Purpose of Analysis
- Trying to predict future performance and risk of the company (i.e. will they repay
the loan?) from past data.
o Looking for trends
o Hoping that the past is a predictor of the future
- Trying to assess past performance (i.e. management decisions)
- Types of Comparisons:
o Time series
Company’s previous numbers
o Cross sectional
Other companies in the industry
o Economic data
Objective of the Analysis
- Analysis can be done for many reasons
- Different users/analysts are interested in different things – will do different type of
o Care about future cash flows to see if debt will be repaid
o Wants the company to be solvent in the long run
o Want to earn dividends and see share price go up
o Willing to take them more risk if its going to give them a higher rate of
Getting Started on the Analysis by Understanding the Business
- What businesses & segments does the corporation operate in?
- Risks, returns, expectations vary by business.
- What strategy do they follow?
- Common Strategies:
o Low-Cost Producer (selling in low price but low profit margin)
o Product Differentiator (operating at the high end, where people are willing to
pay high prices)
- Affects how you interpret the results of the analysis Overview
- Read Auditors’ Report
- Review MD&A - management’s explanation of company’s results
- Look for unusual accounts or large amounts in the F/S.
o Is it going to recur in the future? Or was it a one time expense?
- Read the notes
o Review accounting policy choices
o Look for more detailed information
Time Series Analysis: Company data across time
- Comparing changes in a company’s accounts over time (5 or 10 years; must be a
long enough period to see a trend)
- Can do it in absolute numbers $
- Or as a percentage %
o Common Size Analysis:
Vertical Analysis Horizontal Analysis (growth)
- Helps in looking for changes or patterns
- Most common analysis tool
- Looks at relationship between 2 items (needs to be a logical relationship between
- Easy to do & compare
- Ratios tell you WHAT happened but not WHY. Your job is to interpret the ratios.
Types of Ratios
- Short-term Liquidity
o Can company meet its short-term obligations?
o How efficiently are they using their assets?
- Solvency (Long-term)
o What is the long-term risk?
o How well are they performing?
Financial Position (Assessing risk)
- Use liquidity ratios to assess risk.
- Liquidity: ease of conversion into cash
o Short Term: periods less than a year
o Ability to generate cash & pay debts
- Solvency (Long Term): relative mix of debt and equity and the ability to meet the
interest and principal payments
o Ability to meet long-term obligations
o Example: Property Financial Position (Risk) Short term Liquidity Ratios
- Look at ability to meet short-term obligations (current liabilities) and assess the
quality of the current assets & liabilities.
- Current Ratio = Current assets
o Higher ratio is better (1 or more) in order to be more sure and conservative;
however, the size of the ration depends on the business and the types of
current assets and liabilities that are considered
o Looks at using current assets to pay current debts.
o Current assets is defined as assets that will be used in the next year
- Quick Ratio = Cash + Accounts Receivable + Short-term investments
o Higher ratio is better
o Represent the most liquid (easily made liquid) assets that can pay of
- Operating Cash Flow to Short-term Debt = Operating cash flow
Current ST debt + Current portion of LT debt
- Provide information about the efficiency of asset use and more information about
- ST Activity Ratios tell you about the Quality of Current Assets & Liabilities
(or Is there too much tied up in them?)
o A/R turnover, Inventory turnover & A/P turnover
- LT Activity ratio (Total Asset turnover) tells you about efficiency of total asset use
Short term Activity Ratios
- Accounts receivable turnover = Sales on credit
o Is company collecting their accounts receivable in a timely manner?
o How long does it take the company to collect cash?
o Converting into days: 365/(sales on credit/average A/R) - Inventory turnover = Cost of Goods Sold
o How quickly is the company selling goods?
o Converting into days: 365/(COGS/average inventory)
- Accounts Payable Turnover = Cost of Goods Sold
o Is the company falling behind in its payments?
o Converting into days: 3