A full explanation of the financial analysis of the institution
One of the essential elements of analyzing the resources and capabilities of an organization is the financial analysis and its comparison with competitors. This analysis helps us to know our capabilities in relation to competitors, our ability to enter markets that require huge investments, and our ability to invest capital. For new projects, this analysis is limited to our expected and available financial resources with an analysis of competitors’ financial resources. For already existing companies, the analysis includes analyzing the financial statements and comparing them with the financial statements of competitors, if available. One of the basic indicators in this analysis is the financial ratios such as the profit-to-sales ratio, the profit-to-equity ratio, the return-to-asset ratio, the trading ratio…etc. We also study cash flow, net profit and debt. Analyzing the financial statements gives us a good idea of the strengths and weaknesses of our competitors.
Financial analysis requires familiarity with accounting principles, so I will explain it in detail separately after we proceed with the rest of the steps of strategic planning and feasibility study.
Reading the financial statements…..Financial Statements
Many people who are not accounting professionals need to understand financial statements and extract basic information about companies’ performance from them. The investor needs this to do a feasibility study and then evaluate his performance and analyze the performance of competitors, and the one who invests in stocks needs to estimate the real value of the companies’ shares and anticipate the future value, and the manager needs to understand the impact of his decisions on the company’s budget, and the simple employee needs to know the performance of the company in which he works . Also, anyone would like to understand the balance sheets of companies that are advertised in newspapers, which seem to many people as a large group of numbers and incomprehensible terms. Therefore, I am trying hard in this article to explain the basic principles that anyone needs to read and analyze the financial statements in a simplified way that non-specialists can understand, and therefore I have overlooked some of the fine details that specialists care about.
Let’s ask what things we hope to find out by analyzing the financial statements. What do you want to know about the company you are considering investing in, your company or the competing companies?
The profitability of the institution this year and previous years The ability of the institution to pay off its debts The volume of investments that may lead to increased profits in the coming years The percentage of annual return on capital Net sales compared to previous years and compared to competitors The value of available liquidity The value of debts – that is, short-term and long-term loans The value of the company’s assets The value of inventory Compared to previous years and compared to net sales, earnings per share.
In order to obtain this information, we have to analyze the company’s financial lists, which we may be able to view in newspapers or on the company’s website on the international network or some sites related to the stock exchange. These lists contain numbers that help us answer the above questions. Often all numbers are written in thousands or millions (i.e. all numbers have three or six zeros left from the right) and you find a note at the top of the list. For example, if all numbers are written in thousands of Saudi riyals, you may find one of the following phrases written somewhere in the income statement Sr’000 in thousands of Saudi riyals.
This means that the number 7000 means 7 million Saudi riyals, and the number 950 means 950 thousand riyals, and so on. It is noted that some figures may be excluded, such as earnings per share, which are usually written in ordinary units.
The financial statements are prepared for many purposes, including the legal and administrative aspects, and some aspects of interest to the investor. Therefore, it contains many numbers that are of interest to the different groups that read these lists. The aim of explaining these lists here is for you to understand the basic numbers in each list, what they mean, and how to benefit from them.
There are four types of financial statements, and these statements are integrated in the sense that each of them explains an aspect of the things that we want to know about the company. In the next section we make sense of these lists, and please note that we only want to read the important numbers which are shown with red arrows in each example. Do not be alarmed by the large number of numbers, but look for the important numbers.
Financial Statements
First: Net Income Statement or Profit and Loss Statement
This list gives us an idea of what happened in this institution during the period that the list expresses, which may be three months, six months or a year. This list begins with net sales, which is the total return on sales or revenues, then costs are deducted and include the cost of producing products, the cost of marketing, wages, and any cost we incurred this year, and thus we finally reach the net profit.
This list contains important numbers (shown in the examples with a red arrow) such as:
Sales Revenue or Net Sales or Sales or Revenue
It is the financial value of sales during the year. The more sales from year to year this is a good indicator.
Cost of Goods Sold or Cost of Sales or Cost of revenue
It is the cost of purchasing and manufacturing the products that were sold (in the case of a production firm) or the cost of purchasing the products that were sold (in the case of a business). This cost does not include administrative costs and marketing costs.
Gross Profit
It is the difference between net sales and cost of sales
Income statement of the company … for the year 2009
thousands of pounds
2,600 net sales
(1,900) cost of sales
700 gross profit
(250) administrative, marketing and general expenses
450 profit from operations
(70) Other expenses
40 other income
420 net profit before taxes
(130) Taxes
290 net profit
2.9 Earnings per share – in Egyptian pounds
Net Income or Net Profit
It is the value of financial profits achieved by the company. this
The profits have nothing to do with the cash available to the company now, but it expresses the difference between the net sales and the company’s expenses during the period shown at the top of the income statement (and let’s assume it is a year) according to accounting principles. For example, the equipment that was purchased this year is not fully deducted, but rather A part of its price is deducted every year according to what is called “depreciation”, which is based on the fact that this equipment will be used for several years to produce profitable products for the company. Also, the sales whose value will be paid in the near future are included in the income statement accounts on the basis that the sale has already been completed, but the cash has not yet been received. We should differentiate between the concept of profits and the concept of available cash. Therefore, the third type of list is related to cash flow, and we will explain it shortly.
