FINANCIAL RATIO ANALYSIS PRACTICAL USES FOR THE CPA. Joseph P. Helstrom, CPA

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FINANCIAL RATIO ANALYSIS –

PRACTICAL USES FOR THE CPA

Joseph P. Helstrom, CPA

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Copyright  2012 by

Mill Creek Publishing LLC

P.O. Box 11, Zionsville, IN 46077

Updated February, 2017

permission in writing from the publisher.

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2 Course Description:

Financial ratio analysis is an effective tool for CPAs to evaluate and analyze financial trends to highlight operational efficiencies and inefficiencies. For the CPA in the attest function, financial ratios can be an important tool for audit planning to identify operational issues as well as any potential going concern questions that should be addressed. Through the use of example financial statements, this course demonstrates the practical uses of:

• Common sized financial statements

• Commonly used financial ratios

• The DuPont Model for evaluating return on equity

• Ratios to forecast working capital

• Cash flow ratios to identify potential liquidity issues

Learning Objectives

Upon completion of this course, you should be able to:

• Recognize the elements of common sized financial statements

• Compute commonly used financial ratios

• Differentiate the implications of each ratio to the company being measured

• Recognize the elements of the DuPont model

• Recognize the use of ratios to forecast certain working capital account balances

• Compute commonly used cash flow ratios

Prerequisites: None Level: Overview

NASBA Category: Accounting Recommended CPE: 4 Hours

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Course Overview

A large part of a CPA’s job is to discern trends. Trends are noteworthy. They indicate whether management is improving its oversight of assets, liabilities and profits. Unfortunately, they can also indicate weaknesses in management’s oversight. If the underlying cause of the trend, either positive or adverse, is not readily understood, it should be investigated until the cause is determined.

Financial ratio analysis assists the CPA is spotting and analyzing trends. There are many other practical uses of ratio analysis which include:

• Measuring as management performance objectives

• Using as financial forecasting tools

• Benchmarking performance

• Identifying areas that may require more audit investigation

Ratio analysis can provide many practical insights. Generally, it is best used as an overview tool as most measurements are very broad. However, it can be used to ascertain strengths and weaknesses relative to historical data and industry benchmarks that permit the user to know where to look for

improvement. It can also point the CPA in the attest function toward areas of weaknesses in the company that may require more audit investigation or emphasis.

This course begins with common sized financial statements which take the Balance Sheet and Income Statement components and express these components as a percentage of a total, generally Total Assets and Total Liabilities and Equity on the Balance Sheet and total Revenue on the Income Statement. The use of percentages makes increases or decreases easier to detect and also makes it easier to compare companies of different sizes to each other. It is a simple concept, but very powerful in its application, especially for spotting trends and comparison to other companies. Commonly used financial ratios are then explained followed by computation and analysis for a sample company. An examination of the DuPont model will demonstrate how return on equity may be broken down into component parts and the impact that changes in each component can have on the Return on Equity measurement. The uses of financial ratios in forecasting working capital will be explored. Lastly, ratios that focus on cash flow measurements will be evaluated for their ability to predict liquidity issues.

Common Sized Financial Statements

If the goal is to identify trends, common sized financial statements assist greatly in achieving this goal.

Common sized financial statements compare line items in the financial statement by expressing them as a percentage of a total. As an example, cash would be expressed as a percentage of total assets. On the income statement, an expense such as General & Administrative would be expressed as a percentage of Revenue.

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There are no rules in terms of which totals are used for the percentages. Historically, Total Assets and Total Liabilities and Equity are utilized on the Balance Sheet while Total Revenues are used on the Income Statement. However, if other denominators make sense, the historic usage should not limit the application of this simple yet effective analytical method.

Sample Financial Statements

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To common size the Balance Sheet, start with the assets and take each line item as a percentage of

“Total Assets” (In the case of 2011, this would be a percentage of 11,173,277). Do the same for “Total Liabilities and Equity” (In 2011, this would also be 11,173,277)

Now, some want to know if it is better to use a percentage calculation when the result should be the result of a sum or is it better to sum the percentages. Using the example of Total Liabilities and Total Equity, the question is whether to arrive at the percentage amount for each of these totals compared to Total Liabilities and Equity by dividing each total by Total Liabilities and Equity or is it better to simply add the percentage totals.

Either way should provide the same answer depending on rounding. I prefer to use the same arithmetic that is used in the original spreadsheet as shown below:

The common sized Balance Sheet is presented below.

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A key review point is to ensure that your totals, “Total Assets” and “Total Liabilities and Equity” in this case, are reflected at 100%. It is also recommended that the remaining amounts are scanned for reasonableness.

What trends are evident?

• Accounts Receivable is a higher percentage of overall assets, increasing from 33.0% in 2010 to 38.9% in 2011. This may or may not represent working capital inefficiency as the company is in an increasing sales environment. This is a trend that should be noted for further investigation through ratio analysis and comparisons to industry averages.

• Inventory is a lower percentage of overall assets, decreasing from 59.2% in 2010 to 54.2% in 2011. In an increasing sales environment, this is likely a good trend. However, this will also be confirmed through ratio analysis and comparison to industry averages.

• Property and Equipment represent a diminishing component of overall assets, going from 7.0%

in 2010 to 5.8% in 2011. This begs a question of whether there is enough investment in property and equipment to sustain future growth. This requires more investigation.

• Accounts Payable and Accrued Expenses are at roughly the same combined level as the previous year.

• The Line of Credit has been reduced considerably as a percentage of Total Liabilities and Equity, going from 26.4% in 2010 to 9.9% in 2011. This is a positive trend and indicates that the company is generating adequate cash to pay down debts.

• Retained Earnings is up considerably. Another positive trend indicating that income has exceeded any dividends.

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To common size the Income Statement, start with Total Revenues and take each line item as a

percentage of Total Revenues. Once again, where the results are the result of addition or subtraction, you may either compute the percentages based on the total as a percentage of Total Revenues or apply the same arithmetic formula to the percentages.

The common sized income statement follows.

A review point here is to scan the amounts for reasonableness. Gross Margin should reflect Sales Revenue less Cost of Sales. Income Before Tax should be Gross Margin less total Expenses, etc. A brief review can save problems later.

What trends are evident?

• Cost of Sales is down a full percentage point in 2011 compared to total revenues. This is also a positive trend.

• General and Administrative Expense is down to 31.7% in 2011 compared to 34.4% in 2010, demonstrating good cost control by management.

• Improvements in Cost of Sales and General and Administrative Expense is driving improvements in Income Before tax and Net Income.

Common sized financial statements make spotting trends relatively easy. That is the strength of this analytical tool. Looking for these trends is useful in the following settings:

• For the CPA in the attest function in public accounting – adverse trends such as a significant increase in debt or accounts payable or a significant decrease in cash or profit margins may be highlighted for further investigation. Significant negative trends may create uncertainty about the entities ability to continue as a going concern.

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• For the CPA in industry – trend analysis is important in highlighting management and operational efficiencies and inefficiencies. In the case of inefficiencies, proper focus and attention can be diverted to those areas to correct any problems.

