How do I evaluate a company’s financial performance?

1. Introduction

When evaluating a company’s financial performance, it is important to look at its financial statements. This method is referred to as fundamental analysis, which involves looking at past figures to determine future estimates. Financial statements can be found in a firm’s yearly statements (referred to at 10-Ks), quarterly statements (referred to as 10-Qs), and annual reports. In order to get the most accurate view of a firm’s financial situation, it is best to obtain the numbers from the source: the actual company.

You can usually get a firm’s yearly statements or annual report from its Web site, but you may have to request it by mail. Below are other sources, including free Web sites and library databases, which you can use to find annual reports.

Web Sites

EDGAR Database - US Securities and Exchange Commission (SEC)

All foreign and domestic companies must file registration statements and reports with the US Securities and Exchange Commission (SEC). Use the EDGAR database to find annual company reports from American and international companies. Select "Search for Company Filings" and then choose to search for companies, latest filings, historical EDGAR archives, Central Index Key (CIK), current events analysis, or mutual fund prospectuses. To find company information, choose "Companies and Other Filers". Use the search engine to find company information by company name, state, file number, CIK, or SIC code. A brief database tutorial is provided on the home page.

Search for company financial information, SEC filings, Annual Reports, or bankruptcy filings. Also allows you to compare companies. 100% full text.

Once you have the annual report, it is important to know how to analyze it. Just what do all the numbers mean? What is the firm looking to achieve in the future? What mistakes has it made in the past? Who is in charge of the company and what kind of job are they doing with it? All of these questions can be answered just by taking at look at the Annual Report.

Here are the general contents of the Annual Report and what you should glean from them.

A. What is in a Letter from Management?

An Annual Report usually begins with a letter from upper management, explaining the actions and/or repercussions of their actions over the past year. This won’t give the reader the details of the financial statements, but it will provide an overview of the past year’s performance and some of the highlights of the past couple of years. If this letter confesses to mistakes and wrongdoings, then you can tell the company’s management is forward and honest about things. This honesty is a very positive attribute for a company. Towards the end of the letter, the company’s management should discuss future challenges for the company and how the company will accomplish its future goals.

Example: Procter & Gamble’s Letter to Shareholders 

Click the "Next" button at the top to see the subsequent pages of the letter to shareholders.

Also known as the "Report of Independent Accounts," the Auditor’s Report is important because the auditors review the financial statements of the company. It is the main duty of the auditor to confirm to the public that a company’s financials are accurately expressed and are disclosed properly. This report is usually broken up into three paragraphs:

Ö Tells the auditor’s responsibility and which financial statements were audited.

Ö  Tells how GAAP (General Accepted Accounting Principles) were applied and which parts of the company were assessed using these principles. GAAP is the set of common accounting principles, standards and procedures. When a company follows GAAP in its financial reporting, then it is easier for investors to compare it to other companies.

Ö  Tells the auditor’s opinion on the financial statements.

Again, this is not going to tell you any financial details of the company, but will provide you with the assurance that the financial statements you are analyzing are credible and truthful. Credible financial statements make investor’s decisions easier to make.

Example: Procter & Gamble’s Auditor’s Report 

C. What is on the Balance Sheet?

The balance sheet records performance for a split second in time. This is contrary to how the Income Statement and Statement of Cash Flow reports performance, which is over a period of time. The Balance Sheet is separated into three parts: assets, liabilities and equity. It is called the Balance Sheet because it balances out: Assets = Liabilities + Equity. This can sometimes be remembered as A = L + OE (or ALOE), in which Equity is called by its longer name, Owner’s Equity.

What are included in Assets?

Current Assets – Includes cash, accounts receivables, and other assets that are highly liquid (can be converted into cash easily)

Property and Equipment – This includes not only property and equipment, but also all long-term operating assets, minus depreciation on these assets

Other Assets – Anything that didn’t fit into the categories above that adds value to the company

Goodwill – The excess of the purchase price over the fair market value of an asset

What are included in Liabilities and Owner’s Equities?

Current Liabilities – All of the companies liabilities that will come due within 12 months

Long-term Liabilities – Debt maturing in more than 12 months

Stockholder’s Equity – Reveals how the remainder of the company’s assets are financed, including common and preferred stock, treasury stock and retained earnings

Example: Procter & Gamble’s Balance Sheet 

Procter & Gamble’s balance sheet takes up two pages, so be sure to look at both of them in order to get the full picture.

