Financial analysis is the process of looking at historical performance for hints and indications that might alter expectations about the future of the entity being analyzed. Because it is historical in nature, it is of value (assuming a lack of prurient interest) only to the extent that it can indicate future cash flows of the company. The advent of the computer and spreadsheets has been both a boon and a bane to the process of financial analysis. It is a boon in the sense that it makes the purely mechanical work of financial analysis much less tedious and prone to human error. It is a bane because the computational power often leads analysts to focus more on generating heaping mounds of output rather than focusing their thoughts on critical risks and opportunities facing the company. It might be observed that the "heaping mounds of analysis " generated before difficulties became apparent at Enron, World Com, Global Crossing, Tyco and others were of a nature that it would have been in your best interest to stay upwind of the mounds!
A critical flaw in financial analysis lies in the nature of the financial statements upon which it is based. Leaving aside the obvious challenges faced by the accounting profession and the recent efforts of Congress and other quasi-regulatory bodies to enhance the transparency or validity of financial reporting, there is the issue of a changing economy. The proportion of manufacturing/assembly activities in our economy has been in a well documented decline for many years. We operate in an increasingly technological, marketing, design, distribution or other service based world. Unfortunately for traditional financial analysts, this form of economy relies less on physical assets that can be recorded on a balance sheet and more on intangible assets that cannot be accounted for in the traditional sense. Microsoft, for example, certainly has real assets in the form of its physical facilities and an investment in powerful computer work stations with which its employees perform their development tasks. However, its most significant assets are the quasi-monopoly position its products enjoy on the dominant installed computer base and the talent of those who work for Microsoft. The cliche "most of your assets go home at night and you can only hope they come back tomorrow" means that the actual source of cash flows on the income statement cannot be recorded as an asset on the balance sheet. The same observation could be made of many businesses whose long term viability and ability to create shareholder wealth depends on reputation, location, good marketing, and outstanding employees among other attributes. The intangible assets are accompanied by intangible liabilities which also are not visible on the balance sheet. If future sales are dependent on a consistent and visible marketing program, Coca-Cola for example, a contingent liability exists in the sense that future cash outflows will inevitably involve the sustainment and enhancement of that marketing program. It is one thing to say that your business success is dependent upon having great employees but quite another to make the investment in salaries, training, support, atmosphere and the like that will continue to retain and motivate those employees. The point is that much of what is referred to as analysis of financial statements looks only at a portion of what makes a company successful and able to create shareholder value.
We use the information from both financial statements, but the income statement is much more likely to reflect the on-going creation of value than the balance sheet. An additional challenge with financial statements is the difficulty of assigning costs under accrual accounting and the reality that balance sheet values typically reflect original cost rather than market value. If a physical plant has existed for a period of time and been largely depreciated, its book value will be quite low. The analyst is never quite sure whether the plant is worth more or less than the book value without having it appraised or actually going through the sale process. More will be discussed about depreciation adjustments in the section on asset selection, but suffice it to say that depreciation methods and annual deductions for the wear and tear of equipment have less to do with actual experience than with a desire to use a time-based methodology consistent with taxation and other economic objectives. There is also the problem that the majority of a modern firm's assets leave the building each evening which is, of course, the time, talent and energy of the human capital employed by the firm. We have no way of recording the economic worth of that human talent on a balance sheet which means the real value of many firms is dramatically greater than shown on a set of financial statements. Think about Microsoft and whether you believe its balance sheet reflects the true economic worth of its people, products and stature in the software industry. The stock price, assuming a rational and informed market, is a much better assessment of economic worth than any published financial statements.
Common size statements are simply another way to view the information contained in the financial statements. There are some analysts who see the relationships more clearly in percentage terms than in absolute dollar terms. Thus, the financial statements are restated with balance sheet assets and liabilities divided either by total assets or by sales. (Be sure you check this before using such statements since not every organization does it the same way.) The percentages may make the relationships between various accounts more visible than working in currency terms although greater experience with financial analysis typically results in less use of common size statements. The use of percentages with an income statement is more obvious to most users since items like gross margin or net income are frequently expressed as a percentage of sales.
Since our purpose in doing financial analysis is to create a better forecast, the use of common size statements often provides the raw material for a "first cut" at forecasting next year's balance sheet. If, for example, you observed an accounts receivable balance of $125,000 and a sales volume for the year of $1,375,000; it would be correct to state that accounts receivable are approximately 9.1% of sales. (As an aside, it also means you are collecting your accounts receivable in about 33 days.) If you were to forecast sales for next year at $1,500,000, and do not foresee any significant changes in credit policy, it would be reasonable to multiply the expected sales by 9.1% and forecast next year's accounts receivable as $136,500. More will be made of this "percentage of sales" forecasting methodology in the forecasting material, but common size statements are relatively popular since they set the stage for an initial financial forecast.
