In corporate finance, two fundamental techniques are widely used: ratio analysis of financial statements and the calculation of the present value of future cash flows. These tools are essential for bankers, investors, financiers, CFOs, and entrepreneurs to value assets and make informed investment decisions. YouTube / Polishing Talents
Ratio analysis involves using accounting data from financial statements, which reflect past activities, akin to looking in a rearview mirror when driving. This method provides insight into a company’s historical performance and is a crucial capital budgeting tool.
Understanding Financial Ratios
Financial ratios are created by dividing one financial statement figure by another, forming a performance metric. These ratios can be expressed as percentages or numbers, depending on whether the comparison results in a value greater or less than one. They allow for the comparison of different companies or the same company over different periods, effectively normalizing the data for an apples-to-apples comparison.
Ratio analysis is foundational to the stock market investment strategy known as value investing. This strategy involves examining and comparing companies based on their relative value to determine if they are undervalued or overvalued.
Key Financial Statements
Financial ratios are derived from three primary financial statements:
- Balance Sheet
- Income Statement
- Cash Flow Statement
These statements are interconnected, with financial data flowing from one to another, providing a comprehensive view of a company’s financial health. Current financial statements offer a snapshot of the company’s recent performance, linking the present to the past.
For those needing a refresher on understanding financial statements, refer to my 10 Minute Series book on the subject.
Common Financial Ratios
Price/Earnings (P/E) Ratio
The P/E ratio compares a company’s stock price to its earnings, providing a measure of how much investors are willing to pay for each dollar of earnings. This ratio is particularly useful for comparing public companies and can also be applied to private companies by benchmarking against similar public companies.
Return on Equity (ROE) and Return on Assets (ROA)
These ratios assess how effectively a company uses its assets to generate income.
- ROE is calculated by dividing net income by shareholder equity.
- ROA is calculated by dividing net income by total assets.
Both ratios provide insight into the company’s profitability relative to its equity and total assets.
Debt-to-Equity Ratio
This ratio measures the company’s financial leverage by comparing its total debt to its shareholder equity. It indicates how much of the company’s financing comes from debt versus equity.
Conclusion
Ratio analysis is an invaluable tool for stock market investing. It enables investors to make informed decisions by providing a clear comparison of financial performance across different companies and periods. For those interested in mastering value investing, “The Intelligent Investor” by Benjamin Graham is a must-read. This book is considered the definitive guide on the subject and is highly regarded by successful investors like Warren Buffett.
By using financial ratios, you can eliminate size differences and achieve a pure comparison, ensuring you are comparing apples to apples in your investment analysis.
