The internal and external business environment is changeable, so the ability of a firm to maintain its solvency and financial stability can tell a lot about its prospects. Economics and business require numerical accuracy and do not tolerate subjective and artistic descriptions.
To identify the true state of affairs, a financial analysis was created. It is impartial and clear because it has to do with numbers and metrics. A financially literate person must distinguish a profitable company from a non-profitable one if they intend to make money in the field of business and investment.
Financial analysis is an assessment of the economic health of any company. Financial indicators, ratios, ratings and multipliers are studied and, on their basis, a conclusion is made about the financial condition of the organization.
Who May Need Financial Analysis? For example, the top management of the company. Or investors who want to study whether it is worth investing in it. Even banks that decide whether to provide this organization with a loan. A company can also list its shares on the stock exchange, and this also requires an understanding of its financial condition.
Many are interested in the financial analysis of a particular company, because sometimes even the leaders themselves do not understand that things are very bad. Everything may look just fine at this stage, but in many cases a simple analysis can show that in a year or two the company will go bankrupt. That is why analysis is so important, because it helps to see what the eyes are not capable of.
In this lesson, we will look at situations in which a person has access to all possible company information. But not everyone has access to the true state of affairs in the organization in which he wants to invest money or cooperate with it. For this, you can use indirect sources of information. Of course, this will not always be enough, but you can draw some conclusions. We offer you such tools as:
This is the so-called external data and it can be your tool for assessing the prospects of your investment. For example, if you wanted to buy shares of a company, and you do not have access to financial statements, then the above indicators can partially help you.
Content:
Let's proceed directly to the financial analysis. It has its own goals and objectives, in which all existing tools are revealed. Let's consider what tasks are facing financial analysis and what tools will be required for this.
Understand the difference between income and profit. Income is all the funds that you receive from your activities. Profit is a financial result. That is, if you earned $ 500 from the sale of goods, then this is your income. You took or made these goods somewhere and they cost you 300 dollars. So your profit is $ 200.
There can be a lot of indicators of profitability. Let's consider the most important ones:
The financial independence ratio is a financial ratio equal to the ratio of equity capital and reserves to the sum of the company's assets. For this, the balance sheet of this organization is used. This indicator displays the proportion of an organization's assets that are covered by equity.
This ratio is needed by banks issuing loans. The higher it is, the more likely the bank will give a loan to your company, because you will be able to pay off the debt with your assets. Remember, we already said that the bank considers your liabilities to be its assets? In this case, the difference is that the company's assets are simply necessary, because without most of them, it simply cannot function.
The financial dependence ratio is an indicator that is the opposite of the financial independence ratio. It shows the extent to which the company depends on external sources of funding. This indicator is also necessary for banks to make a decision on granting a loan.
The analysis of the liquidity of assets (property) calculates an indicator that indicates how quickly the organization's assets can be sold if it cannot pay off its loan debts.
Based on this analysis, management decides whether the company will invest in short-term and long-term investments. Some investments are more profitable than others, so the challenge is also to find the most effective ones. To do this, several tools are used: discounted payback period, net present value, internal form of profitability, and return on investment index .
The discounted payback period (DPP) characterizes the change in the purchasing power of money, the value of which, as we recall, decreases over time. You, as an investor, should know how long it will take to start receiving income from your investments and bring this amount in line with the present moment. Sometimes it doesn't even make sense to invest, because either it won't pay off, or it will pay off minimally.
On the Internet, you can find a calculator for calculating the discounted payback period, so we will not give the formula here. Moreover, it is quite complicated. To put it simply, then, for example, you or your company are investing in the amount of 50 thousand dollars. Each year, let's say, you will receive 15 thousand dollars in income. Enter this data into the calculator along with other indicators and you get, for example, 3 and a half years. That is, in 3 and a half years, your investments will begin to bring you real net profit, adjusted for inflation.
There is a tool called Net Present Value ( NPV) . This is the present value of an investment project, determined by taking into account all current and future receipts at an appropriate interest rate. If this indicator is positive, then you can invest in the project.
Net present value can be used not only for investments, but also in business. With this tool, a company can calculate the feasibility of expanding its products. Here everything is exactly the same: if this indicator is positive, then it is worth expanding production.
