The science of understanding and analysing
business financial statements starts here. And,
we've made it easy.
Just as a physician would not rely on any one test to
diagnose a patient, it is important for the credit
analyst to understand that there is no "one test"
that will achieve the goal of fully understanding the
financial health of a business.
For example, some industries, such as electric and
water utility companies, will often have most of their
money invested in "plant, property and equipment",
with large sums of money financing these projects in
the form of "long term debt".
While a wholesaler or retailer will have fewer dollars
invested in fixtures and more money in inventory -
with a great percentage of the money owed as short
term liabilities owed to vendors in the form of
accounts payable.
Other businesses, such as contractors, architects,
design firms and other professional service
organizations will have few dollars in either fixed
assets or inventory; their primary business is
providing a service. So, there is generally little
needed in the way of an inventory of goods or
elaborate fixtures needed.
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So, please bear in mind these two important points:
(1) Financial analysis of businesses should be
compared to other businesses within their "peer
group".
It would be unfair to compare a railroad, with it's
need for infastructure...to a brokerage firm, that
provides financial services.
(2) Trend analysis is important in trying to see into
the future. As investment firms often warn, "past
performance is no guarantee of future results".
But, as a financial analyst, you will often detect
certain trends when you examine the financial
statements of a business over a period of years.
This is why it is important to review more than just
one year's financial statement. Do the math...and
compare results in each year...and try to determine
a trend.
Balance Sheet Components
The balance sheet is the financial statement that
reports the assets, liabilities and net worth of a
company at a specific point in time. Assets represent
the total resources of a company, which may shrink or
increase depending on the results of operations.
Assets are listed in liquidity order - ease of converting
into cash. Typical assets include: cash, accounts
receivable, inventory, fixed assets and a number of
miscellaneous assets we have classified as "other
assets". Liabilities include what a company owes:
accounts and notes payable, bank loans, deferred
credits and "miscellaneous other". All businesses
divide assets and liabilities into two groups: current
(convertible to cash within a year) and non-current.
Net worth is the owner's investment (in the case of a
proprietorship or partnership) or capital stock (original
investment) plus earned surplus (earnings retained in
the business) in the case of a corporation.
Current Assets
Current Assets (sometimes referred to as trading
assets) include cash, trade receivable and inventory.
These are items that can be converted to cash in less
than one year or in the normal operating cycle of a
business. Also included in this category are any
assets held that can be readily turned into cash with
little effort, such as government and marketable
securities.
Current Assets - Cash
Cash refers to cash on hand on in banks, checking
account balances, and other instruments such as
checks or money orders that have not yet been
deposited. A rule of thumb is that cash positions are
generally strongest after the peak selling season.
When cash balances are continually small, it may be
that a business is experiencing slow receivable
collection or some other financial weakness.
Current Assets - Marketable Securities
Marketable securities are found on many balance
sheets. Marketable securities can include: government
bonds and notes, commercial paper, and/or stock and
bond investments in public corporations. Marketable
securities are usually listed at cost or market price,
whichever is lower. Accountants will frequently list
securities at cost with a footnote indicating market
price on the balance sheet date. (When marketable
securities appear on a statement, it frequently
indicates investment of excess cash.)
Current Assets - Accounts Receivable
Sales between most businesses are made on a credit
basis. Accounts receivable indicate sales made and
billed to customers on credit terms. A retailer, such as
a department store, may show its customer charge
accounts billed and unpaid in this category. In many
businesses, accounts receivable are frequently the
largest item on the balance sheet. You should pay
special attention to this category as the company's
financial health depends upon timely collection of
receivables.
Every business that has accounts receivable will
probably have some portion that it is unable to collect
because customers fail to pay for one reason or
another - mismanagement, disaster or intent. Usually a
business will set aside an estimated allowance for
these uncollectable or doubtful accounts. This
allowance called "bad debt" is deducted from the total
receivables shown on the balance sheet. Frequently a
footnote identifying the amount deducted will be found
in the statements.