D. What is on the Income Statement?

The income statement tells you how much money a company brought in, how much it spent, and the difference between the two over a period of time. The outlay of the income statement is as follows:

Revenue – proceeds that come from sales to customers (number of items sold x price for items)

Cost of Goods Sold – (COGS) – expense that shows how much it cost to make each product or good that generates revenue

Gross Margin – (Gross Profit) Revenue minus COGS

Operating Expenses – any expense that doesn’t fall under COGS (i.e. – administrative, marketing expenses)

Net Income before Interest and Tax – net income before taking account for interest and taxes

Interest Expense – payments made on the company’s outstanding debts

Income Tax Expense – Amount payable to the federal/state government (interest expense x the tax rate)

Net Income – Expenses – Revenue (final profit)

Net Income per Share – (EPS) Net income divided by the number of shares (stock) outstanding

Example: Procter & Gamble’s Income Statement 

E. What is on a Cash Flow Statement?

The cash flow statement is much like the income statement, but it doesn’t take into account the non-cash items, such as depreciation. This statement simply tells you where the cash went that the company accumulated. It shows how well the company manages its cash, pays bills, creditors, and finances growth.

The recipe for the cash flow statement is as follows:

Cash from Operations - Cash earned from day-to-day operations of the company

Cash from Investing – Cash used in investing in assets, as well as cash earned on the sale of other businesses, equipment or other long-term assets

Cash from Financing – cash paid when issuing funds or received from borrowing funds. Also included here is dividends paid

Increase or Decrease in Cash – difference between last year and this year; increases are written normally, while decreases are written in (parentheses)

The cash flow statement is important because unlike earnings or dividends, there is little a company can do to manipulate its cash.

Example: Procter & Gamble’s Cash Flow Statement 

F. What is in the Notes to the Financial Statements?

An annual report’s footnotes provide more details to the financial statements. Here, you will find important things such as outstanding leases, maturity dates of outstanding debt, and the origin of the firm’s revenues. Reading these notes will provide you with information that other investors may not take the time or the effort to read.

Two types of footnotes are:

Accounting Methods – these footnotes provide you with the type of accounting policies the company uses, which can help you understand the nature of the firm’s business, the beginning and end of the firm’s fiscal year, how the firm determines its inventory costs, and other accounting principles that the firm feels the public should know.

Disclosure – These footnotes will include specific calculations that were too lengthy or detailed to be included in the regular financial statements. Examples of these include: pension plan liabilities for existing employees and details about any legal issues in which the company is involved.

Example: Procter & Gamble’s Notes to the Financial Statement  

Even though these notes go on for many pages, the information they hold is invaluable.

4. Computing and Analyzing Ratios

Now that you’ve investigated the annual statement, it might be helpful to look at more than just the raw numbers. Part of fundamental analysis is to manipulate the raw data given in annual statements into comparable ratios, so companies with differing information can be easily compared. Below are some ratios that can help you in evaluating companies. However, once you calculate these ratios, it is more important to figure out where the firm stands against its competition. You can do this by computing the company’s main competitors ratios and comparing them to one another. Another way is to relate the firm’s ratios to industry norms.

A. Ratios

Average Interest Rate at which a firm borrows.

Like earnings per share but compares the stockholder’s equity to number of shares outstanding.

The cash a company can generate in relation to its size.
Common Size Analysis – Comparing line items to one common line item (such as sales). Line items are shown as percentages of this common line item in order to compare these items over several years. Also, you can compare different firms and see if their structures are similar.

Tells us the amount of dividends paid out to shareholders.

Shows how much profit was made in relation to how many shares outstanding.

Shows how much of a margin a firm has – in other words, the difference between what a firm sells products for and how much it costs them to make those products.

This ratio determines if a stock is over or undervalued by comparing the current price and earnings. Companies that are losing money don’t have a P/E ratio; if a company has a high P/E ratio, then investors believe that the company will experience more growth in the future.

Shows us the proportion of sales that account for a company’s income. This ratio measures the efficiency of the company and also displays how strong the firm will be in bad times, such as when prices fall, costs rise and sales decrease.

Gives us an idea of the return a firm is making on its assets (also known as the ROI). Efficiently run companies will show a higher return on assets, while those that aren’t will exhibit a lower ROA.

Gives us an idea of what the firm how much of a return is being earned on the shareholder’s investment. (Growth companies usually have higher ROEs). Usually, about 10% is seen as an attractive goal for supplying dividends as well as capital for future growth.

Activity Ratios

Basically showing us the correlation between assets and revenue; more helpful for growth companies to see if they are increasing revenue in proportion to sales.

This computes the number of days it takes for the firm to receive money for its sold products. A higher number may be problematic, as it may suggest the firm has trouble collecting its receivables. However, it should be taken into consideration that different companies may have different selling terms.

Basically tells us how quickly inventory is moved out of the warehouses. If this number is too large, it could mean waste and the risk of product deterioration or obsolescence. Though at the same time, significantly low numbers may be problematic as well. This number may vary widely among companies and should only be compared to industry norms in order to make a valid comparison.

Financing

Shows us how much of a firm’s assets are financed through debt. If this ratio is over 1, it means most of the assets are financed through debt, and if the ratio is under 1, it means most of the assets are financed through equity.

