FINANCIAL STATEMENTS

A financial statement is more than just a snapshot of your business’ health

that you provide to shareholders or potential investors: It’s also a powerful
diagnostic tool business owners can use to evaluate their firm’s strengths
and weaknesses and chart the way forward.

This three-part series will explain how to craft a balance, income and cash
flow statement, guiding you through the criteria and terminology,
demonstrating how to calculate the ratios that reveal your company’s fiscal
health and its standing among the competition, and suggesting ways to
improve your outlook.

A brief explanation of the three statements:

• Balance sheet: The balance sheet is often described as a snapshot of
a company’s performance at a given time, such as the end of a quarter
or fiscal year. The balance sheet identifies your
company’s assets and liabilities -- divided into near- and long-term
obligations -- and stockholders’ equity.
• Income statement: Also known as a profit-and-loss statement, the
income statement summarizes a company’s revenue and expenses for a
given time period.
• Cash flow statement: This records the amounts of cash and cash
equivalents that flowed into and out of a company in a given period. It
is used to measure how much cash a company has on hand, which
influences its ability to pay suppliers and employees and to meet other
near-term obligations.

Interpreting the balance sheet

The information provided

here allows you to calculate several financial ratios that measure company
performance. Additionally, current balance sheets should always present
data from at least one previous period, so you can compare how financial
performance has changed.

Identify a public company in the same industry as your startup and download
their financial statements from their Web site. Using Target Corp. as an
example, we’ll analyze the data in their balance sheet. Here are a few key
ratios to calculate. Note that all figures represent millions of dollars.

Quick ratio: This measures Target’s ability to meet its obligations without
selling off inventory; the higher the result, the better. It is expressed as
current assets minus inventories, divided by current liabilities. In Target’s
case, that is 14,706 minus 6,254, divided by 11,117, which equals 0.76.

Interpretation: If this number declines over time or falls short of your

benchmark, you may be investing too much capital in inventory or you may
have taken on too much short-term debt.
Current ratio: This is another test of short-term liquidity, determined by
dividing current assets by current liabilities. In Target’s case, that is
equivalent to 14,706 divided by 11,117, which equals 1.32.

Interpretation: This number should be above 1, and it’s usually a sign of

strength if it exceeds 2. If this number is below 1, that means your short-
term liabilities exceed your short-term assets. A liability is considered
current if it is due within a year. An asset is current if it can be converted
into cash within a year.

Debt-to-equity ratio: In brief, divide total debt by total equity. In

Target’s case, the denominator is termed a shareholder’s investment
because Target is a public company. Using Target’s data, that ratio is
expressed as 8,675 divided by 15,633, which equals 0.555.

Interpretation: Long-term creditors will view this number as a measure of

how aggressive your firm is. If your business is already levered up with debt,
they may be reluctant to offer additional financing.

Working capital: This refers to the cash available for daily operations. It is
derived by subtracting current liabilities from current assets, which in this
example is 14,706 minus 11,117, which equals 3,589.

Interpretation: If this number is negative, that means your firm is unable to

meet its current obligations. To improve this number, examine your inventory
management practices; a backup of goods and the resulting loss in sales can
take a toll on your business’s cash resources.

Interpreting the income statements

Gross profit margin: The money Target earns from selling a T-shirt, minus
what it paid for that item -- known as cost of goods sold, or COGS -- is
called gross profit. Sales minus COGS, divided by sales, yields the gross
profit margin. According to Target’s income statement, that would be
59,490 minus 39,399, divided by 59,490, which equals 0.337, or 33.7
percent.

Operating income: This is gross profit minus operating expenses minus

depreciation. It is also called EBIT (earnings before interest and taxes).
Using Target’s data, the formula would be expressed as: 59,490 minus
39,399 minus 12,819 minus 707 minus 1,496, which equals 5,069.
Operating profit margin: Use the total derived in the previous step and
divide it by total sales. In this case the equation is 5,069 divided by 59,490,
which equals .085, or 8.5 percent.