Consider this example: a person bought – at the beginning of the year – a machine for 1,000 pounds and paid for it in full, and with the rest of the capital (500 pounds) he bought raw materials and production tools, leaving 100 pounds with him, then he started production in December and produced 100 units of the product and sold them at 20 pounds per unit, and he will They will be paid in January. Do you see this person as a success or a failure?
Of course, he is very successful because he was able to sell during the first year what covers the price of the machine and the capital and increases. But if we look at the cash available with him now, we will find that it is only 100 pounds. Does this mean that he failed? No, we know very well that it works. If we look at his accounting profits, we consider that the sale of 100 units has been completed, and accordingly, the income statement is as follows:
Net sales 2000 pounds
The cost of sales is 500 pounds
Depreciation 100 pounds (we assume that the machine is ten years old)
The net profit is 1400 pounds
This example demonstrates the usefulness of the accounting method for calculating earnings and the difference between net income and available cash
Earnings per Share EPS
Earnings per share is calculated by dividing the net profit by the number of shares. You should know that part of the net profit is distributed to the shareholders, and the rest is invested within the company. Earnings per share are affected by the value of net profit regardless of what is distributed and what is retained. Suppose you own a shop, and you calculated the profits at the end of the year and found that it was 1,000 pounds, and you used a quarter of these profits on your personal and family expenses. Does this mean that the profits were only 250 pounds? Of course not, the profits were one thousand pounds, and you spent a quarter of it for yourself and kept the rest invested in the shop. The part that is distributed from the profits is called English
Dividend
The more the earnings per share increases year after year, that is a good indicator. Earnings per share greatly affect the rise or fall of the share price because it simply expresses the return per share. People often see the profits that are distributed to the shareholders as the most important and the indicator of the success of the company, and this is not true, as companies distribute part of the profits only, but some very successful companies may not distribute profits to shareholders, for example, Microsoft has been for many years not distributing profits to shareholders Despite achieving huge profits, does this mean that the investor loses? No, the value of the share he owns in the market increases year after year because the value of the share’s earnings increases, and therefore the investor, if he wants to sell the share, will get much more than the purchase price. Rather, profits that are not distributed are an indication of an increase in profits in the coming years, because the company’s investments are increasing. But if the investor aims to obtain a cash return on a regular basis, then he is more interested in the percentage that is distributed from the profits
This is the same income statement in English
Income Statement for……Co. for 2009
LE’000
2,600 net sales
(1,900) Cost of Sales
700 gross profit
(250) Selling, general and administrative expenses
450 Operating Income
(70) Other expenses
40 Other Income
420 Earnings before taxes: EBT
(130) Taxes
290 Net Income
2.9 Earnings per share in LE: EPS
Second: the financial position list or the balance sheet
This list enables you to identify the value of the company’s assets, the value of liabilities (deductions or liabilities), and the value of shareholders’ equity at the end of a certain period, such as December 31 of the previous year, or at the end of three months or at the end of six months. Note that the income statement expresses what happened during a period such as a year or a few months, while the financial position statement expresses the company’s financial position at the end of that period and not during it.
The budget or financial position contains three main sections: assets (the company’s property such as money, equipment, products, buildings, land, and money with others, such as customer debts), liabilities (loans that the company will pay in the future, money that must be paid to suppliers for what was purchased in installments or on credit, and overdue rights for employees) Finally, the rights of the shareholders or the owners of the company, including the capital they paid and any profits withheld).
The budget answers the following questions:
What does the company own in terms of equipment, buildings, stock, cash, etc.?
What are the things that the company has to pay in the future, such as loans and the price of things purchased by installments or wages that have not been paid?
What are the shareholders’ rights in this company?
Thus, it enables us to know whether the company’s property enables it to pay its obligations. We also learn about the size of the company’s debts in relation to shareholders’ equity, meaning that we know the extent to which this company relies on borrowing.
Important terms in this list are:
The financial position of the company … on December 31, 2009
thousands of pounds
Current assets
510 cash and the like
90 stock
110 accounts receivable
710 total current assets
Fixed assets
2,250 lands
3,730 buildings
3,130 equipment
9,110 total fixed assets
9,820 total assets
Assets
These are the things that the company owns, such as cash, equipment, inventory, etc. These assets are divided into:
I have two parts
A- Current assets (or current assets).
They are cash and assets that can be converted into cash within less than a year, and accordingly, they include: cash, accounts receivable (cash that will be collected from customers and others), inventory, and securities (stocks and bonds) owned by the company.
