financial analysis of business statements

8/12/2019 Financial Analysis of Business Statements

1/15

FINANCIAL ANALYSIS OF BUSINESS STATEMENTS

The process of examining various financial statement items with the objective of performance, and perhaps more

importantly, projecting future performance and financial condition.

BROAD CATEGORIES OF RISK

General Economic Risk Financial Price Risk

Liquidity Risk O!erati"nal and A#ency i$!licati"ns%

L"n#&Ter$ S"l'ency Risk(Risk ") Financial *istress

Financial Structure Risk

o A#ency Risk !er t+e Incenti'es ") Mana#e$ent%

O!erati"nal Risk(E,ecuti"n Risk

o Sales Risk Acquirin# and Retainin# Clients%

o Credit Risk(Recei'a-les Risk(C"llaterali.ati"n

o Brand(Marketin# Risko Tec+n"l"#ical O-s"lescence Risk

o Indi'idual Pr"/ect Risk And O!!"rtunity Risk%

DIMENSIONS OF RISK

Historical trends 0aria-ility

C"$!ara-le -enc+$arkin#

o Li)ecycle sta#e

o Industry

o Peer )ir$s

OPERATING EFFICIENC3 key areas of operating eciency:

A/R (A/R days should not go up


2/15

Pur!"se2

To better appreciate the relati'esi!e and importance of the various items reported in the balance sheet

"acilitates comparison between firms

"rom the structure of the #$%, an analyst can infer important aspects of the company&s business model.

Possi)le Risks and Si&nals*

*igh cash e+i#ility, #arrier to entry (if credi#le threat of predatory pricing,

for e+a"ple$, not necessarily good for in!estors, liuidity, agency risk(possi#ility of less "anage"ent discipline$

Inventoryif low, suggests 'IT

(ulnerability to demand shoc)s problems and difficulties forecasting demand, seasonality, etc.

*perational ris)

+ossibility of outsourcing

%cale economies being reali!ed or not?

iquidity can add or destroy value by virtue of its operational and agency implications

*e)initi"n2In commonsi!e income statements, all items are expressed as a percentage of total sales.

*e)initi"n2 -nder trend analysis, a base year is identified and the values of a given item in subsequent years are

expressed as a percentage of the base year value. The base year value is usually defined as //, for ease of

interpretation.

RATIO ANA!SISDe+nition*0aking ratios of 'nancial state"ent ite"s designed to "ake indicationsof pro'ta#ility, short-ter" liuidity and long-ter" sol!ency for speci'c 'r"s to "ake

a#solute and relati!e udg"ents (in relation to other co"para#le 'r"s$1

+rofitability ratios operating ris)$efficiency

iquidity ratiosfinancial price ris), operating ris)

%olvency ratiosris)s of financial distress, financial structure ris)

Sustaina-le #r"3t+2 The level of growth that can be sustained by internally generated funds. It is the level of

growth that is sustainable without requiring raising financing through either debt or equity issues, potentially

shifting the capital structure of the firm. 0 1 2*3 4 5d6, where g is the sustainable growth rate, 2*3 is the return

on equity and d is the dividend payout ratio.

PROFITABI!IT RATIOS Rate of Return on Assets: "easures a 'r"2s success in using assets to

generate earnings independent of the 'nancing of those assets (i1e1 de#t!ersus euity$

ROA Analysis

steps:

4alculate R5A

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FINANCIAL ANALYSIS OF BUSINESS

STATEMENTS
http://www.managementvikalp.co.in/http://www.onlinevikalp.com/http://www.managementvikalp.co.in/http://www.onlinevikalp.com/


