Figures in company analysis and their real meaning

The analysis of a listed company rests on financial data, ratios, the history of results and an understanding of the firm's business model. In financial reports there appear, among others, revenue, net profit, debt, margin and ratios showing the profitability, valuation and financial situation of the company. Such data help you assess an enterprise's condition, but on their own they are not enough to understand what situation a firm is in and what its results come from.

A number can show how much a firm earned, how high its debt is or how the market values its results. It does not, however, automatically explain what this result comes from, whether it is lasting in character, whether it was the effect of a one-off event and whether, in a given industry, such a level can be considered strong, average or weak. For this reason the same value can in one company indicate a healthy financial situation, and in another require a more cautious assessment.

A reliable analysis requires putting together several pieces of data and checking how they connect with one another in the picture of the whole firm. Only then can you better understand whether the company is developing in a lasting way, whether its results are repeatable and whether the figures find confirmation in the real picture of the business.

Context gives figures their proper meaning

Context is all the information that helps you properly understand a company's financial data. It includes, among others, the industry in which the firm operates, its size, the stage of development, the economic situation, the history of results from previous years, the level of debt, the dividend payment policy and one-off events that may have affected the result.

This can be seen well in a simple example. Let us assume that two companies achieve the same net profit, meaning the amount that is left to the firm after covering costs, taxes and other charges. Such a result may suggest a similar condition of both firms, but the source of this result matters a great deal. One company may have produced it thanks to stable sales and good cost control, and the other thanks to the sale of part of its property, which improved the result on a one-off basis.

It is here that the real analysis begins. What matters is not only the size of the ratio or result, but also what it results from. Such an approach helps you assess a company more accurately and better understand whether the figures show a lasting quality of the business, or only a momentary improvement.

The industry changes the meaning of figures in company analysis

At the start of learning it is easy to compare companies from different sectors as if they operated by the same rules. Meanwhile, every industry has its own model of operation, a different cost structure, a different pace of development and a different sensitivity to the economic situation. A bank operates in different conditions from a food producer, a technology firm or an energy enterprise, which is why the same figures do not have to mean the same thing.

Net margin shows this well, meaning the part of revenue that is left to the company as net profit after covering costs, taxes and other charges. If the net margin is 20%, it means that from every 100 units of revenue, 20 of net profit are left to the firm. In one industry such a result may indicate very good profitability, and in another fall within the typical range for this kind of activity. The assessment of this number is therefore decided not only by its size, but also by the character of the business, the level of costs and the strength of competition.

The question of debt looks similar. In some sectors higher debt is connected with the model of activity, because firms finance expensive infrastructure and rest on more predictable cash inflows from their core activity. In other industries the same level of debt may mean a greater burden, because revenue is more dependent on changeable demand or a worsening of the economic situation (a weakening of the economy).

This is why figures are worth comparing above all between companies that operate in a similar environment. Comparing a pharmaceutical firm with a clothing company usually says little about the quality of their results. Far more is given by comparing firms from the same sector, because only then can you assess whether a given level of margin, debt or profitability is strong, average or weak.

One year is too little to assess a firm

In assessing a company, time matters a great deal. The result from one year may look very good or weak, but on its own it does not yet show whether the firm is developing stably. A company may have an exceptionally good year, because it took advantage of a favourable situation on the market. It may also do worse in a given period, although its sales, market position and way of operating still remain solid. For this reason financial results are worth analysing over several years, and not only one year.

If a firm shows growth in revenue, it is worth checking whether this growth appears regularly, or is only an improvement after an earlier fall. If net profit rises, it is good to see whether the cash flows from operating activity rise along with it, meaning the cash that the firm actually generates from its core activity. If a company pays a dividend, it is worth checking whether it has done so for many years and whether the size of the payments corresponds to how much the firm really earns and how much cash it has available.

Analysing data from several years lets you see whether a company's results are stable, or perhaps change abruptly. Thanks to this it is easier to assess whether the firm's good condition holds over time. A company that improves its results gradually over several years looks different from one that, after a single very good year, returns to weaker results.

A good number does not always mean a good situation for the company

Very often, when beginner Elegant Investors analyse companies, they focus on valuation ratios that look encouraging. Among the most often discussed is the P/E ratio, meaning price to earnings (in English the price to earnings ratio, P/E for short). It shows how much the market pays for the profit attributable to one share. A low level of this ratio may give the impression that the shares are cheap, but the number alone does not yet explain what such a valuation comes from. A low P/E ratio may mean that investors expect weaker results from the company in the future. Such a situation may appear, for example, when a firm has recorded a fall in sales for several quarters, is losing customers or operates in an industry in which demand is falling. In such a case a low ratio does not have to mean an attractive valuation, but a cautious assessment of the firm's future by the market. It may also result from lower valuations typical of a given industry or from problems that are already starting to affect the enterprise's results.

