What Is Financial Analysis?

Investors often examine a company’s financial statements and use specific ratios to understand its economic health. While this may seem complex at first, the process of financial analysis is not as daunting as it appears. It’s like a puzzle that, once you understand the pieces, becomes clear. This process is frequently part of a Program Evaluation and Review Technique (PERT), a project management tool used to visually outline a project’s timeline. Let’s break it down in a way that’s easy to digest.

Key Takeaways:

• Investors evaluate a company’s financial health by analyzing its financial statements and calculating various ratios.
• A company’s value is reflected in its market value.
• The financial ratios are compared against competitors and industry standards to determine this.

Understanding a Company’s Financial Position

Imagine going to a bank to take out a loan. The bank would require you to disclose the value of all your significant assets (like your house or car) and your considerable liabilities (like your mortgage or credit card debt). The bank assesses this information to determine the strength of your financial position by valuing your assets conservatively and ensuring all liabilities are disclosed.

Similarly, evaluating a company’s financial position involves analyzing its assets and liabilities. However, in the case of a publicly listed company, investors take this evaluation one step further and consider the company’s financial position relative to its market value. Let’s explore how this works.

The Balance Sheet

Like personal finances, a company’s financial position is determined by its assets and liabilities. But there’s an additional component for companies: shareholder equity. All this information is presented on a company’s balance sheet, a critical tool for investors. The balance sheet is like a map that guides you through a company’s financial landscape, providing a clear picture of its assets, liabilities, and shareholder equity.

For instance, let’s analyze a hypothetical publicly traded retailer, “The Outlet,” by examining its balance sheet from the company’s annual report. The standard balance sheet layout begins with assets, followed by liabilities, and ends with shareholder equity.

Current Assets and Liabilities

The balance sheet divides assets and liabilities into current and non-current categories. Current assets or liabilities are those expected to be converted into cash or settled within the next 12 months. For example, The Outlet’s inventory reported as of December 31, 2018, is expected to be sold within the upcoming year, causing a decrease in inventory and an increase in cash.

In many retailers, including The Outlet, inventory is a significant portion of current assets, requiring scrutiny. Managing inventory efficiently is critical to optimizing capital. For instance, if The Outlet reduced its inventory by 20% while increasing sales by 23% in the same period, this indicates effective inventory management and contributes positively to the company’s cash flow.

On the other hand, current liabilities include obligations the company must pay within the next year, such as payments to suppliers, employees, tax authorities, and short-term loans. Companies aim to manage their cash flow carefully to ensure that they have enough cash available to meet these short-term obligations as they come due.

The Current Ratio

The current ratio is a commonly used metric to assess a company’s ability to pay off its short-term obligations. This ratio is calculated as:

Current Ratio = Total Current Assets / Total Current Liabilities

This ratio helps analysts gauge whether a company has sufficient short-term assets to cover its short-term liabilities. The acceptable current ratio varies by industry, but it shouldn’t be too low (which could signal potential insolvency) or too high (which might indicate an unnecessary buildup of cash, receivables, or inventory). Like any ratio, the current ratio should be evaluated over time and compared to industry standards.

Non-Current Assets and Liabilities

Non-current assets and non-current liabilities are those expected to last longer than 12 months. The Outlet’s primary non-current assets might include property, plant, and equipment—the long-term investments needed to keep the business running smoothly.

On the liability side, non-current liabilities include long-term borrowings or lease obligations related to these assets. These liabilities don’t require immediate repayment, giving the company more time to manage them than short-term liabilities.

Financial Position: Book Value

Subtracting total liabilities from total assets gives us the company’s shareholder equity, also called the book value. Essentially, this represents the accounting value of shareholders’ interest in the company. Shareholder equity comprises the capital shareholders contribute and the company’s retained earnings—profits reinvested in the business rather than paid out as dividends.

Market-to-Book Multiple

Investors often compare a company’s market value to its book value to determine whether a stock is undervalued or overvalued. This comparison is known as the market-to-book multiple. It can be a valuable tool for identifying investment opportunities, especially for value investors.

Extensive academic research shows that companies with a low market-to-book ratio tend to outperform those with higher ratios. A low market-to-book multiple indicates that a company’s financial position is strong relative to its stock price, signaling a potentially undervalued investment opportunity.

Comparing the Market-to-Book Ratio

Whether a company’s market-to-book ratio is considered high or low depends on comparisons. To get a clearer sense of how The Outlet’s market-to-book ratio stands, it should be compared to similar ratios of other publicly listed retailers in its industry. This comparison helps investors understand whether The Outlet is undervalued or overvalued relative to its competitors.

Conclusion: Understanding a Company’s Financial Position

A company’s financial position provides crucial insight into its financial health and stability. By conducting a thorough economic analysis—examining the financial statements and reviewing the footnotes in the annual report—investors can make informed decisions about a company’s actual value and whether or not it’s a solid investment.

A detailed financial analysis is essential for any investor who wants to fully understand a company’s economic situation and make sound investment decisions. The key lies in paying attention to the balance sheet, analyzing assets and liabilities, and using critical financial ratios like the current and market-to-book multiple. These ratios are like a compass, guiding you through the company’s economic well-being in the broader market context and helping you make informed decisions about its potential as an investment.