FINANCIAL RATIO ANALYSIS
Profitability of Sample Company
What Is Necessary to Assess the
Company?
What Ratios Have the Most Value?
What Other Factors, Beyond Ratios,
Need To Be Considered?
How Would Your Assessment Criteria
Change If The Company In a Different Industry
Appendix A – Sample Company’s
Financial Statements from 1999 – 2001_ 15
Appendix B – Financial Ratio
Analysis of Sample Company
This research paper will evaluate Sample Company using review standard financial ratio analysis techniques and assess its potential as a good investment. This is written in the form of a memo to the CEO of an Alabama-based firm, looking for sound financial advice with regards to whether of not buying stock in Sample Company is a sound investment.
This research paper will reveal the financial analysis techniques used to evaluate the financial performance of the Sample Company, and evaluate the company’s worthiness as an investment. The paper is divided into three sections. The first section is the memo, which is the main body of the paper. The second section, Appendix A, includes as a reference contains each of the sets of the four financial statements that show Sample Company’s performance from 1999 to 2001. The third section, Appendix B, contains the actual financial ratio analysis techniques, showing the company’s performance in 2000 and 2001, the percent change in performance between these years, a short description of the meaning of each ratio, as well as a short assessment of the company’s change in performance between 2000 and 2001. Using these appendices to support the financial analysis ideas expressed in the memo, the reader should feel that they have a complete set of facts to substantiate these ideas and provide a reference for them.
Date: July 1, 2003
To: Randall K. Black, CEO
Absolutely Alabama Investments
From: William F. Slater, III, Consultant
Slater Technologies
Subject: Financial Analysis Using Ratio Analysis and Recommendation
Dear Randall:
Thank you for the opportunity to review Sample Company’s financial statements and make this ratio analysis, as well as some recommendations about possible investment in this company.
Using financial statements from 1999, 2000, and 2001, along with standard financial ratio analysis, I have been able to develop what I believe is a clear picture of this company’s financial performance. Note that the financial analysis was done using the financial report data from publicly available financial statements for the years 2000 and 2001. I have included these statements for your review in Appendix A
Appendix B contains other measures of Sample Company’s financial performance, as expressed in standard financial ratio analysis techniques using figures from the financial reports in Appendix A.
First, let’s look at the Return on Investment (ROI) for 2000 and 2001, using the Dupont Model, which is margin times turnover. Margin is net income divided by the sales, and turnover is sales / average total assets (Marshall, 2002).
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ROI |
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MARGIN |
x |
TURNOVER |
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OPERATING INCOME |
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Operating Income |
x |
Sales |
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AVERAGE TOTAL ASSETS |
Sales |
Average Total Assets |
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Input: |
498 |
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498 |
x |
8,251 |
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7,196 |
8,251 |
7,196 |
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Result: |
6.9% |
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6.0% |
x |
1.15 |
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ROI |
= |
MARGIN |
x |
TURNOVER |
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OPERATING INCOME |
= |
Operating Income |
x |
Sales |
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AVERAGE TOTAL ASSETS |
Sales |
Average Total Assets |
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Input: |
924 |
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924 |
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10,359 |
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8,659 |
10,359 |
8,659 |
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Result: |
10.7% |
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8.9% |
x |
1.20 |
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At over 55.1%, the increase in ROI between 2000 and 2001 is remarkable and shows that Sample Company increased its sales while increasing the utilization of its assets used to generate these sales. And to achieve these results, the sales, operating income and average total assets had to all increase proportionately. In the short term, this would be a good trend, but if it continues, it could be a sign that Sample Company is not keeping a big investment in assets, because not that as the denominator in this ROI calculation, a low asset figure can be used to help drive up the overall result. Meaning that if this trend continues, it may be an indication of increased operations rather than improvement in asset efficiency.
The common stock value increased 54.8%, from $42/share to $65/share, between 2000 and 2001. This is an indicate that the market likes what it sees in the performance and the management of Sample Company. In addition, it paid 1.2% in dividends for the past two years. Another key indicator, the Price to Earnings Ratio, fell from 12.0 to 10.7. This is not enough to be alarming. In fact, some investors, myself included, feel that lower Price to Earnings Ratios are not necessarily a good thing. The reason being that if a company is struggling to pay out large earnings per share, to make the denominator in the P/E equation large enough to keep the P/E ratio low, then often such financial pressures can take the attention of the management away from the company’s operations and other important issues, like surviving as a going concern in a tough business climate.
The activity ratios measure the company’s management of asset levels and sales (Marshall, 2002). Between 2000 and 2001, Sample Company showed positive performance with its average days sales by over 25% and decreased its number of day sales in accounts receivable over 2%. Together, these ratios show the efficiency of collection relative to the average age of receivables. The inventory turnover fell by 5.9% and the fixed asset turnover increased by 18.8%. These turnover figures overall would suggest that assets are being used efficiently to produce sales.
Leverage is the use of debt to finance company assets (Marshall, 2002). When a company uses leverage, it incurs an additional component in its operations, put it also increases the ROE relative to the ROI. Between 2000 and 2001, Sample Company’s debt ratio increased 32.3% and its debt / equity ratio increased 21.5%. An assumption of greater debt in order to produce the overall increase in performance that Sample Company delivered in 2001 could almost be expected. A very encouraging sign is the 31% increase in the ratio of the times interest earned ratio, because it indicates that Sample Company has an increasingly strong capability to pay the interest on its debts with the income it is producing. This is a positive sign for investors and could help in part to account for the overall increase in stock price.
