The variety of methods can be used to evaluate the current position and effectiveness of the company, based on the financial statement data. Most important are ratio analysis, vertical and horizontal analysis, year-to-year change analysis, competitors comparison, etc. These methods are used to discover the turning points, which are specific events and trends that signal changes that can influence future financial performance of the company.
Ratio analysis is an efficient method of the firm’s performance evaluation, making it possible to approach the company’s financial condition from different angles. Depending on the needs of an analyst, financial ratios may be a tool of measuring the company’s liquidity, financial sustainability, activity or profitability (these are the main existing ratio categories). Applying ratio analysis to the company’s financial statements can be a base for different conclusions on the business health, as well as for the prediction of possible future development trends. It is useful for a wide variety of users: from the company’s owners, searching for the ways of improving their business efficiency, to the existing and potential investors, considering the ratio analysis as their risk management tool.
Liquidity ratios provide the measurement of the company’s ability to meet its current obligations. Objects of the liquidity ratio analysis mainly are the company’s current assets and current liabilities. The ability to pay the short-term debt is an important indicator of the financial stability of a business. The main ratios included to this group are cash ratio, quick ratio, current ratio and others.
To measure the financial sustainability of a firm, debt ratio analysis is being applied. It indicates the ability of a firm to carry its debt in the long run. Normally greater debt means greater bankruptcy risk; that’s why it is important to understand if the company has enough sources of finance to meet its long-term obligations. The main ratios of this category are the debt ratio, times interest earned, debt to equity ratio, etc.
Activity ratios measure the efficiency of the company’s asset utilization. It indicates the level of the company’s asset management efficiency. If the company’s use of its inventories, fixed assets and accounts receivable is effective enough, the activity ratios will reflect the positive trends. This group of ratios includes total asset turnover, accounts receivable turnover, cash conversion cycle and others.
One of the most important measures of the company’s performance is a group of profitability ratios. These ratios measure the ability of the company to earn profit, which is the key goal of the business. Most commonly, profitability ratios are being divided into margins (showing the firm’s ability to transform money from sales into profits) and returns (measuring the ability of the company to generate returns for the stockholders). Key ratios of this category are net profit margin, return on assets and others.
All the data needed for the above-mentioned ratios computation can be obtained from the company’s financial main statements (balance sheet, income statement, etc.). Normally, even if a set of the same ratios calculated for the different periods doesn’t provide enough information for a precise analysis, it still will reflect a positive or negative trend in the firm’s development. To avoid misleading conclusions, it is necessary to compare all the computed ratios with main competitors and with industry averages.
Vertical and horizontal analysis provide insight into the structure and dynamics of the company’s assets, sources of financial resources and financial results. Vertical analysis shows the weight of different elements and helps to understand if they are well balanced. For example, the high share of trade receivables means that clients are distracting part of capital from the operational process. This can lead to the rise of cost of the attraction of additional financial resources. Vertical analysis of the equity and liabilities helps to understand if creditors are well protected. Given a high share of equity, one can assure that in case of insolvency providers of financial resources will receive their money back. Vertical analysis of financial results shows how important different revenues and expenses are for the company and what their role in a profit earning process is.
Horizontal analysis presents the change of the same element value over the period under review. As a part of the horizontal analysis, year-to-year change analysis helps to predict future performance based on the financial information of prior years. Considering industry and macroeconomic trends, an analytic can assess financial risks of the company. For example, year-to-year shortening of working capital can lead to the liquidity loss. A strong trend of losing equity means that company may become a bankrupt.
It’s important to notice that financial conditions differ among industries. For example, the automation software industry is on its rise, while gas-extracting companies have problems related to the low price of fuel on the global market. That’s why the comparison with its major competitors is needed. Companies are working in the same conditions, so it helps better to understand management effectiveness. Better performance on the same market means higher financial effectiveness. An analytic can also compare indicators of the studied company with industry averages.
Overall findings of the company’s financial analysis should reflect the result of every used method. An analytic can emphasize financial strengths and weaknesses and give its opinion on the prospects of the company. Depending on the financial statement analysis goal, one can answer following questions:
1. How effective is a company?
2. How strong is its current position?
3. What is a value of the net assets?
4. How well are the creditors protected?
5. Are there any threats to the company’s financial sustainability?
6. Are there any changes that will influence future performance?