FINANCIAL ANALYSIS

1.   What is Financial Analysis?

      Financial analysis is performed to determine the financial position and performance of a business.

      Financial analysis shows the financial health of a business.

      Financial analysis uses financial statements prepared through the accounting process. 

  2.   Types of Financial Analysis

 

      2.1.      According to the analyst

 

               a.      Internal Analysis:  This analysis is performed by someone inside the business. The analyst is a member of the business.

 

               b.      External Analysis: This analysis is performed by someone outside the business. Creditors (such as banks), investors, suppliers, government, etc. perform external analysis for specific purposes.

 

      2.2.      According to the periods used

 

               a.      Static Analysis: Uses only one period’s data.

               b.      Dynamic Analysis: Uses more than one period’s data.

     

      2.3.      According to the purpose

 

               a.      Management Analysis: The purpose is to determine the financial health of the business and take necessary actions if required.

               b.      Credit Analysis: The purpose is to determine whether to extent a credit or a loan.

               c.      Investment Analysis: The purpose is to determine whether to buy the stock of the business, merge with the business, acquire the business, etc.

     

3.   Horizontal Analysis

 

      Horizontal analysis calculates the percentage change in consecutive two years’ financial data.

 

      Percentage change = [(This year’s value – Previous year’s value) / Previous year’s value] * 100

 

      Results are interpreted as follows:

 

      a.      Percentage chance in net sales revenue

     

            If the percentage change in net sales revenue is significantly less than the inflation rate, sector average, and expectations, then red light.         

         If the percentage change in net sales revenue isn’t significantly less than the inflation rate, sector average, and expectations or greater than the inflation rate, sector average, and expectations, then OK.

 

      b.   Net sales revenue versus cost of sales (cost of goods sold or cost of service sold or cost of merchandise sold)

 

            If the percentage change in cost of sales is significantly greater than the percentage change in net sales revenue, then red light.

 

            If the percentage change in cost of sales isn’t significantly greater than the percentage change in net sales revenue or less than the percentage change in net sales revenue then OK.

 

      c.         Net sales revenue versus trade receivables (net)

 

            If the percentage change in trade receivables is significantly greater than the percentage change in net sales revenue, then red light. Because it means that the maturity is longer or the business cannot collect the receivables on time.

 

            If the percentage change in trade receivables isn’t significantly greater than the percentage change in net sales revenue or less than the percentage change in net sales revenue, then OK.

 

      d.   Net sales revenue versus inventories

 

            If the percentage change in inventories is significantly greater than the percentage change in net sales revenue, then red light. Because it means that the business is building up inventory. In other words, business cannot sell the inventories.

 

            If the percentage change in inventories isn’t significantly greater than the percentage change in net sales revenue or less than the percentage change in net sales revenue, then OK.

 

      e.         Net sales revenue versus selling, marketing and delivery expenses

 

            If the percentage change in selling, marketing and delivery expenses is significantly greater than the percentage change in net sales revenue, then red light. But here you have to be careful. If the increase in selling marketing and delivery expenses stems from an advertising campaign, it is OK. If the increase stems from inefficient expense management, then it is red light.

 

            If the percentage change in selling, marketing and delivery expenses isn’t significantly greater than the percentage change in net sales revenue or less than the percentage change in net sales revenue, then OK.

 

      f.    Net sales revenue versus general administrative expenses

 

            If the percentage change in general administrative expenses is significantly greater than the percentage change in net sales revenue, then red light. This situation indicates inefficient expense management.

 

            If the percentage change in general administrative expenses isn’t significantly greater than the percentage change in net sales revenue or less than the percentage change in net sales revenue, then OK.

 

      g.   Trade receivables (net) versus trade payables        

 

            If the percentage change in trade receivables is significantly greater than the percentage change in trade payables, then red light. This means that the business is collecting the receivables later than it makes the payments. In other words the business makes the payments before it collects the receivables, which is an undesired situation.

 

            If the percentage change in trade receivables isn’t significantly greater than the percentage change in trade payables or less than the percentage change in trade payables, then OK. This means that the business makes the payments after it collects the receivables, which is a desired situation.

 

      h.      Current assets versus bank loans (ST)

 

            If the percentage change in current assets is less than the percentage change in bank loans (ST), then red light. This means that a portion of non-current (fixed) assets is also financed by bank loans (ST).

 

            If the percentage change in current assets isn’t significantly less than the percentage change in bank loans (ST) or greater than the percentage change in bank loans (ST), then OK.

