Financial statement analysis can be used to identify weaknesses in a firm’s operations. Give three examples of the types of problems that can be identified and how the financial analyst might uncover them.
1) Uncollectible accounts receivable – you could compare the firm’s average collection period to other peer firms and look for trends over time that might suggest deterioration in collection times. An increase in the average collection period is often a red flag that collection problems are growing.
2) Unsalable inventory – Compare the firm’s inventory turnover ratio to other firms and to itself over time. If the firm’s inventory turnover is lower than that of its peers, this could suggest the presence of obsolete or unsalable items.
3) Overstated residual (i.e. Values of PPE are overstated) – Look at firm’s fix asset (PPE) turnover ratio through time and against peers. If this deteriorates that it may suggest equipment is obsolete or inefficient utilization of the equipment.
4) Excessive probability of financial distress – You could assess level of debt in firm capital structure as well as its ability to service this debt (coverage ratio or EBIT/Interest, CFO/Interest). These ratios should be compared across time and against peers.