The analysis of financial data applies different techniques to outline the comparative and relative importance of the data displayed and to make the avaluation of the firm position. These techniques comprise ratio analysis, common-size companies' analysis, trend analysis, etc.
The analysis of financial data applies different techniques to outline the comparative and relative importance of the data displayed and to make the avaluation of the firm position. These techniques comprise ratio analysis, common-size companies' analysis, trend analysis, etc. The information obtained from these analysis types should be combined to determine the company financial position. No one type of analysis could provide the overall financial position or satisfy needs of all users.
Financial Ratio Analysis
A ratio can be calculated from a pair of numbers. As financial statements contain large quantity of variables, it is possible to derive a very long list of meaningful financial ratios.There is no standard list of financial ratios or standard methods of their calculations.Each author or source of financial analysis employs a different list and often a different calculation of the same financial ratio.
Ratios are explicable in case of comparison with
- prior period ratios;
- financial ratios of competitors;
- average industry ratios;
- defined standards.
Taking into account the specific interests of the parties concerned, internal and external; financial ratios can be grouped into different classes. The parties are short-term and long-term lenders, owners, management, investors, etc.Each of these parties may require different financial ratios namely:
(i) short-term creditors have main interest in the liquidity state or short-term solvency of the company;
(ii) long-term creditors have main interest in the profitability and long-term solvency of the company;
(iii) owners have main interest in the profitability and financial state of the company;
(iv) investors have their main interest in the every particular part of the company’s financial performance.
Management needs to protect the interest of all company' parties and monitor if the company demonstrates the profitable growth. As result,taking into account the requirements of different users of financial ratios, they can be divided into the following important categories:
|Liquidity ratios;||Debt / Leverage ratios;||Coverage Ratios;|
|Profitability ratios;||Asset Management Ratios||Market value ratios|
Comparison of profit and loss statements and balance sheets in the form of needs can create difficulties due to the timing of financial statements. In particular, the profit and loss statement covers the entire fiscal period; the balance sheet - the end of the period. Thus, ideally, to compare the indicators of the income statement, such as the amount of receivables, you need to know the average receivables for the year that represents the sales figure. However, this data is not available for external analytics. There are cases when an analyst deploysan average of the beginning and ending balance sheet figures.This method removes changes from beginning to end, but it does not eliminate issues related to seasonal or cyclical changes. It also does not represent changes which occur irregularly throughout the year.
Most financial ratios mean little when viewed in isolation. For example, an inventory turnover ratio tells us how many times per year the company’s inventory is sold. A value of 20 is not interesting until we learn that other firms in the industry have an inventory turnover ratio of 3. Similarly, gross profi t margins, liquidity ratios, and activity ratios all vary substantially depending on the industry. Clearly, a grocery store will turn over its inventory more frequently than an auto dealer will.
Cross-sectional analysis is the comparison of one firm to other similar firms. A cross- section of an industry is used as a comparison for the firm’s numbers. There are a variety of sources of cross-sectional information. Value Line, Risk Management Association, and Mergent all publish industry average ratio statistics. One way to identify a firm’s industry is by its Standard Industrial Classification (SIC) code. SIC codes are four-digit codes given to firms by the government for statistical reporting purposes.
Many firms do not have any clear industry to use for comparison, such as conglomerates that do business in dozens of different industries. There are no good guidelines for picking comparison numbers for these types of firms. In other cases, the firm under study so dominates the industry that the industry ratios are simply mirroring that firm. Consider General Motors (GM). With so few firms in the auto manufacturing business, what happens to GM happens to the industry.
One solution to the problem of finding good comparison numbers is to create your own list of competitors. Compare the firm under analysis to the averages found from this list. Often, this approach yields far superior comparison numbers than can be found in the published reference materials.
Another equally important method of financial analysis is time-series analysis , which involves comparing the firm’s current performance to prior periods. This method allows the analyst to identify trends, changes over time that are more or less consistent in one direction. Unless the firm has undergone some type of major restructuring, prior period numbers are a near perfect comparison against today’s figures.