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Ratio analysis of financial statements involves a mathematical interpretation of the financial records of a company, in order to understand its past performance and future prospects. Ratios can be used in understanding corporate performance at two levels:
a. Trend analysis: Comparing the performance of a company over a period of time.
b. Peer group analysis: Comparing the performance of a company with other company’s within the same industry/ sector.
Ratios are a great tool for assessing the efficiency of management by looking at financial trends in light of the progress and opportunities in the business. Financial ratios serve as a great tool in assessing if management’s strategies are realistic and if such strategies are achieving desired results over a given period of time.
Never get carried away with the strength of a (single) ratio: Analysts use many metrics to analyse financial statements and business efficiency, all in order to arrive at a future forecast for a business. Remember, no single ratio can provide a perfect tool for examining a business and in order to conduct a meaningfulstock analysis, it is most critical to understand some key ratios in totality and not in isolation. To take an extreme example, it is easy to accomplish an extremely healthy current ratio by selling off assets and putting money in the bank. A good financial investigation should involve analysis of ratios under 4 main categories:
One may ask, Why should I not always buy FMCG companies on that logic?Compare oranges with oranges: When conducting ratio analysis, it is important to benchmark the performance of a business either with its historic performance or with the performance of another company within the same industry/ sector. Depending upon the industry/ sector, ratios will look different and hence should have different benchmarking standards. For example, FMCG Companies operate with huge profit margins since they have high asset turnover as compared to automobiles. Hence, they have high profitability and efficiency ratios.
The answer mainly lies in the expensive valuations and high price to earnings (P/E) at which these companies trade. Let’s take the example of 2 companies, Auto Limited and Biscuit Limited.
Auto Limited earns 10% ROE while Biscuit Limited earns 30%. Which Company is better? That would depend on the share price or the price at which you acquire the equity. Let’s say an investor wants to invest Rs. 1,000. Lets further assume that the EPS will remain stable in the next year, what return does the investor earn in each case?
The example highlights two important aspects. First, the importance of evaluating ratios in totality (in our case the importance of using P/E ratio in combination with ROE). Secondly, benchmarking the ratios to industry standard and not comparing ROE across different industries.
Avoid benchmarking beyond a point: It is not possible to evolve a standard ratio to judge the performance of all businesses or industries at all times. Financial and economic scenarios are dynamic and the underlying conditions for different firms and different industries are not similar (See point II for more on this). While a benchmark industry standard (i.e. the mean / median approach for every industry) is good to some extent, it should be used with caution.
When evaluating and scoring companies be mindful that different standards must be used for different industries/ businesses. Additionally, the evaluation must constantly be adjusted based on the future outlook of the industry and of the company, which explains why an ROE of 22% for two companies even in the same industry may obtain variable scores.
Basis for calculation of ratios: Before making any intra-company or peer group analysis, be sure that the basis for calculating ratios should be the same. Different companies follow different accounting policies. For example, some companies may report interest/ finance charges as part of total expenditure, while others may disclose it as a separate line item. Similarly, some enterprises charge depreciation on straight line basis while others charge at diminishing value. Make sure that before you seek to draw comparisons based on financial ratios, the financial statements on the basis of which those ratios are drawn are uniformly presented. If not, certain adjustments in the presentation or classification of items will be necessary in order to make a rational comparison.
Try to spot window dressing: Manipulations in financial statements have a synchronised affect on the financial ratios derived from such statements. It is all too easy to improve the appearance of a company’s financial statements for a given period and is mostly done towards the end of an accounting period. For public limited companies, window dressing is even easier given that the large number of public shareholders have little information about the day to day operations of the company. For example a company may delay paying its suppliers for a while in order to make attractive, the cash balance for the end of a given period or may switch its depreciation method.
It is not always easy to spot creative accounting of this nature, but looking at the financial statements and trends over a longer term can give valuable insights and highlight if the accounts are clean, even though it may remain difficult to spot the exact nature of manipulation for a given period.
Give equal if not more importance to qualitative analysis: It is true that the financial figures say what management often times finds hard to. If used correctly, they do present a true picture of the financial health and historical performance of a company.
The biggest problem with financial ratios is that they do not tell anything about qualitative aspects which many times override the quantitative aspects. For example, in a bid to earn ‘interest’, banks usually look at financial ratios before approving loans, even though the character of the borrower often determines the safety of ‘principal’. It is important to understand why the ratios look weak or strong in light of qualitative aspects such as managerial ability and integrity, and the future strategy of the company.
It is easy to confuse Return on Equity (ROE) with return on investment. In the above case, the investment is Rs. 1,000. Return on Equity is determined by the purchasing power of that Rs. 1,000 (i.e., return on the number of shares purchased for this amount of Rs. 1,000). Remember Ben Graham’s definition of stockholders equity: ‘The interest of the stockholders in a company as measured by the capital and surplus.’
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