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
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
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.