We can speak about five aspects of the analysis: liquidity, activity, indebtedness, yield, cover and we complement them with EVA (index of value generation, which, because of its importance is treated in a separate chapter).
We will make an initial presentation; then we will indicate their limitations and afterward we will do, complementary analyses for their better use are suggested. At the end of the document one example is given.
A. LIQUIDITY: measure the capacity of the companies to cancel their short term obligations. They help to establish the facility or difficulty that a company has to pay its current passive with the product to turn into cash its working capital. It helps to determine what would happen if the immediate payment of all its obligations in less than a year was demanded.
We have the following indexes:
It indicates the relationship between the current actives and the short term liabilities
It reveals the capacity of the company to cancel its current obligations, but without counting on the sale of its supplies, basically with the balances of cash, the product of its accounts to receive, its temporary investments, and some other actives of easy liquidation, different from the inventories. It is a relationship similar to the previous one but without considering the inventories.
d. EBITDA = Operative profit + Depreciation + Amortization + provisions
The inventory of merchandise of a company rotates X times during the year, this means, that the inventory becomes X times cash per year or accounts to receive.
It is equivalent to the previous relationship but expressed in days.
Establishes the number of times that the accounts to receive turn on average on a determined period of time, generally a year.
It indicates the number of days that the accounts to receive take to rotate.
It indicates the number of times that the accounts to pay turn in a certain period.
It provides a clue of the general average of days that the company spends to cancel its accounts.
The total actives rotated X times during the year, or each dollar invested in actives generated sales for U.S. $X in the year.
C. INDEBTEDNESS (LEVERAGE): it shows the participation of a third party in the capital of the company. The following indexes are calculated:
For each dollar that the company has invested in actives, $X has been financed by the creditors, or that the creditors are owners of X% of the company and the shareholder's owners of the complement.
For each dollar of the patrimony long term commitments are had for $X, so, each dollar of the owners is long term compromised in X%.
D. COVER: it measures the capacity of the company to cover the fix charges (interests)
It indicates if the company generates during the period a profit before taxes and interest X times superior to interests paid. This means if the company generates enough profits to pay interests superior to the present ones.
It means that the sales of the company generated an X% of profits during the year. In other words, each dollar sold during the year generated $X of net profit.
The net profit corresponds to an X% of the sales during the year, that is to say, that each dollar sold generates $X of net profit during the year.
The profits corresponded to X% on the patrimony during the year; it indicates what corresponds to the partners as yield on their investment.
It shows that it is the same to say, that the net profit with respect to the total actives like an annual percentage, and that each dollar invested in the total active generated $X of net profit during the year.
F. INDICATORS OF VALUE GENERATION:
U: Profits P: equity
CC: cost of capital
If the company is generating Value EVA it must be superior to 0. If EVA is inferior to 0 (negative) the company is destroying value. We refer widely to this indicator in another document.
b. Corrected and projected :
: corrected and projected EVA
U: profit of the period
I&D: investments & development
PMA: environment preservation
CC: cost of capital
A: adjustments to the equity
2. LIMITATIONS OF FINANCIAL ANALYSIS BASED ON ARITHMETIC RELATIONS
A. LIQUIDITY: an imperfection of the traditional analysis consists of ignoring the deadlines of the passives. Arbitrarily it is defined as of long term one that expires in a term superior to a year and as of short terms the rest.
According to this classification, it is considered the same as a debt that expires the following day of the date of the balance, that one that expires 359 days later.
The continuity principle, supposes that the society has an indefinite life, unless the opposite is said specifically. Hendriksen, affirms that liquidity should not be measured by the amount of current assets, because it is assuming that the company is being eliminated, which is not correct most of the times. The important thing is to analyze the capacity of the company to generate cash in the normal course of the business.
The account to receive involves two factors. In the first place, who sell on credit takes the risk that some accounts could not be paid by the indebted; in the second place, it is very common that some clients are delayed in their payments. About the accounting information, it is not possible to be deduced how liquid are the receive accounts; detailed analysis of all the clients is required to be able to draw a conclusion.
The inventories represent a worthy factor to analyze with all the caution needed. We can make three classifications: raw materials, product in-process, and finished product. This last one is next to come in a way of a payment that the previous ones and, the raw material can be more liquid than the product in the process. The financial analysis considers them equally liquid. The quantity of inventories depends on other aspects of the used estimate methods, that can be FIFO (first units in entering, first in leaving), LIFO (last units in entering, last in leaving); average, specific cost.
Finally, if a careful classification does not appear, it would be ignoring the different problems that can be displayed: obsolescence, fashion changes, deterioration, oversupply, etc. As a rescuing formula appears the acid test, which can give one a very deceptive calculation in certain cases such as, would be a supermarket, business that by its nature displays very liquid inventories in most of the cases.
B. ACTIVITY: the cost of the merchandise depends on the system of valuation used for the inventories and its number average is very little representative when they are businesses with stationary sales.
In the portfolio rotation, moreover to the imprecision mentioned in liquidity, we can say, that the average of accounts to receive is little representative when they are businesses that display a concentration of sales at certain times.
C. INDEBTEDNESS: in order to calculate the reason total active/total debt, in the numerator the deadline of the liabilities is ignored, a very important characteristic in inflationary economies.
The total active, in most cases the figures of balance change considerably with relation to the real value. The current part it's already sufficiently analyzed; the stable portion, in almost the totality of the cases is sub valued.