• For the CPA in industry – common sized financial statements provide a great tool to

benchmark operations against competitors and industry averages. If your company deviates greatly from your competitors or industry norms, this area can be pointed out for further investigation. Public company information is readily available. Common sized financial statements remove the size factor when comparing large, public entities to small or mid- market sized entities through the use of percentages rather than the absolute numbers.

Benchmarking Example:

By benchmarking, you may note trends in the industry that change your opinion of your operations. In this example, your company’s margins are below those of your competitor and the industry. Earlier in this analysis, the temptation was to feel really good about reductions in Cost of Sales and Margin improvement. By benchmarking, you now know that there is further work to do in this area. The same is true of General and Administrative costs.

Helpful hints in using Microsoft Excel to create common sized financial statements:

Use absolute references when copying formulas. As an example, if this is your data -

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You can easily create formulas for Cash as a percentage of Total Assets as shown below:

Notice the $ signs in cell references B10 and C10. This is an absolute cell reference that won’t change when you copy data. In this example, the denominator will remain the same as it is copied down. The $ signs may either be entered manually or, after you’ve typed the cell reference, press F4. Now, simply copy the data down and this is the result:

This simple trick saves a great deal of time entering formulas.

So, what are the advantages of common sized financial statements?

• Provides an overview of financial data

• Easily identify trends in the data

• Identify areas for further investigation

• Provides a mechanism to compare data with much larger or smaller entities for benchmarking

• Easily understood by non-financial clients or members of management What are the disadvantages?

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• Only indicate areas of possible strength or weakness. Must be used in combination with other financial analysis tools.

Commonly Used Financial Ratios

Financial ratios are the next step in the analytical process. They generally use other financial statement data to arrive at a result that is much more useful to the user than common-sized financial statements alone. As an example, it was noted earlier in the course that Accounts Receivable as a percentage of Total Assets had increased in 2011 versus 2010. The Days Sales Outstanding ratio would compare the average level of Accounts Receivable to Sales Revenue to determine whether the increase is due to slower collections or simply the result of higher sales levels.

Financial ratios are generally grouped into the following categories:

• Activity ratios

• Liquidity ratios

• Debt ratios

• Profitability ratios

The commonly used ratios in each category are defined and their uses are explored in the following sections.

In discussing these ratios, comparison to industry averages is frequently mentioned. Where would these averages be obtained?

• Public company financial data from same industry (EDGAR on SEC.GOV)

• Trade journals and other publications

• Data from trade associations

Activity Ratios:

Activity ratios measure management’s efficiency in the use of certain assets. There are ratios for both current assets and long-term assets.

Accounts Receivable Turnover Ratio – Sales / Avg. Receivables. This ratio measures the number of times per year that average Accounts Receivable is collected. Lower than expected turnover or a decline in turnover could indicate inefficient collections, customer issues with either product or payment, or the possibility of earnings manipulation (e.g. Booking sales to non-existing customers that will never be

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collected or overstocking customers earlier in the year and extending credit terms plus, perhaps offering a right of return after year end). If all sales are not on credit, the sales figure should just use credit sales.

Days Sales Outstanding – 365 / Accounts Receivable Turnover Ratio. If standard payment terms are used, it should be compared against these payment terms (e.g. If your standard terms are net 60, you would expect your Days Sales Outstanding to be approximately 60). High Days Sales Outstanding could indicate inefficient collections, customer issues with either product or payment, or the possibility of earnings manipulation.

Inventory Turnover Ratio – Cost of Sales / Average Inventory. This ratio measures the company’s efficiency in managing inventory. High turnover generally means more efficient management, unless sales are being lost due to out of stock conditions. Low turnover can mean too much inventory on hand which can indicate management inefficiency and can also heighten the possibility of obsolete or

impaired value items on hand and may also indicate earnings manipulation (e.g. Booking the sales but not the associated cost of sales or booking cost of sales at a reduced amount).

Accounts Payable Turnover Ratio – Purchases / average Accounts Payable. In this measurement, Purchases can be derived from Cost of Sales and beginning and ending inventories. Therefore, Purchases = ending Inventory + Cost of Sales – beginning Inventory. While Cost of Sales may be used, Purchases is the more technically correct measurement as Cost of Sales represents which products were sold rather than purchased throughout the year. High turnover relative to history or industry averages could mean that your company is paying suppliers too fast. If this is driven by payment terms, more lenient terms could be sought to preserve capital. Low turnover could indicate payment problems or product quality issues. Payment problems could indicate liquidity challenges.

Fixed Assets Turnover Ratio – Sales / average Fixed Assets. This ratio measures the relationship between the average investment in Fixed Assets and sales revenue. A low turnover ratio relative to history or industry averages could indicate depressed sales levels relative to the investment in fixed assets or too much fixed asset investment.

Total Asset Turnover Ratio – Sales / average Total Assets. This ratio measures the relationship between investment in all assets and sales revenue. It may be used as a measure of management’s effectiveness in investing in the company’s assets. This ratio should be driven by the culmination of Inventory, Accounts Receivable and Fixed Asset Turnover ratios unless there are other significant assets on the Balance Sheet.

Liquidity Ratios:

Liquidity ratios measure the company’s ability to pay its short-term obligations with short-term assets.

Current Ratio – Current Assets / Current Liabilities.

Quick Ratio – Cash + Marketable Securities + Accounts Receivable / Current Liabilities

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The Quick Ratio is a bit more restrictive in its definition of current assets available for payment of current liabilities. Once again, these relationships should be compared to both history and industry averages. A deteriorating ratio in either case is cause for concern as it signifies fewer short-term assets to pay short-term liabilities. If the current ratio is approaching 1 or is less than 1, this is greater cause for concern as it signifies that liquid assets are insufficient to pay bills that will become due. This is especially of concern to the CPA auditor as it indicates that there may be a going concern issue. If the quick ratio is less than 1, this is also a concern if the Accounts Receivable and Inventory Turnover cycle is substantially longer than the payments cycle and/or there is some concern regarding obsolete

inventory. In this case, it is also necessary to evaluate bank lending sources and the health of the banking relationship.

Debt Ratios:

Debt ratios measure the relationship of debt to other elements of the Balance Sheet as well as provide a measurement of the profit available to pay interest on debt obligations. These and similar ratios are used extensively by lending banks as part of their covenant obligations. If these or other ratios are used as debt covenants, great care should be taken to ensure compliance. It is also a good idea to include debt covenants on forecasted financials so that any covenant compliance issues can be identified early.

Debt to Assets Ratio – Debt / Total Assets. This ratio measures that amount of total assets that were financed through debt. A high ratio indicates higher financial leverage which generally indicates more risk. Some of the risks involved are repayment risk as well as the risk that more financing may not be available in the future.

Debt to Equity Ratio – Debt / Shareholders Equity. This ratio measures the portion of the company’s overall asset financing that is provided by debt as opposed to shareholder’s equity. A high ratio implies a higher level of risk. Some of the risks involved are repayment risk as well as the risk that more financing may not be available in the future.

