Financial Analysis Techniques – Introduction

As discussed in the Introduction and also while discussing Financial Statement Analysis Framework we understood that the techniques and tools used by the financial analyst help users of financial statements in making decisions and help answer the questions like:

  • how the entity is performing compared to similar entities in the same industry or operating within the same environment in similar conditions
  • what are the future prospects of the entity and what are the expectations regarding entity’s performance and financial position in the future

Though the above two questions appear to be the same however, they are about two different time frames. The first one is regarding the past whereas the second is about the future.

As we understood from previous discussions that primary data for financial analysis is entity’s accounting records. Statement of comprehensive income contain information about entity’s financial performance in the past whereas Statement of financial position of the entity tells entity’s current position as a result of past activities. However, they do not contain any information regarding future not even projections and forecasts about future expectations.

Understanding this limitation, for analysts to answer the second question they acquire information in addition to what financial statements can possibly provide.

As we discussed in financial statement analysis framework, one needs to be clear about objective of analysis i.e. for what purpose analysis is required as this helps give direction to analysis and also make it efficient. Broadly we observe two types of analysis:

  1. Equity analysis
  2. Credit analysis

Equity analysis is done with a thought of investing in the business or acquiring the business as a whole. For this purpose entity’s performance and position is judged with a view if it is capable of enhancing investor’s wealth in the future. Because emphasis is on wealth maximization it automatically gets connected with entity’s ability to grow in every aspect like both in terms of operation and also profitability and solvency. So investor is interested in knowing how much value he is getting on acquiring part or whole of the business as the purchase consideration measurement depends on how much will he be able to extract in the future.

Credit analysis on the other hand is done from aspect of lending money. For this purpose lender is more interested in knowing if entity will be able to pay the principal with interest. To know this lender is interested in knowing entity’s ability to generate enough cash flows that ensure both principal payment and interest. For interest however entity needs to make enough profits as well. So lender is more interested in knowing how much risky will it be to lend the money as interest or return depends on the amount of risk involved.

Difference between ‘Numbers’ and ‘Interpretations’ – What – Why – What!

Financial analysis is not just about calculating few equations and computing few ratios. It is about interpreting those numbers so that analyst can answer the two fold mystery of what happened and also why it happened and lastly what to do

What happened help us understand what was in the past and why it happened help us understand the causes and both help us predict what can possible happen in future and accordingly we can make expectations and decided what we should do to keep the odds in our favour.

The what happened + why it happened is where most of the computations are going to be that are later interpreted. The what to do portion is about recommendation part of analysis that are communicated to the users mostly in the form of report.

Financial Analysis Tools – Overview

Financial analysis is simply evaluation of entity based on available information. The basic requirement of every evaluation is that one piece of information needs to be compared with another. So evaluation in essence is comparison. To say if entity is doing good or bad one needs to compare entity’s performance either with entity’s past performance or with another entity’s performance. The conclusion of good or bad depends on type of comparison itself, with what is it compared, timing of comparison and so many other factors.

Following are some of the common tools employed by the analyst in the process:

  1. Ratio analysis
  2. Common-size analysis
  3. Graphical analysis
  4. Statistical analysis

Ratio Analysis

Most of the elements or items of the financial statements are either interdependent or have a certain relationship with others that can be observed and also expected to repeat over a period of time in the absence of any unusual event. For example with the increase in the number of employees, salary expense is expected to increase.

Ratio analysis in simple words is the evaluation or analysis of such relationships that are expected to exist between two values or pieces of information. Mostly the information is quantitative based in nature but it may involve comparisons of qualitative information with quantitative aspect as well. Ratios help express the relations either in the form of ratio or percentage or quotient.

However, one must understand that the ratios and the answers we get by applying such ratios are merely means to end i.e. they in their own are not the answers rather they are pointers and indicators that can help us gauge a certain aspect of entity as they help us identify what happened.

They may or may not provide information about why it happened as for that we need to add up more techniques and tools in our analysis.

Common-size analysis

Common-size analysis helps express a certain item as a ratio or percentage in relation to specific base item. For example in income statement usually the base item is total revenue and in balance sheet the common base item in reference to which others are expressed or evaluated are assets.

Common-size analysis helps understand the impact and influence of each item of financial statement and its contribution to the resultant. For example common-size analysis on income statement can help us understand that how significant are administrative costs in relation to sales and how much of the revenue is consumed by administrative expenses alone.

common size income statement

Graphical analysis

Graphics are getting more and more importance these days and they have shown their significance even in financial analysis. With graphs the comparison and understanding is super fast and much more accurate. The biggest advantage of graphs over any other other analysis technique is their visual power as user is not only crunching number but also can see how these numbers are related to each other.

Statistical analysis

For simple short term analysis comparisons and ratios can do the job, however with situation getting more complex especially because of longer time period considered for analysis many variables come into play and that is where statistics has to be deployed to give us the best insight.

Tools like probability distribution, regression analysis, correlation and many others, understanding the relations and making expectations about the future becomes more methodical and logical using statistical tools. Now a days there are many planning software that let you analyse entity’s performance as a whole or one of its segment on run time basis provided if it is fed with appropriate data input.