Methods
Financial analysts often compare financial ratios (of solvency, profitability, growth…):
Past Performance: Across historical time periods for the same firm (the last 5 years for example),
Future Performance: Using historical figures and certain mathematical and statistical techniques, including present and future values, This extrapolation method is the main source of errors in financial analysis as past statistics can be poor predictors of future prospects.
Comparative Performance: Comparison between similar firms.
These ratios are calculated by dividing a (group of) account balance(s), taken from the balance sheet and / or the income statement, by another, for example :
Net profit / equity = return on equity
Gross profit / balance sheet total = return on assets
Stock price / earnings per share = P/E-ratio
Comparing financial ratios are merely one way of conducting financial analysis. Financial ratios face several theoretical challenges:
They say little about the firm’s prospects in an absolute sense. Their insights about relative performance require a reference point from other time periods or similar firms.
One ratio holds little meaning. As indicators, ratios can be logically interpreted in at least two ways. One can partially overcome this problem by combining several related ratios to paint a more comprehensive picture of the firm’s performance.
Seasonal factors may prevent year-end values from being representative. A ratio’s values may be distorted as account balances change from the beginning to the end of an accounting period. Use average values for such accounts whenever possible.
Financial ratios are no more objective than the accounting methods employed. Changes in accounting policies or choices can yield drastically different ratio values.
They fail to account for exogenous factors like investor behavior that are not based upon economic fundamentals of the firm or the general economy (fundamental analysis) [1].
Credit:ivythesis.typepad.com
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