Introduction to Financial Analysis
Understanding financial performance involves 2 distinct but related activities:
Finding the information and calculating appropriate financial ratios.
Interpreting the various ratios to determining what they reveal about the company.
The first activity is a straightforward exercise – all it requires is some leg work and a little math.
The second activity, however, requires both an understanding of what the individual ratios mean
and an ability to integrate the information from different ratios to reach reasonable conclusions.
Note the use of the term
in the last sentence above.
accurate or correct or some other more concrete and definitive term?
financial performance involves a combination of science, art, judgment, and preference.
would be nice if financial statements and the various ratios we calculate from them were
definitive, the reality is that they never will be.
For one thing, there are a variety of judgments
made by the accountants who initially create the financial statements - for many of these
judgments, there are 3, 4, 5 or even more ways consistent with generally accepted accounting
principles that could determine how the numbers could be stated.
Depending on the judgments
made, the conclusions that the numbers point to could vary substantially.
Next, while there
general rules of thumb regarding how to interpret the value of any given ratio, there are
exceptions for everyone.
Further, when you begin to look across ratios and integrate
interpretations across several different financial areas, the possibility of multiple
Finally, personal preferences and experiences of the person interpreting
the numbers come into play.
What one person considers a risky venture another may interpret as
a reasonable chance for a significant return.
What one person considers too much debt, another
may consider a wise financial choice given the available financing options. In neither of these
cases is there an absolute “right” or “wrong” answer.
The best that we can hope for is a
answer given all of the information available.
Some of you may wonder where this leaves us and why we even bother to calculate the numbers
if there is no “right” answer. This is a reasonable concern. You must always remember, though,
that the numbers do not exist in or come from a vacuum, nor are they really the final end we are
The numbers are a result of various past actions and decisions made by those who
operate the company.
What we are really seeking to understand when we do financial analysis is
a general understanding of how the firm has performed in the past, how they are likely to
perform in the future, and where we should focus our attention in doing further analysis of the
In the information that follows, we will try to gain a clear understanding of where the appropriate