Mtm4 white paper financial ratio and statement analysis

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Financial Ratio and Statement AnalysisIntelligence Collaborative - Mastering the Methods Series

Financial Ratio and Statement Analysis

This White Paper is #4 in a series of intelligence methods being offered to members of the Intelligence Collaborative. It was developed by Dr. Craig S. Fleisher to provide a concise overview of how to apply key intelligence methods to support analysis. Although every effort is made to ensure that the information is accurate and fit for its purpose, the author and Aurora WDC make no implied or explicit warranties as to its applicability or use in your particular work context.

Please direct any questions about this paper to its author at the following:Craig S. Fleisher, Ph.D.

Aurora WDCEmail: [email protected]

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Other White Papers are available on a regular basis from http://IntelCollab.com. Related Methods in the series are:

Industry Analysis

Issue Analysis

Product Life Cycle Analysis


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Abstract

Financial ratio and statement analysis (FR&SA) is an excellent tool for providing critical insight about a company's financial condition and future competitive prospects. Ratios allow analysts to assess current performance, examine business trends, evaluate business strategies, and monitor progress.

The Method’s Primary Value

Ratio analysis is the study of relationships among and between various financial statement accounts. Ratios allow analysts to assess current performance, examine business trends, evaluate business strategies, and monitor progress.

1. Assess performance - Ratios serve as an analytical tool for measuring the performance of an enterprise in terms of margin, asset use and cost control. Ratio analysis also allows analysts to analyse the financial liquidity and stability of the enterprise by reference to the mix of assets and liabilities in place.

2. Examine business trends - When ratios are applied to the results of a number of years, ratio analysis allows analysts to examine trend performance in the context of the target’s existing business strategy.

3. Evaluate business strategies - When ratios are applied to a business plan, ratio analysis allows analysts to examine performance in relation to alternative business strategies.

4. Monitor progress - Having selected their optimum business strategy, managers can monitor the progress of a targeted enterprise by continuing to examine selected key ratios.



Overview of the Method

Ratio analysis is the art of analyzing the relationships between two or more amounts in a company's financial statements. The actual ratio results are even more meaningful when compared with a company's historical results or industry averages. Analysts employ financial ratios because numbers in isolation have little value. The true meaning of figures from the financial statements emerges only when they are compared to other figures. Such comparisons are the essence of why business and financial ratios have been developed. Financial ratios are particularly useful for analyzing a company's performance relative to its industry.

Where the Method Fits in Planning and Strategy

The main competitive analytical purpose of financial ratio and statement analysis is to gain an insight into a company's financial decision making and its operating performance. It therefore reduces the analyst’s reliance on guesses, hunches and intuition, which minimizes uncertainty in decision-making. Comprehensive analysis requires detailed calculations involving financial ratios, historical financials and future growth estimates, combined with industry and economic analysis. The more analysis you do on a targeted competitor company, the more you will learn about it and the success of its offerings.

Although financial statements provide much useful information, the large numbers and varying sizes and accounting practices of companies, especially in multinational contexts, make it quite difficult to compare performance from company to company and from year to year within one company. Ratio analysis is a useful technique for evaluating a company’s various financial characteristics.

Applying ratio analysis to financial statements enables the analyst to make judgments about the competitive success, failure, and evolution of a company over time and to evaluate how a company is performing compared with similar companies in the same industry. Ratio analysis can also help internal management of an organization gain an awareness of their company's strengths and weaknesses (see our MTM white paper on enhanced SWOT Analysis). And, if the analyst finds weaknesses, it can recommend actions to correct them before irreparable damage is done. If the analyst finds weaknesses in a competitor’s performance, the company can take measures to exploit these in the marketplace!

Cautions with Applying this Method

Financial ratios have some limitations that must be considered when the analyst uses them in analyzing a company. The discussion below will highlight some of the most common of these, although a comprehensive listing can be found in most detailed treatments of this area such as those we suggest in the further references section.