B- Fixed Assets (or non-current) Fixed Assets
They are the things owned by the company that cannot be converted into cash within a short period (a year), such as: equipment, buildings, and land. Note that the equipment and buildings are recorded at their book value, which is their actual purchase value less the depreciation value that was calculated since the purchase of this asset (or the beginning of operating the asset) until the date of this statement (financial position). For example, suppose that the company purchased equipment from four years ago at an amount of one million pounds, and it is depreciated regularly over twenty years (for example), and therefore the financial statements during the four years were loaded with an amount of 200 thousand pounds, and therefore the value of this equipment in the statement of financial position is 800 thousand pounds . The price of this equipment in the market may have increased a lot, but this is not taken into account when preparing the financial statements so that the process is not discretionary (except in special cases). Note that if the assets are sold, they are of course sold at the market price and not at the book value.
The financial position of the company … on December 31, 2009
thousands of pounds
current liabilities
110 accounts payable
70 installments for long-term liabilities
30 accrued expenses
210 total current liabilities
long-term commitments
610 long term loan
610 total long-term liabilities
820 total commitments
Liabilities
These are the obligations that the company has to pay off from short-term debts and long-term debts, and the money that the company must pay to suppliers in exchange for services that have already been completed or for things that have been purchased. Liabilities (or deductions or liabilities) are divided into:
A- Current Liabilities
They are the obligations that the company must pay within a year from the date of the statement of financial position and include short-term debts, suppliers’ rights that will be paid in the coming months, and any expenses due soon
B- Non-current (or long-term) liabilities
These are the obligations that the company will pay off in the long run, such as long-term debt
The financial position of the company … on December 31, 2009
thousands of pounds
Shareholders’ equity
6,000 capital
1,700 retained earnings
1,300 reserves
9,000 total shareholders’ equity
Share Holders Equity
Shareholders’ equity includes the capital paid by shareholders when purchasing shares of the company plus retained (or retained) earnings and reserves. Note that part of the company’s profits are distributed and a part is retained to be invested in the company. Therefore, the shareholder’s rights include what he paid to the company for the share (nominal value) in addition to the profits withheld.
It is noted that the financial position statement always achieves the following equation
Assets = Liabilities + Shareholders’ Equity
Or that shareholders’ equity is equal to the difference between assets and liabilities. If the liabilities are equal to zero (for example), the shareholders’ equity is equal to the value of all assets. Thus, the increase in the difference between liabilities and assets at the end of the year compared to the previous year means making profits
This is the same financial position statement in English
Balance Sheet of ……Co. in December 31 2009
LE’000
Current Assets
510 Cash and equivalents
90 Inventory
110 Accounts Receivable
710 Total Current Assets
Fixed Assets
2,250 Land
3,730 Building
3,130 equipment
9,110 Total Fixed Assets
9,820 Total Assets
Current Liabilities
110 Accounts Payable
70 Current portion of long term loan
30 Accrued Expenses
210 Total Current Liabilities
Long Term Liabilities
610 long term debt
610 Total Long Term Liabilities
820 Total Liabilities
Shareholders Equity
6,000 Sahre capital
1,700 Retained Earnings
1,300 Reserves
9,000 Total Shareholders Equity
Third: the cash flow statement
This list shows the cash flows, that is, the cash that flowed into the organization (or out of the organization) by selling products, for example, and the cash that flowed out of the organization by purchasing materials and raw materials, paying debts, and others. The company’s ability to manage cash flows is an important matter that affects the future of the company, so this list was a way to clarify this matter. This list consists of the sum of the increase and decrease that occurred in cash as a result of the company’s buying and selling, debt repayment and borrowing, and therefore this list looks as follows
The cash flows are divided into three sections
Statement of cash flow for the company … for the year 2009
thousands of pounds
cash flows from operating activities
290 net profit
326 depreciation
(126) Changes in inventory
50 changes in accounts receivable
(70) Changes in accounts payable
470 Total cash flows from operating activities
cash flows from investing activities
(70) Purchase of equipment
100 land sales
30 Total cash flows from investing activities
cash flows from financing activities
140 The increase in long-term loans
(70) Loan installments
(50) Dividends
20 Total cash flows from financing activities
520 net increase in cash
250 cash balance on January 1, 2009
770 cash balance on 31st December 2009
Cash flow from operating activities
They are the cash flows due to the company’s basic activity, and therefore they include net profit, change in the value of inventory, accounts receivable, credit and others
Cash Flow from Investing Activities
It includes t
Cash flows as a result of buying fixed assets or selling fixed assets
Cash Flow from Financing Activities
It includes monetary changes as a result of paying off debts, borrowing, buying shares, or distributing dividends
Net Change in Cash
The sum of the previous three parts shows the change in cash at the end of the period (for example, the year) from its beginning. The statement of cash flows also shows the balance of cash at the beginning and at the end of the period
Statement of Cash Flow for……Co. for 2009
LE’000
Operating Activities
290 Net Income
326 Depreciation
(126) Changes in inventory
50 changes in accounts receivable
(70) Changes in payable accounts
470 Total cash flow from operations
Investing activities
(70) Acquisition of equipment
100 selling land
30 Total cash flow from investing activities
Financing Activities
140 Increase in long-term debt
(70) interest expenses
(50) Dividends
20 Total cash flow from financing activities
520 Net change in cash
250 Cash on Jan 1st 2009
770 Cash on Dec 31st 2009
Fourth: List of changes in shareholders’ equity
Statement of retained earnings
This list is additional, and it clarifies the value of the accumulated shareholder’s equity and the details of that in terms of capital, retained earnings, etc. The more shareholders’ equity exceeds the capital, meaning that the greater the cumulative value of retained earnings, the better for shareholders, because it means that their rights increase, meaning that their investments increase.
