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Steps to a Basic Company Financial Analysis

Financial Ratio Analysis (Abridged)

Financial Statements Analysis

 

Steps to a Basic Company Financial Analysis

By Professor Harvey B. Lermack

Philadelphia University

Philadelphia, PA

Revised May 23, 2003

© 2003 Harvey B. Lermack

These are basic steps you may use when evaluating company cases in my graduate and undergraduate business strategy and business policy courses. 

Before you start, you must understand a couple of things.

·          This is not meant to be an exhaustive list; there are other steps that can be followed to get deeper into the meaning of the numbers.

·          You cannot analyze the numbers in a vacuum.  The numbers only provide indicators to trigger further questions in your mind.

·          In order to do a thorough job, you must understand something about the company’s business and strategies, and its industry.  Financial indicators vary from industry to industry; the ratios can only be interpreted when compared and contrasted with other companies in that industry.  For example, financial indicators are (and should be) different among financial institutions, manufacturing companies, companies that provide services, and technology and computer information and services companies.

·          Financial analysis is something of an art.  Experienced managers, investors and analysts develop a data bank of information over time, and after doing many such analyses, that they bring to bear every time they review a company.

Step 1.  Acquire the company’s financial statements for several years.  These may be found in your assigned case study; in a recent annual report; in the company’s 10K filing on the SEC’s EDGAR database; or from other sources found at my LINKS website.  As a minimum, get the following statements, for at least 3 to 5 years.

·          Balance sheets

·          Income statements

·          Shareholders equity statements

·          Cash flow statements

Step 2.  Quickly scan all of the statements to look for large movements in specific items from one year to the next.  For example, did revenues have a big jump, or a big fall, from one particular year to the next?  Did total or fixed assets grow or fall?  If you find anything that looks very suspicious, research the information you have about the company to find out why.  For example, did the company purchase a new division, or sell off part of its operations, that year?  

Step 3.  Review the notes accompanying the financial statements for additional information that may be significant to your analysis.

Step 4.  Examine the balance sheet.  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?  If you find anything that looks very suspicious, research the information you have about the company to find out why. 

Step 5.  Examine the income statement.  Look for trends over time.  Calculate and graph the growth of the following entries over the past several years. 

·          Revenues (sales)

·          Net income (profit, earnings)

Are the revenues and profits growing over time?  Are they moving in a smooth and consistent fashion, or erratically up and down?  Investors value predictability, and prefer more consistent movements to large swings.

For each of the key expense components on the income statement, calculate it as a percentage of sales for each year.  For example, calculate the percent of cost of goods sold over sales, general and administrative expenses over sales, and research and development over sales.  Look for favorable or unfavorable trends.  For example, rising G&A expenses as a percent of sales could mean lavish spending.  Also, determine whether the spending trends support the company’s strategies.  For example, increased emphasis on new products and innovation will probably be reflected by an increased proportion of spending on research and development.  

Look for non-recurring or non-operating items.  These are "unusual" expenses not directly related to ongoing operations.  However, some companies have such items on almost an annual basis.  How do these reflect on the earnings quality?

If you find anything that looks very suspicious, research the information you have about the company to find out why. 

Step 6.  Examine the shareholder's equity statement.  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?

If you find anything that looks very suspicious, research the information you have about the company to find out why. 

Step 7.  Examine the cash flow statement, which gives information about the cash inflows and outflows from operations, financing, and investing.  

While the income statement provides information about both cash and non-cash items, the cash flow statement attempts to reconstruct that information to make it clear how cash is obtained and used by the business, since that is what investors and creditors really care about.

If you find anything that looks very suspicious, research the information you have about the company to find out why. 

Step 8.  Calculate financial ratios in each of the following categories, for each year.  You may use the formulas found in your textbook, or other materials you have from your finance and accounting courses.  A summary of some useful ratios appears at the end of this document.

·          Liquidity ratios

·          Leverage (or debt) ratios

·          Profitability ratios

·          Efficiency ratios

·          Value ratios

Graph the ratios over time, to find the trends in the ratios from year to year.  Are they going up or down?  Is that favorable or unfavorable?  This should trigger further questions in your mind, and help you to look for the underlying reasons.

Step 9.  Obtain data for the company’s key competitors, and data about the industry. 

For competitor companies, you can get the data and calculate the ratios in the same way you did for the company being studied.  You can also get company and industry ratios from the Quicken.com Evaluator, Schwab Stock Evaluator, or other locations on my LINKS website.

Compare the ratios for the competitors and the industry to the company being studied.  Is the company favorable in comparison?  Do you have enough information to determine why or why not?  If you don’t, you may need to do further research.  

Step 10.  Review the market data you have about the company’s stock price, and the price to earnings (P/E) ratio.

