Discussion Post and Two Responses

Evaluating Financial Performance

In this section, we will learn about one of the primary analytical tools commonly used to evaluate the financial performance of the firm—financial ratio analysis. Its use provides a financially sound, analytically powerful, and widely accepted approach for evaluating many critical aspects of a firm's financial performance.

Over the years, many standard financial ratio formulas have been developed and employed to evaluate various and specific aspects of a firm's financial performance. The art of this technique now rests in organizing these ratios for effective implementation, properly applying them in practice, and knowing the limitation of this technique. Because most textbooks cover this subject in detail and adequately develop the theory behind each financial ratio, in this section we will concentrate on two supplemental topics: (1) organizing the key financial ratios according to their application and (2) providing some additional perspectives regarding the uses and limitations of these techniques.

Organizing Financial Ratios by Application

The purpose of a financial ratio is to define a theoretically meaningful relationship between selected activities of the firm's financial statements that can provide insight into the firm's financial performance. Different practitioners and textbooks sometimes group the financial ratios differently. There are at least 15–20 standard financial ratios plus variations of some of them. Therefore, it is easy to lose sight of the forest for the trees.

Also, different practitioners and textbooks often group the financial ratios differently. One of the more logical and useful ways to group these ratios is by their ability to answer the following four key questions related to financial performance evaluation.

1. How liquid is the firm?

2. How effective is the firm in generating profits on its assets?

3. How is the firm financing its assets?

4. Are the shareholder returns adequate?

Using these four questions, the financial ratios can be grouped by category and be readily available to analyze a firm according to four different perspectives. Here is a detailed chart that organizes 10 key standard financial ratio formulas by the above four perspectives.

The Uses and Limitations of Financial Ratios

Who Uses Financial Ratio Analysis?

In addition to the management of the firm, a wide variety of individuals and organizations, for a variety of purposes, use financial ratios to evaluate the financial statements of publicly traded firms. The following is a list of some of the major users of financial ratios and their general purposes for doing so.

1. Investors and investment brokers use analysis to

· evaluate alternative investments' risks versus returns

· identify trends as indicators of a firm's future performance

· identify opportunities and risks in future investment

1. Banks use analysis to

· evaluate loans to firms

· evaluate loans to individuals (personal financial statements)

· establish interest rates (higher risk equals higher interest rate)

· manage clients' investment portfolios

3. Government regulatory agencies use analysis to

· evaluate new public stock issues [Securities and Exchange Commission (SEC)]

· conduct government audits [General Accounting Office (GAO)]

· establish rates for government contracting [the Defense Contract Auditing Agency (DCAA)]

4. The firm uses analysis for

· management planning

· financial planning

· credit management (who to give trade credit and on what terms)

· shareholder reporting

· evaluating potential mergers and acquisitions

· evaluating competitors

· identifying operational problems

· assuring compliance with loan covenants (normal with bank loans)

The Use of Financial Ratio Analysis

The reliability and value of the information gained from financial ratio analysis can vary significantly, depending on how it was conducted and on the quality and comparability of the financial statements, which provide the financial data. By itself, a ratio is just a number and not inherently meaningful. Stand-alone financial ratios are like stand-alone numbers. They have limited value unless associated with other references. For an obvious example, 3 by itself means little unless associated with some base, such as 3 degrees on the centigrade temperature scale.

The two basic approaches for meaningfully associating financial ratios are trend analysis and comparative analysis. In fact, it is the careful integration of trend analysis with ratio analysis that provides the single most powerful technique for evaluating financial performance. Normally, trend analysis is performed on annual or quarterly data because public companies have to report this information to the stockholders.

Of the two sources of data, the annual data are generally considered to be the more significant because of the annual audit requirement. The two approaches can also be used together to provide a more comprehensive picture of financial performance, such as "a comparative analysis of a firm's performance against the industry average over a three-year period."

The reliability of comparative financial ratio analysis is primarily a function of the accuracy and comparability of the two sets of source financial data. The analyst must be aware of the following factors.

1. Different companies may use differing, but GAAP-acceptable, accounting treatments, which can distort comparison of the financial statements and the ratios based on them.

2. Industry standards, although useful, combine many variations in accounting treatments and may also contain inaccurate or incomplete input information from industry members.

3. It should be obvious that comparing significantly differing firms over differing time periods will likely add such distortion as to render any analysis highly questionable.

In summary, the more comparable the financial statements and the more comparable the firms, the more meaningful will be the results of the financial ratio analysis—and vice versa.

Financial Ratio Limitations and Cautions

Remember that financial ratios, although important, are only one piece of the financial performance picture and are best used in conjunction with all other available financial information. In employing financial ratio analysis, it is important to be aware of their implicit weaknesses and limitations, as well as their explicit strengths. Be particularly aware of the following points in using financial ratio analysis.

1. A financial ratio is only as reliable as the accuracy of the financial data.

2. GAAP accounting allows significant variation between companies.

3. Accounting data are historical and therefore may not project current performance.

4. Industry averages can contain significant dispersion and approximations.

5. Industry classifications have problems with multi-product-line companies.

6. Many firms have pronounced seasonal and cyclical variations that can affect ratios.

7. Different fiscal year endings can affect comparability.

8. Any financial ratio evaluation is relative, not absolute.

9. Firms, to the extent possible, try to look their best at reporting time.

 Arnold S. Grundvig, Jr.   http://www.a-systems.net/accounting.htm