INSEAD

How to Understand Financial Analysis

01/98-4725

This note was prepared by Lawrence A Weiss, Associate Professor of Accounting and Control at
INSEAD.

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Understanding a companys financial position requires being aware of how the different
components of the company change over time and how they relate and interact with each
other. Absolute figures as reported in the financial statement do not tell the reader very much.
For example, Coca-Cola reported a $3.5bn profit in 1996. This fact must be related to sales of
$18.5bn that produced the profit and capital employed of $6.2bn (the assets minus liabilities
in the balance sheet). It is the relationships between the numbers that helps us understand
how a company is making money, how it conducts business, and the riskiness of future cash
flows.

There are two basic types of numerical conversions used for financial statement analysis. One
is called common values and entails normalising all the numbers to take account of the
impact of the size of the firm and inflation. The second is called ratio analysis and entails
relating two or more components of a financial statement together. This note will discuss how
to dismantle and match financial statements so that you can:

compare the performance of the company across periods

compare the performance of the company with its competitors

compare the performance of the company with what the directors expected

detect areas of weaknesses to which managers can direct their managerial efforts

Some Introductory Points

Without a specific context, financial statement analysis does not tell the analyst anything. To
understand whether a given number or ratio is good or bad depends on the context and
how it is changing. Financial statement analysis is normally best done by looking at trends
over time and across companies. Before beginning, several words of warning about using
ratios. First - garbage in garbage out. If the numbers underlying the ratios do not reflect
economic reality then the results of ratio analysis will not tell us anything meaningful. For
example, when relating Coca-Colas profit to the capital employed we obtain a ratio of 56%
(3.5/6.2). The number used for net profit may be a reasonable proxy for economic reality.
Unfortunately, the number used for net assets is nowhere near reality. The market value of
Coca-Colas net assets was $130.6bn (shares outstanding multiplied by market price per
share) at year end 1996. Using this value instead of the accounting number, the relationship
between profit and capital employed drops from 56% to 2.7% (3.5/130.6).

Second, ratios can also be used to suppress poor absolute figures. For example, assume a
company reports a 100% growth in sales. This gives the impression of success and progress.
However, the basis for such a calculation could be a low sales figure; or competitors may be
achieving the same or higher sales with lower amounts of capital and labour inputs. In this
situation ratios can disguise the real picture.

Third, there is a wide diversity in approaches to financial analysis. Each analyst has his or her
own opinions on which ratios to use and their definitions. Once the definition is chosen it

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must be applied consistently over time and across companies. Otherwise, inter-period and
inter-company comparisons are invalidated. In ratio analysis it is important to study the trend
of the ratios calculated rather than attempt to arrive at sound conclusions on one years
numbers.

Finally, many ratios contain income statement numbers (which are for a period of time,
normally one year) and balance sheet numbers (which are at an instant in time). The use of
an average for total assets matches the balance sheet numbers with the income statement
numbers. The average is normally computed as the sum of the opening and closing balance
divided by two but could be any average (quarterly, monthly and so on). Many analysts
examining firms that are experiencing rapid growth use year-end total assets in the
denominator instead of an average. Additionally, the year-end balance sheet figures may not
reflect the typical financial position of the business throughout the year. In such a situation,
figures representative of the normal balance should be used for ratios. In all cases it is
important to be sure you understand which number is being used and its impact on the ratios.

Common Values

Financial statement analysis normally begins by examining how the individual accounts have
changed over time and, in a multi-company exercise, how they differ across companies. The
analyst begins this exercise by removing the effects of the size of a firm and inflation from the
analysis. This is accomplished by creating common value financial statements.

A common value balance sheet is created by dividing every number on the balance sheet by
total assets. Each line item now appears as a percentage of total assets. An analyst can now
evaluate how particular assets and liabilities are changing over time and across companies.

