• Return on assets—describes the return that assets are creating for a company
• Return on equity—one of the most used for shareholders and investors, it indicates whether assets are being used to create profit

There are more ratios than those listed. The multitude of ratios in each category can make things very confusing. Stick with the most common ratios unless you need to use others.

Horizontal Analysis

Horizontal analysis is conducting by comparing multiple periods worth of financial information. Using financial ratios, a company can compare current years performance to previous years performance.

This type of analysis is usually performed on income statements and balance sheets.

This analysis provides owners with data on changes. For example, if you were to look at your debt to equity ratio (from your balance sheet) from this year and compare it to the last year, you may see a positive or negative change.

You may not see any change. If your debt to equity is the same as the period previous, you will not see a change. However, if your debt had gone up without an increase in equity you would see your debt to equity ratio go down.

This could indicate a problem, or not, depending on the decisions you had made throughout the year.

Net profit, from your income statement, is a very popular method of viewing the changes in profitability between periods. Differences, in accounting called variances, can also be compared between different periods.

If net profit for years one and two had a variance of $55,000 and years two and three had a variance of $25,000, it could be an indicator something changed.

This is when the ratios and metrics are most valuable. They give you a visual representation of something you may need to investigate.

Vertical Analysis

Vertical analysis is much more simple than a horizontal analysis. It deals with a one year period, revealing the outcomes of the income statement and balance sheet as percentages of sales and assets, respectively.

An income statement vertical analysis provides you with a look at the cost of goods sold, gross margin, and your expenses as a percentage of the value of sales for the period.

A balance sheet vertical analysis is used in the same manner as the income statement. It can be used to show the percent any of the line items are of your total assets. The categories on the balance sheet are assets, liabilities, and equity.

For instance, if you had total assets of $2,000,000 and $200,000 in cash, your cash is 10% of your total assets. Likewise, if your current liabilities were $500,000, then your liabilities are 25% of your total assets.

As you become more familiar with the ratios and financial statements, you’ll be able to make more sense of the information horizontal and vertical analysis provide.

A common size financial statement displays line items as a percentage of one selected or common figure. Creating common size financial statements makes it easier to analyze a company over time and compare it with its peers. Using common size financial statements helps investors spot trends that a raw financial statement may not uncover.

All three of the primary financial statements can be put into a common size format. Financial statements in dollar amounts can easily be converted to common size statements using a spreadsheet, or they can be obtained from online resources like Mergent Online.   Below is an overview of each financial statement and a more detailed summary of the benefits, as well as drawbacks, that such an analysis can provide investors.

Key Takeaways

• A common size financial statement displays items on a financial statement as a percentage of a common base figure.
• For example, if total sales revenue is used as the common base figure, then other financial statement items—such as operating expenses and cost of goods—will be compared as a percentage of total sales revenue.
• Investors use common size financial statements to make it easier to compare a company to its competitors and to identify significant changes in a company’s financials.

Balance Sheet Analysis

The common figure for a common size balance sheet analysis is total assets. Based on the accounting equation, this also equals total liabilities and shareholders’ equity, making either term interchangeable in the analysis. It is also possible to use total liabilities to indicate where a company’s obligations lie and whether it is being conservative or risky in managing its debts.

The common size strategy from a balance sheet perspective lends insight into a firm’s capital structure and how it compares to its rivals. An investor can also look to determine an optimal capital structure for a given industry and compare it to the firm being analyzed. Then the investor can conclude whether the debt level is too high, excess cash is being retained on the balance sheet, or inventories are growing too high. The goodwill level on a balance sheet also helps indicate the extent to which a company has relied on acquisitions for growth.

Below is an example of a common size balance sheet for technology giant International Business Machines (IBM). Running through some of the examples touched on above, we can see that long-term debt averages around 20% of total assets over the three-year period, which is a reasonable level. It is even more reasonable when observing that cash represents around 10% of total assets, and short-term debt accounts for 6% to 7% of total assets over the past three years.

It is important to add short-term and long-term debt together and compare this amount to total cash on hand in the current assets section. This lets the investor know how much of a cash cushion is available or if a firm is dependent on the markets to refinance debt when it comes due.

Analyzing the Income Statement

The common figure for an income statement is total top-line sales. This is actually the same analysis as calculating a company’s margins. For instance, a net profit margin is simply net income divided by sales, which also happens to be a common size analysis.

The same goes for calculating gross and operating margins. The common size method is appealing for research-intensive companies, for example, because they tend to focus on research and development (R&D) and what it represents as a percent of total sales.

Below is a common size income statement for IBM. We will cover it in more detail below, but notice the R&D expense that averages close to 6% of revenues. Looking at the peer group and companies overall, according to a Booz & Co. analysis, this puts IBM in the top five among tech giants and the top 20 firms in the world (2013) in terms of total R&D spending as a percent of total sales.

Common Size and Cash Flow

In a similar fashion to an income statement analysis, many items in the cash flow statement can be stated as a percent of total sales. This can give insight on a number of cash flow items, including capital expenditures (CapEx) as a percent of revenue.

Share repurchase activity can also be put into context as a percent of the total top line. Debt issuance is another important figure in proportion to the amount of annual sales it helps generate. Because these items are calculated as a percent of sales, they help indicate the extent to which they are being utilized to generate overall revenue.

Below is IBM’s cash flow statement in terms of total sales. It generated an impressive level of operating cash flow that averaged 19% of sales over the three-year period. Share repurchase activity was also impressive at more than 11% of total sales in each of the three years. You may also notice the first row, which is net income as a percent of total sales, which matches exactly with the common size analysis from an income statement perspective. This represents the net profit margin.

How This Differs From Regular Financial Statements

The key benefit of a common size analysis is it allows for a vertical analysis by line item over a single time period, such as a quarterly or annual period, and also from a horizontal perspective over a time period such as the three years we analyzed for IBM above.

Just looking at a raw financial statement makes this more difficult. But looking up and down a financial statement using a vertical analysis allows an investor to catch significant changes at a company. A common size analysis helps put an analysis in context (on a percentage basis). It is the same as a ratio analysis when looking at the profit and loss statement.

What the Common Size Reveals

The biggest benefit of a common size analysis is that it can let an investor identify large or drastic changes in a firm’s financials. Rapid increases or decreases will be readily observable, such as a rapid drop in reported profits during one quarter or year.

In IBM’s case, its results overall during the time period examined were relatively steady. One item of note is the Treasury stock in the balance sheet, which had grown to more than a negative 100% of total assets. But rather than alarm investors, it indicates the company had been hugely successful in generating cash to buy back shares, which far exceeds what it had retained on its balance sheet.

A common size analysis can also give insight into the different strategies that companies pursue. For instance, one company may be willing to sacrifice margins for market share, which would tend to make overall sales larger at the expense of gross, operating, or net profit margins. Ideally, the company that pursues lower margins will grow faster. While we looked at IBM on a stand-alone basis, like the R&D analysis, IBM should also be analyzed by comparing it to key rivals.

The Bottom Line

As the above scenario highlights, a common size analysis on its own is unlikely to provide a comprehensive and clear conclusion on a company. It must be done in the context of an overall financial statement analysis, as detailed above.

Investors also need to be aware of temporary versus permanent differences. A short-term drop in profitability could only indicate a short-term blip, rather than a permanent loss in profit margins.

Financial Analysis Examples

Example of Financial analysis is analyzing company’s performance and trend by calculating financial ratios like profitability ratios which includes net profit ratio which is calculated by net profit divided by sales and it indicates the profitability of company by which we can assess the company’s profitability and trend of profit and there are more ratios like liquidity ratios, turnover ratios, and solvency ratios.

Financial Statement Analysis is considered as one of the best ways to analyze the fundamental aspects of a business. It helps us in understanding the financial performance of the company derived from its financial statements. This is an important metric to analyze the company’s operating profitability, liquidity, leverage, etc. The following financial analysis example provides an outline of the most common financial analysis used by professionals.

Top 4 Financial Statement Analysis Examples

Below mentioned are the financial statements of XYZ Ltd & ABC Ltd.

Balance Sheet of XYZ Ltd. & ABC Ltd.

P&L Statement of XYZ Ltd. & ABC Ltd.

Below mentioned are the examples of financial ratio analysis on the basis of financial statements provided above:

Example #1 – Liquidity Ratios

Liquidity ratios measure the ability of a company to pay off its current obligations. Most common types are:

Current Ratio

Current Ratio measures the extent of the number of current assets to current liabilities. Generally, the ratio of 1 is considered to be ideal to depict that the company has sufficient current assets in order to repay its current liabilities.

ABC’s Current Ratio is better as compared to XYZ which shows ABC is in a better position to repay its current obligations.

Quick Ratio

Quick ratio helps in analyzing the company’s instant paying ability of its current obligations.

ABC is in a better position as compared to XYZ to instantly cover its current obligations.

