Some liabilities have low interest rates and some have no interest associated with them. For example, some of a company’s accounts payable may allow payment in 30 days. With those payables it is better to have the liability and to keep your cash in the bank until they become due.

In our personal lives, our first house was probably purchased with a downpayment and mortgage loan. That mortgage loan was a big liability, but it allowed us to upgrade our living space. I viewed my mortgage loan liability as a good thing because it allowed me to own a nice home in a beautiful neighborhood.

So some liabilities are good—especially the ones that have a very low interest rate. Too many liabilities could cause financial hardships.

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The size of the advantage depends on the income tax rate of the company paying the interest. For example, if a corporation issues $10,000,000 of bonds with an interest rate of 8%, its annual interest expense will be $800,000. When the $800,000 of interest expense is entered on the corporation’s income tax return, its taxable income will decrease by $800,000. If the corporation’s combined federal and state income tax rate on this increment is 40%, the corporation will avoid or save paying income taxes of $320,000 ($800,000 of less taxable income X 40%). If the corporation’s income tax rate on this increment is 30%, the corporation will save paying income taxes of $240,000 ($800,000 X 30%).

Due to the income tax savings, the cost of the borrowed money is reduced. For a corporation in the 40% tax bracket, its net cost of the borrowed money is $480,000 ($800,000 of interest minus $320,000 of income tax savings) for a net rate of 4.8% ($480,000 of net expense divided by $10,000,000). For a corporation with a combined tax rate of 30%, the net cost of the borrowed money will be $560,000 or a net rate of 5.6% of $10,000,000.

For example, a corporation might want to see the effects of three different financing options. Therefore, it prepares projected balance sheets, income statements, and statements of cash flows. These projected financial statements are referred to as pro forma financial statements.

Other comprehensive income includes unrealized gains and losses on certain investments in securites, foreign currency items, and certain pension liability adjustments.

Net income is reported on the income statement and is included in the retained earnings section of stockholders’ equity.  Other comprehensive income items are not reported on the income statement, and are included in the accumulated other comprehensive income section of stockholders’ equity.

The accounting for comprehensive income is provided in the Statement of Financial Accounting Standards No. 130, Reporting Comprehensive Income, available for reading at www.FASB.org/st.

The unrealized holding gain is reported on the balance sheet by 1) increasing the asset available-for-sale securities, and 2) increasing the stockholders’ equity component accumulated other comprehensive income.  Note that the holding gains on available-for-sale securities are not reported on the income statement.

Learn more about unrealized gains and other comprehensive income at www.FASB.org/st.

A second advantage of financing asset with bonds instead of stock is that the ownership interest in the corporation will not be diluted by adding more owners. Bondholders and other lenders are not owners of the assets or of the corporation. Therefore, all of the gain in the value of the assets belongs to the stockholders. The bondholders will receive only the agreed upon interest.  This is related to the concept of leverage or trading on equity. By issuing debt, the corporation gets to control a large asset by using other people’s money instead of its own. If the asset ends up being very profitable, all of its earnings minus the interest, will enhance the owners’ financial position.

For example, the numerator in the inventory turnover ratio is the cost of goods sold for the 365-day year, while the denominator reflects the cost of inventory for a just one moment at the end of the last day of the accounting year. To overcome this shortcoming, the denominator needs to be representative of all of the moments during the year.

When the inventory amount on last year’s balance sheet and the amount on this year’s balance sheet are the only amounts available, it is common to use the average of these two balance sheet amounts in the denominator.

Using the average of only two days can also be misleading if the company’s year ends at the low point of business activity. For example, when a company’s peak season is August through May, it is common to set the accounting year to be July1 through June 30. At June 30 its inventory will likely be at their lowest point of the whole year and will not be representative of the amounts during the months of August through May.