Interpretation: This tally is also known as EBIT margin and is an effective

way to measure operational efficiency. If you find this number to be low,
either raise revenues or cut costs. It may help to analyze which of your
customers are the most profitable and concentrate your efforts there.

Net profit margin: Net earnings divided by total revenue yields the net
profit margin. In this case, 2,787 divided by 59,490, which equals .047, or
4.7 percent.

ROA: This stands for return on assets and measures how much profit a
company is generating for each dollar of assets. Calculate ROA by dividing
the revenue figure from the income statement by assets from the balance
sheet. For Target, that equates to 59,490 divided by 14,706, which equals
4.04. In other words, for every dollar Target has in assets, it is able to
generate $4.04 of revenue.

ROE: The same idea as above, but replacing assets with the equity. In this
case, 59,490 divided by 15,633, which equals 3.81.

Accounts receivable collection: Many businesses experience a lag between

the time they bill customers and when they see the revenue. This may be due
to trade credit or because customers are not paying. While you can note this
potential revenue in the balance sheet under accounts receivable, if you’re
not able to collect it, eventually your business will lack sufficient cash.

Interpretation: To measure how many days it takes to collect all accounts

receivable, use this formula: 365 (days) divided by accounts receivable
turnover (total net sales divided by accounts receivable). In Target’s case,
that equates to 365 divided by the sum of 59,490 divided by 6,194, which
equals 38. This means that, on average, it takes Target 38 days to collect on
its accounts. If you find your business has a healthy balance sheet but is
short on cash, increase collection on outstanding accounts.

Interpreting cash flow statements

A cash flow statement, along with the balance sheet and income statement,
are the three most common financial statements used to gauge a company’s
performance and overall health. The same accounting data is used in
preparing all three statements, but each takes a company’s pulse in a
different area.

The cash flow statement discloses how a company raised money and how it
spent those funds during a given period. It is also an analytical tool,
measuring an enterprise’s ability to cover its expenses in the near term.
Generally speaking, if a company is consistently bringing in more cash than it
spends, that company is considered to be of good value.
A cash flow statement is divided into three parts: operations, investing and
financing. The following is an analysis of a real-world cash flow statement
belonging to Target Corp. Note that all figures represent millions of dollars.

Cash from operations: This is cash that was generated over the year from
the company’s core business transactions. Note how the statement starts
with net earnings and works backward, adding in depreciation and
subtracting out inventory and accounts receivable. In simple terms, this is
earnings before interest and taxes (EBIT) plus depreciation minus taxes.

Interpretation: This may serve as a better indicator than earnings, since non
cash earnings can’t be used to pay off bills.

Cash from investing: Some businesses will invest outside their core
operations or acquire new companies to expand their reach.

Interpretation: This portion of the cash flow statement accounts for cash
used to make new investments, as well as proceeds gained from previous
investments. In Target’s case, this number in 2006 was -4,693, which shows
the company spent significant cash investing in projects it hopes will lead to
future growth.

Cash from financing: This last section refers to the movement of cash from
financing activities. Two common financing activities are taking on a loan or
issuing stock to new investors. Dividends to current investors also fit in
here. Again, Target reports a negative number for 2006, -1,004. But this
should not be misconstrued: The company paid off 1,155 of its previous debt,
paid out 380 in dividends and repurchased 901 of company stock.

Interpretation: Investors will like these last two items, since they reap the
dividends, and it signals that Target is confident in its stock performance
and wants to keep it for the company’s gain. A simple formula for this
section: cash from issuing stock minus dividends paid, minus cash used to
acquire stock.

The final step in analyzing cash flow is to add the cash balances from the
reporting year (2006) and the previous year (2005); in Target’s case that’s
-835 plus 1,648, which equals 813. Even though Target ran a negative cash
balance in both years, it still has an overall positive cash balance due to its
high cash surplus in 2004.