Financial ratios are based on historical accrual based accounting information. As such, financial ratios do not offer the analyst any direct insights into cash flow, an important component of value-based management. This can even be more important with embryonic, entrepreneurial firms that have proportionately greater burn rates and needs for cash in their earlier years.

A single ratio will not give you enough information to make a judgment about the firm. You must have additional data to make these judgments. The source of this data might be from comparing the ratios to the industry average or past company performance. Intra-company trends over time can also be enlightening to the analyst. The meaningfulness of an individual ratio also tends to be inversely related to the size of the initial base (i.e., denominator). Therefore, huge percentage changes on ratios with a small starting base are of limited analytical value. Similarly, ratios derived from negative denominators should be carefully interpreted.

Accountants do not include as assets certain items that are critical to the growth and well-being of a company. The quality of its employees is probably the most significant asset for many businesses, yet this vital asset is not reflected in the balance sheet. Financial statements virtually ignore these increasingly important intangible assets – a key source of competitive advantage in an information or knowledge-driven economy. FR&SA is inherently limited as an analytical tool for firms with valuable brand names or corporate reputations, intellectually skilled workforces or other intellectual capital.

Not all financial statements are of equal quality. It is best to use audited financial statements whenever they are available. Audited statements provide you with a far higher probability of using accurate, as opposed to possibly inaccurate, financial information. Bear in mind, however, that published ratios are not subject to public audits with the exception of the EPS ratio.

Even though it is important to use industry norms to evaluate your financial performance against your industry peers, caution should be applied in interpreting the results. Analysts who over-rely on industry comparisons risk leading their firms to the netherworld of what Michael Porter aptly describes as being “Stuck in the Middle” on the industry’s parabolic profit curve (Porter, 1980). Over-reliance on industry norms is akin to benchmarking mediocrity.

When using industry norms, the analyst must also remain aware of the issue of comparing dissimilar industry groups. Direct financial comparisons to rivals outside of your industry group may have low short-term utility. Even comparisons within industry groups are fraught with difficulty when rival firms are operating on a different portion of the industry profit curve by virtue of the chosen low cost, differentiation or scope strategies. Additionally, since most industry norms are calculated from aggregated financial statements, rating your firm’s financial performance to a diversified firm will cause a critical comparability problem if the lines of business are radically different.

In closely held businesses, it is not uncommon for the financial statements to reflect discretionary choices of the business owner as opposed to being limited to stating ordinary and necessary business expenses. The analyst should carefully consider the effects of management choices on the results of operations as reported in the financial statements. Sometimes, significant adjustments can be required to restate the financial statements to accurately portray the operations of the business.



Agency problems run rampant because of the operational flaws that stem from the dual purpose of public accounting. Accounting must satisfy two masters – first, the public regulatory environment and second, management information needs. Earnings management and “window dressing” can severely distort the accuracy of the analysis.

Internal corporate situations may also cause financial statements to be flawed. Some of these situations include:

• Managers who want to increase profits because their bonuses are based on the profits earned by their division. Also increased profits will allow them to be promoted in the company thereby causing them to inflate their earnings.

• Corporate officers can pressure managers to increase income to meet corporate budgets. • Accidental errors made by accounting departments that can cause increased profits or losses. • Corporate executives may pressure managers to report increased earnings so their stock options

and pay packages could be improved. Also when income is below budget the directors and or shareholders usually start to review those divisions that are having the reduced income with the view of reducing cost.

• Sometimes management try to budget for expenses that at a later date turn out to be substantially higher than expected. This can happen in law suits where the reserves set aside to pay for the court award which was based on past court decisions are not enough to pay for the amount awarded by court.

• A combination of the above.

Another problem that one must consider is whether the financial information was developed using the same accounting methods. The choice of an accounting method may have a significant impact on the income reported in the income statement and the value of the asset reported in the balance sheet. This is especially pertinent when doing international competitor comparisons and when competitors have operations in multiple countries that potentially utilize different accounting standard schemes. Some other technical considerations are to keep a sharp eye for differences in accounting policies (different depreciation schedules, inventory valuation, capitalization), account classification, or year-ends across firms that could distort the validity of the comparison.

