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Financial analysis

It is a process where business  is evaluated if its viable, stable and profitable enough. Almost all agrees one way or another that this process  main source is financial statements.

Financial statements

Financial reports, as well have a number of different definitions. One of them, Financial Statements – an accounting information about the company’s financial-economic activities of periodic summary and structured in a certain way. It is also stated that the financial statements of a certain time period or a reflection of the financial position. This is one of the factor to be considered as the company’s activities are continuously and the very next day the company’s results will be other then at the financial statement date. The financial statements do not reflect company’s financial situation changes during the reporting period, only the difference between the beginning and end of the period. To avoid this problem date should be analyzed each day of the financial statement, and then it would be faced with another problem of information overload. Usually is the quarterly 3 month financial statements.  Such period is considered as optimal. Annual reports are mostly more informative.

In different countries financial statements are different, but mostly they are these:

  • Balance;
  • Income statement;
  • Cash Flows;
  • Stockholders equity.

These sheets consist of items that are broken down into even smaller elements. Corporate performance analysis of the book tries by synthesis method to group into logical groups.

Balance

Balance is the oldest form of the financial statements, founded together with the double accounting principle. Balance definition has changed over time with balance forms in time. One of them is that the balance sheet is the company’s financial report form showing assets, liabilities and ownership status of a certain date in terms of money. According to the principle of double entry accounting equation: Assets = Liabilities + Equity (A = L + E). Also it is defined just as it describes the actual state of assets.

Balance sheet items consist of five groups marked with different letters:

  1. Current assets;
  2. Fixed (long term) assets;
  3. Liabilities;
  4. Stockholders’ Equity.

Each of these groups is divided into smaller elements.

Current assets: Cash and cash equivalents, Marketable securities, Accounts receivable, other current asset.

Fixed (long term) asset: Goodwill, Intangible assets (plats, buildings ant other), Tangible assets, Financial assets and other assets.

Liabilities: Accounts payable,  long and short term financial and other debts.

Stockholders equity: Common stocks, Retained earnings.

Income statement

Profit is the most important indicator of the company’s activities. Company has many objectives, but main among them is profit. This is why the financial records of the profit is in a separate report. The income statement can be described simply by the following formula: Profit = Revenue – Expenses (P = R – E).

Income statement consists of 5 items:

  1. Revenues
  2. Cost of revenues
  3. Operating expenses
  4. Interest and other income/expenses.
  5. Provision for income taxes.

And 4 types of profit:

  1. Gross Profit (Revenue – Cost of revenue)
  2. Operating Income (Gross Profit – Operating expenses)
  3. Income before income taxes (Income from operations – Interest and other income/expenses)
  4. Net income (Income before income taxes – Provision for income taxes)

Revenue: shows corporate income earned by sale of typical products and activities during the reporting period.

Cost of revenues: displays cost that are directly related to revenue: the purchase cost of sold goods, cost for works and workers. Sales revenue minus cost of revenue is equal to Gross Profit.

Operating Expenses: shows the normal operating costs that can not be directly linked to sales. These include such costs as staff salaries, rent, utility costs, depreciation of fixed assets and other.  When operating expenses is excluded from Gross profit equal to Operating Income.

Other activities: to company’s ordinary activities unrelated business income and related expense. For example: rental income, income from the sale of fixed assets and others.

Interest: companies cost of borrowing money – interest paid and interest received on deposits.

When added to Operating profit other and  interest income/expenses it results to Income before income taxes. After Provision for income taxes are excluded main companies figure is finally calculated – Net income. This figure is the only one which goes to balance sheet and adds up to Retained Earnings.

Cash Flows

Since income statement and balance reflects only the actual number of periods, a need to crease a report that shows change emerged. In 1987. U.S. Financial Accounting Standards Board introduced a new reporting form – cash flow statement. The main purpose of the report is to shows how, where and how much was received and were the company funds were used.

These are these main groups:

  1. Operating Activities cash flow
  2. Investing Activities cash flow
  3. Financing Activities cash flow

Operating Activities cash flow consists of net income, depreciation and amortization expenses, Changes in Working Capital.

It should be noted that the calculation of operating cash flow is essential to know the cost of depreciation and amortization as these costs does not require any usage of actual money. If added to net profit o very important indicator is reached of how much money the company actual earns – Net Income before depreciation.

There is a popular earning calculation called EBITDA (Earnings before taxes, amortization and depresation) which also excludes taxes and interests from earnings, but since taxes and bank interests  must be paid, so the most important indicator of the companies owners (shareholders) should be the company generated net cash flow mentioned above.

