The selection of the appropriate analytical methods and techniques for assessing a business, or your investment, is crucial to correctly assessing the performance. Businesses generate all sorts of financial and non-financial information and simply choosing what exactly you want to assess can be incredibly difficult. Analyzing both your own business and an investment opportunity involve applying many of the same principles, your answers and decisions on those principles may simply be different.
Areas of Analytical Methods
- Historical Looking Methods: The first thing you want to determine is whether you want to assess the business from a historical or a forward looking perspective.
- Forward Looking Methods: An emphasis on forward looking information includes considering some of the trends related to the ratios and metrics above but also considering the opportunities and threats facing the business. Performing a SWOT analysis or a Porter assessment can help you determine what potentially lies ahead for a company.
- Operational Methods: Assessing the operational performance of a company is crucial for internal management purposes, and something investors are looking at more and more. Seeing how effectively a company is managing their accounts receivables and inventory turnover, and how that information is trending year to year, provides useful insight into the effectiveness of management. Managers want to know this type of information, but so do investors who are looking for different ways to assess how effective management is aside from the pure financial results.
- Financial Analysis: Analytical methods for assessing the financial performance of a company are extensive. Return on Investment, Return on Assets, Return on Equity, and Return on Invested Capital can all be applicable depending on the nature of the company and what the user wants to determine. Some companies are very asset intensive, others hold virtually none, so something like Return on Assets can have varying levels of usefulness. Profitability metrics are important also and while final dividend payments come out of net profit, you also want to consider the gross profit of a company. This looks at the pure revenue generating activities of the company, before admin and other expenses, and can tell you how efficiently a company is managing the direct costs of whatever it is they are selling.
General Principles of Analytical MethodsWhen assessing a business from either an operational or an investment perspective there are some general rules to apply in how you conduct your analytics.
- Multi-Year Comparability: Calculating metrics and performance for a single year, while effective, only provides a very small part of the picture related to that metric. So a company has a Return on Invested Capital of 10%, is that good? Well that can depend on whether their ROIC was 5%, 10%, or 15% the year before. Looking at prior years, as many as you think are relevant, is crucial to providing some context.
- Industry and Competitor Results: Similar to how calculating a single year only provides a small part of the picture, only looking at the one company limits the usefulness of the information. 10% ROI may be an improvement for the company, but what if the industry average is 20%? Or 5%? Looking at competitors and industry averages is very informative when conducting your analysis.