The tools and techniques presented in this article facilitate the financial performance evaluation of a company’s financial data. Performance evaluation generally includes analysis of financial statements. Evaluations require comparisons. The various techniques are given in detail below:
Common-Size Balance Sheet
A common-size balance sheet is prepared by dividing each item by the same period’s total assets and expressing the results as percentages. This highlights the balance sheet’s composition, such as ‘What is the mix of assets being used?’, ‘How is the company financing itself?’, ‘How does one company’s balance sheet composition compare with that of peer companies?’ and ‘What are the reasons for any differences?’
Common-Size Income Statement
In a common-size income statement, we divide each income statement item by revenue or sometimes by total assets, especially for a financial institution.
Cross-sectional statement
A cross-sectional statement compares a specific metric of one company with the same metric of another company or group of companies. This allows comparisons even though the companies might be of significantly different sizes or operating in different currencies.
Time Series Technique
The time series technique is widely used in financial performance evaluation, for which analyzing the financial statements is particularly important. The performance over several years or quarters is compared in the time series. This method is also used for inter-company financial performance comparison. The trend developed from time series analysis can be used to predict future earnings, sales, or ratios. The estimation of future earnings is one of the most critical factors investors should consider before investing. The positive future is what drives the investors into the company. Meanwhile, a dubious future means fewer investors are interested in the company, hence a decline in the stock prices.
Ratios
Ratios are the most widely used technique in analyzing financial statements. There are many relationships between financial accounts and between expected relationships from one point in time to another. Ratios are a helpful way of expressing these relationships. They express one quantity about another. The next section gives a detailed explanation of the ratio.
Risk vs. an Average Gain
Estimation of risk and average gain also plays an important role in evaluating a company’s financial performance. Though they cannot be accurately estimated, an approximate estimation of risks and gains is required as the automotive industry has many risks but incredibly low gains. A company’s risk is calculated using the standard deviation coefficient of its total revenue. Similarly, gains are estimated for each company by calculating the average return rate on assets and then comparing it with risk.
Introduction to Financial Ratio Analysis
Financial analysis tools can help assess a company’s performance and trends in that performance. Various financial analysis techniques exist, such as ratios, standard–size analysis, Cross-sectional analysis, Trend analysis, etc. Financial ratio analysis is one of the best tools for evaluating a company’s performance.
The financial ratio is the numeric outcome obtained by dividing one financial data by another and is used to express the relativity of different financial variables. Balance sheets and income statements are the two most important and most used sources of financial information when calculating ratios. The financial ratio is the numeric outcome obtained by dividing one financial data by another and is used to express the relativity of different financial variables. Financial ratio analysis involves calculating and analyzing ratios that use data from one, two, or more financial statements.
Purpose of Ratio Analysis
The value of ratio analysis is that it can evaluate past performance, assess the company’s current financial position, and gain insights that are helpful in projecting future results. Financial ratios provide insights into:
- A company’s financial flexibility or ability to obtain the cash required to grow and meet its obligations, even if unexpected circumstances develop.
- The ability of the management
- Changes in the company and industry over time
- Comparability with peer companies or the relevant industry
- Limitations of ratio analysis
Limitations include the following
- Companies may have divisions operating in many different industries, making it challenging to find comparable industry ratios for comparison purposes.
- One set of ratios may indicate a problem, while another may suggest that the potential problem is only short-term.
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