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These efficiency ratios include 1) accounts receivable turnover ratio, and the related ratio days’ credit sales in accounts receivable; 2) inventory turnover, and the related ratio days’ cost of sales in inventory; 3) total asset tunover; and 4) fixed asset turnover.

The accounts receivable turnover ratio and the inventory turnover ratio are also used in the context of a firm’s liquidity.

The total asset turnover and fixed asset turnover are indicators of a company’s effectiveness in utilizing its assets.

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Here is an example of window dressing. A company operates throughout the year with a negative balance in its general ledger Cash account. (Its balance at the bank is positive due to the time it takes for its checks to clear its bank account.)  Since the financial statements report the Cash amount appearing in its general ledger account, the financial statements would report a negative amount of Cash. However, the company does not want its December 31 balance sheet to report a negative cash balance, since it will be reviewed by many outsiders. To avoid reporting a negative cash balance the company does not make the payments for amounts that should be paid between December 26 and December 31. This postponement of payments allows its book amount of Cash to temporarily be a positive amount. Then on January 2, the company issues checks for all of the amounts that normally would have been paid at the end of December.

Trading on equity occurs when a corporation uses bonds, other debt, and preferred stock to increase its earnings on common stock. For example, a corporation might use long term debt to purchase assets that are expected to earn more than the interest on the debt. The earnings in excess of the interest expense on the new debt will increase the earnings of the corporation’s common stockholders. The increase in earnings indicates that the corporation was successful in trading on equity.

If the newly purchased assets earn less than the interest expense on the new debt, the earnings of the common stockholders will decrease.

If I want to see the trend of a company’s revenues, net income, and number of clients during the years 2001 through 2007, trend analysis will present 2001 as the base year and the 2001 amounts will be restated to be 100. The amounts for the years 2002 through 2007 will be presented as the percentages of the 2001 amounts. In other words, each year’s amounts will be divided by the 2001 amounts and the resulting percentage will be presented. For example, revenues for the years 2001 through 2007 might have been $31,691,000; $40,930,000; $50,704,00; $63,891,000; $79,341,000; $101,154,000; $120,200,000. These revenue amounts will be restated to be 100, 129, 160, 202, 250, 319, and 379. Let’s assume that the net income amounts divided by the 2001 amount ended up as 100, 147, 206, 253, 343, 467, and 423. The number of clients when divided by the base year amount are 100, 122, 149, 184, 229, 277, and 317.  From this trend analysis we can see that revenues in 2007 were 379% of the 2001 revenues, net income in 2007 was 467% of the the 2001 net income, and the number of clients in 2007 was 317% of the number in 2001. Using the restated amounts from trend analysis makes it much easier to see how effective and efficient the company has been during the recent years.

Trend analysis can also include the monitoring of a company’s financial ratios over a period of many years.

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Another source for your industry’s financial ratios is your industry’s trade association, if it collects financial information from its members.

In addition to comparing your company’s financial ratios to its industry, you will want to compare your company’s financial ratios to its own past and future financial ratios. Spotting a trend early can be very beneficial.

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Learn more about Inventory and Cost of Goods Sold.

This will mean that the profitability ratios will be smaller under LIFO than FIFO. The profitability ratios include profit margin, return on assets, and return on stockholders’ equity.

The inventory turnover ratio will be higher when LIFO is used during periods of increasing costs. The reason is that the cost of goods sold will be higher and the inventory costs will be lower under LIFO than under FIFO.

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To illustrate the accounts receivable collection period, let’s assume a corporation had net credit sales of $360,000 during the past year and its accounts receivable balance was on average $40,000. The average credit sales per day were approximately $1,000 per day ($360,000 of annual credit sales divided by 360 or 365 days per year). The average accounts receivable balance of $40,000 divided by $1,000 of credit sales per day equals 40 days.

An alternative calculation is to use the accounts receivable turnover ratio. In our example, the accounts receivable ratio is 9 times per year ($360,000 of net credit sales divided by $40,000—the average accounts receivable balance). 360 days per year divided by the accounts receivable turnover of 9 equals 40 days.

