FIN 4003 Module 2 Financial Statement and Ratio Analysis Example

Healthy on Paper, Tight on Cash: Reading a Farmstead Creamery's Financial Statements and Ratios

Student Name

American College of Education

FIN4003: Finance and Sustainability in Business

Module 2 Assignment

Instructor Name

October 19, 2026

Introduction

Module 1 built next year's operating budget for the family farmstead creamery and found a margin squeeze. A budget looks forward; financial statements look back and show the whole picture of what the business owns, owes and earns. This paper reads last year's three statements together, calculates the main ratios in four groups, interprets each and explains a puzzle: the creamery earned $88,000 yet ended the year with $118,000 less cash than it started with. The figures are illustrative but internally consistent.

The Three Statements

The income statement shows revenue of $1,820,000, cost of goods sold of $972,000, gross profit of $848,000, operating expenses of $712,000 including $96,000 of depreciation, operating income of $136,000, interest of $48,000 and net income of $88,000. The creamery is an LLC that files as a partnership for tax purposes, so income taxes are paid by the family members rather than the business. The balance sheet at year end shows current assets of $480,000, made up of cash $64,000, accounts receivable $118,000, inventory $286,000 and prepaid expenses $12,000, plus property, buildings, equipment and herd of $1,420,000, for total assets of $1,900,000. Liabilities total $745,000: accounts payable $74,000, accrued expenses $31,000, the current portion of long-term debt $92,000 and long-term debt $548,000. Owners' equity is $1,155,000.

Liquidity

Liquidity ratios ask whether the business can pay its short-term bills. Dividing current assets of $480,000 by current liabilities of $197,000 gives a current ratio of 2.44, which looks comfortable. The quick ratio removes inventory and prepaid expenses, because they cannot be turned into cash quickly: $182,000 divided by $197,000, or 0.92. For a cheese business, the gap between these two ratios matters more than either number, because most current assets are cheese still aging on shelves. The creamery can meet its short-term obligations only if inventory continues to sell on schedule.

Debt and Solvency

Debt ratios show how much the business relies on borrowed money. Total liabilities to equity is $745,000 divided by $1,155,000, or 0.65; interest-bearing debt to equity, using the $640,000 of loans only, is 0.55. Both are moderate for a capital-intensive farm business. Dividing operating income by interest expense, $136,000 by $48,000, shows the creamery covers its interest 2.83 times over. That is adequate but thin; a further decline in operating income like the one the budget projects would leave less room to absorb a bad year.

Profitability

Gross margin is 46.6%, operating margin 7.5% and net margin 4.8%. Set against total assets, net income gives a 4.6% return on assets; set against equity, it gives a 7.6% return on equity. These returns are modest. The family's capital earns less in the business than it might in other investments, which is common for farm businesses where land and buildings are valued highly relative to income, but it means the creamery depends on the family's commitment as well as its profits. A neighboring dairy that sells only fluid milk would likely show thinner margins still, which is one reason the family moved into cheese.

Efficiency

Inventory turns 3.4 times a year when cost of goods sold is set against the inventory balance, or about 107 days of inventory on hand, which reflects aged cheeses that take months to mature. Days sales outstanding, receivables divided by revenue times 365, is 23.7 days, well within the thirty-day terms given to grocers. Asset turnover is 0.96, meaning the business generates slightly less than a dollar of revenue for each dollar of assets, typical of land-heavy operations. The inventory figure is the one to watch: inventory grew by $34,000 during the year, faster than sales.

Why Cash Fell

The cash flow statement explains the puzzle. Operating activities produced $148,000: net income of $88,000 plus $96,000 of depreciation, which is an expense that uses no cash, less $34,000 tied up in additional inventory and $8,000 in receivables, plus $6,000 of increased payables. Investing activities used $110,000 for a new cheese vat and cooler repairs. Financing activities used $156,000: $86,000 of loan principal and $70,000 of family draws. Together these produced a net decrease in cash of $118,000. The business was profitable, but it spent more on equipment, debt repayment and family draws than its operations generated.

Compared With the Prior Year

Ratios mean more when compared over time. Against the prior year, three moved noticeably. Operating margin fell from about 8.6% to 7.5%, as costs grew faster than sales, the same squeeze the budget projects to continue. The current ratio fell from about 2.9 to 2.44 as cash was spent, even though inventory rose. Inventory days rose from about 96 to 107, meaning more cheese was sitting in the aging rooms relative to sales. The debt position improved slightly as loan principal was repaid, and receivables held steady. Taken together, the prior-year comparison shows a business that is paying down debt and investing, which is healthy, while drawing down cash and building inventory, which is not sustainable at the same pace. The trends matter more than any single year's level, because they show the direction the business is moving and how quickly the family needs to act.

Three Warning Signs

Research on business failure has shown that combinations of ratios covering liquidity, profitability, debt and turnover can signal distress well before it becomes obvious (Altman, 1968). The creamery is not in distress, but three signs deserve attention. First, the quick ratio below 1.0 combined with growing inventory means cash depends on selling aged cheese on time. Second, interest coverage below 3 leaves limited room if margins continue to narrow, as the budget projects. Third, cash falling $118,000 in one year, while family draws stayed at $70,000, cannot repeat for long with only $64,000 left.

Implications for the Family

Three steps follow. The family should agree on a limit for draws tied to operating cash flow rather than to net income. Inventory planning should match aging schedules more closely to expected orders, so that cheese is not made faster than it can be sold. And before the next equipment purchase, the family should decide how to fund it, from savings, a loan or new investors. Firms tend to prefer internal funds first, then debt and only then outside owners, partly because outside investors discount what they cannot see inside the business (Myers & Majluf, 1984); the creamery's habits fit that pattern, and Modules 3 and 4 test whether they still serve it. Finally, the monthly comparison of actual results with the new budget, a practice most firms still rely on for control (Libby & Lindsay, 2010), should add a line for cash so that the family sees profit and cash side by side.

Conclusion

Read together, the creamery's statements show a moderately indebted, modestly profitable business with adequate liquidity on paper and tight cash in practice. Ratios explain why: most current assets are aging cheese, interest coverage is thin and cash fell because spending on equipment, debt and draws exceeded operating cash flow. The family can protect the business by linking draws to cash flow, tightening inventory planning and planning how to fund growth.

References

Altman, E. I. (1968). Financial ratios, discriminant analysis and the prediction of corporate bankruptcy. The Journal of Finance, 23(4), 589-609. https://doi.org/10.1111/j.1540-6261.1968.tb00843.x

Libby, T., & Lindsay, R. M. (2010). Beyond budgeting or budgeting reconsidered? A survey of North-American budgeting practice. Management Accounting Research, 21(1), 56-75. https://doi.org/10.1016/j.mar.2009.10.003

Myers, S. C., & Majluf, N. S. (1984). Corporate financing and investment decisions when firms have information that investors do not have. Journal of Financial Economics, 13(2), 187-221. https://doi.org/10.1016/0304-405X(84)90023-0