It is rather difficult for businesspeople to make informed and wise decisions involving the risks, opportunities, and profitability of their ventures unless they have knowledge on the right tools and techniques to utilize. Entrepreneurs and corporations alike need not worry though because they are always take advantage of financial statements whenever they feel the need to examine the performance of their respective enterprises. Through income statements and balance sheets, for instance, businesses can immediately assess their profits, losses, assets, liabilities, and net worth at a given time. Nevertheless, evaluation of companies’ performance should never be limited with these fiscal records alone. To further get enlightenment whether or not to pursue an investment, to carry on with expansion to new places, or to close a losing branch, business tycoons are advised to make an extensive financial statement analysis. After all, this scrutiny will answer “. . .the following purposes: measuring the profitability, indicating the trend of achievements, assessing the growth potential of the business, comparative position in relation to other firms, assess overall financial strengths, assess solvency of the firm” (Lingesiya 15).
The process of financial statement analysis is a complicated one. According to Wikipedia, it should consist of “1) reformulating reported financial statements, 2) analysis and adjustments of measurement errors, and 3) financial ratio analysis on the basis of reformulated and adjusted financial statements.” To further understand these protocols, this write-up will aim to discuss each step in detail.
I. Financial Statements Reformulation
The following fiscal records must be prepared beforehand: income statements, balance sheets, cash flows, statement of retained earnings—which can be secured from the finance and accounting departments of a firm. If, however, one is searching for the financial records of other companies, he can request for the information through mail or look into the annual reports made readily available to the public by the Securities and Exchange Commission. Aside from that, one can also tap published financial data on various investment websites and other similar sources.
It is not enough that you have copies of the necessary financial papers needed for a comprehensive analysis. One must remember that reformulation includes “. . . making the financial statements for a particular period, then changing them, reorganizing the items they contain in order to more accurately depict various aspects of the business” (Lacoma). Ergo after gathering the statements, one should start dividing the items into normal/recurring items and special/non-recurring ones. Examples of those to be included in the recurring list are revenues, additional income, allowances, and the like ; those to be listed as non-recurring items are write-offs of bad debts, repair costs of equipment broken by natural disasters, separation costs among others. After identifying these accounting items, the analyst should then rearrange the entries to get rid of the “noise” in the statements so that only the information of the core operations will be reflected. Once the unimportant data is eliminated, one can now proceed with the next sorting of the information into:
- Net Operating Assets (NOA) – Once the operating entries are parted from financing entries, the NOA can be calculated as the business operating assets less operating liabilities.
- Net Financial Debt – computed as gross financial obligations minus receivables (from derivatives) and liquid assets
- Equity -
- Net Operational Profit After Taxes (NOPAT) – According to Investopedia, NOPAT is a “. . . company's potential cash earnings if its capitalization were unleveraged (that is, if it had no debt). NOPAT is frequently used in economic value added (EVA) calculations.” Its value can be determined after multiplying a firm’s operating income to (1 – tax rate).
- Net Financial Costs - defined as the “ the difference between the cost of financing the purchase of an asset and the asset’s cash yield” (Nasqaq.com).
II. Measurement Error Adjustment and Analysis
In accounting, measurement errors are common. At times, it cannot be avoided that the true value of something is overlooked because of inconsistencies in computations made by both humans and software programs. For that reason, careful evaluation of such variability must be performed. The analyst should be able to identify a trend in the inconsistency so as to correct any errors made. Once all of the mistakes are determined, it will be a lot easier to make a reliable profitability prediction and other financial adjustment reasons.
III. Financial Ratio Comparison
This is perhaps the trickiest part of the entire financial statement analysis process. This is where the analyst needs to use ratios in order to measure a company’s efficiency in terms of risk and profitability management. Of course, to be able to provide a sound examination, he should have knowledge of the four major measurement gauges in accounting, which are:
- Liquidity Ratios – measures the ability of a firm to manage its short-term liabilities.
- Activity Ratios – covers a company’s utilization of its assets and generation of sales.
