FINANCIAL RATIO ANALYSIS AS A
MANAGEMENT EFFECTIVENESS INDICATOR
Robert C. Losik
Professor of Organizational Leadership
and Strategic Management
Dept of Organizational Leadership
School of Business
Southern New Hampshire University
Working Paper No. 2003-05
This is a BETA VERSION (A work in progress).
Please report all errors, omissions, and suggestions
for improvement to email@example.com
Copyright 1999 and 2003 by Robert C Losik, Bow, New Hampshire,
All rights reserved. No part of this book may be reproduced or transmitted in any form or
by any means, electronic or mechanical, including photocopying, recording, faxing,
scanner, or by any information storage and retrieval system, without permission in
writing from the author.
The following persons made major contributions to the book:
Timothy P Losik, BS, MBA, CPA, extensive experience in public
accounting and corporate finance and accounting. Made major
contributions in the areas of technical accuracy, sequencing of material,
use of correct terms, content, and metrics.
Jennifer A Losik, BS, extensive experience in small business
management, comptrollership, and web development and management.
Made major contributions in the areas of readability from the perspective
of the student, sequencing of material, content, and layout.
I also wish to acknowledge the significant contributions of the following persons who
took the time and made the effort to review this book. Their contributions have been
Dr. Burton Kaliski, Professor, SNHU
Dr. Laurence Pelletier, Professor, SNHU
Mr. Stephen B. Townes, CEO, Keystone Aviation
Mr. George D. Livingston, Jr., President and CEO, REALVEST
Dr. Martin Bradley, Associate Professor, SNHU
Dr. Charles White, Professor, SNHU
Dr. Steven Painchaud
TABLE OF CONTENTS
CHAPTER 1: SOME THOUGHTS ON RATIOS 9 - 12
CHAPTER 2: THE BALANCE SHEET, INCOME 13 - 19
STATEMENT AND THE STATEMENT OF
CHAPTER 3: LIQUIDITY RATIOS 20 - 24
The current and quick ratios.
CHAPTER 4: ACTIVITY RATIOS 25 - 31
The asset turnover ratio, the inventory turnover ratio,
and the average collection period.
CHAPTER 5: LEVERAGE OR DEBT RATIOS 32 - 38
The total debt to asset ratio, long term debt to asset ratio,
the debt to equity ratio, and the times interest earned ratio.
CHAPTER 6: PROFITABILITY RATIOS 39 - 48
The gross profit margin, the operating margin, the net
profit margin, return on equity, return on assets as a function
of both operating and net profit, return on fixed assets, return on
investment, and earnings per share.
CHAPTER 7: METRICS 49 - 56
R&D/Net sales, marketing/net sales, administrative
expenses/net sales, net sales per employee, net profit per
employee, cost of waste per employee, overtime hours as a
percent of total hours, cost of quality/net sales, sales per square
foot of floor space.
APPENDIX A: MITIGATING EXTERNAL FACTORS 57 - 58
APPENDIX B: THE CONSOLIDATED CROMWELL 59-63
COMPANY CASE STUDY WITH FINANCIAL
DATA FOR THREE YEARS
"Managers must understand accounting, but they must think and act like strategists"
This handbook was initially prepared for use by non-accounting majors in
appropriate undergraduate business courses at Southern New Hampshire University,
Manchester, New Hampshire. It was envisioned that students will use this handbook as a
ready reference and refresher for all courses in which financial ratio analysis is a part of
the learning or problem-solving process. The goal is for the students to achieve and
maintain a high level of proficiency in the use of financial ratio analysis. This will give
them a solid understanding of both the financial and management implications of
financial ratios from the perspective of a non-accounting major. It may also be of interest
to the accounting major who intends to occupy a management position and for managers,
particularly of small to medium-sized businesses.
The handbook does not purport or pretend to present an exhaustive analysis of
financial ratios. Only selected ratios are used, those that in the judgement of the author
would be the most commonly used by non-accounting majors. Students and managers
seeking additional information on ratio analysis should refer to accounting and finance
texts or appropriate accounting and finance references.
Finance and accounting are integral parts of management. In most companies of
any size, the accountants, as well as all major functions areas, are the management team.
Their advice, insights, and recommendations are both sought after and valued.
Companies that must operate in highly competitive environments cannot afford the
luxury to have the various major management functional areas operate in isolation in
their own fiefdoms and fortified "silos."
While this handbook explains some financial implications of ratios, its primary
purpose is to inform about the MANAGEMENT EFFECTIVENESS INDICATORS
OF FINANCIAL RATIOS. By management effectiveness, we mean how the financial
condition of the company, as it is interpreted through the use of financial ratios, reflects
the management, the decision-making, and the vision of the company, to include how
management plans, implements, organizes, leads, and controls.
To one degree or another, the ratios that we will discuss reflect the overall
performance of the company. They are not simply indicators of the financial health of the
company. They are not, because the financial condition of the company is the product of
everything that goes right and everything that goes wrong inside of an organization.
People, policies, processes, practices, strategies, goals, and procedures determine
financial outcomes. Many internal factors determine the financial performance of an
organization. These include, but are not limited to the organization’s:
a. Mission, long range goals, and the strategies to achieve them;
b. Short range objectives and the tactics used to the achieve them;
c. Management information and feedback systems;
d. Management philosophy; and
e. Values, which form its unique "genetic code."
Because of the above, students and managers should not look at financial
information as sterile, one-dimensional data, which conveys only one meaning. The
financial condition is in many respects the pulse and lifeblood of the organization. The
hyper-focus that some current business students have on their own majors creates in some
students' minds the notion that there is no essential connection between the major
disciplines and sub-disciplines of business. They are unaware that virtually all major
strategic and tactical decisions, as well as most routine decisions, are based on the
financial condition and performance of the organization. They are also unaware that
many human resource, management, marketing, production, service, administrative, and
information systems decisions are made based on the financial condition of the company
as it exists now, and more and more today, as it is projected to exist in the future.
Many business majors will work in organizations where "somebody else crunches
the numbers." Because of this you could also make the argument that "somebody else
interprets the numbers and makes management decisions for the organization." The job of
education, however, is to insure that the student achieves, or at least is given the
opportunity to achieve, a high level of sophistication in information processing and
understanding. We should not be in the business of graduating pieces of the puzzle, but
rather students who can solve the puzzle. A failure to understand the management and
financial implications of ratio analysis undermines the degree to which students will one
day be able to understand their own organization, competitors, suppliers, and clients. The
same is true for current managers.
In business, graduates will work and hopefully learn. In education, students must
not only learn, they must learn how to continue learning. They must learn that ratio
analysis is a means to an end that helps them to continue to learn and understand. The
ratios are not an end in themselves. They are a means to the end of effective management
decision-making and organizational leadership. This learning will then help students
make strategic and tactical recommendations for the organizations they are studying,
informed decisions about their careers, and even wiser decisions when planning and
executing their own financial plans for the future.
Business majors and contemporary managers, however, should be able to take the
analysis of financial data one step further. They should be able to:
1. Draw tentative inferences about the management
effectiveness of the company. Because the financial
performance of a company, to a greater or lesser degree,
reflects the management decisions of a company, we should
be able to make inferences about the effectiveness and the
efficiency of management. These inferences, however, must
be tentative because unusual business situations and
activities, as well as mitigating external factors, can cause
misleading interpretations of the data. For examples of
external factors beyond the control of the company, see
Appendix A. While it is beyond the scope of this book,
management's effectiveness is also measured by how well it
can anticipate and/or react to these external factors and
devise and implement strategies that will attenuate their
effect on the organization. Unusual and extraordinary
internal activities could also depress or inflate any one or all
of the profit margins. With regard to the latter, expenditures
for acquisitions, restructuring, or cyclical research and
development could dramatically impact revenues and
profits. Where these situations seem to exist, the student is
obligated to go beyond the raw financial data and examine
the footnotes and other explanations in the company's
annual report and seek other factors that may have caused
2. Identify potential or actual strengths and weaknesses,
which can be attributed to the major management
functional areas of the company. These areas include, but
are not limited to: management (strategic and human
resource), finance, marketing, production and/or delivery of
a service, and information technology systems.
3. Use the information to aid in the planning and
implementation of both short-range tactics and long
range decisions to:
a. Improve or solidify the company's financial health
and gain for the organization an advantage over its
b. Identify areas in which external factors are
impacting on the financial performance of the
The three points listed above, 1., 2., and 3., are the rationale for the writing of this
handbook. There is more to ratio analysis than calculating ratios; there is more to ratio
analysis than financial analysis. Those same financial ratios also give us insight into
management issues in strategic management, human resource management, marketing,
production, delivery of a service, and management information systems of an
SOME PROCEDURAL REMARKS
GRAPHICS: In order to highlight and differentiate certain areas in this
handbook, we will use the following graphics for emphasis:
Indicates the discussion of a topic.
Indicates the calculation of a ratio or other metric.
Indicates an example of the topic under discussion.
Indicates a tip (suggestion) about the subject matter
Indicates possible manangement implications of
the analysis of the ratio or metric(s).
TARGET RATIOS: With regard to the discussion of the ratios and the tabular
data that shows the management implications of the ratios, no specific target figures for
the ratios are shown. Why? The ideal target number for each of the ratios varies from
industry to industry, and within the industry between the size of company. Therefore,
the use of comparative industry averages for your analysis is important. It is also
important to determine if the company has specific target objectives for its own ratios.
The "management implications" tables show possible management weaknesses and
strengths in terms of whether the ratios are high (hi) or low (lo) or increasing (inc) or
decreasing (dec), without comparison to specific targets.
ABBREVIATIONS: Within the "management implications" tables,
abbreviations are used to reflect the major management functions within a company.
These include: management, which will reflect both strategic management and human
resource management, finance, which will include both finance and accounting,
marketing, production, the delivery of a service, and management information systems.
If you were constructing your own tables, you could break these areas down in finer and
more discrete categories. You could create more categories if you wanted your analysis to
be more detailed, e.g., PURCHASING = PUR, HUMAN RESOURCE MANAGEMNT =
HRM. For the sake of brevity and to facilitate the construction of tables, the following
abbreviations are used for the major management functional areas.
FUNCTIONAL AREA ABBREVIATION
INFORMATION TECHNOLOGY IT
The Importance of Ratios and Metrics
"The Bottom Line: Make sure that you understand the ratios that you are using and
why you are using them and make sure that they are appropriate for the type of
company that you are analyzing."
In an e-mail to the author, Steve Townes, former CEO and President of ASIG
(Aircraft Services International Group) and current president and CEO of Keystone
Aviation offered the following contemporary insights about how management uses
financial ratios and metrics to improve the performance of a company that operates in a
highly competitive environment:
"We use extensive metrics in managing our large, far-flung
company from a tiny headquarters team. We measure not
only the traditional financial ratios and trends, plus
comparatives on those to the industry peer group, but also
many of the operating statistics and workforce statistics that
are the leading indicators that "flag" trend lines long before
we see financial statements. We coach for better
performance using these tools as the centerpiece of weekly
operations and monthly financial budget reviews. I suggest
that most good businesses "measure everything" in this
manner; the trick is picking what you really need to
measure, then measuring properly so the information is
valid. For example, our largest manageable cost pool is
labor---over 7 million man-hours of paid, rampside, touch
labor per annum. You can imagine how many ways we
splice, and dice those man hours, comparing cities to one
another, historicals, budgets, productivity, turnover, spans
of control, and a myriad of other metrics. . . by the way,
these things were not in place when we bought ASIG, our
largest unit. By using what we call our "Key Measures
Program," we have dramatically improved operating
performance and profitability. . . yielding award-winning
Steve Townes' description of the use of financial ratio analysis and metrics should
be a wake up call to all business students, both accounting and non-accounting majors.
Managers use these data as the bases to make major decisions for their companies.
Notwithstanding this, many students simply have trouble with the term, "ratio." They
either do not fully understand it, feel uncomfortable with it, or they feel that it is an
esoteric concept that has no application or value in their lives. At best, it is something to
memorize, pass a test, and forget. Because of this, I suggest to students that they may feel
more comfortable if they think of ratios as relationships or comparisons. Ratio is a
mathematical term; relationship and comparison are analytical terms and may be more
Understanding ratios is complicated by the fact that although they are supposed to
be expressed as a fraction, they generally are not. They are not because the denominator
is always one.
For example, you will frequently see a company's current ratio expressed as 2.25,
when it is actually 2.25 to 1. In most textbooks, the denominator, 1, is dropped as
a matter of convenience. For a student or manager, who is trying to understand
the significance of ratios, there is no reinforcement that they are actually dealing
with a ratio, because nothing is being compared. Visually, 2.25 is not a ratio; therefore,
the comparison is lost. This may be particularly confusing to students who experience
difficulty with math. The notion of a comparison or relationship is reinforced when a
ratio is written as 2.25 to 1, communicating to a student that there are 2.25 dollars of
current assets for each one dollar of current liabilities.
