Income statement
It contains one or more subtotals that highlight significant relationships. It starts with separate computation and
disclosure of gross profit/gross margin which is the excess of sales revenue over the cost of inventory
that was sold (sales revenue – cost of goods sold). The next section of a multiple step income statement
usually contains the operating expenses, which is a group of recurring expenses that pertain to the firm’s
routine, ongoing operations. Examples of such expenses are wages, rent, depreciation, telephone heating
& lighting, advertising etc. we deduct these operating expenses from the gross profit to obtain operating
income (gross profit – operating expense). The next grouping in the multiple-step income statement contains
revenues and expenses which are not directly related to the mainstream of a firm’s operations (nonoperating revenues and expenses). Income before income tax = (operating income – non-operating expenses).
Most companies follow the practice of showing income tax as a separate item that is deducted to arrive at
net income. Net income = income before income tax – tax.
Balance Sheet formats
The account format is where assets are shown on the right side and liabilities and stockholders’ equity is shown on the
right side of the balance sheet. The report format is where assets are shown at the top followed by liabilities and
shareholders’ equity.
Profitability Evaluation Ratios
 Gross Profit Percentage/Gross margin percentage: The gross profit margin looks at cost of goods
sold as a percentage of sales. Gross profit ratio may indicate to what extent the selling prices of goods
per unit may be reduced without incurring losses on operations. It reflects efficiency with which a firm
produces its products. As the gross profit is found by deducting cost of goods sold from net sales,
higher the gross profit better it is. There is no standard GP ratio for evaluation. It may vary from
business to business. However, the gross profit earned should be sufficient to recover all operating
expenses and to build up reserves after paying all fixed interest charges and dividendsThis ratio looks
at how well a company controls the cost of its inventory, manufacturing of its products and
subsequently pass on the costs to its customers. The larger the gross profit margin, the better for the
company. The calculation is: Gross Profit/ Sales = ____%. Both terms of the equation come from the
company's income statement.
 Return on Sales/Net Profit margin: When doing a simple profitability ratio analysis, net profit margin
is the most often margin ratio used. The net profit margin shows how much of each sales dollar shows
up as net income after all expenses are paid. For example, if the net profit margin is 5%, which means
that 5 cents of every dollar earned in sales is profit. The net profit margin measures profitability after
consideration of all expenses including taxes, interest, and depreciation. The calculation is: Net
Income/ Sales = _____%. Both terms of the equation come from the income statement.
 Return on Equity: The Return on Equity ratio is perhaps the most important of all the financial ratios to
investors in the company. It measures the return on the money the investors have put into the
company. This is the ratio potential investors look at when deciding whether or not to invest in the
company. The calculation is: Net Income/Stockholder's Equity = _____%. Net income comes from
the income statement and stockholder's equity comes from the balance sheet. In general, the higher
the percentage, the better, as it shows that the company is doing a good job using the investors'
money. As the primary objective of business is to maximize its earnings, this ratio indicates the extent
to which this primary objective of businesses being achieved. This ratio is of great importance to the
present and prospective shareholders as well as the management of the company.
 Return on Assets: it measures the efficiency with which the company is managing its investment in
assets and using them to generate profit. It measures the amount of profit earned relative to the firm's
level of investment in total assets. The return on assets ratio is related to the asset management
category of financial ratios. The calculation for the return on assets ratio is: Net Income/Total Assets =
_____%. Net Income is taken from the income statement and total assets are taken from the balance
sheet. The higher the percentage the better, because that means the company is doing a good job
using its assets to generate sales.
Liquidity ratios
It is a class of financial metrics that is used to determine a company's ability to pay off its short-terms debts
obligations such as accounts payable (payments to suppliers) and accrued taxes and wages. Short-term
notes payable to a bank, for example, may also be relevant. Generally higher the value of the ratio, larger is
the margin of safety that the company possesses to cover short-term debts. Common liquidity ratios
include current ratio and quick ratio. A company's ability to turn short-term assets into cash to cover debts
is of the utmost importance when creditors are seeking payment. Bankruptcy analysts and mortgage
originators frequently use the liquidity ratios to determine whether a company will be able to continue as a
going concern.
 Current ratio/working capital ratio: The ratio is mainly used to give an idea of the company's ability
to pay back its short-term liabilities (debt and payables) with its short-term assets (cash, inventory,
receivables). The higher the current ratio, the more capable the company is of paying its obligations. A
ratio under 1 suggests that the company would be unable to pay off its obligations if they came due at
that point. While this shows the company is not in good financial health, it does not necessarily mean
that it will go bankrupt - as there are many ways to access financing - but it is definitely not a good sign.