Example #2 – Profitability Ratios

Profitability ratios analyze the earning ability of the company. It also helps in understanding the operating efficiency of the business of the company. Few important profitability ratios are as follows:

Ratio—the term is enough to curl one’s hair, conjuring up those complex problems we encountered in high school math that left many of us babbling and frustrated. But when it comes to investing, that need not be the case. In fact, there are ratios that, properly understood and applied, can help make you a more informed investor.

Key Takeaways

• Fundamental analysis relies on extracting data from corporate financial statements to compute various ratios.
• There are five basic ratios that are often used to pick stocks for investment portfolios.
• These include price-earnings (P/E), earnings per share, debt-to-equity and return on equity (ROE).

5 Basic Financial Ratios And What They Reveal

1. Working Capital Ratio

Working capital represents a company’s ability to pay its current liabilities with its current assets. Working capital is an important measure of financial health since creditors can measure a company’s ability to pay off its debts within a year.

Working capital represents the difference between a firm’s current assets and current liabilities. The challenge can be determining the proper category for the vast array of assets and liabilities on a corporate balance sheet and deciphering the overall health of a firm in meeting its short-term commitments.

Assessing the health of a company in which you want to invest involves understanding its liquidity—how easily that company can turn assets into cash to pay short-term obligations. The working capital ratio is calculated by dividing current assets by current liabilities.

So, if XYZ Corp. has current assets of $8 million, and current liabilities of $4 million, that’s a 2:1 ratio—pretty sound. But if two similar companies each had 2:1 ratios, but one had more cash among its current assets, that firm would be better able to pay off its debts quicker than the other.

2. Quick Ratio

Also called the acid test, this ratio subtracts inventories from current assets, before dividing that figure into liabilities. The idea is to show how well current liabilities are covered by cash and by items with a ready cash value. Inventory, on the other hand, takes time to sell and convert into liquid assets.

If XYZ has $8 million in current assets minus $2 million in inventories over $4 million in current liabilities, that’s a 1.5:1 ratio. Companies like to have at least a 1:1 ratio here, but firms with less than that may be okay because it means they turn their inventories over quickly.

3. Earnings per Share (EPS)

When buying a stock, you participate in the future earnings (or risk of loss) of the company. Earnings per share (EPS) measures net income earned on each share of a company’s common stock. The company’s analysts divide its net income by the weighted average number of common shares outstanding during the year.

If a company has zero or negative earnings (i.e. a loss) then earnings per share will also be zero or negative.

4. Price-Earnings (P/E) Ratio

Called P/E for short, this ratio reflects investors’ assessments of those future earnings. You determine the share price of the company’s stock and divide it by EPS to obtain the P/E ratio.

If, for example, a company closed trading at $46.51 a share and EPS for the past 12 months averaged $4.90, then the P/E ratio would be 9.49. Investors would have to spend $9.49 for every generated dollar of annual earnings.

Note that if a company has zero or negative earnings, the P/E ratio will no longer make sense, and will often appear as N/A for not applicable.

When ratios are properly understood and applied, using any one of them can help improve your investing performance.

Even so, investors have been willing to pay more than 20 times the EPS for certain stocks if hunch that future growth in earnings will give them an adequate return on their investment.

5. Debt-Equity Ratio

What if your prospective investment target is borrowing too much? This can reduce the safety margins behind what it owes, jack up its fixed charges, reduce earnings available for dividends for folks like you and even cause a financial crisis.

The debt-to-equity (D/E) is calculated by adding outstanding long and short-term debt, and dividing it by the book value of shareholders’ equity. Let’s say XYZ has about $3.1 million worth of loans and had shareholders’ equity of $13.3 million. That works out to a modest ratio of 0.23, which is acceptable under most circumstances. However, like all other ratios, the metric has to be analyzed in terms of industry norms and company-specific requirements.

Bonus! 6. Return on Equity (ROE)

Common shareholders want to know how profitable their capital is in the businesses they invest it in. Return on equity is calculated by taking the firm’s net earnings (after taxes), subtracting preferred dividends, and dividing the result by common equity dollars in the company.

Let’s say net earnings are $1.3 million and preferred dividends are $300,000. Take that and divide it by the $8 million in common equity. That gives a ROE of 12.5%. The higher the ROE, the better the company is at generating profits.

The Bottom Line

Applying formulae to the investment game may take some of the romance out of the process of getting rich slowly. But the above ratios could help you pick the best stocks for your portfolio, build your wealth and even have fun doing it. There are dozens of financial ratios that are used in fundamental analysis, here we only briefly highlighted six of the most common and basic ones. Remember that a company cannot be properly evaluated or analyzed using just one ratio in isolation – always combine ratios and metrics to get a complete picture of a company’s prospects.

What Are Good Ratios to Receive Approval for a Commercial Loan?

Ratio analysis is a very useful tool to quantitatively understand a business’s performance. While many managers shy away from ratio analysis, the calculation thereof is not difficult, and it only requires information from the company’s financial statements.

What Is Ratio Analysis?

Ratio analysis is a method by which a company’s operations can be quantitatively evaluated and measured using the balance sheet, the income statement and the cash flow statement. Ratio analysis can be used to determine whether a business is profitable, whether it has enough to pay its bills, whether it is using its assets efficiently and whether it is a good candidate for investment. Ratio analysis facilitates the spotting of trends and provides a way to compare a business with others in its industry.

Balance Sheet Ratios

Ratios calculated using information from the balance sheet, also called liquidity ratios, indicate the ability of a company to turn its assets into cash. They include current ratios, quick ratios and leverage ratios.

The current ratio is one of the best-known measures of financial strength. It indicates whether a company has enough assets to pay off its debt. A generally acceptable ratio is 2:1, but this will vary based on the business itself, its stage in the business lifecycle, etc.
Current Ratio = Total Current Assets/Total Current Liabilities

Quick ratios are sometimes called “acid tests” and are one of the best measures of liquidity. It is more precise than the current ratio because it excludes inventories, focusing instead on truly liquid assets such as those listed in the formula. An acid-test of 1:1 is considered satisfactory. Quick Ratio = (Cash + Government Securities + Receivables)/Total Current Liabilities

Leverage ratios look at the extent to which a business is financed by debt. A high leverage ratio may indicate a risky business. Leverage Ratio = Total Liabilities/Net Worth

Working capital, although more a measure of cash flow than a ratio, is looked at frequently by banks and financial institutions when evaluating loan applications. It is viewed as the company’s ability to meet crises. Working Capital = Total Current Assets – Total Current Liabilities

Income Statement Ratios

Income statement ratios measure profitability. Comparison of these business ratios to those of similar businesses can reveal the relative strengths or weaknesses. Gross Profit = Net Sales – Cost of Goods Sold Gross Margin Ratio = Gross Profit/Net Sales Net Profit Margin Ratio = Net Profit Before Tax/Net Sales

Management Ratios

These ratios are derived from information in both the balance sheet and the income statement.

The inventory turnover ratio reveals how well inventory is being managed. Inventory Turnover Ratio = Net Sales/Average Inventory at Cost

The accounts/receivable turnover ratio indicates how well receivables are being collected. A/R Turnover Ratio = Accounts Receivable/(Annual Net Credit Sales/365)

The return on assets (ROA) ratio measures how efficiently assets are being used.
ROA = Net Profit Before Tax/Total Assets

The return on investment (ROI) ratio reflects the return received on funds invested in the business. ROI = Net Profit Before Tax/Net Worth

Cash Flow Ratios

These ratios tend to be favored more by analysts than auditors. They are used to evaluate risk and can provide a more accurate determination of a company to satisfy its current and future obligations. Cash flow ratios are useful in highlighting potential problem areas

Operating cash flow (OFC) is the company’s ability to generate resources to meet current liabilities. OCF = Cash Flow From Operations/Current Liabilities

Funds flow coverage (FFC) indicates the coverage of unavoidable expenditures. FFC = Earning Before Interest, Tax, Depreciation and Amortization (EBITDA)/(Interest + Debt Repayment + Preferred Dividends)

Cash interest coverage (CIC) is the ability of the company to meet interest payments. CIC = (Cash Flow From Operations + Interest Paid + Taxes Paid)/Interest Paid

Cash current debt coverage (CCDC) is the ability of the company to repay its current debt.
CCDC = (Operating Cash Flow – Cash Dividends)/Current Debt

Cash flow adequacy (CFA) is the basically the company’s credit quality. CFA = (EBITDA – Taxes Paid – Interest Paid – Capital Expenditures)/(5yr Average Annual Debt)

In this summary, we will cover

• What is trend analysis?
• What financial statements can be used to do trend analysis.
• Why trend analysis is important.

