The analysis process and ratio basics

The financial analysis framework

Analysis can serve very different goals: valuing shares, rating a bond, vetting an acquisition. So before computing anything, the analyst pins down the purpose and context: what questions must be answered, how much detail is needed, what data exist, which factors matter and what limitations could impair the work.

The work then runs through six phases. The output of each phase feeds the next, and the last phase loops back to the start as new information arrives.

This module concentrates on phases 3 and 4: turning raw statements into adjusted figures, common-size statements and ratios, and interpreting them.

Computation versus analysis

A pile of ratios, tables and graphs is not an analysis. Analysis integrates them into one coherent story that explains what happened, why it happened and whether value was created.

Looking back, the analyst asks which aspects of performance are critical in this industry, how well the company did on them against a benchmark, and what caused the result. Looking forward, the questions become: what is the likely effect of a trend, how will management respond, what does that mean for future cash flows, what do I recommend and what are the main risks?

A written report should show how conclusions were reached: the purpose, the business context (economy, infrastructure, legal and regulatory setting), governance and strategy, the key assumptions and the conclusions with their limitations and risks. Several years of data, typically 3 to 10, make the narrative stronger.

Why ratios, and their limits

Saying a result is 'good' or 'bad' requires a comparison. Cross-sectional analysis compares a company with others at the same point or over the same period; trend analysis compares it with its own history. The two are complementary, not alternatives: comparing a company with its competitors means checking where its ratios stand against the peers' now (cross-sectional) and how its ratios have moved over time relative to the peers' own trends. A margin above the peer average that is shrinking while peers' margins widen tells a different story from the snapshot alone. Ratios make both possible because they control for size, and if you only compare ratios you do not need to translate different currencies.

A ratio is an indicator, not the answer. A higher net margin tells you one company keeps more of each sale; it does not tell you whether that comes from pricing, cost control or a lower tax rate. Research has found ratios useful for selecting investments and predicting financial distress, and ratios give insight into economic relationships for forecasting, financial flexibility, management's ability, changes over time and comparability with peers.

There is no official list or formula book for ratios. Names and definitions differ between analysts and databases. Faced with an unfamiliar ratio, look at the numerator and denominator: they tell you what is measured and whether higher is better.

• Diversified operations: a company spanning several industries has no clean peer group.
• Consistency: one set of ratios may flag a problem that another set shows to be short term.
• Judgment: ratios alone cannot value a company or set its creditworthiness; the whole business and its economic setting matter.
• Accounting methods: FIFO vs LIFO vs average cost (LIFO not allowed under IFRS), cost vs equity method for affiliates, straight-line vs accelerated depreciation, lessor lease classification under US GAAP. Adjust before comparing.

Practical details: averages, periods and sources

When a ratio puts an income statement or cash flow figure (earned over the year) over a balance sheet figure (a point in time), use an average balance. Ending assets understate performance for a growing company, because some income was earned before the new assets arrived; beginning assets overstate it. Ratios built only from balance sheet data normally need no averaging, except where they are part of a decomposition that uses averages, such as DuPont analysis. For seasonal businesses, an average of quarterly balances is better than a simple two-point average.

Databases make many years of data easy to use and can compute ratios for periods other than the fiscal year, such as the trailing 12 months (TTM) or most recent quarter. TTM = last full fiscal year − the year-ago interim period + the latest interim period.

Vendors define ratios differently and use judgment, for example in deciding what counts as operating income. Use one source consistently and check its definitions. XBRL tags items in regulatory filings so software can collect them automatically. For private companies, industry data are often reported in quartiles, which show where a company ranks.

Ratio families and the context for interpretation

Ratios are grouped by what they detect. Every category helps judge the company's ability to generate cash flow and the risks attached to it.

A ratio means little in isolation. Compare it with prior periods, with expectations set before results were published, with industry peers (care: multiple business lines, different business models, industry-specific relevance and accounting methods all distort norms), with the company's own goals and strategy, and with economic conditions: a cyclical company's ratios improve in booms and weaken in recessions. Even suspiciously stable ratios deserve a look, since they can reflect earnings smoothing.