The third instrument is called the internal rate of return ( IRR) and it is also used both in business and in assessing the feasibility of investment projects. You can also calculate this indicator online. If you get a zero value, you will only recoup your investments, but nothing more. The higher the IRR, the better.
The return on investment ( PI) index is an indicator of investment performance, which is the ratio of discounted income to the amount of investment capital. It is also sometimes called the index of profitability or profitability index.
What are the criteria for assessing the likelihood of bankruptcy? With some indicators , we have already seen:
This is a very difficult job. An average business market value analysis report is about 300 pages long.
There are three approaches to assessing the value of a business : income, expense and comparative. By the way, it is also used before purchasing real estate.
The more income the company brings, the greater the value of its market value. But at the same time, important factors are the length of the period of income generation, as well as the degree and type of risks in this case. The subsequent resale of the business is also taken into account - if it turns out that this is quite likely, then this is another plus when buying it.
The essence of the expenditure approach is that all the assets of the enterprise (buildings, machinery, equipment) are first estimated and summed up, and then liabilities are deducted from this amount. The resulting figure shows the cost of the company's equity capital.
The comparative (market) approach is based on the principle of substitution. Competitive organizations are selected for comparison. Usually, with this approach, it is difficult to compare two companies due to some differences, therefore, it is necessary to adjust the data. All possible information about the company that can be purchased is collected and compared with a similar organization.
The comparative approach uses methods of the capital market, transactions, industry coefficients (market multiplier).
The capital market method is focused on evaluating an enterprise as an operating company, which is supposed to continue to function. It is based on stock market prices.
The transaction method is used when the investor intends to close the enterprise or significantly reduce the volume of production. Therefore, this method is based on the precedent - the cases of the sale of similar enterprises.
The market multiplier method is focused on evaluating an enterprise as an operating company, which will continue to function. The most commonly used valuation multiples are price / gross income, price / net profit, price / cash flow.
All three approaches are interconnected, because none of them in isolation can serve as an objective factor. Therefore, it is recommended to use all approaches. Some companies provide their own business valuation services, but these services are quite expensive.
In the fourth lesson, we explored several sources of income for the average person. In this case, we are talking about the same. There are many ways, and all of them are quite risky. Therefore, banks first of all look at what assets the company has, so that, if necessary, the debt will be repaid from them.
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The break-even point is calculated in units of production, in monetary terms, or taking into account the expected profit margin.
The break-even point in monetary terms is the minimum amount of income at which the costs are fully recouped.
BEP TFC / (C / P), where TFC is the amount of fixed costs, P is the cost per unit of production (sales), C is the profit per unit of production excluding fixed costs.
The break-even point in units of products is the minimum amount of products at which the income from the sale of these products completely covers all costs of its production.
BEP TFC / C TFC / (P-AVC), where AVC is the variable cost per unit of output.
The stock exchange is a financial institution that ensures the regular functioning of the securities market. Some stock exchanges are real places (New York Stock Exchange), while others are purely virtual (NASDAQ).
Why would any company list its shares on the exchange? There are many reasons, but the most important one is that it will allow the company to generate a large return on the shares sold. The downside is that such a company partially loses its independence. For example, Sergey Brin and Larry Page delayed the listing of Google shares on the stock exchange until the last moment and used various strategic tricks. According to the law, they were forced to do this, so Page and Brin found a way out: the shares had two classes - A and B. The first was privileged and was intended only for the company's employees, while the second class was somewhat limited and sold to anyone.
Why would anyone buy stock? He can make a lot of profit and also participate in the management of this company. The downside is that he can lose a lot of his money if things go badly for the company. History knows thousands of cases when people burned out in the game on the stock exchange.
There are, however, those who became billionaires by playing on the stock exchange. It could be a genius like Buffett, or just a random investor who is incredibly lucky. Some people use inside information. For example, when a stock is listed on the stock exchange by a successful company, the prices per share are quite high. Suppose that soon this company wants to change management - then the share price would go down. However, the head of the company does not publicly speak about this, and also may not say about the significant problems of the company. This alone is already a criminal offense, and if such information is passed on to a large future shareholder (who wants to speculate on these shares), then the punishment may await him. Withholding information is one form of lying.