In addition to the term, ratio, there is an aura that ratios are really the primary
concern of accounting and finance and that other business majors need only be vaguely
familiar with them. This is complicated by the fact that other business majors take
introductory accounting with accounting majors, a course that is often taught by
accountants for accountants. The primary orientation of the courses is accounting not
management decision making. Notwithstanding this, any analytical process that helps
anybody in management make better business decisions or any business student make a
more thorough analysis should be learned and used. You can magnify the importance of
this by never letting yourself forget that the primary reason that profit-making
corporations are in business is to make a profit. Better decisions coupled with a profit
orientation should keep taking you back to the centrality of understanding the
significance of analyzing financial data.
Business students are managers-in-training. The primary job of managers is to
make decisions and detect and solve problems. Decision making and problem solving are
more effective when adequate, reliable, and accurate information is available. However,
frequently information is not there for the taking. Facts and data usually are available or
at least mineable through the use of various processes. Ratio analysis is one of those
processes that helps us convert raw data and facts into information that can be analyzed.
Once analyzed, the information is transformed into knowledge. Because comprehensive
ratio analysis is one of these processes, we can conclude that it can make students and
managers better problem solvers and decision-makers.
There is generally a quandary as to what to do with a financial ratio once we
calculate it. Most accountants and managers would agree that one ratio, at one
point in time, tells us little or nothing about the actual financial condition of a company.
A minimum of four criteria should be used to gain a more complete understanding of
The first is trend analysis. Ratios should be compared over a three to five year
period to gain an understanding of the financial health and direction of the organization.
If a pro forma balance sheet and income statement are prepared to project the anticipated,
future financial condition, ratios should also be calculated for the future years in question
so that trends may be observed there also. Trend analysis helps us to understand the
financial performance of an organization over time. Keep in mind that time is relative.
The time horizon for one trend may be inappropriate to use with another trend.
The second is to compare the company's performance with other similar
companies by using industry averages. Using industry averages, we get an "idea" as to
how our performance compares with others. While this can be useful, there are
potentially severe limitations. The industry must be sufficiently populated for the industry
averages to be meaningful. In addition, many larger companies are diversified, but their
net sales are combined in one balance sheet and income statement. It would be difficult
then to compare a company that produces only breakfast cereal with a company that
produces breakfast cereal, milk, dish detergent, and vitamins. To do so would lead to
faulty, inaccurate, and inappropriate conclusions. This became less of a problem in 1999,
when new accounting practices with regard to reporting the financial activities of
strategic business units took effect. Companies will have to be more explicit when
reporting the profits of its components. There could also be instances where the
performance of companies in the industry is affected by regional and seasonal variations,
unknown to the analysts.
The third is to compare the company's actual performance with its own
target ratios. The comparison could be valid, but it could also be misleading. The
company's target ratios may be too low, making performance look unrealistically good or
vice versa. In addition, many companies, particularly smaller companies and privately
owned operations, do not establish performance ratios, making this comparison
The fourth is to check any resource that contains relevant published opinions
about the company or that has evaluated its performance. Much of this information is
available on the Internet and can be easily accessed.
If we are in a situation where industry averages are unusable and the company has
no target ratios, we may be limited to trend analysis and the research of sources that have
evaluated the company. As managers, we cannot disregard the analysis of financial data
because of the inherent limitations and potential inaccuracies. Strategically, we also
cannot afford to take the position that unless there is a guaranteed outcome, we will do
nothing. There is no "silver bullet or magic wand" that gives us absolute, accurate
information. We must learn to live with uncertainty, while trying to reduce it as much as
possible. What this all means is that even though there are limitations in the analytical
process, we still use all of these approaches and keep the limitations in mind. We use
analysis as a means to an end, and not an end in itself.
A tip about calculating ratios whether you are doing them manually, on a
calculator, or on a computer: for ease of calculation, rationalize your numbers. To
rationalize means to make the number smaller in size without changing its
inherent value or the significance of the results when we calculate the ratio.
For example, let's say that we are calculating a current ratio. The company that
we are analyzing has $1, 937, 424, 653 in current assets and $877, 435, 111
dollars in current liabilities. We could divide the current assets by the current
liabilities, using the numbers as they appear and get a result of 2.2 to 1. Or we
could simply drop off the last six digits and divide 1937 by 877 and get a result of 2.2 to
1. Even if you divided 19 by 8.7, the result would be 2.18 and that is close enough. You
can save yourself a lot of work by making the numbers more manageable, without
changing the value of the result or distorting any subsequent analysis that you may make.
Here are two important reminders as we close out chapter one:
First, it is impossible to understand the significance and value of financial ratios
unless you understand the Balance Sheet and Income statement. It is also critical that you
understand the Statement of Cash Flows as well as certain other financial facts. Why?
Many, but not all, financial ratios are calculated from information contained in the
balance sheet and income statements. Most ratios are really nothing more than
comparisons or relationships between components within the balance sheet, between
components within the income statement, or between components of the balance sheet
and the income statement. So, ratios, balance sheets, and income statements go hand in
Second, if you are doing a case analysis or any business analysis where financial
data are available, always analyze that data before you read the case or situation.
Why? You will gain many insights about the financial and management
conditions of the company prior to reading the case. Understanding the financial
and management implications of ratio analysis gives us clues about the operations and
management of the company. Therefore, Chapter Two will deal exclusively with a brief,
general review of the balance sheet, the income statement, and the statement of cash
The Balance Sheet, Income Statement,
and Statement of Cash Flows
The following is a brief discussion of the balance sheet, the income statement, and
the statement of cash flows. They will be discussed in sufficient detail so that you can
understand their primary purpose and also understand the nature of the items that you will
generally find in them. Remember, when looking at financial data, you have to look at
more than one reporting period, usually a fiscal year. It is wise to examine the financial
reports from at least three years and if possible five years ago. Reports that are older than
these are historical documents and tell us little about the current operations of the
company. This is almost always true, because the nature of the organization and the
external environment in which it must function are likely to change dramatically over a
five year period, rendering any old financial data useless for anything other than
THE BALANCE SHEET:
Regardless of your specific academic discipline, it is essential that you understand
and commit to memory the meaning and the purpose of the balance sheet, the income
statement, and the statement of cash flows. If you can't memorize, then keep using this
handout to refresh your memory.
An accountant would say that the balance sheet is a picture, "a snapshot", of the
financial condition of the company at a point in time. Cool, huh? Maybe it would make
more sense to the non-accountant if we said that the balance sheet displays in broad
financial categories, the dollar value of what we own and the dollar value of what we
owe. The "what we own" part is pretty simple. It includes all of our assets, both current
and fixed. Some books call fixed assets long-term assets; others refer to them as plant and
equipment. The key is that they are assets that would generally take a longer time to
liquidate or turn into cash. They are also the primary assets that the company uses to
manufacture its goods and products or with which it delivers or prepares its services for a
customer. The notion of liquidity underpins the asset portion of the balance sheet: current
assets are relatively easy to turn into cash; fixed assets are generally much more difficult.
The asset portion of the balance sheet does not give a detailed listing of all assets. It is not
designed to do this. It gives us the dollar value of assets, at the date of purchase, by
categories that accountants use. It does not represent the value of the asset today. We can
live with that. See Figure 1. For a detailed listing, we would consult other references in
The liability/equity portion of
the balance sheet is a little more
difficult to comprehend. It contains CROMWELL COMPANY, INC
two major categories: liabilities and
owners' and/or stockholders' equity. THE BALANCE SHEET (000)
The liability part is what we owe
others. It is broken down into current 2002
and long-term liabilities. The current
portion shows what we have to cover Cert. of Deposit (Cash Equivalent) 0
(payoff) in the near future. The long
Accounts Receivable 9000
term is exactly that, liabilities that we Other Current Assets 2950
have accumulated that are due Inventory 15000
(payable) beyond a one year period of Total current Asset 31950
time, like a five year loan on a car or a
thirty year mortgage on a house. See
Figure 1. Fixed Assets 141742
Accumulated Depreciation -14174
That's easy to understand, but Net Fixed Assets 127568
why is equity on that portion of the
balance sheet? And why is it in the Intangible Assets 18000
Accumulated Amortization -2700
same part with liabilities? How can
equity be a liability? You have to
stretch your mind a little. It makes Total Assets 174818
more sense to say that everything on
the liability/equity part of the balance
sheet is really funds, materials, and
services that have been invested in the Accounts Payable 8500
company or provided to the company. Notes Payable - Current 10000
That includes money invested by the Other Current Liabilities 12750
stockholders, money obtained from Total Current Liabilities 31250
banks to run the business, and money
that we owe to other businesses for
materials and services that they have Long Term Debt 75628
provided us. We refer to money that
we receive from banks and other Owner Equity 67940
institutions as debt financing. We refer
to money that we receive from Total Liabilities and owner Equity 174818
stockholders as equity financing.
But we don't owe anybody the
equity in a company, do we? If
everything is going well, we don't. If the company is going to go out of business, we do.
Under those circumstances, we would sell all the assets in the company, pay off all the
liabilities, and what was left would be distributed among the stockholders. Stockholders
put the money in the company and that money was used to purchase assets. Therefore,
the value of those assets would appear on the asset portion of the balance sheet. To make
the balance sheet balance, we have to show a corresponding value on the equity portion.
We can't make that entry under liabilities, because the money that stockholders invest is
not a liability. So there has to be a separate category for stockholders' investments in the
company, which is called stockholders' equity. If it were a non stock company, it would
be called owner's equity. See Figure 1 for the balance sheet of Consolidated Cromwell
Company, hereinafter called CONCROMCO or simply 3C. It is the example company
that will be used in this handbook.
So stockholders' equity is really the value of what is left when we subtract the
total liabilities from the total assets. But it is only an accounting approximation. That is
because it assumes that the assets could be liquidated for the value shown on the balance
sheet. In many cases that will not be so. It's the same when you sell your car, a car that
you financed through a bank. Let’s say the remainder of the loan is $400. You would try
to sell it for as much or more than the remaining bank loan. If you succeeded in selling it
for more, let's say $600, you would say that you had $200 equity in the car. In reality,
that may not happen. You may have to sell the car for less than the loan outstanding, let's
say $400. In this case you would have negative equity of $200, and you would have to
make up this amount out of your own pocket. The concept of negative equity daunts
some students, when in fact it is simple. Negative equity occurs in a business when
liabilities are greater than assets. In other words, when you subtract liabilities from assets
and you get a negative number, that number is an expression of the negative equity the
stockholders are experiencing or the extent to which the company has not been provided
with sufficient equity capital. It may also indicate that it has borrowed beyond its
capability to repay. It could eventually mean that the stockholders may have to come up
with more money; the company may have to try to make a payoff deal with its creditors
that would lessen its debt obligation; or the company may face bankruptcy.
While a one-year balance sheet can tell us much, consecutive balance sheets from
sequential quarters or years are invaluable. They show us annual trends in the case of
sequential years and intra-year trends in the case of quarters. It is, however, quite
difficult for the non-accountant to see data specific value from the raw numbers on a
balance sheet. We might, for example, see that our receivables increased 100% over the
past five years. On the surface, this could be viewed as bad. If our revenues increased by
300% during the same period, then it would be viewed as excellent. Why? Because now,
five years later, our receivables are a much smaller portion of our total current assets.
That is why we have to understand the limitations of analyzing raw financial data and
also understand that the calculation of financial ratios helps us make real financial and
management sense out of the data. In a very real sense, ratios turn raw data into usable,
THE INCOME STATEMENT:
The income statement is of more immediate value to the manager than the balance
sheet. It shows primary and secondary revenue totals as well as primary and secondary
expenses. Primary revenues are those that the company realizes as a result of its primary
business activities. For example, a company that produces clothing may generate money
from other ventures such as investments, the sale of property, and currency exchange.
These incomes have not been gained from its primary business function and must be
displayed as such.
Stockholders, investors, management, and bankers want to know how well the
primary business is performing. You also want to know so that you can gain an accurate
picture of the financial results of the company's operations. The income statement shows
the manager whether or not the company is on track to meet its objectives and
accomplish its mission.
It is not uncommon for
companies to publish quarterly
income statements; all of the CONSOLIDATED CROMWELL
publicly traded companies do. COMPANY, INC.
These are readily accessible on
the Internet. Financial advisors, INCOME STATEMENT (000)
investment firms, individual
investors, and institutions are 2002
constantly scrutinizing these
Net Sales $ 140,000
statements. You should do the Cost of Goods Sold $ 112,000
same when data are available. Gross Profit $ 28,000
Let's look at some of Administrative Expenses $ 9,000
the more common items found Selling Expenses $ 7,500
on the income statement. (See Research and Development $ 1,500
Figure 2.) Most income Reorganization Expenses
statements look the same and Currency Exchange $ 500
Write-off of in process R&D $
have a great deal in common.
