Financial Ratio Analysis

Financial Ratio Analysis also referred to as ‘Quantitative Analysis’ is considered to be the most important step while analyzing a company from an investment perspective. It is a study of ratios between various items in financial statements. Ratios are classified as profitability ratios, liquidity ratios, asset utilization ratios, leverage ratios and valuation ratios based on the indications they provide. Balance sheet, Income Statement and Cash Flow Statements are the most important financial statements and if properly analyzed and interpreted can provide valuable insights into a company’s business.

Financial Ratios is commonly used by current and potential investors, creditors and financial institutions to evaluate a company’s past performance to spot trends in a business and to compare its performance with the average industry performance. It also enables them to identify strengths and weaknesses of a business and to justify further investments in the business. Internally, managers use these ratios to monitor performance and to set specific goals, objectives, and policy initiatives.

While analyzing a company from financial point of view, some of the common questions which an investor has are:

1. How did the company perform over the last couple of years and what were the returns it generated for the previous stakeholders?
2. How was the performance relative to the industry it belongs to?
3. Does the company have enough liquidity to overcome any short-term market fluctuations?
4. How does the company handle its working capital?
5. How risky is it to invest in this company?

These are the most common questions any investor has in his mind when he looks at the financial statements of a company he plans to invest in. While massive amount of numbers in a financial statement may be bewildering and intimidating to a layman investor, Financial Ratio Analysis enables him to understand these numbers in an organized fashion.

The most important assumption the analyst should make sure while drawing conclusions based on financial ratios is that the accounting policy of the company has remained constant over the period of review. Changes in accounting policies may distort the indications provided by the ratios. For example, companies that intend to enhance their asset return ratios may change the depreciation accounting method applied; thus providing misleading asset return ratios. The analyst should therefore make adjustments for any material differences in accounting policies before evaluating ratios. Similarly, it is equally important to allow for any material differences in accounting policies while comparing the company with other industry players.

While ratios do provide valuable insight into the company’s past performance and potential problems, they cannot be evaluated on a stand alone basis. For a thorough examination of a business, the analyst must read between the lines and check for any major fluctuations in any line item in financial statements. Non-recurring items and extra-ordinary expense or income items must be excluded for meaningful analysis. Similarly, wide fluctuations in revenue figure or expense figure should be justified. Here the importance of Note to financial statements cannot be overemphasized. Information provided in these notes to financial statements can be very helpful in avoiding inappropriate investment decisions due to misleading financial ratios.