List of changes in the shareholders’ rights of the company ……… in 2009
Total Retained Earnings Capital Reserves
Balance at January 1, 2009 1,300 1,300 8,760 1,460
(50) (50)
Dividends in 2009
290 290
Net profit for the year 2009
9,000 1,700 1,300 6,000 Balance at December 31, 2009
Changes in Shareholders’ Equity for…..Co. for 2009
Total Retained Earnings Reserves Share Capital LE’000
8,760 1,460 1,300 6,000 Balance at Jan 1st 2009
(50) (50)
Dividends
290 290
Net Income for 2009
9,000 1,700 1,300 6,000 Balance at Dec 31st 2009
Summary of key financial figures:
We can now summarize the key numbers that we wanted to know as follows:
Key financial numbers
thousands of pounds
2,600 net sales
700 gross profit
290 net profit
2.9 Earnings per share in Egyptian pounds
710 total current assets
9,110 total fixed assets
9,820 total assets
210 total current liabilities
610 total long-term liabilities
820 total commitments
9,000 total shareholders’ equity
520 net increase in cash
770 cash balance on 31st December 2009
What do we benefit from?
From this information we know:
A- This company has made profits
b- The earnings per share for the year is 2.9 pounds
C- The current liabilities are much less than the current assets, meaning that the company can easily pay its short-term liabilities
D – The company’s fixed assets are very large
C- It is also clear that the company relies on financing its projects through shareholders, because the ratio of liabilities to capital is very low
H- The cash balance in the company is considered high, rather it is much greater than current liabilities, and this may raise a question about a deficiency in cash management because it might have been better to utilize part of the available cash in short-term investments.
G- There is a significant increase in cash from the beginning of the year
If we compare this year’s numbers to last year, we will learn about the development of these numbers, which gives us a good idea of the company’s improvement from year to year, but the financial numbers for the previous year are not known in this example to simplify matters.
General Notes
A- You will often find the budget presented for at least two consecutive periods, such as finding the last year’s budget next to it the figures for the budget of the year before last, so that the reader can compare between them
b- Knowing the main financial figures is a means of analyzing the company’s performance from a financial point of view
C- You may find in the income statement many types of net profit, such as: net profit before tax, net profit before zakat, net profit before tax and interest. These are all types that do not differ from net profit except by an increase in tax, zakat, or tax and interest on debts
D – The capital that we are talking about, which is one of the rights of the shareholders, is the paid-up capital
C- There is a difference in accounting systems from one country to another. You may find some expenses such as research and development in one country that are considered expenses in the sense that they must be deducted from the net sales of the current year, and in another country the systems may allow deduction by the depreciation method, that is, over several years.
H- The budget shall be accompanied by some clarifications, which may contain some things related to the financial statements
g- You can search for the financial statements of a company by looking at the company’s website. You may find the financial statements or a summary thereof, or you can find them within the annual report, and you can view the website of the stock exchange in which the shares of that company are traded. It is a good site to view lists of foreign companies
Reuters and you can register for it for free. To search on this site, select Symbol look up, then search by company name
d- The term debtors means debtors to us, as well as credit balances meaning credit to us, and debit balances meaning debtors to us. Also, the term “customers” may be used to mean customers who owe us, and the term “suppliers” to mean suppliers who are creditors to us.
D – Sometimes the amounts that are deducted (such as the cost of sales or taxes) are written in brackets, and sometimes they are written in brackets and in red, and they may be written without brackets and in the same color as the rest of the numbers. Likewise, if the net profit is negative, meaning that the company has achieved losses, then this may be written in brackets or brackets and in red, or written under the name of net loss without brackets and in the same color as writing the rest of the numbers.
Q analysis
and financial lists
How do we evaluate the financial performance of a company?
After we understand the basic numbers in the financial statements and what they mean, we find ourselves wondering how to use these numbers. What does it mean that a company’s net profit is 10 million pounds this year, and what does it mean that another company’s profits are only 5 million pounds? Is the first company better than the second? Are the two companies successful? Are the two companies have a prosperous future? In fact, all we know from these two numbers is that both companies made profits this year, and we cannot answer any of the questions posed. Why? Because we do not know the value of the investments of both companies until we compare them, and we do not know their profits in previous years until we know whether their profits are increasing or not. We also do not know the profits of similar companies for each of them so that we can evaluate their performance compared to similar companies. This leads us to the different ways of using the financial statements to evaluate the performance of companies, but before that we need to get acquainted with the financial ratios because of their great value in analyzing the financial statements.
