# Financial Ratio

Pages: 19 (3640 words) Published: February 16, 2013
The income statement has some limitations since it reflects accounting principles. For example, a company's depreciation expense is based on the cost of the assets it has acquired and is using in its business. The resulting depreciation expense may not be a good indicator of the economic value of the asset being used up. To illustrate this point let's assume that a company's buildings and equipment have been fully depreciated and therefore there will be no depreciation expense for those buildings and equipment on its income statement. Is zero expense a good indicator of the cost of using those buildings and equipment? Compare that situation to a company with new buildings and equipment where there will be large amounts of depreciation expense.

The remainder of our explanation of financial ratios and financial statement analysis will use information from the following income statement:

Example Corporation
Income Statement
For the year ended December 31, 2011|
|
Sales (all on credit)| \$500,000|
Cost of Goods Sold|   380,000|
| Gross Profit|   120,000|
|
Operating Expenses| |
| Selling Expenses| 35,000|
| | Total Operating Expenses|    80,000|
|
Operating Income| 40,000|
| Interest Expense|    12,000|
|
Income before Taxes| 28,000|
| Income Tax Expense|     5,000|
Net Income after Taxes| \$ 23,000|
|
Earnings per Share
(based on 100,000 shares outstanding)| \$     0.23|
|
|

* Explanation of Income Statement
* Drills for Income Statement
* Crossword Puzzle for Income Statement

Common–Size Income Statement
Financial statement analysis includes a technique known as vertical analysis. Vertical analysis results in common-size financial statements. A common-size income statement presents all of the income statement amounts as a percentage of net sales. Below is Example Corporation's common-size income statement after each item from the income statement above was divided by the net sales of \$500,000:

Example Corporation
Common-Size Income Statement
For the year ended December 31, 2011|
|
Sales (all on credit)| 100.0%|
Cost of Goods Sold|   76.0%|
| Gross Profit|   24.0%|
|
Operating Expenses| |
| Selling Expenses| 7.0%|
| | Total Operating Expenses|  16.0%|
|
Operating Income| 8.0%|
| Interest Expense|    2.4%|
|
Income before Taxes| 5.6%|
| Income Tax Expense|    1.0%|
Net Income after Taxes|    4.6%|
|
|

The percentages shown for Example Corporation can be compared to other companies and to the industry averages. Industry averages can be obtained from trade associations, bankers, and library reference desks. If a company competes with a company whose stock is publicly traded, another source of information is that company's "Management's Discussion and Analysis of Financial Condition and Results of Operations" contained in its annual report to the Securities and Exchange Commission (SEC). This annual report is the SEC Form 10-K and is usually accessible under the "Investor Relations" tab on the corporation's website.

Financial Ratios Based on the Income Statement

Financial Ratio| | How to Calculate It| What It Tells You| Gross Margin| =

=

=| Gross Profit ÷ Net Sales

\$120,000 ÷ \$500,000

24.0%| Indicates the percentage of sales dollars available for expenses and profit after the cost of merchandise is deducted from sales. The gross margin varies between industries and often varies between companies within the same industry.| Profit Margin

(after tax)| =

=

=| Net Income after Tax ÷ Net Sales

\$23,000 ÷ \$500,000

4.6%| Tells you the profit per sales dollar after all expenses are deducted from sales. This margin will vary between industries as well as between companies in the...