The ten largest financial exchanges in the world:
The Dow Jones Industrial Average covers the 30 largest companies in America. The prefix "industrial" is a tribute to history, because at the moment many of the companies included in the index do not belong to this industry. Now, when calculating the index, a scalable average is used - the sum of prices is divided by a certain divisor, which is constantly changing. With some adjustments, we can say that this index is the arithmetic average of the stock prices of 30 American companies.
What does the Dow Jones Index have to do with financial analysis, you might ask? The fact is that this index is unofficially called an indicator of the state of the economy of the United States and the whole world. Of course, this is an indirect indicator, but very eloquent. If 30 of the leading US companies are in crisis, then the entire economy is also in crisis. The higher the index, the better the state of the economy.
This index reached its all-time low in percentage terms on Black Monday 1987. This entailed huge losses on other exchanges - Australian, Canadian, Hong Kong, British. Most curiously, there was no apparent reason for the collapse. This event challenged many of the important assumptions underlying modern economics. Also, strong failures were recorded during the Great Depression and the 2008 global crisis.
The historical maximum was reached recently - on May 19, 2015.
We will not give the names of all thirty companies, we will give only ten of the most interesting and familiar to everyone.
The ten Dow Jones companies are:
Companies are constantly pushing each other out of this list. For example, in 2015, Apple ousted AT&T, the largest telecommunications corporation.
Some economists believe that the best indicator of the American economy is the S&P 500. It is a stock index, which includes 500 selected US public companies in the basket.
Both indices are popular and represent a barometer of the American economy. Now you are armed with this tool too.
In this tutorial, we covered a lot of financial analysis tools.
In the next lesson, we will understand how financial thinking is formed and what needs to be done to leave the old way of thinking and acquire a new one. Many people without financial education receive millions simply because they were either taught financial thinking from childhood, or they themselves came to understand finance. This is a skill and you can learn it too.
The final lesson is about financial thinking.
To identify the true state of affairs, a financial analysis was created. It is impartial and clear because it has to do with numbers and metrics. A financially literate person must distinguish a profitable company from a non-profitable one if they intend to make money in the field of business and investment.
Financial analysis is an assessment of the economic health of any company. Financial indicators, ratios, ratings and multipliers are studied and, on their basis, a conclusion is made about the financial condition of the organization.
Who May Need Financial Analysis? For example, the top management of the company. Or investors who want to study whether it is worth investing in it. Even banks that decide whether to provide this organization with a loan. A company can also list its shares on the stock exchange, and this also requires an understanding of its financial condition.
Many are interested in the financial analysis of a particular company, because sometimes even the leaders themselves do not understand that things are very bad. Everything may look just fine at this stage, but in many cases a simple analysis can show that in a year or two the company will go bankrupt. That is why analysis is so important, because it helps to see what the eyes are not capable of.
In this lesson, we will look at situations in which a person has access to all possible company information. But not everyone has access to the true state of affairs in the organization in which he wants to invest money or cooperate with it. For this, you can use indirect sources of information. Of course, this will not always be enough, but you can draw some conclusions. We offer you such tools as:
- Currency rates.
- The state of the economy, financial sector, political and economic state.
- Securities rates, yield on securities.
- Indicators of the financial condition of other companies.
This is the so-called external data and it can be your tool for assessing the prospects of your investment. For example, if you wanted to buy shares of a company, and you do not have access to financial statements, then the above indicators can partially help you.
Content:
Let's proceed directly to the financial analysis. It has its own goals and objectives, in which all existing tools are revealed. Let's consider what tasks are facing financial analysis and what tools will be required for this.
Financial analysis tools
Profitability analysis
In economic language, "profitability" is understood as "profitability", therefore, in the future we will operate with this very term. The profitability ratio is calculated as the ratio of profit to assets, resources and flows. Profitability metrics are often expressed as a percentage.Understand the difference between income and profit. Income is all the funds that you receive from your activities. Profit is a financial result. That is, if you earned $ 500 from the sale of goods, then this is your income. You took or made these goods somewhere and they cost you 300 dollars. So your profit is $ 200.
There can be a lot of indicators of profitability. Let's consider the most important ones:
- Profitability of products sold. This is the ratio of the profit from sales to the cost of goods sold. If your profit is $ 1000, and the cost of the product you sold is $ 800, then this figure is calculated as follows: (1000/800) * 100% 125%. We hope you do this kind of math without a calculator.
