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Financial statement analysis and interpretation
Financial statement analysis and interpretation

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3.2 Who needs ratios? The manager’s perspective

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Figure 6 Comparisons are vital in analysis of financial statements
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Figure 6 Comparisons are vital in analysis of financial statements

Ratio analysis can also provide managers with a wealth of information and is primarily the reason why the technique is introduced here. A manager might not be expected to become as proficient in ratio analysis as, say, a banking loan analyst, but an ability to use its basic tools will benefit managers in their day-to-day work. For example, it is likely that a manager will at some time need to provide financial data to a bank, perhaps as part of a proposal for project funding. A basic understanding of how the bank will use the information will enable the manager to present their organisation’s case in the best way. However, while the bank example is valid and important, ratio analysis offers far wider benefits to managers. Whatever the manager’s role, it is very likely that they will need, from time to time, an understanding of the financial position of a competitor or a commercial partner. The latter could be a customer (can they pay when required?) or a supplier (can they be relied upon?). In all such cases, a short time spent analysing the organisation’s published information will provide a surprising degree of insight into a potential partner. The information collected will not only provide data about the organisation’s current financial health and how likely it is to survive in the short, medium or long term but also indicates how capable the operational management is in running the business. This will always be helpful in a general way, will usually provide a beneficial negotiating position and will sometimes warn against a very unfavourable relationship with an organisation.

Comparisons

To analyse an organisation’s performance properly using ratios, you need to run comparisons.

Figure 7 shows the three different levels at which comparisons can be performed. Click on each heading to read more about each one.

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Figure 7 A company’s financial data can be compared at three different levels
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Sector comparisons

Sector comparisons allow you to analyse an organisation’s performance and work out whether it is better or worse than the average for the sector. You need to be careful when identifying which sector an organisation belongs to. Take ENI, the Italian energy conglomerate, for example. Is its sector the oil market, the energy market or some other sector?

Competitor comparisons

Competitor comparisons measure the performance of an organisation against that of its competitors. At this level, you can identify, for example, how performance can be affected by different technologies, different market approaches, different financial strategies, and so on. Note once again, though, that it can be hard to ascertain an organisation’s true competitors. Think, for instance, of the leading French retailer Auchan. Is it sensible to compare its performance to that of retailers such as Tesco or Marks & Spencer (hereafter M&S) in the UK? What about Lidl? Is it in competition with Auchan? What about Galeria Karstadt Kaufhof or Walmart? It could be said that the retail sector is complex and that it is easier to determine the competition in the energy sector, for example. ENI’s competitors are surely BP and Royal Dutch Shell. But can you be so sure? What about the fact that, historically, ENI has had a greater focus on natural gas, whereas other energy companies are more fossil-fuel driven? And how useful is it to compare emerging ‘green’ companies that produce and trade in vegetable oil with ENI? There is no easy answer, and each time you have to select organisations carefully when making comparisons – or at least recognise that you are not always comparing ‘like with like’.

Historical comparisons

Historical comparisons look at the trend in the ratios for the same organisation over a period of time. This is a useful tool for examining the success of an organisation’s business strategy. At the same time, it is important to be cautious about extrapolating any future performance on the basis of previous trends. Performance can change very rapidly and sometimes it is impossible to work out future trends from the current ones. What about an organisation whose turnover grew 150 per cent in the last year? Can you assume that it will grow by a similar percentage in the next year and in the year after that? One example is Lehman Brothers, which had a sound trend in performance up until the first quarter of 2008. It filed for bankruptcy in September 2008 – less than six months later!

Figure 7 A company’s financial data can be compared at three different levels
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Any findings should always be investigated and interpreted. Differences with respect to sector average values or historical changes for any ratio may, given the prevailing circumstances, indicate a positive development, a negative development or a change of no significance. Furthermore, each ratio needs to be considered both as an indicator for one piece of the analysis of an organisation and as an element in the overall picture given by the full set of ratios.