Current Assets - Notes Receivable
Notes receivable represent a variety of obligations with
terms coming due within a year. Notes receivable may
be used by a company to secure payments from
past-due accounts, or for merchandise sold on
installment terms. In any case, notes receivable should
be reviewed.
Current Assets - Inventory
You will find that inventory includes different items
depending on whether a business is a manufacturer,
wholesaler or retailer. Retailers and wholesalers will
show goods that are sold "as is" with no further
processing or supplies required before shipping. On
the other hand, many manufacturers will show three
different classes of inventory: raw materials,
work-in-process or progress and finished goods. Raw
materials are considered the most valuable part of
inventory as they could be resold in the event of
liquidation. Work-in-process has the least value
because it would mostly likely require additional labor
before the product is finished and has a value in the
marketplace. Finished goods are ready for resale.
Finished goods values can vary greatly according to
circumstances. If they are popular products in good
condition that can be easily sold, then the value shown
might be justified. If the goods are questionable in
their marketability, the value may be carried too high.
The manufacturer's cost of labor employed in the
production of finished goods and goods in process, as
well as factory expenses is included in the value.
Inventory is normally shown on the balance sheet at
either cost or market value, whichever is lower.
As a company's sales volume increases, larger
inventories are required; however, problems can arise
in financing their purchases unless turnover (number
of time a year goods are bought and sold) is kept in
balance with sales. A sales decline should be
accompanied by a decrease in inventory in order to
maintain a healthy condition. If a business has a
sizable inventory, it may have partially completed or
finished goods that are obsolete, or it could reflect a
change in market conditions.
Current Assets - Other Current
This category includes prepaid insurance, taxes, rent
and interest. Some conservative analysts consider
prepaid items as non-current because they cannot be
converted to cash to pay obligations quickly, and
therefore have no value to creditors. Normally, this
category is not large in relation to other balance sheet
items, but if it is sizable it may require further review.
Non-current Assets
Non-current assets are items a business cannot easily
turn into cash and are not consumed within
business-cycle activity. We have defined current
assets as those that can be converted into cash within
one year. In the case of non-current assets, they are
defined as assets that have a life exceeding a year.
Non-current Assets - Fixed Assets
Fixed assets are materials, goods, services and land
used in the production of a company's goods.
Examples include: real estate, buildings, plant
equipment, tools, machinery, furniture, fixtures, office
or store equipment and transportation equipment. All
of these would be used in producing products for a
company's customers. Land, equipment or buildings
not used in the production of customer goods would
be listed as other non-current assets or investments.
Fixed assets are carried on the company's accounting
books at the price they cost at the time of purchase.
All fixed assets, except land, are regularly depreciated
since they are expected to eventually wear out.
Depreciation is an accounting practice that reduces
the fixed asset's carrying value on an annual basis.
The reductions are considered a cost of doing
business and are called a depreciation charge.
Eventually the fixed asset will be reduced to its
salvage or scrap value. Normally the accounting
procedure is to list the fixed asset cost less
accumulated depreciation, which would be shown on
the statement or in a footnote. Bear in mind, not all
companies can be comparable on this item as some
rent their equipment and premises. If a business rents,
its fixed asset total will be probably be smaller
compared with other balance sheet items.
Non-current Assets - Other Assets
Under the other assets category, several items can be
lumped together. The following items may be itemized
separately on other balance sheets, and if significant,
should be closely examined: investments, intangible,
and miscellaneous assets.
Investments of a business represent assets of a
permanent nature that will yield benefits a year or
more after the date of the financial statement. These
may include: investments in related companies such
as affiliates (partly owned) and subsidiaries (owned
and controlled); stocks and bonds maturing later than
one year; securities placed in special funds; and fixed
assets not used in production. The value of these
items should be shown at cost.
Miscellaneous assets include advances to and
receivables from subsidiaries, and receivables from
officers and employees.
