Steps to a Basic Company Financial Analysis By Professor Harvey B. Lermack Revised May 23, 2003 © 2003 Harvey B. Lermack These are basic steps you may use when evaluating company cases in my graduate and undergraduate business strategy and business policy courses. Before you start, you must understand a couple of things. · This is not meant to be an exhaustive list; there are other steps that can be followed to get deeper into the meaning of the numbers. · You cannot analyze the numbers in a vacuum. The numbers only provide indicators to trigger further questions in your mind. · In order to do a thorough job, you must understand something about the company’s business and strategies, and its industry. Financial indicators vary from industry to industry; the ratios can only be interpreted when compared and contrasted with other companies in that industry. For example, financial indicators are (and should be) different among financial institutions, manufacturing companies, companies that provide services, and technology and computer information and services companies. · Financial analysis is something of an art. Experienced managers, investors and analysts develop a data bank of information over time, and after doing many such analyses, that they bring to bear every time they review a company. Step 1. Acquire the company’s financial statements for several years. These may be found in your assigned case study; in a recent annual report; in the company’s 10K filing on the SEC’s EDGAR database; or from other sources found at my LINKS website. As a minimum, get the following statements, for at least 3 to 5 years. · Balance sheets · Income statements · Shareholders equity statements · Cash flow statements Step 2. Quickly scan all of the statements to look for large movements in specific items from one year to the next. For example, did revenues have a big jump, or a big fall, from one particular year to the next? Did total or fixed assets grow or fall? If you find anything that looks very suspicious, research the information you have about the company to find out why. For example, did the company purchase a new division, or sell off part of its operations, that year? Step 3. Review the notes accompanying the financial statements for additional information that may be significant to your analysis. Step 4. Examine the balance sheet. Look for large changes in the overall components of the company's assets, liabilities or equity. For example, have fixed assets grown rapidly in one or two years, due to acquisitions or new facilities? Has the proportion of debt grown rapidly, to reflect a new financing strategy? If you find anything that looks very suspicious, research the information you have about the company to find out why. Step 5. Examine the income statement. Look for trends over time. Calculate and graph the growth of the following entries over the past several years. · Revenues (sales) · Net income (profit, earnings) Are the revenues and profits growing over time? Are they moving in a smooth and consistent fashion, or erratically up and down? Investors value predictability, and prefer more consistent movements to large swings. For each of the key expense components on the income statement, calculate it as a percentage of sales for each year. For example, calculate the percent of cost of goods sold over sales, general and administrative expenses over sales, and research and development over sales. Look for favorable or unfavorable trends. For example, rising G&A expenses as a percent of sales could mean lavish spending. Also, determine whether the spending trends support the company’s strategies. For example, increased emphasis on new products and innovation will probably be reflected by an increased proportion of spending on research and development. Look for non-recurring or non-operating items. These are "unusual" expenses not directly related to ongoing operations. However, some companies have such items on almost an annual basis. How do these reflect on the earnings quality? If you find anything that looks very suspicious, research the information you have about the company to find out why. Step 6. Examine the shareholder's equity statement. Has the company issued new shares, or bought some back? Has the retained earnings account been growing or shrinking? Why? Are there signals about the company's long-term strategy here? If you find anything that looks very suspicious, research the information you have about the company to find out why. Step 7. Examine the cash flow statement, which gives information about the cash inflows and outflows from operations, financing, and investing. While the income statement provides information about both cash and non-cash items, the cash flow statement attempts to reconstruct that information to make it clear how cash is obtained and used by the business, since that is what investors and creditors really care about. If you find anything that looks very suspicious, research the information you have about the company to find out why. Step 8. Calculate financial ratios in each of the following categories, for each year. You may use the formulas found in your textbook, or other materials you have from your finance and accounting courses. A summary of some useful ratios appears at the end of this document. · Liquidity ratios · Leverage (or debt) ratios · Profitability ratios · Efficiency ratios · Value ratios Graph the ratios over time, to find the trends in the ratios from year to year. Are they going up or down? Is that favorable or unfavorable? This should trigger further questions in your mind, and help you to look for the underlying reasons. Step 9. Obtain data for the company’s key competitors, and data about the industry. For competitor companies, you can get the data and calculate the ratios in the same way you did for the company being studied. You can also get company and industry ratios from the Quicken.com Evaluator, Schwab Stock Evaluator, or other locations on my LINKS website. Compare the ratios for the competitors and the industry to the company being studied. Is the company favorable in comparison? Do you have enough information to determine why or why not? If you don’t, you may need to do further research. Step 10. Review the market data you have about the company’s stock price, and the price to earnings (P/E) ratio. Try to research and understand the movements in the stock price and P/E over time. Determine in your own mind whether the stock market is reacting favorably to the company’s results and its strategies for doing business in the future. Review the evaluations of stock market analysts. These may be found at any brokerage site, or from various locations on my LINKS website. Step 11. Review the dividend payout. Graph the payout over several years. Determine whether the company’s dividend policies are supporting their strategies. For example, if the company is attempting to grow, are they retaining and reinvesting their earnings rather than distributing them to investors through dividends? Based on your research into the industry, are you convinced that the company has sufficient opportunities for profitable reinvestment and growth, or should they be distributing more to the owners in the form of dividends? Viewed another way, can you learn anything about their long-term strategies from the way they pay dividends? Step 12. Review all of the data that you have generated. You will probably find that there is a mix of positive and negative results. Answer the following question: “Based on everything I know about this company and its strategies, the industry and the competitors, and the external factors that will influence the company in the future, do I think this company is worth investing in for the long term?” © 2003 Harvey B. Lermack
Adapted from "Financial Statements Analysis," Courtesy of Professor Philip Russel A popular way to analyze the financial statements is by computing ratios. A ratio is a relationship between two numbers, e.g. ratio of A: B = 1.5:1 ==> A is 1.5 times B. A ratio by itself may have no meaning. Hence, a given ratio is compared to: |
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