Financial Ratio

The income statement has some limitations since it reflects accounting principles. For example, a company's depreciation expense is based on the cost of the assets it has acquired and is using in its business. The resulting depreciation expense may not be a good indicator of the economic value of the asset being used up. To illustrate this point let's assume that a company's buildings and equipment have been fully depreciated and therefore there will be no depreciation expense for those buildings and equipment on its income statement. Is zero expense a good indicator of the cost of using those buildings and equipment? Compare that situation to a company with new buildings and equipment where there will be large amounts of depreciation expense.

The remainder of our explanation of financial ratios and financial statement analysis will use information from the following income statement:

Example Corporation
Income Statement
For the year ended December 31, 2011 | | Sales (all on credit) | $500,000 | Cost of Goods Sold | 380,000 | | Gross Profit | 120,000 | | Operating Expenses | | | Selling Expenses | 35,000 | | Administrative Expenses | 45,000 | | | Total Operating Expenses | 80,000 | | Operating Income | 40,000 | | Interest Expense | 12,000 | | Income before Taxes | 28,000 | | Income Tax Expense | 5,000 | Net Income after Taxes | $ 23,000 | | Earnings per Share
(based on 100,000 shares outstanding) | $ 0.23 | | |

To learn more about the income statement, go to: * Explanation of Income Statement * Drills for Income Statement * Crossword Puzzle for Income Statement

Common–Size Income Statement
Financial statement analysis includes a technique known as vertical analysis. Vertical analysis results in common-size financial statements. A common-size income statement presents all of the income statement amounts as a percentage of net sales. Below is Example