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Thursday, September 11, 2008
Financial ratios- hand outs
Gross margin, Gross profit margin or Gross Profit Rate can be defined as the amount of contribution to the business enterprise, after paying for direct-fixed and direct-variable unit costs, required to cover overheads (fixed commitments) and provide a buffer for unknown items. It expresses the relationship between gross profit and sales revenue.
It can be expressed in absolute terms::
Gross Profit = Revenue − Cost of Goods Sold
or as the ratio of gross profit to sales revenue, usually in the form of a percentage:
Cost of goods sold includes variable and fixed costs directly linked to the product, such as material and labor. It does not include indirect fixed costs like office expenses, rent, administrative costs, etc.
Higher gross margins for a manufacturer reflect greater efficiency in turning raw materials into income. For a retailer it will be their markup over wholesale.
Larger gross margins are generally good for companies, with the exception of discount retailers. They need to show that operations efficiency and financing allows them to operate with tiny margins.
In business, operating margin, Operating Income Margin, Operating profit margin or Return on sales (ROS) is the ratio of operating income (operating profit in the UK) divided by net sales, usually presented in percent.
Profit margin, Net Margin, Net profit margin or Net Profit Ratio all refer to a measure of profitability. It is calculated using a formula and written as a percentage or a number.
The profit margin is mostly used for internal comparison. It is difficult to accurately compare the net profit ratio for different entities. Individual businesses' operating and financing arrangements vary so much that different entities are bound to have different levels of expenditure, so that comparison of one with another can have little meaning. A low profit margin indicates a low margin of safety: higher risk that a decline in sales will erase profits and result in a net loss.
For example, a company produces a loaf of bread and sells it for 10 units of currency. It cost the company 6 units of currency to produce the bread and it also had to pay an additional 2 units of currency in tax.
That makes the company's net income 2 units of currency (10 - 6, before tax, then minus 2 for tax). Since its revenue is 10 units of currency, the profit margin would be (2 / 10) or 20%.
Profit margin is an indicator of a company's pricing policies and its ability to control costs. Differences in competitive strategy and product mix cause the profit margin to vary among different companies.
Return on Equity (ROE, Return on average common equity, return on net worth) measures the rate of return on the ownership interest (shareholders' equity) of the common stock owners. ROE is viewed as one of the most important financial ratios. It measures a firm's efficiency at generating profits from every dollar of net assets (assets minus liabilities), and shows how well a company uses investment dollars to generate earnings growth. ROE is equal to a fiscal year's net income (after preferred stock dividends but before common stock dividends) divided by total equity (excluding preferred shares), expressed as a percentage.
[1]
But not all high-ROE companies make good investments. Some industries have high ROE because they require no assets, such as consulting firms. Other industries require large infrastructure builds before they generate a penny of profit, such as oil refiners. You cannot conclude that consulting firms are better investments than refiners just because of their ROE. Generally, capital-intensive businesses have high barriers to entry, which limit competition. But high-ROE firms with small asset bases have lower barriers to entry. Thus, such firms face more business risk because competitors can replicate their success without having to obtain much outside funding. As with many financial ratios, ROE is best used to compare companies in the same industry.
High ROE yields no immediate benefit. Since stock prices are most strongly determined by earnings per share (EPS), you will be paying twice as much (in Price/Book terms) for a 20% ROE company as for a 10% ROE company. The benefit comes from the earnings reinvested in the company at a high ROE rate, which in turn gives the company a high growth rate.
ROE is presumably irrelevant if the earnings are not reinvested.
The sustainable growth model shows us that when firms pay dividends, earnings growth lowers. If the dividend payout is 20%, the growth expected will be only 80% of the ROE rate.
The growth rate will be lower if the earnings are used to buy back shares. If the shares are bought at a multiple of book value (say 3 times book), the incremental earnings returns will be only 'that fraction' of ROE (ROE/3).
New investments may not be as profitable as the existing business. Ask "what is the company doing with its earnings?"
Remember that ROE is calculated from the company's perspective, on the company as a whole. Since much financial manipulation is accomplished with new share issues and buyback, always recalculate on a 'per share' basis, i.e., earnings per share/book value per share.
In finance, rate of return (ROR), also known as return on investment (ROI), rate of profit or sometimes just return, is the ratio of money gained or lost (realized or unrealized) on an investment relative to the amount of money invested. The amount of money gained or lost may be referred to as interest, profit/loss, gain/loss, or net income/loss. The money invested may be referred to as the asset, capital, principal, or the cost basis of the investment. ROI is usually expressed as a percentage rather than decimal value.
ROI does not indicate how long an investment is held. However, ROI is most often stated as an annual or annualized rate of return, and it is most often stated for a calendar or fiscal year. In this article, "ROI" indicates an annual or annualized rate of return, unless otherwise noted.
ROI is used to compare returns on investments where the money gained or lost — or the money invested — are not easily compared using monetary values. For instance, a $1,000 investment that earns $50 in interest generates more cash than a $100 investment that earns $20 in interest, but the $100 investment earns a higher return on investment.
$50/$1,000 = 5% ROI
$20/$100 = 20% ROI
When considering a continuous process of gaining or losing money with a constant rate of return, the annual rate of return is any value greater than -100%; a positive percentage corresponds to exponential growth of the capital, a value between -100% and 0% exponential decay.
Asset turnover is a financial ratio that measures the efficiency of a company's use of its assets in generating sales revenue or sales income to the company.[1]
"Sales" is the value of "Net Sales" or "Sales" from the company's income statement
"Average Total Assets" is the value of "Total assets" from the company's balance sheet in the beginning and the end of the fiscal period divided by 2.
The Return on Assets (ROA) percentage shows how profitable a company's assets are in generating revenue.
ROA can be computed as:
This number tells you "what the company can do with what it's got", i.e. how many dollars of earnings they derive from each dollar of assets they control. It's a useful number for comparing competing companies in the same industry. The number will vary widely across different industries. Return on assets gives an indication of the capital intensity of the company, which will depend on the industry; companies that require large initial investments will generally have lower return on assets.[1]
Contents
[hide]
1 Usage
2 References
3 See also
4 External links
//
[edit] Usage
Return on assets is an indicator of how profitable a company is before leverage, and is compared with companies in the same industry. Since the figure for total assets of the company depends on the carrying value of the assets, some caution is required for companies whose carrying value may not correspond to the actual market value. Return on assets is a common figure used for comparing performance of financial institutions (such as banks), because the majority of their assets will have a carrying value that is close to their actual market value. Return on assets is not useful for comparisons between industries because of factors of scale and peculiar capital requirements (such as reserve requirements in the insurance and banking industries).
Return on Assets Du Pont is a financial ratio that shows how the return on assets depends on both asset turnover and profit margin. The Du Pont method breaks out these two components from the return on assets ratio in order to determine the impact of each on the profitability of the company.
