FINANCIAL STATEMENT ANALYSIS

Financial statement analysis has long been considered an art. Though the numbers that analysts deal with are specific, the interpretation of those numbers is not, and even the question of which numbers relate in a meaningful way is largely unsettled. For example, in my own research, I have come across nearly 150 different ratios used to gauge financial condition. Each has its coterie of followers ” bankers, financial managers, investment analysts, and CPAs ” who daily seek some clue to the future by examining the financial statements of the past.

Is it possible to predict the outcome of a business venture? Many people think so. Yet there is very little evidence that businesses evolve in a linear way. The random walk of the stock market, the whims of fashion, the variety of life's experiences all testify that if the future held no surprises , that would be the biggest surprise of all.

In recent years , however, a number of developments have acted to make financial statement analysis more scientific and less unpredictable. Included among these are

1. A broader use of mathematics and statistics in defining the major elements of a business and their relationships

2. The use of computers, with their enormous capacity for storing and classifying business data

3. The refinement of accounting practices, which has given us more reliable financial statements

To be sure, the main difficulty with financial statements is what may be called the good news/bad news syndrome. Seldom do financial statements look completely good or completely bad; they nearly always exhibit both qualities. There are two principal ways of analyzing the financial strength of a company. One is through a ratio analysis of recent financial statements. The other involves a financial forecast of the near future. Ratio analysis is the easiest to learn and the fastest to use, and that is the method we will examine first. Financial forecasting is more difficult to learn and complex to apply, but it gives superior results.

Forecasts often require us to make difficult estimates of unknowns, but they deal in specific goals and dates, such as earnings in the coming year or cash flow in the next 15 months. Ratios, on the other hand, are usually easy to calculate, but the results are often abstractions that may he hard to apply to real world problems. Does knowing that the current assets are 200 percent of the current liabilities tell you if you can pay your bills on time?

As we discuss ratios, keep in mind that they are nothing but little numbers unless we have some standard by which to measure them. The 2:1 current ratio mentioned above does not help you much unless you know what number constitutes a good current ratio and whether it gets better as it gets higher, or vice versa.

RATIO ANALYSIS

The dollar values of items on the income statement and balance sheet have little significance by themselves . Rather it is the proportion of accounts, or groups of accounts, one to another that tells us whether a company is financially viable or not. For example: Suppose a businessperson tells you his company has $85,000 in its checking accounts. The figure means virtually nothing unless you can relate it to other aspects of the business. If the man runs a local shoe store, he may be well fixed, but if he turns out to be the president of the Eastman Kodak Company, he is talking about the amount of cash that flows in and out of the company approximately every minute of the business day.

A major problem with this kind of analysis has been the proliferation of different ratios. Every financial statement lists several accounts; they may be compared to each other or to the same accounts in previous periods; combinations of accounts are related to individual items or to other combinations; and ratios themselves are often divided by other ratios to produce super ratios for determining trends. The possibilities and the confusion seem to be without limit. As an example let us look at a balance sheet and income sheet for a hypothetical Company X.

BALANCE SHEET	Company: X
Analyst: Christin R.	Date May 15, 2002	$Millions
------------------------
Statement Date:	12-28-00	12-28-01
ASSETS
Cash & Short Term Investments	1585	613
Accounts Receivable (Net)	1678	2563
Inventories	1703	2072
Deferred Taxes	230	348
Prepaid Expense	50	215
Current Assets	5246	5811
Property, Plant & Equipment	6861	12919
Less: (Accumulated Depreciation)	-3426	-6643
Net Fixed Assets	3435	6276
Investments
Goodwill and Other Intangibles	5	383
Other Assets	68	432
Total Assets	8754	12902
DEBT + EQUITY
Notes Payable
Current Maturities of LT Debt
Accounts Payable	1564	3440
Accrued Liabilities
Taxes Payable	482	209
Dividends Payable	201	142
Current Liabilities	2247	-3791
Long Term Debt	66	911
Deferred Taxes	271	1209
Other	142	603
Total Liabilities	2726	6514
Preferred Stock Common Stock	674	936
Retained Earnings	5354	6533
Less: (Treasury Stock)		-1081
Equity	6028	6388
Debt + Equity	8754	12902

