Assignment title: How's the company doing?

Objective: To provide an intro-level training on financial diagnostics

Appropriate tools: Time series and cross-section analysis; ratio analysis.

Description: This assignment is designed to help you learn the basic tools of financial diagnosis. You are expected to write an executive summary-type report on the financial condition of a company. Your report should be straightforward in its commentary as to how the company is doing. You will comment not only on the current financial condition of the company but also on where in your opinion the company is heading. You would most probably use financial ratios to diagnose the company's liquidity, profitability, operating efficiency, solvency positions. Common ratios to diagnose liquidity include current ratio, quick or acid-test ratio, cash ratio, and working capital. Common profitability ratios include gross profit margin, net profit margin, operating margin, basic earning power, return on assets, return on equity, return on net operating assets (RNOA). Common operating efficiency ratios include total asset turnover (ATO), inventory turnover, receivables turnover, working capital turnover (sales divided by average current assets), days' sales in inventory (DSI), days' sales outstanding or days' sales in receivables (DSO), days' payables outstanding (DPO), capital intensity ratio, etc. Common solvency ratios include debt-equity ratio, debt-to-total assets ratio, times interest earned, net borrowing cost (interest expense divided by average interest-bearing debt).

In addition to the above four aspects of liquidity, profitability, operating efficiency, and solvency of the company, you may be interested in a few capital market ratios such as the price-earnings ratio, dividend yield, earnings yield, and the market-to-book ratio (market capitalization of the company divided by book value of its shareholders' equity).

In order to make a reasonable assessment as to how the company is doing, you would ideally calculate these ratios for at least 2 years so that you can make year-to-year comparisons of relevant ratios. For a comprehensive assessment, one would like to have industry averages of the ratios as benchmarks. However, for the purposes of this assignment, you are not expected to dig out industry averages and those are not provided to you either.

Having done the ratio analysis, ask yourself if you are in a position yet to form an informed opinion about your target company. Even if you have some information about the company's current state of affairs, you are probably not yet in a position to confidently comment on the direction the company is heading. In other words, you are still not comfortable suggesting the future direction of the company. Why? What else do you need? What you need now is some knowledge about the growth in different parameters such as sales, earnings, working capital, and debt. That means you would like to compute the following: (1) sales growth; (2) gross, operating, or net, earnings growth; (3) working capital growth; (4) debt growth; and (5) asset growth.

You can also check the sensitivity of earnings to sales or operating leverage. The degree of operating leverage is calculated as the % change in EBIT divided by the % change in sales. This shows how sensitive your operating profit is to changes in sales. Some other sensitivities are worth checking: % change in accounts receivable in response to % change in sales, % change in sales in response to % change in total assets, or the % change in gross working capital, i.e., total current assets in response to % change in sales.

Finally, cash flow position. You must demonstrate that you understand the importance of cash flows vis-a-vis profit. While reporting handsome earnings constitutes good news but earnings without healthy operating cash flows is not. Therefore, investors wish to see a correspondence between operating profit and operating cash flows. So, you may compute this ratio - operating cash flow or cash flow provided by operating activities divided by EBIT or net income. If you see operating cash flow is consistently trailing operating profit, you must smell trouble.

Finally, watch the company's debt level. This can also be computed by the equity multiplier, which is the total assets divided by shareholders' equity. Equity multiplier is also calculated as 1 plus debt-equity ratio. If the debt level rises without a corresponding rise in total assets, it should be noted as an alarm signal.

Typical signs of worsening financial condition:

i) stagnant, or declining, sales;

ii) declining profit margins - gross, operating, and net;

iii) increasing inventory levels or declining inventory turnover;

iv) increasing receivables levels or declining receivables turnover;

v) declining ROE and ROA;

vi) accumulated loss;

vii) missed, or stopped loan repayments (please check the financing section of the cash flow statement to understand loan repayments);

viii) declining, or negative, cash flow from operating activities;

ix) the company's inability to maintain a stable dividend payout ratio;

x) net loss for consecutive years;

xi) steady decline in the company's stock price, etc.

How to do this assignment?

Please choose a company, preferably a listed one, whose financial statements are easily available. Company financial statements are typically found in the "investor relations" tab of a company's web page. Download financial statements for at least 2 years. Compute the ratios mentioned in the description of the assignment. If possible, compute additional ratios should you feel the need to do that. Provide a brief description of the company and its business. Make comments on the company's financial condition, especially on its profitability and solvency. If you notice unusual levels of inventory, receivables, or debt, start probing further and look for signs of inferior performance. Also see how the company is doing in the stock market, i.e., how its stock has been performing over the past 2 years.