3/15

7ecompose 2*8 into profit margin and assets turnover

7ecompose profit margin into expense ratios for the various cost items

7ecompose asset turnover into various individual turnover rates

ROA is calculated as2

Net Inc"$e 4 5 & Ta, Rate%Interest E,!% 4 Min6 Int6 in Earnin#s

A'era#e T"tal Assets

9e can brea) it down into its constituent parts

ROA 7 Pr")it Mar#in 8 Assets Turn"'er

9

Net Inc"$e 4 Interest 9 Net Inc"$e 4 Interest

E,!ense net ") ta,es% E,!ense net ") ta,es%4 Min"rity Interest 4 Min"rity Interest

in Earnin#s : 7 in Earnin#s: 8 Sales

A'era#e T"tal Assets Sales A'era#e T"tal Assets

Acc"unts Recei'a-le Turn"'er Credit Risk%

:easures how soon sales will become cash

8mount of sales per 8$2prefer a high amount of sales to 8$2

Inverse of the percentage of sales from 8$2

Acc"unts Recei'a-le Turn"'er 7 Net Sales "n Acc"unt

A'era#e Acc"unts Recei'a-le

*ays Recei'a-le Outstandin# Credit Risk%

The rate which 8$2 are being collected

;""ds S"ld




STATEMENTS


4/15

A'era#e In'ent"ry

Inverse of the proportion of inventory in *0%

How much *0% do you get for every @ of inventory

*ays In'ent"ry ?eld

*ays In'ent"ry ?eld 7 ;


5/15

9hen a firm begins to experience financial difficulty, the days payable outstanding typically begins to rise

Too low a rate might imply that the firm is not exploiting the 5implicit6 financing of its operations that

suppliers provide when they sell to the firm on credit

ROE

ROE 7 Net Inc"$e & Pre)erred *i'idends

A'era#e C"$$"n Equity

Or

ROE 7 Net Inc"$e A'aila-le t" C"$$"n

A'era#e C"$$"n Equity

*ec"$!"siti"n ") ROE

C"$$"n Ca!ital

ROE 7 ROA , Earnin#s , Structure

Le'era#e Le'era#e

CEL% LE0%

NI A'ail t" C"$$"n ( A'# CEquity 7

NID ( A'# TA% ,

NI A'ail t" C"$$"n ( NID% ,

A'# TA ( A'# CEquity%

ommon 3arnings everage in which AI4 AI 1 ost of 7ebt and +referred %toc)

The higher 5lower6 is the cost of these sources of capital, the lower 5higher6 will be this multiplier 5i.e. the less

5more6 will be left for common shareholders6

"inancial everage measures the degree to which the firms uses the investment of common shareholders to

finance itself 5how many assets for every @ of equity6

Higher financial leveral

less capital obtained from common shareholders

ris)ier ommon shareholders can 5but not always6 benefit in terms of earning a higher 2*3 when the proportion of

noncommon equity financing in the capital structure is increased

3 and 3( combine to form a multiplier effect on 2*8 that emanates from the use of noncommon equity

sources of finance

3 captures the cost of these other sources of finance

3( captures the proportion of these other sources of finance visBvis common equity

*u P"nt Analysis

2*3 1 Aet Income $ %hareholders& equity

ROE 7 Pr")it $ar#in 8 Turn"'er 8 Le'era#e

+rofit margin 1 Aet Income $ %ales

Turnover 1 %ales $ 8ssets

everage 1 8ssets $ %hareholders equity

2*3 will be greater than 2*8 when 2*8 is greater than the cost of capital provided by creditors and preferred

shareholders




STATEMENTS


6/15

9hen a firm generates earnings using capital provided by creditors and preferred shareholders that exceeds the

costs of such capital, the CexcessD return belongs to common shareholders.

LIUI*ITY RATIOS

%heds light on a firm&s ability to pay for obligations that come due during its operating cycle

Current Rati"

Current Rati" 7 Current Assets

Current Lia-ilities

:atches the amount of cash and other current assets that will become cash within one year against the

obligations that come due in the next year

2ule of thumb> 8 minimum current ratio of ./ 8n increase of equal amount in both a decrease in the ratio when it is higher than ./ ex ante and an increase

in the current ratio if it is less than ./ ex ante

8 very high current ratio may accompany unsatisfactory business conditions

8 falling ratio may accompany profitable operations e.g. lower inventories

In a recessionary period, businesses contract, firms pay current liabilities, current ratio goes up, even though

current assets reach a low point

2everse can occur in a boom

uick Rati"

uick 7 Cas+ 4 Mkt Securities 4 AR

Rati" Current Lia-ilities

Includes only in the numerator those assets that can be quic)ly converted to cash

