Financial Analysis

 

 

 

Financial Statement Analysis

Financial statement analysis involves using accounting information to make business and investment decisions. Such analysis helps investors and creditors predict the amount of expected returns and assess the risk associated with their investments and loans.
When analysing financial statements, it is very important that you apply good judgement. For instance, it is more appropriate to compare the financial results of similar businesses so that you can compare "apples with apples." It is also appropriate to compare the current performance of a business with its performance in previous years.

Common-Size Statements

When comparing the financial statements of different companies, particularly if one is much larger, it is useful to prepare statements showing only percentages. By doing this, changes in proportions are clearer making efficiencies and inefficiencies easier to identify.


Item

Co. X-$

Co. X-%

Co. Y-$

Co. Y-%

Sales (net)

$2,000

100 %

$1,000

100 %

Cost of Goods Sold

500

25 %

250

25 %

Gross Margin

1,500

75 %

750

75 %

Operating Expenses

1,000

50 %

400

40 %

Profit before Taxes

500

25 %

350

35 %

Income Tax

250

12.5 %

175

17.5 %

Net Income

250

12.5 %

175

17.5 %

In the preceding example, by using the "common-size" approach, it is much easier to determine which company is doing better.

Ratio Analysis

Financial statements can be analysed using key financial ratios. A ratio is an expression of a mathematical relationship between one quantity and another (e.g., the ratio of 400 to 200 is 2:1). To be useful, the elements of a ratio must express a meaningful relationship. For instance, there is a relationship between debt and equity.
Ratios are not ends in themselves but provide insights into the operation of a business. They serve as "benchmarks" against which the company can evaluate itself and are only really useful when:

When using ratios, you must understand the factors that enter into the structure of the ratio and the way changes influence the ratio. The proper use of ratio analysis can help you to determine solvency, efficiency, profitability and capital structure. There are a number of ratios which are useful but only some are included in this workbook.

Solvency

A frequently used financial analysis tool is the current ratio where current assets are divided by current liabilities. The term "current" refers to transactions that have to occur within the short term, usually a period of one year.
To determine Newco'scurrent ratio, you would look at the last balance sheet. Current assets include cash ($35,755), the inventory of raw materials ($21,499) and accounts receivable ($50,000). Current liabilities include the principal and interest on the note payable that the company has to repay in the following year ($11,894) and the accounts payable ($25,000). Newco's current ratio is: $107,254/$36,894 = 2.9:1 or 2.9
In other words, Newco has $2.90 of current assets for each dollar of current liabilities. A general rule suggests that a 2:1 ratio is ordinarily satisfactory, although it varies among industries. A very low current ratio would cause concern because it would suggest a cash flow problem is imminent. An excessively high current ratio suggests that the firm is not managing its current assets effectively.
Another, more rigorous measure of solvency is the acid-test or quick ratio which excludes some current assets such as inventory because they might not be readily converted into cash. Generally, a quick ratio of 1:1 is considered appropriate for most businesses. Newco's quick ratio is $85,755/$36,894 = 2.32:1 or 2.32
Analysis: Newco's liquidity levels after 2 years appear to be all right but it is important to note that the comparable ratio in the previous year was 6.8--Newco may be managing its assets better, but the company would be advised to watch its cash flow carefully.

Efficiency

Efficiency ratios are used to measure how well a company manages its assets and how effectively it uses those assets to generate sales.
The inventory turnover ratio measures the relationship between the volume of goods sold and inventory levels. This ratio = cost of goods sold/average inventory. A turnover ratio of 2.9 means goods are bought and sold out more than 2.9 times a year on average. A high inventory turnover indicates that:

Because Newco only produces golf clubs after a customer has ordered, it does not have any finished goods inventory. However, it does have purchased raw materials and it is possible to compute a raw material turnover ratio = cost of raw materials used/average raw material inventory that can be interpreted in a similar manner. Generally, Newco will have a ratio of 1:1 because it uses all of the raw materials purchased in a period.