Try to research and understand the movements in the stock price and P/E over time.  Determine in your own mind whether the stock market is reacting favorably to the company’s results and its strategies for doing business in the future.

Review the evaluations of stock market analysts.  These may be found at any brokerage site, or from various locations on my LINKS website.   

Step 11.  Review the dividend payout.  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?  Based on your research into the industry, are you convinced that the company has sufficient opportunities for profitable reinvestment and growth, or should they be distributing more to the owners in the form of dividends?  Viewed another way, can you learn anything about their long-term strategies from the way they pay dividends?

Step 12.  Review all of the data that you have generated.  You will probably find that there is a mix of positive and negative results.  Answer the following question:

“Based on everything I know about this company and its strategies, the industry and the competitors, and the external factors that will influence the company in the future, do I think this company is worth investing in for the long term?”

© 2003 Harvey B. Lermack

Financial Ratio Analysis (Abridged)

Adapted from "Financial Statements Analysis," 

Courtesy of Professor Philip Russel

Philadelphia University

Philadelphia, PA  

A popular way to analyze the financial statements is by computing ratios. A ratio is a relationship between two numbers, e.g. ratio of A: B = 1.5:1 ==> A is 1.5 times B.  A ratio by itself may have no meaning.  Hence, a given ratio is compared to:

bullet

Ratios from previous years for internal trends

bullet

Ratios of other firms in the same industry for external trends. 

Ratio analysis is a diagnostic tool that helps to identify problem areas and opportunities within a company.  , we will discuss how to measure and interpret some key ratios.

The most frequently used ratios by Financial Analysts provide insights into a firm's

bulletLiquidity
bulletDegree of financial leverage or debt
bulletProfitability
bulletEfficiency
bulletValue

A.  Analyzing Liquidity 

Liquid assets are those that can be converted into cash quickly.  The short-term liquidity ratios show the firm’s ability to meet its short-term obligations. Thus a higher ratio (#1 and #2) would indicate a greater liquidity and lower risk for short-term lenders. The Rules of Thumb for acceptable values are: Current Ratio (2:1), Quick Ratio (1:1).

While high liquidity means that the company will not default on its short-term obligations, one should keep in mind that by retaining assets as cash, valuable investment opportunities may be lost.  Obviously, cash by itself does not generate any return.  Only if it is invested will we get future return.  

1.  Current Ratio = Total Current Assets / Total Current  Liabilities 

2.  Quick Ratio = (Total Current Assets - Inventories) / Total Current Liabilities

In the quick ratio, we subtract inventories from total current assets, since they are the least liquid among the current assets

B.  Analyzing Debt

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.  If the company is unable to pay its debt, it will be forced into bankruptcy. On the positive side, use of debt is beneficial as it provides tax benefits to the firm, and allows it to exploit business opportunities and grow.

Note that total debt includes short-term debt (bank advances + the current portion of long-term debt) and long-term debt (bonds, leases, notes payable).

1.  Leverage Ratios

1a.   Debt to Equity Ratio = Total Debt / Total Equity

This shows the firm’s degree of leverage, or its reliance on external debt for financing.

1b.  Debt to Assets Ratio = Total Debt  /  Total assets

Some analysts prefer to use this ratio, which also shows the company’s reliance on external sources for financing its assets. 

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.  This is a question that can be answered only by further company and industry research.

A frequently cited rule of thumb for manufacturing and other non-financial industries is that companies not finance more than 50% of their capital through external debt.

2.  Interest Coverage (or Times Interest Earned) Ratio = Earnings Before Interest and Taxes / Annual Interest Expense 

This shows the firm’s ability to cover fixed interest charges (on both short-term and long-term debt) with current earnings.  The margin of safety that is acceptable varies within and across industries, and also depends on the earnings history of a firm (especially the consistency of earnings from period to period and year to year).

3.  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)

Since depreciation is usually the largest non-cash item in most companies, analysts often approximate Net cash flow as being equivalent to Net Income + Depreciation.

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 favorable opinion on the company.  nalysts prefer ratio #3 to ratio #2.

C.  Analyzing Profitability 

Profitability is a relative term.  It is hard to say what percentage of profits represents a profitable firm, as profits depend on such factors as the position of the company and its products on the competitive life cycle (for example profits will be lower in the initial years when investment is high), on competitive conditions in the industry, and on borrowing costs. 

For decision-making, we are concerned only with the present value of expected future profits.  Past or current profits are important only as they help us to identify likely future profits, by identifying historical and forecasted trends of profits and sales.  

We want to know 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; and other things that indicate the likely future profitability of the firm.

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

Note:  The terms profits, earnings and net income are often used interchangeably in financial statements.  Be sure to review the statements to understand their components.

