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This three-part series will explain how to craft a balance, income and cash
flow statement, guiding you through the criteria and terminology,
demonstrating how to calculate the ratios that reveal your company’s fiscal
health and its standing among the competition, and suggesting ways to
improve your outlook.
here allows you to calculate several financial ratios that measure company
performance. Additionally, current balance sheets should always present
data from at least one previous period, so you can compare how financial
performance has changed.
Identify a public company in the same industry as your startup and download
their financial statements from their Web site. Using Target Corp. as an
example, we’ll analyze the data in their balance sheet. Here are a few key
ratios to calculate. Note that all figures represent millions of dollars.
Quick ratio: This measures Target’s ability to meet its obligations without
selling off inventory; the higher the result, the better. It is expressed as
current assets minus inventories, divided by current liabilities. In Target’s
case, that is 14,706 minus 6,254, divided by 11,117, which equals 0.76.
Working capital: This refers to the cash available for daily operations. It is
derived by subtracting current liabilities from current assets, which in this
example is 14,706 minus 11,117, which equals 3,589.
Net profit margin: Net earnings divided by total revenue yields the net
profit margin. In this case, 2,787 divided by 59,490, which equals .047, or
4.7 percent.
ROA: This stands for return on assets and measures how much profit a
company is generating for each dollar of assets. Calculate ROA by dividing
the revenue figure from the income statement by assets from the balance
sheet. For Target, that equates to 59,490 divided by 14,706, which equals
4.04. In other words, for every dollar Target has in assets, it is able to
generate $4.04 of revenue.
ROE: The same idea as above, but replacing assets with the equity. In this
case, 59,490 divided by 15,633, which equals 3.81.
The cash flow statement discloses how a company raised money and how it
spent those funds during a given period. It is also an analytical tool,
measuring an enterprise’s ability to cover its expenses in the near term.
Generally speaking, if a company is consistently bringing in more cash than it
spends, that company is considered to be of good value.
A cash flow statement is divided into three parts: operations, investing and
financing. The following is an analysis of a real-world cash flow statement
belonging to Target Corp. Note that all figures represent millions of dollars.
Cash from operations: This is cash that was generated over the year from
the company’s core business transactions. Note how the statement starts
with net earnings and works backward, adding in depreciation and
subtracting out inventory and accounts receivable. In simple terms, this is
earnings before interest and taxes (EBIT) plus depreciation minus taxes.
Interpretation: This may serve as a better indicator than earnings, since non
cash earnings can’t be used to pay off bills.
Cash from investing: Some businesses will invest outside their core
operations or acquire new companies to expand their reach.
Interpretation: This portion of the cash flow statement accounts for cash
used to make new investments, as well as proceeds gained from previous
investments. In Target’s case, this number in 2006 was -4,693, which shows
the company spent significant cash investing in projects it hopes will lead to
future growth.
Cash from financing: This last section refers to the movement of cash from
financing activities. Two common financing activities are taking on a loan or
issuing stock to new investors. Dividends to current investors also fit in
here. Again, Target reports a negative number for 2006, -1,004. But this
should not be misconstrued: The company paid off 1,155 of its previous debt,
paid out 380 in dividends and repurchased 901 of company stock.
Interpretation: Investors will like these last two items, since they reap the
dividends, and it signals that Target is confident in its stock performance
and wants to keep it for the company’s gain. A simple formula for this
section: cash from issuing stock minus dividends paid, minus cash used to
acquire stock.
The final step in analyzing cash flow is to add the cash balances from the
reporting year (2006) and the previous year (2005); in Target’s case that’s
-835 plus 1,648, which equals 813. Even though Target ran a negative cash
balance in both years, it still has an overall positive cash balance due to its
high cash surplus in 2004.
TREND ANALYSIS
There are three main types of trends: short-, intermediate- and long-term.
Trend analysis tries to predict a trend like a bull market run and ride that
trend until data suggests a trend reversal (e.g. bull to bear market). Trend
analysis is helpful because moving with trends, and not against them, will lead
to profit for an investor.