Intangible assets are those that may have great value
to an operating company but have limited value to
creditors. Analysts tend to discount these items or
value them very conservatively. Intangible assets may
be: a company's goodwill, copyrights and trademarks,
development costs, patents, mailing lists and catalogs,
treasury stock, formulas and processes, organization
costs, and research and development costs.
Current Liabilities
Current liabilities are obligations that a business must
pay within a year. Generally they are obligations that
are due by a specific date, usually within 30 to 90 days
of fulfillment. To maintain a good reputation and
successful operations, most businesses find they must
have sufficient funds available to pay these obligations
on time.
Current Liabilities-Accounts Payable
Accounts payable represents merchandise or material
requirements purchased on credit terms and not paid
for by the balance sheet date. When reviewing
balance sheets of small companies, you will frequently
find that liabilities principally fall into the accounts
payable line. Suppliers expect their invoices to be
paid according to the terms of sale specified. These
can range from net 30 to 90 days (after invoice date)
plus discount incentives of 1 percent or more if
payments are made by a specified earlier time.
Companies able to obtain bank loans frequently show
small accounts payable relative to all of their current
liabilities. The loans are often used to cover material
and merchandising obligations. Large payables shown
in conjunction with other outstanding loans, may
indicate special credit terms being extended by
suppliers or poor timing of purchases.
Current Liabilities - Bank Loans
If a business has borrowed from a bank without
collateral, the bank loan would be considered
unsecured (no collateral pledged) which is a favorable
sign. It shows the business has an alternative credit
source available other than suppliers, and the
business meets the strict requirements of a bank. On
the other hand, if collateral has been pledged, then
the loan would be listed as secured (the bank has a
claim on part or all of the borrower's assets). Loan
nonpayment can result in the bank satisfying its claim
by taking possession of the secured asset and selling
it. Some companies have a line of credit (a limit up to
which it can borrow) as a bank customer, which is also
a sign that it is regarded as a good risk. This line is
used by companies frequently during peak selling
seasons. However, if a company has a line, you would
be wise to find out the amount to determine the bank's
evaluation of the company. Bank loans listed under
current liabilities are to be retired within a year. Bank
borrowing needs generally will increase along with the
company's growth.
Current Liabilities - Notes Payable
A company's borrowings from firms and individuals
other than banks may be included in this category.
This may be for convenience or because bank
financing was not available. Also, a company may
have a credit agreement with suppliers for
merchandise or materials covered by notes payable
that would secure their position.
Current Liabilities - Other Current Liabilities
Several items are lumped together in this category.
Since a business acquires debt by either buying on
credit, borrowing money or incurring expenses, this
line serves as a catch all for the expenses incurred
and unpaid at the time the statement was prepared.
These items must be paid within a year. For example,
wages and salaries due employees for time between
the last pay day and the balance sheet date are
included in this category. Various federal, municipal,
and state taxes (sales, property, social security, and
unemployment) appear under the heading accrued
taxes. Federal and state taxes on income or profits
may also be found here. If a balance sheet does not
show a liability for taxes and a profit is claimed, the
company may be understating its current debt.
Long-Term Liabilities
Long-term liabilities are items that mature in excess of
one year from the balance sheet date. Maturity dates
(when payment is due) may run up to 20 or more
years. An example of this would be real estate
mortgages. Normally, items in this area are retired in
annual installments.
Long-Term Liabilities - Other Long-Term
The items most often appearing in this category are
mortgage loans, usually secured by the real estate
itself, bonds, or other long term notes payable. Bonds
are a means of borrowing long-term funds for large
and well established companies. When a company is
big enough and financially sound, it will sometimes be
able to borrow money on a long-term unsecured basis.
