Financial Analysis and Economic Structure of a Company

Posted on Aug 5, 2024 in Economy

Financial Function

Short-Term Goals

  • Liquidity – Solvency
  • Financial Analysis Tools
  • Budget Fund

Long-Term Targets

  • Financial Analysis
  • Analysis of Break-Even Point
  • Project Evaluation (NPV – IRR)

Financial and Economic Structure of the Company in the Financial Situation

Accounting Equation

Assets = Liabilities + Equity

  • Total Assets = Liabilities + Equity
  • Balance Sheet = General Situation showing assets and liabilities of the company.
  • From a financial standpoint, an asset is an investment, and a liability is the source of financing for that investment.

Asset Definition

Assets are all company possessions that generate future revenues or have a certain purpose.

I. Current Assets

All assets of the company with high liquidity:

  • Cash and Banks
  • Inventories
  • Accounts Receivable (Customers)

II. Fixed Assets

All company assets with less liquidity:

  • Capital Goods: Machinery, Land, Facilities, Furniture, and Vehicles.

III. Other Assets

Intangible assets that relate to the cost of organization and execution.

Liabilities Definition

Current liabilities are those obligations of the company with third parties (suppliers, banks, Treasury, and others).

  • A) Short-Term Liabilities: Suppliers – Debt – Banks
  • B) Long-Term Liabilities: Banks, Long-Term Debt
  • C) Equity (Shareholders): Obligations to the owners of the company. Capital – Net Income – Reserves

Working Capital

  • Working Capital: Current Assets
  • Net Working Capital: The difference between current assets and current liabilities.

Net Working Capital = Current Assets – Current Liabilities

Rule of Thumb

  • Short-Term Investments (Assets) should be financed by current liabilities.
  • Long-Term Investments (Fixed Assets) should be financed with long-term liabilities (Long-Term Debt and Capital).

Equity Analysis

We analyze the Balance Sheet and Profit and Loss Statement of a single period.

Reasons for Analysis

  • Liquidity
  • Leverage
  • Profitability

One objective of the finance function is liquidity.

I. Liquidity Ratios

  1. Current Ratio (AC/PC):
    • Formula: Current Assets / Current Liabilities
    • Target: >= 1
    • Net Working Capital should be greater than or equal to zero. It means that part of the permanent capital is financing current assets.
    • Represents a rough measure of the company’s ability to meet its short-term commitments. The greater the excess of current assets over current liabilities, the greater the ease of the company to meet its short-term obligations and vice versa.
    • Although it is difficult to generalize because the current ratio varies by industry, usually, a current ratio between 1.5 and 2.5 indicates an acceptable level of liquidity.
    • Calculation: AC / PC = 270/170 = 1.59
  2. Acid Test ((AC – Inventories) / Current Liabilities):
    • A measure of the degree to which cash and accounts receivable cover current liabilities. It is very similar to the current ratio but more demanding.
    • It deducts the inventory from current assets because, in some cases, their settlement is long-term and is usually the lowest starting level of liquidity in the assets.
    • A reasonable range for the acid test is between 0.8 and 1.3.
    • If less than 0.8, it indicates that there may be liquidity problems. If higher, the company can pay short-term debts without much difficulty.
    • Calculation: (AC-Ex) / PC = (270 -100) / 170 = 1
  3. Average Collection Period (Days Sales Outstanding):
    • Formula: (Accounts Receivable / Credit Sales) x 360
    • Indicates the average number of days it takes to collect on accounts receivable. In other words, the average time customers take to pay.
    • A high average collection period compared to the industry standard indicates an accumulation of funds in accounts receivable, which would mean customers are taking too long to pay.
    • This may cause losses to the company due to non-paying customers.
    • Calculation: 160 x 360 / 300 = 192 days
    • *Of the 364 million in sales, it is assumed that 300 million are credit sales.
  4. Inventory Turnover:
    • Formula: (Cost of Goods Sold / Average Inventory)
    • Establishes the average time in days in which inventories are converted into sales.
    • The fundamental usefulness of this ratio is to measure the degree of liquidity of inventories and the company’s policy regarding them.
    • Calculation: 100 x 360 / 200 = 180 days

II. Debt Ratios (Solvency)

  1. Debt-to-Equity Ratio:
    • Formula: Total Liabilities / Shareholders’ Equity
    • Indicates the proportion of debt used to finance assets relative to the amount of equity used for the same purpose.
    • In general, the leverage should be less than 1.
    • Calculation: 290 / 672 = 0.432
  2. Debt-to-Sales Ratio:
    • Formula: Total Debt / Annual Sales
    • Shows the relationship between the company’s income generation and its total debt to see if it can be repaid.
    • If the ratio is less than or equal to 0.5, the company should be able to meet its commitments.
    • If the ratio is between 0.5 and 1, the situation is considered adjusted.
    • If the ratio is greater than 1, there are potential problems.
    • Calculation: 290 / 394 = 0.797

III. Profitability Ratios

These are calculated from the Income Statement and aim to measure the economic result of the business (profitability).

  1. Gross Profit Margin:
    • Formula: Gross Profit / Sales
    • This index aims to discover the original source of the company’s profit.
    • The net result is what is left from sales after deducting variable costs.
    • Higher than the industry average indicates efficiency in the production process; lower than the industry average indicates inefficiency in the production process.
    • Calculation: Gross Profit / Sales = 164 / 364 = 0.45 = 45.1%
    • This ratio serves to project the operating profit of the company. Suppose sales increase from 364 million to 400 million. What is the Operating Profit?
    • 0.451 x 400 = 180.4 (Gross Profit) – 50 (Operating Expenses) – 40 (Other Expenses) = 90.4 (Operating Profit)
  2. Net Profit Margin (Return on Sales):
    • Formula: Net Income / Sales
    • A measure in percentage terms of the company’s final result to sales.
    • If this index is greater than the industry average, it means that in that year the company was more profitable than normal.
    • If lower, it means there are efficiency problems.
    • Suppose that sales increase from 364 to 400 million.
    • Net sales = 0.137 x 400 = 54.8 million Net Income
    • Calculation: Net Income / Sales = 50 / 364 = 0.137 = 13.7%
  3. Return on Assets (ROA):
    • Formula: Net Income / Total Assets
    • This ratio measures the return on total assets invested in the company.
    • It is necessary to get the most return from all company assets.
    • If the ratio is higher than the industry average, it indicates that the company is making good use of all its assets.
    • If the ratio is below the industry average, it indicates that certain assets are not generating returns as they should.
    • Calculation: Net Income / Assets = 50 / 962 = 0.052 = 5.2%
  4. Return on Equity (ROE):
    • Formula: Net Income / Shareholders’ Equity
    • The return on equity is probably of greater interest to shareholders as it indicates the return on capital invested in the company.
    • If this rate is higher than the industry average, it indicates that the invested capital is becoming more profitable than their competitors.
    • Calculation: Net Income / Equity = 50 / 672 = 0.07444 = 7.44%