Return on assets Du Pont can be expressed as:
ROA Du Pont = (Net income / Sales) x (Sales / Total Assets)
This ratio helps to highlight the impact of changes in asset turnover and profit margin.[1]
Return on net assets
From Wikipedia, the free encyclopedia
Jump to: navigation, search
(abbreviated to RONA) Profit after tax / ( Fixed assets + working capital )
It is a measure of financial performance of a company which takes the use of assets into account.
Return on invested capital (ROIC) is a financial measure that quantifies how well a company generates cash flow relative to the capital it has invested in its business. It is defined as Net operating profit less adjusted taxes divided by Invested Capital and is usually expressed as a percentage. In this calculation, capital invested includes all monetary capital invested: long-term debt, common and preferred shares.
When the return on capital is greater than the cost of capital (usually measured as the weighted average cost of capital), the company is creating value; when it is less than the cost of capital, value is destroyed.
[edit] Basic formula
ROIC = (Net Operating Profit − Taxes)/(Total Capital)
Note that the numerator in the ROC fraction does not subtract interest expense, because demoninator includes debt capital.
Accounting liquidity (liquidity) is a measure of the ability of a debtor to pay their debts as and when they fall due. It is usually expressed as a ratio or a percentage of current liabilities.
Contents
[hide]
1 Calculating liquidity
2 Understanding the ratios
3 Liquidity in banking
4 See also
//
[edit] Calculating liquidity
For a corporation with a published balance sheet there are various ratios used to calculate a measure of liquidity. These include the following:
the current ratio, which is the simplest measure and is calculated by dividing the total current assets by the total current liabilities. A value of over * the quick ratio - calculated by deducting inventories and prepayments from current assets and then dividing by current liabilities - gives a measure of the ability to meet current liabilities from assets that can be readily sold. A better way for a trading corporation to meet liabilities is from cash flows, rather than through asset sales, so;
the operating cash flow ratio can be calculated by dividing the operating cash flow by current liabilities. This indicates the ability to service current debt from current income, rather than through asset sales.
[edit] Understanding the ratios
For different industries and differing legal systems the use of differing ratios and results would be appropriate. For example, in a country with a legal system that gives a slow or uncertain result a higher level of liquidity would be appropriate to cover the uncertainty related to the valuation of assets. A manufacturer with stable cash flows may find a lower quick ratio appropriate than an Internet-based start up corporation.
[edit] Liquidity in banking
Liquidity is a prime concern in a banking environment and a shortage of liquidity has often been a trigger for bank failures. Holding assets in a highly liquid form tends to reduce the income from that asset (cash, for example, is the most liquid asset of all but pays no interest) so banks will try to reduce liquid assets as far as possible. However, a bank without sufficient liquidity to meet the demands of their depositors risks experiencing a bank run. The result is that most banks now try to forecast their liquidity requirements and maintain emergency standby credit lines at other banks. Banking regulators also view liquidity as a major concern.
The current ratio is a financial ratio that measures whether or not a firm has enough resources to pay its debts over the next 12 months. It compares a firm's current assets to its current liabilities. It is expressed as follows:
For example, if WXY Company's current assets are $50,000,000 and its current liabilities are $40,000,000, then its current ratio would be $50,000,000 divided by $40,000,000, which equals 1.25. It means that for every dollar the company owes it has $1.25 available in current assets. A current ratio of assets to liabilities of 2:1 is usually considered to be acceptable (ie., your assets are twice your liabilities).[1]
The current ratio is an indication of a firm's market liquidity and ability to meet creditor's demands. Acceptable current ratios vary from industry to industry. If a company's current assets are in this range, then it is generally considered to have good short-term financial strength. If current liabilities exceed current assets (the current ratio is below 1), then the company may have problems meeting its short-term obligations. If the current ratio is too high, then the company may not be efficiently using its current assets.
In finance, the Acid-test or quick ratio or liquid ratio measures the ability of a company to use its near cash or quick assets to immediately extinguish or retire its current liabilities. Quick assets include those current assets that presumably can be quickly converted to cash at close to their book values. Such items are cash, cash equivalents such as marketable securities, and some accounts receivable. This ratio indicates a firm's capacity to maintain operations as usual with current cash or near cash reserves in bad periods. As such, this ratio implies a liquidation approach and does not recognize the revolving nature of current assets and liabilities. The ratio compares a company's cash and short-term investments to the financial liabilities the company is expected to incur within a year's time.
OR
Generally, the acid test ratio should be 1:1 or better, however this varies widely by industry. [1]
Receivable Turnover Ratio is one of the Accounting Liquidity ratios, a financial ratio. This ratio measures the number of times, on average, receivables (e.g. Accounts Receivable) are collected during the period. A popular variant of the receivables turnover ratio is to convert it into an Average Collection Period in terms of days. Remember that the Receivable turnover ratio is figured as "turnover times" and the Average collection period is in "days".
Inventory turnover ratio is one of the Accounting Liquidity ratios, a financial ratio. This ratio measures the number of times, on average, the inventory is sold during the period. Its purpose is to measure the liquidity of the inventory. A popular variant of the Inventory turnover ratio is to convert it into an average days to sell the inventory in terms of days. Remember that the Inventory turnover ratio is figured as "turnover times" and the average days to sell the inventory is in "days".
Inventory turnover ratio = Cost of goods sold / Average inventory[1]
Average days to sell the inventory = 365 / Inventory Turnover Ratio[2]
It can be expressed in absolute terms::
Gross Profit = Revenue − Cost of Goods Sold
or as the ratio of gross profit to sales revenue, usually in the form of a percentage:
Cost of goods sold includes variable and fixed costs directly linked to the product, such as material and labor. It does not include indirect fixed costs like office expenses, rent, administrative costs, etc.
Higher gross margins for a manufacturer reflect greater efficiency in turning raw materials into income. For a retailer it will be their markup over wholesale.
Larger gross margins are generally good for companies, with the exception of discount retailers. They need to show that operations efficiency and financing allows them to operate with tiny margins.
In business, operating margin, Operating Income Margin, Operating profit margin or Return on sales (ROS) is the ratio of operating income (operating profit in the UK) divided by net sales, usually presented in percent.
Profit margin, Net Margin, Net profit margin or Net Profit Ratio all refer to a measure of profitability. It is calculated using a formula and written as a percentage or a number.
The profit margin is mostly used for internal comparison. It is difficult to accurately compare the net profit ratio for different entities. Individual businesses' operating and financing arrangements vary so much that different entities are bound to have different levels of expenditure, so that comparison of one with another can have little meaning. A low profit margin indicates a low margin of safety: higher risk that a decline in sales will erase profits and result in a net loss.