A common value income statement is created by dividing every number on the income
statement by sales. Each line item then appears as a percentage of sales. Any large percentage
changes should be questioned. For example, assume that telephone expense increased
dramatically and assume this is due to the installation of a toll-free line for customer enquiries
and orders. The analyst or manager can now evaluate whether the increase is justified by a
corresponding increase in sales and profits or competitive pressure (even if profits decline the
firm may have been required to incur this cost to keep pace with competitors). If the change
has no obvious justification, it may represent ineffective management or an item which the
firm should try to reduce in the near future (in this case by cancelling the toll-free phone
number).

Ratios

To help structure the numerous possible interactions, many analysts use four broad categories
of ratios: profitability, activity, leverage and liquidity. Different analysts compute ratios based
on their personal preferences, economic assumptions or bias. A set of common, though not
unique, ratios is presented in Table 1. Given the different approaches, definitions and todays

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computer-assisted calculations, the analyst should always input the raw data himself to ensure
accuracy and consistency.

Profitability can be broken into two key components. First, the ability of a company to sell its
products or services for more than they cost is often referred to as profit margin. This ratio
can be computed both including or excluding the impact of financing. The decision depends
on whether the analyst wants to include the financing decision in the analysis. Second, the
ability of a company to generate a return on invested capital is often referred to as rate of
return. A comparison across companies or over time is complicated since companies have
different financial structures (the percentages of debt and equity). Analysts normally examine
the results both including and excluding the impact of how management has financed the
firms assets.

Return on assets measures the return a firm provides given the amount of assets available
while ignoring the impact of its capital structure. The cost to a firm of interest-bearing debt,
after considering any savings due to taxes, is added in the numerator to remove the impact of
the firms debt structure. Essentially, the numerator is the net income number the firm would
have realised if there were no interest-bearing debt. It is possible to relate profit to any
particular asset. The decision depends on which assets management considers crucial to the
results of the company. Normally the denominator is the total assets available that generate
the firms net income.

Return on equity measures the return the firm provides to a specific group - the owners of the
firm. The impact of the debt structure is included in this computation as the analyst or owner
wishes to know the actual return achieved. If a company does not provide an adequate return
to the owners the share price will fall and the owners may consider replacing management.
From the owners perspective this is clearly one of the most important ratios. To arrive at the
profit attributable to the common shareholder, the numerator is reduced by any dividends paid
or payable (in the case of cumulative shares) to the preferred shareholders. Likewise, the
denominator should include only the amount of retained earnings that could be paid to the
common shareholders (that is, reduced by any dividends in arrears to the preferred
shareholders). Also, as already noted above, when a market number exists for the value of the
common shareholders equity it is often used in place of the accounting book value.

Activity ratios measure how a company is managing its assets. The first two ratios described
below measure the amount of assets required to produce a given amount of sales, the
difference between them being the specific type of assets measured. The last ratio examines
how quickly a company collects its debts.

Inventory turnover is a measure of a companys ability to turn inventory into sales. The higher
the ratio, the less inventory the company maintained per sales. Firms using just in time
manufacturing techniques reduce inventory levels close to zero. This lowers holding costs and
increases profitability and the turnover ratio but also increases the risk of production being
halted because of a stock-out (as Toyota experienced when one of its suppliers had a fire at its
plant). Reducing finished goods inventory may also cost the firm lost sales when there is a
sudden surge in demand. The analyst must assess whether inventory is below acceptable
levels and there is a risk of shortages or lost sales opportunities. Also, if a firm is using the

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last in first out inventory (LIFO) flow assumption (whereby the last item purchased is the
first expensed on the income statement) and the inventory turnover ratio increases
dramatically, the analyst may suspect the firm is manipulating this years accounting profits.
By lowering the physical quantity of inventory, income may be increased as a firm expenses
inventory carried on the balance sheet at an historical cost far below the current market price.
The reader should also note that many analysts prefer to use cost of goods sold in the
numerator, as is done in Table 1, since this reflects the transformation from inventory on the
balance sheet to an expense on the income statement as goods are sold. Some analysts, either
for personal preference or because a figure for cost of goods sold is unavailable, use sales in
the numerator. The difference is not important as long as cost of goods sold is a fairly constant
percentage of sales.