O!eratin# Cas+ Fl"3 t" Current Lia-ilities Rati"

O!eratin# Cas+ Fl"3

A'era#e Current Lia-ilities

#ased on cash flow a)terthe funding needs for wor)ing capital 5i.e. 8$2 and Inventory6 have been made

8verage used in the denominator to be consistent with the numerator 5cash flow from operations generated

over the course of the year6

8 ratio of ./ would be interpreted as> The firm could pay, if it had to, //E of its out of the cash it

generates from operations 5i.e. without external funding6

LON>&TERM SOL0ENCY RATIOS




STATEMENTS


7/15

:easure a firm&s ability to meet interest and principal payments on longterm debt and similar obligations li)e

longterm leases

The best indicator for assessing longterm solvency ris) is the firm&s ability to generate earnings over a period

of years

L"n#&Ter$ *e-t Rati"

L"n#&Ter$ 7 L"n#&Ter$ *e-t

*e-t Rati" L"n#&Ter$ *e-t 4 S+are+"lders Equity

*e-t(Equity 7 L"n#&Ter$ *e-t

Rati" S+are+"lders Equity

Lia-ilities(Assets 7 T"tal Lia-ilities

Rati" T"tal Assets

Interest C"'era#e Rati"

9Net Inc"$e 4 Interest E,!ense 4 Inc"$e Ta, E,!ense 4 Min"rity Interest in

Earnin#s:

Interest E,!ense

Interest coverage ratios less than F./ suggest a ris)y situation.

If a firm must ma)e other required periodic payments 5e.g. pensions, leases6, the analyst could include them as

well 5if so, then referred to as the fixed charges ratio6

-ses earnings rather than cash flows in the numerator

+roblematic since firms pay fixed charges with cash not earnings

"ixed harges 2atio 1 5Aet Income G +eriodic +ayments6 $ Interest 3xpense

Cas+ Interest C"'era#e Rati"

ash "low from *perations G

ash +ayments for Interest G

ash +ayments for Income Taxes

ash +ayments for Interest

-ses cash flow instead of earnings

O!eratin# Cas+ Fl"3 t" T"tal Lia-ilities Rati"

:easures the firm&s ability t

o generate cash flow from operations to service debt

:easures the firm&s ability to generate cash flow from operations in excess of the capital expenditures needed to

maintain and build plant capacity




STATEMENTS


8/15

The CexcessD cash flow can be used to service debt

Cas+ Fl"3 C"ntinuin# O!erati"ns

A'era#e T"tal Lia-ilities

SUSTAINABLE >RO@T? RATE #

The sustainable growth rate, g, is the rate of growth below which the firm can grow by financing itself using

internally generated cash.

8t rates of growth in excess of g, the firm will require external financing, obtained either by issuing debt or by

issuing equity

0rowth in excess of the sustainable growth rate has implications for shifts in the firm&s capital structure

POTENTIAL FLA>S

O!eratin# E))iciency

0rowth through creditdeclining credit quality of customers as evidenced by growth in 8$2 and worsening

8$2 Turnover 5or 7ays 2eceivable6

%ee profitability ratios

%ee cash flow trends

Inventory analysisinventory growth, days of inventory possibly selling to wea) customers

o %tuffing the channel

o Inventory writedown expense?

