07 How to Break Down Operating Capability and Profitability with Income Statement and Balance Sheet？

The three financial statements for US-listed companies, the balance sheet, the income statement, and the cash flow statement, are all linked and dependent on each other.

Understanding how they are connected can help us better look into a company's financial position.

In this tutorial, we'll assess a company's operating capability and profitability using items from both the balance sheet, such as total assets and accounts receivable, and the income statement, including the operating revenue and net income.

We generally use three metrics to measure a company's operating capability.

First, the total asset turnover ratio.

It is the ratio of operating revenue for a fiscal year to the average total assets, which measures the efficiency with which a company uses its assets to produce revenue.

But how to use this ratio?

We need to compare it to its industry average and its historical levels.

Horizontally, if a company's asset turnover ratio is higher than the industry average, it might suggest the company is better managed.

Vertically, if a company's asset turnover ratio grows year over year, it may indicate the company is becoming more efficient in using its assets to generate revenue.

For example, Walmart has seen its total asset turnover ratio grow moderately for the fiscal years 2019 to 2023, delivering stable performance.

However, its ratios were lower than its competitor Costco as a whole for the same period, indicating the two companies might not be identically efficient in deploying their assets.

The second indicator is the accounts receivable turnover ratio.

It is the ratio of operating revenue to average accounts receivable for a fiscal year, measuring how efficiently a company collects its accounts receivable from its clients.

Similarly, when using this ratio as a metric for operating capability, we should compare it to the industry average and historical levels.

ToC businesses, which sell their products and services mainly to individual consumers, tend to have lower accounts receivable levels, leading to a higher turnover ratio.

But ToB companies that target other businesses or organizations, usually have lower accounts receivable turnover ratios.

A company with higher demand for its products or services and greater bargaining power over its clients might have a higher accounts receivable turnover ratio.

Conversely, if the market demand weakens, the company may be forced to offer a lenient credit policy to its customers, lowering the accounts receivable turnover ratio.

What's worse, some receivables might become bad debt and be written off, compressing the company's earnings.

Let's compare Google with Apple.

Google's accounts receivable turnover ratio for the fiscal years 2018 to 2022 was maintained around 7.

But Apple's was more than twice that figure for the same period.

One major reason is that Apple has a higher proportion of the customer base made up of individuals.

The third indicator is the inventory turnover ratio.

As inventory refers to products yet to be sold to generate revenue, we use the cost of revenue instead of operating revenue to measure how effectively the inventory is used.

The inventory turnover ratio is the cost of revenue divided by the average inventory for a given fiscal period.

A possible reason for a low inventory turnover ratio is slow sales, suggesting the company might face difficulties selling its products.

Conversely, a company with a relatively high inventory turnover ratio may indicate high market demand for its products.

This indicator is especially important when assessing industries such as retail, fashion and apparel, and rapidly changing technology because some of their products can become outdated easily.

If a company in such industries cannot sell its products effectively, it will have to write down the value of its inventory and thus might face losses.

Also, this ratio can be a leading indicator for companies.

If a company's inventory turnover ratio keeps falling, it might indicate the company may struggle to remain competitive.

Let's move on to look at how to evaluate a company's profitability using items listed on both the balance sheet and income statement. We'll walk you through two indicators.

First, return on assets (ROA).

It is calculated by dividing net income by average total assets, measuring how efficiently a company uses its assets to generate profits. A higher ROA indicates better profitability.

So how to assess a company's ROA?

Generally, a higher-than-5% ROA is considered good, and a company with an ROA of over 20% is considered to be performing well.

But we'd better compare a company's ROA with its competitors because the type of assets held by companies varies across industries, resulting in the difference in ROA.

For example, banks tend to have far lower ROA than light-asset tech companies.

Second, return on equity (ROE).

It is the ratio of net income to the average shareholders' equity, a key metric of profitability. A higher ROE indicates higher profitability.

Generally, the difference in ROE across industries tends to be less significant compared to ROA.

That's because an industry's ROE advantage may diminish over time due to more intense competition.

A lucrative industry might attract more entrants.

As more competitors enter the market, the existing companies may face increased competition, impacting their profitability.

But it's still necessary for us to compare ROE with industry averages.

If a company can sustain a high ROE, it may suggest the company has a strong competitive edge and may remain profitable.

Companies can increase their ROE by share buybacks and dividend payments.

For example, Apple's ROE for the past two years was over 100%, according to data shown on moomoo.

Such high levels could be partly attributed to the company's sizable share buybacks and dividend payments during this period as these actions reduced shareholders' equity.

However, it should be noted that a company might sharply raise its ROE with higher leverage.

So we should keep an eye on the company's financial stability and whether that high ROE is sustainable.

To wrap up, operating revenue is a key item on a company's income statement.

We may get insights by analyzing the revenue size, structure, growth rate, and growth drivers.