Introduction to financial analysis

This is a brief guide to the complex world of financial analysis. It’ll help you understand the concepts and terminology accountants use when preparing financial statements.

Financial statements these days present a diversity of data.

As well as profit margins, they provide information about returns in invested capital, liquidity ratios, inventory days, debtor days, creditor days and debt ratios. As an in-house lawyer, you won’t need to be a financial expert, but it’ll help to be able to find your way around the modern financial statement and understand why and how it drives management and shareholder behaviours.

Financial analysis – your guide to the basics

Financial statements can be complex, especially if you’re not an accounting expert.

So, to help you understand a company’s performance, we’ve put together this brief guide to the terminology of financial analysis.

Profit margins

Accountants express profit margin in two ways:

  • Gross profit margin: the difference between the prices of products and services and the direct costs of providing them; and
  • Operating profit margin: how much of the organisation’s sales revenues flow to the "bottom line" (of the accounts) after all "operating costs" have been accounted for. Operating costs, broadly, are an allocation of overall costs of running your company that can be attributed proportionately to each product or service sold's costs after the direct costs of providing those products or services have been deducted.

Return on invested capital (ROIC)

ROIC shows how effectively the organisation is using its assets to generate cash flow. External investors use ROIC to estimate their potential returns.

Similar measures include Return on Assets (ROA), Return on Equity (ROE) and Return on Capital Employed (ROCE). However, most analysts prefer ROIC.

Return on Assets

Profit After Tax

Fixed Assets + Net Working Capital

 

Return on Assets (“ROA”) compares net profits to total net assets to see how well a company is able to utilize its asset base to generate profits.

This ratio can be relatively easily inflated by manipulating closing balances on working capital and by adopting a very conservative stance on the valuation of fixed assets.

Return on Equity

Profit After Tax

Shareholder's Equity 

Return on Equity (“ROE”) compares the annual net income of a business to its shareholders' equity. The measure is used by investors to determine the general level of return that an organisation is generating in proportion to the investment they have made in it.

This measure can be artificially improved when a business buys back its own shares from investors, or by using more debt and less equity to fund its operations.

Return on Capital Employed

Earnings Before Interest and Tax

Total Assets – Current Liabilities

 

The return on Capital Employed (“ROCE”) compares the proportion of adjusted earnings to the amount of capital and debt required for a business to function.  It is commonly used to compare the efficiency of capital usage of businesses within the same industry.

For a company to remain viable over the long term, its ROCE should be higher than its cost of capital; otherwise, it is, in effect, destroying shareholder value.

ROCE is a better measurement than ROA and ROE as it shows how well a company is using both its equity and debt to generate a return.

Liquidity ratios

Liquidity is how much immediately available money does a company have - that is not tied up in creditors, assets or slow access bank accounts - in relation to the size of its debts that are due for payment. Liquidity ratios show how well equipped an organisation is to meet its short-term obligations. Poor liquidity could mean it needs to raise cash through emergency measures such as selling assets cheaply, borrowing at high interest rates or selling a stake in the business. There are two types of liquidity ratio:

  • Current ratio. This reveals the organisation’s ability to meet short-term liabilities using short-term assets. A ratio of less than one may indicate insolvency; and
  • Quick ratio. Similar to the current ratio, but with inventory removed. Selling inventory (its product that is made and sitting in the warehouse ready to sell) could take time as customers are needed so it wouldn’t help the organisation meet its short-term liabilities.

Inventory days

Inventory days measures how often an organisation sells or replaces its inventory in a given period.

Generally, the lower the number the better, as this indicates that less working capital is tied up in inventory. A full warehouse of stock that is gathering dust is bad but, at the other extreme, having not enough stock in the warehouse to meet normal levels of demand during the period of time between deliveries to you by your supplier is also not good!

Debtor days

Debtor days is an average of how long an organisation waits to get paid after having issues and valid and undisputed invoice (law firms, which are notoriously bad at managing this,  call it "lock up").

A high number may mean the organisation is too generous with credit terms, so is reliant on excessive working capital to finance its operations. Few companies achieve a debtor days number below 30.

Creditor days

Creditor days indicates how much credit suppliers are giving the organisation.

A high figure allows the organisation to use its suppliers’ working capital. When your company buys something and then resells it, you get money in from your customer before you have to pay your supplier and so are able to temporarily use the money that you have received for other purposes, like getting interest from the bank, before you have to pay the supplier. However, it could also suggest the organisation struggles to pay suppliers.

Debt ratios

Debt ratios, which create a picture of an organisation’s capital and finance structure, are listed in two ways:

  • Debt-to-equity ratio. This compares the capital raised by borrowing, and equity (money paid in return for ownership of shares in the company) contributed by shareholders. Too much borrowing and not enough equity could mean the organisation struggles to pay its debts (as loaned money costs money due to the lending bank in interest payments); and
  • Interest coverage ratio. This indicates how comfortably the organisation can meet its interest payments (on those loans to it from banks) out of the net income that it receives from its activities. Any figure below one spells trouble as it means that it has to pay out more money in interest in order to maintain the loans that are financing the business than it is earning from running the business.

General guidelines

When reading financial statements, bear in mind that:

  • No single figure is prime. Consider a range of indicators to understand the organisation’s overall financial position;
  • The importance of different ratios, such as inventory days, vary from industry to industry, so should be weighted accordingly;
  • Trends over time tell us more than the statements for one financial year only; and
  • It’s a good idea to assess performance in the context of industry benchmarks and that of other organisations of a similar size, maturity and geographical spread.

Conclusion

Financial statements are becoming more complex as organisations are obliged to disclose their performance in ever-increasing detail. The result for non-accounting experts is that they can be overwhelming and incomprehensible. However, if you take a little time to understand the concepts and terminology of financial analysis, you’ll be able to make sense of modern financial statements. The key, however, is to consider financial statements in their entirety, rather than by a single number alone - and put the figures in both an industry-wide and a long-term context.