After you create financial statements, you need some tools to analyze a company’s results. Following are the most frequently used formulas to analyze financial statements. Get familiar with them so that you can analyze statements with confidence.
Components of work-in-process
Direct materials + direct labor + factory overhead applied
Work-in-process (WIP) represents cost incurred in production for partially completed goods. WIP is a subaccount within inventory. When goods are completed, they are moved to finished goods (another inventory account).
Current ratio
Current assets ÷ current liabilities
The current ratio illustrates how easily a company can cover its current bills.
Quick ratio
(Current assets less inventory) ÷ current liabilities
The quick ratio excludes inventory from current assets. The rationale is that inventory is the current asset that will take the longest time to convert into cash. Other current assets, such as collecting accounts receivable, may be converted into cash more quickly.
Asset turnover ratio
Revenue (or sales) ÷ assets
This ratio explains how much profit a company generates for every dollar of assets.
Return on equity
Net income ÷ equity
This ratio explains how much profit a company generates for every dollar of equity.
Debt to equity ratio
Debt ÷ equity
This ratio measures what percentage of a firm’s total capitalization is debt. Capitalization refers to all funds raised by the company to operate the business.
Contribution margin
Sales less variable costs
Contribution margin represents the amount that will be used to cover fixed costs. Any dollars remaining after paying fixed costs is considered profit.
Return on capital
Operating profit ÷ capital
Capital is similar to equity. It represents funds raised to operate a business. Operating profit refers to profit generated from normal business activity.
Break-even formula
Sales – variable costs – fixed costs = $0 profit
The break-even formula calculates the level of sales that will generate a profit of $0.
Formula to assign overhead costs
Total overhead costs incurred ÷ activity level
Overhead costs, such as a factory’s utility costs, can’t be directly traced to a product. Instead, overhead costs are allocated based on an activity level. The activity level chosen should impact the amount of overhead costs incurred. For example, the number of machine hours used drives machinery repair costs. Machine hours should be the activity level for machine repair costs.
