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Check the accounts receivable in days ratio to determine whether the collection period is
lengthening/shortening to determine quality
Accounts Receivable from affiliated companies should be discounted.
Is the amount also being shown net of reserve for bad debts? (it is more conservative to present it this way).
Notes Receivable: may also be short-term trade receivables.
Notes Receivable (Contra / Discounted): a note receivable sold at a discount which represents an asset and
liability at the same time. This is usually shown off-balance sheet as a contingent liability or as a reduction to
notes receivable.
Inventory: raw materials, work in progress, finished goods and inventory in transit; finished goods have greater
value in liquidation, raw materials are merely commodities. Supplies used in operations should not be included in
inventory.
Refundable or recoverable income taxes: are considered collectible in the current year.
Long-term Assets
Notes Receivable: it is hard to determine why a company would hold a long-term note as it is in the business of
selling items and receiving cash. This could be a mortgage the company took back on the sale of fixed assets or
an agreed to long-term financing arrangement.
Net fixed assets: buildings, furniture, fixtures, and equipment net of depreciation. Leasehold improvements are
to property not owned by the subject thus there is uncertainty of their liquidation value and they should really be
shown as intangibles. The historical and the depreciated value of tangible assets is not always the real value:
every asset has some value and there is usually a secondary market for it somewhere. There are som third-party,
on-line websites where one can determine the used / pre-owned value (being offered for sale) of an asset (exact
type and age of the asset or a nearly similar asset).
Capitalized leases: represents property leased rather than purchased; if the asset will be leased for most of its
expected life or has a purchase option at the end of its lease, then it may be capitalized and depreciated similar as
to a purchased asset.
Other assets: if "other" is substantial in relation to the balance sheet, then it should be questioned.
Deferred taxes: are sometimes related to pension items. This represents taxes paid to the IRS but have not yet
been recognized as an expense.
Loans to/due from officers: usually have an unspecified amortization.
Income Statement
Income (Sales, Gross Sales, Revenue, Total Revenue)
Primary manufacturing, product, fabrication, extraction sales (turnover)
Services provided and/or goods sold
Interest income: net? From the investment of excess funds or an additional operation conducted by the
corporation? This item is usually presented in Other Income (Expense) below.
As part of project financing?
Commission and Trading Income: One time gain or loss or a definite trend/operation?
Related party transactions: should be subtracted from sales figures.
Total Income (Net Sales)
Less returns and allowances.
Cost of Goods Sold
Direct charge(s) against the primary manufacturing/sales process. Can be determined by adding Beginning
Inventory, Merchandise Purchases, and Freight Costs, and then subtracting Ending Inventory.
Gross Profit
Total Income (Net sales) minus the Cost of Goods Sold
Operating Expenses and Selling, Administrative and General Expenses
Personnel Compensation
Senior Management
Expenses necessary to run the company
Operating Income (Net operating Profit; Operating Cash Flow)
Sometimes also referred to as EBIT - A company's Earnings Before Interest and Taxes. Typically is used in
presentations by companies to demonstrate cash flow available to fund operations (considered a non-GAAP
financial measure under the SEC?s rules).
Cash Flow Value - The value of a firm based on the cash flow available for distributing to any of the providers
of long-term capital to the firm. The free cash flows equal operating cash flow less any incremental investments
made to support a firm's future growth.
Depreciation Expense
If a company does not accurately depreciate an asset, either knowingly or unknowingly, then the net income
result is higher or lower than it should be. If the company knowingly takes less depreciation then it is pumping up
the earnings of the company. If the company applys too much depreciation then it is decreasing earnings. The
analyst needs to look at what the historical depreciation has been and whether there heve been any recent capital
expenditures (increases depreciation) or asset sales (decreases depreciation). If the company knowingly applys
too much depreciation then it may be looking to push up earnings in a later period by applying the accurate (and
lesser) amount of depreciation during that period. The amount of depreciation charged against earnings each
accounting period is the based on the assumption of management. In addition, companies in a growth phase will
have higher capital expenditures (acutal cash spent, which reduces earnings) than depreciation (non-cash item,
which does not affect actual cash flow).
