The tools of analysis discussed in this article are helpful in making investment decisions, evaluating performance and forecasting future developments.
Comprehensive business analysis, however, calls for going beyond the conventional financial measures to consider qualitative factors relevant for evaluating the performance and prospects of a company. The American Association of Individual Investors (AAII) has summarized these factors as follow:
1) Are the company’s revenues tied to one key customer? If so, the company’s performance may decline dramatically if the customer goes elsewhere. On the other hand, if the relationship is firmly entrenched, this might actually stabilize sales.
2) To what extent are the company’s revenues tied to one key product? Companies that rely on a single product may be more efficient and focused, but a lack of diversification increases risk. If revenues come from several different products, the overall bottom line will be less affected by a drop in the demand for any one product.
3) To what extent does the company rely on a single supplier? Depending on a single supplier may lead to unanticipated shortages, which investors and potential creditors should consider.
4) What percentage of the company’s business is generated overseas? Companies with a large percentage of overseas business are often able to realize higher growth and larger profit margins. However, firms with large overseas operations find that the value of their operations depends in large part on the value of the local currency. Thus, fluctuations in currency markets create additional risks for firms with large overseas operations. Also, the potential stability of the region is important.
5) Competition. Generally, increased competition lowers prices and profit margins. In forecasting future performance, it is important to assess both the likely actions of the current competition and the likelihood of new competitors in the future.
6) Future prospects: Does the company invest heavily in research and development: If so, its future prospects may depend critically on the success of new products in the pipeline. For example, the market’s assessment of a computer company depends on how next year’s products are shaping up. Likewise, investors in pharmaceutical companies are interested in knowing whether the company has developed any potential blockbuster drugs that are doing well in the required tests.
7) Legal and regulatory environment: Changes in laws and regulations have important implications for many industries. For example, when forecasting the future of tobacco companies, it is crucial to factor in the effects of proposed regulations and pending or likely lawsuits. Likewise when assessing banks, telecommunications firms, and electric utilities, analysis need to forecast both the extent to which these industries will be regulated in the years ahead, and the ability of individual firms to respond to changes in regulation.
In common size analysis the items in the balance sheet are stated as percentages of total assets and the items in the income statements are expressed as percentages of total sales. Such common size statements provide a useful perspective, facilitate better understanding and sensitize the analysts to secular changes and emerging trends.
The Du Pont chart is a popular tool of financial analysis. A useful diagnostic tool, it provides an insight into the two determinants of return on total assets: net profit margin and total assets turnover ratio. By including a financial leverage ratio, the Du Pont analysis may be extended to explore the determinants of the return on equity.
Financial ratios may be combined to answer some questions that are commonly raised by investors and others. They may be used to assess corporate excellence, judge creditworthiness of customers, predict bankruptcy, value equity shares, predict bond ratings and measure market risk.
While financial statement analysis can be a very useful tool, there are certain problems and issues encountered in such analysis that call for care, circumspection and judgment.