Refresher: Financial Analysis Terms as a Reminder.
No matter your role (or title) in leading a business or how large or small your business is… we need to have a good grasp on the financial analysis methods and terms and how to use them.
When we are able to run a company without debt (or issuance of stock), of course, the analysis is much more simple… and some of these methods/terms may not apply or be needed for everyone. But, below is a list of some important financial analysis terms and definitions and hopefully this can be a good refresher for all of us… as these can help determine a company’s operational strengths and weaknesses and aid in good decision making.
Horizontal Analysis Results
Horizontal Analysis is completed by taking comparative (for example year to year) statements and analyzing the dollar and percentage change by looking across each row of the statement. Basically, the analysis is completed to assist with decision making based on whether the sales, expenses, and income numbers are increasing or decreasing. Often, the dollar amount change is less important than the percentage change as this will be more relative and helpful over time. To find and complete the horizontal analysis we will “compute the dollar amount of the change from the earlier period to the later period” (Horngren, Harrison, & Oliver, 2008, p. 746) and will then “divide the dollar amount of change by the earlier period amount” (Horngren et al., 2008, p. 747) or what is referred to as the base period. This horizontal analysis will provide us with a “year to year comparison of company performance in different periods” (Horngren et al., 2008, p. 746).
Vertical Analysis Results
Vertical Analysis is analysis of a financial statement to show “the relationship of each item to its base amount, which is the 100% figure. Every other item on the statement is then reported as a percentage of that base. For the income statement, net sales are the base.” (Horngren et al., 2008, p. 749). The base amount when doing an analysis on the Balance Sheet is the Total Assets (or the total liabilities and equity line item). Since the vertical analysis compares the numbers for the line item, to the base amount, it can provide an indication about the performance of the company. For example, if a vertical analysis of the Income Statement showed a Net Earnings of 15% (based on the Net Sales amount) it would show the company to have a very strong earnings percentage. Of course, this would have to be compared to other competitors and industry information but the vertical analysis can provide performance indications.
Trend Analysis Results
Trend Analysis is used to indicate the direction of a business over a period of time. This can be as few as 3 years or as long as 5 or more years. Primarily, the trend analysis will show how Net Sales changes as well as the trend percentages over those same years. The Trend analysis percentages are computed by taking a base year (usually the first year in the trend numbers) and making this base year 100%. So, you take the year item number and divide by the base amount (and then multiply that result by 100) to get the trend percentage.
Ratio Analysis Results
For the ratio analysis, first, we would first look at a company from a liquidity point of view using the Current Ratio, Acid-Test Ratio, Inventory Turnover Ratio, and Average Collection Period.
Working Capital Analysis
Working Capital is defined as the measure of “…the ability to meet short-term obligations with current assets. Two decision tools based on working-capital data are the Current Ratio and the Acid-Test Ratio” (Horngren et al., 2008, p. 755). There are several ways to improve the working capital for a company. They could increase the current assets which include the cash and cash equivalents, increase the short-term investments, and increase the accounts receivables through more sales. They could also reduce the current liabilities such as reducing the accounts and notes payable, reduce the accrued salaries and related expenses, and reduce other accrued expenses.
The Current Ratio is used by the company to evaluate the ability to meet its short term debts and is an evaluation of liquidity. To find the current ratio you divide the Total Current Assets by the Total Current Liabilities. This result will be the current ratio. The higher the current ratio is will allow the company to borrow easier on short term notices. If Competitor A has a current ratio of 4.2 and our company has a current ratio of 5.90 (strength) and then shows a decline the next year to 5.35 (strength) it shows our company sales and liabilities are strong when compared to the competitors current ratio. The example current ratios above can demonstrate that we can meet our short term debts and/or have access to short term borrowing.
The Acid-Test Ratio is used by the company to measure the immediate cash available for short term debts. To find the acid-test ratio you divide the Cash and Cash Equivalents, Short-Term Investments, and Accounts Receivable together and divide by the Total Current Liabilities. The result will be the acid-test ratio. The higher the ratio the more immediate cash is available to satisfy short term debt.
The Inventory Turnover Ratio is used by the company to measure the number of times its inventory is sold during the year. A higher inventory turnover ratio shows that the product is selling well. To find the inventory turnover ratio you divide the Cost of Merchandise Sold by the Average Inventory (found by taking year 1 Merchandise Inventory + year 2 inventory and dividing by 2). The result will be the inventory turnover ratio. If a company only ships their products when they are actually made… they would not have values for this ratio.
