- Published on
Investment - Financial Statements Analysis
Financial statement analysis is the use of information provided by financial statements, as well as information from other sources, to find key links. These relationships may not be evident by reading the financial accounts alone.
The use of ratios allows analysts to standardise financial information and offers a context for making meaningful comparisons between years (time series) and between firms (cross-sectional). Specifically, ratios let investors evaluate companies of different sizes as well as help assess the performance of one company at different points in time.
They also enable managers of the company or outside creditors and investors answer crucial questions relevant to predicting a company’s likely future performance, such as the following:
How liquid is the company?
Is the corporation earning enough returns from its assets?
Does the corporation have too much debt?
Is the corporation delivering sufficient return for its shareholders?
How Liquid Is the Company?
In accounting, liquidity refers to a company’s capacity to fulfill its existing commitments in the short term, often within the next year. Two ratios typically used to assess liquidity are the current ratio and the quick ratio.
CURRENT RATIO
The current ratio assesses the current assets available to meet current liabilities:
If the current ratio is larger than 1, current assets are more than current liabilities and the company appears to be able to cover its debts in the short term.
But not every current asset is easily or rapidly convertible into cash, hence a current ratio of 2 is usually employed as a minimum desired requirement.
Current ratio = Current assets/Current liabilities
QUICK RATIO
Some consider the quick ratio to be a stronger predictor of liquidity than the current ratio since it excludes inventories, which are significantly less liquid than other current assets. A fast ratio of 1 or above is frequently seen as desirable.
Quick ratio = (Current assets – Inventories)/Current liabilities
It is crucial to note that a high current or quick ratio is not necessarily indicative of a problem-free organization. It may signal that the company is hoarding too much cash and not investing in other long-term assets necessary to create greater earnings.
For both ratios, a larger ratio suggests a higher level of liquidity; there is a greater availability of short-term resources to cover short-term obligations.
For example, a company’s balance sheet might give investors information about the company’s capacity to fulfill its outstanding commitments in the short term, commonly known as its liquidity. Investment managers utilize information on a company’s balance sheet to compute the current and quick ratios to measure liquidity. Let’s follow along to see how this is done.
As is the case for most ratios, comparing them with industry norms in the form of average ratios for the industry, ratios for comparable companies, or prior ratios provides a broader context for evaluating the ratios.
Is the Company Generating Enough Returns from Its Assets?
A widely used statistic for analyzing a company’s profitability is the net profit margin, which measures the percentage of revenues that is profit, in other words the percentage of revenues remaining for the shareholders after all expenses have been accounted for.
Net profit margin = Net income/Revenues
Generally, the bigger the net profit margin the better.
Return on Assets
Another ratio used to analyze profitability is return on assets (ROA).
Return on assets = ROA = Net income/Total assets
Return on assets specifies how much return, as measured by net income, is created per monetary unit invested in total assets. Generally, the bigger the return on assets the better.
Some analysts utilize operational income rather than net income when assessing return on assets.
Recall that operating income is the money derived by a company’s assets, excluding how those assets are financed. When calculated using operating income, a better name for the ratio is operational return on assets or basic earning power.
The basic earning power ratio compares the profit earned from operations with the assets utilized to create that income.
Basic earning power = Operating income/Total assets
Whatever ratio is chosen to quantify profitability per unit of assets, it should be utilized consistently when making comparisons.
A Deeper Dive into Return on Assets
To study how the company earns more money from its assets than comparable companies, return on assets can be divided into two components:
ROA = Net income/Total assets = Net income/Revenues x Revenues/Total assets
Similarly, the basic earning power ratio can be divided into two components:
Basic earning power = Operating income/Total assets = Operating income/Revenues × Revenues/Total assets
OPERATING INCOME
The first component of these two enlarged equations is a measure of profitability: It is net profit margin in the return on assets ratio and a ratio called operational profit margin in the basic earning power ratio. Net profit margin and operating profit margin reflect how good the company is at turning revenues into net income or operating income.
In other words, they reflect how successful the organization is at limiting the costs of creating its sales.
Financial statement analysis is the use of information provided by financial statements, as well as information from other sources, to find key links. These relationships may not be evident by reading the financial accounts alone.
The use of ratios allows analysts to standardise financial information and offers a context for making meaningful comparisons between years (time series) and between firms (cross-sectional). Specifically, ratios let investors evaluate companies of different sizes as well as help assess the performance of one company at different points in time.
They also enable managers of the company or outside creditors and investors answer crucial questions relevant to predicting a company’s likely future performance, such as the following:
How liquid is the company?
Is the corporation earning enough returns from its assets?