CAS? FLO@ ANALYSIS

O-/ecti'e2 9e see) to find the determinants of operating cash flow surpluses or shortages. These can be segregated

into the effects of>

0rowth

hanges in operating profitability

hanges in operating efficiency

Two methods> direct and indirect

Indirect method> adjust net income for noncash items

Inferences>

o "lows from selling activity

o ash profitability of sales activity

o urrent growth and changing prospects about growth

>r"3t+2 F effects>

o

2evenue growtho hanges in operating efficiency

>r"3t+ d"es n"t #uarantee an increase in "!eratin# cas+ )l"3

o 2evenue J Increased cash into the company

o 3xpenses J consumption of cash

o If positive operating margin J net effect s+"uldbe positive on operating cash flow

o Investments in accounts receivable and inventory J use of cash


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STATEMENTS


9/15

o Increased accounts payable credit J source of cash

Key factors>

o 2ate of growth

o "irm&s operating profit margin 5gross margin, %0L86

7eclining gross margin J more cash generated by sales used for inventory

Increased %0L8 J :ore revenue dollars spent on these operating items

I$!licati"ns )"r )uture !r")it rates

o :anagement of 8$2, Inventory and 8$+

To calculate the cash flow effects of growth on gross profit, %0L8, we multiply the growth in revenue during

the current year by the prior year&s profitability measures

ash flow effects of growth

o *n 8$2 is computed as the product of growth in revenue per day during the current year by 8$2 days

in the prior year

o *n inventory and 8$+ are the product of growth in sales per day during the current year by the previous

year&s inventory days and 8$+ days, respectively

T+e +i#+er a c"$!anys !r")ita-ility rate and t+e l"3er its required c"$$it$ents t" A(R and In'ent"ryt+e )aster it can #r"3 and !r"'ide !"siti'e "!eratin# cas+ )l"3

ash flow effects of changes in profitability and efficiency>

o :ultiply the change in gross margin and %08E during the current year by the current year&s revenue

o *n 8$2, multiply the change in 8$2 days during the current year by revenue per day in the current year

o *n Inventory and 8$+, multiply the change in Inventory 7ays and 8$+ days during the current year by

the current year&s revenue

Red Fla#s

oo) for creativity in classifying cash flows

8nticipate earnings surprises

>r"3in# discre!ancy -et3een net inc"$e and "!eratin# cas+ )l"3s

o +remature recognition of revenues J operatingMrelated balance sheet assets


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STATEMENTS

Cash Flow Determinant Cah Flow

Affected by Profitability and Efficiency Effect

Increase in gross margin PositiveDecrease in gross margin Negative

Increase in SGA% Negative

Decrease in SGA% Positive

Increase in A! days Negative

Decrease in A! days Positive

Increase in inventory days Negative

Decrease in inventory days Positive

Increase in AP days Positive

Decrease in AP days Negative


10/15

o 3xpenses may be accrued early J increases in operating liability J "!eratin# cas+ )l"3 3ill e,ceed

inc"$e

o -ndervaluation of liabilities

o *vercapitali!ation J income smoothing by capitali!ing costs that are usually expensed, deferring

expenses to a later period

8sset write downs in later periods J no cash flow effect

Investing>

o Increased investment if high growth forecasted by management

o 3ffect of the nature of the business

apital intensive?

7istribution$retailing?

2elationship to current operating performance

"inancing>

o 3ffect of the nature of the business

7ebt capacity of assets increases in>

Tangible assets %teady cash flow generation

Investment not unique to the firm

Tax advantage of debt

2elated to current operating performance

>r"3t+ ass"ciated 3it+ in'estin# and )inancin#

-ses of cash flow statements>

o +erformance assessment

"irm&s ability to generate cash flows

8bility to meet obligations 5shortterm vs. longterm6

#enchmar) criteria>

o (aluation

o +lanning

M"di)ied Cas+ Fl"3 Presentati"n

Net Cas+ Fl"3

Aet Income

8djustments for noncurrent operating accruals 5e.g. depreciation and amorti!ation6 and nonoperating

items 5e.g. interest expense and income6

Investments in wor)ing capital

Investments in longterm assets

Interest expense and income

7ividends

3xternal "inancing 8ctivityAet ash "low

Cas+ Fl"3 Calculati"n

Increase in 8ssets -se of ash

7ecrease in 8ssets %ource of ash

Increase in iabilities %ource of ash

7ecrease in iabilities -se of ash


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STATEMENTS


11/15

N"n&"!eratin# s"urces ") cas+ )l"3 can -e relied u!"n "nly in t+e s+"rt run6

RE0ENUE RECO>NITION

@+at 3as kn"3n

@+at 3as kn"3a-le

*id t+ey !er)"r$ a su))iciently detailed analysis

7epending on the nature of the goods 5typically at the time of delivery6 or services provided, and management