Times Interest Earned – Earnings Before Interest and Taxes (EBIT) / Interest Expense. This ratio

measures profits relative to interest expense and is used as an indicator of the company’s ability to meet its interest obligations. A ratio of less than 1 indicates that the company is not generating enough profits to meet its interest obligations. If this ratio is nearing or less than 1, this should put the CPA in the attest function on alert that there may be some going concern issues either through default or technical default (not meeting a bank covenant).

Fixed Charge Coverage Ratio – EBIT + fixed charges / Interest Expense + fixed charges. This ratio measures the company’s ability to meet its fixed financial charges such as interest and lease payments.

A ratio of less than 1 indicates that the company is not generating enough profits to meet its interest and fixed payment obligations. If this ratio is nearing or less than 1, this should put the CPA in the attest function on alert that there may be some going concern issues either through default or technical default (not meeting a bank covenant).

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Profitability ratios measure the ability of the company to generate acceptable profit. These ratios are measured against history and industry averages.

Gross Profit Margin – Gross Margin / Sales. This ratio measures the average profit from each sale. It is important as it measures the ability of the company to maintain sales prices and control product costs.

Net profit Margin – Net Income / Sales. This ratio measures the company’s ability to control all expenses relative to Sales revenue.

Return on Assets – Net Income / Total Assets. This ratio measures management efficiency in using assets to generate a return. This measurement is best compared across years as well as to industry averages.

Return on Equity – Net Income / Equity. This ratio measures profits relative to the equity of shareholders. Shareholders will compare the return on their investment to other returns such as Treasury Bills, Bank CD’s and stock market performance. Given the risk of investing in a company versus a Treasury Bill or Bank CD, shareholders generally want a higher return than a safer investment. This is a measure of management’s ability to generate that superior return.

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Computation of Ratios and Analysis

Use the following sample financial information:

Computed Ratios Using Sample Financial Information:

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16 Discussion of Computed Ratios -

Activity Ratios:

Accounts Receivable Turnover Ratio – Sales / Avg. Receivables. This ratio shows slight improvement when the trend is evaluated. However, it would also be very useful to compare against competitors or industry averages. If the industry data shows a much higher turnover, then this company may be providing very generous credit terms. Alternatively, if the industry data shows a much lower turnover, this company’s credit terms may be overly restrictive which could be inhibiting sales growth.

Days Sales Outstanding – 365 / Accounts Receivable Turnover Ratio. When translated into average days, the Accounts Receivable Turnover Ratio is much easier to evaluate relative to customer credit terms. If the average standard customer credit term for this company is 30 days, then management is doing a good job with collections. Same other comments as noted above.

Inventory Turnover Ratio – Cost of Sales / Average Inventory. This ratio has also improved

demonstrating that management is doing a better job of managing inventories. Once again this should also be compared to competitors or industry averages. To translate this figure into days, simple divide 365 by the turnover ratio. In this case, inventory turns over approximately every 80 days.

Accounts Payable Turnover Ratio – Purchases / average Accounts Payable. This ratio has improved slightly. While paying slower preserves cash, as long as it doesn’t result in finance charges or irritate suppliers, an improvement in accounts payable turnover is also a sign of financial health. If this were a drastic decline, it could indicate payment problems or product quality problems. Again, this should also be compared to competitors and industry averages. Translating into days (365 / AP Turnover), suppliers are being paid approximately every 56 days. This should conform to average payment terms offered by

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suppliers. If industry data is significantly different, your company may have better or worse terms than offered to others in the industry. Keep in mind that to compute purchases. Take ending Inventory + Cost of Sales less beginning Inventory.

Fixed Assets Turnover Ratio – Sales / average Fixed Assets. Fixed assets are turning faster. This begs the question of whether existing fixed assets are adequate for future growth. There may be a large capital need in the near future and you will need to determine whether sufficient debt capital is available for those needs.

Total Asset Turnover Ratio – Sales / average Total Assets. This ratio shows a slight improvement, mainly influenced by the Fixed Asset Turnover Ratio.

Liquidity Ratios:

Current Ratio – Current Assets / Current Liabilities. This ratio indicates that the company has 1.8 times more current assets than current liabilities. It has improved slightly over the prior year. When

evaluating liquidity, it is necessary to look at the working capital cycle.

Working Capital Cycle:

The working capital cycle is the number of days inventory is in stock PLUS the Accounts Receivable Days Sales Outstanding LESS the number of days Accounts Payable is outstanding. Using the activity ratios, above, the working capital cycle for 2011 is 80 + 30 – 56 = 54 days. So, the company has 54 days of working capital needs to be covered by either cash on hand or debt. Another way to look at this is that from the time that inventory is purchased, it is sold in approximately 80 days. It needs to be paid in 56 days. So, there are 24 days that cash is out the door. Then, it takes another 30 days to collect the Acccount Receivable from the sale. This totals the 54 days that there is a cash need.

This working capital cycle is not large. If the working capital cycle was 6 months, this may pose some concern as cash needs for liquidity would be much greater. In this case, greater emphasis would be placed on the line of credit to ensure that there were no bank covenant violations and there was a strong relationship. However, in this case, if there were a liquidity crisis, it could be cured in 54 days.

Also, since current assets are significantly higher than current liabilities, there appears to be no issue with assets available to satisfy current liabilities.

Quick Ratio – Cash + Marketable Securities + Accounts Receivable / Current Liabilities. On the surface, a quick ratio of .76 does not look good. The difference between the current ratio and the quick ratio in this example is that inventories are not considered in the quick ratio. So, this ratio is basically saying that this company could cover 76% of its current liabilities with available Cash and Accounts Receivable.

To cover the rest, it would need to sell about $1.4 million of inventory, or about 23% of its inventory balance. In the absence of any indication that inventory may be impaired or obsolete (the turnover remains steady), there appears to be no liquidity concern as a minor portion of the inventory balance could be sold to cover current liabilities. Once again, the overall banking relationship should also be evaluated to ensure that it is available to cover the working capital cycle for normal business operations.

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Liquidity ratios are important to the CPA in the attest function as a measurement of the ability of the company to continue as a going concern. The proper application and interpretation of these ratios is an important element in the audit workpapers to support a conclusion.

Debt Ratios:

Debt to Assets Ratio – Debt / Total Assets. 10% of the assets are financed with debt. This appears to be a very reasonable figure and, assuming no inventory issues, no collection problems and that property and equipment is in good working order, one that bank lenders are very comfortable with. The banks are lending 10% of the collateral value. There appears to be room for growth in terms of the company’s ability to expand its debt capital. This ratio has improved greatly compared to the previous year which is reflective of solid earnings.

Debt to Equity Ratio – Debt / Shareholders Equity. In 2010, more debt than equity was used to finance this business. However due to strong earnings in 2011, this ratio reduced to debt being 26% of equity from being 127% of equity. This implies less risk and corroborates the above assumption that more debt capital would be available in the future if it is needed.

Times Interest Earned – Earnings Before Interest and Taxes (EBIT) / Interest Expense. Earnings before interest and taxes is 32 times interest expense. This is very strong and demonstrates the lack of leverage and strong earnings performance of the company. This ratio should be compared to industry averages. In some highly leveraged industries such as certain finance companies, a ratio greater than 1.3 may be acceptable while in other industries, a greater ratio is needed.