Does the corporation have too much debt?
Is the corporation delivering sufficient return for its shareholders?
How Liquid Is the Company?
In accounting, liquidity refers to a company’s capacity to fulfill its existing commitments in the short term, often within the next year. Two ratios typically used to assess liquidity are the current ratio and the quick ratio.
CURRENT RATIO
The current ratio assesses the current assets available to meet current liabilities:
If the current ratio is larger than 1, current assets are more than current liabilities and the company appears to be able to cover its debts in the short term.
But not every current asset is easily or rapidly convertible into cash, hence a current ratio of 2 is usually employed as a minimum desired requirement.
Current ratio = Current assets/Current liabilities
QUICK RATIO
Some consider the quick ratio to be a stronger predictor of liquidity than the current ratio since it excludes inventories, which are significantly less liquid than other current assets. A fast ratio of 1 or above is frequently seen as desirable.
Quick ratio = (Current assets – Inventories)/Current liabilities
It is crucial to note that a high current or quick ratio is not necessarily indicative of a problem-free organization. It may signal that the company is hoarding too much cash and not investing in other long-term assets necessary to create greater earnings.
For both ratios, a larger ratio suggests a higher level of liquidity; there is a greater availability of short-term resources to cover short-term obligations.
For example, a company’s balance sheet might give investors information about the company’s capacity to fulfill its outstanding commitments in the short term, commonly known as its liquidity. Investment managers utilize information on a company’s balance sheet to compute the current and quick ratios to measure liquidity. Let’s follow along to see how this is done.
As is the case for most ratios, comparing them with industry norms in the form of average ratios for the industry, ratios for comparable companies, or prior ratios provides a broader context for evaluating the ratios.
Is the Company Generating Enough Returns from Its Assets?
A widely used statistic for analyzing a company’s profitability is the net profit margin, which measures the percentage of revenues that is profit, in other words the percentage of revenues remaining for the shareholders after all expenses have been accounted for.
Net profit margin = Net income/Revenues
Generally, the bigger the net profit margin the better.
Return on Assets
Another ratio used to analyze profitability is return on assets (ROA).
Return on assets = ROA = Net income/Total assets
Return on assets specifies how much return, as measured by net income, is created per monetary unit invested in total assets. Generally, the bigger the return on assets the better.
Some analysts utilize operational income rather than net income when assessing return on assets.
Recall that operating income is the money derived by a company’s assets, excluding how those assets are financed. When calculated using operating income, a better name for the ratio is operational return on assets or basic earning power.
The basic earning power ratio compares the profit earned from operations with the assets utilized to create that income.
Basic earning power = Operating income/Total assets
Whatever ratio is chosen to quantify profitability per unit of assets, it should be utilized consistently when making comparisons.
A Deeper Dive into Return on Assets
To study how the company earns more money from its assets than comparable companies, return on assets can be divided into two components:
ROA = Net income/Total assets = Net income/Revenues x Revenues/Total assets
Similarly, the basic earning power ratio can be divided into two components:
Basic earning power = Operating income/Total assets = Operating income/Revenues × Revenues/Total assets
OPERATING INCOME
The first component of these two enlarged equations is a measure of profitability: It is net profit margin in the return on assets ratio and a ratio called operational profit margin in the basic earning power ratio. Net profit margin and operating profit margin reflect how good the company is at turning revenues into net income or operating income.
In other words, they reflect how successful the organization is at limiting the costs of creating its sales.
ASSET TURNOVER
The second component is a measure of asset utilization called as total asset turnover. This ratio is expressed as a multiple and represents the volume of revenues being generated by the assets used in the firm, or how successfully the company uses its assets to generate revenues. An growing ratio may imply increased performance, although care should be exercised in interpreting this data.
An increasing ratio may also suggest static revenues and declining assets related to depreciation; in other words, sales are not expanding, and the company is not reinvesting to maintain its plant and machinery up to date. It is always necessary to examine the cause of changes in a ratio.
The second component is a measure of asset utilization called as total asset turnover. This ratio is expressed as a multiple and represents the volume of revenues being generated by the assets used in the firm, or how successfully the company uses its assets to generate revenues. An growing ratio may imply increased performance, although care should be exercised in interpreting this data.
An increasing ratio may also suggest static revenues and declining assets related to depreciation; in other words, sales are not expanding, and the company is not reinvesting to maintain its plant and machinery up to date. It is always necessary to examine the cause of changes in a ratio.
Does the Company Have Too Much Debt?
To analyze financial leverage, which is the extent to which debt is used in the financing of the business, experts use the debt-to-equity ratio. This ratio reflects how much debt the company has relative to equity.
