Google Inc. is a global technology leader. It generates 99% of their revenues from advertising programs related to its internet search engine, video sharing, online maps, online shopping, and e-mail services. However, Google is growing and expanding too rapidly over recent years. Shareholders should be aware of the hidden risks that are not included in Google’s financial reports. We should learn from the mistakes of Enron, don’t overlook the off-balances sheet activities. By evaluating Google financial position, performance, and prospects of using trend analysis and ratio analysis, we can provide the necessary information to the shareholders.
The Form and Content of the Annual Report
There are particularly a number of significant sections included in Google’s annual report, such as Selected Financial Data, Management’s Discussion and Financial Condition and Results of Operation, Quantitative and Qualitative Disclosures about Market Risk, and Financial Statements and Supplementary Data (Google Inc., 2008). Selected Financial Data showed income statements and balance sheet data for the years ended of 2004 to 2008. These data can help analyzing company’s trend over years and predicting company’s future performance. In Management’s Discussion and Financial Condition and Results of Operation section, first there are discussions by the management team of the activities and then it explained what statements regarding Google’s expectations. Google also gave details about how the Company generated revenues, what are trends in their business, and what are their recent developments. In addition, the results of the business section presented vertical analysis data of income statements and advertising revenues from 2006 to 2008. Therefore, we can use these common-size statements to compare with other companies with different size. Above sections I have mentioned is trying to ensure the readers receive the impression of business’ performance and the management. Moreover, the most important parts are Google gave explanations of significant costs and expenses occurred within these years and disclosed liquidity and capital resources.
Furthermore, Market Risk section disclosed changes in currency exchange rates and interest rates, which would affect the Company’s revenues. The last important part is Financial Statements and Supplementary Data. Financial Statements section is considered as the main part of the annual report. Consolidated financial statements of Google are prepared and presented in accordance with Generally Accepted Accounting Principles format (U.S. GAAP), which established by the Financial Accounting Standards Board (FASB). The financial statements included Consolidated Balance Sheets, Consolidated Statements of Income, Consolidated Statements of Stockholders’ Equity, and Consolidated Statements of Cash Flows, and Notes to Consolidated Financial Statements. The accounts of Google and subsidiaries are included in the consolidated financial statements. The balance sheet is known as a statement of financial position, which shows a statement of the assets, liabilities, and owner’s equity. The income statement presents the company’s financial performance, which includes revenues and expenses. And cash flow statement focus on the movements of cash in or out of the company (Alexander & Nobes, 2007). These statements Supplementary Data disclosed ‘information that is not included elsewhere and provided additional details on items which is not on the face of financial statements, and moreover presented accounting policies used for significant transactions and events’ (Alexander & Nobes, 2007: 111).
Analysis of Financial Position
In trend analysis, first I evaluated consolidated statements of income and consolidated balance sheets by using horizontal analysis to calculate percentage change between 2007 and 2008 in order to compare trends over time. Next, I used vertical analysis to make income statements of Google and Yahoo having common size in order to compare their financial statements.
In the income statements, it showed Google’s revenues increased from $16.6 billion to $21.8 billion, which apparently increased 31.35%. Moreover, the Company’s net income has grown 0.6% over the prior year, which increased nearly 23.0 million from $4,204 million to $4,227 million. The financial increases in revenues and net income looked healthy so far. Besides, an increase of 29.7% in cost of revenues was not more than revenues increase. Next noticeable change was total operating expenses. The result in a percentage increase of 34.6% was more than the revenues percentage increase, which was a bad sign to the Company. If operating expenses continued growing faster than revenues do then it might cause the loss in the future. Among the operating expenses, an item of general and administrative expenses was a key item needs to be monitored closely since its change rate was growing at an alarming rate of 40.9%. Google had explained about this change in the annual report. This increase was primarily caused by related costs of professional services, labor and facilities, and bad debt expense (Google Inc., 2008). Investors still should be aware and kept investigating this item in the future. The significance of the changes in the income statements analysis is an item of net interest income and other. It decreased $273.2 million from the year ended December 31, 2007 to the year ended December 31, 2008, which declined by 46.3%. Google has also given details about this decrease in the annual report. This was because an increase costs in foreign exchange and a decrease in interest income. More hedging activity under foreign exchange risk management program and lower yields on cash and investment balances caused these changes (Google Inc., 2008).