When this occurs, the unsecured deferred notes are
called debentures. When reviewing unsecured
long-term note payable, you should determine the
holders of the notes. (This information may be found
in the footnotes to the statement prepared by an
accountant.) In smaller companies the owner or
principals of the business will often hold the notes. In a
corporation, the principals can also become creditors
and collect interest. To do this, they simply loan the
corporation money. They would be able to obtain
repayment along with other unsecured creditors in the
event of liquidation. However, at times, other creditors
will require that in event of bankruptcy, officer or
stockholder loans will be paid back last when assets
are distributed. Money invested by stockholders is
rarely recovered if insolvency occurs. It should be
noted that some analysts categorize officer loans as
current liabilities, primarily when repayment schedules
do not exist.
Long-Term Liabilities - Deferred Credits
A deferred credit may indicate that a business has
received prepayment from customers on work yet to
be completed. Since the completed work is still owed
to the customer, the prepayment continues to be
carried as a liability until the product is completed and
delivered, or the prepayment is returned to the
customer. Some businesses will require an advance or
payment for custom work or as a show of good faith.
Net Worth
Net worth represents the owners' share of the assets
of the business. It is the difference between total
assets and total debts. Remember our balance sheet
formula - total assets minus total liabilities equals net
worth (owner's equity). Basically, this is the investment
the owners have at stake in the business. If liquidation
occurs, assets are sold-off to pay creditors and the
owners/stockholders receive what remains. This is why
equity sometimes is referred to as "risk capital."
In proprietorships (owned by an individual) and
partnerships (owned by two or more individuals) the
net worth figure on the balance sheet represents:
Original investment of owners.
Plus... additional investments they have made.
Plus... accumulated or retained profits.
Less... whatever losses have been sustained.
Less... any withdrawals by partners.
On corporate balance sheets, net worth may be
broken down into the following categories:
Capital stock
Capital stock represents all issued or unissued shares
of common or preferred stock. Preferred stock is a
class of stock with a claim on earnings before payment
may be made to common stockholders. Usually
preferred shareholders are entitled to priority over
common stockholders if a company liquidates.
Common stockholders assume greater risk but
normally have greater reward in dividends and capital
appreciation.
Paid-in or capital surplus represents money or other
assets contributed to the business, but for which no
stock or owner's rights have been issued. (i.e. funds
that exceed the stock's par value.)
Earned surplus
Earned surplus is the amount of earnings retained in
the corporation and not distributed in dividends.
When a corporation shows a net worth that has as its
components capital stock and retained earnings,
capital stock represents shares of equity issued to
owners. Retained earnings are the amount of
corporate profits permitted to remain in the business
by design of the officers. Analysts view a sizable
amount of retained earnings as significant. It shows a
business is profitable and successful if it recognizes
the need for net worth growth as the company
progresses.
While the balance sheet gives a very detailed
description of a business, it does not indicate whether
a company is making a profit or losing money. That
information comes from reviewing the income
statement. The net worth reduction can happen in one
of four ways:
1. A loss was sustained
2. Dividends were paid in excess of profits
3. Capital stock was redeemed
4. Assets were written down.
Net worth goes up when:
1. Earnings are retained
2. Capital is added
3. Assets are written up
4. Liabilities are written down
The Income Statement
The income statement (also called the profit & loss
statement) shows how much money a business makes
or loses over a specific time period - a month, 3
months, 6 months or a year. Income statements are
often prepared 4 times a year but never cover a
period longer than a year. When income statements
are prepared, management or its accountants extract
sales and other income totals along with totals of
various expenses from internal accounting records.
Once expenses are computed, they are subtracted
from income and either a profit or loss is shown. The
results on the income statement affect the balance
sheet from period to period, so it is important to review
both statements to determine the full impact each has
on the other.
Income Statement - Net Sales
The net sales figure is derived by adding up the total
invoices billed to customers during the period covered,
less any discounts taken by customers. Then, any
sales returns accepted from customers during the
period are deducted. Deductions can be important in
some industries. (For example, in retailing they can
run over 10 percent.) After deductions are made, the
remaining figure in net sales which is important for
comparative analysis and percentage calculation.
