Analysts often conduct two types of analysis: (a) cross-sectional (i.e. comparing one company with its peers), and (b) time-series (i.e. comparing a company across time). In conducting cross-sectional analysis, an analyst uses ratios and common-size financial statements standardize a company’s financial results such that a comparison with peers can be made regardless of size. Similarly, horizontal common-size financial statements are useful in understanding performance trends across time.
Ratios express one financial parameter in terms of another. For example, the return on assets (ROA) ratio tells the cents earned per dollar of investment in assets, etc.
Research has confirmed that financial ratios are useful in selecting investments and identifying companies that would experience financial distress. However, there are certain aspects which an analyst keep in mind so as not to over-rely on ratios:
- A financial ratio is just an indicator of a company’s performance or position and not the answer to our analysis objective (without further interpretation).
- Different accounting policies (and standards) may distort ratios.
- Not all ratios are relevant for a particular analysis.
- Interpretation of why a ratio has changed over time is essential.
Published financial ratios
Published ratios must be used with care because (a) there is no consensus on formulas used to calculate different ratios, (b) one ratio may have different names, (c) different ratios may be calculated differently in different industries.
For example, return on assets (ROA) ratio can be calculated by dividing operating income by average total assets or by ending total assets. If the asset base is not stable, the different formulas can result in significantly different values (and conclusions). Generally, it is better to use an average of balance sheet values when the numerator is an income statement item. When both items are from the balance sheet, both values may be ending or beginning, except for a situation in which we are decomposing some ratio (such as the DuPont analysis of ROE).
Value, purpose and limitations of ratio analysis
Ratios provide useful information about a company’s financial performance. They provide information about (a) internal economic relationship which may be useful in projecting earnings and cash flows, (b) a company’s financial flexibility, (c) changes in an industry, and (d) peer group of a company.
However, ratio analysis suffers from serious limitations:
- A company may have exposure to diverse industries making identification of comparable difficult,
- There might be conflicts in conclusions reached using different ratios (for example, one ratio may be very good and another very poor),
- Judgment in needed in determining the reasonable range for a ratio, and
- Different companies, industries, etc. may opt for different accounting policies and methods which can result in a difference in ratios without no difference in underlying economics. For example, some countries may record the cost of sales based on the FIFO method while others may use the weighted average or LIFO methods.
Source of information for calculation of ratios
Ratios may be calculated either directly from the company’s financial statements or obtained from third-party vendors (in which an analyst must confirm the formulas used). There has been progress in automating the process of computation of ratios due to innovations such as XBRL, which is a database that assigns tags to different financial information such that automatic and consistent computations are possible. Peer companies can be selected based on popular industry classification systems.
A common-size analysis involves expression financial statement as a percentage of a single financial statement. There are two types of common-size financial statements: vertical and horizontal.
Common-size balance sheet
A vertical common-size balance sheet is prepared by dividing all balance sheet items by total items. It tells information about a company’s financing mix, its assets mix, etc.
A horizontal common-size balance sheet is prepared by dividing each balance sheet item by the base year value of that item. For example, it is created by dividing inventories in Year 3 by inventories in Year 1. It is useful in trend analysis because it allows us to see how each item on the balance sheet has changed. For example, it helps us see whether an increase in accounts receivable is coupled with a decrease in inventories or vice versa.
Common-size income statement
A vertical common-size income statement presents each income statement item as a proportion of revenue (but sometimes as a proportion of total assets, mainly in case of financial institutions). Revenue is often segregated into different sources. It allows us to see the contribution of different products to total revenue and how that revenue is consumed in different activities and what percentage is left-over as profit.
Cross-sectional analysis (also called relative analysis) involves comparison of financial ratios of a company with another company or a group of companies (called peer group). Standardization through ratios or common-size financial statements allows comparison between companies even if their sizes are different.
Trend analysis focuses on how a company is performed historically. If carried out over a fairly long time horizon, it allows us to uncover any seasonality that may exist in a company’s performance which in turn can be helpful in projecting the company’s financial outlook.
A horizontal common-size balance sheet and income statement are useful in trend analysis. Historical information is most relevant if the general macroeconomic environment has been stable.
Relationship between financial statements
When conducting trend analysis using common-size financial statements, it is important to look at how the component financial statements, i.e. income statement, balance sheet, and cash flow statements are related. For example, a rapid increase in revenue (which can be determined from the income statement) must be corroborated change in total assets (which is obtained from the balance sheet) to see whether efficiency has improved.
Use of graphs
Cross-section, and particularly trend analysis information is best communicated through graphs. It is because they allow us to instantly compare companies with each other and with themselves across time. Pie graphs are useful in showing composition of the total value, such as a breakup of total revenue. Line graphs are useful in showing trends. Similarly, stacked column graphs are used when we want to see changes in composition.
In complex situations, analysts may often use regression analysis to identify the underlying drivers of trends in a company’s financial performance and position. For example, a company’s sales may be regressed against GDP to see how responsive they are to changes in GDP and use GDP forecasts to project the company’s sales.