Financial Research There Are Any

Financial Research

There are any number of methodologies available to determine a company's value. They range from simplistic formulae such as the use of comparable price-earnings ratios to the use of the capital asset pricing model to determine the value based on the firm's historic correlation to market returns. However, sound financial analysis typically requires an examination of the firm's financial statements. A comprehensive evaluation will include a ratio analysis and a common size analysis. Both techniques have their benefits and their drawbacks. Additionally, it is worth noting that these techniques are subject to certain limitations inherent in the financial statements of public entities. For this study of these statistical techniques and their validity in determining the value of an organization, two firms have been selected. One if FedEx Corporation, a Financial Times 500 company (#359) based in Memphis, Tennessee. The other is Thomson Reuters, a Canadian/British firm (#223) in the media business that operates globally.

Ratio Analysis

The ratio analysis helps to determine value because it breaks down the financial statements into sections that outline key business concepts -- solvency, liquidity, profitability and efficiency (Loth, n.d.). A thorough understand of how the business is performing with regards to each of these categories can provide stronger insight into the company's performance and allow the analyst to make conclusions about the true value of the company. The ratios are calculated and can be compared to the firm's past ratios and to the ratios of other firms within the industry.

With respect to solvency, the key ratios are the current ratio, quick ratio and cash ratio. These allow the analyst to determine the company's ability to meet its liability obligations for the coming year. For example, FedEx has a current ratio of 1.57, a quick ratio of 1.25 and a cash ratio of 0.5. The company's solvency ratios are better for fiscal 09 than they have been in recent years, which indicates that FedEx's immediate financial situation is not only strong but improving. Thomson Reuters has a current ratio of 0.8, a quick ratio of 0.57 and a cash ratio of 0.18. These figures are mediocre, but not out of line with the company's past performance. Management is comfortable operating at these levels.

Liquidity ratios, or debt ratios, measure the firm's long-term liquidity situation on the basis of its degree of leverage. FedEx has a debt-to-assets ratio of 0.43, which is lower than it has been in recent years. The debt-to-equity ratio is 0.77, which also represents an improvement over previous years. FedEx therefore is not only a liquid firm but a firm whose liquidity has improved in recent years. Thomson Reuters has a debt-to-assets ratio of 0.44 and a debt-to-equity ratio of 0.78. Both of these figures are within the range of the historic debt levels that the company has carried over the past five years. It can therefore be said on the basis of these ratios that both FedEx and Thomson Reuters are liquid companies.

If we consider that Thomson Reuters did not have strong solvency ratios, a poor showing on the liquidity ratios would have been cause for concern. However, because the company has a strong liquidity position, it could theoretically borrow money in order to lengthen the duration of its liabilities, which would improve the solvency ratios. This is further evidence that not only is the company in a sound solvency position but that management is comfortable operating at those levels.

Profitability ratios indicate the degree to which firms translate their revenues into profits. The most important of these from the shareholder perspective is the net profit margin. However, by calculating gross margin and pre-tax margin the specific areas of strength and weakness throughout the organization's cost structure can be better identified. FedEx has a gross margin of 25.5%, a pre-tax margin of 1.1% and a net margin of -0.3%. These margins are lower than the five-year average for FedEx. However, while the gross margin for FedEx outperforms the industry average both last year and over the past five years, the pre-tax and net margins do not. This indicates that while FedEx has a relatively low cost of goods sold compared with its industry peers, it has higher indirect expenses. Thomson Reuters is the opposite. That firm's gross margin of 47.9% is line with the industry average, but over the past five years the gross margin has been half the industry average (27.6% versus 54.3%). Despite this, the company has historically recorded higher pre-tax and net margins than its industry peers. This indicates that the firm has lower indirect costs than its industry peers, although in the latest fiscal year this was not the case.

Lastly, the efficiency ratios measure the company's ability to turn assets, equity and investment into profit. FedEx turned a loss last quarter, so its efficiency was poor both in relation to the industry and in relation to its historic context. Thomson Reuters returned a 7.5% ROE, a 4.2% ROA and a 4.8% ROI last year. These figures are below both the industry and the five-year average, indicating a challenging but not disastrous year for the company.

