Building a Financial Analysis of an Organization
I.
Preparation
a. Find your industry on Standard and Poor’s Net Advantage website. Read carefully
the “Key Industry Ratios and Statistics” and “How to analyze……” sections.
b. Print your organization’s most recent annual report and read through it carefully,
including the footnotes to the financial statements.
c. Read the “Analyst’s Research” page on your organization available on
Morningstar Library Edition.
II.
Assemble/Compile Raw Materials
a. Spread and common-size three years of FYE financial statement data
b. Identify 6-10 financial ratios that you believe are relevant to understanding the
organization’s financial condition. There should be at least one ratio for each of
the categories identified in your text. Calculate (or find) the ratios for the
organization for the last three FYEs. Place these on an easily understood chart.
c. Identify at least three industry specific metrics that are important to helping you
understand the organization. Document the three metrics for, at least, the most
recent fiscal year end in an easily understandable chart – more if you can capture
it. Among other places, this data is often available on the “Key Industry Ratios
and Statistics” page on the Standard and Poor’s Net Advantage” website
III.
Examine and Explore Raw Materials
a. Before you start, make sure that you are ready to ask the question “why” every
time you discover a factor “of interest.” Factors “of interest” are anything that
stands out to you as important such as a recent change in an important account
from year to year (e.g. changes in revenues, long term debt, etc.), or other metrics
that concern you. For each of these factors you should research “why” or “what
has happened that has caused this?”
b. Spend time reviewing the raw material data that you have compiled. Consider
revenue changes from year to year. Look for trends in important accounts across
the three years on all charts. Think about what changed and why. Pay particular
attention to changes in CGS and SGA as a percent of total revenues, net profit
margin trends, key asset account trends (e.g. accounts receivable if A/R is
significant), and levels of , and changes in, debt vs. equity.
c. Review each ratio for trends. Interpret what they tell you.
d. Review industry specific metrics. What do these tell you about the organization
e. As you begin to come to some conclusions, it will be helpful for you look at the
same data that teammates have compiled on their organizations. How does your
organization look compared to theirs?
IV.
Construct Analysis
a. REVENUES: Start with revenues. Give the reader an understanding of what is
going on with revenues and their sources. For example, you might say, “revenues
increased 10% from FYE 2004-2005 primarily as a result of adding two new
restaurants in Mexico” or you might say, “revenues have declined a combined
22% from FYE 2003 to 2005. Several factors contributed to the declines
including the divestiture of an unprofitable subsidiary and general declines related
to increasing domestic competition.” Revenue changes are always an important
consideration and should be explained as thoroughly as possible. Many industryspecific metrics deal with revenues and these could be discussed here.
b. KEY INCOME STATEMENT ACCOUNT TRENDS: Examine trends in CGS
and SGA as a percent of total revenue. This will give you a sense of the
organization’s ability to manage their cost structure in an environment of
changing revenue levels. For example you might say, “CGS increased as a
percent of total revenues from 24% in 2004 to 28% in 2005 as a result of fuel
price increases that are outside of the control of the company.” Or you could say,
“SGA as a percent of total revenue was relatively stable over the last three fiscal
years despite significant revenue fluctuations. This suggests that the company is
able to manage their overhead costs in a fluctuating revenue environment.”
c. PROFITABILITY: Examine trends in profitability and profit margins. Some
ratios may be helpful here. For example, you might say, “Net profit margin has
remained stable at around 4% over the last three years despite increasing
competition and slightly declining revenue levels” or you might say, “Net Profit
Margin has increased over the last three fiscal years from 7% in 2003 to 11% in
2005. The increase is a result of economies of scale realized following the
acquisition of CPS Company in the fall of 2002.”
d. CURRENT ASSET ACCOUNTS: Examine trends in current asset accounts if the
account is “significant” (say…10% or more of total assets). You might say,
“accounts receivable as a percent of total assets, increased from 12% to 15% from
FYE 2004 to 2005. The increase was a result of an increase in days receivable
from 12 to 18 over the same period. A general recessionary economy has
contributed in the slow down of payments by customers.” You could also say,
“Inventory increased as a percent of total assets from 12% to 14% over the three
year period ending 12/31/05. Days inventory also increased from 21 to 25 over
the same period. The slowdown in inventory was caused by one large customer
who chose to purchase from an Asian supplier. The company is implementing a
new inventory management system in order to address the issue.”
e. SUMMARY STATEMENT: Summarize key factors related to the financial
health of the organization.
f. PROPERTY, PLANT, AND EQUIPMENT: Examine trends in PPE account if the
account is significant (greater than 10% of total assets). Consider composition,
age, remaining life, etc. Also, this is a good place to examine utilization ratios
(conversion of PPE to revenues). For example, you might say, “Carnival Cruise
Line’s PPE account increased 20% from FYE 2003-2005. The increase was the
result of the purchase of 4 new cruise ships. These ships are not replacements,
but additions to the fleet and the plan is to use them primarily on new
Transatlantic routes. CCL currently owns a total of 22 cruise ships with an
average age of 12 years. Net PPE as of FYE 2005 represented over 88% of total
assets and the account is composed almost exclusively of cruise ships.”
g. ACCOUNTS PAYABLE AND OTHER SHORT-TERM LIABILITIES: Examine
trends and levels of short term liability accounts. Remember that increasing AP
accounts as a percent of total assets suggests that the company is slowing their
payment to suppliers in order to slow outgoing cash flow – it can be a red flag.
Increases in short-term notes payable also may indicate that short term liquidity is
needed to meet current cash demands. You might say, “AP increased from 18%
of total assets to 23% from FYE 2004-2005. The increase reflected a need to
slow payments to suppliers in order to cover cash shortfalls resulting from
declining revenues and a pay down of long term debt.” Also look at ratios like
Days Payable, Current ratio, Quick Ratio, etc.
h. LONG TERM DEBT: Examine changes in, and levels of, LTD. This is a critical
account, as high levels of LTD are burdensome on a company in the same way it
would be burdensome on an individual – high interest payments, drain on cash,
periodic required principal paydowns, etc. Look at ratios like Debt/Equity,
LTD/Equity, etc. You might say, “LTD as a percent of total assets increased from
60%-75% from FYE 2004-2005. The increase was a result of borrowings related
to the construction of a new warehouse in Lufkin, Texas. Similarly, the
debt/equity ratio increased from 1.5 in 2004 to 5.0 in 2005. The company’s debt
levels are significantly higher than key competitors. Related increases in interest
expense are putting increased pressure on liquidity.”
i. EQUITY: Consider levels, changes, and composition of equity accounts.
Consider if equity account increases are a result of retained earnings (retaining net
income) or a new stock issue. Is the company buying back its stock (treasury
stock)? Is the company paying dividends? These are all issues related to the
equity position of the company.