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The net amount of fixed assets is the amount of property, plant and equipment reported on the balance sheet after deducting the accumulated depreciation. Ideally, you should use the average amount of net fixed assets during the year of the net sales.

A corporation having property, plant and equipment with an average gross amount of $10 million and an average accumulated depreciation of $4 million would have average net fixed assets of $6 million. If its net sales were $18 million, its fixed asset turnover would be 3 ($18 million of net sales divided by $6 million of average net fixed assets).

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Usually, fast growing corporations have a low dividend yield. Public utilities generally have high dividend yields.

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The calculation of the debt ratio is: Total Liabilities divided by Total Assets.

The debt ratio indicates the percentage of the total asset amounts stated on the balance sheet that is owed to creditors.

A high debt ratio indicates that a corporation has a high level of financial leverage.

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The calculation of the dividend payout ratio is the cash dividends per share of common stock divided by the earnings per share of common stock.

A fast growing corporation often has a low dividend payout ratio in order to retain and reinvest its earnings in additional income producing assets.

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A corporation with a high price earnings ratio is expected to have above average increases in its future earnings per share.

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Assume a product has a cost of $75 and a selling price of $100. Since the gross profit is defined as selling price minus the cost of goods sold, this product will have a gross profit of $25 ($100 minus  $75). The gross margin or gross profit percentage is 25% (gross profit of $25 divided by selling price of $100). The mark up of $25 on the cost of $75 equals 33.333% ($25 divided by $75).

Let’s prove this with one more example. Assume you have a product that you purchased for $9. If you mark it up by 33.333%, you will have a mark up of $3 and the product will sell for $12. The income statement will show a sale of $12 minus its cost of $9 for a gross profit of $3. The gross profit of $3 divided by the selling price of $12 equals a 25% gross margin or gross profit percentage or gross profit ratio.

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For example, a company’s sales may have increased 25% during the past year. However, all of the sales increase was the result of having acquired a competitor. Therefore, it had no organic growth.

AccountingCoach.com has a Dictionary of more than 1,000 accounting related terms.

Others use the term gross margin to mean the gross profit as a percentage of net sales. Perhaps the term gross profit margin means the gross profit percentage or the gross margin ratio.

Learn more about the Income Statement by using the free Explanation of the Income Statement.

For example, if a corporation without preferred stock has stockholders’ equity on December 31, 2007 of $12,421,000 and it has 1,000,000 shares of common stock outstanding on that date, its book value per share is $12.42.

Keep in mind that the book value per share will not be the same as the market value per share. One reason is that a corporation’s stockholders’ equity is simply the difference between the total amount of assets reported on the balance sheet and the total amount of liabilities reported. Long term assets are generally reported at original cost less accumulated depreciation and some valuable assets such as trade names might not be listed on the balance sheet.

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Let’s assume that during the year 2007 a corporation had net sales of $2,100,000 and its total assets during the same 12 month period averaged $1,400,000. The company’s total asset turnover for 2007 was 1.5 (net sales of $2,100,000 divided by $1,400,000 of average total assets).

This ratio will vary by industry, as some industries are more capital intensive than others. Always compare your company’s financial ratios to the ratios of other companies in the same industry.

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Let’s assume that a company had $60,000 of net income after tax during the year 2007. During the same 12 month period its total assets averaged $1,000,000. Its return on assets ratio for 2007 was 6% ($60,000 divided by $1,000,000).

You would compare this company’s return on assets to other companies in the same industry.

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The working capital turnover ratio is calculated as follows: net annual sales divided by the average amount of working capital during the same 12 month period.

For example, if a company’s net sales for the year 2007 were $2,400,000 and its average amount of working capital during the year 2007 was $400,000, its working capital turnover ratio was 6 ($2,400,000 divided by $400,000).