Takeaways

• There are various ways of performing financial statement analysis so as to gauge the financial health of a business. You can do a trend analysis, ratio analysis or a vertical analysis.
• Trend analysis, which is also known as horizontal analysis is when you analyze the financial statements of a business over a period of time to determine the trend or movement of the various financial items such as assets and liabilities. The period can be in months, quarters, or financial years.
• The goal of doing a trend analysis of a company’s financials is to evaluate the overall performance of the company as well as evaluating whether the management is performing as expected.
• Among the many reasons why trend analysis is important, one of them is the fact that it helps management, and an investor or business owner to make strategic decisions. Knowing the various trends over a number of years gives you a chance to make an informed decision when it comes to the finances of the business. It could be increasing the revenues or expanding operations.

Trend analysis helps in identifying any accounting errors that may have happened over a period of years. Any extreme increases or decreases in accounting amounts should be investigated.

Summary

When it comes to gauging how a business is performing financially, financial statement analysis is what furnishes you with all the information you need. This means analyzing the statement of financial position, the income statement, the cash flow statement, and the statement of retained earnings. The main methods used in financial analysis are trend analysis, vertical analysis, and ratio analysis. Today we will concentrate on trend analysis- what it is, why it is important and how it gives clarity on key value drivers and constraints for a business.

Trend analysis also referred to as horizontal analysis is a financial statement analysis method used to show changes in the financials of a business over a period of time. You can choose to do a trend analysis over two years or more, or on different quarters of a financial year. The period of time is not really specific, but all depends on the amount of time you want to analyze. The main aim of trend analysis is to not only calculate the amounts and percentage changes over a period of time but to analyze them as well.

To calculate the amount of change e.g. of the operating income, you less the base year amount from the current year amount. The percentage change is calculated by subtracting the base year amount from the current year amount and dividing this by the base year amount. i.e.

Amount of change= Current Year Amount- Base Year Amount

Percentage Change= (Current Year Amount- Base Year Amount) / Base Year Amount

For example, the operating income of Marriott International Inc. in fiscal years 2017 and 2016 was $2,359 and $ 1,368 (in millions). Taking 2017 as our current year, the amount of operating income change and the percentage change of the operating income of Marriott International Inc. will be as below:

Amount of change ($991) = $2,359 – $1,368

Percentage Change (72.44%) = ($2,359 – $1,368) / $1,368

This shows us that the operating income of Marriott International Inc. increased by 72.44% from 2016 to 2017. It is such a significant change for Marriott International and shows a positive performance of the company in the 2017 fiscal year.

This is just a one-off example. However, when performing a trend analysis for a business’s financials, you will have to evaluate each line item of the financial statements. If you were to analyze the statement of financial position of Marriott International Inc. figure one shown below, you will do a trend analysis of its cash and cash equivalent, and accounts and notes receivable, prepaid expenses, and assets held for sale.

From figure 2, above, we can see the movement of various current assets of Marriott International Inc. between 2016 and 2017 financial years. The cash and equivalents of the company decreased by $475 (-55%) change.

Whether you are doing a trend analysis over a two-year period or more than two years, the formula still remains the same.

Why is trend analysis important? One of the reasons why trend analysis is important is that it can be used in evaluating the performance of a company. By evaluating the changes and percentage movements of items, managers can gauge the performance of the organization and various departments. The trend will help stakeholders determine whether the business is deteriorating or improving in terms of its performance.

Trend analysis can also be used in making strategic decisions of the business. For example, if a trend analysis is done on the income statement of the company, and the expenses increase over the years whereas the sales are decreasing, then the management will notice. This will help them come up with better ways to increase sales and reduce the expenses, which in return will push up the net income. Through trend analysis, management has sufficient information to help improve or reduce the operations and profitability of the organization.

Any accounting variances will also be realized through trend analysis. When you compare financial data of different years, you are able to confirm whether there are any accounting variances such as omissions, errors or presentation of wrong data. As much as variances are expected in accounting data over a period of many years, extreme variances should be questioned and analyzed. From our examples above, it would be ideal to investigate why the cash and equivalents of Marriott International declined by 55%. Was it an accounting error or a management decision that lead to the decline?

Accounting CPE Courses & Books

Ratio analysis is the comparison of line items in the financial statements of a business. Ratio analysis is used to evaluate a number of issues with an entity, such as its liquidity, efficiency of operations, and profitability. This type of analysis is particularly useful to analysts outside of a business, since their primary source of information about an organization is its financial statements. Ratio analysis is less useful to corporate insiders, who have better access to more detailed operational information about the organization. Ratio analysis is particularly useful when used in the following two ways:

Trend line. Calculate each ratio over a large number of reporting periods, to see if there is a trend in the calculated information. The trend can indicate financial difficulties that would not otherwise be apparent if ratios were being examined for a single period. Trend lines can also be used to estimate the direction of future ratio performance.

Industry comparison. Calculate the same ratios for competitors in the same industry, and compare the results across all of the companies reviewed. Since these businesses likely operate with similar fixed asset investments and have similar capital structures, the results of a ratio analysis should be similar. If this is not the case, it can indicate a potential issue, or the reverse – the ability of a business to generate a profit that is notably higher than the rest of the industry. The industry comparison approach is used for sector analysis, to determine which businesses within an industry are the most (and least) valuable.

There are several hundred possible ratios that can be used for analysis purposes, but only a small core group is typically used to gain an understanding of an entity. These ratios include:

Current ratio. Compares current assets to current liabilities, to see if a business has enough cash to pay its immediate liabilities.

Days sales outstanding. Determines the ability of a business to effectively issue credit to customers and be paid back on a timely basis.

Debt to equity ratio. Compares the proportion of debt to equity, to see if a business has taken on too much debt.

Dividend payout ratio. This is the percentage of earnings paid to investors in the form of dividends. If the percentage is low, it is an indicator that there is room for dividend payments to increase substantially.

Gross profit ratio. Calculates the proportion of earnings generated by the sale of goods or services, before administrative expenses are included. A decline in this percentage could signal pricing pressure on a company’s core operations.

Inventory turnover. Calculates the time it takes to sell off inventory. A low turnover figure indicates that a business has an excessive investment in inventory, and therefore is at risk of having obsolete inventory.

Net profit ratio. Calculates the proportion of net profit to sales; a low proportion can indicate a bloated cost structure or pricing pressure.

Price earnings ratio. Compares the price paid for a company’s shares to the earnings reported by the business. An excessively high ratio signals that there is no basis for a high stock price, which could presage a stock price decline.

Return on assets. Calculates the ability of management to efficiently use assets to generate profits. A low return indicates a bloated investment in assets.

Risk & Return in Financial Management

A financial analysis paper details a company’s financial health. While the company’s history, financial statements and stock performance can all summarize different aspects of its financial performance, the financial analysis paper incorporates all of these details and more into a comprehensive and coherent form. Lenders, investors and financial analysts examine the financial analysis paper to determine if a company can deliver a solid return on investment.

Executive Summary

The executive summary section includes the most important findings from the financial analysis in a concise, easy-to-read format. The summary encapsulates the data presented in the rest of the report, including the implications those data have on the industry in general and the company in particular. This section can include brief summaries of the company’s mission, history, current performance and anticipated outlook. This section also includes a summary of the company’s industry, competition and market conditions.

Financial Statements

The core of the financial analysis paper is the collection of the company’s financial statements. These include the balance sheet, income statement, equity statement and cash flow statement. The balance sheet shows the company’s allocations of assets, liabilities and shareholders’ equity. The income statement shows the company’s revenues, expenses and profits or losses. The equity statement shows changes in the amount of shareholders’ equity. The cash flow statement shows where the company obtained its cash and how it spent it.

Industry Analysis

No company exists in a vacuum, so a financial analysis paper must include an examination of the company’s industry. The report will include comparisons between the company’s financial health and that of its competitors, and it will report the company’s market share and prominence in the industry. These factors help investors determine if the company is competitive in its industry and would make a profitable investment.

Financial Ratios

Financial ratios can reveal such aspects as a company’s liquidity, debt load and efficiency. The current liquidity ratio is the ratio of the company’s current assets to its current liabilities. The debt ratio is the ratio of the company’s total debt to its total equity. The return on equity ratio weighs a company’s profits against its shareholders’ equity. The price to earnings ratio can be found by dividing the current market price per share by the after-tax earnings per share.

A balance sheet is a financial statement that details a company’s financial positions as of a given date, typically the end of a fiscal quarter or year. The balance sheet is formatted so it presents a company’s asset base balanced against its liabilities and shareholders’ equity. Total assets minus total liabilities equals the company’s net assets, or shareholders’ equity. Balance sheets can be unclassified or classified. Unclassified balance sheets are crudely prepared and typically used only for internal reporting; the classified version categorizes assets and liabilities as short term or long term and lists them in ascending order of liquidity.

Common Size Analysis

One important step in the analysis is to common size the balance sheet, which involves presenting each asset line item as a percent of total assets and each liability and shareholders’ equity line item as a percent of total liabilities and shareholders’ equity. This allows for making simple comparisons at a highly detailed level. For example, you may want to analyze cash as a percent of total assets if the subject company’s solvency is a concern. Likewise, you may want to observe trends in accounts receivable as a percent of total liabilities and equity, if collections is an item of importance.

