Computerized Investing - Spreadsheet Collection/Spreadsheet Collection.iso/pc/ibm9/ratio.doc

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Financial Statement Analysis
By John Bajkowski
Computerized Investing, May/June 1990

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.

The 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 obliga-
tions 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.

(c) Copyright 1991 by the
American Association of Individual Investors