Asset turnover measures the amount of assets required to generate a unit (dollar) of sales. This
ratio can be computed for any type of asset - fixed assets and total assets are the most
common. Normally the ratio is interpreted as managements effectiveness at turning assets
into sales. The higher the ratio the better as this means the firm has fewer assets and a lower
cost to finance those assets for a given sales level. However, before interpreting this ratio the
analyst must first assess the nature of the firms asset base. For example, periodic major asset
purchases, which may be essential for the firms long-term survival, will cause the fixed asset
turnover ratio (the denominator is average fixed assets) to decline. On the other hand, without
purchases to replace older assets, this ratio will increase due to the impact of depreciation on
the fixed asset balance sheet value. The analyst must examine not only the change in this
ratio over time but also the reason and potential impact of any increase or decrease in the
firms investment in the underlying assets.

Days receivable measures the time required for a firm to collect sales made on credit. Faster
collection time, and a lower ratio, will improve profitability by reducing the need for external
financing. On the other hand, an increasing ratio may be necessitated by market conditions or
industry norms. Additionally, an increase in payment terms and the ratio may be justified by a
corresponding increase in sales.

Leverage measures the likelihood a firm will meet its long-term debt obligations. On one
hand, debt is less costly than equity both because it is less risky (debtholders are normally
repaid before equityholders) and because debt payments are deductible from corporate income
taxes while payments to equity holders (dividends or share repurchases) are not. This means a
firm may improve its profitability by increasing its proportion of debt to equity. On the other
hand, as the percentage increases so does the probability of bankruptcy.

Days payable measures the time a firm takes to pay for purchases made on credit. This ratio
will be of particular interest to a firms suppliers. Slower payment time - a higher ratio - will
improve profitability by reducing the need for external financing, assuming there are no
finance charges for slow payment. Depending on industry norms, a very high rate can
indicate financial problems. Also, a lower rate (faster repayment) could indicate a firm is
taking advantage of discounts or using its own cost of capital to help fund suppliers in return
for lower prices.

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The debt/equity ratio is a comparison of the amount of a firms debt versus equity. As the
proportion of a firms financing by debt increases, so does the risk the firm will be unable to
meet its debt payments and the probability of bankruptcy (bankruptcy occurs when debtors
demand repayment, a firm is unable to pay and asks a court to stop the debtors from seizing
the firms assets). Many analysts use different versions of this ratio and the focus is normally
to change the numerator to specific types of debt, such as all interest-bearing debt, long-term
debt or total debt. The denominator is often total equity, which provides a direct comparison
of the amount of debt to equity. Another option would be to use total assets in the
denominator. This is normally just a transformation of the definition and provides the analyst
with the percentage of the firms total assets funded by debt (the only exception would be
consolidated statements with a significant amount of minority interest). There is also a
version of this ratio that places total assets in the numerator and equity in the denominator.
This version is useful for Dupont Analysis, which is discussed below.

Times interest earned measures the coverage, or margin of safety, interest-bearing debtholders
have in relation to profit. If the ratio is less than one it means the firm is not generating
enough profit to repay the interest on its debt. As the ratio increases, the likelihood of a
default on interest bearing debt decreases.

Liquidity measures a firms ability to repay its short-term debt as it comes due. The current
ratio compares total current assets with total current liabilities. Many analysts used to
evaluate firms as risky if their current ratio was less than two. In reality, a low current ratio
will only become a problem when a firm is seen as unlikely to repay debt from the realisation
of current assets, long-term funding and operations.