After that in operating cash flow a short-term assets and liabilities change can be described as Working capital (calculated as current assets minus current liabilities) change is calculated. It is therefore operating cash flow can be divided into two sections:

  1. Net Income before depreciation.
  2. Cash flow from working capital changes.

Also very important thing is the fact that increase in current assets generates negative cash flow, since the acquisition of assets means spending of the money money spent. Increase of short term liabilities generated positive cash flow.

Investing Activities cash flow, shows the change in fixed assets. Since the acquisition of fixed asset is considered as companies investments, it is called investing activities cash flow.

In order to calculate investments into long term asset cost of depreciation and amortization costs must be added to the change of long term asset. If cost of depreciation and amortization was larger then decrease of companies long term asset that means that company acquired some asset and if smaller that means that company has sold some of its long term asset.

Investment cash flow can be divided into two parts:

  1. Acquisition of property
  2. Acquisition of financial and other asset

Division is needed because financial asset has no depreciation and amortization, so its change reflects its real change and depreciation and amortization must be added only to change in long term property. As the change in current assets and operating cash flow, fixed assets investments generates negative cash flow.

Cash flow from financing activities: reveals the sources of other sources to finance the company. It can be divided into these parts:

  1. Equity change.
  2. Change in financial liabilities.

These two groups are divided into sub-articles, but the mainly equity change if negative reflects dividend payments or companies stock repurchase and if positive reflects companies stock issue to the market. Change in financial liabilities shows increase or decrease companies debts to financial institutions.

Also there is Foreign Exchange Effects.

If properly calculated the sum of all these cash flows should be the same as companies cash change at the balance sheet.

Financial Analysis Types

Almost all literature points out three major types of financial analysis used:

  1. Horizontal Analysis;
  2. Vertical analysis;
  3. Ratio analysis.

Horizontal Analysis: shows figure changes in two or more periods or their dynamics. Figure change can be calculated in percentage or numbers, how much have they changed at evaluated period compared with previous period.

Vertical Analysis: shows figure part or percentage compared to its basic figure. what portion does it makes. Basic figure is always 100%.

In short horizontal analysis shows figure change while vertical analysis its portion as showed below. As can be seen visually this is were its names come from since different figures are layed vertically and different periods horizontally.

Ratio Analysis:  Shows two financial statement figures ratio that are logically linked. This analysis methods is widely used to compare companies. Many ratios are calculated, some of them even don’t even have united name. There is no united grouping of these ratios, many analysts link them differently, but most common are these:

  1. Profitability;
  2. Solvency;
  3. Market ratios.

Profitability ratios  are calculated using different types of profit which basic income statement has 4 (gross profit, operating profit, income before tax, net income), also there is EBITDA and Net income before depreciation. Many more profit types can be created by including or excluding different types of expenses.

The most simple profitability ratios are calculated by dividing different type of profit from revenue. These are also called margins. These are the mostly used:

  • Gross profit margin
  • Operating margin
  • Net income margin

Also another very important figure to add would be EBIDA margin or Net income before depreciation margin which would show how much real earning are generated from one $ of revenue. This ratios are calculated from income statement figures, so they should be used when analyzing income statement data.

Other part of profitability ratios are calculated from dividing different type of profit with different balance sheet figures. Mostly common are these:

  • Asset profitability;
  • Equity profitability.

They are also called ROA – return on asset and ROE – return on equity and calculated mostly by dividing Net income with total asset and Net income with total equity. These figures show how effective companies asset and equity in generating Net income. There is also ROE subratio called ROEC – return on capital employed which is calculated by adding financial debts to equity a and shows how much one $ of borrowed and stockholders owned money generates profit. Reverse ratio would show how many years it would take for companies asset or equity would be earned.

Solvency ratios shows companies ability to cover various type of liabilities. Solvency is sometimes mixed with liquidity, but liquidity is mainly means how fast can some type of asset be converted into cash.

Solvency ratios can be grouped into long term solvency and short term solvency ratios which are linked to companies ability to pay its short term and long term debts.

One of main short term solvency ratio is Liquidity ratio which is calculated by dividing Total current asset from Total current liabilities. This ratio is very important because it shows companies ability to cover its short term debts. Even very profitable companies can run into trouble if to much short term debts matures at once. When this ratio is lower then 1 that shows that company has more short term debts to pay then it has short term asset and thus there is a risk that company can face solvency problems. When ratio is over 2 it can be called a very good and safe one. So here are its evaluations:

  • <1,0 bad
  • 1,0 – 1,5 acceptable
  • 1,5 – 2,0 good
  • >2,0 very good

Also other ratios are calculated by using different type of liquidity asset dividing by current liabilities. There is also quick liquidity ratio which takes only cash and alike asset.

In short term solvency group there are also working capital ratios. Most important is Net working capital (NWC) – which is sometimes called as asset that is left after you exclude current liabilities from current asset. This ratio is linked to current as this type of asset is participating in companies activity and often called working. As can seen below this ratio is nothing more but equity part that participates in short term of working asset.

