Learn the basic of financial accounting with “The Enlightened Accountant“
Disclaimer: the information provided in this article does not represent an investment advice, neither creates any professional relationship with its author. The information provided is for educational purposes only.
In this article I want to introduce a fast and easy way to analyze the performance of any company, the trend analysis. This is the best way to understand the fundamental of any company. In fact, the purpose of this analysis is to determine how the target company performance evolved overtime.
Eventually we will be able through this analysis to grasp what were the factors that most affected the growth (or decay) of our target company’s performance. Where do we start?
- Analysis set up
- Analysis Overview – Don’t make assumptions
- Step-One: financial ratios set-up & two-year comparison
- Step number two: DuPont analysis
- Step-three: select comparable set-up and comparative analysis completion
Analysis set up
We are going to perform this analysis up by taking three simple steps. But before we do that we have to have all the information needed available. Where do we find this information? Easy, we look at the target company’s website.
Check out our previous article on how to set-up an analysis here and read the paragraph “what to look for?”
Analysis Overview – Don’t make assumptions
In many financial analyses (especially those based on forecasts and financial models), the starting point is to make assumptions. In our analysis, instead, we want to make as few assumptions as possible.
In fact, we are going to let the financials speak for themselves. How? Through three simple steps: in step number one, we are going to select a set of financial ratios that we will use as analytical tools to understand our target company.
In step number two, we are going to perform a DuPont analysis to understand how the profitability evolved overtime. Indeed, since we want to make very few assumptions, we are going to drill-down into the ROE and see what influenced it.
And in step number three we are going to compare the financial ratios of our target company against its main comparable. Therefore, before we do that we will have to select a group of comparable companies.
Let’s proceed with order:
Step-One: financial ratios set-up & two-year comparison
In this step we are going to select a set of ratios that will guide us toward our analysis. Financial ratios are metrics that help us in comprehending the main financial statements. To have a more detailed account of how they work check out our previous article on ratio analysis here.
In this phase we have to select some ratios to assess few main aspects of the business that we will divide in four main categories: profitability, liquidity, leverage and efficiency. In this phase we are going to leave valuation out, which we are going to include in the third step of our analysis.
Once selected these ratios we have to run them for the current and previous year. This is because we want to understand how the company’s trend evolved overtime. In this specific case I decided to do an analysis for 2014 and 2015 for simplicity sake.
You can expand the trend analysis to three or five years if you like. For instance, in my course “Financial analysis from scratch to professional level” (you can grab a coupon for the course here if you like), I picked some ratios to analyze Apple Inc. and run them through. See the results in the following table:
As you can see from the above table I picked ten different ratios and run them to understand how Apple Inc. performance changed from 2014 to 2015. The table shows an increased profitability, liquidity, leverage and efficiency.
In fact, the only negative number that you see in this table it is actually a good sign. This is because the receivable in days ratio tells us how long it takes for the company to collect the money from the customers that buy on credit.
In short, the shortest the time it takes for a company to collect money from tis customers the more it becomes liquid overtime. In Apple Inc. specific case, the receivable in days decreased by 12%, from 30.5 days to 26.8 days. This is definitely a good sign. In fact, usually a number, which goes below 60 days, is positive, and in this case below 30 days is an extremely positive result.
After completing step-one we can move forward to our second step.
Step number two: DuPont analysis
In this phase we are going to analyze why the profitability increased and what were the factors the influenced it so much. In short, we are going to drill-down into the ROE to see what is going on there.
In fact, as you can see from the previous table our ROE increased from 33% to 46%. To know more in detail how to perform this analysis check out our previous article on DuPont Analysis here or you can take at look at the table I produced in my course “Financial analysis from scratch to professional level” below (you can grab a coupon for the course here if you like):
As you can see from this table, although the ROE increased substantially it did so due to leverage and profitability. In short, the company was able to improve its revenues but also to contract more debt.
These two factors combined made the company ROE skyrocket. We are ready to move to our third and last step.
Step-three: select comparable set-up and comparative analysis completion
In this phase here we have to select some comparable. In short, we want to select companies, which present the same features of our target firm. Afterward, we can relate the main financial rations of our target company against those of the comparable.
The objective here is to understand the competitive context. In short, although we can make a first assessment of the company’s financials through the first and second step, we are still missing some pieces to complete our puzzle.
Consequently we are going to use two criteria to select our comparable companies: business and financial profile. These two profiles will be our guidelines.
The business profile attains to qualitative aspects of the business, which we can synthetize in four properties:
- Sector – in what sector does the target company operate?
- Product and services – what are the core products and services the target company offers?
- Distribution channel – how does the target company get to its end customers?
- Geography – what is the main market where our target company operates?
For instance Apple Inc. operates in the consumer goods category and electronic equipment category. Its main products are iPhone, iPod, MAC (which make up most of its revenues).
Apple Inc. distributes its products mainly through its own retails stores and the main market is the U.S. (although the company operates worldwide and currently Greater China makes up for 25% of the company’s sales).
The financial profile attains to quantitative aspects of the business. In fact, we are going to consider five main aspects:
- Size – Market cap, revenues, net income
- Profitability – Average net margin, or gross margin last three or five years
- Growth profile – Where does the revenue growth come from? Geography and product analysis
- Return on investment
- Credit profile – What rating was the company assigned lately? Or what level of liquidity the company has?
For instance, Apple Inc. 2015 market cap surpassed $500 billion dollars, with over $230 billion dollar in revenues and over $50 billion in net profit.
In addition, as for the profitability, the company showed an average net margin (net income/sales) of 23% in the last 5 years. Its revenue growth came mainly from one product, the iPhone and one market, Greater China.
It is time to select Apple’s main comparable. In my course “Financial analyst from scratch to professional level” (you can grab a coupon of the course here if you like), I explain more in detail why I picked Google and Microsoft as main comparable for Apple Inc.
For simplicity sake, here I want to highlight the fact that when selected Apple comparable I gave more importance to criteria such as geography, products and services, size, and profitability.
In fact, Apple has been able to achieve a powerful position in so many different industries in the tech world and therefore it has also several direct competitors. For instance, in the smartphone industry Apple’s direct competitors are Samsung, Sony, Lenovo and so on.
In the personal computer industry Apple’s main competitors are Microsoft, Dell, HP and Lenovo. We could go on forever. Although, my assumption here is that de facto Apple’s success was mainly due to its ability to integrate several products through a very intuitive interface that differentiated it from its competitors.
In short, I am assuming (sometimes we have to use assumptions) that the future battle in the tech industry will be played on the software side, rather than the hardware. Therefore, the two biggest players, which are competing against Apple in this respect, are Microsoft and Google.
Perform comparative analysis
We can now run the main financial rations for Apple Inc. and assess them against Google and Microsoft. As reference you can look at the table below taken form my course “Financial analysis from scratch to professional level” below:
In this table is summarized the financial performance of Apple Inc. in comparison with Microsoft and Google for 2015. As you can see from the date Apple has better profitability and efficiency ratios but also worse liquidity, leverage and market valuation ratios.
Wrap-up and Conclusions
In this article we saw how to set up a financial analysis in three steps. In the first step we selected a set of financial data useful to comprehend the performance of our target company. In step-two, we went further and analyzed how the ROE evolved overtime. Eventually in step-three, we sleeted comparable companies, and performed a comparative analysis to determine how our target company performed in comparison to the group of company, which operate in the same context.
From the above analysis you can already be able to draw some conclusions but also investigate further what is going on with our target company. But I hope this article wasn’t too long. Therefore, we will remand our further investigations to another future occasion.
Learn the basic of financial accounting with “The Enlightened Accountant“