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 on the balance sheet by the same period’s total assets and expressing the results as percentages, highlighting the composition of the balance sheet 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 in the case of the financial institution.
A cross-sectional statement compares a specific metric of one company with the same metric of another company or group of companies, allowing 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. Estimation of future earnings is one of the most important factors investors take into consideration before investing. The positive future is what drives the investors into the company. Meanwhile, a dubious future means fewer investors interested in the company hence a decline in the stock prices.
Ratios are widely and most 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. Ratios express one quantity about another. A detailed explanation of the ratio is given in the next section.
Risk versus an average gain
Estimation of risk and average gain also plays an important role in the financial performance evaluation of the company. Though it cannot be accurately estimated, an approximate estimation of risks and gain are required as the automotive industry has a lot of risks but incredibly low gain. The risk of a company is calculated with the coefficient of the standard deviation of companies’ total revenue. Similarly, gains are estimated for each company by calculating the average return rate on assets and then compared with risk.
Introduction to financial ratio analysis
Financial analysis tools can be useful in assessing a company’s performance and trends in that performance. There are various techniques of financial analysis such as ratios, common–size analysis, Cross-sectional analysis, Trend analysis, etc. Financial ratio analysis is one of the best tools for the performance evaluation of any company.
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 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. This can make it difficult to find comparable industry ratios for comparison purposes.
- One set of ratios may indicate a problem, while another may indicate that the potential problem is only short-term.