Another ratio at this group is called Working investments (WI) – and is capital or asset that is participating in companies activity, there are Inventories and Account receivables. These are companies temporary “frozen” cash that are used in its performance until they are paid by its customers and becomes cash again.

A very important ratio is Net working investments (NWI) – calculated as Inventories + account receivables – account payable. This ratio shows how much companies own funds are “frozen” in working investments.

Another important ratio is Working investment financing sources. The more Net working investments in it the better. Good ratio is considered to be over 50% of Net working investments.

Main long term solvency ratio is Equity level which is calculated by dividing equity from total asset. Its bets to be presented in percentage. Low equity level means that companies liabilities compared to equity are high, because all remaining asset is covered by liabilities. This ratio is very important, because at most times if this ratio is good mainly all other ratios are good also. Rate where this ratio would be considered as good is 50%. Lower rate is not deadly as it allows company to maximize its return on equity, but lower then 25% should be considered as dangerous, in contrary above 75% can be considered as very good. So it can be rated accordingly:

  • 0% – 25% bad
  • 25% – 50% low
  • 50% – 75% good
  • 75% – 100% very good

But equity ratio is different for certain sectors for example financial sector good capital ratio is 10% consumer goods and services 40% would be also good ratio, while technologies or energy which needs a lot of investments even 50% would be a bit low equity ratio or a bottom line. So preferable equity ratio would be:

  • 10% Financial
  • 30% –50% Consumer goods, Healthcare and Services.
  • 50% – 70% Energy an Technology.

Other very important long term solvency ratio is Financial leverage which is calculated by dividing all financial debts minus cash from EBITDA. This ratio shows how many years company should work without any dividends or capital investments in order to fully cover its financial debts. General perception that 3,0x leverage ratio is considered as a line which above is quite high. Company with leverage from 3,0x to 5,0x can be considered as high leveraged, but still acceptable at some times (for ex. Utilities), but companies with leverage over 5,0 should be considered as to high. If leverage is bellow 1,5x it should be considered as low and if company has more cash then financial debt (Apple) it should be considered as not leveraged.

  • >5,0x to leveraged
  • 3,0 – 5,0x high leveraged
  • 1,5x – 3,0x normal leveraged
  • 0,0 – 1,5x low leveraged
  • Negative not leveraged

Market ratios are mostly used for investors and shareholders. All of them one way or another are linked to companies share market price. Most popular are these:

  • Market capitalization.
  • P/E ratio.
  • Dividend yield

Market capitalization represents total value of the company calculated by it market share price multiplied by companies share number. In theory this ratio could represent how much company is worth according to market prices.

P/E ratio or Price per earning shows what is the ratio of companies share price divided by amount of money earned to one of its share. This is no other then reversed companies share profitability ratio. This ratio show how many years of companies profit you are paying when you are purchasing the share. General rule in theory is that P/E level over 20 is considered as overpriced and bellow 10 is not valued enough. Of course the P/E ratio is not absolute and it is common that good companies tend to have higher P/E ratio and bad companies lower P/E. Some times it is better to pay over 20 P/E for a good company that will be there for decades to come then 10 P/E for crappy company that is going down.

  • >20 overvalued
  • 10-20 normal value
  • <10 not valued

Another thing that must be mentioned in companies share evaluation is Dividends. Dividends is the main and only real earnings for its shareholders as share value increase is depended on market value and once again on expectations. If expectations goes down with it your investment value. Two most important factors are:

  • Dividend yield
  • Dividend payout ratio.

Dividend yield is percentage of how much dividend you are getting compared to its share market value so is calculated as Annual dividends/share market value. Bad dividends yield can be considered as 2%, then it is better to invest in government bonds or bank deposits, while 5% can be considered as a good dividend yield.

  • <2% bad yield
  • 2-3% low yield
  • 3-5% normal yield
  • >5% good yield

Dividend payout ratio is a figure that shows how much companies earned Net income is spent on dividend payout. Stable companies can pay even up to 100% of its earnings which does not need any additional investments, but that is not good as this eliminated possibilities for company to grow, earn more and in final results increase its dividends, which is called dividend growth stock. For a long time investor such stable and growing companies is a key investments as some companies managed to increase their dividend payouts for 20 or even 50 years in a row. When company pays 1/2 of its earnings to shareholders that can be considered as a normal payout ratio. Range can be set from 30% up to 70% as normal. While <30% is a low payout ratio. Such companies mainly have a very low dividend yields which is also not good for investors.

  • >100% bad payout ratio.
  • 70-100% high payout ratio.
  • 30-70% normal payout ratio.
  • <30% low payout ratio.
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