Dave Carlson - March 27, 2007
Income Statements and Balance Sheets provide a wealth of information for the financial analyst. These documents provide insight into a firm’s past financial performance and current financial position. A financial analyst can use numbers from these financial statements to evaluate a company’s financial health. This article discusses thirteen financial ratios, grouped into four categories, to analyze a company’s financial health. Trends over time generally are more valuable than single snapshots. Additionally, comparing a company’s performance with the performance of other companies in the same business sector helps to sharpen the financial picture. Comparisons of the financial status of a target firm with the numbers gathered from industry leaders will give a credible picture of the financial quality of a firm.
How’s business? is a common question heard at many social gatherings. It is a common ice-breaker question used when two people meet for the first time. On the surface, it appears to be a simple question with a simple answer. A common response to the question is fine. If the purpose for the question is to open a conversation, fine might be an acceptable response. However, if the purpose for asking the question is to solicit a response supporting a decision to invest hard-earned money in a business, then fine is woefully inadequate.
Most investment decisions require more than an intangible response to a query about the state of a business. Beginning investors may not know how to determine if a business is fine or if it is a bad investment. Fox, Bartholomae, & Lee (2005) assert that many Americans have “low financial literacy levels” (p. 195) and do not know how to analyze the value of a business. The purpose of this paper is to present tools an investor can use to analyze the financial condition of a company. Analytical tools presented in this paper will help the investor and business owner move to a better financial vantage point before making an investment decision.
A company’s Income Statement (financial results of a particular period of time) and Balance Sheet (financial snapshot on a specific date) provide a wealth of information for the financial analyst. They can provide insight about a firm’s past financial performance and current financial position (Bernstein & Wild, 2000, p. 6). Comparing various numbers from these financial statements provides insight into the financial condition of the company. Analyzing information from financial statements can provide the basis for predicting future value of an organization (Nissim & Penman, 2001, p. 154).
Fabozzi & Peterson (2006) encourage us to perform a thorough financial analysis of a company by looking at events that help explain the company’s present condition and the affect on its future financial prospects (p. 7). Examining current financial events of a firm is especially useful when compared to and contrasted with the financial results of other companies in the same sector. Many times another firm has followed the same path about to be traveled by the firm being examined. Based on the results generated by the historical firm, an analyst can formulate a reasonably solid future prospects situation for the firm being evaluated.
Results of analysis provide background facts to aid in the decision about investing in a firm and to help determine if the company is making adequate progress along the appropriate financial path. Over time, the results of each analysis, when compared to previous results, develops increasing fidelity of a firm’s financial picture. Bernstein and Wild (2000) contend that “the most important item revealed by comparative financial statement analysis is trend” (p. 32). Given enough information about a company’s financial condition, an analyst can discover “direction, speed, and extent of a trend(s)” (p. 32). This principle of trending encourages both the investor and business owner to analyze not only specific financial snapshots of a firm, but to place the results along side those of other similar firms.
Block & Hirt (2008) recommend thirteen significant ratios as a beginning to measure and analyze a company’s operating performance (pp. 54-55). These ratios are comparisons of the relationships between different financial accounts. The analyst uses these ratios to measure the relative value of one account to another (Fabozzi & Peterson, 2006, p. 96). The important point about ratios is that “the value of a given ratio, however, is rarely informative” (Fabozzi & Peterson, 2006, p. 98). The value of the results of a ratio is how it compares to other ratios; both from the same firm and other organizations within the same business sector. Sometimes these ratios also can be helpful when compared to those of firms in other business sectors.
Along with financial analysis, many other factors must be combined with an analysis of numbers to determine the true condition of a business: company management, physical facilities, location, government regulation, products and services, and many other factors. This paper will limit discussion to analysis of financial ratios categorized into four primary groups (see Table 1): Profitability ratios, asset utilization ratios, liquidity ratios, and debt utilization ratios (Block & Hirt, 2008, p. 55).
|Table 1. Financial Analysis Ratios.|
A. Profitability Ratios
1. Profit Margin
2. Return on Assets (Investment)
3. Return on Equity
B. Asset Utilization Ratios
4. Receivable Turnover
5. Average Collection Period
6. Inventory Turnover
7. Fixed Asset Turnover
8. Total Asset Turnover
C. Liquidity Ratios
9. Current Ratio
10. Quick Ratio
D. Debt Utilization Ratios
11. Debt to Total Assets
12. Times Interest Earned
13. Fixed Charge Coverage
|(Block & Hirt, 2008, p. 55)|
Profitability ratios are barometers of how well a company employs its assets. The ratios measure a company’s ability to earn an adequate return on sales, total assets, and invested capital (Block & Hirt, 2008, p. 55). The primary purpose for most business ventures is to generate a profit for the owners and investors. Public companies have a moral (and sometimes legal) obligation to create a profit for those who invest in the companies through purchase of stocks, bonds, and other financial instruments. The following ratios help quantify the financial strength (or weakness) of a business organization.
