When it comes to financial margins and ratios we like to think they tell us what we need to know about the business. Actually, they tell us very little unless we see them in their proper context.
Why use margins and ratios?
Financial statements are analysed to assess the financial performance and financial position of a business. Lenders also analyse financial statements to understand a business’s need for funding and its ability to service and ultimately repay the debt.
If we can understand the past and current financial performance of a business it enables us to predict the future more accurately.
When we look at the 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 us with a basis from which to make an assessment of the business’ risk profile, sustainability and its ability to repay debt.
A margin or ratio on its own is useless
However, a ratio or margin on its own is useless. It is difficult to gain any meaningful information from a ratio or margin unless it is compared to something. There are two types of comparison;
- Industry comparative analysis (also known as peer analysis) – here the ratios and margins will be compared with those of similar businesses in the same industry to establish a standard – in many countries this information is not readily available, however.
- Time-series analysis – here the ratios and margins of the business for the current accounting period are compared to those for previous periods to establish a trend over time.
These two analysis methods can be used simultaneously where comparative industry information is available.
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 “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
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 bank or 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.
See the post about Fake Financials: How and Why for more information on this point.
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.