Financial Ratio Analysis for Dummies :) [Part 2]
In the previous blog post, we shared a table with you that could be useful to have the basic knowledge for the evaluation of the credit risk of a company, the idea was to give you the opportunity to learn through indicators of the financial statements which may be useful to understand if a company is risky or not (from a financial point of view).
In this post, we want to go a little more in detail with the information, and we will try to give answers to the following two fundamental questions:
1) “But why do we have to evaluate precisely that indicator to understand the financial health of a company?”
2) “OK, I have calculated the indicator, now what?”
Both questions are proper and we try to answer!
1) These financial indicators which can be in thousands of different format, but in the end we used a few tens. Why in the previous post we chose those?
To get a good answer, we have to understand well what we want to obtain. What we want to evaluate by -observing indicators of financial statements- is the quality of the economic and financial situation of a company, in other words, the probability that the company will go default or not (it is easy to understand that the higher the quality of the company, the lower the its probability of default).
Now, we must understand how a single fiscal indicator can predict the state of insolvency. How can you make it? Thanks to the databases held by modeFinance (in partnership with Bureau Van Dijk) we have at home hundreds of millions of financial statements of more than 70 million companies in more than 200 countries worldwide: I would say that the statistics will rescue us!
What you can do then is to see how healthy companies are distributed in comparison to the companies which go bankrupt. The greater the difference between the two distributions, the default will be more closely related to that indicator!
2) Once we have calculated the indicator, then we must understand how its value arises: in the “danger” zone or in the “very good” zone; also in this case the statistical study done earlier helps: in fact we can immediately compare its value with the statistical values of healthy companies and bankrupt companies, and then figure out the quality of financial information by the company.
Below, we show -in detail- the work done for the leverage indicator as an example: What we have done is: 1) to study the distribution of the indicator (calculation of the percentiles); 2) to study the distribution of healthy companies compared to those bankrupt;
What do you understand by these two graphs:
1) The median value of the indicator is about 1 (50th percentile);
2) The number of bankrupt companies increases with the increase of the value of leverage (in fact it represents your debt, thus more debts = greater risk);
3) We have a special case for low value of leverage: the highest probability of failure! But this is easy to understand: the value of leverage can have negative values, which represents Negative Equity; dangerous!
In this way, we can understand why some indicators are important to forecast bankruptcy and we can also give the optimal values! So, here you have the new table; even with an indication of the optimum values! We hope you like it.