Beyond profitability, operating, and leverage ratios, other ways of evaluating the financial health of a company include valuation, economic value added (EVA), and assessing growth and productivity, instructs ‘Understanding Finance’ (www.HBSPress.org).
Valuation, for starters, is the process by which people determine the total value of a company for the purpose of selling it. And the practices can be varied. “For example, a firm that is considering acquiring another firm might rely heavily on estimates of future cash flows to come up with a value for the potential acquisition. Another firm might rely on different data.”
Also, a company can be worth different amounts to different parties, notes the ‘pocket mentor’ book. “For instance, a small, high-tech company may be valued more by a potential acquirer that wants the acquired firm’s unique technology to leverage its other operations.”
Analysts’ approach
Investors and stock market analysts, too, perform valuation, by scrutinising a company’s financial statements and stock performance carefully. Some of the metrics used by them are EPS (earnings per share), P/E (price to earnings ratio), and growth indicators. When EPS falls, stock price too is quite likely to fall; the P/E is a common measure of how cheap or expensive a stock is, relative to its earnings; and the growth measures (such as of sales and profitability) tell a great deal about financial health, the book informs.
A company’s growth allows it to provide increasing returns to its shareholders and to provide opportunities for new and existing employees, but the number of years over which you should measure growth will depend on the business cycle of the industry the company is in, the authors advise. “A one-year growth figure for an oil company – an industry that typically has long business cycles – probably doesn’t tell you very much. But a strong one-year growth figure for an Internet company would be significant.”
Consider the context
First in the list of a few simple tips that the book lays down for analysing financial statements is the need to consider the context, because what looks like a big (or small) number may not be once you understand what’s typical for a business in that particular industry. ‘Watch for trends,’ reads another tip. ‘How have the statements changed since last year? From three years ago?’
A mini-exercise that the authors suggest is to take your company’s statements and to write a paragraph that describes how much profit it is making, how well it is managing its assets, where the money comes from, and where it goes.
Ideal starter material.
