Financial statement analysis applies analytical tools and techniques to financial statements to determine the operating and financial success of a firm. The emphasis of the analysis depends upon one's viewpoint. A credit analyst extending a short-term, unsecured loan to a company might emphasize the firm's cash flow and liquidity. An equity investor, on the other hand, may look closely at growth in earnings and dividends. He would be interested in the variables that might have a significant impact on a firm's financial structure, sales, earnings production and dividend policy.
A spreadsheet template is presented that uses data from the balance sheet, the income statement and the cash flow statement to produce financial comparisons of interest to investors. The spreadsheet is geared toward the analysis of manufacturing firms, but it can be modified for use in analyzing financial and utility companies.
Raw data is entered from the balance sheet and income statement. Data for the next year can be added by copying last year's formulas two columns to the right and entering the new data.
Data Sources
The printed annual report remains the best, most readily available source of information for financial statement analysis. The Securities Exchange Act of 1934 requires that companies provide an annual report that includes audited financial statements (balance sheets for the two most recent fiscal years, income and cash flow statements for the three most recent years), selected quarterly data for each quarterly period for the two most recent years and a summary of selected financial data for the five most recent years.shareholders must receive this annual report in connection with the annual shareholders meeting. Others can contact the company to request a copy of the latest annual report; publications such as Value Line, S&P's Stock Reports and S&P's Register of Corporations can provide the necessary address and phone number.
Electronic information services would seem to be a quick and easy source of data for financial statement analysis, however they contain certain limitations. The Disclosure Service provides a good example of data service limitations. This service is available on-line through vendors such as CompuServe, or on CD-ROM directly from the company. Disclosure covers over 10,000 companies, providing textual information such as the management discussion from the annual report, corporate events and ownership information; financial history, consisting of income statements for the past three years, balance sheets for the past two years, quarterly data for the last three quarters, and a ratio report; and company information such as a listing of officers and directors and their stock holdings. Because Disclosure covers so many companies, it may have to modify and combine data elements to fit its report format. The service does not provide the cash flow statement or notes to the financial statements that are often as important as the statements themselves. One must also consider the cost of the service--through CompuServe a full report would cost $15, plus the standard CompuServe access fee of $12 per hour that is incurred while accessing the Disclosure data.
Formal financial statements issued by companies differ in the level of detail used to present data. For example, some firms may only list a gross property, plant and equipment figure. In the notes that accompany the financial statements in an annual report, however, a more detailed breakdown would be found. The statement of cash flows may also provide some vital data not specifically listed in the income statement. If a firm does not break depreciation out of its selling, general and administrative expenses area, the cash flow statement will provide the amount, allowing you to reconstruct a more detailed and useful statement.
Principal Analysis Tools
The worksheet presented in this article employs three principal tools for financial statement analysis--comparative financial statements, common size statements and ratio analysis.
Comparative Financial Statements
Financial statements are easily compared by setting the statements up next to each other and examining how each category item has changed from year to year. This is generally how financial statements are printed.
When comparing financial statements, the goal is to identify trends and their rate of change. This can be accomplished by examining the statements over a number of years. It is vital to compare the changes of related items. For example, while sales may have been increasing at 10% per year, cost of goods may have been increasing at a rate of 15% per year. Perhaps material costs are rising, and a new competitor prevents the company from passing the cost on to customers. This will have implications for the earnings growth rate and eventually the share price, reshaping investor expectations.
Common Size Statements
Common size statements examine the proportion of a single line item to the total statement. For balance sheets, all assets are expressed as a percentage of total assets, while liabilities and equity are expressed as a percentage of total liabilities and stockholders' equity. Income statement items are expressed as a percentage of revenues.
Common size analysis is often called structural analysis because it examines the internal structure of the financial statements. For balance sheets, examining the asset side reveals how the firm has invested its capital to produce revenues. Examination of liabilities and equity reveals how the assets have been financed. Common size income statements reveal how well management is able to translate sales into earnings. Comparisons over a number of years are important, since no one year can capture the full dynamics of a firm.
Common size statements also allow for comparisons to other companies in the same industry. This analysis disregards the absolute size of companies, and reduces all firms to a uniform format. These intercompany comparisons can pinpoint weak or strong areas that might otherwise have been overlooked. Industry average ratios can be found in Value Line and S&P's Industry Surveys.
The formula for computing the proportion of one item to another is quite simple--the item being compared is divided by the comparison benchmark. For determining the proportion of cost of goods sold to revenues, the formula is:
% of Sales = Cost of Goods Sold . Operating Revenue
When programming the template, the benchmark should be made an absolute row reference so that the formula can be entered only once and then copied down. To program the example above, the following formula would be entered in cell D189:
D189: +D140/D$139
The formula in cell D189 could then be copied down and across to compute the percentage of sales figures for other line items and other years.
Ratio Analysis
Ratios are one of the most popular financial analysis tools. A ratio expresses a mathematical relationship between two values. To be a useful comparison, however, the two values must be related in some way. We have selected some widely used ratios that should be of interest to investors. As in the case of the common size statement, a comparison with other firms in similar industries and a comparison of these ratios for the same firm in different periods is important in determining trends. These ratios are interrelated, so they should be looked at together rather than independently.
Operating Performance Ratios
Operating performance ratios are usually grouped into asset management (efficiency) ratios and profitability ratios. Asset management ratios examine how well the firm's assets are being used and managed, while profitability ratios summarize earnings performance relative to investment. Both of these categories attempt to measure management's abilities and accomplishments.
