Financial Statement Analysis: Ratios & Explanatory Notes
Financial Statement Analysis
Explanatory Notes to Financial Statements
1. What should be done to ensure a valid comparison of two balance sheet items?
The CPI for the previous year’s balance sheet should be applied to make comparisons in real terms over the current year.
2. What is the purpose of the Explanatory Notes to the Financial Statements and when are they most relevant?
The explanatory notes are an essential complement to the financial statements. They provide context and background information, enabling users to make more informed economic decisions.
These notes become particularly important when financial statements are subject to external review (e.g., by a regulatory body) or when the information is of interest to parties outside the company’s administration.
3. What subjects are covered in the Explanatory Notes to the Financial Statements?
The number and specific subjects of explanatory notes can vary. Common topics include:
- Accounting principles used for inventory valuation
- Depreciation methods for fixed assets
- Investment recovery policies
- Foreign currency conversion methods
- Changes in accounting practices
- Investment composition
- Contingencies and indirect responsibilities
- Significant events after the balance sheet date
Financial Ratio Analysis
1. Current Ratio
a) Calculate the current ratio with total current assets of $400,000 and total current liabilities of $250,000.
Current Ratio = Total Current Assets / Total Current Liabilities = $400,000 / $250,000 = 1.6
Comment: This company has a current ratio of 1.6, indicating a good ability to meet its short-term obligations. For every dollar of current liabilities, the company has $1.6 of current assets available.
2. Acid Test (Quick Ratio)
a) Calculate the acid test with the following information:
- Cash: $18,000
- Money in Bank: $23,000
- Accounts Receivable: $48,000
- Total Current Liabilities: $250,000
Acid Test = (Cash + Money in Bank + Accounts Receivable) / Total Current Liabilities = ($18,000 + $23,000 + $48,000) / $250,000 = 0.356
Comment: The company’s acid test ratio is 0.356. This suggests that for every $100 of current liabilities, the company has $35.6 of its most liquid assets to cover them. The company’s current assets are concentrated in inventory, which is less liquid.
3. Accounts Receivable Turnover
a) Calculate the accounts receivable turnover with the following information:
- Period: 30 days
- Net Sales: $250,000
- Accounts Receivable: $48,000
Accounts Receivable Turnover = (Net Sales / Average Accounts Receivable) * 365 Days = ($250,000 / $48,000) * 30 Days= 156.25 Days
Comment: The Accounts Receivable Turnover is approximately 156 days. This indicates that it takes, on average, 156 days to collect on credit sales.
4. Raw Material Inventory Turnover
a) Calculate the raw material inventory turnover with the following information:
- Beginning Raw Material Inventory: $55,000
- Ending Raw Material Inventory: $39,000
- Raw Material Cost: $110,000
- Period: 30 days
Raw Material Inventory Turnover = (Raw Material Cost / Average Raw Material Inventory) * 30 Days = ($110,000 / (($55,000 + $39,000) / 2)) * 30 Days = 38.57 Days
Comment: The raw material inventory turnover is approximately 39 days. This means that the company, on average, turns its raw material inventory into finished goods every 39 days.
5. Finished Goods Inventory Turnover
a) Calculate the finished goods inventory turnover with the following information:
- Beginning Finished Goods Inventory: $190,260
- Ending Finished Goods Inventory: $250,000
- Cost of Sales: $165,000
Finished Goods Inventory Turnover = (Cost of Sales / Average Finished Goods Inventory) * 365 Days = ($165,000 / (($190,260 + $250,000) / 2)) * 365 Days = 262.5 Days
Comment: The finished goods inventory turnover is approximately 263 days. This indicates that the company takes, on average, 263 days to sell its finished goods inventory.
6. Debt Ratio
a) Calculate the debt ratio with the following information:
- Total Liabilities: $1,134,000
- Total Assets: $1,640,000
Debt Ratio = Total Liabilities / Total Assets = $1,134,000 / $1,640,000 = 0.6914 or 69.14%
Comment: The debt ratio is 69.14%. This means that 69.14% of the company’s assets are financed by debt.
7. Profitability Indicators
a) Calculate the following profitability indicators:
- Net Profit: $28,000
- Total Assets: $1,640,000
- Net Sales: $250,000
- Equity (Shareholder’s Equity): $506,000
b) Calculations:
i) Return on Sales (ROS):
ROS = Net Profit / Net Sales = $28,000 / $250,000 = 0.112 or 11.2%
Comment: For every $100 of sales, the company generates $11.20 in net profit.
ii) Return on Assets (ROA):
ROA = Net Profit / Total Assets = $28,000 / $1,640,000 = 0.017 or 1.7%
Comment: For every $100 of assets, the company generates $1.70 in net profit.
iii) Return on Equity (ROE):
ROE = Net Profit / Shareholder’s Equity = $28,000 / $506,000 = 0.0553 or 5.53%
Comment: For every $100 of shareholder’s equity, the company generates $5.53 in net profit.