Just like the Debt/Asset Ratio, this ratio shows us the ratio of equity and debt it used to finance its assets. As above, if this computes to a number over 1, it means that assets are mainly financed with debt, but if it is below 1, then the firm uses equity more often to finance its assets.

Liquidity Warnings

This ratio indicates if a firm has enough short-term assets to take care of its current liabilities. Basically showing us if – without inventory – if the firm is balanced well between assets and liabilities; if it could cover its debt with its assets. If this ratio is 1:1 (1.0), the firm is in a liquid condition. Therefore, the higher the ratio, the more liquid the company.

This ratio shows us what part of a firm’s interest expense can be paid off by its cash flow. If this ratio results in a number below 1, it means the firm is in trouble of not being able to make enough cash flow to pay its interest expenses. An ideal number for this ratio would be over 1.5.

Shows us if a firm has enough assets to cover its liabilities at this moment. If this ratio is under 1, then the firm is said to have "negative working capital" – meaning that it can’t cover its liabilities with its assets. Normally, a ratio of 2:1 or higher is seen as satisfactory because it means that the firm has a safety margin to cover any decrease in value of its current assets. Though don’t be fooled! A high number here is not always a good sign, either, because it may indicate high inventory or uninvested cash.

This ratio compares the funds that are currently (temporarily) being risked by the firm’s creditors with the funds that have been permanently supplied by owners. If the equation is too top heavy, meaning that current liabilities outweigh net worth, then creditors have less security. A good range to be in for this ratio is below 66% (which would mean that current liabilities are less than two-thirds of the firm’s net worth.

This ratio is a good measure of how much a firm depends on earnings from getting rid of its unsold inventory to reconcile its debt. By evaluating both this ratio and the ratio of Net Sales to Inventory, you can deduce how management controls the firm’s inventory. A firm may reduce its liquidity while preserving a steady Net Sales to Inventory ratio. While an increase in sales and inventory levels is beneficial, this situation, when combined with an increase in current liabilities, could signal the fact that the firm’s growth is not being made prudently.

This ratio, when compared to Current Liabilities to Net Worth, can help you determine the effect of long-term (paid for) debt on a firm. The gap between these two mentioned ratios can help you find how much relative long-term debt the firm has, which may come with high interest charges for the company. Usually, total liabilities should not add up to more than net worth, because this situation would mean that lenders have more at risk within the company than the owners of the firm.

This ratio is best when it is lower. If this ratio is high, this can mean that the firm has a low net working capital or has used too much debt to supplement its working capital.

This ratio shows us whether a company is overloaded on liquid assets (more than is needed). This helps to differentiate between companies who have lots of liquid assets and those that have invested more in fixed assets or noncurrent items. The latter firms may have trouble meeting current liabilities and obligations without strain.

Here, we can figure out how the firm is paying its suppliers compared to the volume of sales being made. When comparing this to the industry norm, if this number is higher then it may indicate that the firm might be using its suppliers to fund its operations. This high ratio may also turn off possible short-term creditors because it may signal that the firm has trouble paying the firms it works with.

B. Ratio Calculators and Resources

Web Sites

Yahoo Finance – Sector Summary
This site provides several ratios for each sector. For more detail, you can click on the sector name to reveal a breakdown of industries within that sector and their ratios. From there, click on the industries to view the corresponding companies that make up that industry and their individual financial ratios.

Financial Ratios
By inputting some information about the company, this site will compute some profitability, operating, liquidity and solvency ratios. This can be helpful when you need to compare many companies very quickly.

Bankrate.com Small Business Calculators
This site provides calculators for current, quick and debt to assets ratio, return on assets, gross profit margin and operating profit margin percentage.

The books listed here are held in the Reference collection in the Olin Library, Rollins College. If you are not a Rollins college student, faculty or staff member, please refer to your local public or academic libraries for these books.

Industry Norms and Key Business Ratios
REF HF 5681.R25.I525

Provides statistics on industry norms and business ratios for more than 800 lines of business. Industries are organized by Standard Industrial Classification (SIC) codes.

Business Ratios and Formulas:  A Comprehensive Guide
REF HF 5691.B73 2002

Contains performance measures for accounting, engineering, logistics, production, and sale.  Includes measures to assess financial performance, efficiency, effectiveness, capacity, and market share.

5. Conclusion

While the above instruction is provided for you to analyze a company on your own, there are also places you can go to see what analysts/experts think of the firm. While this information may not be as trustworthy as your own analysis, it can provide a different view and may point out things you did not consider. For further information, please visit our company information site. 

Bankrate.com. 14 May 2003.
<http://www.bankrate.com>. 

Dun & Bradstreet Industry and Financial Consulting Services. Industry Norms and Key Business Ratios. Murray Hill, NJ: Dun & Bradstreet Industry and Financial Consulting Services, 2002.

Investopedia.com Dictionary. 14 May 2003.
<http://www.investopedia.com>.