The following rules are ones we have developed over the
years. We consider them to be guiding principles which, if
applied, will improve the quality of your business plans as well
as the quality of your relationships with others.
Rule 1: Financial analysis techniques are tools to uncover
facts, not define them.
People use a number of financial analysis techniques, such as
ratio analysis, bankruptcy analysis, sensitivity analysis, etc.
The purpose of these exercises is not to arrive at some final
result that looks good. Rather, the analyses are performed in
order to find how the business can be improved. Never be lulled
into thinking everything is good. Things can change on a dime.
Look for areas than can be improved in order to give you a
cushion in case things go bad.
Rule 2: Results are only good or bad within the context of
the whole.
I had someone ask me once if a current ratio of 2.0 was good
for his business. Well, it depends. Granted, a ratio value of
2.0 means that the value of current assets is large enough to
pay off current liabilities twice should the company need to be
liquidated. However, what if the vast majority of the current
assets was made up of inventory that, in a liquidation
emergency, could only be sold for five cents on the dollar?
Also, in this particular case, the current ratio for most
companies in the industry was well over 5. This meant that the
current ratio for his business was much lower than the average
in the industry—a definite cause for concern.
Rule 3: Analysis has limits and results are subject to
distortion.
As shown in the discussion above, results can be misleading
if the values going into the analysis are not understood and
other related variables are not considered.
Rule 4: Analysis conducted in a mechanical, unthinking
manner is dangerous.
See Rules 2 and 3.
Rule 5: The more analytical techniques used, the more likely
of getter a clear picture.
It is relatively easy to be fooled if you only look at one
ratio, for example. In the discussion with my friend above, I
found out that while his current ratio was 2.0 his quick ratio
(similar to the current ratio but without the inventory) was
0.2. This value was clearly not acceptable as it meant that a
huge part of the value of his current assets was tied up in
inventory. When he saw that, he made definite steps to improve
his management of his inventory.
Rule 6: An analytical method that is not understood is
useless.
What value would the ratios analysed in my example above be
to the business owner if he did not understand what the ratios
meant? That's right, nothing. Financial analysis is an
indispensable tool but only if you understand how to interpret
the results and know the right questions to ask.
