Major Aspects of Financial Analysis - Essay Example

Finance & Accounting al Affiliation) Financial Analysis Financial analysis is the selection, examination, and interpretation of financial data, along with other relevant information to aid in financial and investment decision making. Financial analysis helps in making both internal as well as external decisions about the company. Internal issues financial analysis helps evaluate include employee performance, credit policies, and efficiency of operations. External parties may use financial analysis to evaluate the credit-worthiness of borrowers and potential investments in a company. Financial analysts draw data from different sources. The main source of financial analysis is the company’s annual reports and disclosures. Annual reports comprise the balance sheet, income statement, statement of cash flows, and notes to these financial statements. Securities laws may require some businesses to disclose more information on top of the financial statements. Besides the information that companies disclose through financial statements, other information is readily available for analysis. For instance, information on the market prices of securities of publicly traded companies is readily available in electronic media and financial press. The financial press also avails information on stock price indices for the whole market and for specific industries. Electronic data such as Consumer Price Index and Gross Domestic Product are useful in analyzing past performance and the future prospects of a company or an industry. Other than market data, economic data, and financial statement data, examination of events that may explain the present performance of the company and predict future prospects is crucial in financial analysis. Financial analysts are responsible for selecting relevant information, carrying out in-depth analysis, and interpreting the results of the analysis. The results of the analysis enable users of financial information to make judgments on current and future prospects of the company. The primary tool for financial analysis is financial ratios. Financial ratio analysis involves selecting and evaluating relevant financial statement data. Major Aspects of Financial Analysis Actual vs. Planned Performance Companies work on considerable plans before engaging in a business activity. The companies also update different stakeholders with pro forma financial statements. After engaging in the business venture, the company will need to compare its actual performance using current financial statements against the pro forma statements for planned performance. This kind of financial statement analysis should be done on a line-item-by-line-item basis. The analysis shows the discrepancies between planned and actual performance of the company. Managers should be able to explain the existence of these discrepancies. Deficits in the actual performance may indicate inefficiency while surpluses indicate efficient performance and utilization of resources. Analyzing actual performance against planned performance is crucial as it helps the company to change its plans. The company may enroll the services of financial advisors and planners to discuss ideas, informational, and feasible changes in planning. Trend Analysis Trend analysis involves a comparison of current financial statement data with data in previous financial statements. Trend analysis enables the management to keep track of the changes in the performance of the business. The four main areas of concentration in trend analysis are sales, costs, profits, and cash flows. It is every manager’s dream to oversee an increasing trend in sales and profits while a decreasing trend in costs and improvements in cash flows indicate a better performance of the company in the current period in comparison to previous periods. Trend analysis should be done on a line item-by-line item basis to determine the changes in the trend. Emerging trends should guide managers in making changes in plans where necessary. Industry Comparison Industry comparison goes beyond comparing a company’s performance to other company’s performance in the same industry. It also entails comparing standards set by different stakeholders such as creditors, investors, and advisory partners. Financial Ratios Balance Sheet Ratios The balance sheet ratios measure the strength of a business. The most common balance sheet ratios include current ratio, quick ratio, working capital, inventory turnover, and leverage ratio. Current Ratio Current ratio is among the most widely used test of financial strength. The ratio calculates whether a business is able to meet its short-term obligations. The ratio is calculated by dividing current assets by current liabilities. The minimum acceptable ratio is 1:1. Any figure below this ratio implies that the company is not expected to pay its short-term obligations on time. Quick Ratio The quick ratio is also referred to as the decisive test ratio as it concentrates only on liquid assets of the business. The quick ratio is calculated by dividing the sum of cash and receivables by current liabilities. Unlike the