Fundamental Company Analysis Flashcards
(6 cards)
Discuss how revenue, operating costs, and dividend records are important indicators in assessing investment quality:
- A company’s ability to increase revenue is an important indicator of its investment quality. Clearly, revenue growth is desirable, whereas flat or declining revenue trends are less favourable. Likewise, high growth is usually preferable to a low or moderate rate. However, an analyst should keep informed of the reasons for increase in a company’s revenue. A company’s revenue might increase for any of the following reasons: * It increased the prices or volumes of its products. * It introduced new products. * It expanded into a new geographic market.
- OPERATING COSTS After studying revenue, the next step is to look at cost of sales. By calculating cost of sales as a percentage of revenue, you can determine whether costs are rising, stable, or falling in relation to sales. A rising trend over several years may indicate that a company is having difficulty keeping overall costs under control and is therefore losing potential profits. A falling trend suggests that a company is operating cost effectively and is likely to be more profitable in the future.
- DIVIDEND RECORD A company’s dividend record shows how much it generally pays out in the form of dividends to shareholders. The company may have an unusually high dividend payout rate (more than 65%, for example) for any of several reasons: * Stable earnings that allow a high payout * Declining earnings, which may indicate a future cut in the dividend * Earnings based on resources that are being depleted, as in the case of some mining companies Similarly, a low payout may reflect any of the following factors: * Earnings reinvested back into a growth company’s operations * Growing earnings, which may indicate a future increase in the dividend amount.
Discuss how capital structure and the effect of leverage are important factors in assessing investment quality:
- The capital structure of a company refers to the distribution of debt and equity that comprise the company’s finances. Analysis of a company’s capital structure provides an overall picture of its financial soundness because it reveals the amount of debt used in its operations. Analysis may indicate the need for future financing. As well as the type of security that might be used. For example, common shares are suitable for a company with a heavy debt load. In analyzing capital structure, you should consider the following issues: * A large debt issue approaching maturity may have to be refinanced by a new securities issue or by other means. * Retractable securities may also have to be refinanced if investors choose to retract. A similar possibility exists for extendible bonds. * Convertible securities represent a potential decrease in earnings per common share (EPS) through dilution.
- THE EFFECT OF LEVERAGE The earnings of a company are said to be leveraged if the capital structure contains debt or preferred shares. The presence of these securities accelerates any cyclical rise or fall in earnings. In comparison to companies without leverage, earnings increase faster during an upswing in the business cycle and collapse more quickly as economic conditions deteriorate.
Why is trend analysis a useful technique in assessing investment quality and how is it used in relation to ratios?
- Ratios calculated from a company’s financial statements for only one year have limited value on their own. They only become meaningful when compared with other ratios. Internally, they can be compared with the same ratios collected from the same company in different years. Externally, they can be compared with the same ratios collected from similar companies or with industry averages. Analysts identify trends by selecting a base period, treating the figure or ratio for that period as 100, and then dividing it into the comparable ratios for subsequent periods. Table 14.2 shows this calculation for a typical pulp and paper company.
- Table 14.2 uses Year 1 as the base period. The EPS for that year, which is $1.18, is treated as equivalent to 100. The trend ratios for subsequent years are easily calculated by dividing 1.18 into the EPS for each subsequent year.
What does it mean that external comparisons make ratios more useful?
- Ratios are most useful for comparing financial results of companies in the same or similar industries, for example, when a distiller is compared with a brewer. Differences shown by the trend lines help to put the EPS of each company in historical perspective. They also show how each company has fared in relation to others. Different industries may have different standards for the same ratio, and they often employ a range rather than a specific target number.
- Industry standards are different from industry ratios in that the ratios change each year, whereas the standards are relatively static. Ratios show the industry average, which changes depending on the performance of the industry in a particular year. Standards provide a longer-term view and remain the same regardless of the performance of the industry or the economy. For your analysis to be fair and thorough, you must compare the company to both the current average of the industry and the historical industry standard.
Explain the four different types of ratios (liquidity, risk analysis, operating performance, and value):
Liquidity ratios Liquidity ratios are used to judge the company’s ability to meet its short-term commitments. An example is the working capital ratio, which shows the relationship between current assets and current liabilities. Liquidity ratios help investors evaluate the ability of a company to turn assets into cash to meet its short-term obligations. If a company is to remain solvent, it must be able to meet its current liabilities, and therefore it must have an adequate amount of working capital (also called net current assets).
Risk analysis ratios Risk analysis ratios show how well the company can deal with its debt obligations. For example, the debt-to-equity ratio shows the relationship between the company’s borrowing and the capital invested in it by shareholders. The analysis of a company’s capital structure enables investors to judge how well the company can meet its financial obligations. Excessive borrowing increases the company’s costs because it must service its debt by paying interest on outstanding bank loans, notes payable, bonds, or debentures.
Operating performance ratios Operating performance ratios illustrate how well management is making use of the company’s resources. For example, the net profit margin ratio indicates how efficient the company is managed after taking both expenses and taxes into account. These ratios include profitability and efficiency measures. The analysis of a company’s profitability and efficiency tells the investor how well management is making use of the company’s resources.
Value ratios Value ratios show the investor what the company’s shares are worth, or the return on owning them. An example is the price-to-earnings ratio (P/E ratio), which links the market price of a common share to EPS, and thus allows investors to rate the shares of companies within the same industry. Value ratios (sometimes called market ratios) measure the way the stock market rates a company by comparing the market price of its shares to information in its financial statements. Price alone does not tell analysts much about a company unless there is a common way to relate the price to dividends and earnings. Value ratios do this.
Why do the significance of each ratio not hold equal weight for different sectors and industries?
- The significance of any ratio is not the same for all companies. In analyzing a manufacturing company, for example, analysts pay particular attention to the working capital ratio, which is a measure of the use of current assets. In an electric utility company, however, the working capital ratio is not as important, because electric power is not stored in inventory, but produced at the same time that it is used.
