Approaching an Analysis

Start with the question

Analysis without a purpose produces pages of ratios and no conclusion. Different users need different things from the same accounts:

• A lender — will we be repaid? Cash generation, debt capacity, covenant headroom, asset cover.
• An investor — what is it worth and will returns grow? Profitability, return on capital, growth, cash conversion.
• A supplier — will we be paid? Liquidity, payment behaviour, short-term solvency.
• A customer — will they still be here to support this product? Solvency and resilience.
• Management — where is performance weak and what should change? Segmental and operational detail.
• An acquirer — what am I buying and what are the risks? Everything, plus quality of earnings.

Preparation before any ratio

• Confirm the reporting framework, the period covered and whether the figures are consolidated or single-entity.
• Check the audit report and the going concern statement.
• Read the accounting policies, particularly revenue recognition.
• Note any change in policy, period length, or group composition, all of which break comparability.
• Understand the business model before judging any number. The same working capital profile means opposite things in a subscription business and a manufacturer.
• Obtain at least three years so that a trend exists. A single year is a snapshot with no direction.

A working structure

1. Context — what does the business do, in what market, with what model?
2. Common-size and trend — express the income statement as percentages of revenue and the balance sheet as percentages of total assets, across years. This exposes structural shifts immediately, before any ratio is calculated.
3. Profitability — margins and returns on capital.
4. Efficiency — how hard the assets and working capital work.
5. Liquidity — can it pay what falls due?
6. Solvency — can it carry its debt?
7. Cash — does profit convert?
8. Conclusion — a judgement answering the original question, with the evidence and the uncertainties stated.

Disciplines

• A ratio is a question, not an answer. It says where to look.
• Never quote a ratio without a comparison — prior year, budget, competitor or sector.
• Check the definition before comparing with an external source; the same ratio name is computed differently by different providers.
• Watch for year-end effects that flatter balance sheet ratios for a single day.
• Always reconcile the story: the ratios should describe a coherent picture, and where two contradict each other, that contradiction is the finding.