Chris Birkenmaier Pennsylvania Department of Banking

Scope of Financial Analysis 10 Step Basic Company Financial Analysis Limitations to Financial Analysis Net Worth

You cannot analyze the numbers in a vacuum.

The numbers only provide indicators to trigger further questions in your mind.

In order to do a thorough job, you must understand something about the company’s

Business Strategies Its Industry

Financial ratios vary from industry to industry

The ratios can only be interpreted when compared and contrasted with other companies in that industry.

Financial analysis is an art - not a science

Get the company’s financial statements for several years.

3 – 5 years recommended

Balance Sheet Income Statements Shareholder Equity Statements Cash Flow Statements

Quickly scan all the statements to look for large movements in specific items from one year to the next.

Did the revenues have a big jump or large decline from one year to the next?

If you find anything that looks odd or suspicious, research the information you have about the company to find out what happened.

Did the company purchase a new division or other company?

Did they sell off part of its operations?

Review the notes accompanying the audited financial statements for additional information that may be significant to your analysis.

If you find anything that looks odd or suspicious, research the information you have about the company to find our what happened.

Examine the balance sheet.

Look for large changes in the overall components of the company’s

Assets Liabilities Equity

Have fixed assets grown rapidly in one or two years, due to acquisitions or new facilities?

Has the proportion of debt grown rapidly, to reflect a new financing strategy?

If you find anything that looks odd or suspicious, research the information you have about the company to find out what happened.

Examine the income statement.

Look for trends over time in revenue and net income (profit, earnings)

Are the revenues and profits growing over time?

Are they moving in a smooth and consistent fashion, or erratically up and down?

Predictability is valued by investors who seek more consistent movements to large swings.

Look at key expense components on the income statement.

Do the spending trends support the company’s strategies?

Look for non-recurring or non-operating items. These are “unusual” expenses not directly related to ongoing operations.

How do these reflect on the earnings quality?

If you find anything that looks odd or suspicious, research the information you have about the company to find out what happened.

Examine the stockholder’s equity statement.

Has the company issued new shares, or bought some back?

Has the retained earnings account been growing or shrinking?

Are there signals about the company’s long term strategy?

If you find anything that looks odd or suspicious, research the information you have about the company to find out what happened.

Examine the cash flow statement.

This statement gives information about the cash flows and outflows from operations, financing, and investing.

The cash flow statement attempts to reconstruct the cash items to make it clear how cash is obtained and used by the business.

If you find anything that looks odd or suspicious, research the information you have about the company to find our what happened.

Review the dividend payout.

Determine whether the company’s dividend policies are supporting their strategies.

If the company is attempting to grow, are they retaining and reinvesting their earnings rather than distributing them to investors through dividends?

Calculate key financial ratios.

Look for trends in the ratios from year to year.

This should trigger further questions in your mind.

Review all the data that you have generated.

You will probably find that there is a mix of positive and negative results.

Based on everything I know about this company and its strategies, the industry and the competitors, and the external factors that will influence the company in the future, do I think the company is positively viable in the long term?

A popular way to analyze the financial statements is by computing ratios.

RATIOS A ratio is a relationship between two

numbers, e.g. ratio of A:B = 1.5:1 or A is 1.5 times B.

A ratio by itself may have no meaning.

Therefore, a given ratio is compared to:

Ratios from previous years for internal trends

Ratios of other firms in the same industry for external trends

Ratio analysis is a tool that helps to identify problem areas and opportunities with a company.

For regulatory purposes, the most frequently used ratios provide insight into a firm’s”

Liquidity

Degree of financial leverage or debt

Profitability

Liquid assets are those that can be converted into cash quickly.

Short term liquidity ratios show the company’s ability to meet its short term obligations.

Higher ratios would indicate a greater liquidity and lower risk for short-term lenders.

Current ratio = total current assets / total current liabilities

Rule of thumb for acceptable value is 2:1

Although high liquidity means that the company will not default on its short term obligations, it means that retaining assets such as cash you may lose valuable investment opportunities.

Debt ratios show the extent that companies are relying on debt to finance its investments and operations.

If a company is unable to pay its debt, it will be forced into bankruptcy.

Short term debt:

Examples include bank advances.

The current portion of long-term debt.

Long-term debt

Examples include bonds, leases, and notes payable.

Total debt includes both short-term and long-term debt

Debt to Equity ratio = Total Debt / Total Assets

This shows the company’s degree of leverage, or its reliance on external debt for financing.

Debt to Assets Ratio = Total Debt / Total Assets

This shows the company’s reliance on external sources for funding its assets.

In general, with either of the above ratios, the lower the ratio, the more conservative (and probably safer) the company is.

Key Concept – Profitability is a relative term.

Hard to say what percentage of profits represents a profitable firm.

Profits depend on factors such as where they stand on the competitive life cycle.

Depends on the competitive conditions in the industry.

The costs to borrow is also a factor.

We want to know whether profits are generally on the rise.

Whether the market share of the company is◦ Rising◦ Stable◦ Falling

Considerable subjectivity is involved as there is no “correct” number for the various ratios.

It is sometimes hard to reach a definite conclusion when some ratios are favorable and some are unfavorable.

Ratios are based on financial statements that reflect the past and not the future.

Financial statements such as the balance sheet indicate the picture at “one point” in time and may not be representative of a longer period.

Ratios may not be strictly comparable for different firms due to a variety of factors such as different accounting practices or different fiscal year periods.

Just because a specific ratio is better than the average does not necessarily mean that the company is doing well; it is quite possible that the rest of the industry is doing very poorly.

Financial statements do not include all items. Example: it is hard to put a value on human capital (such as management expertise).

Defined (short version) Assets minus Liabilities

Defined (expanded version) Net worth is the retained earnings (amount

left over after dividends are paid) PLUS money in the capital accounts MINUS all short- and long-term debt

On a balance sheet, the major objective of the stockholder’s equity section is to report the capital of the company by source – where the assets came from.

Stockholder Equity has 2 basic subsections:◦ Paid-in capital◦ Earned capital

Measures the resources contributed by owners and others

Consists of stock and any other Additional Paid-in Capital.

Such as: Excess of par Treasury stock Donated capital

Reflects the resources that have been earned by the corporation since it began

MINUS paid out dividends

Assets this is not physical in nature.

Example: Trademarks Patents Brand Name Economic Goodwill (reputation, strategic

location, etc.)

Review of financial statements should lead you to questions about the overall performance and future direction of a company.

There is no one “magic number or ratio” that conclusively summarizes a company’s performance.