Company situation analysis.

Financial diagnosis
1.Analyze the Balance Sheet
 The balance sheet is a statement that shows a company’s financial position at a specific point in time. It
provides a snapshot of its assets, liabilities, and owner’s equity.
 Assets are what a company uses to operate its business. Liabilities refer to money that’s borrowed from other
sources and needs to be repaid by the company. Owner’s equity represents the financing that owners,
whether private or public, put into the business. It’s important to note that assets should always be equal to
the sum of liabilities and owners’ equity. This relationship is the basis of the accounting equation:
 Assets = Liabilities + Owners’ Equity
KEY TERMS
• How much debt the company has relative to equity
• How liquid the business is in the short term (less than one year)
• What percentage of assets are tangible and what percentage comes from financial transactions
• How long it takes to receive outstanding payments from customers and repay suppliers
• How long it takes to sell inventory the business keeps on hand

2. Analyze the Income Statement

 The income statement shows a company’s financial position and performance over a period by looking at
revenue, expenses, and profits earned. It can be created for any period using a trial balance of transactions
from any two points in time.
 The income statement generally starts with the revenue earned for the period minus the cost of production for
goods sold to determine the gross profit. It then subtracts all other expenses, including staff salaries, rent,
electricity, and non-cash expenses, such as depreciation, to determine the earnings before interest and tax
(EBIT). Finally, it deducts money paid for interest and tax to determine the net profit that remains for owners.
This money can be paid out as dividends or reinvested back into the company.
KEY TERMS
• How much revenue is growing over certain accounting periods
• The gross profit margin for goods sold
• What percentage of revenue results in net profit after all expenses
• If the business can cover its interest repayments on debt
• How much the business repays to shareholders versus how much it reinvests

3. Analyze the Cash Flow Statement

 The cash flow statement provides detailed insights into how a company used its cash during an accounting
period. It shows the sources of cash flow and different areas where money was spent, categorized into
operations, investing, and financing activities. Finally, it reconciles the beginning and ending cash balance
over the period.
 The cash flow statement is one of the most important documents used to analyze a company’s finances, as it
provides key insights into the generation and use of cash. The income statement and balance sheet are based
around accrual accounting, which doesn’t necessarily match the actual cash movements of the business.
That’s why the cash flow statement exists—to remove the impacts of non-cash transactions and provide a
clearer financial picture to managers, owners, and investors.
KEY TERMS
• The liquidity situation of the company
• The company’s sources of cash
• The free cash flow the company generates to further invest in assets or operations
• Whether overall cash has increased or decreased

4. Financial Ratio Analysis

 Financial ratios help you make sense of the numbers presented in financial statements, and are powerful tools
for determining the overall financial health of your company. Ratios fall under a variety of categories,
including profitability, liquidity, solvency, efficiency, and valuation.
 Some of the financial ratios you should know include:
• Gross profit margin: The percentage of profit the company generates after the direct cost of sales expenses
have been deducted from the revenue
• Net profit margin: The percentage of profit the company generates after all expenses have been deducted
from revenue, including interest and tax from revenue
• Coverage ratio: The company’s ability to meet its financial obligations, specifically to cover its debt and
related interest payments
• Current ratio: The company’s ability to meet short-term obligations of less than one year
• Quick ratio: The company’s ability to meet short-term obligations of less than one year using only highly
liquid assets
• Debt-to-equity ratio: The percentage of debt versus equity that the company uses to finance itself
• Inventory turnover: How many times per period the entire inventory was sold
• Total asset turnover: How efficiently the company generates revenue from total assets
• Return on equity (ROE): The company’s ability to use equity investments to earn profit
• Return on assets (ROA): The company’s ability to manage and use its assets to earn profit
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.2 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.
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 retailer The Outlet to
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.4
  For example, suppose that the inventories that The Outlet reported as of Dec. 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.5 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 low market-to-book
multiple shows that the company has a strong financial position in relation to its price tag.