The price that an investor pays today to buy a company?s share is not for its current performance, but for the future showing. If that?s the case, how do you ? as an investor ? asses the future financial performance of a company?
To answer this question, we need to know how to analyse the financial statement of a company in a scientific manner.
Essentially, financial statement analysis seeks to evaluate a company?s performance in several important areas, such as profitability, efficiency, risk, and so on. The ultimate goal of this analysis is to help you assess the future performance of the company, which, in turn, will determine whether you should invest your money in it or not.
Financial ratios
Numbers in isolation, typically, convey no or very little meaning. Ratios are basically the relationship between two numbers. Hence, an investor needs to use them in a scientific manner. Knowing that a company earned a net profit of R1 lakh is not as useful as the sales figure that generated this net profit and the assets or capital committed to the company. Thus, ratios
are intended to provide meaningful relationships between individual values in the financial statements.
As the major financial statements include numerous individual items, it is possible to produce a vast number of potential ratios, many of which will have little value. It is important to recognise the need for relative analysis.
Relative analysis
Just as a single number from a financial statement is of little use, an individual financial ratio has little value except in relation to comparable ratios for other entities. That is, only relative financial ratios are relevant. The important comparisons examine a company?s performance relative to (a) the aggregate economy; (b) its industry and its major competitor within the industry; and (c) its past performance.
Aggregate economy: The comparison to the aggregate economy is important because almost all companies are influenced by the economy?s expansion and contraction in a business cycle. For example, it is unreasonable to expect an increase in the profit margin for a company during recession; a stable margin might be encouraging under such conditions. In contrast, no change or a small increase in a company?s profit margin during a major business expansion may be a sign of weakness. Comparing a firm?s financial ratios relative to a similar set of ratios for the economy will also help understand how a company reacts to the business cycle and estimate the future performance of the company during subsequent business cycles.
Relevance of industry and competitors: The most significant comparison relates a company?s performance to that of its industry. Different industries affect the companies within them differently, but this company-industry relationship is always significant. The industry effect is strongest for industries with homogeneous products, such as steel, rubber, glass and wood products, because all companies within these industries experience coincidental shifts in demand.
In addition, these companies employ fairly similar technology and production processes. For example, even the best-managed steel company experiences a decline in sales and profit margins during a recession. In such a case, the relevant question is not whether sales and margins declined, but how bad the decline was and how the company performed relative to other steel companies?
As part of the scientific way of using ratios, one should examine an industry?s performance relative to aggregate economic activity to understand how the industry responds to the business cycle. When comparing a firm?s financial ratios to industry?s, it is not advisable to use the mean industry value when there is wide variation among individual firm ratios within the industry. Alternatively, one may believe that the firm being analysed is not typical; that is, it has a unique component. Under these conditions, a cross-sectional analysis may be appropriate, in which you compare the firm to a subset of firms within the industry that are comparable in size or characteristics.
A problem that arises when comparing a company?s ratios to an industry average is that many large firms are multi-product and multi-industry in nature. During such a scenario, one can construct the composite industry average ratios by computing weighted average ratios based on the proportion of companies sales derived from each industry.
Past performance:
Finally, one should examine a company?s relative performance over time to determine whether it is progressing or declining. This kind of a time-series analysis is helpful when estimating the future performance. For instance, some investors calculate the average of a ratio for a 5-10-year period without considering the trend. This can result in misleading conclusions. Ideally, one needs to examine a company?s time series of relative financial ratios compared to its industry and the economy.
Through scientific analysis of financial statements, one can gain knowledge of a company?s operating and financial strategy and structure. Combining what is known about the company, based on the analysis of historical data, with potential future scenarios, allows investors to reasonably forecast future financial performance.
The writer is an associate professor of finance & accounting at IIM, Shillong