In Google’s Consolidation Balance Sheet, net deferred income taxes were $68,538 in 2007 and $286,105 in 2008, there was a 317.4% increase. There are two reasons for this arises. First, Google accrued an accounting expense in relation to bad debts (current economic downturn has caused risks of an increase in bad debt expense). Second, the Company has operating loss carryforwards for income tax purposes so these tax losses reduce taxable income in future years. For these two situations, tax relief can be obtained only when the provisions are utilized. Next, let’s take a look at current and non-current accounts of prepaid revenue share, expenses and other assets. From 2007 to 2008, these accounts have increased by 102.3% and 157.4% due to prepayments associated with AdSense and distribution agreements, it was a good sign for t for investors to know that the Company is good to be invested in. As we know, Google is a company focused on improving ways for users search with information and generating revenue from these users who click on advertisements. Thus intangible assets are growing continuously since the Company always comes up with new ideas of information technology for their advertisers. Their research and development expenses have an increase of 31.8%. The increase of 123.2% in net intangible assets due to develop information technology and patents that Google’s employees produced. Moreover, goodwill rises from 2.30 million to 4.84 million, which was percentage change of 110.5%. It could increase the Company’s value in order to be a sustainable business.
In vertical analysis, I used common-size comparative income statement to let investors compare Google and Yahoo, which are companies of different sizes. Note that all income statement accounts are stated as a percentage of revenues (revenues is as the base of 100%). First, comparing two companies’ cost of revenues, Google’s cost of revenues was 39.6% of revenues and Yahoo’s cost of revenues was 41.9 % of revenues. Google has the lower percentage of cost of revenues, so it generated greater percentage of gross profit compared to Yahoo. Google’s gross profit was 60.4% of revenues and Yahoo’s gross profit was 58.1% of revenues. Next, I noticed that Yahoo has a high percentage in total operating expenses of revenues, which was 57.9%, compares to Google’s total operating expenses was 30.0% of revenues. Since Yahoo’s total operating expenses has too high percentage of revenues, its income operation from operations only remained 0.2% of revenues. Google still has 30.4% of revenues in income from operations due to higher gross profit and lower operating expenses. Final one is Google’s net income as a percentage of revenue was 19.4% and Yahoo’s was 5.9%. Overall, Google has a positive trend and performance is superior compared to Yahoo’s performance in 2008.
There is a variety of key financial ratios may present available of assessing a company’s financial performance and prospects. They highlight both areas of good and bad performances, and also area of significant change. Also, ratio analysis is helping users to analysis the relationships between items shown in the set of accounts (Arnold, et al., 1994). This whole picture let users understand a company’s past performance and to make predictions about future performance. Ratio analysis might be used to measure profitability, liquidity, investment, and leveraging. If these ratios are used correctly, they are a useful tool for understanding company’s accounts. In ratio analysis, I will mainly compare current period’s (2008) ratio with preceding periods’ ratios from financial statements and also compare ratios with Google’s primary competitors- Yahoo! Inc. and Microsoft Corp..
Liquidity ratios are concerned about the company’s current financial position. If the company has a liquidity problem, there is an increased challenge to achieve long-term objectives and also an increased risk of failing to generate any future cash flows (Arnold, et al., 1994). There are two main liquidity ratios: current ratio and quick ratio. First, current ratio measures the availability of cash to pay its debts when they become due without selling off fixed assets. Google’s 2008 current ratio was 8.77 compare to Yahoo! Inc., its current ratio was 2.78. Although Google has no problem to pay its debts, the Company’s very high ratio might cause the shareholders and loan creditors to question why so much capital has been invested in current assets or doubt the Company may not be used its current assets efficiently (Harrison, 1986). Yahoo has more ideal working capital ratio of 2.78: 1 (ratio should ideally be 2:1). If Google compare current ratio of 8.77 in 2008 to ratio of 8.49 in 2007, ratio in 2008 was fall within its own normal range. The current ratio increased because Google invested their excess cash primarily in four short-term debt instruments of U.S. government: ‘municipalities in the U.S., time deposits, money market mutual funds, and corporate securities’ (Google Inc., 2008). Besides, within the current assets there are items which might not be realizable in the very short term, and then the owners should rely on the other current assets to provide immediate liquidity to meet any demands from short term creditors. Therefore, the company calculated the quick ratio/ acid test ratio, which can test the Company’s ability to pay its immediate liabilities. Google’s quick ratio was 8.03 and Yahoo’s ratio was 2.65. Google has a higher quick ratio then Yahoo, which means that Google has no problem to meet short-term obligations. Although Google does not have a sign of a shortage of liquidity, the Company’ too strong quick ratio might suggest that the Company is having difficulty in collecting its debts due to an economic downturn. Overall, Google has a good liquidity position, but shareholders and creditors should track if these two high ratios have caused other problems that they can’t see on the face of the financial statements.
Profitability ratios measure how effectively the company has used its assets and controlled its expenses to generate investment returns. There are six main profitability ratios: gross profit margin, net profit margin, and return on equity, return on capital, return on capital employed, and return on assets. First, the gross profit margin measures how much each $1 of sales revenue earns as gross profit and efficiency in converting revenue to profit (Elliot, 2008). Google’s ratio was 60.44% in 2008 and 59.93% in 2007. Thus, for each $1 of sales revenue generated, Google earned $59.93 gross profit in 2007 and $60.44 gross profit in 2008. This percentage increased steadily from 2004 to 2008 as Exhibit 1 shows, so it would not need to be investigated. Second, the net profit margin shows the net profit of the business in relation to its sales. From 2006 to 2008, net profit margin has declined from 29.02% to 19.39%, showing the company decreased in efficiency and did not doing well on trimming of overhead expenses. Net profit margin was growing from 2004 to 2006, but it started to fall from 2006. Therefore, net profit margin should be critically investigated to see what the cause of the problem was.