TREND ANALYSIS

An aspect of technical analysis that tries to predict the future movement of

a stock based on past data. Trend analysis is based on the idea that what has
happened in the past gives traders an idea of what will happen in the future.

There are three main types of trends: short-, intermediate- and long-term.

Trend analysis tries to predict a trend like a bull market run and ride that
trend until data suggests a trend reversal (e.g. bull to bear market). Trend
analysis is helpful because moving with trends, and not against them, will lead
to profit for an investor.

USING FINANCIAL RATIOS.

A. Accurate financial information forms the basis of the financial

analysis performed by accountants.
1. FINANCIAL RATIOS are helpful in analyzing the actual
performance of the company compared to its financial
objectives.
2. They also provide insights into the firm’s performance
compared to other firms in the industry.
B. LIQUIDITY RATIOS measure the company’s ability to pay its short
term debts.
1. These short-term debts are expected to be repaid within one
year.
2. The CURRENT RATIO is the ratio of a firm’s current assets to
its current liabilities.
a. current ratio = current assets current liabilities
b. The ratio should be compared to competing firms within
the industry.
 3. The ACID-TEST RATIO (or QUICK RATIO) measures the
cash, marketable securities, and receivables of the firm, to its
current liabilities.
a. acid-test ratio = cash + marketable securities +
receivables current liabilities
b. This ratio is important to firms that have difficulty
converting inventory into quick cash.
C. LEVERAGE (DEBT) RATIOS refer to the degree to which a firm
relies on borrowed funds in its operations.
1. The DEBT TO OWNERS’ EQUITY RATIO measures the
degree to which the company is financed by borrowed funds
that must be repaid.
a. debt to owners’ equity ratio = total liabilities owners’
equity
b. A ratio above 1 (or 100%) would show that a firm actually
has more debt than equity.
2. It is important to compare ratios to other firms in the same
industry.
D. PROFITABILITY (PERFORMANCE) RATIOS measure how
effectively the firm is using its various resources to achieve profits.
1. Management’s performance is often measured by using
profitability ratios.
2. A new Accounting Standards Board rule went into effect at the
end if 1997 requiring companies to report their quarterly
earning per share two ways: basic and undiluted.
3. BASIC EARNINGS PER SHARE (BASIC EPS) measures the
amount of profit earned by a company for each share of
common stock it has outstanding.
a. Earnings help to stimulate growth and pay for
stockholders’ dividends.
b. basic earnings per share = net income after
taxes #shares common stock outstanding
4. DILUTED EARNINGS PER SHARE (DILUTED EPS) measures
the amount of profit earned by a company for each share of
outstanding common stock, but also takes into consideration
stock options, warrants, preferred stock, and convertible debt
securities which can be converted into common stock.
 5. RETURN ON SALES is calculated by comparing a company’s net
income with its total sales.
a. return on sales = net income net sales
b. Firms use this ratio to see if they are doing as well as
other companies they compete against in generating
income from sales.
6. RETURN ON EQUITY measures how much was earned for each
dollar invested by owners.
a. It is calculated by comparing a company’s net income with
its total owner’s equity.
b. return on equity = net income after taxes total owners’
equity
c. The higher the risk involved in an industry, the higher
the return investors expect on their investment.
7. These and other profitability ratios are vital measurements of
company growth and management performance.
E. ACTIVITY RATIOS measure the effectiveness of the firm’s
management in using the assets that are available.
1. INVENTORY TURNOVER RATIO measures the speed of
inventory moving through the firm and its conversion into sales.
a. inventory turnover ratio = cost of goods sold average
inventory
b. The more efficiently a firm manages its inventory, the
higher the return.
c. A lower than average inventory turnover ratio often
indicates obsolete merchandise on hand or poor buying
practices.
d. Inventory control is needed to ensure proper
performance
F. Finance professionals use several other specific ratios to learn more
about a firm’s financial condition.