For example, a company produces a loaf of bread and sells it for 10 units of currency. It cost the company 6 units of currency to produce the bread and it also had to pay an additional 2 units of currency in tax.
That makes the company's net income 2 units of currency (10 - 6, before tax, then minus 2 for tax). Since its revenue is 10 units of currency, the profit margin would be (2 / 10) or 20%.
Profit margin is an indicator of a company's pricing policies and its ability to control costs. Differences in competitive strategy and product mix cause the profit margin to vary among different companies.
Return on Equity (ROE, Return on average common equity, return on net worth) measures the rate of return on the ownership interest (shareholders' equity) of the common stock owners. ROE is viewed as one of the most important financial ratios. It measures a firm's efficiency at generating profits from every dollar of net assets (assets minus liabilities), and shows how well a company uses investment dollars to generate earnings growth. ROE is equal to a fiscal year's net income (after preferred stock dividends but before common stock dividends) divided by total equity (excluding preferred shares), expressed as a percentage.
[1]
But not all high-ROE companies make good investments. Some industries have high ROE because they require no assets, such as consulting firms. Other industries require large infrastructure builds before they generate a penny of profit, such as oil refiners. You cannot conclude that consulting firms are better investments than refiners just because of their ROE. Generally, capital-intensive businesses have high barriers to entry, which limit competition. But high-ROE firms with small asset bases have lower barriers to entry. Thus, such firms face more business risk because competitors can replicate their success without having to obtain much outside funding. As with many financial ratios, ROE is best used to compare companies in the same industry.
High ROE yields no immediate benefit. Since stock prices are most strongly determined by earnings per share (EPS), you will be paying twice as much (in Price/Book terms) for a 20% ROE company as for a 10% ROE company. The benefit comes from the earnings reinvested in the company at a high ROE rate, which in turn gives the company a high growth rate.
ROE is presumably irrelevant if the earnings are not reinvested.
The sustainable growth model shows us that when firms pay dividends, earnings growth lowers. If the dividend payout is 20%, the growth expected will be only 80% of the ROE rate.
The growth rate will be lower if the earnings are used to buy back shares. If the shares are bought at a multiple of book value (say 3 times book), the incremental earnings returns will be only 'that fraction' of ROE (ROE/3).
New investments may not be as profitable as the existing business. Ask "what is the company doing with its earnings?"
Remember that ROE is calculated from the company's perspective, on the company as a whole. Since much financial manipulation is accomplished with new share issues and buyback, always recalculate on a 'per share' basis, i.e., earnings per share/book value per share.
In finance, rate of return (ROR), also known as return on investment (ROI), rate of profit or sometimes just return, is the ratio of money gained or lost (realized or unrealized) on an investment relative to the amount of money invested. The amount of money gained or lost may be referred to as interest, profit/loss, gain/loss, or net income/loss. The money invested may be referred to as the asset, capital, principal, or the cost basis of the investment. ROI is usually expressed as a percentage rather than decimal value.
ROI does not indicate how long an investment is held. However, ROI is most often stated as an annual or annualized rate of return, and it is most often stated for a calendar or fiscal year. In this article, "ROI" indicates an annual or annualized rate of return, unless otherwise noted.
ROI is used to compare returns on investments where the money gained or lost — or the money invested — are not easily compared using monetary values. For instance, a $1,000 investment that earns $50 in interest generates more cash than a $100 investment that earns $20 in interest, but the $100 investment earns a higher return on investment.
$50/$1,000 = 5% ROI
$20/$100 = 20% ROI
When considering a continuous process of gaining or losing money with a constant rate of return, the annual rate of return is any value greater than -100%; a positive percentage corresponds to exponential growth of the capital, a value between -100% and 0% exponential decay.
Asset turnover is a financial ratio that measures the efficiency of a company's use of its assets in generating sales revenue or sales income to the company.[1]
"Sales" is the value of "Net Sales" or "Sales" from the company's income statement
"Average Total Assets" is the value of "Total assets" from the company's balance sheet in the beginning and the end of the fiscal period divided by 2.
The Return on Assets (ROA) percentage shows how profitable a company's assets are in generating revenue.
ROA can be computed as:
This number tells you "what the company can do with what it's got", i.e. how many dollars of earnings they derive from each dollar of assets they control. It's a useful number for comparing competing companies in the same industry. The number will vary widely across different industries. Return on assets gives an indication of the capital intensity of the company, which will depend on the industry; companies that require large initial investments will generally have lower return on assets.[1]
Contents
[hide]
1 Usage
2 References
3 See also
4 External links
//
[edit] Usage
Return on assets is an indicator of how profitable a company is before leverage, and is compared with companies in the same industry. Since the figure for total assets of the company depends on the carrying value of the assets, some caution is required for companies whose carrying value may not correspond to the actual market value. Return on assets is a common figure used for comparing performance of financial institutions (such as banks), because the majority of their assets will have a carrying value that is close to their actual market value. Return on assets is not useful for comparisons between industries because of factors of scale and peculiar capital requirements (such as reserve requirements in the insurance and banking industries).
Return on Assets Du Pont is a financial ratio that shows how the return on assets depends on both asset turnover and profit margin. The Du Pont method breaks out these two components from the return on assets ratio in order to determine the impact of each on the profitability of the company.
Return on assets Du Pont can be expressed as:
ROA Du Pont = (Net income / Sales) x (Sales / Total Assets)
This ratio helps to highlight the impact of changes in asset turnover and profit margin.[1]
Return on net assets
From Wikipedia, the free encyclopedia
Jump to: navigation, search
(abbreviated to RONA) Profit after tax / ( Fixed assets + working capital )
It is a measure of financial performance of a company which takes the use of assets into account.
Return on invested capital (ROIC) is a financial measure that quantifies how well a company generates cash flow relative to the capital it has invested in its business. It is defined as Net operating profit less adjusted taxes divided by Invested Capital and is usually expressed as a percentage. In this calculation, capital invested includes all monetary capital invested: long-term debt, common and preferred shares.
When the return on capital is greater than the cost of capital (usually measured as the weighted average cost of capital), the company is creating value; when it is less than the cost of capital, value is destroyed.
[edit] Basic formula
ROIC = (Net Operating Profit − Taxes)/(Total Capital)
Note that the numerator in the ROC fraction does not subtract interest expense, because demoninator includes debt capital.
Accounting liquidity (liquidity) is a measure of the ability of a debtor to pay their debts as and when they fall due. It is usually expressed as a ratio or a percentage of current liabilities.
