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The New Competitor Intelligence |
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Chapter
9: Building a Financial Statement
"It's amazing," a new analyst would say to me. "How
can you possibly divine out the profit and loss statement or balance
sheet from a privately-held company, or from a small subsidiary of
a large conglomerate?"
What the beginner does not realize is that (1) the estimate comes
from a combination of good data and a knowledge of the manufacturing
or service process under examination; and (2) most of these financials
are "best guesses." These best-guess financials often accurately
interpret the critical financial factors and the impact they have
on the corporation, but they would not pass an accountant's audit.
That is not their purpose. Their purpose is to provide enough insight
in order to make an informed decision.
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Analyzing With Ratios . . . What To Watch Out For
Anyone can play with the numbers, but only the astute analyst can
turn those numbers into insights. The intelligence analyst must use
the ratios for yet another perspective on the competitor. Analysts
should compare what they learn from the numbers with the information
supplied from interviews and other sources. What are some of the questions
the experienced analyst will ask during the analytical process? How
can ratios help place everything he or she may have learned in perspective?
These are some of the analytical guideposts to watch for:
Ability to Pay Current Obligations: A banker who needs to determine
a client's ability to handle debt is in a very similar position to
the competitive analyst. Both must grasp the financial reality with
the company. Both need to take into account other industry factors
and norms not measured by pure ratios. There are three traditional
measures used here.
Current Ratio
The current ratio is the result of Current Assets divided by Current
Liabilities. Bankers and analysts use this ratio to understand a company's
ability to pay short-term obligations -- it liquidity. A company is
generally judged "liquid" if its current ratio is 2-to-1
(though there are differences by industry).
Example: Current Ratio = Current Assets = $250,000 = 2.0
Current Liabilities $125,000
This 2-to-1 ratio is a fairly conservative number and may not reflect
the particular industry you are examining where the ratio may be closer
to 1.5 -to-1. Just using the 2-to-1 relationship, a banker would say
that this company is a safe bet. What the banker is saying to him
or herself is that at least 50% of the current assets can be converted
into cash reasonably fast.
Advice: The intelligence analyst, however, needs to go beyond
these numbers and identify the specific assets. Using such sources
as UCC filings , credit reports, and interviews with suppliers (to
determine payment history and overall reliability) you will soon discover
if a state of liquidity exists or if the numbers are below industry
norms, indicating limits in the competitor's ability to pay or take
chances with aggressive pricing, hiring or marketing campaigns.
Acid Test Ratio (Quick Ratio): The Current Ratio becomes the
Acid Test Ratio by eliminating any non-cash assets, such as inventory.
The Acid Test assumes that since inventory is not cash and could take
weeks or months to be converted the inventory into cash, it is not
truly a liquid asset.
Acid Test Ratio = Cash + Accounts Receivable = $125,000 = 1.0
Total Current Liabilities $125, 000
The typical ratio is 1-to-1. Anything below 1.0 may be considered
financially precarious.
Advice:
The intelligence analyst can draw several inferences from the quick
ratio.
- For example, a high quick ratio could indicate a very conservative
, risk-averse competitor that is unwilling to leverage cash resources.
- On the other hand, a high quick ratio could signal that the
competitor is poised to mount a competitive challenge -- perhaps
one that is already rumored in the industry.
Once again, you need to combine experts' comments with the quick ratios
you have compiled in order to draw any final conclusions. You need
to gather other evidence of activity or inactivity before allowing
the ratios themselves to lead you a decision.
Debt-to-Equity Ratio: This ratio compares Total Liabilities
to Stockholders' Equity. In effect it measures indebtedness and solvency.
Debt/Equity Ratio = Total Liabilities = $400,000 = 1.23
Total Stockholder's Equity $325,000
Advice:
The analyst may be able to determine Stockholders' Equity from annual
reports, regulatory filings, such as the United State's Security and
Exchange Commission filings, credit reports and some state or provincial
government filings (See Chapter 3), but the level of indebtedness
is not an absolute. The "normal" Debt-to-Equity Ratio is
somewhere around 1.0. The above example shows 1.23 and would indicate
a company with slightly more leverage than a banker might feel comfortable
with. But the questions you the analyst must ask are: What is a standard
industry level of debt? Is this resulting number a normal outcome,
or does it indicate a company in trouble? One way to find out is to
consult the Robert Morris Associates Annual Statement Studies,
which lists ratios for actual companies in hundreds of industries.
