Value of Finacial Ratios in Assessing Performance

What is the value of Financial Ratios in Assessing Performance?

• Teams of investment analysts pour over the historical and forecast financial information of quoted companies using ratio analysis as part of their toolkit of methods for assessing financial performance. Venture capitalists and bankers regularly use ratios to support their analysis when they consider investing in, or loaning to businesses.

Ways to assess performance:

• Comparing performance over time:

  • A danger of examining just one year's results is that the numbers can hide a longer-term issue in the business.

  • It is possible to see whether a trend is emerging by looking at data over several years. Public companies in the UK are required to publish a five-year summary of the income statement to help shareholders assess trends.

• Comparing performance against competitors or the industry as a whole:

  • Assuming that the detailed information is available, a comparison against competitors is useful for management and shareholders to assess relative performance.

  • Has the business' revenues grown as fast as close competitors? How has the business performed compared with the market as a whole?

• Benching against best-in-class businesses:

  • Comparisons with other businesses that are not direct competitors can also be useful, particularly if they help set the standard that the business aims to achieve. Care has to be taken with this, though. The benchmark business might operate in a very different industry, with significantly different profit margins and balance sheet norms.

The main strength of ratio analysis is that it encourages a systematic approach to analysing performance:

• However, it is also important to remember some of the drawbacks of ratio analysis

  • Ratios deal mainly in numbers – they don't address issues like product quality, customer service, employee morale and so on (though those factors play an important role in financial performance)

  • Ratios largely look at the past, not the future. However, investment analysts will make assumptions about future performance using ratios

  • Ratios are most useful when they are used to compare performance over a long period of time or against comparable businesses and industries – this information is not always available

  • Financial information can be "massaged" in several ways to make the figures used for ratios more attractive. For example, many businesses delay payments to trade creditors at the end of the financial year to make the cash balance higher than normal and the creditor days figure higher too.

Potential weaknesses in using published financial information to assess performance:

1. Valuing some assets and liabilities on the balance sheet involves subjective judgment. For example, management has some discretion about what provisions they need to make for trade debtors who may not pay or for obsolete stocks.

2. Accounts are largely descriptive about what has occurred in the past – rather than explaining why. Publicly quoted companies are required to provide much more detailed commentary on the financial statements in the Annual Report. However, the vast majority of companies are not publicly quoted!