Debt-to-equity ratio = Debt/Equity
Typically, the debt examined is solely interest-bearing debt, which includes the following:
Short-term borrowing
Portion of long-term debt due within the reporting period
Long-term debt
It does not contain accounts payable and accrued expenses that do not necessitate an interest payment.
Another popular ratio used for analyzing the amount of debt employed by the corporation is the financial leverage ratio, or equity multiplier ratio.
Financial leverage = Equity multiplier = Total assets/Equity
This equity multiplier estimates the amount of total assets supported by one monetary unit of equity. The bigger the equity multiplier, the more debt is being used by the corporation to finance its assets.
A corporation with a low equity multiplier is one largely financed by equity.
Holding a higher amount of debt is riskier because a firm is obligated to service its debt by paying interest, whereas it does not have a similar duty to serve its equity by paying dividends.
For a company with relatively large debt, it may not be in a position to satisfy its interest payments or to respond as fast as its competitors to new opportunities.
In certain nations, the usage of debt finance is referred to as gearing rather than leverage. Highly leveraged or geared corporations are generally referred to as being less solvent. Thus, leverage and solvency are notions that are inversely related.
A company that employs little debt financing is generally considered to be more solvent than a company that uses a high amount of debt financing.
Is the Company Providing Sufficient Returns to Its Shareholders?
It is crucial to examine whether the return made by the company is sufficient from the standpoint of the shareholders. Is the return high enough for investors to still want to purchase the share? One ratio typically employed to answer this question is the return on equity (ROE).
Return on equity = ROE = Net income/Equity
A company’s ROE reveals how much return, as measured by net income, is made per monetary unit of stock.
This statistic can be compared with the company’s ROE over time, with the ROE for other companies, and with the appropriate industry average ROE.
ROE can also be broken into three components: net profit margin, asset turnover, and financial leverage:
ROE = Net income/Equity = Net income/Revenues × Revenues/Total assets × Total assets/Equity
or
ROE = Net profit margin × Asset turnover × Financial leverage
The product of the first two components produces the company’s return on assets. Another element potentially affecting the return on equity is the amount of leverage or debt the company has.
A corporation with more debt will have a higher return on equity as long as the debt returns more than it costs by supporting a return on assets that is greater than the after-tax cost of debt.
Thus, the third component of the ROE decomposition is the financial leverage ratio, the equity multiplier.
To analyze financial leverage, which is the extent to which debt is used in the financing of the business, experts use the debt-to-equity ratio. This ratio reflects how much debt the company has relative to equity.
Debt-to-equity ratio = Debt/Equity
Typically, the debt examined is solely interest-bearing debt, which includes the following:
Short-term borrowing
Portion of long-term debt due within the reporting period
Long-term debt
It does not contain accounts payable and accrued expenses that do not necessitate an interest payment.
Another popular ratio used for analyzing the amount of debt employed by the corporation is the financial leverage ratio, or equity multiplier ratio.
Financial leverage = Equity multiplier = Total assets/Equity
This equity multiplier estimates the amount of total assets supported by one monetary unit of equity. The bigger the equity multiplier, the more debt is being used by the corporation to finance its assets.
A corporation with a low equity multiplier is one largely financed by equity.
Holding a higher amount of debt is riskier because a firm is obligated to service its debt by paying interest, whereas it does not have a similar duty to serve its equity by paying dividends.
For a company with relatively large debt, it may not be in a position to satisfy its interest payments or to respond as fast as its competitors to new opportunities.
In certain nations, the usage of debt finance is referred to as gearing rather than leverage. Highly leveraged or geared corporations are generally referred to as being less solvent. Thus, leverage and solvency are notions that are inversely related.
A company that employs little debt financing is generally considered to be more solvent than a company that uses a high amount of debt financing.
Is the Company Providing Sufficient Returns to Its Shareholders?
It is crucial to examine whether the return made by the company is sufficient from the standpoint of the shareholders. Is the return high enough for investors to still want to purchase the share? One ratio typically employed to answer this question is the return on equity (ROE).
Return on equity = ROE = Net income/Equity
A company’s ROE reveals how much return, as measured by net income, is made per monetary unit of stock.
This statistic can be compared with the company’s ROE over time, with the ROE for other companies, and with the appropriate industry average ROE.
ROE can also be broken into three components: net profit margin, asset turnover, and financial leverage:
ROE = Net income/Equity = Net income/Revenues × Revenues/Total assets × Total assets/Equity
or
ROE = Net profit margin × Asset turnover × Financial leverage
The product of the first two components produces the company’s return on assets. Another element potentially affecting the return on equity is the amount of leverage or debt the company has.