Contents
[hide]
1 Calculating liquidity
2 Understanding the ratios
3 Liquidity in banking
4 See also
//
[edit] Calculating liquidity
For a corporation with a published balance sheet there are various ratios used to calculate a measure of liquidity. These include the following:
the current ratio, which is the simplest measure and is calculated by dividing the total current assets by the total current liabilities. A value of over * the quick ratio - calculated by deducting inventories and prepayments from current assets and then dividing by current liabilities - gives a measure of the ability to meet current liabilities from assets that can be readily sold. A better way for a trading corporation to meet liabilities is from cash flows, rather than through asset sales, so;
the operating cash flow ratio can be calculated by dividing the operating cash flow by current liabilities. This indicates the ability to service current debt from current income, rather than through asset sales.
[edit] Understanding the ratios
For different industries and differing legal systems the use of differing ratios and results would be appropriate. For example, in a country with a legal system that gives a slow or uncertain result a higher level of liquidity would be appropriate to cover the uncertainty related to the valuation of assets. A manufacturer with stable cash flows may find a lower quick ratio appropriate than an Internet-based start up corporation.
[edit] Liquidity in banking
Liquidity is a prime concern in a banking environment and a shortage of liquidity has often been a trigger for bank failures. Holding assets in a highly liquid form tends to reduce the income from that asset (cash, for example, is the most liquid asset of all but pays no interest) so banks will try to reduce liquid assets as far as possible. However, a bank without sufficient liquidity to meet the demands of their depositors risks experiencing a bank run. The result is that most banks now try to forecast their liquidity requirements and maintain emergency standby credit lines at other banks. Banking regulators also view liquidity as a major concern.
The current ratio is a financial ratio that measures whether or not a firm has enough resources to pay its debts over the next 12 months. It compares a firm's current assets to its current liabilities. It is expressed as follows:
For example, if WXY Company's current assets are $50,000,000 and its current liabilities are $40,000,000, then its current ratio would be $50,000,000 divided by $40,000,000, which equals 1.25. It means that for every dollar the company owes it has $1.25 available in current assets. A current ratio of assets to liabilities of 2:1 is usually considered to be acceptable (ie., your assets are twice your liabilities).[1]
The current ratio is an indication of a firm's market liquidity and ability to meet creditor's demands. Acceptable current ratios vary from industry to industry. If a company's current assets are in this range, then it is generally considered to have good short-term financial strength. If current liabilities exceed current assets (the current ratio is below 1), then the company may have problems meeting its short-term obligations. If the current ratio is too high, then the company may not be efficiently using its current assets.
In finance, the Acid-test or quick ratio or liquid ratio measures the ability of a company to use its near cash or quick assets to immediately extinguish or retire its current liabilities. Quick assets include those current assets that presumably can be quickly converted to cash at close to their book values. Such items are cash, cash equivalents such as marketable securities, and some accounts receivable. This ratio indicates a firm's capacity to maintain operations as usual with current cash or near cash reserves in bad periods. As such, this ratio implies a liquidation approach and does not recognize the revolving nature of current assets and liabilities. The ratio compares a company's cash and short-term investments to the financial liabilities the company is expected to incur within a year's time.
OR
Generally, the acid test ratio should be 1:1 or better, however this varies widely by industry. [1]
Receivable Turnover Ratio is one of the Accounting Liquidity ratios, a financial ratio. This ratio measures the number of times, on average, receivables (e.g. Accounts Receivable) are collected during the period. A popular variant of the receivables turnover ratio is to convert it into an Average Collection Period in terms of days. Remember that the Receivable turnover ratio is figured as "turnover times" and the Average collection period is in "days".
Inventory turnover ratio is one of the Accounting Liquidity ratios, a financial ratio. This ratio measures the number of times, on average, the inventory is sold during the period. Its purpose is to measure the liquidity of the inventory. A popular variant of the Inventory turnover ratio is to convert it into an average days to sell the inventory in terms of days. Remember that the Inventory turnover ratio is figured as "turnover times" and the average days to sell the inventory is in "days".
Inventory turnover ratio = Cost of goods sold / Average inventory[1]
Average days to sell the inventory = 365 / Inventory Turnover Ratio[2]
Exams-sep12
1) A balance sheet provides detailed information about a company’s assets, liabilities and shareholders’ equity.
2) Assets are things that a company owns that have value. This typically means they can either be sold or used by the company to make products or provide services that can be sold.
3) Liabilities are amounts of money that a company owes to others.
4) Shareholders’ equity is sometimes called capital or net worth. It’s the money that would be left if a company sold all of its assets and paid off all of its liabilities.
A company’s balance sheet is set up like the basic accounting equation shown above. On the left side of the balance sheet, companies list their 5) assets. On the right side, they list their 6) liabilities and 7)shareholders’ equity. Sometimes balance sheets show assets at the top, followed by liabilities, with shareholders’ equity at the bottom. 8) Assets are generally listed based on how quickly they will be converted into cash. 9) Current assets are things a company expects to convert to cash within one year.
A good example is inventory. Most companies expect to sell their inventory for cash within one year. 10) Non-current assets are things a company does not expect to convert to cash within one year or that would take longer than one year to sell.
Liabilities are generally listed based on their due dates. Liabilities are said to be either 11) current or 12) long-term. 13) Current liabilities are obligations a company expects to pay off within the year.14) Long-term liabilities are obligations due more than one year away.
15) Shareholders’ equity is the amount owners invested in the company’s stock plus or minus the company’s earnings or losses since inception. Sometimes companies distribute earnings, instead of retaining them. These distributions are called 16) dividends.
An 17) income statement is a report that shows how much revenue a company earned over a specific time period (usually for a year or some portion of a year).
An income statement also shows the 18) costs and expenses associated with earning that revenue. The literal “bottom line” of the statement usually shows the company’s 19) net earnings or 20) losses. This tells you how much the company earned or lost over the period.
Compute for the following using the financial statement provided:
Return on Equity
Return on Sales
Return on Total Assets
Debt:Equity Ratio
Net Worth
Dividend Earnings/Share
2) Assets are things that a company owns that have value. This typically means they can either be sold or used by the company to make products or provide services that can be sold.
3) Liabilities are amounts of money that a company owes to others.
4) Shareholders’ equity is sometimes called capital or net worth. It’s the money that would be left if a company sold all of its assets and paid off all of its liabilities.
A company’s balance sheet is set up like the basic accounting equation shown above. On the left side of the balance sheet, companies list their 5) assets. On the right side, they list their 6) liabilities and 7)shareholders’ equity. Sometimes balance sheets show assets at the top, followed by liabilities, with shareholders’ equity at the bottom. 8) Assets are generally listed based on how quickly they will be converted into cash. 9) Current assets are things a company expects to convert to cash within one year.
A good example is inventory. Most companies expect to sell their inventory for cash within one year. 10) Non-current assets are things a company does not expect to convert to cash within one year or that would take longer than one year to sell.