- Return on assets. Reflects the efficiency of using the company's assets to generate profits. That is, you can find out how effectively you are using the assets of your company. If you received a monthly profit of $ 1000, and the average value of your assets is $ 2000, then this indicator is calculated as follows: (1000/2000) * 100% 50%.
- Return on equity. This is the ratio of profit to the average amount of equity capital for the period. Let's say you earned $ 5,000 in a month and you are investing $ 1,000 of equity on average per month. Then you will calculate this indicator as follows: (5000/1000) * 100% 500%. A very good indicator. True, it may not be very objective and will not say anything about the state of affairs of your company, if you do not calculate other indicators.
Financial stability analysis
Coefficients of financial stability of an enterprise are indicators that clearly demonstrate the level of stability of an enterprise in financial terms.The financial independence ratio is a financial ratio equal to the ratio of equity capital and reserves to the sum of the company's assets. For this, the balance sheet of this organization is used. This indicator displays the proportion of an organization's assets that are covered by equity.
This ratio is needed by banks issuing loans. The higher it is, the more likely the bank will give a loan to your company, because you will be able to pay off the debt with your assets. Remember, we already said that the bank considers your liabilities to be its assets? In this case, the difference is that the company's assets are simply necessary, because without most of them, it simply cannot function.
The financial dependence ratio is an indicator that is the opposite of the financial independence ratio. It shows the extent to which the company depends on external sources of funding. This indicator is also necessary for banks to make a decision on granting a loan.
Analysis of solvency and liquidity
Solvency is the company's ability to timely fulfill monetary obligations stipulated by law or contract. Insolvency , on the contrary, shows the company's inability to pay its obligations to the creditor. Can lead to bankruptcy.The analysis of the liquidity of assets (property) calculates an indicator that indicates how quickly the organization's assets can be sold if it cannot pay off its loan debts.
Investment analysis
This is a set of techniques and methods for developing and assessing the feasibility of making investments in order to make an effective decision by the investor.Based on this analysis, management decides whether the company will invest in short-term and long-term investments. Some investments are more profitable than others, so the challenge is also to find the most effective ones. To do this, several tools are used: discounted payback period, net present value, internal form of profitability, and return on investment index .
The discounted payback period (DPP) characterizes the change in the purchasing power of money, the value of which, as we recall, decreases over time. You, as an investor, should know how long it will take to start receiving income from your investments and bring this amount in line with the present moment. Sometimes it doesn't even make sense to invest, because either it won't pay off, or it will pay off minimally.
On the Internet, you can find a calculator for calculating the discounted payback period, so we will not give the formula here. Moreover, it is quite complicated. To put it simply, then, for example, you or your company are investing in the amount of 50 thousand dollars. Each year, let's say, you will receive 15 thousand dollars in income. Enter this data into the calculator along with other indicators and you get, for example, 3 and a half years. That is, in 3 and a half years, your investments will begin to bring you real net profit, adjusted for inflation.
There is a tool called Net Present Value ( NPV) . This is the present value of an investment project, determined by taking into account all current and future receipts at an appropriate interest rate. If this indicator is positive, then you can invest in the project.
Net present value can be used not only for investments, but also in business. With this tool, a company can calculate the feasibility of expanding its products. Here everything is exactly the same: if this indicator is positive, then it is worth expanding production.
The third instrument is called the internal rate of return ( IRR) and it is also used both in business and in assessing the feasibility of investment projects. You can also calculate this indicator online. If you get a zero value, you will only recoup your investments, but nothing more. The higher the IRR, the better.
The return on investment ( PI) index is an indicator of investment performance, which is the ratio of discounted income to the amount of investment capital. It is also sometimes called the index of profitability or profitability index.
Bankruptcy Probability Analysis
As history shows, very often, a few months before bankruptcy, no one in the company even suspects that the company will collapse. Outwardly, everything is going well and there are no prerequisites to think that something will go wrong.What are the criteria for assessing the likelihood of bankruptcy? With some indicators , we have already seen:
- Current liquidity ratio.
- Financial dependence ratio.
- Solvency recovery ratio.
- Autonomy coefficient.
- Coverage of fixed financial expenses.