Total asset turnover measures how well the company's assets
have generated sales. Industries differ dramatically in asset turnover, so comparing firms in similar industries is crucial with this ratio. Too high a ratio relative to other firms may indicate insufficient assets for future growth and sales generation, while too low an asset turnover figure points to redundant or unproductive assets.
Inventory turnover is similar in concept and interpretation to total asset turnover, but examines inventory instead of assets. We have used cost of goods sold rather than revenues because cost of goods sold and inventory are both recorded at cost. If you are using published industry ratios make sure that the figure is computed in this method. Some information services may use revenues instead of cost of goods sold to compute this ratio.
The firm's basic pricing decisions and its material costs are reflected in the gross profit margin. The greater the margin and the more stable the margin over time, the greater the company's expected profitability. Trends in the gross profit margin should be closely followed because they generally signal changes in market competition.
Operating margin examines the relationship between sales and management-controllable costs before interest taxes and non- operational expenses. As with the gross profit margin, a high, stable operating margin is desirable. The net profit margin is the "bottom line" margin frequently quoted for companies. It indicates how well management has been able to turn revenues into earnings available for shareholders.
Return on total assets examines the return generated by the assets of the firm. A high return implies the assets are productive and well-managed. The return on stockholders' equity (ROE) takes this examination one step further and examines the financial structure of the firm and its impact on earnings. Return on stockholders' equity indicates how much the stockholders earned for their investment in the company. The level of debt on the balance sheet has a large impact on this ratio. (The DuPont Analysis Spreadsheet Corner in the January/ February 1990 Computerized Investing discussed this issue in greater detail.) Debt magnifies the impact of earnings on ROE during both good and bad years. When large differences between return on total assets and ROE exist, the liquidity and financial risk ratios should be
closely examined.
Liquidity and Financial Risk Ratios
Liquidity measures indicate how easily the firm can meet its short-term obligations, while financial risk measures indicate the company's ability to meet all liability obligations and the impact of these liabilities on the balance sheet structure.
he current ratio compares the level of the most liquid assets (current assets) against that of the shortest maturity liabilities (current liabilities). A high current ratio indicates a high level of liquidity and less risk of financial trouble. Too high a ratio may point to unnecessary investment in current assets, failure to collect receivables, or a bloated inventory, all negatively affecting earnings. Too low a ratio implies illiquidity and a potential inability to meet obligations on current liabilities.
The quick ratio, or acid test, is similar to the current ratio, but is a more conservative measure. It subtracts inventory from the current assets side of the comparison because inventory may not always be quickly converted into cash or may have to be greatly marked down in price before it can be converted into cash.
The debt-to-total-assets ratio measures the percentage of assets financed by all forms of debt. The higher the percentage, the greater the risk. Interest on debt obligations must be paid, regardless of company cash flow. Failure to due so results in default and potential bankruptcy, if the lender will not restructure the debt. Prudent use of debt, however, can boost return on equity.
Debt to total capital is a popular measure of financial leverage, but its name may cause some confusion. Debt for this ratio only consists of long-term debt, not total debt. Capital refers to all sources of long-term financing --long-term debt and stockholders' equity. This ratio is interpreted in the same way as the debt-to-total-assets ratio; a high ratio indicates high risk. However, a low ratio may not be a true indication of low risk if current liabilities are at a high level.
Interest coverage indicates how well a company is able to generate earnings to pay interest. It directly measures how many times the firm can pay or cover interest payments. The larger and more stable the ratio, the less risk of default.
Market Measures
Market measures indicate how the market place has valued past and, more importantly, expected company performance. The price-earnings ratio is perhaps the most popular market measure. It indicates what the market is willing to pay for earnings. A high price-earnings ratio indicates the market is expecting high earnings growth and offering a higher return for the risk of achieving and maintaining a high earnings growth rate. Conversely, a low price/earnings ratio implies that the market is not anticipating a great deal of earnings growth.
The price-to-book-value ratio relates the stock price to the balance sheet's statement of stockholders' equity. Many factors can influence this ratio, from an accounting understatement of the true value of a firm's assets to the market's expectation of increasing return over time.
The dividend yield relates the cash dividend paid out to shareholders to the current stock price. High dividend yields tend to point to a stable, mature company that chooses not to reinvest earnings and instead pays them out. A high dividend yield may also indicate that the market does not expect the company to maintain the current dividend payout and may cut its dividend. Examining the growth rates of sales and earnings, trends in margins, cash flow and payout ratio can help interpret a high dividend yield. A low dividend yield would tend to point to a growth company whose investors expect to receive their returns through stock price appreciation.
While the dividend payout ratio is not a true market measure in the sense of comparing the stock price to some stated value, it is a valuable tool to help identify the growth stage of a company and confirm the validity of the dividend yield. This ratio indicates what the company is doing with its earnings. Firms with low payout ratios choose to reinvest earnings in the firm because they can find attractive investment opportunities. For more mature companies with a high payout ratio, the dividend yield should also be examined to confirm that the company can continue to pay or even increase the dividend.
The Bottom Line
When examining financial statements, we are trying to get a feel for management performance, capabilities and even philosophy along with the company's potential growth and profitability. We have only touched on the basics of financial statement analysis. Investors wishing to gain more understanding of the area should consider a source such as Leopold A. Bernstein's "Financial Statement Analysis: Theory, Application, and Interpretation," 4th edition, published by Richard D. Irwin, or Eric A. Helfert's "Techniques of Financial Analysis," 6th edition, published by Richard D. Irwin.