current ratio, the quick ratio ignores inventories and other current assets that may have doubtful liquidity. A satisfactory quick ratio, depending on the history of collecting debts is 1:1. Working Capital Creditors concentrate on the working capital as it deals more with cash flows. Working capital is the difference between current assets and current liabilities. Most banks tie loan approvals on a company’s minimum working capital requirement. Inventory Turnover Ratio Not all businesses have inventories that need to be of concern. In such situations, the business ignores the inventory turnover ratio. This ratio tells whether the inventory is turning over fast enough. The net inventory is calculated by dividing net sales by average inventory. Firms that are concerned by their inventory need to watch the inventory turnover ratio carefully and compare it to the industry’s guidelines. Leverage Ratio The leverage ratio shows the extent to which a company relies on debt to keep operating. Creditors such as banks and suppliers are more concerned by this ratio. Leverage ratio is calculated by dividing total liabilities by the net worth of the company. The higher the ratio the more risky it becomes to extend credit to the company. Profit & Loss Ratios Gross Profit Ratio The gross profit ratio is calculated by dividing gross profits by net sales. Different industries have a standard guideline of the gross profit ratio with which companies can compare their specific numbers. Companies need to keep track of the trend of the gross profit ratio and ensure it does not deviate away from the target. EBITDA THE Earnings before Interest, Taxes, Depreciation, and Amortization indicates the operation efficiency of a business with exclusion of non-operational costs. Management Ratios Return on Assets The return on assets ratio indicates how a company efficiently utilizes its assets. Bankers and investors calculate this ratio by dividing net pre-tax profit by total assets. Return on Investment The return on investment ratio is widely used by investors and bankers to determine the prospects of investing or extending a loan to the company. This ratio is calculated by dividing net pre-tax profit by net worth of the company. Limitations of Financial Analysis Financial statement analysis includes stock market, management, and accounting related limitations. Financial ratio analysis is hampered by potential inaccuracy with accounting data in financial statements. Errors in recording accounting data as well as distortions of raw data limit the process of financial analysis. Even though accounting measures have more external standards and evaluations than other ways of benchmarking companies, human error and data distortion remain a major limitation of the use of accounting data. Financial ratios as tools of stock valuation can be limited. The efficient –market hypothesis says that financial markets are informally efficient. Consequently, one cannot achieve results in excess of market returns on a risk-adjusted basis. Weak forms of the efficient market hypothesis asserts that there exists long term benefits to information derived from fundamental analysis while stronger forms assert that ratio analysis will not allow for greater returns. Additionally, analysts argue that sentiments are as much a driver of stock prices as financial data on a given publicly traded company. Behavioral economists link financial market imperfections to a combination of cognitive biases such as overreaction, overconfidence, information bias, representative bias, and other human errors in information processing. This audience also considers ratio analysis as inappropriate predictors of market returns. From a manager or investor’s perspective, ratio analysis may leave out important aspects of the company’s success such as key intangibles like skills, brands, and culture. These items are long-term core drivers of the success of a company even though they are not incorporated in financial analysis. Finally, financial analysis can present an overly simplistic view of the company by converting a great deal of information into numbers. Additionally, any changes in information underlying ratios can limit comparisons over time while inconsistencies within and across the industry can complicate the comparisons. Industry Economics and Strategies Bank of America Corporation is a Delaware corporation, a financial holding company and a bank holding company. JPMorgan Chase & Co. is a financial holding company incorporated under Delaware law in 1968. It is a global leader in financial services and one of the biggest banking institutions in the United States of America. Both companies fall under the banking and financial services industry. Competition JP Morgan Chase bank and Bank of America operate in a highly competitive environment. Competitors include credit unions, thrifts, banks, brokerage firms, investment advisory firms, investment companies, investment banking firms, credit card issuers, insurance companies, mutual fund companies, mortgage banking companies, and e-commerce and other internet-based companies. The companies compete with some of the competitors on a regional, global, and product platform. The main areas of competition include quality and range of products, customer service, price, interest rates on loans and deposits, reputation, customer convenience and lending limits. E ability of the companies to keep up with the competition entails strategic market approaches. Some of the strategies involve employee motivation and managerial compensation. Banking and Financial Services Outlook Even though many banking firms have been able to recover from the 2008 economic depression, most firms in the financial services industry are yet to get a stable footing. However, heading into 2015, there is increasing evidence that firms may have a chance to shift to a higher gear.   