How to Analyze a Company's Financial Position (2024)

What Is Financial Analysis?

To understand and value a company, investors examine its financial position by studying its financial statements and calculating certain ratios. Fortunately, it is not as difficult as it sounds to perform a financial analysis of a company. The process is often a part of any program evaluation review technique (PERT), a project management tool that provides a graphical representation of a project's timeline.

Key Takeaways:

  • Investors value a company by examining its financial position based on its financial statements and calculating certain ratios.
  • A company's worth is based on its market value.
  • To determine market value, a company's financial ratios are compared to its competitors and industry benchmarks.

Understanding an Analysis of a Company's Financial Position

If you borrow money from a bank, you have to list the value of all of your significant assets, as well as all of your significant liabilities. Your bank uses this information to assess the strength of your financial position; it looks at the quality of the assets, such as your car and your house, and places a conservative valuation upon them. The bank also ensures that all liabilities, such as mortgage and credit card debt, are appropriately disclosed and fully valued. The total value of all assets less the total value of all liabilities gives your net worth or equity.

Evaluating the financial position of a listed company is similar, except investors need to take another step and consider that financial position in relation to market value. Let's take a look.

The Balance Sheet

Like your financial position, a company's financial situation is defined by its assets and liabilities. A company's financial position also includes shareholder equity. All of this information is presented to shareholders in the balance sheet.

Suppose that we are examining the financial statements of the fictitious publicly listed retailerThe Outletto evaluate its financial position. To do this, we review the company's annual report, which can often be downloaded from a company's website. The standard format for the balance sheet is assets, followed by liabilities, then shareholder equity.

Current Assets and Liabilities

On the balance sheet, assets and liabilities are broken into current and non-current items. Current assets or current liabilities are those with an expected life of fewer than 12 months. For example, suppose that the inventories that The Outlet reported as ofDec. 31, 2018, are expected to be sold within the following year, at which point the level of inventory will fall, and the amount of cash will rise.

Like most other retailers, The Outlet's inventory represents a significant proportion of its current assets, and so should be carefully examined. Since inventory requires a real investment of precious capital, companies will try to minimize the value of a stock for a given level of sales, or maximize the level of sales for a given level of inventory. So, if The Outlet sees a 20% fall in inventory value together with a 23% jump in sales over the prior year, this is a sign they are managing their inventory relatively well. This reduction makes a positive contribution to the company's operating cash flows.

Current liabilities are the obligations the company has to pay within the coming year and include existing (or accrued) obligations to suppliers, employees, the tax office, and providers of short-term finance. Companies try to manage cash flow to ensure that funds are available to meet these short-term liabilities as they come due.

The Current Ratio

The current ratio—which is total current assets divided by total current liabilities—is commonly used by analysts to assess the ability of a company to meet its short-term obligations. An acceptable current ratio varies across industries, but should not be so low that it suggests impending insolvency, or so high that it indicates an unnecessary build-up in cash, receivables, or inventory. Like any form of ratio analysis, the evaluation of a company's current ratio should take place in relation to the past.

Non-Current Assets and Liabilities

Non-current assets or liabilities are those with lives expected to extend beyond the next year. For a company like The Outlet, its biggest non-current asset is likely to be the property, plant, and equipment the company needs to run its business.

Long-term liabilities might be related to obligations under property, plant, and equipment leasing contracts, along with other borrowings.

Financial Position: Book Value

If we subtract total liabilities from assets, we are left with shareholder equity. Essentially, this is the book value, or accounting value, of the shareholders' stake in the company. It is principally made up of the capital contributed by shareholders over time and profits earned and retained by the company, including that portion of any profit not paid to shareholders as a dividend.

Market-to-Book Multiple

By comparing the company's market value to its book value, investors can, in part, determine whether a stock is under- or over-priced. The market-to-book multiple, while it does have shortcomings, remains a crucial tool for value investors. Extensive academic evidence shows that companies with low market-to-book stocks perform better than those with high multiples. This makes sense since a low market-to-book multiple shows that the company has a strong financial position in relation to its price tag.

Determining what can be defined as a high or low market-to-book ratio also depends on comparisons. To get a sense of whether The Outlet's book-to-market multiple is high or low, it should be compared to the multiples of other publicly listed retailers.

In summary, a company's financial position tells investors about its general well-being. A financial analysis of a company's financial statements—along with the footnotes in the annual report—is essential for any serious investor seeking to understand and value a company properly.

As a financial analyst with a wealth of experience in evaluating company financial positions, let's delve into the concepts discussed in the article "What Is Financial Analysis?" to provide a comprehensive understanding of the key elements involved.

  1. Financial Analysis Overview:

    • Investors assess a company's financial position by studying its financial statements and calculating specific ratios.
    • The process is not overly complex and is often integrated into program evaluation review techniques (PERT) in project management.
  2. Market Value and Worth:

    • A company's value is determined by its market value, which involves comparing its financial ratios with industry benchmarks and competitors.
  3. Balance Sheet:

    • Similar to an individual's financial position, a company's financial situation is defined by its assets, liabilities, and shareholder equity.
    • Shareholders are presented with this information in the balance sheet.
  4. Current Assets and Liabilities:

    • Assets and liabilities are categorized into current and non-current items on the balance sheet.
    • Current assets or liabilities have an expected life of fewer than 12 months.
    • The management of current assets, like inventory, is crucial, and the article highlights the importance of monitoring changes in inventory value.
  5. Current Ratio:

    • The current ratio (total current assets divided by total current liabilities) is a key metric to assess a company's ability to meet short-term obligations.
    • Acceptable current ratios vary across industries and should be evaluated in relation to the company's historical performance.
  6. Non-Current Assets and Liabilities:

    • Non-current assets or liabilities have lives extending beyond the next year.
    • For a company like "The Outlet," property, plant, and equipment are significant non-current assets.
  7. Financial Position: Book Value:

    • Shareholder equity, obtained by subtracting total liabilities from assets, represents the book value of the shareholders' stake in the company.
    • It comprises capital contributed by shareholders over time and retained profits.
  8. Market-to-Book Multiple:

    • Investors can assess whether a stock is under- or over-priced by comparing a company's market value to its book value.
    • The market-to-book multiple is a crucial tool for value investors, and a low ratio often indicates a strong financial position relative to the stock's price.
    • Comparisons with other publicly listed retailers are essential to understanding the market-to-book ratio's significance.

In summary, a thorough financial analysis, including the evaluation of current and non-current assets and liabilities, current ratio, book value, and market-to-book multiple, provides investors with insights into a company's well-being and aids in making informed investment decisions.

How to Analyze a Company's Financial Position (2024)
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