 D.  Analyzing Efficiency

These ratios reflect how well the firm’s assets are being managed.  

The inventory ratios shows how fast the inventory is being produced and sold.

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.  Thus a ratio of 12 would mean that the inventory turns over 12 times, or the average inventory is sold in a month.

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. 

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

Ratio #5 is referred to as the  “shelf-life” i.e. how quickly the manufactured product is sold off the shelf. Thus #5 and #1 are related.

E.  Value Ratios

Value ratios show the “embedded value” in stocks, and are used by investors as a screening device before making investments.  

For example, a high P/E ratio may be regarded by some as being a sign of  “over pricing”.  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.  For example, in the late 1990s Internet stocks tended to have extremely high P/E ratios, despite their lack of profits, reflecting investors' optimism about the future prospects of these companies.  Of course, the burst of the bubble showed that such confidence was misplaced.

On the other hand, a low P/E ratio may show that the company has a poor track record.  On the other hand, 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.

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

F.  Uses and Limitations of Ratio analysis

Uses

1.  To evaluate performance, compared to previous years and to competitors and the industry

2.  To set benchmarks or standards for performance

3.  To highlight areas that need to be improved, or areas that offer the most promising future potential

4.  To enable external parties, such as investors or lenders, to assess the creditworthiness and profitability of the firm

Limitations

1.  There is considerable subjectivity involved, as there is no “correct” number for the various ratios.  Further, it is hard to reach a definite conclusion when some of the ratios are favorable and some are unfavorable. 

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.  Furthermore, if a firm is engaged in diverse product lines, it may be difficult to identify the industry category to which the firm belongs.  Also, just because a specific ratio is better than the average does not necessarily mean that the company is doing well; it is quite possible rest of the industry is doing very poorly. 

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.  Furthermore, financial statements such as the balance sheet indicate the picture at “one point” in time, and thus may not be representative of longer periods. 

4.  Financial statements provide an assessment of the costs and not value.  For example, fixed assets are usually shown on the balance sheet as the cost of the assets less their accumulated depreciation, which may not reflect the actual current market value of those assets.  

5.  Financial statements do not include all items.  For example, it is hard to put a value on human capital (such as management expertise).  And recent accounting scandals have brought light to the extent of financing that may occur off the balance sheet.

6.  Accounting standards and practices vary among countries, and thus hamper meaningful global comparisons.

Financial Statements Analysis

By Professor Philip Russel

Philadelphia University

Philadelphia, PA

August, 2004

This outline discusses how the myriad of information presented in the financial statements is used to facilitate decision making by the managers, investors, regulators, competitors, banks, and other interested groups. The analysis is performed chiefly by summarizing the financial statement information into ratios.  The outline will assist you in getting a general understanding of the financial statements and identifying some of the key ratios.  

CONTENTS

 1.   Introduction

2.   Annual Reports and Financial Statements

3.   What you Need to Know About Financial Statements?

4.   Financial Ratio Analysis

5.   Uses and Limitations of Ratio Analysis

1.  Introduction

Financial statement analysis involves analyzing the firm’s financial statements to extract information that can facilitate decision-making.  For example, an analysis of the financial statement can reveal whether the firm will be able to meet its long-term debt commitment, whether the firm is financially distressed, whether the company is using its physical assets efficiently, whether the firm has an optimal financing mix, whether the firm is generating adequate return for its shareholders, whether the firm can sustain its competitive advantage etc;  While the information used is historical, the intent is clearly to arrive at recommendations and forecasts for the future rather than provide a “picture of the past”.

 The performance of a firm can be assessed by computing key ratios and analyzing: (a) How is the firm performing relative to the industry? (b) How is the firm performing relative to the leading firms in their industry? (c) How does the current year performance compare to the previous year(s)? (d) What are the variables driving the key ratios? (e) What are the linkages among the ratios? (f) What do the ratios reveal about the future prospects of the firm for various stakeholders such as shareholders, bondholders, employees, customers etc.? Merely presenting a series of graphs and figures will be a futile exercise.  We need to put the information in a proper context by clearly identifying the purpose of our analysis and identifying the key data driving our analysis. 

 Financial analysis is performed by both internal management and external groups.  Firms would perform such an analysis in order to evaluate their overall current performance, identify problem/opportunity areas, develop budgets and implement strategies for the future.  External groups (such as investors, regulators, lenders, suppliers, customers) also perform financial analysis in deciding whether to invest in a particular firm, whether to extend credit etc. There are several rating agencies (such as Moody’s, Standard & Poors) that routinely perform financial analysis of firms in order to arrive at a composite rating.