Fixed Charge Coverage Ratio – EBIT + fixed charges / Interest Expense + fixed charges. In this example, the company has no lease payments (which are generally the additional fixed charges). Accordingly, this ratio is the same as the Times Interest Earned Ratio.

The above ratios, or some modification thereof, are likely to be used as bank covenants. If this is the case, particular attention must be paid to these ratios in both historical financial statements and forecasts. Violating a covenant can cause a company to lose its financing in the worst case scenario. In the best case scenario, it may result in expensive waiver fees. By including bank covenants in the forecasting process, you can anticipate if a covenant is going to be a problem and tackle it before the problem occurs, which is generally less troublesome and less expensive.

Profitability Ratios:

Gross Profit Margin – Gross Margin / Sales. This ratio must be measured relative to history and industry norms. It improved by 1 percentage point from 2010 to 2011. This is a tremendous improvement and reflects management’s ability to either (a) raise average selling prices, (b) reduce average product costs or (c) improve sales of higher margin products relative to lower margin products. If this ratio is within industry averages, management is doing a great job.

Net profit Margin – Net Income / Sales. This ratio has improved from 2% to 5% reflecting management’s ability to control costs. This should also be evaluated relative to industry averages.

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Return on Assets – Net Income / Total Assets. This is the level of income returned on the investment in total assets. It has greatly improved from 9% to 19% indicating that management is generating more profit from its asset investment. This should also be evaluated relative to industry averages.

Return on Equity – Net Income / Equity. This represents the return on the shareholder’s investment. In this example, the return is 45% and 51% for 2010 and 2011, respectively. When compared to returns on other investments, this is a very good return. Treasury Bills and bank Certificates of Deposit were fortunate to yield 1% during this time. The S&P 500 yielded approximately 15% in 2010 and 2% in 2011.

We do not know the level of risk inherent in this business so this level of return must also be compared to industry averages. If the level of risk is similar to a normal level for privately owned businesses, this return would be very acceptable.

DuPont Model

The DuPont Model is a methodology that computes Return on Equity by component parts. Business owners and shareholders are very interested in their level of return. As noted earlier, there are

competing, safer investments. A method of consulting with business owners and shareholders on ways to boost Return on Equity would be very valuable to the CPA.

The DuPont Model was first used by the DuPont Corporation in the 1920’s. It breaks down the Return on Equity formula into three basic components; Net Profit Margin, Asset Turnover and Equity Multiplier.

This can be used in conjunction with industry averages or competitor information to pinpoint opportunities to improve Return on Equity (ROE).

ROE = Net Profit Margin x Asset Turnover x Equity Multiplier or

ROE = (Net Income / Sales) x (Sales / Total Assets) x (Total Assets / Equity) Use the following information:

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In its computations, the DuPont Model does not use average assets in the asset turnover formula, so results will be slightly different than shown in the ratio analysis section, above. For 2011, the results of these ratios are shown below:

ROE = (2,167,798 / 45,379,000) x (45,379,000 / 11,173,277) x (11,173,277 / 4,237,947) = .51 or 51%

By looking at the three individual pieces, ROE = .048 x 4.06 x 2.63,you can compare to history and industry averages to see where your company can improve.

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Starting with Net Profit Margin, if there is a shortfall in this statistic, look toward Gross Profit Margins or expenses. Gross profit margins may be impacted by raising prices, selling a different mix of higher margin product or by reducing product cost. A reduction in other expenses on the Income Statement should be a continual goal of management. Benchmarking these items against industry averages can help pinpoint the area(s) that require improvement.

Total Asset Turnover can be impacted by reducing assets relative to sales, if there is a shortfall in this measurement compared to industry averages. Look at Inventory Turnover, Accounts Receivable Turnover and Fixed Assets Turnover to identify the driver of any shortfall.

The Equity Multiplier will be impacted by how assets are financed. If more assets are required and financed by debt rather than through Shareholder’s Equity, this will influence this measurement.

Basically, leverage (more debt) has a positive impact on ROE. However, it’s a dual edged sword as more debt also carries with it more risk.

Assume that you have used public companies in your industry as a benchmark. The following comparisons have been computed for 2011 using the industry benchmark companies:

Net Profit Margin – .045 industry benchmark vs. .048 for the 2011 company information provided Total Asset Turnover – 5.0 industry benchmark vs. 4.06 for the 2011 company information provided Equity Multiplier – 2.5 industry benchmark vs. 2.63 for the 2011 company information provided So, the benchmark ROE is .045 x 5.0 x 2.5 = .563 or 56.3%

When we evaluate this against the previously computed numbers for the provided company

information, the primary difference is in Total Asset Turnover. The example company has better profit margins and a slightly better Equity Multiplier.

Assume that the comparison to benchmark companies yield the following activity ratios:

Accounts Receivable Turnover – 11.75 industry benchmark vs. 11.88 for the 2011 company information provided

Inventory Turnover – 6.0 industry benchmark vs. 4.56 for the 2011 company information provided Fixed Assets Turnover – 65.0 industry benchmark vs. 67.56 for the 2011 company information provided The major discrepancy appears to be in the Inventory Turnover Ratio. The example company has approximately 80 days in Inventory (365/4.56 inventory turnover ratio) while the benchmark companies have approximately 61 days of inventory on hand (365 / 6.0).

You have now isolated an issue for the example company management to address. They may ask you to quantify the impact on ROE if Inventory Turnover is increased to 6.0. Using 2011 as a guide, we can re- compute inventory as if the Inventory Turnover Ratio was 6.0.

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If the Inventory Turnover Ratio is Cost of Sales / Average Inventory and we want the answer to be 6.0, we need to solve algebraically for Average Inventory. We know the beginning inventory is 5,901,293 from the 2010 Balance Sheet and 2011 Cost of Sales is 27,227,400. Therefore, the formula looks like this:

Inventory Turnover Ratio = Cost of Sales / Average Inventory Filling in the known numbers :

6.0 = 27,227,400 / ((5,901,293 + Ending Inventory) / 2) Multiply both sides by Average Inventory.

((5,902,293 + Ending Inventory) / 2) x 6 = 27,227,400 Multiply both sides by 2.

(5,902,293 + Ending Inventory) x 6 = 54,454,800 Expand the left side by multiplying by 6.

35,413,758 + (6 x Ending Inventory) = 54,454,800 Subtract 35,413,758 from both sides.

6 x Ending Inventory = 19,041,042

Solve for ending Inventory by dividing by 6 Ending Inventory = 3,173,507

Just to be certain that we did the algebra correctly, plug the answer back into the Inventory Turnover formula.

27,227,400 / ((5,901,293 + 3,173,507) /2) = 6.0

Now that we know what the 2011 Inventory would be if the Inventory Turnover Ratio was 6.0, we know that Inventory would be lower by 6,050,533 (2011 reported) – 3,173,507 (2011 computed) = 2,877,026.

If Inventory is lower by the amount, then Total Assets must also be lower by 2,877,026. Therefore, Total Assets would be 11,173,277 (2011 reported) – 2,877,026 (computed inventory decrease) = 8,296,251.