Income Statement - Gross Profit
Gross profit is found by subtracting the cost of goods
sold from net sales. Cost of goods sold is comprised of
those expenses it took to manufacture, purchase
merchandise and service customers. The cost of
goods sold takes into account material costs along
with labor and factory expenses involved in producing
the merchandise sold.
Gross profit measures the profitability of a company's
total production. A successful company's gross profit
will cover its costs of doing business with enough left
over to produce a net profit.
Income Statement - Net Profit After Tax
Before coming up with the net profit after tax (often
called net income after tax), you should be aware that
all expenses directly applicable to the company's
operations, including income taxes, have been
deducted from gross profit. Net profit after tax truly
measures the operating success of the company.
When total expenses exceeds net sales, a minus
figure results and a loss has occurred. If there is a
surplus, it is considered net profit and can be added to
retained earnings or distributed to owners and
stockholders as withdrawals or dividends. When
expenses exceed net sales (when a loss occurs), it is
charged against net worth and a reduction in the
owners' equity occurs and is shown on the balance
sheet.
Income Statement - Dividends/Withdrawals
This item can be very important, depending on the
type of business you are reviewing - corporation,
partnership or proprietorship. In the case of a
partnership or proprietorship, this figure would
represent withdrawals by the owners of the business.
When withdrawals or dividends exceed profits they
diminish net worth. This situation may have an
adverse effect on the financial stability of the business.
Working Capital
Working capital represents the funds available to
finance current business operations. Many companies
show this computation prominently in their statement,
but in some instances you may want to compute it on
your own. This figure is important, as it is used to
determine how much excess cash a business has to
fund current expenses. Working capital is the
difference between current assets and current
liabilities. Since a company's sources to pay its current
debt come partly from current assets, a business with
a comfortable margin should be able to pay its bills
and operate successfully. How much working captial is
enough depends on the proportion of current assets
to current liabilities rather than on the dollar amount of
working capital. We'll take up this ratio shortly;
however keep in mind that it is good to have two
dollars or more of current assets to one dollar of
current liabilities than to have less, for most
businesses.
Analyzing The Financial Statement
Previously, we indicated that financial statements are
prepared so management can make informed,
intelligent decisions affecting the success or failure of
its operations. In the business world, outsiders -
creditors, bankers, lenders, investors and
shareholders - have varying objectives in mind when
they look at a company's statements. The type of
analysis and the amount of time spent on it depends
upon the objectives of the analyst. An investor
interested in a publicly owned company might spend
less effort than a banker considering a loan
application. A supplier considering an order from a
small business might spend less time and effort than
the banker. The degree of information available on a
business varies according to the requirements of the
business under review. For example, a banker
considering a sizable loan application would normally
require not only a detailed statement of condition and
income for several years, but inventory breakdowns
and aging schedules of receivables, accounts
payable, sales plans and profitability projections.
When a banker, credit manager or investor receives
the financial information desired, an analysis is started
and the leading tool most analysts use is ratio analysis.
Ratios are a means of highlighting relationships
between financial statement items. There are literally
dozens of ratios which can be complied on any
business. Generally, ratios are used in two ways: for
internal analysis of items in a balance sheet; and/or
for comparative analysis of a company's ratios at
different time periods and in comparison to other firms
in the same industry.
Below find fourteen key business ratios. The ratios are
divided into three groups:
Solvency Ratios - used to measure the financial
soundness of a business and how well the company
can satisfy its obligations.
Efficiency Ratios - used to measure the quality of the
firm's receivables and how efficiently it utilizes its other
assets.
Profitability Ratios - used to measure how well a
company performs.
Solvency Ratios - Quick Ratio
The quick ratio, sometimes called the "acid test" or
"liquid" ratio measures the extent to which a business
can cover its current liabilities with those current
assets readily convertible to cash. Only cash and
accounts receivable would be included, as inventory
and other current assets would require time and effort
to convert into cash. A minimum ratio of 1.0 to 1.0 ($1
of cash receivables to $1 current liabilities) is
desirable.