That does not mean that they
all are. Some very complex Income from Operations $ 9,500
companies present their income
statements in more detailed Interest Expenses $ 6,000
form. The top line will Income before Taxes $ 3,500
generally be net revenues or net
sales. This is income that Income Taxes (Credit) $ 1,400
comes from the company's
Net Income $ 2,100
primary business and does not
include income from other Figure: 2
sources. It is net sales/revenue,
not gross income. It is net because it is the income that we have after all rebates, warranty
claims, and returns. It is the "top line." Next we will generally see “cost of sales", "cost of
services provided" in the case of a non manufacturing firm, “cost of goods sold" or some
variation on this theme. This item will include direct and indirect labor costs, the cost of
materials, waste, the cost of operating machinery, the cost of operating the physical plant,
and storage costs. Almost all manufacturing companies include the depreciation costs of
machinery and physical plant under cost of goods sold. The next item is generally called
the "gross margin", "gross income", or "gross profit." We get this amount by subtracting
the cost of goods sold from the net sales. It is the first crucial profit line on the income
statement. We will discuss more about this when we look at the profitability ratios.
The statement will next show the other expenses that we incur as a result of doing
business. They are referred to as operating expenses. These expenses can include, but are
not limited to, administrative expenses, marketing or sales expenses, officers' salaries,
and research and development. Income statements can vary a great deal. Some firms
make only one entry: general administrative and sales expenses. Just because a firm fails
to list research and development separately does not mean that it has no research and
development program. All it means is that it chooses not to publish that detailed figure
for common consumption.
Another major point should be made here. Many balance sheets and income
statements that are published for general consumption are usually heavily summarized
and are not intended to be used as a vehicle for in-depth analysis. So you have to do the
best that you can or "Go With What You Got" (GWWYG, pronounced Gweegee). Other
firms are more generous in the information that they provide. It all depends on the firm
and the detail that the firm feels that it must provide to stockholders, investors, and
financial institutions. The amount and detail of the information available will enhance or
diminish the value of any financial and management analysis made by the student when
using the income statement.
The next major item is called "operating income", "operating margin", or
"operating profit." They all mean the same thing. It is also referred to as earnings before
interest and taxes or EBIT. After operating income comes net interest expense or income.
Interest expense is subtracted from operating income to get the earnings before taxes or
EBT. Logically then, the next item is taxes. When you subtract taxes from income before
taxes, you get net income, net profit, or net margin. They all mean the same thing.
Income statements can be more complicated. They may also include such items as
interest income, extraordinary income or expenses, restructuring charges, and currency
exchange losses or gains. Generally accepted accounting practices usually dictate where
all entries will be put. Don't be confused by the complexity of the income statement.
They all contain the same essential ingredients and to one degree or another are amenable
to analysis. Remember that you are a manager, owner, or student who must be able to
make sense out of the statements.
THE STATEMENT OF CASH FLOWS:
The statement of cash flows provides you with additional information about the
financial and managerial activities and decision making of the company. It shows you
three major things: how the company gets its money, how the company spends its money,
and the beginning and ending cash. There is a connection between the statement of cash
flows and the balance sheet. The ending cash figure on the statement of cash flows is the
same dollar amount as the entry for cash on the balance sheet. So if you want to know
how the company wound up with a certain amount of cash at the end of the reporting
period, you have only to look at the statement of cash flows. An example of the statement
of cash flows is shown at Figure 3.
CONSOLIDATED CROMWELL COMPANY, INC
STATEMENT OF CASH FLOWS (000)
Cash flows from operating activities:
Net Income (loss) $ 2,100
Write-off of in-process R&D $ -
Depreciation and Amortization $ 3,479
Increase (decrease) in Working Capital $ (2,775)
Net Cash Provided (Used) by Operating Activities $ 2,804
Cash Flows from investing activities:
Purchases of fixed assets $ (19,932)
Acquisition of XYZ Corporation (net cash payments) $ -
Net Cash used in investing activities $ (19,932)
Cash Flows from financing activities:
Proceeds from issuance of long-term debt $ 20,628
Net cash provided by financing activities: $ 20,628
Net increase (decrease) in cash and cash equivalents $ 3,500
Cash and cash equivalents, Beginning of period $ 1,500
Cash and cash equivalents, End of period $ 5,000
Again, looking at a statement of cash flow for only one year may provide you
with limited information. You have to look at the statements for the past three to five
years. The statement of cash flows at Figure 3, above, shows some of the major and
minor headings that are used; both of these will vary somewhat depending on the type of
business that is reporting the information. You will, however, see a high degree of
uniformity between companies because of the uniform reporting standards that have
recently been adopted. On 3C's statement of cash flows, you will see three major areas of
cash movement in the company. These activities are:
a. Net cash from operating activities,
b. Net cash from investing activities, and
c. Net cash from financing activities.
The individual subheadings under each of the above show the more specific cash inflow
and outflow that has occurred. If you add each of these "nets" together, you will get the
net increase (decrease) in cash and cash equivalents. Then add this to the cash and cash
equivalents at the beginning of the period, and you have the cash and cash equivalents at
the end of the period.
The statement of cash flows is another piece to the puzzle that helps us to
understand the nature of the "cash streams" that are financing the operations and other
financial activities of the company. It complements the balance sheet and the income
Note to the Reader: Except where specifically indicated, all ratios and metrics will use
the financial data from the balance sheet, income statement, and statement of cash flows
in this chapter.
The Liquidity Ratios
There are two parts of the balance sheet that we use to calculate the two liquidity
ratios, the current ratio and the quick ratio. They are the company's current assets and its
current liabilities. See Figure 1, in Chapter 2, page 14 for 3C’s balance sheet:
THE CURRENT RATIO:
To calculate the current ratio, divide current assets by current liabilities; both
items are on the balance sheet:
Total Current Assets
= The Current Ratio, or
Total Current Liabilities
Cash + Cash Equivalents + Receivables + Inventory
= The Current Ratio
Accounts Payable + Notes Payable + Other Current Liabilites
Using the data from Figure 1, in Chapter 2:
= or simply
This tells us that for every $1.02 in current assets, 3C has one dollar in current liabilities.
From this we can infer that 3C may have sufficient current assets to meet its current
obligations. We would have to check the industry averages to see whether or not this is
the norm. But there is a clue here. If you had to liquidate all of your assets today to
satisfy your creditors, you would have to be able to liquidate your inventory for the full
value indicated on the balance sheet. Is that a likely prospect? Similarly, if you were
seeking additional credit, a potential loan agency may view a current ratio of 1.02/1 as an
unacceptable credit risk. The upside is that the creditor will probably look at the
seasonality of your business and your credit history. The downside is that you may not
get the loan.
THE QUICK RATIO (THE ACID TEST):
The Quick Ratio is also called the Acid Test. The thinking here is that we will
have a better idea of a company's liquidity if we eliminate the inventory from
consideration. It is the least liquid of the current assets, and it is questionable what value
it will actually have, if you must dispose of it quickly. To calculate the quick ratio,
subtract the inventory from total current assets and divide by the total current liabilities.
All these items are on the balance sheet. You will invariably get a smaller ratio than the
current ratio. For companies that have no inventory, the current ratio is the quick ratio.
Total Current Assets - Inventory
= The Quick Ratio, or
Total Current Liabilities
Cash + Cash Equivalents - Inventory
= The Quick Ratio
Accounts Payable + Notes Payable + Other Current Liabilites
The Quick Ratio:
Using balance sheet data from Figure 1 in Chapter 2:
31,950,000 − 15,000,000 16,950,000 .54
= = or simply
31,250,000 31,250,000 1
This tells us that for every 54 cents in current assets, 3C has one dollar in current
liabilities. Therefore, when we eliminate the inventory from consideration as a
liquid asset, it appears that 3C will have substantial difficulty in meeting its
The liquidity ratios, the current and the quick ratio, provide us with a great deal of
information, or at least indicators, about both the financial and management condition of
the company. Liquidity analysis, in the form of the quick and current ratios, gives us an
idea as to whether we have sufficient current assets to pay those bills. Should you
memorize the names of these ratios? The answer is yes. They are part of what a manager
should know and what a manager should commit to memory.
Accountants say that liquidity refers to the company's ability to meet its current
obligations. As managers we can think of it as our ability to pay our bills in the near
future. To pay those bills, we are going to need cash. Why? Cash is the most liquid asset
that we have and our creditors and suppliers want their bills paid in cash. We are not a
Liquidity is not a straight-forward issue. Any business has to be liquid enough to
pay its bills to continue operating. In this regard, there are factors of which we should be
aware. For example, does the company have an effective policy for identifying and
controlling uncollectible accounts? If you have a large accounts receivable that contains
mostly uncollectable accounts, it will distort the value of your analysis. You can’t easily
liquidate uncollectible accounts at their face value. You may not even be able to do that
with great difficulty.
One thing is certain, if you do not have the money to meet your current
obligations, you must pursue options to stay in business. One option is to go to the bank
for a short-term loan. Many businesses that have uneven cash flows from month to month
must do this. Their liquidity fluctuates wildly with the seasons. Some businesses are so
seasonal that they do as much as 70 percent of their annual sales in a three-month period
and 30 percent in the remaining nine months, such as Toys R Us and L.L. Bean. They
have no alternative but to rely on short-term loans to meet their operating expenses
during the slow-sales-part of the year.
When we talk about liquidity, we are really talking about either how much cash
we have on hand or the assets that we can reasonably convert to cash. Assets are things
that we own or that are owed to us by someone else. Some assets are easily turned to
cash; others are turned to cash only with some or considerable difficulty. A certificate of
deposit is easily turned into cash. Accounts receivable are quite different. Accounts
receivable are only as liquid as our ability to collect them. Let’s say that we have
numerous accounts receivable that past due for a long period of time, say 45 to 90 days.
These accounts may be uncollectable in the next 30-day period. In this case, our accounts
receivable are a questionable part of our liquidity, affecting our ability to pay our current
Inventory is also an issue. It is only as liquid as our ability to convert it to cash. It
is worth only what someone is willing to pay for it. In a worst case scenario, if we sold
off or auctioned off all of our inventory for cash to pay our current bills, we would have
nothing more to sell and would risk going out of business.
There is a contemporary saying in many businesses, particularly those in
manufacturing: "More inventory is bad." Manufacturers strive to create a zero
inventory situation. Cash tied up in inventory is cash that is not working for the
company. Similarly, retailers try to stock products that move quickly.
An option for the firm in financial difficulty is to try to restructure its obligations
and debt with its suppliers and creditors. It may, for example, pay all of its utility
bills each month but work out some sort of a deferred payment plan with its
suppliers and creditors. Suppliers usually get nervous when this happens because
they have already incurred the financial obligations associated with whatever they
provided the firm. Now they, the suppliers, are going to experience problems paying their
own current obligations. The supplier has the option of cutting the firm off or insisting on
cash payments for future supplies and arranging a negotiated payment each month on the
existing debt. Creditors also get nervous and are usually reluctant to extend further credit
to the firm, negating the possibility of any further debt financing. Investors who are
aware of this also become reluctant to put any money into the company, reducing the
probability of equity financing.
The Management Effectiveness Indicators of Liquidity
The liquidity ratios can give us an indication about strengths and weaknesses in
management, marketing, finance, production, and management information
systems. The following table is a list of possible strengths and weaknesses listed
by major management functional area for the results of liquidity ratios. These are
possibilities that are designed to help you focus on the management situation within the
organization. Remember the analysis caveat in item number 1, which was discussed on
page 6. We say that these are "possible" management strengths and weaknesses. You
must also check to make sure that the financial condition of the company was not caused
by external mitigating factors or unusual internal factors, such as recent acquisitions,
divestitures, restructuring, or cyclical expenditures.
If the possible strength and weakness indicators were indeed showing us
something about the company, we would use them as part of our basis to develop
strategies to build on the apparent strengths or develop strategies to minimize the effect
of or eliminate the possible weaknesses. In life as in business, information upon which
we do not act is a missed opportunity. Some of the possible management strengths listed
in the remainder of the handbook will also be listed as weaknesses. This is the case
because in one situation, the favorable external factors will permit us to carry out one
policy; however, when those same external factors become unfavorable, that policy is no
For example, if interest rates were low and sales were strong, a company could
carry more debt, because it could earn more in profit than it paid in interest on that
debt. If the external situation changed, however, and interest rates went up, the
company may not be able to pay the interest on its debt. Many financial policies
are determined by external factors over which the company has no control. Some of these
are opportunities for the company to exploit; others are threats, the effects of which it
must try to attenuate. For a more detailed list, see Appendix A.
POSSIBLE INTERNAL STRENGTH INDICATORS
LIQUIDITY STRENGTH MGT AREA
Hi cash Excess cash available to develop and implement new MGT
Hi inventory Sufficient inventory to meet customer demand. MKT
Low cash No excess funds just "sitting around" and not being MGT
Low cash All invested funds working for the company. MGT
Hi receivables Liberal credit policy to stimulate revenue growth. MKT
Low Aggressive receivables staff; decisive company policies MGT
receivables on credit.