Financial ratios
Suppose a company has sales of 10 million and a net profit of 1 million, then the following year the sales are 20 million and the profits are 1.2 million. How do you see the company’s performance? The company has succeeded in increasing sales and has succeeded in increasing profits, but the problem is that the increase in profits is not equivalent to the increase in sales, which explains the increase in cost. The same applies if current liabilities double and current assets increase by 10%, and profits double and fixed assets quadruple. Therefore, analysts have created some ratios that help us link these indicators together. Of famous and important proportions.
profitability ratios
Profitability ratings
profitability ratios
Gross profit, net sales, gross profit margin
net profit, net sales, net profit margin
Net Profit Average Equity Rate of Return on Equity
Net Profit Average of Total Assets The rate of return on assets
A- Gross profit margin
Gross profit margin
It is the ratio of gross profit to net sales. The higher this ratio compared to competitors, the more efficient the operating operations, because the ratio of cost of sales to net sales is lower than that of competitors
Example: Suppose you manufacture school bags and at the end of the year you find that you have sold 100 bags at a price of five pounds, while the cost of producing one bag is four pounds. This means that:
Net sales 500 pounds
The cost of sales is 400 pounds
The total profit is 100 pounds
gross profit margin 20%
What if your competitor achieves a gross profit margin equal to 25%, which means that he is able to increase the difference between the cost of the bag and the price of the bag, and this means a greater ability to reduce the cost of the product.
B- net profit margin
Net profit margin
It is the ratio of net profit to net sales. This ratio shows the company’s ability to make a profit as a result of sales. Note that the profit margin charged may be high while the net profit margin is low, because the cost of sales does not include the additional costs of marketing, administrative expenses, and loan interest. In this case, this is an indication of the success of the basic process, while the failure of the company in other respects, meaning that there is an additional cost charged to the company’s expenses that has nothing to do with the basic cost of the product.
Example: Suppose in the previous example that your net profit margin during the past year is 10%, while your competitor achieved only 8%. This means that even though your competitor was able to maximize their gross profit margin, their extra expenses were more than yours. This may be due to excessive marketing expenses, costly supervisory operations, or excessive debt interest, and so on.
C- the rate of return on equity (or equity)
Return On Equity ROE
It is the ratio of net profit to average shareholders’ equity. Since shareholders’ equity at the beginning of the year differs from that at the end of the year, we use average equity
Average Equity = 0.5 * (Average Equity at the beginning of the year + Average Equity at the end of the year)
Some use the average shareholder’s equity as shown above and some use the shareholder’s equity at the end of the year, and this is repeated in other ratios
This is a very important indicator because it shows the percentage of return on investment represented in shareholders’ equity. The lower the value of this ratio, the worse it is for the company’s performance.
Example: You and your friend participated in a stationery store and each of you paid half of the capital, which is twenty thousand dinars, then you made profits in the first year that amounted to one thousand dinars, and they were withheld, then in the second year they amounted to four thousand dinars. What is the rate of return on equity in the second year?
Average shareholder equity = 0.5 * (20,000 + 21,000) = 20,500 dinars
Return = 4,000 dinars
Return on Equity = 4,000 / 20,500 = 19.5%
Is this ratio good? As for the bank’s return, it is considered a good percentage because the bank usually does not give a return close to this percentage. Note that the return in the first year was very low, but this is not considered a bad indicator because it is normal for the profits of the first year to be less than the profits of the following years due to the lack of knowledge among customers of the company and therefore the need to bear high advertising expenses as well as some other expenses. This shows that the financial numbers are not analyzed in isolation from the rest of our information about the company.
D- The rate of return on assets
Return On Assets
It is the ratio of net profit to total assets (i.e. the sum of current and fixed assets). Total assets or average total assets can be used.
This ratio is similar to the rate of return on equity in that they both measure return on investment in one way or another. The rate of return on assets measures the company’s ability to invest the assets it owns, such as equipment, buildings, land and inventory. You might think that some activities need more assets than others, that’s right
Therefore, comparing this percentage between two companies operating in two different fields does not give us an indication of the failure of this or the success of that. However, we can compare the value of this indicator for the same company year after year, or compare it with similar companies in terms of the nature of activity.
Activity efficiency measurement ratios or asset management measurement ratios
Efficiency Ratios or Asset Management Ratios or Activity Ratios
Activity efficiency measurement ratios
Cost of sales Average inventory Inventory turnover
Net sales Average accounts receivable Turnover rate Amounts under collection
Net sales Average total assets Turnover of total assets
A- Inventory turnover rate
Inventory Turnover
It is obtained by dividing the cost of sales by the average inventory (or inventory).
This indicator shows the number of times inventory turnover during the period (a year, for example). This ratio enables us to calculate the average period of stay of the product in stock, which is:
Average product remaining in stock in days = number of days in the period (365 in the case of a full year) / inventory turnover
This ratio shows how quickly products are sold.