Solvency Ratios - Current Ratio
The current ratio expresses the working capital
relationship of current assets to cover current
liabilities. A rule of thumb is that at least 2 to 1 is
considered a sign of sound financial strength.
However, much depends on the standards of the
specific industry you are reviewing.
Solvency Ratios - Current Liabilities to Net Worth
Current liabilities to net worth ratio indicates the
amount due creditor within a year as percentage of
the owners or stockholders investment. The smaller
the net worth and the larger the liabilities, the less
security for creditors. Normally a business starts to
have trouble when this relationship exceeds 80
percent.
Solvency Ratios - Current Liabilities to Inventory
Current liabilities to inventory ratio shows you, as a
percentage, the reliance on available inventory for
payment of debt (how much a company relies on funds
from disposal of unsold inventories to meet its current
debt).
Solvency Ratios - Total Liabilities to Net Worth
Total liabilities to net worth shows how all of the
company's debt relates to the equity of the owners or
stockholders. The higher this ratio, the less protection
there is for the creditors of the business.
Solvency Ratios- Fixed Assets to Net Worth
Fixed assets to net worth ratio shows the percentage
of assets centered in fixed assets compared to total
equity. Generally the higher this percentage is over 75
percent, the more vulnerable a concern becomes to
unexpected hazards and business climate changes.
Capital is frozen in the form of machinery and the
margin for operating funds becomes too narrow for
day to day operations.
Efficiency Ratios - Collection Period
Collection period ratio is helpful in analyzing the
collectability of accounts receivable, or how fast a
business can increase its cash supply. Although
businesses establish credit terms, they are not always
observed by their customers for one reason or
another. In analyzing a business, you must know the
credit terms it offers before determining the quality of
its receivables. While each industry has its own
average collection period (number of days it takes to
collect payments from customers), there are observers
who feel that more than 10 to 15 days over terms
should be of concern.
Efficiency Ratios - Sales to Inventory
Sales to inventory ratio provides a yardstick for
comparing stock-to-sales ratios of a business with
others in the same industry. When this ratio is high, it
may indicate a situation where sales are being lost
because a concern is understocked and/ or customers
are buying else where. If the ratio is too low, this may
show that inventories are obsolete or stagnant.
Efficiency Ratios - Assets to Sales
Assets to sales ratio measures the percentage of
investment in assets that is required to generate the
current annual sales level. If the percentage is
abnormally high, it indicates that a business is not
being aggressive enough in its sales efforts, or that its
assets are not being fully utilized. A low ratio may
indicate a business is selling more than can be safely
covered by its assets.
Efficiency Ratios - Sales to Net Working Capital
Sales to net working capital ratio measures the
number of times working capital turns over annually in
relation to net sales. A high turn over can indicate
over trading (an excessive sales volume in relation to
the investment in the business). This ratio should be
reviewed in conjunction with the assets to sales ratio.
A high turnover rate might also indicate that the
business relies extensively upon credit granted by
suppliers or the bank as a substitute for an adequate
margin of operating funds.
Efficiency Ratios - Accounts Payable to Sales
Accounts payable to sales ratio measure how the
company pay its suppliers in relation to the sales
volume being transacted. A low percentage would
indicate a healthy ratio.
Profitability Ratios - Return on Sales (Profit
Margin)
Return on sales (profit margin) ratio measures the
profits after taxes on the year's sales. The higher this
ratio, the better the prepared the business is to handle
downtrends brought on by adverse conditions.
Profit Ratios - Return on Assets
Return on assets ratio is the key indicator of the
profitability of a company. It matches net profits after
taxes with the assets used to earn such profits. A high
percentage rate will tell you the company is well run
and has a healthy return on assets.
Profitability Ratios - Return on Net Worth (Return
on Equity)
Return on net worth ratio measures the ability of a
company's management to realize an adequate return
on the capital invested by the stockholders/owners of
the company.
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