Tools and Tips for Analyzing Financial Statements

What do you do with the 4 financial statements once they’ve all been updated, reconciled, and audited?

The next best action to take is to analyze the information in preparation for business and financial decision-making. There are several methods in evaluating financial statements. For the sake of our discussion, we will focus on the two common methods that are used in practice. The two common methods of analysis are the ratio analysis and the Dupont System of Analysis. The ratio analysis is the basic method and the Dupont System of Analysis is the more complex method of the two. Short-term (less than one year) and long-term (more than year) approaches must be considered by management. Both analyses will help an individual or organization gain better insight on their current financial situation.

Method #1: Ratio Analysis

The basic ratio analysis uses several ratios to show the value of each measure. Plotting the data on a graph, trend lines can be displayed to show which direction the measure is trending. Whether the trend lines are trending upwards or downwards. Liquidity, activity, debt, profitability, and market ratios when combined provides the decision-makers (internal or external) to make conscience, well-informed business and financial decisions. Separately, they allow the decision maker to make direct, targeted adjustments. Some ratios may not need to be improved and can wait for the next quarterly or annual review, while others may require action.

Liquidity Ratios

Liquidity ratios reflect a firm’s ability to satisfy its short-term obligations as they come due (Chad J. Zutter, 2019, p. 92). There are several liquidity ratios: current ratio, cash ratio, working capital, and quick ratio.

Liquidity ratios are relevant and have importance because forecasts can be executed in a manner where the financial manager can determine if they will have sufficient funds to pay their obligations within one year. A financial manager can stay ahead of the curve by addressing any liquidity problems before the situation gets out of hand. The most predominantly used liquidity ratios, are the current ratio and the working capital ratio. They are simple and straight to the point. If an individual or organization wants to know if they are sufficiently liquid and can pay their obligations within the year, they can refer to the liquidity ratios to get quick feedback.

Activity Ratios

Activity ratios measure the speed with which various asset and liability accounts are converted into sales or cash (p. 94). Inventory turnover, average collection period, average payment period are activity ratios that can help the financial manager figure out how efficient they are operating along several areas. Such as collections and inventory management. If we were to think in terms of competitive advantage good management will keep a pulse on these operational viewpoints. Activity ratios can lead to management to making changes in their payment plans, credit term agreements, or warranty agreements. The activity ratios can and should be used as a competitive advantage. Favorable client payment options and good credit terms can be the difference between increased and decreased market share so management will monitor these ratios.

All four activity ratios provide information that the financial manager or outside investor can gauge to determine if the firm are making inroads in terms of a) how fast the organization is collecting money owed to them in a reasonable time frame, or b) by how fast their sales are converted into cash.

While all of the activity ratios are relevant and have importance, the total asset turnover ratio is the ratio you’d want to stay on top of. If a financial manager or investor are interested in monitoring whether the organization’s operations are financially efficient in using their assets to generate income, they will want to pay close attention to the total asset turnover ratio.

Debt Ratios

The debt position indicates the amount of money the firm uses that comes from lenders (p. 99). Debt ratio, debt to equity ratio, and times interest earned (or interest coverage) ratio are the three debt ratios that are evaluated. These three debt ratios are important to any organization, especially if their financial objective is to improve credit rating. Good management will focus their attention to these ratios and stay on top of them.

While keeping the debt ratio and debt-to-equity ratios under control, management will center their focus on the long-term debts that commit them to contractual debt payments for any time period over one year. This is the focus of the interest coverage ratio. The interest coverage ratio measures the organization's ability to make its contractual obligations. These type of contractual debt payments can be a business loan that is 2, 5, or 10+ years. In personal finance, this can be a 30-year mortgage loan or a 5-year car loan. At any rate, the organization should center their attention to those long-term debts where they are bound by agreement and keep the interest coverage ratio a high ratio. An example of an interest coverage ratio is 1.0. At worse, the value of an unfavorable interest coverage ratio value should hold steady if it is not increasing. Different industries have different industry averages but the organization should be aware of their particular industry average and make efforts to be above industry average. This diligence and action have the potential to ‘anchor’ the organization.

In terms of dollar amounts, the greater the long-term debt amount, the greater the risk the borrower may not be able to make the contractual debt payments. From an investor’s standpoint, they pay close attention to this value because if an organization has to be liquidated and can't pay their debt obligations, they won't be able to pay them.

Not all debt is bad debt though. Good debt exists too. Good debt is used when the organization has room to leverage assets with debt and it does not negatively impact the debt (debt-to-assets) ratio. Organizations are aware that it is cheaper to borrow capital in the form of debt rather than equity because the cost of debt is cheaper than the cost of equity. After all, interest expense is tax-deductible. This explains why most companies take the cheapest approach when raising capital by obtaining debt capital instead of equity capital. Debt financing (capital) is considered cheaper and less risky than equity financing. In some cases, some organizations will elect to obtain debt capital rather equity capital and pay the interest expense up front, lowering the principal. Any time the interest expense is paid up front that means the borrower will be paying less and the creditor will receive less. Possessing debt without interest expense to cover can be a deliberate strategy for an organization. This is the art of borrowing for less than quoted and investing the influx of immediate cash into value-generating assets. Regardless, organizations are bound by law to make good-faith payments to their creditors…as the borrower of funds...so the financial manager should exercise fiscal responsibility at all times under any financial strategy.