Although the economy is showing some positive signs, challenges remain for industry managers. Margins are under great pressure and product structures and business models are becoming more identical, derivatives and mortgages being two examples. Regulatory concerns re shifting from uncertainty over direction to uncertainty over long-term results. Agility may drive operational efficiencies while technological advances are expected to play a key role in supporting growth, security, and customer experience. Firms in the industry are also expected to leverage analytics to improve cross selling and market segmentation. How liquid are the Companies? Liquidity ratios are financial metrics used to determine a company’s ability to pay off its short-term debts obligations. A higher liquidity ratio indicates a company has a larger safety margin to cover short-term debts. The most widely used liquidity ratios are the quick ratio, current ratio, and the operating cash flow ratio. Quick Ratio (Cash+ cash equivalents)/current liabilities Bank of America = (469,861M)/1649112M =0.28 J P Morgan = (974343M)/1928385M = 0.51 Current Ratio Current Assets/Current Liabilities Bank of America = 653021M/1649112M =0.4 J P Morgan = 1169153M/1928385M = 0.61 Operating Cash flow Ratio Cash flows from operations/Current Liabilities Bank of America =92817M/1649112M = 0.06 J P Morgan = 107953M/1928385 = 0.06 Are the managers generating adequate operating profits on the company’s assets? To determine whether the managers are generating adequate profits on the assets, one must calculate the returns on assets ratio. Returns on Assets =Net profits/total assets Bank of America = 11431/2102273 = 0.005 J P Morgan = 17923/2415689 =0.007 How are the companies financing their Assets? The leverage ratio helps in calculating the proportion of debt and equity that finances the firm’s operations. Leverage Leverage = Total liabilities/ (total assets-total liabilities) Bank of America = 1869588M/ (2102273M-1869588M) = 8% J P Morgan = 2204511M/ (2415689M-2204511M) = 10.4% Are the Company managers providing good returns on the capital provided by stockholders? To determine whether the managers are providing good returns on stockholders’ capital, we must calculate the returns on capital ratio. Return on Capital Return on capital = net profit/capital stock Bank of America = 11431M/219333M = 0.05 J P Morgan = 17923M/200020 =0.09 Are the Company managers creating shareholders’ value? The earnings per share ratio help in determining whether managers are creating value for shareholders. Earnings per Share EPS = Net income/Number of shares Bank of America = 11431m/12700m = $0.9 per share J P Morgan = 17923/4120 = $4.35 per share Conclusion of the Financial Analysis From the above analysis of the 2013 financial statements of Bank of America and JP Morgan Bank, several comparisons on the performance of the firms can be deduced. Firstly, JP Morgan bank is financially healthier than Bank of America. JP Morgan has a better quick ratio and current ratio indicating its financial strength over Bank of America. Both the managers at Bank of America and JP Morgan bank are not creating enough profits on assets. The proportion of profits for Bank of America and JP Morgan bank that is attributable to assets is 0.5% and 0.7% respectively. These figures are low compared to the financial services industry standards. Bank of America is financing its assets through 8% debt and 92% equity while JP Morgan bank finances its assets through 10.4% debt and 89.6% equity. Bank of America’s return on capital is 5% while JP Morgan’s figure is 9%. Both company’s managers are providing a good return on capital to their respective stockholders. The managers at JP Morgan are creating more shareholder value than those at Bank of America. JP Morgan bank has an EPS of $4.35 compared to Bank of America’s $0.9. References Muro, V. (1998). Handbook of financial analysis for corporate managers (Rev. Ed.). New York: AMACOM. Top of Form Bottom of Form Rodgers, P. (2008). Financial analysis (4th Ed.). Oxford: CIMA. Top of Form Bottom of Form The Basics of a Financial Analysis Report. (n.d.). Retrieved December 1, 2014, from http://www.investopedia.com/articles/investing/032113/basics-financial-analysis-report.asp Top of Form Bottom of Form U.S. Securities and Exchange Commission | Homepage. (n.d.). Retrieved December 1, 2014, from http://www.sec.gov/ Read More