Liabilities are generally listed based on their due dates. Liabilities are said to be either 11) current or 12) long-term. 13) Current liabilities are obligations a company expects to pay off within the year.14) Long-term liabilities are obligations due more than one year away.
15) Shareholders’ equity is the amount owners invested in the company’s stock plus or minus the company’s earnings or losses since inception. Sometimes companies distribute earnings, instead of retaining them. These distributions are called 16) dividends.
An 17) income statement is a report that shows how much revenue a company earned over a specific time period (usually for a year or some portion of a year).
An income statement also shows the 18) costs and expenses associated with earning that revenue. The literal “bottom line” of the statement usually shows the company’s 19) net earnings or 20) losses. This tells you how much the company earned or lost over the period.
Compute for the following using the financial statement provided:
Return on Equity
Return on Sales
Return on Total Assets
Debt:Equity Ratio
Net Worth
Dividend Earnings/Share
Thursday, September 4, 2008
Balance Sheet Analysis
Balance Sheet Analysis
Introduction
In this section, we will look at some of the tools you can use in making an investment decision from balance sheet information. If you are not familiar with balance sheets, you are advised to first read the section entitled, "Understanding the Balance Sheet". It provides a good overview of the functions of a balance sheet and its components. We will cover the following topics here:
Why You Should Analyze a Balance Sheet
Liquidity Ratios
Leverage
Tying It All Together
A thorough analysis of a company's balance sheet is extremely important for both stock and bond investors.
Why You Should Analyze a Balance Sheet
The analysis of a balance sheet can identify potential liquidity problems. These may signify the company's inability to meet financial obligations. An investor could also spot the degree to which a company is leveraged, or indebted. An overly leveraged company may have difficulties raising future capital. Even more severe, they may be headed towards bankruptcy. These are just a few of the danger signs that can be detected with careful analysis of a balance sheet.
Beyond liquidity and leverage, the following section will discuss other analysis such as working capital and bankruptcy. As an investor, you will want to know if a company you are considering is in danger of not being able to make its payments. After all, some of the company's obligations will be to you if you choose to invest in it.
We will start with Liquidity Ratios, an important topic for all investors.
Liquidity Ratios
The following liquidity ratios are all designed to measure a company's ability to cover its short-term obligations. Companies will generally pay their interest payments and other short-term debts with current assets. Therefore, it is essential that a firm have an adequate surplus of current assets in order to meet their current liabilities. If a company has only illiquid assets, it may not be able to make payments on their debts. To measure a firm's ability to meet such short-term obligations, various ratios have been developed.
You will study the following balance sheet ratios:
Current Ratio
Acid Test (or Quick Ratio)
Working Capital
Leverage
These tools will be invaluable in making wise investment decisions.
Current Ratio
The Current Ratio measures a firm's ability to pay their current obligations. The greater extent to which current assets exceed current liabilities, the easier a company can meet its short-term obligations.
Current Assets
Current Ratio =
---------------------------
Current Liabilities
After calculating the Current Ratio for a company, you should compare it with other companies in the same industry. A ratio lower than that of the industry average suggests that the company may have liquidity problems. However, a significantly higher ratio may suggest that the company is not efficiently using its funds. A satisfactory Current Ratio for a company will be within close range of the industry average.
Acid Test or Quick Ratio
The Acid Test Ratio or Quick Ratio is very similar to the Current Ratio except for the fact that it excludes inventory. For this reason, it's also a more conservative ratio.
Current Assets - Inventory
Acid test =
---------------------------
Current Liabilities
Inventory is excluded in this ratio because, in many industries, inventory cannot be quickly converted to cash. If this is the case, inventory should not be included as an asset that can be used to pay off short-term obligations. Like the Current Ratio, to have an Acid Test Ratio within close range to the industry average is desirable.
Working Capital
Working Capital is simply the amount that current assets exceed current liabilities. Here it is in the form of the equation:
Working Capital = Current Assets - Current Liabilities
This formula is very similar to the current ratio. The only difference is that it gives you a dollar amount rather than a ratio. It too is calculated to determine a firm's ability to pay its short-term obligations. Working Capital can be viewed as somewhat of a security blanket. The greater the amount of Working Capital, the more security an investor can have that they will be able to meet their financial obligations.
You have just learned about liquidity and the ratios used to measure this. Many times a company does not have enough liquidity. This is often the cause of being over leveraged.
Leverage
Leverage is a ratio that measures a company's capital structure. In other words, it measures how a company finances their assets. Do they rely strictly on equity? Or, do they use a combination of equity and debt? The answers to these questions are of great importance to investors.
Long-term Debt
Leverage =
----------------------
Total Equity
A firm that finances its assets with a high percentage of debt is risking bankruptcy should it be unable to make its debt payments. This may happen if the economy of the business does not perform as well as expected. A firm with a lower percentage of debt has a bigger safety cushion should times turn bad.
A related side effect of being highly leveraged is the unwillingness of lenders to provide more debt financing. In this case, a firm that finds itself in a jam may have to issue stock on unfavorable terms. All in all, being highly leveraged is generally viewed as being disadvantageous due to the increased risk of bankruptcy, higher borrowing costs, and decreased financial flexibility.
On the other hand, using debt financing has advantages. Stockholder's potential return on their investment is greater when a firm borrows more. Borrowing also has some tax advantages.
The optimal capital structure for a company you invest in depends on which type of investor you are. A bondholder would prefer a company with very little debt financing because of the lower risk inherent in this type of capital structure. A stockholder would probably opt for a higher percentage of debt than the bondholder in a firm's capital structure. Yet, a company that is highly leveraged is also very risky for a stockholder.
When a firm becomes over leveraged, bankruptcy can result. Read on to learn more about this dreaded occurrence.
Tying It All Together
Analyzing a balance sheet is fundamental knowledge for anyone who wishes to carefully select solid and profitable investments. The balance sheet is the basic report of a firm's possessions, debts and capital. The composition of these three items will vary dramatically from firm to firm. As an investor, you need to know how to examine and compare balance sheets of different companies in order to select the investment that meets your needs.
After reading this section, you should have an understanding of liquidity, leverageand know how to apply basic ratios to measure each. These ratios should be compared to other firms in the same industry in order for them to have relevance. Be careful, however, that the firms are not fundamentally different even if they are in the same industry.
Introduction
In this section, we will look at some of the tools you can use in making an investment decision from balance sheet information. If you are not familiar with balance sheets, you are advised to first read the section entitled, "Understanding the Balance Sheet". It provides a good overview of the functions of a balance sheet and its components. We will cover the following topics here:
Why You Should Analyze a Balance Sheet
Liquidity Ratios
Leverage
Tying It All Together
A thorough analysis of a company's balance sheet is extremely important for both stock and bond investors.
