The Twelve Basic Tools Used in Analyzing a Balance Sheet and an Income Statement1 P.J. van Blokland2 1. This is EDIS document FE 333, a publication of the Department of Food and Resource Economics, Florida Cooperative Extension Service, Institute of Food and Agricultural Sciences, University of Florida, Gainesville, FL. Published April 2002. Please visit the EDIS website at http://edis.ifas.ufl.edu 2. P.J. van Blokland, professor, Department of Food and Resource Economics, Florida Cooperative Extension Service, Institute of Food and Agricultural Sciences, University of Florida, Gainesville, FL. The Institute of Food and Agricultural Sciences is an equal opportunity/affirmative action employer authorized to provide research, educational information and other services only to individuals and institutions that function without regard to race, color, sex, age, handicap, or national origin. For information on obtaining other extension publications, contact your county Cooperative Extension Service office. Florida Cooperative Extension Service/Institute of Food and Agricultural Sciences/University of Florida/Christine Taylor Waddill, Dean. This publication helps to illustrate the 12 basic tools used in income statement and balance sheet analyses. It is essentially a beginner's guide of what to examine in these two financial statements. Hopefully, it will encourage firm owners to use these tools to calculate trends, which are useful because they can show when things are or are not going well. Income Statement Income Statetment Tools TOOL NUMBER 1 Gross Profit Margin (GPM) is Gross Revenue minus Cash Costs divided by Gross Revenue times 100. For example, (110 60) 100 = 45% [$1 Gross Revenue gives $0.45 GPM]. TOOL NUMBER 2 Operating Margin (OM) is Gross Revenue minus Total Costs divided by Gross Revenue times 100. For example, (110 75) 110 = 32% [$1 Gross Revenue gives $0.32 OM]. TOOL NUMBER 3 Net Profit Margin (NPM) is Net Income divided by Gross Revenue times 100. For example, 25 110 x 100 = 23% [$1 Gross Revenue gives $0.23 NPM].
The Twelve Basic Tools Used in Analyzing a Balance Sheet and an Income Statement 2 TOOL NUMBER 4 Rule of 72 tells how long it takes to double your money. What is your annual percentage return? To determine Rule 72, divide 72 by your annual percentage (in this case, 8%). For example, 72 8 = 9 [It would take nine years for your money to double at 8% return]. TOOL NUMBER 5 Net Firm Income can only be spent on four things (acronym is TIPS): 1. (T) = Your income and FICA taxes 2. (I) = Investing in the firm for growth 3. (P) = Principal Payments 4. (S) = Your salary Net Income is profit or earnings; it can only be spent on three things (acronym is SIP): 1. (S) = Your salary 2. (I) = Investing in the firm for growth 3. (P) = Principal payments Balance Sheet Balance Sheet Tools TOOL NUMBER 6 (Liquidity) Working Capital is Current Assets minus Current Liabilities. For example, 100 50 = 50. The higher your working capital, the better; illiquid means you cannot pay your bills. TOOL NUMBER 7 (Liquidity) Current Ratio is Current Assets divided by Current Liability. For example, 100 50 = 2 [There are $2 to cover $1 of debt]. What is a good ratio? TOOL NUMBER 8 (Liquidity) Debt Structure Ratio is Current Liability divided by Total Liabilities. For example, 50 950 = 0.05 [5% of the firm's total debt is due in the next quarter]. What is a good percentage? TOOL NUMBER 9 (Solvency) Equity is the residual value of a firm beyond liabilities. If equity is positive, the firm is solvent. A business should have Equity growth [Compare with alternatives]. At what rate would you like your money to grow? TOOL NUMBER 10 (Solvency) Leverage (borrowing power to increase your rate of return from an investment) is Total Liabilities divided by Equity. For example, 950 450 = 2.11 [This means you owe $2.11 for every $1.00 you own]. What is a good ratio? Profitability Tools TOOL NUMBER 11 Return on Assets (ROA) is Net Firm Income plus Interest minus your salary divided by Beginning Assets times 100. For example, (35 + 15 10) 1400 x 100 = 2.85%. TOOL NUMBER 12 Return on Equity (ROE) is Net Income minus Your Salary divided by Beginning Equity times 100. For example, (25 10) 450 x 100 = 3.33%.