Working capital is defined as the total amount of current assets minus the total amount of current liabilities. As indicated above, you should use the average amount of working capital for the year of the net sales.

As with most financial ratios, you should compare the working capital turnover ratio to other companies in the same industry and to the same company’s past and planned working capital turnover ratio.

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Contribution Margin is Net Sales minus the variable product costs and the variable period expenses. The Contribution Margin Ratio is the Contribution Margin as a percentage of Net Sales. 

Let’s illustrate the difference between gross margin and contribution margin with the following information:  A company had Net Sales of $600,000 during the past year. Its inventory of goods was the same quantity at the beginning and at the end of year. Its Cost of Goods Sold consisted af $120,000 of variable costs and $200,000 of fixed costs. Its selling and administrative expenses were $40,000 of variable and $150,000 of fixed expenses. 

The company’s Gross Margin is: Net Sales of $600,000 minus its Cost of Goods Sold of $320,000 ($120,000 + $200,000) for a Gross Profit of $280,000 ($600,000 - $320,000). The Gross Margin or Gross Profit Percentage is the Gross Profit of $280,000 divided by $600,000, or 46.7%.

The company’s Contribution Margin is: Net Sales of $600,000 minus the variable product costs of $120,000 and the variable expenses of $40,000 for a Contribution Margin of $440,000. The Contribution Margin Ratio is 73.3% ($440,000 divided by $600,000).

Learn more under the Explanation of Breakeven Point.

The free cash flow calculation often begins with the cash flow from operating activities shown on the statement of cash flows (SCF). Next the amount of capital expenditures, taken from the investing activities section of the SCF for the same period, is deducted to arrive at the amount of free cash flow.

There are variations of the above calculation. For example, the dividends to stockholders might be viewed as a requirement and will be deducted along with the capital expenditure amount.

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To illustrate, let’s assume that a corporation’s net income after tax was $100,000 for the year 2007. Let’s also assume that it did not have any preferred stock outstanding and that its stockholders’ equity was $950,000 at the beginning of 2007 and was $1,050,000 at the end of 2007. The increase was at a uniform rate throughout the year. The return on stockholders’ equity will be 10% ($100,000 divided by the average stockholders’ equity of $1,000,000).

If a corporation has preferred stock outstanding, the relevant name is return on common equity and will be calculated as follows: net income after tax minus the required dividends on its preferred stock, divided by the average amount of common stockholders’ equity during the period of the income.

As with most ratios, you should compare your corporation’s return on equity with the ratio for other corporations in your industry.

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Net income available for common stock is the corporation’s net income after income taxes minus the required dividend for the corporation’s preferred stock, if it has preferred stock outstanding.

Additonal information on the calculations and presentation of a corporation’s earnings per share are contained in the Financial Accounting Standards Board’s Statment of Financial Accounting Standards No. 128, Earnings per Share. It can be read at no cost at www.FASB.org/st.

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For example, if a company has $900,000 of current assets and has $400,000 of current liabilities, its working capital is $500,000. If a company has $900,000 of current assets and has $900,000 of current liabilities, it has no working capital.

Other people use the term working capital ratio to mean the current ratio, which is defined as the amount of current assets divided by the amount of current liabilities.

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The gross margin ratio is computed by dividing the company’s gross profit dollars by its net sales dollars.

To illustrate the gross margin ratio, let’s assume that a company has net sales of $800,000 and its cost of goods sold is $600,000. This means its gross profit is $200,000 (net sales of $800,000 minus its cost of goods sold of $600,000) and its gross margin ratio is 25% (gross profit of $200,000 divided by net sales of $800,000).

A company should be continuously monitoring its gross margin ratio to be certain it will result in a gross profit that will be sufficient to cover its selling and administrative expenses.