The quick, or acid, test ratio is
including all current assets in
included. This usually means
sometimes include inventory if
example, aluminium).
a more conservative version of the current ratio. Instead of
the numerator, only those easily converted into cash are
inventory and prepaid expenses are excluded. Analysts
it is in the form of commodities with a ready market (for

Dupont Analysis

Dupont Analysis is a method of bringing several key ratios together, as illustrated in Figure 1.
The name comes from the Dupont chemical company, which was one of the first companies
to use this analysis (and make it public). Essentially, this type of analysis breaks down the
two profitability return ratios into their component parts. It allows an analyst to visualise how
the income statement and balance sheet ratios interact to produce profitability. Specifically,
the return on total assets is broken into the profit margin and total asset turnover ratio or the
ability of the firm to sell products for more than they cost and the amount of sales produced
per unit (dollar) of total assets. The return on equity ratio adds capital structure management
or the leverage ratio to include the ability of the firm to increase the returns to shareholders by
managing the firms financing. It is because of Dupont Analysis that some analysts use total
assets/equity to measure the riskiness of a firm instead of the more intuitive debt/equity or
debt/total assets.

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Other Ratios

Different industries and different analysts may care about particular items. For example, if
research and development is important, an analyst may examine the percentage of sales spent
on R&D. Many firms today report sales per employee. Investors who care about dividend
payments may compare profit with dividend payments - a ratio similar to times interest earned
but reflecting the degree of protection shareholders have or the likelihood of dividend
payments. Firms also normally report earnings both in aggregate and on a per share basis.
The per share calculation is done using a weighted number of shares outstanding during the
year - basically the daily average adjusted for any stock splits and dividends. The earnings
per share number is then divided into the market price for the shares to obtain the
price/earnings or P/E ratio. This ratio informs the analyst as to the markets expectation for a
firms future earnings. For example, firms with P/E ratios above the market average indicate
the market expects their earnings to grow significantly in the future.

Window Dressing

Management can manipulate financial statements by entering into artificial interactions whose
sole purpose is to improve certain ratios. This is called window dressing. An example would
be for a firm to borrow a large sum of money just before year end and repay it immediately
after year end. This would increase both current assets and current liabilities since cash and
short-term debt would increase. If the ratio prior to this borrowing was less than one, then the
impact of this action would be to increase the current ratio (it would approach one as the size
of the borrowing increased). If the ratio prior to the borrowing was more than one, the impact
would be to make the liquidity look worse by reducing the current ratio. If window dressing
is suspected, the analyst should alter the numbers. In this instance, the analyst could simply
net cash against short-term debt and thereby nullify the impact of the loan.

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Table 1
Financial ratios

Profitability:
Profit Margin Ratio
(before interest effects)
Net Income + Interest Expense (net of taxes)
___________________________________
=
Sales

Net Income - Preferred Stock Dividends

Profit Margin Ratio
(after interest effects)
Return on Assets
________________________________
=
Sales
Net Income + Interest Expense
___________________________________ (net of taxes)
=
Average Total Assets during the Period

Net Income - Preferred Stock Dividends

_______________________________________________
Return on Common Equity =
Average Common Shareholders Equity during the Period

Activity:
Cost of Goods Sold
_____________________________
Inventory Turnover =
Average Inventory during thePeriod

Sales
___________________________
Asset Turnover =
Average Assets during the Period

365 * Average Accounts Receivable

___________________________________________ during the Period
Days Receivable =
Net Sales on Account

Leverage:
365 * Average Accounts Payable during
___________________________________________ the Period
Days Payable =
Purchases

Total Liabilities
____________
Debt / Equity Ratio =
Total Assets

Average Total Assets during

___________________________________________ the Period
Leverage Ratio =
Average Common Shareholders Equity during the Period

Net Income before Interest and Income Taxes

____________________________________
Times Interest Earned =
Interest Expense

Liquidity:
Current Assets
______________
Current Ratio =
Current Liabilities

Highly Liquid
________________ Assets
Quick or Acid Test Ratio =
Current Liabilities

Other:
Net Income - Preferred Stock Dividends
_______________________________________________________________
Earnings per Share =
Weighted - Average Number of Common Shares Outstanding during the Period

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Figure 1
Dupont Analysis

Net Income Sales

ROA = x
Sales Total Assets

Net Income Sales TA

ROE = x x
Sales Total Assets Equity

Profit Margin x Total Asset Turnover x Leverage

Income Statement x IS & BS x Balance Sheet

Management of Management of Management of
Conversion Resources Financial Structure

Copyright 1998 INSEAD, Fontainebleau, France.