Benchmark Analysis

A benchmark analysis is critical to analyzing the balance sheet. It requires obtaining benchmark balance sheet data — in ratio form and common sized — from a peer group for comparison. It is important that the peer group is highly comparable in terms of line of business, size and other quantitative and qualitative factors so the comparison is meaningful. The Risk Management Association published its “Annual Statement Studies,” which provides a large amount of detailed financial data, broken down by industry. It is useful for this type of analysis.

Ratio Analysis

The ratio analysis is also a critical component of analyzing the balance sheet and ties in to the benchmark analysis. A ratio analysis requires using the balance items to calculate various financial ratios, which can be compared to financial ratios obtained from the benchmark peer group. For example, a liquidity ratio like the current ratio — equal to current assets divided by current liabilities — can be compared against the peer group median. Working capital is another important measure. By calculating ratios using historical results, you can observe any upward or downward trends in the data. If no trend exists, erratic performance may imply a certain level of operational risk associated with the company.

• By Dubos J. Masson, PhD, CTP, FP&A
• Published: 3/9/2018

(Ed. Note: This article has been updated.)

For any financial professional, it is important to know how to effectively analyze the financial statements of a firm. This requires an understanding of three key areas:

1. The structure of the financial statements
2. The economic characteristics of the industry in which the firm operates and
3. The strategies the firm pursues to differentiate itself from its competitors.

There are generally six steps to developing an effective analysis of financial statements.

1. Identify the industry economic characteristics.

First, determine a value chain analysis for the industry—the chain of activities involved in the creation, manufacture and distribution of the firm’s products and/or services. Techniques such as Porter’s Five Forces or analysis of economic attributes are typically used in this step.

2. Identify company strategies.

Next, look at the nature of the product/service being offered by the firm, including the uniqueness of product, level of profit margins, creation of brand loyalty and control of costs. Additionally, factors such as supply chain integration, geographic diversification and industry diversification should be considered.

3. Assess the quality of the firm’s financial statements.

Review the key financial statements within the context of the relevant accounting standards. In examining balance sheet accounts, issues such as recognition, valuation and classification are keys to proper evaluation. The main question should be whether this balance sheet is a complete representation of the firm’s economic position. When evaluating the income statement, the main point is to properly assess the quality of earnings as a complete representation of the firm’s economic performance. Evaluation of the statement of cash flows helps in understanding the impact of the firm’s liquidity position from its operations, investments and financial activities over the period—in essence, where funds came from, where they went, and how the overall liquidity of the firm was affected.

4. Analyze current profitability and risk.

This is the step where financial professionals can really add value in the evaluation of the firm and its financial statements. The most common analysis tools are key financial statement ratios relating to liquidity, asset management, profitability, debt management/coverage and risk/market valuation. With respect to profitability, there are two broad questions to be asked: how profitable are the operations of the firm relative to its assets—independent of how the firm finances those assets—and how profitable is the firm from the perspective of the equity shareholders. It is also important to learn how to disaggregate return measures into primary impact factors. Lastly, it is critical to analyze any financial statement ratios in a comparative manner, looking at the current ratios in relation to those from earlier periods or relative to other firms or industry averages.

5. Prepare forecasted financial statements.

Although often challenging, financial professionals must make reasonable assumptions about the future of the firm (and its industry) and determine how these assumptions will impact both the cash flows and the funding. This often takes the form of pro-forma financial statements, based on techniques such as the percent of sales approach.

6. Value the firm.

While there are many valuation approaches, the most common is a type of discounted cash flow methodology. These cash flows could be in the form of projected dividends, or more detailed techniques such as free cash flows to either the equity holders or on enterprise basis. Other approaches may include using relative valuation or accounting-based measures such as economic value added.

The next steps

Once the analysis of the firm and its financial statements are completed, there are further questions that must be answered. One of the most critical is: “Can we really trust the numbers that are being provided?” There are many reported instances of accounting irregularities. Whether it is called aggressive accounting, earnings management, or outright fraudulent financial reporting, it is important for the financial professional to understand how these types of manipulations are perpetrated and more importantly, how to detect them.

Dubos J. Masson, PhD, CTP, FP&A is Clinical Associate Professor of Finance for the Kelley School of Business, Indiana University.

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Copyright © 2020 Association for Financial Professionals, Inc.
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Common-size analysis

Common-Size Statement

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Analysts also use vertical analysis of a single financial statement, such as an income statement. Vertical analysis consists of the study of a single financial statement in which each item is expressed as a percentage of a significant total. Vertical analysis is especially helpful in analyzing income statement data such as the percentage of cost of goods sold to sales. Where horizontal analysis looked at one account at a time, vertical analysis will look at one YEAR at a time.

Financial statements that show only percentages and no absolute dollar amounts are common-size statements . All percentage figures in a common-size balance sheet are percentages of total assets while all the items in a common-size income statement are percentages of net sales. The use of common-size statements facilitates vertical analysis of a company’s financial statements.

The calculation for common-size percentages is: (Amount / Base amount) and multiply by 100 to get a percentage. Remember, on the balance sheet the base is total assets and on the income statement the base is net sales. The video showed an example using the balance sheet so we will look at Synotech, Inc.’s income statement with common-size percentages (calculations provided in last column).

What does this common-size percentage tell you about the company? Since we use net sales as the base on the income statement, it tells us how every dollar of net sales is spent by the company. For Synotech, Inc., approximately 51 cents of every sales dollar is used by cost of goods sold and 49 cents of every sales dollar is left in gross profit to cover remaining expenses. Of the 49 cents remaining, almost 35 cents is used by operating expenses (selling, general and administrative), 1 cent by other and 2 cents in interest. We earn almost 11 cents of net income before taxes and over 7 cents in net income after taxes on every sales dollar. This is a little easier to understand than the larger numbers showing Synotech earned $762 million dollars.

The same process would apply on the balance sheet but the base is total assets. The common-size percentages on the balance sheet explain how our assets are allocated OR how much of every dollar in assets we owe to others (liabilities) and to owners (equity). Many computerized accounting systems automatically calculate common-size percentages on financial statements.

The net profit margin, also known as net margin, indicates how much net income a company makes with total sales achieved. A higher net profit margin means that a company is more efficient at converting sales into actual profit. Net profit margin analysis is not the same as gross profit margin. Under gross profit, fixed costs are excluded from calculation. With net profit margin ratio all costs are included to find the final benefit of the income of a business. Similar terms used to describe net profit margins include net margin, net profit, net profit ratio, net profit margin percentage, and more. To calculate net profit margin and provide net profit margin ratio analysis requires skills ranging from those of a small business owner to an experienced CFO. As a result, this depends on the size and complexity of the company.

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Net Profit Margin Calculation

For example, a company has $200,000 in sales and $50,000 in monthly net income.

Net profit margin = $50,000 / $200,000 = 25%

This means that a company has $0.25 of net income for every dollar of sales.

Steve has $200,000 worth of sales yet his net income is only $50,000. By decreasing costs, he can increase net income. In conclusion, he evaluates his decision and decides to implement the online system he was thinking about.

Net margin measures how successful a company has been at the business of marking a profit on each dollar sales. It is one of the most essential financial ratios. Net margin includes all the factors that influence profitability whether under management control or not. The higher the ratio, the more effective a company is at cost control. Compared with industry average, it tells investors how well the management and operations of a company are performing against its competitors. Compared with different industries, it tells investors which industries are relatively more profitable than others. Net profit margin analysis is also used among many common methods for business valuation.

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Financial ratios can be a great tool in your analysis toolbox as an investor. They can help you gauge the strength, profitability, efficiency, and quality of a business from a variety of different angles, as well as monitor changes in the firm’s core operating metrics over time.

It can help you both offensively, looking for opportunities, and defensively, seeking to protect yourself whether you own the stock, invest in the bonds, or somehow expect to enter into a real estate investment with the business, such as a landlord doing a sale-leaseback transaction with a major drug store or restaurant chain. It’s important that you memorize the most important of these financial ratios. It helps to classify them into five major categories mentally.

