 Personal Finance Powerpoint Presentation. Analyze a company's financial position. Prepare to get financially fit by practicing personal finance. Most of this information comes from Investopedia, how to analyze a company's financial position, which you can find online. Take a look at the references, resources, continue your research from there. This by Ben McClure updated May 15, 2022. In prior presentations, we've been taking a look at investment goals, investment tools, investment strategies, keeping in mind the two major categories of investments, that being fixed income, typically bonds, equities, generally stocks. We're focused here on the stock side of things. So let's give a quick recap of what they are. Remember that a corporation is a separate legal entity breaking the ownership into stocks or shares, representing an equal value or equal claim of ownership per share. Oftentimes when we are investing, we are investing in companies that are on a exchange, being publicly traded companies, the exchange making it easier for the corporation to issue the shares and thereby generate capital or cash that they can then invest in the growth of the company. And of course, investors, more individual investors included, then have the capacity to be investing in the stocks. Now note, we also wanna be considering what our individual objectives are for the investing strategy. Are we investing in individual stocks? Or possibly we will be using tools if we're individuals investing, say for retirement, like mutual funds or ETFs, allowing us to have smaller kind of investments that can still go a long ways in terms of diversification by using those tools to pool the investments together. We've talked about them more in prior presentations. When we're putting our investments into individual stocks, it's worthwhile to understand how we're gonna be valuing the individual stocks. And of course that would come down, hopefully to looking at the financial statements. The financial statements are gonna give us an idea of where the company stands, what their performance has been. We would think that the value of the stocks would depend in large part on those financial statements and then other conditions or other circumstances, such as where's the market at this current point in time and what do we think's gonna happen given market conditions going into the future. So what is financial analysis? To understand and value a company, investors examine its financial position by studying its financial statements and calculating certain ratios. Now if the company is publicly traded, then oftentimes in order to be publicly traded, they have to provide their financial statements and they have to make their financial statements, hopefully honestly, and in a way that will be comparable to other financial statements, which is great because that should open up transparency so that we have more information to make better decisions on the investing side of things. Fortunately, it is not as difficult as it sounds to perform a financial analysis of a company. The process is often part of any program evaluation review technique, that's the P-E-R-T, a project management tool that provides a graphical representation of a project's timeline. So understanding and analysis of a company's financial position. If you borrow money from a bank, you have to list the value of all your significant assets as well as all your significant liabilities. So if we compare this to our individual finances, then when are people concerned with our individual finances? When we try to get financing, when we try to get money, when we try to get a loan to buy a house or something like that, same for the corporation. The corporation is trying to get money, capital to grow. That's why they're going from private to public, going to an exchange, why they would like to sell their stocks. We have similar kind of questions for the company as a bank has to us. So 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, meaning they're typically going to want it if they're gonna error on the conservative side of things, like undervaluing your assets because we wanna make sure that you're able to repay the loan in that instance. So the bank also ensures that all liabilities, such as mortgage and credit card debt, are appropriately disclosed and fully valued. So on the liability side of things, what the company owes money to or you owe money to, you can imagine if you're trying to get a loan from the bank, you would try to look good on the asset side of things and not good. I mean, you try to remove, if you could, any liabilities side of things. But obviously we want to see them and that's part of the transparency that we're hoping that we have from the publicly traded companies to show us the liabilities that they have to make a better judgment. So the total value of all assets, less the total value of all liabilities gives your net worth or equity. So when we think about it in our individual terms, assets minus liabilities might be called net assets. For example, from a company's side of things, assets minus liabilities is the equity. Equity section of the balance sheet is in essence kind of like the value of the company on a book value basis, kind of like the starting point for valuing the company, although it gets more complex than that. So 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. So we got the balance sheet. Like your financial position, a company's financial situation is defined by its assets and liabilities. So the company is just kind of, you can think of it as a shell, it's a separate legal entity, but obviously it's just a company, right? So it's holding on to assets, liabilities. The difference between the assets and the liabilities is the equity. So a company's financial position also includes shareholder equity. So all of this information is presented to shareholders in the balance sheet. So the balance sheet represents where a company stands at a certain point in time. So suppose that we are examining the financial statements of the fictitious, publicly traded retailer, the outlet to evaluate its financial position. So we've made up this one, the outlet. So to do this, we review the company's annual report, which can often be downloaded from a company's website. So if you wanna think it's a publicly traded company and you want to find their financial statements, you could typically go to their website. Sometimes it takes a little bit of digging, but you can typically find their financial statements to be breaking this down, that being the balance sheet and the income statement. So the standard format of the balance sheet is assets followed by liabilities and then shareholders' 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. So it's kind of an arbitrary breakout, these current assets and liabilities versus non-current, but it's important because the current liabilities are gonna be coming due shortly. Typically you're gonna owe money on them shortly and therefore you need enough current assets in order to pay those. That's why we use that kind of arbitrary 12 month time frame. So for example, suppose that the inventories that the outlet