B- The turnover rate of amounts under collection
Receivables turnover
It is obtained by dividing net sales by average accounts receivable (or accounts receivable at the end of the period). Thus, we can calculate the average collection period in days = number of days of the period (365 in the case of a full year) / turnover rate of amounts under collection
This percentage indicates the shortness or length of the collection period. Note that the long collection period does not necessarily indicate an administrative failure, because some companies allow customers to pay the value of the product after a month or two, or in installments, and this is considered an encouragement to customers to buy.
T- Total assets turnover ratio
Total Assets Turnover
It is obtained by dividing net sales by the average total fixed and current assets (or total assets at the end of the period). The higher this ratio, the better, but it must be taken into account that this ratio varies from one sector to another because some activities require large fixed assets, while other activities may not require large fixed assets.
Liquidity ratios or financial strength ratios
Liquidity Ratios or Financial Strength Ratios
Liquidity ratios
Current assets, current liabilities, turnover rate
Fast current assets, current liabilities, fast turnover
A- Turnover rate
CurrentRatio
It is the ratio of current assets to total current liabilities. If the current assets are much less than the current liabilities, this indicates that this company will face problems in paying its obligations.
Example: You are a rich man, and a person who owns an investment project came to borrow from you because he suffers from a lack of cash, and this person tries to convince you of his ability to pay, and imagine this dialogue
Rich: I don’t mind lending you, but I see that your business is faltering, and you will not be able to repay it
Borrower: Actually, my business is doing very well and we have made profits this year that we have not made before
Wealthy: But this is not proof of your ability to pay
Borrower: It is true that I need to borrow now, but I have a lot of things that will help me pay in a few months, as many customers will pay for the goods in the next two months, and I also have a stock estimated at two months of sales and it will be sold soon, and I also have many shares that I will sell This month
Al-Thary: Good talk. But I know that you owe others, so how can you repay all this? I don’t think you can do that?
The Borrower: Yes, I borrowed from my uncle and a friend of mine, and I have some arrears to suppliers, but all these dues are equal to half of what I own in terms of inventory, dues from clients, and the value of shares that I own, and therefore I have no problem with repayment.
Don’t you see that they are discussing the value of the turnover rate? Whenever this ratio is greater than one, this indicates the existence of current assets with the company that enable it to pay obligations such as debts and arrears of the company.
b- Rapid turnover rate
quick ratio
It is the ratio of quick current assets (which is total current assets minus inventory) to total current liabilities. This ratio is similar to the turnover ratio except that it excludes inventory on the grounds that it takes time to convert to cash
In the previous example, the rich man could have responded to the borrower when he talked about the existence of his stock by saying:
Rich: I don’t care if you have stock, because we don’t know that you will find someone who will buy it or that it will not perish in the stores.
Hence the importance of the fast turnover rate, because it does not take into account the inventory and thus gives greater guarantee of the company’s ability to fulfill its obligations.
Borrowing Ratios (or Leverage Measurement)
Financial leverage ratios or debt ratios
borrowing ratios
Total Liabilities Total Assets Borrowing Ratio
Total Liabilities Equity Equity Ratio of Borrowing to Equity
A- Borrowing ratio
Debt Ratio
It is the ratio of total liabilities to total assets. This ratio shows the company’s ability to meet its short and long term obligations.
B- Borrowing to Equity Ratio (or Financial Leverage)
Debt to equity ratio
It is the ratio of total liabilities to shareholders’ equity. This ratio shows the extent to which the company relies on borrowing to finance investments.
Dividend ratios
A- The rate of profit distributed per share
Dividend Yield
Dividend ratios
Dividend per share Market price per share Dividend rate per share
Dividend Dividend Net Profit Distribution Percentage
It is the ratio of the annual dividend per share to the market value of the share. This ratio is important for the investor who is interested in the periodic cash return. Suppose that a person wants to buy shares in order to obtain an annual return of not less than a certain value, in this case knowing this percentage affects his decision to buy the share or not to buy it
b- Distribution ratio
Payout Ratio
It is the ratio of dividends to net profit. This ratio shows S
The company’s policy in distributing profits.
Market value measurement ratios
Market ValueRatios
Market value measurement ratios
Market price of a share Annual return per share The coefficient of share price to earnings
Market price per share Book value per share The ratio of share price to book value
a- Share price-to-earnings coefficient (or price-earnings multiplier)
Price to Earnings Ratio P/E
It is, as it appears from the name, the ratio of the share price in the market to the return (distributed and retained) on the share. The more investors in the stock market expect the company’s profits to increase year after year, the higher this percentage will be.
Example: Would you accept buying a share whose annual profitability is 100 riyals annually (which has been fixed for several years and is expected to be stable for years to come) for 2000 riyals?
Most likely, you will not agree, because the return in this case reaches 5% annually, which is a small return. What if you expect profits to more than double in the next year? If the profits doubled, the return would be 10% per annum, so you might be willing to pay 2,000 riyals for this stock now.