POSSIBLE INTERNAL WEAKNESS INDICATORS
LIQUIDITY WEAKNESS MGT AREA
Hi overall Needlessly stockpiling cash and/or inventory. MGT
Hi overall "Strategic bunker mentality"; saving for a "rainy day." MGT
Hi cash No definite strategic plans. MGT
Hi cash Lack of a dividend plan. MGT
Hi cash Failure to upgrade current plant and equipment. MGT
Hi inventory Lack of inventory control system. IT
Hi inventory Loss of market share. MKT
Hi inventory Questionable purchasing practices. MKT
Hi inventory "If the customer may want it, we have to have it in MKT
stock" attitude; trying to be all things to all people
without a clearly defined target market.
Hi inventory Sales personnel not aggressive. MKT
Hi inventory Lack of adequate sales personnel. MKT
Hi inventory Lack of “new business development leadership." MGT
Hi inventory Ineffective sales manager. MKT
Hi inventory Keeping a non-competitive product or service too long. MKT
Hi inventory Ineffective strategic plan or lack of strategic plan. MGT
Hi inventory Management arrogance, e.g., “They buy what we sell!” MGT
Hi receivables Incompetent or ineffective receivables manager. MGT
Hi receivables Weak or untrained receivables staff. MGT
Hi receivables Lack of effective receivable policy. MGT
Hi receivables Indecisive management. MGT
The Activity Ratios
"Ahhhh, what's up doc?" (Attributed to Bugs Bunny)
There are four activity ratios with which you should be concerned. They are the
asset turnover ratio, the inventory turnover ratio, and the average collection period. Not
surprisingly, they give us an indication of how well we are managing our assets, how
well we are managing our inventory, and how well we are managing those to whom we
have sold a product, performed a service, or extended credit for that product or service.
Based on the repetitive use of the word "managing", we can conclude that the activity
ratios will tell us a great deal about the management of the firm. These ratios are easy to
THE TOTAL ASSET TURNOVER RATIO:
= Total Asset Turnover Ratio (Asset Turns)
Total Asset Turnover Ratio:
Let's calculate the asset turnover ratio for 3C using total assets. Get the net sales
and total assets from the income statement and balance sheet in Chapter 2.
= or simply
This gives us a total asset turn ratio of .8 to 1 (.8/1). The ratio tells us that for each dollar
in assets, there is eighty cents in sales. This ratio has to be tracked over time and
compared with similar other companies. Experience and comparison will tell us whether
this is an acceptable outcome.
THE NET FIXED ASSET TURNOVER RATIO:
= Fixed Asset Turnover Ratio
Net Fixed Assets
Net Fixed Asset Turnover Ratio:
To calculate the net fixed asset turnover ratio for 3C:
140,000,000 1.09 140 1.09
= or simply =
127,568,000 1 128 1
This gives us a fixed asset turn ratio of 1.09 to 1 (1.09/1). This tells us that for every
dollar in fixed assets, there is one dollar and nine cents in net sales.
The fixed asset turnover ratio is a variation of the asset turnover ratio. Here we
divide net sales by total fixed assets (our plant, machinery, and equipment). The
argument here would be that it would be a useful indicator to know just how our
well our fixed assets are performing. It’s a good argument. Many manufacturing
firms prefer to use this ratio instead of the "total asset turnover ratio."
The total asset turnover ratio and net fixed asset turnover ratio tell us how many
dollars or fractions thereof we are making for each dollar in total assets or fixed assets
that the firm owns. We spend money to buy assets so that those assets can make money
for the company. This ratio gives us an idea of how our assets are performing. Industry
averages and trend analysis are important in determining the significance of the ratio.
Use the ratio that makes the most sense or use both. I prefer net sales/total assets
because total assets represent all of the money that is invested in the company.
THE INVENTORY TURNOVER RATIO:
Cost of Goods Sold
= Inventory Turnover Ratio
Inventory Turnover Ratio:
Referring to Figure 1and 2 for 3C, in Chapter 2, we would divide the cost of
goods sold from the income statement by the inventory from the current assets
section of the balance sheet.
112,000 7.46 112 7.46
= or =
15,000 1 15 1
The inventory turnover ratio is an artificial way of telling us how many times we
have sold our inventory based on the dollar value of that inventory shown on the
balance sheet. Another way of saying this is: "How many times has the inventory
has turned over?" Inventory turns vary wildly from industry to industry. A
convenience store may turn its inventory 12 times a year, or once each month. A
franchised recreational vehicle dealership might turn its inventory only once a year.
To be more accurate, before we calculate this ratio, we actually should get the
dollar value of the inventory at four separate times during the year. Then average these
figures and use the average to calculate inventory turns.
Does the answer that we get when we calculate this ratio mean that we have sold
the entire inventory exactly the same number of times? No! Part of the inventory may be
turning over very rapidly, while part of the inventory may be turning over slowly. For
example, in a franchised auto dealership's service department, the spark plug inventory
may turnover 98 times a year, while the alternator inventory may turn over only four
times a year. What is financially sound? How many inventory turns does it take to keep
the company in business and making money for the owners or stockholders? It is not as
simple as this.
From a financial perspective, the number of inventory turns needed to insure
financial health varies greatly from industry to industry. The company's target market and
overall strategy has to be taken into consideration. The inventory turn ratio has
comparative analytical value. We can compare ourselves to other firms in the industry.
We can see trends over years in the number of times that we turn the inventory over. By
doing this, we convert raw data, inventory turns, into information. This information can
be used in management decision-making, the results of which become knowledge we can
apply again or modify as appropriate.
A slowing down in turns could indicate that too much money is tied up in
inventory that does not move quickly. Or it could be caused by external factors. A
recession or federal government fiscal policies could cause a lowering of demand. If the
company is involved in international trade, declining demand in overseas markets,
increased competition, or a strengthening of the U.S. dollar could also account for a
slowing down of net sales and hence a decline in the number of inventory turns. There is
a lesson to be learned here. Because of the interdependence of the economies of
countries, both large and small, economic changes in other countries can dramatically
affect the performance of domestic companies. A significant increase in the number of
inventory turns does not mean that a company is enjoying prosperity. Sometimes, firms
have no choice but to get rid of inventory at bargain prices, causing inventory turns to be
up but net profit to be stagnant or show a decline. So, there no virtue in winning the
“inventory turnover contest” if you wind up losing money.
Caution: This ratio is meaningless for companies that do not have saleable
products in inventory. Most service firms have a small inventory of office and
maintenance supplies. YOU SHOULD NOT calculate an inventory turn ratio for
these firms. It is irrelevant to calculate how many times your inventory of copy
paper, paper napkins, mops and brooms, and bathroom tissue turn over in a year.
That inventory may be turning over, but it does not represent sales.
THE AVERAGE COLLECTION PERIOD:
First, we have to calculate average daily sales. To do this, divide net sales by 360:
STEP ONE Annual Net Sales
= Average Daily Sales
Then we have to divide the receivables by the average daily sales.
STEP TWO = AverageCollection Period
Average Daily Sales
The Average Collection Period:
Calculate these ratios for 3C using the data from the balance sheet and income
statement in Chapter 2:
STEP ONE : Calculate Average Daily Sales = 388,889
STEP TWO : Calcualte Average Collection Period = 23 days
What we have actually calculated is the dollar amount of the average daily sales
for which we have not as yet been paid. Remember, this is just a daily average
that is calculated for analytical purposes; it does not necessarily represent 23
actual days of sales. If our average collection period is 23 days, it means that, on
average, we have 23 days of sales for which we have not been paid. The only way that
we can calculate the actual average collection period is to sum the age of all accounts
receivable and divide that total by the number of accounts receivable. The key is that we
have not yet been paid for products delivered or services rendered. We are in fact
extending an interest free loan to those accounts.
You should not be surprised to learn that at the operational level, companies know
the "age" of every account. In fact, the credit history of every client is well documented.
Most companies have a system for showing the "age" of their accounts receivable. They
will, for example, group together accounts that are equal to or less than 30 days old; have
a separate group for accounts that are 31 to 45 days old; have a group for accounts that
are 46 to 60 days old; and a final group for accounts receivable that are more than 60
The accounts receivable entry on the balance sheet tells us how much money we
are owed for the goods and/or services that we have already provided to someone. If the
average collection period for these accounts gets too long, the company may have
difficulty in paying its current obligations. Insufficient cash flow can force the company
to take out short-term loans to meet cash requirements. In an acute situation where the
company is too heavily in debt, the lending institutions could cut off this credit. In a
worst case scenario, the company could become insolvent and be forced into bankruptcy.
A company that is overly reliant on debt financing and does not have adequate equity
financing would be most vulnerable under these circumstances.
The Management Effectiveness Indicators of Activity
There are many factors within an organization that contribute to its success or
failure. There are also a number of factors, from a management perspective, that
should be taken into consideration when trying to understand the implications of
the activity ratios. With this in mind, tables have been constructed to illustrate
some of the major internal factors that contribute to asset turns, inventory turns, and
average collection period from a management perspective. Remember, assets just don't
"turn" by themselves. People, policies, practices, strategies, procedures, and leadership
cause assets to turn.
There are also external factors, over which the company has no control, that may
be the primary mitigating factors. These factors could determine asset turns, inventory
turns, or the average collection period regardless of the internal strengths and weaknesses
of the organization. They include: economic recession, economic growth, change in
consumer demand for better or worse, the opening up of new, lucrative markets,
increased competition from higher quality and lower priced products, or a sudden decline
in viable competition. A longer list of external factors that can affect business operations
is shown at Appendix A.
Possible Internal Strength Indicators
RATIO CONDITION MGT
Hi Well-defined target market.* MKT
Hi Growing demand for product.* MKT
Hi Aggressive sales force.* MKT
Hi Well- defined goals, strategies, and objectives.* MGT
Hi Management encourages creativity and change. MGT
Hi Effective total quality management program.* MGT
Hi Shared values and expectations.* MGT
Hi Assets appropriate for the mission. MGT
Hi Effective human resource management policies. MGT
Hi Motivated, committed work force. MGT
Hi High levels of productivity. MGT
Hi Efficient, up-to-date physical plant. PRD
Hi Effective maintenance and replacement policy. PRD
Hi Effective and efficient waste control program. PRD
Hi Effective and efficient quality control programs. PRD
Hi Effective system for collecting, analyzing, and distributing IT
information throughout the organization.
* The asterisked management and marketing factors listed
above also apply to inventory turns.
Hi Responsiveness to market demand. MKT
Hi Responsiveness to customer needs. MKT
Hi Efficient distribution system. MKT
Hi Effective working relationship with suppliers. MKT
Hi Efficient, computerized, inventory control system. IT
Hi Prompt return to suppliers of unused or slow moving PRD
Hi Effective and efficient inventory control policies. PRD
Hi Efficient purchasing policies. PRD
Average Some of the factors will be identical to the receivable factors
Collection under the liquidity ratios. They are worth repeating because of
Period the importance of this activity to management. The average
collection period is the specific ratio that deals with the
Lo Decisive collection policies. FIN
Lo Aggressive accounts receivable staff. FIN
Lo Excellent accounts receivable record keeping. FIN
Lo Competent receivables manager. FIN
Lo Effective relationships with clients. MGT
Lo A high-quality list of clients. MGT
Lo Appropriate incentives for early or on-time payment. MGT*
Lo Appropriate credit terms for appropriate clients, in other MGT*
words, firm doesn't have a credit policy that encourages late
payment or that gives credit to non-deserving clients.
Possible Internal Weakness Indicators
RATIO CONDITION MGT
The possible internal weaknesses that we could associate with
low asset turns, low inventory turns, and a high average
collection period are the reverse of those items that were listed
under strengths. Therefore, they will not be repeated for the
sake of showing this reversal. Students and managers can
easily do these themselves. There are several weaknesses,
however, that are not readily apparent by reversing the
strengths, particularly for the average collection period.
Lo Excessively stringent credit policy. MGT
Lo Over reliance on cash and cash equivalent payments. MGT
Lo A "cash on delivery" policy for all clients. MGT
The Leverage or Debt Ratios
There are three leverage ratios with which we should concern ourselves: the debt
to asset ratio, the debt to equity ratio, and the times interest earned ratio. They are
important because they give us an idea about how the company is being financed,
the degree to which it relies on debt financing, and its ability to generate
sufficient revenue to discharge its debt obligations. These ratios help us determine
whether or not the company can attract debt financing and its vulnerability to an
The financial implications of the leverage ratios can be far-reaching and can affect
the continued viability of the company. First, few companies can afford to do business
without borrowing money. Major sources of loans are banking institutions. Banks are
primarily interested in their own profits; therefore, banks need to determine the financial
health of their client companies. They want to know if the companies can "carry the
debt", that is, make the payments on the loan in a timely manner. Simply put, when the
bank loans money, it wants it back with interest and on time. Banks are profit-making
organizations; they are accountable to their stockholders just like any other company.