reported as of December 31st, 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 inventory represents a significant proportion of its current assets and so should be carefully examined. So when we think about current assets, inventory is typically included because we expect hopefully the inventory to be sold in the short run within basically a year. If it was sold in that time, it will be converted to cash and we'll be able to use the cash to pay off the liabilities would be the idea that our current liabilities that will be coming due in the short period of time. Now, if we'd look at some company that's a retail store, inventory is a huge factor, of course. So 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 and 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 that they are managing their inventory relatively well. This reduction makes a positive contribution to the company's operating cash flow. Current liabilities are the obligation the company has to pay within the coming year and include existing or accrued obligation 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. So when you're looking at managing the assets, you don't want so much cash that you're just holding on to cash for no reason because you wanna be putting that cash to work, possibly buying inventory or other machinery and equipment that you're gonna be making money on. On the other hand, you don't want too little cash so that you cannot meet your current obligations, those that are coming due within the next year, for example, the current liabilities. So the current ratio, key ratio, the current ratio, which is total assets divided by total current liabilities, 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. So in other words, we can compare the assets that are current assets to the current liabilities to see how many times over we can pay off the liabilities with the assets, the higher the number, the better we look in terms of being able to pay off the liabilities. So an acceptable current ratio varies across industries. So you might look at current ratios from different industries and you need to know the industry standards to see whether or not that current ratio would be appropriate for it. So, but should not be so low that it suggests impending insolvency or so high that it indicates an unnecessary buildup of cash, receivables, or inventory. So you would think the higher the number, the better, and it is better in the fact that you should be able to pay off your current liabilities, your solvent, but if it's too high, you would think you're mismanaging your cash because you should be able to put that cash somewhere else and make money, buying more inventory, buying machinery, or if not that, give it to the owners in the terms of dividends if you don't need it. So 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. So now we've got those non-current, clearly not within the year. So for a company like the Outlet, its biggest non-current asset is likely to be property, plant, and equipment the company needs to run its business. So the building, the land, the equipment that we have, these are non-current. We're not gonna be able to liquidate them easily to pay off the current liabilities. It's important to understand current and long-term because if you look at some industries like farming for example, you can see that you can have a situation where they have a lot of assets and so they look good from assets minus liabilities equity perspective, but all of their assets are in land, for example, in equipment. So if there's a liquidity problem, it's gonna be difficult sometimes to get the money to pay off the current liabilities. So these are things we need to be mindful of with regards to liquidity versus just equity assets minus liabilities. So long-term liabilities might be related to obligations under property, plant, and equipment leasing contracts and along with other borrowings. Financial position, book value. If we subtract total liabilities from assets, we are left with a shareholder equity. So that's kind of like the book value of the company. So if you take the assets with the company owes minus the obligations that they have in total, the net then is the equity, the value in the company, which you would think would be attributable to the owners. That's why it's equity investments when we're investing in stocks. Now that's a book value of the equity if they were to liquidate, meaning sell the assets and then pay off the liabilities. You might not of course have the same number as the book value of equity, but that's kind of like a starting point for valuating the company, the equity of the company. So essentially, this is the book value or accounting value of the shareholders' stake in the company. So 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. So market to book multiple. By comparing the company's market value to its book value, investors can in part determine whether stock is under or overvalued. So once we know the company's book value, and again, remember when we looked at those book value, assets minus liabilities, that's the equity. That equity is important, but you also have to be comparing the liquidity, meaning the current assets and the current liabilities to make sure that they could still pay off, are they solvent? But once we know what the book value is, we can say, okay, well, what is the market value of the company? Well, how do we know that? Well, it's trading. The stocks are trading on the market. So now we can say, okay, I know what the book value is. I could compare that then to the market value and get some idea of what the price is related to the book value. So the market to book multiple, well, it does have a shortcomings, remains a crucial tool for value investors. So extensive academic evidence shows that companies with a low market to book stock performance 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. So you would think that the book value, if the price, if you take the book value and compare it to the price, how much of a multiple is the price of the book value? If the price is multiple book values over versus another company that is closer to the book value, you would think that the second one closer to the book value would be more appropriately valued or possibly be a more valuable investment because the underlying conditions are closer to what the market price is. This can get really skewed in some sectors where you've got like speculatory sectors and you're speculating on growth and so on and so forth, but it can be a good tool to kind of ground your investment decisions and individual stocks. So 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 outlets book to market multiple is high or low, it should be compared to the multiples of other public listed retailers. So clearly once we get this number, we might not be able to compare it across all companies. We could try that, but it would be easiest to compare to other outlet stores that are in the same sector to see it in relation to other companies in its industry. 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 investors seeking to understand and value a company's properly.