The current ratio can give a sense of the efficiency of a company's operating cycle or its ability to
turn its product into cash. Companies that have trouble getting paid on their receivables or have long
inventory turnover can run into liquidity problems because they are unable to alleviate their obligations.
Because business operations differ in each industry, it is always more useful to compare companies
within the same industry. Current assets and current liabilities make up the current ratio. The current
ratio is calculated from balance sheet data as Current Assets/Current Liabilities.
 Quick ratio/Acid-test ratio: The quick ratio, sometimes called the acid-test, is a more stringent test of
liquidity than the current ratio. This is because it removes inventory from the equation. Inventory is the
least liquid of all the current assets. A business has to find a buyer if it wants to liquidate inventory, or
turn it into cash. Finding a buyer is not always easy. The quick ratio is calculated from balance sheet
data as Current Assets - Inventory/Current Liabilities. If a business firm has $200 in current assets
and $50 in inventory and $100 in current liabilities, the calculation is $200-$50/$100 = 1.50X. The "X"
(times) part at the end is important. It means that the firm can pay its current liabilities from its current
assets (less inventory) one and a half times over. This is obviously a good position for the firm to be in.
It can meet its short-term debt obligations with no stress. If the quick ratio was less than 1.00X, then
the firm would have to sell inventory to meet its obligations So, a quick ratio great than 1.00X is better
than a quick ratio of less than 1.00X with regard to maintaining liquidity and not being forced into the
position of having to sell inventory. Companies with ratios of less than 1 cannot pay their current
liabilities and should be looked at with extreme caution. Furthermore, if the acid-test ratio is much lower
than the working capital ratio, it means current assets are highly dependent on inventory. Retail stores
are examples of this type of business. The term comes from the way gold miners would test whether
their findings were real gold nuggets. Unlike other metals, gold does not corrode in acid; if the nugget
didn't dissolve when submerged in acid, it was said to have passed the acid test. If a company's
financial statements pass the figurative acid test, this indicates its financial integrity.
Financial Ratios
Earnings per share: The earnings per share is a good measure of profitability and when compared with EPS
of similar companies, it gives a view of the comparative earnings or earnings power of the firm. EPS ratio
calculated for a number of years indicates whether or not the earning power of the company has increased. It is
the portion of a company's profit allocated to each outstanding share of common stock. Earnings per
share serve as an indicator of a company's profitability.
Price Earnings Ratio: The ratio is calculated to make an estimate of appreciation in the value of a share of a
company and is widely used by investors to decide whether or not to buy shares in a particular company. Price
earnings ratio helps the investor in deciding whether to buy or not to buy the shares of a particular company at
a particular market price. If the P/E ratio falls, the management should look into the causes that have resulted
into the fall of this ratio. From the investors viewpoint, investing in stocks of companies which are trading at low
P/E ratio and have strong fundamentals and balance sheet, along with good past history will be profitable.
Dividend Yield Ratio: Dividend yield ratio is the relationship between dividends per share and the market
value of the shares. Share holders are real owners of a company and they are interested in real sense in the
earnings distributed and paid to them as dividend. Therefore, dividend yield ratio is calculated to evaluate the
relationship between dividends per share paid and the market value of the shares. This ratio helps as intending
investor knows the effective return he is going to get on the proposed investment.
Dividend payout ratio: Dividend payout ratio is calculated to find the extent to which earnings per share
have been used for paying dividend and to know what portion of earnings has been retained in the business. It
is an important ratio because ploughing back of profits enables a company to grow and pay more dividends in
future. A complementary of this ratio is retained earnings ratio. The payout ratio and the retained earnings
ratio are the indicators of the amount of earnings that have been ploughed back in the business. The lower the
payout ratio, the higher will be the amount of earnings ploughed back in the business and vice versa. A lower
payout ratio or higher retained earnings ratio means a stronger financial position of the company.
Market/Book ratio: It provides an assessment of how investors view the firm's performance. it relates the
market value of the firm's shares to their accounting value. Formula: Market price per share / Book value per
share. The book value of the share is calculated as Common equity stock / number of shares of common
stock outstanding. The stocks of the firms that are expected to perform well - improve profits, increase their
market share, or launch successful products - typically sell at higher M/B ratios than the stocks of firms with
less attractive outlooks. Like PE ratios, MB ratios are typically assessed cross-sectionally, to get a feel for the
firm's risk and return compared to peer firms.