INCOME STATEMENT	Company: X
Analyst: Christine R.	Date: May 15, 2002	$Millions
Statement Date:	12/28/00	12/28/01
Period:	Year	Year
Net Sales or Revenues	9734	11550
Less: Cost of Sales	6085	7613
Gross Profit	3649	3937
Expenses:
Selling, G&A	1753	2693
Depreciation
Research and Development
Operating Expenses	1753	2693
Operating Income [EBIT]	1896	1244
Interest Expense or (Income)	-86	71
Other Expense or (Income)	19	55
Nonrecurring Expense or (Income)		520
Income Taxes	809	224
Net Income	1154	374
Cash Dividends	517	551

Ratio analysis encompasses scarcely a half dozen generations of analysts, so ratio names are not well settled or precisely defined. They are more so within particular groups such as CPAs, bankers, and stock market analysts. But between those groups the same ratio may have different names and the same name may be used for different ratios. Since this book is meant for a broad range of executives, I have used names and definitions as I found them in general business use, rather than in the specialty fields.

Liquidity Ratios

Liquidity refers to the ease with which an asset can be converted to cash. The liquid assets in a business are cash itself and those things that are near to being cash, such as accounts receivable, or that are readily convertible , such as marketable securities. The Securities and Exchange Commission and countless analysts have defined liquidity as the ability to pay debts when they come due. A gutsier definition might be simply "enough cash." But enough for what? The answer to that is usually found in the denominator of liquidity ratios. Enough cash to pay the bills coming due; enough to pay recurring expenses such as payroll; and enough to cover unexpected needs and opportunities. In addition, that simple question often yields a perplexing answer. The elements of liquidity are in an active state of flux. Both the amount of cash a business has on hand and the amount it is obligated to pay changes with virtually every transaction that occurs. And even a modest- sized company may have 1000 employees spending its money ” and 10,000 customers sending cash in.

It is difficult if not time-wasting, therefore, to contemplate cash needs moment to moment. Most firms try to forecast cash flows in and out for a day, a week, or a month, and then add a cushion to cover normal variances. An even more serious problem in managing liquidity is that we are obliged to weigh an uncertainty against a certainty .

There is little in life that is as fixed, certain, and unremitting as a debt owing. On the other hand, few things are as inconstant, fickle, and capricious as payments promised , loans pending, and sales forecasted. In using liquidity ratios it helps to identify the certain and uncertain elements, and how much of the latter it takes to balance the former. For example, in the popular current ratio (current assets/current liabilities), we see a blend of uncertainties in the numerator. We can count on the cash we already have, but the timing of receivable collections is somewhat uncertain , and the sale of inventory even more so. The amounts and due dates of the current liabilities, however, are known and fixed. In matching up the two elements, therefore, we know instinctively there should be more current assets than current liabilities in order to offset the uncertainty of the former.

Can a firm be too liquid? Can it have too much cash for its own good? There are certain "conventional truths" that circulate among businesspeople that do not bear close scrutiny so well. One of them says that the company with abnormally high cash balances may be "missing investment opportunities that could bring growth and profits." In my view, cash is the beginning asset in business and the final asset. And during the game it is like the queen on a chessboard. It travels in all directions, any number of squares. That is, it is the most powerful and flexible of assets, and as long as you have plenty of it you are in a superior position for taking advantage of opportunities that float your way.

Financial Leverage

Financial leverage is the mix of debt and equity in a business. The perfect mix is one that exactly balances the entrepreneur's love of leverage and the creditor's fear of it.

Leverage is the relationship between the amount of money creditors put in a business and the amount the owners contribute. Where there is plenty of debt and not much equity we speak of high leverage. Where there is little debt and lots of equity we talk of low leverage. Since leverage refers to the relationship of a firm's debt and equity, it stands to reason that a ratio of debt to equity will measure it. And debt to equity is in fact the most popular ratio for gauging leverage.

Other well-known leverage ratios include equity/debt, assets/equity, and debt/assets. All of these ratios have a direct mathematical link and tell exactly the same story. Only the scale is different. The problem is not in measuring leverage so much as it is in knowing when a company reaches a reasonable debt limit. Unfortunately, we cannot tell how much leverage is enough except by noting when there is too much. When a company goes bankrupt, we can say with a measure of confidence that the company should have had a little less leverage. At that point, however, the question itself is usually academic.

Coverage Ratios

Coverage ratios are intended to measure a company's ability to pay the interest on its debt from its earnings. Some financial people consider these a form of leverage ratios, but in reality they are nothing more than earnings ratios, when they are useful at all. The most popular coverage ratio is the Times Interest Earned ratio. The formula is

[Profit before interest and taxes]/Interest

Earnings

Of the three major financial characteristics ” liquidity, leverage, and earnings ” the last is the most complex but the easiest to understand. Simply stated, earnings are derived out of accounting's most fundamental formula:

Sales - Expenses = Earnings

It is a formula that applies to the largest oil company, the smallest lemonade stand, and everything in between.