 2.  Annual Reports and Financial Statements

 The annual reports of companies typically contain: (a) CEO/President’s letter to shareholders (b) Financial statements (c) Other information

 (a) CEO/President’s letter summarizing the operations of last year, explanations for good/bad performance, and a discussion on the goals for the immediate and long-term future. It will be a good idea to review the letter to shareholders of some prominent companies.  Warren Buffet of Berkshire Hathaway is famous for writing the most insightful letters. 

 (b) Four Financial Statements

 The financial statements (typically published every quarter and annually) are prepared according to GAAP and audited by “independent auditors”. However, as the recent corporate scandals have revealed, there are definitely too many gaps/loopholes in how the GAAP is implemented!!. Nonetheless, financial statements are an invaluable source of information.

 B1. Balance Sheet (also known as the Statement of Financial Position): This provides the value of firm’s assets (what the firm owns), liabilities (what the firm owes to outsiders) and equity (what the inside shareholders or owners own) on a particular date.  The value of assets will equal the value of liabilities plus owner’s equity (or A = L +E).  Items in the balance sheet are listed based on conservative principle i.e. if estimating or in doubt of the actual value, the value of assets is not be overstated and the value of liabilities is not be understated.

 What do we see in the balance sheet? Assets: Current assets (ex. cash, marketable securities, accounts receivable, inventory, prepaid expenses) that are more liquid than the long-term/fixed assets (ex. equipment, land), assets that are intangible and yet valuable (ex. goodwill, patents, deferred charges).   Liabilities could include current liabilities (ex. bank advances, income tax payable, accounts payable, accrued expenses), deferred income taxes (difference between the tax reported on the income statement and tax reported on the tax return), Minority interest in subsidiary companies (representing outside ownership in subsidiary companies), long-term debt (ex. Bonds, capital leases). Shareholder’s Equity includes Share capital (par or stated value of shares received at the time of original issue), Paid-in-capital (when shares are sold for more than the par or stated value), retained earnings/deficit (undistributed earnings), foreign currency translation adjustment (fluctuation in the value of assets of foreign subsidiaries due to changes in exchange rates). Equity is also expressed as “residual interest” (E=A-L). If E is negative, the firm is technically bankrupt.

 Net worth or Book Value refers to what is available to common shareholders and is given by:

             Total Assets – Total Liabilities – Preferred Stock = Net Worth

             Net worth divided by number of common shares outstanding will give us the book value per share.  The market value is equal to the price per share times the number of shares outstanding (also referred to as the market capitalization of a company). We can estimate the intrinsic value of stock by using discounted cash flow models. 

bulletAll assets (except Land) lose their value over time and this is accounted for through depreciation (for fixed assets), depletion (for natural resources) and amortization (for intangible assets/deferred charges).   

Limitations of Balance Sheet: The balance sheet records the values of assets and liabilities in terms of their original cost.  This is especially misleading for fixed assets (that could have significantly changed in value). Also, it is difficult to value intangible assets.  Current assets are less troublesome, partly because of their short-term nature (inventories and marketable securities are listed at lower of their cost or market values).  Liabilities are also not biased (since they are generally contractual, and market values will be equal to their book values; For example, if the company has taken a loan, the dollar amount of loan obligation does not change with time).  Also, an analyst should pay close attention to “off-balance sheet items”.

 B2. Income Statement (also known as The statement of earnings or profit & loss statement or the statement of operations): The income statement provides information on the various revenue and expense items during a certain period.  Thus this statement shows the total income generated in a certain period.  Items in the income statement are based on accrual principle i.e. transactions (such as sales) are recognized when they occur and not when actual cash is received. Furthermore, the expenses are matched to when the revenue is recognized and not when the actual payment is made.  The above principle makes it obvious that there could be wide discrepancy between a firm’s revenue and actual cash flow.

 There are several forms of income statement. An example of a generic form is as follows: 

Sales Revenue

- Cost of Good Sold               

=     Gross Profit               

- Selling and Administrative expenses

- Depreciation

=    Earnings Before Interest and Taxes (EBIT)

- interest expenses (on bank loans and bonds)

+ interest income

=   Earnings before Taxes (EBT)

- taxes (current and deferred)

=    Earnings after Taxes (EAT)

+    income from subsidiaries (equity income)

+/- Gains/Losses from discontinued operations

+/-  Gain/loss on extraordinary items

=    Net Earnings

- Preferred Stock Dividends

=    Earnings available for common shareholders

 Limitations of Income Statement: In finance, the focus is on “valuation” that requires knowledge of expected cash flows rather than historical earnings.  Note net income does not equal the actual cash flow.  This is because the income statement reports revenue/expenses when they are earned/accrued and not when actual cash is received.  Further, several items are subjectively determined (ex. depreciation).  Also, depreciation is based on historical cost of the asset.  Thus, during periods of inflation, depreciation expense will be understated as it is based on historical cost while the revenues reflect the current market price.... such non-synchronization leads to inflated earnings. Furthermore, a traditional income statement only records transactions and not “opportunities”.  As Block, Hirt, and Short (1998, pp. 34) note, “The economist defines income as the change in real worth that occurs between the beginning and the end of a specified time period.  To the economist, an increase in the value of a firm’s land as a result of a new airport being built on an adjacent property is an increase in the real worth of the firm. It, therefore, represents income.  The accountant does not ordinarily employ such a broad definition of income”.

