Introduction to Financial Analysis

For any individual or company seeking investors a financial statement is an important resource. It is a clear description of a companies financial health.

What is financial analysis?  A financial statement analysis is what you do as an individual or a company in order to review the companies finances through its financial statements in order to make better and well advised economic decisions.

Which Reports are Mainly Used in Financial Analysis?

The three most important financial statements your company should have are the cash flow statement, the income statement and the balance sheet. They serve the following purposes:

Cash Flow Statement

The Cash flow statement has three major segments.

1. Operating Activities – activities that your company is doing to generate income and the other activities that your company is not investing or financing. All in all the cash flows from current assets and current liabilities.
2. Investing Activities – these are the activities that result in cash from the sale or acquisition of long term assets and any other of your companies investment.
3. Financing Activities – activities that bring out cash as a result in changes in the size and composition of the contributed equity capital or bonds stock and dividends.

Income Statement

Income statement is also known as a profit and loss statement. This financial statement shows a report of your companies revenues and expenses during a designated period of time. (Revenue – Expense = Net Income). The statement shows how your companies revenues are converted into the net income or the net profit.

Balance Sheet

Balance sheet is in balance when the value of the assets equals the combined value of the liabilities and shareholder’s equity. This financial statement displays the companies total assets. It also indicates how your assets are financed. It could be either through debt or equity.  It is a basic balance of income and expenditure over a period a time.

Balance sheet underlying equation is (Assets = Liabilities + Shareholder’s Equity).

Fundamental Analysis vs Technical Analysis

Fundamental analysis and technical analysis are two ends of the same market analyzing spectrum. Fundamental analysis evaluates your companies securities by measuring them to the elemental value of a stock by measuring and analyzing earnings, expenses, assets and liabilities; while technical analysis evaluates by analyzing the stock price and the volume.  Technical analysis operates on the assumption that all the known factors are already factored in the price. The differences are very technical and we will delve into them in another post.

What are Financial Ratios and Which are Commonly Used

A financial ratio or an accounting ratio is as a result of relating to at least two numerical values taken from financial statements. One may use the ratios to evaluate the overall financial condition as an individual or as an enterprise.  Ratios are used to compare relative strengths and weaknesses of the companies. Financial ratios vary across various industries and comparing the different companies brings inaccurate and invalid results.

These are some commonly used financial ratios:

1. Receivables turnover – This ratio is calculated by dividing your organizations net revenue by its average receivables. The ratio is a measure of how quickly and effectively a company collects on its outstanding bills.
2. Payable turnovers – The ratio is calculated by dividing credit purchases by average payables. Payable turnovers measure how quickly your company pays off the money it owes to its suppliers.
3. Current Ratios – This ratio is used to measure your company’s current assets against its current liabilities. The current ratio indicates if the company can pay off its short term liabilities in an emergency by liquidating its current assets. A low ratio may indicate that a company is having difficulty paying their current liabilities short run.
4. Solvency Ratios – Solvency ratios are used to measure your company’s ability to meet its longer term obligations. Solvency ratios allow your investors to realize how much debt a company is in and how possible it would be to cover the debts by utilizing its existing assets.
5. Debt to asset Ratio – Debt to asset ratio measures the percentage of your company’s total assets financed by debt. The ratio is calculated by dividing your company’s total liabilities by your total assets. A higher ratio means increased financial risk for the company as it is using a larger amount of its financial leverage.
6. Profitability Ratios – It refers to a group of ratios which are commonly used in analyzing your company’s invest ability. They are also referred to as ‘margin’ ratios.

These include:

Gross profit margin is calculated by dividing gross income (Revenue-Cost of Goods Sold) and the net revenue. The ratio indicates your company’s pricing decisions and product costs. If a company has a high gross profit margin it would mean it has a competitive advantage in the market. Be it through its quality, perception or branding. It is good to note that just because your company has high gross profit margins that may not mean it is long term as competition is part of any market.

Operating profit margin is calculated by dividing operating income (gross income – operating expenses) by net revenue. It determines the relationship between sales and management controlled costs. Increasing your company’s operating margin is good. It is important to note that you want your company to have increasing and consistent operating profit margin; that is what investors will be looking for.

Net profit margin compares a companies net income to its net revenue. It is calculated by dividing net income and net revenue. Investors will be looking at your companies ability to translate sales into profit for the shareholders, so they will be looking for increasing and consistent net profit margins.  For example, a 10.4 % margin indicates that for every dollar that your company makes your investors will enjoy 0.104$ of that.

Return on Assets and Return on Equity – these are profitability ratios that are commonly used as well. ROA (return on assets) is calculated as net income divided by total assets. It measures how efficiently a firm utilizes its assets. A high ratio will indicate that your company has the ability to generate earnings using its assets. ROE (return on equity)measures the level of income attributed to shareholders’ investment in the company.