Analyze this: An overview of financial statement analysis

Financial statement analysis is an important part of every valuation assignment. By benchmarking a company against its competitors and itself over time, the valuator gauges risk and estimates expected return.

4 financial performance components - A comprehensive financial analysis addresses four components of a company’s financial performance:

1. Profits - To evaluate profitability, valuators may track revenues, gross margins, operating cash flows, net income, or earnings before interest, taxes, depreciation and amortization (EBITDA). Growth — in terms of revenues, earnings and assets — is another important consideration.

All else being equal, companies that demonstrate steady, positive profitability and growth generally are more attractive to investors than those in decline or showing erratic trends. But unprofitable companies are rarely valueless. It’s important to recognize that financial statement analyses review historic performance, which may reflect future expectations. Consider, for example, a promising startup venture that’s currently in the red — but is projected to turn a substantial profit within three years.

2. Liquidity - Liquidity measures assess whether a company has sufficient cash and other current assets to meet its short-term obligations. Companies with excess liquidity are better positioned to weather unexpected events and economic downturns.

Working capital — the difference between current assets and current liabilities — is one way to gauge liquidity. Another popular liquidity metric is the current ratio (current assets divided by current liabilities). High working capital and current ratios equate with high liquidity and low credit risk.

3. Activity ratios - Common activity ratios that measure operating efficiency include:

Total asset turnover (annual sales / average total assets). This ratio estimates how many dollars in sales the company is generating from each dollar in assets. It assesses productivity and reveals underused or non-operating assets.

Accounts receivable turnover (annual credit sales / average accounts receivable). This metric estimates how quickly a company collects its trade receivables. It may reveal lax collection efforts or excessive bad debts.

As an alternative to calculating the number of times receivables turn over each year, some analysts prefer to show the average days outstanding — which typically is calculated by dividing 365 days by the accounts receivable turnover.

Inventory turnover (annual cost of sales / average inventory). With the exception of service businesses, inventory is often a major balance sheet account. Excess inventory can strain cash flow, take up stor-age space and risk pilferage, obsolescence or damage. As with receivables, inventory turnover sometimes is calculated as days-in-inventory (365 divided by inventory turnover).

4. Capital structure - How a company chooses to finance its operations — via debt or equity — can have a significant impact on risk. Valuators typically use debt-to-equity and debt-to-total-assets ratios to evaluate financial risk.

Although debt initially costs less than equity and offers tax advantages, the benefits of leverage are limited. At some point, leverage becomes cost prohibitive. The most efficient businesses strike a balance between debt and equity called the “optimal capital structure.”

When computing financial ratios, valuators apply formulas consistent with benchmarking data sources. For instance, some sources may use year-end receivables (rather than average receivables) to compute turnover. Or they may use 360 days (instead of 365 days) to calculate days outstanding.

No absolutes - In financial analysis, few hard and fast rules apply. An inferior ratio in one industry may be exceptional in another sector. For example, a current ratio of 2.0 is typically the norm in auto or other manufacturing companies. But in some service businesses with minimal inventory, such as hair salons or investment trading companies, the current ratio may be closer to 1.0.

Some metrics may act as both a blessing and a curse. Quick accounts receivable turnover, for example, typically indicates that management is staying current with collections and bad debts are minimal. But it may also mean that the company’s credit policy is unduly strict and hindering sales.

Financial analysis affects value - Financial statement analysis is more than a rhetorical exercise. It has a direct impact on a valuator’s final conclusion.

Consider a company with below-average profits, declining sales and inadequate working capital compared with its competitors. To account for this hypothetical company’s relatively high risk, a valuator might select a pricing multiple from the lower end of the guideline comparables. Or the valuator could increase the company-specific component of the cost of capital when applying the income approach. At the opposite end of the spectrum, a comprehensive financial analysis might reveal additional value. For example, a company with excess liquidity might warrant an add back to the valuator’s preliminary value for excess working capital.

Financial analysis also may facilitate other parts of the valuation process. For instance, preliminary financial statement analysis can help prepare a valuator for site visits and management interviews by highlighting irregularities and potential risk factors.

Something to consider - A company’s value is determined by investors’ expectations about its future performance. Historic financial statements often provide a glimpse of what the future may look like. But the insight provided by financial statement analysis is only as transparent as the financial data on which it’s based.

Sidebar: Back to the future

For comparative purposes, financial statements should be prepared in accordance with Generally Accepted Accounting Principles (GAAP) and industry accounting conventions. Deviations may skew or invalidate a valuator’s analysis. Because many companies prepare and use income-tax-based statements, it’s important to make adjustments as needed to obtain objective and useful financial information.

This peril is especially common among unaudited private firms. In some cases, valuators may adjust financial statements — for example, for unconventional accounting treatment, quasi-business expenses or nonrecurring items — to obtain the clearest possible understanding of future expectations.