Analysis of the market value of a business
This can be useful for those who want to buy a ready-made business. A businessman hires a financial analyst who makes all the calculations - the recommended business value and the potential income of the enterprise after a certain period of time. If an investor hires a financial analyst, then for him, first of all, it is important to understand one simple thing - whether the indicated value corresponds to his investment interests.This is a very difficult job. An average business market value analysis report is about 300 pages long.
There are three approaches to assessing the value of a business : income, expense and comparative. By the way, it is also used before purchasing real estate.
The more income the company brings, the greater the value of its market value. But at the same time, important factors are the length of the period of income generation, as well as the degree and type of risks in this case. The subsequent resale of the business is also taken into account - if it turns out that this is quite likely, then this is another plus when buying it.
The essence of the expenditure approach is that all the assets of the enterprise (buildings, machinery, equipment) are first estimated and summed up, and then liabilities are deducted from this amount. The resulting figure shows the cost of the company's equity capital.
The comparative (market) approach is based on the principle of substitution. Competitive organizations are selected for comparison. Usually, with this approach, it is difficult to compare two companies due to some differences, therefore, it is necessary to adjust the data. All possible information about the company that can be purchased is collected and compared with a similar organization.
The comparative approach uses methods of the capital market, transactions, industry coefficients (market multiplier).
The capital market method is focused on evaluating an enterprise as an operating company, which is supposed to continue to function. It is based on stock market prices.
The transaction method is used when the investor intends to close the enterprise or significantly reduce the volume of production. Therefore, this method is based on the precedent - the cases of the sale of similar enterprises.
The market multiplier method is focused on evaluating an enterprise as an operating company, which will continue to function. The most commonly used valuation multiples are price / gross income, price / net profit, price / cash flow.
All three approaches are interconnected, because none of them in isolation can serve as an objective factor. Therefore, it is recommended to use all approaches. Some companies provide their own business valuation services, but these services are quite expensive.
Analysis of the sources of financing of the enterprise
The management of the company must determine which sources are more profitable and available to them. It is also important to determine for how long to take out a loan and whether it is worth it at all. Should there be more own or borrowed funds? When should you go public with your shares?In the fourth lesson, we explored several sources of income for the average person. In this case, we are talking about the same. There are many ways, and all of them are quite risky. Therefore, banks first of all look at what assets the company has, so that, if necessary, the debt will be repaid from them.
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Break even
Break-even point (BEP) is the volume of production and sales of products at which expenses will be offset by income, and with the production and sale of each subsequent unit of production, the enterprise begins to make a profit. It is also sometimes called the critical point or CVP point.The break-even point is calculated in units of production, in monetary terms, or taking into account the expected profit margin.
The break-even point in monetary terms is the minimum amount of income at which the costs are fully recouped.
BEP TFC / (C / P), where TFC is the amount of fixed costs, P is the cost per unit of production (sales), C is the profit per unit of production excluding fixed costs.
The break-even point in units of products is the minimum amount of products at which the income from the sale of these products completely covers all costs of its production.
BEP TFC / C TFC / (P-AVC), where AVC is the variable cost per unit of output.
Stock exchanges
We simply cannot pass by the stock exchange and some indicators related to the global economy.The stock exchange is a financial institution that ensures the regular functioning of the securities market. Some stock exchanges are real places (New York Stock Exchange), while others are purely virtual (NASDAQ).
Why would any company list its shares on the exchange? There are many reasons, but the most important one is that it will allow the company to generate a large return on the shares sold. The downside is that such a company partially loses its independence. For example, Sergey Brin and Larry Page delayed the listing of Google shares on the stock exchange until the last moment and used various strategic tricks. According to the law, they were forced to do this, so Page and Brin found a way out: the shares had two classes - A and B. The first was privileged and was intended only for the company's employees, while the second class was somewhat limited and sold to anyone.
Why would anyone buy stock? He can make a lot of profit and also participate in the management of this company. The downside is that he can lose a lot of his money if things go badly for the company. History knows thousands of cases when people burned out in the game on the stock exchange.
There are, however, those who became billionaires by playing on the stock exchange. It could be a genius like Buffett, or just a random investor who is incredibly lucky. Some people use inside information. For example, when a stock is listed on the stock exchange by a successful company, the prices per share are quite high. Suppose that soon this company wants to change management - then the share price would go down. However, the head of the company does not publicly speak about this, and also may not say about the significant problems of the company. This alone is already a criminal offense, and if such information is passed on to a large future shareholder (who wants to speculate on these shares), then the punishment may await him. Withholding information is one form of lying.