A corporation with more debt will have a higher return on equity as long as the debt returns more than it costs by supporting a return on assets that is greater than the after-tax cost of debt.
Thus, the third component of the ROE decomposition is the financial leverage ratio, the equity multiplier.
When any of these component ratios improve, all else being equal, the return on equity increases. Although it makes obvious sense that a firm’s performance increases when generating more profit from revenues and more revenues from its assets, a corporation can also boost its return on equity by supplementing its equity with borrowing, or in other words, employing leverage.
But borrowing may not be a viable idea if the company would struggle to satisfy its financial obligations. An increase in return on equity due to borrowing comes with increased risk.
Decomposing ROE into the three components, net profit margin, total asset turnover, and financial leverage, is valuable because it allows analysts to better understand why the company’s return on equity is changing and to analyze the origins of that change.
Market Valuations
So far, we have measured performance using financial statements. Another way is to evaluate performance in terms of creating or destroying value for the company’s shareholders.
Two ratios, both dependent on a company’s share price, are often used to judge management’s success.
PRICE-TO-EARNINGS
The first ratio compares a company’s share price with its earnings per share.
A price-to-earnings ratio, or P/E multiple, informs us how much investors are ready to pay for every dollar of earnings per share. For example, a firm with a P/E of 15 suggests that investors are willing to pay 15.00 for every 1.00 of earnings per share.
If the price-to-earnings ratio is higher for one company than it is for another in the same industry, it may signal that investors think that the company with the higher price-to-earnings ratio has more growth potential. Alternatively, the firm with the lower price-to-earnings ratio may be undervalued by the market.
Price-to-earnings ratio = Market price per share/Earnings per share
PRICE-TO-BOOK
The second ratio based on the share price is the price-to-book ratio (P/B). It compares the company’s share price with the company’s book value per share.
The book value of stock generally represents historical costs and measures the amount shareholders have invested in the company across its lifetime. Therefore, a P/B ratio larger than 1 suggests that investors feel the company is worth more in the long run than the money shareholders have put in it.
In other words, the company’s management has created value for shareholders since their original investment. A ratio less than 1 is often an indicator that the company’s managers have destroyed value. But in actuality, listed businesses could trade at a price-to-book ratio of less than 1 for many other reasons, ranging from ephemeral undervaluation, negative industry sentiment, or a substantially inflated book value.
Price-to-book ratio = Market price per share/Book value per share
Where Book value per share = Equity recorded on the balance sheet/Number of shares outstanding
But borrowing may not be a viable idea if the company would struggle to satisfy its financial obligations. An increase in return on equity due to borrowing comes with increased risk.
Decomposing ROE into the three components, net profit margin, total asset turnover, and financial leverage, is valuable because it allows analysts to better understand why the company’s return on equity is changing and to analyze the origins of that change.
Market Valuations
So far, we have measured performance using financial statements. Another way is to evaluate performance in terms of creating or destroying value for the company’s shareholders.
Two ratios, both dependent on a company’s share price, are often used to judge management’s success.
PRICE-TO-EARNINGS
The first ratio compares a company’s share price with its earnings per share.
A price-to-earnings ratio, or P/E multiple, informs us how much investors are ready to pay for every dollar of earnings per share. For example, a firm with a P/E of 15 suggests that investors are willing to pay 15.00 for every 1.00 of earnings per share.
If the price-to-earnings ratio is higher for one company than it is for another in the same industry, it may signal that investors think that the company with the higher price-to-earnings ratio has more growth potential. Alternatively, the firm with the lower price-to-earnings ratio may be undervalued by the market.
Price-to-earnings ratio = Market price per share/Earnings per share
PRICE-TO-BOOK
The second ratio based on the share price is the price-to-book ratio (P/B). It compares the company’s share price with the company’s book value per share.
The book value of stock generally represents historical costs and measures the amount shareholders have invested in the company across its lifetime. Therefore, a P/B ratio larger than 1 suggests that investors feel the company is worth more in the long run than the money shareholders have put in it.
In other words, the company’s management has created value for shareholders since their original investment. A ratio less than 1 is often an indicator that the company’s managers have destroyed value. But in actuality, listed businesses could trade at a price-to-book ratio of less than 1 for many other reasons, ranging from ephemeral undervaluation, negative industry sentiment, or a substantially inflated book value.
Price-to-book ratio = Market price per share/Book value per share
Where Book value per share = Equity recorded on the balance sheet/Number of shares outstanding
0 Comments