company analysis
Strategic Management Tool Ten
MGT 4810
Dr. Amye Melton
Tool Ten
Financial Analysis, by the numbers
There are three parts to Tool 10.
Financial Ratios with graphs
Common Sizing
Productivity Analysis
Tool Ten
First, with regard to the simple calculation of ratios, little can be gleaned from a single number. Ratios are a comparative tool, which must be interpreted through the lens of another industry competitor [benchmarks], an industry average, or as part of a multi-‐year trend analysis of the same ratio for the same firm. The latter approach usually requires a minimum of five years of financial data.
Industry averages, or acceptable standards for ratio values, vary by industry and are typically hard to come by unless the analyst has access to industry trade associations and specific market or brokerage reports.
Tool Ten
This brings us to the selection of benchmark companies that can be used to compare to the subject firm. One method is to select three companies; the one directly above in terms of size as measured by gross sales (usually an industry leader), the firm competing most directly with the subject company in terms of size and markets served, and a firm that is considered the fastest growing in the subject firm’s market.
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A Sample Financial Ratio Grid is provided that combines example ratios, five years of calculations, and interpretative data in the form of trend conclusions, industry averages, and benchmark companies. This grid will change significantly from analysis to analysis based upon the specific ratios selected, the data years available, the comparative methodology employed, and/or the benchmark company(s) selected.
Sample Financial Ratio Grid
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Financial ratios may be classified into four groups:
liquidity ratios
leverage ratios
activity ratios
profitability ratios.
Common ratios in these four categories are illustrated in on the next slide accompanied by their formulas and general meanings. A common question raised by new analysts and students concerns the necessity of calculating ALL of the ratios for the analysis of a specific company. The simple answer is NO. ALL of the ratios do NOT have to be calculated, only the most relevant ones (which are most).
If the company is predominantly service-‐based (e.g. airlines), and has little or no inventories, the relevance of quick ratios and inventory turnover ratios is reduced.
If a company has little or no debt, the need for the leverage ratios is eliminated.
Conversely, if a company is dependent upon fixed assets, like Boeing or GM, fixed asset turnover and total asset turnover are extremely relevant.
If a firm has a high level of debt service, then the times-‐interest-‐earned ratio is critical.
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It is also very important to select appropriate profitability ratios for inclusion in the analysis. This is the one area that is the most flexible (and the most forgiving) to apply. This analyst finds the complete profitability picture is best captured by the use of ROS (Return on Sales), ROE (Return on Equity), ROI (Return on Investment), and the calculation of working capital. Try to avoid stock market ratios and indicators such as EPS, Annual Growth Rates, Price/Earnings Ratios, and Dividends per Share. They are useful indicators of success but not necessarily conducive to long-‐term planning.
Calculate the ratios for your company. If you know how to use Morningstar, it will do this for you. In many cases, you can find all of this online and you will not need to calculate the numbers.
5 year ratio analysis
Once you have completed the Financial Ratio Grid, plot the information into graphs for each type of ratio. Example:
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Common-‐sizing of key financial statements, namely the income statement and balance sheet, serves not only to potentially discover additional financial strengths and weaknesses but also as internal validation of those already discovered by ratio analysis.
At a minimum, the income statements and balance sheets for the subject company covering a period of three contiguous years should be common-‐sized. Ideally, the most current, complete year plus two years back.
Additionally, the common-‐sized income statement and balance sheet for the selected benchmarked company(s) (refer to the Ratio Analysis previously discussed) should be included for the most current, complete year.
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Stated simply, common sizing involves converting all the line items, expressed in dollars on the financial statement, into percentages based on net sales for the income statement (net sales = 100%) and, total assets for the balance sheet (total assets = 100%).
Some years ago, in the pre-‐Steve Jobs return era, this analyst performed a common-‐sizing analysis of Apple Computer using Compaq and Dell Computer as benchmarked companies. This analysis is reproduced in and offered as an example common-‐sizing format. Another example is illustrated in Wendy’s International, 2003-‐2007
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The final component of the financial analysis is a rudimentary productivity calculation. The measure utilized here is Total Net Sales divided by the number of FTE (Full-‐Time Equivalent) Employees. This is calculated for the subject firm as well as for the benchmarked competitors using data for the most current, complete fiscal year available. This measure is considered rudimentary because of its widespread acceptance and near applicability across all economic sectors.
Both Net Sales and FTE Employees can be easily found in public corporation 10K’s filed with the SEC (www.sec.gov). If additional depth is required, each sector has more specific measures of productivity. For example, retail, which may be considered a subsector of the consumer cyclical or noncyclical sectors, employs a series of specific productivity measures such Net Sales per Square Foot, Median Sales (per store) per Square Foot, and Net Sales per Sales Associate.
A sample Productivity Analysis is shown on the next slide.
Tool Ten