Using computed Total Assets of 8,296,251 for the restated Total Asset Turnover Ratio = 45,379,000 / 8,296,251 = 5.47 Total Asset Turnover Ratio.

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If Inventory Turnover was to reach the industry benchmark of 6 times, this would boost ROE to 69%, well above the industry benchmark. This provides a discrete target for management focus so that ROE can be maximized.

Like most of ratio analysis, the DuPont model is a broad analytical tool. However, it does allow for the CPA analyst to pinpoint areas of strength and weakness for further examination and action in order to maximize Return on Equity.

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Data for Review Questions

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Review Questions

1. In 2011, approximately how many days is the working capital cycle of this company?

a. 91 days b. 52 days c. 95 days d. 56 days

2. What is 2011 Accounts Receivable Turnover?

a. 6.52 b. 7.14 c. 5.00 d. 55.97

3. What is 2011 Inventory Turnover?

a. 3.82 b. 4.07 c. 4.00

4. What is the 2011 Accounts Payable Turnover?

a. 3.82 b. 2.25 c. 2.63 d. 3.27

5. What is a disadvantage of common-sized financial statements?

a. Provides an overview of financial data b. Easily understood

c. They are only an indicator of strength or weakness that must be used in conjunction with other analysis tools

d. Provides a mechanism to benchmark against larger or smaller companies 6. What is the 2011 Times Interest Earned Ratio?

a. 1.10 b. 3.26 c. 5.39 d. 0.48

7. What is 2011 Return on Equity?

a. .05 b. .07 c. .73 d. .11

8. If long term debt recorded at the end of 2011 is the only debt available to the company, is there a liquidity concern?

a. No. The current ratio is still at 1.8

b. No. While the quick ratio is at .95, there is a short working capital cycle.

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c. Yes. The current and quick ratio is deteriorating and the level of cash on the balance sheet is decreasing at a rapid pace. If no other debt is available, it appears that the company may run out of cash

9. Which formula computes ROE for the above company using the DuPont Model?

a. 68 / 93

b. (68 / 1,500) x (1,500 / 1,033) x (1,033 / 93) c. (68 / 1,500) x (1,500 / 1,033) x (940 / 93) d. (113 + 37 + 50) / 93

10. In 2011, management wants to know the impact on Return on Equity if the net profit margin changed to .05. What would be the recomputed 2011 Return on Equity using the DuPont Model assuming no other changes in 2011 figures?

a. .73 b. .81 c. .65 d. 1.45

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Return on Invested Capital Overview

The return on invested capital ratio (ROIC) is a measure of an entity’s operating return on all capital invested in the business, including debt. It may be viewed as the operating profit generated by each additional dollar of debt or equity invested in the business, assuming that it’s a positive number.

ROIC – NOPAT x (1-tax rate) / Total debt + total stockholder’s equity – cash

Generally, the numerator for this ratio is net operating profits after tax (NOPAT). This may be calculated as earnings before interest and taxes (EBIT) x (1-tax rate). Using this measure as the numerator will exclude non-operating factors that may have a material influence on net income such as currency gains and losses or other non-operating items. The use of NOPAT also excludes interest expense. Since its purpose is to measure operating returns from capital investment, this non-operating capital cost is excluded from the calculation.

The denominator represents capital invested in the business. This includes not only stockholder equity but debt capital as well. Usually, only interest bearing debt is included. Cash is deducted from the calculation as it may be used to reduce debt.

Example:

EBIT $2.0M

Tax Rate 25%

Net Income $1.0M

Total Debt $10.0M

Total Equity $10.0M

Cash $1.0M

ROIC numerator = NOPAT x (1-Tax rate) = $2.0 x (1-0.25) = $1.5M

ROIC denominator = total debt + total equity less cash = $10+$10-1 = $19.0M ROIC = $1.5/$19.0 = 7.89%

For every dollar of debt or equity invested, this company returns about eight cents in operating profit.

Notice that ROE is 10% (net income of $1.0M divided by equity of $10.0M). Why is this higher than the 7.89% just computed? The difference is that ROE does not evaluate debt while ROIC includes it and ROIC uses operating profit after tax while ROE uses net income.

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ROIC should be evaluated over time. Like ROE, a higher number is more desirable. ROIC is sometimes considered a more desirable measure of profitability since it includes all elements of the capital

structure instead of just the equity component and excludes non-operating gains and losses, which may not be indicative of future performance.

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Using Ratios to Forecast Working Capital

Working capital may be forecasted by looking at ratio trends. For working capital accounts, these trends are found in financial ratios such as days sales outstanding, inventory turnover and accounts payable turnover.

Assume that the balance sheet for the past two years consisted of the following:

The relevant ratios related to this information are:

Assume that for forecasting purposes, the 2012 plan calls for more relaxed credit terms to help spur new sales and continue existing sales. The expectation is that the average term will be 40 days. Your discussion with operations executives indicate no expected change in inventory turns for 2012. You also know that the plan is to continue to pay vendors at or around the 2011 rate of 56 days.

Forecasting Accounts Receivable

Given this information, you can forecast accounts receivable, inventory and accounts payable. It is essentially an algebra problem. Using days sales outstanding as an example, we know that the answer

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for 2012 is 40 days. Assuming that forecasted sales for 2012 is 53,320,325, we can solve the ratio for accounts receivable.

So, if days sales outstanding = 365 / Accounts Receivable Turnover, which would be 365 / ((Sales / average Accounts Receivable), then average Accounts Receivable should be days sales outstanding x (Sales/365). Take a moment to do the algebra.

DSO = 365 / AR Turnover. This is DSO = 365 / (Sales/Average Accounts Receivable) Multiply both sides by (Sales / Average Accounts Receivable).

DSO x (Sales / Average Accounts Receivable) = 365 Multiply both sides by Average Accounts Receivable.

DSO x Sales = 365 x Average Accounts Receivable Solve for Average Accounts Receivable.

DSO x Sales / 365 = Average Accounts Receivable.

Average Accounts Receivable = Days Sales Outstanding x Sales / 365.

Once you have average Accounts Receivable, we just want the forecasted ending Accounts Receivable balance. Average Accounts Receivable = (beginning Accounts Receivable + ending Accounts Receivable) / 2. Since we know the beginning Accounts Receivable balance, we now just need to solve for the ending Accounts Receivable balance.

To solve for ending Accounts Receivable:

Ending AR = (average AR x 2) – beginning AR

Applying these formulas to a Days Sales Outstanding of 40, 2012 forecasted sales of 53,320,325 and 2011 Accounts Receivable of 4,351,411, the 2012 forecasted average Accounts Receivable is:

Average Accounts Receivable = Days Sales Outstanding x Sales / 365.

Avg. AR = 40 x (53,320,325/365) = 5,843,323 Ending Accounts Receivable for 2012 will be:

Ending AR = (average AR x 2) – beginning AR

Ending AR = (5,843,323 x 2) – 4,351,411 = 7,335,235

What’s the significance? From a cash flow standpoint, you now know that Accounts Receivable will grow and that will be a use of cash. The extent of that usage at the end of 2012 will be the 2012 forecasted balance of 7,335,235 less the 2011 beginning balance of 4,351,411 which equals 2,983,824.

