Netflix Financial Ratio and SWOT Analysis (2008–2010)

Introduction to Financial Ratio Analysis

Financial ratio analysis can shed significant insight into the operations of a company. Ratio analysis typically focuses on liquidity, solvency, profit margins, operating efficiency, and returns as key metrics from which an analyst can draw conclusions about a firm's performance. The financial ratios for Netflix for the past three years are contained in Appendix A. These ratios are focused on activity, leverage, and profitability. In general, Netflix saw improvements in profitability and leverage over the past year, but experienced a decline in activity levels during that same period.

Financial Ratio Analysis of Netflix

Based on this analysis, Netflix has been a successful company over the past few years. Most of the financial metrics improved during this period, and although performance was not uniformly positive, Netflix appears to hold a strong market position. The company's margins improved over the course of the past two years — gross, operating, and net margins all increased. This broad improvement suggests that most of the gains occurred at the top line, indicating that Netflix strengthened its pricing power relative to either sellers or buyers. The fact that top-line improvements carried through to the net margin suggests that Netflix grew its operations without an undue expansion in its cost structure.

The company's returns are also generally strong. Return on equity (ROE) increased sharply in 2009 and 2010, but this can be explained by the increased use of debt, as evidenced by the debt-to-equity ratio. The lower the proportion of equity in the capital structure, the higher the ROE will be, all other things being equal. More encouraging, then, is the improvement in ROA and ROI over the same period. The leverage the firm undertook in 2009 was partially paid down in 2010. The current debt level is perhaps high for a company as young as Netflix, but the fact that it has reduced some of its debt load — at least on a percentage basis — is a positive sign. It is also possible that Netflix adopted this capital structure to take advantage of the low interest rates available at the time. If so, the firm may be well positioned to shift its capital structure back toward equity once interest rates begin to rise. For now, the debt-to-equity ratio is more something to monitor than something to be alarmed about.

The main trouble area for Netflix in terms of financial ratios relates to activity levels. The company's inventory turnover decreased in 2010 from prior-year levels, and days of inventory expanded to 48.66 days from 36.80 days in 2009. Rising inventory levels can be a warning sign that a company's activity is slowing. Ideally, Netflix would recognize this trend and adjust its inventory levels to bring turnover back to historical norms. If the increase represents a temporary deviation, there is little cause for concern. However, a sustained trend of increasing inventory levels would be problematic, particularly because movie rental inventory can become stale and generally diminishes in value over time. Turnover must be kept high by moving out extra copies of slow-moving titles and ensuring that existing inventory reaches paying consumers.

Netflix does not record accounts receivable on its balance sheet. This makes it impossible to calculate an average collection period, and therefore no judgment can be made regarding the firm's ability to turn over its receivables.

Cost Advantages and Competitive Positioning

Cost advantages typically arise from economies of scale, which give a firm improved pricing power over suppliers. This pricing power can in turn be passed on to consumers through lower prices as a means of gaining market share. At its current stage of development, Netflix should hold a cost advantage over its primary competitor in the video rental business, Blockbuster, given its relative size. When Netflix launched, this was not the case, but Blockbuster failed to leverage its pricing power to undercut Netflix. Netflix ultimately prevailed through a superior business model.

However, Netflix may not hold a cost advantage over companies that function as substitutes, such as media vendors Amazon and Walmart. Compared with those firms, Netflix lacks the economies of scale necessary to achieve a cost-leader position. Those competitors are currently substitutes for Netflix, but there is a real risk that they could become direct competitors. As such, Netflix may benefit from expanding its scale in order to strengthen its buying power and establish a more durable cost advantage within the video industry.

SWOT Analysis

Netflix's strengths include a large installed base of users, which represents a captive audience and delivers economies of scale in purchasing and distribution. The company also benefits from a strong brand, having established itself as a leader in online video rentals. In addition, Netflix has built strong relationships with the media industry over the course of its operations, giving it access to virtually all major media properties.

A key weakness is Netflix's lack of international presence, which constrains growth opportunities. The company is also heavily reliant on the video rental business with no meaningful diversification. This concentration was a contributing factor in the decline of Blockbuster, the company Netflix displaced, and it could pose a similar risk for Netflix in the event of a significant technology shift.

International expansion represents a significant opportunity, as the Netflix business model has not yet been widely replicated in international markets. There is also opportunity in shorter-form content better suited to smartphones and other portable devices. Expanding into music or other media product lines would provide additional diversification. On the threat side, technological change poses the greatest risk, given Netflix's single-business focus. The company could also face increased competition from larger retailers that choose to adopt the Netflix model. Finally, Netflix carries a high degree of leverage; if it becomes overleveraged in pursuit of growth, solvency issues could emerge.