Financial statements reveal a lot more about a company than what
it earned, what it owes and the historical value of its assets. To bring
the economics of a firm into focus you need to study and thoroughly
analyze its financial statements. It is important to realize that no
individual figures on a financial statement are very useful in and of
themselves. You might, from time to time, hear (or even have said)
something like, "You don't need to throw all those numbers at me. I'm
only interested in the bottom line."
There is a big difference between profit and profitability. While Company B made twice the profit, it was less than half as profitable as measured by return on assets. Why? Because, as our ratio makes apparent, it used its assets less efficiently than did Company A. This simple ratio was useful in providing us with a bit more insight into these two companies. Ratios show the relationship of one item to another. We can express this relationship between any two items that can be quantified. In order for a ratio to be relevant, however, there must be a significant relationship between the two items it compares. In a sense, then, our discussion of financial statement analysis is about relationships.
Let's suppose we have calculated the significant ratios and thoroughly analyzed the relationships between all of the relevant items on a firm's financial statements for the current year. We've made a good start. We still, however, don't know as much as we should to make informed judgments about the performance or financial health of the firm. To get a further insight into the firm, we need to compare the results of our computations with some type of benchmark or, better yet, benchmarks. There are generally four benchmarks we might use: past performance of the company (i.e. horizontal, or trend, analysis), the performance of the best-performing companies in the same industry, industry averages, and a pre-set target. The name of the game in financial analysis is comparison, comparison, comparison.
Trend analysis compares this year's results with past years' and is useful in revealing the direction, speed and extent of trends. It allows us to compare trends in related items. For example, we can compare the rate of change in sales with the rate of change in accounts receivable. Under normal conditions we would expect them to change at roughly the same rate. If the rate of change in accounts receivable is significantly greater than the rate of change in sales we should ask why. Perhaps the firm changed its credit policy and is now extending credit to higher-risk customers. Perhaps more accounts receivable are in danger of not being collected. Similarly, the rate of change in cost of goods sold should parallel that of labor costs. If not, we should ask why.
There is a big difference between profit and profitability. While Company B made twice the profit, it was less than half as profitable as measured by return on assets. Why? Because, as our ratio makes apparent, it used its assets less efficiently than did Company A. This simple ratio was useful in providing us with a bit more insight into these two companies. Ratios show the relationship of one item to another. We can express this relationship between any two items that can be quantified. In order for a ratio to be relevant, however, there must be a significant relationship between the two items it compares. In a sense, then, our discussion of financial statement analysis is about relationships.
Let's suppose we have calculated the significant ratios and thoroughly analyzed the relationships between all of the relevant items on a firm's financial statements for the current year. We've made a good start. We still, however, don't know as much as we should to make informed judgments about the performance or financial health of the firm. To get a further insight into the firm, we need to compare the results of our computations with some type of benchmark or, better yet, benchmarks. There are generally four benchmarks we might use: past performance of the company (i.e. horizontal, or trend, analysis), the performance of the best-performing companies in the same industry, industry averages, and a pre-set target. The name of the game in financial analysis is comparison, comparison, comparison.
Trend analysis compares this year's results with past years' and is useful in revealing the direction, speed and extent of trends. It allows us to compare trends in related items. For example, we can compare the rate of change in sales with the rate of change in accounts receivable. Under normal conditions we would expect them to change at roughly the same rate. If the rate of change in accounts receivable is significantly greater than the rate of change in sales we should ask why. Perhaps the firm changed its credit policy and is now extending credit to higher-risk customers. Perhaps more accounts receivable are in danger of not being collected. Similarly, the rate of change in cost of goods sold should parallel that of labor costs. If not, we should ask why.