In this knowledge blog post, we discuss what is the purpose of financial statement analysis and the 5 key questions to be asked when it comes to assessing a firm’s operations. We also address briefly the limitations of financial ratios analysis.
1. The Purpose of Financial Analysis
Financial analysis is about more than reviewing financial statements.
It can be used both to:
1. Evaluate historical performance
2. Serve as a basis for making projections about and improving future performance.
Financial ratios are used to standardize financial information so that we can make comparisons.
There are 2 ways of making meaningful comparisons of a firm’s financial data:
1. We can examine the ratios across time (e.g for the past 5 years)
2. We can compare the firm’s ratios with those of other firms
Financial analysis is not just a tool for financial managers; it can also be used effectively by investors, lenders, suppliers, employees and customers.
2. Measuring Key Financial Relationships
There are 5 important questions to ask about a firm’s operations.
QUESTION I: How liquid is the firm?
Liquidity is defined as a firm’s ability to pay its bills on time. Liquidity is related to the ease and speed which a firm can convert its noncash assets into cash.
In our analysis, we are interested in both (1) the amount of current assets relative to current liabilities and (2) the quality of the individual current assets that will be used in meeting current debt payments.
When it comes to the relative size of current assets to current liabilities, the most commonly used measure is the current ratio: Current ratio = current assets / current liabilities
A revised ratio is the acid-test (or quick) ratio. This is a more stringent measure of liqudity because it excludes inventories and other current assets from the numerator: Acid-test ratio = (cash + accounts receivable) / current liabilities
When it comes to the quality of the individual current assets, we can compute how long it takes to collect the firm’s receivables on average: Days in receivables = account receivable / daily credit sales = account receivable / (annual credit sales / 365)
We can also measure how many times accounts receivables are « rolled over » during a year, using the accounts receivable (A/R) turnover ratio: A/R turnover ratio = (annual credit sales / accounts receivable)
It is also possible to know the quality of the inventory, as indicated by how long the inventory is held before being sold. This is called days in inventory: Days in inventory = inventory / daily cost of goods sold = inventory / (annual cost of goods sold / 365)
QUESTION II: Are the firm’s managers generating adequate operating profits from the company’s assets?
To answer to this question, we’re using operating profits rather than net income as operating profit exclude interest expense, i.e the cost of financing, as we want to isolate the operating aspects of the company’s profits (the effect of financing will be considered in the 2 questions that follow)
While knowing the dollar amount of a firm’s operating profits is important, we also want to know the amount of operating profits relative to the total assets employed:
Operating return on assets = operating profits / total assets
Higher operating return on assets comes from (1) how effectively the company’s income statement was being managed (= operations management); (2) how efficiently assets are being managed to generate sales (= asset management).
We can recalculate the operating return on assets equation by isolating the 2 effects: Operating return on assets = operating profit margin x total asset turnover = (operating profit / sales) x (sales / total assets)
The Operating profit margin is an overall measure of operating effectiveness.
The Total asset turnover is an overall measure of asset efficiency based on the relation between a firm’s sales and the total assets.
QUESTION III: How is the firm financing its assets?
The key issue is management’s choice between financing with debt or with equity.
To begin, we want to know what percentage of the firm’s assets is financed by debt. To answer this question, we can compute the debt ratio as follows: Debt ratio = total debt / total assets
The second perspective regarding the firm’s financing decisions comes from looking at the income statement and measure a firm’s ability to meet its interest payments from its annual operating earnings: Times interest earned = operating profits / interest expense
QUESTION IV: Are the firm’s managers providing a good return on the capital provided by the shareholders?
We now want to determine if the firm’s owners (shareholders) are receiving an attractive return on their equity investment compared to the return on equity at competing firms. For this, we use the return on equity (ROE): Return on Equity = Net income / Total common equity
QUESTION V: Are the firm’s managers creating shareholder value?
There are 2 ratios commonly used to compare a firm’s stock price to earnings and to accounting book value of its equity. These 2 ratios indicate what investors think of management’s past performance and future prospects:
Price / earnings (P/E) ratio = market price per share / earnings per share
Price to book (P/B) ratio = market price per share / equity book value per share
The P/B ratio indicates whether the shareholders think the firm’s equity is worth more or less than the amount of capital they originally invested. How is shareholder value created or destroyed? Quite simply, it is created when a firm earns a rate of return on the capital invested that is greater than the investor’s required rate of return.
The Economic Value Added (EVA) measures a company’s economic profit (instead of accounting profit) by including not only interest expense as a cost but also the shareholder’s required rate of return on the investment: EVA = (Operating return on assets – cost of capital) x total assets
3. The Limitations of Financial Ratios Analysis
These are the 5 limitations we might encounter as we compute and interpret financial ratios:
1. It is sometimes difficult to determine an appropriate industry within which to place the firm;
2. Published industry averages are only approximations, not scientifically determined averages;
3. Accounting practices differ widely among firms and can lead to differences in computed ratios;
4. An industry average may not be a desirable target ratio or norm;
5. Many firms experience seasonal business conditions. As a result, the ratios calculated for them will vary with the time of the year the statements are prepared.
In spite of their limitations, financial ratios provide us with a very useful tool for assessing a firm’s financial condition.
(image source: vectorstock)