- Profitability Ratios – determines how well a business minimizes its operating costs to augment its income.
- Coverage Ratios – evaluates a company’s ability to cover long-term financial obligations. If the firm has a high coverage ratio, it means that it can pay its debts to the lenders promptly.
III.A. Liquidity ratios
- Current ratio – According to an article from the book Intermediate Accounting For Dummies, “This ratio tells you the company’s ability to pay current debt without having to resort to outside financing.” This is computed as current assets divided by current liabilities. For instance, a firm has $130,000 as current assets and $20,000 as current liabilities. The current ratio is therefore 6.5, as shown below:
Current Ratio=Current assets-current liabilities
= $130,000 - $20,000
Note: A positive current ratio implies that a business has enough resources to fulfill its financial obligations, without having to borrow from other lenders.
- Quick Acid-test ratio – Very much like the current ratio, the acid-test ratio is only different because of the addition of quick assets (available cash or assets that are readily convertible to cash like stocks in other firms). It is computed as:
Quick Acid-test Ratio=(Cash and Cash Equivalent+Accounts Receivables+Marketable Securities)Current Liabilities
Please note that ideally “. . . the acid test ratio should be 1:1 . . . the higher the ratio, the greater the company's liquidity” (Gallagher, 94-95).
III.B. Activity ratios
- Asset Turnover – This term is defined as the speed of inflow and outflow of income-producing assets (e.g. merchandise). If a company has a quick asset turnover, it means that it is able to generate sales effectively. Asset turnover ratio is computed as:
Asset Turnover=Net SalesAverage Total Assets
If a firm has net sales of $45,000 and average total assets of $54,000, its asset turnover is 0.83. Therefore, it must perform better and improve its net sales in order have a good asset turnover ratio.
- Inventory Turnover – This deals with the company’s efficiency when it comes to handling inventory—from replenishment and timeliness of sales. If a company has a lower number of inventories, it only means that the storage and handling costs are also lower. To learn about a company’s inventory turnover, the cost of goods sold must be divided by its average inventory.
Inventory Turnover=Cost of Goods Sold (COGS)Average Inventory
Assuming that the COGS is $15,000 and the average inventory is $800. The inventory turnover ratio is 18.75 times, which is a very good number. Of course, the analyst still needs to compare this figure with other firms in the industry for better gauging.
III.C. Profitability ratios
- Return on Assets (ROA) – This answers the question as to the performance of a company in terms of using its assets to generate income. This ratio is computed as:
Return on Assets ROA=Revenue-ExpensesAverage Total Assets
Supposing that a company has this data: revenue - $67,000, expenses - $12,000; average total assets - $105,000; then its ROA would be 52.38 percent. This implies that for every $1 asset of the firm, it also earns 52.38 centavos. Remember that the higher the ROA, the better the performance of the company is.
- Return on Equity (ROE) – This is the result of dividing a business’ net income by its average owners’ equity. This ratio is used to examine the profit earned by a company for every dollar it invests in stocks. In equation, it is:
Return on Equity ROE=Net IncomeAverage Owners'Equity
- Net Profit Margin – This tool is utilized when identifying the after-tax profit of a business for each dollar it earns as sales. This ratio can be computed in two ways.
1.) Net Profit Margin=Net Income After TaxRevenue
2.) Net Profit Margin=(Net Income+Interest+Tax-Adjusted Interest)Revenue
As a general rule, a high Net Profit Margin would tell you how well a business is run. However, there are some companies that hold lower ratios. This is sometimes the case when a business relies on high volume to compensate for their lower pricing strategy.
- Retention Ratio – This tool will help identify a firm’s earnings that are credited as retained earnings and are not paid out in dividends. It can be calculated as:
Retention Rate=1-Dividend Payout Ratio
Please take note that the dividend payout ratio is the number of a company’s dividends divided by its net income.