Profitability

Profitability refers to the ability of the business to earn income. Net income is the single most significant measure of profitability. Investors and creditors have a great interest in evaluating the current and prospective profitability of a business, and profitability ratios have been developed to measure operational performance.
Profit margin or return on sales indicates the dollar amount of net income the business receives from each dollar of sales. This ratio reflects management's ability to control costs relative to sales. Using Newco's last income statement for the second year, return on sales = $1,113/$201,875 = 0.0055 or 0.55%.
Analysis: This represents a significant decline in profitability from the first year of operation when return on sales = $5,824/$212,500 = 0.0274 or 2.74%. It is clear that Newco must act to improve profitability or its future will be very uncertain.
Return on assets indicates the company's performance in using the company's available resources to produce income. There should be a reasonable return on money committed to the enterprise, and this return can be compared to alternative uses of the money such as investing in Canada Savings Bonds. During their second year of business, Newco's return on assets = net income/total assets = $1,113/$247,254 = 0.0045 or 0.45%.
Analysis: This also represents a significant decline in profitability from the first year when return on assets = $5,824/$225,000 = 0.0259 or 2.59%. This too suggests that Newco must take action to improve profitability. Keep in mind, profitability depends on some combination of increasing sales volumes or prices, and reducing costs.
A particular business may be profitable, but still doing poorly compared with its competitors that are more profitable. The less profitable company becomes continually weaker and even less competitive. Therefore, it is useful to compare profitability with industry standards. However, any business making regular losses must take some action to remedy the situation.
Many analysts consider return on investment (ROI) a critical ratio for evaluating profitability. A common ROI measure is return on stockholder's equity which indicates management's success or failure at maximizing the return to stockholders based on their investment in the company.
This ratio emphasizes the income yield relative to the amount invested. After their second year of business, Newco's return on stockholder's equity = net income/stockholder's equity = $1,113/$156,712 = 0.0071 or 0.71%.
Analysis: Again, this represents a significant decline in profitability from the first year when the company's return on stockholder's equity = $5,824/$155,824 = 0.037 or 3.7%. Newco must take action to improve profitability.
Again, it is more useful to compare measures such as the return on investment with businesses that are in the same industry. If the business is performing well against similar companies this will generally indicate good management. If the business performs poorly, people will begin to think that they should invest in another opportunity.

Capital Structure

The relative amount of a company's capital that was obtained from various sources is very important in analysing the soundness of the company's financial position.
From the company's point of view, debt capital is risky because if creditors are not paid properly, they can take legal action to obtain payment. Equity capital is much less risky because shareholders cannot force bankruptcy.
However, because shareholders have less certainty of getting their money out of the business, they are usually unwilling to invest unless they see a reasonable expectation of making a higher return than creditors such as banks. Therefore, business must make a trade-off between the risk that creditors might force them into bankruptcy and the higher cost associated with raising equity from new shareholders.
As its name suggests, the debt to equity ratio simply measures the relationship between debt and equity. Again, it is best to compare this ratio with a company's past performance or to a similar business in the same industry. At the end of its second year of business, based on information contained in Newco's last balance sheet, the debt to equity ratio = total liabilities/owner's equity = $90,317/$156,712 = 0.576 or 57.6%.
Analysis: Compared with the first year when the company's debt to equity ratio = $90,400/$155,824 = 0.58 or 58.0%, there has been relatively little change in this measure.

Recommendation

I would highly recommend quarterly financial statements in order to monitor the stability. The company is in the state of change (with the sale of the window division and current losses) and needs to be closely watched. If one assumes that the asset side is being managed efficiently, the losses will probably continue to be funded by an increased debt load (or slowing of payments to vendors.) In Mr. Hoppen's letter, he states that there has been significant progress. However, it is interesting to note that he does not say that they have operating income or net income for the current six month period. This is a red flag to me to take a look at what is currently happening within this company. Although he states they are making progress, have they actually succeeded in stopping the losses?

 

 

 

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