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The cost of relaxing credit terms and increased sales will be the need of approximately $3 million more working capital. This would be important to know and plan for. This methodology permits the CPA to anticipate the working capital need rather than react to it.

Forecasting Inventory

The scenario for forecasting 2012 Inventory will be done in the same manner. In this case, assume that forecasted Cost of Sales is 32,525,398.

If the Inventory Turnover Ratio is Cost of Sales / Average Inventory and we want the answer to be 4.56, we need to solve algebraically for Average Inventory. We know the beginning inventory is 6,050,533 from the 2011 Balance Sheet. Therefore, the formula looks like this:

Cost of Sales / Average Inventory = Inventory Turnover Ratio Or, expressed a little differently, it is:

Cost of Sales / Inventory Turnover ratio = Average Inventory 32,525,398 / 4.56 = Average Inventory

Average Inventory = 7,132,763

Now, we know that (Beginning Inventory + Ending Inventory) / 2 = Average Inventory Expressed differently, this is:

(Average Inventory x 2) – Beginning Inventory = Ending Inventory To solving for Ending Inventory, we have:

(7,132,763 x 2) – 6,050,533 = Ending Inventory 8,214,993 = Ending Inventory

This will also represent an increase in an asset which will be a cash need. In this case, Inventory is projected to increase by 8,214,993 (2012) less 6,050,533 (2011) = 2,164,460. Once again, this would be important to know and plan for.

Forecasting Accounts Payable

To forecast Accounts Payable, there will be a slight deviation from the formula. Earlier, it was noted that Cost of Sales may be used in this ratio rather than Purchases. To help simplify the math, the forecasting component will use Cost of Sales to approximate Purchases. If forecasted Cost of Sales is 32,525,398 and Accounts Payable Turnover remains constant at 6.46 (approximately 56 days), we need to solve algebraically for Average Accounts Payable. The formula for Accounts Payable Turnover is presented below:

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Accounts Payable Turnover = Cost of Sales/average Accounts Payable Expressed a little differently, this is:

Cost of Sales / Accounts Payable Turnover = Average Accounts Payable 32,525,398 / 6.46 = Average Accounts Payable

Average Accounts Payable = 5,034,891

Now, we know that (Beginning Accounts Payable + Ending Accounts Payable) / 2 = Average Accounts Payable.

Expressed differently, this is:

(Average Accounts Payable x 2) – Beginning Accounts Payable = Ending Accounts Payable We also know, from the Balance Sheet, that Beginning Accounts Payable is 4,537,900.

To solving for Ending Accounts Payable, we have:

(5,034,891 x 2) – 4,537,900 = Ending Accounts Payable Ending Accounts Payable = 5,531,882

The 2012 forecast calls for an increase in Accounts Payable of 5,531,882 (2012) less 4,537,900 (2011) = 993,982

This increase would be a source of cash.

Forecasting the Overall Working Capital Impact on Cash

Combining the cash effect of the changes in all working capital accounts yields the following:

Accounts Receivable – (2,983,824) Inventory – (2,164,460) Accounts Payable - 993,982 Net Cash Need – (4,154,302)

At the end of 2012, forecasted changes in working capital accounts will result in a net cash need of approximately $4.2 million. It will be important to plan for this cash need along with other forecasted cash needs.

This forecasting methodology can be combined with other forecasting methods to arrive at a full Balance Sheet and Income Statement forecast. However, changes in working capital accounts are a significant component of Cash Flow from Operations on the Statement of Cash Flows. It is essential to

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have a good idea of the balance of these accounts in the future to help plan for cash needs and possible liquidity issues. Cash Flow ratios make extensive use of Cash Flow from Operations and are used to help predict liquidity issues.

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Cash Flow Ratios

Most ratios focus on the Balance Sheet and Income Statement. However, for measuring a company’s liquidity, there are many advantages of using the Statement of Cash Flows in this assessment.

The current ratio and quick ratio measure current assets versus current liabilities. However, they do not measure the company’s ability to generate cash from operations to pay for unavoidable obligations such as interest and debt. If the company is unable to generate adequate cash to pay these obligations, then there is a liquidity crisis. It is important for the CPA in the attest function to foresee these challenges as both an advisor to management as well as properly assessing whether the company can continue as a going concern.

We will use the following information to explore cash flow ratios:

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When examining the Statement of Cash Flows, some items pop out, such as:

• Cash flow from operations in 2011 is negative

• The largest source of cash in 2011 is Accounts Payable

• Cash has consistently declined over the past two years

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Assume that the recorded debt of $500 is the extent of the company’s ability to obtain financing.

Using traditional ratio analysis of liquidity and debt, we see the following:

While the current ratio and quick ratio are deteriorating, there appears to be adequate current assets to satisfy current liabilities, assuming no collection issues or inventory obsolescence. The debt ratios have all improved in 2011 versus 2010. So, is there a liquidity issue?

Cash flow ratios look at how much cash the company has been generating and whether that level of cash generated is adequate to satisfy current liabilities as well as current fixed obligations such as debt payments and interest. It uses Cash Flow from Operations as a basic measure. Simply stated, Cash Flow from Operations is Net Income + Depreciation +/- changes in working capital accounts (Accounts

Receivable, Inventory and Accounts Payable).

Since changes in working capital are such a large component of Cash Flow from Operations, it is good to understand how these items have performed.

So, the Statement of Cash Flows shows large increases in Accounts Receivable, Inventory and Accounts Payable. A portion of the increase in Accounts Receivable is due to an increase in sales. However, Days Sales Outstanding has gone from 51 days in 2010 to 56 days in 2011.

Accounts Payable Days has gone from 90 days in 2010 to 78 days in 2011. This is an improvement.

Increases in the balance appear to be the result of more purchases to support operations. Days in inventory are slightly worse, moving from 90 to 91 days. Again, increases in the balance appear to be the result of more purchases to support operations.

Certain cash flow ratios are designed to test whether the company can meet its payment commitments and remain solvent. The three that we’ll explore are the Operating Cash Flow ratio, Cash Interest Coverage ratio and the Cash Current Debt Coverage ratio.

Operating Cash Flow Ratio

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The Operating Cash Flow ratio measures the ability of the company to pay current liabilities with cash provided by operating activities. The Operating Cash Flow ratio is expressed as Cash Flow from Operations / Current Liabilities.

In this example company, the Operating Cash Flow ratio for 2011 is -38 / 390 or -0.10. For 2010, the Operating Cash Flow ratio is 3 / 190 or 0.02. This indicates that the company, as it is currently operating, is not generating adequate cash to cover current liabilities. This number will vary greatly among

different industries, so it is important to compare this number to industry averages. However, in this case it is clear that there is a concern, even without industry averages.

Cash Interest Coverage Ratio

The Cash Interest Coverage ratio measures the same basic coverage as the Times Interest Earned ratio, just using a different numerator. While the Times Interest Earned ratio uses Earnings before Interest and Taxes, this ratio uses Cash Flow from Operations + Interest Paid + Taxes Paid as its numerator. Like the Times Interest Earned ratio, the intent is to measure the company’s ability to make interest

payments on debt. A low multiple indicates more risk of being unable to make interest payments than a high multiple. A multiple of less than 1.0 indicates a high risk of default.