 B3. Statement of Retained Earnings (also known as the Statement of changes in shareholder’s equity, statement of shareholders’ investment or statement of changes in shareholders’ equity): It shows the balance in retained earnings after making adjustments for current profits and current dividend.  It also shows information on treasury stock, any new shares issued, the impact of exercised options, preferred stock details and additional paid-in-capital.

 B4. Cash Flow Statement: It shows how the company obtained cash and for what purpose they were used.  Thus cash balance at the end =  

Cash in the beginning

+ Net Cash flow from operating (income statement cash items)

+ Net Cash flow from financing (ex. proceeds from sale of bonds, repayment of    loan, payment of dividends)

+ Net Cash flow from investing activities (ex. Sale/purchase of asset).

 (c) Other information in the annual report

 1. Notes to financial statements[1]

2. The Auditor’s report

 3.    What You Need to Know About Financial Statements

 (Reference: Prentice Hall Publishers; Authors: Unknown, 2003) 

As the Enron fiasco has brought to light, there is plenty wrong with the way financial results are reported. Congressional committees will determine how much of Enron’s troubles were due to criminal activity, and how much due to poor judgment and loopholes. But "managing results" is an old game on Wall Street. The pros know how to read between the lines to identify shaky financials. They read the footnotes to the financial statements carefully for clues that will tell them how aggressively the company is pushing to use legal, but misleading GAAP, rules to their limit.

So here is a list of things to look for in financial statements that will tell you as much or more about the company than the actual reported results.

First, Wall Street is not your friend. Making money in a stock market that is trading flat is a zero sum game. For you to profit, someone else must lose. Be skeptical and very careful where you get your investment advice. Question the motives of so-called experts. As of yet, there are no rules ensuring that they disclose their conflicts of interest.

Proforma Earnings Announcements - Many companies now issue Proforma Earnings Statements that exclude certain expense items as being "extraordinary". It is now a normal part of business for many firms, particularly tech firms. The trouble is that there are no standards for reporting Proforma Statements, leaving the door open to manipulating earnings and misleading investors. Outgoing SEC Chief Economist Lynn Turner says pro forma earnings are effectively "EBS" earnings--"Everything but the Bad Stuff." A study that compares the unaudited Proforma Earnings Statements to the NASDAQ 100 companies with the audited statements they filed with the SEC shows a huge $101 billion difference for the first three quarters of 2001.

Frequent Restructuring Charges and Write-Downs - As businesses adjust their internal structure, they incur costs for shutting down one activity and starting another. In a small company, charges for these activities would occur infrequently, but in a large company, they will be routine. If charges and write downs for restructurings occur regularly, the company may be classifying normal business expenses as extraordinary to create the illusion that the core business is more profitable than it really is.

Reserve reversals - Companies generally establish reserves to cover the costs of restructuring. Reserves allow management to "store profits" for later use if the reserves are unusually large. At a later time, they can reverse the reserve for the amount that was not spent and it flows directly to the bottom line.

Pension Funds - are great sources of earnings manipulation. Boost earnings by under funding them or by overestimating the investment return of the fund so that current payments will be lower and profits higher. If the fund does particularly well, pull the excess back into the income statement to boost profits.

Footnotes to Financial Statements - Statements can mislead and evade but they must come clean in the footnotes or face criminal charges. That’s why the pros look here first. You will learn about risk exposure, debt that changes character under certain conditions, the use of aggressive accounting practices and all sorts of other details that management would like to avoid telling you.

Sales/Non-Sales - Look at the revenue and receivable numbers over several years. Is the ratio of receivables to sales increasing? If yes, then the company is shipping goods faster than customers are paying for them. Are deferred revenues dropping? If so, the company is living off last year’s sales. In the current slowdown, customers look to change sales terms to use the supplier’s money as much as possible by acknowledging the sale as late as possible.

Cash Flow is King - The pros know that it is too easy to manipulate earnings numbers. So they focus on cash flow as being a more reliable indicator of performance because the cash is either there or it isn’t. One expert, thinks a comparison of cash flow vs. non-cash revenue could have been an early tip of to Enron investors.