Since gross margin ratios vary between industries, you should compare your company’s gross margin ratio to companies within your industry. However, you should keep in mind that there can also be differences within your industry. For example, your company may use LIFO while most companies in your industry use FIFO. Perhaps your company focuses its sales efforts on smaller customers who also require special administrative services. In that case, your company’s gross margin ratio should be larger than your industry’s in order to cover the higher selling and administrative expenses.

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The calculation for determining the days’ sales in accounts receivable is the number of days in the year (usually 360 or 365 days is used) divided by the accounts receivable turnover ratio for a specific year. If a company’s accounts receivable turnover ratio was 10, then the days’ sales in accounts receivable is 36 days (360 days divided by the turnover ratio of 10).

Since the accounts receivable turnover ratio used in the days’ sales in accounts receivable was based on 1) credit sales during a one-year time period, and 2) the average accounts receivable balances during that one-year period, the 36 days calculated above is an average. It is possible that within the accounts receivable there are some accounts which are 120 days or more past due. This information might be hidden by the average, because the average included some accounts that paid early. Therefore, it is best to review an aging of accounts receivable by customer to understand the detail behind the days’ sales in accounts receivable ratio.

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The before tax profit margin ratio expresses the corporation’s income before income tax expense as a percentage of net sales.

The profit margin ratio is most useful when it is compared to 1) the same company’s profit margin ratios from earlier accounting periods, 2) the same company’s targeted or planned profit margin ratio for the current accounting period, and 3) the profit margin ratios of other companies in the same industry during the same accounting period.

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The liquidity ratios include the current ratio and the acid test or quick ratio. The current ratio and quick ratio are also referred to as solvency ratios. Working capital is an important indicator of liquidity or solvency, even though it is not technically a ratio.

Liquidity ratios sometimes include the accounts receivable turnover ratio and the inventory turnover ratio. These two ratios are also classified as activity ratios.

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To illustrate the times interest earned ratio, let’s assume that a corporation’s net income after tax was $500,000; its interest expense was $200,000; and its income tax expense was $300,000. Given these assumptions, the corporation’s income before interest and income tax expense is $1,000,000 (net income of $500,000 + interest expense of $200,000 + income tax expense of $300,000). Since the interest expense was $200,000, the corporation’s times interest earned is 5 ($1,000,000 divided by $200,000).

The higher the times interest earned ratio, the more likely it is that the corporation will be able to meet its interest payments.

The times interest earned ratio is also referred to as the interest coverage ratio.

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For example, if a company had an inventory turnover ratio of 9, the company’s inventory turned over 9 times during the year. If we use 360 as the number of days in the year, the company had (on average) 40 days of inventory on hand during the year (360 days divided by the inventory turnover ratio of 9).

Since the inventory turnover ratio reflects the average amount of inventory during the year, and since sales usually fluctuate during the year, the days’ sales in inventory is an approximation.

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To illustrate the inventory turnover ratio, let’s assume 1) that during the year 2007 a company’s Cost of Goods Sold was $3,600,000, and 2) the company’s average cost in its Inventory account during same 12 months of 2007 was calculated to be $400,000. The company’s inventory turnover ratio is 9 ($3,600,000 divided by $400,000) or 9 times.

The higher the inventory turnover ratio, the better, provided you are able to fill customers’ orders on time. It would be foolish to lose customers because you didn’t carry sufficient inventory quantities.

A company’s inventory turnover ratio should be compared to 1) its previous ratios, 2) its planned ratio, and 3) the industry average.

Even with a favorable inventory turnover ratio, a company may have some excess and obsolete inventory items. Therefore, it is wise to compare the quantity of each item in inventory with the recent sales of each item.

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A corporation with $1,200,000 of liabilities and $2,000,000 of stockholders’ equity will have a debt to equity ratio of 0.6:1. A corporation with total liabilities of $1,200,000 and stockholders’ equity of $400,000 will have a debt to equity ratio of 3:1.

Generally, the higher the ratio of debt to equity, the greater is the risk for the corporation’s creditors and its prospective creditors.

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