Before we go into how the ratios are calculated, we should discuss the term
"leverage." Why use the term leverage? The answer to that question is tied to the
discipline of physics. In physics we learn that we can use a bar (lever) and a fulcrum to
create a mechanical advantage that helps us to move heavy objects more easily.
Similarly, in business we can use the assets of a company, its growth potential, and/or its
management prowess as a lever and a fulcrum to attract debt financing for the company.
When we have reached a point that banks are no longer willing to loan us any more
money, we tend to say that the company is "leveraged out" as far as it can go. That means
that banks feel that the company is incapable of satisfying the obligations of any more
debt. It may also mean that the bank feels that the assets of the company will not be able
to generate enough money if they are sold to cover any additional debt. The bank may
say that we do not have sufficient collateral to cover the debt.
When we say that a company is in a strong leverage position, we mean that it can
afford to take on more debt financing. The reverse is true for a company in a weak
leverage position. Leverage then is directly tied to a company's ability to either attract
financing or take on the obligation of additional debt. Debt is debt. It doesn't make any
difference whether it is short term or long term, or whether it is from a bank or obtained
through the issuance of bonds. A debt is any obligation that a company incurs that must
be paid back, almost always with interest. If the owner of a business or the uncle or aunt
of the owner gives the business a loan, that is also debt.
THE DEBT TO ASSET RATIO AND LONG TERM DEBT TO ASSET RATIO:
The total debt to asset ratio, also called The Debt Ratio:
Total Debt (Liabilities)
= Total Debt to Asset Ratio, The Debt Ratio
The Debt to Asset Ratio:
Again we get 3C’s debt and asset information from the company's balance sheet
in Chapter 2.
106,878,000 .61 107 .61
= or simply =
174,818,000 1 175 1
The ratio tells us that for every dollar in assets, we have 61 cents in debt. This ratio is
meaningful as a comparison of the relationship of our debt to our assets. It could have
ultimate value to a lending institution that wants its loans secured by assets. If that were
the case, in this situation we could only use 39% of our assets to secure additional debt.
The debt to asset ratio shows management and the banks the relationship
between the assets of the company and the amount of debt owed by the company.
It does not show the amount of assets that were actually purchased by debt
financing. In reality, equity financing could have purchased all of the assets.
Assets are either purchased with cash, debt or equity financing. The ratio actually shows
us how much of the debt of the company is covered by assets.
So, if we have a situation where there are 200,000 dollars in assets and 100,000
dollars in debt, we will have a debt ratio of .5 to 1. We divided the total assets by total
debt. The .5 tells us that for each 50 cents in debt, there is one dollar in assets. Is this
good or bad? It all depends on the industry. It could also depend on the current activities
of the company. For example, a company like 3C, our case company for this handbook,
recently used debt financing for a substantial acquisition. In this case, we should expect
that for a period of time its debt ratio would be higher than the industry average. We
would also expect that over time, the company would be engaged in strategies to improve
its leverage position as it "digested" the acquisition and made it an integral part of the
The long term debt (long term liabilities) to asset ratio:
Total Long Term Debt
= Total Long Term Debt to Asset Ratio
The Long term Debt to Asset Ratio:
Now we'll calculate 3C’s long-term debt to asset ratio:
75,628,000 .43 76 .43
= or simply =
174,818,000 1 175 1
This ratio tells us that for every dollar in assets we have about 43 cents in long-term debt.
About 43% of our assets are covered by long term debt.
The long term debt to asset ratio is an alternative or complement to the total debt
to asset ratio. Be careful when you use it. It can provide a misleading picture of the
company's liability structure, particularly when a company is heavily reliant on short-
term debt and not on long term debt. Eliminating the short-term debt from your analysis
in this case can lead to a false or inaccurate interpretation. When in doubt, use both ratios.
That will give you a more complete understanding of the leverage position of the
It is also obvious from our analysis that while the company is heavily reliant on
long-term debt (.43/1), it also has substantial short-term debt. We know this because the
two ratios are dissimilar, .61/1 for the total debt to asset ratio versus .43/1 for the long-
term debt to asset ratio. By subtracting .43 from .61, we can see that the company also
has 18 cents in short term debt for every dollar in assets (or .18/1). We can verify this
figure by dividing the total current liabilities by total assets, 31,250,000 by 174,818,000
(or simply 31,250 by 174,818). This also gives us a ratio of .1787 to 1, or rounding off,
THE DEBT TO EQUITY RATIO:
= The Debt to Equity Ratio
Total Stockholders' or Owners' Equity
Debt to Equity Ratio: Let's calculate the debt to equity ratio for 3C. Again, we
refer to the balance sheet in Chapter 2.
106,878,000 1.57 107 1.57
= or simply =
67,940,000 1 68 1
This means that for every dollar and fifty-seven cents of borrowed money (debt) there is
one dollar in money invested by 3C’s stockholders (equity). Conclusion: the bank has
more money invested and at risk in the company than the stockholders. Borrowing
additional money will be very difficult for this company.
The debt to equity ratio shows us the comparison of the amount of money that the
company has borrowed from creditors to the amount of money that the
stockholders/owners have put in the company. The ratio is important because it
gives lenders an idea of the financial vulnerability of the company, as well as
inability to attract additional equity financing. Lending institutions get increasingly
concerned when debt financing exceeds equity financing. Why? Because it means that
the lending institution has more invested in the company than the stockholders/owners of
the business. Banks are not philanthropic institutions; they want reasonable safeguards
that the money that they are lending will be repaid. As an aside, remember that
stockholders of the bank also want to enjoy a profit on their investment. Banks are
accountable to their stockholders for the financial health of the bank.
The debt ratio is not an issue if the company does not intend to borrow. However,
reality for most companies is that at some point, they must borrow money to operate. As
part of the lending process, and as a result, banks will look at the amount of money that
the stockholders/owners have invested in the company. They will also look at the amount
that the company has borrowed from banks or acquired with other loan instruments.
For example, if the company has $2,500,000 in debt and $1,000,000 in equity, the
debt to equity ratio would be 2.5 to 1. That means that for every $2.50 cents in
debt, there is one dollar in equity in the company. Who cares? The banks do; any
serious investor in the company should care. What this means is that the banks
have two and one half times more money invested in the company than the stockholders.
A company that is heavily in debt, with a debt to equity ratio of 2.5to 1, is very
vulnerable to changes in the domestic and, if applicable, the international economic
environments, specifically to adverse changes in the prime interest rate. That could prove
to be a very vulnerable position for the bank.
Banks will generally loan out money at an interest rate that is either at or above
the prime rate. The interest they charge will depend on the creditworthiness of the
borrower. The prime rate is the rate that banks charge their most creditworthy customers.
Usually, the interest rate on the loan varies as the prime rate varies; it is not "locked in"
for the life of the loan. If your company can comfortably borrow $10,000,000 at 1
percentage point over a prime rate of 6.5%, it may not be able to afford the cost of
carrying the debt if the prime rate goes to 15%. Why? Because the interest charges on
that loan have more than doubled. Your "rapid-fire" response to this may be something
like: "We'll pass the additional debt service cost on to the consumer." That’s great if you
can do it; most businesses cannot afford to do that because there is simply too much
regional, national, and international competition. In 1979-80, when the prime rate
hovered near 20%, new car sales plummeted in the United States as consumers bought
more affordable, less expensive, used cars. Home sales also dropped dramatically for the
same reason. Many new car dealers were forced out of business because they could not
pay the principal and the vastly greater amount of interest on their loans.
What's the bottom financial line for a company? The higher the debt to equity
ratio, the less likely that the company will be able to attract debt financing, the more
vulnerable it is during an economic downturn. The latter condition presumes that the
company has competitors and/or is under pressure to deliver a high quality product or
service at a reasonable price within its market niche.
THE TIMES INTEREST EARNED RATIO (THE NUMBER OF TIMES THAT
THE INTEREST IS COVERED):
Operating Income (EBIT) Times Interest Earned or
Interest Expense Times the Interest is Covered
Times Interest Earned Ratio: Calculate this ratio for 3C with the operating
income and interest expense from the income statement in Chapter 3.
9,500,000 1.58 95 1.58
= or simply =
6,000,000 1 60 1
This means that for every dollar and fifty-eight cents in operating income, 3C has one
dollar in interest expense, or its operating income is 1.75 times its interest expense. It has
earned its interest 1.75 times. Is this sufficient to satisfy 3C's creditors? We would have
to know what the creditors' expect in this area. We would also have to check the pertinent
The ramifications of the times interest earned ratio are closely tied to the debt to
equity ratio and the total debt to asset ratio. The financial implications of this ratio
are pretty straightforward. It tells lenders about the relative ability of the company
to pay the interest on its debt obligations. Looking at it realistically, when you
divide the operating income by the interest on the debt, if you come up with a figure that
is less than one, it means that there is not enough operating income being generated to
pay the interest on the debt. This sends up a red flag for the lender and suggests that the
company may not be financially strong enough to carry more debt. It is also a signal to
the company that it may have to develop strategies to change its debt and/or equity
structure or to reduce its cost of sales or operating expenses.
THE MANAGEMENT EFFECTIVENESS INDICATORS OF
Not only does debt affect the financial situation of the company, it has clear
implications for management and management decision-making. Most strategies
cost money to implement; some much more than others. An organization must
either have the money to implement or it must be able to attract financing. If it does
not have the financial wherewithal and cannot attract it, the consequences for the
company are serious. The debt to asset ratio and the debt to equity ratio are strongly
correlated with each other. If you have a high debt to asset ratio, you will almost always
have a high debt to equity ratio. The same is not true for the times interest earned ratio.
You could have a low debt to asset and a low debt to equity and still have a low or
unfavorable times interest earned ratio. That is because the times interest earned ratio is
dependent on a healthy income statement, while the other two ratios are dependent on a
healthy balance sheet.
Possible Internal Strength Indicators
RATIO CONDITION MGT
Lo Company able to assume more debt. FIN
Lo May be able to get most favorable interest rate. FIN
Lo Can contemplate goals and strategies that are unavailable MGT
without additional financing.
Lo Can contemplate expanding into new geographic areas-usually MKT
a high cost strategy.
Lo Can consider purchasing or buying into companies that are MGT
their primary suppliers-a high cost strategy.
Lo Makes the company more attractive as a strategic partner. MGT
Lo Company is more attractive to lenders because FIN
stockholders/owners have a large stake in the company.
Lo Can contemplate a wider range of strategic options because MGT
debt financing is a viable option.
Hi Company is using borrowed money. In a strong economy with FIN
low interest rates, this means that the return on equity for
stockholders will be higher.
Lo Makes the company more attractive as a strategic partner. MGT
Hi Company is attractive to lenders. FIN
Hi Company is attractive to potential investors. FIN
Possible Internal Weakness Indicators
RATIO CONDITION MGT
Debt to asset
Hi Company will be unable to upgrade or replace expensive PRD
means of production.
Hi Companies unappealing to both lenders and investors. FIN
Hi Moderate and high cost strategies cannot be contemplated, MGT
restricting the strategic options of the company.
Hi May not be able to aggressively pursue strategic opportunities MGT
as they develop because of lack of financing.
Lo Possible takeover target, because the company is in an MGT
excellent leverage position.
Hi Lenders and investors view the company as high risk. FIN
Hi Either there is too much debt or too little equity in the FIN
company, forcing the company to pursue equity financing. If
company is in an unfavorable leverage position; it will not get
sufficient equity financing.
Hi In a weak economy with rising interest rates, company will FIN
probably lose money.
Lo Possible takeover target because the company may not be MGT
Lo Unattractive to investors and lenders. FIN
Lo Restricts the strategic options of the company. MGT
The Profitability Ratios
There are six profitability ratios with which we must be concerned. They are the
gross profit, operating profit, net profit, return on equity, return on assets, and the
earnings per share. You could make a powerful argument that profitability is really the
only thing that counts. While that may be true, you will not be profitable unless you can
pay your bills (liquidity), are generating an adequate amount of business (activity), and
have a viable debt position (leverage).
THE PROFIT MARGINS:
GROSS PROFIT MARGIN:
= answer × 100 = Gross Margin as a Percent of Net Sales
The Gross Profit Margin:
To calculate the gross margin for 3C:
= .20 × 100 = 20% or simply = .20 × 100 = 20%
The result of this operation is very significant. It tells us that 80% of the money from our
net sales has been used to manufacture 3C's products. Only 20% is left for all of the other
expenses that the company incurs.