judgment, revenue might be recogni!ed>

8t the time an order is placed by a customer

7uring the production process

8t the time of shipment of the goods or providing of services

8fter acceptance of the goods by the customer

8fter all return privileges have expired

8fter collection of the amount billed

+hilosophically, we are loo)ing for>

8 transfer of legal ownership

3xternal certification where possible

The effect in the current period

The effect on future expectations of revenue and cash flows 5something that is especially important for growing

companies6

+roblems may arise from>

There are material uncertainties about quality

:anagerial incentives to overstate

8lternative schemes across firms in the same industry

+remature revenue recognition 5with implications for the reali!ability of sales since A(R take l"n#er t" c"llect

and t+e A(R -alance #r"3s6

"ictitious revenue recognition entails recogni!ing revenue without regard to whether it will materiali!e with

intent 5causing overstatement of earnings, assets and shareholders& equity6 J inc"nsistency 3it+ M*GA

c"$!ara-les etc>

o 8$2 days increases

o Inconsistent reduction in estimates of uncollectible accounts, possibly

o 0rowth in inventory days

o osses in previous years due to cost overruns

Be3are a c+an#e in !"licy

2evenue metrics to compare with other firms in industry include>

o 2evenue per employee

o 2evenue per dollar of fixed assets

o 2evenue per dollar of total assets


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STATEMENTS


12/15

o -nbilled receivables as a percentage of cumulative contract revenue for each of the last four to six

quarters J trend analysis

o +ercentage rate of change in unbilled receivables with the percentage rate of change in contract

revenue

E8PENSE RECO>NITION

:atching +rinciple and onservatism

"ocus> *n expenses that begin as capitali!ed expenditures, or assets, and are subsequently charged to expense

through amorti!ation

apitali!ation is permitted under the matching principle when future periods are expected to benefit from

expenditures incurred currently

8mounts capitali!ed are reported as assets and are amorti!ed over future years

7eciding whether future periods will benefit requires management&s judgment

onservative approach> expense amounts incurred

Future earnin#s 3ill -e ne#ati'ely a))ected i) c"sts ca!itali.ed in !re'i"us years are n"t reali.ed and $ust

-e 3ritten "))

Incentives to -nderstate 3xpenses>

Higher management compensation

Higher stoc) price J lower cost of equity capital and increased value of ownership sta)es in company for

managers

:ore slac) in debt covenants

ower apparent firm ris) J reduced cost of debt capital

:ay signal management&s confidence that growth will continue J writeoff when growth slows

Red Fla#s2

7o policies differ substantively from those of the firm&s competitors?

7oes the company expense more, ta)ing a more conservative approach?

9hat do capitali!ed costs represent?

o 8n identifiable asset with an ascertainable mar)et value?

o Aot an identifiable asset whose mar)et value, if any, is tied to the general fortunes of the company?

7o capitali!ed costs exceed net reali!able value?

9hat proportion of software costs are being capitali!ed?

o How does this percentage compare with competitors& software policies?

%hould capitali!ation of interest costs be discontinued?

o Is the asset under construction complete and available for intended use?

o 7o costs incurred on the asset under construction give an indication of exceeding net reali!able value? Have there been construction delays?

Have there been cost overruns?

7oes the company use the successful efforts method 5expensing option6 or the fullcost method 5capitali!ation6

for oilgas to account for exploration expenditures?

o 7o capitali!ed costs appear reali!able?

Has the company proven to have been aggressive in the past regarding its capitali!ation policies?

Has the company selected extended amorti!ation and depreciation periods for capitali!ed costs?