In effect, about the machinery and equipment, we found in the balance an equivalent value in books at the cost of acquisition except the accumulated depreciation.
Due to the inflationary problem, when it is national capital goods or the devaluation of the money with relation to the dollar in the case of imputed goods, generally while the actives serve economically, its value is increased based on current money, the same for register sales.
In greater proportion, the phenomenon appears witch the lands, that not even accountable are depreciated and that by the phenomenon of restricted supply with increasing demand, increase their value in constant dollars (considering the loss of the buying power of the money). With the constructions that have so long useful life a very similar phenomenon happens.
ACTUARIAL CALCULATION OF PENSIONS
Depending on the retirement system of each country, the value of the obligation for future retirement at the end of the year deserves special consideration when analyzing the indebtedness. In very simple terms, it can be affirmed that if the company were to be liquidated, it would have to allocate the item indicated by the actuary - based on complicated technical calculations, involving both mathematical and statistical aspects - to attend to labor obligations.
Here it should be clarified that, in most countries, the pension or retirement savings plan has become the responsibility of the government or private funds, which is why pensions are no longer an employer obligation. Under this new modality, the employee makes a monthly contribution, by deducting his payroll and, upon meeting the retirement conditions, the fund or the government entity must cover the worker's pension. Two main schemes are used: the medium premium scheme, or the programmed individual savings scheme.
E. YIELD: the main problem of the conceptual type. The accounting in most of the cases recognizes the profit at the moment of the sale.
The rent is generated through all the production cycles, including the activities of buying raw materials and the collection of portfolios. Also, the value of the profit depends on the accounting policies about depreciation, amortizations, valuations of inventories, punishments of portfolios, etc.
The value of the equity (total active - total passive), is considerably affected
by the observations previously done in relation to the actives, passives, and very specially, by the value of the intangible ones that in many cases constitute a highly representative figure in proportion to the total of actives of the company.
3. HOW TO IMPROVE THE FINANCIAL INFORMATION
The fundamental thing is that the analyst has a clear knowledge of the previously listed limitations. We have to look for information about the company, its partners, its products, its consumers, system of distribution, competitors, etc. Accepting as a great limitation of general type in the analysis, its character of static, because it is done base on a cut of accounts to the date, it is recommendable that analyzes the financial situation by the use of balance (minimum three) in order to observe the tendency that shows the different indicators and hopefully based on projected financial statements if the decisions are oriented to the future.
Before calculating the current reason, it is recommendable to analyze the portfolio and to exclude the accounts of doubtful collection and those that are considered losses. About the number of inventories, we must make a careful classification that allows us to see if they comprise or not the characteristic of quality, if some supplies are obsolete or old-fashioned, if the supplies are enough or if on the contrary excesses appear. Moreover, we have to examine the criterion of valuation used and its effect on the used indicators.
The EBITDA must be related to the net sale and be expressed in percentage.
B. ACTIVITY: we must review carefully the method of estimation of the inventories to determine the cost of the merchandise sold. In order to determine the average of accounts as a receipt and inventories, it is recommended to use the appropriate statistical measurement as an indicator of the central tendency (average, mode, medium), complementing it with dispersion indicators.
As far as possible the averages are due to calculate base on the monthly figures, especially if they are seasonal sales. If the data presents much dispersion the medium one is preferable. If relative concentration exists the mode is more recommendable than the average Arithmetic. As far as portfolio it is very advisable to ask for aging or decaying of the total by the past due date. Empirically it has been possible to conclude that the older the account, the more difficult it is its collection.
C. INDEBTEDNESS: before entering to calculate indexes it is recommendable to update the figures of balance bringing the actives to real value. In the case of current actives, the situation has been sufficiently analyzed. For the stable active a technical estimate conducted by experts is desirable. As far as the debt, it agrees to calculate the net present value according to the model of financial mathematics.
D. COVER: in order to calculate these indexes the same observations analyzed for the yield indicators are valid, recommending the use of the indicator of total cover because it considers the amortizations of the debt.
In general for the investment decisions, valuation of companies, alternatives of financing, absorptions, and mergers, it is recommended to work with indicators calculated based on the projections of the company and very specially the calculation of to which, given its importance, we talked about in another chapter.
E. YIELD: before taking the figure from profits an analysis of the qualitative type is recommendable. In the first place, we must separate the operative profit of the occasional, of possession or both.
Of course, the yield indexes are due to calculate according to the operative profit and must be subjected to the internal generation of cash flow; the profits obtained by the yield of other investments and by the accomplishment of assets must separately be analyzed. In a specific moment, the accomplishment of assets can be a great decision of managerial, as also it can be at the moment of the investment. The important, at the moment of the sale, consists of taking care of the fulfillment of the basic objective of the financial function: permanent generation of value to increase the value of a share in the market with high indexes on stock-exchange.
the performance of the companies, as it is the enterprise group to that belong, the sector in which they develop, the domestic and international economic situation, by this the indexes are due to consider that to calculate on the factors previously mentioned, since it would be possible to be spoken of a financial analysis of the enterprise reality that is being lived; otherwise, the financial decisions would be bad, because it would be losing vision of the present financial position of the company in the economy.
*1: Assuming that neither the product in process nor the portfolio with more than 180 days are easily attainable in the particular case.