OPERATING PROFIT MARGIN:
= Answer × 100 = Operating Profit as a Percent of Net Sales
The Operating Profit Margin:
To calculate 3C’s operating margin:
= .0678 × 100 = 6.78% or simply = .0678 × 100 = 6.78%
This tells us that 13.22% of the money from our net sales (gross margin, 20%, minus
operating margin, 6.78%) is being used for operating expenses. This figure seems high
and should be a concern to us.
Think about this: If we could reduce our operating expenses to ten percent of net
sales, it would improve our operating profit by 3.22% to 8.8%. That is a 3.22% increase
in operating profit. Net profit, after taxes, would increase by .0202% (.0322 times .40, the
tax rate, = .012; .0322 minus .012 = 0202), resulting in a new net profit for 3C of 3.52%
(1.5% + 2.02%) without manufacturing or selling any additional product. That would put
a small smile, or perhaps a large smile, on the stockholders' faces.
NET PROFIT MARGIN:
= Answer × 100 = Net Profit Margin as a Percent of Net Sales
The Net Profit Margin: To calculate the net profit margin for 3C:
= .015 × 100 = 1.5% or simply = .015 × 100 = 1.5%
This seems rather low, but we can't be sure. This result, however, should act as a "red
flag" that signals us to look for answers or ask questions. Is this normal for companies in
this industry? Have any unusual external factors conspired to cause this to happen? Have
any unusual activities internal to the company contributed to the seemingly low margin?
What about the leadership of the company? Are we going in the right direction? Or is this
an anomaly caused by the recent acquisition?
The profit margins: From a financial point of view, the profit margins give us an
opportunity to view the income and costs of a company that are associated with
its primary business operations and with extraordinary financial occurrences in an
orderly and logical manner. From a company's perspective, it is most desirable that the
gross profit margin increases over time. As it increases, there is a higher degree of
probability that the net profit of the company will be higher, but there are never any
guarantees. A declining gross margin tells us that either net sales are declining or our cost
of sales is increasing, or some combination of both is occurring.
Interpretation of the financial meaning of the operating margin is less clear-cut.
All of our operating expenses could have remained the same. It may be that variations in
the gross margin alone are causing changes in the operating margin. Alternately, we
might observe that changes in our operating expenses over a period of time are affecting
the operating margin.
Unfortunately, with the profit margin ratios, there are no quick answers. You have
to analyze the data you have to determine the cause of change in the various
margins. The same applies to the net profit margin. It is not uncommon for a firm
to report a substantial increase in the operating margin, only to report a net loss
for the period. Why? Interest expenses or extraordinary one-time expenses may be so
large as to exceed the operating profit, resulting in a net loss for the period. This is
neither good nor bad. It depends what is going on both inside and outside of the
MANAGEMENT EFFECTIVENES RATIOS:
RETURN ON EQUITY (ROE):
= Answer × 100 = Return on Equity as a Percent of Net Sales
Return on Equity:
Calculate 3C’s return on equity:
= .031 × 100 = 3.1% or simply = .0309 × 100 = 3.09%
A return on equity of 3.1%, a figure that seems rather low. In 2002, you could not have
done this well investing in a Certificate of Deposit or a Money Market Account.
Return on stockholders' or owners' equity is straightforward. It tells us the
percent of return on the total amount of stockholders' equity. Does this mean that
the stockholders are actually going to realize this level of return? It does not mean
this at all. It only reflects the percent that the net profit is of the owner's
(stockholders') total equity. It is an analytical "return" and nothing more. But it has great
value in illuminating the financial performance of the company from the perspective of
all of the money that has been placed in the company by the stockholders or monies that
have been invested in the company by management and the board of directors on behalf
of the stockholders.
RETURN ON ASSETS (ROA), RETURN ON FIXED ASSETS (ROFA), AND
RETURN ON INVESTMENT (ROI) AS A FUNCTION OF NET PROFIT:
RETURN ON ASSETS (ROA)
= Answer × 100 = Net Profit as a Percent of Total Assets
Return on Assets:
From the Balance Sheet and Income statement, calculate 3C'S return on total
= .012 × 100 = 1.2% or simply = .012 × 100 = 1.2%
This result means that assets of $158, 568, 000 have generated a net profit of only 1.3%
or $2,100,000. An ROA of only 1.3% should raise a red flag and cause us to search for
RETURN ON FIXED ASSETS (ROFA)
There is a variation on the return on total assets. You may opt to calculate the
return on fixed assets (ROFA) as well. To do so, divide net sales by net fixed
assets. Be careful though. Do not choose to use only the return on fixed assets
ratio for a company that has very few fixed assets but significant current assets.
You will get a distorted ratio that does not represent the true return on assets.
Return on Fixed Assets:
Calculate the return on fixed assets for 3C:
= .0164 × 100 = 1.64% or simply = .0164 × 100 = 1.64%
This ratio yields a return of 1.64%, a figure that is not that much better than the ROA.
RETURN ON INVESTMENT
You will also see from time to time a reference to the ratio, return on
investment (ROI). This can be both a confusing as well as redundant because
there are several ways to calculate the ratio. The first is to calculate return on
investment as net sales divided by total investment. The total investment is all of the
money invested in a company. It is all of the money borrowed or owed-the total
liabilities-plus total stockholders' equity. If that is the case, then return on total assets
(ROA) equals return on total investment (ROI), and it is redundant with return on total
assets. Why? On the balance sheet, total assets equal total liabilities plus total equity.
The second is to define return on investment as net sales divided by total
liabilities minus total current liabilities plus total equity. If that is the case, then return on
assets will not be the same as return on investment. Some have other criteria for
calculating this ratio, making it all the more confusing. Make sure you know the
"ingredients" of this ratio before you analyze its significance for an organization.
Return on Investment:
Calculate the return on investment for 3C using the second formula so as not to
be redundant with return on assets (ROA):
= .0146 × 100 = 1.46% or simply = .0146 × 100 = 1.46%
106,878,000 − 31,250,000 1435
While the ROI is somewhat better than the ROA and somewhat less than the ROFA, it
seems that no matter which ratio we calculate, ROA, ROFA, or ROI, 3C is not generating
much net profit on its assets or investment for the company during fiscal 1998.
RETURN ON ASSETS AS A FUNCTION OF OPERATING PROFIT:
= Answer × 100 = Operating Return on Total Assets as a Percent
ROA Calculated on Operating Profit:
To calculate this ratio for 3C:
= .0543 × 100 = 5.43% or simply = .0543 × 100 = 5.43%
This gives us an operating profit return on assets of 5.43%, compared to an ROA on net
profit of only 1.3%. Which ratio is better? Neither; they tell us different things that can be
used to compare with past performance and/or progress toward existing goals.
Some analysts believe that is more appropriate when calculating ROA to use
operating profit in the numerator rather than net profit. The thinking is that ROA
is a better representation of return on assets if taxes and interest are not taken into
consideration. This would give us an ROA that is based on our net sales, cost of sales,
and operating expenses.
Here's the bottom line: make sure that you understand the ratios that you are using
and why you are using them; make sure that they are appropriate for the type of
company that you are analyzing.
Return on assets is one of the most important performance ratios that you can use.
It is wise to calculate both the net return on assets as well as the operating return
on assets. Both ratios go a long way toward telling us not only how well the
company is performing financially, but also how well management is utilizing the
assets of the company to generate profit. Remember that we are supposed to purchase
assets for the sole purpose of using them to generate a profit. The return on assets ratios
gives us a pretty good idea as to whether that is occurring or not.
Normally, we calculate the net profit return on assets ratio because it tells us how
much money our assets have made for us after all of our business expenses have been
taken into consideration. It's the "bottom line" divided by the total assets. Sometimes, this
ratio does not give us a complete picture of the financial performance of the company.
This would occur in cases where high debt and attendant interest payments burden the
company or when the company suffers or chooses to suffer extraordinary one-time
expenses. The latter could be associated with the expenses of downsizing or restructuring
or the costs of warding off a hostile takeover bid. In these cases, we would also want to
look at the operating return on assets, a ratio that is not contaminated with these
exceptional interest and one-time costs. Doing so gives us a clearer picture of the
performance potential of the company when these expenses do not encumber it.
EARNINGS PER SHARE:
= Earnings Per Share (EPS)
Number of Shares of Common Stock Outstanding
Earnings Per Share of Common Stock:
For 3C this ratio is calculated as follows:
= .35 or simply = .35
This gives us an EPS of 35 cents per share. We need to track this ratio over time (trend
analysis) and compare it with similar companies in the industry in order for the ratio to
provide us with a useful meaning. We need to compare it with industry averages as well
as the average of similar companies in your sector of the industry. We also have to
compare it with the target ratio that the company may have established.
The earnings per share ratio. This ratio shows the relationship between the
number of common shares outstanding and net profit. Does this mean that each
share of common stock will be given that amount of money? The answer is no,
unless the board of directors chooses to pay all of the net profit in dividends to the
common stock holders, an event that rarely, if ever, occurs. But, this brings up an
interesting point. To whom does the net profit of the company belong? Answer: it
belongs to the stockholders. It must either be paid to the stockholders in the form of
dividends or it must be reinvested in the company. In the latter case, it becomes part of
retained earnings in the equity potion of the balance sheet and an appropriate
corresponding entry would be made in the assets portion of the balance sheet, under
current or fixed assets, depending on the disposition of that retained net profit.
How important is this ratio? Over time, it tells us a great deal about the financial
performance of the company. It is one of the ratios that Wall Street pundits,
financial gurus, and investors watch closely as an indicator of the investment
worthiness of a company. Companies “live and die” on Wall Street with the
report of their earnings, which is expressed in terms of earnings per share. Will the
company meet or exceed the anticipated earnings per share?
Stock prices can go up or down, depending on the company's performance. This
would be a major issue if the company were planning to issue more stock (equity
financing). The company is also accountable to the stockholders about its performance.
Many companies do not pay dividends. They rely on the performance of the company to
enhance shareholder value by having the company operate in such a manner that the price
of its stock will go up. This adds value for the stockholder's in the company. Companies,
which meet or exceed the anticipated earnings per share, have a higher probability of
having their shares increase in value over time. We have to say higher probability,
because there are no guarantees. Some companies meet the expectations of Wall Street
with regard to earnings per share only to have the market price of the stock go down.
There are no absolute one to one relationships that exist with regard to the performance
of a company and the value of its stock to investors and investment houses.
Management Effectiveness Indicators of the
The profitability ratios are potentially the richest source of information for the
manager. They are because they give us indications about the performance of the
company as it relates to its costs of manufacturing a product or delivering a
service. We also gain insights into the functioning of the company as it relates to
our operating expenses.
POSSIBLE INTERNAL STRENGTH INDICATORS
RATIO CONDITION MGT
The Gross Net sales and the cost of goods sold or the cost of sales, the
Margin variable costs of the company, affect the gross margin.
Therefore, all of the sub-components of the cost of sales
mentioned in the discussion of the income statement in
Chapter 3 are possible factors when analyzing the gross
margin and its tendencies over time. In cost of goods sold we
must remember that this includes all of the operational and
strategic factors that make or break the company. These factors
determine the productivity of the company, the quality of the
product or service, and the company's competitiveness. For
some of the factors listed below, the term "under control" is
used. While seemingly vague, this comment means that the
expenditures are appropriate or consistent with the company's
Hi or Net sales increasing and cost of sales remaining constant. MKT
Hi or Inc Experience in manufacturing the product or delivering the PRD
service is generating efficiencies.
Hi or Inc Direct labor costs are under control or are declining. PRD
Hi or Inc Company is making maximum use of technology to improve PRD
Hi or Inc Effective and efficient waste management program. PRD
Hi or Inc Quality control programs are effective and efficient. PRD
Hi or Inc Experienced personnel are being retained by the company. MGT
Hi or Inc Has more than one qualified supplier competing for company's PRD
Hi or Inc Effective maintenance program for machinery. PRD
Hi or Inc Effective training programs for personnel. MGT
Hi or Inc Employees involved in quality improvement. MGT
Hi or Inc Clients, suppliers, and all phases of the internal operation are MGT
tied together to create the most effective product or service.
Hi or Inc Management's organizational focus and objectives are MGT
understood by all employees.
Hi or Inc Effective, open, lateral and vertical communications in the MGT
Hi or Inc Managers required to train subordinates to the highest level of MGT
proficiency as leaders, managers, and problem solvers.
Hi or Inc Finished goods storage costs are declining. PRD
Hi or Inc Operational problem solving occurs at the lowest appropriate MGT
Hi or Inc Indirect labor costs are under control. MGT
Hi or Inc Timely and usable reports available to monitor and control IT
Hi or Inc Effective report dissemination system. IT
Hi or Inc Minimum barriers to communication. MGT
Hi or Inc Upper level management emphasis on organizational goals and MGT
de-emphasis of fiefdoms, personal spheres of interest and
power silos, and cronyism.
Hi or Inc Emphasis on creativity in all aspects of operation and MGT
minimum infatuation with the status quo.