Even when a firm’s financial ratios appear to conform to industry averages, this does not mean that the firm has no financial or other strategic management problems. For example, perhaps the firm is neglecting to exploit a clear differential advantage by which it could far outstrip average industry performance. Alternatively, perhaps the firm’s finances look good at the moment, but a serious competitive threat could wipe it out in the near future. In short, financial ratio analysis is a very useful tool for analyzing strategic management, but it cannot replace other types of analysis and careful consideration of the issues in the case.

Applying the Method

Performing a financial ratio analysis can be divided into several steps. First, the analyst must choose the appropriate ratios to analyze. Next, the appropriate sources must be located in order to provide the raw



data in which to calculate the ratios, a topic better covered in one of the many books available on the larger competitive intelligence data collection process. Following this, the analyst makes comparisons of the ratios. Lastly, a check is performed for opportunities and problems.

Calculate the Key Ratio Types

The major ones of these include:1. Activity or efficiency ratios2. Leverage or Solvency analysis ratios3. Liquidity analysis 4. Profitability5. Other (shareholder return or capital markets) ratios

Make comparisons:1. Against industry benchmarks2. Over time performance comparisons3. Consolidated and segmented analyses

Develop the context to understand opportunities and problems:To complete the picture, you must acquire more information about the company's products, people, technology, and other resources that may give it a competitive advantage in the marketplace. One of the best sources of supplemental information is the nonfinancial section of the annual report. This section, usually in front, often provides an outline of top management's views on the company's future and ability to compete.

In summary, FR&SA is a critical part of a larger, integrated financial statement analysis plan. This plan should include the following key steps:

1. Determine the objectives of the financial statement analysis. 2. Review the current, predicted economic conditions in the company’s industry. 3. Consult the annual report and other regulatory filings to glean information about management

and the company's accounting methods. 4. Analyze the financial statements using the means described in this chapter. 5. Draw relevant conclusions based on the initial objectives.



Complementary Methods

• Business Model analysis• Competitive Cash Flow analysis• Competitive Simulations/War Gaming• Forecasting• Nine Forces (Industry) analysis• Sustainable Growth Rate analysis• SWOT analysis• Trend analysis

Additional Resources

See chapter 6 (pg. 81-108) on Financial Ratios and Statement Analysis in the (2013) book Analysis without Paralysis: 12 Tools to Make Better Strategic Decisions, 2nd Ed., by Babette E. Bensoussan and Craig S. Fleisher, Upper Saddle River, NJ: FT Press.

Business and Competitive Analysis: Effective Application of New and Classic Methods by Craig S. Fleisher and Babette Bensoussan, 2007, Upper Saddle River, NJ: FT Press.

Strategic and Competitive Analysis: Methods and Techniques for Analyzing Business Competition by Craig S. Fleisher and Babette Bensoussan, 2003, Upper Saddle River, NJ: Pearson/Prentice Hall.



Complementary Methods

• Business Model analysis• Competitive Cash Flow analysis• Competitive Simulations/War Gaming• Forecasting• Nine Forces (Industry) analysis• Sustainable Growth Rate analysis• SWOT analysis• Trend analysis

Additional Resources

See chapter 6 (pg. 81-108) on Financial Ratios and Statement Analysis in the (2013) book Analysis without Paralysis: 12 Tools to Make Better Strategic Decisions, 2nd Ed., by Babette E. Bensoussan and Craig S. Fleisher, Upper Saddle River, NJ: FT Press.

Business and Competitive Analysis: Effective Application of New and Classic Methods by Craig S. Fleisher and Babette Bensoussan, 2007, Upper Saddle River, NJ: FT Press.

Strategic and Competitive Analysis: Methods and Techniques for Analyzing Business Competition by Craig S. Fleisher and Babette Bensoussan, 2003, Upper Saddle River, NJ: Pearson/Prentice Hall.


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Mtm4 white paper financial ratio and statement analysis