Jacob Augustine

Finance For Managers

Financial Statement Analysis

Balance Sheet

Our first analysis of Google begins with the Balance Sheet. The balance sheet is

sometimes referred to as a financial snapshot, because it represents the business only at

specific time periods.

First, it is essential to evaluate what the business is worth. This brings up what is

known as the value problem: involving the conflicting issue between the book value and

the market value. The book value of the company is simply the shareholder’s equity,

which is found on the balance sheet. This is because the accounting equation, A=L+OE

refers to the assets minus the claims against the assets to equal the book value of the

company. However, this does not represent Google’s actual value. The market value of

the company more accurately reflects the true worth of the corporation. There are two

reasons for the discrepancy:

1. Financial statements are transaction based. The transaction figures are recorded

when they occurred and entered into the balance sheet. The figures are never

adjusted for the time value of money so there is very little relevance. Also,

depreciation does not accurately reflect the true worth of assets.

2. Investors buy the stock for expectations of future earnings, not for the underlying

value of investors. This is an important distinction, especially in a technology

company like Google’s where investors rely so heavily on intangible assets,

which are very difficult to assign an intrinsic value to.

The market value of Google was found to be $145.4 Billion. (See Appendix A-1).

The market value is calculated by multiplying shares outstanding by the price per share.
Jacob Augustine
Finance For Managers
This is also referred to as market capitalization. Google’s market capitalization compares

to $38.4 Billion for Yahoo, its closest competitor. This shows that Google has established

an enormous market share, due to its strong core competencies, which will be mentioned

later.

To compare the two, market value and book value, we use the Price to Book value

ratio, which is found by dividing the company’s market capitalization by the book value

of the equity. Google’s Price to Book ratio is 8.67 (See Appendix A-2). It is used to

compare the stock’s market value to its book value. As would be expected, the market

value of the stock is much greater than the book value. This is because of the intrinsic

value of the intangible assets, such as intellectual property, which is not reflected in the

financial statements.

Yahoo Google Microsoft

Price to Book 4.192 8.668 7.467
As can be seen by comparing it to the industry standard, the price to book is

higher, indicating that the business is almost entirely based on intangibles.

Another important method to evaluate the market’s representation of value is

known as the price to earnings ratio. This number compares its current market value per

share to the earnings per share. Due to its continually high earnings, Google’s P/E ratio

is 42.5 (See Appendix A-3). Price to earnings is at the industry average for other

companies in the industry, those in the technology sector.

Yahoo Google Microsoft

Price to
Earnings 56.1 42.5 22.0

According to Investopedia, “The P/E is sometimes referred to as the "multiple",

because it shows how much investors are willing to pay per dollar of earnings. If a
Jacob Augustine
Finance For Managers
company were currently trading at a multiple (P/E) of 20, the interpretation is that an

investor is willing to pay $20 for $1 of current earnings”. (Investopedia.com, 2007)

Because a company in the technology sector has such a high level of intangible assets, it

can be very difficult to evaluate. This is why as we mentioned earlier, the book value is

irrelevant. Valuation is based more on expectations of future earnings. Having such a

high P/E multiple means that Google needs to consistently hit the high expectations that

investors set. As a result, it seems that there may exist more downside than upside with a

company in this industry as seen during the tech crash of 2001.

To continue, it is important to see how liquid the business is. Having short-term

liquidity will aid the company to meet its short-term obligations when the business is in

financial distress. We can use the current ratio, or the quick ratio to measure this. The

current ratio includes all current assets divided by all current liabilities. The quick ratio,

or acid test, is the more conservative approach because it excludes inventory due to its

low resale value. However, it turns out that the two ratios are the same because Google

does not carry any inventory. By avoiding use inventory, Google is able to save

substantial carrying costs (i.e. storing in warehouses). The quick ratio turns out to be

10.0 (See Appendix A-4, A-5), which is extremely liquid. Generally a ratio above 2.0 is

considered positive. However, generally the ratio only has meaning when compared to

others in its industry.

Yahoo Google Microsoft

Quick Ratio 2.561 9.995 2.118
Current Ratio 2.561 9.995 2.184
Google’s quick ratio is much higher than its competitors. Thus, it has very little difficulty

meeting short-term obligations compared to its competitors.

Next, we analyzed how much working capital Google has. Working capital is
Jacob Augustine
Finance For Managers
used to measure both a company’s efficiency and its financial health (short term).

Working capital is calculated by subtracting current liabilities from current assets.

Google’s working capital is found to be $11,735,260,000(See Appendix A-6). By itself

the figure is insignificant. The large working capital signifies that Google is not in danger

of having trouble paying off current liabilities. For further meaning to the working capital

figure, we compared it to previous years. This is because working capital provides insight

into how efficient the operations are. If money is tied up in inventory or accounts

receivable, the company lacks liquidity to pay off obligations.

Working

Year Current Assets Current Liabilities Capital

2003 560.2 235.5 324.7
2004 2,693.50 340.4 2,353.10
2005 9,001.10 745.4 8,255.70
2006 13,039.80 1,304.60 11,735.20
The increase in working capital seems like a positive attribute of growth. However, it also

can indicate that a company is not operating efficiently. This suggests further analysis

into the collection of the company’s current assets (accounts receivable). In fact, its

accounts receivable are among the worst in the industry with 35.96 days worth of

outstanding sales. (See Appendix A-7). This verifies the null hypothesis that revenues are

not being collected in an efficient manner.