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STATEMENTS


13/15

How does the average amorti!ation period for longlived assets compare with competitors or other firms in the

industry?

o alculated as average asset costs, excluding land and constructioninprocess, divided by the annual

amount of depreciation or amorti!ation expense

9atch out for extended amorti!ation periods in the following situations>

o "irm&s industry is experiencing price deflation

o "irm in an industry that is experiencing rapid technological change

EARNIN>S MANA>EMENT

*e)initi"n2The active manipulation of accounting numbers to create an altered impression of performance. urrent

year earnings are boosted$lowered at the expense$to the benefit of future years. Inc"$e s$""t+in#6

Tec+niques Used in Earnin#s Mana#e$ent

engthening the useful lives of depreciable assets J lower current year depreciation charges J raises current

year&s incomeand lowers future income

+remature revenue recognition

8ggressive cost capitali!ation

3xtended amorti!ation periods

8$2, Inventory and Investments carried at valuations exceeding reali!able amounts 5i.e. postponing income

charges6

-ndervaluation of liabilities J lower service costs G future shoc) when adjusted to correct level

7iscretionary accounting changes 578s6

o C+an#es in Acc"untin# Princi!le2the change from one accepted accounting principle to another

%how the cumulative effect of the change on net income of prior years as a single amount 5net

of tax6 in the income statement in the year of change, reported in the body of the income

statement and not highlighted

"ootnote disclosure in the year of the change is the only disclosure provided of the current

year effect

o C+an#es in Acc"untin# Esti$ates2 3stimates are used in determining the useful lives of equipment,

residual values, the portion of 8$2 that will not be collected and the +( of pension obligations

:any used to improve reported results

Timed management actions 5T:8s6>

o The use of management discretion in the timing of its operating decisions

3xample> *netime gains from the sale of appreciated land

+ostponement of operating expenses

Takin# a Bat+2*ccurs when a firm uses wholesale asset writedowns and liability accruals to turn what

appears to be a poor quarter or year into a complete rout>

o

8ll the bad news is historyo Increased future earnings N lower charges and liability accruals

o owers the bar for future performance

o +articularly useful for a new management team

C+ecklist

B""stin# Current&Year Per)"r$ance




STATEMENTS


14/15

?a'e acc"untin# tactics -een used t" increase current&year inc"$e

+remature revenue recognition,

8ggressive cost capitali!ation,

3xtended amorti!ation periods,

3xcessive asset valuation, or

-ndervaluation of liabilities.

?as current&year inc"$e -een increased t+r"u#+ t+e use ") *ACs

8re changes in accounting principles disclosed on the I$% and notes?

9hat is the currentyear effect of the change on income?

8re there changes in accounting estimates disclosed in the notes?

9hat is the currentyear effect of the change on income?

How is the firm doing in the absence of the effects of 78s?

Have the 78s resulted in asset boo) values whose reali!ability may be questioned?

Has the li)elihood of a future writedown of these assets been increased?

9hat does the change do to comparisons of results with prior years?

Has management been )nown to boost earnings with 78s in the past?

?as $ana#e$ent ti$ed acti"ns t" -""st current&year inc"$e

Is there evidence of significant nonrecurring gains on asset sales?

Have expenses been postponed?

2L7?

Has the dollar amount of 2L7 declined significantly?

9hat are the implications for the firmOs research agenda?

Ad'ertisin# e,!enses

If %08E declined, what was the reason for the decline? 7id a reduction in advertising play a role?

If %08E declined, is the decline a longterm improvement?

Reducin# Current&Year Per)"r$ance

Has the firm used changes in accounting estimates to reduce currentyear income?

2educed useful lives of assets,

2educed reali!able values of assets necessitating writedowns,

Increased reserves or contraasset accounts, or

*veraccrued liabilities.

Have timed management actions been used to reduce currentyear income?

%ale of assets at a loss.

Increased discretionary expenses.

Is the firm reporting income earned in prior years?

%udden reductions in reserves or contraasset accounts.

7eclines in accrued liabilities.

-nexpected improvements in gross margin or %08E.


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STATEMENTS


15/15

Has the firm ta)en a big bath in recent periods?

Has current performance benefited as a result?

How will performance loo) when the benefits of the CbathD wear off?




STATEMENTS

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