It is worth looking at profitability similarly, meaning a firm's ability to generate profit in relation to revenue, property or capital. In English you will come across here, among others, such terms as profitability, return on assets, meaning ROA, and return on equity, meaning ROE. High profitability may indicate good quality of the business, but it is worth checking whether it does not result from a one-off sale of assets, momentarily lower costs or an exceptionally favourable market situation. The value of the ratio alone is therefore not enough to assess whether a firm achieves a good result in a lasting way.

Financial results make sense only when you understand the firm

Financial data show a company's result, but they do not explain on their own how the firm earns money and what its situation depends on. To assess the figures well, it is worth knowing what the company sells, whom it sells to, what its costs depend on and what may improve or worsen its results.

This can be seen well when a firm shows a higher net profit, meaning a larger final gain after subtracting costs and taxes, but does not show a similar improvement in the cash from its core activity. This means the money that actually comes into the firm in connection with its ordinary activity, for example from the sale of products or services. If profit rises, but the cash does not increase to a similar degree, it is worth checking what this difference results from and whether the improvement in the result has lasting foundations.

It is also worth looking at the number of a company's shares. A share is a small part of a firm, and the number of shares shows into how many parts the company is divided. If a firm issues new shares, meaning it releases more of them onto the market, the stake of existing shareholders becomes smaller. In such a situation the profit of the whole company may rise, but the profit attributable to one share may improve more slowly.

The way a firm conducts its activity also matters. Such a way of operating is called the business model. If a company earns on the sale of everyday products, such as food, cleaning products or basic medicines, its revenue is often more stable, because customers buy such things even in weaker economic periods. If, on the other hand, a firm operates in an industry dependent on the prices of raw materials, for example oil, gas or metals, its results may change more strongly, because they depend on prices over which the company itself has no full control.

It is similar with competition. When many firms operate on the market selling very similar products, it is harder to keep a high margin, meaning the part of revenue that is left to the firm after covering costs. If competitors constantly fight on price, the firm often has to sell more cheaply, and this can lower its profit. This is exactly why figures are always worth combining with the question of how the business operates and what its results depend on.

What is worth checking during company analysis

When analysing a company it is worth putting in order a few basic areas. It is good to first establish how the firm earns money, whether its sales grow regularly or change unevenly, whether profit finds confirmation in the cash from operating activity, whether the level of debt corresponds to the realities of a given industry, whether the number of shares stays stable and whether the improvement in results holds over several years, or concerns only one period. Such an arrangement helps you keep the analysis in order and better assess which changes are lasting in character, and which may be only a short episode. Thanks to this it is easier to tell a typical level of a ratio apart from an untypical result, and a strong condition of a business apart from a situation that looks good only for a moment.

In practice it is worth starting from comparing the company with similar firms from the same sector. Then it is good to look at data from several years, check the source of the result and put selected figures together with other information. Such a way of working lets you better understand the firm and reduces the risk of hasty conclusions.

How to move from data to assessing a firm

Figures are an important part of company analysis, because they show the firm's results, the level of debt, profitability and the changes taking place over time. The data alone, however, are not enough to assess an enterprise. The industry, the source of the result, the firm's situation in previous years and the way the company conducts its activity also matter. Only such a view lets you assess whether a good result is lasting, or appeared only in one period, whether the level of a ratio is strong against similar firms and whether the improvement in results finds confirmation in the whole picture of the company. Thanks to this the analysis becomes more logical and gives a better basis for understanding the firm.

This is exactly what the significance of context in analysing a listed company consists in. A number shows a fragment of the situation, and context helps you assess what this fragment means. The better you understand the relationships between the data, the more accurately you can assess the quality of the business and the condition of the enterprise.

Sources:

Investopedia (definitions of financial ratios, valuation and profitability, https://www.investopedia.com), CFA Institute (investor education on financial statement analysis, https://www.cfainstitute.org), Morningstar (analysis of company fundamentals and valuation, https://www.morningstar.com), Aswath Damodaran (educational resources on valuation and ratios, https://pages.stern.nyu.edu/~adamodar), Harvard Business Review (articles on business models and competition, https://hbr.org), IFRS Foundation (international standards for financial statements, https://www.ifrs.org), U.S. Securities and Exchange Commission (investor education on financial reports, https://www.sec.gov), OECD (data and analysis on economic conditions, https://www.oecd.org), Bank for International Settlements (analysis of financial conditions and debt, https://www.bis.org), McKinsey & Company (analysis of corporate performance, https://www.mckinsey.com)

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