1. Leverage: The financial ratios that give you an idea of the leverage inherent in the business, such as the debt-to-equity ratio or other ratios that allow you to see a company’s capital structure, along with the potential benefits and risks of such a capital structure and how it compares to those of competitors in the same sector or industry, are what I call leverage financial ratios. It helps to put them in context with a complete understanding of the variables at play in a DuPont ROE analysis of a firm.
2. Liquidity: Liquidity financial ratios show the solvency of a company based on its assets versus its liabilities; things like working capital per dollar of sales and the current ratio. In other words, it lets you know the resources available for a firm to use to pay its bills, keep the lights on, and pay the staff. Do not underestimate the importance of liquidity as a lack of it has caused even highly profitable businesses to go bankrupt.
3. Operating: This category of financial ratios shows the efficiency of management and a company’s operations in utilizing its capital, especially through the cash conversion cycle in pursuit of profit. In the retail industry, this would include metrics such as inventory turnover and accounts receivable turnover. Companies that consistently have superior operating financial ratios often possess something known as franchise value.
4. Profitability: A firm’s profitability financial ratios are designed to give you an idea of how lucrative it is relative to some particular metric. A firm that has high gross profit margins from a sustainable business from a core product like bleach, laundry detergent, or chocolate, to provide an illustration, is going to be much harder to put out of business when the economy turns down than one that has razor-thin margins.
   Likewise, a company with high returns on capital, even with smaller margins, is going to have a better chance of survival because it is so much more profitable relative to the shareholders’ contributed investment. Of particular importance is return on equity and return on assets.
5. Solvency: The final major category of financial ratios new investors should know is meant to give you a reasonable idea, to the extent it can be predicted from the historical financial statements, the chances of a company being unable to cover its obligations when liabilities are subtracted from assets.
   Even the most wonderful business can be in danger of wipe-out if it is undercapitalized and lacks the equity to absorb any challenges should the economy enter a recession or depression.

One More Thing

As useful as financial ratios are, they can’t tell you everything. Imagine you were considering investing in a horse and buggy manufacturer when Henry Ford came out with the Model T. The historical income statement, balance sheet, and financial ratios wouldn’t have told you what you needed to know as the business you were examining was on the brink of suffering a significant decline in income.

On the other side, imagine looking at the incredibly ugly financials of what was then called Apple Computer, now just Apple, prior to the return of Steve Jobs from exile when he transformed the business he founded, taking it on a run that ended up resulting it in having the world’s largest market capitalization.

6. RATIO ANALYSIS

The next analysis appearing in the financial plan should be your Forecasted Ratio Analysis. In a nutshell, Ratio Analysis is a general technique for analyzing the performance of an existing or potential business.

Ratios involve dividing numbers from the Balance Sheet and Income Statement to create percentages and decimals. When aspiring entrepreneurs and existing business owners apply for a loan, for example, bankers usually look at their forecasted ratios and compare them to ratios of other businesses operating within the same industry.

Your projected ratios should be calculated over a three year forecasted period. Many business plan writers calculate the ratios and provide a narrative discussion, depicting how each has changed over the three year forecasted period. Others calculate the ratios and provide a footnote stating “a complete analysis regarding the forecasted ratios is available upon request. Yet other business plan writers feel the need to calculate various ratios and compare them to ratios of other businesses within the industry. The later approach can be time consuming and may not be “cost effective”. Below provides an example of J&B’s forecasted Ratio Calculations.

The information provided in the above example depicts the name of each ratio, the formula required in calculating each ratio, the dollar amounts for each formula item, and the ratio calculation for each of the forecasted years. It is important to stress that these dollar amounts have been taking from J&B’s forecasted Balance Sheet and Forecasted Income Statement. Therefore, the forecasted balance sheet and income statement must be complete before forecasted ratios can be calculated.

Also notice: J&B decided to calculate the ratios without providing any narrative discussion. Moreover, the company states that a “complete analysis is available upon request”. If you want to impress the investor, it might be in your best interest to use the narrative ratio analysis approach. To do this, simply calculate each ratio for the three year forecasted period and then briefly discuss the variable(s) causing the change in the ratio value.

This concludes our discussion on how the projected ratio analysis should appear in your Financial Plan. Remember, it is imperative to understand the theory behind the ratio analysis before attempting to forecast your own. To learn more about how to read or determine the meaning behind ratios, please refer to the section entitled “Ratio Analysis”. This section also provides other ratio formulas which you may decide to include in your analysis.

Horizontal analysis (also known as trend analysis) is a financial statement analysis technique that shows changes in the amounts of corresponding financial statement items over a period of time. It is a useful tool to evaluate the trend situations.

The statements for two or more periods are used in horizontal analysis. The earliest period is usually used as the base period and the items on the statements for all later periods are compared with items on the statements of the base period. The changes are generally shown both in dollars and percentage.

Dollar and percentage changes are computed by using the following formulas:

Horizontal analysis may be conducted for balance sheet, income statement, schedules of current and fixed assets and statement of retained earnings.

Example:

An example of the horizontal analysis of balance sheet, schedule of current assets , income statement and statement of retained earnings is given below:

Comparative balance sheet with horizontal analysis:

Comparative schedule of current assets:

Comparative income statement with horizontal analysis:

Comparative retained earnings statement with horizontal analysis:

In above analysis, 2007 is the base year and 2008 is the comparison year. All items on the balance sheet and income statement for the year 2008 have been compared with the items of balance sheet and income statement for the year 2007.

The actual changes in items are compared with the expected changes. For example, if management expects a 30% increase in sales revenue but actual increase is only 10%, it needs to be investigated.

103 Comments on Horizontal or trend analysis of financial statements

I know how to calculate the % change from year 1 to year. However, I am having difficulty understand the increase and decrease in each items on the income statement and balance sheet. Is the increase/decrease a weakness or strength and why it’s a strength or weakness?

% increase in net sales is favourable …………….hope it will be clear now

Why does % increase in net sales favourable?

Thank you for using accountingformanagement.org. The answer of your question is in the last two lines of the main article.

Horizontal analysis does not fully discloses the weaknesses or strengths of a company. The following are the main purposes of horizontal analysis:

(1). to see the trend of various income statement and balance sheet figures of a company.
(2). to evaluate whether the management is achieving its objectives or not.
(3). to investigate unexpected increases or decreases in financial statement items.
(4). to evaluate overall performance of the company

In a horizontal analysis the the changes in income statement and balance sheet items are computed (in dollars and percentage) and compared with the expected changes. For example, you start an advertising campaign and expect a 25% increase in sales. But if sales revenue increases by only 5%, then it needs to be investigated. Or if you find an unexpected increase in cost of goods sold or any operating expense, you can investigate and find the reason.

To know about strengths and weaknesses of a company, different combinations of financial ratios are used.

Hi can you help me interpret the horizontal analysis of a company?

Vertical analysis of financial statements is a technique in which the relationship between items in the same financial statement is identified by expressing all amounts as a percentage a total amount. This method compares different items to a single item in the same accounting period. The financial statements prepared by using this technique are known as common size financial statements.

This analysis is performed on the income statement as well as the balance sheet.

When applying this method on the balance sheet, all of the three major categories accounts (i.e. assets, liabilities, and equity) are compared to the total assets. All of the balance sheet items are presented as a proportion of the total assets. These percentages are shown along with the absolute currency amounts. For example, suppose a company has three assets; cash worth $4 million, inventory worth $7 million and fixed assets worth $9million. The vertical analysis method will show these as

Cash: 20%
Inventories: 35%
Fixed Assets: 45%

• Income Statement:

And when applying this technique to the income statement, each of the expense is compared to the total sales revenue. The expenses are presented as a proportion of total sales revenue along with the absolute amounts. For example, if the sales revenue of a company is $10 million and the cost of sales is $6 million, the cost of sales will be reported as 60% of the sales revenue.

The main advantage of using vertical analysis of financial statements is that income statements and balance sheets of companies of different sizes can be compared. Comparison of absolute amounts of companies of different sizes does not provide useful conclusions about their financial performance and financial position.

Usually the vertical analysis is performed for a single accounting period to see the relative proportions of different account balances. But it is also useful to perform vertical analysis over a number of periods to identify changes in accounts over time. It can help to identify unusual changes in the behavior of accounts. For example, if the cost of sales has been consistently 45% in the history, then a sudden new percentage of 60% should catch the attention of analysts. Reasons behind this change should be investigated and then measures should be taken to bring this percentage back to its normal level.

The four major ratio measurements that users of the financial statements perform to gauge the effectiveness and efficiency of a company’s management are liquidity, activity, profitability, and coverage. But you may be asking, isn’t an investor interested only in how profitable a company is? Not necessarily.

Liquidity, which is how well a company can cover its short-term debt; activity, which shows how well a company uses its assets to generate sales; and coverage, which measures the degree of protection for long-term debt, are all measurements that have to be considered along with profitability to form a complete picture of how well a business is doing.

Current ratio

This ratio tells you the company’s ability to pay current debt without having to resort to outside financing. Let’s say you’re looking at a company’s balance sheet. Current assets are $100,000 and current liabilities are $45,000. The current ratio is 2.2 ($100,000 / $45,000). In this case, the company has sufficient current assets to pay current liabilities without going to outside financing.

The electric ratio acid test

The acid test ratio is similar to the current ratio, but it includes only quick assets. Wait, what the heck is a quick asset? A quick asset is readily convertible to cash or is already in the form of available cash — think money in the company’s operating checking account.

To figure the acid test ratio, you first add together cash, temporary cash investments (like stock in other companies that the business plans to sell within one year of the balance sheet date), and accounts receivable. Then you divide that total by the company’s current liabilities.

