Chapter 9: Building a Financial Statement


What Ratios Can't Tell You: Biotech Example

Based on the above ROE formula, the biotechnology industry should not exist today. The biotechnology industry has spawned hundreds of start-up companies over the past decade. A large number of them are still not profitable, yet they continue to receive funding through stockholders or venture capitalists.

Biotech is a great example of why the intelligence analyst should understand and use ratios, but at the same time not get lost in their simplicity.

With some biotech companies, you would be investing in their future, products and income, their future ROE. A current ROE would look disastrous. Therefore, when analyzing this ROE, you need to understand far more than just the strict ratio. You must technically review the future product portfolio and the income it may generate. For example, if the FDA just approved a new genetically-engineered healthcare treatment in a much needed treatment area, the future ROE may be immense -- although, right now it's in the basement.

If I were a banker doing this analysis, I might tell the biotech company that it is currently a big risk, and a loan is probably out of the question. I f I were a stockholder, ready to speculate or a large pharmaceutical house wanting to diversify for future growth, I might place my money on the table by purchasing shares or supplying venture capital.

Aside from pure ratio analysis, you really need a partial mix of Wall Street financial wisdom, scientific analysis and personality profiling. You need an analysis team, consisting of technical and general business expertise. The scientist, accountant and business analyst may each come up with totally different views -- none of which may be accurate. Together, they have a far better chance of understanding the whole picture, financial and otherwise. This team needs to answer a variety of questions, such as:

What is their current ROE? What might it be five years from now, when the approved drugs or treatment is fully tested and on the market? (Projected cash flow is the key at this stage).

How deep does this start-up's pockets need to be? What additional money will it need to pump into R&D, testing and ultimately marketing and selling? Will it become a money pit?

Who manages the company? How successful have the managers been with past start-ups?

Are the patents and treatments technically unique? Will they likely maintain a
market edge, or will they be superseded by a more potent medication or treatment?

Lesson: The investment answers will come from a variety of areas of expertise, including financial analysis. Financial ratios often prescribe the normal operating boundaries for a company, assuming that company operates under normal conditions. They are a useful tool, but not an exclusive one. Analysis done piecemeal, or by only looking at one aspect of the question (such as making a buying decision based purely on examining the company's financial ratios), is asking for trouble. Lack of time is no excuse here. You must spend the time add layers of expertise and interpretation to any ratio analysis to gain the proper perspective.

Return to Chapter 9