The Portable MBA in Finance and Accounting, 3rd Edition

Using Financial Statements 25

The use of percent-of-sales ratios is a simple but powerful technique for
analyzing profitability. Generally used ratios include:

• Gross Profit.


• Operating Expenses:
  a. In total.
  b. Indiv idually.


• Selling, General, and Administrative Expenses (often called SG&A).


• Operating Income.


• Income before Taxes.


• Net Income.

The second category of profitability ratios is profitability in relation to
investment.

Profitability in Relation to Investment

To earn profits, usually a firm must invest capital in items such as plant, equip-
ment, inventory, and /or research and development. Up to this point we have
analyzed profitability without considering invested capital. That was a useful
simplification in the beginning, but, since profitability is highly dependent
on the investment of capital, it is now time to bring invested capital into the
analysis.
We start with the balance sheet. Recall that Working Capital is Current
Assets less Current Liabilities. So we can simplify the balance sheet by includ-
ing a single category for Working Capital in place of the separate categories for
Current Assets and Current Liabilities. An example of a simplified balance
sheet follows:

Example Company

Simplif ied Balance Sheet as of December 31, 200X

Assets Liabilities and Equity

Working capital $ 40,000 Long-term debt $ 30,000
Fixed assets, net 80,000 Equity 90,000
Total assets $120,000 Liabilities and equity $120,000

A simplified Income Statement for Example Company for the year 200X is
summarized below:

Income before interest and taxes (EBIT) $36,000

Less interest expense 3,000

Income before income taxes 33,000

Less income taxes (40%) 13,200

Net income $19,800