Asset turnover

Turnover analysis shows how quickly income-producing assets such as merchandise inventory comes in and goes back out the door. The quicker, the better! In normal circumstances, efficiently moving assets indicates a well-run business. Therefore, the asset turnover ratio measures how efficiently a company uses its assets to generate sales.

The basic formula for calculating asset turnover is net sales divided by average total assets. If net sales are $135,000 and average total assets are $87,500, asset turnover is 1.54 times. In other words, the company earns $1.54 for each $1 it invests in assets. That turnover ratio looks pretty good, but to truly give this ratio meaning, you have to compare it to asset turnover for similar companies.

Inventory turnover

This activity measure shows how efficiently the company is handling inventory management and replenishment and how fast the products are being sold. The less inventory a company keeps on hand, the lower its costs are to store and hold it. This strategy lowers the cost of inventory that must be financed with debt or owners’ equity, or the ownership rights left over after deducting liabilities.

To compute this ratio, divide the cost of goods sold by average inventory. Suppose that the cost of goods sold is $35,000 and average inventory is $8,500. Inventory turnover is 4.12 times ($35,000 / $8,500). Again, comparing this inventory turnover figure against industry averages, the higher the ratio, the better!

Accounts receivable turnover

This ratio shows the average number of times accounts receivable (A/R) is turned over — that is, booked and paid — during the financial period. The sooner a company collects receivables from its customers, the sooner the cash is available to take care of the business’s needs.

Why is this such a big deal? Well, the more cash the company brings in from operations, the less it has to borrow for timely payment of its liabilities.

Return on assets (ROA)

This ratio shows how well a company is using its assets to make money. Basically, the premise is that how well a company uses its assets to generate revenue goes a long way toward telling the tale of its overall profitability.

A business that is effectively and efficiently operated, which this and other activity measures show, generally is more successful than its less effective and efficient competition.

Figure ROA by dividing net income, which is revenue minus expenses by average total assets. So if net income is $55,000 and average total assets total $87,500, ROA is 63 percent. By any accounting ratio, that number is pretty good: It shows that, for each dollar in assets, the company earned 63 cents.

For effective ratio analysis, you need to use similar types of companies or measure ROA for the same company over a period of years. (This approach, known as trend analysis, looks at the same ratios over several time periods.)

Return on equity (ROE)

Return on equity (ROE) measures the profit earned for each dollar invested in a company’s stock. You compute it by dividing net income by average owners’ equity.

The higher the ratio, the more efficiently the company’s management is utilizing its equity base. This measurement is important to stockholders and potential investors because it compares earnings to owners’ investments. Having net income grow in relation to increases in equity presents a picture of a well-run business.

Profit margin on sales

Profit margin on sales is net income divided by net sales. This ratio gives the users of the financial statements the 411 on how well the company is handling expenses: It measures the net income (revenue minus expenses) generated by each dollar of sales.

Debt to equity

Equity shows the owners’ investment interest in the company and is represented by stock and additional paid-in capital. The debt-to-equity ratio gives users an idea of how a company is financed: through debt or equity. This consideration is important because a company with a high debt-to-equity ratio can have wild fluctuations in net income due to interest expense.

Book value per share

Compute this ratio by dividing total common stockholders’ equity (all paid-in capital attributable to common stock plus retained earnings) by the number of shares of common stock outstanding. If total common stockholders’ equity is $65,000 and the number of shares of common stock outstanding is 9,900, book value per share is $6.57.

What you will learn in this post:

• How to implement financial ratio analysis the right way!
• What is the purpose of financial ratio analysis?
• The most important financial ratios that you must learn before starting to invest in the stock market
• 5 major types of financial ratios that help you evaluate any business on the planet
• All financial ratio formulas with detailed explainations and examples

​Are you looking for a complete list of financial ratios? – If your answer is YES, you’ve come to the right place!

This article will look into five major categories of financial ratios that you can use to evaluate your company’s financial health.

So what is financial ratio analysis?​

Financial ratios are mathematical tools, used to assess and analyze a business’s financial standing and performance.

They can be very useful when evaluating and comparing the fundamentals of various companies, especially when you’re looking at them in terms of potential investment opportunities.

Here is the complete list of financial ratios:

• Liquidity Ratios
• Solvency Ratios
• Efficiency Ratios
• Profitability Ratios
• and Business Valuation Ratios

In the list of financial ratios above, as you can see that there are five major categories of financial ratios. These ratios are commonly used by investors, and we’ll take a closer look at each of them, in turn, below.

Don’t let yourself be intimidated by the fact that financial ratio analysis involves combing through a company’s financial statements to determine and understand its financial position, trends and effectiveness over a period of time.

The ratios involved in performing this fundamental analysis are actually quite easy to grasp and compute, and when used properly, will give you a useful and meaningful way to compare the financial situations of businesses both large and small, across a range of industries.

Liquidity Ratios

​The first category of ratios included in our list of financial ratios is the liquidity ratio.

Liquidity describes the state of a company’s assets, in terms of how quickly and easily it can turn those assets into cash when necessary.

When you use a liquidity ratio to analyze a business’s financial statements, you’re basically determining its ability to cover its short-term debts, and this can give you some idea of how successful it will be in continuing its current operations.

More specifically, the liquidity ratio measures a company’s liquid assets against its liabilities, and there are several versions of this measurement, including the quick ratio, the current ratio, and the operating cash flow ratio, that you can use.

Each version is valuable in its own way, but whether you’re measuring a company’s income alone against its liabilities, or a combination of its cash-on-hand plus its receivables, the higher the ratio value involved, the more confidence you can have in a company’s current ability to service its short-term debt load.

So what is the financial ratio used to assess a company’s liquidity?

List of Liquidity Ratios: Formula & Analysis

Solvency Ratios

​The second category of ratios included in our list of financial ratios is the solvency ratio, which is also the most important financial ratio.

Unlike liquidity that deals with an ability to handle short-term debt, solvency deals with a company’s ability to service its long-term liabilities.

In other words, does the company have the resources to support its continuing financial obligations, and are those resources based on equity or debt?

For example, a business with a highly variable, or unpredictable income, runs a far greater risk of insolvency when it chooses to fund large portions of its operations with borrowed money, rather than with its own assets.

Two of the most common solvency ratios you can use are the debt-to-equity ratio, and the times interest earned ratio.

Also known as leverage ratios, solvency ratios directly measure a company’s total debt against its assets, equity, and earnings.

While both solvency and liquidity ratios are essential in measuring a company’s ability to pay off debt, solvency ratios are more concerned with long-term sustainability.

And unlike liquidity, a higher solvency ratio value is less desirable, since it may indicate that a business has incurred a higher debt load than it can handle.

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How to Evaluate Law Firm Financials

Revenues and expenses and benchmarks, oh my!

Law schools teach the law but they don’t teach business. I recently started my own estate planning firm and am struggling to make what I think I should. Are there benchmarks for earnings and expenses I can use?

— Name withheld by request

I know a bunch of lawyer jokes but not much about the business of law, so I asked the American Academy of Estate Planning Attorneys (AAEPA), an organization that provides its members with educational materials, research, and practice management techniques for insight.

The following are benchmarks the AAEPA uses to analyze a new member firm’s financials. (Keep in mind the figures were developed from analyzing 17 year’s worth of results for rural and urban estate planning firms across the U.S. so they may not apply to personal injury, criminal defense, or other areas of practice.)

While specifics vary from firm to firm, the following tends to be fairly consistent:

Revenue per employee on payroll: $150,000

Easy to calculate: Gross revenue divided by total employees. A half-time employee counts as a .5, an employee who works four days a week counts as a .8, etc.

If your firm falls below $130,000 per person that’s a huge warning sign. (Of course, since your practice is new it could take time to get there.) Otherwise your firm is likely to be over-staffed and/or inefficient.

Revenue between $150,000 and $175,000 per employee is great. To get there you’ll need to charge consistent fees, not under-sell your value, put solid systems in place, and maintain an extremely low employee turnover rate.

I know what you’re thinking: “How can my paralegal generate $150,000 a year?” Obviously he won’t, but your setup should ensure that you are freed up to as much high-revenue work as possible–which then raises your per-employee average.

Revenue per attorney: $500,000

Gross revenue divided by attorneys on staff.

Well-run firms tend to have per-attorney revenue of at least $500,000, but many of the AAEPA’s member firms are closer to $1 million per attorney. Of course those firms have worked long and hard to reach that level and their structure supports it; a two-attorney firm might have one “back-office” lawyer fulfilling the majority of the other lawyer’s $1 million rainmaking, client-landing efforts.

Since you’re new a lack of clients may be your biggest revenue issue. Past that, firms that tend to fall below this benchmark tend to do so because their attorneys are doing non-attorney work like drafting correspondence, drafting and editing documents, attending final signing meetings, checking the mail–all the stuff that should be delegated.

