The Portable MBA in Finance and Accounting, 3rd Edition

Using Financial Statements 23

In summary, the ratios used to assess long-term solvency are Interest Cov-
erage and Long-Term Debt to Equity.
Next, we consider the ratios for analyzing profitability.

PROFITABILITY

Profitability is the lifeblood of a business. Businesses that earn incomes can
survive, grow, and prosper. Businesses that incur losses cannot stay in opera-
tion, and will last only until their cash runs out. Therefore, in order to assess
business viability, it is important to analyze profitability.
When analyzing profitability, it is usually done in two phases, which are:

1. Profitability in relation to sales.


2. Profitability in relation to investment.

Profitability in Relation to Sales

The analysis of profitability in relation to sales recognizes the fact that:

or, rearranging terms:

Therefore, Expenses and Income are measured in relation to their sum, which is
Sales. The expenses, in turn, may be broken down by line item. As an example,
we use the Nutrivite Income Statement for the first three years of operation.

Income Statements for the

Years Ending December 31

Year 1 Year 2 Year 3

Sales $720,000 $800,000 $900,000
Less cost of goods sold 480,000 530,000 600,000
Gross profit $240,000 $270,000 $300,000

Less expenses
Salaries $ 40,000 $ 49,600 $ 69,000
Rent 36,000 49,400 54,400
Phone and utilities 14,400 19,400 26,000
Depreciation 3,600 3,600 3,600
Interest 6,000 6,000 6,000
Total expenses $100,000 $128,000 $159,000

Income before taxes $140,000 $142,000 $141,000
Income tax expense (40%) 56,000 56,800 56,400
Net income $ 84,000 $ 85,200 $ 84,600

Sales=+Expenses Income

Income Sales Expenses=−