Profitability/ Return on Investment: The two basic measures
here are Return on Equity (ROE) and Return on Assets (ROA). These
would become critical measures if your company were to acquire another
firm, or begin its due diligence work for a joint venture or alliance.
As a potential investor or acquirer, you definitely want to know the
relative return to expect from your investment.
Return on Equity = Net Income = $200,000 =20%
Total Stockholders' Equity $1,000,000
A 20% return is typically considered a healthy return on equity for
most companies. In any case, you always need to compare your findings
with industry averages in order to draw a conclusion about your target
company's standings.
Expert Advice: What Ratios
Can't Tell You: Biotech Example
Return on Assets: This ratio helps determine how much profit a company
is able to generate from each dollar of assets on its balance sheet.
The before-tax ROA ratio is calculated as follows:
| ROA (Before Taxes)= |
Operating Earns Before Interest/Taxes=
Total Assets |
$350,000 = 17.5%
$2,000,000 |
If you think of the ratio in terms of dollars and cents, this company
earned 17.5 cents for every dollar of assets. One way to make use
of this ratio is to compare it to your own ROA; another way to use
it would be in an acquisition analysis to compare it to members of
an industry peer group. Let's take ROA analysis a step further: If
the same company can earn 17.5 cents on each dollar of assets, it
can earn 17.5 cents on assets supported by borrowed funds. If the
borrowed funds only cost the company 8% on average (taking into account
zero-interest trade payables, equipment loans, lines of credit, mortgages,
etc.), then it has the ability to generate healthy 9.5% returns on
leveraged assets. In other words, the amount the company earns on
borrowed funds is greater than the amount it pays in interest expense.
This is called financial leverage, and is very important to prospective
investors, acquirers or shareholders in a company.
Bear in mind that extraordinary gains or losses, heavily depreciated
fixed assets, or a high level of intangible assets (for example, goodwill)
can distort the ROA figure. Always remember to analyze the ratio in
the proper context, taking into account the company's unique business
dynamics and those of the industry in general.
Appreciating Depreciation
Depreciation is an accounting approach to spreading the cost of a
fixed asset, such as plant or office machinery, over an estimated
useful life. For the analyst, understanding and interpreting a company's
depreciation numbers can explain a great deal about its manufacturing
process or approach to business. A great deal of the client's cost
difference lay in its penchant for buying bigger and more expensive
machines. Hence, they had a far larger depreciation number. The competitor,
producing nearly the same amount of product, was able to sell its
product at a far lower cost. Analyzing the competitor's depreciation
numbers also shed light on its overall spending and investment philosophy
-- a vastly different one, it turned out, than that of the client's.
The competitor was thrifty in every way; the client, on the other
hand, wanted only the best, and shiniest equipment -- and paid for
it.
Understanding depreciation, therefore, offers insight on a company's
operations, not the entire answer.
All companies must make three decisions when deciding to depreciate
assets. They are:
The depreciation method to use:
(1) Straight-line depreciation: This approach assumes that
the asset steadily declines in value, and at the same rate each year.
An asset -- let's say a photocopier -- worth $10,000 with a 10-year
life span, depreciates at 10% per year. Each year it declines in value
by $1,000. After 10 years it is worth $0 and is taken off the books.
(2) Double declining balance depreciation: This is an accelerated
means of depreciating assets. For example, if an asset has a 10-year
life and would have been depreciated at 10% per year for 10 years
in a straight-line depreciation, the double declining approach would
apply a rate of 20%. After five years, the assets are effectively
worth nothing.
(3) Sum-of-the-year's digits method: The approach here is more
complicated than the double declining approach, but offers similar
results. It, too, accelerates depreciation.
Always consult with an accountant before applying any depreciation
figures to your analysis. The accountant who knows accounting rules
and regulations will be able to tell you what depreciation standards
your target company has been using.
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