Financial statements, together with financial ratios, provide a valuable way of “keeping score” in respect of current business performance and the way in which performance has changed, or is forecast to change, over time.
Financial statements record values for assets, liabilities, income, expenditure, cash flow and retained earnings. “Accounting values” are based on a range of accounting standards and methods. They are recorded within financial statements and enable analysis of the financial health of a business through the production of key ratios which throw light on important aspects such as profitability, liquidity, working capital management, reliance on borrowed money and the market for shares.
Profitability ratios measure how effectively an organisation uses its assets and controls its expenses in order to generate an acceptable financial return on capital. It should, however, be noted that the profit for “accounting purposes” may bear little relationship to value created by the business. This is because many of the value drivers for the future success of a business, such as the accuracy and reliability of knowledge and processes or the quality and effectiveness of leadership and relationships, are not included within financial statements.
Liquidity ratios measure the ability of the business to generate the cash needed to service debt. Demonstrating the ability to cover interest and repay borrowing is a key determinant of “Access to Finance”. It should be noted that virtually all the assumptions for business forecasts and sensitivities are, again, intangible in nature. The ability to do the deals which end up being recorded within financial statements is what really matters and winning or losing deals will depend on both financial and non financial aspects of the business.
Working capital ratios measure the efficiency (speed) with which an organisation is able to covert its non-cash working assets like raw materials, work in progress, finished goods and debtors into cash. Other activity related ratios may include the impact of changes in sales on profitability or the relationship between sales and the utilisation of capital assets like plant and machinery, office equipment, premises and so on.
Debt ratios measure the ability of the business to repay long term interest-bearing debt. Interest-bearing debt is referred to here to distinguish between creditor finance (e.g. suppliers, staff, government taxes) and specialist creditors (e.g. debt providers like banks and finance companies).
Market ratios measure the desirability of owning shares in terms of issues like, earnings per share, the extent to which earnings are paid as dividends, the Market Price per share / Earnings per share (P/E) ratio, market to book ratio, earnings growth and so on.
The Value of Financial Ratios
Financial ratios allow benchmarking of business (hence management) performance against something comparable. For example, companies which operate in the same sector, between different activities within the same sector, or between different markets. Understanding relative performance or relative contribution (benchmarking) helps management to choose how best to allocate their resources between different activities to achieve their overall objectives. Ratios also provide a starting point for throwing light on reasons for changes in performance of a business over time and for assessing the impact of future plans on the financial health and creditworthiness of the business.
Problems with Financial Analysis
Financial statements are easily distorted by, for example:
- Application of differing accounting treatments
- Timing of expenditure such as repairs, training, advertising
- Recognition of income arising from contracts and agreements
- Decisions regarding values for stock or work in progress
Financial statements only include values which arise from financial transactions, they do not reflect value creation or value destruction due to changes in efficiency, safety, reliability, quality, reputation, training, knowledge, ideas, innovation and a wide range of other “intangibles”.