Salaries: 65 percent of gross revenue

Of that amount, a firm’s owner should be paying themselves 40 percent of gross revenue. In your case that might be high since you’ve likely made significant early investments in furnishings, equipment, etc.

Then 25-30 percent of gross revenue should go to staff and non-equity attorneys. You might fall on the low range because your employees are relatively new and possibly inexperienced. Firms with long-term skilled employees may decide to pay a little more, both to reward service and to keep turnover low.

Marketing: 8-10 percent of gross revenue

Generally speaking, spend less than 8% of gross revenue on landing new clients and you’ll probably struggle to meet revenue goals. Spend more and you’re probably not marketing wisely.

Another way to look at marketing results is on a per-case rather than per-client basis. If you land me as a client, that’s one client. If you do an irrevocable trust, a family limited partnership, and a durable power of attorney for me, those count as three cases. Divide your marketing expense by the number of cases you handle. If you’re spending more than $250 per case your marketing is relatively inefficient.

Rent: 6-7 percent of gross revenue

You might spend more for prestige address, and only you can decide if that expense is worth it.

Otherwise, spending more probably means your space is too large. Total office space, counting offices, lobby, conference rooms, and other common areas, should range between 250 and 350 square feet per employee.

If your number is higher you could consider moving, but you could also consider subletting space to a complementary firm like a CPA or financial planner. Not only will you reduce expenses, you might create a nice cooperative setup that benefits both firms.

Common Warning Signs

According to the AAEPA, here are some common business issues struggling law firms tend to share:

1. Unhealthy fees. Too low or too high.
2. Fudged fees. Different fees for different clients, different fees from one attorney to another in the same firm, tossing in additional services at no extra charge for some clients and not for others. in short, sloppy fee structures.
3. High employee turnover. Constantly training and ramping up new employees.
4. Poor marketing plans. To paraphrase Field of Dreams, “Spend it. but they won’t necessarily come.”
5. Attorneys performing non-attorney tasks. Leave non-attorney work to non-attorneys; attorneys should generate revenue.
6. Ignoring additional work. The client who comes to you for a Will may also needs a Trust, a Durable Power of Attorney, maybe a Pourover Will–basic needs meetings can often uncover additional client needs–if you’re paying attention.

Your results may eventually vary (hopefully in a good way), but for now, use these benchmarks as targets to shoot for as you build your practice.

And then call your law school and ask, “Granted I took business law, but why didn’t you teach me anything about the actual business of law?”

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How to Evaluate Law Firm Financials

Revenues and expenses and benchmarks, oh my!

Law schools teach the law but they don’t teach business. I recently started my own estate planning firm and am struggling to make what I think I should. Are there benchmarks for earnings and expenses I can use?

— Name withheld by request

I know a bunch of lawyer jokes but not much about the business of law, so I asked the American Academy of Estate Planning Attorneys (AAEPA), an organization that provides its members with educational materials, research, and practice management techniques for insight.

The following are benchmarks the AAEPA uses to analyze a new member firm’s financials. (Keep in mind the figures were developed from analyzing 17 year’s worth of results for rural and urban estate planning firms across the U.S. so they may not apply to personal injury, criminal defense, or other areas of practice.)

While specifics vary from firm to firm, the following tends to be fairly consistent:

Revenue per employee on payroll: $150,000

Easy to calculate: Gross revenue divided by total employees. A half-time employee counts as a .5, an employee who works four days a week counts as a .8, etc.

If your firm falls below $130,000 per person that’s a huge warning sign. (Of course, since your practice is new it could take time to get there.) Otherwise your firm is likely to be over-staffed and/or inefficient.

Revenue between $150,000 and $175,000 per employee is great. To get there you’ll need to charge consistent fees, not under-sell your value, put solid systems in place, and maintain an extremely low employee turnover rate.

I know what you’re thinking: “How can my paralegal generate $150,000 a year?” Obviously he won’t, but your setup should ensure that you are freed up to as much high-revenue work as possible–which then raises your per-employee average.

Revenue per attorney: $500,000

Gross revenue divided by attorneys on staff.

Well-run firms tend to have per-attorney revenue of at least $500,000, but many of the AAEPA’s member firms are closer to $1 million per attorney. Of course those firms have worked long and hard to reach that level and their structure supports it; a two-attorney firm might have one “back-office” lawyer fulfilling the majority of the other lawyer’s $1 million rainmaking, client-landing efforts.

Since you’re new a lack of clients may be your biggest revenue issue. Past that, firms that tend to fall below this benchmark tend to do so because their attorneys are doing non-attorney work like drafting correspondence, drafting and editing documents, attending final signing meetings, checking the mail–all the stuff that should be delegated.

Salaries: 65 percent of gross revenue

Of that amount, a firm’s owner should be paying themselves 40 percent of gross revenue. In your case that might be high since you’ve likely made significant early investments in furnishings, equipment, etc.

Then 25-30 percent of gross revenue should go to staff and non-equity attorneys. You might fall on the low range because your employees are relatively new and possibly inexperienced. Firms with long-term skilled employees may decide to pay a little more, both to reward service and to keep turnover low.

Marketing: 8-10 percent of gross revenue

Generally speaking, spend less than 8% of gross revenue on landing new clients and you’ll probably struggle to meet revenue goals. Spend more and you’re probably not marketing wisely.

Another way to look at marketing results is on a per-case rather than per-client basis. If you land me as a client, that’s one client. If you do an irrevocable trust, a family limited partnership, and a durable power of attorney for me, those count as three cases. Divide your marketing expense by the number of cases you handle. If you’re spending more than $250 per case your marketing is relatively inefficient.

Rent: 6-7 percent of gross revenue

You might spend more for prestige address, and only you can decide if that expense is worth it.

Otherwise, spending more probably means your space is too large. Total office space, counting offices, lobby, conference rooms, and other common areas, should range between 250 and 350 square feet per employee.

If your number is higher you could consider moving, but you could also consider subletting space to a complementary firm like a CPA or financial planner. Not only will you reduce expenses, you might create a nice cooperative setup that benefits both firms.

Common Warning Signs

According to the AAEPA, here are some common business issues struggling law firms tend to share:

1. Unhealthy fees. Too low or too high.
2. Fudged fees. Different fees for different clients, different fees from one attorney to another in the same firm, tossing in additional services at no extra charge for some clients and not for others. in short, sloppy fee structures.
3. High employee turnover. Constantly training and ramping up new employees.
4. Poor marketing plans. To paraphrase Field of Dreams, “Spend it. but they won’t necessarily come.”
5. Attorneys performing non-attorney tasks. Leave non-attorney work to non-attorneys; attorneys should generate revenue.
6. Ignoring additional work. The client who comes to you for a Will may also needs a Trust, a Durable Power of Attorney, maybe a Pourover Will–basic needs meetings can often uncover additional client needs–if you’re paying attention.

Your results may eventually vary (hopefully in a good way), but for now, use these benchmarks as targets to shoot for as you build your practice.

And then call your law school and ask, “Granted I took business law, but why didn’t you teach me anything about the actual business of law?”

Related

The value of a business depends on so many variables that calculating the market value of a business is more an art than a science. According to Bankrate.com, banks regularly use more than 150 financial ratios to determine the financial health of a business. That is why it is usually best to hire a qualified accountant to perform the ratio analysis of a business. However, business managers should have a working knowledge of the most common financial accounting ratios to help inform their business decisions.

Quick Ratio

The quick ratio of a business is a measure of its financial liquidity. It determines how easily a business could convert assets into cash to cover its liabilities. Companies that have a low quick ratio present a higher risk to investors. Figure the quick ratio of a company by deducting the value of its inventory from its current assets and dividing the total by its current liabilities. For example, if a company has $2 million in assets, of which $1 million is tied in its inventory, and $500,000 in liabilities, it has a quick ratio of 2 to 1.

Current Ratio

The current ratio of a company is similar to its quick ratio, and investors also use it to determine a business’ liquidity. Figure the current ratio of a business by dividing its current assets by its current liabilities. For example, a business with $2 million in current assets and $500,000 in liabilities would have a current ratio of 4.

Return on Assets

Investors and managers base the market value of a business on the profit it generates. The return on assets, or ROA, of a business is a ratio commonly used to calculate profitability. Figure the ROA ratio of a company by dividing its net income over a period of time by its average total assets. For example, if a business generates $10 million in profits and has a total of $5 million in assets, its ROA ratio is 5 to 1.

Inventory Turnover

Companies that are based on the sale of a product depend on regular sales to generate a profit. In these cases, the financial health of a business depends on its inventory turnover, or in other words, how many times a year it sells its average inventory. Calculate the inventory turnover of a company by dividing total sales in a year by the value of its average inventory. For example, a toy factory with an average inventory worth $1 million and $5 million in sales would have an inventory turnover of 5 to 1.