 

Note: A 10 % or higher difference (greater or less) is accepted as significant.

 

4.   Trend Percentages

 

      Trend percentages analysis uses more than two consecutive years’ financial data. A year is chosen as the base year and percentages are calculated according to the base year. Trend percentages analysis gives a trend.

 

      Trend percentage = (Any year’s amount / base year’s amount) * 100

 

      For example, the analyst obtains a net sales revenue trend. This trend must be compared with inflation and sector average trends. If the net sales revenue trend is greater than the inflation or sector average trends, then it is favorable. Otherwise, it is unfavorable.

 

      Likewise a trend for trade receivables (net) can be obtained. If the net sales revenue trend is greater than the trade receivables trend, then it is favorable. Otherwise, it is unfavorable.

 

      All comparisons in horizontal analysis (for example net sales revenue versus inventories, net sales revenue versus general administrative expenses, trade receivables versus trade payables, etc.) can be done in trend percentages.  In horizontal analysis percentage change is compared, in trend percentages trend is compared.

 

5.   Vertical Analysis

 

      Vertical analysis prepares common size balance sheet and income statement. In common size balance sheet and income statement there are percentages instead of monetary values. Percentages are calculated according to the bases. Base in the balance sheet is total assets, base in the income statement is net sales revenue.

 

      Percentage (%) = (Value of an item / Value of the base) * 100

 

      Percentages are compared with the sector averages.

 

      If cash and cash equivalents percentage is less than the sector average, then red light. Otherwise it is OK.

      If trade receivables (net) percentage is greater than the sector average, then red light. Otherwise it is OK.

      If inventories percentage is greater than the sector average, then red light. Otherwise it is OK.

      If tangible assets (net) percentage is greater than or less than the sector average (isn’t equal to the sector average) , then red light. Otherwise it is OK.

      If total liabilities percentage is greater than the sector average, then red light. Otherwise it is OK.

      If shareholders’ equity percentage is less than the sector average, then red light. Otherwise it is OK.

      If the sale return percentage is greater than the sector average, then red light. Otherwise it is OK.

      If the cost of sales (cost of goods sold, cost of service sold, cost of merchandise sold) percentage is greater than the sector average, then red light. Otherwise it is OK.

      If gross margin percentage is less than the sector average, then red light. Otherwise it is OK.

      If selling, marketing and delivery expenses percentage is greater than the sector average, then red light. Otherwise it is OK.

      If general administrative expenses percentage is greater than the sector average, then red light. Otherwise it is OK.

      If operating income percentage is less than the sector average, then red light. Otherwise it is OK.

      If finance expenses percentage is greater than the sector average, then red light. Otherwise it is OK.

      If net income percentage is less than the sector average, then red light. Otherwise it is OK.

 

5.   Ratio Analysis

 

      Ratios are calculated by using balance sheet and income statement items. There are four groups of ratios. Groups and ratios in each group are discussed below:

 

      a.      Liquidity Ratios

 

            Liquidity ratios measure the ability of a business to pay its maturing liabilities. Liquidity ratios are as follows:

 

            Current ratio = Total current assets  / Total short-term liabilities

 

            If the current ratio is less than 1,5, it is red light. If the current ratio is equal to or greater than 1,5, it is OK.

 

            Acid test ratio = (Total current assets – inventories) / Total short-term liabilities

 

            If the acid test ratio is less than 1, it is red light. If the acid test ratio is equal to or greater than 1, it is OK.

 

            Cash ratio = Cash and cash equivalents / Total short-term liabilities

 

            If the cash ratio is less than 0,25, it is red light. If the cash ratio is equal to or greater than 0,25, it is OK.

 

      b.      Efficiency Ratios

 

            Efficiency ratios measure how efficient a business uses and manages its assets. Efficiency ratios are as follows:

 

            Inventory turnover = Cost of sales (cost of goods sold or cost of merchandise sold) / Inventories

 

            If inventory turnover is less than the sector average, it is red light. If inventory turnover is equal to or greater than the sector average, it is OK.

 

            Days in inventory = 365 / Inventory turnover

            If days in inventory is greater than the sector average, it is red light. If days in inventory is equal to or less than the sector average, it is OK.

 

            Red light in inventory turnover and days in inventory indicate that the business cannot manage its inventories efficiently and inventory policy of the business should be examined.

 

            Receivables turnover = Net sales revenue / Trade receivables (net)

 

            If receivables turnover is less than the sector average, it is red light. If receivables turnover is equal to or greater than the sector average, it is OK.