III.D. Coverage ratios
- Debt Service Coverage Ratio (DSCR) – This leverage ratio’s purpose is to find out a firm’s capability to repay its debt and interest using its cash profits. It is calculated as:
Debt Service Coverage Ratio DSCR=Annual Net Income+Depreciation+Interest Expense+Non-Cash ItemsPrincipal Repayment+Interest Payments+Lease Payments
If a company has a positive / higher DSCR, it means that it can immediately secure a loan from a bank or other financial institutions.
- Interest Service Coverage Ratio (ISCR) – This ratio guides the analysts and stockholders of a company’s ability to repay the interests of its loans. This is equated as:
Interest Service Coverage Ratio=Earnings Before Interest and Taxes (EBIT)Interest Expense
Should a firm hold a negative ISCR, lenders will hesitate to let the business borrow money since it does not have the capacity to pay the interests on its debts.
- Total Cash Flow Coverage Ratio – Based in an entry in ReadyRatios.com, the total cash flow coverage ratio is “. . . an indicator of the ability of a company to pay interest and principal amounts when they become due. . . A ratio equal to one or more than one means that the company is in good financial health . . . A ratio of less than one is an indicator of bankruptcy of the company within two years if it fails to improve its financial position.” It is simplified as:
Total Cash Flow Coverage Ratio=Operating Cash FlowsTotal Debts
This ratio has some variations, however. Sometimes, the analyst will include payments for preferred dividends, rental payments, and the like to calculate the cash flow coverage. If he pleases to come up with a conservative ratio, he might prefer free cash flows over operating cash flows.
Benefits and Limitations for a Financial Statement Analysis
Although the financial statement analysis proves to be a great technique to monitor the performance of an enterprise, an analyst must always ask himself if it is the right tool to utilize during a particular situation. If he aims to provide possible investors with attracting profitability potential of a company, then this type of finance record scrutiny will be necessary. The same thing is true if an analyst, agency, or stockholder aims to review the accounting standards and taxation practices that a specific company adopts. Finally, with these ratios, a firm can help evaluate its performance properly, compare its existing records with the previous years and benchmark the results with the industry average, and develop new strategies to further augment its capacity to generate sales and improve its income.
Even though financial statements can be acquired easily, an analyst will still find it difficult to compute ratios and examine the financial health of a company especially when other information provided from outside sources is vague. For instance, there are cases when the industry averages shown to the public are not realistic but rather ideal. There are also times when it is not clear as to which sector to associate a company with, making it more confusing to compare with its supposed competitors. In addition, variations in ratio computations cannot be avoided, therefore making it even harder for the analyst to interpret the ratios and to get a good grasp of the firm’s capability to pay debt or its liquidity. Finally, it is very challenging to benchmark the financial statement analysis of a company with other firms simply because of their difference accounting practices. Although there is a standard GAAP convention, other businesses adopt a special accounting standard. Because of all these complexities, an analyst must always see to it that he gathers as much information that he needs in order for him to come up with an unquestionable analysis at the end of the day. Of course, it is always better for him to take advantage of other accounting software programs to lessen his margin of errors along the way. Aside from that, it is highly advisable for him to add other techniques and tools to represent the financial situation of a firm so that he can look at the company in an unbiased way. After all, there are other business evaluation and forecasting tools that accountants and finance analysts rely on.
Lingesiya, Y. "Importance of Financial Statements Analysis." PDF file.
“Financial Statement Analysis.” Wikipedia. Web. 26 October 2013.
Lacoma, Tyler. “Why Reformulate Financial Statements?” eHow. n.d. Web. 22 November 2013.
“Net Operating Profit After Tax – NOPAT.” Investopedia. n.d. Web. 22 November 2013.
Loughran, Maire. “Ten Ratios for Financial Statement Analysis.” Intermediate Accounting for Dummies. New Jersey: John Wiley & Sons, 2012. Print.
Gallagher, Timothy. Financial Management. Englewood Cliffs: Prentice Hall, 2003. pp. 94–95. Print.
“Cash Flow Coverage Ratio.” ReadyRatios. n.d. Web. 20 November 2013.