Question

How is investment potential different to financial performance. What financial Ratios tells us this?

Answer 1

Financial performance is a subjective measure of how well a firm can use assets from its primary mode of business and generate revenues. The term is also used as a general measure of a firm's overall financial health over a given period.

                 There are many ways to measure financial performance, but all measures should be taken in aggregate. Line items, such as revenue from operations, operating income, or cash flow from operations can be used, as well as total unit sales. Furthermore, the analyst or investor may wish to look deeper into financial statements and seek out margin growth rates or any declining debt. Six Sigma methods focus on this aspect.

    Often, the financial statements (e.g., balance sheet, income statement, and statement of cash flows) of a company are used to measure the financial performance of a firm. No single measure should be used to define the financial performance of a firm.

a. Balance Sheet

The balance sheet is a snapshot of the financial balances of an organization. It provides an overview of how well the company manages its assets and liabilities. Analysts can find information about long-term vs. short-term debt on the balance sheet. They can also find information about what kind of assets the company owns and what percentage of assets are financed with liabilities vs. stockholders' equity.

b. Income Statement

The income statement provides a summary of operations for the entire year. The income statement starts with sales or revenues and ends with net income. Also referred to as the profit and loss statement, the income statement provides the gross profit margin, the cost of goods sold, operating profit margin, and net profit margin. It also provides an overview of the number of shares outstanding, as well as a comparison against performance the prior year.

c. Cash Flow Statement

The cash flow statement is a combination of both the income statement and the balance sheet. For some analysts, the cash flow statement is the most important financial statement because it provides reconciliation between net income and cash flow. This is where analysts see how much the company spent on stock repurchases, dividends, and capital expenditures. It also provides the source and uses of cash flow from operations, investing, and financing.

              Ratios can be invaluable tools for making decisions about companies you might want to invest in. Across the industry, they are used by individual investors and professional analysts, and there are a variety of ratios to use. Financial ratios are typically cast into four categories:

1. Profitability ratios

2. Liquidity ratios

3. Solvency ratios

4. Valuation ratios

a. Ratios - i.e. one variable divided by another - are used widely in financial analysis to understand how companies are doing internally and relative to one another.

b. Financial ratios can be computed using data found in financial statements such as the balance sheet and income statement, and form the basis of fundamental analysis.

c. In general there are 4 common types of ratios used in analysis: profitability; liquidity; solvency; and valuation.

d. Common examples of ratios include price-to-earnings (P/E) ratio, net profit margin, and debt-to-equity.

Profitability Ratios

Profitability is a key aspect to analyze when considering investing in a company. This is because high revenues alone don't necessarily translate into high earnings or high dividends. In general, profitability analysis seeks to analyze business productivity from multiple angles using a few different scenarios. Profitability ratios help provide insight into how much profit a company generates and how that profit relates to other important information about the company. These are used to assess a business's ability to generate earnings relative to its revenue, operating costs, balance sheet assets, and shareholders' equity over time, using data from a specific point in time.

Liquidity Ratios

Liquidity measures how quickly a company can repay its debts. This also shows how well company assets cover expenses. Liquidity ratios give investors an idea of a company’s operational efficiency. They also show how quickly and easily a company is in generating cash to purchase additional assets or to repay creditors quickly, either in an emergency situation or in the course of normal business.

Solvency Ratios

Solvency ratios, also known as leverage ratios, are used by investors to get a picture of how well a company can deal with its long-term financial obligations. As you might expect, a company weighed down with debt is probably a less favorable investment than one with a minimal amount of debt on its books.

Valuation Ratios

Valuation ratios are some of the most commonly quoted and easily used ratios for analyzing the attractiveness of an investment in a company. These ratios primarily integrate a company’s publicly traded stock price to give investors an understanding of how inexpensive or expensive the company is in the market. In general, the lower the ratio level, the more attractive an investment in a company becomes.

Ratios are comparison points for companies. They evaluate stocks within an industry. Likewise, they measure a company today against its historical numbers. In most cases, it is also important to understand the variables driving ratios as management has the flexibility to, at times, alter its strategy to make its stock and company ratios more attractive. Generally, ratios are typically not used in isolation but rather in combination with other ratios. Having a good idea of the ratios in each of the four previously mentioned categories will give you a comprehensive view of the company from different angles and help you spot potential investment.