16 Understanding the Numbers
The Microsoft financial statements contain numbers very much greater
than those for Nutrivite. But there is no difference in the general format of
these two sets of financial statements.
HOW TO ANALYZE FINANCIAL STATEMENTS
Imagine that you are a nurse or a physician and you work in the emergency
room of a busy hospital. Patients arrive with all kinds of serious injuries or ill-
nesses, barely alive or perhaps even dead. Others arrive with less urgent in-
juries, minor complaints, or vaguely suspected ailments. Your training and
experience have taught you to perform a quick triage, to prioritize the most
endangered patients by their vital signs—respiration, pulse, blood pressure,
temperature, and ref lexes. A more detailed diagnosis follows based on more
thorough medical tests.
We check the financial health of a company in much the same fashion by
analyzing the financial statements. The vital signs are tested mostly by various
financial ratios that are calculated from the financial statements. These vital
signs can be classified into three main categories:
- Short-term liquidity.
- Long-term solvency.
- Profitability.
We explain each of these three categories in turn.SHORT-TERM LIQUIDITY
In the emergency room the first question is: Can this patient survive? Simi-
larly, the first issue in analyzing financial statements is: Can this company sur-
vive? Business survival means being able to pay the bills, meet the payroll, and
come up with the rent. In other words, is there enough liquidity to provide the
cash needed to pay current financial commitments? “ Yes” means survival. “No”
means bankruptcy. The urgency of this question is why current assets (which
are expected to turn into cash within a year) and current liabilities (which are
expected to be paid in cash within a year) are shown separately on the balance
sheet. Net current assets (current assets less current liabilities) is known as
working capital. Because most businesses cannot operate without positive
working capital, the question of whether current assets exceed current liabili-
ties is crucial.
When current assets are greater than current liabilities, there is sufficient
liquidity to enable the enterprise to survive. However, when current liabilities
exceed current assets the enterprise may well be in immanent danger of bank-
ruptcy. The financial ratio used to measure this risk is current assets divided