Goodwill - Companies account for the premium over book value that they pay for an acquired company as goodwill. Under the older accounting rules, companies could write down the payment for goodwill with a charge against earnings spread out over decades. First Call estimates that, because of the goodwill accounting change, analyst forecasts for 2002 are about three percentage points too high. As companies restate prior year earnings to account for the change, earnings will shrink.

Employee Stock Options - 78% of companies with sales over $10 billion compensate management with stock options. Yet accounting rules do not require the issuing of the option to be accounted for with an expense. In the wake of Enron, this controversial and questionable rule may be changed. If so, one expert estimates that many large tech companies may see an annual reduction in earnings of 1/3.

4.  Financial Ratio Analysis

 A popular way to analyze the financial statements is by computing ratios. A ratio is a relationship between two numbers, e.g. ratio of A: B = 30:10==> A is 3 times B.  A ratio by itself may have no meaning.  Hence, a given ratio is compared to (a) ratios from previous years - internal trends, or (b) ratios of other firms in the same industry - external trends. Ratios are more of a diagnostic tool that helps us to identify problem areas and opportunities within a company.  In this section, we will discuss how to measure and interpret some key ratios. Obviously, since ratio is simply a comparison of two variables, the possibilities for number of ratios are endless! There is no “one” way of classifying various ratios so you may find different groupings depending on what text or article you read. Also, there are no specific rules on what is an “ideal or acceptable” number for a ratio, although there are some rules of thumb.

 The key ratios that are determined by the financial analysts provide insights on (a) liquidity (b) degree of financial leverage or debt (c) profitability (d) efficiency and (e) value.

 A.  Analyzing Liquidity

 Liquid assets are those assets that can be converted into cash quickly.  The short-term liquidity ratios show the firm’s ability to meet short-term obligations. Thus a higher ratio (#1 and #2) would indicate a greater liquidity and lower risk for short-term lenders. The Rule of Thumb (for acceptable values): Current Ratio (2:1), Quick Ratio (1:1)  While high liquidity means that the company will not default on its short-term obligations, note that by retaining assets as cash, valuable investment opportunities might be lost.  Obviously, Cash by itself does not generate any return ... only if it is invested will we get future return.  In quick ratio, we subtract the inventories from total current assets since they are the least liquid (among the current assets).

1.         Current Ratio                = Total Current Assets/Total Current Liabilities 

2.       Quick or Acid-test Ratio       = Total Current Assets - Inventories /Total Current Liabilities

 B.  Analyzing Debt

 These ratios show the extent to which a firm is relying on debt to finance its investments/operations and how well it can manage the debt obligation (i.e. repayment of principal and periodic interest).  Obviously, if the company is unable to repay its debt or make timely payments of interest, it will be forced into bankruptcy. On the positive side, use of debt is beneficial as it provides valuable tax benefits to the firm. Note total debt should include both short-term debt (bank advances + current portion of long-term debt) and long-term debt (such as bonds, leases, and notes payable). Some texts may include only long-term debt. Again, what you use will depend on what your question is.

 1.  Leverage Ratios

 1a Asset-Equity Ratio or Leverage Ratio= Assets/Shareholder’s Equity

             This shows firm’s reliance on external debt for financing (or the degree of leverage).  Any number above 100% shows that the company relies on external debt for financing some of its assets. If the number equals 100%, it implies that the assets are fully financed by the shareholders.

  Some analysts tend to use the Debt ratio (given by total Debt/total assets) or Debt/Equity ratio (given by total long-term debt/equity).  These ratios also show company’s reliance on external sources for financing its assets. Ratio 1d shows what proportion of the total long-term capital comes from debt.

 1b Total Debt ratio = Total Debt/Total assets

1c. Debt-Equity Ratio = Total Debt/Equity

1d. Long-term Debt to capital = Debt/Debt + Equity

 For a lender, more important than the degree of leverage is the firm’s ability to service the debt and this is captured in the following two ratios.

 2. Interest Coverage Ratio              = EBIT/ Annual Interest Expense 

             This shows the firm’s ability to cover fixed interest charges (on both short-term and long-term debt).  The margin of safety that is acceptable will vary within and across industries, and will also depend on the earnings history of a firm.

  3. Cash Flow Coverage  = Net Cash flow/Interest Expense

 Net Cash flow is equal to Net Income +/- non-cash items (-equity income + minority interest in earnings of subsidiary + deferred income taxes + depreciation + depletion + amortization expenses).  Since depreciation is the biggest dollar term, oftentimes analysts would approximate Net cash flow as being equivalent to EBIT + depreciation.

 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 favorable opinion on the company.  Financial analysts prefer using ratio #3 to ratio #2, although ratio #2 is more widely reported.

