Economic and Financial Analysis of a Company
1. Economic Analysis of the Company
The analysis of the income statement allows us to understand the company’s ability to generate profit and the factors affecting profitability.
Benefits and Profitability
Figures for the company’s profit within a given time are absolute. They provide valuable information and acquire a more precise meaning when compared to other magnitudes.
The profitability ratio is obtained by the ratio between profits and capital invested over time. Profitability is an indicator of the return on funds employed by the company.
Static and Dynamic Study
The static study involves understanding the profitability of U.S. companies at a given moment.
The dynamic study analyzes the company’s profitability information over several years. This allows for determining how the data has evolved and how it is expected to develop in the future.
The Income Statement
The income statement shows the origin and composition of the company’s results. Company results give rise to different types:
- Operating result (EBIT) = Operating income – operating expenses
- Profit before tax (BAT) = EBIT – financial costs
- Profit for the year or net profit (BN) = BAT – taxes
Analysis of the Income Statement
This allows us to analyze the following indicators:
- Destination of each euro entering the business
- Economic margin on sales or trading margin, obtained as a ratio between profit and sales
- Growth of sales, the ratio of sales in one year compared to the previous year
- The company’s position in the sector, using the concept of market share: Market share = (company sales / industry sales)
2. Economic and Financial Performance
Profitability (REC)
The benefits associated with total invested capital, represented by total assets.
RE = (EBIT / total assets) x 100
This measures the company’s ability to remunerate the invested capital.
Financial Performance (RF)
Net profits associated with equity and resources, indicating the net return on capital.
Economic returns can be decomposed as a product of two factors: a trade margin and the sales turnover ratio.
The company can increase its profitability by achieving the same sales amount with a higher profit margin, selling more while maintaining the same profit margin, or both.
3. Profitability and Financial Structure of the Company
A company’s investment is financed either by equity capital or external resources, or a combination of both. The choice of funding influences both the return on equity (RF) and financial stability. The use of external capital usually requires paying interest.
Financing new investments with external capital instead of equity increases the return on equity if two conditions are met:
- RE (economic efficiency) is greater than the interest rate
- The debt ratio is within recommended limits to avoid increasing the company’s financial risk
The company must achieve a financial structure that maximizes the return on capital.
Leverage Effect
Financial leverage is the effect on the company’s profitability due to using debt to finance investments. This leverage is positive when increased debt increases the company’s financial profitability.
If the profitability of the company’s assets exceeds the total interest paid for using external capital, it may be desirable to finance investments this way, as it increases the return on equity.
Economic and Financial Analysis
From an economic perspective, it is beneficial to continue borrowing as long as the return on total assets exceeds the interest rate on external resources. However, while borrowing may be economically appropriate, it may not be financially sound, as it may entail liquidity or solvency risks.
The ratio indicates how the company distributes its funding between equity and debt. The debt ratio examines the proportion of debt concerning total resources.
Values above 0.5 indicate a risky financial structure.
The opposite is also not advisable. A company with no financial risk because it only uses its own resources would be missing an opportunity to increase profitability, even though its financial security would be excellent.
Therefore, the company faces a dilemma and must seek a balance between the two types of funding, aiming to maximize financial returns within the limits of financial prudence.