Profit margin is the most basic financial analysis ratio. It answers one of the first analysis questions most novice business owners ask themselves about their new business: What is the percentage of return on investment for all my hard work?
After the business owner determines his net income and total sales, he wants to know if the return was worth the effort. Would he be better off just putting his money into the bank and collecting interest or is this business concern returning enough profit to make it worth his while? Some business owners might initially want a minimum of 10% profit margin. That may sound like a good profit if the owner compared it to a savings account returning 1% (or less) on his money. But, is 10% really better than 1%? It depends on many other factors.
The result of a profit margin ratio does not tell the entire story; nor does a single result give enough information to make a reasonable decision about the financial stability of a firm. Let us consider the following three examples:
Which example shows the best Profit Margin? The financial analyst is not able to give a credible answer to that question without more meaningful information. If Example #1 represented a company in an industry where the majority of firms showed a 6% Profit Margin, the results would be quite discouraging. If Example #3 represented the same industry, the results would indicate the company may be on solid financial footing.
Example #2 may show a low Profit Margin, but the low percentage may be insignificant if you consider it is from a sole proprietorship that is considering an Initial Public Offering (IPO) of stock; especially, if the analysis was for a one-month period. In this case, the net income for one person might be more significant than the percentage. After all, 1% of $5,000,000 is much more significant than 8% of $400,000 in certain situations.
The point the reader should take away from this discussion is that raw financial numbers are relative when compared to other numbers. What is good in one situation may be very bad in a different situation. A serious financial analyst will realize that numbers viewed in a vacuum are worth little more than the amount of air in a vacuum. The analyst must evaluate the entire financial circumstances of the situation being analyzed before making a decision based on the numbers.
Return on Assets (Investment)
A popular method for evaluating a firm’s profitability is the Return on Assets ratio. This ratio compares the amount of income a company generates with the amount it invests in total assets. Combined with company and industry trends, this ratio can tell the financial analyst how well a company is investing its assets to generate sales. It provides insight on how well a company is managing the assets under its control (Pratt, 2000, p. 270).
Return on Equity
Most shareholders are especially interested in this ratio. Return on Equity measures the effectiveness of management’s use of investor money, called equity capital (Bernstein & Wild, 2000, p. 42). The number generated by this analysis is a significant indicator of the type of return a stockholder can expect in the future. It may even directly influence dividends or stock prices.
Additionally, a potential investor also would be very interested in the trend of this ratio. A high Return on Equity, along with other factors might indicate if the company’s stock would be a good investment. Conversely, a low (and falling) Return on Equity might be an indicator that investment money should seek a more hospitable home.
Asset Utilization Ratios
Asset utilization ratios reveal the ability of a company to turn over its assets (Block & Hirt, 2008, p. 59). It is a measure of the ability of a company to use its assets to make the company stronger financially. The primary emphasis of these ratios is to evaluate the company’s ability to sell goods or services, collect payments for their transactions, and maintain serviceable fixed assets.
This ratio indicates how many times during the period of evaluation that credit sales are generated and the success the business has collecting on those credit accounts. It is a good indicator of how successful a firm is at collecting on credit sales.
For example, if an annual analysis reveals that a company turns receivables more than twelve times per year we can conclude that most customers routinely pay their accounts within 30 days. Assuming the company has a credit policy of 30 days net, the financial analyst can conclude that the company is successful at enforcing its credit policy and, perhaps, the company has an exceptionally valuable customer base. This is a very useful ratio for someone who would like to assess the effectiveness of a company’s credit policy (Fabozzi & Peterson, 2006, p. 107).
Average Collection Period
A more refined analysis of a company’s use of customer credit is the Average Collection Period ratio. This ratio evaluates the average number of days a credit account remains outstanding (Moyer, McGuigan, & Kretlow, 2006, p. 73). Depending on industry averages, a low number here would be a good indicator of the effectiveness of a company’s credit policy.
This is a measure of how inventory is made to work toward helping the firm become and remain financially sound. This number is not good or bad when reviewed by itself. The financial analyst must consider what is typical in the related industry. Additionally, the analyst must determine if the numbers, over time, reflect appropriate responses to seasonal demands (Fabozzi & Peterson, 2006, p. 106). Inventory Turnover ratios must be compared to their corresponding profitability ratios to determine if the company is reflecting appropriate returns on owner or stockholder investments.
Fixed Asset Turnover
This is an evaluation of how well fixed assets (e.g. buildings, vehicles, etc.) contribute to sales. This ratio can be used to evaluate the use of any category of assets used to generate a profit. It can be fine-tuned to reflect the value of purchasing additional display fixtures, larger delivery trucks, hiring additional employees, increasing store hours, and almost any other business consideration that would expend the company’s resources.
As with all financial ratios, the results are meaningless when they stand alone. They must be compared with other turnover ratios over time to paint an accurate picture of the company’s true financial condition.
Total Asset Turnover
The Total Asset Turnover ratio measures how well total assets influence sales. If an increased expenditure on assets results in a corresponding increase in sales, then it was worth the additional investment. Conversely, if spending money to purchase more assets does not result in an increase in sales, it would be prudent to question the expenditure.
