Understanding Financial Analysis
To recognize and examine a enterprise's economic health, investors have a look at its monetary statements and calculate precise ratios. Fortunately, conducting a financial analysis is not as daunting as it sounds and is often part of the Program Evaluation Review Technique (PERT), a project management tool that provides a graphical representation of a project's timeline.
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Assessing a Company's Financial Position
When you borrow money from a bank, you must list the value of all significant assets and liabilities. The bank uses this information to evaluate your financial strength, considering the quality of assets like your car and home, and applying a conservative valuation. Similarly, all liabilities, including mortgage and credit card debt, must be fully disclosed and accurately valued. The total value of assets minus liabilities gives your net worth or equity.
Evaluating a Listed Company's Financial Position
Evaluating a listed company's financial position is similar, but investors also consider the financial position in terms of market value.
The Balance Sheet
A company's financial situation is described by its assets, liabilities, and shareholder equity, all presented in the balance sheet.
Current Assets and Liabilities
On the balance sheet, assets and liabilities are classified as current (expected life of less than 12 months) and non-current. For example, if inventories are expected to be sold within the next year, the inventory level will fall, and the cash amount will rise.
For retailers, inventory represents a significant share of current assets and must be closely examined. Efficient inventory management, like reducing inventory costs while increasing sales, positively impacts operating cash flows.
Current liabilities are obligations the company must pay within the coming year, including payments to suppliers, employees, tax authorities, and short-term financiers. Companies manage cash flow to ensure funds are available to meet these short-term liabilities.
The Current Ratio
The current ratio, calculated by dividing current assets by current liabilities, is used by analysts to assess a company's ability to meet its short-term obligations. An acceptable current ratio varies across industries but should not indicate impending insolvency or an unnecessary build-up of cash, receivables, or inventory.
Non-Current Assets and Liabilities
Non-current assets and liabilities have lives extending beyond the next 12 months. For a retailer like the Outlet, significant non-current assets may include property, plant, and equipment.
Financial Position: Book Value
Subtracting total liabilities from assets leaves shareholder equity, representing the book value of shareholders' stake in the company. This includes capital contributed by shareholders and retained earnings.
Market-to-Book Multiple
Comparing the company's market value to its book value helps investors determine if a stock is under- or over-priced. Although it has limitations, the market-to-book multiple is a crucial tool for value investors. Companies with low market-to-book ratios often perform better than those with high multiples. However, determining high or low multiples depends on industry comparisons.
Financial Ratio Analysis: Definition, Types, Examples, and Use
What is Ratio Analysis?
Ratio analysis is a quantitative method to gain insights into a company's liquidity, operational efficiency, and profitability by analyzing its financial statements.
What Does Ratio Analysis Reveal?
Investors and analysts use ratio analysis to evaluate a company's financial health by examining past and current financial statements. Comparative data can demonstrate a company's performance over time and estimate future performance. This information also compares a company's financial standing with industry averages and competitors.
Types of Ratio Analysis
- Liquidity Ratios: Measure the company's ability to repay short-term debts using current assets.
- Solvency Ratios: Assess the company's debt levels relative to assets, equity, and earnings.
- Profitability Ratios: Indicate how well a company generates profit from operations.
- Efficiency Ratios: Evaluate how effectively a company uses assets and liabilities to generate sales and profits.
- Coverage Ratios: Measure the company's ability to make interest payments and meet debt obligations.
- Market Prospect Ratios: Commonly used in fundamental analysis to predict earnings and future performance.
Application of Ratio Analysis
Ratio analysis compares multiple figures to derive a calculated value, helping to assess a company's financial health over time, across companies, and against benchmarks.
Ratio Analysis Over Time
A company performs ratio analysis over time to understand its performance trajectory, assess what changes have worked, and identify future risks.
Ratio Analysis Across Companies
Comparing financial ratios with competitors helps a company understand its performance relative to others in the same industry.
Ratio Analysis Against Benchmarks
Companies set internal objectives for financial ratios or meet external benchmarks set by lenders to maintain financial health.
Examples of Ratio Analysis in Use
For example, the net profit margin is used to compare profitability within the same sector, while the P/E ratio helps assess how much investors are willing to pay per dollar of earnings.
Summary
A company's financial position informs investors about its overall well-being. Conducting a financial analysis of a company's statements, including footnotes in the annual report, is crucial for investors seeking to understand and value a company accurately. Ratio analysis, which compares various financial metrics, provides deeper insights into a company's performance over time, against competitors, and relative to internal and external benchmarks.