Financial Ratio Analysis
There are essentially two basic techniques that are used in Corporate Finance. One is the ratio analysis of financial statements and the other is calculating the present value of future cash flows. Bankers, investors, financiers, CFOs and entrepreneurs use these tools and techniques to value assets and make decisions.
Lets look at using financial ratios as a capital budgeting tool. There are lots of different accounting ratios that get used inside of a firm. In fact, a lot of times the same accounting ratio gets called different things at different firms.
By ratio analysis I mean taking two numbers from financial statements and dividing one by the other. What we are doing is taking two pieces of accounting data, put one over the other, and this forms a ratio. We are taking two pieces of data and forming a performance metric. Ratios are usually presented as a percentage or a number depending on whether the usual case is bigger or less than one.
Besides being a capital budgeting tool, ratios allow us to compare different companies or a company over time. Ratios are great tools to do this comparison because they allow us to “normalize” the numbers. A ratio eliminates any size differences and allows for pure comparison so you can compare apples to apples.
Financial ratios are derived from accounting information and rely on an understanding of financial statements. If you need a primer on the subject download a FREE copy of MBA ASAP 10 Minutes to Understanding Financial Statements. It will get you up to speed on this critical business skill quickly. The NACVA uses this book as a preliminary text in their training.
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A particularly common valuation of companies done by ratio analysis is based on multiples of Earnings. The Price/Earnings ratio, or P/E for short, is a way companies are compared based on their stock price relative to their earnings. The earnings number is the bottom line of the Income Statement. Earnings are also referred to as Net Income or Profit.
This ratio works well for comparing public companies that report these numbers. This technique can also be used to value a private company by comparing its earnings and valuation range to an average of public reporting companies in similar industry sectors and markets.
Related: The Big Picture of Financial Statements: Interconnection and Flow
Other common ratios based on the Balance Sheet are Return on Equity (ROE) and Return on Assets (ROA). A company can basically be thought of as a bunch of income producing assets. Theses assets are bought using two types of funds, Equity, which is money investors put in, and Debt, which is borrowed from a bank or other lender.
We can use ROE and ROA to analyze the performance of the Assets of a company. Here we take the money generated by the income producing assets and divide it by Equity for ROE or total assets for ROA.
Ratio analysis is a powerful tool for investing in the stock market. If you like the idea of being a player in stock market and making good investments, check out The Intelligent Investor by Benjamin Graham. It is the bible of value investing and it’s the way Warren Buffett and other successful investors do it.
The above blog post is excerpted from our eBook MBA ASAP 10 Minutes to Understanding Corporate Finance.
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