For taking loans: Your banker will quickly analyze the financial statement to determine your capability of paying back a loan. For investment: Your investor(s) will do the analysis to determine if you have been performing according to plan, and/or whether your business is a good investment. For purchasing raw material: Your suppliers will analyze your financial statements to determine your credit worthiness—and so on.
How it is done
Technical analysis (Trend analysis) Fundamental analysis (Ratio analysis)
Steps Involved in Analysis
Calculate and graph the growth of the following entries over the past several years.
Net income (profit, earnings)
Investors value predictability, and prefer more consistent movements to large swings.
Rising G&A expenses as a % of sales could mean lavish spending.
Also, determine whether the spending trends support the company’s strategies.
e.g., increased emphasis on new products and innovation will probably be reflected by an increased proportion of spending on R & D.
Has the company issued new shares, or bought some back?
Has the retained earnings account been growing or shrinking? Why?
Are there signals about the company's long-term strategy here?
Step1: Acquire the company’s financial statements for several years Step2 : Examine the balance sheet Step3: Examine the income statement Step4: Examine the shareholder's equity statement Step5: Examine the cash flow statement Step6: Calculate financial ratios Step7: Review the dividend payout Step8: Review all
Graph the payout over several years.
Determine whether the company’s dividend policies are supporting their strategies.
For example, if the company is attempting to grow, are they retaining and reinvesting their earnings rather than distributing them to investors through dividends?
Leverage (or debt) ratios
As a minimum, get the following statements, for at least 3 to 5 years.
Shareholders equity statements
Cash flow statements
It gives information about the cash inflows and outflows from operations, financing, and investing.
Look for large changes in the overall components of the company's assets, liabilities or equity.
For example, have fixed assets grown rapidly in one or two years, due to acquisitions or new facilities? Has the proportion of debt grown rapidly, to reflect a new financing strategy?
Suspicious ? If you find anything that looks very suspicious, research the information you have about the company to find out why.
1. Liquidity ratio
The liquidity ratios show the firm’s ability to meet its short-term obligations.
Liquid assets are those that can be converted into cash quickly.
Liquidity ratio contd.. 1. Current Ratio = Total Current Assets / Total Current Liabilities 2. Quick Ratio = (Total Current Assets - Inventories) / Total Current Liabilities The Rules of Thumb for acceptable values are: Current Ratio (2:1), Quick Ratio (1:1).
Liquidity ratio contd..
2. Leverage/debt Ratios Debt to Equity Ratio = Total Debt / Total Equity Debt to Assets Ratio = Total Debt / Total assets Total debt includes short-term debt (bank advances + the current portion of long-term debt) and long-term debt (bonds, leases, notes payable)
Leverage/Debt Ratios contd.. Debt ratios show the extent to which a firm is relying on debt to finance its investments and operations, and how well it can manage the debt obligation, i.e. repayment of principal and periodic interest.
Leverage/Debt Ratios contd.. In general, with either of the above ratios, the lower the ratio, the more conservative (and probably safer) the company is. However, if a company is not using debt, it may be foregoing investment and growth opportunities. Debt to Equity ratio is used by bankers to determine if your business is credit worthy. A rule of thumb for manufacturing and other non-financial industries is that companies not finance more than 50% of their capital through external debt
Leverage/Debt Ratios contd.. Interest Coverage (or Times Interest Earned) Ratio= Earnings Before Interest and Taxes / Annual Interest Expense Cash Flow Coverage = Net Cash Flow / Annual Interest Expense Net cash flow = Net Income +/- non-cash items (e.g. -equity income + minority interest in earnings of subsidiary + deferred income taxes + depreciation + depletion + amortization expenses)
Leverage/Debt Ratios contd.. Cash flow is a “critical variable” in assessing a company. If a company is showing strong profits but has poor cash flow, you should investigate further before passing a favourable opinion on the company. Analysts prefer ratio #3 to ratio #2.
3. Profitability Ratio In this we see whether profits are generally on the rise; whether sales stable or rising; how the profits compare to the industry average; whether the market share of the company is rising, stable or falling; other things that indicate the likely future profitability of the firm.
Profitability Ratio contd.. 1. Net Profit Margin = Profit after taxes / Sales 2. Return on Assets (ROA) = Profit after taxes / Total Assets 3. Return on Equity (ROE) = Profit after taxes / Shareholders’ Equity (book value) 4. Earnings per Common share(EPS) = (Profits after taxes - Preferred Dividend) / (# of common shares outstanding) 5. Payout Ratio = Cash Dividends / Net Income
4. Efficiency Ratio These ratios reflect how well the firm’s assets are being managed. 1. Inventory Turnover = Cost of Goods Sold / Average Inventory This ratio shows how quickly the inventory is being turned over (or sold) to generate sales. A higher ratio implies the firm is more efficient in managing inventories by minimizing the investment in inventories. 2. Total Assets Turnover = Sales / Average Total Assets This ratio shows how much sales the firm is generating for every dollar of investment in assets. The higher the ratio, the better the firm is performing.
Efficiency Ratio contd.. 3. Accounts Receivable Turnover = Annual Credit Sales / Average Receivables 4. Average Collection period = Average Accounts Receivable / (Total Sales / 365) Ratios #3 and #4 show the firm’s efficiency in collecting cash from its credit sales. While a low ratio is good, it could also mean that the firm is being very strict in its credit policy, which may not attract customers. 5. Days in Inventory = Days in a year / Inventory turnover
5. Value Ratios 1. Price To Earnings Ratio (P/E) = Current Market Price Per Share / After-tax Earnings Per Share 2. Dividend Yield = Annual Dividends Per Share / Current Market Price Per Share
Value Ratios contd.. When the markets are bullish (optimistic) or if investor sentiment is optimistic about a particular stock, the P/E ratio will tend to be high. On the other hand, a low P/E ratio may show that the company has a poor track record. It may simply be priced too low based on its potential earnings. Further investigation is required to determine whether the company would then provide a good investment opportunity.
Limitations 1. There is considerable subjectivityinvolved, it is hard to reach a definite conclusion when some of the ratios are favourable and some are unfavourable. 2. Ratios may not be strictly comparable for different firms due to a variety of factors such as different accounting practices or different fiscal year periods. 3. Ratios are based on financial statements that reflect the past and not the future. Unless the ratios are stable, it may be difficult to make reasonable projections about future trends. 4. Financial statements provide an assessment of the costs ¬ actual value. 5. Accounting standards and practices vary among countries, and thus hamper meaningful global comparisons.