Why You Should Analyze a Balance Sheet
The analysis of a balance sheet can identify potential liquidity problems. These may signify the company's inability to meet financial obligations. An investor could also spot the degree to which a company is leveraged, or indebted. An overly leveraged company may have difficulties raising future capital. Even more severe, they may be headed towards bankruptcy. These are just a few of the danger signs that can be detected with careful analysis of a balance sheet.
Beyond liquidity and leverage, the following section will discuss other analysis such as working capital and bankruptcy. As an investor, you will want to know if a company you are considering is in danger of not being able to make its payments. After all, some of the company's obligations will be to you if you choose to invest in it.
We will start with Liquidity Ratios, an important topic for all investors.
Liquidity Ratios
The following liquidity ratios are all designed to measure a company's ability to cover its short-term obligations. Companies will generally pay their interest payments and other short-term debts with current assets. Therefore, it is essential that a firm have an adequate surplus of current assets in order to meet their current liabilities. If a company has only illiquid assets, it may not be able to make payments on their debts. To measure a firm's ability to meet such short-term obligations, various ratios have been developed.
You will study the following balance sheet ratios:
Current Ratio
Acid Test (or Quick Ratio)
Working Capital
Leverage
These tools will be invaluable in making wise investment decisions.
Current Ratio
The Current Ratio measures a firm's ability to pay their current obligations. The greater extent to which current assets exceed current liabilities, the easier a company can meet its short-term obligations.
Current Assets
Current Ratio =
---------------------------
Current Liabilities
After calculating the Current Ratio for a company, you should compare it with other companies in the same industry. A ratio lower than that of the industry average suggests that the company may have liquidity problems. However, a significantly higher ratio may suggest that the company is not efficiently using its funds. A satisfactory Current Ratio for a company will be within close range of the industry average.
Acid Test or Quick Ratio
The Acid Test Ratio or Quick Ratio is very similar to the Current Ratio except for the fact that it excludes inventory. For this reason, it's also a more conservative ratio.
Current Assets - Inventory
Acid test =
---------------------------
Current Liabilities
Inventory is excluded in this ratio because, in many industries, inventory cannot be quickly converted to cash. If this is the case, inventory should not be included as an asset that can be used to pay off short-term obligations. Like the Current Ratio, to have an Acid Test Ratio within close range to the industry average is desirable.
Working Capital
Working Capital is simply the amount that current assets exceed current liabilities. Here it is in the form of the equation:
Working Capital = Current Assets - Current Liabilities
This formula is very similar to the current ratio. The only difference is that it gives you a dollar amount rather than a ratio. It too is calculated to determine a firm's ability to pay its short-term obligations. Working Capital can be viewed as somewhat of a security blanket. The greater the amount of Working Capital, the more security an investor can have that they will be able to meet their financial obligations.
You have just learned about liquidity and the ratios used to measure this. Many times a company does not have enough liquidity. This is often the cause of being over leveraged.
Leverage
Leverage is a ratio that measures a company's capital structure. In other words, it measures how a company finances their assets. Do they rely strictly on equity? Or, do they use a combination of equity and debt? The answers to these questions are of great importance to investors.
Long-term Debt
Leverage =
----------------------
Total Equity
A firm that finances its assets with a high percentage of debt is risking bankruptcy should it be unable to make its debt payments. This may happen if the economy of the business does not perform as well as expected. A firm with a lower percentage of debt has a bigger safety cushion should times turn bad.
A related side effect of being highly leveraged is the unwillingness of lenders to provide more debt financing. In this case, a firm that finds itself in a jam may have to issue stock on unfavorable terms. All in all, being highly leveraged is generally viewed as being disadvantageous due to the increased risk of bankruptcy, higher borrowing costs, and decreased financial flexibility.
On the other hand, using debt financing has advantages. Stockholder's potential return on their investment is greater when a firm borrows more. Borrowing also has some tax advantages.
The optimal capital structure for a company you invest in depends on which type of investor you are. A bondholder would prefer a company with very little debt financing because of the lower risk inherent in this type of capital structure. A stockholder would probably opt for a higher percentage of debt than the bondholder in a firm's capital structure. Yet, a company that is highly leveraged is also very risky for a stockholder.
When a firm becomes over leveraged, bankruptcy can result. Read on to learn more about this dreaded occurrence.
Tying It All Together
Analyzing a balance sheet is fundamental knowledge for anyone who wishes to carefully select solid and profitable investments. The balance sheet is the basic report of a firm's possessions, debts and capital. The composition of these three items will vary dramatically from firm to firm. As an investor, you need to know how to examine and compare balance sheets of different companies in order to select the investment that meets your needs.
After reading this section, you should have an understanding of liquidity, leverageand know how to apply basic ratios to measure each. These ratios should be compared to other firms in the same industry in order for them to have relevance. Be careful, however, that the firms are not fundamentally different even if they are in the same industry.
Understanding balance Sheets
Understanding Balance Sheets
Introduction
In this section, we will learn the importance of balance sheets to you as an investor. We will cover what they represent, how to understand them and how they are presented. We will also provide some useful equations and an example of a balance sheet.
This section will cover the following topics:
Understanding the Balance Sheet
Why Should the Balance Sheet Be Important to You?
The Basic Concept Behind a Balance Sheet
What Are Assets?
What Are Liabilities?
What Is Shareholders' Equity?
Example of a Balance Sheet
Tying It All Together
Understanding the Balance Sheet
In order to make an informed investment decision, you should review a company's balance sheet. Let's look at what a balance sheet entails.
The balance sheet is one of the most important financial statements of a company. It is reported to investors at least once per year. It may also be presented quarterly, semiannually or monthly. The balance sheet provides information on what the company owns (its assets), what it owes (its liabilities), and the value of the business to its stockholders (the shareholders' equity). The name, balance sheet, is derived from the fact that these accounts must always be in balance. Assets must always equal the sum of liabilities and shareholders' equity.
Why Should the Balance Sheet Be Important to You?
The balance sheet is the fundamental report of a company's possessions, debts and capital invested. Before investing in any company, an investor can use the balance sheet to examine the following:
Can the firm meet its financial obligations?
How much money has already been invested in this company?
Is the company overly indebted?
What kind of assets has the company purchased with its financing?
These are just a few of the many relevant questions you can answer by studying the balance sheet. The balance sheet provides a diligent investor with many clues to a firm's future performance. In this section, you will learn the basic building blocks necessary to do such analysis. Once you completely understand the balance sheet, making informed investment decisions should be much easier for you.
The Basic Concept Behind a Balance Sheet
The concept behind the balance sheet is very simple. In order to acquire assets, a firm must pay for them with either debt (liabilities) or with the owners' capital (shareholders' equity). Therefore, the following equation must hold true:
Assets = Liabilities + Shareholders' Equity
Total Liabilities
P30,000
Shareholders' Equity
P50,000
Total Assets
P80,000
What Are Assets?