Ratios in and of themselves are relatively worthless since it is just mathematics. In order to make the ratios of value to an analyst, they must be related to some form of reference point or "comparable". The most common comparable is to look at industry averages whether they are compiled by Robert Morris Associates, Dun & Bradstreet or an industry association. Industry categories are currently being converted from SIC (Standard Industrial Classification) codes to NAISC (North American Industry Standardization Codes) with the switch due to be finalized by 2005-2007. Every product is categorized by a code number and you would compare your ratio results to the industry average for that code grouping. Since most companies are product diversified, it means you have to build your own set of comparables by performing a weighted average of the industry grouping ratio values with weights based on the proportion of sales within the company. Unless it is really important to your decision, you can see why comparables are often broad estimates rather than detailed values. Put another way; a firm collecting its accounts receivable in 33 days would likely not be criticized for its credit policy if the industry average or comparable were 30 days or 35 days. There are finite limits to the accuracy of this data so it is wise to be flexible when using them as a standard or measure of performance.
Another common strategy is to perform a trend analysis over a recent period of time wherein you would plot each ratio and attempt to interpret the resulting graph as being either an improvement or decline in the ratio. Unfortunately, unless you know the date upon which "they got it right", such interpretation is likely to be of little value since there are no absolute standards. This form of analysis has been enhanced in terms of its presentation quality with the use of graphing functions in spreadsheets, but it is still just math!
The groupings below are based on the Dupont approach to measuring Return on Equity which provides insight into the "metrics" that influence shareholder return. The major groupings of "Profitability", Asset Performance" and "Financing" all influence the Return on Equity (ROE). It would be faster to simply calculate the ROE directly, but you would lose a great deal of insight into how the firm managed to accomplish that return. The source of any deviation from expected ROE would not be apparent whereas the groupings encourage further analysis into how the firm achieved the final result.
It should also be noted that a firm can only sustain a growth rate equal to the ROE adjusted for any dividend payouts. If dividends equal 25% of earnings for example, the firm is retaining the remaining 75% for investment in the firm. Multiplying the ROE times this "retention percentage" provides a measure of the growth that the firm can afford given its management of the three metrics noted above. The implied assumption is made that the firm will continue to finance itself as indicated by the existing assets over equity metric which indicates that any debt strategies now used will also be employed in the future. If the firm were to choose not to expand its borrowings, its level of manageable growth would be limited to ( net income * retention %)/assets.
For example, assume a firm has the following shareholder return components:
Net Income on Sales = 8.5%
Asset Turnover = 1.6 times
Equity Multiplier (Assets/Equity) = 1.5 times
Dividends = 35% of earnings
The ROE is 20.4% while inherent growth, assuming they continue to borrow 1/3 of any funds needed for new assets, would be 13.26% per year [20.4% * (1-.35)]. If the firm made a policy decision to grow using only internal equity funding, the manageable growth would drop to 8.84% per year. Note: They retain 65% of income on sales so 8.5% * .65 = 5.525% per dollar of sales is available to acquire new assets. The asset turnover of 1.6 times implies that the firm must invest 62.5 cents in assets for each dollar of new sales. Relate the 5.525% you earn and keep from each dollar of sales to the 62.5% needed to support those sales and you arrive at the 8.84% internal growth rate.
You will note the use of "average" accounts receivable or inventory rather than the amount stated on the end of period balance sheet. The average is found by adding the beginning value (end of last period) to the ending value and dividing by 2. The income statement measures activity across a period of time while the balance sheet reflects values at a moment in time. Average balance sheet values are utilized when comparing to items from the income statement such as sales or income. It does not address the issue of seasonality in the financial statements and may not be a true measure of average amounts invested in these assets, but it is an attempt to make them more comparable.
Inventory turnover is traditionally calculated relative to cost of goods sold to avoid the problem of the profit margin being part of the result. Recent years have seen an increase in the number of analysts using sales rather than cost of goods sold since the comparison information is often calculated relative to sales. The only problem occurs when you compare results using one methodology with comparables that were calculated using an alternative methodology.
[For example; take annual sales of $1,277,500 and divide by 365 to get average days sales of $3500. The firm has an average accounts receivable balance of $141,000. The days sales outstanding would be $141,000/$3500 = 40.28 days. Divide this by 365 and you have 11.04% (which is the same as dividing receivables of $141,000 by sales of $1,277,500) or divide the 40.28 into 365 to get a 9.06 times per year turnover.]
The Statement of Cash Flows is a modern presentation of the 'sources and uses' statement wherein the analyst looks at the financial statements for any two periods and determines whether the changes in each asset and liability account represent a source or a use of cash. The easiest way to recall sources and uses is to think of it as a grid:
Increase in Liability Account
Increase in Asset Account
Decrease in Asset Account
Decrease in Liability Account
The changes are reflected in the Statement of Cash Flows which summarizes changes in the firm's cash position by separating activities into three categories plus a summary where the cash balance is reconciled:
Risk creation and management is the mechanism by which corporate or personal wealth is enhanced or destroyed. Without risk there is no return other than that available from Treasury Bills. Business or operational risk is associated with simply being in business and is created when new assets, products or markets are acquired by the firm. The most common view is to look at the concept of breakeven analysis wherein the firm is taking the risk of acquiring assets with associated fixed costs in anticipation of using those assets to create higher revenues and greater cash flow. The firm is calculating the minimum level of sales needed to cover fixed operating costs and leave them "breaking even" or not losing money. A favorite evaluation tool is a breakeven chart although there are some limits to its applicability across wide ranges of sales levels. This topic will be covered in further detail in the block of material concerning financing strategies.