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Evaluate Past Financial Performance

Evaluate Past Financial Performance

The evaluation of a company’s past financial performance can serve many purposes. Among other things, this evaluation can assist with market-based valuations, provide a basis for forward-looking analysis, and can provide information useful for evaluating the quality of a company’s management. It can also indicate how a company’s financial performance reflects its strategy.

Evaluating Past Financial Performance

The data used in evaluating a company’s past financial performance may come from several sources. These sources include financial statements, corporate press releases, proxies, trade publications, and industry surveys. The data may be processed by common-sizing the financial statements, computing financial ratios, and reviewing or computing industry-specific metrics.

Companies enjoy discretion concerning their choice of accounting standards (IFRS, US GAAP, or other home-country GAAP), the assumptions they make, and the estimates that they rely on when preparing financial statements. This can significantly limit the comparability of financial data across companies. As a result, adjustments are sometimes made to a company’s financial statement data to facilitate comparison with other companies or with the overall industry.

A comparison of a company’s levels of financial performance and trend financial data can provide insight into how the company performed. The company’s management may also present views on the possible causes of this performance in the Management, Discussion, and Analysis (MD&A) section of the company’s annual report and during periodic conference calls with analysts and investors. Additional information may also be obtained from industry information or consumer surveys.

How Strategy is Reflected in Past Financial Performance

An analysis of a company’s financial performance over time can indicate how successful the company is in achieving its strategic objectives. For example:

  • strategies that focus on product differentiation, lower input costs, and/or a change in sales mix are usually intended to lead to a company recording higher gross margins;
  • liquidity management strategies aimed at, for example, (i) maintaining sufficient cash and cash equivalents to ensure that a company can meet its short-term obligations, (ii) avoiding excessive cash, and (iii) accumulating cash for acquisitions or other financing decisions, will be reflected in the company’s balance sheet composition and computed financial ratios.

Question 1

Which of the following statements is the least accurate?

  1. The evaluation of a company’s historical performance addresses the question of what happened.
  2. The evaluation of a company’s historical performance addresses the question of how the performance reflects the company’s strategy.
  3. The evaluation of a company’s historical performance may only be carried out using the company’s financial statements.

Solution

The correct answer is C.

The data used in evaluating past financial performance may be obtained from sources such as corporate press releases, trade publications, and industry surveys. Financial statements do not provide data for evaluating a company’s past or historical financial performance.

Options A and B are accurate statements.

Question 2

It is most suitable to forecast a company’s future financial performance based on its historical financial results if that company:

  1. is in the commodities business.
  2. operates in a single business segment; or
  3. is a large company operating in a mature industry.

Solution

The correct answer is C.

If a company operates in a stable industry and is considered large enough among its peers, its financial results should be stable over the years.

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