For FedEx, the ratio analysis reveals a company that is having a difficult year in 2009 in terms of its profitability. The firm has uncharacteristically lost money (although it turned a small profit in fiscal 2009), but nonetheless FedEx managed to take steps to improve its situation for the long run. Its solvency and liquidity have improved consistently. However, the profitability ratios revealed that the company has been consistently underperforming its industry peers in the area of cost control over the past five years, a concern that FedEx may wish to address.

Thomson Reuters, by contrast, did not have strong solvency ratios but is clearly a liquid company. Their profitability and efficiency were hurt in the last fiscal year, but nonetheless performance was strong and profitability maintained. Nor did the company need to take on additional debt in order to maintain a healthy balance sheet.

Common Size Analysis

A common size analysis begins with a top line number and then breaks down the components. For example at FedEx, revenues would be given a value of 100, with cost of goods sold being 74.4, reflecting that COGS is 74.4% of revenue. Net profit have been for fiscal 2009 0.2, reflecting $98 million in profit on $35.497 billion in revenue. At Thomson Reuters, the accounts receivable would be (based on a top line of assets) 4.9. This reflects that receivable accounted for 4.9% of the firm's assets in fiscal 2008.

The value of the common size analysis is twofold. First, it allows the firm's financial statements to be compared year over year. We can see, for example, that the cost of goods sold at FedEx was 73.1 in 2007, 72.2 in 2006, 71.9 in 2005 and 72.2 in 2004. This indicates that the current level is higher than it has been at any point in the past five years. The company's cost of goods sold, in fact, has increased steadily for the past four years. With Thomson Reuters, the receivables were 4.3 in 2007, 6.8 in 2006, 6.0 in 2005 and 8.3 in 2004. This indicates that the firm has in the past two years tightened its receivables, a sign of increasing efficiency.

The other main use of common size analysis is that it allows for easy comparison between different companies, by eliminating the question of company size and focusing on the percentages (Netmba, 2007). This form of analysis, for example, could be used to compare the performance of FedEx and Thomson Reuters. Thomson Reuters has a cost of goods sold of 74.1, which represents an improvement over past years. This shows that there is presently little difference in the cost of goods sold between FedEx and Thomson Reuters. With respect to receivables, on FedEx's common size they would be 13.9 this year, down from 17.0 last year. This indicates that FedEx has a considerably slower collection period than does Thomson Reuters.

Drawbacks

However, comparison between firms as different as these is fraught with difficulty. Ratios and percentages that are normal in one industry could be completely different in another industry. FedEx, for example, has substantially more of its asset base tied up in property/plant/equipment. This represents the company's stations and truck fleet (airplanes are leased and thus off balance sheet). Reuters, not bound by the necessity for heavy investments in plants and vehicles, has a substantially lower percentage of its asset base in p/p/e. Comparisons using common size analysis are best done between firms in the same industry.

Another drawback to common size analysis is that it will not reflect a change in the firm's accounting policy. For example, when Reuters lowered the level of receivables on its books in the past two years, this was taken to reflect tighter receivables management. However, the company saw massive increase in size in those past two years. The lower level of receivables is more likely, then, to reflect the acquisition that caused the size increase and the policies of the acquired company.

Another point of difficulty is that different firms may use different calendars when reporting. For example, the fiscal year at FedEx ends at the end of May, while at UPS the fiscal years ends at the end of December. This makes for a difficult comparison. For example, fuel prices escalated rapidly in early 2008. Comparing a FedEx FY09 and UPS FY08 would be very difficult, given that one of those statements would reflect the fuel price increase and the other would not.

There are also limitations to accounting analysis as a whole. At best, these forms of analysis are only as good as the financial statements from which they are produced. A large number of variables contribute to those statements, including accounting policy, accounting accuracy (or lack thereof), outdated information and changes in the accounting standards (NetTom, n.d.)