Digging deeper, we looked at fixed asset turnover. It is an important measure of

capital intensity, with a low turnover implying high intensity. The fixed asset turnover is

found to be 4.43(See Appendix A-8). This number gives the investors an idea of how

effectively management is using the assets. It is a measure of the productivity of a

company’s fixed assets with respect to generating sales. By itself the number is irrelevant

though. It must be compared to its competitors.

Jacob Augustine
Finance For Managers
Yahoo Google Microsoft
Fixed Asset
turnover 6.9 4.43 15.3
The above comparison suggests that Google has higher capital intensity than that of its

competitors. Also, it suggests possible inefficiency of using its assets.

The total asset turnover is found by dividing sales by assets. It is found to be 0.57.

(See Appendix A-9). This figure represents the amount of sales generated for every

dollar’s worth of assets in the business. It measures Google’s efficiency in generating

revenue with its assets. Generally it is inversely related to profit margin. The lower profit

margin it has, the higher its asset turnover will be and vice versa. Sure enough, because

Google has a low asset turnover, its profit margin is high. It is found to be .290 or 29%.

More importantly, it increased from .239 in 2005. This signifies an asset intensive

business. It is consistent with others in its industry (i.e. Yahoo).

Yahoo Google Microsoft

Total Asset Turnover 0.5581 0.5741 0.6363

Another important ratio for analysis is known as Return on Assets. This

profitability ratio shows how much a company is earning on its total assets. Thus, it is an

indicator of asset performance. Google’s ROA figure is calculated to be 0.1666. (See

Appendix A-10). This means that the business earned 17 cents on every dollar tied up in

the business from both creditors and owners. It increased from 14.3 cents last year. Thus,

it appears to be more effectively using its assets.

Return On Assets Yahoo Google Microsoft

2004 9.15% 12.05% 8.66%
2005 17.51% 14.27% 17.30%
2006 6.53% 16.66% 18.10%
Jacob Augustine
Finance For Managers
Another key profitability ratio is return on equity used for measuring the

efficiency with which a business uses owners’ capital. It measures the percentage of

return to owners on their investment (ROI). If investors are not being rewarded for their

investment, they will no longer be motivated to invest. There are three levers for

controlling ROE: profit margin, asset turnover, and the financial leverage. The Return on

Equity was calculated to be 18.047% (See Appendix A-11), an increase of about 2.5%

from the previous year. The discrepancy between ROA and ROE can be explained by

Google’s small use of financial leverage.

Return On Equity Yahoo Google Microsoft

2004 11.8% 13.6% 10.9%
2005 22.1% 15.6% 25.5%
2006 8.2% 18.1% 31.4%

To continue, we analyzed debt more closely. Having debt can greatly restrict a

company’s flexibility. However, Google has no long-term debt. This is because they are

able to use entirely equity based financing. There is little inherent financial risk to the

business because it has a very conservative capital structure. It does not rely on leverage.

While Google is still exhibiting substantial growth, it is beginning to reach

maturity as indicated by its sole use of equity financing. Google essentially has more cash

than it can use-- a cash cow.

Income Statement

After thoroughly analyzing the balance sheet, we progressed to the income

statement. The key formula for the income statement is revenues (sales) – expenses = net
Jacob Augustine
Finance For Managers
income (profit). Businesses that are operating without a profit will not last very long in

the marketplace.

First, we analyzed Google’s profitability. There has been a consistent increase in

net income.

Change
Change from
Net Income (Millions, from last
USD) Yahoo last yr Google Change from last yr Microsoft year
2003 105.6 105.6 7,531.00
2004 839.6 695% 399.1 278% 8,168.00 8%
2005 1,896.20 126% 1,465.40 267% 12,254.00 50%
2006 751.4 -60% 3,077.40 110% 12,599.00 3%

The company is growing exponentially. One factor is its increase in overall sales

volume (revenue) from $6.1 billion to $10.6 billion. Also, it has been able to reduce the

portion of sales devoted to cost of goods sold (variable costs) from 41.89% to 39.67%.

Google is thus exhibiting strong economies of scale and improvement of the business

process, providing value to all of its stakeholders.

By earning a consistently increasing profit year after year, Google is able to

service its debt. However, according to GARP, revenue is recognized when the service is

performed, not when the money is received. Thus, cash flow obviously plays a significant

role, which will be explored in the following section.

Cash Flow

The third financial statement that must be analyzed is the cash flow statement. It

focuses on solvency, having enough cash in the bank to pay off all obligations. By using
Jacob Augustine
Finance For Managers
the “two finger approach”, we identified the principle sources and uses of cash in the

business.

The principle sources are from revenue and financing (mainly issuance of

common stock). The 2006 figure for issuance of stock decreased substantially from 2005

($4,372.26 million) to 2006 ($2,384.67 million). This signifies that Google doesn’t have

as much need for funding as in 2005. There exists more demand to purchase common

stock than Google needs for operating the business.

The principle uses of cash include investing. Google has been making substantial

increases in its investing in the last couple years. This is indicative of its shift to maturity.

Google is essentially buying growth. Google has more cash than it knows what to do

with. Thus, it is important to note that even though Google shows a net change in cash of

$-332.50 million for the period ending 2006, it is not at risk for cash flow turmoil. This is

simply due to its substantial investment increase.