 

            Average collection period = 365 / Receivables turnover

 

            If average collection period is greater than the sector average, it is red light. If average collection period is equal to or less than the sector average, it is OK.

 

            Red light in receivables turnover and average collection period indicate that the business cannot manage its receivables efficiently and receivables policy of the business should be examined.

 

            Current assets turnover = Net sales revenue / Total current assets

 

            If current assets turnover is less than the sector average, it is red light. If current assets turnover is equal to or greater than the sector average, it is OK.  Red light in current assets turnover indicates that the business cannot manage its current assets efficiently and current asset policy of the business should be examined.

 

            Asset turnover = Net sales revenue / Total assets

 

            Asset turnover shows the net sales revenue earned for every TL of investment in assets. If asset turnover is less than the sector average, it is red light. If asset turnover is equal to or greater than the sector average, it is OK.  Red light in asset turnover indicates that the business cannot manage its overall assets (current assets and fixed assets) efficiently and investment policy (both investment in current assets and fixed assets) of the business should be examined.

 

      c.      Leverage Ratios

 

            Leverage ratio = Total liabilities / Total assets

 

            If leverage ratio is greater than 0,5, it is red light. If leverage ratio is equal to or less than 0,5, it is OK.

           

            Time interest earned = Operating income / Finance expenses

 

            If time interest earned is less than the sector average, it is red light. If time interest earned is equal to or greater than the sector average, it is OK.

 

      d.      Profitability Ratios

 

            Profitability ratios measure how profitable the business is. Profitability ratios are as follows:

 

            Gross profit margin = Gross margin / Net sales revenue

 

            Gross profit margin is the percentage left from net sales revenue after cost of sales is deducted. It measures the ability of a business to manage costs and dictate price (pricing power).

 

            Operating profit margin = Operating income / Net sales revenue

 

            Operating profit margin is the percentage left from net sales revenue after cost of sales and operating expenses (selling, marketing and delivery expenses, and general administrative expenses) are deducted. It measures the ability of a business to manage costs and operating expenses.

            EBITDA margin = EBITDA / Net sales revenue

        EBITDA is earnings before interest, tax, depreciation, and amortization. EBIT is operating income. EBITDA is calculated as follows:

          EBITDA = Operating income (EBIT) + Depreciation in cost of sales and operating expenses + Amortization in cost of sales and operating expenses

          EBITDA is the operating income that excludes depreciation and amortization. EBITDA margin measures the basic earning power of a business independent of its investment and financing policies.

            Net profit margin = Net period income / Net sales revenue

 

            Net profit margin is the percentage left from net sales revenue after cost of sales and all expenses are deducted. It measures the ability of a business to manage costs and all expenses.

 

            Return on assets = Net period income / Total assets

 

            Return on assets shows the net period income earned for every TL of investment in assets.    

            Return on invested capital = (Period income + finance expenses) / (Intrest bearing debt + equity)

           Interest bearing debt includes short-term and long-term bank loans, and bonds and bills issued. Interest bearing debt excludes trade payables, taxes and other duties payable, advance payments receives, and unearned revenue.

            Return on invested capital shows income earned for every TL of invested capital.

 

            Return on equity = Net period income / Total shareholders’ equity

 

            Return on equity shows the net period income earned for every TL of the owners’ investment in equity. 

 

            If profitability ratios are less than the sector average, it is red light. If profitability ratios are equal to or greater than the sector average, it is OK.

 

6.   Du Pont Equation

     

       Du Pont equation expresses return on equity as follows:

 

      Return on equity = (Net period income / Net sales revenue) * (Net sales revenue / Total assets) * (Total assets / Total shareholders’ equity)

 

      When you look at the ratios, you can see that Du Pont equation can be re-written as follows:

 

      Return on equity = Net profit margin * Asset turnover * Equity multiplier

 

      A business must increase its net profit margin, asset turnover, and equity multiplier in order to increase its return on equity.

 

      Equity multiplier = Total assets / Total shareholders’ equity

 

      If total shareholders’ equity decreases equity multiplier increases. Decrease in total shareholders’ equity means increase in total liabilities. Because assets = liabilities + shareholders’ equity. Du Pont equation says that a business should use debt in order to increase its return on equity.  But debt must be used wisely.

 

      Du Pont equation says that, in order to increase a business’ return on equity, the business must manage its costs, expenses, investments (investment in both current and fixed assets), and debt wisely.