Ian McIsaac

Tailored and Public Courses

10 Financial Analysis Tips

This is a recommended list of issues to consider when assessing the health and performance of a company.

1 - BUSINESS RISK: is the company in a risky sector or a stable sector? The level of business risk sets the expectations for the level of financial risk a company can afford.

2 - SALES: is turnover increasing or declining? Increasing sales reflect an increased market or increasing market share.

3 - REVENUE RECOGNITION: Check the revenue recognition policies in the accounting policies. Be careful of companies, for example, which have rising sales but declining deferred income balances in the creditors note. This may indicate boosting this year’s revenue in favour of next year’s.

4 - PROFIT MARGINS: compare the various ‘layers’ of profit (e.g. gross profit, profit after tax) to turnover. Can you tell what is causing a change in these margins (staff costs, interest costs etc.)? Compare the profit margins with the industry average if you are able to find this information.

5 - RETAINED PROFITS: are profits being consistently ploughed back into the business?

6 - MIX OF LIABILITIES AND ASSETS: Is the shareholders’ funds ‘cushion’ adequate or is the debt to equity ratio increasing to finance the asset side of the balance sheet?

7 - NET WORKING ASSETS: are stock, trade debtors (receivables) and trade creditors (payables) being managed efficiently and broadly moving in line with sales? Be careful of fast-growing companies with slow cash conversion cycles that are showing sharp increases in debtors and stock.

8 - CASH FLOW: by how many times does operating cash flow cover the interest payable and is it sufficient to cover all the priority payments of interest, tax and dividends? Compare the operating cash flow with the operating profit. How much cash does the company have on the balance sheet in current assets?

9 - CAPITAL INVESTMENT: Is the company replacing assets as fast as they are depreciating. Check to see if the company is making a profit on the sale of any fixed asset disposals. This is a useful screen to see if the depreciation policy is sufficiently conservative.

10 - READ THE ACCOUNTS BACKWARDS: are there any horrors lurking in the notes? The contingent liabilities (guarantees, impending lawsuits) are shown towards the back of an annual report. Watch companies that have significant investments in associates and derive an income from them.