 C.  Analyzing Sales and Profitability

 Profitability is a relative term. It is hard to say “what % of profits” represents a profitable firm as the profits will depend on the product life cycle (for example profits will be lower in the initial years), competitive conditions in the market, borrowing costs, expense management etc.  Profits can also be analyzed using the framework of CVP (cost-volume-prices).  Analysts will be interested in the (historical and forecasted) “trend” of sales/expenses/profits … are the profits generally on the rise, are the sales stable or rising, how do the profits compare to the industry average, is the market share of the company rising/stable/falling? Are the expenses rising, stable or falling? The set of ratios here include some of the traditional earnings based performance measures such as ROS, ROA, ROI, and ROE.  For a better understanding of growth rates, it will be useful to know the “real growth rate” as opposed to “nominal growth rate”. For example, it is quite possible that the sales growth rate figures are impressive due to inflation (rather than an increase in the number of items sold).  This is particularly useful if we are dealing with high inflation period or conducting an extending time series analysis. 

 1.         Sales Growth Rate                 = {(Current year sales – last year sales)/last year sales}*100

2.       Expense analysis                   = Various expenses /Sales

3.       Gross Margin/Sales                     = Gross Profit/Total Sales

4.       Operating Profit/Sales       = Operating Profit/Net Sales

5.       EBIT/Sales                           = EBIT/Net Sales

6.       Return on Sales (ROS) or net profit ratio = Net Income/Net Sales

7.       Return on Investment (ROI)                = Net Income/Total Assets

8.       Return on Assets (ROA)              = Net Income/Total Assets

9.       Return on Equity       (ROE)         = EAT/Shareholders’ Equity

10.     Payout ratio                       =  Cash Dividends/ Net Income

11.       Retention ratio                       = Retained Earnings/Net Income

12.     Sustainable growth rate (SGR)      = ROE * Retention Ratio

 It is useful to disaggregate the ROE figure into three elements as follows to get a better insight 

bulletROE = {Net Income/Sales} * {Sales/Assets} * (Assets/Equity)

 The above formulation clearly shows that if management wishes to improve their ROE, they need to improve profitability, efficiently use the assets, and optimize the use of debt in their capital structure.  Thus two companies with similar profitability may have different ROEs depending on their degree of financial leverage. If we combine this with ratio #10, we can see that a firm’s growth rate will depend on all of these factors plus their divided policy. Thus it covers the three main financial decisions in any corporation: investment decision, operating decision and financing decision.

 SGR shows how much the company will grow in the future if some of the key ratios remain the same as in previous years.  It is useful to disaggregate the sustainable growth rate as follows.

 SGR      = f(Profitability, Asset Efficiency, Leverage, Dividend policy) 

= Return on Sales * Asset turnover ratio * Leverage * Retention ratio           

            = (Net income/sales) * (sales/assets) * (assets/equity) * (RE/net income) 

D. Analyzing Efficiency

 These ratios reflect how well the firm’s assets are being managed.   The inventory ratios show how fast the inventory is being produced and sold.  Ratio #1 shows how quickly the inventory is being turned over (or sold) to generate sales ... higher ratio implies the firm is more efficient in managing inventories by minimizing the investment in inventories.  Thus a ratio of 12 would mean that the inventory turns over 12 times or the average inventory is sold in a month.  Obviously, this ratio should be higher for WAWA (selling perishable goods) relative to a VW car dealer.  Some texts prefer to use “ending inventory” rather than “average inventory”.  High ratio by itself does not mean high level of efficiency as high ratio could also mean shortages. Ensure that there has been no change in inventory reporting policy (LIFO, FIFO) during the analysis period.  Ratio #2 is referred to as the “shelf-life” i.e. how many days the inventory was held in the shelf. Ratio #3 shows how much sales the firm is generating for every dollar of investment in assets … naturally, higher the better.  However, note that this ratio is biased (as assets are listed at historical costs while sales are based on current prices).  Ratios #4 and #5 show the firm’s efficiency in collecting from 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 drive away some customers.  Ratios #6 and 7 focus on efficiency in making payments.  Combining inventories, accounts receivable and accounts payable we get ratio #8, which shows the financing period to fund working capital needs. Longer the period, greater the short-term liquidity risk.     

