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An Introduction to Financial Analysis

Updated on December 11, 2016

Introduction

They are quite quick and effective means of establishing a true picture of the entity, by looking at the financial accounts.

We have gone through one already in Working Capital Ratios, but there are many other areas that you can analyse using Financial Ratio analysis.

  • Profitability and return
  • Long-term solvency and stability
  • Short-term solvency and liquidity / working capital
  • Efficiency
  • Shareholder’s investment ratios

Ratios are an effective means of analysing, but must not be used alone when assessing a company.

Here are some things that you should also bear in mind:

  • The wider economy and political situation. Look at this locally, nationally etc.
  • Market conditions in the industry
  • The age and nature of the company’s assets
  • The suppliers and customers and their stability
  • Accounting policies
  • Additional notes in the accounts
  • Other news

One key measure to see the profitability of an entity is to find the PBIT (profit before Interest and Tax) on the P&L. This is also often referred to as the Operating Profit.

If you are dealing with retail or manufacturing business, you may wish to find the Gross Profit also. The Gross Profit is the Revenue – Direct Costs attributed to the sale of those items.

Comparing these profits can be difficult across companies, due to differences in the relative size. If you have a large company it will have large bottom line profit, but it will not necessarily have a good return on investment. One way to check profitability in a more relative way is to look at the margins.

Source

Operating Profit Margins

This shows the relative efficiency of the company and the profits generated compared to the costs. This is an important aspect to see how truly profitable the company is.

The above margin tells us the relative efficiency of the direct costs for sales.

What does a Low Operating Margin mean?

What does a Low Gross Margin mean?

If the Gross Margin is high and Operating Margin is high, what is the issue?

How could you correct a low Gross Margin?

How could you correct a low Operating Margin?

Source

LIFO

LIFO (Last In First Out) is the opposite of FIFO. Instead of the oldest inventory being considered as sold first, the newest product is sold first. While the factory analogy works for the FIFO, consider a bakery. By lunch or evening, the bread baked from the morning will not sell as well as the fresh ones from the afternoon batch.

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