Financial Ratio Analysis Methodology

‘Static’ numbers on your financial statements by themselves are useless. They do not tell you anything. To obtain valuable knowledge from these numbers, you must compare them to (1) the historical values of the same items on the previous statements; (2) values of same items on financial statements of other companies, usually in the same industry – this is called ‘benchmarking’, and (3) compare these values with values of other items (‘accounts’) on the same or other financial statements.

The latter requires calculation of the difference or, much more often, the ratio between these items (e.g. debt and equity on your balance sheet). These ratios are called – for obvious reasons – financial ratios.

Thus, financial ratios refer to a special category of KPI (no surprise here) or ‘metric’ used to measure and maximize a certain aspect of corporate financial performance. This category is ‘special’ in a sense that every KPI in this category is, indeed, a ratio of items from the same or different financial statements.  

For the abovementioned reasons, financial ratios analysis is a very important component of financial analysis and the CBA in general. Therefore, to maximize the value of this analysis, your financial analyst must follow the optimal ratio analysis methodology. Which must give the right answers to the following four key ratio analysis questions:

1.      Which ratios to choose out of literally hundreds that can be computed?

2.      How to best structure them?

3.      How to analyze them?

4.      How to optimize their values?

Well, there are definitely two obvious ways to structure financial ratios – by financial statement (balance sheet, P&L, cash flow statement and statement of retained earnings) and by their function in analyzing your financial performance. In other words, which dimension of your financial performance a particular ratio allows to measure and optimize. The latter usually cover two sub-dimensions: performance proper and risk.

I will start with the most natural – and by far the easier – classification. By financial statement. As I did before with other corporate objects and KPI, I will cover these ratios from the internal (management and active investor) perspective rather than from external - passive investor – perspective.

For each ratio, I will give a brief description of its meaning and function in financial analysis, explanation of computation methodology (when needed) and another methodology – for optimizing the value of a financial ration in question. 

You would analyze each ratio as you would any other KPI – compare it with historic values and other companies to do ‘ACRC’ – analysis write-up, make conclusions, develop recommendations and make comments (if needed).  

And follow with development and implementation of financial and operational plan for optimizing the value of the KPI in question – supported by textual comments and all relevant corporate documentation.  

Your key analysis and optimization tool is, obviously, your KPIS – KPI Scorecard, a component of both the CBA Toolkit or much more functional CBA Workbench (CBAW).