Assets are economic resources that are expected to produce economic benefits for its owners. Assets can be buildings and machinery used to manufacture products. They can be patents or copyrights that provide financial advantages for their holder. Let us begin with a look at a few of the important types of assets that exist.
Current assets are assets that are usually converted to cash within one year. Bondholders and other creditors closely monitor a firm's current assets since interest payments are generally made from current assets. They include several forms of current assets:
Cash is known and loved by all. It is the most basic current asset. In addition to currency, bank accounts without restrictions, checks and drafts are also considered cash due to the ease in which one can turn these instruments into currency.
Cash equivalents are not cash but can be converted into cash so easily that they are considered equal to cash. Cash equivalents are generally highly liquid, short-term investments such as C.B.. government securities and money market funds.
Accounts receivable represent money customers owe to the firm. As more and more business is being done today with credit instead of cash, this item is a significant component of the balance sheet.
A firm's inventory is the stock of materials used to manufacture their products and the products themselves before they are sold. A manufacturing entity will often have three different types of inventory: raw materials, works-in-process, and finished goods. A retail firm's inventory generally will consist only of products purchased that have not been sold yet.
Now that we have looked at some of the most important short-term assets, let us move forward to examine long-term assets.
Long-Term Assets
Long-term assets are grouped into several categories. The following are some of the common terms you may encounter:
Fixed assets are those tangible assets with a useful life greater than one year. Generally, fixed assets refer to items such as equipment, buildings, production plants and property. On the balance sheet, these are valued at their cost. Depreciation is subtracted from all except land. Fixed assets are very important to a company because they represent long-term illiquid investments that a company expects will help it generate profits.
Depreciation is the process of allocating the original purchase price of a fixed asset over the course of its useful life. It appears in the balance sheet as a deduction from the original value of the fixed assets.
Intangible assets are non-physical assets such as copyrights, franchises and patents. To estimate their value is very difficult because they are intangible. Often there is no ready market for them. Nevertheless, for some companies, an intangible asset can be the most valuable asset it possesses.
Remember that every company will have different assets depending on its industry. However, it is important to know and understand the major accounts that will appear on most balance sheets. Now, we will talk about what the company owes to others: its liabilities.
What Are Liabilities?
Liabilities are obligations a company owes to outside parties. They represent rights of others to money or services of the company. Examples include bank loans, debts to suppliers and debts to employees. On the balance sheet, liabilities are generally broken down into current liabilities and long-term liabilities.
Current liabilities are those obligations that are usually paid within the year, such as accounts payable, interest on long-term debts, taxes payable, and dividends payable. Because current liabilities are usually paid with current assets, as an investor it is important to examine the degree to which current assets exceed current liabilities.
The most pervasive item in the current liability section of the balance sheet is accounts payable.
Accounts payable are debts owed to suppliers for the purchase of goods and services on an open account. Almost all firms buy some or all of their goods on account. Therefore, you will often see accounts payable on most balance sheets.
Long-term debt is a liability of a period greater than one year. It usually refers to loans a company takes out. These debts are often paid in installments. If this is the case, the portion to be paid off in the current year is considered a current liability.
That wraps up our short review of liabilities. You only have one piece left of the balance sheet left to learn - shareholders' equity. Remember that assets minus liabilities equals shareholders' equity.
What Is Shareholders' Equity?
Shareholders' equity is the value of a business to its owners after all of its obligations have been met. This net worth belongs to the owners. Shareholders' equity generally reflects the amount of capital the owners invested plus any profits that the company generates that are subsequently reinvested in the company. This reinvested income is called retained earnings.
Now that we understand the major components, let us move forward to examine a sample balance sheet.
Example of a Balance Sheet
Below you will see an example of a balance sheet and the various components that you have been studying earlier. The most important lesson to learn in viewing this example is that the basic balance sheet equation holds true.
Assets = Liabilities + Shareholders' Equity
The following balance sheet is arranged vertically starting with assets and then proceeding to detail liabilities and shareholders' equity. Note that the balance sheet gives a snapshot of the assets, liabilities and equity for a given day. In our case, that is December 31. Often a balance sheet shows information for two successive periods as the one below. This gives the investor a better perspective of the company's operations by showing areas of growth.
Judiite’s Potato & Pasta, Inc.Balance Sheet Ending December 31st
2006
2007
ASSETS
Current Assets
Cash and cashequivalents
P10,000
10,000
Accounts receivable
35,000
30,000
Inventory
25,000
20,000
Total Current Assets
70,000
60,000
Fixed Assets
Plant and machinery
P20,000
20,000
Less depreciation
-12,000
-10,000
Land
8,000
8,000
Intangible Assets
2,000
1,500
TOTAL ASSETS
88,000
79,500
LIABILITIES AND SHAREHOLDERS' EQUITY
Liabilities
Accounts payable
P 20,000
15,500
Taxes payable
5,000
4,000
Long-term bonds issued
15,000
10,000
TOTAL LIABILITIES
40,000
29,500
SHAREHOLDERS' EQUITY
Common stock
P 40,000
40,000
Retained earnings
8,000
10,000
TOTAL SHAREHOLDERS' EQUITY
48,000
50,000
LIABILITIES & SHAREHOLDERS' EQUITY
P 88,000
79,500
As you can see, total liabilities and shareholders' equity equals total assets.
Tying It All Together
You have now learned the basic construction of a balance sheet and should have a clearer understanding of its importance. The basic financial statement reveals what a company owns, what a company owes to others, and the investments its owners made. It details how a company finances its operations and what assets the company has acquired with this financing.
The key to understanding the balance sheet is in the most basic and fundamental of all accounting equations: Assets must equal liabilities plus shareholders' equity. All of our further balance sheet analysis will be based upon that building block.
Introduction
In this section, we will learn the importance of balance sheets to you as an investor. We will cover what they represent, how to understand them and how they are presented. We will also provide some useful equations and an example of a balance sheet.
This section will cover the following topics:
Understanding the Balance Sheet
Why Should the Balance Sheet Be Important to You?
The Basic Concept Behind a Balance Sheet
What Are Assets?
What Are Liabilities?
What Is Shareholders' Equity?
Example of a Balance Sheet
Tying It All Together
Understanding the Balance Sheet
In order to make an informed investment decision, you should review a company's balance sheet. Let's look at what a balance sheet entails.
The balance sheet is one of the most important financial statements of a company. It is reported to investors at least once per year. It may also be presented quarterly, semiannually or monthly. The balance sheet provides information on what the company owns (its assets), what it owes (its liabilities), and the value of the business to its stockholders (the shareholders' equity). The name, balance sheet, is derived from the fact that these accounts must always be in balance. Assets must always equal the sum of liabilities and shareholders' equity.
