Financial and Operational Results Analysis

Analysis

If the title of this article drew your attention, then probably you immediately thought I will write about, or even list, the relevant key financial indicators that provide the perfect mix for translating the financial information provided by a company. While knowing a good recipe and applying a standard set of ratios for any given company is the hidden secret that no analyst knows, but all squeeze their minds to develop, what I will do next is provide a common sense approach on how an efficient Financial and Operational Results Analysis should look like.

Identify the Key User:

This is the ground stone of your report. The analysis report must be designed to be understandable and relevant for the key user of information. Whether your user is internal like the CFO, CEO, COO, Sales Director and Purchasing Director or external like a potential investor, a potential lender or the general public, your message needs to go through and be decodable by any user. This is common sense knowledge that is related to sending a message. Your message is useless if your recipient does not understand your code – in this situation the financial lingo, therefore the secret ingredient of any analysis report is presentation. I am pretty sure most of you, and I am referring now to financial analysts, dislike having to put all that information in a “one pager” or 2-3 PowerPoint slides but that is a proper channel to send the information to a non-financial user and even a financial user that wants to see the bigger picture.

Understand the Business:

While being profitable and generating cash is the purpose of any business, analyzing financial ratios will be useless, unless the analyst has a thorough understanding of the business. That means knowing the industry, the geographical region/s of operations, the target customers, the production methods, the sales approach and the overall strategy of the company.

Take the food retail sector, it is useless to compare two supermarket chains that operate in the same region if they use different strategies. A discounter may be much more profitable in a less developed country, while a hypermarket that provides better service and niche product categories like bio food will for sure be more profitable in a well-developed country. Comparing profitability, even in the same sector will not be relevant unless the comparison is made with direct competitors in the same region. This is basically the reason why financial ratios must never be interpreted without a prior good understanding of a business and its strategy.

Identify the relevant sources of data:

The starting point of any financial analysis is the annual report of a company. The analysis can spread over a period of several years and choosing the right period must be based on qualitative considerations like the overall economic status in the region, the development of the business sector and the likely future developments in the industry. This decision must be tuned in with the user of the analysis.

Other equally important sources of information are industry wide ratios and benchmarks, competitor data and overall economic sector trend.

All the data and information must be first filtered and cleansed. One-time events that affected the financial statements must be eliminated if they had a significant impact on the accounts but are not likely to happen in the future and have never happened in the past. The key aspect here is having comparable data and information that will help the user of the report make a decision based on the regular business operation.

Calculate the ratios

The financial ratios used in a report are divided into four categories:

  • Profitability ratios
  • Liquidity ratios
  • Capital Structure ratios
  • Investor ratios

I will go through these ratios, each category at a time but do not expect to find in this articles the ratios formulas or interpretation. That information is one google away and I did not make a purpose out of this article to list information found in thousands of sources, but to provide general aspects, mostly qualitative, to prepare a financial analysis report that is reaching its target audience – namely the key users.

  1. Profitability ratios

The analysis starts by looking at the first key indicator – Revenue – this drives the profitability and analyzing the changes in revenue is the first thing any user will seek. It is the simplest information provided and is the ground stone of the profitability ratios analysis.

The key ratios in this analysis are the margin ratios (gross profit margin, operational profit margin, net profit margin) followed by the return ratios (return on capital employed – ROCE, return on assets – ROA, return on equity – ROE). These ratios are the most important for shareholders, potential investors and the general public.

  1. Liquidity ratios

These ratios provide information that banks and suppliers will be most interested in. The short term liquidity ratios like Current Ratio and Quick Ratio show the ability of the company to pay short term liabilities as they fall due. I mentioned previously that these ratios are of interest to short term lenders or suppliers but also the shareholders will be pretty interested in these ratios as the risk of overtrading could jeopardize the entire company, therefore they will be interested in the evolution of these indicators over time.

The other relevant ratios for this liquidity analysis are the Working Capital Cycle ratios like the Inventory Holding Period, Receivables Collection Period or Payables Payment Period. These are the ratios that show the financial efficiency of a company’s operations – how soon can the company roll over the cash – the so called Cash Conversion Cycle.

  1. Capital Structure ratios

These are the ratios that deal with the long term financing of the business, be it equity capital financing or debt financing, therefore the key users of these ratios will be the shareholders, the potential investors and the debt finance providers like banks or bond investors.

The key ratio here is the gearing ratio that shows how the company is financed or the proportion of each of the two sources of funds in the total invested capital. The other auxiliary ratios are focused on the ability of the company to pay interest for debt financing or dividends for equity financing.

  1. Investor ratios

A particular type of ratios that allow an investor to browse easily through multiple investment opportunities and find one that is suitable for their portfolio. The Price Earnings ratio is a benchmark ratio that provides a good starting point for further analysis. A risk loving investor will always go for a higher risk and higher profitability investment with low P/E ratio while a more risk adverse one will seek longer term investments with higher P/E ratios that provide a more comfortable position in terms of risk but at the same time will not be able to offer high returns on the dollar.

The other ratios of interest to investors are the dividend related ratios. These ratios also provide information that allows an investor to analyze and pick a company that is suitable for their investment strategy – investors who prefer dividends instead of capital gains will go for high Dividend Yield companies while the others will prefer companies that retain more of their earnings for reinvestment – these later ones have higher Profit Retention Ratios.

Prepare the Report

This is the last phase of the analysis and is probably one of the most important. While keeping in mind all the recommendations from the prior steps, fine tune the report to suit the key users. Your most relevant findings must be disclosed in this report together with your explanations and recommendations. Don’t be afraid to point things out, as long as you understand the company and its strategic objectives. Remember you have made the financial X-Ray of the company and although the company might be doing just fine in the eyes of most of the managers, hidden risks might only be visible to a financial analyst that deep dived into the figures – therefore don’t be afraid to disclose them – any bad news is best brought forward sooner than later.

I have mentioned this before but I feel it is best I say it out again now, at this phase – I have always tried to put myself in the shoes of the target audience of my reports and understand their main interest. It is pointless to recommend a company, whose mission is to become no.1 in terms of quality and customer satisfaction, to reduce overheads related to quality control. You are the analyst and it is your job to provide the information and recommendations that will be reflected later in the overall success of the business, but you should always consider the impact of your recommendation on the other non-financial KPIs of the company. Your mission is to be a business partner so don’t get stuck with the numbers and look at the overall picture.

The format of the report pretty much depends on the users and their preferences – stay flexible. I understand that a state of the art analysis would probably require at least ten pages of comments and conclusions but keep in mind that even if you are asked to present the same analysis under 6 lines on a slide, that is probably due to the fact that the attention span of the users on this topic might require a shorter presentation with roughly 80% comments and 20% numbers.

If the report is presented in full, always put the calculations and ratios on the back of the report in the appendix. Users are mainly interested in the story behind the numbers so put that first. As I said it before, the difference between a good and a poor financial analyst stands in their communication skills and not their technical skills, therefore start working on that!

Author’s conclusions

I have tried through this article to provide a more practical approach on recommending the structure and contents of an effective financial analysis exercise. I guide myself by the principle that common sense should be behind our every action and my recommendations above are based on common sense knowledge and experience in working with people. In my opinion a great financial analyst must possess, apart from her/his technical skills, also good people skills or the ability to understand human behavior and tune the report to match the key users not just as a function but also as people. Two different individuals on the same function will require different formats of a report and in most cases you should be the one to understand what suits who, therefore start to know your users as people and not just as the function they represent.

I invite you to comment on my article and share your own experience in presenting, or working with, financial analysis reports and data.

Photo Credit – Luis Llerena – Unsplash.com

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