Days Receivable Ratio

Another measure of a business’ liquidity is how long it takes for the company to collect payments from clients, also known as days receivable ratio. Figure the days receivable of a business by dividing its average gross receivables by its annual net sales divided by 365. For example, a company with annual net sales of $365,000 and average gross receivables of $40,000 would have a days receivable ratio of 40 days.

Just as apples can’t be compared to oranges, meaningful comparisons can’t be made across different-sized companies without first making adjustments to their financial statements that level the playing field.

Why Are Common Size Financial Statements Important?

Common sizing is one way to level the field. This process makes financial statements from different companies comparable, allowing analysts and investors to gain insight into the profitability of each company that might be obscured by raw numbers.

Common-sized financial statements allow for easier comparisons across groups of companies. Analysts can quickly identify which companies in the group are the most efficient, profitable and/or financially sound.

Analysts convert the dollar amount of each line item into a percentage of a common amount. These percentages often convey relevant information that may be hidden by the raw numbers.

The two financial statements that analysts common size most often are the income statement and the balance sheet. Analysts study the income statement for insights into a company’s historic growth and profitability. The balance sheet provides relevant information about a company’s liquidity and financial strength.

Common Size and Income Statements

Analysts common size an income statement by dividing each line item (for example, gross profit, operating income and sales and marketing expenses) by the top line (sales). Each item is then expressed as a percentage of sales.

For example, gross profit as a percent of sales (also known as gross margin) is calculated by dividing gross profit by sales. Assuming sales are $100 million and gross profits are $50 million, the resulting gross margin is 50% (50/100).

Some financial ratios derived from common sizing are considered more useful than others. Analysts are typically most interested in knowing the gross margin, operating margin (operating income/sales) and net margin (net income/sales). In evaluating expense items on the income statement, analysts mainly look at sales and marketing/sales and general and administrative/sales.

Common Size Financial Statement Example

Here is a simple example of useful information revealed by common-sizing income statements. Suppose Company A reports sales of $100 million and operating profits of $25 million. Company B, which is smaller, reports sales of $20 million and operating profits of $15 million. At first glance, it would appear Company A is the better performer because it earns a larger profit.

However, a look at the common size financial statement of the two businesses, which restates each company’s figures as a percent of sales, reveals Company B is actually more profitable. The common size income statement for Company A shows operating profits are 25% of sales (25/100). The same calculation for Company B shows operating profits at 75% of sales (15/20). The common size statements make it easy to see that Company B is proportionally more profitable and better at controlling expenses.

Common Size and Balance Sheets

To common size a balance sheet, the analyst restates each line item contained in the balance sheet as a percent of total assets. Analysts are generally most interested in ratios that measure liquidity such as cash/total assets and financial strength, which is often measured by long-term debt/assets.

Here is an example of how useful information is revealed by the common size balance sheets.

Assume Company A has long-term debt of $200 million and total assets of $800 million. Company B, which is smaller, has long-term debt of only $100 million and total assets of $300 million.

At first glance, Company A looks more risky because of a larger dollar amount of long-term debt. However, a comparison of the common-size balance sheets reveals it is actually Company B which is more risky.

Long-term debt represents 33% of the capital structure of Company B (100/300) but only 25% of the capital structure of Company A (200/800). Analysts look at percentages of debt and equity in the capital structure to determine if a company is financing its operations by issuing stock or through long-term borrowings. The latter increases leverage and financial risk, while the former is dilutive to existing shareholders.

The Drawbacks of Common Size Financial Statements

Common size financial statements help analysts understand individual businesses at a higher level. However, there are several drawbacks to using them.

For example, common size financial statements may give the appearance of fair comparisons across companies, but can’t take into account that companies may be using different accounting methods or fiscal year-ends. Another drawback of common size financial statements is that they can’t be used to compare companies across different industries. What may be considered a favorable ratio in one industry may indicate poor performance in another.

For example, an operating margin of 6% would indicate exceptional performance by a distribution company but a poor result from a manufacturing company. Low margins are normal for a distribution company, which relies on volume rather than profit per unit to drive overall profits.

The Bottom Line

By looking at common size financial statements, analysts can easily determine which companies within a given industry are the most cost-effective and profitable. Overall, common size financial statements are widely used and an effective tool for comparing companies.

Financial statement analysis can help stock investors digest hard-to-read financial statements.

John Foxx/Stockbyte/Getty Images

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Stock investors can learn an incredible amount from analyzing a company’s financial statements. The company’s income statement, balance sheet and statement of cash flows are especially useful to understanding how a company functions, its stability and how much its stock is worth.

Open the company’s most recent financial statements. Publicly traded stocks provide financial statements on a quarterly basis to the Securities and Exchange Commission as 10-Q and 10-K filings. These filings are available at the SEC’s website and can be searched by using a stock’s ticker symbol. These records are also available at the “Investors” or “Investor Relations” section of the company website.

Locate the income statement in the filing and check for trends in top-line sales, major expenses and bottom line income. Growing sales and earnings are excellent, but declining sales, declining earnings and increasing expenses suggest the company is struggling. Review footnotes for nonrecurring items and determine for yourself if similar losses or gains are likely in the future.

Analyze the balance sheet. Notice whether the company paid down or increased its debt or if any items declined substantially in value. You should also note how much book value is assigned to intangible assets and goodwill. If these are large numbers, double-check the footnotes to make sure they could be useful to the firm in the future.

Analyze the cash flow statement. For operating cash flows, consider whether each past source or use of cash could be repeated in the future. Unsustainable sources and uses of cash should not be used to make future cash flow projections. Calculate free cash flow to investors by summing cash flows from operations and capital expenditures (an item in investing cash flows). Investors should be attracted to firms with the potential to produce positive free cash flows. Consider investing and financing cash flows as well. Verify whether the firm needed to cover investing and operating cash flows by borrowing or issuing shares, and try to determine if it will do it again in the future.

Adjust historical accounting values to make them reflect today’s economic reality. Items listed as nonrecurring items or those likely to continue should be added back to net income. Adjust balance sheet items to reflect their economic values if they are different from their accounting values.

Calculate or look up valuation ratios. Valuation ratios reveal how dear a stock is to investors and include the price-to-book ratio, price-to-earnings ratio and price-to-sales ratio. These ratios divide the market capitalization of a company by the book value (equity listed on the balance sheet), earnings (net income on the income statement) and sales (the top line of the income statement).

Calculate other financial ratios. Liquidity ratios reveal whether a company is capable of paying its creditors. The current ratio is calculated by dividing current assets by current liabilities. The quick ratio is calculated by dividing current assets minus inventory by current liabilities. Current ratios under 1.5 and quick ratios under 1 are cause for concern and might indicate that a firm could have trouble paying creditors.

Make comparisons. Financial ratios can be compared between peer firms that use the same accounting conventions and operate in the same industry. They can also be used to compare a stock’s current valuation and performance against its historical valuation and performance.

Definition

Dividend Coverage Ratio states the number of times an organization is capable of paying dividends to shareholders from the profits earned during an accounting period.

Formula

Dividend cover in respect of ordinary share capital may be calculated as follows:

Explanation

Dividend Coverage Ratio indicates the capacity of an organization to pay dividends out of profit attributable to the share holders. A dividend cover of 3 implies that a company has sufficient earnings to pay dividends amounting to 3 times of the present dividend payout during the period.

When calculating dividend coverage for ordinary share capital, it is necessary to deduct any dividend paid on irredeemable preference shares from the net profit earned during the accounting period in order to arrive at the earnings attributable to ordinary share holders. Dividend on redeemable preference shares is already deducted from the income statement as interest expense (finance cost) and hence no further adjustment is required in its respect in the dividend cover calculation.

Example

Following information relates to the financial statements of ABC PLC for the year ended 31st December 2012:

Dividend Cover in respect of ordinary shares may be calculated as follows:

As dividend paid on redeemable preference shares would have been already accounted for in arriving at the net profit of ABC PLC, no further adjustment is required in the calculation of earnings attributable to ordinary shareholders.

Interpretation & Analysis

Dividend Coverage is a measure of the ability of an organization to pay dividends. Although dividend payments are usually discretionary, companies normally seek to maintain a reasonable level of dividend payout in line with the market expectations.

Generally, companies would aim to sustain a dividend cover of at least 2 times in order to avail adequate financing through retained earnings while providing a reasonable cash return on shareholder’s investment. A higher or lower dividend cover may be appropriate depending on the level of stability in earnings of the organizations.

Dividend cover consistently below 1.5 may suggest that the company might not be able to maintain the present level of dividends in case of adverse variation in profit in the future.

A high dividend cover may suggest that the company is retaining a higher portion of its earnings to meet its financing requirements which may result in higher dividend payouts in the future.

Importance

Investors use dividend cover ratio to gauge the level of risk associated with the receipt of dividends on their investment. A low dividend cover may suggest investors that the company may not be able to sustain the current level of dividends in case of a downward trend in company’s profitability in the future which could impact the valuation of shares.