Financial ratio analysis and fund flow analysis offer two ways to gain insight into a company's financial performance by refining raw financial data. Both ratio analysis and fund flow analysis may be useful to internal and external stakeholders, including managers, investors and lenders. These techniques reveal different sets of information and are useful for making different kinds of decisions, but both may be helpful as part of a comprehensive investment-research strategy.
Financial ratio analysis compares different financial-statement items to reveal trends and add relevance to inter-company comparisons. Different types of ratios reveal different information. Liquidity ratios, such as the current ratio, for example, shed light on a company's ability to make cash purchases and cover short-term debt payments. Debt ratios, such as debt-to-assets and times-interest-earned ratios, reveal a company's ability to repay its debts on time and balance cash expenditures with debt purchases. Profitability ratios, such as return-on-assets, shed light into how proficient a company is at generating a profit on sales.
Fund Flow Analysis
Fund flow analysis deals with a more specific set of information than the wide range of ratio metrics. Fund flow analysis reveals information about the inflows and outflows of capital for a specific period of time. Fund flow analysis may reveal why certain ratio valuations are relatively high or low in a company by digging down into the actual movement of cash and assets into and out of a company. Fund flow analysis involves creating fund flow statements that match capital inflows with outflows.
Ratio analysis derives its main advantage from the comparability between companies and industries. Raw financial data can become less useful when comparing companies with large size discrepancies; ratios level the playing field by providing easily comparable metrics. Ratio analyses' comparability allows investors to compare their company against their main competitors or industry averages, and to compare different industries on a range of metrics. Because of the mix of large-scale and small-scale insight it provides, fund flow analysis can be more useful for internal decision-making. Managers may determine whether the flow of funds in their company needs to be addressed to generate more free cash flow, and they can also identify exactly where discrepancies in inflows and outflows lie.
Ratio analysis valuations can have a large influence on stock prices, making ratios of the utmost importance to corporate executives. This can lead to situations where executives develop tunnel vision, focusing on ratio valuations at the expense of other crucial issues, such as employee relations or social and environmental responsibility. Obsession with high ratio valuations can also lead accounting departments to bend or break the rules of ethical reporting. Thorough fund flow analysis requires information that may not be readily available to outside investors, making this technique disadvantageous for traders researching stocks.
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