The ten largest financial exchanges in the world:
- NYSE Euronext. It is a group of companies formed from the merger of the world's largest New York Stock Exchange (NYSE) and the European exchange Euronext.
- NASDAQ. This exchange specializes in high-tech stocks. Shares of 3200 companies are placed on it.
- Tokyo Stock Exchange. The exchange is a member of the Federation of Asia and Oceania Stock Exchanges. All securities traded on the Tokyo Stock Exchange are worth more than $ 5 trillion.
- London Stock Exchange. Officially founded in 1801, however, in fact, its history began in 1570, when the Royal Exchange was built. In order for a company to list its shares on this exchange, it needs to fulfill several conditions: have a market capitalization of at least £ 700,000 and disclose financial, commercial and management information.
- Shanghai Stock Exchange. The capitalization of the stock market is $ 286 billion, and the number of companies that have placed their shares is 833.
- Hong Kong Stock Exchange. Has a capitalization of US $ 3 trillion.
- Toronto Stock Exchange. The volume of capitalization is 1.6 trillion dollars.
- Bombay Stock Exchange. It has a capitalization of $ 1 trillion, and the number of companies that have placed their shares is about 5 thousand.
- National Stock Exchange of India. The second stock exchange from this country.
- São Paulo Stock Exchange. The largest stock exchange in Latin America.
Dow Jones
It's time to get acquainted with the Dow Jones Industrial Average. You will understand how simple it is, what it means and how to interpret it.The Dow Jones Industrial Average covers the 30 largest companies in America. The prefix "industrial" is a tribute to history, because at the moment many of the companies included in the index do not belong to this industry. Now, when calculating the index, a scalable average is used - the sum of prices is divided by a certain divisor, which is constantly changing. With some adjustments, we can say that this index is the arithmetic average of the stock prices of 30 American companies.
What does the Dow Jones Index have to do with financial analysis, you might ask? The fact is that this index is unofficially called an indicator of the state of the economy of the United States and the whole world. Of course, this is an indirect indicator, but very eloquent. If 30 of the leading US companies are in crisis, then the entire economy is also in crisis. The higher the index, the better the state of the economy.
This index reached its all-time low in percentage terms on Black Monday 1987. This entailed huge losses on other exchanges - Australian, Canadian, Hong Kong, British. Most curiously, there was no apparent reason for the collapse. This event challenged many of the important assumptions underlying modern economics. Also, strong failures were recorded during the Great Depression and the 2008 global crisis.
The historical maximum was reached recently - on May 19, 2015.
We will not give the names of all thirty companies, we will give only ten of the most interesting and familiar to everyone.
The ten Dow Jones companies are:
- Apple. The company entered the index only in 2015.
- Coca- Cola. Entered the index in 1987.
- Microsoft. Entered the index in 1999.
- Visa. Entered the index in 2013.
- Wal- Mart. Entered the index in 1997.
- Walt Disney. Entered the index in 1991.
- Procter & Gamble. Entered the index in 1932.
- Of McDonald's. Entered the index in 1985.
- Nike. Entered the index in 2013.
- Intel. Entered the index in 1999.
Companies are constantly pushing each other out of this list. For example, in 2015, Apple ousted AT&T, the largest telecommunications corporation.
Some economists believe that the best indicator of the American economy is the S&P 500. It is a stock index, which includes 500 selected US public companies in the basket.
Both indices are popular and represent a barometer of the American economy. Now you are armed with this tool too.
In this tutorial, we covered a lot of financial analysis tools.
In the next lesson, we will understand how financial thinking is formed and what needs to be done to leave the old way of thinking and acquire a new one. Many people without financial education receive millions simply because they were either taught financial thinking from childhood, or they themselves came to understand finance. This is a skill and you can learn it too.
Test your knowledge
If you want to test your knowledge of the topic of this lesson, you can take a short test consisting of several questions. In each question, there can be only one correct answer. After you have selected one of the options, the system automatically proceeds to the next question. The points you receive are influenced by the correctness of your answers and the time spent on passing. Please note that the questions are different each time, and the options are mixed.The final lesson is about financial thinking.
