When you look at financial statements it’s of course possible to see changes in the figures from one accounting period to the next but it’s not easy to get a sense of what the change means to the business’ overall financial performance or financial position.
To overcome this, the information contained in the income statement, balance sheet and cash flow statement is used to calculate a number of percentages and ratios that provide you with a basis from which to make an assessment of the business’ risk profile, sustainability and its ability to repay debt.
How many ratios should you use in your analysis?
There are many ratios and margins that can be used but that’s not to say they should be used. The ideal is to get a clear view of the business’ financial performance and financial position with as few ratios and margins as possible. Using too many can lead to a situation known as “analysis paralysis” when too much data makes it difficult to reach a final decision.
Ratios alone are not enough
Ratios and margins are an important part of financial analysis but they are only one piece of the credit risk assessment process. Never forget that the financial information that you see is the result of a given set of business circumstances such as;
- The current phase of the economic cycle
- The current level of competition
- The technology in use to deliver the product or service to market
- The effectiveness of the business’ strategy
- The ability of the management team
- The availability of capital and other funding…………to name but a few.
Successful credit risk assessment requires an understanding of the business, its internal and external operating environments and its future plans. Ratios and margins are merely indicators of how the various factors in these environments have affected the business, either positively or negatively up to that point in time and, at best, only help you to identify the questions that have to be asked of the management of the business to get a clear view of the credit risk.
It pays to be skeptical
When you analyse financial information it pays to be skeptical about the accuracy of the information. It’s possible, for example, that the information has been generated specifically for the tax authorities and so may not be a true representation of the real financial position of the business in the sense that profits may be much less than they really are.
Also, check whether the financial statements have been independently audited or reviewed by someone reliable and trustworthy. If not, you should take the information at face value and then try to find ways to check some of the key figures for yourself.
Don’t confuse ratios and margins with actual values
When you work a lot with ratios it’s easy to forget what the actual values are. For example, you might feel that a business with a profit margin of 5% is not very profitable. But, if revenues are US$200m, then that 5% translates into a profit for the year of US$10m which is not a small amount.
Ratios and margins are not predictors of the future
The ratios and margins that are used in financial analysis are generally historical in that they are based on financial statements that are, at best, a few months old. Remember that the financial information is the result of a set of specific circumstances in the business’ operating environments and there’s no guarantee that those circumstances will still be the same in the current or next financial period.
We use the ratios as a basis from which to project forward what the business’ performance and financial position might be like in the future based on our understanding of what the business environment may be like in the next several months and our understanding of what the business’ drivers are and the way they impact the financial results.
The most obvious forward-looking calculation that you can do is to add in the interest cost and approximate capital repayments on any new debt that the business may now be requesting (which is often the reason for conducting a financial analysis).
Limitations of Ratio Analysis
- They may be based on stale financial information – financial statements may be several months old by the time they are received for analysis.
- Some of the figures contained in the balance sheet may, themselves, be historical in the sense that fixed assets are brought onto the balance sheet at their initial cost which could have been some years before. The true value of the assets may be different and this could mean that some of the ratios would not tell the true story.
- The ratios are based on balance sheet information which is representative of only one day in the accounting period. It is relatively easy to manipulate some of the figures in the balance sheet and so the analysis and interpretation of the information may not be a true reflection of the business’ real financial position.