Interest Expense
If you are increasing facilities or the company is increasing borrowings to fund an acquisition or expansion of
operations then this figure will be increasing.
Deferred Income: Money received from customers in advance of performance of revenue activities. This amount will be
spent on goods or services, or will be repaid to the customer.
Taxation
Is the rate consistent with the past several years?
Net Income
What is the trend compared to the previous year(s)?
How much is committed to dividends? Is the payout consistent with previous years?
Vertical Analysis / Financial Statement Analysis
Any item on the Balance Sheet or the Income Statement can always be compared to a sub-total or a toal amount. For
instance, Cash = $43,000, Total Assets = $789,000. Thus, Cash represents 5.45% of Total Assets of the company.
($43,000 / $789,000 = 0.0545 x 100 = 5.45%). In addition, items in Assets, Liabilities and Equity can be compared to
each other, and items on the Income Statement can be compared to the Balance Sheet.
All of the mathematics involved in financial statement analysis is arithmetic. A ratio is just an indication that one number
is being divided by another number.
Operating Cycle
The operating cycle is the duration of time required to convert a product or service order from a customer into an actual
cash receipt.
1. Product order received and the company invests its own cash, time and resources into purchasing raw
materials, services, utilizing existing inventory, plant space and equipment to produce the product or service.
2. Fulfill the terms of the sales contract by either initially shipping or completely shipping the product(s) or
service in full or partial completion / assembly.
3. Receiving partial payment during the process and / or extending credit to the purchaser on specific terms (net
30 days due, 60-days, discount for rapid payment, etc.) and creating an account receivable.
4. Receiving full payment or collecting the account receivable, and creating cash (costs + profit) for the company.
Cash Flow Analysis
A simple cash flow is cash receipts minus cash disbursements. This may approximate what is happening in the Income
Statement or in the cash account on the balance sheet, which results in a net cash position. The result may not always be a
positive number as it will fluctuate with the operations / operating cycle of the company. Cash receipts consist of billed
sales, advance payments from customers, work-in-progress payments, investment income. The ratio of an individual
receipt item to total receipts would indicate which item is the greatest source of cash.
The Statement of Cash Flows indicates a company's major sources of cash receipts and major uses of cash payments for a
given period.
Operating activities entered into for the purpose of earning net income.
Financing activities include obtaining resources from owners and creditors and providing them with a return, or return on,
such a interest, dividends and payment of principal; proceeds from issuance of equity securities (preferred and common),
bonds and other short-term and long-term borrowing. Payments of cash dividends, acquisition of treasury stock and
repayments of amounts borrowed.
Investing activities include acquiring and selling or otherwise disposing of securities which are not cash equivalents, and
productive assets that are expected to generate revenues over the long term.
Free cash flow, which is someties defined as net cash provided by operating activities of continuing operations in the
period minus payments for property and equipment made in the period, is considered a non-GAAP financial measure
under the SEC?s rules but is still an important financial measure for use in evaluating a company?s ability to generate
additional cash from business operations.
Profitability
Under GAAP guidelines, a company's income statment includes non-cash items. The amount of the these items is derived
by management's estimate, and what ever the company's auditors will agree to.
How do companies smooth or manage their earnings:
Plan ahead: time store openings or asset sales to show earnings rising.
Aggressively book sales and/or revenue recognition at the end of a weak quarter, or hold off if the quarter's
goal has already been met.
Capitalize expenses (amortization or lengthening a depreciation schedule) as oppose to expensing it.
Writ-off a restructuring in order to lower one quarter to make it easier to meet future earnings quarters.
Utilize reserves to reduce income by building them up for allowances or potential insurance losses, and then
draw them down to bolster earnings.