B- The ratio of the market price to the book value
Market to Book Value
It is the share’s market value to its book value
Book value per share = shareholders’ equity / number of shares
This ratio indicates whether the share’s value in the market is lower or higher than its arithmetic value based on the rights owned by this share with the company. Thus, it shows whether investors in the money market expect an increase in the company’s profitability in the future or not.
Example
We want to calculate all the financial ratios of a company knowing that the financial figures for two consecutive years are as follows:
Key financial numbers
thousands of pounds
2004 year 2005
1,410,000 1,500,000 net sales
685,000 780,000 cost of sales
725,000 820,000 Gross profit
420,000 546,000 net profit
1,500,000 1,820,000 Current assets
2,700,000 3,300,000 Total assets
1,330,000 1,550,000 Current liabilities
1,400,000 1,910,000 Total liabilities
1,300,000 1,390,000 Total shareholders’ equity
380,000 350,000 Inventory
260,000 310,000 Accounts receivable
112 127 The share price in the market is in pounds
31,500,000 31,500,000 number of shares
390,000 455,000 Dividends distributed
We first start by calculating some of the values that we will need to calculate the financial ratios
Some numbers needed to calculate financial ratios
thousands of pounds
1,345,350 average shareholders’ equity
365,000 average inventory
285,000 average accounts receivable
3,000,000 average total assets
17.3 Earnings per share in Egyptian pounds
14.4 Earnings per share in Egyptian pounds
44.1 The book value of the share in Egyptian pounds
Then we calculate the financial ratios, and we get the following ratios:
The financial ratios of the company ………………… for the year 2005
54.7% Gross Profit Margin
36.4% net profit margin
40.6% Return On Equity (ROE)
18.2% Return On Assets (ROA)
2.14 Inventory Turnover
5.26 Accounts Receivable Turnover
0.5 Total Assets Turnover
1.17 Current Ratio
0.95 Quick Ratio
0.58 Debt Ratio
137.4% Debt to Equity Ratio
11.4% dividend rate per share Dividend Yield
83.3% payout ratio
7.3 Price to Earning Ratio
2.9 The ratio of market price to book value
different analysis methods
When the doctor evaluates the condition of a patient, he begins by estimating whether this person is actually sick or not, then compares the results of the patient’s analyzes with the results of his ilk, i.e. the usual numbers for a normal person and the usual numbers for those of his age, and he may also be asked to perform analyzes at intervals in order to see if Was his condition improving or not? This is what we can do to evaluate the performance of companies using the financial statements and the ratios derived from them.
A- Absolute Analysis:
This analysis means evaluating the company’s current performance. If the company is making losses, then this is a bad indicator. If the value of current liabilities exceeds current assets, then this is a bad indicator. If the return on investment is less than the bank’s return, then this is a very bad indicator, and so on.
Example: Look at these numbers and financial ratios and try to deduce information about the company’s performance
The total profit is one million pounds
Net profit million pounds
The rate of return on equity is 2%.
The share price-to-earnings coefficient 5
Rapid turnover rate of 0.4
What do we conclude from these numbers?
It is clear that the company achieved profits this year, but many numbers and ratios do not bode well. The rate of return on shareholders’ equity is very low, the rate of rapid trading indicates a lack of liquidity, and the coefficient of the share price to its profitability shows the fear of investors in the capital market about the future of this company.
This analysis gives us a simplified idea of the company’s performance, but it does not take into account the evolution of the company’s performance over time, its performance compared to competitors, and the effect of the nature of the activity on some financial ratios.
b- Historical analysis
This method means analyzing the development or deterioration of the company’s performance over time. For example, if profits increase with time, this is a good indicator, and vice versa. The company may achieve high profits, but it is much less than last year, or the return on equity is high, but it is less than last year, or vice versa. Analyzing the numbers and financial ratios of the same company for several consecutive years enables us to know whether this company is improving or declining.
Example: Look at the following graph that shows the change in a company’s earnings from 2002 to 2005. What do you notice?
The company’s profits are constantly increasing, which indicates an improvement in performance from year to year and heralds a better future for this company.
Another example: Look at the change in the net m value
Another company’s sales from year to year. what do you notice?
Net sales are significantly lower from year to year, which indicates a decline in the company’s performance from year to year for four consecutive days. Note that sales reach 60 million pounds in the last year, which is a large number for other small companies, but it does not reflect that the company’s performance is remarkable, as we have noticed a decline in net sales year after year.
C – proportional analysis
As the doctor compares the results of the patient’s analyzes with the usual results for a normal person in the world, as well as the usual results for someone of the same age as the patient and in the same country in which he lives, it is natural to compare the results of the company and similar companies in the world, as well as similar companies in the same region and the same country . Why? Because the success of the company may be due to the prosperity of the market last year or vice versa, as well as some percentages may be low due to the nature of the activity. As we mentioned, some industries need huge fixed assets, while other industries or some services do not need this amount of fixed assets. Therefore, comparing the company’s performance with competing companies or operating in the same field gives a more accurate picture.
Example: The following table shows the financial ratios of a company and those of competing companies. How do you comment on the company’s performance based on the available information?