The complex nature of earnings becomes apparent when you try to analyze them. Why are some companies profitable while others are not? And why do some firms, profitable for decades, suddenly turn stagnant? The key elements of profitability are:

• Demand for the firm's products or services

• The severity of competition

• The effectiveness of cost control

• Employee motivation

• Management knowledge, experience, and judgment

• To a larger extent than we usually acknowledge ” luck

Of these, demand for the company's products or services is not only the greatest influence on earnings, but whatever is in second place (probably luck) is way behind it. Demand is the condition of being sought after, and it is made manifest in business by the willingness , coupled with the ability, of customers to buy what you are selling. This is the reason this section on accounting and finance is included in a discussion of six sigma/DFSS. Unless we internalize the concept of demand in relation to the functional requirements that the customer is ever seeking, we are not going to be profitable.

Demand is a fickle friend; it comes often without warning and disappears the same way. It is not something we have a great deal of control over. Rather, it is a condition that arises within our customers and is difficult to predict ” even by the customers themselves ” unless we spend some time and investigate their needs, wants, and expectations. Businesses can stimulate demand a little with advertising and other marketing efforts, but by and large it is created by the customer in a way that we do not completely understand.

All of this leads us to the basic business risk ” the reason companies are deserving of making a profit. When you start a business, you have to create a product, gather the people and materials needed to make it, set up a distribution system, and advertise the product, all before you have the first evidence that people will buy the product from you.

Earnings Ratios

There are a number of earnings or profitability ratios in current use. Just about all of them use numbers from both the balance sheet and the income statement. Some are better than others, and we will touch on the most popular ones.

Le ROI

The king of the earnings ratios is often referred to as ROI ” Return on Investment. That is the ratio of profit to equity. But in recent years, the interest in these measurements has multiplied so that there is now a whole family of ROI ratios, and ROI has become a generic term for several different kinds of measures.

Most earnings ratios are called Return on Something, and the method of calculation is fairly standard. "Return on" indicates that some profit figure is in the numerator, and the "something" is the denominator of the fraction. The result usually falls into a range between 0 and .5 and is normally expressed as a percentage figure.

Many of the return ratios come in two colors, profit before tax and profit after tax (PAT). Both types are commonplace, but the latter is about twice the size of the former, so you have to pay attention to what you are looking at. I will always be referring to PAT unless I say otherwise . Here is a brief description of the three most popular Return ratios, all three of which are calculated by most companies.

ROE: Return on Equity

ROE is the last word in profitability ratios. When the smoke and mirrors of this "special factor" and that "extra adjustment" are put aside, this is the measurement that tells you whether you really have a business or not.

ROA: Return on Assets

You will remember that Assets = Debt + Equity, so ROA is like ROE except that the denominator is bigger and the percentage return is therefore smaller than ROE. This ratio is popular among larger companies for measuring the performance of subsidiaries and divisions. ROE would be a better measure, but when companies cannot determine a true equity figure for a division, this works pretty well.

ROS: Return on Sales

ROS tells how many cents out of each sales dollar go into the owners' pockets. Nearly every company calculates this ratio, but it is not really very useful because there is no standard to gauge it by, as there is with ROE. For example, Company A may cater to the carriage trade and have limited sales but a high ROS. Company B may be a mass merchandiser with a low ROS, yet B could have a higher ROE than A because profit is the product of ROS and the volume of sales.

The average ROS for all companies in the US is between 5 and 6%, but the number varies widely from company to company, even in the same industry.

Other Return Ratios

There are dozens of other return ratios in active use, but their definitions are not well settled. Here are a few of the more common 3+ letter jobs, but even with these, definitions vary among users.

RONCE: Return on Net Capital Employed ” The denominator, net capital employed, usually refers to total debt plus equity minus non-interest- bearing debt such as accounts payable. But this is not always what it means, so if it is important for you to know the precise meaning, ask the user to define the ratio.

ROAM: Return on Assets Managed ” Often used in management bonus plans; similar to RONA, which follows .

RONA: Return on Net Assets ” Here the denominator starts out with total assets and then certain ones are deducted. Often the assets taken out are those not directly related to the running of the business ” for example, investments.

ROGA: Return on Gross Assets ” This is likely to be the same as ROA, Return on Assets.