Techniques of Financial Statement Analysis

Is your business as profitable as it should be? Do you have enough liquidity to pay the bills on time? Is the financial structure healthy, or does the company have too much debt? All of these questions can be answered using various techniques of financial statement analysis.

Accountants typically prepare four types of financial statements for a business:

• the income statement
• a balance sheet
• a statement of cash flows
• a statement of changes in shareholders' equity
  

A number of different ratios and financial analysis tools and techniques can be taken from the financial statements and can give business owners, analysts and creditors a view of the performance and strength of a company.

These accounting analysis tools cover:

• profits
• liquidity
• activity
• leverage 
• valuation
  

Profits are measured at several points on the income statement.

Starting at the top of the income statement, the first measure is the gross profit, which is defined as total sales less cost of goods sold, or COGS. COGS includes the costs of direct labor, materials and manufacturing overhead used in the fabrication of a product or in providing a service.

Gross profit must be high enough to cover general and administrative overhead, interest charges and taxes and leave an adequate amount of net profit.

The next profit measure is operating profit, also known as earnings before interest costs and taxes, or EBIT. Operating profits focus on how well a company is producing and selling its products and paying overhead expenses. Since this profit indicator is taken before deductions for interest and taxes, it excludes the effects of how the company's operations are financed and the results of any tax planning or avoidance.

Finally, net profit is the amount left after deductions of all operation expenses, overhead, interest and taxes. Net profits are then used to calculate the company's return on shareholder equity, a crucial measure of financial performance.

Each one of these profit indicators can be expressed as a percentage of sales and used for trend analysis and comparisons to previous years.

For example, operating profit margin is EBIT/sales x 100, and similarly, net profit margin is net profit/sales x 100.

The most common measures of liquidity are the current and quick ratios. The current ratio is calculated by dividing total current assets by total current liabilities. Having $2 in current assets for each $1 in current liabilities, a 2:1 ratio, is generally considered a comfortable level of liquidity.

The quick ratio is a harsher measure of liquidity. It is calculated by adding cash balances to accounts receivable and dividing by total current liabilities. Inventories are excluded from this ratio. A good quick ratio should be in excess of 1:1.

Activity ratios measure how efficiently the company is using its current assets.

Average collection period: This ratio indicates how quickly the business is collecting its accounts receivable and compares it to the terms of sales to the customers. The formula is: sales made on credit/accounts receivable balance.

For example, if a company makes annual sales on credit of $720,000 and has a current accounts receivable balance of $90,000, accounts receivable are turning over eight times per year, or every 45 days. If the company's terms of sales are net 30 days, then some portion of the accounts receivable balance is past due and needs attention.

Cash conversion cycle: Businesses want to turn their cash as quickly as possible. The cash conversion measures the time it takes to buy raw materials, make a product, sell to customers and, finally, collect the cash from payments.

Businesses invest a lot of money in inventory, so turnover is important.

Inventory turnover: The formula for calculating inventory turnover is cost of goods sold divided by average inventory balance. For instance, if COGS is $980,000 and the average inventory balance is $163,000, inventory is turning over six times a year, or every 60 days.

The amount of debt that a company owes relative to its total equity capitalization is a measure of financial strength. A moderate amount of debt is good, but too much can be risky if sales decline in an economic downturn.

Acceptable debt-to-equity ratios vary by industry. Manufacturers generally have $1 in total debt for each $1 in equity, a 1:1 ratio. Financial institutions, on the other hand, might have debt/equity ratios up to 15:1. Utilities typically have ratios around 6:1.

Another way to measure the risk of debt is by the ratio of earnings before interest and taxes divided by total interest charges. Let's say a company had an EBIT of $120,000 and interest expenses of $30,000. The interest coverage ratio would be 4:1, or $120,000 divided by $30,000.

Vertical analysis involves calculating line items on the income statement as percentages of total sales and the accounts on the balance sheet as percentages of total assets. These figures are used for horizontal year-to-year comparisons.

Horizontal analysis compares the ratios from several years of financial statement side by side to detect trends. These include comparisons for profit margins, liquidity, turnovers and financial leverage. As an example, suppose the average accounts receivable days outstanding three years ago was 38 days. Then, the next year it rose to 41 days, and last year, days outstanding showed 52 days. Unless the company had changed its terms of sales to its customers, this would be a disturbing trend that requires management attention.

Businesses always have some type of competition, and managers need to know how well they are doing compared to their competitors. Comparing industry average ratios with the company's will provide an indication of the company's strength and weaknesses.

Let's say the gross profit margin for an industry is 42 percent, and the company's gross margin is 36 percent. This difference should be cause for alarm. Why is the company's profit margin lower? Is it because of a different product mix, or is it because the company's cost to fabricate its products is higher and less efficient than its competitors? Any of these reasons means that management needs to investigate and find the problem.

Profits are important, but they can be manipulated by using different accounting methods. As an example, depreciation methods can be accelerated or, conversely, spread out over more years. Either way will change the amount of reported profit.

Flow of funds analysis, on the other hand, tells more of the truth: where the money came from and, more specifically, where it went. Suppliers, expenses and employees are paid with cash, not profits.

Studying the flow of funds statement will reveal if the company is actually producing a positive cash flow from operations or is relying on borrowed money and supplier credit to fund its operations. This type of information is not available from an income statement.

The first hurdle for a business owner is to sell enough products or services to at least cover all the company's fixed costs. This is the break-even sales volume.

An objective for managers is to find ways to lower the break-even point. This could be done by reducing fixed costs, improving productivity, lowering the cost of goods sold or selling more of the products that have higher profit margins.