Question

Explain what benchmarks are, describe how they are prepared, and discuss why they are important in financial statement analysis.

What are some qualitative factors analysts should consider when evaluating a company’s likely future financial performance? What are some potential problems and limitations of financial ratio analysis?

Answer 1

Benchmarks are the performance indicators which can be used as a reference for comparing the performance of companies on various fronts. Usually the benchmarks are the highest achievable metrics, which has been selected basis a research of existing companies and their operations. They can act as aspirational target and help in measuring the performance and driving improvement measures. They are important in financial statement analysis as these helps in comparing the state of business of the company, which we are analyzing, versus the best in business. This would help the financial analyst to get a sense of the current operations and compute its efficiency on a relative scale.

The qualitative factors which should be considered in evaluating the company’s likely future performance are:

• Strength of its corporate governance framework
• Leadership and management effectiveness & style
• Company’s culture and its outlook towards corporate ethics
• Company’s people policies and employee turnover.

Potential problems and limitations of financial ratio analysis:

• It does not give a proper picture for high growth companies
• It only shows the current state of business and fails to capture future probable scenario.
• It does not showcases or capture qualitative issues such as management effectiveness, employee morale etc.
• It does not work well for companies which are monopolies as there are not many companies to be compared for relative evaluation.