Financial ratios of competing companies
Competitor Company B Competitor Company A Our Company
9% 8% 7% rate of return on assets
15% 16% 12% Rate of return on equity
9% 5% 6% net profit margin
6 3 2.5 Inventory turnover
2.3 2.7 2.2 Turnover
28% 35% 20% distribution percentage
It is clear that the company’s overall performance is lower than that of competitors. The rate of return on assets and the rate of return on equity are lower than these two rates of the two competing companies. The inventory turnover rate is much lower than that of competing companies, which means that the inventory will remain for a long time within the company compared to competitors. The net profit margin is higher than one of the two competitors but lower than the other. Turnover and distribution ratios are comparable to competing firms. It seems that this company needs to study ways to increase sales in order to improve the return on assets and shareholders’ equity, and this may require a review of marketing methods or a review of the product itself.
Some websites and agencies calculate average financial ratios for each sector, so these websites and agencies enable us to compare our performance with the average of the sector. If this information is available, using it enables us to compare our performance with the average performance in the sector in which we operate.
Example
A company working in the field of furniture industry. Some of the financial ratios for this company and the average companies working in the field of furniture industry were as follows
The financial ratios of a company and the average ratios of the sector
Average sector our company
6.0% 5.5% rate of return on assets
11% 14% rate of return on equity
4% 5% net profit margin
10 8 inventory turnover
1.8 1.1 turnover
40% 70% distribution percentage
Comparing the financial ratios of this company with the industry average shows that the company’s performance relative to the industry average is good, as the rate of return on shareholders’ equity is higher than the industry average, as well as the net profit margin. The rate of return on assets is close to the industry average. It is noted that the company needs to improve its inventory turnover rate, which is below the industry average. The company’s turnover ratio is less than the industry but it is not bad because it is greater than one. The distribution ratio shows that this company distributes a higher percentage of profits than the industry average, which means that it retains a lower percentage than the competing companies.
Note that in the absolute and historical analysis we can use both the numbers in the financial statements as well as the financial ratios. In the case of relative analysis, we can only use financial ratios, as it is meaningless to compare the obligations of one company with another company, or the profits of one company with another company, but comparing the net profit margin, rate of return, or other ratios enables us to compare the performance of one company in relation to other companies.
D – Comparison with the previously set goals
Before the beginning of each year, the company’s management sets the company’s goals for the following year, including some financial figures. After the end of the year, the company’s management compares what was achieved with what was planned to identify areas of weakness and determine the reasons for not achieving some of the goals. This analysis is only concerned with the employees of the company.
General Notes
You won’t find all the information in the financial statements
The financial statements contain very important numbers, but we need to analyze them in light of many variables such as market fluctuations, the entry of new competitors, the start of investing in new projects, the existence of temporary financial burdens, and others. For example, a successful company may realize losses after it was making profits because it started a new project that will bear fruit in the coming years. Also, a company may achieve profits as a result of a surge in demand for its product, and expectations for the continuation or collapse of this demand determine our view of the company’s expected performance in the coming years.
There are many other ratios
In explaining the financial ratios, we limited ourselves to the most used financial ratios, but there are many other ratios that you may encounter. In light of the understanding of the financial ratios mentioned here, we can understand the usefulness of any financial ratios. We may also introduce financial ratios that show the company’s performance in a specific part. For example, to find out if a company spends on research like other companies, we measure it by the ratio of research expenses to net sales. And if we also want to know whether spending on marketing is exaggerated, we compare the ratio of marketing expenses to net sales compared to competing companies.
Use more than one method to analyze corporate performance
In most cases, absolute, historical and relative analysis is used, and one is not indispensable to the other. For example, it may be a company that operates in a very troubled sector, but it is one of the best companies and achieves the least losses.We may consider changing the company’s activity, liquidating it, or not investing in it. As I mentioned earlier, the company’s achievement of good financial ratios, but they are much lower than the average of competing companies, means that the company’s performance is poor. Therefore, the use of the three methods gives us a more integrated picture. As for the method of comparing the results with what was planned, it is a matter for the management of the company, and the investors are not able to know these plans and do not care about them in the first place.
Use the numbers and financial ratios that influence your decision
According to the objective of the financial analysis, some numbers and financial ratios are more important. If you are going to lend this company, you care about liquidity ratios, and if you are thinking of buying shares in it, you care about profitability ratios and market value ratios more than other ratios, and if you compare your company to competitors, you care about most ratios, and if you care about comparing the company’s performance in basic operations such as Manufacturing you care about the gross profit margin ratio and so on. Therefore, it is not necessary to analyze all numbers and all ratios in every financial analysis, but rather the relevant numbers and ratios are analyzed for the purpose of financial analysis.
Beware of different definitions of financial ratios
There are some differences in defining financial ratios, such as using the average of total assets or total assets according to their value in this year’s budget when calculating the return on assets. When using financial ratios from a website or publications and comparing them with financial ratios from another source, you should make sure that the financial ratios are calculated in both cases using the same method.
