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Chapter 11

FINANCIAL ANALYSIS

 

by josavere

INTRODUCTION

The financial analysis constitutes a tool of lots of analytic usefulness. It allows us to make relative comparisons of different businesses and facility decisions of investment, finances, action plans, control of operations and dividends distribution.
First of all, it must be verified that the financial statements are prepared in accordance with IFRS and duly signed by the company president; Equally by the accountant and the fiscal auditor with their existing enrollments.

A generalized series of financial reasons exist. As a base of this article we will use the formulas commonly used by he recognized authors in this matter.

 

1. GENERAL PRESENTATION

We can speak about five aspects of the analysis: liquidity, activity, indebtedness, yield, cover and we complement them with EVA (index of value generation, witch, because of its importance is treated in a separate chapter).

We will make an initial presentation; then we will indicate their limitations and afterwards 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 were demanded.

We have the following indexes:

It expresses in amount that the current reason display as a relation. It
indicates the value that would be left to the company, represented in current cash or other liabilities, after paying all its short term liabilities, in case that they had to be cancelled immediately.

It indicates the relationship between the current active 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

B. ACTIVITY: constitute an important complement of the liquidity reasons.
They measure the duration of the productive cycle and the period of portfolio.
The following indicators are used:

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 in 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 shareholders 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%.

 

It is a complementary version of the index of total indebtedness; it shows the importance that the long term debt has on the structure of capital of the company. It indicates % of the long term structure that is represented by the debt with a third.

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.

E. YIELD: measure the productivity of the funds compromised in a business.
Let us remember that at long term the important thing is to guarantee the permanence of the company in market increment and therefore its value. It allows us to watch the behavior of the company in comparison with the sales and the capital.

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:

a. EVA=

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 EVACp (josavere):

EVACp: corrected and projected EVA
U: profit of the period
I&D: investments & development
Po: positions
PMA: environment preservation
CC: cost of capital
P: equity
A: adjustments to the equity

2. LIMITATIONS

A. LIQUIDITY: an imperfection of the traditional analysis consists on 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 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 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, 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 process. The financial analysis considers them equally liquid.

The quantity of inventories depends between 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, more over 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, 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 an 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.

D. COVER: these indicators are affected by the same way to those of yield.
For these indexes of analysis of the internal generation of cash flow is critical.

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 productive cycle, including the activities of buying of raw materials and collection of portfolio. Also, the value of the profit depends to the accounting policies about depreciations, 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 about the previously listed limitations. We have to look for information about the company, its partners, their products, their 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 a representative number of balance (minimum three) in order to observe the tendency that shows the different indicators and hopefully base on projected financial statements if the decisions are oriented to the future.

A. LIQUIDITY: the idea is to study the projection of the cash flow. This
has a dynamic character and it allows seeing with clarity if the company in its normal operation it's in conditions to honor its commitments on time, as it corresponds to the objective of the financial function.

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 accounts to pay constitute a certain number at the moment of the analysis.
It is important to consider that the due date plays a definitive role to estimate the present value, which is ignored in the financial analysis. An account with deadline in few days more than 360 must be included as current.

The EBITDA must be related to the net sale and be expressed in percentage.

These considerations made we proceed to calculate the refined test (josavere).
This does not obey to a specific formula. It is characterized essentially by being, of good criterion on the part of the analyst, to calculate the times that the realizable active covers the current passive in a specific moment. This test emphasizes in the capacity to generate cash by the normal activity of the company. For example, we could calculate it by the following formula:

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 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 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 in according 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 EVACp to which, given its importance we talked about in another chapter.

E. YIELD: before taking the figure from profits an analysis of 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 yield of other investments and by 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 share in the market with high indexes on stock-exchange.

At the time of making a financial decision a great risk is taken if the internal financial analysis is only considered (own organization), because it is not possible not known that other types of factors exist that obviously affect
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.

Click here to download practical exercise

*1: Assuming that neither the product in process nor the portfolio with more than 180 days are easily attainable in the particular case.a

 

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