Hi or Inc Effective inventory control system, e.g., JIT. PRD
Hi or Inc Organization is sensitive to and responds to changes in the MGT
major factors in the external environment.
The All of the factors mentioned above for the gross margin also
Operating affect the operating margin. The operating margin is also
Margin affected by the fixed costs.
Hi or Inc General administrative costs under control or declining. MGT
Hi or Inc Corporate officers’ salaries under control. MGT
Hi or Inc Marketing costs are under control. MGT
Hi or Inc Research and development costs are under control. MGT
Hi or Inc Currency translation is positive for the company. FIN
The Net All of the factors that affect the gross margin and the operating
Margin margin also affect the net margin.
Hi or Inc Net sales are growing and cost of sales and operating expenses MKT &
are under control. MGT
Hi or Inc Interest expenses are under control or they are appropriate for FIN
the company and the current market conditions.
Return on Return on total equity is a function of the net profit margin and
Equity total stockholders/owners' equity.
Hi or Inc Net profit is high, which is a product of all of the factors on the MGT
income statement. This is why it is so important for
managers/owners to pay close attention to the income
statement. One of the organization's financial goals should be
to improve return on equity; this keeps management focused
on its primary reason for existence, which is to improve
Return on Return on assets is a function of net profit and either the total
Assets assets or the fixed assets of the company, depending on which
ratio you are using.
Hi or Inc Company has sufficient, appropriate assets to do the job. MGT
Hi or Inc Company assiduously divests non-performing and under MGT
performing assets as well as those that do not fit in the future
strategic plans of the company.
Hi or Inc Strategic priorities are clearly developed and pursued at all MGT
levels of the organization.
Hi or Inc High priority strategies are given preference for organization's MGT
Hi or Inc Upper management thinks, plans, and acts strategically. MGT
Hi or Inc Upper management is successful in keeping the organization MGT
focused on the goals.
Hi or Inc Creativity, risk-taking, leadership, problem solving are MGT
rewarded; turf defenders and "archers" are not. Marginal
personnel and those who do not develop are not retained by the
organization. A word of explanation. Archers are those who
incessantly find fault in the plans and ideas of others and
actively resist them because those plans threaten their power
and positions. Or at least they see those plans and ideas as
Earnings Earnings per share is a function of the total number of shares
per Share of common stock outstanding and net profit. Therefore, all of
the factors that affect the net profit of the company also affect
the earnings per share.
Hi or Inc Net profit is increasing while the number of common shares MGT
outstanding remains relatively constant.
Hi or Inc Management has not issued an excessively large number of MGT
Hi or Inc Management has actively repurchased outstanding shares of MGT
common stock while net profit has remained constant.
POSSIBLE INTERNAL WEAKNESS INDICATORS
RATIO CONDITION MGT
As we have mentioned with other ratios, the weakness
indicators are the reverse of the possible strength indicators.
Rather than repeat the reverse of all of the strengths, the
student can easily transpose the factors mentally. There is one
caveat. Net sales, which is a factor in all of the profit margins
and dramatically affects return on equity and return on assets,
can be significantly impacted by external factors. Economic
recession, tight money policies by the Federal Reserve, intense
foreign competition, technological advances, and market
saturation can all conspire to decrease the net sales of the
company. What this means is that a company can be doing
everything right from both a management and financial
perspective and still record low profit margins and returns on
equity, assets, and earnings per share.
"Financial ratios and other metrics yield raw data; when analyzed the data can
become information; when that information can be put into action, it can become
knowledge; that knowledge can be the basis for management decision-making."
In addition to all of the financial ratios discussed in the previous chapters, there
are other performance ratios, now more commonly called metrics. Metrics help the
manager understand how the company is performing. They provide the manager with raw
data, which can be analyzed, converted into information, and used in the decision-making
process. In the 40 Top Tools for Manufacturers, Walter J. Michalski defines metrics as
"Quantitative and qualitative metrics (measurements) in four areas of interest: resource,
process, results, and customer satisfaction." We could more generally define a metric as
anything specific that is measurable which we could compare with something else. These
metrics supplement the financial ratios and give us insights into the current effectiveness
and efficiency of the organization and its management. They are discussed below.
Remember: Because you can compare anything of interest and value, the number and
type of metrics that you can develop to help you understand the performance of a
company are limited only by your imagination.
SOME GENERAL METRICS FROM THE INCOME
RESEARCH AND DEVELOPMENT:
Research and development (R&D) refers to those activities which a company
carries out to improve its products or services, develop new products or services,
or improve the manner in which these products or services are manufactured or
delivered. Some companies, such as drug and high tech organizations, spend a
great deal on R&D; others, such as broom manufacturing companies, do not. The nature
of the industry and new technology, which the industry can use, are the major factors that
drive R&D expenditures. Each company determines the actual amount that it must spend
in order to be competitive. One way that we can evaluate R&D spending is to determine
what percent it is of net sales. To calculate this ratio, we simply divide R&D
expenditures, as shown or if shown on the income statement, by net sales, also taken from
the income statement.
R & D Expenditiures
= Answer × 100 = Percent of Sales Spent on R & D
Research and Development as a Percent of Sales: Using the income statement in
chapter two, for the year 2001, we can calculate this ratio for 3C as follows:
= .0107 × 100 = 1.07% or simply = .0107 × 100 = 1.07%
We find that research and development expenses are 1.07% of sales. We would have to
track this ratio over time to see if there was any consistency from year to year in R&D
expenditures. We would also have to compare it with similar-sized competitors. We are
looking for some sort of a relationship between R&D and sales. Why? Because we would
want to spend an adequate amount to be competitive; however, we would not want to
exceed that amount and waste money.
Marketing (Selling) Expenses
= Answer × 100 = Marketing as a Percent of Net Sales
Marketing as a Percent of Sales:
Calculate this metric for 3C using the income statement from chapter two as
= .0535 × 100 = 5.35%
We find that sales expenses are 5.35% of sales. Again, we have to track this ratio over
time to determine the relationship between sales expenditures and sales that can help us
to infer something about the results of the marketing effort of the company. Again, we
are trying to determine at what point our selling expenses have the most beneficial effect.
We do not want to waste money on any unnecessary marketing activities.
Just as we did with R&D, we can also track administrative expenses. We take the
administrative expenses from the income statement, if shown, and divide them by net
sales. As with many other ratios, this one must be viewed over a period of time.
= Answer × 100 = Admin Expenses as a percent of Net Sales
Administration as a Percent of Sales:
Again, using the income statement from chapter two, calculate this ratio for 3C:
= .064 × 100 = 6.4%
We now know that administrative expenses are 6.4% of net sales. That means that 6.4%
of the company's net sales income is being used for administrative activities. It also
means that there is as much money being spent on administration as there is on selling
and R&D combined. Is this normal? Looks like another potential red flag. This could be
an area where we may be able to make expense reductions. Look at it this way: If all of
your cost-cutting programs have reduced the cost of goods sold as much as you can, then
you have to look at all of your operating expenses as possible sources of savings. Or, it
may be wiser to monitor these expenses on a regular basis to make sure they are adequate
but not excessive.
SOME EMPLOYEE PERFORMANCE METRICS
As companies grow, whether they are manufacturing or service companies,
control systems have a tendency to lag behind. Waste control, productivity
control, and hiring control procedures, policies, and practices that are appropriate
for a company with $70,000,000 in net sales may be ineffective and/or inefficient
for a company with $140,000, 000 in net sales.
Historically, in the United States, success in some companies has often tended to
breed complacency, insensitivity, and arrogance. As a firm grows and prospers,
unnecessary personnel are hired, unnecessary or inappropriate equipment is purchased,
and unneeded consultants are retained. Why does this happen? Because managers at all
levels have no significant experience in controlling the new larger and/or more successful
operation. Growth, whether through increased market share or acquisition, creates
adjustment problems. Ideally, these problems should be anticipated, and plans, policies,
and procedures should be developed to deal with them. Information acquisition,
processing, and analysis play a key role, as do communications, coordination, and
management training. One of the keys is to know what information to acquire so that we
have at our disposal the data that we need to transform it into information that can be
used as a basis for effective decisions.
Data are raw facts; data do not make decisions; managers make decisions. Well,
anyhow, that's what they get paid to do. If managers let the data make decisions
for them, they have failed to meet their responsibilities to exercise authority and
take responsibility. If data could make decisions, we wouldn't need managers.
Remember: Data (raw facts) must be converted into information, which when used, can
be transformed into knowledge that can be stored, modified, or reused.
If we know the number of employees in a company, we can calculate and analyze
some employee performance ratios. These ratios can give us an idea of how
productive our work force is. They can indicate if we have a personnel problem, a
management problem, a communications problem, an equipment problem, or a
data acquisition problem. Metrics can tell us if we are getting "too fat," that is, hiring
unnecessary employees or hiring the wrong type of employees. Again, we need to track
these ratios over time, either by quarters, semiannually, or from year to year.
A word of caution: Employee performance ratios should be used to help make
better decisions, improve the quality of operations, make the company more
competitive, increase productivity, and improve the bottom line. Unfortunately, in
many organizations, they are not a means to an end; they are an end in
themselves. Ratios become the objective at the expense of sound decision-making, when
managers take action to achieve the desired ratio level rather than using the ratio to
achieve the objectives of the organization.
NET SALES PER EMPLOYEE:
This is a ratio that we could use as a performance and productivity indicator. We
could monitor this trend on a monthly or quarterly basis. On observing the trend,
we would then determine the factors that are contributing to the trend and take
whatever action is appropriate. We have to be careful to look both inside and
outside the company for answers.
Total Net Sales
= Net Sales Per Employee
Total Number of Employees
Net Sales Per Employee:
In 3C’s case, there are 687 employees. We divide net sales, 140,000,000, by 687
= or $283,784 in Net Sales Per Employee
This gives us a ratio of 283,784 to 1 in net sales per employee per year. Is this good or
bad? It is another one of those performance ratios that we have to monitor over time. Our
goal should be to produce the highest quality product for the lowest price in order to be
profitable, the competitive, and increase market share. With a competent sales staff and
effective strategic management, we should be able to increase our net sales per employee,
providing there are no mitigating factors in the external environment that upset our plans.
The worst thing that you can do as a manager is to set a target of a specific amount of net
sales per employee. Why? When you establish an arbitrary internal objective, your
subordinates and colleagues will make arbitrary and irrational decisions to achieve the
objective number. Their focus is no longer the strategic goal of the company, but
arbitrary internal standards. This is how an organizational incentive can create a gap
between the managers' goals and the goals of the company. We have created an
organizational problem, not solved one.
NET PROFIT PER EMPLOYEE:
This ratio could also have value in tracking the performance of the company.
However, like all performance ratios, it must be analyzed over time.
Total Net Profit
= Net Profit Per Employee
TotalNumber of Employees
Net Profit Per Employee: Calculating this ratio for 3C, we take the net profit
from the 2001 income statement, 2,100,000, and divide it by the number of
This ratio tells us that while we are generating $283,784 in net sales per employee, we are
only making $305 in net profit per employee. This ratio only has value if we understand
it as part of a trend and are aware of external factors and internal operations that could
impinge on it.
COST OF WASTE PER EMPLOYEE AND AS A FUNCTION OF NET SALES:
There is increasing pressure on most businesses to reduce waste as a cost
reduction activity. As environments become more competitive and costs and
selling prices become more difficult to control, there is more emphasis on
controlling the internal operations of an organization. Almost all operations
produce waste of one kind or another: wasted time, wasted money, wasted travel, wasted
raw materials, wasted talent, wasted potential, and wasted energy. Some waste is
inevitable and acceptable; anything beyond this is intolerable. Think about this for a
minute: Let’s say that we have a situation where waste is 10% of our cost of goods sold.
If we can cut that waste by 90%, we have just added 9% to our gross profit and
potentially, 9% net profit to our bottom line. And we did this without selling any more
product or service, without purchasing any more equipment, and without hiring any more
Total Cost of Waste
= Cost of Waste Per Employee
Total Number of Employees
Cost of Waste Per Employee: For the purpose of creating an example, let us
assume that a team of experts has determined that within 3C’s cost of goods sold,
there is $80,000,000 worth of materials and products that are used in the
manufacturing process. The team has also determined that because of
inefficiencies, obsolete equipment, inexperienced labor, excessive supervision, needless
rechecking of quality, and redundant processes, that the system wastes 24% of its
materials. First let's calculate the waste per employee. Multiply 80,000,000, the cost of
materials, by 24%, the probable waste. This means that we may be creating $19,200,000
dollars in waste each year. Sounds like a lot of money. As one wise old senator said
during a hearing in Washington some years ago: "A million here, a million there; it all
adds up." Now we divide the possible total waste in dollars, 19,200,000, by the total
number of employees, 687.
That’s $27,947.60 in waste each year per employee. Is this normal for this industry?