1.         Inventory Turnover     = Cost of Goods Sold/Average Inventory

2.       Days in Inventory          = (Average Inventory/Cost of Sales)*365

3.       Assets turnover           = Net Sales/Total Assets

4.       Receivables Turnover       = Credit Sales/Accounts Receivables

5.       Average Collection period      = (Accounts Receivable/Net Sales)*365

6.       Accounts Payable turnover = Purchases/Accounts Payable

7.       Days AP outstanding    = (Accounts Payable/Cost of Sales)*365

8.       Financing Period      = Average Collection period + days in inventory – days AP outstanding

 E.  Analyzing Value

 Earnings per share (EPS) is widely reported although it is now less closely followed (after academic theory insights into the drawback of EPS and importance of cash flow based measures).   SEC requires that the company report both basic and diluted EPS. Basic EPS uses the actual number of shares currently outstanding in the market while diluted EPS uses currently outstanding shares + all potential shares (due to convertibility of debt or preferred stock as well as exercise of stock options, rights and warrants).  Dividend yield, while widely reported, may not contain much useful information by itself (especially when comparing across firms) since dividend policies vary across firms.  Furthermore, price appreciation (as opposed to dividends) is the more important source of yield for shareholders.

 Value ratios such as PE ratio show the “embedded value” in stocks and are used by the investors as a screening device before making their investment.  For example, a high P/E ratio may be regarded by some as being a sign of “over pricing”.  When the markets are bullish or if the investor sentiment is optimistic about a particular stock, the P/E ratio will tend to be high indicating that investors are willing to pay a high price for company’s earnings.  For example, in late 1990s internet stocks had extremely high P/E ratios (despite their lack of earnings) reflecting investor’s optimism about the future prospects of these companies. Of course, the burst of the bubble showed that such confidence was misplaced. PS ratio can be combined with PE ratio to analyze a company. Ratio #7 is useful for valuing companies such as internet services or cable services that rely primarily on members to generate income. Thus an assessment of members (total members, current and future expected growth rate, and average spending by member) can provide useful guideline in valuing such companies (especially when planning acquisitions).

1.         Earnings per Common share (EPS)   = (Net Earnings - Preferred Dividend)   

# of shares outstanding

 2.       Earnings Yield                       = 1/EPS

3.       Cash flow per Share (CPS)               = Net Cash Flows/# of shares outstanding

4.       Dividend Yield                       = Annual Dividend / Current Market price

5.       Price-earning Ratio (PE)       = Market Price per share / EPS

6.       Price-Sales Ratio (PS)        = Market price per share/Sales per share

7.       Membership Value                  = # of members * value per member

8.       Free CF per share       =  (Net Cash flow from Operations – Capital Expenditure)/# of shares

9.       Total Shareholder Return (TSR) = (Ending Price + Dividend – Beginning Price)/Beginning Price

10.     EVA = EAT – Cost of Financing (that is, Net Capital Assets Employed * WACC)

 5 Uses and Limitations of Ratio analysis

 Uses 

1.         To evaluate performance (compared to previous years & peers);

2.       To set benchmarks or standards for performance;

3.       To highlight areas that need to be improved or highlight areas that offer the most promising future potential;

4.       To enable external parties (such as investors/lenders) in assessing the creditworthiness/profitability of the firm.

 Limitations 

1.         There is considerable subjectivity involved as there is no theory as to what should be the “right” number for the various ratios.  Further, it is hard to reach a definite conclusion when some of the ratios are favorable and some are unfavorable.

2.       Ratios may not be strictly comparable for different firms due to a variety of factors such as different accounting practices, different fiscal year.  Furthermore, if a firm is engaged in diverse product lines it is difficult to identify the industry category to which the firm belongs.  Also, just because a specific ratio is better than the average does not necessarily mean that the company is doing well (it is quite possible rest of the industry is doing very poorly)

3.       Ratios are based on financial statements that reflect the past and not the future.   Unless the ratios are stable, one cannot make reasonable projections about the future trend. 

4.       Financial statements provide an assessment of the costs and not value.  For example, the market value of items may be very different from the cost figure given in the balance sheet.

5.       Financial statements do not include all items.  For example, it is hard to put a value on human capital (such as management expertise).

6.       Accounting standards and practices vary across countries and thus hamper meaningful global comparisons.

7.       Management decision making is a dynamic process in a constantly changing environment while ratio analysis is a static analysis based on historical data.

8.       The linkage among various ratios is not readily obvious. 

bulletLearn by Doing:  Review the website of any publicly traded company and review the annual report and see if you can understand the various items on the financial statements.  Next, compute the various ratios based on this outline and interpret them. 
bulletSome good sources of information on financial statements

o        On reading annual report:  http://www.ibm.com/investor/financialguide/gs/gs3b.phtml

o        On reading financial statements: http://www.ibm.com/investor/financialguide/

o        Our library also has some excellent links to databases: http://www.philau.edu/library/

  

[1]  Some of the items commonly found in the notes are: An explanation of the accounting methods used for depreciation, off-balance sheet items (such as derivative contracts), details on leases, impact of divestiture and acquisition on the financial statements.