Third, the return on equity (ROE) measures how well a company uses investment funds to generate earning growth. Google created a return of 14.97% after tax, which was a acceptable level. Comparing with Yahoo’s ROE of 3.77%, Google has high ROE with large asset bases so the company has higher barriers to entry. Fourth, the return on capital measures how well the company generates cash flow relative to the capital it has invested in its business. Google’s ROC of 18.29% was high compares to the industry’s ROC of 15.00%. Fifth, the return on capital employed (ROCE) indicates management efficiency and measures profitability generated by the company with the investment (the total value of fixed and current assets). Google’s ROCE ratios rose from 13.19% in 2007 to 14.01% in 2008, reflecting a healthy return on capital invested. Google’s increased rate indicated that profits can be reinvested into the company for the benefit of shareholders. The last important investment return ratio is the return on assets (ROA). It shows how profitable the company generates revenue with its assets. This ratio is easier to understand for the non-financial manager who may find difficulty to understand capital employed that used in ROCE. In 2008, Google’s ROA ratio was 13.31% and Yahoo’s ratio was 3.10%. Google’s high ROA ratio presented that the Company was earning more money on less investment.
Next is investment ratios (market ratios), such as earnings per share (EPS), price/earnings ratio (P/E ratio), and price to book ratio are indicators of what investors respond of the company’s past performance and future prospects. A ratio of earnings per share tells what profit has been earned by the common shareholder for every share held. Google’s earnings per share (EPS) increased from $10.21 in 2006 to $13.53 in 2007 and then slightly decreased from $13.53 in 2007 to $13.46 in 2008. These price changes seemed not stable. Investors might dislike this erratic performance since profits widely fluctuated (Walsh, 2008). Next, price/earnings ratio measures the price paid for a share bears to earnings. At the end of year 2008, Google’s P/E ratio has significantly dropped from 104.10 to 35.10 (since 2004). During an economic recession, Google lost more than half of its value because Google is the company with a high P/E ratio so it fell faster than other companies with a low P/E ratio. For comparison, from 2004 to 2008 Yahoo increased its value from 51.6 to 72.4 and Microsoft decreased constantly from 35.7 to 16.3. Looking at the P/E ratio graph in Exhibit 2, we can see Yahoo increased slightly over years and Microsoft did not sharply decline as Google did. Investors probably have realized that it’s risky to invest in a company like Google, which has a high P/E ratio. Overtimes investors are only willing to pay $35.10 for $1 of current earnings. Besides of an economic downturn, reasons for E/P ratio of Google dropped sharply might because its size increases, a greater proportion of liabilities, or greater rates of inflation.
Price to book ratio gave the final and last assessment of the company’s overall stock market status. P/B ratio is calculated by dividing market capitalization by total ordinary funds (the book value of the equity). Investors would be able to gather information on Google’s performance of profits, balance sheet strength, liquidity, and growing potential by analyzing the P/B ratio. When compared Google with those in the technology sectors, Google’s P/B ratio was just in between (show as following). For the rule of thumb, the considerable range of P/B ratio is between 1.0 and 2.0. Thus, Google’s P/B ratio is better than the guideline which produced a factor of 3.43.
Finally, I analyzed the Company of using leveraging ratios, such as debt ratio and debt-to-equity ratio (D/E) are known as risk ratios, which measure the company’s ability to repay long-term debt (financial leverage). Google’s debt ratio, which indicated the company’s ability to repay long term debt, was 0.11 and Yahoo’s debt ratio was 0.18. And Google’s debt-to-equity ratio, which indicated the relative proportion of liabilities and equity used to finance the company’s assets, was 0.12. The owners want to take lesser risk on their investment and also increase their earnings per share by paying lower fixed rate of interest with using outside financing. On the other hand, the creditors want owners to invest and risk their share of proportionate investments. Therefore, a ratio of 1:1 is usually considered as a satisfied ratio. However, comparing to Yahoo’s 0.22, Google’s D/E ratio of 0.12 stated the Company did not generate earnings from relying on outside financing (debt).
During the Global Economic Recession, evaluations of both trend and ratio analysis proved Google Inc. has the good performance and the strong market position compared to the overall industry. By using horizontal and vertical analysis techniques, Google’s financial statements presented a healthy financial condition when compared data with previous years and with companies in the same industry. Ratio analysis found out there might be some potential problem factors in liquidity, profitability, and investment for shareholders and creditors to monitor, but overall Google has a positive trend and its ratios are at the acceptable level.