While industry averages, if available, could give us some clues, we need to examine in
detail the internal operations of company to determine possible causes for the waste and
eliminate them. This company looks like a perfect candidate for a “continuous
Total Cost of Waste
= Answer × 100 = Waste as a Percent of Net Sales
Waste as a Percent of Sales:
Let's calculate the waste as a percent of net sales. Divide total waste, 19,200,000,
by net sales, 140,000,000.
= .1357 × 100 = 13.57%
That means that 13.57% of the money from net sales is being spent on non-productive
waste. Think about this for a minute. If we could cut our waste in half with no substantial
expenditures for equipment or consultants, we could raise our after tax net profit from a
meager 1.5% to 5.57%. How? Take 50% of 13.57%. That gives us 6.785%, which is the
percent of net sales revenue that will no longer be spent on waste. Multiply 6.785 by .6
because we are in a 40% tax bracket and get to keep only 60%. That equals 4.07% which
we add to 1.5%, our net profit, for a new net profit of 5.57%. We have just increased our
net profit by 270% with no increase in sales. That may not make the stockholders
deliriously happy, but it should put huge smiles on their faces.
OVERTIME HOURS AS A PERCENT OF TOTAL HOURS:
To hire new personnel or not to hire new personnel, that is the question. Many
firms not only watch the total hours worked by the regular employees very
closely, they are also very concerned with the number of overtime hours.
Although it varies from company to company, there is a point at with it is no
longer economical to pay overtime, a point when it makes good business sense to start
hiring new full-time employees. Each organization should be aware of the "marginal
benefit versus the marginal cost” of the additional employees. The formula to calculate
overtime hours as a percent of total hours is as follows:
Total Overtime Hours
= Answer × 100 = Overtime Hours as a Percent of Total Hours Worked
Total Hours Worked
Overtime Hours as a Percent of Total Hours: Let's assume that each one of the
employees involved in manufacturing at 3C averages four hours of overtime
during a week beyond the normal 40. Add this to the weekly overtime, 40 plus 4,
and we get 44 total hours per employee per week. Let us further assume that of
the total 687 employees at 3C, that 512 are involved in the manufacturing process. Total
overtime hours for these would be 512 times 4, or 2,048. The total hours worked would
be 512 times 40, to get the total number of regular hours worked for the 512 for one
week, plus the 2048 overtime hours. This gives us a total hours worked of 22,528. Now
we can divide the total overtime hours, 2,048, by 22,528. Converting to percent, this
shows us that overtime hours are 9.1% of the total hours worked. 3C will have to decide
at what point it is no longer economical to pay more overtime, the point at which it
should hire new employees. We calculated this for one week, but you could do this for a
month, quarterly, semiannually, or yearly, whatever meets the needs of the firm.
OTHER PERFORMANCE METRICS
SALES PER SQUARE FOOT OF FLOOR SPACE:
It is not uncommon in retail operations to calculate the dollar value of sales per
square foot. Retailers use every available square foot of floor space to realize the
most in sales. Idle space is costly space. Many retailers have raised the use of
space to an art form. Their historical and experiential data tells them to put in a store with
a certain size floor space for a community or market area of a given size. Little is left to
chance. You can always expand; it is very difficult to contract.
Total Net Sales
= Net Sales Per Square Foot of Floor Space
Total Usable Square Feet of Floor Space
Sales Per Usable Square Foot of Floor Space: Let us assume that3C has a factory
outlet store at its original plant location. This store sells products, which are
perfectly usable, but failed to pass all stringent quality inspections, such as
slightly discolored external packaging or slightly dented packaging. Let us further
assume that the store is a modest 1,200 square feet, 30 by 40 feet and that “breakeven
cost” for running the store is $44,104 per year or $36.75 per square foot.
Let us also assume that total sales for the store in 2002 were $75,697. Using the
formula above, we would divide total net sales by total square feet of floor space, 75,967
by 1,200, to get annual net sales per square foot of $63.08 per square foot. That’s a
substantial $31,593 in net profit for the store, $75, 697 - $44, 104. In 3C’s case the
continued operation of the store is worthwhile because it needs only $36.75 per square
foot to break even. This is "sweetened" by the fact that if 3C had to dispose of the
product to a deep-discount-salvage-markdown store, it would realize only about $8,000
per year, which is less than the cost of production.
Michalski, Walter J. 40 Top Tools for Manufacturers. Productivity Press, Portland, OR.,
External Factors That Can Affect a Company's Financial Performance
COMPETITION, BOTH FOREIGN AND DOMESTIC
Direct and indirect; local, regional, national, international.
Taboos, consumers' tastes, attitude toward products and services, quality and price
expectations, religious influence and other factors.
Distribution by age and sex, birth rate, death rate, population shifts, available labor pools,
quality of available labor, depth of labor pool, education levels.
Interest rates, inflation rate, unemployment rate, prime rate, recession, depression,
disposable income, average indebtedness.
Lines of communication, available transportation, lines of communication, available
natural resources, nature of terrain, weather, "acts of God", e.g., floods, hurricanes
(typhoons west of the 180th meridian), earthquakes, tidal waves (tsunami), plagues. Why
do we blame all the bad stuff on God?
Laws, regulations, oversight, restrictions, lawsuits.
Ease of entry, expanding, mature, dying, fragmented, oligopoly, regional, national,
international; levels of integration, sources of supply, availability of raw materials.
Ease of operation, restrictions, laws, currency exchange rates, import/export duties,
customs, economic and political stability, profit repatriation restrictions, method of entry
restrictions, and size of opportunity in foreign markets.
Pressure, interest groups, Political Action Committees, Trade Associations, Professional
Associations, Political Parties, Lobbyists, Public Outrage, Public Opinion, graft,
Availability, relationships with, willingness to accede to company's policies, standards,
A CASE STUDY
The Consolidated Cromwell Company (3C) was founded in 1979 in the aftermath
of the third oil embargo suffered by the United States in less than ten years (1972-1980).
It was formed when seven small companies, each with less than two million dollars in
annual sales and operated by independent entrepreneurs, banded together to form what
they felt would be a stronger, more productive company. To assuage the egos of the
seven original owners, a unique and non-controversial name was adopted for the
company. The seven companies all manufactured a "corrosion-resistant-outer-material"
for certain components used in water wells, oil wells, and natural gas wells. They all
agreed that the acronym "crom" from "corrosion-resistant-outer-material" would be
combined with its primary application, the well, to form the name Cromwell. It would be
called "consolidated' as a result of the consolidation of seven companies. Originally a
closely held company, 3C went public with an "IPO" (initial public offering) of stock in
3C experienced a 3.1% average annual growth rate in its first 21 years.
Management expertise and competency were easily able to grow and develop during this
period. At the beginning of 1999, 3C management exuded confidence in its ability to
continue the prosperity that the company had enjoyed over the years. A new and
pervasive threat, however, has emerged in the past several years that was characterized
by numerous acquisitions and mergers in the industry. Conglomerates have acquired
many competitors, which produced only the well coating product as a sole source of
revenue. 3C is one of a handful of companies that remains a single product manufacturer.
Facing a possible takeover by several larger companies, 3C decided that it could remain
competitive and that it would expand through acquisition. In January 2001, 3C acquired a
competitor through a one hundred percent stock purchase. The acquired company had
been poorly managed and "held out the promise" of a significant increase in profitability
once it was integrated into 3C. The acquisition appeared even more desirable because
there was only a 14% overlap in clientele, and the acquired company had begun modest
international operations by exporting its products to Mexico, England, and Venezuela.
The latter gave 3C a much-needed and highly desirable foothold internationally.
3C operates primarily in the volatile, cartel-laden oil and natural gas services
industry and the fresh water extraction industry. The latter has grown dramatically in
importance because of the finite supply of fresh, potable drinking water. The "outer-
surface-coating" industry, as such, does not exist. It is a very specific but important
product, the manufacture of which has been absorbed by a number of diversified
companies that produce paints and other surface preparation and protection materials. 3C,
since the acquisition, is positioned as the largest independent manufacturer of the
corrosion-resistant-outer-material in the United States. It holds 13.5% of the domestic
market. The other 86.5% is fragmented among fifteen other manufacturers. Eleven of
these manufacturers have greater flexibility than 3C simply because they do not rely on
revenues from the coating product as a sole source of income. They are better able to
withstand downturns in demand in the industry as well as weakened demand caused by
Although 3C’s management team is very qualified, highly professional, and
operates as a complementary, integrated team, it remains to be seen whether or not 3C
can digest an acquisition that virtually doubled its size and added a small, but unfamiliar
international operation. As a single product company, 3C is bucking an "industry trend."
As such, it will be in financial difficulty if it does not successfully absorb and integrate
the acquired company. If it is too successful, it may become a takeover target for one of
the many expanding, diversified, global conglomerates. Notwithstanding this, 3C chose
to grow through acquisition and become a major player "in the industry" rather than
being forced out of business by its conglomerate competitors.
While the 2001 financial data paint the picture of a company that is experiencing
some difficulty, the management of 3C is actually in the process of "digesting" a major
acquisition. While sales growth is on track, there are many questions that have to be
answered. Should the company consolidate operations in one location? Should research
and development be done on an as-needed, contractual basis? What new applications can
be found for the company's products so as to minimize its reliance on the petroleum and
natural gas services industries? Is diversification into related products and services
realistic and possible? Should the company consider manufacturing its products offshore?
How can the company reduce its operating expenses? What actions can it take to reduce
significantly the level of waste in the manufacturing process? Should marketing activities
be controlled from a central location? Should upper management be compensated on a
"value-added" basis? In other words, should management receive bonuses only if the
company exceeds its stated performance objectives?
All of these questions need to be answered. Where appropriate, strategies must be
developed and implemented. Unless 3C can complete the digestion of its acquisition
successfully, it may become the target of a takeover by convincing the stockholders that
the potential acquirer can do a better job than the present management.
THE CONSOLIDATED CROMWELL COMPANY, INC.
FINANCIAL DATA 2000-2002
THE BALANCE SHEET (000)
2000 2001 2002
Cash 10000 1500 5000
Cert. of Deposit (Cash Equivalent) 5000 0 0
Accounts Receivable 4000 8575 9000
Other Current Assets 0 3000 2950
Inventory 6000 13500 15000
Total current Asset 25000 26575 31950
Fixed Assets 62560 121810 141742
Accumulated Depreciation -5590 -12495 -14174
Net Fixed Assets 56970 109315 127568
Intangible Assets 0 18000 18000
Accumulated Amortization 0 -900 -2700
0 17100 15300
Total Assets 81970 152990 174818
Accounts Payable 5500 6500 8500
Notes Payable - Current 500 10000 10000
Other Current Liabilities 6500 15650 12750
Total Current Liabilities 12500 32150 31250
Long Term Debt 2000 55000 75628
Owner Equity 67470 65840 67940
Total Liabilities and owner Equity 81970 152990 174818
Exhibit 1: Balance Sheet.
THE INCOME STATEMENT (000)
2000 2001 2002
Net Sales $ 68,900 $ 137,500 $ 140,000
Cost of Goods Sold $ 41,340 $ 111,650 $ 112,000
Gross Profit $ 27,560 $ 25,850 $ 28,000
Administrative Expenses $ 4,823 $ 11,688 $ 9,000
Selling Expenses $ 4,048 $ 7,563 $ 7,500
Research and Development $ 619 $ 1,500
Reorganization Expenses $ $ 20,014
Currency Exchange $ $ 156 $ 500
Write-off of in process R&D $ $ 30,500 $
Income from Operations $ 18,345 $ (44,688) $ 9,500
Interest Expenses $ 188 $ 5,038 $ 6,000
Income before Taxes $ 18,157 $ (49,726) $ 3,500
Income Taxes (Credit) $ 7,263 $ (596) $ 1,400
Net Income $ 10,894 $ (49,130) $ 2,100
Exhibit 2: Income Statement.
THE STATEMENT OF CASH FLOWS (000)
Cash flows from operating activities:
Net Income (loss) $ (49,130) $ 2,100
Write-off of in-process R&D $ 30,500 $
Depreciation and Amortization $ 7,805 $ 3,479
Increase (decrease) in Working Capital $ (4,925) $ (2,775)
Net Cash Provided (Used) by Operating Activities $ (15,750) $ 2,804
Cash Flows from investing activities:
Purchases of fixed assets $ (1,250) $ (19,932)
Acquisition of XYZ Corporation (net cash payments) $ (59,000) $
Net Cash used in investing activities $ (60,250) $ (19,932)
Cash Flows from financing activities:
Proceeds from issuance of long-term debt $ 62,500 $ 20,628
Net cash provided by financing activities: $ 62,500 $ 20,628
Net increase (decrease) in cash and cash equivalents $ (13,500) $ 3,500
Cash and cash equivalents, Beginning of period $ 15,000 $ 1,500
Cash and cash equivalents, End of period $ 1,500 $ 5,000
Exhibit 3: Statement of Cash Flows.