The liquidity of a company is the
ability to meet its loan obligations as it relates to its current assets and
its current liabilities (Marshall,
2002). Appendix B shows that we have
analyzed three important liquidity ratios:
1) Current Ration, 2) Acid Test, and 3) Working Capital. Of these three, the best indicators of
liquidity, when trying to show trends, are the Acid test and the Current
Ratio. A current ratio of 2 and an acid
test of 1.0 are considered “adequate liquidity” (Marshall, 2002). Sample Company’s Acid Test numbers for 2000
and 2001 were .84 and .79, and its Current Ratio numbers for 2000 and 2001 were
1.45 and 1.54. Each sets of these ratio
figures indicate that Sample Company could possibility have some difficulties
in meeting its financial obligations, so these numbers will be important to
watch closely in the future.
Besides doing this detailed financial ratio analysis, it would critical to research the annual reports for 1999 – 2001 and read the explanatory notes and other financial information. There we would find an inside look at organization beyond the numbers, and the bases for how these financial reports were assembled. These notes contain essential information about its significant accounting policies. These policies can and should include information about the depreciation methods that was used, employee benefits, amortization of intangible benefits, earnings per share, stock option and purchase plans. Other types of information that should be disclosed are details of other financial statement amounts (such as detailed explanations of long-term debt), other disclosures such as any possible accounting principle change, business combinations (mergers, acquisitions, dispositions), contingencies and commitments (i.e. disclosures of possible pending lawsuits), events subsequent to the balance sheet date, impacts of inflation, business segment information (i.e. geographic segments), and a possible management’s statement of responsibility.
Other financial information that can found in these reports: a statement showing management’s discussion and analysis, a summary of past financial data, an independent auditor’s report, and a compilation report.
Without the explanatory notes and other financial information, the true picture of an organization’s financial circumstances cannot be known.
Finally, we
would want to take additional time to run a Dun and Bradstreet report on the
company, to I would want to know how the company pays its bills and treats its creditors. Specifically, I would like to see these
Dun and Bradstreet reports on the company: D&B Rating, PAYDEX®, and Score
Tables. The US D&B (5A to HH)
ratings reflect company size based on net worth or equity as computed by
D&B. These ratings are assigned to businesses that have supplied D&B
with current financial information (Dun
& Bradstreet, 2003).
There is also a Financial Stress
Score. The Financial Stress model
predicts the likelihood of a firm ceasing business without paying all creditors
in full, or reorganizing or obtaining relief from creditors under state/federal
law over the next twelve months. Scores were calculated using a statistically
valid model derived from D&B's extensive data files (Dun & Bradstreet,
2003).
There is also a Commercial Credit
Score. The US Commercial Credit Score
predicts the likelihood of a firm paying in a delinquent manner (90 + days past
terms) during the next 12 months, based on the information in D&B's file.
The score was calculated using statistically valid models derived from D&B's
extensive data files (Dun & Bradstreet, 2003).
Dun and Bradstreet reports are among the most respected in the world. Also, if I know how a company treats its creditors, then I will have some idea of how serious the company is about its reputation and about being in business. These reports would give us a greater sense assurance knowing that we now have obtained objective information from one of the world’s most respected sources of financial analysis. To obtain these reports easily, we can go to Dun and Bradstreet at http://dunandbradstreet.com/us/ and order a report on the company using a credit card transaction over the web.
Which ratio has the most value,
really depends on what aspect of the company you are attempting to
measure. For the aggressive investor,
that ration will likely be the ROI. For
a person who is evaluating the risks associated with the ability of the company
to remain solvent, a ratio like the acid test, or the debt ratio will have
considerable importance. So the answer
to the question of which ratio has the most value is really who is asking and
what do they hope to find. To
paraphrase a common quip on standards, the nice thing about ratios is that you
have so many to choose from.
As mentioned above in the section on
what is necessary to evaluate the company, we would want to obtain annual
reports and also Dun and Bradstreet reports.
In addition to all this, we would want evaluate such things as the
performance of the company’s competitors, the standard average financial ratios
for the industry this company is in, and measure Sample Company’s performance
against these averages. Other factors
would be the company’s image in the community, any possible litigation the
company is involved in either as plaintiff or defendant, customer testimonials
(good and bad), the market behavior of the market the company is in, any
offshore threats to competition, workforce demographics and availability, and a
detailed review of the company leadership, including the executive staff
(president and vide presidents), and the board of directors.
What Type of
Industry Do You Think The Organization Is and Why?
I think this is probably a
manufacturing company because the following indicators are within the range of
what would be a manufacturing concern (Marshall, 2002):
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Ratio |
Sample Company 2001 Value |
Manufacturing Typical Value |
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ROI |
10.7% |
10% to 15% |
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ROE |
16% |
10% – 15% |
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Margin |
8.9% |
10% – 15% |
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Asset Turnover |
1.2 |
1.0 to 3.0 |
The table below shows how my
assessment would change if the industry of this company were different.
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Industry |
Change in Assessment |