Okay, although people who are business finance majors will not want to admit this, it turns out that accountants are actually better at analyzing financial statements than finance majors are. What evidence do I have of this argument? Simply this, accountants are the ones creating the numbers and placing them on the financial statements that the finance majors analyze. If you believe that everything on those statements is cold hard fact, then you would be very, very wrong. Accountants agonize over the exact number to place and they use methodologies and judgments to come up with these numbers. Most finance majors have no idea where these numbers come from and simply do a bunch of ratio analysis trusting everything we beloved accountants say.
If you want to be a master in the analysis of financial statements, then suck it up, get a degree in accounting, and read the notes at the end of the financial statements. These notes will tell you what the creators (accountants) of this information did to come up with these numbers. If you’re just looking for some quick, albeit weak analysis then use the information below.
So at the bottom of this article I will list some of the commonly used ratios for financial statement analysis; however, before I get there I want to give a brief introduction of how to use these. First of all, most rookies in the business have a tendency to see these ratios, plug them all into excel, and try and draw conclusions. These beginners are missing the most important step.
Step #1: Develop an expectation. In this step you will need to have some form of expectation of what you think the ratios should be. At this point you need to ask questions like what would be a good ratio? What would be a bad ratio? What’s the industry average? Too many people rush to the calculations and then try and do this step afterwards. Once you’ve performed the calculation you are anchored or biased towards what you’ve calculated. For example let’s say you calculate the day’s receivables outstanding ratio and find it to be 25 days. Your initial reaction will be that you have a winner. However after some research you find that the industry average is 20 days. Now the company you’re analyzing isn’t looking so good. Develop expectations before jumping into the calculations
Step #2: Define thresholds. Now that you have your expectations clearly defined you may want to set some thresholds. I’m talking about setting limits. For example you may say that if this stock beats the industry averages by more than 3% then I will invest in it. Otherwise I will not. It helps to have these thresholds preset so that you don’t talk yourself into some poor decisions post calculations.
Step#3: Perform calculations. Now that you have your expectations and thresholds clearly defined, you may proceed to do the calculations (most finance majors will begin their financial statements analysis here: rookies).
Step #4: Form Conclusions. You’ve calculated your ratios and now can test them against your thresholds and form your conclusions.
For a good list on some common ratios I would recommend visiting: http://www.cpaclass.com/fsa/ratio-01a.htm