As mentioned in Assets vs. Liabilities vs. Equity, whether the short-term or long-term perspectives are in question, the debt (debt-to-asset ratio) ratio should be consistently less than 30%. Management should strive to meet or beat that measure each period. If they are above 30%, management should take the necessary actions to make sure the measure is trending downwards.

Profitability Ratios

Profitability ratios enable internal and external stakeholders to evaluate the firm’s profits with respect to its sales, assets, or the owner’s investment (p. 103). Profitability ratios are what most individuals and organizations have been exposed to, heard of, or are familiar with. Gross profit margin, operating profit margin, net profit margin, earnings per share (EPS), return on assets (ROA), and return on equity (ROE) all show profitability and they all should trend upwards. The higher the ratios, those who have interest in or are affected by these profitability ratios will have something to smile about.

Return on assets (ROA), or another commonly used term the return on investment (ROI), is the profitability ratio that attracts the most attention. Most individuals and organizations want to know if they are making money or returns on the assets they own or have invested into.

Market Ratios

Market ratios relate to the firm’s market value, as measured by its current share price, to certain accounting values (p. 110). Market ratios include price/earnings (P/E) ratio and market/book (M/B) ratio. These two ratios can be simplified to the following explanation. If an organization wants to determine what investors are willing to pay for each dollar of their earnings, they will pay close attention to the price/earnings ratio. The market/book (M/B) ratio looks at the market price of common stock of an organization and compares it against what the book value is (as of the value on the balance sheet).

Ratio analysis is the most commonly used method because it is simple and provides valuable information. These ratios are included in benchmark analysis, time-series analysis, market analysis, or cross-section analysis. Each analysis has their own separate purpose so it depends on the decision-maker and the strategy or objective.

Method #2: The Dupont System of Analysis

The Dupont System of Analysis is used to “dissect the firm’s financial statements and to assess its financial condition” (p. 118). This analysis drills down to a level where the person evaluating the information can see visually what is driving and impacting the organization’s performance. Dupont puts together information from both the income statement and the balance sheet into a summary with measures of profitability, return on equity (ROE), and return on assets (ROA). The upper portion analyzes and summarizes activities from the income statement. And, just the opposite, the lower portion analyzes and summarizes activities from the balance sheet.

If the organization wants to find the “bottleneck” or issue in what is driving the positive or negative performance the organization are seeking or experiencing, they may find the Dupont System of Analysis to be most effective. Targeting a specific business measure (sales, net profit margin, ROA, etc.) can help the organization match their actions with their intent.

In conclusion, being exposed to the different financial ratios used in any type of analysis will allow internal and external stakeholders to make business and financial decisions that will bring value and profit to their organization. Microsoft Excel is not an accounting software it is an accounting system; but it is a very helpful tool. Use of Microsoft Excel can get you what you are looking for. There are plenty videos and examples on YouTube and other channels that has tutorials/etc. that can be learned on your own pace. If that is not the preferred approach, individuals and organizations can use accounting software, such as Wave or QuickBooks, to help them develop the financial statements with ease. All organizations should retain or outsource their accounting to a professional where audited statements can be obtained. A CPA not only does tax preparation but they can also prepare financial statements. A trustworthy, certified public accountant (CPA) is ideal as they can save an organization time and money by ensuring accuracy of the statements as well as ensuring tax benefits for the organization are identified and realized. In addition, they can produce specific, more detailed financial reports for their clients. The performing organization can use the financial report(s) as an input to other processes and activities, such as budget or annual strategy meetings.

Whether the financial goals are short-term (within 1 year) or long-term (over 1 year), it is wise for management to use the information from these analyses by making the necessary adjustments and re-aligning their strategy and operations towards achieving the organizational goals!

References

Chad J. Zutter, S. B. (2019). Principles of Managerial Finance, 15th Edition. New York City: Pearson Education.

Smith, N. (2024, March 28). Assets vs. Liabilities vs. Equit. Saint Petersburg , Florida, USA.

Smith, N. (2024, April 2). The Purpose of the 4 Financial Statements. Saint Petersburg, Florida, USA.

Tracie Miller-Nobles, B. M. (2018). Financial & Managerial Accounting, 6th Edition. Pearson Education.

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Meet Nikia Smith, the Project Management Consultant driving success at Business and Wealth Generations. With over a decade of advisory expertise, Nikia orchestrates strategy and operations, spearheading growth and innovation. Beyond his professional endeavors, Nikia actively participates in his community, having served on the Board of Directors at the Project Management Institute Florida Suncoast Chapter in different roles for several years. Recognized for his contributions, he received the PMI Florida Suncoast Chapter Award in 2018 for significantly boosting membership and retention and was also selected to attend the 2019 PMI North America Leadership Institute Meeting in Philadelphia. Nikia holds a bachelor’s degree in management and organizational leadership with a focus on Project Management, alongside several business certificates from St. Petersburg College. He is also certified in CAPM and PMP by the prestigious Project Management Institute. For collaboration opportunities, reach out to Nikia at info@thebusinesswg.com.