2.3 Interrelationships Between Balance Sheet and Income Statement

The balance sheet and income statement are closely linked, showing a company's financial health from different angles. Understanding their connection is key to grasping a firm's overall financial picture.

Ratios derived from these statements offer insights into efficiency, profitability, and financial strength. They help analyze how well a company uses its assets, manages debt, and generates returns for shareholders.

Balance Sheet and Income Statement Ratios

Turnover Ratios

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• Accounts Receivable Turnover measures how efficiently a company collects its receivables by calculating the number of times receivables are collected during the period
  • Calculated as $\frac{Credit Sales}{Average Accounts Receivable}$
  • A higher ratio indicates the company is collecting receivables more frequently and has a shorter cash conversion cycle (more liquid)
• Inventory Turnover measures how efficiently a company sells its inventory by calculating the number of times inventory is sold and replaced during the period
  • Calculated as $\frac{Cost of Goods Sold}{Average Inventory}$
  • A higher ratio suggests strong sales and effective inventory management while a low ratio may indicate weak sales, excess inventory, or obsolete inventory
• Asset Turnover measures how efficiently a company uses its assets to generate sales
  • Calculated as $\frac{Net Sales}{Average Total Assets}$
  • A higher ratio indicates the company is generating more sales per dollar of assets

Profitability Ratios

Return Ratios

• Return on Assets (ROA) measures how profitable a company is relative to its total assets
  • Calculated as $\frac{[Net Income](https://www.fiveableKeyTerm:Net_Income)}{Average Total Assets}$
  • Indicates how efficiently management is using assets to generate earnings
  • Allows for comparison of profitability between companies and industries
• Return on Equity (ROE) measures a corporation's profitability by calculating how much profit the company generates with the money shareholders have invested
  • Calculated as $\frac{Net Income}{Average Shareholder's Equity}$
  • Useful for comparing the profitability of a company to that of other firms in the same industry
  • A rising ROE suggests a company is increasing its ability to generate profit without needing as much capital

Financial Statement Analysis

DuPont Analysis

• DuPont Analysis is a framework for analyzing fundamental performance popularized by the DuPont Corporation
• Breaks down Return on Equity (ROE) into three components: Profit Margin, Asset Turnover, and Financial Leverage
  • $ROE = (Profit Margin) \times (Asset Turnover) \times (Financial Leverage)$
  • $= (\frac{Net Income}{Sales}) \times (\frac{Sales}{Assets}) \times (\frac{Assets}{Equity})$
• Provides insights into the sources of a company's ROE and compares the operational and financial performance of two similar firms
• Acts as a tool to analyze changes in ROE over time and to compare companies within an industry

Retained Earnings Analysis

• Retained Earnings represent the portion of net income that is retained by the company rather than distributed to shareholders as dividends
  • Increases when a company earns a profit and decreases when dividends are distributed
• Analyzing retained earnings provides insights into a company's dividend policy and growth prospects
  • Growing retained earnings over time indicates the company is retaining profits for reinvestment and growth
  • Declining retained earnings may signal financial trouble or an unsustainable dividend payout
• The retention ratio measures the percentage of net income that is retained
  • Calculated as $\frac{Retained Earnings}{Net Income}$
  • A higher retention ratio indicates a company is retaining more profits for growth while a lower ratio suggests profits are being paid out as dividends