The ideal state of this ratio is to show that an increase in total assets produces a greater increase in corresponding sales. For example, if a company spends $50,000 to purchase additional display fixtures in a retail store and the sales during the period evaluated increase by $85,000, the numbers indicate that was a good investment. The resulting increase of $35,000 and the corresponding increase in the ratio percent would be a very positive financial indicator.
Liquidity ratios provide a comparison between what a company owns and what it owes. Morgan Stanley Investments (2007) defines liquidity as “the ease with which an asset can be turned into cash” (¶ 1). Liquidity is a measure of the ability of a company to pay all its current bills if it converts all assets to cash. The desired result is for a company to have cash remaining after it pays all its current bills. The amount of cash remaining can be used as a measure of the company’s financial strength.
The amount of liquidity a company requires depends a great deal on its operating cycle. “The operating cycle is the duration between the time cash is invested in goods and services to the time that investment produces cash” (Fabozzi & Peterson, 2006, p. 100). In other words, it is the time between when a company buys goods with cash and sells the goods to replace the cash.
Current ratio is the most common ratio used to assess short-term liquidity. It reflects current assets that are available to satisfy current liabilities. Current assets include inventory and other assets which could be turned into cash. This ratio is helpful in determining the value of a company if it sold everything, paid all its bills, and split the remaining cash between all owners and investors.
Sometimes, analysts use more stringent criteria called the quick ratio or acid test ratio. This ratio considers only the most liquid current assets, such as cash, short-term investments, and accounts receivable (Bernstein & Wild, 2000, p. 42). This ratio is more helpful than the Current Ratio for someone interested in evaluating the ability of a firm to meet unexpected financial emergencies which will require cash within a relative short period of time.
Caution: If this ratio is too high (compared to appropriate industry averages) there may be a problem with the company investing in assets that will not generate additional profits. This could be an indicator that the company is not making the best use of its assets (Fabozzi & Peterson, 2006, p. 105).
Debt Utilization Ratios
Debt utilizations ratios demonstrate “the prudence of the debt management policies of the firm” (Block & Hirt, 2008, p. 60). This type of analysis indicates whether or not the company is making a wise use of their debt. How much they owe verses how much they own tells the analyst a great deal about the firm’s management of debt. Additionally, comparing interest expense with income helps refine the analysis. A firm that holds too much debt might not be a wise investment. However, the analyst must remember to compare and contrast results with historical trends of both the company being examined and those firms in similar situations.
Debt to Total Assets
This ratio may give good picture of the financial stability of a company. It is an indicator of how well the company is managing its debt. If the ratio between total debt and total assets is too high it may indicate the company may be in serious financial trouble. Gentle, Härdle, & Mori (2004) use this ratio as an indication of how likely a company may be a candidate for bankruptcy (p. 826). A company on the verge of bankruptcy may not be a good long-term investment, but might be a good target for take over at a bargain price.
When comparing companies against industry standards, generally, the companies with lower debt-to-asset ratios are better financial investments. Since there always are exceptions to any rule, the prudent financial analyst will review industry trends over time before drawing any conclusions about debt-to-asset ratios.
Times Interest Earned
The Times Interest Earned ratio indicates how much money is available to cover interest payments on financial obligations. A high number reflected by this ratio would be most assuring for someone performing a credit analysis on the firm (Bernstein & Wild, 2000, p. 42). Having a high income, relative to interest payments, is an indicator that the firm may have a solid financial foundation.
Fixed Charge Coverage
Forbes (2007) defines Fixed Charge Coverage as “A measure of a firms ability to meet its fixed-charge obligations: the ratio of (net earnings before taxes plus interest charges paid plus long-term lease payments) to (interest charges paid plus long-term lease payments)” (¶ 1). This is another ratio for measuring the financial stability of a company. An indication that a company is having problems paying its fixed charges would cause an investor to evaluate very carefully the prudence of investing in that company.
The financial analyst must consider this ratio carefully. Some industries have a natural seasonal downturn. As with all financial ratios, the individual numbers must be compared with appropriate company and industry trends.
There are several financial ratios in a financial analyst’s toolbox. Each of them provides insight into the financial condition of a firm. Profitability ratios, asset utilization ratios, liquidity ratios, and debt utilization ratios all work together to piece together an accurate financial picture of a business. However, the full financial picture may not reveal itself unless the analyst compares several ratios and related factors. After calculating a financial ratio, the analyst needs to evaluate it in the context of other parts of a company’s financial condition and performance, along with the performance of other firms in the same industry (Fabozzi & Peterson, 2006, p. 99).
Trends over time generally are more valuable than single snapshots in time. Additionally, comparing a company’s performance with the performance of other companies in the same business sector helps to sharpen the financial picture. Companies that lead their industry are there for a reason. Comparisons of the financial status of a target firm with the numbers gathered from industry leaders will give a credible picture of the financial quality of a firm.
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