The Average Collection Period (Day’s Sales in receivables) is used by the company to measure the average time (in days) that is takes to collect cash from credit customers. If the days in receivables are taking a longer and longer time to get paid, there is an increased chance we will experience trouble paying our own payables. To find the Day’s Sales in receivables we take 365 (number of days in a year) and divide this by the Accounts Receivable Turnover ratio. The accounts receivable Turnover is used by the company to measure the number of times the accounts receivable amount is collected each year. Using this ratio you can easily determine the number of days for AR and compare this to our company policy for credit time. A declining accounts receivable turnover ratio can indicate a collection issue and may be illustrating bad debts that need to be addressed. To find the accounts receivable turnover ratio you take the Annual Credit Sales and divide this by the Average Accounts Receivable. The result will be the Day’s Sales in receivables. If the result is a larger number of day’s sales in receivables when compared to other companies we may need to review our accounts receivable policies and billing practices to determine how we can reduce this period so we can get paid faster.
Reviewing the Liquidity Ratios can show overall company strength or weakness.
Next, Profitability Ratios, are the basic financial ratios on how well we are performing in terms of profit.
The Debt Ratio, often called the Debt to Equity Ratio and sometimes called the Financial Leverage Ratio is used by the company to indicate the extent that we rely on debt financing. A high Debt Ratio can indicate a problem or difficulty with paying interest and principal if we obtain more funding. To find the debt ratio we take the company’s total Debt and divide this by the company’s Total Equity. The result will be the Debt Ratio. If the debt ratio gets too high the company would need to review the debt financing arrangements to get the debt ratio down… or better yet pay off the debt, if possible, and not incur additional debt.
The Gross Profit Margin is used by a company to indicate the percentage of Gross Profit when compared to the base amount of the Net Sales. Using the vertical analysis data from the Comparative Income Statement can determine the Gross Profit Margin (taking the gross profit value and dividing it by the net sales value). If the company has a lower gross profit margin (compared to the industry standard and/or a competitor) it may indicate weakness for the profitability potential. If this is the case the company needs to review their product pricing and manufacturing materials cost to determine if the ratio can be improved.
The Operating Profit Margin is used by a company to indicate the percentage of Operating Profit when compared to the base amount of the Net Sales. Using the vertical analysis data from the Comparative Income Statement can determine the Operating Profit Margin (taking the Operating Income value and dividing it by the net sales value). If the company has a lower operating profit margin (compared to the industry standard and/or a competitor) it may indicate weakness for the profitability potential.
The Net Profit Margin is used by the company to indicate the percentage of Net Profit when compared to the base amount of the Net Sales. Using the vertical analysis data from the Comparative Income Statement can determine the Net Profit Margin (taking the Net Income value and dividing it by the net sales value). If the company has a lower net profit margin (compared to the industry standard and/or a competitor) it may indicate weakness for the profitability potential.
The Earnings Per Share of Common Stock is used by the company to show the amount of net income created per share of the outstanding common stock. To find the earnings per share of common stock you take the Net income – Preferred Dividends and divide by the Number of Shares of Common Outstanding Stock (found by taking the Issued Stock and subtracting the Treasury Stock). The result will be the earnings per share of common stock. Most companies strive for a maximum increase or decrease of 10% – 15% change annually. Companies that show weak Earnings Per Share of Common Stock need to work hard to avoid a trend of remaining weak going forward and will need to either increase net income or reduce expenses to create strong earnings per share of common stock in the future.
The Rate of Return on Total Assets is used by the company to show how efficiently each dollar is used that is invested in the company assets. A low rate of return on total assets indicates that the earnings are low for the amount of assets a company has. To find the rate of return on total assets we take the Net Earnings + Interest Expense and divide this by the average Total Assets. The result will be the Rate of Return on Total Assets. If the Rate of Return on Total Assets decreases year to year it shows weakness for the company and they would need to work harder the next year to use each dollar more efficiently to raise this rate.
Next, we will discuss the investment and stock exchange ratios. These ratios are of interest to those who have invested or will invest in a company in the future.
The Rate of Return on Common Stockholder’s Equity is used by the company to show the return on the common equity. To find the rate of return on common stockholder’s equity you take the Net Income – Preferred Dividends and divide the average amount of stockholder’s equity. The results will be the rate of return on common stockholder’s equity. It will be important that a company avoid weakness (or at least improve it the next year) to avoid investor fear. When we compare to the industry averages it is important that the variation from year to year remains within the normally accepted range.
The Price Earnings Ratio is used by a company to show the market price of the common stock compared to the company earnings (per share). It is best to think of this as the way to show the market price for every $1 of earnings. To find the Price Earnings Ratio you take the Market Price per share of common stock and divide by the Earnings per share. The result is the price earnings ratio.
The Times Interest Earned Ratio, sometimes called the interest coverage ratio, is used by the company to measure earnings that are available to meet interest payments. A lower times interest earned ratio means there are less earnings available for interest payments and this makes the business more susceptible to increases in interest rates. To find the times interest earned ratio we take the Operating Income and divide this by the Interest Expense. This result is the Times interest earned ratio. The higher the number the better a company can pay interest expense on debt. A weakness number relates to being in a worse position to pay the interest expense on debt. Increasing the operating income next year will improve the Times Interest Earned Ratio.