(Gross Profit) Sales / Revenue minus Cost of Goods Sold (profit remaining after the cost of goods sold has been deducted
from sales; Cost of Goods sold, or perhaps more accurately cost of sales, are the direct costs incurred to either make or
produce a product or provide a service).
Gross Profit Margin equals Gross Sales or Total Revenue or Net Sales (net of bad debt allowance) minus Cost of Goods
Sold, divided by Net Sales
(Profit Margin) Net Income divided by Sales or Net Sales.
(Operating Profit Margin) equals Operating Profit divided by Sales. This is the core cash flow source that is expected to
grow year to year as the business grows, and it excludes interest expense, taxes, and extraordinary items such as asset
sales. Higher profitability from one year to the next is generally considered a good sign for the company.
Structural costs are expenses that company has little or no control over such as income tax, employee benefits
(particularly health care costs) and compliance.
Gross Profit (Sales or Revenue minus Cost of Goods Sold) / Sales or Revenue
Then, multiply the number by 100 to obtain the percentage.
Example: $1,500,000 (Sales or Revenue) - $1,150,000 (Cost of Goods Sold) = $350,000 / $1,500,000 = 0.233 x 100 =
23.3% Gross Profit Margin. Thus, for every dollar in gross sales, the company earns 23 cents after direct production
costs.
If the margin is declining from period to period then:
Gross sales are decreasing and the cost of goods is stable or increasing.
The cost of production / raw commodities may be increasing while sales are stable or decreasing.
If the margin is increasing from period to period then:
The product or service that is in high demand, or highly regarded, by the customer base, and sales are
increasing while the cost of goods sold is stable, decreasing or increasing at a rate lower than an increase in gross
sales amount.
The cost of production / raw commodities may be decreasing while sales are stable, increasing or decreasing at
a rate lower than the decline in gross sales amount.
A positive ratio, especially one that is high, indicates that the company is either not overpaying for materials and/or has a
product or service that is in demand. The Gross Profit Margin is different for various industries.
The converse ratio would be the Cost of Sales Ratio: Cost of Goods Sold / Sales or Revenue. Using the the numbers in
the above example the ratio would be 76.7%. The ratio isolates direct costs / expense as a percentage of sales. Specific
components of the cost of sales, for instance a sepecific commodity or employee labor, can also be measured as a
percentage of sales.
Profit Margin / Net Profit Margin / Return on Sales
Net Income / Sales or Revenue (Net sales would be less any allowance for bad credit sales)
Then, multiply the number by 100 to obtain the percentage.
Example: $8,000 (Net Income) / $100,000 (Sales or Revenue) = 0.080 x 100 = 8.00%
Measures the profit after taxes on present year sales. The higher the ratio, the better prepared the business is to handle
downward trends.
The ratio is also of value for estimating what the net income may be for the upcoming period. Example: If Sales are
estimated at $130,000, then x 8.0% (0.08) = $10,400. However, the ratio needs to have been relatively stable over a
several year period in order to be used a predictor.
Return on Average Assets (ROAA)
Net Income (annualized) after taxes (including realized gain or loss on investment securities) / Total Average Assets
(assets at the previous fiscal year plus assets at this current fiscal year divided by 2) for a given fiscal year
Then, multiply the number by 100 to obtain the percentage.
Example: Net Income year 2 = $245,000; Year 1 Assets $1,850,00 + Year 2 Assets $2,245,000 = $4,095,000 / 2 =
$2,047,500; $245,000 / $2,047,500 = 0.1197 x 100= 11.9%.
This is a key indicator of a company's profitability. It matches net profits after taxes with the assets used to earn such
profits. A high percentage rate will indicate that the company is well managed, and has invested in an adequate group or
type of assets in order to earn an adequate return. However, by using average assets, the ratio does not indicate whether
the assets that produced the profit were acquired earlier or later in the year. If the assets were acquired later in the year
then the upcoming year may see substantial improvement in profitability.
If the company is a Subchapter S Corp. then the coporation is treated as a pass-through entity and is not subject to Federal
income taxes at the corporate level.
