Financial Analysis – 101 Review

Three important financial accounting concepts you must know: Liquidity, Debt, and Profitability. Even if you are not an accounting major, you need to recognize these three accounting concepts play important role in the company’s future growth and sales.

So let’s review these in brief format.

Analyzing Liquidity  

Liquidity is important during a company’s bankruptcy, or converting assets into cash. Oftentimes, high liquidity refers to the company’s ability to pay back its debt in short period.  

Liquid assets are those that can be converted into cash quickly.  The short-term liquidity ratios show the firm’s ability to meet its short-term obligations. Thus a higher ratio would indicate a greater liquidity and lower risk for short-term lenders. The Rules of Thumb for acceptable values are: Current Ratio (2:1), Quick Ratio (1:1).

While high liquidity means that the company will not default on its short-term obligations, one should keep in mind that by retaining assets as cash, valuable investment opportunities may be lost.  Obviously, cash by itself does not generate any return.  Only if it is invested will we get future return. (Source: Wikipedia)

  1. Current Ratio = Total Current Assets / Total Current  Liabilities
  2. Quick Ratio = (Total Current Assets – Inventories) / Total Current Liabilitie

Analyzing Debt

Debt ratio shows the extent to which a firm is relying on debt to finance its investments and operations, and how well it can manage the debt obligation. (Example: Re-payment of principal and periodic interest)  If the company is unable to pay its debt, it will be forced into bankruptcy. On the positive side, use of debt is beneficial as it provides tax benefits to the firm, allowing it to exploit other business opportunities and grow.

Note that total debt includes short-term debt (bank advances + the current portion of long-term debt) and long-term debt (bonds, leases, notes payable).

Leverage Ratios
 1a.   Debt to Equity Ratio = Total Debt / Total Equity
This shows the firm’s degree of leverage, or its reliance on external debt for financing.

1b.  Debt to Assets Ratio = Total Debt  /  Total assets
Some analysts prefer to use this ratio, which also shows the company’s reliance on external sources for financing its assets.

The lower the ratio for both, the more conservative. If the company is not using debt, it may be foregoing investment and growth opportunities. A frequently cited rule of thumb for manufacturing and other non-financial industries is that companies do not finance more than 50% of their capital through external debt.

Interest Coverage (or Times Interest Earned) Ratio
= Earnings Before Interest and Taxes / Annual Interest Expense

Interest Coverage Ratio shows the firm’s ability to cover fixed interest charges (on both short-term and long-term debt) with current earnings.  The margin of safety that is acceptable varies within and across industries, and also depends on the earnings history of a firm (especially the consistency of earnings from period to period and year to year).

Cash Flow Coverage = Net Cash Flow / Annual Interest Expense
Net cash flow = Net Income +/- non-cash items
(Example: negative equity income + minority interest in earnings of subsidiary + deferred income taxes + depreciation + depletion + amortization expenses)


Analyzing Profitability 

Profitability is difficult since you would have to know what percentage of profits represents a profitable firm, as profits depend on several factors, including the position of the company and its products on the competitive life cycle.

For decision-making, we are concerned only with the present value of expected future profits.  Knowing the historical profit data, we can potentially identify the likely future profits, estimated trends of profits and sales.

We can utilize below equations to better understand whether our company is profitable or not. ROE, ROA, EPS, NPM are all important equations to remember.

  1. Net Profit Margin = Profit after taxes / Sales
  2. Return on Assets (ROA) = Profit after taxes  / Total Assets
  3. Return on Equity (ROE) = Profit after taxes / Shareholders’ Equity (book value)
  4. Earnings per Common share (EPS) = (Profits after taxes – Preferred Dividend)/ (# of common shares outstanding)
  5. Payout Ratio = Cash Dividends / Net  Income

If you are planning to become a CEO or general manager of a company, then your ability to evaluate financial stability of a company will play key role. Financial analysis is part of the criteria for becoming efficient manager – (1)Provides details of debt and profit, (2) Identify opportunity to leverage P&L evaluation incurred from the market changes, and (3) Work with operation manager in building improve infrastructure and high profit-margin with low variable cost business model.

Thank you for reading my blog, and if you have any question, feel free to e-mail me.