Using the formula (Cash Flow from Operations + Interest paid + Taxes paid) / Interest paid, our example company has a Cash Flow Coverage ratio of (-38 + 50 + 44) / 50 or 56/50 = 1.12 This is a low multiple, indicating more risk.

Note that the Times Interest Earned ratio is much higher. Using the formula Earnings before Interest and Taxes / Interest = 159 / 50 = 3.18. The difference is that by using Cash Flow from Operations, the company’s cash investment in working capital is also considered, which provides a much different answer.

Current Debt Coverage Ratio

The Current Debt Coverage ratio is expressed as (Cash Flow from Operations – Dividends) / Current Portion of Long-term Debt. It is intended to measure the company’s ability to meet its debt repayment obligations. The higher the ratio, the higher the comfort that the company is able to meet its debt commitments. A lower ratio indicates more risk.

In our example company, the Current Debt Coverage ratio is -38 / 50 = -0.76. The ratio is negative which indicates great concern that cash will be available to meet the debt repayment obligation. In this example, the attest auditor should have great concern about the ability of the company to repay its current debt as well as its ability to continue as a going concern.

Using these ratios can provide more insight as to the future solvency of a company. CPA’s in the attest function should make use of these ratios in the audit planning process as well as in the overall

evaluation of the audit client to ensure that any concerns are properly addressed. Other CPA’s should use these ratios to consult with management regarding possible liquidity issues before they arise.

Planning for a cash flow problem is much easier than trying to address it as it happens.

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Overview of Gross Margin Analysis Concepts

Margin analysis explains variances at the margin level using four components: the impact of price, the impact of volume, the impact of product mix and the impact of product cost. Three of the four components are easy to understand. Higher prices mean more margin. Selling more also equates to more margin (selling 5 units at $20 margin is $100 in Gross Margin while selling 10 units at $20 margin is

$200 in Gross Margin). Equally intuitive, if product costs are higher or lower, it has a negative or positive impact on Gross Margin.

Product mix is a more difficult concept. Product mix acknowledges that different products have different prices and, therefore, more or less impact on Gross Margin. If you sell more of a higher than average margin item than expected, this will have a positive impact on the overall margin variance. If you sell more than expected of a lower than average margin item, this will have a negative effect on the margin variance.

The following example illustrates the concept of mix:

Assume that you had sold 3,000 units of product in the prior year and the prior year margin was

$280,000. When the current year results were compiled, you sold 3,000 units of product, however, current year Gross Margin was only $200,000. What is driving this difference?

At first glance, it looks like it could be a pricing issue. The prior year overall average Gross Margin per unit is $93.33 ($280,000/3,000 units) while the current year average Gross Margin per unit is $66.67 ($200,000/3,000 units). Once we look at the detail, we can see that is really a product mix issue:

Units Gross Margin Total Prior Year

1,000 $ 40 $ 40,000 2,000 $120 $240,000 3,000 Avg. $93.33 $280,000 Actual

2,000 $ 40 $ 80,000 1,000 $120 $120,000 3,000 Avg. $66.67 $200,000

After examining the detail, we can see that even though we sold the same number of units as the prior year, 3,000, there was a change in the units sold. In the prior year, we had sold only 1,000 units of the

$40 margin product and in the current year sold 2,000. In the prior year, we had sold 2,000 units of the

$120 margin product and only sold 1,000 in the current year. Even though more of the lower priced units were sold, the result is a margin variance of ($80,000). So, in this example, there was no change in the overall volume of product sold and no change in margins of the individual products. The entire

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variance in prior year versus current year Gross Margin is explained by product mix (selling less of the higher than average margin units and more of the lower than average margin units).

The calculation of Price, Volume, Mix and Cost impacts on Gross Margin is the result of a series of calculations outlined, below:

Price: (Current Year Price – Prior Year Price)*Current Year Units

Volume: (Current Year Units – Prior Year Units)*Overall Prior Year Average Unit Margin

Mix: (Prior Year Margin per unit – Overall Prior Year Avg. Unit Margin)*(Current Year Units - Prior Year Units)

Cost: (Prior Year Cost – Current Year Cost)*Current Year Units

Margin Analysis – Example

CY PY CY PY CY PY

CY PY Unit Sales Sales Price Unit Unit Cost CY PY Margin Margin Units Units Diff Price Price Diff Cost Cost Diff Margin Margin P/Unit P/Unit

A

300 250 50 100 105

(5) 70 75 5

9,000

7,500 30 30

B

500 600 (100) 50 55

(5) 35 40 5

7,500

9,000 15 15

C

300 400 (100) 300 290 10 205 210 5

28,500

32,000 95 80 Total

1,100 1,250 (150)

45,000

48,500 40.91 38.80

Price component:

A ($100 - $105) x 300 = ($1,500) B ($ 50 - $ 55) x 500 = ($2,500) C ($300- $290) x 300 = $3,000 Total Price component = ($1,000)

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(1,100 – 1,250) x 38.80 = ($5,820) Mix component:

A ($30 - $38.80) x ( 300 – 250) = ($ 440) B ($15 - $38.80) x ( 500 – 600) = $2,380 C ($80 - $38.80) x ( 300 - 400) = ($4,120) Total mix component = ($2,180)

Cost component:

A ($ 75 - $ 70) x 300 = $1,500 B ($ 40 - $ 35) x 500 = $2,500 C ($210 - $205) x 300 = $1,500 Total Cost component = $5,500

Total margin variance = ($3,500) - $45,000 current year Margin less $48,500 prior year Margin.

This is intended to be a simple overview of Gross Margin analysis. The goal is an understanding that there are more detailed analysis techniques that can be applied beyond financial ratio analysis. In this case, ratio analysis may indicate higher Gross Margin rates, but does not pinpoint the underlying reason for higher Gross Margin rates. Margin analysis can pinpoint how decisions affecting product volume, pricing, mix and cost impact Gross Margins and the company’s Income Statement.