Return on Average Equity (ROAE)
Net Income after taxes (including realized gain or loss on investment securities) / Total Average Equity (equity at the
previous fiscal year plus equity at this current fiscal year divided by 2) for a given fiscal year
Then, multiply the number by 100 to obtain the percentage.
Measures the ability of a company's management to realize an adequate return on the capital invested by the owners in
a company.
This ratio is affected by the level of capitalization of the company.
Measures the ability to augment capital internally (increase net worth) and pay a dividend.
Measures the return on the stockholder's investment (not considered an effective measure of earnings performance
from the company's standpoint).
In the long run, a return of around 15% to 17% is regarded as necessary to provide a proper dividend to shareholders
and maintain necessary capital strength in the event of an earning decline.
Liquidity/Working Capital
Liquidity refers to a company's ability to convert an asset into cash. The faster the conversion the more liquid
the asset. Illiquidity is a risk in that a company might not be able to convert the asset to cash when most needed.
Moreover, having to wait for the sale of an asset can pose an additional risk if the price of the asset decreases
while waiting to liquidate.
Is a measure of how much cash does a company have on hand for immediate use.
A company will have both on balance sheet liquidity and off-balance sheet sources of liquidity. On balance
sheet will be actual issued debt, commercial paper. Off-balance sheet will consist of committed, unused bank
credit facilities to support commercial paper.
What is the mix of debt according to maturity, rate structure (mixed versus floating rate), and currency?
Key Ratios for Examining Liquidity
Current Ratio
Cash Ratio
Computes the number of times ordinary income before interest and taxes covers interest payments.
Net Credit Sales (Sales on Credit) / Average Accounts Receivable (Accounts receivable at the beginning of the period +
accounts receivable at the end of the period / 2)
The ratio measures how often a credit sale / account receivable is created and then collected during the period.
A receivable is essentially an interest-free loan by the company to the customer. Thus, it is an asset that is not earning a
return (in addition, the company already had to pay for the materials, sub-assembly or services in order to produce the
product or service). Thus, the faster the the receivable is turned over, the faster the company has received the cash plus
profit back to cover the cost of producing the product or service.
Please note: the numerator must be Credit Sales or Net Credit Sales (usually net of returns). If the company sells a
product or service for cash then no receivable was created. Thus, the numerator cannot be Gross Sales, Net Sales or Sales.
It is only when a company extends credit for 30, 60 or 90 days that a receivable is created.
Average Day Sales on Credit
Inventory / Average Day of Cost of Goods Sold (Cost of Goods Sold / 365)
Example: $450,000 (Inventory) / $4,795 ($1,750,000 Cost of Goods Sold / 365) = 93.8 days
The ratio measures the duration of time necessary to convert an investment in inventory into sold goods. The end of the
year figure must be representative of the entire year in order for it to be "average".
Total Asset Turnover Ratio
The ratio measures how much of the asset side of the balance sheet, and the money invested in the mix of assets, results
in sales.
Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA; or some other cash flow measure) / Debt
Service Costs (interest, scheduled amortization, fees)
Measures annual cash requirements to meet interest and repayment obligations on debt and provides an indication of the
company's ability to pay.
Liabilities To Equity
Total Long-Term Debt (Total Debt less Short-Term Debt) / Total Equity
Long-term assets are usually financed with long-term debt. this debt includes plant and equipment term loans, and
commercial real estate mortgages. The lower the ratio, the less income / cash flow the company must pay on interest
payment and scheduled principal amortization, and refinancing costs. Conversely, the bank does receive and depreciation
expense tax benefit.
Debt To Tangible Equity Ratio
Sovereign Ceiling suggests that the debt rating of a corporation can not exceed that of the nation of domicile
although the company's own position and ability, or parent support, or external guarantees may suggest
otherwise. Through some intervention by the government, or simply by how it manages economic conditions, the
corporate entity will have no recourse other than to mirror the country's actions.