Why Should the Balance Sheet Be Important to You?
The balance sheet is the fundamental report of a company's possessions, debts and capital invested. Before investing in any company, an investor can use the balance sheet to examine the following:
Can the firm meet its financial obligations?
How much money has already been invested in this company?
Is the company overly indebted?
What kind of assets has the company purchased with its financing?
These are just a few of the many relevant questions you can answer by studying the balance sheet. The balance sheet provides a diligent investor with many clues to a firm's future performance. In this section, you will learn the basic building blocks necessary to do such analysis. Once you completely understand the balance sheet, making informed investment decisions should be much easier for you.
The Basic Concept Behind a Balance Sheet
The concept behind the balance sheet is very simple. In order to acquire assets, a firm must pay for them with either debt (liabilities) or with the owners' capital (shareholders' equity). Therefore, the following equation must hold true:
Assets = Liabilities + Shareholders' Equity
Total Liabilities
P30,000
Shareholders' Equity
P50,000
Total Assets
P80,000
What Are Assets?
Assets are economic resources that are expected to produce economic benefits for its owners. Assets can be buildings and machinery used to manufacture products. They can be patents or copyrights that provide financial advantages for their holder. Let us begin with a look at a few of the important types of assets that exist.
Current assets are assets that are usually converted to cash within one year. Bondholders and other creditors closely monitor a firm's current assets since interest payments are generally made from current assets. They include several forms of current assets:
Cash is known and loved by all. It is the most basic current asset. In addition to currency, bank accounts without restrictions, checks and drafts are also considered cash due to the ease in which one can turn these instruments into currency.
Cash equivalents are not cash but can be converted into cash so easily that they are considered equal to cash. Cash equivalents are generally highly liquid, short-term investments such as C.B.. government securities and money market funds.
Accounts receivable represent money customers owe to the firm. As more and more business is being done today with credit instead of cash, this item is a significant component of the balance sheet.
A firm's inventory is the stock of materials used to manufacture their products and the products themselves before they are sold. A manufacturing entity will often have three different types of inventory: raw materials, works-in-process, and finished goods. A retail firm's inventory generally will consist only of products purchased that have not been sold yet.
Now that we have looked at some of the most important short-term assets, let us move forward to examine long-term assets.
Long-Term Assets
Long-term assets are grouped into several categories. The following are some of the common terms you may encounter:
Fixed assets are those tangible assets with a useful life greater than one year. Generally, fixed assets refer to items such as equipment, buildings, production plants and property. On the balance sheet, these are valued at their cost. Depreciation is subtracted from all except land. Fixed assets are very important to a company because they represent long-term illiquid investments that a company expects will help it generate profits.
Depreciation is the process of allocating the original purchase price of a fixed asset over the course of its useful life. It appears in the balance sheet as a deduction from the original value of the fixed assets.
Intangible assets are non-physical assets such as copyrights, franchises and patents. To estimate their value is very difficult because they are intangible. Often there is no ready market for them. Nevertheless, for some companies, an intangible asset can be the most valuable asset it possesses.
Remember that every company will have different assets depending on its industry. However, it is important to know and understand the major accounts that will appear on most balance sheets. Now, we will talk about what the company owes to others: its liabilities.
What Are Liabilities?
Liabilities are obligations a company owes to outside parties. They represent rights of others to money or services of the company. Examples include bank loans, debts to suppliers and debts to employees. On the balance sheet, liabilities are generally broken down into current liabilities and long-term liabilities.
Current liabilities are those obligations that are usually paid within the year, such as accounts payable, interest on long-term debts, taxes payable, and dividends payable. Because current liabilities are usually paid with current assets, as an investor it is important to examine the degree to which current assets exceed current liabilities.
The most pervasive item in the current liability section of the balance sheet is accounts payable.
Accounts payable are debts owed to suppliers for the purchase of goods and services on an open account. Almost all firms buy some or all of their goods on account. Therefore, you will often see accounts payable on most balance sheets.
Long-term debt is a liability of a period greater than one year. It usually refers to loans a company takes out. These debts are often paid in installments. If this is the case, the portion to be paid off in the current year is considered a current liability.
That wraps up our short review of liabilities. You only have one piece left of the balance sheet left to learn - shareholders' equity. Remember that assets minus liabilities equals shareholders' equity.
What Is Shareholders' Equity?
Shareholders' equity is the value of a business to its owners after all of its obligations have been met. This net worth belongs to the owners. Shareholders' equity generally reflects the amount of capital the owners invested plus any profits that the company generates that are subsequently reinvested in the company. This reinvested income is called retained earnings.
Now that we understand the major components, let us move forward to examine a sample balance sheet.
Example of a Balance Sheet
Below you will see an example of a balance sheet and the various components that you have been studying earlier. The most important lesson to learn in viewing this example is that the basic balance sheet equation holds true.
Assets = Liabilities + Shareholders' Equity
The following balance sheet is arranged vertically starting with assets and then proceeding to detail liabilities and shareholders' equity. Note that the balance sheet gives a snapshot of the assets, liabilities and equity for a given day. In our case, that is December 31. Often a balance sheet shows information for two successive periods as the one below. This gives the investor a better perspective of the company's operations by showing areas of growth.
Judiite’s Potato & Pasta, Inc.Balance Sheet Ending December 31st
2006
2007
ASSETS
Current Assets
Cash and cashequivalents
P10,000
10,000
Accounts receivable
35,000
30,000
Inventory
25,000
20,000
Total Current Assets
70,000
60,000
Fixed Assets
Plant and machinery
P20,000
20,000
Less depreciation
-12,000
-10,000
Land
8,000
8,000
Intangible Assets
2,000
1,500
TOTAL ASSETS
88,000
79,500
LIABILITIES AND SHAREHOLDERS' EQUITY
Liabilities
Accounts payable
P 20,000
15,500
Taxes payable
5,000
4,000
Long-term bonds issued
15,000
10,000
TOTAL LIABILITIES
40,000
29,500
SHAREHOLDERS' EQUITY
Common stock
P 40,000
40,000
Retained earnings
8,000
10,000
TOTAL SHAREHOLDERS' EQUITY
48,000
50,000
LIABILITIES & SHAREHOLDERS' EQUITY
P 88,000
79,500
As you can see, total liabilities and shareholders' equity equals total assets.
Tying It All Together
You have now learned the basic construction of a balance sheet and should have a clearer understanding of its importance. The basic financial statement reveals what a company owns, what a company owes to others, and the investments its owners made. It details how a company finances its operations and what assets the company has acquired with this financing.
The key to understanding the balance sheet is in the most basic and fundamental of all accounting equations: Assets must equal liabilities plus shareholders' equity. All of our further balance sheet analysis will be based upon that building block.
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