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Review Questions

11. If 2013 forecasted sales are $2,500,000 and the forecasted days sales outstanding are 40 and the end of the year 2012 accounts receivable is $250,000, what is the forecasted end of the year 2013 accounts receivable balance?

a. $47,945 b. $297,945 c. $596,000 d. $357,945

12. If 2013 forecasted Cost of Sales is $1,500,000 and the forecasted Inventory Turnover is 4.5 and the end of the year 2012 Inventory balance is $300,000, what is the forecasted end of the year 2013 Inventory balance?

a. 366,667 b. 333,333 c. 375,000 d. 450,000

13. If 2013 forecasted Cost of Sales is $1,500,000 and the forecasted Accounts Payable Turnover is 6.0 and the end of the year 2012 Accounts Payable balance is $225,000, what is the forecasted end of the year 2013 Accounts Payable balance?

a. 187,500 b. 150,000 c. 275,000 d. 250,000

14. Using 2013 forecasted amounts for Accounts Receivable, Inventory and Accounts Payable computed in 11-13, above, what is the forecasted cash flow impact from changes in Accounts Receivable, Inventory and Accounts Payable in 2013?

a. Usage of cash of 32,306 b. Usage of cash of 64,612

c. Changes in working capital does not impact cash flow 15. If a company is profitable, can it have a liquidity issue?

a. No. If it’s profitable, there should always be adequate cash

b. Yes. Investment in inventory, accounts receivable and capital expenditures necessary for growth can drain a company of cash

c. No. As long as current assets exceed current liabilities, there should be adequate liquidity

d. Yes. But it is always possible for a company to obtain a line of credit

16. If Net Income is $500,000 and Depreciation is $50,000 and the net change in working capital items is $(250,000) and these are the only relevant items, what is Cash Flow from Operations?

a. $800,000 b. $200,000 c. $300,000

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17. If Cash Flow from Operations is $40,000 and the current portion of long-term debt is $100,000, which statement is most appropriate concerning a CPA in the attest function for this company?

a. This should not impact audit planning b. This should not influence audit procedures

c. There should be no notation of this in the workpaper documents supporting the audit d. There should be planning and procedures performed and documented in the audit

workpapers that address whether the company can reasonably be expected to continue as a going concern given that it is not generating adequate cash to make its debt

payment obligation

18. The Operating Cash Flow ratio uses which financial statement line items?

a. Net Increase/(Decrease) in Cash, Current Liabilities

b. Net Cash Provided by Operating Activities, Interest Expense c. Financing Activities, Current Liabilities

d. Net Cash Provided by Operating Activities, Current Liabilities

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Glossary

Activity ratios – measure management’s efficiency in the use of certain assets. The ratios covered in this course include accounts receivable turnover, days sales outstanding, inventory turnover, accounts payable turnover, fixed assets turnover and total assets turnover.

Cash interest coverage ratio – measures the ability of the company to make interest payments on debt using cash provided by operating activities.

Common sized financial statements – compare line items in the financial statement to historical data and to industry averages by expressing them as a percentage of total assets, total liabilities and equity or total revenue, whichever is applicable.

Current debt coverage ratio – measures the ability of the company to meet its debt repayment obligations using cash provided by operating activities.

Debt ratios – measure the relationship of debt to other elements of the balance sheet and provide a measurement of the profit available to pay interest on debt obligations. The ratios covered in this course include debt to assets, debt to equity, times interest earned and fixed charge coverage.

DuPont Model – a methodology that computes return on equity by breaking it down into three

components; net profit margin, asset turnover and equity multiplier. It is expressed as Net Profit Margin x Asset Turnover x Equity Multiplier.

Margin analysis – explains variances at the gross margin level using four components; Price, volume, product mix and product cost.

Profitability ratios – measure the ability of the company to generate an acceptable profit. Ratios covered in this course include gross profit margin, net profit margin, return on assets and return on equity.

Operating cash flow ratio – measures the ability of the company to pay current liabilities with cash provided by operating activities.

Working capital cycle – the number of days of inventory in stock plus the days sales outstanding in accounts receivable less the number of days accounts payable is outstanding.

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Index

absolute cell reference, 10

Accounts Payable Turnover Ratio, 12, 16 Accounts Receivable Turnover Ratio, 11, 12, Activity ratios, 11 16

benchmarking, 9, 10 Cash Flow Ratios, 34

Cash Interest Coverage ratio, 36, 37 common sized financial statements, 2, 4, 9, CPE, 2 10

Current Debt Coverage ratio, 36, 37 Current Ratio, 12, 17

Days Sales Outstanding, 12, 16, 17, 30, 36 debt covenants, 13

Debt ratios, 11, 13

Debt to Assets Ratio, 13, 18 Debt to Equity Ratio, 13, 18 DuPont Model, 19, 20, 26, 51 Fixed Assets Turnover Ratio, 12, 17 Fixed Charge Coverage Ratio, 13, 18

Forecast Working Capital, 29

going concern, 8, 13, 18, 34, 37, 42, 54 Gross Profit Margin, 14, 18

Inventory Turnover Ratio, 12, 16, 21, 22, 31 Liquidity ratios, 11, 12, 18

Margin analysis, 38 Net profit Margin, 14, 18

Operating Cash Flow ratio, 36, 37 Product mix, 38

Profitability ratios, 11, 14 Quick Ratio, 12, 13, 17 ratio, 30

ratios, 29

Return on Assets, 14, 19 Return on Equity, 4, 14, 19, 23 return on invested capital, 27 ROIC, 27

Statement of Cash Flows, 32, 34, 35, 36 Times Interest Earned, 13, 18, 37 Total Asset Turnover Ratio, 12, 17, 22 working capital cycle, 17, 25, 50, 51

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Test Questions

Use the following information to answer the test questions:

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1. In 2011 and 2010, what are the working capital days?

a. 154 days in 2011, 55 days in 2010 b. 62 days in 2011, 52 days in 2010 c. 37 days in 2011, 39 days in 2010 d. 55 days in 2011, 57 days in 2010

2. What is the Times Interest Earned ratio in 2011?

a. 3.29 b. 1.49 c. 2.31 d. 2.86

3. What is the Accounts Receivable Turnover ratio in 2011?

a. 1.69 b. 2.31 c. 6.51 d. 4.05

4. What is the Inventory Turnover ratio in 2011?

a. 1.49 b. 2.32 c. 3.29

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5. What is the Accounts Payable Turnover ratio in 2011?

a. 4.24 b. 6.21 c. 4.05 d. 3.75

6. What is the LARGEST driver of the difference in working capital days between 2011 and 2010?

a. Accounts receivable b. Inventory

c. Accounts payable

d. All three are equally significant

7. Which statement is most correct given 2011 and 2010 data?

a. The increase in inventory should be of no concern to an auditor of the financial statements

b. There has been minimal change in the Gross Profit Margin ratio from 2010 to 2011 c. The increase in inventory combined with the increase in Gross Profit Margin ratio in

2011 should make the auditor skeptical that earnings manipulation has occurred d. Accounts receivable should be the primary focus of audit effort

8. What is the Debt to Assets ratio in 2011?

a. .75 b. .70 c. .63 d. .55

9. What is Return on Equity for 2011?

a. .10 b. .15 c. .20 d. .25

10. For purposes of computing Accounts Payable Turnover in 2011, what are Purchases?

a. 75,000 b. 78,080 c. 49,920 d. 100,480

11. Is there a risk that this company may not be able to pay its current debt due?

a. No. Its current ratio is well above 1.0 at 1.69

b. No. Its Times Interest Earned ratio is adequate at 3.29

c. Yes. Its Current Debt Coverage ratio is less than 1.0 as is its Operating Cash Flow ratio and its primary source of cash in 2011 was an increase in long-term debt

d. No. Its Cash Interest Coverage ratio is higher than 1.0 at 1.09

12. Which of the following represents the DuPont Model formula for this entity for 2011?

a. 17,550 / 71,402

b. (17,550 / 150,000) x (150,000 / 261,000) x (261,000 / 71,402)

FINANCIAL RATIO ANALYSIS PRACTICAL USES FOR THE CPA. Joseph P. Helstrom, CPA